ASIAN DEVELOPMENT BANK RRP: PAK 34327

REPORT AND RECOMMENDATION

OF THE

PRESIDENT

TO THE

BOARD OF DIRECTORS

ON

PROPOSED LOANS,

GUARANTEE,

AND TECHNICAL ASSISTANCE GRANT

TO THE

ISLAMIC REPUBLIC OF PAKISTAN

FOR THE

SMALL AND MEDIUM ENTERPRISE SECTOR DEVELOPMENT PROGRAM

November 2003

CURRENCY EQUIVALENTS (as of 21 November 2003)

Currency Unit – Pakistan rupee/s (PRe/PRs)

PRe1.00 = $0.0175 $1.00 = PRs57.2

ABBREVIATIONS

ADB – Asian Development Bank BDS – business development services BSF – Business Support Fund CFC – common facility center CPMU – core program management unit DFI – development finance institution EA – Executing Agency FI – Financial institution GAM – Guarantee Administration Memorandum GDP – gross domestic product IA – implementing agency KRA – key result area LIP – labor inspection policy LPP – labor protection policy MOF – Ministry of Finance MOIP – Ministry of Industries and Production MOL – Ministry of Labour and Overseas Pakistanis PCG – partial credit guarantee PD – Program director PFI – participating financial institution PPTA – Program preparatory technical assistance PRSP – Poverty Reduction Strategy Paper SBP – State Bank of Pakistan SDP – sector development program SME – small and medium enterprise SMEDA – Small and Medium Enterprise Development

Authority TA – technical assistance TF – task force

NOTES

(i) The fiscal year (FY) of the Government ends on 30 June. FY before a calendar year

denotes the year in which the fiscal year ends, e.g., FY2003 began on 1 July 2002 and ended on 30 June 2003.

(ii) In this report, “$” refers to US dollars. This report was prepared by a team consisting of R. Hartel (team leader), M. Endelman, M. Good, V. John, and S. Thongplengsri with contributions by B. Ericsson, W. Liepach, A. Sharma, and C. Vandenabeele.

CONTENTS Page

PROGRAM, LOANS, GUARANTEE, AND TECHNICAL ASSISTANCE SUMMARY

I. THE PROPOSAL 1

II. THE SECTOR: PERFORMANCE, PROBLEMS, AND OPPORTUNITIES 1 A. Sector Description and Performance 1 B. Issues and Opportunities 6

III. THE PROPOSED SECTOR DEVELOPMENT PROGRAM 12 A. Objectives and Scope 12 B. Important Features 12 C. The Program Loan 12 D. The Project 17 E. Implementation Arrangements for the Sector Development Program 20 F. Partial Credit Guarantee Facility 23

IV. TECHNICAL ASSISTANCE 26

V. PROGRAM BENEFITS, IMPACTS, AND RISKS 26 A. Benefits and Impacts 26 B. Risks 27

VI. ASSURANCES 28

VII. RECOMMENDATION 30

APPENDIXES 1. Program Framework 31 2. Development Policy Letter and Policy Matrix 33 3. SME Bank Limited 39 4. Subproject 1: Policy Formulation and Implementation 42 5. Subproject 2: Small and Medium Enterprise Business Support Fund 47 6. Subproject 3: Market Development for SME Finance 50 7. Project Cost Estimates and Financing Plan 54 8. Implementation Arrangements 56 9. Partial Credit Guarantee Facility for Enhancing Access to Credit for SMEs 63 10. Technical Assistance Grant for Supporting Coordination of the SME SDP 69

SUPPLEMENTARY APPENDIXES (available upon request) 1. Ineligible Items 2. Summary Poverty Reduction and Social Strategy 3. Development Coordination and Implementation

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PROGRAM, LOANS, GUARANTEE, AND TECHNICAL ASSISTANCE SUMMARY Borrower Islamic Republic of Pakistan Classification Poverty Classification: Other

Thematic: Economic Growth, Good Governance

Environment Assessment

Program and Project: Category C Partial Credit Guarantee: Category FI

Rationale Pakistan’s comprehensive structural reforms started in 1997 and are showing positive results. It is now timely for the Government to build an enabling business environment for the private sector, especially small and medium enterprises (SMEs), which represent about 80% of urban employment and contribute about 30% to gross domestic product. With the rapid growth of Pakistan’s urban centers, the significance of SMEs in absorbing labor and contributing to growth will increase. Despite many efforts to promote SMEs in the past, direct government support has proven ineffective to enhance competitiveness of the SME sector. There is a clear need for a well-articulated SME policy determining the role of government in policy making and facilitating the development of the SME sector, while the private sector should be responsible for delivering services to SMEs. Existing service providers in the private and public sectors have so far been unable to provide needed services to SMEs in a significant way and to upgrade their competitiveness. There is a need for developing service markets since single providers will not be able to cater to the diverse needs of SMEs. Similarly, access to formal sources of finance is an important constraint of SME growth. Traditionally, SMEs were regarded as the clients of financial institutions (FIs) in the public sector. This approach has failed and the Government is now inclined to follow a private sector-led approach to SME finance. However, the FI management’s traditional reluctance of entering the SME market must be overcome through establishment of pioneering examples, which will encourage development of a broader market. The SME Sector Development Program (SDP) aims at filling an important gap in the strategic agenda of the Government and the Asian Development Bank (ADB), complementing ADB’s interventions in Pakistan in rural and microfinance and capital market development, and providing market-based access to services. The SME SDP builds on lessons learned from other emerging markets and considers existing and planned interventions of ADB and other funding agencies to minimize overlap. The Government recently affirmed the important role of SMEs and their potential for economic growth, employment, and income generation in its Poverty Reduction Strategy Paper, which is also supported by the International Monetary Fund, the World Bank, and ADB’s country strategy and program.

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Objectives The goal of the SDP is to improve SMEs’ contribution to economic

growth, employment, and poverty reduction. The objective is to improve SMEs' competitiveness. The SDP will support (i) policy reforms to improve the business climate with an emphasis on leveraging private sector interventions; (ii) private FIs and business development services (BDS) intermediaries in building up capabilities to serve SMEs; (iii) market-based outreach of FIs through a partial credit guarantee (PCG) facility under ADB’s private sector operations; (iv) the State Bank of Pakistan (SBP), Pakistan’s central bank, in assuming the unambiguous lender of last resort function vis-à-vis SME Bank; and (v) the Government in disengaging from ownership of SME Bank through privatization. The SDP consists of four parts: (i) a program loan supporting policy reforms, (ii) a project loan supporting participatory policy development and building institutions and markets for BDS and credit for SMEs, (iii) a PCG through ADB’s private sector operations to leverage market-based credit to SMEs, and (iv) a technical assistance (TA) grant for coordination of the SDP.

Program Loan

The SDP supports three major policy outcomes. The first is to improve the SME policy environment through (i) development of an SME policy, (ii) establishment of effective labor protection and labor inspection policies, and (iii) enhancement of the effectiveness and outreach to SMEs of the Small and Medium Enterprise Development Authority (SMEDA). The second outcome is to improve market-based SME access to BDS through the establishment of a Business Support Fund (BSF) managed by the private sector. The third outcome is to improve the market-based access to and delivery of SME finance, which entails improving the regulatory and credit information infrastructure, building private FI capacity for SME finance, and restructuring SME Bank.

Cost Estimates

The costs of adjustment (excluding the project costs) are estimated at $279.5 million over the period FY2004–2007, reflecting the reform and development efforts of the Government, investments of SMEs in upgrading their competitiveness, investments of FIs in building SME finance capability, and the restructuring and privatization of SME Bank.

Financing Plan Loan Amount and Terms

ADB will provide a loan of ¥16,436.52 million ($152 million equivalent) from its ordinary capital resources with a 15-year term including a 3-year grace period, and an interest rate to be determined in accordance with ADB’s London interbank offered rate (LIBOR)-based lending facility, a commitment charge of 0.75% per annum, and a front-end fee of 0.5% of the loan amount.

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Tranching The loan will be released in four tranches subject to compliance

with agreed conditions from the date of loan effectiveness up to the loan closing date of 30 June 2007. The first tranche, in the amount of ¥3,244.05 million equivalent, will be released upon effectiveness of the loan. The release of an incentive tranche in the same amount is expected within 7 months of the release of the first tranche. The second tranche in the same amount and the third tranche comprising the remaining funds are expected in June 2005 and December 2006, respectively.

Implementation Arrangements

The Ministry of Finance will be the Executing Agency and will also constitute the core program management unit in charge of monitoring and program coordination. The Ministry of Industries and Production, SMEDA, Ministry of Labour, BSF, SBP, SME Bank, and the Ministry of Finance will be implementing agencies.

Procurement The loan will be used to finance the foreign exchange cost of items produced in ADB member countries (except ineligible items).

Counterpart Funds Counterpart funds of the program loan will be used for SME Bank restructuring and SMEDA’s outreach program.

Project Loan Components

The Project is structured into three subprojects. Subproject 1 supports policy formulation, including SME policy and labor protection and inspection policy. Subproject 2 supports market development for SME BDS through the SME BSF. Subproject 3 supports market development for SME finance, including regulatory policy development, credit information, and capacity building for financial Institutions; and SME Bank restructuring.

Cost Estimates The total project costs are estimated at $28.0 million. ADB will provide a loan of SDR12.501 million ($18.0 million equivalent) including $7.91 million equivalent in foreign exchange and $10.09 million equivalent in domestic currency. The remainder of the cost will be borne by the Government, SMEs, and FIs through fees and cost-sharing arrangements.

Financing Plan ADB will provide the loan from its Special Funds resources for a term of 32 years, including a grace period of 8 years, and with an interest charge at the rate of 1.0% per annum during the grace period and 1.5% per annum thereafter. The Project has a 5-year duration and the closing date is expected to be 30 June 2009.

Executing and Implementing Agencies

These are the same institutions and have the same arrangements as for the program loan.

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Procurement and Consulting Services

Procurement of goods and services is in accordance with ADB's Guidelines for Procurement. All consultants who are to be financed from the proceeds of the ADB loan will be recruited in accordance with ADB’s Guidelines on the Use of Consultants and other arrangements for the engagement of domestic consultants satisfactory to ADB.

Partial Credit Guarantee Facility

Objective The objective of the PCG facility under the SME SDP is twofold: first, to leverage through a market-based approach existing financial resources of the financial system for lending to an SME segment currently underserved by FIs; and second, to provide catalytic support for innovative financial products and approaches in new and less familiar markets. Once successfully tested with participating financial institutions (PFIs), such products will be expanded among a larger number of FIs. The expected outcome of the PCG facility is a higher volume of SME lending by commercial FIs in Pakistan.

Design Features ADB will share with PFIs the credit risk of SME loans. ADB will have identified these PFIs according to the parameters of the PCG facility. ADB will issue PCGs to PFIs to guarantee repayment of an agreed portion of a loan portfolio. The PCGs will have agreed cover amounts and time frames to be selected following a due diligence process. To underscore the market approach, the PCG facility will be provided through ADB’s private sector operations without counterguarantee of the Government. The PCG facility will have an overall limit of $65 million. Sublimits per PFI are set at up to $20 million equivalent. Since the product is new both in Pakistan and for ADB, the PCG facility will commence operation with commercial FIs that have both well-established underwriting procedures of an international standard and experience in similar lending methodologies elsewhere, before expanding to domestic FIs. Once ADB is satisfied with the track record of the PFI and its SME borrowers, portfolio targets will be revised to encourage PFIs to expand further to riskier segments. Guarantee limits with PFIs will be in US dollar terms under each PCG, but PFIs will extend loans to SMEs under the PCGs in local currency. The PCG facility will be available for issuance of PCGs to PFIs for 5 years from the expected date of ADB approval, until 31 December 2008.

Executing Agencies PFIs identified through a due diligence process.

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Safeguard Policies The PCG facility is classified as “Financial Intermediary.” ADB will

perform due diligence of the PFIs’ policies and practices and their compliance with ADB’s policies. Accordingly, an environment management system will be established, which will be documented in a guarantee administration memorandum. This memorandum will set out the accountability of ADB departments in the selection of PFIs and management under the facility considering developmental, commercial, and ADB’s safeguard policies and will ensure that the guarantee agreements require PFIs to adhere to ADB’s Environment Policy and Environmental Assessment Guidelines, as well as to ADB’s policies on involuntary resettlement and indigenous peoples.

Technical Assistance Grant

The TA will assist the Government and private sector stakeholders in the coordination of the reforms. The total cost of the TA is estimated to be $315,000. ADB will provide $250,000 equivalent on a grant basis from the ADB-funded TA program. The TA will be implemented over 45 months. An individual consultant will be recruited in accordance with ADB’s Guidelines on the Use of Consultants and other arrangements for the engagement of domestic consultants satisfactory to ADB.

Small and Medium Enterprise Sector Development Program Benefits and Impact Policy

BDS and financial services directly enhance SME competitiveness and productivity, which have a direct and positive impact on SME profitability and favorably impact job security and employment creation. The private sector BDS providers and the FIs will be able to favorably respond to policy reforms. The SDP provides the framework for developing a consistent SME policy and provides a critical linkage of reforms with knowledge enhancement and financial resource flow to SMEs. The SDP also supports the creation of a level playing field in the financial sector through privatization of SME Bank and termination of SBP’s special relationship with SME Bank consistent with SBP’s role of a regulator and the privatization efforts under the financial sector reform program.

Institutional The SDP will support the rationalization and restructuring of two

public sector institutions, SMEDA and SME Bank. SMEDA will follow a business plan to expand its outreach and policy support to SMEs, and its management will benefit from business rules enhancing its accountability. SME Bank will go through substantial rationalization to reduce excessive cost and contingent liabilities of its owner, and start building a viable banking business followed by its privatization under the SDP.

Outreach to Beneficiaries SMEs in the informal and formal sectors will be beneficiaries. About 8,000 SMEs will benefit from the operations of the BSF and about 30,000 SMEs will benefit from access to financial services.

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Risks The program design makes a number of assumptions with varying

degrees of risk. It is assumed that Pakistan will not suffer from major adverse geopolitical changes affecting its external and internal stability. It has been assumed that the Government remains strongly committed to the reforms undertaken since 1997 supporting the poverty orientation of public expenditure, the promotion of SMEs, and financial sector reforms. So far, the Government has demonstrated strong ownership and maintains high priority for the development of SMEs. The reforms involve a number of agencies in the public and private sectors. The implementation risks have been addressed through the establishment of strong oversight, implementation coordination, and governance provisions in the implementation framework. Reforms will be implemented through agencies experienced with other complex reform programs, and the establishment of a strong core program management unit at the Ministry of Finance will ensure that progress and implementation risks are properly managed. Credibility of the reforms in the private sector and society at large is essential. The program design mitigates the risk through the establishment of task forces representing stakeholders and through awareness building and consultation mechanisms in developing policy and disseminating the content. Public sector institutions also bear a risk of low public credibility and of politicization. To reduce this risk, SMEDA will prepare and implement business plans, which will be shared with the public. SME Bank will prepare and implement a restructuring plan followed by a privatization plan, which will be shared with the public once it is finalized. Activities supporting public sector institutions and the private sector under the SDP will be subject both to scrutiny by the SDP steering committee and to regular performance audits, carried out by auditing firms associated with respected international partners. Overall program risks have been lessened through utilization of several institutions, predominantly in the private sector. The use of a number of institutions, for example private sector FIs or private BDS providers, puts the program foundations on a broader base and thereby reduces the risk if an institution fails to deliver. The Program also adopts an approach of pilot testing before rollout, which also effectively reduces the risk of failure.

I. THE PROPOSAL

1. I submit for your approval the following report and recommendation on proposed loans to the Islamic Republic of Pakistan and a proposed private sector partial credit guarantee (PCG) facility for the Small and Medium Enterprise Sector Development Program (SME SDP). The report also describes proposed technical assistance (TA) for Supporting Coordination of the SME SDP, and if the Board approves the proposed loans and the PCG facility, I, acting under the authority delegated to me by the Board, will approve the proposed TA.

II. THE SECTOR: PERFORMANCE, PROBLEMS, AND OPPORTUNITIES

A. Sector Description and Performance

1. Business Climate and Regional Competitiveness

2. A good business climate is essential for an enabling environment for investment and growth and a key factor for competitiveness. A recent assessment1 highlighted Pakistan’s competitiveness with other Asian countries. Exposed to regional instability through its conflict with India, and wars in neighboring Afghanistan and in the Middle East; and domestically due to frequent changes in government; Pakistan’s private sector investment stagnated at below 10% of gross domestic product (GDP), well below India’s 17% in the 1990s. 3. Businesses are also affected by predatory practices of government officials, especially in the inspection functions and in the contracting of services; by poor enforcement of law; by poor access to, and poor reliability and high cost of, infrastructure such as electricity and transportation; and by cumbersome import and export clearance procedures. Pakistan’s competitiveness is undermined by an unfavorable business climate, the combination of high labor costs, high capital intensity per worker, and low productivity. Average wages are about 50% higher than in Bangladesh, average capital per worker exceeds Bangladesh’s by nearly 50%, but overall productivity is about the same as in Bangladesh. The 1990s have proven a difficult period, characterized by deteriorating GDP growth and business opportunities and an increasing incidence of poverty. 4. During the second half of the 1990s, the Government undertook significant structural reforms, which have finally begun paying off.2 Since FY2002, economic conditions have improved, associated with a rebound in industrial production, exports, and private sector credit. Economic growth accelerated from 3.4% in FY2002 to a provisional 5.1% in FY2003. After years of stagnation, exports surged in FY2003 by an impressive 21% to $11.0 billion, while the trade deficit narrowed to about $1.1 billion. Fueled by increased remittances from abroad, the current account surplus built up to $4.0 billion in FY2003 and gross foreign exchange reserves increased to about $10.7 billion equivalent to 12 months of import value, by June 2003. The external inflow of liquidity was largely reflected in the growth of bank deposits (18%) and financial investments (30%) over the previous 21 months, especially in government securities. These positive trends provided room for an accommodative monetary policy and the State Bank of Pakistan (SBP) substantially reduced its discount rate from 14.0% in July 2001 to 7.5% in November 2002. The recent recovery demonstrates the Government’s skillful economic management under challenging conditions of global recession and political instability. It sets the 1 World Bank. 2003. Pakistan Business Climate Assessment conducted by the World Bank and the Small and

Medium Enterprise Development Authority (SMEDA) in 2002. Unpublished. May. 2 ADB. 2003. Pakistan Country Economic Update. Manila; State Bank of Pakistan (SBP). 2002 Annual Report.

Karachi; SBP 2003 Quarterly Reports. Karachi. Available: http:// www.sbp.org.pk.

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foundation for a second set of reforms aimed at improving the business climate and Pakistan’s competitiveness and thus strengthening the private sector’s role in sustaining economic growth, employment, and poverty reduction.

2. Characteristics and Significance

5. Large Informal Economy. Pakistan’s informal economy is a significant contributor to gross national income (estimated at 37%), employment, and livelihoods. The share of Pakistan’s informal economy is high compared with large Asian countries such as the People’s Republic of China, India, and Indonesia, where the informal sector accounts for less than 23% of gross national income. This highlights the fact that entrepreneurs face high barriers to entry and operation in the formal economy. Although small enterprises may have substantial business turnover, current legislation allows enterprises employing 10 staff or below to remain largely unregulated and thus avoid taxation, registration, licensing, and supervision requirements. A survey undertaken in 1988 (footnote 3) indicated that about 97% of enterprises operated in the informal sector. Most enterprises are family owned as sole proprietorships and partnerships. 6. Economic Importance understated. Although no official definition exists, the Small and Medium Enterprise Development Authority (SMEDA) uses the legal requirement for formalizing a business (i.e., 10 or more full time staff) as the minimum threshold for defining a small and medium enterprise (SME). Unlike in other developing countries, where thresholds of about 5 employees are common, all informal enterprises, irrespective of business volume, are classified as microenterprises, and units employing between 10 and 100 staff are classified as SMEs. Using this definition by SMEDA, about 80,000 SMEs and 2.2 million microenterprises are estimated to exist.3 If an internationally more common definition was applied (for example, units employing 5 or more staff), the total number of SMEs could be more than 250,000. The high share of microenterprises reflects distortions and understates the size and potential of the SME economy, which official statistics estimate at 8% of GDP, while SMEDA estimates it at 30 %.4 7. Significant Source for Urban Employment. Since independence, the share of rural employment and the rural sector’s contribution to GDP has seen a falling trend. Currently, the rural economy accounts for 47% of employment and contributes 24% to GDP. While Pakistan’s overall population grew at an annual 2% in 1991–1998, the urban population grew at above 3% a year, outpacing the growth in rural Pakistan. The nine largest cities, each of which has a population exceeding 0.5 million, have grown at faster than 4% a year over the last two decades. With growing urbanization, the significance of the private sector has increased and, with it, the pressure to contain the growing gap between new entrants to the labor market (2.4% a year) and additional employment generated (1.6% a year). 8. SMEDA estimates that enterprises employing 100 staff and below contribute 78% to overall urban employment, of which those employing 10 staff and below contribute about 60%. SME employment in services and in trade is most significant with 40% and 36%, respectively, followed by manufacturing with 24%, while employment in the smallest units is highest in trade, followed by far less significant employment in the manufacturing and services subsectors.

3 Since no official data for the informal sector exist and enterprise surveys are outdated, SMEDA extrapolated the

results of a survey of establishments carried out in 1988. Currently, the Federal Bureau of Statistics is preparing a comprehensive survey, the “Economic Census,” which will serve as a basis for better information on SMEs.

4 In its new prudential regulations for SME finance issued on 28 October 2003, SBP has defined the upper threshold for SMEs as enterprises employing up to 250 employees and an annual business turnover of up to PRs300 million ($5 million), while having no definition of a lower threshold. The upper threshold for employment and the use of business turnover are in line with international practice.

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Official statistics report SME employment at only 5.8 million. However, the Labor Force Survey (1997–1998) estimated that 53% of the work force or 19 million people are employed in trade, services, and manufacturing, suggesting that official statistics substantially understate the size of the urban labor force and its absorption by SMEs. 9. Distribution by Sector and Region. Most SMEs are concentrated in trade and services, accounting for about 51% and 34% of them, respectively, while manufacturing represents only 15% of SMEs. The main manufacturing activities of SMEs in the urban formal and informal economies are textile production, food processing, metal production including automotive spare parts and electrical items, surgical goods, sporting goods, and leather production. Most SMEs are concentrated in the urban agglomerations. The industrial centers of Faisalabad, Gujranwala, Lahore, Sheikhupura, and Sialkot, which were originally centers for agricultural production and trade, are now home to manufacturing enterprises both for the domestic and international markets. Some SMEs that originally started in small industry clusters have become exporters. However, a recent survey of about 1,000 entrepreneurs (footnote 1) indicates that only 15% of sales are related to exports and 8% of supplies are purchased from abroad. Only scant information on SMEs in the trade and service subsectors is available and little attention has so far been paid to them because of their small size, presence in the informal economy, and domestic market orientation. However, given their large number and contribution to employment, their economic potential is significant. 10. The term SME covers highly heterogeneous groups of enterprises. Despite difficulty in obtaining reliable information, these can be broadly characterized as follows:

(i) Very small enterprises or microenterprises typically employ up to four staff, mostly from the same family. Activities include handicraft, textile, shops, trade, and services, often at the home premises of the owners. Professional, managerial, marketing, and technical skills are usually limited to producing single products or products and services for the daily needs of households. The business is mainly oriented toward generating the necessary income for survival of the family and very few have a growth orientation. There is anecdotal evidence of a high closure rate of such entities within the first 2 years of starting operation. These enterprises usually work through a network of families and are almost exclusively in the informal sector.

(ii) Small informal enterprises typically employ from five to nine staff and are

largely family-based, having grown from the micro stage. Business sectors are similar to those of microenterprises. Professional, managerial, and technical skills are higher than in the microenterprises, obtained mainly through on-the-job experience of the owners. These units are more growth oriented, and use a significant part of their business revenues to invest in expansion. Business growth relies heavily on family relationships. Typically, these enterprises lack access to formal credit and support services. They have good growth potential if they are supported by the financial sector and other business services.

(iii) Small formal sector enterprises5 typically employ between 10 and 100 staff.

Based on family management, these enterprises usually have well-established

5 International classifications often define SME units from 5 to 50 staff as small- and from 50 to 250 as medium -

sized. Since there are no reliable statistics at the moment on the number of enterprises according to this definition, small formal sector enterprises are defined in this report as those employing between 10 and 100 staff.

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relationships with larger manufacturing and trade concerns and are growth oriented. Because of their family roots, a number of enterprises in this group face challenges of leadership and management as the business grows and with it the complexity of management. Most enterprises in this category draw their financial resources from retained earnings, and long-standing supplier and buyer relationships. Since business information and documentation is not readily available, many enterprises in this group face difficulty in accessing finance from financial institutions (FIs). This segment, which SMEDA estimates at 80,000 units, has, however, significant growth potential if external support for business services and finance is available.

(iv) Medium-sized enterprises typically employ between 100 and 250 staff, and

have well-established supplier and buyer relationships with small formal and informally operating enterprises, as well as with large domestic and international corporate entities. Usually, these enterprises are in the manufacturing business both in the domestic and export markets. Although this segment normally has professionally sophisticated management, there is a need to maintain competitiveness in these markets. This enterprise type is an important source of employment and of linkage between the formal and informal economies. Access to finance is normally constrained through the FIs’ still existing focus on large and government customers.

3. Policies and Public Sector Support

11. The Government recognizes the importance of SMEs for employment and income generation and has made the development of SMEs one of four key areas of intervention under its 10-year development plan for 2001–2011 and the Poverty Reduction Strategy Paper. The Government established SMEDA in 1998 to spearhead the development of SMEs through (i) policy advice, (ii) provision and facilitation of services, and (iii) becoming itself a lobbying force of SMEs with the Government. Initially, SMEDA focused on the preparation of sector studies and dissemination of information for SMEs. Since FY2000, SMEDA has provided direct services to SMEs, such as training courses reaching about 5,000 participants and preparation of business plans for about 40 SMEs. SMEDA has also contributed to research and has commissioned surveys to study the business climate. Despite its achievements, SMEDA’s outreach to SMEs needs to be strengthened to go beyond direct involvement in providing services at below market prices. Under the program preparatory technical assistance (PPTA),6 SMEDA’s performance was analyzed and a draft business plan was prepared to help SMEDA focus on policy development and on facilitation of the development of regional and industry business clusters. 12. In addition to SMEDA, the federal Government supports exporting enterprises through the Export Promotion Bureau. As a special department under the Ministry of Commerce, the Export Promotion Bureau provides support for marketing, research, fairs and exhibitions, and trade delegations, and provides linkages with business membership organizations. The Export Promotion Bureau has no specific SME focus.7 Provincial governments have established their own business support institutions to develop industrial estates, provide low-cost credit to SMEs, and offer vocational training. However, the federal and provincial governments’ initiatives, 6 ADB. 2002. Technical Assistance to the Islamic Republic of Pakistan for Preparing the Small and Medium

Enterprise Sector Development Program. Manila. 7 Under the Small and Medium Enterprise Trade Enhancement Finance Project (Loan 1796-PAK), ADB supports the

Ministry of Commerce in developing a holistic approach to trade facilitation, which includes the needs of SMEs.

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mainly in response to perceived market failure, have had limited success in providing services to SMEs because of the supply-led approach and the high discretion of officials in the allocation of support, which have undermined the credibility of such schemes among the public.

4. Representation and Access to Business Services

13. Business Membership Organizations. SMEs are represented in 29 active chambers of commerce and industry, in 84 national associations for industry and trade, and in provincial and cluster business associations. Dominated by the larger members, most chambers represent the interests of the large businesses in their interaction with the Government. The more progressive chambers of Karachi, Lahore, and Sialkot provide training and advisory services for quality management and trade promotion. SMEs have a higher participation in the business associations, which are strongest in manufacturing, followed by services. The trade subsector, a mainstay for SMEs, is poorly represented by the business organizations. A few associations, including the All Pakistan Textile Mills Association and the Institute of Chartered Accountants, have established dedicated training programs; most associations, however, while interested in tangible outputs of technical process upgrading, marketing, and skills upgrading, lack the resources to conduct such programs.

14. Private Business Service Providers. There are a number of business schools, international training centers, and nongovernment organizations (NGOs), which provide training in entrepreneurship. However, the target audience for many of these courses is the well-educated, often English-speaking middle class; these courses are not accessible to the vast majority of Urdu-speaking entrepreneurs. Business advisory services are available, but are usually targeted more to wealthy individuals or large corporate entities. A survey conducted under the PPTA highlighted the low awareness of the availability and low usage of business development services (BDS) among SMEs. SMEs expressed the need for external support in (i) marketing, market research, and market information; (ii) technical quality management, especially for exporters; (iii) technical processing; and (iv) strategic planning. The survey echoes international experience that the needs for external support are varied and depend on the business sector and on the age of the enterprise. The variety of needs is so wide that it is impossible for a public service provider to accommodate such demand.

5. Mobilization of Financial Resources

15. Private FI Domination of Support for SMEs. Pakistan’s banking system consists of 40 banks, most of which are privately owned. Thirty of these banks report lending to SMEs (SME definition varies by bank), equivalent to about 15% of the banking system’s total loans. Despite its mandate to serve SMEs, SME Bank, a development finance institution (DFI), contributes only 0.5% of all loans to SMEs. About 91% of the current banking system’s lending to SMEs is generated by private banks (including Habib Bank Limited, which is being privatized), leaving a marginal 9% of the market to state-owned banks. This is consistent with the Government’s policy of privatizing the banking system. 16. Uneven Growth of Commercial Lending to SMEs. Consistent with SBP’s reduction in the discount rate, the average spread of the banks8 decreased from 8.5% to 5.7% during the July 2001 to June 2003 period, while average lending rates were lowered from 14.5% to 7.6%. Following a 2% increase during FY2002, credit to the private sector declined slightly by 0.8% during the first 9 months of FY2003 to PRs1,056 billion ($18.3 billion). The largest total lending

8 Defined as the differential between average lending and deposit rates of the banking system.

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exposure of banks is to the textile industry (25%) followed by agribusiness (10%), while loans to trade and commercial enterprises, which represent about 50% of all business establishments, represented an extremely low share of total lending exposure (3%). During the first half of FY2003, lending to large corporate clients increased by 7% and to consumer finance by 17.3% (although from low levels), while lending to SMEs declined by 4.5%. 17. This uneven performance in a period of easing monetary policy and high liquidity in the market is partly explained by the risk-averse attitude of banks, and the rigidity in prudential regulations of SBP, especially with regard to lending limits and the restriction on FIs to lend against collateral. SBP and the private sector’s credit information bureaus maintain incomplete coverage of loan exposures for loans below PRs500,000, which makes it difficult for FIs to obtain the necessary credit information for smaller borrowers. Also, the existing secured transactions law and the commercial court system are ineffective, thereby contributing to a market that is not conducive to lending to SMEs. By improving credit information and enabling provision of loans collateralized by movable assets, financing to the SME sector, especially the informal/nonregistered SMEs, could be facilitated and SME access to finance broadened. 18. SME Finance Activities. SMEs, especially those in the informal sector, are largely financed through the private savings of the owner, retained earnings of the enterprise, and/or family and friends. Access to finance from other informal sources is insignificant. According to a recent survey of approximately 1,000 SME manufacturers (footnote 1), only 1% of those surveyed borrowed money from formal sources for working capital purposes. Other sources of financing, such as trade credit, amounted to less than 5% of those surveyed. Utilization of credit from FIs by manufacturers employing fewer than 100 employees is only 7%. In general, the lending policies of banks tend to favor the manufacturing sector, and although the majority of SMEs are in trade and services, overall formal credit to trade and services is insignificant. 19. Credit Access Limited at All SME Levels. Despite the large number (1.7 million) of very small enterprises employing fewer than five employees, total lending by the formal sector to this segment is negligible. Even for the 250,000 SMEs with five or more employees, it is estimated that less than 5% have access to formal credit.9 Recent surveys10 indicate somewhat better access to credit for the medium SME manufacturers, although still only about 13% of manufacturing SMEs with more than 100 employees reported access to formal financing for working capital, and 24% reported access to investment capital. Access improves gradually with firm size, although the majority of SMEs with business turnover below PRs300 million and 250 employees appear underserved. Loan accounts up to PRs100 million account for less than 10% of total banking loan exposure. Many surveys confirm that from an entrepreneur’s perspective, lack of access to and cost of bank financing are significant impediments to growth. All this signals that there is significant market potential and likely demand for FIs to lend to SMEs at all levels, including for the trade and service sectors and for financing working capital. B. Issues and Opportunities

1. Business Climate and Small and Medium Enterprise Policy

20. Although SMEs constitute the mainstay of the urban economy, industrial and trade policies and laws have favored larger businesses; smaller units are particularly affected by the poor business climate. Many laws, regulations, and practices developed prior to Pakistan’s

9 Information from banks confirms that lending up to PRs5 million is insignificant, with only about 10,000 borrowers. 10 Footnote 1 and the World Bank, Pakistan’s Small Entrepreneur, Gallup World Bank Survey (2001).Unpublished.

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independence and during a period of interventionist approaches to development are now redundant. Written in the English language, laws and most policies are not accessible to the vast majority of the population. Unprotected and ignorant of their rights and duties, many SMEs are exposed to “predatory” practices of inspectors, who are claiming fees for alleged noncompliance with laws and regulations. 21. Despite the strategic importance of SMEs for economic activity in general, and employment in particular, the Government has so far not articulated consistent policies for the SME sector and has resorted to a practice of ad hoc interventions. A policy is needed to establish (i) the role and accountability of the Government and its agencies and the private sector in developing SMEs and (ii) effective interface mechanisms between these organizations. Issues to be addressed in an SME policy are diverse, and policy development and implementation will need to go through a participatory process. The process requires careful preparation and implementation under which the following principal issues will be addressed. 22. Improvement in the Business Environment. An important step is the review of legislation and regulation, which is currently being made through the Deregulation Commission aiming to simplify laws and administrative procedures.11 Another important step is making laws and rules transparent and understood through dissemination in the local language and through access to free basic legal advice.12 23. Definition of the Role of Private and Public Sector Stakeholders. This entails (i) the identification of market failure and failure of government institutions to assess the possible need and potential for successful direct government intervention; (ii) based on the limitations identified under (i), the assignment of accountability to the Government and the private sector in shaping policy, and facilitating development of SMEs; (iii) responsibilities at the federal, provincial, and local levels; (iv) topic-specific lead functions among government departments and agencies; (v) the role of the Government in facilitating BDS; (vi) the role of the private sector in facilitating and providing BDS; and (vii) preparation of a strategic framework for institutional reform of government agencies involved in the support of SMEs. 24. Clear Definition of SMEs. This is essential to determine the boundary for targeting policy interventions. Because of the large variety of institutions, the issue of formal and informally operating units must be addressed. 25. Development of Strategy and Institutional Framework. The strategy would articulate the government and private sector contribution toward policy development, including an institutional framework for implementing the policy. 26. Development of an SME Database and Performance Monitoring Mechanism. Reliable information on SMEs is unavailable, as the last comprehensive survey of enterprises was undertaken 15 years ago. The Economic Census currently being prepared by the Ministry

11 The Deregulation Commission is chaired by the Minister of Industries and Production and has undertaken the

review of the Factories Act (1934), which constitutes the umbrella legislation for many enterprise-related laws. The Ministry of Labour has undertaken to simplify labor laws and is consolidating 42 laws into six laws. The World Bank is assisting the work of the Deregulation Commission.

12 There are other issues essential for improving the business environment such as the access to public utilities, transport, communication, financial services, and facilitation of customs, which will not be necessarily addressed under an SME policy. These issues are being addressed by the Government and international financial institutions through sector-specific programs. ADB is addressing these through its operations in the power and transport sectors.

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of Economic Affairs and Statistics provides an opportunity for an update analysis of SMEs. Further, an annual update of statistical information could promote a sound basis for assessment of developments of the SME sector and for policy decisions.

2. Labor Protection and Inspection

27. Feedback from the private sector, government stakeholders, and studies points to the abuse of power of tax and labor inspectors, which absorbs significant entrepreneurial time. Conversely, the benefits of maintaining basic labor standards for a good work environment and the consequent positive impact on profitable enterprises are not understood. Current labor laws are to a large extent outdated, and reform efforts to simplify laws and inspection procedures are carried out in a policy vacuum. It is therefore necessary to formulate labor protection policies as an adequate framework for the development of a labor inspection function to be characterized by least intervention, awareness building of employers and employees, development of self-inspection, and subcontracting arrangements with the private sector. Such policies need to be developed in a consultative process with stakeholders, and shared with the public.

3. Public Sector Support

28. Since its establishment in 1998, SMEDA has undergone major changes in its organization to become more responsive to the needs of SMEs. Although SMEDA has gained permanent status as an authority by virtue of an ordinance, the ordinance provides excessive powers and discretion to the board, unless executive powers are delegated to the chief executive officer through business rules and performance benchmarks. In addition, SMEDA’s policy advisory role needs to be firmed up in providing active support in the development of the SME policy. Direct interventions in SME training and in the preparation of business plans have produced quality outputs but have been constrained by limited outreach. While SMEDA has made a commendable contribution to making laws and regulations, and sector studies and reviews available to an English-speaking audience, these outputs will need to be made available in the local language to ensure a broader outreach.13 SMEDA has established some connections with regional and industry SME clusters, for example to upgrade processing and product quality in the textile sector. It is now timely that SMEDA moves to medium-term planning and monitoring of its activities with a focus on outreach to SMEs through facilitation.

4. Market Access to Knowledge-Based Services

29. Pakistan provides public sector support to manufacturing and exporting enterprises. However, hands-on business support to SMEs is rare. Located in the public sector, institutions are constrained by the lack of strategic direction, exposure to government directives, and lack of business expertise. A number of private sector service providers focus on legal matters, tax and audit, and management consulting. There are an estimated 30,000 legal advisers and 476 chartered accountants, among whom 11% provide management consulting services. Also, there are a number of private sector providers in the education sector in response to the often limited service outreach and quality provided by the public sector. Clearly, service providers are highly fragmented and have not yet identified SMEs as their clientele. As these services in the public sector are not demand driven and lack professionalism, there is a large unmet demand for market-based services for SMEs. 13 ADB. 2001. Report and Recommendation of the President to the Board of Directors on Proposed Loans to the

Islamic Republic of Pakistan for Access to Justice Program . Manila. (under Loans 1897-PAK and 1898-PAK, approved on 20 December 2001 for $330 million, the Government committed to issue a simplified Urdu version of any new law).

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30. The PPTA identified needs in the areas of practical and strategic business advice, financing, marketing, and technology upgrading. Since SMEs cover a high diversity of businesses characterized by stage of development, sector, target market, and educational background, the needs are highly diversified. International experience suggests that public service providers are ineffective in reducing the knowledge gap though, and are unable to respond to the variety of needs of the market. On the other hand, information asymmetry between potential users and providers of services is an important reason for the lack of developed service markets. Since the early 1990s, various government-supported facilities have been established to support the development of market-based services for entrepreneurs. Under such schemes, a business support facility provides support to SMEs on a first-come-first-served basis, after satisfactory evidence of the business support case. Such facilities are best placed and managed in the private sector, with the Government playing an important supervisory role. Stakeholder feedback from the private sector obtained during the preparation of the SDP clearly identified the need to kick-start development of a BDS industry for SMEs.

5. Market Access to Finance

31. Ineffective Government Promotion of SMEs. Mismanagement of government-owned banks and DFIs brought Pakistan to the verge of a banking crisis in 1996. Recognizing the failure of interventionist policies, the Government has conducted, since 1997, an aggressive reform by strengthening the autonomy and capacity of SBP, privatizing banks, consolidating the sector through increased capital requirements, and gradually phasing out DFIs through merger with or transformation into commercial banks. While the reforms improved the performance of the FIs, the risk-adverse mind-set of the new managers has led to a standstill of lending to smaller SMEs. In light of recent high liquidity in the market, FIs increasingly see the need to develop new markets for SMEs. Among the reasons for the low FI outreach to SMEs are:

(i) most SMEs are in the informal economy and not considered creditworthy; (ii) based on physical collateral, lending processes and products are not adapted to

the characteristics of SMEs; (iii) SMEs lack physical collateral to pledge as security for loans; and (iv) FIs lack the requisite lending and risk management processes to determine the

cash-flow generation capacity without documentation. 32. Credit Information Systems. SBP and FIs also recognize the importance of good credit information systems for improving the outreach of SME finance. Currently, one public and three private service providers are established in Pakistan. The coverage of the services, however, is highly fragmented and the public credit information bureaus need to improve data integrity and coverage. International experience shows that well-established credit information and registry systems exist both in the public and private sectors, and that the role of the private sector depends on its willingness to provide full coverage of credit information at reasonable cost even on the smallest borrowings. There is a need for a strategy of developing credit information and registry systems and linking the public and private systems, enhancing their outreach. 33. Prudential Regulations. Until very recently, prudential regulations required banks to apply the same criteria for lending to small and large clients. “Clean lending” on a cash-flow basis was limited to $1,700 equivalent. There is significant overlap between SME and consumer finance since the goods and services financed can be of use for businesses as well as private consumers. For small enterprises, the border between the private and business spheres is usually blurred. SBP therefore recognized the need to revise regulations for encouraging the banks to develop innovative but prudent ways for SME and consumer finance.

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34. Stimulating the Market for SME Finance. Given the large diversity of financial needs and degrees of sophistication of SMEs, one approach alone will not suffice to stimulate the market. Innovative approaches supporting higher risk taking through proven lending processes based on the cash flow of the borrower are warranted to replace the classic collateral-based lending. Commercial FIs need to develop dedicated SME finance capacity through a client-focused approach and lending process that differ substantially from existing processes for corporate and retail lending. Internationally, a downscaling approach has been successfully tested to incentivize banks to move down market. This also leads the way for Pakistan’s FIs. 35. Traditional Efforts and Lessons Learned for SME Lending. Traditional efforts to improve credit flow to SMEs often include targeted credit. Experience in Pakistan and elsewhere has shown mixed results, with (i) low utilization of credit lines when channeled through private FIs, characterized by a lack of adequate incentives and responsiveness to market change; and (ii) high default of credit when channeled through public sector FIs, resulting from inherent moral hazard and poor governance. A key lesson learned is that incentives matter. Collateral-based lending is costly for small loans, and there are alternatives with more attractive risk-reward structures. Hence, access to capital is not merely an issue of availability of funds, but of risk management and establishment of appropriate incentives for FIs to lend to SMEs. 36. Mobilizing Existing Liquidity in the Market for SME Lending. A number of capacity-building as well as policy measures have recently been initiated, to be supported under the proposed SME SDP. This includes the development of commercial banks’ capability to extend credit to and manage risks of SMEs, through the buildup of dedicated SME business units. However, FIs continue placing large amounts of liquidity in low-risk government bonds and corporate loans, reflecting an important barrier of their highly risk-averse approach that needs to be overcome through suitable lending processes, and products. 37. The ADB’s PCG instrument—which in a partnership with selected FIs shares some of the risks, and rewards, associated with SME lending—is a suitable vehicle to raise the comfort level of participating FIs (PFIs) for SME lending, by (i) mitigating the impact on the FIs’ capital base in case of systemic risk occurrence, (ii) supporting increased flow of funds to SMEs through effective leveraging of the PFIs’ equity, (iii) assisting PFIs to gradually develop client relationships with smaller SME clients, and (iv) introducing to Pakistan international good practice in SME lending processes and products. 38. Disengaging from Government Ownership in SME Bank. The Government established SME Bank in January 2002 through the merger of two failed DFIs.14 SME Bank inherited all assets, liabilities, staff, privileges, and duties of the precursor DFIs, including a nonperforming loan portfolio exceeding 85% of outstanding principal. SME bank’s biggest liability, however, is the more than 1,000 unqualified staff with permanent employment status, representing about 90% of total staff strength. Previously, management assigned 900 of these to recover the old loan portfolio, which after initial success is now witnessing substantial decline. As more difficult cases are to be resolved, average monthly recovery has dropped to below 60% of its peak in FY2001. SME Bank now needs to rigorously reduce unqualified but highly paid staff, who put increasing pressure on profitability and add to the Government’s contingent liabilities. 39. The SME Bank’s new business since January 2002 has generated a high level of nonperforming loans. Over the past 6 months, the proportion of past dues above 90 days has

14 The Small Business Finance Corporation and the Regional Development Finance Corporation.

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increased from 6% to 13% of the outstanding loans, emphasizing the need for a different, commercially oriented approach. Appointment of a head for SME credit is essential since only a few of SME Bank’s staff in the lending operations have the requisite commercial skills to develop the business. SME Bank still enjoys significant privileges with SBP, through a profit and loss sharing arrangement and subsidized loans from SBP, which constitute about 83% of the bank’s overall resources. This has allowed SME Bank to make profits through investments in high-interest government bonds. As part of the reform and restructuring of SME Bank, the Government and SBP agreed to terminate the special privileges of SME Bank and to eliminate SBP’s shareholding in the bank. The SME Bank is envisaged to be privatized within 3 years.

6. Lessons Learned

40. Operational lessons learned from Pakistan and numerous emerging markets relevant for the design of the SME SDP include the following:

(i) Governments play a key role as facilitators for market development, while direct service provision should be left to the private sector;

(ii) Regulatory support, and stimulation of market-based BDS, has proven effective in promoting economic growth and employment;

(iii) Policy development must take place in a consultative and participatory process involving a wide range of stakeholders to gain credibility;

(iv) Government provision of services to SMEs bears high risks of missing targeted needs and should be strictly limited to interventions, where market failure prevents delivery through the private sector;

(v) Because of the diversity of the needs, a large number of services is needed; (vi) BDS should be demand driven; (vii) Subsidies should be terminated when markets and products are established; and (viii) Rigorous controls and business ethics must be established to ensure good

governance and public credibility of the schemes. 7. Rationale

41. The SME SDP aims at filling an important gap in the Government’s and ADB’s strategic agenda, and complements ADB’s interventions in rural finance and microfinance and in capital market development, supporting provision of market-based access for the beneficiaries. The SME SDP builds on lessons learned from other emerging markets and considers existing and planned interventions of ADB and other funding agencies to minimize overlap. SME access to physical infrastructure and trade facilitation are important areas supported under ADB’s operations in the power and transport sectors and the Small and Medium Enterprise Trade Enhancement Finance Project. Neither fiscal reform, including the inspection function for tax inspectors, nor the work of the Deregulation Commission, were included in the scope of the Program, since the International Monetary Fund and the World Bank support these areas. The Government recently affirmed the important role of SMEs and their potential for economic growth, employment, and income generation in its Poverty Reduction Strategy Paper, which is also supported by ADB’s country strategy and program, the International Monetary Fund, and the World Bank.

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III. THE PROPOSED SECTOR DEVELOPMENT PROGRAM

A. Objectives and Scope 42. The long-term goal of the SDP is to improve the SME sector contribution to economic growth, employment, and poverty reduction. The objective of the SDP is to improve SMEs' competitiveness. The SDP will support (i) the Government in policy reforms to improve the business climate with an emphasis on leveraging private sector interventions, (ii) private FIs and BDS intermediaries in building up the requisite capabilities to serve SMEs, (iii) market-based outreach of financial intermediaries through a PCG facility under ADB’s private sector operations, (iv) SBP to assume an unambiguous lender of last resort functions vis-à-vis SME Bank, and (v) the Government in disengaging from ownership in SME Bank through privatization after restructuring its insolvent operations. 43. The SDP consists of four parts: (i) a program loan supporting policy reforms; (ii) a project loan, the SME Sector Development Project comprising three subprojects supporting participatory policy development, and building institutions and markets for BDS and SME finance; (iii) a PCG through ADB’s private sector operations to enhance credit to SMEs; and (iv) a TA grant to support implementation of the SDP. The program framework summarizes the design (Appendix 1). The development policy letter and the policy matrix summarize the agreed policy reforms (Appendix 2). B. Important Features 44. Government Focus on Policy Setting and Facilitation. The SDP supports the focus of the Government and its agencies on policy setting, catalytic support, and coordinating efforts of the private sector in the SME sector, while refraining from direct intervention in areas where services are and can be provided by the private sector. 45. Building Credibility Through Good Governance. The SDP supports the Government’s efforts to strengthen governance through enhanced transparency of regulations and their implementation in order to reduce interference and possibilities for rent seeking by officials. The SDP also supports the establishment of the SME Business Support Fund (BSF) managed by the private sector under strict business ethics, rules for conflict of interest, and external audit. 46. Blending ADB Instruments and Adopting Lessons Learned. The Program integrates ADB’s public and private sector operations and mobilizes domestic resources of the FIs to finance SMEs through the PCG facility, thereby promoting a market-based approach and avoiding risks of failures associated with traditional credit-line support. 47. Privatization of SME Bank. The SDP supports (i) containing the fiscal risks associated with an insolvent institution; (ii) termination of special lender of first resort and shareholding relationship with SBP; and (iii) transfer of the operations to the private sector. C. The Program Loan

1. Components and Outputs

48. The Program entails three policy outcomes in six key result areas (KRAs):

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Outcome 1 Improve SME Policy Environment KRA 1.1 Develop SME Policy KRA 1.2 Establish Effective Labor Protection and Labor Inspection Policies KRA 1.3 Enhance SMEDA’s Effectiveness and Outreach to SMEs Outcome 2 Improve Market-Based SME Access to Business Development

Services KRA 2 Enhance SME Competitiveness Through Private Sector Services Outcome 3 Improve Market-Based Access to and Delivery of SME Finance KRA 3.1 Improve Regulatory and Credit Information Infrastructure and Build

Private FI Capacity KRA 3.2 Restructure and Privatize SME Bank

a. Improve SME Policy Environment

49. Develop SME Policy. Under the SDP, the Government will establish a task force to develop in a participatory and consultative process an SME policy framework paper and to provide the background analysis and basis for its development. The policy will cover (i) a strategy and action plan, (ii) enterprise size definition, (iii) the focus of government support through policy reforms and targeted inventions using services from the private sector, (iv) the role of the private sector in providing services and shaping SME policy, and (v) other priority issues identified by the task force. The task force will delegate specific topics to focused policy advisory groups facilitated by a government representative and private sector representatives and will consult with provincial government and consider ongoing reforms at the provincial level as appropriate. The results of the advisory groups will be consolidated and prioritized into an overall draft policy and action plan in a consultative process. The SME policy will be issued by the Government and supplemented by an action and resource plan for implementation during the second half of the program period. This includes the publication of the first SME development report in Urdu. 50. Establish Effective Labor Protection and Labor Inspection Policies. To improve the understanding of the purpose of labor protection and its positive impact on enterprise efficiency, and to provide a reasonable benchmark for the approaches and objectives of labor inspection, a national labor protection policy based on core labor standards will be developed in a consultative process with all stakeholders. To curb the abuse of power of labor inspectors, a new labor inspection policy based on the labor protection policy and characterized by least intervention of the Government, awareness building of employers and employees, and development self-inspection and subcontracting arrangements with the private sector, will be developed once the labor protection policy is in place. These national policies will be communicated through awareness-building seminars and publications for implementation at the provincial level.15 Subsequent to the issuance of the labor inspection policy, the Government will revise the Factories Act (1934) as necessary to reflect the reforms of the labor protection and inspection policies. 51. Enhance SMEDA’s Effectiveness and Outreach to SMEs. The Government will improve the governance and business focus of SMEDA through the appointment of a full-time professional chief executive officer and implementation of a 5-year SMEDA business plan, to be

15 Development of the SME policy and the labor protection and inspection policies will be supported by consultants to

be hired under Subproject 1 as detailed in Appendix 4.

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approved by 30 June 2004, according to clearly defined performance benchmarks. To improve its outreach to SME clusters, SMEDA will also determine the design of and implement a 5-year business plan for developing shared facilities for SME clusters under common facility centers (CFCs) against clearly defined performance criteria. To enhance its policy advisory role, SMEDA will establish a secretariat for the SME policy task force at SMEDA. To clarify the role of the SMEDA management, the SMEDA board will issue business rules to ensure accountability of the management team for day-to-day operations. The performance of SMEDA and its CFC program will be supervised by its board and will be subject to independent performance audits.

b. Improve Market-Based SME Access to Business Development Services

52. BDS have internationally been proven as a tool to enhance competitiveness of enterprises through knowledge transfer and direct application at the enterprise level. To ensure a demand-led approach for BDS, the Government will establish the SME BSF under Article 42 of the Companies Ordinance, 1984. The SME BSF will be accessible for SMEs to meet a large variety of knowledge-service needs to enhance their productivity and competitiveness. SMEs will submit proposals for accessing the SME BSF, which will be evaluated on a first come, first served basis. Services will be customized by private sector providers to meet the needs of SMEs and will include the development of business plans, process improvement, identification of markets, marketing, and product and service quality improvement. The SME BSF will be created by a private sector-led task force appointed by the Government, which will approve the draft articles of association, the business plan and standard operating procedures; hire the facility manager; and coordinate the legal and operational establishment. The SME BSF will be supervised by its board of directors and will be subject to independent performance audits.16

c. Improve Market-Based Access to and Delivery of SME Finance

i. Improve Regulatory and Credit Information Infrastructure and Build Private Financial Institution Capacity

53. Improve Prudential Regulations. While aiming at prudent lending, the SBP prudential regulations were largely oriented toward the corporate and wealthy clientele of FIs, undermining the emergence of innovative and risk-effective products and processes for service delivery to smaller clients. Under the program, SBP has issued new regulations for SME and consumer lending to stimulate innovative services to SMEs and their clients, the consumers. SBP will periodically review the impact of these prudential regulations on the uptake of lending and the portfolio quality of the FIs, and revise the regulations as necessary. 54. Improve Quality and Outreach of Credit Information Systems. Well-functioning and integrated credit information systems provide essential information to support lending decisions of prospective creditors. Currently, Pakistan maintains one public and three privately owned credit information systems. SBP intends to strengthen the role of private sector credit bureaus in building the credit information infrastructure. However, international experience regarding the ownership, information sharing, and financing of credit information systems is mixed, warranting a thorough review of international experience and domestic conditions before finalizing a strategy and action plan. SBP is commissioning a World Bank-funded study, which will determine the strategy and action plan, especially the scope and mix of accountability of private and public sector bureaus. Subject to the outcome of the study SBP will, in cooperation with the

16 The BSF operations will be funded and managed through Subproject 2 under this SME SDP.

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private sector, develop and implement an action plan for improving the quality and coverage of an integrated credit information system. 55. Build Awareness of FIs and Support Capacity Building for SME Finance. International experience suggests that innovative lending processes and products utilizing (i) a combination of qualitative and quantitative skills in determining cash flow and creditworthiness of borrowers, (ii) specific sector knowledge, or (iii) information from supplier and buyer relationships have successfully resulted in downscaling FI markets from an orientation on large and asset-rich customers to the large market for smaller businesses. Under the SDP, SBP will, as an independent broker, promote targeted awareness among FIs of SME finance processes and products through workshops, training on a cost-sharing basis, and assistance to FIs that have demonstrated management commitment in building dedicated SME finance capacity.

ii. Restructure and Privatize SME Bank 56. SBP to Terminate Special Lender of First Resort Relationship. SBP is currently the primary lender to and a major shareholder of SME Bank. Under the Program, SBP, SME Bank, and the Government will terminate SME Bank’s special relationship through immediate transfer of SBP’s shareholding to the Government and repayment of 57.2% of SBP’s outstanding loans to SME Bank within the first year and the remainder through repayment of 21.4% of the SBP loans in each of the following years of the program. 57. Government to Disengage from SME Bank Ownership. Consistent with its approach to financial system reform and cognizant of the important role of the private sector in serving SMEs, the Government supports a market-based approach refraining from directed lending to SMEs. Under the SDP, the Government and SME Bank management prepared a restructuring plan aiming at SME Bank’s privatization within the 3-year program period.17 According to SME Bank’s restructuring plan, the business will be reorganized into two units: an SME business unit and a distressed portfolio recovery unit. Additionally, the restructuring plan includes (i) a time-bound action plan to reduce the number of bank branches and to rationalize staff of the recovery unit to a sustainable cost level, and (ii) an independent human resource audit to: (a) evaluate the skills of the employees at the bank; (b) identify and match skills for specific jobs within the bank; (c) identify alternative job opportunities for employees; and (d) provide active job-search assistance and reemployment training for personnel. The restructuring plan entails a package of sequenced operational and financial restructuring measures reducing the liabilities related to excessive unqualified staff and an excessive branch infrastructure (Appendix 3).

2. Costs and Financing Plan

58. Costs of Adjustment. These are illustrated in Table 1 and reflect costs for the restructuring and privatization of SME Bank, investment costs of FIs in building SME finance capability, investment costs of SMEs in upgrading their competitiveness, and the reform and development efforts of the Government and SMEDA. The costs of adjustment reflect a substantial initial effort of SME Bank to downsize branch and regular staff to cut operational costs of the unprofitable recovery operations, followed by a gradual rationalization of branches and staff. The SME Bank financial restructuring similarly reflects an upfront effort to provision the nonperforming loan portfolio and repay SBP’s loans. The SMEDA costs reflect an expected 17 Several options were explored in detail including (i) an early liquidation and/or sale of SME Bank, (ii) the transfer of

the bad portfolio and staff to an asset recovery agency, and (iii) the creation of legally separate “good bank” and “bad bank” entities. The Government opted for the restructuring of SME Bank followed by privatization because of the political risks involved in a large upfront staff separation scheme.

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gradual increase of its outreach program to industry clusters. The rest of the costs of adjustment reflect the FIs’ investment in SME capacity-building and lending programs, and SMEs’ investment in innovative technology, production, and marketing processes. The costs of adjustment under the Program are net of the project costs.

Table 1: Estimate of Adjustment Costs ($ million)

Item FY2004 FY2005 FY2006 FY2007 Total

A. Restructuring SME Bank 86.1 34.0 10.8 21.5 152.4

B. FI Investment for SME Finance 9.2 23.7 38.9 71.8 C. SME Investments 6.0 17.5 19.9 43.4 D. SMEDA CFC Outreach Program 2.0 4.0 6.0 12.0

Total 86.1 51.2 55.9 86.3 279.5 CFC = common facility center, FI = financial institution, SBP = State Bank of Pakistan, SME = small and medium enterprise, SMEDA = Small and Medium Enterprise Development Authority. Source: ADB staff estimates. 59. Financing and Tranching. The Government has requested a loan of ¥16,436.52 million ($152 million equivalent) from ADB’s ordinary capital resources to help finance the cost of the Program. The loan will have a 15-year term including a 3-year grace period, and an interest rate to be determined in accordance with ADB’s London interbank offered rate (LIBOR)-based lending facility, a commitment charge of 0.75% per annum, and a front-end fee of 0.5% of the loan amount, and other terms and conditions set out in the draft program Loan Agreement. (The front-end fee for loans approved in 2003 has been reduced from 1.0% to 0.5%.) The proceeds will be available for withdrawal upon satisfactory compliance with agreed conditions from the date of loan effectiveness up to the loan closing date on 30 June 2007. The first tranche, in the amount of ¥3,244.05 million, will be released upon effectiveness of the loan, subject to compliance with the first tranche conditions. The release of an incentive tranche in the same amount is expected within 7 months of compliance with the conditions of the first tranche. The second tranche in the same amount and the third tranche comprising the remaining funds will be made available upon compliance with agreed conditions and are expected in June 2005 and December 2006, respectively. The financing amounts under the Program are net of amounts financed under the Project.

3. Procurement and Disbursement

60. Procurement and Disbursement. The program loan will follow ADB standard procedures for procurement and disbursement. Proceeds of the loan will be utilized to finance the full foreign exchange costs, excluding local duties and taxes, of eligible imports produced in and procured from ADB’s member countries. All procurement under the program loan will be in accordance with ADB’s Guidelines for Procurement and undertaken through normal commercial practices for the private sector or the Government’s prescribed procurement procedures acceptable to ADB, with due consideration to economy and efficiency. Disbursements under the program loan will be made in line with ADB‘s simplified disbursement procedures and audit requirements. To withdraw the proceeds of the loan, the Borrower will certify that the value of eligible imports exceeds the amount of ADB’s projected disbursements under the program loan

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in a given period. ADB will have the right to audit the use of loan proceeds and to verify the accuracy of the Borrower’s certification. 61. Counterpart Funds. As part of SME SDP, it has been agreed that the Government will contribute counterpart funds for the SME Bank restructuring and SMEDA’s CFC program. The first tranche amount will be utilized for repayment of SME Bank’s liabilities to SBP. The proceeds of the incentive tranche will be used for the further repayment of SME Bank’s liabilities to SBP and reimbursement to SME Bank for the expenditures related to staff separation. The proceeds of the second and third tranches will cover adjustment cost related to SME Bank staff separation and include earmarking of up to $6 million equivalent each for SMEDA’s CFC program. The borrower will certify the utilization of counterpart funds in line with the Loan Agreement through audited statements acceptable to ADB. All other implementation arrangements for the program and project loans are under Section E below. D. The Project

1. Components and Outputs

62. The SME Sector Development Project supports the implementation of policy reforms and the building of a market-based infrastructure for BDS and financial services to SMEs and is structured in three subprojects. Details of the rationale, scope, and approach of each of the subprojects are described in Appendixes 4, 5, and 6. The costs and financing are summarized in Appendix 7 and implementation arrangements are detailed in Appendix 8.

Subproject 1: Policy Formulation and Implementation Component 1.1: SME Policy Development Component 1.2: Labor Protection and Inspection Policy Development Subproject 2: SME Business Support Fund Subproject 3: Market Development for SME Finance Component 3.1: Regulatory Policy Development, Credit Information, and Capacity

Building for Financial Institutions Component 3.2: SME Bank Restructuring

a. Subproject 1: Policy Formulation and Implementation

63. The purpose of the subproject is to assist the Government to develop the SME policy (Ministry of Industries and Production [MOIP] supported by SMEDA for component 1.1), and the Labor Protection and Inspection Policies (Ministry of Labour [MOL] for component 1.2) and to establish state-of-the-art processes for participatory preparation of the policies, topic-specific policy advisory groups involving all stakeholders, and awareness building and dissemination at the provincial and local levels utilizing local language. Project component 1.1 will as well support SMEDA in the establishment and analysis of an SME database for annual updating to monitor policy reform impact (Appendix 4).

b. Subproject 2: SME Business Support Fund 64. The subproject will establish the SME BSF as a company within three months of loan effectiveness, with a nine-member board led by private sector members and composed of at least six representatives from the private sector. The fund will provide SMEs with direct access

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to market-based knowledge services to enhance their productivity and competitiveness. The utilization will be demand driven and SMEs will access the funds on a cost-sharing basis after their proposals have gone through scrutiny by a dedicated facility management team. In supporting the SME applicants, the BSF will utilize and effectively leverage the knowledge services available in the private sector and thus stimulate the downscaling of the market for business advisory services to the level of SMEs. 65. The design and establishment of the SME BSF has utilized best practice in emerging markets. The legal and governance structure of the SME BSF is modeled after the Poverty Alleviation Fund, which is successfully managed under the leadership of the private sector, with participation of NGOs and the Government. The Ministry of Finance (MOF) will establish the SME BSF based on its own experience gained with this model. Besides having sound management experience, it is critical that the management of the SME BSF applies strong professional ethics including rules dealing with conflict of interest, the separation of business origination and management, and the external recruitment of an experienced facility manger. These arrangements will not only serve to establish a strong governance environment within the BSF, but will also be critical for the reputation of the SME BSF among the public as an accessible institution serving the needs of the clients. Under the PPTA, memorandum and articles of association were drafted and a business plan and standard operating procedures prepared and reviewed by MOF (Appendix 5).

c. Subproject 3: Market Development for SME Finance—Component 3.1 66. The objective of this subproject component is to increase SMEs’ access to finance through the private sector. The component focuses on (i) developing a conducive regulatory and policy environment for SME finance, (ii) encouraging FIs to develop SME lending capability, and (iii) providing capacity building to PFIs committed to establish SME finance units (Appendix 6). 67. Developing a Conducive Regulatory and Policy Environment for SME Finance . In order to have a well-functioning financial system for SME lending, regulations, supervision, and monitoring of the FIs must be improved and FIs’ policies and procedures for SME lending must be introduced. To improve their ability in performing proper credit analysis on SMEs, more comprehensive credit information must be provided to FIs. Additionally, to enhance SME access to credit, the legal framework for secured transactions will be reviewed and developed. A banking regulation and supervision expert with extensive experience in SMEs will assist in the review of SBP’s regulations, supervision, and approach to the SME segment. 68. Encouraging FIs to Develop SME Lending Capability. Commercial SME finance is relatively new in Pakistan. Capacity building on SME finance will be offered to both SBP and FIs. Seminars and workshops will be conducted by experts on the strategies and methods of establishing SME finance capability at the FIs. This entails market research, product development, lending processes, control systems, and capacity building of professional staff. Advisory support will also be provided to assist FIs in developing SME business strategies. 69. Customized Capacity Building of FIs. FIs committed to establish an SME financing unit may qualify for consulting services by submitting a business plan for approval to SBP and ADB. Upon approval of the FI’s business plan, the FI will obtain consulting services on a cost-sharing basis to implement the business plan and establish the SME finance capability. This activity may also prepare FIs for participation in the PCG facility described in Section F.

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d. Subproject 3: Market Development for SME Finance—Component 3.2 70. This component will assist SME Bank with the implementation of its restructuring plan, and provide expertise to (i) identify market niches for SME Bank, (ii) establish lending policies and procedures, (iii) develop financial products, (iv) develop marketing strategies to enhance outreach, and (v) develop sound risk management through appropriate incentives for staff, controls, and sound management information systems. SME Bank will have an international expert as head of its new SME business unit, who will assist in building up the commercial SME business including the deposit and lending products. A committee composed of representatives of SME Bank and core program management unit (CPMU) will select the expert (Appendix 6).

2. Cost and Financing

71. Amounts and Terms. The total project costs are estimated at $28 million equivalent. The Government has requested a loan of SDR12.501 million ($18 million equivalent) including $7.91 equivalent in foreign exchange and $10.09 million equivalent in domestic currency to help finance the Project. The remainder of the cost will be borne by the Government and the private sector SMEs and FIs through fees and cost-sharing arrangements. The project loan will be provided from ADB’s Special Funds resources for a term of 32 years, including a grace period of 8 years, interest rate of 1% per annum during the grace period and 1.5% per annum thereafter, and other terms and conditions set out in the draft project Loan Agreement. The Project has a 5-year duration and the closing date will be 30 June 2009. The proceeds of the project loan will be passed on in the following manner: (i) as a budgetary allocation to MOL ($350,000 equivalent, Component 1.2), and MOF (CPMU) ($960,000 equivalent); and (ii) as a grant to SBP ($8,000,000 equivalent, Component 3.1), SMEDA ($200,000 equivalent, Component 1.1), SME BSF ($7,190,000 equivalent, Component 2), and SME Bank ($800,000 equivalent, Component 3.2).

Table 2. Summary of Project Cost and Financing

($’000)

Foreign Local Total Item Exchange Currency Cost A. ADB Financing 1. Subproject 1: Policy Formulation and Implementation 174.0 376.0 550.0 2. Subproject 2: SME BSF 2,350.0 4,840.0 7,190.0 3. Subproject 3: Market Development for SME Finance 4,886.0 3,914.0 8,800.0 4. Implementation Support (CPMU) 0.0 960.0 960.0 5. Interest during implementation period 500.0 0.0 500.0 Subtotal (A) 7,910.0 10,090.0 18,000.0 B. Government and Beneficiary Financing 1. Subproject 1: Policy Formulation and Implementation 0.0 216.0 216.0 2. Subproject 2: SME BSF 0.0 5,740.0 5,740.0 3. Subproject 3: Market Development for SME Finance 0.0 3,834.0 3,834.0 4. Implementation Support (CPMU) 0.0 210.0 210.0 Subtotal (B) 0.0 10,000.0 10,000.0 Total 7,910.0 20,090.0 28,000.0

ADB = Asian Development Bank, BSF = Business Support Fund, CPMU = Core Program Management Unit, FIs = financial institutions, SME = small and medium enterprise. Source: Asian Development Bank estimates.

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3. Procurement and Consulting Services

72. Procurement of goods and services will be in accordance with ADB's Guidelines for Procurement as described in Appendix 8. Procurement will be limited to office equipment and a vehicle estimated at a total of $71,800 equivalent, which will be procured under direct procurement procedures. All consultants to be financed from the proceeds of the ADB loan will be recruited in accordance with ADB’s Guidelines on the Use of Consultants and other arrangements for the engagement of domestic consultants satisfactory to ADB. The Government requested that domestic consultants may be required to collaborate with international consultants. The consulting services under component 3.1 require an innovative approach to awareness building, and identification of PFIs and PFI senior management commitment of their SME finance business plans, before assistance packages can be customized. Since there is no standardized approach for delivery of such services and since the tasks of developing systems, lending processes, and procedures for SME finance are complex and require highly specialized skills and a significant degree of flexibility in the allocation of expertise, the quality-based selection method will be applied for the capacity-building portion of this component (Table 3, 3.1b,). Since the participating FIs will be identified in the awareness-building process through short-term consultants, the requisite terms of reference and specialized skills will be customized to the needs of the individual PFI. It is expected that up to four PFIs will benefit from the capacity-building measures. All other consulting positions will be advertised and selected on an individual basis as set out in Table 3.

Table 3. Summary of Consulting Services and Selection Procedures

Project Component

International Expertise (months)

Domestic Expertise (months)

Total Expertise (months)

Selection method

1.1 SME Policy Development 1.5 11.0 12.5 Individual 1.2 Labor Policy Development 6.0 20.0 26.0 Individual 2. SME BSF 32.0 0.0 32.0 Individual 3.1a SME Finance Short-term consultants

16.0

16.0

32.0

Individual

3.1b SME Finance FI capacity building

124.0

184.0

308.0

Quality-based selection, up to four bids

3.2 SME Bank restructuring 4. Implementation Support (CPMU)

24.0 0.0

0.0 238.0

24.0 238.0

Individual Individual (five consultants)

BSF = Business Support Fund, CPMU = Core Program Management Unit, FI = financial institution, SME = small and medium enterprise. Source: ADB staff estimates E. Implementation Arrangements for the Sector Development Program

1. Program and Project Management Oversight

73. Because of the linkage of reforms in the program and project activities, strong implementation and coordination arrangements will be put in place. The TA grant described under Section IV will provide for a domestic full-time specialist allocated to ADB’s Pakistan Resident Mission to support the coordination of the SDP. The implementation responsibilities are detailed in Appendix 8. The following entities will implement the SDP:

(i) the steering committee; (ii) the CPMU representing MOF as the Executing Agency (EA); and

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(iii) the implementing agencies (IAs) (MOF, MOIP, MOL, SBP, SMEDA, and SME Bank), as well as the BSF upon incorporation as a nonprofit company.

74. Steering Committee. The steering committee will be chaired by the Minister of Finance and consist of the secretaries of the Ministry of Economic Affairs and Statistics; MOF; MOIP; MOL; and the deputy governor of SBP. The steering committee will establish a stakeholder review process for ensuring adequate private sector feedback on the policy outputs; and establish an audit review process for ensuring adequate performance review and addressing issues raised in audits of the program, including compliance with policy conditions, loan covenants. The financial and performance audits will be conducted by a firm associated with an internationally recognized auditing firm based on terms of reference and a shortlist agreed with ADB.

2. Program and Project Management Coordination

75. CPMU. A permanent CPMU representing the MOF as the EA will be established to assure that reforms are well managed, coordinated, and communicated among government agencies and private sector stakeholders. In addition to its oversight and coordination functions, the CPMU will also act as the IA for (i) the SME Bank restructuring component, (ii) the initial setup of the SME BSF, and (iii) the TA grant to support program coordination. The CPMU will maintain the following functions: (i) focal point for ADB and consultants; (ii) lead coordinator of IAs and private sector stakeholders; (iii) lead program monitoring, management, and reporting; and (iv) ensuring adequacy and timely availability of counterpart funding. 76. The CPMU comprises six full-time staff, including (i) the program director, who will be a joint secretary and will directly report to the steering committee; (ii) manager, SME policy and labor policy development, in charge of supporting and overseeing the development of policy reform initiatives and related project components under outcome 1; (iii) manager, BDS development, in charge of supporting and overseeing the development of policy reform initiatives and related project components under outcome 2; (iv) manager, SME Bank restructuring in charge of overseeing the complex downsizing and business building process for SME Bank, including the Government’s divestiture from SME Bank under outcome 3; and (v) two research analysts, in charge of providing analytical support for policy analysis, data research, program monitoring and reporting, and implementation support as necessary. All staff except the program director will be recruited in a competitive process from the market and will be financed under the project loan.

3. Program and Project Implementation Units

77. The SDP will be implemented by the following IAs: 78. IA 1—SMEDA. MOIP will appoint its secretary to oversee the implementation of the following tasks to be performed by SMEDA and coordinated by SMEDA’s chief executive officer, who will act as project director (PD-IA 1):

(i) SME policy development, including the composition of an SME policy document in a consultative process with SME stakeholders and the implementation of such policy (KRA 1.1). Project component 1.1 will provide consulting services to support this initiative; and

(ii) enhancement of SMEDA’s effectiveness and outreach to SMEs (KRA 1.3).

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79. IA 2—MOL has established a team chaired by a joint secretary at MOL, as project director (PD-IA 2), and adviser at MOL as coordinator supported by 3 professional staff to carry out the development of the labor protection and inspection policies (KRA 1.2) and to disseminate these to, and develop consensus at, the provincial level. MOL will obtain periodical support from an international labor policy specialist and full-time support from a domestic consultant recruited under project component 1.2. 80. IA 3—MOF/BSF. Project director CPMU will be in charge on a limited time basis to facilitate the selection and appointment of a task force to incorporate the BSF and select board of directors in charge of overseeing the operations of the SME BSF (KRA 2), approve the memorandum of association, the business plan and standard operating procedures. 81. The SME BSF will implement program KRA 2 and project component 2 and its board will recruit an internationally experienced facility manager through a competitive process supported by domestically recruited professional staff as determined in the BSF business plan; and oversee the SME BSF’s business. The SME BSF will establish a unit, comprising the facility manager/project director (PD-IA 3) on a full-time basis and will be in charge of managing the preparation and implementation of the BSF operations, including the (i) compliance of tranche release conditions, and (ii) ensuring timely recruitment of experts and management of experts’ outputs. 82. IA 4—SBP has established a unit to carry out the following tasks:

(i) lead the development of SME finance policy, institutional support infrastructure for credit enhancements for SMEs, and analysis of the private sector banks’ response to the policies (KRA 3.1);

(ii) implement project component 3.1 supporting SME regulatory policy development and the development of supporting information infrastructure; and promoting awareness among commercial bankers for commercial approaches to SME finance and promote investment of banks into building dedicated SME units; and

(iii) oversee, in its function as regulator, the restructuring of SME Bank. 83. IA 4 comprises a project director and three full-time staff in charge of (i) training and knowledge management, (ii) SME finance capacity building, (iii) monitoring of relevant tranche release conditions, and (iv) ensuring timely recruitment and management of consultants and their outputs. 84. IA 5—MOF. The CPMU will maintain the function of the IA overseeing the restructuring of SME Bank from the perspective as its owner. The CPMU will specifically:

(i) oversee the restructuring process; (ii) recruit experts supporting the restructuring process; (iii) coordinate with IA 4 to ensure adequate coordination of restructuring measures

and participation in the training measures offered to commercial banks; and (iv) monitor implementation of the restructuring plan and restructuring targets and

agreement between the Government and SBP, terminating all loans to and shareholding in SME Bank.

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4. Monitoring, Performance Management, and Auditing

85. Monitoring. To monitor implementation of the Program and the Project, the EA through the CPMU will liaise closely with the IAs, collect information from the IAs and other relevant sources, and prepare quarterly progress reports as well as an annual report. The CPMU will establish a performance monitoring system during inception of the Project. Within 3 months of completion, the Government will furnish to ADB completion reports providing a detailed evaluation of the SDP design, costs, consultants’ performance, social and economic impact, and other details as may be requested by ADB. 86. Accounting and Auditing. The EA and IAs will establish and maintain separate accounts for the SDP components in accordance with accounting and financial management procedures acceptable to ADB. Imprest accounts will be established for each of MOF, SBP, and SMEDA as described in Appendix 8. The steering committee will commission financial and performance audits of the CPMU and IAs and their accounts in accordance with auditing standards acceptable to ADB. Certified copies of the audited accounts and financial statements and the reports of the auditors will be submitted to ADB in English within 6 months of the end of each fiscal year. The CPMU will ensure that each IA submits reports on a timely basis and will consolidate the reports for transmission to ADB. F. Partial Credit Guarantee Facility

1. Rationale and Objective

87. Rationale. As described under Section II B5, “Issues and Opportunities,” the introduction of market-based products enhancing the channeling of existing liquidity of the financial system to SME lending is a key innovation supported under the SDP. ADB’s PCG facility, which in partnership with selected PFIs shares the credit risks and rewards associated with SME lending, will raise the comfort level of PFIs by (i) leveraging the PFIs’ resources, (ii) assisting PFIs to develop client relationships with smaller SME clients, and (iii) introducing international good practice for SME lending to Pakistan. The PCG facility will initially draw on international FIs based in Pakistan, which have experience in SME lending in other emerging markets. Once ADB has gained initial experience with the PCG, domestic FIs are expected to follow the international FIs and develop similar methodologies for SME lending. 88. Objective of the PCG Facility. The objective of the PCG facility under the SDP is twofold: first, to leverage through a market-based approach existing financial resources of the financial system for lending to an SME segment currently underserved by FIs; and second, to provide catalytic support for innovative financial products and approaches in new and less familiar markets. Once successfully tested with PFIs, such products will be expanded among a larger number of FIs. The expected outcome of the PCG facility is a higher volume of SME lending by commercial FIs in Pakistan. Details of the PCG facility are in Appendix 9.

2. Facility Design

89. Structure. ADB will share with PFIs, identified by ADB in a due diligence process, the credit risk of SME loans. ADB will issue PCGs to PFIs to guarantee repayment of an agreed portion of a loan portfolio. The PCGs will have agreed cover amounts and time frames to be selected following a due diligence process. The PCGs will detail the risk- and reward-sharing arrangements for individual loans within a defined portfolio of loans extended by the PFIs to SMEs. The loan portfolio covered under each PCG may be revolving, and the portfolio

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composition may change over time based on lending decisions of the PFI as agreed with ADB. ADB will not be involved in the lending decisions of the PFIs, but will agree with the PFIs on the lending selection and risk management process. To underscore the market approach, the PCG facility will be provided through ADB’s private sector operations without government counterguarantee. Terms and conditions will be market based. 90. Scope. The PCG facility is proposed to have an overall limit of $65 million. PCGs will be issued for each PFI based on demand and prudent practices, starting with lower amounts that can be gradually increased within the overall PCG facility limit. Sublimits will be set at up to $20 million equivalent for each PFI. Risk sharing with PFIs will take place on two levels on an individual loan basis. First, a first loss limit will be defined that will be fully absorbed by the PFI. The first loss will be a function of the strength of the financial institution, its past SME lending history, and its risk management systems. The level of first loss may be fixed between 0% for strong institutions with an established track record up to 30% for new market entrants. Second, any loss in excess of the first loss will be shared with the PFI at an agreed rate, normally 50%. 91. Prudent Phasing-in and Close Monitoring. Since the product is new both in Pakistan and for ADB, the PCG facility will commence operation with commercial FIs that have well-established underwriting procedures of an international standard and experience in similar lending methodologies elsewhere, before expanding to domestic FIs. Likewise, the portfolio of guaranteed loans will expand gradually. The tenor of guaranteed loans will be limited to 36 months, although initially the PCG will be targeted at shorter maturities. Once ADB is satisfied with the track record of the PFI and its SME borrowers, portfolio targets may be revised to encourage PFIs to expand further to riskier segments. 92. Guarantee limits with PFIs will be in US dollar terms under each PCG, but PFIs will extend loans to SMEs under the PCGs in local currency. Any risk as a result of currency fluctuations beyond the US dollar PCG limit for each PFI will be for the account of the PFI, since ADB’s risk exposure will be capped with the dollar amount to be specified in the guarantee agreement with each PFI. The PCG facility will be available for issuance of PCGs to PFIs for 5 years from the expected date of ADB approval, until 31 December 2008. 93. SMEs supported under the facility will be for example suppliers and vendors maintaining business with corporate clients of the PFIs, in industries that have reasonably integrated supply chain structures, such as the pharmaceutical, automobile, engineering, and consumer goods industries. For example, corporate entities in the pharmaceutical industry provide their products to about 200 pharmacies in Karachi alone. Many of these pharmacies have an annual business turnover of about PRs50 million to PRs150 million, but currently face constraints in accessing working capital. Larger pharmacies, wholesale distributors, and hospitals usually do not have difficulty in accessing credit. It is envisaged that most SMEs included in the guaranteed loan portfolio will not have a borrowing relationship with the PFI prior to the PCG agreement. The relation between the PFI and the SME may be established either through (i) confirmation of the PFI’s corporate client that the SME is one of its suppliers, vendors, or established clients; or (ii) a guarantee of the corporate client on behalf of the SME. Existing SME clients of the PFI may also be included if this entails an increase in their credit limit. Direct relationships of PFIs with SME clients are also encouraged within an agreed lending approach. PCGs issued to PFIs will be limited to SME loan portfolios. All financially sound FIs in Pakistan established in the private sector are eligible to access the facility, subject to a satisfactory due diligence result. 94. Pricing. The PFI will pay to ADB a predetermined fee either as a fixed rate based on the PFIs’ profit in lending to SMEs in the agreed portfolio and reviewed semiannually, or as a

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variable rate reflecting the PFIs’ profit as documented in the PFIs’ financial statements. The fee will be market based and determined for each PFI based on the risks identified during the due diligence process and the risk-sharing mechanism agreed between ADB and the PFI, as approved by ADB’s Guarantee Committee chaired by the Office of Cofinancing Operations. In accordance with market practice no front-end fee will be charged.

3. Implementation and Monitoring

95. Guarantee Agreements, Reporting, and Management by ADB. ADB will enter into PCG agreements with each PFI, which will define the portfolio to be covered including the PFI’s SME target benchmarks and the loss limit for that PCG. The conditions of each PCG will be determined on a case-by-case basis based on the due diligence of the PFI and its SME lending processes and operations. Terms and conditions for each PCG will be detailed in a term sheet in line with the parameters described in this RRP, subject to review by ADB’s Guarantee Committee and procedures detailed in a Guarantee Administration Memorandum (GAM) prior to its finalization. Each PCG agreement will follow a standardized format and detail the requirement for quarterly reporting, as well as prompt information on any potential losses or defaults in the portfolio. ADB will monitor the utilization of the PCG facility through semiannual on-site review of the PFIs’ exposure to SMEs, especially the portfolio quality underwritten by the PFIs and the PFIs’ meeting of agreed business targets of providing credit to additional lower segments of SMEs as reflected in the agreed business plans, and will allow monitoring compliance with negative lists. ADB has the option to modify existing guarantee parameters, with adequate notice, or suspend new SME loan inclusions under the guaranteed portfolio. 96. Guarantee Administration Memorandum. The GAM will be prepared by the South Asia Department and set out the respective responsibilities of ADB departments concerned (Office of Cofinancing Operations; Office of the General Counsel; Regional and Sustainable Development Department; Pakistan Resident Mission; Private Sector Operations Department; and Governance, Finance and Trade Division, South Asia Department) in the selection of PFIs and management of the facility, including developmental and commercial aspects, and the establishment of an environment management system as prescribed in ADB’s Environment Policy. 97. Loss Determination, Adjustment, and Claims Payment. Risks guaranteed under each PCG are losses, in accordance with the agreed loss-sharing ratios, which result from irrecoverable principal and interest payment default on loans included in the guaranteed portfolio. Losses are determined by the PFI in a transparent manner, which will include appropriate documentation of defaults of loans included in the guaranteed portfolio. ADB will reimburse the PFI for the guaranteed percentage of losses arising from guaranteed risks. Claims will be paid in Pakistan rupees, subject to the US dollar limit of the PCG for that PFI. 98. Safeguard Policies. The PCG facility is classified as “Financial Intermediary” for the purpose of compliance with ADB’s safeguard policies. ADB will establish an environment management system, which will be detailed in the GAM and specified for each PFI under the guarantee agreement to ensure PFIs’ adherence to ADB’s Environment Policy (2002) and Environmental Assessment Guidelines (2003) as well as to ADB’s policies on involuntary resettlement, indigenous peoples, and procurement. The GAM will also require PFIs under the guarantee agreements to acknowledge in progress reports that all borrowers comply with health, safety, and environmental regulations and standards as well as public consultation requirements applicable in Pakistan. Since the PFIs’ loans to SMEs will be largely in the trade and light-manufacturing sector, it is unlikely that involuntary resettlement or detrimental impacts

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on indigenous peoples will occur. As for environmental safeguards, ADB’s due diligence will identify areas for remedy, including negative lists and training as necessary.

IV. TECHNICAL ASSISTANCE

99. The TA will assist the Government and private sector stakeholders in the coordination of the SDP reforms. The total cost of the TA is estimated to be $315,000 equivalent, all in local currency. ADB will provide $250,000 equivalent on a grant basis from the ADB-funded TA program to cover part of the local currency cost of the TA. The Government will provide the remaining $65,000 through the provision of counterpart staff, offices, transportation, and incidental expenses. The TA will be implemented over 45 months. An individual consultant will be recruited in accordance with the Guidelines on the Use of Consultants and other arrangements satisfactory to ADB for the engagement of domestic consultants (Appendix 10). 100. ADB Implementation Arrangements. In addition to the consultant, ADB will support program implementation through a team including (i) a full-time professional staff person to be located at the Pakistan Resident Mission in charge of the day-to-day coordination of the SDP; (ii) the mission leader located in ADB’s South Asia Regional Department; and (iii) team members from the Private Sector Operations Department, Office of Cofinancing Operations, and the Office of the General Counsel to support implementation of the PCG facility. ADB will conduct jointly with the Government at least semiannual reviews.

V. PROGRAM BENEFITS, IMPACTS, AND RISKS

A. Benefits and Impacts 101. Policy. BDS and financial services directly enhance SME competitiveness and productivity, which have a direct positive impact on SME profitability and favorably impact job security and employment creation. The private sector BDS providers and the FIs will be able to favorably respond to policy reforms under the SDP. The SDP provides the framework for developing a consistent SME policy and provides a critical linkage of reforms with knowledge enhancement and financial resource flow to SMEs. The SDP also supports the creation of a level playing field in the financial sector through privatization of SME Bank and termination of SBP’s special relationship with SME Bank, consistent with SBP’s role of a regulator and the privatization efforts under the financial sector reform program. A strong CPMU supports the implementation of a consultative approach of policy development, and close coordination with stakeholders and within the Government. The policy reforms will:

(i) determine the role of the Government and the private sector in SME development by limiting the role of the Government to policy setting and facilitation, and supporting development of service markets by the private sector;

(ii) set a standard for labor protection and inspection for employers and employees through acknowledgment of basic labor rights, enhancing labor productivity, and reducing interference and costs of doing business through a policy of least intervention by the Government;

(iii) focus public sector institutions on policy support and facilitation; (iv) improve access of SMEs to BDS; (v) improve the FIs’ capacity and financial resource flow to serve SMEs; and (vi) terminate SME Bank’s role in the public sector through privatization.

27

102. Institutional. The SDP will support the rationalization and restructuring of two public sector institutions, SMEDA and SME Bank. SMEDA will, under the Program, follow a business plan to expand its outreach and policy support to SMEs, and its management will benefit from business rules enhancing its accountability for day-to-day operations. SME Bank will go through a substantial rationalization effort to reduce excessive cost and contingent liabilities to the Government, and start building the foundations for a viable bank followed by its privatization. 103. Outreach to Beneficiaries. SMEs in both the informal and formal sectors will be the beneficiaries of the SDP. It is estimated that about 8,000 SMEs will benefit from the operations of the BSF over the 5-year program period. It is expected that through the SME finance capacity-building program, four commercial FIs will establish dedicated SME finance units and will be able to benefit about 30,000 SMEs over the project implementation period. This will secure and generate substantial employment. 104. Safeguards. Since the major thrust of the SDP is on capacity building and no construction is involved, the SME SDP will not have adverse impacts on resettlement and indigenous peoples and the environment and will thus not trigger mitigating measures in accordance with ADB’s policies on indigenous peoples and on involuntary resettlement. Staff retrenchment at SME Bank will be addressed through severance packages, job counseling, and retraining to facilitate the reemployment of redundant staff. The summary poverty reduction and social strategy is in Supplementary Appendix 2. 105. With regard to the PCG facility, the compliance of the PFIs with ADB’s safeguard policies will be examined at due diligence of each PFI. However, because of the short-term nature of the loans guaranteed and the negative list applied, it is unlikely that the interventions under the PCG facility will trigger actions under ADB’s safeguard policies. B. Risks 106. The program design makes a number of assumptions with varying degrees of risk. It is assumed that Pakistan will not suffer from any adverse geopolitical changes affecting its external and internal stability. Furthermore, the Government is expected to remain strongly committed to the reforms undertaken since 1997, supporting the poverty orientation of public expenditure, the promotion of SMEs, and financial sector reforms. So far the Government has demonstrated strong ownership and maintains high priority for the development of SMEs. 107. The reforms involve a number of agencies and the private sector. The implementation risks have been addressed through the establishment of strong oversight, implementation, coordination, and governance provisions in the implementation framework. Reforms will be implemented through agencies experienced with other complex reform programs, while the establishment of a CPMU at MOF will ensure that implementation risks are properly managed. 108. Credibility of the reforms in the private sector and in society at large is essential. The program design mitigates the risk through the establishment of task forces representing stakeholders and through awareness building and consultation mechanisms in developing policy and disseminating the content. Public sector institutions also bear a risk of low public credibility and of politicization. To reduce this risk, lead institutions such as SMEDA will prepare and implement business plans, which are shared with the public. SME Bank will prepare and implement a restructuring plan followed by a privatization plan, which will be shared with the public once it is finalized. Support for public and private sector institutions under the SDP will be subject to scrutiny by of the steering committee and to regular performance audits.

28

109. SME Bank has been a politicized organization and staff values could adversely affect restructuring and privatization. Autonomy of management could be eroded and expected improvements in operations may not materialize. To mitigate these risks, the Government will agree to a restructuring plan, which involves a substantial upfront rationalization of staff and thus reduction of operational costs. In addition, credit management will be strengthened through the appointment of a new head for the SME business unit, which will lead the buildup of the new operations. Recruitment for the new business operations of SME Bank will be done in a transparent manner through the market. Support is also made contingent on the performance of and emphasis on operational restructuring and the tranching of the loan. 110. Overall program risks have been mitigated through utilization of a number of institutions, predominantly in the private sector. The use of institutions such as private sector FIs or private BDS providers puts the program foundation on a broader basis and thereby reduces the risk if an institution fails to deliver. The Program also adopts an approach of pilot testing BDS and financial services before rollout, thereby lessening the risk of failure. Finally, the SDP builds on existing initiatives of other funding agencies and thereby reduces the complexity of the Program. An overview of funding agency activities is in Supplementary Appendix 3.

VI. ASSURANCES

111. The Government has given the following assurances, in addition to the standard assurances, which have been incorporated into the program and project loan documents:

(i) The Government will maintain the policies adopted and actions taken prior to the date of the Loan Agreement for the SME SDP and promptly adopt the other policies and take the other actions included in the SME SDP, in each case as described in the development policy letter and the policy matrix, and ensure that such policies and actions continue in effect for the duration of SME SDP and subsequently.

(ii) The Government through SMEDA will ensure, with respect to the SME policy

task force at MOIP, (a) wide private sector participation through the establishment of private sector-led subcommittees to identify policy issues and solutions for key areas of the SME policy, and (b) consultation with provincial governments and consideration of reforms ongoing at the provincial level.

(iii) The Government will ensure, with respect to the task force at MOL, (a) an active

consultation process with wide stakeholder participation, including representatives of employee and employer groups, provincial governments and consideration of reforms ongoing at the provincial level as appropriate, and (b) that core labor standards 18 are the guiding principles in the labor protection policy and the labor inspection policy.

(iv) The Government will ensure that (a) the BSF is incorporated under Section 42 of

the Companies Ordinance, 1984 within 3 months of loan effectiveness; (b) the board of directors of BSF includes nine directors with at least six representatives of the private sector, one of whom will be the chairperson, and the remainder

18 Core labor standard include (i) freedom of association and the effective recognition of the right to collective

bargaining; (ii) the elimination of all forms of forced or compulsory labor; (iii) the effective abolition of child labor; and (iv) the elimination of discrimination in respect of employment and occupation.

29

representing the Government; and (c) immediately following incorporation, the board of directors approves the business plan, standard operating procedures, conflict of interest rules, and code of conduct for staff and directors.

(v) The Government will ensure that (a) SBP’s shareholding in SME Bank is

terminated through the purchase of SBP-held shares by shareholders or otherwise, (b) SME Bank will repay PRs7 billion in loans to SBP in agreed phases over the program period and (c) the Government will repay the remainder of SME Bank loans to SBP.

(vi) The Government will ensure that the proceeds of the first tranche of the loan and

a portion of the second tranche of the loan will be retained by SBP for repayment of the SME Bank liabilities.

(vii) The Government will ensure that SME Bank is restructured in accordance with

the financial and operational restructuring plans and the plans for Government disengagement from ownership set out in the restructuring plan and the agreed restructuring targets.

(viii) A banking license will only be issued to SME Bank upon compliance with all

applicable SBP regulations and satisfaction of agreed19 restructuring targets for the incentive tranche.

(ix) Notwithstanding any other provision of the SME SDP Loan Agreements or

covenants, and except as ADB may otherwise agree, SME SDP disbursements will temporarily stop if SME Bank fails to achieve the agreed performance indicators in the restructuring plan, until a special financial review mission of ADB will have carried out a financial and operational review of SME Bank, and an agreement is reached between ADB, SME Bank, and the Government regarding the recommendations of this review mission.

112. Additional assurances for the project loan include:

(i) The Government will ensure that the BSF will, immediately following its

incorporation, enter into an agreement with ADB setting out the responsibilities of BSF.

(ii) The Government will ensure that, until SME Bank is sold to the private sector,

SME Bank will exercise its magisterial powers under the Land Revenue Act only as a last resort after ordinary legal recourse and at all times not exceeding the powers given thereunder.

113. Conditions for Effectiveness of the Program Loan. The following conditions for loan effectiveness have been incorporated into the Loan Agreement:

(i) the project Loan Agreement will have been duly executed and delivered on

behalf of the Borrower, and all conditions precedent to its effectiveness (other

19 These measures include agreed (i) reduction in the number of recovery branches, (ii) rationalization of employment

of regular staff, (iii) settlement of liabi lities to SBP, and (iv) appointment of the head of the SME business unit.

30

than those requiring the effectiveness of the program Loan Agreement) will have been fulfilled;

(ii) the CPMU will have been established, adequately staffed, and assigned proper

functions and powers to the mutual satisfaction of the Government and ADB;

(iii) each of SBP, SME Bank and SMEDA will have entered into the Program Agreement with ADB; and

(iv) the outstanding conditions for release of the first tranche have been met.

114. Condition for Effectiveness of the Project Loan. The following conditions for loan effectiveness have been incorporated into the Draft Loan Agreement:

(i) the Project has been duly approved by the competent authority; and (ii) each of SBP, SME Bank and SMEDA will have entered into the Project

Agreement with ADB.

VII. RECOMMENDATION

115. I am satisfied that the proposed loans and partial credit guarantee facility would comply with the Articles of Agreement of ADB and recommend that the Board approve:

(i) the loan of ¥16,436,520,000 to the Islamic Republic of Pakistan for the Small and Medium Enterprise Sector Development Program from ADB’s ordinary capital resources with interest to be determined in accordance with ADB’s LIBOR-based lending facility; a term of 15 years, including a grace period of 3 years; and such other terms and conditions as are substantially in accordance with those set forth in the draft Loan and Program Agreements presented to the Board;

(ii) the loan in various currencies equivalent to Special Drawing Rights 12,501,000 to

the Islamic Republic of Pakistan for the Small and Medium Enterprise Sector Development Project from ADB’s Special Funds resources with an interest charge at the rate of 1% per annum during the grace period and 1.5% per annum thereafter; a term of 32 years, including a grace period of 8 years; and such other terms and conditions as are substantially in accordance with those set forth in the draft Loan and Project Agreements presented to the Board; and

(iii) the partial credit guarantee facility for market-based SME finance, without

counterguarantee, in an amount not exceeding $65,000,000, to guarantee to participating financial institutions repayment of an agreed percentage of loans in an agreed portfolio, on such terms and conditions as are substantially in accordance with those set forth in this report, and as may be reported to the Board.

Tadao Chino President

28 November 2003

Appendix 1

31

PROGRAM FRAMEWORK

Design Summary Performance Indicators and Targets Monitoring Mechanisms Assumptions and Risks Goal Improve economic growth, employment and poverty reduction

• Poverty reduced from 33% to 15% in 2011 • Economic growth increased to 5% p.a. • Private sector contribution to GDP increased • Government reduces fiscal risks through

disengagement from ownership in FIs

• National statistics • PRSP update reports • Government reports

• No major adverse geopolitical

changes affecting Pakistan’s stability

• Government remains committed to PRSP reforms

• Positive association exists between private sector growth and poverty reduction

Purpose/Objectives Improve SME competitiveness

• Export volume of exporters with turnover up to $5

million p.a. • Volume of FIs’ loans to SMEs exceeds 25% of total

loans provided FIs FY 2009

• National statistics • EPB/MOC reports • SBP statistics • Economic Census 2004

• Business climate does not

deteriorate • Private sector access to transport,

communications, and utilities does not deteriorate

Output 1. Improve SME Policy Environment

KRA 1.1 Develop SME Policy KRA 1.2 Establish Effective Labor Protection and Inspection Policies KRA 1.3 Enhance SMEDA’s Effectiveness and Outreach to SMEs

• Task force prepares SME policy in consultative process by June 2005

• Government implements SME policy • Task force established to develop LPP and LIP

(October 2003) • Government issues LPP and LIP, and commences

implementation (June 2005) • Government revises LPP and LIP parts of the

Factories Act (December 2006) SMEDA to: • assume policy advisory and facilitator role • establish effective internal controls • perform in accordance with performance

benchmarks and BP • approve and revise business rules (June 2005) • publish business registration and licensing

guidelines in Urdu (June 2005) • establish SME database (December 2006) and

conduct sample surveys for policy impact analysis • prepare BP and SOP for common facility center

(CFC) program (June 2004) • perform consistent with its BP and CFC BP and

performance benchmarks

• Task force composition and TOR for SME policy

• SME annual report • SME policy document • Publication of task force

composition and TOR for LPP and LIP

• Publication of policies • Progress reports of CPMU • SMEDA strategy and business

plan • SMEDA business rules • SMEDA analytical reports • External and internal audit

reports • Progress reports of CPMU • Independent performance and

financial audit of CFC program by firm associated with international audit firm

• Continued government support for policy development

• Effective representation of private sector in SME policy development

• SMEDA is capable to run the CFC

program

32

Appendix 1

Design Summary Performance Indicators and Targets Monitoring Mechanisms Assumptions and Risks Output (continued) 2. Improve Market-based

SME Access to BDS KRA 2 Enhance SME Competitiveness Through Private Sector Services

• MOF to select private sector establishment committee for SME BSF finalizing (i) memorandum of articles for incorporation for BSF, (ii) BP and SOP for BSF board

• BSF established (June 2004) • BSF to perform consistent with the BP and SOP

semiannual reviews, starting June 2005

• Independent performance and financial audit of BSF by firm associated with international audit firm (October 2006)

• Effective private sector representation in BSF

• Effective BSF fund utilization and management

3. Improve Market-based Access to and Delivery of SME Finance

KRA 3.1 Improve Regulatory and Credit Information Infrastructure and Build Private FI Capacity KRA 3.2 Restructure and Privatize SME Bank

• Regulations for SME and consumer finance • SBP effectively lender of last resort to SME Bank • Improved credit information system (December

2006) • Feasibility study on secured transactions (June

2005) • SME Bank implements agreed restructuring plan • SME Bank implements agreed privatization plan • Number of FIs and volume of credit to SMEs • Delivery of courses in SME finance

• SBP circulars and reports • Feasibility study reports • Restructuring plan • Privatization plan • Quarterly progress reports • External performance and

financial audits • Consulting reports

• FIs recognize commercial market potential for SME finance and invest in building dedicated capacity to serve this market segment

• Government commitment to privatization of SME Bank

Inputs and Activities 1. Program Loan 2. Project Loan for a. Policy formulation (i) SME policy (ii) Labor policy

b. SME BSF c. SME finance

(i) Regulatory policy, credit information, and capacity building for FIs

(ii)SME Bank restructuring

3. PCG facility 4. TA for program

coordination 5. CPMU and IA staffing

and budget

• Effective loans ($152 million OCR/$18 million ADF) • SME policy: 1.5 months international, 11 months

domestic consultants • Labor policy: 6 months international, 20 months

domestic consultants, stakeholder seminars • SME BSF: 32 months for international facility

manager, 8 permanent domestic staff, fund • SME Finance: 140 months international, 200

months of domestic consultants, stakeholder seminars

• SME Bank:24 months international consultant • PCG facility ($65 million); agreements with PFIs • TA letter agreement ($0.25 million) • Full functionality of CPMU (238 months domestic

consultants) and units under MOF, MOL, MOIP, SMEDA, SBP

• Program documents and agreements

• TA letter agreement signed,

consultant fielded

• Timely effectiveness • Consultants are selected in an

early stage and effectively conduct tasks

ADF = Asian Development Fund, BP = business plan, BSF = Business Support Fund, BDS = business development services, CD = cluster development, CEO = chief executive officer, CPMU = core program management unit, CV = curriculum vitae, EPB = Export Promotion Bureau, FI = financial institution, GDP = gross domestic product, IA = Implementing Agency, KRA = key result area, LIP = labor inspection policy, LPP = labor protection policy, MOC = Ministry of Commerce, MOIP = Ministry of Industries and Production, OCR = ordinary capital resources, p.a. = per annum, PCG = partial credit guarantee, PFI = participating financial institution, PRSP = Poverty Reduction Strategy Paper, SBP = State Bank of Pakistan, SME = small and medium enterprise, SMEDA = Small and Medium Enterprise Development Authority, SOP = standard operating procedures, TA = technical assistance, TOR = terms of reference. Source: Asian Development Bank Staff.

Appendix 2 33

DEVELOPMENT POLICY LETTER AND POLICY MATRIX

34 Appendix 2

Appendix 2 35

36 Appendix 2

Appendix 2

37

POLICY MATRIX – TRANCHE RELEASE ACTIONSa

First Tranche

Incentive Tranche (within 7 months of first

tranche release)

Second Tranche (within 18 months of first tranche

release)

Third Tranche (within 18 months of second

tranche release) Policy Outcome 1: Improve SME Policy Environment KRA 1.1 Develop SME Policy

• Government to establish task force including private sector stakeholders to develop SME Policy

• Government to (i) submit detailed process and time bound action and resource plan for consultative preparation and implementation of SME policy; (ii) issue SME policy specifying the role of the private and public sector in SME development, and (iii) implement action and resource plan

• Statistics Division of the Ministry of Economic Affairs and Statistics to publish Economic Census

• Government to implement SME policy in accordance with the priorities set out in the time bound action and resource plan, including publication of first annual report on SME development in Urdu

KRA 1.2 Establish Effective Labor Protection and Inspection Policies

• Government to notify in the public Gazette the constitution of a task force in the MOL, responsible for developing national LPP and LIP; and task force to endorse action plan for passage of the LPP and LIP

• Cabinet to approve and publish LPP and subsequently LIP and to advise implementation by provincial governments

• Task force to initiate awareness-raising workshops on LPP and LIP at the provincial level

• Government to prepare a draft amendment to the Factories Act to reflect LPP and LIP as required, and Ministry of Law to have vetted draft amendment

KRA 1.3 Enhance SMEDA’s Effectiveness and Outreach to SMEs

• SMEDA Board to appoint a full-time professional CEO and CEO to assume office

• SMEDA to (i) prepare final draft

of SMEDA’s 5-year business plan; and (ii) establish in- house secretariat for SME policy task force

• SMEDA Board to (i) approve business rules; (ii) revise business rules based on experience, (iii) approve SMEDA business plan, and (iv) approve 5-year business plan and standard operating procedures for Cluster Development - CFC Program

• SMEDA to perform consistent with SMEDA and CFC business plans and meet benchmarks of both plans

• SMEDA to publish essential business registration and licensing guidelines in Urdu

• SMEDA to establish (i) SME database and analysis based on results of Economic Census, and (ii) mechanism for periodic sample surveys to enable analysis of policy issues and measure impact of policy actions

• Government, through Steering Committee, to conduct independent performance and financial audit of CFC Program by firm associated with international audit firm

Policy Outcome 2: Improve Market-based SME Access to BDS KRA 2 Enhance SME Competitiveness Through Private Sector Services

• Government to constitute private sector led task force to establish the SME BSF for finalizing the memorandum and articles of association for incorporation under Section 42 of the Companies Ordinance, the business plan, and the SOP

• BSF to perform consistent with the business plan and SOP, approved by its board of directors upon incorporation

• Government, through Steering Committee, to conduct independent performance and financial audit of BSF by firm associated with international audit firm

a Release of incentive, second, and third tranche conditional on continued compliance with previous tranche conditions, satisfactory to Asian Development Bank.

38 A

ppendix 2

First Tranche

Incentive Tranche (within 7 months of first

tranche release)

Second Tranche (within 18 months of first tranche

release)

Third Tranche (within 18 months of second

tranche release) Policy Outcome 3: Improve Market-based Access to and Delivery of SME Finance KRA 3.1 Improve Regulatory and Credit Information Infrastructure and Build Private FI Capacity

• SBP to issue prudential regulations for SME finance and consumer finance

• Agreement between

Government, SBP, and SME Bank to terminate all SBP loans to and shareholding at SME Bank in the approved restructuring plan

• SBP to have terminated equity participation in SME Bank

• SBP to (i) review performance of FIs in SME Finance; (ii) revise prudential regulations if necessary, and (iii) conduct feasibility study and prepare action plan for expanding outreach of credit information coverage to enterprises and individuals b

• SBP to (i) conduct workshops/meetings

to raise awareness among FIs on innovative approaches for SME finance; and (ii) assist FIs in building dedicated SME finance capacity

• SBP to initiate implementation of credit information action plan including roles for public and private sector based on feasibility study

• SBP to have become lender of

last resort through full repayment of all SME Bank credit lines to SBP

•

KRA 3.2 Restructure and Privatize SME Bank

• Government and SME Bank Board to approve, in consultation with ADB, Restructuring Plan consistent with restructuring targets (including branch and staff reduction targets, results of the portfolio audit and agreement to sell SME Bank to the private sector)

• SME Bank to (i) announce

branch reduction plan consistent with restructuring targets, (ii) offer VSS to all regular staff, and (iii) repay First Tranche agreed amount to SBP to reduce SME Bank’s liabilities

• SME Bank to have implemented Restructuring Plan consistent with restructuring targets for (i) reduction of recovery branches, (ii) limitation of new business branches, (iii) completion of HR audit and reassignment of staff, (iv) limitation of number of nonregular staff; (v) rationalization of employment of regular staff, and (vi) appointment of the head of the SME business unit

• SME Bank to (i) have implemented Restructuring Plan consistent with restructuring targets; and (ii) repay Second Tranche agreed amount to SBP to reduce SME Bank’s liabilities

• Government to (i) prepare, approve and

initiate implementation of SME Bank Privatization Plan; and (ii) conduct independent performance and financial audit of SME Bank by firm associated with international audit firms

• Government to have followed sequencing and timing of the Privatization Plan to bring SME Bank to the point of sale

• SME Bank to (i) have implemented Restructuring Plan consistent with restructuring targets; and (ii) repay Third Tranche agreed amount to SBP to fully repay SME Bank’s liabilities to SBP

• Government to ensure that an

independent performance and financial audit of SME Bank is conducted by a firm associated with international audit firms

BSF = Business Support Fund, CEO = chief executive officer, CFC = Common Facility Center, FIs = financial institutions, HR = human resources, KRA = key result area, LIP = Labor Inspection Policy, LPP = Labor Protection Policy, MOL = Ministry of Labor, SBP = State Bank of Pakistan, SME = small and medium enterprise, SMEDA = Small and Medium Enterprise Development Authority, SOP = standard operating procedure, VSS = Voluntary Separation Scheme. b Feasibility study being financed under a World Bank loan. Source: ADB Mission and Government of the Islamic Republic of Pakistan.

Appendix 3 39

SME BANK LIMITED

1. Legal Framework, Ownership and Basic Objectives. On 1 January 2002 the Government merged two failed development finance institutions (DFIs), the Regional Development Finance Corporation and the Small Business Finance Corporation into SME Bank, a public limited company, pursuant to the RDFC and SBFC Amalgamation and Conversion Ordinance 2001. SME Bank inherited PRs9.5 billion of nonperforming loans (the “old portfolio”). The Bank’s main function is to provide term credit to SMEs. Despite its mandate, loan exposure is only 0.5% of the total SME loans provided by the banking system. Seriously undermined by the burden inherited from its precursor institutions, its operations have never been profitable. The Government believes that it is vital that SME Bank continues to provide financing to SMEs, especially to the underserved lower end of SMEs with annual revenues of up to PRs100 million and maximum loan size of PRs10 million. 2. Ownership and Management. The share ownership of SME Bank was determined by the proportional amount of ownership by the shareholders in Regional Development Finance Corporation and Small Business Finance Corporation and the net asset values of the two banks as of 31 December 2001. The total authorized share capital is PRs10 billion consisting of PRs1 billion of ordinary shares of PRs10 each. Through direct ownership—57.1%—and indirect ownership—(State Bank of Pakistan [SBP] 12.8%), National Bank of Pakistan (2.6%), and Habib Bank (8.2%)—the Government owns the majority of the Bank. The board of directors consists of seven members including the chief executive officer, two government officials, two presidents of state-owned banks, and two presidents of privatized banks. The management consists of the president and seven executive directors. Means available to the management for assessing liquidity, interest rate, and credit risks are weak. 3. Organization and Staffing. From its head office in Islamabad, SME Bank operates four provincial offices and 59 branches, and a leasing subsidiary with seven branches. Most branches are used for loan recovery. The Bank inherited approximately 1,000 employees with regular employment status, of which almost none have proper lending skills. About 900 of the employees have been assigned to recover loans from the old portfolio. Despite their low qualifications, the staff benefit from above-market salary and benefit packages and can be considered SME Bank’s largest liability. Since there has been only a limited change in staff, recent operations have shown that the proportion of classified loans of the new loan portfolio has substantially increased. It is assumed that portfolio quality will further deteriorate unless a significant change is introduced. 4. Lending Policies and Procedures. SME Bank provides term loans of up to 7 years, at an average term of 3 years and an average size of about PRs0.4 million. Branches and regional offices have loan approval authority ranging up to PRs0.2 million and from PRs0.2 million–0.3 million to PRs2.0 million, respectively, while headquarters approves all other loans. Loans are primarily approved on the basis of collateral. There is no formal policy for offering differential interest rates based on the client’s credit rating, term, or type of lending. The average interest rate for all loans is about 13%. Based on the bank’s cost of funds, historical loan defaults, and recovery, it is believed that the loans are priced at a loss. SME Bank’s income recognition and provisioning for bad debts are in compliance with SBP prudential regulations. For loans more than 90 days overdue, the income accrual is suspended and the loans are categorized as “other assets especially mentioned.” Long-term loans delinquent for more than 365 days are classified as substandard, 730 days as doubtful, and above 3 years as loss. SBP requires that provisions be made for 20% of substandard accounts, 50% for doubtful debts, and 100% for the loss category. Provisioning for loan losses as of year-end 2002 was PRs6.7 billion or 76% of the old portfolio. Recoveries from the old portfolio amounted to PRs1.4 billion over SME Bank’s 18 months until June 2003, and 11% of the new portfolio are classified loans only after 18 months

40 Appendix 3

of operation. SME Bank’s portfolio quality has been affected by (i) weak loan appraisal, (ii) absence of credit risk management, and (iii) inadequate internal audit controls. The bank’s efforts for collection of the overdue loans related to its new operations have been modest. 5. Resource Mobilization. Total assets increased marginally since SME Bank’s creation. Deposits as part of Regional Development Finance Corporation’s activities dropped by 50%, since SME Bank lacks a banking license. Receiving 83% of its resources in June 2003 through interest-free loans, SME Bank enjoys special privileges from SBP, which were invested in profitable government bonds (Table A3.1).

Table A3.1: SME Bank Summary of Assets and Liabilities (PRs million)

Item

Opening Balance

1 Jan 2002a

31 Dec 2002

30 Jun 2003b

Composition 30 Jun 2003

(%)

Change Jan–Dec 2002 (%)

Change Jan–June 2003 (%)

Total Assets 15,052.7 15,140.3 15,212.4 100 0.6 0.5 Loans 3,139.8 2,597.5 2,506.8 16 -17.3 -3.5 Old Portfolio 9,542.6 8,837.0 8,365.7 -7.4 -5.3 Provisions (6,768.4) (6,712.9) (6,733.3) -0.8 0.3 Net Old Portfolio 2,774.2 2,124.1 1,633.4 11 -23.4 -23.1 Net New Loans 365.6 473.5 874.4 6 29.5 84.9 Investments 4,227.1 6,773.5 7,657.4 50 60.2 13.0 Cash and Short-Term Investments

3,243.6

1,263.8

863.8 6 -61.0 -31.7

Receivable from SBP 3,764.8 3,521.2 3,352.6 22 -6.5 -4.8 Other Assets 677.4 984.4 831.8 5 45.3 -15.5 Total Liabilities and Equity 15,052.7 15,140.3 15,212.4 100 0.6 0.5 Advances from SBP 13,261.8 12,882.6 12,686.5 83 -2.9 -1.5 Deposits from Customers 478.6 447.1 242.4 2 -6.6 -45.8 Other Liabilities 1,330.4 835.3 1,170.0 8 -37.2 40.1 Equityc (18.2) 975.3 1,113.5 7 14.2 SBP = State Bank of Pakistan. a The SME Bank was formed on 31 October 2001 but was not operational until 1 January 2002. b Unaudited results. c Includes surplus on revaluation of investment of PRs576 million for 31 December 2002 and PRs711 million for 30

June 2003. Source: SME Bank. 6. Profitability. During 2002, SME Bank reported a net profit of PRs34 million. A substantial portion of the profit was generated from investment income. After adjustments for investment income, SBP share of profits, and taxes paid, the banking operations generated a net loss of PRs390 million. For the 6 months of 2003, SME Bank reported a net profit of PRs30 million and banking operations registered a net loss of PRs147 million (Table A3.2).

Table A3.2: SME Bank Profitability (PRs million)

Item Jan–Dec 2002 Jan–June 2003a Income from Banking Operations 817 426 Income from Investments 725 352 Interest Expense 81 4 Administrative and Other Operating Expenses 798 281 Provisions for Doubtful Assets 368 292 Net Profit/Loss 34 30 Return on Total Assetsb 0.2% 0.2% a Unaudited results. b Based on actual year-end figures. Source: SME Bank

Appendix 3 41

7. Accounting and Management Information System (MIS). SME Bank follows accounting standards consistent with the requirements for the banking industry. The income, borrowing costs, interest on deposits, and other expenses are accounted on an accrual basis. The accrued interest for a loan that is delinquent for more than 90 days is reversed from the income account and transferred to a suspense account. Independent external auditors audit the annual accounts. The MIS and information technology (IT) platform are outdated. In the absence of network information systems, information gathering from branches is characterized by delays and inaccuracies. A fully automated banking system is now being implemented. 8. Restructuring SME Bank. The SME Bank board of directors and the Government decided that it is necessary to restructure SME Bank, since (i) its operation is not sustainable; (ii) there is a need to meet the demand for financial services for the underserved lower end of the SMEs; and (iii) the bank’s financial weakness deters SME lending. To determine the scope of the restructuring, an audit was performed by Taseer Hadi Khalid & Co., a firm associated with KPMG. The plan indicates that operating self-sufficiency of banking operations could be obtained by implementing a plan, which includes substantial reductions in the number of regular staff and branches. The Government and SME Bank management prepared a restructuring plan aiming at SME Bank’s privatization within a 3-year period. The business will be reorganized into an SME business unit and a distressed portfolio recovery unit. Additionally, the plan includes (i) a time-bound action plan to reduce the number of bank branches and rationalize staff of the recovery unit to a sustainable cost level; and (ii) an independent human resources audit to (a) evaluate the skills of the employees at the bank; (b) identify and match skills for specific jobs within the bank; (c) identify alternative job opportunities for employees; and (d) provide job-search assistance and reemployment training for personnel. Performance benchmarks are summarized in Table A3.3.

Table A3.3: SME Bank Restructuring Targets

Item Dec 2003 Jun 2004 Jun 2005 Jun 2006 Staff Rationalization Targets (confidential) Branch Rationalization and Development Distressed Assets Unit 59 25 15 3 SME Business Unit 0 8 10 14 Total Branches 59 33 25 17 Termination of Borrowing from SBP (PRs million) Net loans from SBP (opening balance) 9,334 4,000 4,000 2,000 Repayment by SME Bank 3,000 2,000 2,000 Repayment by Government 2,334 Net loans from SBP (closing balance) 4,000 2,000 0 Financial Performance Targets Maximum New Loan Portfolio Outstanding (PRs million) 1,500 2,700 4,000 Recovery of Old Loan Portfolio (PRs million) 500 600 400 Loan Loss Provisioning as % of Loans Disbursed for New Loans 5 5 5 5 Maximum New Loan Portfolio At Risk in % of new Loan Portfolioa 15 10 5 5 Liquidity: Loans/Deposits and Borrowings (%) 30 50 80 Provisioning of Loans Past Due > 365 days (%) 100 100 100 Growth of New Loans in % Over Previous FY (%) 80 45 Growth of Deposits in % Over Previous FY (%) 200 85 SBP = State Bank of Pakistan, SME – small and medium enterprise a Portfolio at risk is defined as past dues of 90 days and above. Source: ADB and SME Bank.

42 Appendix 4

SUBPROJECT 1: POLICY FORMULATION AND IMPLEMENTATION1 A. Component 1.1: Small and Medium Enterprise Policy Development

1. Background and Rationale 1. Pakistan’s poverty reduction strategy has explicitly identified the small and medium enterprise (SME) sector as one with strong potential for poverty reduction. A developed and appropriately supported SME sector can facilitate poverty reduction by generating new enterprises, employment, and labor productivity, thereby increasing competitiveness, improving income distribution, broadening the accumulation of wealth, and cushioning business cycle effects. It is essential to develop an SME policy to recognize and promote appropriate mechanisms by which the poverty-reduction impact of SME promotion can be maximized. The Ministry of Industries and Production (MOIP) through the Small and Medium Enterprise Development Authority (SMEDA) has taken on the mandate to prepare the SME policy. The SME policy will reflect the Government’s objective of encouraging SME development and competitiveness, by specifying the role of the private and public sectors in SME development and institutionalizing SME support. 2. Task Force. The SME policy will require inputs from a wide range of stakeholders. To develop the SME policy, MOIP will establish a task force (TF) chaired by the Secretary of MOIP, which will comprise representatives from the following organizations:

(i) MOIP; (ii) Ministry of Commerce; (iii) Ministry of Finance; (iv) State Bank of Pakistan (SBP); (v) Ministry of Labour, Manpower and Overseas Pakistanis (MOL); (vi) Export Promotion Bureau; (vii) provincial economic development departments; (viii) chambers of commerce; (ix) industry and trade associations; (x) professional organizations; (xi) financial institutions; and (xii) private sector representatives of SMEs and/or SME organizations from each

province. 3. The TF will determine its rules of business (and may determine that private sector representatives will be nonvoting members). Other organizations and individuals can be invited to join the TF at the discretion of the TF. The TF may also invite written submissions from the general public. MOIP has appointed SMEDA to maintain the secretariat functions for the TF including maintaining records of meetings, providing administrative support and, under the guidance of the TF, assisting in the preparation of drafts of the SME policy. 4. The purpose of the SME policy is to:

(i) develop a definition of SME, based on numbers of employees and/or annual turnover, including subdivisions into different sizes of SMEs, and determine

1 Costs and financing of the subproject are summarized in Appendix 7. Implementation arrangements of the

subproject are detailed in Appendix 8.

Appendix 4 43

whether and how the definition should vary for different purposes, such as registration, financial assistance, access to support services, and industry specifics ;

(ii) define the roles of different stakeholders in SME support, including national ministries, provincial and local government departments, private sector SME and SME organizations, employer and worker organizations, academia, and nongovernment organizations; and adopt a least-intervention government approach;

(iii) institutionalize the SME support system to ensure regular communication between the national, provincial, and local governments and the target stakeholders through (a) permanent national policy committee, (b) regular coordination among different levels of government and different ministries/departments, (c) regular monitoring and independent evaluation, (d) continuous absorption and integration of international experience to refine the support system, and (e) biannual report to Parliament on SME development;

(iv) communicate legislation and its purpose effectively through the dissemination of policy, regulation and support services, and timeliness of translation of laws into appropriate regulations utilizing local language;

(v) identify and address major demand-side SME concerns including (a) business environment (regulation, inspection, annual fiscal policy changes, and region-specific concerns), (b) competitiveness (including adequate human resources and access to premises), and (c) access to finance; and

(vi) expand support services through encouraging private sector providers, start-up assistance, assistance to companies, sole proprietorships and partnerships, technology transfer, competitiveness research, and international trade.

5. Developing SME Policy. The TF will (i) draft an issues paper, (ii) draft the SME policy, and (iii) consult with key stakeholders including SMEs and SME organizations in each province on each draft of the SME policy. 6. Development and Implementation of Action Plan. The TF will present a detailed process and time-bound action and resource plan for consultative preparation and implementation of the SME policy to the minister of industries and production by 30 June 2004. The TF will operate in accordance with the time-bound action plan. The TF will submit the final SME policy to the minister by June 2005. By December 2006, the Government will implement the SME policy in accordance with the priorities set out in the time bound action and resource plan, including publication of the first annual SME report in Urdu.

2. The Assistance: Objectives and Scope 7. The Project will provide consulting services to SMEDA and the TF in developing the SME policy. The objective of the assistance is to support the TF in the timely development and dissemination of the SME policy through:

(i) advice to the TF and other stakeholders on international good practice; (ii) support and facilitation of activities building stakeholder consensus; (iii) collaboration with MOIP, TF, the core program management unit, and Asian

Development Bank (ADB) on any policy or implementation issues and recommendation of specific remedies;

(iv) development of a consistent policy document and a focused action plan reflecting priorities of SME policy; and

44 Appendix 4

(v) assistance to organize and moderate discussions and workshops with stakeholders and sharing of relevant information with the public.

3. Consulting Services

8. The implementing agency will be SMEDA. The assistance will be implemented intermittently over 36 months. An international SME policy specialist (1.5 months), and domestic SME specialists (11 months) will support the TF. SMEDA will provide office facilities for the consultants. The consultants will have expertise in policy development and will be selected by the implementing agency after concurrence by ADB on an individual basis in accordance with ADB’s Guidelines on the Use of Consultants and other arrangements for the engagement of domestic consultants acceptable for ADB. Besides the terms of reference, the consultants will prepare quarterly progress reports and a final report at the end of the task. 9. The consultants will provide the following services to the TF:

(i) assist private sector led policy advisory groups in identifying issues, solutions and priorities for action, and assist in preparing concise recommendations for policy reform;

(ii) assist the TF in drafting an SME policy in a consultative process; (iii) assist the Government in issuing the policy and preparing and action and

resource plan for its implementation; (iv) improve depth and accuracy of statistics to monitor SME policy impact, including:

(a) developing a plan to conduct an SME survey on annual basis; (b) designing a database for an SME survey and recommending the

parameters that should be included in the database; (c) designing an SME survey and choosing a firm to conduct the first or

baseline survey; (d) designing a computer database to permit SME information to be retrieved

when needed and for yearly statistics to be combined or analyzed; and (e) developing a detailed plan for publishing and distributing the survey.

B. Component 1.2: Labor Protection and Inspection Policy Development

1. Background and Rationale 10. MOL has undertaken the mandate to prepare a labor protection policy (LPP) and labor inspection policy (LIP). The policies fall within a hierarchy of policies under which national development policies determine national labor policy. The national labor policy will determine the LPP, which sets the framework for the LIP. The LPP and LIP will reflect the Government’s objective of promoting business opportunities, enhancing productivity, and improving competitiveness, and ensuring that workers are adequately protected and benefit from the nation’s economic progress. 11. Task Force. To develop the LPP and LIP, MOL has established a TF chaired by a senior representative of MOL, which will comprise representatives from the following organizations:

(i) MOL; (ii) Ministry of Finance; (iii) MOIP;

Appendix 4 45

(iv) Ministry of Commerce; (v) Ministry of Social Welfare and Women’s Development; (vi) provincial labor departments; (vii) Pakistan Employers’ Federation; (viii) Pakistan Federation of Trade Unions; (ix) All Pakistan Federation of Labor; and (x) Workers Employers Bilateral Council of Pakistan.

12. Other organizations and individuals can be invited to join the TF at the discretion of the chairperson and the TF itself. The TF may also invite written submissions from the general public. MOL will appoint a secretary and support staff to the TF, who will be responsible for maintaining records of meetings, providing administrative support and, under the guidance of the TF, assisting in the preparation of LPP and LIP drafts. 13. Developing LPP. The TF will draft a policy titled Labor Protection Policy 2004 and consult with key stakeholders including representatives of employers and workers and provincial labor departments on the draft, finalize the LPP, and submit the final LPP to the minister of labor by 31 March 2004. The purpose of the LPP is to ensure that workers’ rights are protected, working conditions are fair, and enterprise efficiency and competitiveness are encouraged. The objectives of the LPP are to:

(i) protect workers in all sectors engaged under various employment arrangements including (a) formal employment contracts, (b) self-employment, (c) agricultural and informal sector, (d) seasonal, and (e) home work;

(ii) contribute to labor productivity enhancement, and assist enterprises to become more efficient and competitive; and

(iii) alert employers, workers, potential investors, and the international community that Pakistan is committed to improving labor protection as part of its development strategy.

14. Developing LIP. Draft a policy titled Labor Inspection Policy 2004 and consult with key stakeholders including representatives of employers and workers and provincial labor departments on the draft, finalize the LIP based on consultations as required, and submit the final LIP to the minister of labor by 30 September 2004. 15. The purpose of the LIP is to ensure that appropriate institutional arrangements are in place to effectively implement the LPP. The objectives of LIP are to:

(i) adopt an innovative approach to labor inspection that is flexible, transparent, and fair;

(ii) ensure that inspection also covers informal sector enterprises; (iii) encourage the private sector to provide labor inspection services; (iv) encourage enterprise compliance with labor policies and laws through means

other than rigid law enforcement; and (v) encourage increased harmony and dispute prevention in enterprises between

workers and managers. 16. Implementation of Action Plan. The TF will operate in accordance with a time-bound action plan drafted by MOL, to be endorsed by the TF. The work of the TF will be assisted by two policy outlines prepared by MOL to highlight key issues and give a focus to the TF’s deliberations without limiting the breadth and scope of discussions. The TF will strive for

46 Appendix 4

consensus on the policy issues. Where this proves to be impossible, different viewpoints will be recorded and presented to the minister of labor for advice and, if necessary, final decision. The TF is concerned solely with policy matters and is not required to involve itself in legislation. Once both the LPP and LIP have been finalized and endorsed by the Cabinet, the TF will conduct awareness raising for employers’ and workers’ organizations on both policies at the provincial level.

2. The Assistance: Objectives and Scope 17. ADB will provide assistance through consulting services to the MOL Central Labour Advisory Unit and the Social Security Unit and the TF in developing the LPP and LIP. The objective of the assistance is to support the TF in the timely development and dissemination of the LPP and LIP, and will include the following areas:

(i) advice to the TF and other stakeholders on international good practice; (ii) support and facilitation in building stakeholder consensus; (iii) collaboration with MOL and TF, the core program management unit, and ADB on

any policy or implementation issues and recommendation of specific remedies; (iv) follow-up on the progress of the LPP and LIP policy measures; and (v) assistance to organize and moderate discussions and workshops with

stakeholders and sharing of relevant information with the public.

3. Consulting Services

18. The implementing agency will be MOL. The component will be implemented over 24 months. An international labor policy specialist (6 months), and a full-time domestic labor specialist (20 months) will support the TF in conducting its task. MOL will provide office facilities for the consultants. In addition to the tasks specified under para. 17, the consultants will assist the TF in preparing progress reports, and ADB missions. The consultants will be experienced labor policy specialists and recruited on an individual basis consistent with ADB’s Guidelines on the Use of Consultants and other arrangements for the use of domestic consultants satisfactory to ADB. Besides the terms of reference, the consultants will prepare quarterly progress reports and a final report at the end of the task.

Appendix 5 47

SUBPROJECT 2: SMALL AND MEDIUM ENTERPRISE BUSINESS SUPPORT FUND1 A. Background and Rationale 1. Business development services (BDS) are a key instrument to enhance competitiveness of small and medium enterprises (SMEs). Business development services are demand driven and include a large variety of services including business planning, production management, product design, quality standards and control, productivity studies, marketing, information systems, and training. Currently, Pakistan lacks a BDS market for SMEs, with constraints on both the supply and the demand side. On the supply side, BDS providers target the larger well-established enterprises, while on the demand side SMEs lack access to a wide range of competitively priced services targeted to their business needs. 2. International experience with BDS in developing markets shows that two basic approaches have been followed: (i) creation of a public sector service provider; and (ii) facilitation of a demand-driven, decentralized market for private sector service providers. Experience illustrates that the first approach has not succeeded because setting up one dominant or single service provider in the public sector places that entity in a privileged position, enabling it to undermine other market participants because of free or highly subsidized services; it is also supply driven, and thus particularly unresponsive to market preferences. Putting government-facilitated programs for supporting BDS in the private sector is effective because the market allocation process is more efficient in determining the demand. There should be a range of different providers, providing a variety of different services. The individual SME purchaser of the services should be free to identify its particular BDS needs, select its service provider(s), and negotiate the terms of the services provided. Building up an industry in BDS provision strengthens this market allocation of demand and supply in SME development. One design of government facilitation of the private sector to meet SME development needs that has been particularly successful in recent years is the cost-sharing grant scheme. 3. The key features of cost- sharing grant schemes are:

(i) a fund is created and advertised widely to BDS users and providers; (ii) SMEs prepare a plan showing how they intend to improve their competitiveness; (iii) SMEs will gain access to services provided by service providers through a grant,

if the plan is supported by the managers of the cost-sharing grant facility; and (iv) assistance is given to SMEs to prepare the plans.

4. The cost-sharing grant schemes work for the following reasons:

(i) the SME remains in control of the transaction, choosing what the plan will look like, what services to buy and in what order, which service provider to buy the services from, and whether the result is satisfactory and thus whether to pay;

(ii) there is free access to the facility on a first come first served basis for proposals of suitable quality;

(iii) a market is encouraged in BDS services. Only those service providers that have delivered quality BDS services at competitive prices are likely to be selected by subsequent SMEs. The facility disseminates market information to potential buyers of services;

1 Cost and financing of the subproject is summarized in Appendix 7. Implementation arrangements of the subproject

are detailed in Appendix 8.

48 Appendix 5

(iv) the scheme is deliberately temporary, intending to jump-start the BDS market; and

(v) the scheme is deliberately partial with a high SME contribution in order to promote sustainability beyond the period of the scheme.

5. How Cost-Sharing Grant Schemes Have Worked in Other Countries. Recent studies have looked at 10 cost-sharing grant schemes in Bangladesh, India, Indonesia, Kenya, Mauritius, Mexico, South Africa, and Uganda. The studies measured direct impact, in terms of additional exports generated per dollar of cost-sharing grant support: 48 times within 5 years in India; 36 times within just 1 year in Indonesia; 30 times in just 1 year in Kenya; 160 times within 1 year in Mauritius. The studies identified the following as key areas in the success of the schemes: grant size and payment arrangement, fund governance and management (including overheads), service provider quality control, realistic SME and subproject eligibility and simple procedures, and adequate monitoring and evaluation. B. The Assistance: Objectives and Scope 6. The Project will establish a cost-sharing grant scheme, the SME Business Support Fund Company, to facilitate SME development through a market-based BDS service provision, the Business Support Fund (BSF). To ensure direct access of SMEs to BDS, strong governance in selection and management of BSF-funded projects, and private sector support for the initiative, the design of the BSF envisages its establishment through a Government endowment as a nonprofit company2 with the majority of the directors of the board representing the private sector, and an independent management unit led by an experienced facility manager. The board of directors will approve a business plan and standard operating procedures (SOP) for the management of the BSF based on final drafts, which have been developed. 7. The BSF will support an expected 1,500 subprojects, of which more than 95% are expected not to exceed a cost-sharing grant value of $15,000. These projects are estimated to benefit about 8,000 SMEs. The implementation plan, performance indicators and targets, and institutional setup for the facilities have been included in the business plan for the BSF. The SOP specify among others (i) eligibility criteria for SMEs and application process; (ii) rules to avoid conflicts of interest and misuse of funds; and (iii) procedures for facility management including the appraisal of applications, disbursement procedures, program monitoring, and annual review of the performance of the BSF through the board of directors. 8. The Project will:

(i) support the establishment of the BSF as a nonprofit company with a management and governance structure reflecting international best practice in developing markets through consulting services;

(ii) provide the funds for the cost-sharing grant facility; and (iii) provide operating expenses, including costs for competitively selected,

experienced, competent, professional management for the BSF including the facility manager and permanent staff to be recruited by the BSF on proposal by the facility manager.

2 Under Section 42 of the Companies Act, 1984. Articles of association have been prepared.

Appendix 5 49

C. Consulting Services 9. The Executing Agency will be the Ministry of Finance represented by the core program management unit. The implementing agency will be the Ministry of Finance prior to establishment of the BSF, and then BSF, commencing on the date on which BSF enters into a project agreement with Asian Development Bank. 10. The subproject will be implemented over 60 months. An internationally experienced BDS specialist will be recruited on an intermittent basis to establish and manage the facility (32 person-months over 5 years), provide on-the-job training for staff, and induce a senior staff to take over the management function for the BSF. The international expert will be recruited on an individual basis consistent with the Guidelines on the Use of Consultants. Besides the terms of reference, the consultants will prepare brief quarterly progress reports and a final report at the end of the task. The specialist will provide the following services to the BSF:

(i) finalization of the articles of association for BSF and the business plan and SOP for the matching grant facility and incorporation of BSF as a nonprofit company;

(ii) start-up assistance prior to approval of the board of directors of the business plan and SOP, assistance in selection of the management team;

(iii) assistance in advertising the BSF to SMEs and BDS providers; (iv) management of the fund; (v) recruitment of deputy manager and up to full-time professional staff; and (vi) training of staff.

11. Procurement of goods and services will be in accordance with Asian Development Bank's Guidelines for Procurement. Procurement will be limited to office equipment estimated at $31,800 equivalent, which will be procured under direct procurement procedures.

50 Appendix 6

SUBPROJECT 3: MARKET DEVELOPMENT FOR SMALL AND MEDIUM ENTERPRISE FINANCE1

A. Component 3.1: Regulatory Policy Development, Credit Information, and

Capacity Building for Financial Institutions

1. Background 1. Recent Developments. Consistent with the reduction in the discount rate of the State Bank of Pakistan (SBP), the average spread of the banks2 has decreased from 8.5% to 5.7% from July 2001 until June 2003, while average lending rates decreased from 14.5% to 7.6% in that period. After a 2% increase during FY2002, credit to the private sector slightly declined by 0.8% during the first 9 months of FY2003 to PRs1,056 billion ($18.3 billion). The largest total lending exposure of banks is to the textile industry (25%) followed by agribusiness (10%), while loans to trade and commercial enterprises, which represent about 50% of all business establishments, represented an extremely low total share of total lending exposure of 3%. During the first half of 2003, lending to large corporate clients increased by 7% and to consumer finance by 17.3% (although from low levels), while lending to SMEs declined by 4.5%. 2. The small increase in lending since 2001 and the decrease during 2003 in a period of easing monetary policy and high liquidity in the market could partially be explained by the risk-adverse attitude of banks, and the rigidity in prudential regulations of SBP, especially with regard to lending limits and the restriction on banks not being permitted to lend based upon the borrowers’ cash flows unless the loans are secured by well-documented assets (e.g., legal documents showing proof of ownership). Additionally, SBP and the private sector’s credit information bureaus maintain incomplete coverage of loan exposures, which make it difficult for financial institutions (FIs) to obtain the necessary credit information for the smaller borrowers such as SMEs. Also, existing secured transactions law and the commercial court systems are ineffective, thereby contributing to a market that is not conducive to lending to SME clients. By improving credit information and making it possible to offer loans collateralized by movable assets, financing to SMEs, especially the smaller informal/nonregistered SMEs, could increase. 3. SME Finance Activities. SMEs, especially those in the informal sector with fewer than 10 employees, are largely financed through the private savings of the owner, retained earnings of the enterprise, and/or family and friends. Access to finance from other sources is insignificant. According to a recent survey of approximately 1,000 SME 3 manufacturers, only 1% of those surveyed borrowed money from formal sources and such borrowings were mainly for working capital purposes. Other sources of financing, such as trade credit, amounted to less than 5% of those surveyed. The SME survey confirms that utilization of credit from formal financial institutions by manufacturers with fewer than 100 employees is only 7%. In general, the lending policies of banks tend to favor the manufacturing sector, and since the majority of SMEs are trade and service entrepreneurs, utilization of formal credit is insignificant for these enterprises. 4. Information received from banks lending to SMEs indicates that borrowing of up to PRs5 million is far less significant and represents about 10,000 borrowers and less than 25% of the total loans outstanding. According to SBP, loans of up to PRs10 million only represented 0.1%

1 Cost and financing of the subproject is summarized in Appendix 7. Implementation arrangements of the subproject

are detailed in Appendix 8. 2 Defined as the differential between average lending and deposit rates of the banking system. 3 World Bank and SMEDA. 2003. Investment Climate Assessment of Pakistan. Unpublished.

Appendix 6 51

of total lending of the banking system. While leasing companies are financing SMEs, their overall impact is marginal because of their small market share of total lending in the country. 5. Credit Demand: Small SME Segment. A number of surveys confirm that from an entrepreneur’s perspective, lack of access to and cost of bank financing are significant impediments to growth. While these factors do not determine actual market demand, less than 5% of the estimated 230,000 SMEs (employing 5 or more staff) have access to formal credit. 6. Credit Demand: Medium and Large SME Segment. While the above sample survey indicates far better access to credit for the medium SME manufacturers, about 13% of manufacturing SMEs (with more than 100 employees) reported access to financing for working capital and 24% reported access to investment capital. There should be significant market potential for SMEs in the trade and service sectors as well as financing for working capital. This fact is underscored by SBP statistics, which report that loan amounts of up to PRs100 million represented less than 10% of banking system lending. The upper limit of the SME market, representing exposures of between PRs100 million and PRs300 million, has an estimated 1,000 borrowers and appears to be better served. According to information received from banks, more than two thirds of the banks’ exposure to SMEs serves this segment of the market. 7. Government Policies. As a result of the failure of the Government’s program for directed lending by development finance institution (DFIs) to the private sector, it adopted a policy to gradually eliminate DFIs through privatization and/or liquidation. To encourage private sector lending, SBP and the Government have introduced appropriate regulatory and policy procedures for banks to develop their own SME business strategies. In addition to its regulatory function, SBP publishes debtor information to help serve financial institutions (FIs) in their credit analysis. Currently, SBP’s Credit Information Bureau maintains a registry of loans with a minimum size of PRs 500,000, but does not aggregate the credit information by debtor. The Credit Information Bureau is planning to expand its registry to include loans with a minimum size of PRs200,000. Additionally, SBP is beginning to explore the possibilities of the private sector providing such services to improve credit information for FIs. Secured financing is another means of enhancing access to credit for SME borrowers. Effective legislation would allow (i) borrowers to offer security interests in movable property, (ii) creditors to establish priority rights to such security interests, (iii) enforcement mechanisms on priority rights, and (iv) the establishment of a registry for security interests. If secured financing were available, businesses other than FIs might also offer credit to suppliers and customers against secured collateral.

2. Objective and Scope 8. The objective of this project component is to increase SMEs’ access to finance. The component focuses on (i) developing a conducive regulatory and policy environment for SME finance, (ii) encouraging private FIs to develop SME lending capability, and (iii) providing capacity building to participating private FIs (PFIs) committed to operate SME finance units. 9. Developing a Conducive Regulatory and Policy Environment for SME Finance. In order to have a well-functioning financial system for SME lending, regulations, supervision, and monitoring of the FIs must be improved and FIs’ policies and procedures for SME lending must be introduced. To improve FIs’ ability in performing proper credit analysis on SMEs, more comprehensive credit information must be provided to the FIs. Additionally, a feasibility study for improving the existing framework for secured transactions will be prepared under a separate Asian Development Bank (ADB) funded grant. A banking regulation and supervision expert with

52 Appendix 6

extensive experience in SMEs will be hired to assist in the review of SBP’s regulations, and supervision approach to the SME segment. 10. Encouraging FIs to Develop SME Lending Capability. Commercial SME finance is relatively new in Pakistan. Capacity building on SME finance will be offered to both SBP and FIs. Seminars and workshops will be conducted by experts on the strategies and methods of establishing SME finance capability at the FIs. This entails market research, product development, lending processes, control systems, and capacity building of professional staff. Advisory support will also be provided to assist FIs in developing SME business strategies. 11. Customized Consulting Services to PFIs. FIs willing to establish an SME financing unit will be able to access consulting services by submitting a business plan for approval by SBP and ADB. Upon approval of the FI’s business plan, the FI will be entitled to consulting services on a cost-sharing basis to implement the business plan. 12. Consulting Services. Consultants to be financed under this subproject will be recruited in accordance with ADB’s Guidelines on the Use of Consultants and other arrangements for the engagement of domestic consultants satisfactory to ADB. The services require an innovative approach to awareness building, identification of PFIs, and PFI senior management commitment of their SME finance business plans, before assistance packages can be customized. Since there is no standardized approach for delivery of such services and the tasks of developing systems, lending processes, and procedures for SME finance are complex and require highly specialized skills and a significant degree of flexibility in the allocation of expertise, the quality-based selection method will be applied for the capacity-building portion of this component (308 person-months of which 124 months are international and 184 months are domestic expertise). Since the participating FIs will be identified in the awareness-building process through short-term consultants, the requisite terms of reference and specialized skills will be customized to the needs of the individual PFI. It is expected that four PFIs will benefit from the capacity-building measures. The short-term positions (32 person-months of which 16 months are international and 16 months are domestic expertise) will be advertised and selected on an individual basis. The experts will have a strong track record in emerging markets in the following areas: (i) SME finance policy/regulation, (ii) awareness building and training, and (iii) design and implementation of downscaling programs for SME finance. B. Component 3.2: SME Bank Restructuring

1. Background and Rationale

13. On 1 January 2002, the Government merged two failed DFIs, the Regional Development Finance Corporation and the Small Business Finance Corporation, into SME Bank, a public limited company. The Government owns directly and indirectly approximately 97% of the bank. Since its creation, SME Bank has experienced operational losses, primarily due to (i) substantial fixed costs (i.e., overstaffing and too many branches), and (ii) lack of appropriate credit analysis and risk management skills necessary to run and operate a bank specializing in SME lending. Since the Government believes it is vital for the development of the private sector in Pakistan that SME Bank continues to provide term financing to SMEs, especially to the lower segment of the SME market, the SME Bank has recently prepared a restructuring plan to improve its performance. According to the restructuring plan, SME Bank’s business will be reorganized into) an SME business unit, and a recovery unit. Additionally, the restructuring plan includes (i) a time-bound action plan to reduce the number of bank branches and rationalize staff of the recovery unit to a sustainable cost level; and (ii) an independent human resource audit to (a)

Appendix 6 53

evaluate the skills of the employees at the bank, (b) identify and match such skills for specific jobs within the bank, (c) identify alternative job opportunities for certain employees, and (d) provide active job-search assistance and reemployment training for personnel.

2. Objective and Scope 14. This component will be implemented over 24 months and will assist the Government and SME Bank with the implementation of the restructuring plan, and provide expertise to (i) identify market niches for SME Bank, (ii) establish lending policies and procedures, (iii) develop financial products, (iv) develop marketing strategies to enhance outreach, and (v) develop sound risk management through appropriate incentives for staff, controls, and sound management information systems. SME Bank will recruit an individual international expert as head of its SME business unit, who will lead for a 24-month period the buildup of the commercial SME business unit including the use of deposit and lending products for its clients. The expert will be selected in a competitive process by a committee composed of SME Bank and the core program management unit. Recruitment will be in agreement with ADB and consistent with the Guidelines on the Use of Consultants. The expert will prepare quarterly reports and a final report at the end of the task. The expert will have (i) at least 8 years experience in (a) establishing and managing SME banking for commercial FIs; (b) SME credit origination, management, and risk management; and (c) analytical, management, marketing, and interpersonal skills; and (ii) the following responsibilities:

(a) prepare strategy and business plan to establish and manage the SME business, (b) conduct market research surveys to identify business potential, (c) develop a marketing plan to develop the image of SME Bank, (d) based on the business plan develop products for SME finance, (e) prepare a credit policy and risk management process for SME lending, (f) establish credit administration and risk management systems, (g) assist in the recruitment and staff development for the new business unit, (h) train the bank’s senior management and the board of directors, (i) oversee the implementation of the capacity building/training program for staff, (j) provide on the job assistance to officers, lending and loan recovery, and (k) supervise SME business operations and performance.

.

54 Appendix 7

PROJECT COST ESTIMATES AND FINANCING PLAN ($'000)

Foreign Local Total Item Exchange Currency Cost A. ADB Financing 1. Subproject 1: Policy Formulation and

Implementation

a. SME Policy Development i. Consultants a. Remuneration and Per diem i. International Consultants 22.5 4.5 27.0 ii. Domestic Consultants 0.0 48.4 48.4 b. International and Local Travel 6.0 6.6 12.6 c. Reports and Communication 0.0 10.0 10.0 ii. Training and Seminar 0.0 75.0 75.0 iii. Contingencies 4.5 22.5 27.0 Subtotal (1a) 33.0 167.0 200.0 b. Labor Policy Development I Consultants a. Remuneration and Per diem i. International Consultants 108.0 24.8 132.8 ii. Domestic Consultants 0.0 83.8 83.8 b. International and Local Travel 15.0 9.0 24.0 c. Reports and Communication 0.0 4.0 4.0 ii. Training and Seminar 0.0 60.0 60.0 iii. Contingencies 18.0 27.4 45.4 Subtotal (1b) 141.0 209.0 350.0 2. Subproject 2: SME BSF a. Fund Value 1,500.0 4,240.0 5,740.0 b. Fund Management i. Consultants 736.0 186.9 922.9 ii. Administrative Costsa 0.0 305.7 305.7 iii. Office Equipment 0.0 31.8 31.8 iv. Contingencies 114.0 75.6 189.6 Subtotal (2) 2,350.0 4,840.0 7,190.0 3. Subproject 3: Market Development for SME Finance

a. Regulatory Policy Development, Credit Information, and Capacity Building for FIs

i. Consultants a. Remuneration and Per diem i. International Consultants 2,725.0 490.5 3,215.5 ii. Domestic Consultants 0.0 833.0 833.0 b. International and Local Travel 144.0 121.0 265.0 c. Reports and Communication 16.0 16.0 32.0 ii. Training and Seminars 461.3 1,463.3 1,924.6 iii. Surveys 0.0 130.0 130.0 iv. Contingencies 833.7 766.2 1,599.9 Subtotal (3a) 4,180.0 3,820.0 8,000.0

a Includes office rent, utilities, and eight full-time officers, including travel cost for the facility management unit.

Appendix 7 55

55

Foreign Local Total Item Exchange Currency Cost b. SME Bank Restructuring i. Consultants a. Remuneration and Per diem 600.0 72.0 672.0 b. International and Local Travel 14.0 10.6 24.6 ii. Contingencies 92.0 11.4 103.4 Subtotal (3b) 706.0 94.0 800.0 4. Program Implementation Support a. Consultants 0.0 495.0 495.0 b. Audit Expenses 0.0 120.0 120.0 c. Vehicle 0.0 20.0 20.0 d. Office Equipment 0.0 20.0 20.0 e. Operating Expensesb 0.0 180.0 180.0 f. Contingencies 0.0 125.0 125.0 Subtotal (4) 960.0 960.0 Subtotal (1a + 1b + 2 + 3a + 3b + 4) 7,410.0 10,090.0 17,500.0 Interest during implementation period 500.0 0.0 500.0 Subtotal (A) 7,910.0 10,090.0 18,000.0 B. Government Financing

1. Subproject 1: Support Policy Formulation and Implementation

a. SME Policy Development 0.0 96.0 96.0 b. Labor Policy Development 0.0 120.0 120.0 2. Subproject 2:SME BSF a. Cost of SME beneficiaries 0.0 5,740.0 5,740.0 3. Subproject 3: Support Market Development for SME

Finance

a. Regulatory Policy Development, Credit Information, and Capacity Building for FIs

i. Office and Staff 0.0 660.0 660.0 ii. Course Fees (Financial Institutions) 0.0 2,356.0 2,356.0 b. SME Bank Restructuring Support 0.0 818.0 818.0 4. Program Implementation Support a. Office and Staff 0.0 210.0 210.0 Subtotal (B) 0.0 10,000.0 10,000.0 Total 7,910.0 20,090.0 28,000.0

ADB = Asian Development Bank, BSF = business support fund, FIs = financial institutions, SME = small and medium enterprise. b Includes travel cost for the Core Program Management Unit. Source: Asian Development Bank estimates.

56 Appendix 8

IMPLEMENTATION ARRANGEMENTS A. Program and Project Components

1. The Program supports three policy reform outcomes in six key result areas (KRAs):

Outcome 1 Improve Small and Medium Enterprise (SME) Policy Environment KRA 1.1 Develop SME Policy

KRA 1.2 Establish Effective Labor Protection and Inspection Policies KRA 1.3 Enhance Small and Medium Enterprise Development Authority’s

(SMEDA’s) Effectiveness and Outreach to SMEs Outcome 2 Improve Market-based SME Access to Business Development

Services (BDS) KRA 2 Enhance SME Competitiveness Through Private Sector Services Outcome 3 Improve Market-based Access to and Delivery of SME Finance KRA 3.1 Improve Regulatory and Credit Information Infrastructure and Build

Private Financial Institution (FI) Capacity KRA 3.2 Restructure and Privatize SME Bank

2. The SME Sector Development Project entails three subprojects in five components:

Subproject 1: Policy Formulation and Implementation Component 1.1: SME Policy Development

Component 1.2: Labor Protection and Inspection Policy Development

Subproject 2: SME Business Support Fund (BSF) Subproject 3: Market Development for SME Finance

Component 3.1: Regulatory Policy Development, Credit Information, and Capacity Building for Financial Institutions

Component 3.2: SME Bank Restructuring

3. To ensure the linkage of reforms in the program and project activities, joint implementation and coordination arrangements will be put in place. The mapping of the responsibilities is illustrated in Figure A8. The technical assistance (TA) grant will provide for a domestic full-time specialist housed at the Pakistan Resident Mission of the Asian Development Bank (ADB) to support the coordination of the program. Details of the TA are in Appendix 10. B. Key Program and Project Management Entities

4. The following entities will ensure proper implementation of the Program:

(i) The steering committee (SC) (ii) The core program management unit (CPMU) representing the Ministry of

Finance (MOF) as the Executing Agency (EA); and (iii) The implementing agencies (IAs, namely, MOF, Ministry of Industries and

Production [MOIP], Ministry of Labour [MOL], State Bank of Pakistan [SBP], SMEDA, and SME Bank), as well as the BSF upon incorporation as a company.

5. Steering Committee. The SC will be chaired by the minister of finance and consist of the secretaries of the Ministry of Economic Affairs and Statistics; MOF; MOIP; MOL; and the

Appendix 8 57

deputy governor of SBP. The SC, supported by CPMU acting as its secretariat, will meet at least on a semiannual basis and guide and oversee the implementation of program reforms and project progress. 6. Private Sector Stakeholder Review. The SC will establish a stakeholder review process for ensuring adequate private sector feedback on the policy and project outputs. The private sector stakeholders will represent regional and SME sector interests including banking and finance, trade, service and manufacturing, professional and academic organizations, and SME business associations to be proposed by the EA. 7. Audit Review. The SC will establish an audit review process for ensuring adequate performance review of the program and the project and addressing issues raised in financial and performance audits to be conducted by a firm associated with an internationally recognized auditing firm based on terms of reference and a shortlist agreed with ADB. The audit review process will include members representing Government and professional and academic organizations to be proposed by the EA. Members of the stakeholder review and audit review processes will resign from their board membership or other advisory posts in IAs. The members will exercise their duties on a nonprofit basis and will be reimbursed for their travel, accommodation, and food costs. 8. Core Program Management Unit. MOF has appointed its joint secretary, banking to coordinate the preparation of the Program and the Project among the government agencies and ADB. Since the reform measures cover a number of line ministries and stakeholders and involve the development of policies in a consultative manner, a permanent CPMU representing MOF as the EA will be established prior to loan effectiveness to ensure that reforms are well managed, and coordinated and communicated among government agencies and private sector stakeholders. In addition to its oversight and coordination functions, the CPMU will also act as the IA for (i) the SME Bank restructuring component, (ii) the initial setup of the SME BSF, and (iii) the TA grant to support program coordination. MOF will establish the CPMU including the requisite office infrastructure in Islamabad, recruit/assign staff, and provide adequate budgeting for the CPMU and the SC. 9. CPMU Staffing. The CPMU comprises the following full-time staff, of which all positions except the program director will be financed by the project and selected individually in a competitive process in compliance with ADB’s Guidelines on the Use of Consultants and other arrangements for the engagement of consultants acceptable for ADB

(i) program director (PD-CPMU), who will be a joint secretary in charge of communicating among the IAs, stakeholders, the consultants, and ADB. The PD-CPMU will also directly liaise with SBP, which is in charge of developing SME finance under KRA 3.1 and component 3.1 of subproject 3. The PD-CPMU will directly report to the SC;

(ii) manager (SME policy and labor policy development), in charge of supporting and overseeing the policy reform and related project components under Outcome 1;

(iii) manager (BDS development), in charge of supporting and overseeing the policy reform and related project components under Outcomes 1.3 and 2;

(iv) manager (SME Bank restructuring), in charge of overseeing the complex downsizing and business-building process for SME Bank, including the Government’s divestiture from SME Bank under Outcome 3; and

(v) two research analysts in charge of providing analytical support for policy analysis, data research, program monitoring and reporting.

58 A

ppendix 8

Figure A8: Small and Medium Enterprise Sector Development Program Implementation

ADB = Asian Development Bank, BDS = business development services, BSF = Business Support Fund, CFC = common facility center, CPMU = core program management unit, EAD = Economic Affairs Division, KRA = key result area, MOF = Ministry of Finance, MOIP = Ministry of Industries and Production, MOL = Ministry of Labour, NAB = National Accountability Bureau, PD = project director, SBP = State Bank of Pakistan, SECP = Securities and Exchange Commission of Pakistan, SME = small and medium enterprise, SMEDA = Small and Medium Enterprise Development Authority, TA = technical assistance.

Audit Review ProcessPerformance, Compliance & Financial Audits

members representing NAB, MOF, SECPand private sector

Private Sector Stakeholder Review Processmembers representing regions &

industry sectors

Program KRA 1.1SME Policy

Development

Project Component 1.1.SME Policy

DevelopmentSMEDA

Program KRA 1.3SMEDA Corporate

Development &Cluster (CFC) Program

Implementing AgencySMEDA Chief Executive Officer+ 4 full time professional staff

Program KRA 1.2Labor PolicyDevelopment

Project Component 1.2Labor PolicyDevelopment

Implementing AgencyMOL

Joint Secretary [PD]Coordinator + 3 part-time staff

Policy Outcome 1SME Policy, Labor Policy

MOIP/ SMEDA, MOL

Program KRA 3.1SME Finance

Policy Developmentand Capacity Building

Project Component 3.1SME Finance Policy& Credit Information

Development

Implementing AgencySBP Policy Department

Project Manager+ 3 full-time professional staff

Program KRA 3.2SME Bank

Restructuring

Project Component 3.2SME Bank

Restructuring

Implementing Agency MOF CPMU

KRA 2/Component 2 SME BSFBoard of Directors BSF

Facility Managerand 8 professional staff

Policy Outcomes 2 & 3SME Finance Policy and Service Development,

BDS DevelopmentSBP and MOF

Executing Agency MOFCPMU

Full-time Joint Secretary+ 5 full-time professional and research staff

ADB on-site Program CoordinatorPakistan Resident Mission (ADB professonial staff)

Full-time consultant (TA Grant)for implementation support

Program Steering CommitteeSecretary EAD, MOF, MOIP, MOL, Deputy Governor SBP

Secretariat: CPMU

Appendix 8 59

10. The CPMU will obtain part-time support from the IAs through secondment of staff and temporary assignment to the CPMU. This type of support will be specified in rolling semiannual implementation plans to be prepared by the CPMU and agreed with the IAs. 11. CPMU Functions. The CPMU will be familiar with, and will ensure that IAs become familiar with, ADB’s program and project administration procedures, including consultant recruitment and disbursement and reporting requirements and procedures through printed material and training offered by ADB. The CPMU will be in charge of the tasks set out below, which will be modified as needed during program implementation in agreement with ADB. C. Implementing Agencies

12. IA 1–SMEDA. SMEDA’s chief executive officer will be the project director (PD-IA 1), responsible for the implementation of the following tasks:

(i) KRA 1.1, SME policy development, including the preparation of a policy document in a consultative process with stakeholders and the implementation of such policy supported by consulting services under Component 1.1; and

(ii) KRA 1.3, enhancing the capability of SMEDA, in (i) SME policy development and (ii) its outreach to SMEs through its common facility center program.

13. SMEDA will establish (i) a team consisting of four full-time professionals guiding the consultative process for developing the SME policy; (ii) a task force to finalize the business plan, prepare the business rules, and update these documents as necessary; and (iii) assign a department for preparing and implementing the SME common facility center program. The PD-IA 1 will manage the preparation and implementation of the tasks listed above, including the preparation of an organization, staffing, and work plan to reflect the proposed implementation of policy and project measures under the Sector Development Program (SDP), meeting of tranche release conditions, and ensuring timely recruitment of consultants and management of outputs. The PD-IA 1 will also maintain coordination and reporting with the PD-CPMU. The IA 1 will be charged with the following tasks:

(i) acting as the focal point for CPMU, ADB, and consultants, including (a) participation in ADB missions, review of relevant documents, feedback to ADB and CPMU within 5 working days, (b) confirmation of relevant agreements, and (c) communication with CPMU, and ADB;

(ii) iterative stakeholder consultation and awareness building with the SME community and sharing of relevant information;

(iii) recruitment and management of consultants, and organization of workshops; (iv) program monitoring and management, which entails planning and updating of

policy and project implementation schedules, compliance monitoring, quarterly progress reporting, annual performance and financial audits; and

(v) ensuring adequacy and timely availability of counterpart funding, and preparing the business plan, standard operating procedures, accounting and auditing arrangements, and operational budget for the common facility center program.

14. IA 2—MOL has established a team chaired by a joint secretary at MOL, as project director (PD-IA 2), and adviser MOL as coordinator supported by three professional staff to develop the labor protection and inspection policies under KRA 1.2 in a consultative process and to disseminate these to and develop consensus at the provincial level. MOL will obtain periodic support from an international labor policy specialist and full-time support from a domestic

60 Appendix 8

consultant recruited under Component 1.2. The PD-IA 2 will manage the preparation and implementation of KRA 1.2 and Component 1.2, including (i) meeting tranche release conditions and (ii) ensuring timely recruitment of consultants and management of their outputs. The PD-IA 2 will also coordinate with and report to the PD-CPMU. IA 2 will be in charge of the following tasks:

(i) acting as the focal point for CPMU, ADB, and consultants, including (a) participation in ADB missions, review of documents, feedback to ADB and CPMU; (b) communication with CPMU, ADB, and consultants;

(ii) coordination with stakeholders, including establishment of the labor policy task force and stakeholder consultation as detailed in the action plan of MOL;

(iii) recruitment and management of consultants and organization of workshops and seminars in coordination with CPMU and ADB;

(iv) program monitoring and management, which entails planning and updating of policy and project implementation schedules, compliance monitoring, quarterly progress reporting, annual performance and financial audits, and communication of any issues to CPMU and ADB that may adversely affect implementation; and

(v) ensuring adequacy and timely availability of office infrastructure for the consultants, and counterpart staffing and funding.

15. IA 3—MOF/BSF. Project director CPMU will be in charge on a limited time basis to facilitate the selection and appointment of a task force to incorporate the BSF and select board of directors in charge of overseeing the operations of the SME BSF (KRA 2), approve the memorandum of association, the business plan and standard operating procedures. The SME BSF will implement program KRA 2 and project component 2 and its board will recruit an internationally experienced facility manager through a competitive process supported by domestically recruited professional staff as determined in the BSF business plan; and oversee the SME BSF’s business. 16. Staffing. IA 3 will establish a unit, under the BSF comprising the facility manager/ project director (PD-IA 3), on a full-time basis in charge of communicating with SME stakeholders, business service providers and management and coordination of the policy development, and awareness, and capacity building with the stakeholders. The PD-IA 3 will manage the preparation and implementation of the SME BSF, including the (i) meeting of tranche release conditions, (ii) ensuring timely recruitment of domestic staff, and (iii) coordinating with and reporting to the PD-CPMU. The IA 3 will be accountable for:

(i) iterative stakeholder consultation and awareness building with SMEs; (ii) recruitment and, management of experts and organization of workshops; (iii) management of the BSF; (iv) program monitoring including planning and updating of policy and project

implementation schedules, compliance monitoring, quarterly progress reports, annual performance and financial audits, and communication of any issues to CPMU and ADB that may affect the implementation;

(v) ensuring adequacy and timely availability of counterpart funding; and (vi) preparation of organization, staffing, and work plans to reflect implementation of

program and project measures. 17. IA 4—SBP Policy Department will establish a unit to carry out the following tasks:

(i) lead the reforms of SME finance policy, credit information management systems, and analysis of the FIs response to reforms (KRA 3.1);

Appendix 8 61

(ii) implement subproject project component 3.1 supporting SME regulatory policy development and the development of information infrastructure, promoting awareness among FIs for commercial approaches to SME finance, and promote investment of banks into building dedicated SME units and programs; and

(iii) oversee as regulator the restructuring of SME Bank. 18. Staffing. IA 4 has established a unit, led by a project director and comprising three full-time staff, including:

(i) project director (PD-IA 4), in charge of communication within SBP and with banking sector stakeholders, CPMU, consultants, and ADB. PD-IA 4 will be in charge of managing and coordinating the policy development, awareness, and capacity-building process with the stakeholders, especially participating banks and banks participating in the SME finance committee under SBP;

(ii) training and knowledge management specialist, a full-time staff member who will prepare training sessions and disseminate SME finance policy information to the public with the assistance of experts familiar with training in SME finance; and

(iii) SME finance capacity building and consulting specialist, a full-time staff member assigned by SBP who will be in charge of assisting interested participating banks in the preparation of market studies and business plans for SME finance, and in the development of suitable consulting packages for participating banks.

19. The PD-IA 4 will manage the preparation and implementation of the tasks listed above, including the (i) monitoring tranche release conditions, (ii) approval of the project by the Government, and (iii) ensuring timely recruitment of consultants and management of consulting outputs. The PD-IA 4 will coordinate with PD-CPMU and be accountable for the following:

(i) acting as the focal point for CPMU, ADB, and consultants, which entails (a) participation in ADB missions, review of mission documents, and feedback to ADB and CPMU; (b) confirmation of agreements relevant to SBP; and (c) day-to-day communication with CPMU, ADB, and consultants;

(ii) coordinating with private FIs, including stakeholder consultation with FIs participating in SBP’s SME finance committee and SME finance capacity-building training, and sharing relevant information with the FIs in meetings and workshops. This also includes the identification of PFIs for the capacity building;

(iii) recruitment of consultants, preparation and management of consulting contracts, and organization of workshops and seminars;

(iv) program monitoring and management, which entails planning and updating of policy and project implementation schedules, compliance monitoring, quarterly progress reporting, annual performance and financial audits; and

(v) ensuring adequacy and availability of counterpart funding, and preparing and updating staffing and work plans.

20. IA 5—MOF SME Bank Restructuring. The CPMU will maintain the function of the IA overseeing the restructuring of SME Bank. The CPMU will specifically (i) oversee and monitor the timely implementation of all measures under the restructuring plan and related policy conditions, and (ii) recruit the expert supporting the restructuring in coordination with SME Bank. 21. Monitoring by CPMU. To monitor implementation, the CPMU will undertake regular visits to the IAs, collect information from the IAs and other relevant sources and prepare

62 Appendix 8

quarterly progress reports as well as an annual report on program implementation. The CPMU will establish a project performance monitoring system at inception of the SDP. 22. Procurement. Supply contracts for equipment or material estimated to cost the equivalent of more than $500,000 will be procured using international competitive bidding procedures, estimated to cost the equivalent of $500,000 or less (other than minor items) using international shopping procedures, and estimated to cost the equivalent of $50,000 or less using direct procurement procedures, in each case according with the ADB's Guidelines for Procurement and procedures acceptable to ADB. 23. Imprest Account. An imprest account will be established at the National Bank of Pakistan for each of MOF, SBP and SMEDA. Each such imprest account will be established, managed, replenished and liquidated in accordance with ADB's "Loan Disbursement Handbook" dated January 2001, as amended from time to time, and detailed arrangements agreed upon between the Borrower and ADB. The initial amount to be deposited into each such imprest account will not exceed the equivalent of $500,000 for each MOF and SBP, and $50,000 for SMEDA. The total initial amount for the imprest accounts will not exceed the lesser of 10% of the Loan amount or six months’ estimated expenditure. Any individual payment to be reimbursed or liquidated under the statement of expenditures procedures will not exceed the equivalent of $100,000 for MOF and SBP, and $10,000 for SMEDA. 24. Accounting and Audit. The EA and the IAs will establish and maintain separate accounts for the project components in accordance with accounting and financial management procedures acceptable to ADB. The SC will establish an audit review process and commission financial and performance audits of the CPMU and IAs and their accounts to auditing firms associated with internationally recognized firms in accordance with auditing standards acceptable to ADB. Certified copies of the audited accounts and financial statements and the report of the auditors will be submitted to ADB in English within 6 months of the end of each fiscal year.

D. Implementation Schedule

25. The implementation schedule for the SME SDP is set out in Table A8.

Table A8: SME Sector Development Program Implementation Schedule Item 2004 2005 2006 2007 2008 A. Loan Effectiveness B. Tranche Payments C. Program Components 1. Improve SME Policy Environment 2. Improve Market-based SME Access to BDS 3. Improve Market-based Access to and Delivery of SME Finance

D. Project Components 1. Policy Formulation and Implementation 2. SME BSF 3. Market Development for SME Finance 3.1 Capacity Building for FIs 3.2 SME Bank Restructuring E. Monitoring and Review F. Consulting Services BDS = business development services, BSF = business support fund, FIs = financial institutions, and SME = small and medium enterprise.

Appendix 9 63

PARTIAL CREDIT GUARANTEE FACILITY FOR ENHANCING ACCESS TO CREDIT FOR SMALL AND MEDIUM ENTERPRISES

A. Rationale and Objective

1. Rationale. As described in Sections II B5. and III E. in the main text, the development of market-based products to enhance the channeling of existing liquidity of the financial system to small and medium enterprises (SMEs) is a key innovation supported under the Small and Medium Enterprise Sector Development Program (SDP). 2. Objective: Increase SME Lending. The objective of the partial credit guarantee (PCG) facility under the SDP is twofold: first, to leverage through a market-based approach existing financial resources of the financial system for lending to SMEs not currently served by financial institutions (FIs); second, to provide catalytic support for innovative financial products and approaches in new markets. Once successfully tested with participating financial institutions (PFIs) at the initial stage, such products will be expanded among a larger number of FIs. The expected outcome of the PCG facility is a higher volume of SME lending by commercial FIs. 3. A Market-Based Alternative to Traditional Credit Lines. The PCG facility aims to provide a market-based and more sustainable alternative to the traditional credit lines. Rather than injecting additional liquidity into a market that is already highly liquid, the PCG facility aims to channel existing sources into the SME sector by addressing risk allocation concerns fundamental to the FI’s lending decisions. Hence, the emphasis of the PCG facility will be on enhancing access to credit, not reducing prices, which will be market determined. The design of the PCG facility also largely avoids issues that are related to currency mismatches that arise in the case of credit lines in foreign exchange. B. Facility Design

1. Structure 4. Identifiable Guarantee Contracts for Sharing of Risk and Rewards. Through the PCG facility, the Asian Development Bank (ADB) will share with PFIs the credit risk of selected SME loans in return for a fee. Within the overall parameters of the PCG facility, ADB will issue specific PCGs with agreed cover amounts and time frame to PFIs in Pakistan, which are selected following a due diligence process. The PCGs will detail the risk- and reward-sharing arrangements for individual loans within a defined portfolio of loans extended by the PFIs to SMEs. The loan portfolio covered under each PCG may be of a revolving nature, and the portfolio composition may change over time based on lending decisions of the PFI within agreed parameters. ADB will not be involved in individual lending decisions by the PFIs, but will agree with the PFIs the lending selection and risk management process. 5. A Public-Private Partnership Anchored in the SDP. The PCG is anchored in the SDP, which supports measures to ensure an enabling policy and institutional environment for SME lending. The PCG is an alternative approach to traditional credit lines in overcoming limited access to credit encountered by SMEs. Hence, the integration of the PCG in the SME SDP makes this a genuine public-private partnership, providing support to the private sector to take advantage of the reforms supported by ADB’s public sector operations. To underscore its market-based approach, the PCG facility will be provided through ADB’s private sector operations without counterguarantee of the Government. Terms and conditions will be market based.

64 Appendix 9

2. Scope 6. Fixed Facility Amount with Flexible Sublimits for PFIs. The PCG facility is proposed to have an overall limit of $65 million, which represents the maximum aggregate amount of all PCGs outstanding and ADB’s maximum exposure under the PCG facility. The PCGs will be issued for each PFI based on demand and prudent practices, starting at PCG sublimits with lower amounts that can be gradually increased within the overall PCG facility limit. To avoid a high concentration of risks to any single PFI, sublimits will initially be set at $20 million equivalent for each PFI, but ceilings may be adjusted from time to time in line with actual utilization, loss experience, and soundness of the PFI. The total size of the PCG facility can be increased at a later stage for a supplementary amount, based on experience and demand, subject to a separate approval by ADB’s Board of Directors at such time. 7. Comprehensive Risk Coverage. The proposed PCG facility will, under each PCG issued, share the credit risk on both principal and interest payments for individual loans in a portfolio of eligible SME loans issued by each PFI, based on the lending decision by the PFI within defined risk parameters. The determination of the SME loan portfolio, and the PFI’s approach to SME lending, are the crucial parameters that determine risk exposure, and will be specified in the guarantee agreement with each PFI following a due diligence process. 8. Risk Sharing with PFIs. Risk sharing with PFIs will take place on two levels, on an individual loan basis. First, a first loss limit will be defined that will be fully absorbed by the PFI. The first loss will be a function of the strength of the financial institution, its past SME lending history, and its risk management systems. The level of first loss may be fixed between 0% for strong institutions with an established track record up to 30% for new market entrants. Second, any loss in excess of the first loss borne by the PFI will be at an agreed risk sharing percentage, normally expected at 50% with the PFI. 9. Prudent Phasing-in and Close Monitoring. Since the PCG product is new both in Pakistan and for ADB, the PCG facility will commence operation with commercial FIs that have well-established underwriting procedures of international standard and demonstrated experience in applying similar lending methodologies elsewhere, before expanding to domestic FIs. Likewise, the portfolio of eligible loans will expand gradually. The tenor of guaranteed loans will be limited to 36 months, although initially the PCG may be targeted at shorter maturities. A bigger share of SMEs in the middle market (with turnover between PRs100 million and PRs300 million) may be allowed, following a prudent approach. Once ADB is satisfied with the track record of the PFI and its SME borrowers, portfolio targets may be revised to encourage PFIs to expand further to smaller SMEs and expand tenors. 10. PCG Limits in US Dollars for Risks Denominated in Local Currency. Guarantee limits with PFIs will be in US dollar terms, but PFIs are expected to extend loans to SMEs under the PCG in local currency. Any risk as a result of currency fluctuations beyond the PCG limit for each PFI will be for the account of the PFI, since ADB’s risk exposure will be capped with the dollar amount specified for each PFI under the guarantee agreement. 11. Facility Available Until End-2008. The availability of the facility is about 5 years from the expected date of ADB approval, until 31 December 2008. During this period, PCGs can be issued by ADB and adjusted until the final facility date, which may be up to 31 December 2011.1 Upon expiration of the facility availability period on 31 December 2008, all outstanding loans

1 If a 36-month loan was issued under a PCG on the last availability day of the facility, the exposure for ADB would

be until 31 December 2011.

Appendix 9 65

covered under the PCGs will remain covered until they fall due, but no new loans or renewals of existing loans will be covered by the PCGs.

3. Eligibility and Selection of Loans 12. Targeted SME Profile. Typical SMEs targeted under the facility would be suppliers and vendors of and to larger corporate clients of the PFIs, in nontraditional industries that have reasonably established and integrated supply chain structures in Pakistan, such as the pharmaceutical, automobile, engineering, and consumer goods industries. For example, large corporate entities in the pharmaceutical industry provide their products to about 200 pharmacies in Karachi alone. Many of these pharmacies have an annual business turnover of about PRs50 million to PRs150 million, but currently face large constraints in accessing working capital. Larger pharmacies, wholesale distributors, and hospitals usually do not have difficulty in accessing credit from FIs. 13. Relationship Between PFIs and SMEs. It is envisaged that most SMEs inc luded in the guaranteed loan portfolio will not have a borrowing relationship with the PFI prior to the PCG agreement. The relation between the PFI and the SME may be established either through (i) confirmation of the PFI’s corporate client that the SME is one of its suppliers, vendors, or established clients; or (ii) a guarantee of the corporate client on behalf of the SME. Existing SME clients of the PFI may also be included if this entails an increase in their credit limit. Direct relationships of PFIs with SME clients are also encouraged within an agreed lending approach. 14. Eligibility of SMEs. PCGs issued to PFIs will be limited to coverage of loan portfolios with the following borrower characteristics:

(i) SMEs with an annual business turnover of up to PRs300 million will be eligible to receive loans covered by the PCG (in line with the State Bank of Pakistan’s SME regulations);

(ii) new SME borrowers are eligible, or additional credit limits to existing SMEs; (iii) SMEs must have 2 years minimum period of profitable operation, and no

negative credit history; (iv) pricing of covered loans is market based; (v) SME’s operating in any business listed in a specified negative list will not be

eligible;2 (vi) SMEs meet credit policies and procedures established by the PFI and acceptable

to ADB; and (vii) SMEs maintain a good credit track record throughout the duration of the PCG.

15. Flexibility to Fine-Tune Targeting. SME characteristics may be revised based on actual experience and the eligibility thresholds under the facility may be adjusted by ADB, in consultation with the PFIs, to better target smaller SMEs.

4. Eligibility and Selection of Participating Financial Institutions 16. All Private Sector and Financially Sound FIs in Pakistan. All licensed and financially sound FIs in Pakistan established in the private sector are eligible, in principle, for a PCG under the facility. All PFIs will demonstrate in a business plan their intention to move from the existing

2 In addition to the items listed in the negative list attached in Supplementary Appendix 1, SMEs involved in

production processes, which are environmentally hazardous as defined in ADB’s environment policy, are not eligible for the PCG cover. It also excludes construction activities involving resettlement, and procurement from ADB non-member countries.

66 Appendix 9

customers to smaller customers over time. This entails a starting point of SMEs with a business turnover of PRs 300 million and a gradual lowering of the business turnover and loan sizes for individual customers. The review process will evaluate the PFIs’ performance against the agreed targets. A due diligence process will be carried out by ADB for each potential FI, to determine the likely outreach of the PFIs to SMEs, and the PFI’s financial soundness, management, and risk management quality. Each potential PFI must demonstrate sound management track record in managing credit risk over the last 3 years, and uninterrupted access to liquidity to finance the business. Capital at risk defined as past dues exceeding 90 days may not exceed a certain percentage of the total outstanding portfolio, as defined in line with prudent banking practice. Rescheduled loans will be reported separately. 17. Due Diligence Process. The due diligence process will include (i) a review of the PFI’s business plans (demonstrating the gradual move down market to smaller customers), and identification of the target SME portfolio and the expected uptake of loans; (ii) assessment of the PFI’s soundness in underwriting loans and managing credit risk, especially in the targeted segment; (iii) determination of lending and risk parameters; (iv) analysis of the PFI’s environmental policy and its incorporation in the lending and risk management process; (v) description of the PFI staff’s accountability for environmental concerns in the loan origination and management process; (vi) capability of the management and staff dealing with environmental assessment (proposed remedies as necessary), determination of the first loss to be borne by the PFI, and of a risk sharing rate for the credit risks beyond the first loss; and (vii) description of the monitoring, reporting, and semiannual review process on the utilization, compliance with meeting SME lending targets, environmental and other safeguards, and implementation arrangements of the PCG facility. In light of the above, the PCG amount for each PFI will initially be determined and will reviewed semiannually and adjusted as necessary. 18. Start with Established International FIs. ADB has to date (November 2003) developed the detailed PCG product design and performed due diligence on the SME credit selection and risk management processes of two international FIs operating in Pakistan, namely Citibank and Standard Chartered Bank. ADB found them to be financially sound, with well-established credit management systems, although they adopted different approaches to SME lending. Once initial experience has been gained, domestic FIs are expected to follow. This process must be gradual and driven by demand, since supply-induced efforts to increase outreach have proven unsustainable. Under the SME SDP, domestic FIs will have access to support in upgrading their business processes and products to serve SMEs. It is expected that successful completion of the capacity building will help identify domestic FIs that may qualify as PFIs under the facility.

5. Pricing 19. Market-Based Profit Sharing. The PFI will pay to ADB a predetermined fee either as a fixed rate based on the PFIs profit in lending to SMEs in the agreed portfolio and reviewed semiannually, or as a variable rate reflecting the PFIs profit as documented in the PFIs financial statements. The fee will be market based and determined for each PFI based on the risks identified during the due diligence process and the risk sharing mechanism agreed between ADB and the PFI, as approved by ADB’s Guarantee Committee chaired by the Office of Cofinancing Operations. In accordance with market practice front-end fees will not be charged to the PFIs. C. Implementation and Monitoring of the Partial Credit Guarantee Facility 20. Legally Binding Guarantee Agreement. ADB will enter into a PCG agreement with each PFI, which governs all aspects of the PCG. This will define the portfolio loans to be

Appendix 9 67

covered (including the PFI’s SME target benchmarks in terms of SME outreach, such business turnover, number of loans, loan tenors, and credit volume), scope of cover and determination of loss, loss and revenue-sharing rates on the defined loan portfolio, claims and recovery procedures, as well as other relevant aspects. 21. Standardized PCG Contracts with Customized Terms and Conditions. Guarantee agreements with PFIs will follow a standardized format and outline. However, because each potential PFI differs in the (i) approach to access the SME market and (ii) quality of the lending process, the conditions of the PCG will be determined on a case-by-case basis based on the due diligence of the FI and its SME lending processes and operations. Terms and conditions for each PCG will be detailed in a term sheet in line with the parameters described in this RRP, subject to review by ADB’s Guarantee Committee and procedures detailed in a Guarantee Administration Memorandum (GAM) prior to its finalization. 22. Performance Reviews and Monitoring. Each guarantee agreement will detail the requirement for quarterly performance reporting and as well as prompt information on any potential losses or defaults in the portfolio. ADB will monitor the utilization of the PCG facility including its developmental and environmental impacts through semiannual on-site review of the PFIs exposure to SMEs, especially the portfolio quality underwritten by the PFIs and the PFIs’ meeting of agreed business targets of providing credit to additional lower segments of SMEs as reflected in the agreed business plans. Based on the semiannual reviews, ADB has the option to modify existing guarantee parameters, with adequate notice, or suspend new SME loan inclusions under the guaranteed portfolio. 23. Guarantee Administration Memorandum. A GAM will be prepared by the South Asia Department. The GAM will set out the respective responsibilities of ADB departments concerned (Office of Cofinancing Operations; Office of the General Counsel; Regional and Sustainable Development Department; Pakistan Resident Mission; Private Sector Operations Department; and Governance, Finance and Trade Division, South Asia Department) in the selection of PFIs and management of the facility, including developmental and commercial aspects, and the establishment of an environment management system as prescribed in ADB’s Environment Policy. Reporting requirements and information to be provided by the PFIs will also be detailed in the PCG agreements. D. Loss Determination, Claims Payment, and Loss Adjustment

24. Loss Determination. Risks guaranteed under each PCG are losses, in accordance with the agreed loss-sharing ratios, that result from irrecoverable principal and interest payment default on SME loans included in the guaranteed loan portfolio. Losses are determined by the PFI in a transparent manner, which will include appropriate documentation that there is a nonpayment of an amount due under a loan included in the guaranteed SME portfolio, and such nonpayment continues for a period to be determined individually for each PFI, net of any recoveries that may have been realized since initial loss identification or provisioning. To substantiate a claim, the PFI has to demonstrate:

(i) substantial recovery efforts as soon as the loan is classified below “normal”, including acceleration of repayments and collection from guarantors, if any, and

(ii) that the PFI has met and continues to meet its obligations under the PCG through: (a) immediate notification of ADB at the end of the month, when the loan is

classified below “normal”;

68 Appendix 9

(b) submission of monthly reports on the whole relationship account with the borrower, advising ADB on the collection and provisioning status and recovery efforts;

(c) restructuring of loans to ensure repayment of the principal and interest; and

(d) initiating legal proceedings for liquidation of collateral and securities held to offset interest and principal.

25. Claims Payment. ADB will reimburse the PFI for the guaranteed percentage of losses arising from guaranteed risks in excess of the first loss, after the receipt of a valid claim providing satisfactory evidence of the PFI’s right to compensation in the amount claimed net of legal expenses. Claims will be paid in the currency in which the loss has arisen, subject to the US dollar limit of the PCG for that PFI, based on an agreed reference rate of exchange. 26. Loss Adjustments. If the PFI recovers any credit loss after having received a guaranteed payment from ADB under the PCG, that recovered amount will be applied to the credit loss amount on a pro rata basis between ADB and the PFI, net of agreed external recovery expenses, for reimbursement to ADB. E. Compliance with ADB Safeguard Policies: Environment, Resettlement, and

Indigenous Peoples

27. Safeguard Policies. The PCG facility is classified as “Financial Intermediary” for the purpose of compliance with ADB’s safeguard policies. ADB will establish an environment management system, which will be detailed in the GAM and specified for each PFI under the guarantee agreement to ensure PFIs’ adherence to ADB’s Environment Policy (2002) and Environmental Assessment Guidelines (2003) as well as to ADB’s policies on involuntary resettlement and indigenous peoples. The GAM will also require PFIs under the guarantee agreements to acknowledge in progress reports that all borrowers comply with health, safety, and environmental regulations and standards as well as public consultation requirements applicable in Pakistan. Since the PFIs’ loans to SMEs will be largely in the trade and light-manufacturing sector, it is unlikely that involuntary resettlement or detrimental impacts on indigenous peoples will occur. As for environmental safeguards, ADB’s due diligence will identify areas for remedy, including negative lists and training as necessary.

Appendix 10 69

TECHNICAL ASSISTANCE GRANT FOR SUPPORTING COORDINATION OF THE SMALL AND MEDIUM ENTERPRISE SECTOR DEVELOPMENT PROGRAM

1. Rationale. The policy reforms under the Small and Medium Enterprise (SME) Sector Development Program (SDP) will be developed and implemented in close consultation with stakeholders in the private sector, a number of government agencies, nongovernment organizations, and the Asian Development Bank (ADB). To effectively implement the reform agenda supported by the SME SDP, strong coordination mechanisms need to be established. technical assistance (TA) will be required to engage a domestic consultant to coordinate on a full-time basis the reform efforts and maintaining momentum as a focal point between the above stakeholders to support the timely preparation and implementation of all SDP-related activities and to foster participation of and coordination among stakeholders through discussions and workshops. 2. Objectives and Scope. The objectives of the TA are to support the timely implementation of the SDP and build awareness and foster coordination among stakeholders to ensure smooth implementation. The TA will cover the following:

(i) Timely Implementation. The consultant will coordinate activities under the SDP and facilitate timely communication between the core program management unit (CPMU) at the Ministry of Finance (MOF), the implementing agencies (IAs), other private and public sector stakeholders, and external agencies including ADB; and

(ii) Promote Effective Stakeholder Participation and Coordination and Collect Relevant Information. The consultant will organize discussions and workshops among stakeholders to support consultation and consensus through transparent and participatory process in the development and implementation of the SME-related policies and collect and share information related to reforms.

3. Costs and Financing. The costs of the TA are estimated at $315,000 equivalent in local currency costs. ADB will finance $250,000 equivalent on a grant basis from ADB’s TA funding program. The Government will provide the balance amounting to $65,000 equivalent for counterpart staff, office accommodation, and logistical support.

Table A10: Cost Estimates and Financing Plan

($’000)

Foreign Local Total Item Exchange Currency Cost A. Asian Development Bank Financinga 1. Consultants a. Remuneration and Per Diem 0.0 202.0 202.0 b. Local Travel 0.0 10.5 10.5 c. Reports and Communications 0.0 2.0 2.0

2. Equipment 0.0 3.0 3.0 3. Contingencies 0.0 32.5 32.5 Subtotal (A) 0.0 250.0 250.0 B. Government Financing 1. Office Accommodation and Transport 0.0 19.5 19.5 2. Remuneration, Per Diem of Counterpart Staff 0.0 45.5 45.5 Subtotal (B) 0.0 65.0 65.0 Total 0.0 315.0 315.0

a Financed from Asian Development Bank’s technical assistance funding program. Source: Asian Development Bank estimates.

70 Appendix 10

4. Executing and Implementing Agencies. The Executing Agency and IA for the TA will be MOF, which will also maintain the CPMU for overseeing the implementation of the SME SDP. The CPMU will provide the necessary counterpart staff, their local transportation, and other necessary services. 5. Schedule, Reports, and Reviews. The TA will commence will be implemented over the implementation period of the SDP. The consultant will provide assistance to the CPMU to prepare and submit regular progress reports to ADB in a timely manner. Further, the consultant will assist relevant agencies in organizing stakeholder consultative discussions on policy reform; participate in the forums; and ensure that appropriate comments from stakeholders are duly considered. The consultant will also ensure that the implementation progress is published and regularly updated through the electronic homepage for the SDP at the MOF web site. 6. Consulting Services. The TA will engage a long-term domestic consultant for a total of 45 person-months. The consultant must have relevant experience in the SME sector and thorough understanding of the ADB’s and the Government’s program and project modalities and procedures. The consultant will do the following:

(i) liaise with relevant stakeholders from Government, private sector and funding agencies to foster participation in the implementation of the SDP;

(ii) assist in organizing and participate in stakeholder workshops, and report to ADB important issues arising from the stakeholder feedback;

(iii) follow up with the CPMU and IAs on the implementation progress of all measures SME SDP to ensure timely implementation, and convey to ADB any issues in the implementation and ensure that appropriate actions are taken without delay;

(iv) serve as a resource person for the CPMU and IAs on overall supervision, implementation, and monitoring of various activities under the SME SDP, and provide guidance on ADB’s project administration procedures, including active support in the consulting bidding and selection process;

(v) assist the CPMU and IAs involved in the implementation in preparing regular progress reports and coordinate with MOF and other relevant agencies so that information is regularly updated on their web sites; and

(vi) assist ADB’s missions in conducting its duties including organizing meetings with relevant agencies and private sector stakeholders.