Dcmaf The World Bank CR. KENYA. August 28, 1986

Transcription

1 Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Dcmaf The World Bank FOE omciul USE ONLY CR.,>gi~/-1 STAFF APPRAISAL REPORT KENYA KIE SECOND SMALL SCALE INDUSTRY CREDIT August 28, 1986 Eastern and Southern Africa Projects Department Industrial Development and Finance Division Report No KE This document has a restcted distribution and may be used by recipients only in the performance of their official duties. its contents may not otherwise be disclosed without World Bank authorization.

2 CURRENCY EQUIVALENTS Currency = Shilling US$1 = 16.5 K Shs K Shs = US$0.06 FISCAL YEAR July 1 - June 30 ABBREVIATIONS CBK Central Bank of Kenya DFCK Development Finance Company of Kenya EADB ICDC IDB IPA KCB KCFC KFW KIE KITI KTDC NBFI NORAD RIDC SEFCO TSC East African Development Bank Industrial and Commercial Development Corporation Industrial Development Bank Industrial Promotion Area Kenya Commercial Bank Kenya Commercial Finance Company Kreditanstalt fur Wiederaufbau Kenya Industrial Estates Kenya Industrial Training Institute Kenya Tourist Development Corporation Non-Bank Financial Institution Norwegian Agency for International Development Rural Industrial Development Center Small Enterprise Finance Company Technical Service Center

3 FOR OMCIAL USE ONLY KENYA KIE Second Small Scale Industry Credit Staff Appraisal Report Table of Contents Credit and Project Summary i - ii Basic Data iii - iv I. SECTORAL BACKGROUND Economic Setting 1 The Manufacturing Sector 1 The Small Scale Industry Sector 3 Government Objectives and the Role of Small-Scale Inidtstry 4 The Financial Sector 6 Bank Strategy 10 II. THE PROJECT Project Objectives 11 Project Description 11 The Institution 12 III. THE CREDIT Features of the Proposed Credit 29 Project Implementation 30 Disbursement 31 Benefits and Risks 31 IV. AGREEMENTS AND UNDERSTANDINGS REACHED AT NEGOTIATIONS 32 This report is based on findings of an appraisal mission to Kenya in February-March 1985, consisting of Paul Murgatroyd (mission leader), Michael Sarris, Melanie Horton and Kanella Vasiliades. r tis document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.

4 List of Annexes Para. Ref. Annex 1 Interest rate Structure in Kenya 1.25 Annex 2 SSI Term Lenders in Kenya: A Comparison of Terms and Portfolio Size 1.28 Annex 3 Analysis of KIE Subproject Performance 2.06 Annex 4 Analysis of IDA Subproject Performance 2.09 Annex 5 KIE Organization Chart 2.10 Annex 6 KIE Program for Improving the Selection of Entrepreneurs and Projects 2.17 Annex 7 KIE Industrial Estate Facilities 2.26 Annex 8 KIE Policy Statement 2.33 Annex 9 KIE Actual and Projected Operations 2.35 Annex 10 KIE Loan Portfolio Composition 2.38 Annex 11 KIE Actual and Projected Income Statements 2.42 Annex 12 KIE Actual and Projected Balance Sheets 2.42 Annex 13 KIE Projected Sources and Uses of Funds 2.42 Annex 14 KIE Actual and Projected Financial Ratios 2.42 Annex 15 KIE Projened Resource Statement 2.44 Annex 16 Disbursement Schedule 3.10 Annex 17 Selected Documents and Data Available in the Project File

5 - i - KENYA KIE Second Small Scale Industry Credit Credit and Project Summary Borrower: Republic of Kenya Beneficiary: Kenya Industrial Estates (KIE) Amount: Terms: A credit of SDR 5.8 million (US$6.0 million equivalent) Standard Relending The Government of Kenya would onlend the credit component Terms: (US$5.0 million) to KIE at a fixed rate of interest of 6.0% p.a. and a fixed amortization schedule for 15 years, including three years c, grace. The Government would bear the foreign exchange risk. KIE would relend the funds to its borrowers at interest rates of between 14% and 15% p.a. (including a i% p.a. supervision fee). Government would make available the technical assistance component of US$1.0 million to KIE as a grant. Project The project would support the Government's program of DIPSrittion: providing financial assistance, training and management counselling through KIE to small-scale industries (SSIs) and would make KIE a more efficient channel for implementing this program. The IDA credit would involve (i) a $5 million line of credit to KIE for on-lending to an estimated 200 SSIs; anu (ii) a technical assistance component of US$1 million to include (a) US$.9 million to finance two advisors in supervision and entrepreneur training as well as continued funding of the Finance Manager position; and (b) US$.1 million for entrepreneur training development and a survey to identify opportunities for SSIs to provide intermediate inputs to medium and large-scale industry. Benefits The project would support Government objectives to provide and Risks: more effective assistance to small-scale industrialists by increasing the supply of credit to them. Through its technical assistance, the project would also consolidate recent gains in KIE's performance and enhance its ability to provide assistance to SSIs. The credit and the sponsors' contributions together would also help provide employment opportunities for about 1,500 workers at an average cost per job of US$5,000, develop new African entrepreneurs, and make consumer goods based on domestic materials available to lower income groups at the local level.

6 - ii - The major project risk is that KIE may not continue its recent rapid progress toward becoming a more effective, financially self-sufficient and autonomous institution capable of preparing better projects and providing valuable technical assistance and training to its clients while collecting debts in a timely and effective manner. This risk is reduced, however, through a number of safeguards, some already contained in KIE's policies and guidelines, and some to be added in the context of this credit. Moreover, Bank staff will continue to work closely with KIE to build on the momentum of KIE's recent achievements and ensure further progress. Finally, Government commitment to KIE's program to become a sound institution provides further assurance that pressures for non-economic decisions will be reduced. Estimated Cost: Local Foreign Total (US$ million) Credit Component Technical Assistance Component Subtotal Financing Plan: Bank Loan NORAD and KFW Government loans KIE self-generated funds Total Estimated Disbursements: _/ Bank FY (US$ million) Annual Cumulative Rate of Return: n/a 1/ Based on the region-wide IDF disbursement profile.

7 - iii- KENYA KIE Second Salf ScUale Industry Credit Basic Data (Ksh million: 1US$- Ksh 16.5) 1. Date of Establishment (as separate institution): Share Ca ital: (as of June 30, 1986) or ze : Paid-in Capital: Owne rsllip: Ksh 200 million Ksh 153 million 100% Government of Kenya 3. Resource Position as of June 30, 1986 (Ksh million) Sources: Beginning Cash Balance Government Loans 20.4 Uncommitted KFW & NORAD Loans 34.1 Internal Cash Generation - FY Total Sources Non-Lending Uses: Fixed Assets 4.4 Change in Working Capital 11.6) Subtotal 16.0 Available for Lending: Available for Disbursements Less Disbursements 37.8 Available for Future Disbursements IT ". Of which Unutilized Lines of Credit: 22.1 Of which Ending Cash: Less Undisbursed Commitments 30.6 Available for Future Commitments Interest Rates and Other Charges Interest Rates : 14% p.a. minimum to enterprises requiring loans of more than Ksh I million. 13% p.a. minimum for loans of K Sh 1 million or less. Penalty Interest : 2% for loans; 14% for rent in arrears, with additional 2% penalty if over 6 months past due. Commitment and Commitment (1% p.a. on undisbursed balance); Other Fees : appraisal (0.5% of loan amount); feasibility study (0.5% of loan amount where applicable). Foreign Exchange Risk : Borne by Government. 5. Summary of Operations (Ksh million) Actual Budget Year Ending June Loan Approvals (net) Loan Commitments n.a.l/ n.a.1/ Loan Disbursements Fixed Asset Disbursements Number of Loans J KIE did not distinguish between approvals and commitments until FY84.

8 - iv - 6. Financial Position and Operating Results (Ksh million) Actual Budget Year Ending June Loan Income Industrial Estate Income Other Income 2/ Gross Income Expenses Administrative (incl. deprec.) Interest Profit Before Provisions Provisions 3/ Taxes Profit (Loss) (20.8) 4.6 (T116) Net Current Assets Portfolio (Gross) Less Provisions (51.5) (51.3) (57.0) (58.0) (62.0) Net Portfolio Net Fixed Assets Total Net Assets Long--Term Debt Capital Retained Earnings (Losses) (72.9) (69.0) (80.5) Net Worth Total Liabil. and Net Worth Selected Financial Ratios Actual Budget Year Ending June Loan Income as Z of Average Lending Assets Interest Expense as % of Average Long Term Debt Spread (before provisions) on Lending Activities Lending Admin. Expenses as % of Average Lending Assets Net Profit as Z of Average Total Assets (3.6) 1.2 (3.1) Long-Term Debt/Equity Provisions as % Gross Portfolio Arrears 3 months as % of Gross Portfolio Z of Value of Portfolio 52% 66% 62% 60% 64% Affected by Arrears Loan Collection Ratio n.a. n.a. 61% 90% 80% 2/ Mostly interest on fixed deposits. 3/ Provision expenses and, t'nerefore, net profits are not strictly comparable to those of prior years because of significant changes in the accounts.

9 I. SECTORAL BACKGROUND A. Economic Setting 1.01 Kenya's first two decades following independence in 1963 have witnessed quick growth and structural transformation in the early years, as well as declining growth rates in recent years with the emergence of structural constraints. GDP grew at an average annual rate of 6.62 during , 4.7% from 1974 to 1981, 3.9% during , O.9Z during the drought-affected year 1984 and an estimated 4.2% in Per capita income thus declined in as population was growing at a rate of nearly 4% per annum. Kenya's slowdown in economic growth, as well as the emergence of serious financial and economic imbalances, are to a large extent due to the impact of external shocks (the terms of trade declined by 39% between 1960 and 1982) and the delayed policy response to these shocks in the early 1980s Several policy-related problems on the domestic front, however, contributed to the deceleration of growth. These included: changes in the internal terms of trade which favored an industrial sector heavily dependent on protection at the expense of agriculture; inadequate incentives for agricultural producers; institutional weaknesses in the distribution of inputs and in marketing; overexpansion and inadequate management of the parastatal sector; and rapid population growth with resulting pressure on scarce land and other resources While policy-related constraints continued to affect the efficiency and growth prospects of the Kenyan economy, by the end of 1983 the Government had made important progress in reducing fiscal and external deficits to sustainable levels through stabilization measures. In addition to tighter fiscal and monetary management and a restrictive wage policy, Kenya adjusted the exchange rate in nominal terms on several occasions after 1981 and began to formulate and implement policy reforms in the industrial and agricultural sectors The essence of the Government's strategy was to establish a new set of price signals to encourage an efficient pattern of industrial development, more rapid growth of agriculture and expansion and diversification of exports. To achieve this, the Government began moving toward a trade regime involving less variation in the level of effective protection provided to different branches of industry, and more moderate protection to industry relative to agriculture. In addition, the Government strategy involved fiscal support for exports and measures to rationalize the selection of public sector investments. Some progress has already been achieved in the implementation of this strategy to which the Government is still devoting its efforts.

10 -2. B. The Manufacturing Sector 1.05 The performance of Kenya's manufacturing sector mirrored trends in the economy. The sector grew at average annual rates of IIZ between 1964 and 1974, 5.6% between 1974 and 1981, and then dropped to about 3.7% in However, the sector's share of GDP grew from about 8% in 1964 to 13.4% in Rising agricultural incomes, protectionism and Government promotion of manufacturing ventures fuelled the rapid growth prior to Primarily as a result of the last two factors, Kenya's manufacturing sector is oriented toward import substitution, relies heavily on imported inputs and is dominated by large, capital intensive firms, many of which are government-owned Things were not always so. Manufactured exports were high in the 1960s, but their contribution to industrial growth declined sharply thereafter-the share of exports in manufactured output fell from 22.6% in 1972 to 9.3 % in This decline was particularly due to the dissolution of the East African Common Market (EAC), as well as to the development of import substitution industries in neighboring countries and economic difficulties in these countries. However, exports to non-eac countries, which grew rapidly during the late 1970's, also declined as domestic inflation eroded Kenya's comparative advantage. The share of imports in the domestic supply of manufactured goods dropped from 44.3% in 1972 to 20.9% in a further indication that the Kenyan economy was becoming less open Although Kenya's manufacturing sector has developed in an environment encouraging private sector investment (domestic and foreign), governmient participation in the ownership of industrial firms increased substantially during the 1970s. The Government now has at least a minority interest in firms producing 50% of manufacturing value added. Growing Government participation in manufacturing reflects to some extent pressures to Africanize the economy. More recently, the Government has put increased emphasis on promoting African-owned enterprises, mainly small-scale, rather than on creating public enterprises Employment generation in manufacturing, representing about 10% of the country's registered employment, has been limited because of the high share of large, capital intensive firms and because the overall system of incentives reduced the relative price of capital with respect to labor. While manufacturing output grew between 1972 and 1984 at an average annual rate of 8.2%, employment grew by only 4.8% per year. Furthermore, since 1979, industrial employment has grown more slowly than the labor force (2% p.a. compared to 3.5%). Partly because many new plants were established to serve the regional market, installed capacity in some subsectors (e.g. textiles) exceeds domestic demand by a large margin, leading to low capacity utilization and high average costs. About 70% of industrial activity is concentrated in the major urban centers of Nairobi and Mombasa Although more than half of manufacturing value added is accounted for by food processing, textiles, clothing, leather and wood, 43% of value

11 - 3 - added is contributed by more capital intensive subsectors, i.e., electrical machinery and transport equipment, chemicals, and paper. About 75% of manufacturing value added is contributed by 605 firms which employ more than 50 persons. These larger companies, which represent only 22% of the total number of registered firms (2,669), employ 95% of the 149,000 employees in the formal manufacturing labor force. The remaining 7,000 formal manufacturing jobs are provided by some 2,000 registered small-scale firms In addition to the registered small industries there are an estimated 14,000 small unregistered manufacturing enterprises 1/ employing some 31,000 persons not included in the formal sector statistics. Therefore, about 16,000 smaller enterprises (the registered plus the unregistered firms) employing less than 50 workers produce about 20% of manufacturing value added and employ 38,000 people or 22% of the manufacturing labor force. The share of units employing less than 50 persons in both total manufacturing value added and employment in Kenya is considerably smaller than in other developing countries with similar factor endowments and at about the same level of development, indicating that Kenya's manufacturing sector is overly dominated by the larger companies. C. The Small Scale Industry Sector 1.11 Sectoral Characteristics. Kenya's small-scale industry sector consists of about 14,000 traditional rural (mostly non-wage household) enterprises or urban wage-paying units employing one or two individuals and 2,000 modern small-scale manufacturing units employing between three and fifty employees. Traditional enterprises engage mainly in relatively simple activities such as charcoal making, weaving, knitting, tailoring, furniture making and repair services. Most of these enterprises use hand-operated equipment and their owners have well-developed technical skills. However, they lack managerial skills, produce low quality products which are only marketed locally, and generally have their financial needs met from outside the formal financial system. The traditional subsector usually expands by replication rather than by growth in unit size. A few voluntary agencies provide financial and technical assistance to this group The modern small-scale industry sector accounts for 3% of GDP and 4% of national employment. The range of products manufactured by the modern sector is far greater than that of the traditional sector. For example, the metal goods subsector produces paper clips, rivets, electrical fixtures, milk churns, bicycles, farm implements, and other products. 1/ For statistical purposes Kenya's Central Bureau of Statistics defines all manufacturing establishments employing less than 50 employees as small-scale industries. Small enterprise statistics, which are less reliable than for large-scale enterprise, do not include enterprises that are based solely on non-wage labor.

12 - 4 - Other important modern small-scale industries include: food processing, grain milling, wood products, clothing, leather goods, pottery and glass, metal work, furniture and fixtures. This sector has proven to be an important source of basic goods for low-income households and the major seedbed for developing African industrialists. Much of the modern small enterprise sector has developed around Nairobi and Mombasa, and about 60% of the employment it provides is located there. Although there is considerable potential for additional small-scale enterprise formation, a number of constraints have slowed down the sector's development relative to the large-scale sector SSI Problems and Constraints. Lack of entrepreneurial and management skills is one of the most serious constraints facing Kenya's small-scale industry. As in many African countries, failure rates are high both for the entrepreneurs who try to move out of the traditional informal sector to the modern small-scale industry sector, where they must change attitudes, organizational and management styles and augment existing skills, as well as for new entrepreneurs. The Government as well as the financial institutions that have provided credit to small-scale industrialists have made special efforts to address these problems through training and technical assistance. The proposed project will support a training program in entrepreneurial and management skills (para. 2.21) Lack of access to term finance affects small-scale industry's capacity to grow, particularly for those small enterprises which attempt to market on a wider regional or national basis. One of the major objectives of the proposed credit is to address this problem as discussed below. Small enterprises are also not well-positioned to tender for larger orders, or obtain government approvals and tax incentives which can significantly affect profitability. In addition, small enterprises are at a disadvantage in competing with larger firms in that they often cannot purchase materials in optimal quantities at favorable prices or have limited access to well-developed distribution channels and to foreign exchange allocations. The Government, through the Ministry of Commerce and Industry, is providing support to small industrialists in overcoming these constraints. A new Government policy to move significant public sector procurement decision-making to the district level has enhanced the ability of small industrialists to compete for this business. D. Government Objectives and the Role of Small-Scale Industry 1.15 The Government's current objectives for the manufacturing sector, reiterated in the Sessional Paper No. 1, 1986, Economic Management for Renewed Growth, include accelerated employment creation, a larger share of tactor payments for lower income groups in areas outside Nairobi, increased use of local inputs, emphasis on rehabilitation and expansion, the production of Inexpensive consumer goods and the development of a significant African entrepreneur sector. This is a sensible change from past policies towards the industrial sector. High effective protection for import substitution industries, for example, resulted in increased domestic

13 (nominal) value added but in little expansion of employment, while at the same time the high-cost products of these enterprises, produced with imported materials, were not accessible to Kenya's low-income consumers. It has also discouraged the development of intermediate goods industries, thus reducing the potential for linkages between small and large-scale enterprises and has forced these enterprises to secure many of their inputs from large enterprises producing low quality intermediate products at high prices The adjustment policies that the Government is pursuing in order to increase the economic efficiency of the industrial sector (para. 1.04) should go a long way towards correcting these anomalies. In an effort to reverse the effects of past policies, the Government has, in recent years, offered more effective encouragement to the small enterprise sector, primarily through expanding and strengthening Kenya Industrial Estates (KIE), its largest program (para. 2.03) for financial and technical assistance to support small firms. Although such support will not substitute for policy reforms, it will accelerate and expand the role of these enterprises in Kenya's economy, in accordance with Government objectives. 1,17 Small-scale industrial development would contribute to Kenya's short-term strategy in several ways. First, small enterprises would provide employment to persons displaced from other subsectors. Second, SSI production (largely domestic resource--based) of Import substitutes would reduce pressure on the balance of payments during the adjustment period. Thlird, the broadening of the entrepreneurial class through increased African participation could be an effective antidote to the potential social unrest associated with the adjustment process Small-scale industrial development programs can thus proceed in parallel to the ongoing structural adjustment process with the latter being the main vehicle for sector policy reform and the former providing much needed support during the adjustment process. As KIE is the major Government program for small-scale industry support, Government has asked for continued Bank Group support to reinforce the positive momentum KIE has achieved toward improving its effectiveness as a viable, self-supported lending institution The increased emphasis on small-scale industrial development, reflected in Government's current Five-Year Plan for industry, is sound and represents an appropriate strategy for pursuing Government's longer-term objectives. First, SSI tend to be labor intensive, creating jobs at a low US$5,600 (para. 2.07) cost per job (considerably less than the US$25,000 cost per job for larger industrial projects in Kenya). Small-scale industry also absorbs relatively more unskilled workers than large-scale industry and provides a training ground for the development of entrepreneurial and technical skills of the informal labor force. In addition, SSIs offer a better opportunity than larger industries to develop new African entrepreneurs, use primarily local materials and provide

14 - 6 - consumption goods to lower-income groups at the local level. Rural-based s&all.scale industry is regionally more evenly distributed than large-scale Lndustry which is concentrcted in the urban centers Small enterprise development is also consistent with, and is likely to receive a boost from, the increased attention Government intends to give to agriculture in an effort to meet the country's food requirements with domestic supplies. Growth in agricultural output is likely to stimulate development of a variety of rural based small-scale industries which process agricultural inputs. Growing agricultural incomes tend to stimulate the small-scale enterprise sector which, in turn, makes incentive goods available to encourage increased agricultural production. This is due to the relatively high proportion of total income that the lower-income farm population spends on typical small-scale enterprise products and to the advantage that these enterprises have in being located close to dispersed sources of increased demand for manufactured consumer products and simple capital goods. E. The Financial Sector 1.21 For a country of its income level, Kenya has a diverse and sophisticated financial system. Tne sector includes a central bank, 24 commercial banks, 48 non-bank financial institutions (NBFIs), 30 insurance companies, a postal savings bank, a social security system, numerous pension plans, six industrial development banks, other specialized financial intermediaries, a stock exchange and over 900 savings and credit cooperatives Kenya's commercial banking system is dominated by two Government banks and two British banks, which together hold nearly two-thirds of total bank deposits. Although the commercial banks continue to dominate the financial system, their relative position has declined due to the unprecedented growth of NBFIs. NBFIs, because they are able to charge and pay higher interest rates than commercial banks, have grown rapidly in number, with deposits growing on average 25% between 1981 and During the same period, their share of private sector credit increased from 30% to 40%. Many NBFIs are under-capitalized,however; a recent amendment to the Banking Act will strengthen the regulatory and supervisory framework for NBFIs While commercial banks and NBFIs compete vigorously for term deposits, regulations have provided them with separate lending markets. Only commercial banks may extend overdraft facilities, deal in foreign exchange, issue letters of credit and lend to firms more than 15% foreign owned. On the other hand, only NBFIs may finance property and provide hire-purchase finance for vehicles and selected equipment. Moreover, while commercial banks prcvide some working capital facilities to SSIs (para. 1.27), NBFIs are the second largest source of term finance (mostly hire-purchase) to SSIs after the development banks. NBFIs have been more willing to lend to smaller firms on a hire purchase basis because

15 . 7- of their ability to charge higher rates (at present 19% vs. 14% for commercial banks) but continue to require substanr'_'l -collateral and seldom lend for more than three years Six development finance institutions (DFIs) operating in the industrial sector have carved out niches in areas where commercial banks and NBFIs have not operated. Government owns the Industrial Development Bank (IDB), Industrial and Commercial Development Corporation (ICDC) and the Kenya Tourist Development Corporation (KTDC) as well as KIE. It also has minority shares in the other two DFIs, the East African Development Bank (EADB), also serving Uganda and Tanzania, and the Development Finance Company of Kenya (DFCK), which is privately controlled. IDB, EADB and DFCK, taking advantage of their foreign sources of funds, have specialized in foreign exchange term lending, mainly to medium- and large-scale enterprises. KTDC has specialized in tourism and KIE in lending to SSIs Resource Mobilization and Interest Rates. Total deposits of commercial banks, NBFIs and the Post Office Savings Bank (POSB) grew at an average annual rate of about 11% between 1981 and Annex 2 illustrates the evolution of the interest rate structure for deposits and loans from 1980 to The CBK sets maximum lending and minimum deposit rates. Minimum deposit rates allow little, if any, spread for maturity and thus severely limit mobilization of long term local currency resources. Although past deposit and lending rates have been predominantly negative in real terms, since 1982, upward adjustments in nominal rates, accompanied by declining inflation (at present about 10-11%), have made real rates positive. As of December 31, 1985, commercial banks charged 14% _nterest on overdrafts The Role of Commercial Banks in Lending to SSI. As in many developing countries, commercial banks have generally been reluctant to assist small enterprises, particularly on a term basis, and tend to minimize risk by lending to prime borrowers and to those with strong collateral. USAID has prepared a Rural Private Enterprise Project setting aside US$24 million to encourage commercial banks to provide term lending to small and medium-scale private enterprises. Projects eligible for these funds must be in the private sector, have a low cost per job created and cannot be located in Nairobi or Mombasa. No bank has draw*n down funds yet, but three commercial banks have indicated limited interest in the program: the Kenya Commercial Bank Group's (KCB - para. 1.27) subsidiary, Kenya Commercial Finance Company (KCFC), Barclay's and Standard Banks. The program includes incentives to encourage the banks to lend to smaller enterprises, but sets no maximum loan size. Barclay's and Standard anticipate using the funds primarily for their traditional larger, well established clientele With respect to short term lending to SSI, the commercial banks have been reluctant to provide working capital loans and thus have hampered the ability of SSIs to grow successfully. Term lenders such as KIE, beyond lending for permanent working capital as part of total project cost, are

16 - 8 - not well equipped to assist entrepreneurs meaningfully with this problem because of their lack of rapid decision-making apparatus and their inability to monitor and control daily account activity. KIE intends to make working capital loans in cases where an SSI has a firm order from a client who will agree to make payments directly to KIE. In addition, USAID is considering a plan (formulated with the help of IDA) to encourage commercial banks to provide more working capital finance to SSIs by guaranteeing a portion of the ultimate loss for working capital loans. Under this scheme, these loans would be secured against receivables from Government and other select institutions as well as inventories Institutions Providing term Finance to Small-Scale Enterprises. KCFC, DFCK and ICDC as well as KIE provide term loan assistance to SSIs in Kenya. (Annex 3 provides comparative data on lending to SSIs). KIE, the beneficiary under the proposed credit and Government's principal tool to support SSI development, continues to be the most prominent and most regionally decentralized institution lending to SSIs. It had a portfolio valued at US$17 million equivalent in June 1986 and made an average of US$3 million in new loans annually during KCFC has developed a special term lending program for SSIs with the assistance of about $9 million in lines of credit from USAID, IFC 2/ and OPEC. It has also established a Business Advisory Service Unit with four staff to help clients prepare feasibility studies for a fee. KCFC is not resource constrained and is not expected to overlap significantly with KIE's lending program, as its clients consist largely of more established entrepreneurs who can meet KCFC's requirements for minimum collateral totalling 160X of the size of the loan and substantial previous business experience DFCK, a privately controlled DFI, established a separate subsidiary, SEFCO, in 1984, to handle small-scale industrial lending. SEFCO's program, although serving the same clientele as KIE, is much smaller, its total portfolio amounting to less than US$2 million. Moreover, as SEFCO has a small professional staff (six) and lacks a branch network, it has initially focused its operations on two provinces and two subsectors (wood and food products). Although SEECO has been established with sound policies and procedures and adequate technical assistance, it has had to curtail its new lending to deal with a mounting arrears problem. Its external shareholders have made funding available on attractive terms and conditions to meet all of SEFCO's rather limited needs over the time period, forecast optimistically at US$4 million equivalent The Government's ICDC, which owned KIE prior to Its establishment as an independent institution, has operated a small-scale industrial and 2/ IFC has provided US$7 million under two industrial lines of credit of which about $6.7 million was disbursed by June 30, 1986.

17 w 9 e commerical lending program for a number of years. ICDC's portfolio is dominated by commercial loans, with industrial loans comprising less than 20% of portfolio. Because of poor collections performance, ICDC's arrears are high, in excess of 50% of total amounts due. Because of this poor performance, and the need to rehabilitate medium- and large-scale industrial investments, ICDC largely suspended lending to small-scale ventures in March As many of its larger scale investments have now been revitalized, ICDC has the resources to allocate K Sh 20 million to renew its lending to small-scale industrial and commercial enterprises. It is the view of Government and IDA that ICDC's ongoing small-scale lending should be limited to commerce, as these appraisals are less complex and few other sources of financing exist for African-owned ventures without requiring substantial collateral. ICDC's SSI lending overlaps with KIE's client base and has duplicatory costs, far less adequate staffing, (it has only seven provincial representatives throughout Kenya) inadequate procedures and infrastructure support; thus it has performed poorly. On the other hand, ICDC's five professional staff at headquarters who appraise and monitor small-scale industrial loans (small commercial loans are handled by other staff) have gained valuable experience in rehabilitating a number of ICDC's large scale industrial holdings and could play an invaluable role in helping to restructure other medium- and large-scale industries in Kenya. During negotiations, Government confirmed that it would continue to discourage ICDC, which has not been a significant lender to SSIs of late, from reviving its SSI lending program. Even without ICDC's involvement in SSI lending, however, KIE will continue to face healthy competition in lending to small-scale enterprises, particularly as the KCFC and SEFCO programs expand Demand for SSI Term Loans. DFCK, KCFC, ICDC and the commercial banks are expected to provide about $15 million in term loans over the period to small-scale industrial enterprises. Projected demand for these funds, based on historical borrowing and investment data, is expected to significantly exceed that level during KIE's $15 million in projected lending would cover the majority of the gap with the remainder financed by loans from overdrafts, hire-purchase and sources outside formal markets. Studies suggest that small enterprises, particularly those in the traditional sector, meet a significant part of their initial capital requirements from famlly, friends, money lenders, etc. F. Bank Strategy 1.34 The Bank strategy for the industrial sector is to support the Government's objectives (para. 1.15) through fostering the development of an efficient sector, capable of generating a growing share of the country's output and employment on a regionally dispersed basis, and in which private entrepreneurs will play an increasingly significant role. To implement this strategy the Bank Group relies on a range of instruments, including project and non-project lending, and economic and sector work. Past

18 lending to the sector includes four loans to the Industrial Development Bank (IDB) for medium! and large-scale..nvestments and one loan to KIE for small-scale industry. It also includes three non-project lending operations in support of policy reform. For the future, a policy-based sector loan will aim at strengthening Kenya's policy and institutional enviroament while a complementary rehabilitation project will provide assistance to large scale industry in selected sectors during this period of adjustment. In project lending, high priority is given to providing support to small-scale industry for the development of industrial employment and local entrepreneurship, particularly amongst the African population. In addition to being a major government objective, opportunities for socio-economic advancement to aspiring Africans are likely to soften the short-term adjustment impact associated with sectoral policy reforms. To this end, the proposed credit would provide effective assistance to small-scale industrialists and enhance the ability of KIE to deliver financial and technical assistance to these industrialists In addition, continued IDA involvement with KIE is important at this time as KIE is still in the early stages of a turnaround in performance (para. 2.04). KIE, with ID4, assistance, has already taken significant steps to improve its portfolio, strengthen its financial base and institute better appraisal and supervision procedures. IDA participation through the proposed project would also help KIE's development as an autonomous institution whose lending decisions are dictated by technical and financial considerations. Finally, the proposed credit would enable IDA to play a role in improving coordination between KIE's various lenders and sources of technical assistance. II. THE PROJECT A. Project Objectives 2.01 The proposed project is IDA's second line of credit to KIE for Kenya's small-scale industrial sector. Its main objectives are to: (i) provide resources to small-scale enterprises with good potential for income-generation and job creation at a relatively low cost; (ii) help develop the capabilities of small-scale entrepreneurs, mainly Africans, in Kenya by strengthening KIE's capability to provide intensive entrepreneur training, project supervision and technical assistance; and (iii) make KIE a more efficient channel for SSI lending by strengthening its financial base and rationalizing its lending and industrial estate activities; and (iv) maintain, through the dialogue with IDA, KIE's substantial momentum toward improvement which it has generated in the past 18 months. B. Project Description 2.02 The project would support Government's program of providing financial assistance, training and management counselling to SSIs in Kenya through the following components:

19 (a) (b) a credit component of US$5 million, representing 83% of the IDA credit, in the form of a line if credit to KIE for onlending to an estimated 200 SSIs for plant and equipment, machinery, and permanent working capital; and a technical assistance component of US$1 million to finance (i) two Deputy Managers for the new entrepreneur training and supervision functions; (ii) continuation of the services of KIE's Finance Manager; (iii) development costs for the entrepreneur training program; and (iv) a survey to identify areas where SSIs could competitively provide intermediate inputs to medium- and large-scale industry. C. The Institution 2.03 Background. KIE was established in 1967 as a wholly-owned subsidiary of ICDC in an effort to strengthen Government's small-scale industrial development programs. It became an independent parastatal under the Companies Act in In pursuing its objectives of entrepreneur development throughout Kenya, KIE has combined industrial estate construction and management, as well as lending functions, on a nationwide basis. During the last nine years, KIE has developed as Government's principal tool to support SSI development. It has grown into an institution with total assets of K Sh 528 million (US$32 million), 28 regional centers, 397 sheds for rent to entrepreneurs, 427 employees (including 114 higher level staff), and a portfolio of 630 subloans Experience under the First IDA Credit. IDA made its first credit 3/ to KIE in Experience under the first line of credit was disappointing in that KIE, until early 1984, did not make satisfactory progress toward becoming a sound financial institution and developing a successful lending program. KIE staff emphasized promotion and portfolio growth, paying insufficient attention to project selection and supervision. Consequently, while KIE proved dynamic and dedicated to assisting small scale entrepreneurs, many SSIs it financed have not been successful; as a result, KIE's arrears were high, debt collection efforts and portfolio supervision were inadequate, the industrial estate activities were not financially viable, and KIE experienced losses. 3/ From the original US$10 million credit (750-KE), atout US$3.3 million sas cancelled (because the expiration date for commitments on the subloan component was not extended and the industrial estate component was largely unutilized); currently only about US$1 million remain available in a technical assistance component. KIE is using some of these remaining funds to finance a computerization study, real estate management study, viability studies for two proposed industrial estates and work toward the design of an entrepreneur training program, as well as to extend the contract of the Finance Manager. As the closing date is September 30, 1986, some amounts (approximately US$0.8 million) are likely to be cancelled.

20 KIE, with the active encouragement of Government and IDA, has fundamentally altered its attitudes and, over the past 18 months, has taken a number of significant steps to strengthen itself. In 1984, it approved a new Policy Statement and Guidelines for Operations (paras and 2.33) incorporating a number of changes IDA has been advocating for some time, e.g., raising minimum equity investment requirements for its subborrowers, increasing interest rates, and limiting future KIE industrial estate investment to projects which were financially viable. KIE has also launched a major effort to improve debt collections, resulting in substantial increases in collections, and some improvement in the arrears position. Together with the Ministry of Finance and the Ministry of Commerce and Industry, KIE has formulated a comprehensive financial restructuring program (para. 2.41) to help it become financially self-sufficient. In addition, growing Treasury concern that KIE (as well as other parastatals) become financially viable-thus reducing future funding requirements-has reduced the level of political pressures on KIE to build new estates and make loans of marginal quality Characteristics of KIE Projects. A representative sample of 232 enterprises financed by KIE between 1977 and 1985 (about 40% of KIE projects) was analyzed in terms of sector, capital intensity, relative size, and geographical location (Annex 1). The exercise was undertaken to identify the major characteristics of small-scale industries and determine which ones are most associated with successful and unsuccessful projects in order to assist KIE (para. 2.17) in improving its lending strategy. The analysis shows that 82% of the projects (about 68% of commitments) are in the relatively labor intensive food, clothing, leather, wood and furniture industries. The remaining 18% are distributed among the more capital intensive metal works, chemicals and engineering industries. Some 25% of the enterprises are located in the major urban centers of Nairobi and Mombasa, another 25% in four medium-size cities, while the remaining 50% are dispersed in rural areas and minor urban centers Projects involving a KIE loan of more than K Shs 3 million (about US$180,000) amount to only 6% of total projects but account for 40% of commitments, while projects of less than K Shs.5 million (under US$30,000) represent more than 70% of all projects but account for less than 20% of commitments. As a group, the enterprises in the sample imported only 9% of their raw material requirements, confirming the hypothesis that small enterprises primarily use locally produced inputs. Larger projects, however, particularly those costing more than $200,000, tend to import a higher proportion of their raw material needs. The average cost per job created by small enterprises is US$5,600, although it is almost US$8,000 for the projects in the relatively capital intensive sectors. Some 60% of all jobs were created by projects costing less than US$30,000, at an average cost per job of about US$1,700. Similarly, the cost per job created in the major urban areas averages US$9,200 compared to an average cost of US$2,800 for jobs created in rural areas.

21 The relative success of projects by size, sector and location can be ascertained on the basis of KIE evaluations of performance (para. 2.22). The most successful projects have been those costing less than US$30,000 and those located off estates, in medium-sized cities and in rural areas. Among subsectors, the pattern is less clear, although service and food industries appear to be more successful than other indus -ies. Least successful were projects in the wood, printing, clothing, leather and the construction industries A post evaluation of 109 subprojects (Annex 4) funded under the first IDA credit shows that the IDA subprojects fared better than KIE's non-ida portfolio: 73% of the projects are rated successful and 16% unsuccessful, compared to 55% and 33% respectively for the non-ida portfolio. Some 800 jobs were created by 65 IDA subprojects for which information is available at a cost of about US$3,600 per job compared to US$5,600 for the entire KIE portfoliu. About 75% of the subprojects were for loans below $30,000. Some 64% of the subprojects are owner-managed, 81% are headed by individuals with previous experience in management and/or with technical skills relevant to the present type of operation, and 93% are located outside the estates. These subprojects have had a significantly better success record than those that do not meet these criteria. Over 80% of the IDA subprojects were in relatively labor intensive subsectors, with food products representing the largest single subsector, and 50% were located in small towns or rural areas. Experience with these subprojects suggests that (i) IDA's involvement in subproject review has improved the prospects for project success; (ii) projects which were owner-roperated, located off estates, small, labor intensive and located outside major cities, in addition to furthering Government objectives better than other types of projects, have also been more successful; and (iii) KIE has used the first IDA credit predominantly for projects with the same characteristics which KIE, with IDA encouragement, is now targeting for all of its lending (para. 2.17) Organization and Management. KIE's organization chart is shown in Annex 5. In March, 1986, a new Managing Director was appointed. KIE's previous Managing Director had served since 1977 and was key to a significant reorganization and reorientation of KIE. The new Managing Director is committed to implementing the reforms initiated by her predecessor. KIE's Operations Manager, who has been with KIE since its inception, is also committed to the new program of reforms At headquarters, KIE has nine departments including three lending operations departments (newly reorganized in consultation with lda) for Appraisals, Implementation, and Supervision and Entrepreneur Training; two small departments for industrial estate and technical service center (TSC) activities; and four administrative and financial support departments: the personnel, finance, legal and internal audit departments. In addition, eight regional managers report to senior management and, in turn, supervise 20 Rural Industrial Development Centers (RIDC) and Investment Promotion Area (IPA) managers within their respective regions (para. 2.26). KIE's

22 organization is appropriately decentralized, with regional managers wielding considerable influence regarding project selection, promotion and appraisal, as well as industrial estate management. Almost 70% of KIE's support staff are employed outside headquarters in the regions Personnel and Staff Training. KIE has a personnel department consisting of five staff to handle personnel, administrative and staff training functions. KIE's manpower plan for the next four years does not show much overall growth, except for supervision and training officers (para. 2.20) and the establishment of a new Entrepreneur Credit Evaluation Unit (para. 2.18) While staff turnover is satisfactory, morale is high, and the staff is enthusiastic and hard working, KIE finds recruiting and retaining high quality professional staff difficult because it was assigned (at a time when it was largely a promotional rather than a financial institution) a significantly lower salary grade structure than other parastatal development banks and commercial banks with whom KIE competes for staff. As KIE's salary structure is not congruent with its functions and places it at a significant competitive disadvantage in building a high quality staff, IDA is actively supporting KIE's request to obtain an upward revision in its salary structure classification. Government has approved a scheme to review public service salaries, including KIE, and intends to harmonize the salaries and terms of service for its DFIs-an action which would result in improving KIE's salary structure. During negotiations, Government agreed to keep IDA informed of progress on its review of KIE's salary structure. In the interim, KIE does have some latitude to -pgrade salaries to more realistic levels through generous job ratings, c:.g., rating project officers as Deputy Division Managers- and providing better fringe benefits, e.g., home mortgages to key staff KIE has given high priority for several years to upgrading its staff through an effective training program and utilized US$300,000 from the first IDA credit, among other sources, for its training programs in-country and abroad. KIE has prepared a new three-year staff training program which utilizes both local, in-house capacity as well as overseas institutions for training in project processing, accounting and financial analysis. The finance and project appraisal staffs (both at headquarters and in the regional offices) would be the chief beneficiaries of the training program. NORAD has indicated an interest in supporting this program. In addition, the proposed Deputy Managers for Project Supervision and Entrepreneur Training (para and 2.21) would be important sources of in-house training for KIE's staff Project Appraisal and Lending Guidelines. KIE's headquarters appraisal department consists of five professional engineers and economists who carry out Nairobi area appraisals and review the bulk of the appraisals prepared regionally. Each region has an economist, an engineer and RIDC/IPA managers who prepare the appraisals. All project loans of over K Sh 500,000 (about US$30,000) are reviewed by a headquarters Project Review

23 Committee which is chaired by the Operations Manager and includes the managers of project preparation, supervision, project implementation, finance and the legal department before being presented to KIE's Board. KIE has requested German technical assistance to finance a Financial Analyst for two years to provide technical assistance in the financial evaluation of project proposals to help strengthen the department. During negotiations, it was agreed that a Financial Analyst, with qualifications, experience and terms of referen e suitable to IDA, would be appointed no later than December 31, To capitalize on the experience of its supervision officers, KIE also plans to utilize its supervision personnel to prepare a number of expansion and rehabilitation projects which are expected to result from the improved supervision program KIE's appraisal reports have, in the past, been of mixed quality because of, inter alia, overly optimistic assumptions and inadequate attention to marketing, managerial and working capital requirements. To strengthen its appraisals, KIE has implemented an expanded appraisal report format, giving better coverage to assumptions used, marketing analysis, project risks, sensitivity of financial rate of return and debt service coverage to lower than projected levels of production, the entrepreneur's managerial capability, and a simplified economic rate of return analysis for projects over K Sh 500,000. KIE has also begun to prepare subsector industry profiles based on actual KIE experience in various subsectors which outline project costs, unit sales prices and costs, production and sales levels, and problems. The initial profiles have been very useful in improving the quality of assumptions and projections for new appraisals and in anticipating potential problems In its future project appraisals, KIE plans to shift its emphasis to more successful subgroups which are more fully congruent with Government objectives. KIE has changed its loan targeting (Annex 6) and will not ordinarily make a first loan to an entrepreneur of more than K Sh 3 million (US$180,000) or lend to projects with total fixed assets in excess of US$300,000. In no case will disbursements to any one project total more than K Sh 5 million (US$300,000). KIE will place more emphasis on experienced entrepreneurs, owner-operated projects, expansions of successful smaller projects, and projects which do not, themselves, directly import raw materials or depend on tariff protection. Although making KIE's appraisal criteria more stringent may slow the growth of its portfolio, projects with these characteristics have been more successful, entailing less risk for KIE (and less provisions expense) as well as producing relatively higher economic benefits. KIE is also considering lending for tourism and local transport projects in addition to its industrial, construction and service industry lending. KIE has amended its operational guidelines to incorporate agreed changes in lending policy and targeting and has agreed not to amend its operating guidelines without prior consultation with IDA Many KIE projects have experienced serious problems due to inadequate capitalization, cost overruns, implementation delays and larger

24 - 16 < than anticipated working capital requirements. To reduce these risks, in June 1984 KIE increased its minimum equity requirements from 15% of total project cost to 30% for owner-operated enterprises and 40% for projects that are not owner-operated. KIE now requires senior officers to interview prospective entrepreneurs before a project is approved and is setting up a new entrepreneur credit evaluation section within the Finance Department. The unit will prepare a separate written credit evaluation which will examine the entrepreneurs' financial position, credit reputation and ability to raise equity and any required revolving working capital requirements. KIE, per its objectives, will continue to lend to many entrepreneurs who could not get loans from commercial banks and NBFIs because of the conservative collateral requirements of these institutions, but its collateral requirements are sufficient (including all items financed under its loans) to reduce KIE's risk and commit the entrepreneur fully to the project. During negotiations, KIE agreed to recruit a qualified Kenyan to head its credit evaluation section as a condition of effectiveness Project Implementation, Supervision and Entrepreneur Training. KIE established two new departments in October 1984 to provide effective support to its clients so as to reduce the number of failing projects and assist entrepreneurs to grow. The first, a Project Implementation and Technical Support Department, has four engineers, under the Chief Engineer, with responsibilities for reviewing appraisal documents, assisting entrepreneurs in dealing with suppliers, providing routine support for installation of plant and machinery, liaising with accounting on disbursements, briefing entrepreneurs on correct maintenance and machine usage procedures, and providing a consulting service to troubleshoot on technical problems for ongoing operations KIE's recent decision to establish the second department for supervision and entrepreneur training represents a fundamental change in KIE's strategy to prepare projects and entrepreneurs more carefully and provide them with substantial technical assistance. It reflects a recognition on KIE's part that project follow-up is necessary to maximize the prospects that its loans will prove successful and is a much needed break with the past emphasis on aggressive promotion. The new department, initially staffed with six project officers and managed by its most experienced project officer, will consist of a supervision division and an entrepreneur training division. The supervision division will have 12 professional staff, including at least one in each region. It plans regular visits to all projects during the first two years of operation and intensive visitation to problem projects to assist entrepreneurs to evaluate their financial position, solve problems, identify any need for a KIE engineer to provide consulting assistance, as well as to file reports with headquarters. This division will also be responsible for implementing KIE's efforts to rehabilitate selected problem projects and will appraise expansion projects which may be identified in the context of its supervision visits. Once KIE's project implementation and supervision functlins are soundly established in the regions, it hopes to expand these

25 services to assist non-kie financed entrepreneurs (for a fee). IDA has agreed to finance a Deputy Manager for supervision for two years under the new credit to establish effective procedures and reporting systems and to train a counterpart take over this new function In another positive development, KIE is also recruiting professional staff for a new entrepreneur training division which will expand KIE's ongoing training programs for existing entrepreneurs (handled previously by the personnel department) and establish a "front-end" training program, obligatory for all prospective entrepreneurs before project implementation, with the exception of those with unusually strong business experience. KIE's past entrepreneur training efforts have had mixed results, as differing approaches were implemented by individual expatriate advisors with little KIE staff participation. As a result, KIE was unable to develop a consistent or clearly defined overall KIE program. Consultants, funded under Credit 750-KE, have assisted KIE in assessing its training needs and preparing preliminary guidelines for setting up a comprehensive training program for its clients. KIE is now in the process of selecting a training expert for the Deputy Manager position for Entrepreneur Development. As in the case of its supervision support, KIE plans to make its training programs available to non-kie financed entrepreneurs as well as its own clients. IDA has agreed to fund the position of Deputy Manager for entrepreneur training for two years under the new credit to establish the program on a sound footing and to train a counterpart. It was agreed during negotiations that recruitment of the Deputy Managers for supervision and entrepreneur training would be a condition of effectiveness Debt Collection. KIE has recently promoted one of its most senior regional managers to the position of Chief Debt Collector and shifted the credit control division (five professional staff) from Finance to his unit. This was done to strengthen debt collection further and to oversee implementation of a more effective debt collection system which, since August 1984, has already improved collections substantially (para. 2.37). The new system places primary responsibility for debt collection on the regional managers, rather than on the accounting department as previously, and involves active participation by senior management to demonstrate that, after years of neglect, KIE is now serious about being repaid. The new system comprises a management reporting system which provides monthly comparative information on each regional manager's debt collection performance. Rewards and penalties are imposed on regional managers for unusually good and poor performances. On a quarterly basis, an arrears committee classifies all projects into four categories: "A", having no problems; 'B", needing technical assistance to solve problems; C", having major problems requiring legal counsel involvement; and -D', hopeless projects to be wound up. With the support of Government, KIE has begun to turn a number of accounts over to external legal counsel for collection.

26 < In action consistent with IDA advice to -clean up- KIE's portfolio, the Legal Department, staffed with three lawyers, has acted decisively on the nearly 200 projects turned over to them over the past two years. It has initiated an active program of threatened and actual legal action to obtain payment and/or to collect what money KIE can from hopeless situations. As a result, KIE has sold some projects to other entrepreneurs, successfully rehabilitated some others, and liquidated and written-off a third group. As this intensive 'sweep' of the portfolio covered a backlog of cases that have accumulated over a number of years, the need for legal action on new projects is expected to lessen in the future Finance and Accounts. KIE's Finance Department has been ably managed since September of 1982 by an expatriate, funded under IDA Credit 750-KE. The proposed credit will fund an extension of the Finance Manager's contract for three years. During negotiations, it was agreed that recruitment of a suitable counterpart for this position would be a condition of effectiveness. The headquarters professional staff in finance inc]lude a chicr accountant, seven other accountants, a statistical officer and a data processing officer. The headquarters staff have responsibility for budgeting and planning, monitoring branch accounts, general accounting functions and preparing financial statements. Regional offices are staffed with accounts clerks and bookkeepers to handle branch accounts KIE, with IDA agreement, appointed new external auditors in 1984 who have provided constructive advice to KIE regarding its accounts and record keeping procedures and helped KIE arrive at a satisfactory provisions policy. Although additional improvements are needed, KIE's accounts are generally satisfactory. KIE has implemented numerous changes in the last two years to improve TSC records, reconcile its fixed assets register, establish a register of securities, and ascertain that project assets are adequately insured and tenancy agreements are valid. Although provisions have fluctuated widely in the past because of changes in provisions policies, KIE now has a satisfactory provisions policy calling for specific provisions based on the valuation of realizeable collateral. The major weakness is an inadequate mechanized accounting system. KIE is retaining consultants, funded under Credit 750-KE, to recommend microcomputer hardware and appropriate software to computerize KIE's accounts, improve its management information systems and train its staff in microcomputer applications Industrial Estate Operations. KIE's industrial estate operations, which began with the initial construction of sheds in 1967, has expanded to the point where KIE has constructed and manages about 907,000 sq,uare feet of buildings in 28 locations (Annex 7) involving a total investment in gross fixed assets of about K Sh 174 million (about US$10.5 million). Based on the size of the estate, the number of staff and its responsibilities for regional management, the 28 locations are classified as Industrial Estates (the eight largest, with regional management responsibilities), 11 Regional Industrial Development Centers (RIDCs) which

27 e 19 - are mid-sized, and nine small Investment Promotion Areas (IPAs). Eighteen locatious have TSCB to provide metal and wood working services to entrepreneurs. KIE now has 397 sheds (765,000 sq. ft.) for rent of which 337 (82%) were rented in June, This is a significant improvement over occupancy rates in 1985, which stood at 61%. Vacancy rates in the past have been high primarily because KIE has had difficulty in finding entrepreneurs to rent space in a number of locations. The industrial estate program employs 296 people, (many work on lending as well as estate functions) of whom 56 are higher level employees While KIE has implemented physical construction of industrial estate facilities reasonably efficiently, the program as a whole has not been successful and has been a heavy drain on KIE financially as well as administratively. The industrial estate operations lost an estimated K Sh 7.6 million (about US$500,000) representing 66% of KIE's total loss in 1983/84 and a further K Sh 3.8 million in 1984/85 before interest expense. KIE's projections (assuming no new construction and increasing rents) show that KIE will continue to experience losses on the industrial estates until 1989 when occupancy rates are projected to reach 90%. Principal reasons for poor financial performance are the low occupancy rates and below market rental rates. Poor rental collections, high administrative costs (budgeted at 6.4% of average net fixed assets in 1985/86), inefficient management procedures and TSC losses (para. 2.31) also contributed to the losses KIE's industrial estate facilities have been a substantial element in the Government program for supporting SSI in Kenya and for encouraging investment in smaller towns where the lack of adequate rental facilities and infrastructure may create an obstacle to local SSI development. Industrial estates are a highly visible form of Government's commitment to SSI development and political considerations have played an important role in decisions as to where and whether to build such facilities. In addition to poor financial performance, it is also questionable as to how successfully the estate program has fulfilled some of its socio.-economic objectives for the following reasons: (a) facilities have been built without feasibility studies, hence the number of sheds and their size do not always relate well to market demand and construction costs sometimes bear no relationship to realistic market rental rates for that locale; (b) estates are often located several kilometers away from the market center and from public transport. Such locations are not appropriate for many SSIs, particularly those that provide services and sell retail to the public; and (c) once built, KIE is under pressure to fill the sheds and appears to have financed more marginal projects (those rated wc and "D") on estates than off estates as well as some projects for which shed size and location are not optimal.

28 20 Analysis in 1985 shows that for 190 KIE loans on estates, 50% of these projects are rated as unsuccessful (compared to 23% rated as unsuccessful among 502 loans off estateg), arrears affect 88% of portfolio value (compared to 49% for off estate loans) despite presumably easier access for debt collection visits, and arrears add to 30% (compared to 11%) of portfolio values In response to the problems associated with industrial estate activities, KIU is preparing a real estate management study (carried out by consultants and funded under the first line of credit) designed to improve the efficiency of estate management, including inter alia formulating policies and procedures for reviewing and negotiating rental rates and terms. KIE has been reluctant to raise rents (they were last raised in 1982) although its policy statement calls for rents to be raised to full market rates over the long term because previous efforts, where all rents on an estate were simultaneously raised substantially, were met with loud protest. The consultants will also recommend procedures for physical maintenance functions, other changes which might improve efficiency or reduce costs, and will design a management information system for the industrial estate activities. In addition, KIE has chenged its rental lease agreements (most of which are up for renewal annually) to charge 14% interest on overdue rent together with 2% penalty interest on rental arrears of more than six months KIE has sharply reduced its new industrial estate construction program in recent years having initiated construction of only three new estates since Two additional estates involving sheds costing US$380,000 equivalent are presently under consideration for future construction. In accord with its Statement of Policy [para (c)], KIE has already agreed not to construct these sheds unless they are finaacially viable or unless Government agrees that they be constructed for Government's account under a managed funds agreement. At negotiations, Government and KIE agreed that KIE would not construct any new industrial estate facilities unless they are supported by a feasibility study, satisfactory to IDA, which demonstrates their financial viability. KIE has amended its policy statement accordingly KIE has been administering 18 TSC's, which are workshops equipped with woodworking and metal working equipment and are manned by 50 KIE technical personnel. These workshops, designed to provide access to lathes, saws and other costly equipment to small-scale entrepreneurs on the estates for a fee, represent a heavy financial and administrative drain on KIE. For 1984/85 the TSCs lost K Sh 1.2 million. Subsequently, KIE has made substantial improvements in these operations by leasing facilities and sharply cutting back on credit sales and estimated a K Sh 0.1 million loss in 1985/86 from these activities. The facilities operate at relatively low levels of capacity and lose money because: (a) accounting control over inventories and cash sales is poor; (b) bad debt expense is high due to poor credit policies and poor collections; and (c) KIE employees have

29 < 21 - little incentive to inc-ease sales to clients off estates, provide good service to clients, or make profits KIE has recogaized that sale or lease of existing TSC's would improve KIE profitability, reduce administrative burden, provide opportunities for new entrepreneurs and would probably improve the quality of the technical services provided 4/. Therefore, KIE has agreed to lease or sell all of its TSCs with the exception of those in Nairobi, Mombasa, Nakuru and Nyeri (which will be kept longer to allow redeployment of TSC workers who are displaced and cannot be absorbed elsewhere in KIE). During negotiations, KIE agreed to sell or lease 12 TSCs by December 31, As of June 30, 1986, KIE has been able to lease nine of these TSCs. Efforts are already underway to implement this aspect of the project and interested lessees have been identified for several of the remaining facilities Policy Statement. KIE's Board adopted a new policy statement (Annex 8) and operating guidelines which were implemented in July Among the significant changes are: (a) requiring a 30% minimum equity contribution from owner-operated projects and 40% from sponsors of projects managed by non-owners; (b) increasing its interest rates to 14% for projects with loans exceeding K Sh 1 million, and 13% for smaller loans (up from 11% and 10% respectively); and (c) confining construction of new industrial estates to financially viable schemes supported by a feasibility study The policy statement requires KIE to protect itself against foreign exchange risk, maintain a debt to equity ratio not exceeding 3:1, and prohibits investing in enterprises with total fixed assets exceeding K Sh 5 million (US$300,000). In adlition, it states that KIE will give preference in its lending to e2terprises utilizing local materials and technologies and oriented toward exports. KIE also has Operational Guidelines (para. 2.17) which contain a detailed discussion inter alia of KIE's role in promotion, loan targeting and lending guidelines. With incorporation of a changed policy relating to industrial estate construction (para. 2.30) and changes in loan targeting, KIE's policy statement and operational guidelines are satisfactory. Agreement was reached at negotiations that KIE would not make changes to its policy statement which would significantly affect its operations and financial condition without the prior agreement of IDA. 4/ As an example, about one year after KIE leased a TSC in Kisumu to a private entrepreneur, employment increased from one to 24 people and sales and profits have improved considerably.

30 22 t 2.35 Operations. KIE's net approvals, after growing rapidly to K Sh 58 million in 1981, have remained relatively constant from 1981 to 1984 (Annex 9) and sharply dropped during its fiscal year ending June 30, This drop was due to a KIE decision to consolidate its position by (i) improving its internal procedures and policies; (ii) strengthening its appraisal capabilities; and (iii) concentrating on collections. Disbursements averaged about K Sh 45 million per year over the FY82-85 period. KIE did not keep separate data on commitments until Undisbursed commitments at June 30, 1986 amount to K Sh 31 million or about six months of commitments, which is not excessive KIE expects FY86 approvals to reach K Sh 79 million and then increase 10% in real terms from 1987 onward. KIE estimates these approvals would comprise about 200 projects (most of them located off estates) in FY86 growing to about 280 by FY90. KIE's net portfolio wi'l grow from K Sh 218 million in 1985 to K Sh 400 million in 1990, a 13% p.a. increase. As a result of KIE's imposition of the 30% minimum equity requirement during 1985, average loan size dropped by about 32%. Experience during the year supported KIE's view that its increased equity requirements would not significantly impair its ability to meet projected lending targets. KIE's project pipeline as of June 30, 1985 consisted of over 500 projects totalling K Sh 216 million (US$13.1 million) in total project costs and requiring K Sh million (US$9.1 million) in loans from KIE. KIE's pipeline and promotional activities are considered sufficient to ensure timely commitment of the proposed project. Labor intensive sectors, such as food, clothing, and woodworking were most heavily represented. In addition, over 15Z of the pipeline consisted of expansion projects, which are anticipated to increase more rapidly as KIE begins its more intensified supervision program (para. 2.20). Decisions in principle by NORAD, KFW and IDA (all following a period in which they were not providing any new support) to again provide funding for KIE in response to the significant improvements KIE has recently implemented will enable KIE to fund this program of moderate growth Portfolio. As of June 30, 1986, KIE had K Sh 358 million (US$21.7 million), in loans outstanding encompassing 678 loans. With the recent improvements in KIE's collections performance, KIE's arrears situation has begun to improve. Nonetheless, KIE's portfolio continues to have a high level of arrears relative to amounts outstanding, as demonstrated below.

31 - 23- (as of Jum 3D, 1986) Pwtfolio Afectd by Armars of PkqsectB Total kareas of auer 3 mt 3hm3Itl Value d Value Value Part. Total % of No. of Ptfolio of D. of Z of (K Sh Affecte as % (K Sh Ttal Pr ts (K Sh fixi) Wam1 1oelPjcshi ) Vta Port. min) Bortfolio, A. OpeGtk vdlut pro % % S B. peratirg with probls % % 37.6 IC% C. & D. -xal wlth mjor prohlm Z S % 35.5 loz otal as of 6/30/ % % Z Total as of 12/31/ % % BZ % Total as of 12/31/ % % m % Tor3l as of 12/31/ % % % llactior Perf vonme (Ksh Wd1f) 'MMW adig bal NNiw Atms Gfrg amral e Amts CUwted ai llfectxi Patio (%) S-bPtser 30, Dieber 31, % 54% 1- d1 31, % Juz 3D, % Setmber 30, % ;icamber 31, % 1- cb31, Z Jur 3D, % September 30, % Diter 31, z arch 31) Cllecti ratio for year edjure 30, % CODlectiixs ratio for yar eded Jume 30, Z odlectios mrtio for 6 nmdts &add Deribe 31, % Cllectiors ratio for 6 mmtit wad Juete 3D, Z

32 Between December 31, 1983 and December 31, 1984 arrears of more than three months declined as a percentage of portfolio from 23% to 19%, and the percentage of projects experiencing arrears had dropped from 69% to 56%. The value of the portfolio affected by arrears of three months remained unchanged, however, at 60%, due to the new accrued interest on accounts with large arrears. Provisions constituted a high 18% of outstanding balances, primarily due to large provisions expenses in the period Collections ratios since January 1, 1985 have averaged over 80% of new amounts coming due compared with 65% during In recent months, however, KIE's arrears situation has deteriorated some, as it had initially tackled the most 'collectable- arrears. KIE's senior management also originally spearheaded the collections drive, but has since had to again turn attention to other matters as well. KIE now has a Chief Debt Collector in place and improved debt collection procedures and enhanced project implementation support and supervision should help KIE to gradually improve its arrears situation. In the quarter ended March 31, 1986 KIE was able to boost its collections performance, collecting about 93% of new amounts coming due in the quarter. While arrears remain serious, as in the case of many development finance institutions (DFIs) world-wide, KIE's portfolio is improving and is, in fact, better than that of several other Eastern African DFIs. Annex 10 shows that in 1984 nearly 60% of KIE's loans, representing about 40X of loan balances outstanding were rated as relatively problem free, while 30% of loans (32% of loan balances outstanding) represented major problem projects. By 1986, 65% of loans and 51% of loan balances outstanding were rated as problem-free KIE inherited a number of loans from its parent ICDC in 1978 including 41 loans which, as of December 1984, had a balance of K Sh 44.4 million outstanding. By June 30, 1986, KIE had reduced these loans to 32, with a balance of K Sh 38.4 million. One hundred percent of the value of these loans is affected by arrears which amount to more than 11% of the amounts outstanding and constitute 23% of KIE's total loan arrears. Eighteen of these projects are categorized as -C- or -D- projects, collections are low, and KIE has already taken about K Sh 25 million in writeoffs and provisions against the ICDC portfolio. To the extent possible, KIE has been taking legal steps to liquidate the worst performing projects in this group Some 20 "sensitive" loans (five inherited from ICDC) to politically influential persons in Kenya, constitute some 3% of KIE's projects but account for 15% of portfolio balances. KIE, with support from Government, has begun an aggressive effort to collect arrears on sensitive loans in conjunction with its other collections. KIE has collected in full or disposed of three additional -sensitive- loans, and is steadily collecting from many other accounts. KIE is dealing satisfactorily with the sensitive loan problem by continuing to make active efforts to collect these loans, taking legal action where possible, 'publicizing these arrears to the Board and Government and, more importantly, avoiding new loans of this type by raising equity requirements to 40% and applying the same rigorous criteria applied to all KIE loans.

33 Financial Restructuring Plan. The Ministry of Finance and the Ministry of Commerce and Industry have, with active KIE support, prepared a cabinet paper 5/ proposing a major financial restructuring of KIE designed to place it on a sounder financial base, achieve financial self-sufficiency and meet its debt service obligations to Government as scheduled. The proposed restructuring is a clear signal from Government that it supports KIE's objective to become a financially autonomous institution. Without this restructuring, KIE's debt to equity ratio would soon exceed KIE's 3 to 1 debt to equity ratio limitation. KIE would also experience losses over the next several years and would not service its debt due to Government. Its major elements include: (1) conversion of K Sh million in Government loans, equivalent to the book value of the industrial estates, to equity (this would reduce the debt to equity ratio from 2.8 to 0.6); (2) conversion of K Sh 108 million in loans (including funds onlent from IDA), into a 'Term Loan Fund' repayable over 15 years and carrying interest of 6Z p.a. 6/; (3) conversion of the remaining K Sh 114 million in Government loans7into a non-repayable "Revolving Loan Fund" bearing interest of 3% p.a.; (4) requiring KIE to repay a K Sh 17.4 million loan to ICDC and to pay its debt service obligations to Government on schedule; and (5) directing KIE to pay 15% of future profits as dividends. The cabinet paper, in a form satisfactory to IDA, has just been approved by Cabinet. During negotiations, it was agreed that satisfactory implementation of the plan by KIE would be a condition of effectiveness Financial Condition and Performance. KIE's actual and projected financial statements for are shown in Annexes 11, 12 and 13 and selected financial ratios are contained in Annex 14. KIE made losses in three of the past five years, due primarily to large provisions for bad debt. Although net losses have fluctuated widely because of inconsistent accounting policies for provisions expense, KIE's operating profits before provisions (averaging 1Z of average total assets between 1982 and 1984) have steadily improved as they rose to K Sh 7.1 million in 1984 (1.6% of average total assets) and reached K Sh 14.7 million (3% of average total assets) in KIE's past poor financial performance can be attributed to Mi) losses incurred on its industrial estate and TSC activities; (ii) necessarily high administrative costs; and (iii) high provisions due to the poor quality both of its loan portfolio and of the loans inherited from ICDC. 5/ In 1984, the Government announced its intention to restructure the debt burden of some parastatals as a step towards subjecting them to more financial discipline and facilitating repayment of debt to Government. KIE is the first such parastatal to be considered in light of this new policy orientation. 6/ The onlending agreement for IDA fund, under Credit 750-KE specifies a 6% interest rate.

34 KIE anticipates steady improvements in profitability in future years as its change in strategy in cunjunction with the proposed IDA credit should lead to better projects, lower provisions, smaller losses on industrial estate activity and higher spreads due to increased interest rates. Given the wide geographic dispersion of KIE's activities and the labor intensive nature of lending to SSIs, KIE's administrative expenses as a percentage of total assets are at a reasonable level. Administrative costs as a percentage of average assets for KIE's lending activities (the appropriate basis for comparison with other DFIs) will remain near or about their present level of 4.3%. KIE's total administrative costs will necessarily be slightly higher as a percentage of total assets, however-averaging 5.3% during the same period-because of KIE's extensive estate activaties (for which administrative costs will rise to about 7% of average assets by 1990 as assets are depreciated and costs rise with inflation). To reduce administrative costs, KIE is taking a number of steps to improve its efficiency including: (i) computerization of its accounts; (ii) implementation of appropriate management information systems for lending and estate operations; (iii) selling or leasing TSCs; and (iv) undertaking a real estate management study. Profits before tax budgeted at K Sh 10.1 million in 1986 are projected to rise steadily to K Sh 30.6 million (4.6% of average total assets) by Assuming that KIE will be subject to income tax under the terms of the financial restructuring, KIE's net profits will improve during the forecast period, averaging 2.6% of net worth between , compared with its negative return on equity during the period With better collections, provisions are projected to decline from 17% of gross portfolio in 1985 to 12% in 1990, and arrears of three months or more will also decline from 19% in 1985 to 15% in During negotiations, KIE agreed to submit its Operating Plan to IDA by April 1 of each year for review. The Or rating Plan includes operations and financial projections for 5 years on a rolling basis, with targets for improving profitability, increasing collections and lowering arrears. Through its annual review of KIE's Operating Plan, IDA will be able to monitor KIE's efforts to continuously improve its performance during the life of the project KIE's recent growth has been modest, with average total assets growing about 15% per annum in nominal terms during the last three years. Its financial condition is sound with its June 30, 1985 audited balance sheet showing a very strong 0.6 following restructuring (para. 2.41). KIE has consistently maintained a strong liquidity position with ample cash balances. About 28% of KIE's total assets were invested in net fixed assets on industrial estates in 1985, which earn a negative return on assets employed (para. 2.27). This relative burden will decrease as net fixed assets drop steadily to 20% of total assets by 1990, and as KIE takes steps to improve the profitability of these activities. Debt service coverage will be a low 1.0 in 1987 when KIE expects to repay a K Sh 17 million ICDC loan in full, but will rise to a satisfactory 2.4 by 1990.

35 Cash Impact on Government Budget. KIE's improved financial position will enable it to cease being a net burden on the Government budget. Indeed, KIE plans to pay in to Government a net of about K Sh 159 million in positive cash inflow during compared with a net K Sh 106 million outflow during as shown below. KIE Net Cash Impact on Government (K Sh million) Government Cash Outflows to KIE Equity Contributions Loans (excluding those donor sources) onlent from foreign Total Government Cash Inflows from KIE Loan Interest Loan Repayments Dividends Taxes Total - 19Z 8 Net Cash Flow (Outflow) to Government (106.5) Resources. KIE depends largely on Government and donor agencies for funding. As 100% shareholders of KIE, Government had provided K Sh 153 million in equity and K Sh million in loans and income notes as of June 30, In addition, KIE has received K Sh 67 millioa in loans from KFW, K Sh 49 million from IDA and K Sh 39 million in grants from NORAD. The Basic Data shows KIE's resource position as of June 30, At that time, KIE had K Sh 102 million (about US$6.2 million) available for future commitments KIE's projected total resource requirements for the three and one-half year period ending December 31, 1989 are estimated at K Sh 422 million (US$25.6 million) with a gap (Annex 15) before external funding of K Sh 202 million (US$12 million). In addition to the proposed US$5 million line of credit which would fund 42% of KIE's total resource gap, KIE expects to receive additional external funding including a new K Sh 45.4 million line of credit (US$2.7 million equivalent) from KFW, K Sh 17.3 million (excluding K Sh 6 million in technical assistance funds) in new

36 grants from NORAD (US$1.0 million) and K Sh 14.6 million in new Government loans (US$0.9 million). In addition, KIE is discussing a possible new line of credit with the African Development Bank. III. THE CREDIT A. Features of the Proposed Credit 3.01 The proposed IDA credit of SDR5.8 million (US$6 million equivalent) would be made to the Government of Kenya on normal IDA terms. The Government would onlend US$5 million from the proposed credit to KIE, under a subsidiary loan agreement satisfactory to IDA, with a fixed amortization schedule for 15 years, including three years grace. The Government would pass on US$1 million to KIE as a grant for technical assistance (para. 3.06) The Government would onlend US$5 million equivalent by way of a credit line to KIE at 6% interest p.a. This rate is consistent with the onlending agreement for the first credit, with the terms set forth by Government under the proposed financial restructuring of KIE and with their general policy for interest rates to be charged for other parastatals. In addition to the interest expense, KIE has agreed to place funds equivalent to 3% annual interest on the IDA funds onlent from Government ($150,000 when fully disbursed) under the credit into a supervision expense account to cover the significant new costs associated with intensive technical assistance and training support for entrepreneurs. Given the lack of sophistication of small-scale borrowers who would benefit from this line of credit, Government would bear the exchange rate risk on the proceeds onlent to KIE. Clients would, however, be charged a new 1% p.a. supervision fee (to be charged on all new KIE loans in lieu of a foreign exchange risk fee which would apply only to some lending) in addition to interest charges KIE would relend funds from the line of credit to its borrowers at its usual interest rates of 13% and 14% p.a., plus the 1% p.a. supervision fee with fixed amortization schedules depending on the nature and debt servicing capacity of the subproject. In addition, KIE charges commitment fees of 1% p.a. on undisbursed commitments, up to 1% for appraisal and feasibility studies, and 2% penalty interest on arrears. KIE's interest rates are essentially the same as present commercial bank interest rates and are positive in real terms (inflation was 10.7% as measured by a CPI index in and is expected to decline further). Nonetheless, during negotiations KIE agreed to consult with IDA on its interest rate structure on an annual basis in light of prevailing economic conditions and commercial bank overdraft lending rates The subloans would finance plant and equipment, machinery and permanent working capital requirements of subprojects. As most SSI projects would require loans for goods either imported or locally fabricated with imported inputs, IDA funds would finance 90% of the amount

37 of the individual KIE subloans, equivalent to the estimated direct and indirect foreign exchange costs of subprojects KIE would be allowed a free limit of US$75,000. This limit would enable IDA to review about 10X of the subloans financed under the credit. In addition, supervision missions will review a sample of free-limit subprojects to ascertain that these projects meet acceptable appraisal standards and are in line with project objectives The technical assistance component would provide $900,000 to finance Deputy Managers for the new entrepreneur training and supervision functions and continued financing of the Finance Manager position. This component will also include $100,000 to fund entrepreneur training costs and a survey to identify opportunities for SSI to provide more intermediate term inputs to medium- and large-scale industry. B. Project Implementation 3.07 Reporting Requirements. During negotiations, KIE agreed to submit quarterly reports which would include a summary of operations, financial statements, cash flow statements, debt collection performance, and statement of arrears. It would also be required to submit audited annual accounts, prepared in accordance with IDA guidelines for audits of DFCs, by qualified auditors acceptable to the Bank, within six months after the close of the fiscal year. Finally, KIE agreed to submit its Annual Operating Plan (para. 2.43) by April 1 each year to IDA for review, in order to monitor KIE's progress in improving its financial and portfolio performance. KIE's past audit report and quarterly submissions have been satisfactory Procurement and Consultants' Services. Procurement of goods and services under the line of credit to KIE would be in accord with KIE's procurement guidelines and consistent with procedures followed by other IDA-assisted DFIs, namely requiring the entrepreneur to obtain three quotations through comparative shopping. KIE's procurement policies are satisfactory. The qualifications and terms and conditions of employment of advisers to KIE, financed under the technical assistance component, would be subject to the approval of IDA and would comply with Bank Group guidelines. C. Disbursement 3.09 Proceeds of the credit component to KIE would finance 90% of the amount of subloans approved by KIE, representing the estimated direct and indirect foreign exchange costs of subprojects. Proceeds of the technical assistance component would finance (i) 100% of salary, airfares and transport expense for expatriate consultants and (ii) 80% of the cost of local consultants and related office expenses.

38 In order to expedite disbursement of funds under the credit, Government will establish a Special Account in KIE's name with an initial deposit of US$300,000 equivalent with a commercial bank from which KIE would finance expenditures (consultants' services and training) against full documentation and expenditures for subloans against statements of expenditure certified by KIE. The account would be replenished by IDA in accordance with agreed procedures. During negotiations, it was agreed that establishment of the special account would be a condition of effectiveness The estimated disbursement schedule (Annex 16) corresponds to the region-wide disbursement profile for the IDF sector (eight years). Assuming the loan becomes effective by the second quarter of FY87, the credit component is expected to be fully disbursed by the second quarter of FY95. The technical assistance component should be fully disbursed by the fourth quarter of FY89. The last date for submission of subprojects would be December 31, 1989 and the closing date would be December 31, D. Benefits and Risks 3.12 The project is expected to play a significant role in supporting the Government's objectives to provide assistance to small-scale enterprises in the form of an integrated program of credit, training and technical assistance. Strengthening KIE, Government's primary channel for SSI support, is an important element in enhancing the effectiveness of this program. KIE has already significantly improved its efficiency and performance during project preparation and further improvements are expected during its implementation. Tangible support to KIE at this point in its institutional development would help maintain the momentum created by its recent achievements with resulting benefit to the Kenyan small-scale industry sector. As KIE continues to mature as a financially responsible institution (while retaining its developmental orientation), its new projects are expected to be better prepared and supervised than were its previous ones (paras ). It is estimated that about 200 entrepreneurs would be assisted by the project and some 1,500 jobs would be created at an estimated average cost per job of US$5, Most KIE projects would be located in rural areas where economic expansion, resulting from the Government's increased emphasis on agriculture, provides a stimulus. Consequently, the credit would provide for parallel and mutually reinforcing growth in both agriculture and industry: small-scale industry would supply simple manufactured goods to satisfy demands originating from growing agricultural incomes and would also process agriculture products. In addition to furthering Government's regional development objectives, the project would reduce pressure on the balance of payments through the production of goods for the domestic market using primarily local inputs. The broadening of the entrepreneurial class through the creation of a namber of new, geographically widely-dispersed African entrepreneurs ir, pernaps, the most important benefit. This is particularly timely as the success of the macro-economic adjustment policies of the Government depend on visible improvement in the fortunes of

39 - 31 < segments of the population which will be most positively affected by this project The major project risk is that, despite the substantial progress to date, KIE may depart from its present drive toward becoming a more efficient, more financially independent channel for providing financial and technical assistance services to small enterprises. This risk is mitigated, however, by several safeguards already built into KIE's operational guidelines to include: (i) constructing industrial estates only if they can be shown to be financially and economically viable; (ii) placing more emphasis on expansion of existing successful small enterprises; and (iii) giving preference to smaller new projects which can later expand if successful. Government commitment to the KIE program and its objectives to become a sound institution provides further assurance that pressures for non-economic decisions will be reduced. KIE's improved performance, which has now been sustained for over a year, has been followed closely by other donors and has convinced them to revive their support for the institution. KIE will also receive continued technical assistance in the area of financial management and new technical assistance in the areas of entrepreneur training and supervision. KIE's recent improvements have been achieved in close cooperation with IDA staff. As previously, supervision missions will closely monitor KIE's progress and assist in the implementation of the agreed program. IV. AGREEMENTS AND UNDERSTANDINGS REACHED AT NEGOTIATIONS 4.01 During negotiations, agreements and understandings were reached with the Government and KIE on the following: (a) With the Government that it will: (i) keep IDA informed of progress on its review of KIE's salary structure within the framework of its ongoing review of salaries of its public service staff (para. 2.13); and (ii) establish a Special Account in KIE's name with a commercial bank for expediting disbursements out of the IDA credit before credit effectiveness (para. 3.10). (b) With KIE that it will: (i) recruit a qualified person to head its entrepreneur credit evaluation section (para. 2.18) and a qualified counterpart to the expatriate Finance Manager (para. 2.24) before effectiveness; (ii) make no amendments in its operational guidelines without prior consultation with IDA (para. 2.17);