Sri Lanka: Crisis Response Small and Medium Enterprises Development Facility Project Region

Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized PROJECT INFORMATION DOCUMENT (PID) CONCEPT STAGE Report No.: AB5595 Project Name Sri Lanka: Crisis Response Small and Medium Enterprises Development Facility Project Region SOUTH ASIA Sector General Financial Sector 100% Project ID P121328 Borrower(s) Government of Sri Lanka Implementing Agency Ministry of Finance and Planning, Government of Sri Lanka Environment Category [ ] A [ ] B [ ] C (proposed) [x] FI [ ] TBD Date PID Prepared March 22, 2010 Estimated Date of May 31, 2010 Appraisal Authorization Estimated Date of Board September 20, 2010 Approval 1. Key development issues and rationale for Bank involvement 1. Background: Small and medium-sized enterprises (SMEs) play a very important role in the Sri Lankan economy owing to their considerable share in the total number of enterprises and in total employment. The Government of Sri Lanka announced in its National Strategy for SME Sector Development to a significant array of programs aimed at making SMEs more competitive, more efficient by applying modern technology to improve production processes, and more effective exporters. One of the major priority areas for SME policies has been broader access to medium-term finance. Moreover, the World Bank 2009-2012 Country Assistance Strategy builds on the Government s vision for economic development laid out in the Mahinda Chinthana 1, calling for expanding economic opportunities in lagging regions and improving the investment climate and competitiveness, in an economy driven by SMEs. 2. After being severely underserved during the conflict and in the aftermath of the 2004 tsunami, SMEs had been making inroads in gaining access to credit, but the crisis has reversed that trend in both relative and absolute terms. The proposed Crisis Response Small and Medium Enterprises Development Facility Project aims to respond to the developmental need for broadening and deepening access to medium term funds for investment and working capital to SMEs. This lending operation marks the re-engagement of the World Bank in financial sector development in Sri Lanka, building on past previous World Bank-supported programmatic SME financial intermediation loans 2. Macroeconomic and Sector Background 3. Overall GDP growth between 2008 and 2009 declined from 6 percent to 3.5 percent, a decline of 2.5 percent. Like most other countries in the South Asia Region, exports was the main channel through which the Global Financial Crisis (GFC) hit Sri Lanka, while 1 The last two National Development Plans of Sri Lanka, the Mahinda Chinthana 2005 and 2010, both recognize that SME sector as the engine of growth for the national economy. 2 Sri Lanka Small and Medium Industries Projects 1-4, 1979-1991

direct impacts through the financial sector was muted, in large part because Sri Lankan financial institutions did not have any exposure to toxic assets. During the first 10 months of 2009, total exports were more than 15 percent lower than during the same period in 2008. As a result, in the first half of 2009, economic growth slowed to only 1.8 percent (against 6.3 percent during the same period in 2008). As the Sri Lankan economy teetered on the brink of a balance of payment crisis, banks cut back lending and consumer spending slowed. Data for the third quarter of 2009 suggest that the economy is now slowly recovering (real GDP grew 4.2 percent yoy in 2009-Q3), but exports and industrial production in export oriented branches continue to be depressed. 4. In addition to the Global Financial Crisis, the Sri Lankan economy has also in recent years been significantly buffeted by the armed ethnic conflict and by the tsunami. Armed confrontations in the north intensified during the 2008, and peaked during the first half of 2009, just when the GFC was most severely felt. The end of the war has put strains on public finances due to the need to rapidly launch reconstruction efforts in the war-affected areas and the need to provide assistance to a large number of newly internally displaced persons. The room for maneuver on the fiscal side has been further reduced by a significant drop in tax revenues, in particular from import duties and VAT as trade declined. One of the main lessons learned in post conflict countries is that employment opportunities are critical for faster recovery. The Government s focus on the SME sector is therefore critical. 5. In line with the national focus on SMEs, the Government of Sri Lanka is concerned that SMEs have been particularly hard hit 3 as a result of the GFC, and has requested World Bank support. This is because SMEs, compared to larger-scale corporates have more limited access to finance, are less well diversified in terms of products and markets, and also entered the crisis with thin cushions and fewer built up reserves. The sectors most affected by the GFC are the apparel, agribusiness (tea, rubber, fisheries a.o.) and tourism industries, sectors that retain a substantial number of SMEs and account for a significant proportion of employment 4. In particular, in the garment industry, which contributes around 45 percent of total export earnings in 2008 and makes up about 20 percent of the Sri Lankan manufacturing sector, exports in October 2009 were 7.2 percent lower than a year earlier. Banking Sector Background 6. The Sri Lankan banking sector has proven resilient to the effects of the global credit crisis, although the system is showing signs of strain. The system remains well capitalized and profitable. However, the performance of corporate and commercial loans and mortgages has deteriorated, in particular NPLs on SME loans have grown considerably. The NPL ratio for the system as a whole was 8.8 percent at end-sept 2009 and twice this amount among loans to SMEs. Capital adequacy was relatively high at 14.5 percent at the end of the same period, since bank credit portfolios contracted significantly under the GFC, though it may be overstated given the sharp decline in the provisioning ratio. 3 There is no single, uniform definition of SMEs. Most commercial banks use a mix of data for turnover (generally less than Rs300 mill. annually), total asset value (less than Rs100 million, depending on whether land is included), and in some cases number of employees to define SMEs. 4 According to a UNDP report on the GFC, the industry and service sectors lost 217,000 jobs y-o-y in Q2-2009.

Table 1: Banking Sector Financial Strength Indicators Percent 2004 2005 2006 2007 2008 Sept. 2009 Gross Nonperforming 9.15 7.05 5.63 5.15 6.32 8.82 loans/ Total loans Provisions/NPL 63.8 65.8 66.9 64.5 60.9 47.4 ROA before tax 1.7 1.9 1.9 1.9 1.9 2.1 ROE 18.1 16.4 15.2 14 13.4 14.7 Loans/deposits 19.61 22.71 25.94 25.24 24.39 18.12 CAR 11.4 13.4 13.3 14.1 14.5 14.5 Liquid assets ratio 33.8 31.7 30.4 30.4 31.3 38.6 Source: Central Bank of Sri Lanka - Annual Audited Accounts 1/September numbers not annualized. 7. Nevertheless, as a result of the global credit crisis and the ensuing uncertainty, lending volumes have fallen while exposure to government securities has skyrocketed. Since end 2008, commercial bank loan volumes have decreased by 3.9 percent, whereas securities holdings increased by over 130 percent (Source: CBSL) 8. Access to finance is a key Supply Side Constraint. Credit to the private sector has steadily decreased since Jan 2009 and had contracted by 6 percent yoy as of Oct 2009 (see graph). Despite declining interest rates (from high rates) and improved liquidity in the financial sector in recent months, access to finance for SMEs remains significantly constrained. The GFC has led to a reversal in the recent years trend toward lower Non Performing Loan (NPL) ratios in the banking sector (from 5 percent in 2007 to 8.6 percent by end of 2009), in particular in SME lending. This higher risk of lending to SMEs exacerbated by an uncertain global environment makes banks reluctant to % Change in Credit to Private Sector since Oct 2008

extend credit to SMEs. While some banks have restructured the debt of affected SMEs, this trend has not occurred across the country, as capacity in conducting risk management for SMEs varies among banks and between banks branches. The lack of a backstopping facility and lack of knowledge from banks to lend to SMEs are key issues driving the lack of access to finance for SMEs in Sri Lanka. 9. The findings from the 2005 Investment Climate Assessment points to access to finance as a large obstacle to growth, and to interest rates on loans and collateral based lending as the highest costs of finance. In this connection, while lending rates, after peaking in September 2008, have been on a downward trend, there is segmentation in the market, with rates charged to SME clients exceeding by far those offered to larger corporate clients. Moreover, the 2006 Report on the Observance of Standards and Codes (ROSC) also highlights high bank interest spread, enforcement of unsecured rights, credit risk management and weak implementation frameworks for corporate insolvency laws as areas requiring strengthening in Sri Lanka. 10. The financial sector is expected to be a continued source of strength but remains risk-averse. Sri Lanka s domestic financial system, although it is well-capitalized and prudential regulations meet modern standards, is shallow, with total banking sector credit accounting for about just under half of GDP, less than regional averages. After surviving the consequences of the tsunami, the ethnic conflict and now the GFC, the Sri Lankan banking sector has been understandably conservative faced with the high uncertainty of late 2008 and early 2009. In this connection, the central bank has eased monetary policy and has taken steps to reactivate credit activity and mitigate risk-averse behavior in the banking system. This has been effective in decreasing lending rates but lending volumes remain constrained. 2. Proposed project development objective(s) 11. The main aim of the planned Crisis Response Window (CRW) Small and Medium Enterprise Development Facility (SMEDeF) project will be to broaden and deepen the access of small and medium enterprises to medium and long-term finance, with a view to ultimately contributing to an expansion of productive activities, investment, and job creation. The Project Development Objective is to improve access to finance (including term finance) for SMEs affected by the GFC in Sri Lanka. In accordance with the requirements of OP 8.30, credit would be extended on market terms. This CRW-financed operation would build on the design and implementation arrangements of the on-going World Bank Renewable Energy for Rural Economic Development (RERED) Financial Intermediation Loan (FIL).

12. The development and implementation results will be monitored through several indicators that may include: (i) Number of loans and volume of finance to SMEs across the country supported by the facility, (ii) number of loans and volume of finance that has original maturity greater than 1 year in the supported sectors, (iii) number of loans and volume of finance classified as non-performing according to the lenders classification, in the supported sectors (iv) lending rates to enterprises, and (v) employment and annual turnover by participating SMEs. 3. Preliminary project description 13. The proposed $58mn SMEDeF loan is a three-year Financial Intermediary Loan 5 consisting of a credit line and a risk sharing facility available to both public and private participating financial institutions (PFIs). Selection would be based on clearly defined eligibility criteria that would ensure minimum performance and profitability of the PFIs 6 and focus on SME lending. The project will be designed to comply with OP 8.30 guidelines. The following components are proposed, working toward enabling IFC participation (see Annex 2 for more detail): a) A wholesale Line of credit to increase the liquidity for SMEs in selected export-oriented sectors: Based on established demand, the World Bank would provide a credit line of to participating commercial banks for SMEs, with a focus on affected sectors. Access, modalities and pricing would include features such as competitive interest rates and maturities in line with on going commercial practices and OP 8.30, so that no market distortions are created. b) Partial guarantee facility to reduce the risk of lending to SMEs: The purpose of the guarantee facility would be to backstop commercial lenders losses in case of default. This well tested instrument would provide an additional incentive for commercial banks to engage in short to medium term lending to SMEs. The guarantees would be issued on a portfolio basis, and the loan portfolios eligible for guarantees would include commercial banks loans to viable SMEs of the affected sectors. The IFC has expressed interest in acting as a second loss partner in selected private banks, in agribusiness and possibly tourism. By sharing up to 50 percent of the credit risk with PFIs, the guarantee will leverage lending from banks to SMEs amounting at a minimum to twice the amounts invested. c) Capacity building for lending institutions and SMEs: In partnership with the IFC, provide technical assistance to (i) the commercial banks benefitting from the credit line, in order to help build capacity in lending services to SMEs; (ii) to SMEs to assist in business development services such as preparation of loan application, provision of relevant financial information, marketing, supply chains (iii) to the banking sector in Sri Lanka to help develop guidelines and practices for debt restructuring of SMEs and to support the policy and regulatory framework for insolvency. 14. The project aims to use an incentive approach to support bank downscaling in supplying credit to SMEs. The incentive approach would combine the provision of appropriate financing instruments to banks (line of credit and guarantee facility) with commitments from participating banks to strengthen their SME lending capability over time. The project would also provide complementary technical assistance at the SME level to increase their bankability. 5 The CRW is a global IDA facility set up to assist eligible countries in developing, implementing and monitoring programs to manage the poverty, social, and economic impact of the crisis. The operation will need to be successfully negotiated by the end of FY10 in order to access CRW resources. 6 These would include

15. The envisaged project is to be implemented through the Administrative Unit (AU) of the DFCC Bank, using similar implementation arrangements as the existing credit lines under RERED. The AU will be staffed with qualified personnel and capable of satisfactorily implementing all aspects of the project. Its responsibilities will also include: (i) on-lending to PFIs for final lending to sub-borrowers (ii) ensure effective functioning of the on-lending facility to final borrowers through PFIs; (iii) on-going monitoring of the PFIs to ensure compliance with project criteria; (iv) responsibility for adherence to all fiduciary and safeguard requirements of the World Bank for final borrowers; and (v) monitoring and evaluation based on key project development indicators. The eligibility criteria for PFIs creditworthiness and internal operating practices and procedures would be determined by the World Bank in close collaboration with the Government of Sri Lanka and the Central Bank. 4. Safeguard policies that might apply Environmental Category: [] A [] B [] C [ ] FI [ ] TBD Safeguard Policies Triggered Yes No TBD Environmental Assessment (OP/BP 4.01) Natural Habitats (OP/BP 4.04) Forests (OP/BP 4.36) Pest Management (OP 4.09) Cultural Property (OPN 11.03) Indigenous Peoples (OP 4.10) Involuntary Resettlement (OP/BP 4.12) Safety of Dams (OP/BP 4.37) Projects on International Waterways (OP/BP 7.50) Projects in Disputed Areas (OP/BP 7.60) 5. Tentative financing Source: ($m.) BORROWER/RECIPIENT TBD IDA 58 Total 58 Contact points Cecile Thioro Niang Title: Economist Tel: +1 202 473 0959 E-Mail: cniang@worldbank.org Location: Washington DC, USA