Document of The World Bank FOR OFFICIAL lUSE O)NLY I;>. 4 N Report No. 10072-CUIA a1*)1.. t. .A:;;Y . '. STAFF APPRAISAL REPORT CHINA FINANCIAL SECTOR TECHNICAL ASSISTANCE PROJECT AUGUST 25, 1992 County-y Operations Division China and Mongolia Department East Asia and Pacific Region This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. CURRENCY EQUIVALENTS (as of Augusc 1992) Currency Name - Renminbi; Currency Unit Yuan (Y) $1.00 Y 5.50 Y 1.00 $0.18 FISCAL YEAR January 1 - December 31 WEIGHTS AND MEASURES Metric system ABBREVIATIONS AND ACRONYMS AAPRC - Audit Administration of the People's Republic of China ABC - Agricultural Bank of China ADB - Asian Development Bank ATM - Automated Teller Machine BOC - Bank of China BOCOM - Bank of Communications CFCC - China Finance Computer Company CIB - China Investment Bank CICPA - Chinese Institute of Certified Public Accountants CITIC - China International Trust and Investment Corporation CPA - Certified Public Accountants CPE - Continuing Professional Education CSA - Chinese Society of Accountants DAAA - Department of Accounting Affairs Administration EIS - Electronic Interbranch System GAAP - Generally Accepted Accounting Principles GDP - Gross Domestic Product GNP - Gross National Product GOC - Government of China GOJ - Government of Japan ICBC - Industrial and Commercial Bank of China IMF - International Monetary Fund ITIC - International Trust and Investment Corporation JGF - Japanese Grant Facility MIS - Management Information System MOF - Ministry of Finance NBFI - Nonbank Financial Institution OTC - Over-the-Counter PBC - People's Bank of China PCBC - People's Construction Bank of China PCR - Project Completion Report PICC - People's Insurance Company of China ABBREVIATIONS AND ACRONYMS (cont'd) PPAR - Project Performance Audit Report PRC - People's Republic of China RCC - Rural Credit Cooperative SAEC - State Administration for Exchange Control SEZs - Special Economic Zones SOE - State-Owned Enterprise SPC - State Planning Commission SRC - System Reform Commission STAQS - Securities Trading Automated Quotations System TIC - Trust and Investment Corporation TVEs - Township and Village Enterprises UCC - Urban Credit Cooperative ZACS - Zhonghua Accounting Correspondent School FOR OFFXICAL USE ONLY CHINA FINANCIAL SECTO ECHNICA CE PROJECT Credit and Proiect Summary Borrower: People's Republic of China Beneficiarvs The People's Bank of China (PBC) Amount: IDA credit: SDR 42.1 million (US$60.0 million equivalent) Terms: Standard, with 35 yeira maturity Proiect Obiectives The proposed project is designed to lay the foundations and Descrintion: for continued financial sector reform by strengthening key elements of financial sector infrastructure. The project will support modernization of the national pay- wn.ts and clearing system and other central bank func- tions in the areas of financial sector regulation and supervision, accounting and internal audit, research and statistics, fiscal agent and monetary policy, and train- ing in economics and banking. The project will further support the government's efforts in modernizing the overall national accounting framework, strengthening its domestic debt management and modernizing the framework for external auditirg. Benefits and Risks: The improved functioning of the financial system would contribute to more efficient mobilization and allocation of savings. A sound regulatory and supervisory system would help to preserve stability in the context of a rapidly evolving financial sector with a larger number and greiter diversity of financial institutions and instruments. Modernization of the accounting and audit- ing framework will give banks and enterprises the tools for more efficient management and facilitate capital market development. A modern payments and clearing system is an integral component of successful economic reform, while a stronger public debt management system and monetary policy function will be conducive to macro- economic and price stability. The risk that financial sector reform will not proceed at a pace required to provide a meaningful project context is mitigated by the expectation that the Government, which has professed a continuing commitment to reform, will feel more confi- dent in taking new refcera measures as macroeconomic stability is sustained. Moreover, since institution building is a long-term process, it is important to lay the ground now for the time when reforms accelerate. To guard against the risk that the project will overtax the This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. absorptive capacity of project beneficiaries, each institution has established effective project management arrangements, while IDA will closely supervise the proj- ect. Estimated Costs: Local Foreign Total - ($ million) … Peoi2le's Bank of China Regulation and supervision 0.5 5.8 6.3 Payment and clearing 0.1 42.5 42.6 Accounting 0.7 3.5 4.2 Internal audit 0.1 - 0.1 Research and statistics 0.1 1.5 1.6 Fiscal agent/monetary policy <0,1 1.6 1.6 L3gal 0.1 0.2 0.3 PBC Graduate School - 0.5 0.5 Automation Strategy Study <0.1 0.2 0.2 Directed Credit Study <0.1 - <0.1 Ministry of Finance Accounting 0.7 2.4 3.1 Domestic Debt Management <0.1 1.1 1.1 Debt Monitoring 0.1 0.2 0.3 Audit Administration Standards Development <0.1 0.2 0.2 Total Base Costs 2.5 59.7 6,:.2 Physical contingencies 0.2 1.6 1.8 Price contingencies 0.1 1.6 1.7 Total Project Costs 2.8 62.9 65.7 Financing Plan: Local Foreign Total …- ($ million) --------- IDA 1.5 58.5 60.0 JGF 0.2 4.4 4.6 PBC 0.9 0.9 MOF 0.2 0.2 AAPRC <0.1 - <0.1 Total 2.8 62.9 65.7 Estimated IDA Disbursements: PY93 FY94 FY95 FY96 Y97 FY98 FY99 FY2000 ------------------ ($ millionj ----------------- Annual 3.0 2.7 4.4 9.6 12.0 16.8 9.0 2.5 Cumulative 3.0 5.7 10.1 19.7 31.7 48.5 57.5 60.0 CHINA FINANCIAL SECTOR TECHNICAL ASSISTANCE EROJECT Table of Contents Page No. I. INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . 1 II. THE FINANCIAL SECTOR . . . . . . . . . . . . . . . . . . . . 2 A. The Macroeonomic Context . . .........e . 2 B. The Financial Sector: Reforms and Issues . . . . . . . . 4 Background . . . . . . . . . . . . . . . . . . . . . . 4 Reforms and Development Strategy . . . . . . . . . . 4 III. BANK GROUP SUPPORT FOR THE FINANCIAL SECTOR . . . . . . . . . 16 A. Past Bank Group Support . . . . . . . . . . . . . . . . . 16 B. Bank Group Objectives and Strategy . . . . . . . . . . . 17 IV. THE PROJECT . . . . . . . . . . . . . . . . . . . . . . . . . 19 A. Project Rationale and Objectives . . . . . . . . . . . . 19 B. Project Components . . . . . . . . . . . . . . . . . . . 21 Prudential Supervision and Regulatlon Component . . . 21 National Payment and Clearing System Component . . . . 22 Accounting and Auditing Component . . . . . . . . . 24 Internal Audit Component . . . . . . . . . . . . . . 26 Research and Statistics Component . . . . . . . . . . 27 Government Domestic Debt Management/PBC Fiscal Agent and Monetary Policy Component . . . . . . . . . . . 27 Legal Component .. . . . . . . . . . . 29 PBC Graduate School . . . . . . . . . . . . . . . . . 29 PBC Autoiration Strategy Study Component . . . . . . 30 Study on Directe Credit . . . . . ... . . . . . . . 30 MOF Debt Monitoring Component . . . . . . . . . . . . 30 This report is based on the findings of an appraisal mission in September 1991, composed of B. Kafka (Mission Leader), F. Montes-Negret (Senior Economist) and N. Lichtenstein (Senior Counsel). The report also reflects contributions made during preparation and preappraisal by V. Sundararajan, C. McAuliffe, M. Quintyn , M. Fetherston, M. Bell, H. Rhor (IMF); V. Polizatto, A. Sheng, R. Ng, P. Hsueh, R. Venkateswaran (Bank); and W. Stone, M. Mould, H. Keefe, H. Sui, S. Lo (Consultants). Peer reviewers comprised: D. Kochav (EM4IF), M. Wormser (AF1IE) and K. Siraj (ASTIF). The report was updated by S. Katsu (Task Manager). The Division Chief is David Pearce (EA2CO) and the Department Director is Shahid Javed Burki (EA2DR). Page No. V. COSTS. FINANCINGAND MANAGEMENT . . . . . . . . . . . . . . . 31 A. Summary of Costs . . . . . . . . . . . . . . . . . . . . 31 B. Financing Plan . . . . . . . . . . . . . . . . . . . . . 31 C. Main Features of hIe IDA Credit . . . . . . . . . . . . . 33 VI. PROJECT BENEFITS AND MAIN RISKS . . . . . . . . . . . . . . . 37 A. Project Benefits . . . . . . . . . a. . . . . . . . 37 B. Main Risks . . . . . . . e . . . . . . . . . . . . . * . 38 VII. AGREEMENTS REACHED AND RECOMMENDATION . . . . . . . . . . . . 39 TABLES IN TEXT 5.1 Project Cost Estimates . . . . . . . . . ....... 32 5.2 Project Financing Plan . . . . . . . . . . . . . . . 33 5.3 Summary of Proposed Procurement Arrangements . . . . . . 34 ANNEXES 1. Structure of the Financial System . . . . . .... . . . . 42 2. Government Domestic Debt Management and the Development of a Government Securities Market M . . . . .. . . . . . . 43 3. Structure of Interest Rates . . ...... . . . . . . .. 47 4. Agreed Coverage of Prudential Regulations . . . . . . . . . . 50 S. Legislat4ve Framework, Prudential Regulation and Supervision . . . . . . .. . . . . . . . . . . . . . 52 6. Accounting and Auditing Framework and PBC Accounting and Internal Audit . . . . . . . . . . . . . . . . . . . . . . . 60 7. Current Status of Payment System Development in China . . . . 65 8. Terms of Reference for Strengthening Prudential Supervision and Regulation . . . . . . . . . . . . . . . . . . 73 9. Terms of Reference for Payments System Design Study . . . . . 113 10. Ministry of Finance, Department of Accounting Administration Affairs: Terms of Reference for Development of Accounting Star.dards . . . . . . . . . . . . . . . . . . . . . . . . . . 126 11. China Institute of Certified Public Accountants: Terms of Reference for the Design of a Program of Continuing Professional Education (CPE) . . . . . . . . . . . . . . . . 130 12. Ministry of Finance, Department of Accounting Administration Affairs: Terms of Reference for Special Adviser . . . . . . . 136 13. People's Bank of China and Financial Sector: Terms of Reference for Strengthening Accounting . . . . . . . . . . . 141 14. Terms of Reference for Consultancy to the Audit Administration of PRC (AoPRC) . . . . . . . . . . . . . ... . 149 15. People's Bank of Chinat Program for Strengthening Internal Auditing . . . . . . . . . . . . . . . . . ... 152 16. People's Bank of China: Research and Statistics Component . 155 - iii - Page No. ANNEXES (cont'd) 17. MOF Debt Management and PBC Fiscal Agent/Monetary Policy Components Terms of Reference . . . . . . . . . e . 166 18. Summary of Technical Assistance to Legal Department . . . . 175 19. PBC Graduate School: Terms of Reference for Adviser . . . . 176 20. PBC Graduate School: Equipment List . . . . . e . . . 0 . . 178 21. People's Bank of China: Terms of Reference for Automation Strategy Study . . . * . * . * . . . * a . . . . . . . . . 179 22. Terms of Reference for Study on Directed Credit . . . . . . . 183 23. Estimated Disbursements . . . . . . .... . .. . .. .. 185 24. Rey Monitoring I.dicators. . . . . . . . . . . . . . . . o . 186 25. Matrix of Monitorable Indicators . . . . a . . . . . . . . . 189 26. Supervision Plan . . . * * . * . . . . . . . . . . . . . . 194 27. Selected Documents and Data Available in the Project File . . 198 CHARTS 1. The People's Bank of China (PBC): Organization Chart . . . 199 2. The Ministry of Finance (MOF): Organization Chart . . . . 200 3. The Audit Administration of the People's Republic of China (AAPRC): Organization Chart . . . . . . . . . . . . . 201 4. Project Implementation and Supervision Schedule . . . . . . . 202 CHINA FINANCIAL SECTOR TECHNICAL ASSISTANCE PROJECI I. INTRODUCTION 1.1 Starting in 1978, the Government of China (GOC) emDarked on an ambi- tious process of economic reform. As part of this process, major changes were initiated in the financial sector, which has since undergone a pronounced transformation. While much has been accomplished, further policy reform, institutional strengthening and modernization of the sector are necessary. Ongoing reform of the sector must be a complement to the reforms being imple- mented in other areas of the economy. Strengthening of the financial sector would enhance the efficiency of resource mobilization and allocation and help to achieve sustainable growth with price stability. 1.2 The Bank Group's involvement in China's financial sector began in the early 1980s when it helped to establish the China Investment Bank (CIB), a development finance institution. Since then, the Bank Group has provided a series of loans to both CIB and the Agricultural Bank of China (ABC), one of the country's four major specialized banks, and channeled funds for industrial development and restructuring through several other intermediaries. Two major pieces of sector work have been produced in collaboration with Chinese coun- terparts: the 1987 Finance and Investment Study (Report No. 6445-CHA) and the 1990 Financial Sector Review (Report No. 8415-CHA). The proposed Financial Sector Technical Assistance Project is a product of the Bank Group's increased understanding of the sector and builds upon the analyses of previous interven- tions. It is the first project in the sector focusing on strengthening key financial sector infrastructure, which is fundamental for successful reform. 1.3 The proposed project was prepared by a series of missions which involved members of the Bankle Industry and Energy Operations Division and Country Operations Division, China and Mongolia Department, East Asia and Pacific Region; the Technical Department, Asia Region; the Financial Policy and Systems Division of the Country Economics Department; the Information, Technology and Facilities Department; the International Monetary Fund; as well as several consultants. Background documents concerning the project are listed in Annex 27 and are available in the ProjecL File. -2- II. THE FINANCIAL SECTEO A. The Macroeconomic Context 2.1 China's economic reforms commenced in the rural sector with the introduction of the household responsibility system, giving households control of their own production, and subsequently moved into the industrial, financial and other economic sector4. From the start of the reform era ln 1978 through 198&, real GNP growth averaged nearly 10 percent annually; real per capita incomes increased by 6-7 percent each year in the urban areas and those in the rural sector more than doubled. Farm labor made redundant by rural reforms was largely absorbed by growth of rural industries organized mostly as collec- tive (township and village (TVE)) and private enterprises and currently employing some 90 million workers. China's high savings rate permitted corre- spondingly high levels of investment to be financed largely through domestic savings and, until 1986, the economy was close to resource equilibrium. The reforms brought a progressive opening of the economy, a diversification of exports and an lnflow of foreign direct investment. Significant strides were made in the critical areas of price and enterprise management. Price reform has led to a two-tiered pricing system with controlled prices for production to meet planned output targets, and market-related prices for output above plan targets. Some 53 percent of prices are now determined by the market, with another 17 percent floating within approved ranges and about one-third thus fixed by the state. Enterprise reforms have included, among other things, the introduction of a system of contract management responsibility5 a uniform basic tax rate (55 percent) (although in practice this to date has been implemented with limited results to the extent that taxes are subject to ad hoc negotiations through contracting), wage incentives for workers and higher profit retention. 2.2 As long as macroeconomic policies remained relatively conservative, high growth coexisted with stable prices. However, industrial decentraliza- tion, accompanied by decentralized implementation of credit and revenue policy beginning in the mid-1980s, weakened the center's ability to control monetary aggregates and severely eroded the Government's revenue base. The budget deficit gradually widened and, starting in 1984, monetary policy became highly expansionary. Inflation flared briefly in 1985 (8.7 percent), slowed during 1986/87, but by the latter half of 1987, free market prices and urban living costs began again to climb rapidly, serving to prime expectations regarding inflation. When in May 1988 the Government announced its intention to imple- ment major price reforms, households embarked on a spending spree. Urban consumer prices soared at annual rates of over 60 percent in the third quar- ter, forcing the authorities to rescind the proposed price reforms and initi- ate a stabilization program. 2.3 The approach to stabilization taken by the Chinese authorities starting in September 1988 called for the coordinated use of several instru- ments: administrative action to restrict capital spending and reduce invest- ment demand; slower money supply growth, tight credit ceilings and increased nominal interest rates on deposits to revive savings and on loans to discour- age borrowings; more strictly enforced guidelines on wages and bonuses as well as the collection of taxes on excessive bonus payments; a narrowing of the budget deficit through increased taxes and reduced subsidies; and stricter price controls. These measures resulted in a decline in retail price infla." tion from 18.5 percent in 1988 to 17.8 percent in 1989 and 2.1 percent in 1990, a marked slowdown in economic growth to an annual rate of 3.9 pereent in 1989, and a massive accumulation of inventories of unsold goods. WThile growvth began to pick up in 1990 to 4.9 percent for the year and accelerated to 7 per- cent in 1991, this was made possible by an easing in monetary policy. While inflation remained a low 2.9 percent in 1991, there are now signs that thes easing together with an acceleratior of real wages and incomes are increasing inflationary pressures, calling for careful monitoring on the part of the authorities. 2.4 The stabilizatlon program has entailed increased use of administra.- tive controls, which detract from the progress made towards the use of market mechanisms to regulate the economy. Indeed, the success in restoring stabil- ity should be seized as an opportunity for implementing key price, fiscal and enterprise reforms; the adjustments made in 1990 and 1991 in admJnistered prices across a range of commodities were courageous steps in this spirit. China's rapid growth over the past decade is attributable largely to the eco- nomic reform process initiated in 1979 and its future prospects will depend critically on continued reform and opening to the outside world. China's leaders have expressed a continuing commitment to reform and the challenge will be to recover the momentum while maintaining stability. 2.5 The authorities recognize in particular that further price and enterprise reform is necessary for successful financial sector reform. As long as prices do not reflect market values, commercial lending decisions by financial tnstitutions will be biased towards entities with high financial returns but possibly very low economic returns or poor longer-term prospects. Ultimately, this will lead to losses all around. Administrative intervention is a poor remedy; governments have seldom consistently been good judges of crejitworthy endeavors. Moreover, directing credit to endeavors which are not profitable under administered prices threatens the viability of financial institutions. Similarly, enterprise reforms are needed to make enterprises disciplined in thei- investing and borrowing decisione and to give financial institutions the confidence that they are lending to responsible and account- able entities. 2.6 The future price reform agenda will have as its objective the estab- lishment, in the second half of the 1990s, of a mixed management system, in whicic a few strategic and important products and services (important raw mate- rials, infrastructural facilities and urban services, and agricultural pro- curement prices for products still under almost exclusive government purchase) are to be priced by the Government while the rest will be freed and subject largely to market forces. The prices of products and services remaining under government control will be adjusted to bring them closer to market levels and to facilitate the eventual abolition of the two-tier price system; prices of all other categories of goods and services will be gradually liberalized. In the area of enterprise reform, the GOC plans to improve the contract responsi- bility system, with minor modifications, and to actively study and experiment with alternative forms of enterprise ownership, the introduction of company law and the implementation of bankruptcy legislation. Of particular impor- tance are current efforts to design a shareholding system ("joint-stock owner- -4- ship") suitable for Chinese state-ofned enterprises; guidelines to establish national enterprise groups which can operate across sectoral and local boun- daries have been issued as well. Moreover9 the authorities are now turniing to the deaign of housing and social security reform programs, both of which are fundamental prerequisites for successful enterprise reform. B. The Financial Sector: Reforms and Issues Baground 2.7 rrior to 1979, China had virtually a monobank system in which most financial transactions were handled by the People's Bank of China (PBC). Two other banks provided specialized services: the People's Construction Bank of China (PCBC) channeled budgetary funds to state enterprises and construction projects, and the Bank of China (BOC) handled foreign exchange and financed international trade. A large network of rural credit cooperatives (RCCs), one in each township, provided a narrow range of financial services, mainly deposit taking and provision of seasonal credit. A nonbank financial system was virtually nonexistent, as was any significant informal financial interme- diation. Allocation of resources was primarily by fiscal directive, and mone- tary policy was an adjunct of fiscal policy. Reforms and Development Strategy 2.8 Restructuring of the financial sector began in 1979 with the resto- ration of FBC as the country's central bank and the reestabliihment of the Agricultaral Bank of China (ABC) as a specialized banlc to take over PBC's rural banking functions. In 1984, PBC's formal establishment 6a the central bank was completed with the divestiture of its urban commercial banking func- tions to the newly teated Industrial and Commercial Bank of China (ICBC). Some nonbank financial institutions, many with an international orientation, were also established. Reforms began to deepen in 1986, and the financial cector has since undergone a rapid transformation. The range of financial institutions and instruments has markedly increased; financial savings have grown rapidly; capital m-rkets have begun to develop, though to a still limited extent; specialized banks have been given greater autonomy and an increased mandate of operations; the use of indirect monetary policy instru- ments has somewhat increased; and the financial system has come to play an important role in investment financing. Notwithstanding these advances, major development challenges remain and will be the focus of ongoing reform efforts. 2.9 Role and Organization of PBC. PBC's new mandate is embodied in provisional regulations on banking enacted in 1986, which designate PBC as the monetary authority and regulatory and supervisory agency for the entire finan- cial sector, including all financial institutions as well as money and (less clearly) capital markets. In response to this new mandate, PBC has begun to reorient and develop its institutional approaches, policy instruments and organizational structure, the latter to provide for greater interaction between functional departments and planning, policy and research areas. PBC's main objective has shifted from that of a passive supplier of cash and credit in accordance with planned targets to fulfilling the traditional functions of a central bank. This shift in focus notwithstanding, PBC continues to lend directly or through the specialized banks to key state enterprises and to -5- promrote regional. development. These direct lending activities merit review as to their appropriateress for a central bank. PBC has made significant prog- reas in strengthening key functions since its reconstitution eo a traditional. central bank. Nevertheless, time elapsed has been short, and further strengthening would be supported under this project. 2.10 As of 1979, PBC had about 15,000 offices at various levels through- out the country and employed a staff over 300,000. By the e;Ld of 1990, five years after completing the divestiture of its commercial bank:lng functiono, PBC's branch network had been reduced to 2,344 and its total staff to 99.644. Branches largely correspond to administrative boundaries: thera were 30 pvo vincial level branches with a staff of 8,492; 14 branches at the level of cities designated as independent plan units with a staff of 3,181; 310 iiwnici- pal and prefectural levy' subbranches with a staff of 32,285; 1,964 county offices with a staff of 057; and 26 lower level offices with a sta£f of 379. In addition, PBC ha, i4l colleges, schools, and training cent:ers emnploy- ing 10,747; 15 printing enterprises with a staff of 20,220; and 30 otheor sub- sidiaries with a staff of 1,216. PBC's head office is divided into somen 23 departments and has a staff of 2,250 (Chart 1). 2.11 PBC is furctionally equivalent to a line Ministry under the State Council, and .tc key policy making body is a Council which includes the Governor and five Deputy Governors of PBC as well as one Vice-Minister each from the Ministry Df Finance (MOF), State Planning Commission (SPC), Systemn Reform Commission (SRC) and the presidents of the four specialized banks and the People's Insurance Company of China (PICC). Almost all economic decisions of the PBC Council must be referred to the State Council for approval. WIile PBC is nominally accountable only to the State Council, the membership of the PBC Council, and the strength of other line ministries therein, in practice constrain PBC's independence at the national level. Despite progress since 1988, when PBC head office was empowered to appoint provincial and local. PBC managers, the continuing strong influence of provincial and lower levi Cov- ernments has limited the effectiveness of PBC's control over its brarcs.ts. The matter of PBC's independence is one which the authorities recognize as deserving serious review in the drafting of the planned new banking law. At the same time, PBC is considering reorganizing its branch network to coi;ncide with economic rather than political regions, which would serve to further strengthen the control of PBC headquarters. 2.12 Financial Institutions and Activity Sco2pe. The reforms have resulted in a very different financial sector than that of 1979 or even 1986, with a much wider range of institutions. As per latest figures, the banking sector consisted of the central bank; the four specialized banks (ICBC, ABC, PCBC, BOC); two national-level comprehensive banks (the Bank of Communications (BOCOM), reestablished in 1986, and the China International Trust and Invest- ment Corporation (CITIC) Industrial Bank, established in 1987, a bank (CIB) and a vast network of 57,185 rural credit cooperatives (RCCs) and 3,518 urban credit cooperatives (UCCs). RCCs and UCCs operate under the tute- lage of ABC and ICBC, respectively. There was also a large number of nonbank financial intermediaries (NBFIs), which proliferated at a remarkable pace: 361 trust and investment companies (TICs) and 14 international trust and investment companies (ITICs), 19 finance companies, 9 leasing companies, 68 security corporations approved by PBC and 300 security agents carrying out -6- security transactions under the tutelage of MOF, 3 insurance companies, in a market overwhalmingly dominated by PICC, and a network of rural nongovern- mental financial institutions. The number of TICs is a significant reduction from the peak of 745 existing in 1988, following the decision to close, or merge with specialized banks, those TICs established by counties, that is by administrative levels below the national, provincial and city governments. A number of foreign banks have been allowed to open oranchas in the Special Economic Zones (SEZs) with a limited business scope, mostly foreign trade related operations. The increased institutional diversity is a welcome devel- opment, although of concern is the apparent undercapitalization of some of the nawer intermediaries established in a framework of inadequate regulation of the sector (paras. 2.35-2.37). The closure of lower level TICs was largely designed to deal with this problem. Annex 1 provides key indicators of the institutional structure. 2.13 Notwithstanding these developments, the assets of financial institu- tions remain heavily concentrated in the banking sector and particularly among the specialized banks. The banking system as a whole accounts for more than 90 percent of finqncial institution assets. Specialized banks alone account for almost 90 percent of banking system assets. 2.14 The reforms have brought about a decentralization of financial activity and a change in institutional roles. Banks now play an important part in investment financing. While in 1981 the budget provided 28 percent of fixed asset investment financing and banks only 13 percent, in 1989 the share of the budget had declined to 8 percent while that of bank loans had increased to 17 percent (down from a peak of 23 percent in 1987, with retained earnings and extrabudgetary funds constituting the balance). Since 1985, the special- ized banks officially have been able to undertake and compete for general banking business irrespective of the economic sector. The new comprehensive banks are allowed to compete across the range of specialized banks' activi- ties, and the UCCe and RCCs have begun to compete with the specialized banks. Overlaps developed not only within the bar.king system but also between the system and the NBFIs. Many TICs began to function almost like banks, while banks have entered into nontraditional activities; however, a decision was taken in 1990 that TICs would no longer be able to take household deposits or grant working capital loans. 2.15 Although it has increased, competition in the sector continues to be constrained by structural issues and a variety of informal and formal regula- tory controls. Full overlap in the functions of the specialized banks remains inhibited by the structure of their preexisting branch networks. To control enterprise borrowing during the retrenchment program, the authorities reverted temporarily to the previous practice of requiring enterprises to choose one basic bank with which to do banking business. Credit and interest rate policies (paras. 2.24-2.29) also inhibit competition. The inability to com- pete on prices has induced intermediaries to try to function as far as possible across the range of activities and impeded the development of market niches based upon comparative advantage. In mapping out avenues for future reform, China's leaders face the challenge of trying to increase efficient competition while maintaining sector stability. Given the immaturity of the system, the reforms to take place in the real sector and the still undeveloped - 7 - state of financial sector infrastructure, GOC would be wise to proceed steadily but cautiously in this area. 2.16 Financial Assets and Markets. A further product of the reforms has been an increase in the range of financial instruments, previously limited to cash, bank deposits and treasury bonds (the latter only introduced in the early 1980s and, until recently, allocated mainly on a mandatory basis). A small interbank market has bee.a operating since December 1986. Indexed depos- its, enterprise and financial bonds, bond-like en:erprise sharea, and money market instruments--bankers acceptances, trade bills, certificates of deposit and coamercial paper--now contribute to the growing variety of financial instruments available to borrowers and savers. 2.17 Nevertheless, securities accounted for only 15 percent of end-1991 financial assets, up from 3 percent in 1985, and less than 20 percent of GNP (for comparison, in 1985, in the United States, Japan, and Malaysia, bonds and equities represented on the order of 50 percent of GNP and money market instruments on the order of 100 percent of GNP). Securities consist princi- pally of a variety of government/quasi-government bonds, of which some Y 97.3 billion remained outstanding as of end-1991. Amounts of other bonds (e.g., financial bonds, local enterprise bonds) and particularly shares have been relatively small; as of end-1991, shares outstanding amounted to only Y 7 billion (of which only a fraction is publicly listed and traded) and financial and local enterprise bonds to Y 70.0 billion. 2.18 The development of securities has been impeded by the absence of an adequate legal and regulatory framework for capital and money market activi- ties and restrictions on secondary market trading. With regard to the former, there is a need to elaborate company and securities laws at the national level, stipulate disclosure and other requirements and detail the rules and regulations required to give practical effect to the bankruptcy law. At pre- sent, some local governments are developing their own rules and regulations; while these are useful as experiments, at the same time there is a danger of fragmented local markets governed by different rules. The development of a national framework would be a superior approach. The authorities recognize these dangers, and PBC has successfully sought assistance (a recently approved grant of $600,000 equivalent) from the Asian Development Bank (ADB) in paral- lel with the proposed proj:ct to help develop capital markets, including a national securities law. .rn addition, the proposed project would support the development of selected regulations having particular relevance for the devel- opment of a voluntary market in government securities. 2.19 Development of markets has also been constrained by restrictions on secondary trading. In the past, PBC felt that these restrictions were war- ranted in view of the lack of experience of both issuers and savers with the new instruments, ongoing price distortions and other factors influencing the use of funds. Prior to 1988, government securities were not officially trade- able. Starting in 1988, PBC allowed trading of treasury bonds issued to indi- viduals in 1985 and 1986; now all treasury bonds sold to individuals are tradeable in markets established in 63 cities. However, trading of other government securities remains prohibited. Spurred by the introduction since 1988 of treasury bonds of shorter maturities (para. 2.20), and a decline in inflation and deposit rates, trading of securities grew from Y 2.8 billion in -8- 1988 to Y 60.0 billion in 1991; about 75 percent of total trade in 1991 was still in treasury bonds. The significant increase in trading volume reflects the paucity of alternative savings instruments available to savers and demon- strates the great potential which exists to develop financial markets, 2.20 The development of a voluntary market in government securities is further impeded by the nature of issuing procedures, limitations in the 1enom- ination and maturities of issues and pricing considerations (Annex 2). Until 1991, placement was entirely by administrative means to individuals, enter- prises and more recently financial institutions. As burgeoning fiscal defi- cits and refinancing needs have forced the Government to broadern the placement of its securities, it has taken steps to make them more attractive by shorten- ing their maturities and increasing their coupon rates. These measures made it possible for MOF in April 1991, for the first time, to issue Y 2.5 billion to voluntary subscribers through a highly successful experimental underwriting syndicate of treasury securities dealers. While some resort to mandatory allocation may continue in the short term, the Government plans to further develop its debt management system along market lines. Development of an efficient government securities market will help lay the foundations for broader-based capital markets. As discussed in Chapter 4 (paras. 4.22-4.26), the proposed project includes support in this area. 2.21 "Stock" markets now exist in some 54 Chinese cities, compared with only 7 in 1987, Formal stock exchanges were opened in Shanghai in late 1990 and Shenzhen in 1991; however, the number of shares listed and traded is small (only 17 in Shenzhen and 18 in Shanghai (end-1991)]. Active trading in these markets, despite a lack of clarity with respect to the definition of owner- ship, again indicates the great potential which exists, under the right cir- cumstances, for the development of capital markets. 2.22 Financial Deepening. China's extraordinarily high domestic savings rate together with the financial reforms have produced substantial financial deepening. As a share of GDP, broad money (M2) rose from 37 percent in 1979 to 69 percent in 1988 before declining to 60 percent in the first half of 1989 as a result of accelerating inflation. With the subsequent decline in infla- tion and rapid rise of household financial savings, the ratio rebounded to 98 percent as of end 1991. The depth of China's financial sector compares favorably with countries of similar income levels. However, as noted earlier, most of the depth comes from the banking system, and the share of NBFIs and markets is smaller than in some other low income and Asian countries, 2.23 Monetary Policy. Since it was established as the country's central bank, PBC's tools for monetary management (previously limited to direct lend- ing to enterprises and administration of credit ceilings for specialized banks) have grown also to include direct lending to the banking system, changes in reserve ratios (currently 13 percent with an additional 5 to 7 per- cent in mandatory excess reserves), adjustment of interest rates and, increas- ingly, discount operations. In spite of these developments, PBC's main instrument for regaining monetary control has been the application of manda.. tory credit ceilings, now applicable also to NBFIs. While this may have been appropriate under recent economic conditions and at this stage in China's development, in the longer term PBC plans to rely increasingly on indirect levers. In the meantime, it is desirable that PBC modify the process of deriving and implementing the credit plan and credit ceilings to make them leas rigid for the financial sector, broaden the scope of the plan to explicitly cover goverrnent financing needs, enhance the effectiveness of PBC's relending policies and discount operations, and gradually initiate the use of open market operations. The proposed project includes support to help strengthen PBC's monetary policy functions (para. 4.25) as well as its policy research and analytical capabilities (para. 4.21), which must become more effective to underpin monetary policy decisions. Increasing t'he range aneh efficiency of monetary policy instruments will in turn make a significant contribution to the development of money and short-term government securities markets and, thereby, improvements in domestic debt management. 2.24 Directed and Subsidized Credit. Through the investment and credit plans, the Government has historically played an important role in allocation of resources in China. Recently, as part of the stabilization and rectifica- tion program, the use of directed credit and priority (that is subsidized) lending seems to have increased. A March 1989 decision of the State Council instructs banks to give priority to key industries, including energy, agricul- ture, raw materials, telecommunications and transport. In the Government's view, these sectors have had inadequate access to finance as a result of pres- ent budgetary constraints (emanating in part from revenue sharing arrangements reducing the central government's share relative to that of the provincial governments and declining profitability of state-owned enterprises (SOEs)) and the banlks' preference for lending to more profitable light industry. At the same time, subsidized lending rates have been prescribed for certain key sec- tors now making up some 30 percent of fixed asset financing. Another vehicle for directing credit has been the imposition of subceilings, within the over- all credit ceilings, for township and village enterprises and fixed asset linancing. 2.25 The experience of most countries with directed and subsidized credit has been poor: it has seldom achieved its intended purpose, it has distorted resource allocation, and it has had severe detrimental financial consequences for the intermediaries through which it has been channelled. In China, some government intervention in credit realistically will persist for a number of years to come. However, the extent of such intervention should be reduced, in tandem with price and enterprise reforms. In the meantime, the effects of directed credit on the performance of financial intermediaries should be clearly isolated and demonstrated to the authorities. Under the proposed project, PBC would undertake a study on possible approaches for treatment of directed and subsidized credit (para. 4.30). 2.26 Interest Rates. Interest rates in China cannot play the same role as in market economies, given the incomplete status of price, enterprise and tax reform (and the continuing soft budget constraint) and limited competition in thb financial sector. Their utility as a tool of monetary policy is con- strained by the use of credit ceilings as the basis for control of monetary aggregates. These factors notwithstanding, in recent years, interest rates have become an increasingly important instrument in the management of aggre- gate demand, resource mobilization and, to a lesser extent, credit allocation and have been shown to have a significant impact on these variables. - 10 - 2.27 Interest rates have been adjusted 13 times since the beginning of 1985. Interest rate adjustments through February 1989 sought to increase rates above their historically very low levels and to respond to the bouts of high inflation. Over this period, interest rat2e on PBC's own credit were raised progressively; the rates on some type of deposits more than doubled; and the rates on working capital loans for enterprises rose by about 60 per- cent, Adjustments in 1990 and 1991 responded to the rapid deceleration of inflation by a lowering of the general interest rate level. Interest rate adjustments over the years (Annex 3) have reduced to some degree the tradi- tional multiplicity of loan and deposit rates (depending on purpose, location9 social priority, enterprise ownership, etc.), including by removing the major anomaly of lower rates on deposits from enterprises than on deposits from individuals. In 1989, to encourage long-term savings in the inflationary environment, the authorities introduced indexing of longer-term (3 years or more) deposizs from individuals. GOC also, for a time, permitted tanks to charge up to 30 percent higher or lower interest rates than the PBC-set basic rates for working capital loans, although this leeway has since been reduced to 10 percent below or 20 percent above the officially prescribed rate to gain greater control in the retrenchment program. 2.28 The interest rate adjustments have been significant developments. Recent interest rates in most cases have been positive in real terms, in some cases highly so, although some deposit rates remain only marginally above or, in the case particularly of sight deposits, below inflation. On the basis of current inflation expectations, some currently positive rates will become only marginally positive or slightly negative in real terms in the absence of new adjustments; however, recent history suggests that the authorities will respond quickly by raising the general rate structure as necessary in line with changing price levels. There remains a wide dispersion and multiplicity of rates, with more than 25 deposit rates and 50 lending rates in PBC's pub- lished rate schedule. Over time, interest rate adjustments have respitted in a reduction in the spread between deposit and lending rates, with negative con- sequences for bank margins, although the most recent adjustment indicates an effort to rectify this trend. To the extent banks wish to match the maturi- ties of their assets and liabilities, in some cases marginal spreads are excessively low. 2.29 China's interest rate policy continues to be a subject of dialogue with the Bank Group in the context of the Bank Group's economic and sector work program and lending operations. Given incomplete price and enterprise reform and limited competition in the financial sector, full liberalization of interest rates is not advisable presently in China. However, a gradual increase in the flexibility allowed MOF in fixing the rates on its own securi- ties and banks in determining deposit and lending rates would contribute to the development of financial markets and enhance the efficiency of resource mobilization and allocation. A new regulation inter alia to allow MOF to adjust its rates within bands without recourse in every case to the State Council is under diacussion internally in the Ministry and would facilitate development of a more market-oriented government domestic debt management system. Progress in promulgating and implementing this regulation would be monitored as part of the annual reviews of financial sector reform develop- ments (para. 4.1). - 11 - 2.30 Trends and Issues Among the Specialized Banks, The specialized banks account for more than three quarters of financial institution assets and hence their performance is a critical determinant of overall sector performance. There are signs that as a group the banks have come under stress, although conditions may vary from bank to bank. Overall, the bankcs are facing narrowing interest margins as a result of changes in the adminis- tered interest rate structure and in the composition of their liabilities. Historically, a significant proportion of bank deposits were low cost enter- prise, government and sight deposits. While the base rates on most enterprise deposits have been harmonized with those for individuals' deposits, index- ation, an important factor during the recent period of high inflation, applied only to the deposits of individuals. The share of enterprise deposits fell steadily from 49 percent of total deposits in 1985 to 38 percent in 1990, and the share of sight deposits declined from 48 percent of total deposits in 1985 to 39 percent. Moreover, the share of inflation-indexed deposits increased during the same period, although the decline in inflation mitigated the conse- quences for bank margins. Banks were further instructed to lend to identified priority sectors and key SOEs at subsidized rates. 2.31 At the same time, the quality of bank portfolios has clearly deteri- orated, although precise and up-to-date data are not available. Officials estimate that 30 percent of state-owned enterprises are operating at a lose; the counterpart of this is worsening portfolio quality. Rapid deposit growth, declining margins, and difficulties in collecting interest on problem loans have contributed to a decline in the ratio of banks' capital to assets from 9.8 percent in 1985 to 7.75 percent in 1989; most likely further deterioration in the ratio of at least some banks has taken place since. While a stated level of near 8 percent is acceptable under international standards, erstwhile MOP guidelines have limited bank loan loss provisions to between 0.1 and 0.2 percent of loan portfolios, levels far below what the quality of their portfolio dictates. If capital were adjusted to reflect true portfolio condi- tions, its adequacy would almost certainly be called into question. 2.32 The Government recognizes a need to relax restrictions on provisions policy, undertake special audits to ascertain the true quality of bank port- folios and condition and review policies affecting bank financial performance. In preparation for this project and other future operations through financial intermediaries, MOF decided to increase in 1992 the ceiling on the permissible level of provisions for the financial sector overall to 0.5 percent of a bank's portfolio and eventually, as conditions permit, to 1.0 percent. (This is for financial intermediaries other than CIB, for which agreement has already been reached, under Loan 3075-0-CHA, on an increase in provisions to at least 2.0 percent by the end of 1992.)1/ While the proposed increase to 0.5 percent is welcome and significant, it remains inadequate in the light of the probable quality of bank portfolios. Assurances on this proposed 1992 increase were obtained' an understanding was also reached that Provisioning policv would be one sublect for annual review during the course of proiect implementation (para. 4.1). with reference to developments in bank portfolio cuality. PBC would undertake comprehensive asset reviews of the four special- 1/ The authorities have indicated that these provisions will not be tax- deductible, limiting tax benefits to loan write-offs. - 12 - ized banks in 1993-981 the findings of these reviews would provide inputs for evaluating future provisioning policy. The proposed project would finance consultant services to provide on-the-job guidance to PBC staff undertaking a comprehensive review of BOCOM and the reviews of selected, but representative branches of some of the specialized banks (para. 4.3). 2.33 All of the banks require substantial institutional strengthening and upgrading of basic banking and management skills, despite progress made in recent years. Currently, bank organizational structures provide for inade- quate overall control by headquarters, while planning and budgeting tend to emphasize compliance with plan targets without adequate consideration of objectives, financial performance, risk and reward. Credit and financial management policies and procedures need to be better articulated and account- ing systems modernized. While individual banks all have their own network of training centers, these in many instances provide general education oriented toward high school or college degrees rather than specific bank skills upgrad- ing. Moreover, training has tended to be more academic than practical. The proposed project will support modernization of accounting standards and sys- tems applicable for banks (para. 4.18). Through its support for PBC's Gradu- ate School (para. 4.28), whose graduates join sponsoring banks, the project also would support strengthening of banking staff skills. Other ongoing or future Bank Group-supported operations would provide technical assistance for institutional upgrading of individual banks. 2.34 Chinese banks appear to have more autonomy than in the past, but this is still quite limited. Banks seem to have developed some degree of latitude in deciding whether to accept or reject loans, although, as noted above, government intervention in credit allocation increased under the recti- fication program. All of the specialized banks are now in principle respon- sible for their own profits and losses and are subject to the same 55 percent income tax applicable to all large- and medium-sized enterprises, plus a 7 percent "adjustment tax." However, a share of bank personnel and other operating expenses continues to be borne by government budgets, and a soft budget constraint implicitly continues to exist. Banks have now begun to come under the contract responsibility system, starting with ABC which already applies the concept throughout its provincial branch network. Development of more enterprise and bank autonomy remains a government objective but clearly will be a gradual process. 2.35 Prudential Regulation and Supervision. The basic legal framework for banking lies in regulations promulgated in January 1986 by the State Coun- cil. This legislation gives to PBC responsibility for banking regulation and supervision and the sole authority for approving the establishment, merger, or dismantling of specialized banks and other financial entities. Other regula- tions require PBC to supervise banks' compliance with state laws, the credit and other plans and state economic and financial policies. An additional body of legislation governs different types of financial firms and activities. 2.36 The current body of law is a loose amalgamation which focuses on economic aspects of regulation, consistent with the general philosophy of a centrally planned economy. As further reforms are introduced into the econ- omy, China will need a comprehensive body of banking laws, which must pre- scribe the role and functions of the PBC; level the playing field across - 13 - institutions; prescribe rules of entry and exit; and elaborate prudential regulations designed to ensure the safety and soundness of the system by including exposure limits to one borrower or a group of related borrowers, limits on insider transactions and minimum capital adequacy ratios, and by granting PBC the necessary authority and enforcement powers to correct unsound practices. While PBC has initiated work in this area, it needs to be com- pleted and implemented. Support would be provided under the project to assist PBC in drafting prudential regulations and to recommend a timetable for their implementation. Agreement on key areas to be covered in the regulations, as articulated in Annex 4, was confirmed at negotiations. A comprehensive banking law is now in the drafting stage. 2.37 PBC has made good strides in building the foundation of a supervi- sion function. However, supervisory activities are guided by the above legal framework and hence have tended to focus on the social and developmental role of banks and on compliance with economic regulation. There is a need to reorient supervisory activities to safeguarding the safety, soundness and stability of financial institutions and the system as a whole by focusing on the appraisal an1 management of financial institutions' risks. In due course, as banks begin to operate as more cohesive entities, supervision should take the form of an overall institution, top-down approach, as contrasted to the current situation where local PBC branches evaluate local bank branches almost as if the latter were independent entities. To develop a strong prudential bank supervision function, PBC will need to develop new supervision methodolo- gies and manuals, train and employ staff in new and more relevant skills and review the adequacy of the current organizational structure of its supervision activities. The project supports a comprehensive technical assistance and training program towards this end (paras. 4.3-4.7). Annex 5 contains a more detailed discussion of bank legislation/regulation and PBC's supervision func- tion. 2.38 Accounting and Auditing. Pursuant to the 1985 Accounting Law, responsibility for nationwide accounting rests with MOF, which, in practice, has delegated operational responsibility for establishing the accounting framework for banks to PBC. MOF and PBC have issued detailed rules and regu- lations governing accounting in the corporate and financial sectors, including basic charts of accounts, and the standard of bookkeeping in China appears high. However, while accounting principles are generally consistent with international standards in the broadest sense, they do not comply with gener- ally accepted accounting principles (GAAP) in many key areas. For example, contingent liabilities tend to be pzesented as part of the balance sheet, allowances for uncollectible debts are not established, interbranch balances are not netted out and valuation at lower of cost or market is not used. More generally, there is no distinction between financial and tax accounting, which underlies many of the existing anomalies. 2.39 The accounting standards and systems in force may have been suitable for use in a centrally planned and closed economy, but will not suffice for an increasingly open economy influenced by market forces. Current accounting standards are oriented to ensure compliance with rules, rather than to produce information needed for management purposes. This applies to both financial and nonfinancial enterprises, and is the most fundamental shortcoming of the existing standards. Bank lending decisions are made difficult by the lack of - 14 - reliable and informative financial statements on the part of potential borrow- ers, which will similarly inhibit the development of capital markets. Bank financial statements do not convey the information depositors and lenders will need to decide on the placement of their funds, once banks assume full respon- sibility for their profits and losses. These concerns are shared by govern- ment officials and members of the accounting profession; both HMO and the Chinese Society of Accountants (CSA) have established task forces to consider revisions of accounting standards with reference to international practice. The proposed project would support these efforts through a program of techni- cal assistance to MOP and PBC to help modernize accounting standards for the corporate and financial sectors and strengthen PBC's own accounting systems and practices (paras. 4.13-4.18). 2.40 External auditing of state-owned entities is the responsibility of the Audit Administration of the People's Republic of China (AAPRC), directly and throagh guidance of provincial audit bureaus. AAPRC has made significant progress since its establishment in 1983; nevertheless, it is constrained by an inadequate number of trained and experienced staff and audits therefore are undertaken too infrequently (target of 3-5 years) and are lacking in thorough- ness. Audits also tend to focus on compliance with rules. Under the Planning Support and Special Studies Project (Credit 1835-CHA), the Bank Group is providing some technical assistance to help strengthen AAPRC (which is also benefitting from technical assistance financed by ADB). The Bank Group fur- thermore is engaged in a continuous dialogue with AAPRC on the quality of audits for Bank Group-supported projects. Under the proposed project, a small amount of support will be provided to AAPRC to assist it in elaborating audit- ing standards (para. 4.19). It is expected that the auditing standards developed would be utilized not only by AAPRC and its lower level counterparts but also by the growing body of Chinese auditing firms which fall under the jurisdiction of AAPRC; these standards will also provide a useful model for the accounting firms which fall under MOF's jurisdiction, with respect to their auditing work. Annex 6 provides a more detailed discussion of the accounting and auditing framework in China. 2.41 External Debt Management. China has taken important steps since 1979 under its "open door" policy to liberalize access to foreign exchange to modernize the economy. The open door policy represents one of the most wide- ranging elements of the reform and is a major departure from the preceding decades of self-reliance and autarkic development. Since 1979, foreign direct investment as well as borrowing have supported technology transfer, moderniza- tion of equipment and import of capital goods, machinery and materials in short supply. These imports have contributed significantly to higher effi- ciency and growth in the Chinese economy. 2.42 Responsibility for external debt management and reporting rests with the State Administration for Exchange Control (SAEC), an agency under PBC, and HOF. The latter is responsible for reporting on borrowing by the Government and government entities and all borrowing from official sources, the former for producing China's balance of payments as well as overall debt management/ reporting and specifically reporting on borrowing by and from nonofficial entities. Under the proposed project, a small amount of support would be provided to MOF to strengthen its management of Bank Group debt by helping to establish an effective management information system (MIS) (para. 4.31), while - 15 - possible future Bank Group and IMF efforts may assist in strengthening SAEC's technical skills. 2.43 Pavment and Clearing System. Cash is the predominant means of pay- ment by consumers in China; checks are used primarily by enterprises and government entities and are restricted to the settlement of transactions within the same city clearing zone. Intercity or interprovincial paymento are settled mainly by mail orders or wire transfers sent through the national postal system. There is no nationwide check clearing system nor check docu- ment and coding standardization5 and check clearing, through PBC-run clearing centers, is highly labor-intensive, given the requirement for each bank branch to clear with each other as if it were a separate bank. Mail orders by letter may take up to a month to clear because of the inadequate transportation net- work and the country's vast size. 2.44 Existing payment and clearing methods result in significant payment delays, float and idle clearing balances, with detrimental implications for overall economic development. The lack of an efficient system for intercity and interprovincial transfers is also one factor constraining the development of integrated securities markets, which currently remain mainly local in char- acter. Modernization of the payment and clearing system is recognized by government officials as integral to ongoing economic reforms. Central to such modernization has been the initiation by PBC of the multiphased development of a national automated payment and clearing system based on a dedicated satel- lite communications system for electronic bank interbranch payments. The first phase of this development was initiated in April 1989; as of November 1991, 105 cities were equipped with satellite earth stations and 21 of these cities also were served by the computer network, the Electronic Interbranch System (EIS). As of end-March 1992, another 51 cities joined the EIS, bring- ing the total to 72. It is planned that an additional 60 branches will be linked to the EIS by January 1993, increasing the total to 132 city branches linked. Other efforts at modernization have included expanding the number of local clearing houses, widening their geographic scope and initiating the automation of the clearing house settlement process. Annex 7 provides further details on the current status of payment system development in China. The proposed project would support future phases of payments system development (paras. 4.8-4.12). 16 - III. BANK GROUP SUPPORT FOR THE FINANCIAL SECTOR A. Past Bank Group Support 3.1 The Bank Group's financial sector lending operations in China began with the approval of the first China Investment Bank (CIB) Project (Loan/ Credit 2226/Credit 1313-CHA) in December 1982, for $70.6 million. Four subse- quent loan and credit operations to CIB have been approved (Loan/Credit 2434/ 1491-CHA in FY84 for $175 million, Loan/Credit 2659/1594-CHA in FY86 for $100 million, Loan/Credit 2783/1763-CHA in March 1987 for $300 million and Loan 3075-0-CHA in May 1989 for $300 million). Bank Group involvement also com- prises four Rural Credit Projects implemented by the Agricultural Bank of China (ABC) in a total of 16 provinces/autonomous regions/nunicipalities (Credit 1462-CIA, FY84, Credit 1642-CHA, FY86, Credit 1871-CHA, FY88, and Credit 2182-CHA/Loan 3265-CHA, FY91, all together totaling $585 million equi- valent). In addition, the Bank Group has channeled support for various industrial development and restructuring operations through a variety of financial intermediaries: (a) a $20 million industrial development component of the Gansu Province Project (Loan 2812-CHA and Credit 1793-CHA, FY88) through the Gansu Investment and Trust Corporation; (b) a loan of $154 million (Loan 3022-CHA, FY89) through CIB for the Tianjin Light Industry Project; (c) a credit/loan of $114.3 million for the Rural Industrial Technology (Spark) Project (Loan 3274-CHA/Credit 2186-CHA, FY91) through ABC, CIB and the Jilin Province Economic Development Investment Corporation; and (d) a loan of $150 million for the Shanghai Industrial Development Project (Loan 2784-CHA, FY91) through BOCOM, CIB, ICBC, the Shanghai Investment and Trust Corporation and PCBC. All of these projects include some technical assistance and/or training for the concerned intermediaries. 3.2 Apart from some delays in the first CIB operation, disbursement of the CIB loans and credits has proceeded satisfactorily. Project Completion Reports (PCRs) have been prepared for the first three CIB projects and a Proj- ect Performance Audit Report (PPAR) has been prepared for these projects. Lessons learned from the implementation of the earlier projects were reflected in the design of subsequent CIB projects supported by the Bank Group. The reports conclude that, while the projects' specific objectives have been fully achieved, CIB is now facing new challenges, the mismanagement of which could jeopardize CIB's future role in the financial sector and the gains from previ- ous achievements. With continued Bank Group support, CIB's capacity in proj- ect design, selection and appraisal has improved significantly since its establishment, and its appraisal manual has become a model which enjoys wide use in China. Overall implementation of subprojects supported by CIB with the proceeds of the credits and loans was satisfactory, and most beneficiaries are operating successfully. However, since 1988, the quality of CIB's loan port- folio has deteriorated, mainly dua to the general economic downturn; strength- ening of CIB's capabilities to supervise subprojects and cope with problem loans continues to be a priority of Bank Group assistance to CIB. As a result of its dependence on the Government and international organizations for the majority of its resources and the changing financial sector environment, CIB confronts an uncertain future. While diversification of CIB's funding base and expansion of its product range were objectives in the design of CIB V, progress has been less than anticipated. The Bank Group has recently initi- - 17 - ated a dialogue with CIB and government authorities on CIB's future role and strategy to deal with these new issues. Implementation of the Tianjin and Gansu projects is proceeding satisfactorily; the Shanghai and Spark project implementation has picked up speed since becoming effective approximately one year ago. 3.3 Implementation of Rural Credits I, II, III and IV has been satisfac- tory. In addition to supplementing ABC's resources for long-term lending, these projects also provided technical assistance for ABC'a institutional development with a focus on enabling it to respond efficiently to its changing role from a fiscal agent of the Government to a more autonomous financial institution responsible for resource mobilization and allocation. The PCR prepared for Rural Credit I, which completed disbursements six months ahead of the appraisal estimate in November 1988, indicates that this project made a significant contribution to the region's economy and to the institutional development of ABC's Guangxi branch, with demonstration effects on branches in other provinces. Rural Credits III and IV are much broader than their prede- cessors in geographical coverage and in the scope of their ABC institutional development components. The former supported preparation of selected techni- cal manuals, strengthening of ABC's in-house training capability, and studies in ABC operations and system reforms. Rural Credit IV supports a number of institutional development activities, including those aimed at upgrading ABC's financial management and management information system, training and lending policies. 3.4 Bank financial sector work has consisted principally of two studies: Finance and Investment (Report No. 6445-CRA, FY88) and Financial Sector Revinw: Financial Policies and Institutional Development (Report No. 8415- CHA, FY90). The recommendations of the latter report, which was discussed with the Government in early 1990, form the basis for the design of the pro- posed project and for the Bank Group's ongoing dialogue with the Government on financial sector reforms. B. Bank Group Obiectives and Strategv 3.5 The Bank Group's overall long-term objectives in the financial sector are to assist the Government to: (a) improve the policy framework for the sector as a whole; (b) strengthen financial sector infrastructure; and (c) build sound institutions and practices for financial intermediation. In the near term, emphasis would be placed on strengthening and enhancing the banking system, which must play an increasingly important role as other eco- nomic reforms proceed, and strengthening key financial sector infrastructure, through reforms des'.gned to: (i) safeguard banks' financial viability, through attention to the adequacy of their interest rate spreads and accurate reflection of their portfolio quality; (ii) improve bank management and staff skills; (iii) strengthen prudential regulation and supervision of the finan- cial system; (iv) improve the overall accounting framework; (v) develop an efficient payments system; and (vi) strengthen other key central bank func- tions, such as policy research and statistics and monetary policy capabili- ties. Other reforms to be supported in the near to long term include develop- ing more robust money and capital markets, improving the overall level and structure of interest rates, developing the system's legal infrastructure and enhancing competition in the banking system. - 18 - 3.6 The present and emerging operational pipelines reflect the above strategic thrust. The present project would support strengthening of some of the key foundation elements for financial sector reform. Other future Bank Group operations in the financial uector include support for various interme- diaries designed to foster their overall institutional development in a more competitive banking environment. In the case of CIB, further support will depend upon the institution's articulation of a clear strategy designed to enable CIB to evolve into a financially self-sustaining entity dependent on neither the Government nor the Bank Group for its funding. While their large market share argues for upgrading the nationwide specialized banks, strengthening some of the newer dynamic intermediaries will also be reviewed. Pinancial intermediaries would also continue to help support operations with principally real sector objectives. Under such operations, the intermediaries would be expected to satisfy minimum eligibility criteria and would receive support for targeted institutional improvements. The future lending strategy is consistent with Bank Group guidelines for financial sector operations. - 19 - IV. THE PROJECT A. Proiect Rationale and.oblectives 4.1 The review in Chapter 2 indicated that the Chinese Government has made substantial progress towards building a financial sector more responsive to market forces and the development needs of the overall economy. At the same time, it revealed that the sector continues to confront a number of weak- nesses. As China's economic reforms progress, the need for a robust financial sector will become increasingly important to ensure that adequate resources are mobilized and in turn allocated to the most efficient investments. Wihile reform of the sector will be a long-term process, it is important that the momentum of the reform not be lost, and that steps are taken now in certain key areas including, in particular, financial intermediary management and financial sector infrastructure. The Bank Group has played an important role in identifying sector issues and providing recommendations for their resolu- tion, most recently in the framework of the 1990 Financial Sector Review. The proposed project would provide a vehicle for supporting the 4mplementation of key recommendations of this report. Moreover, it would help to ensure the success of other Bank Group operations involving financial intermediaries, whose safety and soundness depend on the adequacy of supporting financial infrastructure. At the same time, these financial intermediary operations would complement the proposed project by supporting institutional strengthen- ing of individual banks. These various considerations and the strong poten- tial for further strengthening the sector provide the rationale for an IDA- supported project which would have the following key objectives: (a) building a strong system of prudential supervision and regulation to safeguard the soundness of the sector as market reforms and increased decentralization make it more vulnerable to change and distress; (b) developing an efficient national payment and clearing system to facilitate timely financial transactions; (c) modernizing the national accounting framework to provide for reli- able and transparent financial accounts on the part of enterprises and financial institutions; (d) strengthening PBC's accounting, internal audit, monetary policy, research and statistics and legal functions; (e) developing a more market-oriented domestic debt management system to enable financing the Government in a noninflationary manner and strengthening PBC's role as a fiscal agent; (f) strengthening PBC's Graduate School; (g) undertaking a PBC automation strategy review and a study on approaches for treatment of directed credit; and (h) developing a Bank Group Debt 1-Management Information System for MOP. - 20 - In addition to the above objectives, the project would provide a vehicle for continued dialogue between the Bank Group and the GOC on the progress of other financial reforms. Asaurances were obtained at negotiations that GOC. IDA and PBC would annually review proaress in financial sector reform, with reference to selected areas agreed with IDA. An understanding was reached to include the following areas: (a) Interest Rates: their level (maintenance of positive real rates), their structure (number and dispersion) and the margin between deposit and lending rates; also MOF's flexibility in setting the terms and conditions of its securities issues and the consistency of the rates on its issues with generally prevailing rates; (b) Directed Credit: progress by PBC in undertaking the study on directed credit and thereafter implementing the study recommenda- tions; share of directed total credit and absolute amounts; progress in segregating directed credit from banks' general operations; (c) Financial Performance and Condition of Banks: capital adequacy, profitability, liquidity and asset/liability structure with refe- rence to international norms; banks' portfolio quality, as ascer- tained on the basis of the special asset reviews, and implications for financial performance and concd_ions; (d) Provisioning Policy: implementation of agreed increases of level of provisions to at least 0.5 percent of portfolios as an interim mea- sure; adequacy of provisions and provisioning policy in relation to banks' portfolio quality, particularly as revealed by special asset reviews; (e) Financial Sector Legislation: progress in drafting and promulgating key financial sector laws and regulations, including inter alia banking law, securities law, negotiable instruments law, regulations for implementing bankruptcy law, laws governing secured instruments, regulations relating to issuance and trading of government securi- ties. Reviews of these areas would complement periodic reviews of progress in pro- ject implementation and in enacting procedures, regulations and standards developed under the project with the help of technical assistance (para. 5.10 and Annexes 2' and 25). The discussion would also serve as a vehicle for the Bank Group to update its knowledge of the composition and structure of the financial system. 4.2 The modernization of China's financial sector will take a number of years. The present project would support the J.nitial phases of reforms designed to strengthen key financial infrastructure and the role and capabili- ties of the central bank. It is expected that this project would be followed by successors which would build on the progress made under this first opera- tion. - 21 - B. Prolect Components Prudential Supervision and Regulation Component ($6.3 million equivalent) 4.3 This component would help PBC refocus the emphasis of bank supervi- sion and regulation from setting and monitoring achievement of economic tar- gets to ensuring the safety, soundness and stability of the financial system. The component would provide technical assistance in two phases over a three- year period. The initial phase would be implemented over one year, and would comprise: (a) a pilot bank examination of BOCOM, undertaken by PBC with the guidance of international consultants, designed to demonstrate modern on-site examination techniques and the usefulness of examination findings to policy- makers; and (b) a high level symposium and a series of domestic and overseas seminars, study tours and secondments designed to heighten awareness and understanding of ban'k supervision practices in foreign countries. Phase 2 would take two yeats and include technical assistance to help (a) undertake a study of the organization and staffing of PBC's supervision function and its adequacy to meet the changing focus from economic to prudential supervision; (b) develop uniform procedures and methodologies to guide on-site supervision of banks; (c) formulate and plan the implementation of prudential regulations; (d) develop an effective automated off-site surveillance function and the design of related prudential reports; (e) elaborate an in-house training pro- gram in prudential supervision, including development of course curricula, lesson plans and training materials and training of trainers; and (f) provide support to PBC in its conduct of special asset reviews of selected, but repre- sentative, branches of ABC, BOC and ICBC.1/ Phase 2 would also continue the program of seminars, secondments and study tours initiated in Phase 1 (each year two domestic seminars, one study tour, seminars abroad for eight staff and secondments for five staff). Terms of reference for the program of tech- nical assistance were agreed at negotiations and are provided in Annex 8. To ensure e-fective management of the technical assistance program, building on lessons earned and continuity of approach, it is anticipated that it would be carried out by one firm, which would also coordinate the various training activities. The total number of staff-months of internationally recruited technical assistance is estimated at 132. 4.4 The asset reviews of selected specialized bank branches supported by the technical assistance (para. 4.3) would serve as inputs for PBC's conduct of comprehensive special asset reviews of all the specialized banks in the next several years. Assurances were obtained that PBC will complete these comprehensive reviews (covering off-balance sheet items and at least 70 per- cent of each bank's loan portfolio) of the four specialized banks by June 30 1998, using asset classification criteria agreed with IDA. 4.5 Because of China's vast size and complexity, the effectiveness of the technical assistance will depend even more than in other countrie;; oxn lt BOC branches to be covered would include Dalian Branch, Qingdao Branch, Shanghai branch and Guangzhou Branch; for ICBC the Shaanxi Branch was selected. These selections are preliminary and would be firmed up once the technical assistance program is under way. ABC branches to be cov- ered would include Sichuan, Jilin, Fujian, Jiangsu, and Qingdao. 22 - close coordination with PBC counterparts. The design of the program (Annex 8)9 therefore, envisages that PBC would establish a series of counter- part teams which would work with international consultants on different aspects of the program. These counterpart teams would be coordinated by an umbrella committee comprised of high level officials from the departments responsible for prudential supervision, enactment of prudential regulations and licensin6 of financial institutions. It is expected that at least six other subgroups would be established with different functional assignments. 4.6 Phase 2 of the program would also include support for the acquisi- tion for PBC headquarters of the minimum level of computers and peripherals necessary to support pilot implementation of the automated off-site surveil- lance capacity, with data from selected major centers where both data entry equipment is available and data transfer could be assured. This would include a minicomputer for processing and maintaining a large data base and a limited number of microcomputers to permit access and analysis. The automation would permit establishment of a large bank data base; calculation of standard ratios and peer groups; and ad hoc reports. PBC would make available at least 24 staff-months of systems analysts and programmers to help establish the off- site surveillance system and work together with the internationally recruited consultants. Phase 2 would also support PBC's decision to establish, using existing building facilities, a separate training center to meet the special- ized training needs of PBC's large contingent of supervisory staff. The proj- ect includes funds for the acquisition of audiovisual equipment, computers and other instructional aids for the center. Detailed cost estimates for the supervision and regulation component are available in the Project File. 4.7 Given the importance of these activities to the overall success of the project, conclusion of a contract with the consultants, satisfactory to IDA. for the nrop-ram of technical assistance will be a condition of credit effectiveness. PBC has already initiated the consultant selection process. In addition, at negotiations, an understanding was reached on the Drinciples of prudential regulation (Annex 4) to be developed under the project. Given the possible need to phase in the implementation of prudential regulations, a decision on the implementation timetable would need to await the recommenda- tions of the consultants. Assurances were obtained that within four months of the completion of the consultancy on this particular aspect. PBC would furnish to IDA for comment a plan for implementing the regulations. Progress in implementing the plan, taking into account IDA comments, would be covered in periodic project progress reports (para. 5.10) and would be a key indicator of project performance. National Payments and Clearing System Component ($42.6 million equivalent) 4.8 A sound payment and clearing system is fundamental for the efficient functioning of a country's financial system and overall economy. As discussed in Chapter 2, China's payment and clearing system needs modernization to facilitate timely, cost effective and reliable settlement of monetary transac- tions. PBC has already initiated steps to modernize the system, with the development of the first phase of a satellite-based communications system and the expansion and automation of local clearinghouses. A portion ($250,000 equivalent) of the Japanese Grant Facility (JGF) (para. 5.4) approved for this 23 proiect has been allocated for software development, engagement of local con- sultants and training to support these developments. 4.9 While PBC's efforts to modernize the payment system have thus far been quite successful, PBC and IDA concur that a comprehensive master design study is needed to provide the conceptual and technical design for further system development. Accordingly, with financing ($1.8 million equivalent, including contingencies) under the JGF, the Bank Group, as executing agency, has engaged PA Consulting (United Kingdom) to undertake the master design study, terms of reference for which are provided in Annex 9. The study is developing a vision for the future development of payments mechanisms and the priorities to be attached to different instruments; recommend the respective roles of PBC and other system participants in the development and operation of the payment system; and develop a detailed organizational, regulatory, finan- cial, economic and technical design for future development phases. The terms of reference for the study outline six guiding principles behind the design, establishment and operation of the system, as follows: (a) universality of access by financial instituticns; (b) cost efficiency and self-financing through cost recovery; (c) minimization of payment system risks; (d) integrity and reliability; (e) active user participation in all phases of system devel- opment; and (f) cost minimization in system design through trade-off between operational presence and regulatory measures. 4.10 The study and subsequent implementation have involved the establish- ment of several project teams to work with and advise PBC and PA Consulting. The PBC Steering Committee, chaired by the Deputy Governor of PBC, provides overall guidance to the effort and has established a payment system project office as its executing agency. This project office has appointed various subcommittees to help design the system. PBC has appointed a Domestic Advis- ory Panel with representatives of the specialized banks, the Ministry of Posts and Telecommunications and system users (consumers and enterprises) to involve the system participants actively in the design and operation of the system. PBC has also established an International Advisory Panel, comprising represen- tatives of the central banks of Germany, Japan, Switzerland, the United Kingdom, and the United States. This panel, which has already met three times during the course of the study and involves IDA participation, is providing policy guidance particularly in the conceptual design phase. Expenses related to the panel ($100,000 equivalent) are being funded under the JGF. The first panel meeting took place in Beijing in November 1991, the second meeting in February 1992, and the third in July 1992. A fourth meeting is scheduled for November 1992. 4.11 The design study, which commenced in October 1991, is expected to take some 15 months up to the time of issuance of tender proposals for imple- menting the system. Support under the IDA Credit would cover a part of the hardware and software investment for future development as well as future technical assistance. A budget of $40.5 million (determined as a residual) has been allocated for this purpose under the IDA Credit, of which tentatively $36.7 million has been reserved for hardware and software and $4.0 million fnr technical assistance. On the basis of the recommendations of the design study, the program of technical assistance and related equipment and materials purchases to be funded under the project would be agreed with IDA prior to any diobursements for this component. - 24 - 4.12 PBC has thus far expended some $20 millior. equivalent 2/ in devel- oping the satellite-based system and further amounts for local clearinghouses. It is impossible at this stage to estimate future funding requirements for further system development without pre-judging the outcome of the design study. However, costs are expected to significantly exceed availability of IDA funds, which would therefore finance only a portion of medium-term invest- ment needs. It is expected that further development would be supported by a combination of budgetary allocations and additional external support. PBC anticipates significant budgetary allocations during the Eighth Five-Year Plan period (1991-95) for the payments system, b'it this is still under discussion internally. Once total near term costs of system development are defined by the design study, it may be necessary to complement funding under the proposed project by other external support, including a possible successor Bank Group project, and/or to phase the implementation in line with available funding. Accounting and Auditing Component ($7.5 million equivalent) 4.13 As discussed in Chapter 2, the current accounting framework was developed in the context of a centrally planned economy and needs moderniza- tion to permit satisfactory financial management in an environment increas- ingly influenced by market forces. The proposed component would provide sup- port to MOF, PBC, and the AAPRC to develop and implement a reform program designed to bring Chinese accounting and auditing standards in line with international standards. 4.14 MOF. Support to MOF would include an estimated 273 staff-months of the services of qualified international and local consultants (in the form of a joint-venture between an international accounting firm and a local CPA firm) to help MOF develop the basic 28-30 general accounting standards along with chart(s) of accounts, reporting formats and implementation procedures; design appropriate publicity campaigns and advisory services to help disseminate the new standards; and provide training seminars and design training mate:ials covering the use of the new standards and systems. Unless otherwise agreed with IDA, MOF intends to develop most of the general standards--at least 25-- during the first two years of the technical assistance program, giving priority to standards important as a framework for the financial sector stan- dards to be developed by PBC (para. 4.18), and to complete the full set of general standards and practices by the end of the third year. As a basis for the proposed reforms, MOF prepared an overall framework (concepts) for the new standards; a draft of this framework was reviewed by IDA and members of the profession in China. The new framework and standards to be developed will be in harmony with international generally accepted accounting principles (GAAP). 4.15 The consultants would work closely with and rely heavily on the inputs of a full-time counterpart group to be established within MOF's Depart- ment of Accounting Affairs Administration (DAMA), to be responsible for stan- dard setting, and liaise as appropriate with other MOP divisions and depart- ments and other sectoral ministries. Conclusion of a contract with the con- 2/ Excluding physical construction work; the main station is leased and the satellite capacity is free. - 25 - sultants, satisfactory to IDA, will be a condition of effectiveness. Terms of reference for this technical assistance, which were agreed at negotiations, are provided in Annex 10. According to these terms of reference, the consul- tants and the DAAA are expected to agree on a list of, and timetable for, the general standards to be developed within two months of the start of the assignment. Assurances were obtained that MOF would prepare and. promptly upon its completion, furnish to IDA for comment a work propgra for developing general standards and practices as outlined above (paras. 4.14 and 4.15). and. thereafter. MOF would implement the work proRram as agreed with IDA. The consultants and the DAAA are expected to agree on a draft strategy for imple- menting the new standards within six months of the start of the assignment, with the understanding that this may need to be modified as the work progresses. The draft strategy would cover implementation of financial sector standards, based on inputs from PBC (para. 4.18). Assurances were obtained that the draft strategy (and-anv material modifications subsequently) would be furrished to IDA. Progress in implementing the new standards and practices, taking into account IDA comments on the strategy, would be covered in periodic progress reports (para. 5.10) and would be a key indicator of project perfor- mance. 4.16 Under MOF auspices, but under a separate contract, the Chinese Institute of Certified Public Accountants (CICPA) will engage internationally qualified consultants (an estimated 4 and 14 staff-months of foreign and local consultants, respectively) to undertake a feasibility study to define the future parameters ox a program of Continuing Professional Education (CPE). Support would be provided under tbe project for this purpose. The CPE program would define the levels of training all certified public accountants (CPAs) would need to maintain for continued certification. In the first instance, this program would be a vehicle for training existing CPAs in the new stan- dards and systems to be developed (para. 4.14). Agreed terms of reference for this technical assistance are provided in Annex 11. This study would be com- pleted by December 1993. 4.17 The program of support and reforms contemplated represent major initiatives for China and will require close monitoring and coordination. Accordingly, the project provides for 6 staff-months of a technical adviser to the Director of DAAA, to assist the Director in coordinating and guiding the various activities, and in conceptualizing follow-up measures which will be needed for successful reform of the accounting framework in a country of China's dimensions. These will need to involve inter alia major reform of accounting education in China and development and implementation of a certifi- cation examination. Agreed terms of reference for the adviser are provided in Annex 12. 4.18 PBC. In parallel with the program of assistance with MOF, under the project PBC would engage, under one contract, an estimated 274 staff-months of foreign and local consultants to assist it in preparing revised accounting standards and practices specifically for financial institutions, including a revised chart of accounts, financial reporting formats and implementation procedures. This team of consultants would coordinate cloeely with the con- sultants working with MOF. The consultants would also assist PBC in strengthening its own accounting system through the development of appropriate procedures, manuals, and reporting formats, review of organizational structure - 26 - and preparation of training programs and materials for training PBC staff in the new system. The consultants would work closely with a PBC counterpart committee and appropriate subcommittees. Conclusion of a contract with the consultants, satisfactory to IDA. would be a condition of effectiveness. PBC and the consultants would develop a tentative strategy for implementing the new standards within 10 months of the start of the assignment, with the under- standing that this may need to be modified as the work progresses. Such plan would take into account the interface between the standards to be developed for the financial sector and the general standards to be developed by MOP. Assurances were obtained at negotiations that. promptly upon-its completionL PBC would furnish to IDA for comment the above implementation plan. Progress in adopting the new standards and practices for the financial sector would be covered in periodic project progress reports (para. 5.10) and would be a key indicator of project performance. Agreed terms of reference for this tech- nical assistance are provided in Annex 13. The project would also support a series of domestic and overseas seminars (8 and 4, respectively), overseas secondments (8 staff) and study tours (2 with 6 staff each) designed to fami- liarize staff at different levels with accounting practices internationally and train staff in the new accounting standards and system; these would be coordinated by the consultants engaged by PBC to help develop the new stan- dards and accounting systems. 4.19 AAPRC. The project would irnclude a small amount of support (an estimated 12 staff-months of international and local consultants) to assist AAPRC in elaborating auditing standards in line with international practice and in training in the new standards. As noted earlier (para. 2.40), it is expected that the auditing standards developed would be utilized in their auditing work by entities other than AAPRC. At negotiations. assurances were obtained that AAPRC would provide for IDA review the proposed new auditing standards within four months of the completion of the related technical assis- tance and that these would be implemented, as agreed with IDA. starting the following year. The consultants would work closely with an AAPRC counterpart team. Agreed terms of reference for this technical assistance are provided in Annex 14. Detailed cost estimates for the full accounting and auditing compo- nent for MOF, PBC, and AAPRC are available in the Project File. Internal Audit Component ($0.1 million equivalent) 4.20 This component would support the strengthening of PBC's internal audit functions. PBC would establish a committee and embark on a program to develop and implement internal audit procedures, manual, report formats and audit work programs, all consistent with international norms, as well as review the organization and staffing of PBC's internal audit function and prepare training programs and materials for training PBC staff in the new system. PBC will provide its own funds to finance the agreed program of activities (Annex 15). It would draw as needed on local advisors/consultants. Progress in the implementation of this component will be reviewed with the Bank Group at regular intervals with reference to the timetable of key imple- mentation steps. Should such reviews indicate the need for assistance from international experts, PBC and the Bank Group will examine financing options. - 27 - Research and Statistics Comiponent ($1.6 million equivalent) 4.21 The market-oriented economic reforms undertaken by China starting in 1978 have created significant new economic management responsibilities for PBC, highlighting the need to develop appropriate statistics, policy analysis and research activities to provide a sound foundation for policy decisions involving greater use of indirect monetary policy instruments. While this need has been well recognized by PBC, with notable improvements in recent years, there is considerable scope for further progress. The proposed project would support such strengthening through targeted assistance over a three-year period to the various departments (Research and Statistics, Policy Research, Planning and Funds Management, Interest Rates and Savings Management and Financial Research Institute) which have a role to play in this area. The program of support would be initiated with a series of three one-month inter- mediate-level refresher courses covering modern macroeconomics, banking and monetary theory, and econometrics. These would be followed by a phased pro- gram of seven research projects, involving about 33 staff-months of interna- tional experts who would work closely in each case with small PBC counterpart teams in the following areas: survey research, demand for money, flown of funds, financial models, savings behavior analysis, business cycles models, and background research studies (subjects to be defined). The project would also support three focused study tours and secondments for 12 staff at other central banks as well as an international seminar on monetary policy. Finally, the project would support a minimum level of automation required to enable the strengthening of PBC's research and statistics function. Annex 16 provides a description of the program, including agreed terms of reference for the various consultants; detailed cost estimates are available in the Project File. Government Domestic Debt Management/PBC Fiscal Agency and Monetary Policy ComRonent ($2.7 million equivalent) 4.22 This component would assist MOF and PBC, the latter in its role as a fiscal agent, to develop and implement a more market oriented domestic debt management system; such development would also provide the basis for PBC to strengthen its monetary policy functicn through open market operations. Direct support for strengthening PBC's monetary policy function would also be provided. Until 1991, government fiscal deficits were financed almost entirely by borrowing from the central bank and the mandatory annual alloca- tion of government securities to enterprises, individuals and, more recently, financial institutions. Government financing needs have begun to outpace the scope for raising funds, without inflationary recourse to the central bank, through forced placement of bonds. The GOC, therefore, needs to further develop its debt management strategy to p.trmit it to finance its deficits and maturing debt by issuing securities to voluntary subscribers. This will require close coordination with PBC in both operational and policy areas. 4.23 The design of the component recognizes that institutional roles regarding the development of a government securities market are in the process of evolving, and that in the transition, some overlap of functions between MOF and PBC will occur. For example, both PBC and MOF are developing government securities book-entry systems, the former for the proposed issuance of PBC bills, the latter for medium- and long-term treasury bonds, although the two - 28 - eystems could eventually converge. Moreover, in this transitional period, PBC is likely to play less of a role as a fiscal agent than eventually may be the case. Two staff-months of expert assistance, to be shared by PBC and MOP, is provided under the project to advise the authorities on longer-term options for an appropriate division of labor (para. 4.24). 4.24 MOF. With regard to MOF, the project would support some 32 staff- months of consultant services over a three-year period to assist in: (a) rec- ommending institutional roles (para. 4.23); (b) developing new wholesale debt instruments offering a wider range of attractive features in terms of maturi- ties, denominations, pricing, frequency and other characteristics and develop- ing retail savings instruments and selling techniques; (c) strengthening MOP debt programming and cash management; (d) conducting seminars on the develop- ment of new government debt instruments and selling techniques, including auctions; (e) developing regulations governing auctions and government securi- ties dealers; and (f) developing software and related training to support MOF's debt programming function. Two study tours would also be included to familiarize concerned MOF staff with practices overseas; one of these tours would be undertaken jointly with staff of PBC. Finally, the project would support a limited amount of hardware and software to strengthen both MOF's Monitoring Center, which monitors primary and secondary market deve opments in government securities, as well as its debt programming function. Based on the recommendations of the consultants, MOF would provide a list of hardware and software to be procured for the Monitoring Center for IDA approval prior to any disbursements for such items. With respect to the subject of developing a temporary book entry system for MOF for an interim period until PBC could fully assume its fiscal agency role, an understanding was reached that the possibility of allocating some credit proceeds for financing advisory services would be examined, should funds be available after all technical assistance contracts have been signed. 4.25 PBC. The project would also provide support to strengthen PEC's fiscal agent role and monetary policy function: in addition to the institu- tional expert (para. 4.23), 53.5 staff-months of international experts would assist PBC in (a) developing auctions of PBC bills, leading to the introduc- tion of open market operations; (b) developing its capabilities in short-term reserve money forecasting and monitoring; (c) developing regulations governing the interbank market and auctions of PBC bills; (d) strengthening the func- tioning of PBC's Quotation Center, to enable it to support PBC's monetary policy function; and (e) undertaking a design study on the development of an automated book-entry system for PBC bills, which could be modularly expanded to accommodate treasury and other securities, and supporting the initial stages of its implementation. Support would also be provided for three study tours, one in conjunction with MOF (para. 4.24) and one seminar, also in con- junction with MOF. A small amount of equipment and software would also be included to support the strengthening of PBC's reserve forecasting and moni- toring. The above services would complem3nt work to be undertaken for PBC with financing from the ADB grant to study the future functioning of the PBC Quotation Center and develop a national securities law. Agreed terms of ref- erence for the program for MOF and PBC are provided in Annex 17; detailed cost estimates are available in the Project File. - 29 - 4.26 The above program of support assumes for MOP some increased flexi- bility with regard to determining the timing and terms of its securities issues, within bands approved by the State Council. As noted earlier, a draft regulation which would provide this flexibility for MOF is under discussion in MOP and progress in implementing the regulation would be reviewed in the context of the annual reviews of financial sector reform (para. 4.1). During the annual reviews, IDA and MOF would also examine the consistency between rates on MOF securities and other interest rates in the economy. Legal Component ($0.3 million equivalent) 4.27 Development of a sound legal framework for financial transactions and institutions is fundamental for financial sector reform. Some of the components discussed in earlier sections will support the elaboration of regu- lations and legislation. In addition, the PBC has an ambitious program over the next several years to develop legislation in other areas. The project would support these efforts through a targeted program of assistance, which could be followed up under successor operations. In particular, the project would support two seminars on banking legislation, one for high level policy makers from the State Council, PBC, MOF, System Reform Commission and other relevant bodies, and one for middle-level officials and PBC staff; two staff- months of the services of an international expert to advise on the drafting of the banking law; and equipment and software for the development of a financial sector legal data base. A summary of the technical assistance activities pro- vided to PBC's Legal Department is provided in Annex 18. PBC Graduate School ($0.6 million equivalent) 4.28 The PBC Graduate School is cofunded by PBC, the specialized banks, and the PICC. The Graduate School, now 10 years old, offers masters and doc- toral programs to students who then are absorbed by PBC or onp nf the other banks supporting the School. The School is small--currently, 120 students, of which 18 doctoral candidates, are enrolled--but has a strategic role in pro- viding to the financial system a base of staff with a theoretical as.well as practical foundation in economics and international finance and banking. The School has in the past benefited from technical assistance from the IMF. Discussions with the IMF and PBC have revealed that, despite the School's impressive achievements to date, considerable strengthening is necessary, both in terms of quality of education and physical resources. The project would therefore provide support to the School in three areas. First, the project would support the services, for two years, of an internationally recruited expert, with at least 5-10 years experience as a graduate school professor, to help the School define its curriculum and course content as well as to deliver two courses/seminars each semester. Agreed terms of reference for this expert are provided in Annex 19. Second, the project would support expansion of the Graduate School's language lab, such that it could also provide language training for PBC staff (and in due course, staff of other banks), which is essential to enable staff to benefit from overseas secondments and work pro- ductively with foreign experts visiting China (see equipment list in Annex 20). Finally, the project would support the School's import of books and other reference materials. - 30 - PBC Automation StrategL Study Component ($0.2 million equivalent) 4.29 PBC's current level of automation is very limited, as is the case for the banking system at large, and enhancement is a necessity. This will be a costly exercise and, therefore, will need to be phased in over time in line with identified priorities. At the same time, it will be important that auto- mation of individual functions be implemented within a coordinated framework to avoid fragmentation and inefficiencies. In order to provide the basis for future automation, and the context for any automatiorn to be supported under the proposed project} PBC would engage internationally recruited consultants (9 staff-months) to undertake a broad automation strategy study. This study may start prior to the start of the project with JGF funding. The study is expected to be completed within an elapsed time of four months, and at the latest by end August 1993. Agreed terms of reference for the study are pro- vided in Annex 21. Studv on Directed Credit (<$O.1 million equivalent) 4.30 There is a need in China to progressively reduce government inter- vention in credit allocation and subsidized lending, in tandem with price and enterprise reforms. In the interim, ideally all lending which does not con- form to banks' objective commercial lending criteria should be handled by the banks on a managed fund basis with all profits and losses accruing to the State. Even in so far as budgetary implications lead the authorities to con- sider this impossible in the short term, it will be important to take actions to clearly segregate such lending so that its impact is transparent and even- tually the losses can be compensated. Alternatively, all directed and subsi- dized lending could be concentrated in one institution, leaving the rest of the financial system clean. Both alternatives have their advantages and dis- advantages and their complexities. Under the project, PBC would undertake a study which wculd have as objectives defining what constitutes directed credit in China's context, determining the volume of such credit and evaluating and prioritizing alternatives for segregating such credit from banks' commercial operations. Agreed terms of reference for this study are provided in Annex 22. PBC would complete the study no later than December 31, 1993, and would review results with IDA. MOF Debt Monitoring Component ($0.3 million equivalent) 4.31 MOF manages a large program of Bank Group debt, but lacks the neces- sary management information system (MIS) to enable it to effectively fulfill this function. The JGF associated with the project has provided a small amount of support to design and implement such a system. The system became operational in early 1992. - 31 V. COSS, FIIMNCINC ,ND MANAGEMNNT A. Summary of Costs 5.1 The total cost of the project, including contingencies, is estimated at $68.2 million equivalent. This total includes only those payments system development costs to be financed by IDA as total costs as of now are unknown. The estimated cost by component is summarized in Table 5.1. Base costs are expressed in prices of mid-1991. The exchange rate used to convert the base cost estimates from yuan to dollar3 is Y 5.38 to $1. Physical contingencies were calculated at 10 percent of base costs. Price contingencies for the foreign exchange costs were calculated on the basis of projected international inflation rates of an average of 3.7 percent per annum, and for local currency costs on the basis of projected local inflation rates of 6.0 percent for 1992 and 5.0 percent thereafter. Purchasing power parity was assumed. Imported equipment and materials would be exempt from duties. 5.2 Project costs include expenses related to technical assistance, pro- curement of equipment and materials and training. Equipment costs were based on estimates made by the implementing entities and reviewed by IDA. Costs of international and local consultants reflect differences in type of specialty and seniority. Overseas secondments were estimated at $2,500-3,750 per month per person, depending on the length of the visit and comprising round-trip airfare and per diem; overseas study tours were estimated at $89000 per per- son; and overseas seminars were estimated at $12,500 per person, including round-trip airfare, per diem and training fees. Local cost estimates include the costs of local goods and services, and local taxes (about 25 percent of the cost of local goods). B. Financing Plan 5.3 The project financing plan is shown in Table 5.2. The proposed IDA credit of $60.0 million equivalent would finance 93 percent of the foreign exchange requirements plus 53 percent of the local currency requirements. The balance of costs would be met by cofinancing (para. 5.4), and by PBC, MOF, and AMPRC. 5.4 Cofinancing. In June 1987 the Government of Japan (GOJ) agreed to make available Yen 30 billion for the financing on a grant basis of selected programs supported by the Bank Group. Under the umbrella of this facility, the GOJ has approved cofinancing for this project in the form of a grant amounting to Yen 607.5 million ($4.6 million equivalent). The Japanese Grant Facility (JGF) is administered by the Bank Group and allows for untied pro- curement. Part of the JGF is being utilized for pre-project activities, in particular to finance expenses related to the payments system master design study. The total amount of the JGF has been divided evenly between MOF and PBC. - 32 - Table 5.1: PROJECT COST ESTIMATES of Y thousand $ thousand Base Local roreign Total Local Foreign Total coSta PBC Tegulation and SuDervision Technical ansistance and training 2,348 28,914 31,262 427 5,257 5,684 9 Equipmeant and materials 264 3,130 3,394 48 569 617 1 Payments and Clearing Sstem a /b Fecnatcal assistance and trannmg 550 32,010 32,560 100 5,820 5,920 9 Equipment and materials - 201,861 201,861 - 36,702 36,702 59 AccontinR TchaicaNl assistance and training 3,927 19,349 23,276 714 3,518 4,232 7 Equipment and materials -- - - - Internal Audit Technicai assistance and training 644 - 644 117 - 117 <1 Equipment and materials - - - _ Research and Statistics TecanIcal assistance and training 655 6,924 7,579 119 1,259 1,378 2 Equipment and materials - 1,320 1,320 - 240 240 <1 Fiscal Agency Monetary Policy/Functlons Tecanical assistance and training 127 8,530 8,657 23 1,551 1,574 3 Equipment and materials - 220 220 - 40 40 '1 Legal Techanical assistance and training 280 990 1,270 51 180 231 <1 Equipment and materials - 165 165 - 30 30 <1 PBC Graduate School Technical assistance and training - 2,200 2,200 - 400 400 1 Equipment and materials - 847 847 - 154 154 C1 Automation StratIegy Study 990 11 Tech Ica ass stance17 1,007 3 180 83 Dilrected Credit Study Incremental PMC expenses 22 - 22 4 - 4 <1 MOP Techninal assistance and training 3,894 10,973 14,867 708 1,995 2,708 4 Equipment and materials - 2,200 2,200 - 400 400 1 Domestic Debt Management Technical assistance and training 148 4,301 4,449 27 782 809 1 Equipment and materials - 1,562 1,562 - 284 284 <1 Debt MonitorinR T,Ehnicl asaistance and training /a 385 193 578 70 35 105 <1 Equipment and materials - 990 990 - 180 180 <1 AAPRC Technical assistance and training 165 1,018 1,183 30 185 215 <1 Materials _ _- - - - <1 Base Cost 13,426 328,685 342,110 2.441 59.761 62.202 100 Physical contingencies 1,287 8,932 10,219 234 1,624 1,858 3 Price contingencies 1,128 8,151 9,279 205 1,482 1,687 3 Total 15,840 345,768 361,608 2. d0 62,867 65,747 106 2 of total 4 96 100 4 96 100 a Continsencies have not been provided separately for the PBC payments system component (other than tfose calculated for master design study) since the amount allocated for the payment system is determined as a residual; nor have contingencies been allocated for the HOF debt monitorin component, for which the cost is firm. lb All but $100,000 in defined costs are assumed to be foreign. J Out of thie core programm of 100 s/m of international consultant,t 10 e/m have been taken off, but added to physical contingencies, in case need is confirmed. Any savings out of the PBC- Accounting component will be transferred to the Payment System development component. 1d The total for equipment and contingencies for the MOF-Accounting component is estimated at $430,000 including contingencies. Note: The category "technical assistance and training" includes training materials for specific training seminars and incremental expenses of PBC, HOP and AAPRC, as applicable. - 33 - Table 5.2: PROJECT FINANCING PLAN ($ thousand equivalent) Local Foreign Total PBC MOF AAPRC IDA JGF PBC Regulation and supervision 378 - - 7,093 - 7,471 Payment and clearing system - - - 40,472 2,150 42,622 Accounting 248 - - 4,979 5,227 Internal audit 117 - - . - 117 Research and statistices 86 - - 1,807 - 1,893 Fiscal agency/monetary policy functions 25 - - 1,905 - 1,930 Legal 59 - - 243 - 302 PBC Graduate School - - - 645 - 645 Automation strategy study 3 - - 56 150 209 Directed Credit Study 4 - - - - 4 Subtotal 920 57.200 2.300 60.420 MOP Accounting - 179 - 1,540 1,800 3,519 Domestic debt management - 29 - 1,260 - 1,289 Debt monitoring - - - - 285 285 Subtotal 208 2.800 2.085 5.093 AAPRC Auditing La - - 19 - 215 234 Subtotal - 19 215 234 Total 920 208 19 60.000 4.600 65.747 /a The foreign costs of assistance to MAPRC will be financed under MOF's share of the JGF. C. Main Features of the IDA Credit 5.5 Onlending Terms. The proposed IDA Credit of $60.0 million equiva- lent would be made to the GOC, which would make available relevant proceeds to PBC over 20 years including 5 years of grace at 2 percent interest plus a 0.5 percent commitment fee. 5.6 Procurement. For goods, contracts of $200,000 equivalent and above would be awarded on the basis of international competitive bidding (ICB), according to the Bank Group's Procurement Guidelines. A preference equal to 15 percent of the c.i.f. cost or to the customs duties and other import taxes, whichever is lower, would be extended to local manufacturers in the evaluation of bids. Contracts below $200,000 equivalent would be awarded on the basis of local competitive bidding (LCB) or international or local shopping depending on the nature of the items to be purchased. Items of a proprietary nature may be procured through direct contracting. The list of items to be procured directly from suppliers would be approved by IDA. The aggregate value of items to be procured by methods other than ICB will not exceed $2.2 million ($1.6 million for PBC and $0.6 million for MOF). Consultants' services would be obtained in accordance with Bank Group Guidelines for the Use of Consul- - 34 - tants; consultants for the payment system master design study have already been selected and the study is underway (para. 4.9). Training services would be obtained under arrangements satisfactory to IDA. The procurement arrange- ments for the project are summarized in Table 5.3. The final list of contract packages can only be ascertained after equipment lists have been finalized (in some cases on the basis of consultant recommendations) and/or further discus- sions with the implementing entities. Accordingly, assurances were obtained that prior to any procurement for these goods. the relevant entity would gre- sent for IDA review and agreement a Drocurement plan, including lists of con- tract packages, method or procurement and timetable for implementation. The GOC will be asked to nominate one of the tendering agencies in China to admin- ister procurement under the project before the first invitation is issued. Table 5.3s SUMMARY OF PROPOSED PROCUREMENT ARRANGEMENTS la ($ million equivalent) Procurement Method Total Project Element ICB LCB Other lb N.B.F. /c Cost 1. Goods 1.1 Payment System Equipment 36.7 - - - 36.7 (36.7) (36.7) 1.2 Other - 1.0/d 1.0Jd 0.2 2.2 (1.0) (1.0) (2.0) 2. Technical Assistance - - 23.l1eIf 3.7 26.8 and Training (21.3) (21.3) Total 36.7 1.0 24.1 ~ .9 65.7 (36.7) (1.0) (22.3) (60.0) la Figures in parentheses are the amounts to be financed by the IDA Credit. Ib International or local shopping. lc N.B.F. - Not Bank-Financed. Includes administrative overheads to be financed by MOF, PBC and AAPRC as well as items to be financed by the JGF in parallel with the IDA Credit. Id Amounts allocated are indicative until final detailed procurement plans are developed by PBC and MOF and agreed with IDA. .La Includes $1.8 million in consultant services to be financed by the JGF under one contract with services to be financed by the IDA Credit. If Consultant services would be procured in accordance with World Bank "Guidelines: Use of Consultants by World Bank Borrowers and by the World Bank as Executing Agency" (Washington, D.C., August 1981). 5.7 Bid packages for all goods to be procured under ICB, and proposal invitation packages for consulting services would be subject to IDA's prior review and approval of procurement documentation (from bidding documents through contract award). The prior review is estimated to cover more than - 35 90 percent of the IDA-financed procurement. The balance of contracts would be subject to ex-post review by IDA after contract award. Conclusion of con- tracts for consultant services for the PEBCMOF accounting components and the PBC supe-vision component would be conditions of effectiveness. Bidding docu- ments would be based on the standard forms agreed to by the Bank Group and GOC. 5.8 Disbursements. Disbursements would be made for: (a) goods-- 100 percent of foreign expenditures, 100 percent of local expenditures (ex- factory) and 75 percent of other items procured locally; and (b) consultant services and training--100 percent of expenditures. Disbursements for goods' contracts of $200,000 or more and for all consulting contracts would be made against full documentation. Disbursements for goods' contracts of less than $200,000 would be made against statements of expenditure, with full documenta- tion held by the implementing agency, as appropriate, for review by IDA super- vision missions. All project activities financed by IDA are expected to be completed within three years of the project's start with the possible excep- tion of the payment system which may extend an extra year or two. However, the standard profile for technical assistance loans in the East Asia and Pacific Region has been applied (Annex 23). The complet'on date would be March 31, 1999 and the closing date would be September 30, 1999. 5.9 To facilitate project disbursements, MOF and PBC will each establish and maintain in dollars a Special Account, in a bank acceptable to IDA and on terms and conditions satisfactory to IDA. Initial deposits of $3.0 and $0.1 million, approximately equal to aa estimated four months' average eligible expenditures, would be made into the Accounts of PBC and MOF, respectively. Applications for replenishment would be submitted monthly or when the amounts withdrawn are equal to 50 percent of the initial deposit, whichever comes first. A Special Account has also been established under the JGF; the initial deposit was $0.2 million equivalent. 5.10 Reporting and Auditing Requirements. PBC, MOF and AAPRC will submit to IDA semi-annual reports on the progress of project activities. These reports will specifically compare implementation with agreed monitorable indi- cators. A list and matrix of such indicators are provided in Annexes 24 and 25; these indicators cover not only implementation of technical assistance and training under the project but also progress in enacting the various proce- dures, regulations and standards developed with project support. PBC, MOF and AAPRC would maintain separate project accounts. All project accounts, state- ments of expenditure and the Special Accounts would be audited on an annual basis by independent auditors acceptable to IDA. All audited accounts and statements would be submitted to IDA within six months after the end of the fiscal year, that is by June 30 of each year. Understandings were reached on the above reporting requirements. and assurances were obtained on the auditina reouirements. 5.11 Prolect Implementation Management and Supervision. Following up on the progress reports to be submitted by PBC, MOF, and AAPRC (para. 5.10) and the agreement to conduct an annual in-depth exchange on progress of reform in the financial sector (para. 4.1), the Bank would normally field two supervi- sion missions per year. Given the know-how transfer-oriented character of the project, the supervision requirements are higher than those for average - 36 _ investment projects. The projected investment in staff-time should be benefi- cial, however, in allowing for enhanced dissemination of Chinese accounting and auditing standards with direct relevance to the overall Bank Group portfo- lio in China, and furthermore, in facilitating the design of future lending operations in the financial sector as well as deepening the dialogue with the Chinese authorities in this sector. An indicative Bank Group supervision timetable is shown in Annex 26. A project implementation schedule is provided as Chart 4. PBC, MOF and AAPRC would each be responsible for managing the implementation of project components within their jurisdictions. PBC has established an internal Leading Group, with senior-level representation from concerned departments, to guide and facilitate project implementation. It has also established a 10-person Project Office to work under the direction of the Leading Group. In addition, a series of counterpart committees have been or will be established to manage the implementation of individual project compo- nents, as discussed in Chapter 4. Overall responsibility for the management of MOF project components would rest with a Project Office within the Foreign Affairs Department; counterpart arrangements for specific project components are also detailed in Chapter 4. AAPRC has established a counterpart group to be responsible for its project components. Assurances were obtained that PBC. MOF and AAPRC would maintain satisfactory proiect management and counterpart arrangements, with adequate and competent staff, as detailed in Chapter 4 and in this paragraph. This would cover, among others, for PBC its Leading Group and Project Office, for MOF its Project Office, and for all three project entities a variety of counterpart groups. Assurances were also obtained that: training would be carried out in accordance with a proam agreed with IDA: all studies would be carried out with terms of reference and_timing agreed with IDA: and study results would be reviewed with IDA. PBC and MOP would procure goods through experienced procurement agencies. 5.12 More generally, since financial sector reform involves a number of different government agencies, the Bank Group has suggested to the GOC the establishment of an interagency Financial Sector Leading Group. This proposal is under consideration. Such a group would provide an effective forum for internal discussion on financial sector reform and coordination of the imple- mentation of the present and other forthcoming externally assisted projects. - 37 - VI. PROJECT BENEFITS AND MAIN RISKS A. Prolect Benefits 6.1 Much has been accomplished during the past decade in reform of China's financial sector. However, there remains substantial scope for fur- ther strengthening. The project is expected to make a significant contribu- tion in furthering the development of the sector by upgrading the infrastruc- tural framework. The improved functioning of the system in turn would contribute to more efficient mobilization of savings and their allocation to the most productive investments. 6.2 Financial sector reform has led to the proliferation of institutions and instruments and, to a lesser extent, greater competition, in an environ- ment still characterized by significant economic distortions, soft-budget constraints and administrative guidance. Unless accompanied by the appropri- ate safeguards, the benefits of these developments may be outweighed by enhanced sector instability. By helping to develop the safeguards through strengthening banking regulation and supervision, the project will make a major contribution in ensuring that the full benefits of the reform can be reaped. Provided banks are progressively granted greater autonomy, a sound regulatory and supervisory framework will help to instill greater discipline in financial intermediaries and help protect the long-term solvency of banks and the interests of depositors and, ultimately, tax payers. The special asset reviews which PBC would undertake, with project support, would enable the Government to clearly understand the financial condition of the key Chinese intermediaries and provide the basis for any remedial action necessary to safeguard the stability and development of the system. 6.3 The modernization of the accounting and auditing framework to be supported under the project is fundamental for further development of the financial sector and the economy as a whole. By increasing the transparency and reliability of financial information, the reforms will make it possible for depositors and creditors to accurately judge the solvency of the interme- diaries to which they are lending and for banks to judge the performance of their borrowers. More importantly, it will give bank and enterprise manage- ments the tools to understand their true conditions and accordingly adapt their management strategies. The improved accounting framework would also be esse..- 1 for the continued development of China's capital markets and would greatly facilitate promotion of foreign direct investment in China. 6.4 The development of the payments and clearing system is also an essential prerequisite for the smooth functioning of China's financial system. The improvements to be supported will help to ameliorate service levels in the sector and provide the foundation for development of integrated financial markets. 6.5 Strengthening government domestic debt management will help to miti- gate the prospects for further inflationary surges by enabling the Government to finance itself in a manner conducive to price stability. At the same time, a more market-oriented financing strategy can have major spin-off effects by - 38 - creating the initial foundations for a more robust and diversified money and capital market. B. Main Risks 6.6 One project risk is that financial reforms will not proceed at the pace required to create a favorable environment for project implementation. The three-year austerity program has entailed some strengthening of adminis- trative controls in the financial system. However, the process of transition from a centrally planned to market-influenced economy is bound to be uneven as adjustments are made for experiments which prove unsuccessful or inappropri- ately timed. The Chinese leadership remains committed to financial sector reform as a necessary adjunct to real sector reforms and, under the project, has reaffirmed its belief in the importance of tackling some of the most important areas of weakness. It is therefore expected that financial reforms will pick up as the Government becomes confident that the macroeconomic sta- bility it has achieved is sustainable. Even if this process is delayed, the project is still considered justified, given that institutional development is a long-term process and the need to prepare now for the time when reform momentum accelerates. A further project risk relates to the speed with which _nfrastructural reforms can be implemented, given the low level of skills in the system and the still evolving definition of institutional roles. This risk is mitigated by the emphasis given under the project to staff training both on the job and overseas. The project design has been based on a recogni- tion that institution building is a long-term process, and the project accord- ingly aims to support the initial steps. Continued actions will be required to sustain the strengthening of the institutions. To guard against the risk that the project will overtax the absorptive capacity of beneficiary institu- tions, each has established project management teams, while IDA will closely supervise the project. - 39 - VII. AGREEMENTS REACHED AND RECOMMENDATION 7.1 At negotiations, the following was reviewed and ae applicable confirmed/agreed: (a) IDA agreed with PBC, MOF and AAPRC on terms of reference for the various technical assistance activities (paras. 4.3, 4.15, 4.16, 4.17, 4.18, 4.19, 4.21, 4.25, 4.28, 4.29 and 4.30); (b) IDA and PBC agreed on the scope of the activities under the internal audit program (para. 4.20). 7.2 Conditions of effectiveness would be: (a) approval by the State Council of the Credit Agreement; and (b) conclusion of contracts satisfactory to IDA for the provision of technical assistance regarding regulation and supervision (PBC) (para. 4.7) and accounting (PBC and MOF) (paras. 4.15 and 4.18). 7.3 In addition, the following assurances were obtained at negotiations: (a) from PBC: Mi) PBC to undertake and complete comprehensive asset reviews (covering off-balance sheet items and at least 70 percent of each bank's loan portfolio) of all the specialized banks by June 30, 1998, using asset classification criteria agreed with IDA (para. 4.4); (ii) implementation plan for introduction of prudential regulations to be presented to IDA for comment within four months of com- pletion of related consultancy (para. 4.7); (iii) proposed plan for implementing new accounting standards for financial sector to be provided to IDA upon its completion (para. 4.18); and (iv) annual reviews of financial sector reform with reference to selected areas (para. 4.1). (b) from GOC: (i) Ceiling for permissible level of loan loss provisions to be raised by MOF to no less than 0.5 percent of outstanding port- folios in 1992 (para. 2.32); (ii) annual reviews of financial sector reform with reference to selected areas (para. 4.1); (iii) MOF to furnish to IDA a work program for development of general accounting standards in harmony with international GAAP and, _ 40 - unless otherwise agreed with IDA, including completion of at least 25 general standards within two years of the start of the accounting technical assistance program and the balance of general standards within three years; MOF would thereafter implement the work program as agreed with IDA (paras. 4.14 and 4.15); (iv) MOF to provide to IDA a draft strategy for the implementation of general standards to be elaborated (para. 4.15); (v) terms and conditions of onlending to PBC and MOF (para. 5.5); and (vi) AAPRC to provide IDA new auditing standards upon completion of related technical assistance and implement them, taking into as agreed with IDA from the start of the following year (para. 4.19). (c) from PBC and GOC: (i) PBC and MOP to provide procurement plans (para. 5.6); (ii) PBC, MOF and AAPRC to establish and maintain satisfactory coun- terpart and project management arrangements for the project (para. 5.11); (iii) all training to be carried out in accordance with programs agreed with IDA; and all studies to be carried out in accor- dance with terms of reference and timing agreed with IDA and study results to be reviewed with IDA (para. 5.11); and (iv) auditing requirements (para. 5.10). 7.4 The following understandings were reached at negotiations: (a) from GOC, scope of annual reviews of financial sector reforms (para. 4.1). (b) from PBC, principles of prudential regulation to be developed under the project (para. 4.7). 7.5 Subject to the above conditions, the proposed project would consti- tute a suitable basis for an IDA credit of SDR 42.1 million ($60.0 million equivalent) on standard IDA terms. -41- ANNEX 1 CHINA FINANCIAL SECTOR TECHNICAL ASSISTANCE PROJECT Structure of the Financial System (1991) No. of Assets No. of branches employees (Y billion) Banking System Central Bank PBC 2,438 132,693 894.4 Specialized Banks ICBC 30,108 485,415 1,138.9 ABC 55,147 493,400 558.1 BOC (domestic and foreign) 6,362 73,371 859.1/a/d PCBC /c 26,483 218,192 401.5/L dlniversal Banks BOCOM (including Hong Kong) 72 15,000 72.5 CITIC Industrial Bank 9 449 21.4 Development Banks CIB 57 1,500 17.4 Cooperatives RCCs 57,885 488,116 380.0 UCCs 3,518 68,587 56.3 Other Deposit Takers Foreign deposit-taking banks 37 635 NA Foreign joint-venture banks & finance cos. 4 95 22.6 Nonbank Financial Institutions TICs and ITICs (nationwide-14 15,960/c 69.4/c local-361) PICC (domestic) 3,034 84,750 23.8 PICC (abroad) 54/d 750/d 0.6 Finance companies 19 400 3.2 Financial leasing companies 9 300/c 0.7 Security agents (MOF) 300 2,000 NA Security companies (PBC) 68 600 0.8 a Includes BOC's foreign exchange operations. b Includes MOF's trust portfolio. /c Staff and assets include ITICs. d 1990 figure. Source: PBC. -42 - ANNX 2 CHINA FINANCIAL SECTOR TECHNICAL ASSISTANCE PROJECT Government Domestic Debt Management and The Develonment a Government Securities Market Overview and General Characteristics of the Government Securities Market 1. In the past, as in many developing countries, the Government of China (GOC) financed its deficits almost entirely by borrowing from the cen- tral bank and/or domestic banking system. Eighty-Five percent of the budget was financed this way in 1981, the first year in which the GOC issued treasury bonds. By 1987, treasury bonds covered more than 45 percent of the Govern- ment's financing needs. The Ministry of Finance (MOF) placed between Y 4 and 5 billion each year in 1981-84. Volumes subsequently rose in each year, reaching Y 6.06 billion in 1985; Y 6.25 billion in 1986; Y 11.69 billion in 1987; Y 18.88 billion in 1988; Y 22.39 billion in 1989; and Y 29.12 billion in 1990. The 1990 issue included Y 9.4 billion in the form of five-year conver- sion bonds, which were effectively roll-overs of maturing debt which MOF was unable to redeem. In 1991, government issued Y 35.12 billion of bonds, including Y 7 billion of roll-overs. In 1992, planned issues of new govern- ment securities total Y 38 billion of which Y 31 billion treasury bonds and, Y 7 billion of fiscal bonds. 2. Treasury bonds are placed with enterprises and individuals (and starting in 1988 also with financial institutions). Since 1985, treasury bonds issued to houtaholds have been the major component of government debt. Through 1990, placements were entirely by mandatory allocation; in April 1991, MOP for the first time placed Y 2.5 billion in new issues on a voluntary basis through an experimental but highly successful underwriting syndicate of secu- rities dealers. Initially bonds had maturities of ten years. However, as the Government's financing needs grew, it sought to make its issues more attractive. Accordingly, it reduced bond maturities progressively and recent issues to institutions have had maturities of five years, while those to indi- viduals have had maturities as short as three years. Other efforts to increase the attractiveness of treasury bonds have included a progressive raising of their coupon rates, opening up trading of certain bonds (para. 4) and making bonds eligible as collateral for enterprises. In 1992, Y 31 bil- lion of treasury bonds were issued, in two stages, through large underwriting syndicates. The first was a 10.5 percent coupon, 5-year issue of Y 11 bil- lion, priced at about 1.5 percent above five-year deposit rates; the second was a 9.5 percent coupon, three-year issue of Y 20 billion priced about 1.22 percent above three-year deposit rate. 3. Interest on treasury bonds are paid in full at redemption. Interest is not compounded, resulting in an effective compound yield to maturity well below the quoted coupon rate. Until 1989, bonds sold to enterprises carried lower nominal rates than those sold to individuals. In 1989 and 1990 issues to individuals carried rates of 14 percent and those to institutions rates of -43- ANNEX 2 15 percent, with the former, however, indexed. The 1991 underwriting issue was priced at a coupon rate of 10 percent (representing a spread of about two percentage points above the prevailing rate for three-year banlc time deposits). 4. Prior to 1988, government securities were not officially tradeable. Treasury bonds issued to individuals in 1985 and 1986 were made tradeable in 1988; now all treasury bonds issued to individuals are tradeable. However, other government securities, such as treasury bonds issued to enterprises, and fiscal bonds, issued to financial institutions, are still nontradeable. More- over, until recently, treasury bonds issued to individuals could not be acquired by other entiti-s. Secondary market activity is dominated by govern- ment debt. Trading volume has grown rapidly from Y 2.8 billion in 1988 to Y 60 billion in 1991. Trading in treasury bonds is mainly conducted over-the- counter (OTC) by some 68 securities companies and over 300 Trust and Invest- ment Companies (TICs) across China. 5. Treasury bonds are issued to individuals in bearer paper form, in denominations that range from a minimum of Y 5 to a maximum of Y 100, which places heavy administrative burdens on entities involved in issuing, redeem- ing, and trading the bonds. The small denominations make it impossible for MOP to make periodic interest payments. Bonds are issued to enterprises in book-entry form. 6. There is a high degree of segmentation of ownership of government securities. State enterprises are not allowed to purchase treasuty bonds or fiscal bonds; individuals can only hold treasury bonds; and fiscal bonds can only be held by financial institutions. In addition, the State Council must approve the interest rate, frequency, maturity, and other terms of each MOF issue. While the People's Bank of China (PBC) is consulted on each debt man- agement decision, the MOF is the final authority. The interest rAtes on trea- sury bonds are set at about 1' percentage points above the rates on savings deposits of comparable maturity. The rates on fiscal bonds, however, may be below deposit rates. In addition, treasury bonds face some limited competi- tion from enterprise bonds, which are approved by the PBC offering interest rates of up to 40 percent above comparable savings deposit rates. 7. Beginning in 1987, the Government found it necessary to tap addi- tional sources of funds through the sale of quasi government securities. These have included "key construction bonds" and "key enterprise bonds" sold by the People's Construction Bank of China (PCBC), "Capital Construction Bonds" sold by the State Planning Commission (SPC) and special state bonds sold by MOP. While MOF regards construction bonds as obligations of the issu- ing entity, it is likely that MOF will have to bear the repayment burden. 8. There have been significant institutional developments in the sec- ondary market for government securities, including the opening of the Shanghai Stock Exchange in 1990 and the Shenzhen Stock Exchange in 1991. In addition to fostering increased trading in government securities, the development of regional stock exchanges has also served to narrow price differentials of securities traded across regions, as government bonds issued outside the region are also traded on the stock exchange. By end 1991, a computerized information Quotation Center was established by the PBC. At present, 84 - 44 - ANNEX 2 members in 44 cities have access to price and volume information (with a one- day lag and no trading). In addition, the opening of the Securities Trading Automated Quotations System (STAQS), in late 1990, has also contributed to increased secondary market activity. STAQS, an on-line computerized quotation and OTC trading system, connects securities companies and other traders in six cities where securities trading is active. These institutions centralize securities trading; stimulate competition; increase the transparency of market conditionsa and inspire the confidence of investors. In addition, the MOP has established a Monitoring Center to compile information on bond price quota- tions and bond sales in various cities and to arrange for intervention, if needed, through various Government Bond Service Centers. The Debt Management Process 9. Annually in September, MOF presents to the State Council its pro- jected deficit and proposed financing plan based on analyses of placement possibilities with individuals and enterprises through a process involving also SPC and the State Statistical Bureau. Subsequently, MOP's State Debt Management Department convenes a national conference including representatives of all provincial finance bureaus and the ministries which supervise state enterprises. The conference fixes the proportion of bonds to be allocated at the provincial level for the coming years to individuals (generally 2-3 per- cent of salary), groups and institutions. Subsequently, each provincial Finance Bureau calls a provincial conference to determine allocation of bonds within the province. All sales are supposed to have been completed by Septem- ber. MOF's State Debt Management Department is responsible for issuing the bonds. PBC Beijing prints the bonds and distributes them to PBC provincial headquarters. In each province, PBC distributes bonds to the specialized banks, which serve as distribution agents. The bonds sold to individuals are in bearer form; enterprises receive only a depository receipt. Bonds are redeemed through PBC. Rev Issues 10. Currently, monetary and fiscal policy are not well integrated. PBC's credit plan implicitly assumes that MOF can finance its needs without recourse to the banking system. Thus, the need for large amounts of PBC financing in 1988 and 1989 was unanticipated and had the obvious consequences for monetary aggregates and inflation. While the superior approach would be to eliminate the deficit, to the extent this is not feasible, there is a need for the planning process to set prudent targets for monetary growth which consider government financing needs. 11. The shortening of maturities over the past several years has resulted in a debt bunching problem: Y 24.51 billion matured in 1990 and Y 18 billion in 1991; Y 33.02 and Y 10.14 billion are scheduled to mature in 1992 and 1993, respectively. Following Y 24.28 billion in 1994, government debt scheduled to mature would reach their peak in 1995 with Y 39.71 billion. The 1996 projections point to Y 26 billion, and Y 20 billion in the years there- after as government debt to be redeemed. Coupled with the current deficit, this translates to large financing requirements. As noted above, starting in 1990, MOF was unable to redeem some of its maturing debt and had to roll over - 45 - ANEX 2 significant portions. MOF's future debt management strategy needs to plan for an overall amortization schedule which is supportable. 12. MOF needs to develop a long-term debt management strategy which enables it to compete effectively at market rates for public savings. Such a strategy should involve broadening the mix (in terms of denominations and maturities) of debt instruments designed to appeal to different groups of investors; scheduling more frequent offerings of its securities; and developing a well-functioning secondary market, both retail and wholesale. At the end of 1992, total outstanding treasury debt will likely reach about Y 110 billion, of which around Y 70.5 billion in the secondary market, i.e., held by individuale. The remainder is held by institutions and enterprises and is not traded. In the coming years, MOF envisages to follow the strategy outlined in the 1991 report prepared by the IMF/World Bank Technical Assis- tance mission and issue both short- and longer-term bonds. The details of such strategy will be worked out during the next few months with the assis- tance of the consultants under the project. In principle, MOP would like to experiment with 20- and even 30-year savings bonds, as ell as issue short-term debt (i.e., 3-, 6- and 12-month T-bills). PBC expects to issue its own short- term paper to banks who would be legible to hold such paper in lieu of main- taining excess reserves on deposit with PBC. This would enable more flexible liquidity management. It will also be necessary to develop the accounting, communications and security custodial systems needed for development of these markets. 13. As noted above, the State Council needs to approve the interest rate, maturity and other terms of each issue. If MOF is to develop a more market-oriented strategy, it will need to have greater flexibility in deciding both the timing and the terms of its issues; as long as other interest rates are administered, such flexibility with regard to the interest rate should be within approved bands. A draft regulation which would provide MOF with the needed flexibility is under discussion internally, but has yet to be put for- ward to the State Council for approval. 14. Coordination between PBC and MOF in fiscal and monetary policy is less than ideal; this applies also to the development of the government secu- rities market. Institutional roles, and particularly the nature of PBC's role as a fiscal agent, have not been fully defined and are evolving; in this tran- sitional period, there has been overlap, for example, with regard to the plans of both institutions to develop book-entry systems, albeit for different types of securities, rather than merging their efforts. Greater clarity of roles and better coordination will be needed in the longer term. 46 _ CHINA FINANCIAL SECTOR TECHNICAL ASSISTANCE PROJECT Structure of Interest Rates Nominal Annual Interest Rates on Deposits 1979 1980 1902 1963 1985 1985 1986 1986 1987 1987 1988 1989 1990 1990 1991 Item 04101 04t01 04/01 12121 04/01 08/01 03/01 08/01 06/21 08/14 09/01 02/01 04/15 08/21 04/21 1. Houaebold Dopeosits 1.1 Sight 2.16 2.88 2.88 2.88 2.88 2.88 2.86 2.88 2.88 2.88 2.88 * 2.88 2.16 1.60 1.2 Time 1.2.1 Fixed in, fixed out 1/2 year 3.60 4.32 4.32 4.32 5.40 6.12 6.12 6.12 6.12 6.12 6.48 9.00 7.74 6.48 3.40 1 year 3.96 5.40 5.76 5.76 6.84 7.20 7.20 7.20 7.20 7.20 8.64 11.34 10.08 8.64 7.56 2 yeara * - - - - 9.18 12.24 10.98 9.36 7.92 3 years 4.50 6.12 6.84 6.84 7.92 8.28 8.28 8.28 8.28 8.28 9.72 13.14 11.88 10.08 8.28 5 years 5.04 6.84 7.92 7.92 8.28 9.36 9.36 9.36 9.36 9.36 10.60 14.94 13.68 11.52 9.00 8 years 5.04 6.84 9.00 9.00 9.00 10.44 10.44 10.44 10.44 10.44 12.42 17.64 16.20 13.68 10.08 1.2.2 Plezible in, fixed out I yoar 3.60 4.32 4.68 4.68 5.40 6.12 6.12 6.12 6.12 6.12 7.20 9.54 8.28 7.20 6.12 3 yeare 3.96 5.40 6.12 6.12 6.84 7.20 7.20 7.20 7.20 7.20 8.64 11.34 10.08 8.64 6.84 5 ysars 4.50 6.12 7.20 7.20 7.56 7.92 7.92 7.92 7.92 7.92 9.72 13.14 11.88 10.08 7.56 1.2.3 Fixed prinotpal I year 3.60 4.32 4.32 4.32 5.40 6.12 6.12 6.12 6.12 6.12 7.20 9.54 8.78 7.20 6.12 3 years 3.96 5.40 5.76 5.76 6.84 7.20 7.20 7.20 7.20 7.20 8.64 11.34 10.08 8.64 6.64 5 years 4.50 6.12 6.84 6.84 7.56 7.92 7.92 7.92 7.92 7.92 9.72 13.14 11.88 10.08 7.56 1.2.4 Fixed in. flexiblo out 1 year 3.60 4.32 4.32 4.32 5.40 6.12 6.12 6.12 6.12 6.12 7.20 9.54 - 6.12 3 years 3.96 5.40 5.76 5.76 6.84 7.20 7.20 7.20 7.20 7.20 8.64 11.34 - - 6.84 5 years 4.50 6.12 6.84 6.84 7.56 7.92 7.92 7.92 7.92 7.92 9.72 13.14 - 7.56 1.2.5 Convertible deposit 1/2 year or leoo e 1/2 - I year ................................-lower thsn household deposit rate by 102 _ -.------------------------- 1 year or more J 2. Depoosto from Overseso Chinose 1 year 4.68 5.76 6.48 6.48 7.20 8.28 8.28 8.28 8.28 8.28 9.72 13.14 11.88 10.08 8.28 3 yeare 5.04 6.48 7.20 7.20 8.28 9.36 9.36 9.36 9.36 9.36 10.80 14.94 13.68 11.52 9.00 5 years 5.40 7.20 8.28 8.28 9.00 10.44 10.44 10.44 10.44 10.44 11.88 16.74 15.48 13.68 9.90 3. Enterprisae Deposits 3.1 Sight 1.80 1.80 1.80 1.80 1.80 1.80 1.80 1.80 1.80 1.80 2.88 2.a8 2.88 2.16 1.80 3.2 Time, 1/2 year - - - - - - - 4.32 4.32 6.48 9.00 7.74 6.48 5.40 1 year . 3.60 3.60 4.32 4.32 4.32 4.32 5.04 5.04 8.64 11.34 10.08 8.64 7.56 2 years * * 4.32 4.32 5.04 5.04 5.04 5.04 5.76 5.76 9.18 12.24 10.98 9.36 7.92 3 years - - 5.04 5.04 5.76 5.76 5.76 5.76 6.48 6.48 9.72 13.14 11.88 10.08 8.28 5 yeare - - - - - - 10.80 14.94 13.68 11.52 9.00 8 years - - - - - - - - 12.42 17.64 16.20 13.68 10.08 4. Insurance Compan Depoits Sight - 1.80 1.80 1.80 1.80 1.80 1.80 1.80 1.80 1.80 2.88 2.88 2.88 2.16 1.80 Total reserves _ - - 4.20 4.20 4.20 5.04 5.04 5.04 5.04 6.48 8.64 7.92 6.84 6.12 Contingent reservea Lo Resorves against proporty claims l . - - _ . _ _ _ . . _ _ Life ineurance reserves Lb - - - - - - - - 5. Individual Enterpriee Depootts . 1.80 1.80 1.80 2.88 2.88 2.88 2.88 2.88 2.88 L Lb Jb _ L 6. Lsrge CDe state-own or collective units Equivalent saturity tie deposit rate plus 102 Individuals /a Same ratee paid by PBC to the epeaialised banks. lb Sme rates paid on boueebold deposits. Notesl (1) This table does not include P8C's interest rates on specislized banke' depoe9te. (2) Before September 21. 1988. interest rates on deposits in TICs could float vitbin a 202 range from quoted rates. (3) Sinee September 10. 1988, interrtt rates on time deposits with maturities of three years or more were indexed to tbh rate of tiflation (CPl). Sources PBC. 1992/8. _4 7 _ ANNX 3 PINIISNCAL SECTOII T2CIOUCAL AO9OTAI1CE PROJECT structur of 2ntereat Bstes Peeopl's Bank of China.dntereet Rates on Deponsts and Lotna 1985 6 1987 1988 1989 1990 1991 0o/01 08601 -01X08 '007 09/21 0912-1 I2/2I oiliO of/0o 020 03I21 0/21 UT25 Deposits Froi Pirancial Institutions As "reserves requirement' 4.32 4.32 4.32 4.32 4.32 4.32 5.04 5.04 5.04 7.20 7.92 6.84 6.12 As "xcese res.rvo requireslnts 4.32 4.32 4.32 5.76 5.76 5.76 5.76 5.76 6.48 8.64 7.92 6.84 6.12 From Insurance Companies Sight 1.80 1.80 1.80 1.80 1.80 1.80 1.80 1.80 2.88 2.88 2.88 2.16 1.80 Reeerves against property claims 4.20 4.20 5.76 5.76 5.76 6.48 6.40 6.48 6.48 8.64 7.92 6.84 6.12 Contingent reservee l lemil, insurance reserves Life insurance reserves Id Irom Rural Credit Union* 7.92 7.92 7.92 9.00 . - . 10.80 To FivnoU nI_nstitutions Annue) 4.68 4.68 4.68 4.68 6.48 7.20 7.20 7.20 8.28 10.44 9.00 7.92 7.20 Seasonal 5.04 5.04 5.04 6.84 6.84 7.20 6.84 6.84 7.56 9.72 9.00 7.92 7.20 Ordinary 5.04 5.04 5.04 6.48 6.48 7.20 6.48 6.48 6.84 9.00 9.00 7.92 7.20 Rolled over ST loans Jj 4.68 4.68 4.68 4.68 4.68 7.20 7.20 7.20 8.28 10.44 9.00 7.92 7.20 Original funding losn. 4.32 4.32 4.32 5.76 5.76 5.76 5.76 5.76 6.48 8.64 7.92 6.84 6.12 Rediecounting L -32 7. 52 -7.5S -7.5S -7.52 -7.52 - - Overdue loans 4112 +112 411Z 4112 .112 +18.252 . - - Some. Lons throush Co C cal Banks Special lo.n to te least developed areat 3.60 3.60 3.60 3.60 3.60 3.60 3.60 3.60 4.68 7.02 5.76 5.76 5.76 Regional development I year or lese 5.04 7.92 7.92 7.92 7.92 7.92 7.92 7.92 9.00 11.34 10.08 9.36 8.46 1.3 years 3.76 8.64 8.64 8.64 8.64 8.64 8.64 8.64 9.90 11.34 10.08 9.36 8.46 3-S years 6.48 9.36 9.36 9.36 9.36 9.36 9.36 9.36 10.80 11.34 10.08 9.36 8.46 5.10 yars 7.20 10.08 10.08 10.08 10.08 10.08 10.08 10.08 13.32 11.34 10.08 9.36 8.46 Above 10 years 7.92 10.80 10.80 10.80 10.80 10.80 10.80 10.80 16.20 - 10.08 9.36 8.46 To Purcbhse Foreign Exchante For working capital 7.92 7.92 7.92 7.92 7.92 7.92 7.92 7.92 9.00 11.34 10.08 9.36 8.64 For technology upgrading 1 year or less 5.04 7.92 7.92 7.92 7.92 7.92 7.92 7.92 9.00 11.34 10.08 9.36 8.64 1-3 years 5.76 8.64 8.64 8.64 8.64 8.64 8.64 8.64 9.90 11.34 10.08 9.36 8.64 3-5 years 6.48 9.36 9.36 9.36 9.36 9.36 9.36 9.36 10.80 11.34 10.08 9.36 8.64 5.10 yeare 7.20 10.08 10.08 10.08 10.08 10.08 10.08 10.08 13.32 11.34 10.08 9.36 8.64 Above 10 years 7.92 10.08 10.08 10.08 10.08 10.08 10.08 10.08 16.20 11.34 10.08 9.36 8.64 For 14 Coastal Cities 6. 8E2e Fixed assets I year or lose 5.04 7.92 7.92 7.92 7.92 7.92 7.92 7.92 9.00 11.34 10.08 9.36 8.46 1-3 yeari 5.76 8.64 8.64 8.64 8.64 8.64 8.64 8.64 9.90 12.78 10.80 10.08 9.00 3-3 years 6.48 9.36 9.36 9.36 9.36 9.36 9.36 9.36 10.80 14.40 11.52 10.80 9.54 5-10 yesre 7.20 10.08 10.08 10.08 10.08 10.08 10.08 10.08 13.32 14.26 11.88 11.16 9.72 Longer than 10 yaare 7.92 10.80 10.80 10.80 10.80 10.80 10.80 10.80 16.20 - 11.88 11.16 9.72 Preferential rates - - - 2.88 2.86 2.88 2.88 5.88 /b - _ (For Y 2 billion)i '5 years - - - - 4.32 4.32 4.32 4.32 7.32 lb Lb For Gold 6 Silver Production I year 5.04 5.04 5.04 5.04 5.04 5.04 5.04 5.04 6.12 8.46 7.92 7.20 5.76 3 years 5.76 5.76 5.76 5.76 5.76 5.76 5.76 5.76 6.84 9.18 7.92 7.20 5.76 5 years 6.48 6.48 6.48 6.48 6.48 6.48 6.48 6.48 7.56 9.90 7.92 7.20 5.76 Industries in Poor Counties 3.60 4.68 7.02 5.76 5.76 5.76 interbranch Transaetions 4.50 4.50 4.50 4.50 4.50 6.12 6.12 6.12 6.73 8.892 8.46 7.38 6.60 a Theme are short-term lotn which bave been rolted over and made long term. i Refers to 'infrastructure lane to coastal areas." Sam Sa the "eaceas reserVO requirement" interest rate. Sam as the "bousebold deposits" interest rate. r* quiv4snt maturity tim loan rate plus or SMUS 5-10 percent. totes pinancial inatitutions include specislised and compreensive banks. but do not include tinurance companiec. Sources PBC. 1992/8. - 48- ANNEX 3 COm PUINWCIAL SECTOR TECIONICAL ASSISTANICE PROJECT Structure of Interest Rates Nominal Annual Irterost Rate. on Loanu Year, 1979 1980 1980 1981 1982 1983 1984 1985 1985 1986 1987 1988 1989 1990 1990 1991 Date, 01101 01/01 04/01 01/01 01/01 01/01 01101 04/01 08/01 09/21 01/01 09/01 02/01 03/21 08/11 04/21 I. Working Capital Loans to 1.1 2 no_utry 5.04 5.04 5.04 5.04 7.20 7.20 7.20 7.92 7.92 7.92 7.92 9.00 11.34 10.08 9.36 8.64 1.2 Cossirce 3.04 3,04 5.04 3.04 7.20 7.20 7.20 7.92 7.92 7.92 7.92 9.00 11.34 10.08 9.36 8.64 1.3 A.griculturo 4.32 4.32 4.32 4.32 7.20 7.20 7.20 7.92 7.92 7.92 7.92 9.00 11.34 10.08 9.36 8.64 1.4 Constructiou 3.04 3504 5.04 5.04 3.60 3.60 3.60 4.32 4.32 4.32 4.32 9.00 11.34 10.08 9.36 8.64 1.3 Foreign trade 5.04 3.04 5.04 5.04 7.20 7.20 7.20 7.20 7.20 7.20 7.20 9.00 9.00 9.00 8.28 7.74 1.6 Tcvn&6villaego enterprise (T2E) 4.32 4.32 4.32 5.04 7.20 7.20 7.20 8.64 8.64 S.64 8.64 9.00 11.34 10.08 9.36 6.64 1.7 ludividual enterprisea - - 5.04 3.04 7.20 7.20 8.64 11.52 11.32 11.52 11.32 9.00 11.34 10.08 9.36 8.64 1.8 Farmers 4.32 4.32 4.32 5.04 7.20 7.20 7.20 7.92 7.92 7.92 7.92 9.00 11.34 10.08 9.36 8.64 1.9 Preferential rates 1.9.1 Listed price food & oil 2.52 2.52 2.52 2.52 3.60 3.60 3.60 3.60 3.60 3.96 3.96 9.00 10.08 9.00 8.28 7.74 1.9.2 Food purehae 4.32 4.32 4.32 4.32 I.76 5.76 5.76 5.76 - - 3.96 9.00 10.08 9.00 8.28 7.74 1.9.3 Rice aced companies 2.52 2.52 2.2 2.52 3.60 3.60 3.60 3.60 60 0 3.96 7.92 9.00 10.08 9.00 8.26 7.74 1.9.4 Youtb-run TVEs 4.32 4.32 4.32 4.32 4.31 4.32 4.32 4.32 4.32 4.32 7.92 NA NA - . 5.76 1.9.5 Hinoritya Production & trade - - 3.96 3.96 3.96 3.96 3 96 3.96 3.96 5.04 6.12 8.46 7.20 6.48 5.76 1.9.6 Minority, Handorafts - - - 3.96 3.96 3.96 3.96 3.06 3.96 3.96 5.04 6.12 8.46 7.20 6.48 3.76 1.9.7 Chineas uedicinel not in Beijing - - 5.76 3.76 5.76 5.i6 5.76 5.76 7.92 - 11.34 - - 1.9.8 Chinese medicinal in Beijing 5 - - * 3.76 5.76 5.76 5.76 5.76 7.92 * 11.34 1.9.9 fousabold ites . . . 5.76 5.76 5.76 5.76 5.76 5.76 7.92 - 11.34 - - 1.9.10 Nonprofit government entities - * ^ - - 5.76 5.76 6.34 6.34 6.34 6.34 7.50 11.34 State-run comerciAl entities (SCE) 1.9.11 Floatins Ca.ital 8 - - - 6.84 6 6.84 4 6.4 6.4 6.84 6.84 11.34 - - 1.9.12 Sbort-term loans * * . * 7.20 7.20 7.20 7.20 7.2v 7.20 9.00 11.34 1.9.13 Otbhr loans - - - 7.56 7.56 7.56 7.56 7.36 7.56 9.00 11.34 1.9.14 Cotton . - . - . . 7.20 7.20 7.20 7.20 9.00 10.06 9.00 - 7.74 1.9.13 SCE, Comror 4 medicne - - - 3.93 3.96 3.96 3.96 3.96 3.96 3.96 5.04 6.12 11.34 - 4 8.64 1.9.16 Settlesent loans 3.04 3.04 5.04 3.04 7.20 3.60 3.60 3.60 3.60 3.60 7.92 9.00 11.04 - - 6.64 1.9.17 Discounting of bills UI. Fixed Assets 2.1 Oruinary ratee 2.1.1 I year or leas - 3.00 3.00 3.00 5.04 5.04 5.04 5.04 7.92 7.92 7.92 9.00 11.34 10.08 9.36 8.46 .1.2 1-3 years - 3.00 3.00 3.00 5.76 5.76 5.76 5.76 8.64 8.64 8.64 9.90 12.78 10.80 10.08 9.00 2.1.3 3- yrsr - 3.00 3.00 3.00 6.48 6.48 6.48 6.48 9.36 9.36 9.36 10.80 14.40 11.52 10.80 9.54 2.1.4 5-10 yeare - 3.00 3.00 3.00 6.48 6.48 6.48 6.48 10.08 10.08 10.08 13.32 19.26 11.88 11.16 9.72 2.1.5 Hore than 10 year - 3.00 3.00 3.00 6.48 6.48 6.48 6.48 10.80 10.80 10.80 16.20 - 11.88 11.16 9.72 2.2 Preferential rates Lo 2.2.1 3 years or less _ _ _ _ _ _ 5.76 5.76 7.92 9.00 8.64- 8.64- 7.56- 9.36 7.36 810 2.2.2 5-10 years _ _ * * * * * _ _ 6.48 6.48 8.64 10.08 9.36- 9.36- 8 10- 9.34 9.34 8.28 2.2.3 More than 10 years - - - - - - - - 7.20 7.20 9.36 13.88 9.54 9.54 8.28 2.3 14 coastal cities & SE2I (up to 2 billion yuan) 2.3.1 5 years or lass - - - - - - - - - - 2.88 2.88 2.88 - - - 2.3.2 More than 5 year - - - - - - - - - - 4.32 4.32 4.32 - - 2.4 1983 SBM-term lotna for equipnta - - - - - 2.52 2.52 2.52 2.52 2.32 2.32 2.32 11.34 10.08 9.36 8.46 2.3 Loans for abiRas Sixtb five-year plan period - - - 4.03 4.03 4.03 4.03 4.03 7.92 7.92 7.92 9.00 11.34 10.08 9.36 8.46 2.6 Loans for motorcycles 4 carst sm - - - 5.04 3.04 5.04 5.04 5.04 7.92 7.92 7.92 7.92 - - - 2.7 Loasu to gold proAuctiou 2.71 1 y ar 2.16 2.16 2.16 2.16 4.32 4.32 4.32 5.04 5.04 5.04 5.04 6.12 8.46 7.92 7.20 5.7C 2.7.2 3 year. 2.16 2.16 2.16 2.16 4.32 4.32 4.32 5.76 5.76 5.76 5.76 6.84 9.18 7.92 7.20 5.76 2.7.3 5 yar 2.16 2.16 2.16 2.16 4.32 4.32 4.32 6.48 6.48 6.48 6.48 7.56 9.90 7.92 7.20 5.76 2.8 Loans to mirror productiou * - - 4.32 4.32 4.32 - - - - - - - 2.9 Energy consrvation (S) - - . 2.52 2.52 2.52 2.52 2.52 2.52 - - - - - - - 2.10 Rural antsrpriees (TVEs) 4.32 4.32 4.32 5.04 7.20 7.20 7.92 9.36 9.36 9..6 9.36 13.32 11.34 10.08 9.36 8.64 RiU. Grants into Loanu 3.1 hlect-onics, textile, light industries - - - 3.60 3.60 3.60 3.60 4.20 4.20 4.20 4.20 4.20 4.20 4.20 4.20 4.20 3.2 Stool. mschanic, automobile - - 3.00 3.00 3.00 3.00 3.60 3.60 3.60 3.60 3.60 3.60 3.60 3.60 3.60 3.3 Agriculture, forestry fishery - - 2.40 2.40 2.40 2.40 2.40 2.40 2.40 2.40 2.40 2.40 2.40 2.40 2.40 3.4 Surplus &, energy insulficient projects - - _ 12.00 12.00 12.00 12.00 12.00 12.00 12.00 12.00 12.00 12.00 3.5 Other 3.00 3.00 3.00 3.00 3.00 3.00 3.00 3.00 3.00 3.00 3.00 3.00 3.00 IV. Special Loana - - - - - - - 12.00- 12.00- 10.80- 10.80- 10.88- - 12.96 10.80 9.72 14.00 14.00 14.00 14.00 14.00 V. Interbank Loana .......... Nagotist VI. ntrt Penaltica 6.i overcue soans - - _ 202 *202 +202 t20z +202 +202 +202 +202 *202 e202 +302 +202 +202 +202 6.2 Loansu above working capital limits +302 e302 +302 +302 +302 *302 +302 +302 +302 +30Z +302 +302 +302 +302 6.3 Surplus & problem products . +302 +302 +302 .302 +302 +302 .302 +302 +302 +302 +302 +302 +302 +302 6.4 Loans used for unauthorised purposes * - +502 +302 +f0Y +502 + 502 +502 +502 +502 +0 502 +1002 +502 +502 +502 Urvaighted Av rage 3.92 3.92 3.98 3.90 3.15 5.18 3.66 6.10 6.61 6.72 7.14 8.48 11.82 - . - IU - Do longer applicable. Souree, P8C, 199219. - 49 ANNEX 4 CHINA FINANCIAL SECTOR TECHNICAL ASSISTANCE PROJECT ARreed Coverage of Prudential Regulations 1. Prudential regulations addressing the following topics would be formulated under the project. Where appropriate, phase-in periods may be required for their implementation. The list is not exhaustive, and should be supplemented by additional regulations drafted by the international consul- tants in cooperation with PBC's Subgroup on Prudential Regulation. (a) Minimum Capital Adeguacy Guidelines. A minimum capital adequacy guideline would be formulated. The preferred approach is to use a risk-weighted measure similar to the guideline adopted by the Basle Committee on Banking Supervision. This measure captures both bal- ance sheet and off-balance sheet risks and relates that risk to the bank's capital funds. A ratio of 8 percent has been adopted for well-managed, firiancially sound banks that have recognized actual losses and provided adequate reserves for potential losses. Most banks require a higher percentage. (b) Adequate Provisions. Prudential regulations should require that banks provide adequate reserves for actual and potential losses. The amount of reserves considered adequate depends on many factors, such as the quality of lending management, lending policies, antici- pated loan growth, historical loan loss experience, earnings cover- age, the economic environment, etc. However, asset quality provides the most direct indication of the level of reserves required. An in-depth portfolio review which grades the quality of assets, based on the borrower's ability eo repay through cash flow or the business asset conversion cycle, will determine the loss potential existing within various classes of assets. Note that collateral and guaran- tees are normally considered as secondary sources of repayment and require careful evaluation as to the likelihood that they will pro- vide an adequate means of debt recovery. Typically, the reserve for losses should be at least equal to the sum of the following: 100% of assets classified as loss 50% of assets classified as doubtful 20Z of assets classified as substandard 52 of assets criticized as especially mentioned 12 of remaining assets Other systems for grading assets are acceptable provided that they adequately define risk and loss potential. (c) Rxposure Limits. Prudential regulations should limit the aggregate outstanding amount of creditt in any form, that could be extended to a single borrower or a group of related borrowers. In most coun- tries, limits range from 10 percent to 25 percent of the bank's - 50 - -mEEL_ capital. The limit is designed to ensure adequate diversification of risk. (d) Loans to Insiders. Prudential regulations should establish rules on loans and other transactions involving bank insiders. Insiders includes major shareholders, executive officers and directors, and others who have the ability to influence or control decision-making within the institution., (e) Enforcement Powers. Prudential regulations should provide bank supervisors with an assortment of intermediate enforcement powers or sanctions which could be applied to effect correction of unsafe and unsound practices. These might include: (i) cease and desist authority; (ii) the power to prohibit dividends; (iii) the power to remove managers and directors; (iv) the power to levy fines and penalties against individuals, as well as institutions; (v) the power to cause banks to increase loan loss provisions or to write- off loans; and (vi) the ability to withhold approval of new branches or other corporate activities. 2. There are many other regulations that are necessary or, at the least, highly desirable. Among these are regulations designed to enable PBC to deal with troubled and/or insolvent institutions. However, this body of legislation is more complex and will require expert assistance to formulate and draft. 51- X 5 CHINA FINANCIAL SECTOR TECHNICAL ASSISTANCE PROJECT Legislative Framework. Prudential Reriulation and Supervision Legal and Regulatory Framework 1. The existing legal framework for banking is a loose amalgamation of regulations. The "Provisional Regulations of the People's Republic of China on the Control of Banks" provide the legal basis for PBC's supervisory activi- ties. This legislation, which was promulgated in January 1986 by the State Council, makes PBC the sole government authority responsible for supervising, regulating, and inspecting financial institutions. It also grants to PBC sole authority for approving the establishment, merger, or dismantling of special- ized banks and other financial organizations. 2. Other aspects of PBC's involvement in bank supervision are governed by the "Provisional Regulations on Auditing by the People's Bank of China." These regulations require that PBC focus on supervising the business activi- ties of financial organizations as they relate to executing the economic and financial policies of the State; the laws, decrees, and regulations of the State and the central bank; and, the credit, cash, foreign currency, and financial plans.. In addition, provisional regulations have been promulgated for different types of financial firms and activities, such as Trust and Investment Corporations (TICs) and Urban Credit Cooperatives (UCCs). There are no special regulations governing the activities of banks as a group. These complete the body of law which loosely defines the legal framework for banking. In general, the focus of the provisional regulations is on economic aspects of regulation, consistent with the general philosophy of a centrally planned economy. However, prudential regulations, designed to limit and con- trol the risks that banks assume, are virtually nonexistent. 3. There are many areas of intense debate within Chlna which need to be resolved in the elaboration of more comprehensive banking legislation. For instance, there is the question of whether PBC should be granted greater independence and autonomy in formulating and implementing monetary policy. There is discussion as to whether PBC should report to the State Council or the People's Congress. There is a question whether there should be but a single, comprehensive banking law or separate banking and central bank laws. Another debate centers around whether the specialized banks should have the same legal status as the comprehensive banks and the freedom to engage in all banking sctivities, or whether they should only participate in activities related to their area of sectoral specialization. Another question is whether the number of financial institutions of various types should be limited by law. - 52- ANNEX 5 4. A draft banking law 1/ is under preparation and, when completed, will be circulated to the various government agencies and provincial authori- ties for comment. After comments are received, another draft is to be circu- lated prior to submission to the State Council and thereafter the Standing Committee of the National People's Congress for approval. The eventual enact- ment of the draft law will bring together many of the provisional regulations into a more permanent document. Thue,. its careful draiting is important in charting the future development of the financial system in China. Present Supervisorv Arrangements 5. Supervisory activities in China are guided by the lega'l framework described above. Since the existing legal framework emphasizes the social and developmental role of banks, bank supervision activities have thus far focused on ensuring compliance with economic regulation in the form of the national development plan rather than on the more traditional objectives of bank super- vision which are to ensure the safety, soundness, and stability of the finan- cial system. The following sections discuss existing supervisory arrangements and the changes required to reorient supervisory activities to focus on pru- dential concerns. OrRanization 6. To carry out its responsibility for supervising financial institu- tions, PBC has established the Department of Bank Supervision and Audit. This department is organized on a decentralized basis and is responsible for super- vision of more than 80,000 banking offices and financial institutions having resources in excess of Y 1 trillion (see Table 1 below). The department is organized into six divisions, three of which are responsible for compliance examinations of the specialized and comprehensive banks. Other divisions supervise the foreign/joint venture banks and overseas branches of Chinese banks, provide administrative and technical support, or perform internal audit of PBC itself. The department employs a nationwide staff of 5,600. Of this number, only about 200 are at the level of senior economist or senior accoun- tant with slightly more than 1,300 in the middle grades. In addition to head- quarters staff in Beijing, bank supervisors are assigned throughout China at all provincial branches of PBC, all city and prefectural branches, and approx- imately 30 percent of PBC's county-level branches. The Bank Supervision Process 7. Since the Department of Bank Supervision and Audit was only estab- lished in 1985, the supervision function is relatively new to China and its activities are still evolving. Unlike its counterparts in most market econo- mies, the Department has thus far focused primarily on ensuring compliance with the developmental priorities of the national credit plan. To meet this objective, the supervisory process at each level of PBC is two-tier, both 1/ As an alternative to a single banking law, many countries have adopted separate banking and central bank laws. Both alternatives are considered acceptable. -53- AN $ Table it FINANCIAL INSTITUTIONS SUPERVISED BY PBC (1991) Head Provincial City Sub- Office branch branch branch Other la Total Specialized Banks 4 173 1,095 9,432 - 10,704 Comprehensive Banks 2 13 34 - - 49 Foreign Banks 35 - - - - 35 Trust & Investment Cos. 14 -- 361 -- - - 375 Leasing Companies 9 - _- - 9 Securities Companies 68 - - - - 68 Insurance Companies 1 44 339 2,390 - 2,774 Urban Credit Coops. - - - 3,518 3,518 Rural Credit Coops - - - - 57,885 57,885 PBC lb 1 44 315 2,058 - 2,418 /a Supervision of the rural credit cooperatives has been delegated to the Agricultural Bank of China. Supervision of some urban credit cooperatives has been delegated to the Industrial and Commercial Bank of China. tb The Department of Bank Supervision and Audit is responsible for the inter- nal audit of PBC itself. Source: People's Bank of China. horizontal and vertical, in that organizational units of PBC supervise banking units at the same level but communicate the results of their supervisory efforts upwards to the next highest level PBC unit for approval and consolida- tion with those of other similar units. In this sense, the supervisory pro- cess may be said to function from the "bottom-up" since findings are filtered upward from the lowest level unit until they eventually reach the highest level unit. For example, a city-level branch of PBC is responsible for the supervision of city-level branches of the specialized banks. Administra- tively, this PBC city-level branch reports to a PBC provincial branch. Find- ings from its inspection activities are forwarded to the provincial branch, where they are approved and consolidated with the results of other city-level branchee. If remedial action is required, the provincial branch of PBC will take up the matter with the appropriate provincial branches of the specialized banks responsible for the lower level city-level branches. 8. At the headquarters level, the duties assigned to supervisory per- sonnel are to draft laws and regulations, formulate the national plan of supervision and examination, and participate in on-site inspections of spe- cialized banks and financial institutions at the national level. In addition, they perform special investigations at the request of PBC's Governor or Deputy Governors and test experimental inspection procedures. Supervisory personnel at the provincial level are responsible for formulating specific supervisory policies for their areas of responsibility. In addition, they participate in on-site inspections at the provincial level and perform supervisory projects - 54 MANEX 5 assigned by PBC headquarters. Supervisory personnel at the level of city and prefectural branches and county-level subbranches are primarily engaged in on- site inspections of horizontal level banking units. It is at these levels that most of tho detailed inspection work is performed. It is noted that much of the work performed at this level is in the nature of traditional audit activities, e.g., ensuring that payments and receipts are properly posted to the books and ensuring compliance with laws, rules, and regulations. 9. On-Site Inspections. Regular on-site inspections are scheduled once every three years for state-owned banks, foreign banks, and nonbank financial institutions. Collectively owned financial institutions are inspected every two years. In some instances, for inspections of specialized banks, staff from the bank's own internal audit department assist in the inspection. In other cases, due to their own lack of resources and the huge number of banking offices, the supervisors rely totally on the results of the bank's own inter- nal audit. In addition, PBC has delegated supervisory responsibility over some 60,000 rural credit cooperatives to the Agricultural Bank of China. Similarly, in some provinces, urban credit cooperatives are supervised by the Industrial and Commercial Bank of China. 10. Where the supervisors conduct their own regular inspection, it is carried out in three stages: preparation, execution, and report writing. During the preparation stage, the supervisors gather appropriate background information concerning the institution and draft out the objectives and plan of execution for the on-site inspection. Following completion of the draft inspection program, the plan is submitted to the head of the supervision unit for approval. Thereafter, the financial institution is notified that an inspection will commence. 11. The execution stage includes the actual on-site visit and typically includes, as its primary focus, an assessment of the institution's performance in meeting credit and deposit targets. Supervisors also determine whether the institution is complying with interest rate policies and is operating within the scope of activity governed by its license and articles of association. In this regard, a determination is made whether profits have been earned through legal means. Where credit targets have not been met, the supervisors may instruct the institution to adjust the structure of its loans, scale back credit to general borrowers, extend credit to key projects, and make adjust- ments to control the aggregate amount of lending. Sanctions for illegal activities typically include fines, forfeiture of illegal profits, and/or a reduction in bonuses. 12. Loans are evaluated to determine their prospects for repayment. However, the level of loan loss reserves is established arbitrarily 2/ end bears no linkage to portfolio quality. For problem loans, an evaluation is made to determine if the problem originated due to an unforeseen policy change or because of the borrowing firm's poor management. In the case of the for- mer, the problem borrower could receive a free appropriation/subsidy from the 2/ Currently, banks are limited to a level ranging from 0.1 percent to 0.2 percent of outstanding loans. - 55 - QE&_5 budget. In the case of the latter, management of the borrowing firm is answerable. In extreme cases, the borrowing firm could even be forced into liquidation. More common, however, is the rescheduling of the debt while the borrower attempts to restructure its operations. For large loans (above Y 100,000) to be written-off an institution's books, PBC must submit its rec- ommendation to the State Council for approval. As the result, provisioning and write-offs have not been seen as a normal cost of doing business. 13. In the report writing stage, the draft findings of the inspection are assessed and commented upon in a free-flowing narrative report. The report is submitted to the head of the supervision unit for his approval before being communicated to the banking unit under inspection. Additional copies of the report are upstreamed to the next level office of PBC and the parallel level of the unit inspected. The transmittal letter accompanying the report establishes a time frame for comments and progress reports to the extent that corrective action is necessary. In case of disagreement with the findings of the report, a second inspection, not lasting more than three days, may be deemed necessary. Thereafter, progress is monitored through reports and subsequent inspections. 14. It should be noted that where remedial actions are required, it is the head of the institution's audit department that is chiefly responsible for resolving problems. Senior management of the institution may not be aware of problems unless they are deemed to be of a sufficiently serious nature. 15. In addition to regular inspections, nonregular supervisory activi- ties are also conducted. These include special projects initiated by PBC headquarters and investigations authorized by PBC's Governor or Deputy Gover- nor. This often occurs when it is suspected that an institution is engaging in unauthorized or illegal activities or is exceeding interest rate guide- lines, or where fraud may be involved. Further, PBC recently tested experi- mental examination procedures which introduced some aspects of prudential supervision into the examination process. During 1990, 108 branches of the Industrial and Commercial Bank of China (ICBC) were examined using new, expe- rimental examination procedures that required an assessment of the five CAMEL 3/ components in the branches examined. 16. Off-Site Supervision. Financial institutions are required to submit four different types of reports to PBC on a regular basis. These are: (a) the institution's annual credit and resource mobilization plans; (b) sta- tistical returns which document the actual execution of the plans; (c) a statement of payments and receipts; and (d) for new institutions, a balance sheet and profit and loss statement. Reports are filed at the corresponding level branch of PBC and then upstreamed, both within the institution and within PBC, to the next highest level for consolidation. The frequency of each report is determined by the level of the reporting unit, e.g., county level branches and financial firms are required to file reports more fre- quently than a provincial branch. It should be noted that these reports are 3/ CAMEL is an acronym used by bank supervisors for: capital, asset qual- ity, management, earnings, and liquidity. - 56 AN 5 used primarily for consolidating financial institution and industry-wide sta- tistics within a political boundary rather than compiling financial statements for individual banks. The two-tier consolidation process provides a double- check as to accuracy. However, once consolidated, this information does not normally find its way into the supervisory process as a means for financial or early-warning analysis. Instead, it is simply filed away as historic data for statistical purposes. Licensing 17. The licensing of financial institutions is carried out by PBC's Financial Administration Department. The licensing decision is based on the following factors: (a) sufficiency of paid-up capital; (b) qualifications of prospective management; (c) the need for economic development, consistent with the proposed volume of operatiorts and scale of operations; (d) comprehensive articles of association; (e) a permanent business location; and (f) conformity with business accounting principles. If all criteria is met, PBC issues a Permit to Carry on Financial Business. This permit allows the organizers to register for a business license with the Industrial and Commercial Administra- tion Bureau before commencing business. Bankine Supervision Issues 18. The compliance function performed by PBC stands in marked contrast to the supervisory function performed in most market economies in which the primary objective is to ensure the health and stability of the financial Sys- tem. As China continues to introduce market-oriented economic reforms, PBC intends to place greater emphasis on the prudential aspects of supervision. 19. However, it will not be easy to transform bank supervision from its present compliance role to that of a prudential role. Several challenges exist. Different skills are required on the part of bank supervisors since they will be moving from an audit process to one of appraisal. Prudential supervision requires a great deal of judgment, skill, expertise, and experi- ence. Staff must be highly trained in a variety of disciplines such as credit analysis, asset and liability management, financial management, and bank anal- ysis. Their knowledge in these disciplines must be equal to or greater than the skills of the bankers if they are to provide the expertise that would be required to assist the banks in establishing the management systems and con- trols necessary to prudently manage their institutions. To support a change in focus from compliance activities to prudential supervision and to provide guidance to bank supervision staff, it will be necessary to develop and docu- ment new supervisory methodologies, including procedures for on-site examina- tions, and to develop an improved system of off-site surveillance capability. 20. Another challenge is to resolve the basic conflict between instruct- ing banks to make loans to priority projects that may not be sound credit risks (enforcing compliance with the national development plan) and criticiz- ing those same loans for not being creditworthy. When such conflicts occur, the likely result is that sound credit principles will be compromised. One option for dealing with this inherent problem from an organizational stand- .point is to separate the compliance function from that of prudential - 57 - ANNEX 5 supervision by creating a separate department responsible £or prudential supervision over financial institutions. This department would have its own staff and mandate, i.e., to ensure the health and stability of the financial system, which might permit it to avoid the dominant role that the compliance function now assumnes. It would also have the opportunity to recruit staff with a different mix of skills than exists now, thus strengtheninS its ability to render objective judgments concerning the quality of portfolio and a bank's overall financial condition and performance. In addition to its responsibili- ties for prudential supervision, the department might also be granted licens- ing authority for new financial institutions and enforcement powers related to managers of supervised banks who engage in unsafe and unsound banking prac- tices. The latter might include the ability to levy fines or penalties against managers for engaging in unsound banking practices and repeat viola- tions of law, to remove incompetent or abusive managers, and to instruct banks to cease and desist from unsafe and unsound banking practices. The powers to license and discipline managers are presently within the purview of other PBC departments. 21. The emphasis placed on compliance activities has dictated the "bottom-up" approach used by the supervisors during their on-site inspections. One result is that supervisory resources are concentrated at the lower levels of PBC's supervisory organization. Less than 50 supervisory personnel are assigned to PEC headquarters while fewer than 30 supervisory personnel, in the aggregate, are assigned to PBC's branches in Beijing and Shanghai, even though these rank as China's two most important and influential financial centers. These numbers contrast with provinces such as Hebei, Shandong, and Hunan where more than 300 supervisors are assigned to each. Another result is that resources are not always used efficiently since examiners are assigned to inspect branches or activities that may be sound while others that pose greater risks to the banking system may be left unattended for extended periods. 22. As the banking system further develops and each bank's branches become more integrated into a single, cohesive organization, it would be appropriate to supervise these banks, as well as other financial institutions, on a consolidated basis, rather than each branch as an autonomous entity. This would permit bank supervisors to redistribute personnel and increase staffing levels at major financial centers, to more efficiently target these scarce human resources to the activities or branches of greatest risk, and to examine using a "top-down" approach. Such an approach would emphasize the bank's management, strategies, objectives, and policies for lending and other important activities.4/ 23. The change in supervisory focus from complianice with the national development plan to prudential concerns for the safety and soundness of 4/ The exception to this top-down approach is the examination of the loan portfolio to determine the quality of assets. Given its importance to the overall determination of a bank's solvency, examiners should base their conclusions in this area on their own detailed analysis of portfo- lio quality. - 58 financial institutions assumes that financial institutions will be granted greater authority to make their own credit decisions. This also implies a greater responsibility on the part of institutions to manage their affairs in a prudent and efficient manner. An important aspect of this process io to ensure that problem borrowers are recognized in a timely manner so that cor- rective actions can be initiated to collect or otherwise strengthen the credit and to set aside adequate provisions for potential losses arising from these problematic situations. - 59 - ANNEX 6 CHINA FINMCIAL SECTOR TECHNICAL ASSISTANCE PROJECT Accounting and Auditing jrgmewory and PBC Accounting and Internal Audit Roles and Reseonsibilities 1. Ministry of Finance (MOP). The Accounting Law of 1985 adopted by the National People's Congress, vests the Ministry of Finance (MOF) wlth over- all responsibility for instituting a uniform accounting system within China and administering the accounting activities of the whole country. Within MOF, this responsibility has been delegated to the Department of Administration of Accounting Affairs (DAAA), which has a director and two deputy directors and a permanent staff of 60 organized as follows: (i) Division 1 (9 staff), respon- sible for general and overall policy and standards, including the supervision of accounting work; (ii) Division 2 (13 staff), responsible for accountir.g standards and systems in industry, transport, post office, telecommunications, financial institutions, and tourism trade; (iii) Division 3 (8 staff), respon- sible for accounting standards and systems in construction and real estate; (iv) Division 4 (5 staff), responsible for accounting standards and systems of joint ventures; (v) Division 5 (15 staff), responsible for administration of MOP programs and facilities for training accounting personnel nationwide; (vi) Division 6 (7 staff), responsible for administration and technical assessment of accounting personnel nationwide; and (vii) office (3 staff), responsible for the DAAA's personnel and administrative matters. In addition5 the DAMA has a task force with seven members established in 1988 to formulate new accounting standards with reference to international practice. This task force is still in the initial stages of information gathering from interna- tional sources. MOF's local counterpart bureaus are given authority under the Law to formulate accounting systems for their jurisdictions, provided these are approved by MOF and do not contravene the state uniform accounting system. In addition to defining the role of MOF and local Bureaus of Finance (BOFa), the Law also deals with accounting practices, supervision, offices, staff and legal liability. 2. In practice, MOF handles national level accounting matters, while provincial BOPs guide accounting affairs at the local level, including by supervising the day to day activities of local enterprises to insure that accounting systems are being followed. The observations of Bank Group mis- sions suggest that accounting standards and systems in the country are fairly uniform, despite some measure of latitude allowed at the provincial level. MOF has issued accounting systems (charts of accounts and accounting reports) to date covering inter alia state-owned industrial enterprises, state-owned distribution and sales enterprises, state-owned construction/contracting enterprises/units, industrial joint ventures and township enterprises. MOF has also issued a number of other regulations implementing the Accounting Law, including regulations on the appointment of accounting staff and regulations on specific accounting aspects, such as accounting foc leasing fixed assets and payment of education surcharge. - 60 - M-M%6 3. The People'sBank of China (PBC). MOF has de facto delegated responsibility for accounting of financial institutions to PBC. PBC accord- ingly promulgated in April 1987 a uniform accounting system for banks and in June 1987 an accounting system for its own use. The systems promulgated include charts of accounts and reporting formats. 4. PBC's Accounting Department at headquarters has a staff of 44 including a director and two deputy directors with the balance organized into five divisions as follows; (i) Accounting Division (9 staff), responsible for setting the accounting standards ane systems for PBC and other financial institutions; (ii) Administration Division (5 staff), responsible for the Department's personnel and administrative matters; (iii) Settlements Division (9 staff), responsible for regulating clearing and settlement of inter and intrabank payments transactions; (iv) Revenue Expense Division (10 staff), responsible for PBC revenue and expense control; and (v) Operations Division (8 staff), responsible for reserve deposits from specialized banks and other financial institutions, funds for settlement, gold and foreign exchange and others. Provincial and lower level PBC branches have counterpart accounting departments. 5. Responsibility for internal audit of PBC rests at headquarters with one of six divisions located within the Department of Supervision and Audit, which is also responsible for supervising banks. The division has 52 staff. At provincial and lower level branches, there i8 no clear distinction between internal auditors and bank supervisors. Since March 1, 1990, PBC's internal audit function has been governed by a new set of regulations, "Internal Audit and Supervision System of PBC", which requires that all PBC branches and affiliated organizations establish internal audit and supervision departments. The PBC internal audit function is dually responsible to PBC and the Audit Administration of the People's Republic of China (AAPRC). In practice, PBC's internal auditors have no audit manual or written instructions to guide their work. The scope of work to be performed is decided by the audit team and approved by the director. In 1990, internal audits were undertaken of 3 of PBC's 44 provincial level branches as well as of the International, Foreign Affairs, Education and Administrative Departments, and two PBC affiliated enterprises. In 1991 seven provincial branches were audited. In 1992, plans are to audit 10 provincial branches. 6. Audit Administration of the People's Republic of China (AAPRCa. External auditing of governmental bodies and state-owned enterprises is the responsibility of the AAPRC, which was established in 1983 based on provisions of the 1982 Constitution. AAPRC is directly responsible to the State Council; the auditor general is nominated by the Premier, approved by the People's Congress and appointed by the President. AAPRC's activities are governed by regulations approved by the State Council and published in November 1988; these followed up provisional regulations which had been in force since August 1985. Additional authority is given to AAPRC by the 1985 Accounting Law which provides for auditing of each state unit by the audit agency. AAPRC has pro- vincial counterpart bureaus which are dually responsible to the local govern- ment and AAPRC. 7. AAPRC has 525 personnel in Beijing, divided among 15 offices and departments, as follows: (i) General (60 s.,aff); (ii) Coordination (32 - 61 - ANNEX 6 staff); (iii) Regulation and Criterion making (20 staff); (iv) Industry and Communication (40 staff); (v) Monetary Audit (responsible for banks) (29 staff); (vi) Commerce and Trade (29 staff); (vii) Agriculture, Forestry and Education (30 staff); (viii) Nonprofit Units and National Defense Audit (32 staff); (ix) Capital Construction (33 staff); (x) Foreign Investment Audit (32 staff); (xi) Foreign Affairs (20 staff); (xii) Finance Audit (50 staff); (xiii) Audit System Directing (20 staff); (xiv) Personnel (including Education and Training) (38 staff); and (xv) Administration (60 staff). AAPRC has an additional 3,100 staff elsewhere; 41 in Beijing in various ministries, 30 at provincial audit bureaus for specific audit assignments, 430 at prefectural level, and 2,600 at coun-y level. AAPRC also has three training centers, including the Nanjing ALdit College. 8. About 800,000 units are subject to audit by the AAPRC system. Of these, some 200,000 were audited in 1989 and 110,000 up to June 30, 1990. About 60 large audits were carried out by AAPRC itself. The Monetary Audit Division made head office audits of six banks in 1989 and focused on the Agri- cultural Bank of China (ABC) and the Industrial and Commercial Bank of China (ICBC) in 1990. In practice, therefore, units are subject to audit only once every three or more likely five years, due to a shortage of qualified staff. 9. AAPRC has recently received a grant from the Asian Development Bank (ADB). With financing from this grant, the Foreign Investment Audit Depart- ment (FIAD) has engaged Coopers and Lybrand (Hong Kong) inter alia to help develop an audit manual to guide audits of entities with foreign financing. The Accounting and AuditinR Profession 10. Professional accounting and auditing is divided into three distinct areas. First, there are Certified Public Accounting (CPA) firms which are controlled by MOF and may perform all types accounting servicc= and audits of nonstate enterprises. CPAs must also be approved by MOF and must work for CPA firms or they lose their titles. Second, there are auditing firms which are authorized by AAPRC and are allowed to perform audits of state enterprises on behalf of AAPRC. Third, there are Chinese offices of international accounting firms whose activities are limited to management consulting and other nonauditing services. According to an unofficial estimate, there are 200 CPA firms in China. A total of 40,000 persons are estimated to be working nation- wide in accounting and auditing firms. To date, the only CPAs which have been approved as such by MOF are university professors and others with similar credentials. A system of testing and certification is currently under consid- eration but has yet to be implemented. 11. There are a number of professional societies. The Chinese Society of Accountants (CSA) is headquartered in Beijing, with local chapters, and is mainly academically oriented. The CSA has also organized a Task Force on modernization of Chinese accounting standards; the CSA and MOP Task Forces are working independently, but do liaise with one another. Membership in the CSA is currently open to anyone with the title of accountant, but there are plans to adopt a more restrictive membership policy. Another organization is the China Institute of Certified Public Accountants (CICPA), which also has local chapters. Its membership is limited to CPAs. A third group is the Auditing Society of China. - 62 - ANNEX6 12. Accounting education is provided at several levels in China based on exisiting standards with international standards used as a reference. A number of universities offer undergraduate and postgraduate degree programs (usually Bachelor of Arts in Economics) with specialization in accounting; two (the Shanghai University of Finance and Economics and Xiamen University in Fujian Province) have been authorized and receive special support from the State Education Commission. There are also trade schools which are either entirely devoted to accounting or have accounting as a separate faculty. There are in addition adult schools for on the job training and correspondence courses. Auditing is offered as a separate area of concentration from accounting. Key Issues 13. Weaknesses of Accounting Standards/Systems. Chinese accounting standards are embodied in a combination of the regulations/systems issued by MOP and PBC and tradition. There is no comprehensive codified set of account- ing standards. Accounting standards practiced are in many respects similar to international generally accepted accounting principles (GAAP). For example, there is double-entry bookkeeping; consistency of accounting standards over time; historical cost valuation of assets; and the assumption that the accounting entity is a going concern. 14. However, in a number of important respects, standards differ con- siderably from international practice. For example, foreign exchange liabili- ties are carried at original costs (although in the banking sector there is apparently revaluation at year-end compared to at least monthly in interna- tional circles); reserves for bad debts are not Latablished at adequate lev- els; valuation at lower of cost or market is not used; depreciation is not necessarily linked to an asset's useful life; and balance sheets are inflated by the inclusion of contingent liabilities and the failure in the banking system to net n"t interbranch balances in the process of consolidation. More generally, there is no distinction between tax and financial reporting wlhich underlies a number of the existing anomalies in practice (e.g., relatir.g to depreciation expense and bad debt provisions). 15. The accounting standards and systems in force were suitable for use in a centrally planned and closed economy and are understandable in that con- text. However, they will not suffice for an increasingly open economy influ- enced by market forces, as is present day China. At present, accounting stan- dards are oriented to ensure compliance with rules rather than to produce information useful for management purposes or for enabling investors in/lend- ers to enterprises or banks make judgments as to financial condition. The absence of reliable and accurate financial information becomes increasingly important as enterprises and financial institutions assume greater responsi- bility for their own profits and losses. Moreover, as China continues its process of opening up to the international community, there will be a need to make financial statements easily understandable to foreign investors. 16. Joint ventures are subject to a separate set of accounting standards as promulgated by MOP regulations. These are in practice similar to interna- tional standards with a few differences. -63 - ANNEX 6 17. PBC Accounting and Internal Audit. PBC's own accounting standards and systems mirror the problems encountered in the accounting systems of other banlcs and enterprises. Accounting focusses on compliance with rules; finan- cial statements do not offer PBC management the information required for man- agement purposes. In addition, the accounting methodologies and practices involve long delays, stemming in part from the need to rely on manual consoli- dation. There are also deficiencies in the organization and management of accounting processes. A comprehensive modernization of PBC's accounting stan- dards and systems is hence required, as is an intensive effort in staff train- ing. 18. PBC's internal auditing function seems similarly to be oriented towards checking compliance with rules. The absence of internal auditing standards, audit plans and manuals make it impossible for PBC to carry out an efficient, consistent and well controlled series of audits. There is a need to review the organization of PBC's internal audit function; ideally, internal audit should be separated from the Department of Supervision and report directly to top management. Training in internal auditing techniques is fun- damental. 19. AAPRC. Despite its short history, AAPRC has made considerable pro- gress. It is trying to carry out audits in a professional manner and give attention to training its staff. However, AAPRC's inadequate resources limit its ability to undertake audits with the desired annual frequency and leads to audits which often lack the necessary depth. AAPRC should give priority to finalizing auditing standards for its own use and that of the general profes- sion,l/ finalizing its auditing manual(s) and training. While AAPRC's orga- nizational structure seems adequate, an issue is the dual reporting system of its lower level counterparts, which limits its autonomy. j/ According to MO?, AAPRC doee hot have the authority to dictate auditing standards for CPA firms (which fall under MOF's jurisdiction). %While NOF has been gradually issuing auditing standards for use by CPA firms, only a few have been issued to date. - 64 -ANNEXZ CHINA FINANCIAL SECTOR TECHNICAL ASSISTANCE PROJECT Current Status of Payment System Development in China Introduction 1. The People's Bank of China (PBC) recognizes that a reliable, effi- cient and secure payments system is an integral component of a sound financial system. The development of a modern payment and clearing system is a high priority for the Central Bank. This objective logically supports the monetary responsibilities of PBC, and is essential to support macroeconomic objectives. 2. The present payment and clearing system in China was established in the 1950s, based partly on the Soviet model. The PBC was created as the mono- bank that fulfilled both central banking and commercial banking functions. Payment transactions were segregated into broad categories: consumer payments to each other and businesses; and business-to-business payment and settle- ments. Consumer Payments 3. Consumers save mainly through savings accounts in China, of which there are about 800 million, with an outstanding value of Y 600 billion. Due to the relatively early stage of computerization of banks, consumers with savings passbooks are still confined to deposit or withdrawal transactions with the bank branch where the savings account is opened. For administrative reasons, consumers do not have checking accounts with banks, there being only about 1009000 individual checking accounts. Consequently, consumers settle almost all transactions by cash, and remittances by consumers out of the local township are conducted through mail transfers, bank drafts or telegraphic transfers. In recent years, two banks have begun to issue debit cards. The Bank of China (BOC) has issued a Great Wall card and the Industrial and Com- mercial Bank of China (ICBC) has issued a Peony card. There are about 200,000 debit cards issued, with an annual turnover of Y 3.3 billion in 1989. The banks have installed about 200 stand-alone automated teller machines (ATHs), and there are plans to network the ATMs in the future. 4. Since cash transactions still play a large role in consumer pay- ments, currency in circulation remains fairly high, amounting to Y 209.5 bil- lion at the end of July 1990, or roughly one third of narrow money supply (MI). Business-Related Payments 5. Under the old system, all enterprises and public departments and authorities were required by law to open checking accounts with the PBC. All business-related payments and settlements were effected through PBC, in the fore of checks, mail transfers, bank drafts or telegraphic transfers. It was - 65- ANNEX 7 estimated that 95 percent of transactions in the economy were conducted through the PBC, while only 5 percent of total transactions was by cash. 6. The old system had several administrative features which have car- ried on into the present day. Intratown transactions by enterprises were generally settled by checks or credit transfers, which were cleared through the town or city branch of PBC. Nonlocal transactions, that is payments out- side a town or city clearing district, had to be effected through a mail or telegraphic transfer through PBC. Checks were not allowed for settlements outside of the town or city clearing region. In the monobank system, since all enterprises and the banking system were state-owned, it was considered that there could be no defaults and hence it was not required to physically present documentation on settlement. Remittances of funds between two differ- ent branches of PBC required only the physical transfer of an interbranch transaction statement--there was no actual movement of funds, as balances between branches were settled in PBC headquarters' books. The PBC maintained a computer system to track and check that all interbranch transfers were prop- erly effected. 7. The PBC estimated that business-related transactions amounted to 2.5 billion transactions in 1989 valued at Y 63 trillion. Check transactions dominate local (intratown or city) payments and has been growing at around 8 percent per year in volume terms in the 19809. In 1989, 584 million checks were issued amounting to Y 12.9 trillion, equivalent to 69 percent of local transactions by number and 95 percent by value. There are currently no national standards for checks, since checks are not used for nonlocal transac- tions. Checks, however, must have a minimum value of Y 100 and have a valid- ity period of five days. Bank drafts must have a minimum value of Y 500 and a validity period of one month. The statistics of checks for transfer and cash. in 1989 are listed in TaLble 1. 8. Local checks and bank drafts are cleared manually at the nearest town or city branch of PBC's clearinghouse. By and large, each bank branch within the same clearing zone clears both intrabank and interbank as if it is an autonomous bank, since each bank branch must maintain separate statutory reserves and clearing balances with the nearest PBC branch. Consequently, instead of six or seven major banks clearing intrabank first before clearing interbank at the PBC clearinghouse, the larger check clearing centers would have as many as 300 bank branches clearing manually with each other daily. 9. Practices vary slightly from center to center. Beijing and Guangzhou clear checks twice per day at around 7:30 AM and 12:30 PM, while Shanghai clears at 1:20 PM and 6:20 PM respectively. Generally, all partici- pants in the clearing zone would clear in the morning clearing, while the second clearing would be restricted to the main branches closer to the center. In recent years, due to the growing popularity of check usage, outlying branches as far away as 120 km were brought into the main clearing centers of Beijing, Shanghai and Guangzhou. -66 - ANNEX table lt CHECKS FOR TRANSFER AND CASH STATISTICS, 1991 Number 2 of Value % of (million) nation's total (Y billion) nation's total Nationwide Transfer 554.54 100.0 10,271.4 100.0 Cash 22.34 100.0 205.2 100.0 Beijing Transfer 21.66 3.9 652.8 6.4 Cash 3.94 17.6 57.5 2.8 Shanghai Transfer 17.68 3.2 343.4 3.3 Cash 8.16 36.5 81.3 39.6 Guangzhou /a Transfer 15.85 2.8 193.8 1.7 Cash 2.43 9.7 31.4 1.2 La 1989 figures. Source: PBC. 10. The larger check clearing centers exchange approximately 100,000 to 160,000 checks or credit transfers daily. Returned checks are relatively low in number (not more than 200 per day), due to strict controls by banks. The clearing process is highly labor-intensive, with over 200 representatives of each clearing branch physically exchanging checks with each other and manually counting the number and value of checks received. The exchange process takes roughly 60-90 minutes to complete. Each participant gives an inward/outward total docket to the PBC clearinghouse manager, who balances all clearing totals and verifies that the net settlement is equal to zero, before the par- ticipants are allowed to leave the center. The balancing of the settlement process has now been computerized for Beijing, Shanghai and Guangzhou using PCs, but in many cities, this process is still manually calculated. The PBC charges the participating banks a small fee for clearinghouse services and also collects fines on banks which make errors in their settlement totals. 11. Other payment instruments used in business-related payments include the promissory note, bank drafts, and trade bills of exchange. In 1991, 130,000 promissory notes having a value of Y 50 billion were issued. The bank draft has a wider usage. In 1991, 476 million bank drafts were issued, with a value of Y 1.8 trillion, accounting for 23 percent by number and 33 percent by value of total payment transactions. The trade bill is aloc used in local and nonlocal payments for business transactions. In i991, 4 million trade bills valued at Y 60 billion were issued. At present, there is still no law of negotiable instruments to regulate the issue and operations of different types - 67- of bills of exchange. Such paper-based payment instruments are subject to regulation by PBC. Recent Reforms in Banking Structure 12. The old payment system functioned reasonably well until the 1970s, but could not cope with the rapid changes in the Chinese economy in the 1980s. In the 1980s, the Chinese authorities initiated major reforms in the financial structure, which resulted in a significant increase and diversity in the number both of financial instruments and financial institutions. By 1989, the volume of nonlocal transactions had increased 20-fold over transactions recorded in 1978. l<. Given these major changes in the financial sector, and in the light of significant growth in the real enonom;, the payments system became subject to considerable capacity and operating stresses. The growing usage of checks by enterprises in towns placed considerable strain on the capacity of PBC clearing centers to handle the work manually. There are constraints on avail- able office space, since in some of the larger centers, more than 300 branches are participants. In the nonlocal interbranch transfers, there are signifi- cant delays in the transfers due to postal and other administrative bottle- necks. Transfers within the same province may take up to one week, but inter- provincial transfers, particularly to rural areas, may take more than two weeks. This results in a large amount of float (estimated at Y 60 billion) which has several negative consequences. Enterprises usually sacrifice liquidity and working capital because of these clearing delays. Their accounts are charged immediately when payments are initiated while the receiver of funds may be paid a week or more later. Specialized banks are often the bene- ficiary of this float because they have the use of funds until final clearing takes place. The free use of the float does not encourage the specialized banks to develop procedures to speed the clearing of these payments. The implementation of monetary policy is also complicated by fluctuations in the size of the float during periods of tight money. Current Reforms in Payments System 14. In 1986, the PBC began efforts to investigate possible improvements to the Chinese payments systems. The result of those efforts was a decision to pursue several potential improvements. Six specific, related improvement opportunities were undertaken: (a) Development of a PBC owned and operated electronic payments system. (b) Expansion of the number of local clearinghouses. (c) Expansion of the geographical coverage of existing clearinghouses to include nearby counties. (d) Addition of microcomputers to improve clearinghouse settlement pro- cesses. (e) Introduction of automated check processing equipment to replace some manual check processing. - 68- ANNEX 7 (f) Initiation of some standardization and coding systems. 15. Each of the above improvement efforts is in various stages of devel- opment and is described below. Satellite-Based Electronic Interbranch System (EIS) 16. In order to reduce the size of the float and to improve the central bank's monitoring and management of payments in China, PBC sought and obtained permission from the State Council to establish a centralized satellite-based interbranch payments system that is wholly owned and operated by PBC. The establishment of a satellite-based national payment system is aimed at auto- mating only the inter-city (nonlocal) payment transfers, leaving the intra- city payments to the current manual process or as separate development efforts. The electronic payments system was designed and developed by the PBC and its wholly owned subsidiary, the China Finance Computer Company (CFCC). The system is designed to handle primarily credit transfers but will also handle a small number of debit payments. The current technical approach to tha EIS comprises the following: (a) the use of satellite-based communications technology for transmit- ting payment transactions; (b) the use of a single star cc.figuration to centralize the processing (clearing) at a single site; (c) the use of microcomputers at user locations for preparation, sending and receiving of payment transactions; and (d) the use of PBC branch offices as the local transmission stations for all banks in the region (city or municipality). 17. As of November 1991, 105 PBC branches in major cities and provincial centers were equipped with satellite earth stations and 52 of these also with the associated microcomputers (386 equivalent PCs). The system uses the Very Small Aperture Terminal (VSAT) communication technique. The mainframe com- puter (2 x IBM 4381s with 32 MB memory and 10,000 MB disc running on I4VSLESA OS) at the (temporary and rented) central site at Shahe, near Beijing, is also operational. The host computers run the network monitoring, controlling and switching, as well as data processing for the EIS. Application software was developed by PBC, Stone and No. 32 Research Institute of the Ministry of Machinery and Electronic Industry . 18. The system has been under testing with test data since mid-September 1990. On November 4, 1991, 21 cities went live and the parallel manual system was discontinued; another 51 have since gone live. PBC expects that an addi- tional 60 cities will go "live" by early 1993, for a total of 132 cities. In addition to the EIS, the satellite system is also developing a "Fund infor- mation 10-day report" to transmit monetary statistics between PBC branches. 19. Shahe station is designed to link a total of 236 remote stations. The construction of the permanent hub station at the Huairou suburb of Beijing, and the back-up earth station in Wuxi, Jiangsu province, will begin - 69 - ANNEX 7 soon. PBC expects that the number of stations on the network will reach 600 by the end of 1995. Further development programs may include expanding the capacity of the system in order to add additional PBC offices to the networks possibly exteiiding communications capability to some large branches of the specialized banks, adding to the functionality of the system and operating at more rapid speeds. The additional functions considered include the transmis- sion of statistical and bank supervision data and the possible addition of voice and facsimile capability. Local Clearinghouses 20. The second direction was to expand the number of local clearing- houses. There are currently 2,500 clearinghouses managed by the PBC. The volume of payments cleared locally has continued to grow and now, for the first time, exceeds the volume of nonlocal payments. 21. In addition to expanding the number of clearinghouses, the PBC has been widening their geographic scope so more payments could be cleared locally. There is a continuing effort to encourage additional financial institutions to participate in clearinghouse exchanges. 22. There also has been encouragement to automate the clearinghouse settlement process. Formerly, this was a manual process which required a second handling of paper information for the posting of appropriate accounts. The use of microcomputers speeds the functioning of settlement entries for accounting purposes and avoids additional manual handling. The larger clear- inghouses have either already automated this function using microcomputers or are being encouraged to do so in the near future. 23. The PBC is in the process of introducing automated check processing equipment into the clearinghouse process. This equipment, which includes NCR medium speed check reader/sorters, will reduce the amount of manual paper sorting required by all participants in the clearinghouse exchange. The pilot testing of this equipment is taking place in Guangzhou city and is expected to go into production in 1991. Preliminary results indicate certain problems with the quality of check paper and printing, which have been rectified. Several other large clearinghouses may also install check sorting equipment during the next year. Because of limited funds for hardware procurement and the need to upgrade check paper quality, printing and incorporation of MICR coding, this effort will probably move relatively slowly. 24. Both the design of the electronic payments system and the introduc- tion of check processing equipment have included investigation of the required coding issues. There currently is no national, consistent bank identification numbering scheme. A standard routing number coding scheme is being used in the pilot test in Guangzhou, where the growth potential of checks is highest and where the pressures to automate are highest. However, the actual routing numbers appear to be assigned with some random. Moreover, the identification numb%ra used to identify individual financial institutions in the electronic payments system use a format different than the standard routing number. 25. The check pilot project has also initiated the move to standard document size, paper quality and quality of MICR encoding. Ideally, document - 70 - MEN 7 standardization should come well before investments are made in processing hardware. Some of the larger PBC branches appear to be planning to begin some standardization efforts. Generally speaking, documents are not now standar- dized and the quality of many of the paper documents will prevent automated processing until they are replaced by better quality paper with machine-read- able codes that would facilitate automation and recording. 26. In addition to the direct efforts of the PBC in the payments area, specialized banks have also begun to initiate electronic banking. During the past several years, two specialized banks have introduced credit cards, numbering about 200,000 in total. These function, however, effectively mainly as debit cards, usable at about 200 ATM locations. At least one enterprise is reportedly depositing payroll funds into the savings account of its employees, who can access the funds through an ATM. To support a credit card system an authorization system would need to be established in China. The PBC has had some preliminary thinking on this issue, but has not yet laid down policies and regulations relating to debit or credit card development. 27. Currently there is no cohesive plan for what payments alternatives might be available to consumers in the future. Payment options available to them at this point are limited, and further consideration of this issue is required. Given the limited processing capabilities of the check clearing centers, it may not be practical to extend check facilities to consumers at this stage. Extension of checks to nonlocal transactions may also not be cost effective, given the long distances for physical transportation of paper-based instruments. 28. The inherent limitations of the present EIS setup, the inability to handle large volumes of transactions and inability to link more than about 21 stations effectively mean that the EIS architecture and hardware need to be upgraded in the immediate term to allow a more orderly transition into the proposed China National Financial Network system that would form the basis for the medium- and longer-term development of China's electronic payments sys- tems. The concept plan developed by PA Consultants in conjunction with the PBC Payment System Project Office proposes the development of four functional features, including, local clearing house automation, bulk electronic process- ing of interprovincial payments, high value funds transfer system, and a nationwide electronic authorization system to permit the integration of newly developing ATM and debit card systems. 29. The immediate investment requirements in the migration plan from the present setup to the proposed national standard are for the development of a National Processing Center for ele:tronics payments, a Disaster Recovery Cen- ter and development of the interfaces at 64 superbranches and up to 333 PBC grassroots branches. The communications backbone would be the present EIS satellite base. However, geographical expansion of the EIS would be frozen until the basic processing capacity is installed and reliability and system responss times are substantially improved. The migration to a higher techni- cal standard would be carried out over two years. The migration away from the satellite base to more secure terrestrial links would await the expected development of the national optical fiber cable links during the course of the 8th Five-Year Plan. The Ministry of Posts and Telecommunications is planning to development over 20,000 km of such linkages during the next five years, and - 71 - the technological changes expected to be wrought would dramatically change the reliability and system standards. 30. Under the proposed project, the investments to be financed would comprise the computer hardware and communications and network equipment for the national processing center and the disaster recovery center, as well as hardware for the first level superbranches, which are defined as provincial centers and other key centers in the national backbone network. Software and applications development would also be funded under the project. In addition, extensive training and manpower development needs would be identified and funded. The next phase of the payments systems study project would develop the detailed migration plan and the immediate investment requirements, together with the bidding and procurement documentation. - 72- ANNEX 8 CHINA FINANCI SECTOR TECHNICAL ASSISTANCE PROJECT Terms of Reference for Strengthening Prudential Supervision and Regulation To: Engagement of an International Consultant Terms of Reference Introduction 1. China has embarked on a wide range of reforms in its financial sys- tem. These reforms require strong prudential bank supervision to ensure the safety, soundness, and stability of the financial system. To achieve this goal, the role of bank supervision is to change from that of ensuring compli- ance with social and developmental goals to one which is better balanced and focuses on the appraisal and management of risk. These terms of reference outline a comprehensive program for technical assistance designed to hasten the transition to prudential bank supervision. Integral parts of this program include the drafting of prudential regulations, new on-site examination meth- odologies, off-site monitoring of banks, a possibly revamped organizational structure, and a systematic training effort. As the primary supervisor of banks and financial institutions, the People's Bank of China (PBC) desires to engage the services of an international consulting firm to collaborate with its Department of Bank Supervision and Audit to implement this comprehensive program of technical assistance and training. Background 2. As of 1988, the banking sector in China comprised the PBC, four specialized banks,l/ two national-level comprehensive banks,2/ a develop- ment bank,3/ a network of rural nongovernmental financial institutions, 17 finance companies of which two are national in ecope,A/ 745 trust and investment companies, 34 international trust and investment companies, nine 1/ The four specialized banks are: the Industrial and Commercial Bank of China, the Agricultural Bank of China, the Bank of China, and the People's Construction Bank of China. 2/ The two national-level comprehensive banks are: the Bank of Communica- tions (BOCOM) and CITIC Industrial Bank (CITIC). 3/ The development bank is the China Investment Bank (CIB). 4/ The two national finance companies are: Everbright Finance Company and China Venturetech Investment Corporation. - 73- ANEX 8 leasing companies, 34 securities companies approved by the PBC, and 61 securities offices carrying out security transactions under the tutelage of the Ministry of Finance. Also, as of early 1989, there was a vast network of more than 60,000 rural credit cooperatives and 3,274 urban credit cooperatives. There are also three insurance companies in a market overwhelmingly dominated by the People's Insurance Company of China (PICC). The total assets of these financial institutions exceed Y 2 trillion, with the four specialized banks holding nearly 70 percent of the total. 3. To supervise this system, the PBC created a Department of Bank Supervision and Audit in 1985. This department is responsible for (1) con- ducting compliance examinations, (2) performing internal audits of PBC itself, and (3) exercising prudential supervision over the banking system through on- site examinations and off-site surveillance. The department operates on a decentralized basis and is responsible for supervising the more than 150,000 banking offices and financial institutions in China. The department is orga- nized into six divisions, three of which are principally responsible for com- pliance examinations of the specialized and comprehensive banks. Other divi- sions supervise the foreign/joint venture banks and overseas branches of Chinese banks, provide administrative and technical support, or perform inter- nal audit of PBC itself. The department employs a nationwide staff of 5,600. Of this number, only about 200 are at the level of senior economist or senior accountant with slightly more than 1,300 in the middle grades. In addition to headquarters staff in Beijing, supervisors are assigned throughout China at all provincial branches of PBC, all city and prefectural branches, and approx- imately 30 percent of PBC's county-level branches. Proposed Activities 4. The following activities are to be carried out in collaboration with the PBC under the guidance of the international consultant: (a) a pilot bank examination of the Bank of Communications; (b) an organizational study of the bank supervision function; (c) the development of on-site examination proce- dures which focus on prudential concerns; (d) the development of an off-site surveillance capability; (e) the drafting of prudential regulations; (f) a systematic training effort, including the development of course curricula, lesson plans, and training materials; and (g) special asset reviews of ABC branches in Sichuan, Jilin, Jiangsu, Fujian and Qingdao, and branches of the other specialized banks in (to be completed). In addition, the international consultant wiJl coordinate study tours, secondments, and training opportuni- ties abroad, lAs well as seminars drawing on foreign speakers/trainers. These activities; as well as expected outputs, are described in detail in Attach- ments 1 through 7. Chinese Counterpart Teams 5. An umbrella committee will manage the PBC's participation in this comprehensive program of technical assistance and will serve as the principal counterpart to the international consultant. The committee will include high level officials from the departments responsible for prudential supervision, enactment of prudential regulations, and licensing of financial institutions. Subgroups under the umbrella committee will collaborate closely with the international consultant in the performance of the various tasks under the - 74 - EE&LE program. These PBC counterpart teams are expected to carry out much of the actual work and are critical to the ultimate success of the program. There- fore, the international consulting firm engaged for the purpose of carrying out this program of technical assistance, after closely reviewing the terms of reference for the various activities, will be asked for recommendations con- cerning the number and level of staff and the composition of each counterpart group expected to work with the consultant. 6. The Chinese counterpart team for each of the proposed activities follows: (a) Pilot Bank Examinations PBC Counterpart Examination Team. A coun- terpart team of PBC supervisors will work with the international consultant to conduct the examination of the Bank of Communications (BOCOM) using examination methodologies designed to assess the bank's overall financial condition, performance, and future pros- pects. It is expected that many of the members of this counterpart examination team will later serve as members of other PBC subgroups. (b) Organizational Study: PBC Umbrella Committee. Given the importance of the organizational framework in facilitating an effective capa- city for prudential bank supervision, this committee, comprising high-level officials from the departments responsible for prudential supervision, enactment of prudential regulations, and licensing of financial institutions, will work directly with the international consultant to determine the most effective organizational arrange- ment for prudential supervision. (c) Development of On-site Examination Procedures: PBC Suberoup for On- site Examinations. This subgroup will work with the international consultant to develop, draft, and implement written examination procedures, an examination manual, and an examination report which focus on the safety and soundness of financial institutions. Its composition will include supervisors with significant hands-on exam- ination experience who have good knowledge and understanding of banks' existing management systems, accounting, and administrative controls. (d) Drafting of Prudential Reaulations: PBC Subgroup for Prudential Regulations. This subgroup will work with the international consul- tant to further develop the prudential regulatory framework, includ- irg the formulation, drafting, phasing, and enactment of prudential regulations and, if appropriate, the banking law. The composition of this subgroup will include supervisors and legal personnel. (e) Development of Off-site Surveillance Capability: PBC Subgroup for Off-site Surveillance. This subgroup will work with the interna- tional consultant to develop an off-site surveillance capability. In addition to bank supervision, the subgroup will include computer professionals and PBC experts having in-depth knowledge of the PBC's existing computer and accounting systems and their potential capa- bilities. -75 ANNEX 8 (f) Training Activitiest PBC Subgrouo on Bank Supervision Trainin . This subgroup will work with the international consultant to develop an in-house training program and to coordinate training activities, both home and abroad. The composition of the subgroup will include members from the bank supervision department who may later partici- pate in "train-the-trainer" sessions. (g) SDecial-Asset Reviews. This subgroup will work with the interna- tional consultant to undertake special asset reviews of selected branches of ABC and the other specialized banks. This subgroup will include expoiienced PBC bank supervisors (most likely staff trained in the BOCOM pilot examination). Terms of Reference 7. The expected scope and outputs for each of the technical assistance activities are discussed below. Estimated Budget Allocation and Seguencin2 of Activities 8. An indicative allocation of the total budget for this assignment is provided below. These budget allocation shares are estimates only and the consultants are encouraged to based their proposals on what they consider will actually be required to accomplish each task. Estimated consultant staffing requirements total 132 staff-months as follows: (a) Pilot Examination t34 percent of total budgeti Indicative Types of Expertise: Examiner-in-Charge Credit Treasury/Foreign Exchange Bank Analysis Other (b) Organizational Study r3 percent of total budget] Expert in management/organizational theory. (c) On-site Examination Procedures J8 percent of total budget] Bank examiner with significant on-site examination experience. (d) Prudential Regulations [3 percent of total budgetl Lawyer with expertise in banking law and prudential regulation. (e) Off-site Surveillance System i.l gercent of total budget1 Bank supervisor with significant experience in off-site analysis [7 percent of total budget]. Computer system analyst (4 percent of total budget]. (f) Training Activities t3 persons: 18 vercent of total budretl Bank supervision trainers (3) [6 percent each). (g) SRecial Asset Reviews t23 percent of total budgetl Bank supervisors - 76 - ANNEX 8 9. With regard to the activities undertaken with the help of the inter- national consultant, the following sequence of activities is envisioned. Note that the graph illustrates the relative start and completion of each activity. In most instances, there will be intervening periods when the members of the consulting team are engaged in other activities outside China. SEQUENCING OF ACTIVITIES YEAR 1 YEAR 2 YEAR 3 -- - - - - - - ---------------I --------------- Pilot Examination ----------I Organizational Study I-- - On-site Examination Procedures ------------------------------ Prudential Regulations --------I Off-site Surveillance System ------------------------------- Training Advisors j---------------------------------------------- Special Asset Reviews I------------------------------- 10. Overseas/domestic secondments, seminars and study tours will occur throughout the duration of the project commencing in the first year. Interim Reportina 11. You will be required to report in writing to the PBC and the World Bank on the status of your work program and preliminary results on a bimonthly basis. The purpose of this reporting is twofold: (a) to ensure that the program is meeting expectations in terms of scope, content, and approach; and (b) to ensure that the required tasks are completed within the expected time frames. Therefore, you should plan your work carefully to ensure that the objectives of the engagement are being met and that appropriate resources are being devoted to ensure timely completion of activities. In this regard, you should expect to involve PBC's counterpart team extensively in the design, development, and implementation of your work products. 12. The final examination report on BOCOM should be completed within nine months of the start of the consulting assignment. The organizational study should be completed in final draft form by the end of month 20 and in final form six weeks later. On-site examination procedures, examination hand- book and examination report format should be completed in draft form by the middle of year 3 and in final form six weeks later: the same timetable applies to the various outputs for the development of PBC's off-site surveil- lance capability. Draft prudential regulations, law manual and plan for implementing the prudential regulations should be completed in draft form by the end of month 20 and in final form six weeks later. The training plan and materials should be completed by month 18. The special asset reviews of ABC branches in Sichuan, Jilin, Jiangsu, Fujian and Qingdao should be completed by the end of month 24 and of the other specialized bank branches by the end of month 34. The consultant's draft final report is due by the end of month 34 and in final form six weeks later. - 77- ANNEX 8 Qualifications of Consultants 13. Curriculum vitae (CVs) should be provided by the principals who would be responsible for planning and directing this program of technical assistance, together with the CVs of managers, supervisors, and key personnel likely to be employed in the actual performance of the various tasks. CVs should include details on prior assignments carried out by these staff. Sig- nificant bank examination experience is essential. Previous experience in bank auditing, while valuable in its awn right, is not an acceptable substi- tute for bank examination experience. In addition, it is highly desirable that some members nf the consulting team are fluent in written and spoken standard (Mandarin) Chinese. Other Matters 14. Information derived from this engagement is to be considered confi- dential and should only be discussed with the parties affected, such as BO.OM in the case of the pilot bank examination, and appropriate officials within the PBC and the World Bank. You will not communicate to any person or entity any unpublished information known to you by reason of your engagement without the prior approval of the PBC. Submission of Proposal 15. You are invited to submit a proposal and work plan for carrying out the activities under this technical assistance program. Since training and the transfer of skills are important objectives of all activities, your pro- posal should outline the work and training activities in which Chinese coun- terpart teams will be involved. Any proposal and work plan which you may wish to submit should address the terms of reference. You are encouraged to submit modifications to these terms of reference. 16. Your response to the terms of reference and breakdown of costs should distinguish between activities to be undertaken as Phase 1 (which covers activities in Year 1 of the project) and activities to be undertaken as Phase 2 (which covers ectivities in Years 2 and 3 of the project). It is PBC's intention to sign a contract with one firm for both phases of work. However, the contract will be worded so as to enable PBC at the conclusion of Phase 1, to revise the terms of reference for Phase 2, if appropriate, and, in the event of any material changes in the terms of reference, permit a conse- quent renegotiation of costs. -78 - ANNEX 8 Attachment 1 CHINA FINANCIAL SECTOR TECHNICAL ASSISTANCE PROJECT Terms of Reference for Strenathening Prudential Supervision and Regulation ACTIVITY 1: PILOT BANK EXAMINATION 1. As a first step, the international consultant will plan and direct a pilot bank examination of the Bank of Communications (BOCOM). This is a Sig- nificant undertaking that promises to establish a sound foundation for future technical assistance activities. The pilot examination is to be conducted jointly with a counterpart examination team from the PBC's Depattment of Bank Supervision and Audit. The objectives of the pilot examination are. (a) to demonstrate the use of modern on-site examination methodologies and conlduct training of PBC bank supervision staff in examination skills and techniques; (b) to effectively communicate examination findings to Chinese decisionmakers in a manner which will demonstrate the value and usefulness of prudential examinations; (c) to develop written examination procedures which focus on prudential concerns yet are applicable within tle realities of the Chinese environment; and (d) to provide direct input into other technical assistance activities designed to strengthen prudential supervision and regulation over the financial system. The pilot exam is expected to be completed within an elapsed time of six to nine months. The Bank of Communications 2. The Bank of Communications (BOCOM) was originally established in 1908? in 1949 it was nationalized and suspended all operations on the main- land, -while keeping a small head office in Beijing and continuing its opera- tions in its Hong Kong branch. In 1986, as part of the economic and financial reforms, the State Council reestablished BOCOM on the mainland and reallocated its head office to Shanghai. BOCOM is a national comprehensive bank that is empowered to engage in a full range of commercial banking and other financial activities including foreign exchange, the buying and selling of securities, and various kinds of domestic and international insurance other than life insurance. In China, BOCOM has a reputation as operating most like a western commercial bank; it is the first national financial institution since 1949 to be financed by shareholdings; has full responsibility for its own profits and losses; and has the freedom to choose its own clients and to locate its branches according to economic rather than administrative boundaries. It has a complex capital structure gathered by the sale of shares to the People's bank of China, local governments, enterprises, collectives, and individuals. While BOCOM headquarters and the Hong Kong branch constitute one legal entity, BOCOM's domestic "branches" are distinct legal entities by themselves. 3. BOCOM is empowered to open branches both at home and abroad. While it has expanded rapidly since its reestablishment, it remains small in size when compared to other Chinese financial institutions. As of the end of 1989, - 79 - ANNEX 8 Attachment 1 BOCOM had a head office in Shanghai, ten domestic branches (in Shanghai, Nanjing, Shenyang, Dalian, Qingdao, Wuhan, Guangzhou, Chongqing, Beijing, and Xian), 50 domestic subbranches, a branch and 23 subbrenches in Hong Kong, and a representative office in New York. The Hong Kong branch is particularly important to its overall operations and accounted for some 40 percent of BOCOM's total assets in 1988, down to 22 percent at the end of 1990. However, management control of the Hong Kong branch remains effectively with the Bank of China's Hong Kong branch, although there is some reporting to BOCOM head office. BOCOM employs a staff of about 5,000 and had total assets of some Y 49 billion (excluding contingent liabilities included in the balance sheet in published financial statements) as of December 31, 1989. ScoRe of the Pilot Bank Examination 4. The pilot bank examination should be sufficiently comprehensive in scope so that the final examination report will accurately portray BOCOM's fi.nancial condition, performance, and future prospects. In this regard, it is expected that the scope of the examination will, at a minimum, include: (a) An evaluation of the quality of management and board supervision. In evaluating, the quality of management, consideration should be given not only to the bank's actual financial condition and perfor- mance but also to the quality and effectiveness of the bank's management systems, including planning processes, budgeting and financial management, policies and procedures, internal controls, management information systems, and risk management systems. (b) An evaluation of me-agement's written or implied policies and over- all administration of the bank's major activities. Particular attention should be devoted to the loan portfolio. In this regard, you should evaluate policies and procedures related to the granting of credit, including procedures for approving credit; establishing and enforcing repayment programs; rescheduling, extending, modify- ing, or otherwise refinancing problem credits; collecting past due loans; provisioning for actual and potential losses; writing-off bad assets, pricing loans; ensuring appropriate diversification; and managing related foreign exchange and off-balance sheet risks. With regard to investment policies and practices, you should evalu- ate whether policies outline: investment objectives; permissible types of investments; diversification guidelines; maturity sched- ules; valuation procedures; trading, dealing, and underwriting guidelines; standards of quality; and guidelines for managing related foreign exchange and off-balance sheet risks. (c) An evaluation of asset I/ quality. This evaluation should iden- tify problem assets and classify them according to criteria for l/ Including off-balance sheet commitments and contingencies. -80 - ANNEX 8 Attachment 1 substandard, doubtful, and loss categories 2/ (or in accord with an alternative recognized and acceptable classification scheme). Actual and potential losses should be clearly identified. With regard to the portfolio of loans and advances, it is expected that the sample selected for review should not be less than 70 percent, by value, of the portfolio outstanding. (d) An opinion on the adequacy of capital 3! and loss reserves. In assessing the adequacy of capital, you should consider the adequacy of capital in relation to the volume of risk assets; the volume and severity of marginal and inferior quality assets; growth experience, plans, and prospects; management's strengths and weaknesses; the retention of earnings; and access to capital and financial assis- tance. If loss reserves are inadequate, you should recommend an appropriate level of reserves and a methodology for ensuring that adequate reserves are maintained. The methodology used to determine the level of reserves considered as adequate should be clearly demon- strated in the examination report. (e) The identification and quantification of concentrations of credit and large exposures representing 10 percent or more of capital funds (credit funds). These concentrations may result from credit (in the form of loans, investments, or other instruments) extended to a single borrower or related group, an economic or industrial sector, a political jurisdiction or geographic area, bank insiders or con- nected parties, or assets dependent upon a single factor that could affect repayment prospects for the entire group of assets (such as a group of borrowers dependent upon the price of a single commodity such as oil). (f) An evaluation of BOCOM's practices for accruing interest on nonper- forming assets. You should determine whether the bank has an appro- priate policy for designating nonperforming assets and suspending the accrual of interest. If interest continues to be accrued on nonperforming or seriously delinquent credits, you should determine the amount of at'ch interest credited to the profit and loss account as income and recommend appropriate adjustments. (g) An as6essment of administrative and accounting internal controls. This assessment should also address the adequacy and effectiveness of the bank's internal management information systems. 2/ Sample definitions are attached as an addendum to the terms of reference. The consultant is encouraged to suggest refinements or alternative crite- ria when submitting the proposed work plan for this project. 3/ BOCOM has a complex capital structure that will require close investiga- tion by the consultant. - 81- ANNEX 8 Attachment 1 (h) An assessment of asset and liability management practices employed by BOCOM to provide adequate liquidity and protection against inter- est rate and foreign exchange risk. In this regard, you should consider the volatility of deposits; the frequency and level of borrowings; the reliance placed on interest-sensitive funds; access to money markets or other ready sources of cash; the ability to readily convert assets into cash; the capacity to meet unexpected deposit withdrawals and other demands for payment; the ability to readily fill reasonable credit demands; the overall adequacy, effec- tiveness, and compliance with liquidity, asset and liability manage- ment policies; and the nature, volumes and anticipated usage of credit commitments, contingent liabilities, and guarantees. You should evaluate foreign exchange risk and quantify actual and potential foreign exchange losses. You should also assess manage- ment's ability to manage foreign exchange risk, the reasonableness of foreign exchange trading limits and controls, the segregation of duties, accounting and revaluation procedures, and management reporting requirements. (i) An assessment of the bank's earnings. In this regard, you should consider the accuracy of reported earnings, taking into account loan provisioning and interest suspension policies; the level, quality, and composition of major income and expense components; earnings trends; and the ability of earnings to cover losses and provide for adequate capital. Where appropriate, you should propose recommenda- tions for achieving greater efficiencies, cost savings, or enhanced revenues. 5. In devising the plan of work for the pilot bank examination, you should take into consideration the effectiveness and reliability of accounting and administrative systems and internal controls in order to determine the degree of reliance to be placed upon them, and the extent of testing and veri- fication that needs to be performed. 6. It is expected that the scope of work performed will be sufficient to demonstrate how: (a) the examination was planned, e.g., scope of work, staffing, etc.; (b) examination tools, such as internal control questionnaires and written examination procedures, are used; (c) the work is documented through written working papers; (d) the examination report is compiled from the work performed in various areas; and (e) examination results are communi- cated to bank management and the board of directors. Examination Report to be PreRured by the Consultant 7. The final examination report should provide a comprehensive view of BOCOM's financial condition, performance, and future prospects. Therefore, it should address the following topics in clear and concise narratives. It is important that you clearly state your conclusions concerning the bank's over- all financial condition and for each topical area, e.g., "the overall quality -82 - ANNEX 8 Attachment 1 of assets is... (good, satisfactory, unsatisfactory, poor]" .A/ Supporting information should be included in an appendix to the main report. In addition to the information requested below, you are encouraged to submit additiornal information which addresses important issues not specifically identified below, supports your findings, or serves to inform and educate the reader. 8. MAIN REPORT (a) Maior Findings and Matters of Concern. This section should high- light the major conclusions of the examination and matters of sig- nificant importance that should receive the attention of bank man- agement, the board of directors, and higher-level supervisory per- sonnel. You should clearly state your conclusion regarding BOCOM's overall financial condition, performance, and future prospects. (b) Management and Board Supervision. This section should describe BOCOM's management processes and render a conclusion concerning the overall quality of management and board supervision. In assessing the quality of management, you should consider: technical compe- tence, leadership, and administrative ability; ability to plan and respond to changing circumstances; the adequacy, effectiveness, and compliance with management systems, including written policies and procedures, internal controls, internal audit, budgeting, planning, and management information systems; depth and succession; tendencies towards self-dealing; compliance with banking laws, rulings, and regulations; and the financial condition and operating performance of the institution. (c) Violations of Laws. Rules, and Regulations. This section should identify violations of laws, rules, and regulations and actions taken or needed to correct the violations. Emphasis should be placed on those violations which reflect unsafe and unsound banking practices. An assessment of the adequacy of the existing laws, rules, and regulations should also be included, with any suggestions for reforms/amendments. (d) Summary of Classified Assets. This section should include a summary of criticized assets by category of classification (e.g., substan- dard, doubtful, or loss). The criteria used in assigning classifi- cations should be defined and any unusual factors that served to influence the classifications assigned should be explained. In addition, the summary of classifications should distinguish between those credits granted in accord with the national credit plan or at the specific direction of government officials and those credits granted wholly on a commercial basis. 4/ It is critical that the examination process communicates conclusions effectively. Statements such as "marginally adequate," "marginally satisfactory," etc. are inappropriate. Simply stated, if something is not adequate, then it must be inadequate. -83- ANNEX 8 Attachment 1 (e) Loan Portfolio Management. This section should describe the crite- ria used for selecting loans for review and state the percentage of the portfolio reviewed in terms of the volume of loans outstanding. In addition, you should describe the lending function, including BOCOM's lending activities; the amounts outstanding by category or type of loan, economic subsector, policy vs. nonpolicy, or other appropriate breakdown; reporting relationships; lending authorities; a flow chart of the credit approval process; and other information considered necessary to provide the reader a comprehensive under- standing of the bank's credit process and lending activities. You should also comment on the quality of management with respect to the lending function; the causes of existing problems and adverse trends; the quality and effectiveness of loan policies, practices, procedures, and internal controls; undue concentrations of credit; loan review practices (if any); loan pricing policies; actions rec- ommended for the correction of problems; future expectations con- cerning the quality and administration of the loan portfolio; and other matters of importance requiring attention. Lastly, this section should also include your conclusion concerning the overall quality of the loan portfolio and its impact upon the soundness of the institution. In this regard, you should consider the level, distribution, and severity of classified assets; the level and composition of nonearning and reduced rate assets; the adequacy of valuation reserves; management's ability to administer and collect problem assets; undue concentrations of credit; and the adequacy, effectiveness, and adherence to loan policies and credit administration procedures. (f) Adeguacy of the Reserve for Loan Losses, In this section, you should render a conclusion concerning the adequacy of loan loss reserves and a description of the methodology you employed to deter- mine adequacy. If reserves are inadequate, you should recommend appropriate additions to the reserve and a methodology for ensuring that the reserve will be maintained at an adequate level in the future. (g) Concentrations of Credit. In this section, you should provide a summary of all large exposures and concentrations of credit repre- senting 25 percent or more of capital funds (credit funds). These concentrations may result from credit extended to a single borrower or related group, an economic or industrial sector, a political jurisdiction or geographic area, bank insiders or connected parties, or loans dependent upon a single factor that could affect repayment prospects for the entire group of borrowers (such as a group of bor- rowers dependent upon the price of a single commodity such as oil). In addition, you should group loans made at the direction of govern- ment officials or in accord with the national credit plan if the aggregate of such loans exceeds the 25 percent threshold. You should highlight those concentrations which you consider unwarranted or for which a significant portion is criticized. In addition, you - 84 - ANNEX 8 Attachment 1 should comment on the factors that may affect each concentration and note any adverse trends. Where undue concentrations exist or where there are weaknesses in the systems for identifying and monitoring concentrations of credit, you should make appropriate comments and recommendations for correction. (h) Loans to Connected Parties. In this section, you should provide a summary and comment on credit extended to parties connected to the bank and their related interests. These parties typically include directors of the bank, executive officers, major shareholders, and their related interests. In addition, enterprises connected through ownership or management such as bank affiliates and significant equity participations, or where influence or control is otherwise exercised, should also be included in the definition of a connected party. You should render appropriate comments where credit is extended on a preferential basis or where loans to connected parties are classified as problem assets. If widespread abuses or problems are apparent, you should also make appropriate comments in the sec- tion on loan portfolio management and in your summary of major find- ings. Where weaknesses exist, you should recommend appropriate corrective actions. (i) Investment Portfolio Management. This section should describe BOCOM's investment, dealing, trading, and/or underwriting in securi- ties. In addition, you should render a conclusion concerning the overall quality of the investment portfolio and how that quality relates to the overall soundness of the bank. You should also determine the adequacy, effectiveness, and adherence of investment policies, practices, procedures, and internal controls. Where weak- nesses are cited, you should recommend specific actions designed to effect correction. (j) Liauiditv. Asset and Liability Management. In this section, you should render a conclusion concerning liquidity, asset and liability management practices. In this regard, you should describe existing practices for providing liquidity and managing exposure to changes in interest rates. You should also comment upon the size and level of net rate sensitive assets at various intervals. Where deficien- cies have been identified? you should propose recommendations for strengthening or correcting the weaknesses. In reaching your conclusion, you should comment upon the volatility of deposits; the frequency and level of borrowings; the reliance placed on interest-sensitive funds; access to money markets or other ready sources of cash; the ability to readily convert assets into cash; the capacity to meet unexpected deposit withdrawals and other demands for payment; the ability to readily fill reasonable credit demands; the overall adequacy, effectiveness, and compliance with liquidity, asset and liability management policies; and the nature, volume, and anticipated usage of credit commitments, contingent liabilities, and guarantees. - 85 - ANNEX 8 Attachment 1 (k) Earnings and Capital. In this section you should assess the quality of earnings and the adequacy of capital. In assessing the quality of earnings, you should comment on the accuracy of reported earn- ings; the level, quality, and composition of major income and expense components; earnings trends; and the ability of earnings to cover losses and provide for adequate capital. Where appropriate, you should propose recommendations for achieving greater efficien- cies, cost savings, or enhanced revenues. With regard to capital, you should assess solvency and the adequacy of capital in relation to the volume of risk assets; the volume and severity of marginal and inferior quality assets; growth experience, plans, and prospects; management's strengths and weaknesses; the retention of earnings; and access to capital and financial a8sis- tance. If you conclude that capital is inadequate or that the bank is technically insolvent, you should estimate the amount of capital necessary to absorb losses, bring capital to an adequate level, and ensure its ongoing viability. (1) Internal Controls. This section should contain your conclusion regarding the banks's overall system of internal controls. Wihere significant weaknesses are apparent in the bank's accounting and administrative controls, you should comment upon the nature of the weakn'.ss and its potential risks, and recommend specific corrective measures. Less significant internal control weaknesses should be itemized in the Appendix, together with your explanation and recom- mendations for correction. (m) Internal and External Audit Activities. In this section, you should render a conclusion concerning the adequacy of internal and external audits. In this regard, for both internal and external auditors, you should consider their independence, competence, experience, and technical skills; the scope, content, and frequency of their audit programs; the scope, content, and format of audit reports; the appropriateness of conclusions and recommendations; the internal channels for receiving and acting upon audit recommendations; and the effectiveness of follow-up activities to ensure that corrective actions are implemented. Where an opinion on financial statements is also rendered, you should assess the reasonableness of the audit opinion and the accuracy of financial statements disclosed to the public. (n) Foreign Exchange Activities. This section should describe BOCOI's foreign exchange activities (distinguishing between operations on the mainland and in Hong Kong), including a quantification of actual and potential foreign exchange losses and significant exposures by currency, counterparty, maturity, etc.; a conclusion regarding man- agement's ability to manage foreign exchange risk; an assessment of the reasonableness of trading limits; and, an evaluation of other foreign exchange controls, such as those requiring the segregation of duties, accotunting and revaluation procedures, and management reporting requirements. - 86 - ANNEX 8 Attachment 1 (o) Insurance Activities. This section should render a conclusion con- cerning BOCOM's insurance business, including an assessment of actual and potential risks. In addition, it should discuss the types and amounts of insurance underwritten, the reasonableness of the actuarial or other basis for establishing premiums, general underwriting criteria for different types of insurance, los8 experi- ence by type of insurance coverage or class of risk, internal con- trols and management information related to these activities, and other relevant information. (p) Other Matters. This section should address significant matters not otherwise addressed elsewhere in the report. (q) Future Prospects. In this section, you should comment on BOCOM's future prospects. Consideration should be given to BOCOM's existing strengths and weaknesses, its future planned activities, opportuni- ties and threats, environmental factors, and other matters of impor- tance that may affect BOCOM's future prospects and viability. 9. APPENDIX (a) Financial Statements. Financial statements, including a consoli- dated balance sheet and profit and loss statement should be pro- vided. These statements should be provided both (a) before and (b) after the adjustments required to accurately reflect BOCOM's true financial condition and performance, whether or not entries have actually been passed through the general ledger and profit and loss statements. If entries have not been passed, you should so state. Supporting information should describe and quantify the adjustments which were necessary. These adjustments could include, for example, loan write-offs and additional loan loss provisions. (b) Off-Balance Sheet Contingencies. This schedule should aggregate off-balance sheet commitments and contingencies by type. You should also comment upon any significant associated risks. (c) Trend of Earnings. This schedule should show the trend of earnings over a three-year period with sufficient detail to permit a reason- able analysis of the various income and expense components. In addition, various ratioe should be calculated. These should include: major income and expense components expressed as a percent of average assets; yields on various earning assets and loans; costs of various interest-bearing liabilities; net interest margins and spreads; noninterest income and expense components as a percent of average assets; growth rates in assets, loans, and capital; and other ratios considered appropriate to an in-depth evaluation of profitability eind efficiency. (d) Reconcilement of the Capital Account. This schedule should include a reconcilement of the capital account showing the beginning bal- ance, capital itucreases, net profits, dividends, other decreases, and the ending balance for the period. - 87 - ANNEX 8 Attachment 1 (e) _omputatio- of Risk-Based Capital Adequacy. This schedule should c'ticulate capital using a risk-weighted capital adequacy formula such as the one adopted by the Basle Committee on Banking Supervi- sion. (f) Reconcilement_of the Reserve for Loan Losses. This schedule should include a reconcilement of the reserve for loan losses, showing the beginning balance, provisions, recoveries, charge-offs, other adjustments, and the ending balance for the period. (g) Trend of Delinquencies. This schedule should provide an aggregate summary of all past due,5/ nonperforming, and renegotiated loans,6/ priority sector vs. nonpriority sector, by category or type of loan expressed (1) in renminbi amount and (2) as a percent of total outstandings in that category. You should define the cri- teria used to determine past due, nonperforming, or renegotiated status. In addition, you should comment upon the bank's existing policies for interest suspension or nonaccrual and recommend changes where appropriate. (h) Listing of Significant Nonperforming Accounts. This section should list significant past due, nonperforming, and renegotiated loans. You should indicate the name of the borrower, the amount outstand- ing, the number of days payments are in arrears, whether a policy loan, and any other pertinent information. (i) Criticized Loan Comments. This section should include written loan comments for all criticized loans exceeding the sampling cut-off amount. These written comments should provide a brief description of the credit including the history of the indebtedness, the repay- ment plan and actual performance, a brief analysis of the borrower's financial statements, a description of the collateral and/or guaran- tees (if any), and the reasons the loan is classified. (j) Other Assets Subject to Classification. This schedule should include an aggregate listing of other assets subject to classifica- tion. These might include foreclosed properties or the assets of a bankrupt firm acquired by the bank for a debt previously contracted. In addition, other assets subject to classification might include old, outdated reconcilement itemss accrued interest on nonperforming assets, accounts receivable in arrears, stale cash items, suspense items, unlocated differences, etc. The aggregate of these items 5/ For all past due, nonperforming, and renegotiated loans, the outstanding balance of such loans should be reported rather than only payments affected. 6/ "Renegotiated loans" refers to those credits whose terms have been modi- fied due to the borrower's inability to perform in accordance with the terms of the original contract. Examples include a reduced interest rate, extensions, renewals and/or extension of the final maturity date. - 88 - ANN% Attachment 1 should be brought forward to the summary of classified assets in the main report. (k) Loans Not Suiported by Current and Satisfactory Financial Informa- tion. This schedule should list loans not supported by current and satisfactory financial information or lacking a satisfactory defini- tion of the loan's purpose and repayment plan. The listing should include the name of the borrower, the outstanding balance of the loan, and the nature of the credit file exception. (1) Loans Not SuR2orted by Complete Collateral Documentation. This schedule should list loans not supported by complete collateral documentation. The listing should include the name of the borrower, the outstanding balance of the loan, and the nature of the collat- eral exception. (m) Anticipated Funding Needs and Sources. This schedule should summa- rize BOCOM's anticipated funding needs for relevant periods and its anticipated funding sources to meet those needs. (n) Rate Sensitivity and Gap Reports. This schedule should summarize the bank's rate sensitivity position at various intervals by means of a cumulative gap report. The gap (rate-sensitive assets less rate-sensitive liabilities) and sensitivity ratio (rate-sensitive assets divided by rate-sensitive liabilities) should be calculated for each interval. In addition, the (positive or negative) gap should be compared to total assets. (o) Foreign Exchange Exposures. This schedule should quantify foreign exchange positions by currency, maturity, counterparty, etc. To the extent that foreign exchange losses have been incurred, these should be quantified and details provided. ,p) Internal Control Weaknesses. This section should itemize internal control weaknesses, together with your explanation of the weakness, its potential riske, and your recommendations for correction. (q) Other Schedules. These schedules should include other information you consider important or necessary to support your conclusions. - 89 - ANNEX 8 Attachment 1 Addendum CHINA FINANCIAL SECTOR TECHNICAL ASSISTANCE PROJECT Sample Definitions for Grading the Quality of Assets 1. In order to determine the quality of the loan portfolio, as well as other assets and off-balance sheet contingent liabilities, it is first neces- sary to establish criteria by which to evaluate assets. In general, this criteria is used to assess the borrower's financial capacity and ability to repay. Many countries have adopted a system of classification in which assets are categorized as current, substandard, doubtful, or loss. 2. Those assets which are considered current do not exiibit credit weaknesses that might jeopardize collection of the debt in the manner agreed to upon the loan's inception. Such loans are properly structured so that repayment is effected in a timely a.nd realistic manner and are otherwise sound in every respect. In essence, they are good loans to good ente':prises and good persons. 3. The latter three categories are considered problem assets. Their definitions follow: A substandard asset is one which has a well-defined credit weakness, or weaknesses, which jeopardizes the liquidation of the debt. It is inadequately protected by the sound net worth or payment ability of the borrower. Substandard assets are characterized by the distinct possibility that the ' Aik will sustain some loss if the credit weakness is not corrected. Loss potential, while existing in the aggregate amount of substandard assets, does not have to exist i'. individual assets classified substandard. 4. For example, a substandard borrower is one which lacks adequate cash flow to service or repay its currently maturing debts. This credit weakneas may be determined from an actual lack of performance or it may be concluded on a prospective basis through an analysis of the enterprise's financial state- ments. In some instances, borrowers may appear to perform on their debts but in fact do not. It is only through the capitalization or refinancing of interest which is due and unpaid that the loan appears current. In the Chinese context, substandard assets might include loans to enterprises which are fundamentally viable but which require a moderate degree of restructuring in their operations to improve efficiency and profitability, a more conducive operating environment (e.g., decontrol of prices for their products), and a stretching out or change in the mix of their liabilities. The objectives of restructuring would be to improve the enterprises' operations so that they are more efficient, more competitive, and sufficiently profitable to adequately service their debts and provide a reasonable return to their owners. In effect, the credit weaknesses in such enterprises are, to a very large degree, - 90 - Q Atj-chme-n" Addendm controllable and correctable over the short term with a minimum of state intervention. A doubtful asset has all the weaknesses inherent in one classified substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. S. One example of a doubtful asset is a loan which exhibits the charac- teristics of a substandard asset but which is also seriously past due and inadequately protected by the reAlizable value of any collateral pledged. For example, assume that inventory is the sole asset of an enterprise pledged as collateral. Its sale under distressed conditions or during a forced li uida- tion might only bring a fraction of its original cost in real terms, thus significantly exposing the credit to a high probability of loss. As the result, the ultimate collection of the indebtedness in full would be consid- ered highly unlikely if the corrower were also seriously delinquent and unable to provide additional security. 6. In China, the definition of a doubtful asset should be extended to those enterprises which ar- fundamentally viable but require significant restructuring of their operations and debt relief or forgiveness to remove the massive overhang of obligations they owe. The assumption is that the amount of debts forgiven will be reflected on the banks' balance sheets as a write- down of the carrying value of the credit with the loss flowing through provi- sions to the banks' profit and loss statements. Significant involvement of the state may be required to effect rehabilitation. Assets classified loss are considered uncollectible and of such little value that their continuance as bankable assets is not warranted. This does not mean that the asset has absolutely no recovery or salvage value, but rather it is not practical or desirable to defer writing off this basically worthless asset even though partial recovery may be effected in the future. 7. In China, assets considered as loss would include loans to those enterprises which are not viable in the ohort term under any reasonable cir- cumstances barring intervention by the state in the form of massive subsidies. These assets would generally fall into three categories: (a) Those that require major rehabilitation over the long term, most probably involving state intervention. These enterprises could possibly be made viable on their own merits but are not considered worthy of being carried as active assets on the books of the bank. (b) Those enterprises which are not viable but servo an essential social need, e.g., railroads, utilities, airlines, etc. Such enterprises may be kept alive bocause of their importance to society; however, -91 8 AttachMent 1 Addendum the costs should be made explicit through direct subsidies from the state rather than indirect subsidies in the form of bank financing. (c) Those enterprises which are not viable under any circumstances. These snterprises should be closed and their assets liquidated. 8. In establishing criteria for grading the quality of credit, it should be understood that many enterprises which are viable today, may not be in the future as subsidies are removed and changes occur in prices for all types of goods and services. It would be difficult at best to forecast all the price changes that might occur as well as their linkages. Many enter- prises will only show up as problem borrowers at subsequent reviews of portfo- lio quality. Therefore, one should not expect that all problem borrowers will be identified during an initial portfolio review. 9. The process of portfolio review should be a continuous one that is systematically carried out by each bank's own staff, as well as by bank super- visors and auditors, as an integral part of management's controls over the lending function. In this way, problem borrowers can be identified in a timely manner so that measures can be taken to strengthen or otherwise collect the credit before it deteriorates into a hopeless situation. -92- ANNEX 8 Attachment 2 CHINA FINANCIAL SECTOR TECHNICAL ASSISTANCE PROJECT Terms of Reference for Strenpthening Prudential Supervision and Regulation ACTIVITY 2: ORGANIZATIONAL STUDY OF THE BANK SUPERVISION FUNCTION 1. Since its creation in 1985, the Department of Lank Supervision and Audit has focused on its compliance role of ensuring that banks lend for key projects and developmental priorities as elaborated in the national credit plan. However, there is concern that this focus frequently contradicts the department's emerging prudential responsibilities. For instance, PBC has, in the past, instructed banks to require the early repayment of loans to nonpol- icy borrowers so that additional credit could be extended to borrowers covered by the national credit plan. Even though many of these borrowers were ineffi- cient, loss-making, and problematic, prudential considerations related to asset quality were overruled in their favor. Thus, there is some question concerning the efficacy of placing the responsibility for compliance and pru- dential supervision within a single department. 2. The emphasis on compliance has also dictated a "bottom-up" approach during examiners' on-site inspections with a result that supervisory resources are concentrated at the lower levels of PBC's supervisory organization where most of tLe compliance activities are undertaken. Less than 50 supervisory personnel are assigned to PBC headquarters and fewer than 30 supervisory per- sonnel, in the aggregate, are assigned to the PBC's branches in Beijing and Shanghai, even though these rank as China's most important financial centers. These numbers contrast to provinces such as Hebei, Shandong, and Hunan where more than 300 supervisors are assigned to each. Because supervisory resources are concentrated at the lower levels of the organization, there is a concern that adequate resources are not being targeted to the areas of greatest sys- temic risk. 3. In addition, there are concerns that the different responsibilities of the Department (compliance, internal audit, and prudential supervision) require different staff skills. It is also noted that certain traditional bank supervision functions are currently outside the purview of the Department of Bank Supervision and Audit. These include the licensir. of banks and financial institutions and the imposition of disciplinary sanctions against bank managers. 4. Given these many concerns, you should work closely with the PBC's umbrella committee to conduct an organizational study of the bank supervision function to determine whether changes in the existing organization are neces- sary or desirable. -93- ANNEX8 Attachment 2 Scope of Work and Outputs to be Prepared by the Consultant 5. The organizational study should assess present institutiosnal arrangements for bak supervision, including information flows. The consultant should identify existing weaknesses and recommend changes, including a pro- posed new organizational chart, clearly specified job descriptions, informa- tion flows and reporting functions. Specific issues which should be addressed by the consultant include the following: (a) Should PBC create a separate department for the purpose of enhancing its prudential bank supervision activities, or should the existing arrangement remain intact, with a change in supervisory focus achieved through a transitional process? The advantages and disad- vantages of each option should be thoroughly discussed, together with your conclusion. Your discussion should address the differing responsibi.lities of the existing department and their impact on the department's organization and approach to prudential bank supervi- sion, the mix of skills needed to fulfill the differing roles, the deployment and mobility of staff, and other factors you consider relevant. (b) If a separate department is recommended for the purpose of conduct- ing prudential supervision, how should it be organized and staffed? You should make specific recommendations concerning number of staff, skills, education, and experience. Your recommendations on organi- zation and staffing should address these issues both within PBC headquarters and at PBC branches. (c) If, instead, a "transitional" arrangement is proposed, i.e., moving the existing Department of Bank Supervision and Aud't from a compli- ance role to one of prudential supervision, you should provide spe- cific recommendations and guidance concerning: the time required to transform the existing supervisory function from compliance to pru- dential supervision; how this transformation is to occur; and the sequence of activities required to implement your recommendations. Your recommendations should include specific suggestions on the number and deployment of staff both within PBC headquarters and nationally. (d) Should other prudential bank supervision activities, such as licens- ing and the enforcement of sanctions against managers who engage in unsafe and unsound practices, be consolidated into a single depart- ment, or should other departments continue to perform these activi- ties? The advantages and disadvantages of each approach should be thoroughly discussed, together with your conclusion. - 94- ANNEX 8 Attachmentg3 CHINA FINANCIAL SECTOR TECHNICAL ASSISTANCE PROJECG Terms of Reference for Strengthening Prudential Sunervision and Regulation ACTIVITY 3: DEVELOPMENT OF ON-SITE EXAMINATION PROCEDURES 1. Consistent with the overall intent of this technical assistance program, the objective of this activity is to reorient on-site examinations to focus on prudential concerns. To accomplish this, the international consul- tant, together with the PBC's Subgroup for On-site Examination, should develop examination methodologies and document written examination procedures for on- site examinations of banks and nonbank financial institutions. Written exami- nation procedures, including internal control questionnaires and verification procedures, are needed to provide consistency and objectivity among examiners, to support examination conclusions, and to serve as learning aids for new and developing staff. The examinp::ion procedures should be tailored for the Chinese banking environment and should emphasize the most critical areas of risk assessment, including the CAMEL 1/ components, as well as the develop- ment of management systems within financial institutions. Outputs to be Prepared by the Consultant 2. It is expected that the following documents will be prepared in draft and final form during the period of the engagement with substantial input and assistance from the PBC's SubgrouR for On-site Examination. (a) Written examination procedures and, where appropriate, internal control questionnaires and verification procedures for all signifi- cant aspects of banking activity and examination interest. (b) A written examination handbook which compiles the examination proce- dures, together with explanation and background. (c) A format for a written examination report. The format should require that all examination findings are substantiated and that conclusions are rendered for all significant areas of banking activ- ity and examination interest. 3. In addition to these outputs, you are expected to conduct training activities to ensure appropriate dissemination and understanding of these new methodologies. In this regard, it is expected that you will also lead teams of examiners into financial institutions to provide hands-on training in using the on-site examination procedures that have been dftveloped. 1/ CAMEL is an acronym standing for capital adequacy, asset quality, manage- ment, earnings, and liquidity, asset and liability management. _ 95 - ANNEX 8 Attachment_4 CHINA FINANCIAL SECTOR TECHNICAL ASSISTANCE PROJECT Terms of Reference for Strengthening Prudential Supervision and Regulation ACTIVITY 4: DRAFTING OF ERUDENTIAL REGULATIONS 1. The purpose of this task is to assist in the further development of the legal and regulatory framework for financial institutions in China. Together with the PBC's Subgroup on Prudential Regulation, the international consultant should propose and help implement recommendations designed to reduce economic regulation, strengthen the prudential framework, enforce safe _:nd sound banking practice, and deal with troubled financial institutions. Outputs to be Prepared by the Consultant 2. It is expected that the following will be prepared in draft and final form during the period of the engagement with substantial input and assistance from PBC's Subgroup on Prudential Regulation: (a) Draft prudential regulations designed to: (i) strengthen PBC's ability to license, regulate, and supervise banks and financial institutions; (ii) establish prudential controls and limits (such as exposure limits, capital adequacy guidelines, and loans to insiders); (iii) enforce corrective measures tirough legal sanctions and other remedies; and, (iv) deal with troubled institutions. (b) A law manual that explains and interprets the legal framework; (c) Where appropriate,l/ a plan for phasing the implementation of pru- dential regulations. This plan should have specific targets and time parameters to ensure that compliance is achieved within the phase-in period. 1/ For example, if banks cannot now meet capital adequacy requirements, a phase-in period could be established wherein the banks would have to retain profits, raise capital, and control growth so that they miglht meet a minimum target each year until they could finally comply with the capi- tal adequacy requirement. -96 - ANNEX 8 Attachment 5 CHINA FINANCIAL SECTOR TECHNICAL ASSISTANCE PROJECT Terms of Reference for Strengthening Prudential SuDervision and Reaulatio ACTIVITY 5: DEVELOPMENT OF AN OFF-SITE SURVEILLANCE CAPABILITY 1. The purpose of this task is to develop and implement an automated early warning/off-site surveillance system for monitoring the financial per- formance and condition of banks and nonbank financial institutions. This system should be based on prudential reports submitted to the People's Bank of China which the international consultant will design in close cooperation with the PBC's Subgroup for Off-Site Surveillance. In this regard, the interna- tional consultant should develop uniform accounting and reporting standards for banks and nonbank financial institutions, including definitions for past due and nonperforming loans and advances, the treatment of accrued interest on nonperforming assets, the capitalization of interest, and provisions for actual or potential losses. The team undertaking this activity should include a systems analyst who will design the automated application and oversee the work of Chinese programmers. In addition, the international consultant will be expected to develop training programs and conduct training in off-site surveillance methodologies. 2. Ideally, the off-site surveillance system would be based on pruden- tial reports submitted by banks on a consolidated basis. However, given the decentralized nature of most Chinese financial institutions and the absence of effective management information systems, it is not clear, if the system is to function in a timely manner, whether the off-site surveillance system should, in the near term, be based on prudential reports submitted at the branch level or for the consolidated institution. This question will need to be resolved by the international consultant, in consultation with the counterpart team, before significant work is undertaken. System Reauirements 3. At a miniLum, the proposed automated off-site surveillance system should possess the f.1llowing characteristics: (a) The system. should provide for the compilation of raw data into a database. Information from prudential returns should be maintained for a minimum period of five annual periods and the last 15 quar- ters. Examination data should be maintained for the last ten exami- nations. The system should possess a capability to archive older data. (b) The systeu for data entry should include processes for checking the accuracy of data input from prudential returns and examination -97- ANNEX 8 Attachment 5 reports. In addition, the system should prevent unwarranted access or manipulation of data by unauthorized users. (c) The system should provide the ability to query the database using keyed short names, to download data into spreadsheet models, and to produce ad-hoc reports through automated means. Selected ratios should be calculated automatically and maintained as part of the database. (d) The system should produce periodic standard output reports which permit comparison and anal"sis against peers, as well as prior peri- ods. These standard output reports should include the calculation of standard ratios, the establishment of peer groups, time series which permit trend analysis, and percentile rankings versus peer. The system should also permit the creation of customized peer groups. (e) The system should permit both asynchronous and bisynchronous commu- nication links with microcomputer users. Outputs to be PreRared by the Consultant 4. The outputs you are expected to produce (in draft and final form), with substantial input and assistance from the PBC's SubRroup for Off-Site Surveillance, include the following: (a) The design of a prudential report (balance sheet, profit and loss statement, and supporting schedules) to be submitted by financial institutions and accompanying instructions for its preparation. The prudential report should permit the extraction of data from existing accounting records but in a format usable for financial analysis by bank supervisors. The instructions for preparation of the pruden- tial report should define the underlying principles to be used and the data to be reported in the schedules under the various account categories. (b) In cooperation with the systems aivAyst, the design of an automated off-site surveillance system, including the processes for checking the accuracy of data, compiling the raw data, and establishing a database. You will provide input to the systems analyst on user needs such as the ability to query the database and produce ad-hoc reports through automated means. (c) The design of standard output reports which permit comparison and analysis against peers, as well as prior periods. These standard output reports should include the calculation of standard ratios, the establishment of peer groups, time series which permit trend analysis, and percentile rankings versus peer. -98 - ANNEX 8 Attachment 5 5. In addition, you will provide on-the-job training in off-site sur- veillance methodologies and techniques, including basic microcomputer modeling and simulation techniques, and assist in the implementation of the off-site surveillance system as a supervisory tool. -99 - Attachment 6 CHIN FINANCIAL SECTOIR TECIHNICAL ASSISTANCE PROJECT Terms of Reference for Strengthening Prudential Suy,ervision-and Regglationq ACTIVITY 6: DEVELOPMENT OF AN IN-HOUSE TRAINING PROGRAM AND COORDINATION OF TBAINING ACTIVITIES 1. The change in supervisory focus from one of compliance to prudential supervision will require a substantial training effort to improve skill levels and banking expertise. Training courses are required in banking-related topics such as credit analysis, asset/liability management, foreign exchange, bank analysis, etc. In addition, PBC's supervisors will require training in the new supervisory methods. Therefore, the international consultant is to develop a comprehensive training program in close cooperation with the PBC's Suberoup on Bank Suiervision Training and to conduct "train-the-trainer" pro- grams for PBC staff. In addition, the international consultant is expected to coordinate training activities for PBC bank supervision staff both in China and abroad. Outputs to be Prepared by the Consultant 2. The work products you are expected to produce, with substantial input and assistance from PBC's Subaroug on Bank Supervision Training, include the following: (a) course curricula, including training in the new examination and off- site surveillance methodologies developed through the work of other consultants and PBC subgroups; (b) lesson plans, teaching materials, and audiovisual aids for the courses to be taught; (6) training materials and student handouts for the courses to be taught; (d) criteria for selecting candidates as PFC instructors; and (e) a rolling three-year training plan listing the frequency of training programs, proposed timing, number of staff to be trained, and target participants. 3. In addition, you are expected, to conduct not less than three "train- the-trainer" sessions using the materials and lesson plans you have prepared. 4. The training activities to be coordinated by you, in consultation with the Suberouo on Bank SuDervision TraIni , include the followings - 100 ANNEX8 Attachment 6 (a) Study Tours, For each year of the program, one study tour will be conducted in order to heighten the awareness of senior supervisory personnel (general supervisors and division chiefs). Each study tour will include five persons and an interpreter. The study tours will seek to acquaint the participants with practices in other coun- tries, with particular reference to the areas of activity to be covered by the teichnical assistance program, i.c., off-sitc surveil- lance, on-site examinations, prudential regulations, bank oupervi- sion training, and organization of the ban!. supervision function. Ideally, the participants should be drawn from the members of the counterpart teamsE responsible for the various activities. (b) Secondment Abroad. Each year, five bank supervision staff will be seconded to bank supervision agencies abroad for a period of six months to one year. The individuals seconded will return to the PBC's bank supervision department at the completion of their assign- ments and will form the core of future trainers or otherwise serve on the subgroups established under the project. The secondments should seek to expose the participant to one or more of the major areas addressed under the technical assistance program such as on- site examination, off-site surveillance, prudential regulation, and the ectablishment of in-house training and development programs. (c) raiing Seminars. Training seminars to be organized within China should be of two types: the first is a high-level seminar for senior supervisory personnel. The second is directed towards junior and mid-level bank supervision staff. These are described below. (i) Seminars for Senior Supervisors. An annual two-week seminar to be held each year during the project for approximately 30 senior supervisors. These seminars will include lectures by both foreign and Chinese experts. Topics will include current supervisory issues of relevance. (ii) Seminars for Junior and Mid-Level Supervisors. A second two- week seminar will be held in China each year for junior and mid-level bank supervision staff. These seminars will include both foreign and Chinese experts; however, unlike the high- level seminars above, these seminars should be more training oriented, addressing topics such as. (a) loan portfolio man- agement, credit analysis, asset classification, adequacy of loan loss reserves; (b) bank analysis (earnings, capital, etc.); (c) liquidity, asset/liability management; (d) appraisal of managemegnt; (e) examination methodologies; (f) off-site surveillance techniiques; (g) internal and external audit activ- ities; (h) banking laws and prudential regulation; and (i) for- eign exchange. (iii) Training Programs Abroad. Eight bank supervision staff will attend semiLnars abroad each year of the program. In general, the seminars should be consistent with the overall program of technical assistance. The seminars or training programs will - lei - M1U a Attachmemnt last :wom two to four weeks in length. Fluent foreign language skills in the language of instruction are essential for parti- cipation. - 102- 8IEKS CHI_NA PINANCIAL S-ECTOR TECM-.9AL SS STANCE PROJECT Termg of Reference for Strengthening PrudentiLal Supervision and ReRulation ACTIVITY 7: SPECIAL ASSET OUALITY REVIEWS 1, The international consultant will work in close cooperation and with the support of the PBC's Department of Bankr Supervision and Audit. The objec- tives of th6 special asset quality reviews are to evaluate the quality of asoets in (a) branches of the Agricultural Bank of China (ABC) in Sichiuan, Jilin, Jiangsu, Fujian and Qingdao (year 2); (b) branches of the Bank of China (BOC) in Dalian, Qingdao, Shanghai, and Guangzhou; and (c) the Shaangxi Branch of the Industrial and Commercial Bank of China (ICBC) (year 3) in order to: (a) determine the overall quality of assets, with a particular emphasis on the quality of each branch's loan portfolio, and to relate that determination to the overall financial condition and soundness of the provincial branches concerned; (b) determine the amount of provisions necessary to establish adequate reserves for actual and potential losses existing within each branches' portfolio of assets; (c) assess each bank's policies and procedures for manal:ing and adminis- tering its loan portfolio and other risk assets, anc ensuring the adequacy of loss reserves; and to recommend improvemants in those areas requiring strengthening; and, (d) expose PBC bank supervision staff to modern asset evaluation tech- niques, credit principles, and loan review skills. 2. Given the size of the institutions involved, you are expected to rely heavily on the participation of the PBC's counterpart teams working under your guidance. Since the transfer of skills is also an important objective of this program, you should outline training activities to be conducted as an integral component of your proposal. SvnoDsis of the Banks 3. Industrial and Commercial Bank of China. ICBC is China's largest bank with a network of 30,798 offices and some 491,000 staff. Its primary purpose is to mobilize deposit resources from both enterprises and individu- als, mainly in urban areas, and recycle these to provide credit for China's industrial development. Total assets at the end of 1990 were Y 938 billion. 4. Agricultural Bank of China. ABC is China's agricultural bank and serves the same purpose in rural areas as does ICBC in urban centers. It -103- ANNEX8 AttacRIwMit7 operates a vaSt branch network of more than 55,000 offices and employs aome 408,000. Total assets at the end of 1990 were Y 480 billion. 5. Peole's Construution Bankjof China. PCBC is China's third largest financial institution domestically. Although its role is gradually changing to assume more of a commercial lending role, PCBC remains the principal bank for construction and real estate, and major capital-intensive projects. It operates more than 3,000 branches and employe a staff of some 217,000. Total assets at year-end 1990 ware Y 518 billion, including the Ministry of Finance's trust portfolio. 6. Bank of China. The BOC in China's principal foreign exchange bank. It has a significant overseas network including significant operations in Hong Kong. Altogether, it operates nearly 1,500 branches, both domestic and abroad, and employs a staff of 73,000. Total assets at year-end 1990 were Y 859 billion. 7. Further informatio. oncerning these banks and conditions in the banking eystem may be obtained from the World Bank Country Stuzdys China: F-inancial Sector Policies and Institutional Development. Scope and Detail of the Asset Qualitv Reviews 8. At a minimum, the scope of the special asset quality reviews should cover the following: (a) An sssesombnt of lending and investment policies and practices and management's overall administration of its loan and investment port- folios. Particular attention should be paid to lending policies and prac- tices. In this regard, the review should include an evaluation of policies and procedures related to the granting of credit, including procedures for approving credit; obtaining and analyzing financ 1 information; establishing and enforcing repayment programs; res :d uling, extending, modifying, or otherwise refinancing problem credits; collecting past due loans; provisioning for actual and potential losses; writing-off bad assets; pricing loans; ensuring appropriate diversification; and managing related foreign exchange and off-balance sheet risks. With regard to investment policies and practices, there should be an evaluation as to whether policies outline: investment objectivos; permissible types of investments; diversification guidelines; matur- ity schedules; valuation procedures; trading, dealing, and under- writing guidelines; standards of quality; and guidelines for manag- ing related foreign exchange and off-balance sheet risks. - 104 - ANNEX 8 Attachment 7 (b) An e"aluation of a8set / quality. This evaluation should iden- tify problem as8ets and classify them according to criteria for substandard, doubtful, and loss categories 2/ (or in accord with an alternative recognized and a'^ceptabKe classification scheme). Actual and potential losses should be clearly identified. It is expected that the sample of loans selected for review should not be less than 60-70 percent, by value, of the portfolio outstanding. (c) An opinion on the adequacy of loss reserves. If reserves are inade- quate, a recommendation should be made on an appropriate level of reserves and a methodology for ensuring that adequate reserves are maintained. The methodology used to determine the level of reserves considered as adequate should be clearly demonstrated in your final report. (d) The identification and quantification of concentrations of credit and large exposures representing 10 percent or more of capital funds (credit funds). These concentrations may result from credit (in the form of loans, investments, or other instruments) extended to a single borrower or related group, an economic or industrial subsec- tor, a political jurisdiction or geographic area, bank insiders or connected parties, or assets dependent upon a single factor that could affect repayment prospects for the entire group of assets (such as a group of borrowers dependent upon the price of a single commodity such as oil). (e) For banks which accrue interest income,3/ an evaluation of the bank's practices for accruing interest on nonparforming assets. A determination should be made as to whether the bank has an appropri- ate policy for designating nonperforming assets and suspending the accrual of interest. If interest continues to be accrued on nonper- forming or serioudly delinquent credits, there should be a determi- nation on the amount of such interest credited to the profit and loss account as income and a recommendation on appropriate adjust- ments. (f) An assessment of administrative and accounting internal controls in the lending and investment areas. This assesoment should also address the adequacy and effectiveness of the bank's internal man- agement information and reporting systems for these areas. Including off-balance sheet commitments and contingencies. 2/ Sample definitions are attached as Addendum 1. The consultant is encour- aged to suggest refinements or alternative criteria when submitting the proposed work plan for this project. 3/ Banks in China generally do not accrue interest income, but take interest into income only when paid on a cash basis. - 105 - ANNEX 8 Attachment 7 (g) An evaluation of foreign exchange risk resulting from the bank's lending and investment activities,A/ if any, and a quantification of actual and potential foreign exchange losses. (h) An assessment of the bank's loan pricing policies and funding costs. To the extent that banks are granted latitude to establish loan pricing,5/ there should be a determination as to whether such pol- icies are sufficiertly differentiated to address the inherent risks in different loan types and maturitiec and whether loan pricing policies require a premium for riskier borrowers. It should also be determined whether loan yields provide a sufficient return to cover funding and administrative costs, loan loss provisions, and other expense items while, at the same time, ensuring an adequate return for owners and capital growth. (i) An assessment of the bank's funding sources. Without performing a comprehensive evaluation of asset and liability management prac- tices, the following should be determined: growth patterns of lend- ing and investment activities and their funding sources; whether there have been any significant shifts in the mix of deposits, bor- rowings, and other liabilities; and whether interest rate premiums are being paid to attract and retain funding. There should also be an assessment as to the stability or volatility of funding and an identification of any significant exposures to liquidity and inter- est rate risk. If significant risks exist, an attempt should be made to quantify those risks and recommend alternatives for their reduction. (j) An assessment of the quality of lending and investment management and board supervision over the lending and investment functions. 9. In devising the plan of work under the special asset quality reviews, the consultant should take into consideration the effectiveness and reliability of accounting and administrative systems and internal controls in order to determine the degree of reliance to be placed upon them, and the extent of testing and verification that needs to be performed by the consul- tant. Report to be Prepared by ;.e Consultant 10. At a minimum, the final report should include the following informa- tion in the format prescribed. However, the report is encouraged to include 4/ These risks may result, for example, from: (1) borrowing foreign curren- cies to fund domestic lending and investmcnt activities in local cur- rency, (2) lending or investing in foreign currencies, or (3) actual or potential defaults by borrowers in foreign currencies who cannot generate sufficient foreign exchange to repay their indebtedness. _/ Traditionally, there has been little latitude in China for banks to set or differentiate interest rates. - 106 - ANNEX 8 Attachment 7 additional information relevant to the findings which will serve to inform and educate the reader. (a) A description of the criteria used for selecting the samples of loans, investments, and other assets for review and a statement as to the percentage of the portfolios reviewed in terms of both the number and volume of assets outstanding. (b) A description of significant accounting policies and practices. (c) A description of the lending function, including a description of the types of lending activities; the amount of outstandings by cate- gory or type of loan, economic sector, policy 6/ vs. nonpolicy, or other appropriate breakdown; reporting relationships; lending authorities; a flow chart of the credit approval process; and other information considered necessary to provide the reader a comprehen- sive understanding of the bank's credit process and lending activi- ties. (d) A narrative assessment of lending and investment activities based on your findings. This assessment should address the following: (1) the quality of assets and its impact upon the soundness of the institution; (2) the quality of management with respect to the lend- ing and investment functions; (3) causes of existing problems and adverse trends; (4) the quality and effectiveness of loan and investment policies, practices, procedures, and internal controls; (5) the adequacy of loss reserves; (6) undue concentrations of credit; (7) loan pricing policies; (8) other matters of importance requiring attention such as foreign exchange, liquidity, or interest rate risks; (9) actions recommended for correction of problems; and (10) future expectations concerning the quality and administration of the loan and investment portfolios. (e) Summaries of criticized assets by: (1) category of classification; (2) economic sector; (3) policy loans vs. nonpolicy loans; and (4) currency (for those loans denominated in foreign currencies). The report should also define the criteria used in assigning classi- fications and explain any unusual factors that served to influence the classifications assigned. (f) Written loan comments for all criticized assets exceeding the sam- pling cutoff amount. In the case of loans, these written comments should provide a brief description of the credit including the his- tory of the indebtedness, the repayment plan and actual performance, a brief analysis of the financial statements, a description of the collateral and/or guarantees (if any), and the reasons the loan is 6/ Policy loans refers to those loans granted in accord with the national credit program or at the direction of government officials in contrast to those loans granted on commercial terms, originated by the bank on the basis of an appropriate evaluation of credit risk and other factors. - 107 - AELX_8 Attachment 7 classified. For investments and other assets, the report should provide a description of the asset, its outstanding balance, and a summary of the factors leading to its classification. (g) A summary statement of all concentrations of credit. The report should highlight those concentrations in which a significant portion is criticized. In addition, the report should comment on the fac- tors that may affect the performance of the group and note any adverse trends. (h) A description of the methodology employed to determine the adequacy of loss reserves and to recommend additions to such reserves. (i) A summary statement of all past due,ZI nonperforming, and renego- tiated loans,i/ policy loans vs. nonpolicy loans, by category or type of loan expressed (1) in renminbi amount and (2) as a percent of total outstandings in that category. The report should define the criteria used to determine past due, nonperforming, or renegoti- ated status. In addition, the report should comment upon the bank's existing policies for interest suspension or nonaccrual and recom- mend changes where appropriate. (j) A listing of large 2/ past due, nonperforming, and renegotiated loans. The report should indicate the name of the borrower, the amount outstanding, the number of days payments are in arrears (if appropriate), whether a priority sector credit, and any other perti- nent information. (k) A summary statement of off-balance sheet commitments and contingen- cies. The report should identify commitments and contingencies and comment upon any associated risks, whether credit, funding, interest rate, or foreign exchange. (1) A listing of loans not supported by current and satisfactory finan- cial information or lacking a satisfactory definition of the loan's purpose and repayment plan. The listing should include the name of the borrower, the outstanding balance of the loan, and the nature of the credit file exception. LI For all past due, nonperforming, and renegotiated loans, the outstanding balance of such loans should be reported rather than only payments affected. 8/ Renegotiated loans refers to those credits whose terms have been modified due to the borrower's inability to perform in accordance with the terms of the original contract. Examples include a reduced interest rate, extensions, renewals, and/or an extension of the final maturity date. i/ Generally, these would include loano which exceed the cut-off amount used to select the sample of loans for review. - 108 - ANNEX 8 Attachment 7 (m) A listing of loans not supported by complete collateral documenta- tion. The listing should include the name of the borrower, the outstanding balance of the loan, and the nature of the collateral exception. - 109- ANNEX 8 Attachment 7 Addendum 1 CHINA FINANCIAL SECTOR TECHNICAL ASSISTANCE PROJECT Terms of Reference for Special Asset Quality Reviews Sample Defirnitions for Gradina the Quality of Assets 1. In order to determine the quality of the loan portfolio, as well as other assets and off-balance sheet contingent liabilities, it is first neces- sary to establish criteria by which to evaluate assets. In general, this criteria is used to assess the borrower's financial capacity and ability to repay. Many countries have adopted a system of classification in which assets are categorized as current, substandard, doubtful, or loss. 2. Those assets which are considered current do not exhibit credit weaknesses that might jeopardize collection of the debt in the manner agreed to upon the loan's inception. Such loans are properly structured so that repayment is effected in a timely and realistic manner and are otherwise sound in every respect. In essence, they are good loans to good enterprises and good persons. 3. The latter three categories are considered problem assets. Their definitions follow: A substandard asset is one which has a well-defined credit weakness, or weaknesses, which jeopardizes the liquidation of the debt. It is inadequately protected by the sound net worth or payment ability of the borrower. Substandard assets are characterized by the distinct possibility that the bank will sustain some loss if the credit weakness is not corrected. Loss potential, while existing in the aggregate amount of substandard assets, does not have to exist in individual assets classified substandard. 4. For example, a substandard borrower is one which lacks Adequate cash flow to service or repay its currently maturing debts. This credit weakness may be determined from an actual lack of performance or it may be concluded on a prospective basis through an analysis of the enterprise's financial state- ments. In some instances, borrowers may appear to perform on their debts but in fact do not. It is only through the capitalization or refinancing of interest which is due and unpaid that the loan appears current. In the Chinese context, substandard assets might include loans to enterprises which are fundamentally viable but which require a moderate degree of restructuring in their operations to improve efficiency and profitability, a more conducive operating environment (e.g., decontrol of prices for their products), and a stretching out or change in the mix of their liabilities. The objectives of restructuring would be to improve the enterprises' operations so that they are more efficient, more competitive, and sufficiently profitable to adequately - 110 - ANNEX 8 Attachmant 7 Addendum 1 service their debts and provide a reasonable return to their owners. In effect, the credit wealknesses in such enterprises are, to a very large degree, controllable and correctable over the short term with a minimum of state intervention. A doubtful asset has all the weaknesses inherent in one classified substandard with the added characteristic that the weaknesses make collection or liquidation in fullp on the basis of currently existing facts, conditions, and values, highly questionable and improbable. 5. One example of a doubtful asset is a loan which exhibits the charac- teristics of a substandard asset but which is also seriously past due and inadequately protected by the realizable value of any collateral pledged. For example, assume that inventory is the sole asset of an enterprise pledged as collateral. Its sale under distressed conditions or during a forced liquida- tion might only bring a fraction of its original cost in real terms, thus significantly exposing the credit to a high probability of loss. As the result, the ultimate collection of the indebtedness in full would be consid- ered highly unlikely if the borrower were also seriously delinquent and unable to provide additional security. 6. In China, the definition of a doubtful asset should be extended to those enterprises which are fundamentally viable but require significant restructuring of their operations and debt relief or forgiveness to remove the massive overhang of obligations they owe. The assumption is that the amount of debts forgiven will be reflected on the banks' balance sheets as a write- down of the carrying value of the credit with the loss flowing through provi- sions to the b=11ks' profit and loss statements. Significant involvement of the state may be required to effect rehabilitation. Assets classified loss are considered uncollectible and of such little value that their continuance as bankable assets is not warranted. This does not mean that the asset has absolutely no recovery or salvage value, but rather it is not practical or desirable to defer writing off this basically worthless asset even though partial recovery may be effected in the future. 7. In China, assets considered as loss would include loans to those enterprises which are not viable in the short term under any reasonable cir- cumstances barring intervention by the state in the form of massive subsidies. These assets would generally fall into three categories: (a) Those that require major rehabilitation over the long term, most probably involving state intervention. These enterprises could possibly be made viable on their own merits but are not considered worthy of being carried as active assets on the books of the bank. (b) Those enterprises which are not viable but serve an essential social need, e.g., railroads, utilities, airlines, etc. Such enterprises - 1ll - ANNEX 8 Attachment 7 Addendum 1 may be kept alive because of their importance to society; however, the costs should be made explicit through direct subsidies from the state rather than indirect subsidies in the form of bank financing. (c) Those enterprises which are not viable under any circumstances. These enterprises should be closed and their assets liquidated. 8. In establishing criteria for grading the quality of credit, it shlould be understood that many enterprises which are viable today, may not be in the future as subsidies are removed and changes occur in prices for all types of goods and services. It would be difficult at best to forecast all the price changes that might occur as well as their linkages. Many enter- prises will only show up as problem borrowers at subsequent reviews of portfo- lio quality. Therefore, one should not expect that all problem borrowers will be identified during an initial portfolio review. 9. The process of portfolio review should be a continuous one that is systematically carried out by each bank's own staff, as well as by bank super- visors and auditors, as an integral part of management's controls over the lending function. In this way, problem borrowers can be identified in a timely manner so that measures can be taken to strengthen or otherwise collect the credit before it deteriorates into a hopeless situation. - 112 - ANNEX 9 CHINA FINANCIAL SECTOR TECHNICAL ASSISTANCE PROJECT Terms of Reference for Payments System Design Study Background 1. The Government of China has received a grant from the Japanese Grant Facility (JGF) to assist in the preparation and implementation of the proposed Financial Sector Technical Assistance Project. With the proceeds of the grant, the World Bank, as executing agency, is engaging a Consulting Firm (the Consultant) to assist the People's Bank of China (PBC) to develop a master plan, or feasibility study, for the further development of a nationwide pay- ment and clearing system. Study Objectives 2. The objective of the assignment detailed under these terms of refer- ence is to comprehensively address the policy, economic, financial, organiza- tional and technical aspects of further system development and recommend how implementation of a new system should be phased. The PBC has identified that the objectives of the national payments system should be to: * Strengthen Central Bank (PBC) macroeconomic management * Reduce float, speed up circulation of funds, and increase effi- ciency of funds transmission * Improve convenience and service to users * Achieve a reliable, secure, and integral payment, clearing and settlement system to meet the needs of a growing economy * Expand flexibly and modularly to suit Chinese conditions Guiding Principles 3. The guiding principles behind the design, establishment and opera- tions of the national payments and clearing system include, but are not exclu- sively limited to the following: (a) Universality of Access by financial institutions (b) Cost efficiency and self-financing through cost recovery (c) Minimization of payment system risks (d) Integrity and reliability (e) Active user participation in all phases of system development (f) Cost minimization in system design through trade-off between opera- tional presence and regulatory maasures -113 ANX 9 Scope of Study Work 4. Based upon the objec4'ves, guiding principles and scope of work indicated above, the Consultant is expected to work with counterparts to evolve a vision of the national payment and clearing system over a medium-term horizon, agree on priorities of development of payment instruments, payments accounting, processing, clearing and transmission systems, and design a flexi- ble integrated national payment and clearing system up to the bidding stage. The Consultant will also help PBC prepare and evaluate a request for informa- tion (RPI) and prepare and evaluate responses to a Request for Proposal (REP), with a final recommendation on the best ranked response. In a subsequent phase, with separate terms of reference and separate funding, the Chinese may wish to engage the Consultant to advise on the implementation of payments system installation and operations. 5. The scope of work for this assignment covers the following: (a) Stocktaking * undertake an independent evaluation of the current payments system, steps taken thus far to modernize the system and atten- dant strengths and weaknesses. This will require obtaining an understanding of China's economic, financial and regulatory structure, including the nature of business and consumer transactions and the composition and roles of institutions in the financial sector. * assess the changes which can reasonably be expected to take place in business, consumer and interbank transactions and the likely evolution of the money and capital markets in China; and * ascertain the status of specialized banks' own efforts in devel- oping automated payment systems, the state of automation and telecommunication facilities and their compatibility with the national system(s) under implementation and likely to be pro- posed for the future. (b) Vision * develop a broad vision of the payment systems which may be nec- essary to support likely changes identified over a 10-year hori- zon; * assess which types of payments instruments (credit-based, debit- based, cash, check, money-order, electronic, truncated checks) should be used in China for various purposes (high and low value business transactions, high and low value government transac- tions, high and low value consumer transactions and high and low value financial transactions, etc.) and within various geograph- ical localities (intra/intercity, intra/interprovincial, intra/interregional); * develop projections of the growth in volume and value of various existing and new payment instruments. The study may draw upon - 114 ANNEX 9 the experience of payments system development in other coun- tries, and special features and characteristics that may be relevant to the design of a modernized Chinese payments system; o assess the priorities in development of different payment in6truments, and suggest the criteria whereby such priorities can be ranked; (c) Conceptual Design * determine the objectives of the new system and subsystems, and their related applications, as well as a realistic the timetable for their incorporation. Among the applications which should be considered are: (i) Interbank payments (ii) Business payments (iii) Consumer payments (iv) Book entry securities * make allowances in proposed systems design for linkages with international payment systems * note that the development of high speed data transmission capa- bilities to support payment systems should also provide the facilities for the transmission of additional data necessary for PBC to exercise its central banking functions. These may include: - Monetary and other economic statistics reporting to PBC - Prudential/bank supervision data submission requirements - Other internal needs of the central bank, which may include text, voice and facsimile messages * determine the necessary linkages between subsystems (connect- ability); * assess (and minimize under the design) the associated payments system risk for each of the systems and instruments identified, and identify risks for the central bank and all other payments participants; * assess the impact of the present and proposed alternative sys- tems on float, the efficiency of funds transmission, timeliness and ability to measure and predict funds flows; * integrate into the system design features of reliability, secur- ity and data integrity. (d) Role of PBC and System Participants * recommend roles of PBC, specialized banks and other participants in payment system; - 115 - * recommend a suitable organization for managing and operating the system; (e) Regulatory and Accounting Framework * determine the legal and regulatory framework for the payment and clearing system in support of the instruments and systems iden- tified, and the supervision over the system; e where practical, use (and recommend) regulations as substitute for operational presence; * design accounting standards and systems to support the instru- ments and systems identified; * identify the standardization of documents and coding (numbering system for banks, branches and customers) that would facilitate the development of the national payment system noting that, where possible, standards used should comply with international standards; (f) Separate terms of reference for the legal and accounting framework have been agreed as set out in Attachment 1 and 2 to this Annex (available in project file). (g) Computer and Transmission System o design a computer and transmission system with an architecture to support the operations of identified instruments and payments systems taking into consideration efficiency, flexibility in network configuration and capable of being modularly enhanced. The design should be sufficiently detailed to permit potential systems suppliers to respond in a comparable manner to the bid- ding documents. * provide cost estimates for planning purposes. (h) Phasing and Implementation Schedule * design implementation phasing and scheduling of the proposed payments system. (i) Training and Technical Assistance * identify and elaborate training and technical assistance requirements. (j) Cost Estimates and Cost Recovery * estimate operation costs; * develop method of cost recovery. - 116- ANNEX I (k) Separate terms of reference for work ou cost recovery have been agreed as set out in Attachment 2 to this Annex (available in proj- ect file). (1) Bidding Documents * develop bidding documents for software and equipment procurement and necessary consultant activities to bring project into imple- mentation; * assist in a multi-stage International Competitive Bidding pro- ceses including: - Stage 1. Informal supplier contact leading to preparation of Request for Information (RFI) and, if RFI is to be used for prequalification, elaboration of evaluation criteria and evaluation of responses to establish short list of qualified firms; - Staze 2. Preparation of Request(s) for Proposal(s) (RFP) and elaboration of evaluation criteria; and - stage 3. Evaluation of bids, including participation in vendors' conference, response to questions posed by vendors, preparation of any revision to RPP and final evaluation of bids leading to the recommendation of the best ranked vendor. Note that model bidding documents and contracts in conformity with World Bank requirements have already been prepared. (m) Interim Enhancements * given the lag time in implementing any new payment system design, examine how the existing satellite system can be enhanced and upgraded to meet rising current payment system demands. System Design Considerations 6. The design of the national payments and clearing system is crucial to the development of the financial sector in China. The following seeks to elaborate on the scope of work and identify some, but not all of the system features, characteristics and issues to be studied, on which recommendations should be made by the Consultant and policy decisions made by PBC and incorpo- rated into the system design. This is not an all inclusive listing and the design characteristics should not be limited to these elements. The Consul- tant may wish to make alternative suggestions or solutions to issues, including incorporating into the final system design viable suggestions received from vendors responding to the Request for Information (RFI) and Request for Proposal (RPP). The Consultant may engage in earlier informal contact with interested suppliers in order to: * obtain technical information; - 117- ANNEX 9 * check on the feasibility of meeting requirements with technical solutions likely to be available in the market; * check on the ability of suppliers to conform with poten- tial technical architecturesl and * speed up the process of reaching agreement on a viable technical design. (a) Projections and System CaBacity (i) Current volume of transactions by financial instrument, appli- cation type and regions. (ii) Projected volumes by instrument (including new instruments), application type at intervals over the next 10 to 15 years and indicate broad scenarios of peak traffic. (iii) Vision of development of payments transactions geographically. (b) System Characteristics (i) Choice of payment instruments (paper-based vs electronic funds transfer) and systems and use of check truncation. (ii) Use of debit and credit payment systems and linkages between the two. (iii) Choice of telecommunications system, including appropriate backup, for example, the possible usage of packet-switching system being developed by PTT. (iv) Linkage between automated subsystems and manual systems (sub- systems connectability and compatibility). (v) On-line vs. batch processing. (vi) System accessibility (means of assuring universal access to clearing services/openness to nonclearing bank institutions). (vii) Convenience--system must be user-friendly, adapted to culture, habits and local conditions. (viii) Capacity and upgradability--system should have medium- to long- term horizon capability to meet projected volume of transac- tions, and be modularly enhanced without complete overhaul. (ix) Flexibility and compatibility--system should be easily inte- grated with other subsystems, such as ATM network, EFTPOS, payroll payments and new instrument/applications and processes. (x) Policy with regard to use of daylight/overnight overdrafts, regulations/procedures to ensure adherence to adopted policy, monetary policy implications of different approaches. -118 - ANNEX 9 (xi) Integration with internal accounting systems of PBC and other banks, including methodology of settlement at clearing bnlances with PBC branches. Examine where methodology of reserve main- tenance a 1 accounting could be simplified and improved without reducing monetary control. (xii) Design of payments grid (centralization V8 decentralization, levels of clearing). (c) Standards. Security and Reliability (1) Uniform numbering system and coding (ii) Document standards and formats (iii) Communications protocols and standards (iv) Compliance with international standards (v) Minimum requirements for system security and reliability (vi) Internal controls and audit trails (vii) Restart/recovery procedures (viii) Contingency backup arrangements (ix) Authentication procedures (d) Organization (i) The roles of the PBC, specialized banks and other banks in owning and operating the modernized payments system. Who should own and operate the system: PBC? a subsidiary of PBC? a consortium of banks? a consortium of banks and PBC? If owned and operated by PBC, what would be the incentives for banks to use the system? Examine the ownership, composition, membership and organizational structure and issues. (ii) Organization of the system: Detailed recommendations regarding organizational structure, management and staffing, staff train- ing programs, budgets, timetables for institutional develop- ment, internal reporting arrangements and other pertinent mat- ters. (iii) System of supervision over payments system, including stan- dards, operations and development. Who will supervise and how. (iv) Legal and regulatory framework for payments, including defini- tion of contractual rights and obligations for payment instru- ment (t.g., paperless funds transfers). Adequacy of existing framework and recommendations on new legislation/regulation which may be necessary for the new system. -119- X (v) Framework for information flows with respect to bank supervis- ory, monetary and system safety needs. (e) Financing and Cost Recovery (i) Cost/benefit analysis by application type and viability of proposed system design. Evaluate alternative system design costa. (ii) Method and allocation of funding development costs (iii) Product pricing and cost recovery principles by application type. (f) Implementation Phasing and Schedule (i) Recommend phasing of different applications, subsystems and other system designs, such as legal framework, standardization work and training. (ii) Recommend the timing of expansion and enhancement to the satel- lite transmission systema and coordinate with developments in other subsystems, such as check clearing system. Ciii) Draw up design, tender, installation, training and cut-over schedule. (iv) Wheve pilot tests and phased installation in different locali- ties are required, develop criteria for prioritizing installa- tion by geographical region. *g) Tra iing and Technical Assistance Ci) Define and elaborate technical assistance and training require- ments Cincluding nature, phasing, costing, terms of reference) for PBC in order to implement and operate the new systems. (ii) Define and elaborate technical assistance and training require- ments also for specialized banks and system participants, if needs identified. (h) Technical Specifications (i) Define technical specifications for any hardware and software (with cost estimates) in sufficient detail to enable vendors to submit proposals as to: hardware configuration to meet system needs * subsystem software package specifications, plus necessary overall system software system telecommunications network and infrastructure - 120 - ANNEX 9 * development of system procedures and operation manuals * estimates of time and costs as to installation, mainte- nance and operations (ii) Assess the desirability of enhancing the existing satellite- based system and the issues and problems of incorporating the existing satellite-based system as the core system within the whole system architecture. (i) ProRosal Evaluation (i) Based on invited bids according to international competitive bidding procedures of the World Bank, help evaluate vendor proposals and bid as to: Vendor's technical and financial capacity to meet specifi- cations submitted Understanding and experience of work environment and regu- latory framework in China Responsiveness to criteria and technical specifications of bidding documents Ability to draw upon relevant international and regional skills and experience, particularly those with Chinese language capabilities * Proposals for alternative and more efficient solution to system design * Demonstration of vendor installation, operational and support experience in projects of equivalent size, scope and complexity * Cost and overall effectiveness of proposal Proiect Management 7. The Project involves the close coordination and cooperation of dif- ferent parties within China (e.g., various governmental agencies, PBC (includ- ing different departments therein), the banking system, telecommunications authorities, etc.), the World Bank and the proposed panel of central bank experts. To ensure such coordination, a number of planning, advisory and implementation groups would be formed. The Consultant will provide backup, liaison and technical advice to these groups as and when necessary. 8. The following constitute preliminary ideas on the types of groups which may be formed and their membership. The PBC Steering Committee, which will designate a project office as its executive agency, and two Advisory Groups are expected to be established for the Project. Other ad hoc groups may be established, depending on the level of design activity and complexity involved. The Consultant would be expected to advise on the formation of - 121- ANNEX 9 these groups to ensure that relevant skills, resources, action and reports are coordinated and produced on schedule. The overall chart of the organization of -.he payment system project is provided in Attachment 3 to this Annex. Attachment 4 lists some of the consultant's assumptions about the basis for workin3 with the PBC, the relevant committees and subcommittees and others involved in the project. (Attachments may be found in project file.) (a) PBC Payments System Steering Committee 9. This PBC in-house committee will include senior PBC staff with func- tional responsibility for areas involving the new payments system, in terms of both planning, implementation, operations and policy implications. Such rep- resentation should include, but not necessarily be limited to: (a) The chairmanship, by senior PBC management with direct responsibil- it, for the project (b) Accounting (c) Data processing/data communications (d) Research/economics (e) Supervision and regulation (f) Central Bank clearing house/payment operations (g) Money and foreign exchange market trading function (h) Legal (i) Project Consultant 10. Committee representatives will have associate members (being techni- cal staff assigned full time to the design team) who will provide the techni- cal backup in terms of data collection, analysis, coordination and follow-up. Being intensely involved in the design and planning stage, these individuals will be able to provide the continuity and institutional memory in the imple- mentation of the new payments system. (b) Domestic Advisory Group 11. This is the domestic advisory and coordination group that may help the design and implementation of the new payments system, and may include (but is not restricted to) the following members: (a) Chairman from PBC (Deputy Governor or his representative) (b) Representatives from specialized banks--at levels able to advise on policy and technical specifications (a) Representative of Telecommunications Department, able to help coor- dinate work with national telecommunications planning - 122 ANNEX 9 (d) Representatives of consumers or enterprises, who are able to offer user points of view (e) Project Consultant 12. This group is expected to meet at least on a monthly basis. It is noted that policy decisions on the payments system rest with the PBC, which has the legal responsibility for the national payments system. (c) International Advisory Panel 13. The PBC has decided to invite a panel of experienced experts from major international central banks/payments systems to be selected in consulta- tion with the World Bank to provide guidance and technical advice to the PBC in the design and implementation of the new payments system. These experts would form an Advisory Panel which would meet periodically to provide policy guidance to the Steering Committee. The World Bank ia expected to participate in all Advisory Panel meetings. 14. These experts are expected to provide a breadth of experience and knowledge on the problems, issues and complications in the design, planning and implementation of a large payments systems, on which the Steering Commit- tee may draw upon periodically. Areas on which the Panel may be called upon to advise may cover the following: (a) the role of the Central Bank in the payments system: supervision, ownership of automated clearing system, the transmission of pruden- tial and monetary information through the network, and implicatione on monetary policy; (b) the regulatory framework of large volume consumer payments, and low volume/high value interbank payments; (c) the experience of central banks in installing, owning or -ooperating in management of automated interbank clearing/payments system and the policy options regarding the acceptability or not of daylight overdrafts; (d) the open access nature of modern clearing system, which allows non- bank entities to supply payment instructions in pre-agreed format that facilitates large number of payments through one central instruction; (e) the availability of specialist skills, software or hardware that may help expedite project design, installation or operations; (f) the telecommunications implications and problems in setting up multi-polar networks/clearing centers moving funds over long dis- tances. 15. The Consultant is normally expected to participate in discussions between the Steering Committee and the Advisory Panel, but is not envisaged to report to the Panel, as the Consultant will be directly responsible to the Steering Committee. -123- ANNEX 9 (d) Other Subcommittees 16. Other subcommittees may be established or convened as needs are identified. The Consultant will be expected to lead these subcommittees or task forces, by helping to design terms of reference, and generally be respon- sible for reports that help in the formulation of design alternatives, policy choices and decisions by the Steering Committee. The composition of these subcommittees will depend on the nature of tasks assigned. They will comprise PBC staff members and may include experts drawn from specialized banks and other fields. Not precluding other subcommittees being formed, it is expected that five subcommittees may be established, comprising a Payment Systems Sub- committee to consider the detail of alternative payment instruments and their associated clearing and settlement systems, a Research and Statistics Subcom- mittee that will help in volume projections and research studies, a Legal and Regulatory subcommittee to study and prepare drafts of law and regulations, an Accounting and Standards Subcommittee to decide on standardization of documen- tation, numbering systems, etc., and a Computer and Telecommunications Subcom- mittee to undertake detailed technical specification and design work. 3e) Lucal Experts 17. Given the language problem facing foreign consultants, and the need to understand well Chinese financial structure, regulatory framework, account- ing practices and general conditions, Chinese experts other than PBC counter- part staff may be appointed to participate actively in the Project, to facilitate communications, contribute and interact on technical issues. (a) PBC may include a Chinese expert on the International Advisory Panel (other than the Chairman). (b) Local experts may be appointed as members of the subcommittees. These experts are not paid by the Consultant. Project Schedule 18. The advanced stage of implementation of the satellite-based trans- mission system and other related work in Phase I, plus the rising volume of transactions indicate that the design and lmplementation work for the National Payments and Clearing System is urgent. Given time constraints, and the con- siderable body of preparatory work already accomplished, it is anticipated that the Consultant will be able to complete the main body of work (i.e., through finalization of the Request for Proposal (RFP)) within 15 months. Assuming PBC issues the REP between month 17 and month 21, the balance of work (i.e., through evaluation of final bids in response to the RFP) should be completed within between 21 to 28 months from the start of the assignment. Should PBC require more than six months to issue the RFP, the Consultant will have the option under Section 3.02 td) or 6.04 (a) of the contract to termi- nate the services and the Bank accordingly to reduce the amount to be paid. During the early part of the assignment, the Consultant will draw up a detailed work program, outlining priorities and identifying key areas where subteams should begin work immediately. This work program should be discussed and agreed between the Consultant and the Steering Committee. - 124 - ANNEX 9 Consultant OutPut 19. During the duration of the assignment, the Consultant is expected to produce the following written major reports and output (month 1 being October 1991): (a) Stocktaking report end month 4. (b) Vision Report, including operating capacity projections by mid-month 6; (a) Interim enhancement report by mid-month 6; (d) Preliminary Concept Design by end-month 6; (e) Request for Information (RFI) by end month 10; (f) Detailed System Design Report: First draft by end month 9 and final draft by end month 10; (g) Draft Request for Proposal (RFP) to the PBC and world Bank by end month 13; (h) Finalize RFP (assuming timely receipt of comments from PBC and World Bank) by end month 15; and (i) Vendor evaluation report, subject to paragraph 18. A bar chart reflecting the above schedule of outputs is included on page 2 of Appendix B (in project file). 20. The Consultant will also be expected to submit brief progress reports on activities detailing achievements, problems encountered and solu- tions proposed, every month. These reports will include information on expenditures incurred and a proposed budget for the next period. More detailed reports will be prepared quarterly. - 125 - ANNEX 10 CHINA FINANCIAL SECTOR TECHNICAL ASSISTANCE PROJECT Ministry of Finance The Degartment of Accounting Administration Affairs Terms of Reference for Development of Accounting Standards Introduction 1. Starting in 1978, China began a process of economic reform involving the introduction of market forces to increase economic efficiency and a pro- gressive opening up of the economy internationally. The Ministry of Finance (MOF), which is responsible for administering the national accounting frame- work per the 1985 Accounting Law, recognizes that in order to support these changes, it urgently needs to fundamentally redesign current accounting stan- dards and systems to bring them in harmony with international practice. 2. The existing accounting standards and systems are oriented to ensure compliance with rules and were suitable for use in a centrally planned economy with limi'.ed decision making at the level of the enterprise or individual. However, an economy influenced by market forces requires standards and systems which provide clear and transparent financial information to enable managers to effectively manage and external interested parties--regulators, creditors, shareholders, depositors--to readily measure and compare financial performance of economic entities at all levels. This requires standards which possess consistent qualitative characteristics, such as understandability, relevance, materiality, reliability, fair presentation and timeliness. China's existing accounting standards and systems do not provide this essential information, support and confidence. 3. In 1988, MOF established within its Department of Accounting Admin- istration Affairs (DAAA) a seven person Task Force with a mandate to develop a new accounting framework for the nongovernmental sectors, elaborate new accounting standards in harmony with international practice and revise related accounting manuals, charts of accounts and reporting formats. This Task Force has made strides in designing a work program and researching accounting stan- dards and practices internationally. It is preparing the necessary groundwork by designing the fundamental framework of accounting concepts, a first draft of which was prepared in November 1991, and is expected to be promulgated latest by end-1992, after revisions based on comments on the draft. The framework will be in harmony with the framework adapted by the International Accounting Standards Committee (IASC), suitably adapted for accounting opera- tions in China, and will explicitly recognize the need to provide for finan- cial accounts and reporting which are independent of tax accounts and taxation reporting requirements, as compared to the existing requirement that state- ments for financial reporting purposes must conform to those for tax purposea. 4. Much work remains to be done in a very limited time, particularly to complete the essential 28-30 general (or basic) accounting standards, and to - 126 - ANNEX 10 commence the formulation9 publication and promulgation of sector and enter- prise-specific accounting standards. The DAAA intends to develop at least 25 of the general standards within two years of the start of the technical assis- tance program (see para. 7) and to complete the general standards within three years of the start of the program. In developing the general standards, priority will be given in the first two years to standards important for the financial sector, both because its activities impact oni most other sectors and to provide the framework for parallel work on the part of the PBC to develop, on behalf of MOF, specific standards for the financial sector. 5. Because of the importance and ongoing nature of the accounting stan- dards modernization program, the DAAA intends to designate a permanent group of at least seven qualified and excperienced staff charged with elaborating the new standards9 with the Task Force continuing to play a key consultative role. This group will collaborate closely with other DAAA divisions having responsi- bility for accounting control of specific sectors and forms of enterprises; with other departments of the MOF, such as the Taxation Policy Department; with PBC which has operational responsibility for accounting standards and systems in the financial sector; and with line Ministries which are concerned withi the monitoring and control of the performance of enterprises and organi- zations in their sectors. It will also collaborate closely with the Chinese Society of Accountants (CSA)9 which has established an advisory group to assist the DAAA Task Force in the elaboration of new accounting standards. 6. Promulgation and implementation of new accounting standards will need to be preceded by a very large program of information dissemination mostly through seminars, advisory services and training. The DAAA intends to use its available facilities and organizations, such as the Zhonghua Account- ing Correspondent School (ZACS) based in Taiyuan, and the China Institute of Certified Public Accounts (CICPA). Assistance will also be obtained from universities a,-' technical schools. O}verall Technical Assistance Prgram 7, The proposed Financial Sector Technical Assistance Project will support a three-pronged program of technical assistance for MOr, PBC and the Audit Administration of the People's Republic of China (AAPRC) to modernize China's accounting and auditing framework. Support to MOF will include ser- vices of a consulting firm to assist DAAA in developing and promulgating new general accounting standards and financial reporting formats and in under- taking related activities (the subject of this Terms of Reference); the ser- vices of a consulting firm to assist the CICPA, which is under the overall direction and control of the DAAA, to help design a nationwide system of Continuing Professional Education (CPE) for certified public accountants (CPAs); and a technical adviser to help coordinate and manage the overall program oi activities under the DAAM's jurisdiction. Support to PBC will include consultant services and training activities to assist PBC in develop- ing accounting standards specifically for financial institutions and in strengthening PBC's own accounting and internal audit systems. Support to the AAPRC will include consultant services to help AAPRC develop auditing standards. - 127 - ANNX 1Q Obi2ctLve andl Se Iofth A -nmt 8. DAAA proposes to engage the services of an international accounting firm, in collaboration with a local CPA firm (hereinafter referred to as the Consultant), to assist in developing and introducing miodern accounting stan- dards and systems which are in harmony with international practice. The DAMA standard setting group, to be established (para. 5), will be desigrnated as the Consultant's counterpart and as such will work closely with and provide any necessary assistance and inputs to the Consultant during the course of the assignment. The services to be provided by the Consultant includeg Part A. General accounting standards--to advise and assist the DA&& in the design, drafting and exposure of drafts of the basic 28-30 general accounting standards, chart or code of accounts and forms of financial reporting statements; conduct of review meetings of expo- sure drafts; reviews of comments on exposure drafts; preparation of final drafts; and promulgation activities. The Consultant and DAAM will elaborate and agree, within two months of the start of the assignment, on a work plan specifying which standards are to be developed and the sequence and timetable in which they will be developed. The consultant will also elaborate a strategy and time- table for implementing the newq general standards. Part B. Seminars--to advise on the design and arrangements for and deliver at least five seminars (for central and local level staff of MOF and line ministries as well as key enterprises) of international standard to discuss and review the emerging new accounting standards and financial reporting requirements; organize the attendance of appropriate speakers; prepare reports on proceedings; and recommend on the use of the results in the preparation and delivery of accounting standards. Unless otherwise agreed with the DAAA9 the Consultant will deliver one seminar in the first year of the assign- ment, two in the second year and two in the third year. Part C. Publicity and advisory services--advise on the design of appropriate publicity campaigns and advisory services; design and recommend on the organization needed to deliver such campaigns and services by DAA and organizations nominated by DAAA to assist in these activities; design publicity and other information documenta- tion on new accounting standards and systems, including "hovw-to-use" information and advice on sources of guidance, in order to achieve maximum coverage by well-prepared announcements and advisory mate- rial at all levels of accounting and financial management in China. Part D. Training--advise on and design appropriate training materi- als in the appropriate form (textt, audio-visual and computer presen- tation) for the training of accotnting staff in China at all levels in the application and use of the new accounting standards and related systems. In particular, the designs should reflect the needs of universities, colleges and other training establishments such as the MOP's ZACS, which will be required to train new students as well as retrain alumni (past students) in the new approaches and techniques. The Consultant will also advise the CICPA on a plan for the design and delivery of an appropriate training program for CPAs - 128 - ANNFX 12 to enable the latter to provide an immediate service to clients with respect to implementation of the proposed accounting reforms. Duration of the Assigment 9. The assignment is to be completed in three years from the date of award of the contract. ReDorts to be Provided 10. The Consultant will be required to produce the following outputs: (a) a draft work plan and timetable for developing and sequencing the general standards (para. 8, Part A) by the end of the first month of the assignment and, assuming receipt of DAAA comments within two weeks, a final plan agreed with DAAA by the end of the second month; (b) a draft strategy and timetable for implementing the new standards by the end of the fifth month of the assignment, and assuming receipt of DAAA comments within two weeks, a final draft strategy agreed with DAAM by the end of the sixth month (para. 8, Part A); This strategy would be subject to amendment as the work progresses; (c) completion of at least 25 general standards within 24 months of the start of the assignment and the remaining general standards within three years of the start of the assignment;1/ 'd) a quarterly report setting out the progress of the assignment under each Part A, B, C, and D; details of staff engaged during the period covered by each report and proposed budget for the next period; and any matters to which the attention of the DAAA should be drawn; and ae) a draft final report two months before the end of the assignment and a final report one month thereafter. 11. The DAAA will give comments on any report submitted by the coneul- tant, within an elapsed time of no more than four weeks, except as otherwise indicated above. Location of the Assignment 12. The primary location of the assignment will be in Beijing. However, the Consultant will be expected to travel in China as necessary to fulfill the Terms of Reference. Other Considerations 13. The consultant is expected to liaise with other concerned agencies, particularly PBC and AAPRC, in undertaking the assignment to ensure consis- tency. l/ If called for during the course of the assignment, changes to this sched- ule could be made, but only with the agreement of the DAAA, the consul- tant and IDA. - 129- ANNEX 11 GHINA FINANCIAL SECTOR TECHNICAL ASSISTANCE PROJECT China Institute of Certified Public Accountants Terms of Reference for the Design of a Program of Continuing Professional Education (CPE) Introduction 1. Professional accounting and auditing services in China are provided by two different types of domestic entities. Certified Public Accounting(CPA) firms fall under the jurisdiction of the Ministry of Finance (MOF) and are empowered to undertake all types of accounting services and audits of nonstate enterprises. CPA firms, by regulation, must be staffed by CPAe, who also fall under the jurisdic'tion of MOF and who maintain their CPA title only if they work for a CPA firm or as independent accounting consultants. Auditing firms are authorized by the Audit Administration of the People's Republic of China (AAPRC) and may undertake audits of state enterprises. There are also office. in China of international accounting firms, but their activities are limited to management consulting and other nonaudit services. 2. In 1986, MOF established the China Institute of Certified Public Accountants(CICPA) with the objective to develop, improve and maintain the highest standards of accounting and auditing services in the country. MOP has delegated to the CICPA, which is headquartered in Beijing, responsibility for providing day-to-day regulation and performance monitoring of CPAs and CPA firms. Accordingly, the CICPA has authority to approve the establishment of CPA firms and to define their work functions; to designate persons as CPAs by examinations conducted by CICPA (though CICPA has yet to conduct its first examination) or by reference to length of service and nature of experience; to formulate and enforce a code of ethics for CPAs; and to monitor training of CPAs. Training is to include Continuing Professional Education(CPE). Overall Technical Assietance Program 3. The proposed Financial Sector Technical Assistance Project will support a three-pronged program of technical assistance for MOF, the People's Bank of China (PBC) and the Audit Administration of the People's Republic of China (AAPRC) to modernize China's accounting and auditing framework. Support to MOP will include the consulting services to assist the MOF Department of Accounting Administration Affairs (DAAA) in developing and promulgating new general and sector specific accounting standards and financial reporting for- mats and in undertaking related activities; the consulting services to assist the CICPA to help design a nationwide system of Continuing Professional Educa- tion (CPE) for certified public accountants (CPAs) (the subject of this Terms of Reference); a technical adviser to help coordinate and manage the overall program of activities under the DAAA's jurisdiction; a series of training seminars, study tours and secondments for DAAA staff; and some essential equipment, essentially for the Zhonghua Accounting Correspondent School - 130 - (ZACS). Support to PBC will include consultant services and training activi- ties to assist PBC in developing accounting standards specifically for finan- cial institutions and in strengthening PBC's own accounting and internal audit systems. Support to the AAPRC will include consultant services to help AAPRC develop auditinig standards and an auditing manual as well as some training. Oblectives of Asseinment 4. A CPE program is vitally important to ensure the maintenance of a continuing high level of skills in the accounting profession. Accordingly, the CICPA proposes to engage the services of consultants (hereinafter referred to as the Consultant) to undertake a study wi':h the following objectives: (a) recommend the levels of CPE which must be required by each CPA to maintain CPA certification; (b) define appropriate training programs to achieve the levels of CPE in (a) above; (c) define the minimum time inputs (annually or per any other acceptable period) which a CPA must devote to CPE in order to maintain CPA certification; (d) recommend the most appropriate means for the CICPA (directly or through other entities) to deliver the training programs recommended in (b) above; and (e) design a system for recording and monitoring the attendance and performance of CPAs undertaking CPE. Scone of the Work 5. The Consultant is required to provide the following outputs: A. Definition of Levels of Knowledge and ComDetence Reauired 6. Provide precise expressions and definitions of the level of know- ledge and professional competence in such subjects as accounting, financial management, financial reporting, auditing and economic law, which each CPA should consistently possess to maintain the highest qualifications achievable in China. Such levels of knowledge and competence should be greater than required of candidates taking the CPA, university and/or college examinations, since CPE is intended for persons having already qualified as CPAs. The con- sultant should consider all relevant matters, particularly: (a) Law. Awareness of, and competence in applying, all regulations relating to accounting, auditing, financial management and financial reporting as well as the legal framework covering the operations of financial and nonfinancial enterprises, including laws covering joint stock companies, joint ventures, banking operations, conglom- erates and consolidated financial reporting. - 131 - AEX (b) Knowledge and application of accounting and auditing standards, guidelines, and practices, including s-etor-specific accounting systems and financial reporting requirements. (c) The need for skill and experience in new and modern approaches to accounting and auditing, particularly management and cost accounting techniques, e.pplication and use of computing software and computer auditing techniques. (d) The need for capabilities to train others and prepare relevant training materials. (e) Knowledge of current international developments in accounting, financial management, financial reporting and auditing. (f) Knowledge of and competence in applying cW.rrent taxation laws and regulations. (g) Knowledge of state, provincial and other applicable law :lnvolving legal actions relating to accounting, financial reporting and audit- ing. B. Development of Outline Training_ Pro rams 7. The Consultant is required to prepare two broad outlines of feasible (practical) CPE training programs which will address the subject areas identi- fied as per A. above. One outline will cover "refresher training," that is training to maintain skills in subject areas already familiar to the CPA; the other will cover "new skills training," that is training in subjects with which a CPA may not be skilled because the subject was not taught at the time when he qualified. Each outline should be two tiered, with the first tier defining subject areas (e.g., cost and management accounting, bankruptcy and receivership, basic accounting etc.) and the second tier defining courses within each subject area (e.g., within cost and management accounting, possi- ble courses would include "Just in time," inventory control, materials manage- ment and floy, etc.). Courses identified within subject areas should be designated as primary or secondary courses. C. Recommended Time Inputs by CPAs for CPE 8. Refresher Training. With regard to refresher training, the consul- tant should recommend the overall number of hours of training which a CPA should undertake per a given elapsed time period, for example, every one or two years, to give a reasonable assurance of the maintenance of CPAs' general skills and competence. In making this recommendation, the Consultant should aim for a CPA to be able to u,idertake the training programs recommended in B above within a reasonable elapsed time period, for example five to seven years. The Consultant should further recommend on appropriate mixes of train- inS subjects which a CPA should undertake as a minimum. For example, it would not be acceptable for a skilled auditor to undertake only auditing courses; he should also be required to take courses in other subject areas. In additiorn, the Consultant should recommend how often refresher training in those courses most appropriate to a CPA's normal or regular duties and responsibilities - 132 - ANNEX 11 should be undertaken in order to ensure maintenance of adequate skills. As an example, for a CPA skilled in audit sampling techniques, it may be necessary to advise on a refresher course once in every five years; for a CPA skilled in computing software for accounting, in which there may be frequent changes, an updating seminar every two years may be appropriate. 9. New Skills Training. A number of CPAs may not be skilled in certain subjects, such as computing, or management accounting, because these subjects were not in existence, or not taught at the time when they graduated or quali- fied. It is, therefore, necessary for the Consultant to recommend a list of basic training courses and/or seminars, with time requirements, which a CPA must attend to acquire new knowledge and skills. These training courses/seminars would be a key element in CPE but would be additional to the recommended periodic time inputs recommended for refresher training in para 8 above. D. Recommend on Methods of Delivery of CPE Trainina 10. The Consultant is required to recommend appropriate approaches to training in the various subject areas (for example, classroom instruction by professcrs, instruction by audio-visual techniques). In addition, the Consul- tant should acquire a working knowledge of those training facilities which could provide accommodation and facilities for accounting training at CPE levels in China. These should include the principal universities and col- leges, and the nationwide accounting training facilities of the various State and provincial g_~vernments, such as the MOF's Zhonghua Accounting Correspon- dent School(ZACS). Based on this knowledge, and with the inclusion of any practical ideas for accounting training not yet developed in China, the Con- sultant should dev3lop and recommend on locations, premises, facilities, equipment, teaching materials and texts likely to be required to implement the CPE program. The Consultant's recommendations should be practical and suit- able for implementation in China. Priority should be given to the use of existing facilities. 11. The following is offered to the Consultant as one means of defining the training accommodation, facilities, etc., requirements; the suggestion is not required to be adopted by the Consultant, but he should offer a similar "package" approach which can be used to determine future physical and funding requirements. The CICPA wishes to be able make investment decisions, if possi- ble, on the simplest of possible numerical calculations. 12. The suggested approach is to develop modular training packages, by numbers to be trained, the subjects to be delivered at a training center and the minimum facilities required, for example, a training facility to accommo- date xxx CPAs for CPE, to deliver xxx one-hour subjects per week would require xxx square centimeters of accommodation, and Y xxxx investment in equipment, materials, etc. Such a modular training package would include accommodation, associated facilities such as rooms for instructors, equipment, etc., which would accommodate specified numbers of persons. As an example only, Module 1 might be for 20 persons, Module 2 for 30 persons, and so on. 13. The Consultant is to recommend on packages which incorporate features such as the following: - 133 - ANNEX 11 (a) locations and facilities which are available for CPE training with- out adaption of premises, that is, at no cost (other than rent); (b) locations and facilities which could be made available for CPE training, but which would require an investment of, for examples - not exceeding Y 50,000 - between Y 50,000 and Y 100,000 - between Y 100,000 and Y 200,000 (c) descriptions, quantities and prices of equipment required for defined levels of training package; (d) required textbooks and other required instruction materials; and .e) any other physical requirements to achieve satisfactory delivery of CPE. 13. The Consultant should estimate in 1992 prices the start-up and annual operating costs for each of the above inputs for specific packages, rAnd should estimate the numbers of each type of package likely to be required centrally and in each province in the years 1995, 2000 and 2005. The Consul- tant should also recommend possible systems for cost recovery for CPE training for elaboration under future contracts to be awarded by CICPA. E. Design of a Monitoring and Evaluation System of CPE Performances 14. The Consultant is required to design (but not install) all parame- ters of a monitoring and evaluation system for the CPE program, with the objective of enabling the CICPA centrally, and at provincial levels, to deter- mine the continuing effectiveness of the CPE program. The system should enable the CICPA to (a) monitor the attendanca and evaluate the performance during CPE of each attendee and (b) evaluate the performance of instructors and systems of program delivery, e.g., audio-visual systems. Design of the system should include an estimate of the quantity and cost of the personnel, equipment, materials, records, etc. which will be required to set up and main- tain the proposed monitoring and evaluation programs. Duration of the Assignment 15. The assignment is to be completed within five months from the date of contract signing. Reports to be Provided 16. The Consultant is required to provide the following reports; (a) a draft report on Parts A, B and C within 9 weeks of commencing work; (b) a draft report on Part D within 12 weeks of commencing work; (c) a draft report on Part E within 14 weeks of commencing work; - 134 - &NNEX II (d) a final draft report on the assignment within 16 weeks of commencing work; and (e) a final report at the conclusion of the assignment. 17. The CICPA will provide the Consultant with comments on the draft reports within 14 days of the receipt thereof. In the event that no comments are received by the Consultant on a draft report within that time frame, the consultant shall be free to proceed with the remainder of the assignment on the assumption that the draft report was acceptable to the CICPA. 18. Reports should be produced in Mandarin Chinese and in English. Location of the Assignment 19. The assignment will be based in Beijing, where the CICPA head- quarters are located. However, it is expected that the Consultant will need to travel widely in China to obtain key data, and that numerous enquiries may need to be made by telephone, fax or other such means. Therefore an opera- tional center having immediate access to these facilities will be desirable. Submission of Proposals 20. Proposals to execute this assignment should be made in copies and should be received by not later than close of business on (date) by: Zhang Deming, Secretary General, CICPA, 2 Nanhengjie Sanlihe, Xichengqu, Beijing 100045 - 135 - AMMLJ CHINA FINACIAL SECTOR TECHNICAL ASSISTANCE PROJECT Hinistry of Finance Department of Accounting Administration Affairs Terms of Reference for Special Adviser Introduction 1. The 1985 Accounting Law of the Peoples' Republic of China vests the Ministry of Finance (MOF) with overall responsibility for mandating nationwide accounting standards and related matters. Per its mandate, the MOF has issued a series of accounting regulations governing different sectors and functions. 'While retaining the right of final approval, MOP, however, has left opera- tional responsibility for elaborating the accounting systems of financial institutions with the People's Bank of China (PBC), the Central Bank, and relied on the inputs of line ministries for the accounting systems of some nonfinancial sectors. Within the MOF, the Department of Accounting Adminis- tration Affairs (DAAM) has the responsibility for accounting matters. DAAA exercises this responsibility through a staff of 70 organized into six divi- sions, an accounting standards Task Force (see below) and an administrative office. Responsibility for audit of state-owned entities lies with the Audit Administration of the People's Republic of China (AAPRC), established in 1983. 2. The accounting standards and systems in force in China, by regula- tion or tradition, are oriented to ensure compliance with rules. They were suitable for a centrally planned economy with limited decision making at the level of the enterprise or individual. However, since 1979, China has embarked on a program of economic reform, involving progressive opening up to the outside world and introduction of market forces. Successful implementa- tion of this program will require a fundamental redesign of current accounted standards and systems to bring them in harmony with generally accepted accounting principles (GAAP) internationally. The accounting standards to be developed would need to possess consistent qualitative characteristics, such as understandability, relevance, materiality, reliability, fair presentation and timeliness. This would enable financial statements to meet the essential requiremi...; of providing enterprise managers clear and transparent informa- tion on the performance of their enterprises as well as providing external interested parties--creditors, shareholders, depositors, etc.--effective means of measuring and comparing financial performance of economic entities at all levels. 3. The DAAA has for some time recognized the need for a fundamental redesign of Chinese accounting standards and systems. In 1988 the DAAA estab- lished a seven person Task Force to develop a new accounting framework for the nongovernmental sectors, elaborate new accounting standards in harmony with international practice and, accordingly, revise related accounting manuals, charts of accounts and reporting formats. This Task Force has made impressive strides in designing a work program and researching accounting standards and - 136 - ANNEX 12 practices internationally. It is preparing the necessary groundwork by designing the fundamental framework of accounting concepts, which will be ready in draft form in October 1991 and is expected to be promulgated in the first quarter of 1992; after revisions based on comments received on the draft. The concepts will be in harmony with the framework adapted by the International Accounting Standards Committee (IASC) suitably adapted for accounting operations in China. 4. Much work remains to be done in a very limited time, particularly to complete the essential general (at least 28-30) (or basic) accounting stan- dards, and to commence the formulation and publication of sector and enter- prise-specific accounting standards. The DAAA intends to develop at least 25 of the general standards within two years of the start of the technical assis- tance program (see para. 7), to complete the general standards as well as sector-specific standards for at least three sectors within three years of the start of the technical assistance program and to complete sector-specific standards for an additional seven sectors within four years of the start of the program. In developing the general standards, priority will be given in the first two years to standards important for the financial sector, both because its activities impact on most other sectors and to provide the frame- work for parallel work on the part of the PBC to develop, on behalf of MOF, specific standards for the financial sector. Attachment 1 contains a tenta- tive listing of the sectors which the DAAA will target in this three-year period. 5. Because of the importance and ongoing nature of the accounting mod- ernization program, the DAAA intends to designate a permanent group of at least seven qualified and experienced staff, charged with elaborating the new standards setting, with the Task Force continuing to play a key consultative role. 6. Promulgation and implementation of new accounting standards will need to be preceded by a very large program of information dissemination mostly through seminars, advisory services and training. The DAAA intends to use its available facilities and organizations, such as the Zhonghua Account- ing Correspondent School (ZACS) based in Taiyuan, and the China Institute of Certified Public Accounts (CICPA). Assistance will also be obtained from universities and technical schools as well as the China Society of Accountants (CSA), which has established an advisory group to work in parallel and coordi- nate with the DAAA Task Force on the elaboration of new accounting standards. Technical Assistance Program 7. The proposed Financial Sector Technical Assistance Project and asso- ciated Japanese Grant Facility (JGF) will support a three-pronged program of technical assistance for MOF, PBC and the AAPRC to modernize China's account- ing and auditing framework. Support to MOP will include the services of a consulting firm to assist DAAA in developing and promulgating new general and sector-specific accounting standards and financial reporting formats and to arrange seminars, training and an information dissemination programS the ser- vices of a consulting firm to the CICPA, which is under the overall direction and control of the DAAA, to help design a nationwide system of Continuing Professional Education (CPR) for CPAs; a special adviser (the subject of this terms of reference) to help coordinate and manage the everall program of I - 137 - ANNEX 12 activities under the DAAA's jurisdiction; a series of training seminars, study tours and secondments for DAAA staff and some essential equipment, principally for ZACS. Support to PBC will include consultant services and training activ- ities to assist PBC in developing accounting standards specifically for finan- cial institutions and strengthening PBC's own accounting and internal audit systems. Support to the AAPRC will include consultant services to help AAPRC develop auditing standards and an auditing manual as well as some training. Obiective and Scope of the Assigriment of the Special Adviser 8. The overall objectives of the Special Adviser's (the Adviser) assignment are to assist DAAA Director in managing, coordinating and exercis- ing quality control over the various technical assistance activities envi- sioned in the program period. The Adviser would furthermore advise the DAAA on priorities for and next steps in what must be an ongoing effort to modern- ize accounting standards and systems in China and ensure the adequacy of training and information dissemination activities nationwide. Specific activities will include the following: (a) assist the DAAA and CICPA in the selection and management of con- sulting firms engaged for the activities discussed in para. 7 and below and any other consultants which the DAAA may from time to time engage during the course of the project period. In this regard, the Adviser will help establish the short list of consulting firms to undertake the various assignments, elaborate evaluation criteria by which to judge their submissions and evaluate the final proposals from the short listed firm. He will also help to draft the terms of reference for any consultants (to be financed independently) which may be needed but which have not been envisioned at this present time; (b) review and advise on the approaches to, and the progress of account- ing standard and system reforms being developed by the DAAA and the consulting firm. In particular, the Adviser will review and comment upon: (i) drafts of the Accounting Framework to ensure the adequacy of its coverage and consistency with international norms; (ii) the systems and methods 'nvolved in the design of the basic general accounting standards, drafting of exposure drafts, review of com- ments on exposure drafts, and the preparation of final drafts of basic accounting standards for publication, all with a view to ensuring quality control of the complete process and the consistency of standards developed with international norms; (iii) the systems and methods involved in the design of sector specific accounting standards and systems (charts of accounts, model financial state- ments, etc.), similarly with a view to ensuring quality control of the complete process and the consistency of standards developed with international norms; and (iv) the timetable and approach recommended by the consulting firm and DAAA for promulgating the general and sector specific accounting standards and systems (e.g., sector by sector, etc.); (c) assist the DAAA in liaising with the PBC and AAPRC teams (staff and consultants) working on developing accounting standards for the financial sector and on developing auditing standards to - 138 - ANNEX%,12 ensure consistency in the three entities' approaches and schedules and timely promulgation of the new standards; (d) review and advise the Secretary-General of the CICPA on the organi- zation and management of the CICPA, including the CPE consulting assignment referred to in parae. 7; (e) review and advise the DAAA on the progress of work and recommenda- tions made by the consulting firm regarding the design and delivery of publicity campaigns necessary to ensure that enterprise account- ing staff and managers are fully informed of proposed changes to accounting standards and systems, clasoifications and financial statements; (f) advise on the need for, and nature of, training facilities and other educational and instructional requirements necessary for persons likely to use the new accounting and financial reporting system; (g) advise the DAAA on near term organization and staffing changes to implement the program of activities discussed above during the proj- ect period; (h) advise on, and assist in the organization of seminars, study tours, secondments and other activities for the development and improvement of accounting and auditing practices in China, both those to be financed under the project as well as any others which may be envi- sioned; (i) advise the Director and Division Chiefs of DAAA on new developments in accounting (both generally and with regard to key sectors), in other countries and economic groupings, e.g., the European Economic Community and ASEAN; (j) assist the DAMA in discussions and negotiations with foreign lenders and donors likely to support accounting development China; (k) advise on next steps in implementing accounting and auditing reforms in China; and (1) carry out any other reasonable requests by DAAA related to the objectives of the assignment. Location of the Assignment 9. The assignment will be primarily based in Beijing. However, the Adviser is expected to travel to other locations in China as needed to fulfill the scope of the assignment. The Adviser may also be required to visit appro- priate international centers, either independently or in the company of DAAA staff or consultants working with the DAAA on the accounting reforms. Duration of_the Assienment 10. The assignment is expected to take an elapsed time of some 36-40 months from the signing of the contract. During this period, the Adviser is - 139 - ANNEX 12 expected to allocate 6 staff-months in total, including two staff-months each year over a three-year period. Visits to China shall be set up at such inter- vals and for such periods as may be agreed between the Adviser and the Director of DAAA, excepting that the Adviser is expected to visit China not less than three times each year and that the DAAA reserves the right to have a visit of the consultant at no longer interval than three months from the pre- ceding visit, and for a period of no less than two weeks of continuous ser- vice. Qualifications and ExeRrience 11. The Adviser will be required to demonstrate the following qualifica- tions and experiences - possession of a current recognized professional accounting qualifi- cation awarded by a professional body of accountants; - at least ten years experience in accounting research and develop- ment, including management accounting development; - at least three years' attendance as a member of a national or inter- national accounting standards setting body; - at least ten years as a manager or partner in an organization having accounting as a primary function; - preferably at least five years experience in the public sector; - ability to operate EDP equipment to design and manage the operation of computing facilities; and - extensive experience as a trainer, and organizer of accounting training operations. Reporting 12. The Adviser shall report to the Director of the DAMA, or to any one nominated by the Director. The Adviser will be requir2d to submit a detailed report to the Director of the DAAA and the World Bank at the conclusion of each assignment/visit before leaving Beijing, or the last center in China to which he has been assigned for a particular visit. The Adviser will also prepare any other reports which may be requested by the DAAM. The Adviser will also be expected to review the various reports prepared by consultants working for MOF on the accounting reforms and provide comments thereon in writing to the DAAA and World Bank. - 140 - ANNEX 13 CHINA PINANCIAL SECTOR TECHNICAL ASSISTANCE PROJECT PeoRle's Bank of China and Financial Sector Terms of Reference for Strengthening Accounting Introduction 1. Overall responsibility for accounting in China rests with the Minis- try of Finance (MOF). In practice, MOF has effectively delegated operational responsibility for accounting in the financial sector to the People's Bank of China (PBC), the country's Central Bank. In April 1987, PBC issued regula- tions governing the accounting system for banks and nonbank financial institu- tions and, in June 1987, it issued regulations for its own accounting system. 2. The accounting standards and practices in general and in the finan- cial system in particular are oriented to ensure compliance with rules, rather than to convey the type of information-needed by managers and investors for decision-making purposes. While perhaps suitable for use in a centrally planned economy, the current standards and practices will not serve China adequately as the economy becomes increasingly open to the outside world and influenced by market forces. Chinese leadership has therefore decided that a major reform of the accounting and auditing framework is urgently necessary, to harmonize it with international practice. Overall Technical Assistance Program 3. In support of this program of reform. the proposed World Bank financed Financial Jector Technical Assistance Project includes a three- pronged program of technical assistance for MOF, PBC and the Audit Administra- tion of the People's Republic of China (AAPRC) to modernize China's accounting and auditing framework. Support to MOF will include consulting services to assist MOF (through its Department of Accounting Affairs Administration (DAAA) in developing and promulgating new general accounting standards and financial reporting formats and in undertaking related activities. Support to PBC (the subject of this Terms of Reference) will include consultant services and training activities to assist PBC in developing accounting standards specifi- cally for financial institutions and in strengthening PBC's own accounting systems. Support to the AAPRC will include consultant services to help AAPRC develop auditing standards and an auditing manual as well as some training. 4. MOP's DAAA is currently working on the overall framework of concepts for new accounting standards; this is expected to be promulgated in early 1992. With the assistance of consultants, the DAAA plans to complete 25 of the essential general (or basic) accounting standards by the end of the second year of the project, giving priority to standards important for the financial sector and to complete an additional 3 or more general standards by the end of the third year of the project. PBC plans to implement the accounting stan- dards promulgated by MOP by developing accounting standards and practices -141 - ANNE_ 13 specifically designed for financial institutions and, at the same time, strengthen its own accounting practices and systems. The financial sector standards and systems developed by PBC would need to be approved by HOP. Proposed Activities 5. The following activities are to be carried out under the PBC program of technical assistance: (a) Research and Standard Setting. Design, draft and implement account- ing standards for the financial sector, including PBC. Prepare an action plan for implementing the standards. (b) Systems Analysis. Ensure compatibility and consistency between automation and the improved PBC accounting system and provide pro- grammers for that purposes. (c) Organization Study. Study the current organization and staffing of the accounting functions at PBC headquarters and branches, analyze strengths and weaknesses, and recommend the most effective organiza- tional arrangement for the accounting functions. Cd) PBC's Accounting and Financial Reporting System. Design and imple- ment a modern management information system which incorporates the new accounting standards and practices and prepare an accounting manual and chart of accounts. (e) Financial Sector Financial Reporting System. Design and implement modern accounting and reporting systems for banks and nonbank finan- cial institutions which will serve their own needs and for reporting to FBC, and prepare a chart of accounts and accounting manual. (f) Training. Develop and execute a systematic training program of study tours, training seminars for senior accounting personnel and for junior and mid-level bank accounting staff. Chinese Counterpart Teams 6. The program of technical assistance would be undertaken by interna- tionally recruited consultants which would work in close collaboration with PBC counterparts. PBC would establish a senior level steering committee with representation from the Accounting Department. This committee will establish subcommittees to work with the consultants as appropriate. PBC counterparts are expected to carry out much of the actual work under the technical guidance of the consultants and are critical to the success of the program. It is understood that decisions in response to recommendations made will be taken by PBC. PBC working level counterparts will be expected to devote much, if not all, of their time to this activity. Therefore, the consultant selected to undertake this assignment will be asked for recommendations concerning the nature and the composition of counterpart team(s) expected to work with the consultants. - 142 - ANNEX 13 7. The Chinese counterpart team(s) will work with the consultants in the information gathering and analysis aspects of accounting standards. With the asssistance of the conoultants, all pertinent data as to Chinese and inter- national banking standards and practices will be accumulated and compared. As the O?OF accounting standards project progresses, the team will adapt MOF stan- dards to the Chinese financial sector. A series of fi.nancial sector account- ing standards will be formulated. The team will also study PBC's management information needs and design an accounting system and financial reporting oystem to meet those needs. It will be responsible for preparing the detailed procedures to be followed at headquarters, provincial branches and at each level of accotnting and reporting (i.e., city, county or operations offices-- the locations at which books of original entry or accounting records are posted and retained), consolidation procedures, the instructions for implemen- tation and the reporting formats. The team will also study management infor- mation systems at the specialized banks and the nonbank financial institutions with a view to strengthening those systems and their internal and external financial reporting. Accounting requirements for such institutions will be promulgated as well as a revised chart of accounts and accounting manual. This counterpart team, together with the consultants, will analyze PBC's organization and staffing, with reference to the accounting functions. Utili- zation of personnel and efficiency of operations at the various levels will be reviewed. The team will also work with the consultants to develop a training program for accountants and coordinate accounting training activities in China and abroad. Scope of Work 8. The expected scope of work and outputs from the consultants for each of the activities includes the activities described below. Budget allocation shares given below are estimates only and the consultant is encouraged to base their proposals on what they consider will be actually required to accomplish each task. (a) Overall consultant coordinator (elapsed time of 36 months) (13 per- cent of total budget). You will be responsible for coordination, quality control in all areas and compliance with expected time frames. You will prepare detailed work programs for each member of your team and monitor their progress throughout the project. You will prepare and submit quarterly progress reports (para. 11) and the final report (para. 18) and approve other reports (paras. 12- 17). You will provide technical expertise to the Chinese counter- part team in the areas of international central bank accounting. (b) Research and Standards Setting (elapsed time of 36 months) (13 per- cent of total budget). You will prepare an inventory of (a) all existing Chinese accounting standards9 principles and practices applicable to the financial. sector, whether in rules, regulations, laws accounting systems, charts of accounts or elsewhere; (b) accounting standards and practices in the bankling industry, central banks and financial institutions in selected countries; and (c) financial sector accounting standards approved by international organization, such as the International Accounting Standards Committee. You will prepare a time schedule and plan for conside- -143 _AWNEX 1.3 ration by the Chinese counterpart team for imp:lemenlting the now accounting standards for the financial sector; this plan should provide for the introduction of the ne; standards in the first fls- cal year following the completion of the standards (para. 8(a)) 9 unless otherwise clearly justified. In prepar:Lng this plan, you x¢111 consider the progress and timetable of MOF f:or developing and implementing the new basic accounting standards. You will draft, discuss and finalize for issuance (following MOF approval) account- ing standards for the financial sector oxn the basis of the basie accounting standards to be produced as the MOP accounting standards project progresses. (a) Organizational Study (elapsed time of 13 months) (5 percent of the budget). You will study the current organization and staffing of PBC's accounting function at headquarters and the branches and ana- lyze needs at all levels so as to make recommendations as to the most effective organizational structure throughout the PBC system. Y7ou will highlight all deficiencies encountered and suggest actions to overcome them, includilng, as appropriate, changes in the organi- zational structure and reporting flows and redeployment of staff. YOU will also recommend an implementation plan and timetable for introducing recommended changes. 'd) System Analyst (elapsed time of 24 months) (9 percent of the total budget). You will provide the expertise needed to assure compati- bility and consistency between automation and the improved account- ing system. This will include programmers to design application programs based on the new accounting system. .,e) PBC Accounting and Financial Reporting System-- (elapsed time of 24 months) (30 percent of the total budget). You will design, discuss and implement a financial management information system designed to meet PBC9s financial reporting needs. It must incorporate the new accounting standards and other practices determined to be useful in China. Management information needs at all levels within PBC must be observed. Legal, tax and other regulatory requirements must be observed. You will prepare and publish a revised chart of accounts and a revised internal accounting manual that will cover practices and implementation procedures and other reporting rpquirements. (f) Financial Sector Financial Reporting System--(elapsed time of 24 months) (12 percent). You will broadly study and analyze the cur- rent' accounting and reporting systems at the specialized banks and nonbank financial institutions under PBC9s control, recommend broad guidelines for strengthening the existing accounting and reporting systems and recommend the changes and improvements that should be implemented. Such systems must embody the standards and practices prescribed by MOF and PBC and include prudent accounting practices for the recognition by lending institutions of nonperforming assets and losses, suspension or nonaccrual of interest on nonperforming assets and the establishment of adequate valuation (e.g., loan loss) reserves, including the introduction of a frameviork for the grading of -risk in bankts' portfolios. (You should note, however, that cur- - 144 - ANNEX 13 rent MOF guidelines limit the amount of bad debt provisions finan- cial institutions may establish and the practices prescribed may take time to actually implement.) You will also draft, discuss and issue a revised uniform chart of accounts and a revised accounting manual covering practices and implementation procedures and other reporting requirements for financial institutions; unique aspects of development and agricultural loan operations, finance companies, trust activities etc., must be provided for in the chart of accounts and the accounting manual. (g) Training--(elapsed time of 36 months) (18 percent of budget). You will prepare a systematic training program for PBC accounting per- sonnel to implement revised procdures. It will include: (i) preparation of training materials and course curricula; (ii) preparation of lesson plans, teaching materials and audio vis- ual aids for the courses to be taught; (iii) compilation and preparation of training materials and student handouts for the courses to be taught; (iv) a rolling three-year training plan listing the frequency of training programs, proposed timing, number of staff to be trained and target participants; and (v) establishment of criteria for selecting instructors. In addition, you will be expected to conduct at least two "Train the Trainers" sessions using the materials and lesson plans prepared. Moreover, you will be expected to organize and coordinate the fol- lowing training activities to be funded separately under the World Bank Project: (i) one two-week study tour each in the first two years of the project to heighten the awareness of senior PBC accounting personnel. Each study tour will include about five persons and an interpreter. The study tours will seek to acquaint partici- pants with practices in other countries, with particular refer- ence to the areas of activity covered by the technical assis- tance program; (li) training seminars in China for senior accounting personnel (two in the first year and one each in the second and third years) and junior and mid-level accountants (one each in the first and second years and two in the third year). All training seminars will be for two weeks each; (iii) seminars abroad for four PBC accountants each year (two to four weeks in length); and (iv) secondments overseas of five PBC accountants each year for three months during the second and third years. - 145 - ANEEX 13 9. It is expected that all work will be completed within a 36 months period. There will be intervening periods when the international consultants will be engaged in other activities outside China. SEQUENCING OF ACTIVITIES Year 1 Year 2 Year 3 s----- - ----:-----+ ----: ----- ---s Overall Coordinator :------------------------------------------ Standard Setting :------------------------------------------ Organizational Study …-----------…-: Systems Analysis :------------------------------s PBC Accounting & FRS :------------------ -----------s Financial Sector FRS s----------------------------------- Training -------------------------------------------s 10. Certain of the Standard Setting, PBC Accounting FRS and Financial Sector FRS activities are dependent on the component of this same project being handled by the Department of Accounting Administration Affairs of the Ministry of Finance. This linkage will require close coordination by the Chinese counterpart teams and the international consultants to avoid delays or wasted efforts. Interim and Final Reportina 11. You will be required to report in writing to PBC and the World Bank on the status of your work program and preliminary results on a quarterly basis. The purpose of this reporting is two-fold: (a) to ensure that the program is meeting expectations in terms of scope, content and approach, and quality; (b) to ensure that the required tasks are completed within the expected time frame. These reports must set out the progress in each area of activities, details of personnel participating in the project during the quar- ter and any matters to which PBC's attention should be drawn. Therefore, you should plan your work carefully to ensure that the objectives of the engage- ment are being met and that appropriate resources are being devoted to ensure timely completion of activities. In this regard, it is essential that PBC's counterpart team(s) and the international consultants work in close coordina- tion in the design development and implementation of the work program. 12. The inventory of Chinese and international accounting standards and practices in the financial sector and your proposed time schedule and action plan for implementing new accounting standards will be due in final draft form no more than ten months from the date of the date your work commences and in final form four weeks later. A complete set of accounting standards for the financial sector, including and based on the general standards prepared by MOP, should be completed within 36 months from the start of the assignment. 13. The organizational study report will be due in final draft form no later than 12 months from the date your work commences and will include your recommendations as to the most efficient manner of organizing the accounting functions throughout the PBC organization, the deployment of staff and - 146 - ANNEX i3 maximizing efficiency, together with a proposed implementation plan. The final report will be due 4 weeks thereafter. 14. Work of the systems analyst(s) will commence in year two of the assignment. The output, to be completed by the and of the assignment will consist of software to enable automation based on PBC's new accounting system and recommendations on the priorities and strategy for automation of the accounting function at headquarters and at the branches. 15. Work on the PBC financial management information/accounting system is expected to commence six months after the start of the overall assignment. The final draft report on the financial management information system will be due no later than 12 months later, with the final report due 4 weeks there- after. The report including the draft PBC revised chart of accounts and accounting manual will be due no later than 22 n.onths after the start of work on the PBC financial management information/accounting system and will be due in final form four week thereafter. By this time, it is expected that MOF would have elaborated the majority of the new basic general accounting stan- dards, especially those which are most relevant for the financial sector. However, you should be prepared to make any modifications necessary in the systems (manual, chart of accounts, etc.) which appear necessary in the third year of the assignment based on new standards issued by MOF. 16. Work on the f£nancial sector financial reporting system will also commence six months after the start of the overall assignment. The final draft report on the financial reporting system will be due no later than 12 months later, with the final report due 4 weeks thereafter. The report including the draft revised chart of accounts and accounting manual will be due no later than 22 months after the start of work on the financial sector reporting system and will be due in final form four weeks thereafter. How- ever, as with the PBC accounting system (para. 15), you should be prepared to make any modifications necessary in the systems (manual, chart of accounts, etc.) which appear necessary in the third year of the assignment based on new standards issued by MOP. 17. The draft rolling training program, courac curricula, criteria for instructors and initial set of teaching materials should be ready by the mid- dle of year one of the assignment. Elaboration and updating of the training plan, curricula, criteria and materials should take place thereafter, accord- ing to a schedule the Consultant should recommend in making its proposal. A final and complete set of teaching materials and training plan should be com- pleted by the end of the assignment. 18. Your draft final report will be due 35 months after the start of this assignment and the final version four weeks later. Qualifications of Consultants 19. Currizulum vitae (CVs) should be provided for supervisory personnel who would be responsible for planning and directing this program of technical assistance, together with the CVs of managers and other key personnel likely to be employed in the actual performance of the various tasks. CVs should include details on prior assignments carried out by these individuals. All - 147 - ANNEX 13 foreign experts will be expected to possess a current professional qualifica- tion (CA, CPA or equivalent) awarded by a recognized body of professional accountants. It is highly desirable that most, if not all, of the members of the consulting team be fluent in written and spoken standard (Mandarin) Chinese. 20. The international consultants should ideally have the relevant expe- rience specified below: (a) Overall Consultant Coordinator--At least 15 years experience in central bank accounting or auditing with at least 5 years in a senior central bank management position. (b) Research and Standards Setting Expert--At least 10 years experience in accounting research with a major international accounting from or with an accounting standards setting body of international stature. (a) Organizational Study Expert(s)--At least 5 years experience at a managerial level of an accounting firm specializing in organization and methods or in financial management of an enterprise with the same specification. (d) Systems Analyst(s)--At least 5 years experience in system analysis as a consultant. (e) Expert(s) for PBC and Financial Sector Financial Reporting Systems-- At least 10 years experience in central bank and commercial bank accounting and reporting systems, financial analysis and modern computer applications. (f) Training Advisor(s)--At least 3 years experience in the design prep- aration and delivery of training courses, preferably on topics relating to accounting and auditing. (g) Local Consultants--At least 3 years experience in their area of expertise. Submission of Proposal 21. You are invited to submit a proposal and work plan for carrying out the activities under this technical assistance program. Since training and the transfer of skills are important objectives of all activities, your proposal should outline the work and training activities in which the Chinese counter- part teams will be involved. You are encouraged to submit modifications to these terms of reference. - 148 - ANNEX 14 CHINA FINANCIAL SECTOR TECHNICAL ASSISTANCE PROJECT Terms of Reference for Consultancy to Audit Administration of PRC (MAPRC) Background 1. The Audit Administration of the People's Republi.c of China (AAPRC) was established in 1983 and is responsible for external auditing of governmen- tal bodies and state owned enterprises, either directly or through lower level audit bureaus. Approximately 800,000 units are subject to audit by the AAPRC system. 2. AAPRC's responsibilities and authority are clearly spelled out in the Constitution and the 1988 "Regulation on Audit of the People's Republic of China." As the highest auditing authority in the country, it reports directly to the State Council and is responsible to it. 3. To date, no authoritative generally accepted auditing standards (GAAS) have been published, even though AAPRC personnel are familiar with international GAAS and auditing practices in other countries. 4. Under the World Bank finauced Financial Sector Technical Assistance Project, the AAPRC plans to develop auditing standards in line with inter- national practice, building on the work already in progress in drafting GAAS and work to develop an audit manual and audit guidelines for AAPRC's Foreign Investment Audit Department, with financing from the Asian Development Bank (ADB). To successfully carry out this project, it is anticipated that train- ing and technical assistance will be needed in developing a coherent and work- able auditing framework. As a result, the AAPRC desires to engage the services of internationally recruited consultants to collaborate in the imple- mencation of this program of technical assistance and limited training. Scoge of the Technical Assistance and Training Effort 5. AAPRC has prepared a first draft of auditing standards and an out- line of an aldit manual. Substantial revision and additions will be needed to the auditing standards. To assist MAPRC in the finalization of the auditing standards, qualified international consultants with broad experience in inter- national auditing standards and practices will be contracted by AAPRC, under World Bank guidelines, to assist in developing auditing standards and in training AAPRC personnel. Chinese Counterpart Team 6. Senior officials from the concerned MAPRC departments (e.g. Regula- tion and Criterion Making Department, Monetary Audit Department, Finance Audit Department and Personnel and Education Department) will be appointed as coun- terparts to work within the consultants in overseeing and supervising this project. The Chinese counterpart team is expected to carry out much of the - 149 - ANNEX 14 actual work and is critical to the success of the project. Therefore, the international consultauts engaged for purposes of carrying out this program of technical assistance will be asked for recommendations concerning the number and level of staff and the composition of the counterpart team expected to work with the consultants. The role of the consultants will be to provide professional guidance and expertise to the team. Terms of Reference 7. The expected scope and ou-puts for each of the activities are dis- cussed below. (a) Auditing Standards (elapsed time of 6 months). You are expected to produce a "Framework of Auditing Standards" and a full set of gener- ally accepted auditing standards (GAAS) (probably 25 to 30) in har- mony with international GAAS and that have been adapted to the cur- rent Chinese practices and constraints. (b) Training (elapsed time of 3 months). You will prepare training programs, materials and course curricula on implementation of the new auditing standards and familiarize AAPRC staff with auditing manuals used in other countries and "train the trainer" sessions. You will participate as a lecturer in the training sessions. SEQUENCING OF ACTIVITIES Year 1 Year 2 :- - ……I Auditing Standards l- - - - - - Training Advisors: 1 - I Interim Reporting 8. You will be required to report in writing to AAPRC and the World Bank on the status of your work program and preliminary results on a bimonthly basis. The purpose of this reporting is two-fold: (a) to ensure that the program is meeting expectations in terms of scope, content and approach; and (b) to ensure that the required tasks are completed within the expected time frame. Therefore, you should plan your work carefully to ensure that the objectives of the engagement are being met and that appropriate resources are being devoted to ensure timely completion of activities. In this regard, it is essential that AAPRC's counterpart teams and the international consultants work in close coordination in the design, development and implementation of the work program. 9. The auditing standards will be due in final draft form no later thani five months from the date your work commences. The final report will be due four weeks thereafter. 10. The training program and implewentation plan should be submitted by the end of month ten of the assignment. - 150 - AMEX 14 11. Your final report will be due 30 days after the completion of the auditing standards and training program. Oualifications of Consultants 12. Curriculum vitae (CVs) should be provided for supervisory personnel who would be responsible for planning and directing this program of technical assistance, together with the CVs of managers and other key personnel likely to be employed in the actual performance of the various tasks. CVs should include details on prior assignments carried out by these individuals. It is highly desirable for most, if not all, of the members of the consulting team to be fluent in written and spoken standard (Mandarin) Chinese. 13. The foreign consultants will be expected to have the relevant expe- rience specified below: (a) Auditing Standards Expert--At least 10 years experience in account- ing research with a major international accounting firm or with an accounting standards setting body of international stature. Experi- ence is also desirable in governmental auditing, including at a supervisory level with an auditor general, comptroller general or similar national auditing institute. (b) Training Expert--At least 5 years experience in the design of train- ing programs, materials and course curricula and the delivery of seminars and training sessions, preferably on topics relating to governmental auditing. - 151 - ANNEX 15 CHINA FINANCIAL SECTOR TECHNICAL ASSISTANCE PROJECT People's Banik of China Program for Strengthening Internal Auditing Introduction 1. The People's Bank of China (PBC) intends to strengthen its internal audit function. This program will complement technical assistance activities in PBC, including support to modernization of PBC's accounting system and strengthening of PBC's banking supervision function. It will also complement assistance being provided to the Audit Administration of the People's Republic of China (AAPRC) by the Asian Development Bank (ADB) and under this project to develop auditing standards and an audit manual. Responsibility for internal auditing in PBC rests at headquarters with one division within the Department of Supervision and Audit, which also is in charge of supervisitg banks. In PBC branches, the internal audit function generally does not have a separate division but is the responsibility of the department or divisidn in charge of bank supervision. PBC internal audit staff at headquarters numbero about 52. Proposed Activities 2. The following act'vities are to be carried out under the PBC program to strengthen internal auditingt (a) Organization Study. Study the current organization and staffing of the internal audit function at PBC headquarters and branches, ana- lyze strengths and weaknesses, and recommend the most effective organizational arrangement for the internal audit function. (b) Internal Audit Function. Design and implement a program to modern- ize PBC's internal auditing function, in line with international norms, through documentation of procedures and practice and through improved internal audit reports, all to be supplemented by training [para. 5(c)1. Prepare an internal audit manual (which could be modeled, with respect to relevant sections, on the new AAPRC Audit Manual(s) of which one for the Foreign Investment Audit Department will be ready in draft form in 1992]. (c) Trainin2. Develop and execute a training program for internal audi- tors to implement revised procedures. Steering Committee 3. The program would be undertaken under the supervision of a PBC senior-level Steering Committee which would have final responsibility for any decisions which need to be taken. The Committee would establieh three working-level subcommittees which are expected to carry out much of the actual - 152 - ANNEX 15 work and are critical to the success of the program. PBC working-level staff will be expected to devote much, if not all, of their time to this activity. Scope of Work 4. The expected scope of work and outputs are described below. (a) An overall coordinator, designated by the Steering Committee (elapsed time of 36 months), will be responsible for coordination, quality control in all areas and compliance with expected time frames. The coordinator will prepare detailed work programs for each team and monitor their progress throughout the project. The coordinator will prepare and submit quarterly progress reports (para. 7 for review by the steering committee). (b) Subcommittee for the Organizational Study (elapsed time of 13 months). This subcommittee will study the current organization and staffing of PBC's internal audit function at PBC's headquarters and branches and analyze needs at all levels so as to make recommenda- tions as to the most effective organizational arrangement for the function. The subcommittee will highlight all deficiencies encoun- tered and suggest actions to overcome them, including, as appropri- ate, changes in the organizational structure and reporting flows and redeployment of staff. The subcommittee will also recommend an implementation plan and timetable for introducing recommended changes. (c) Subcommittee for PBC's Internal Audit Program (elapsed time of 36 months). This subcommittee will prepare, discuss and issue written internal auditing procedures, internal auditing reporting practices consistent with current international norms and sample audit work programs, documentation and report formats suitable for internal auditors, all consistent with current international norms. Comput- erized auditing procedures and auditing in a computer environment will also be included. The subcommittee will prepare training and operations plans for the internal audit division and a time schedule for implementation, taking into account the organization plan recom- mended by the organization subcommittee [para. 4(b)1. The subcom- mittee will prepare an internal audit manual for PBC drawing as appropriate on relevant inputs from the new AAPRC audit manual(s). (d) Subcommittee for Training (elapsed time of 36 months). This subcom- mittee will prepare a systematic training program for PBC internal audit personnel to implement revised procedures. It will include: (i) preparation of training materials and course curricula; (ii) preparation of lesson plans, teaching materials and audio visual aids for the courses to be taught; (iii) compilation and preparation of training materials and student handouts for the courses to be taught; - 153 - ANNEX 15 (iv) a rolling three-year training plan listing the frequency of training programs, proposed timing, number of staff to be trained and target participants; and (v) establishment of criteria for selecting instructors. In addition, the subcommittee will be expected to conduct pilot ses- sions using the materials and lesson plans prepared. 5. It is expected that all work will be completed within a 36-months period. SEQUENCING OF ACTIVITIES Year 1 Year 2 Year 3 s + --:- --+ - ---- + -----: Overall Coordinator ------------------------------------------s Organizational Study ----------------: Internal Audit -------------------------------------------- Training -------------------- ----------------: Outputs 6. The coordinator will report in writing to the PBC Steering Committee on the status of the work program and preliminary results on a quarterly basis. 7. The organizational study report will be due in final draft form no later than 12 months from the date work commences and will include recommenda- tions as to the most efficient manner of organizing the internal auditing function throughout the PBC organization, the deployment of staff and maximiz- ing efficiency, together with a proposed implementation plan. The final report will be due four weeks thereafter. 8. The report on internal audit procedures, practices and programs will be due in final draft form no later than the end of Year 1. The final report will be due four weeks thereafter. The PBC internal audit manual will be due in final draft form no later than the end of Year 2. The final draft report will be due four weeks thereafter. 9. The draft rolling training program, course curricula, criteria for instructors and initial set of teach materials should be ready by the middle of Year 1. Elaboration and updating of the training plan, curricula, criteria and materials should take place thereafter, according to a schedule PBC should develop during the first few months of Year 1. A final and complete set of teaching materials and training plan should be completed by the end of these activities. - 154 ANNEX 16 FINANCIAL SECTOR TECHNICAL ASSISTANCE PROJECT People's Bank of China Research and Statistics Component 1. The proposed project would include the follewing program of activi- ties, for which detailed costs are available in the Project File. (a) Training. The program will begin to address PBC's vast training needs for its professional staff in the research areas, focusing otl increasing their absorptive capacity in order to maximize the use- fulness of the proposed policy research projects. The proposed strategy in this area includes the following activities: targeted training in economics for PBC's technical staff; a high-level sympo- sium on monetary policy drawing on foreign speakers; international exposure to the experience of foreign central banks and research institutes, by means of secondments and study tours abroad, of PBC's technical staff; and, finally, hands-on training in the process of developing new or perfecting existing research activities/tools (see below). Training assistance in the first set of activities will be provided in three ways: (i) Lectures (Ln ChinaL, It is proposed to start this component of the TA program with one-month refresher courses, at an interme- diate level, covering three topics: modern macroeconomics; banking and monetary theory; and econometries. The lectures will be conducted at PBC's headquarters (groups of 25-30 par- ticipants) by Chinese speaking lecturers in economics. The various teaching modules, materials and lecturers would be designed/identified in consultation with the IMF. (ii) Seminar (in China). During the second year of the program, an international seminar on the (broad) topic of "Monetary Policy: Goals and Methods" will be financed under the program. Chinese and foreign experts (from universities, central banlcs, the IMF and/or the World Bank) will survey recent theoretical develop- ments and the experiences of a group of selected countries, in the areas of monetary targeting, the central bank's toolkit, real/financial interactions, models of financial intermedia- tion, interaction of exchange rate policy and monetary policy, and the impact of government deficits on monetary policy. The main objective will be to present comparative experiences and draw some lessons relevant for China's policymakers in this area. The target audience (50 participants) will be high-level staff from PBC headquarters and a representative group of branch Governors. The length of the seminar will be one week, drawing on a panel of 5 foreign speakers. - 155 - AEX 16 (iii) Training Overseas. Two types of activities abroad will be financed under the program: three study tours and a three-year program of secondments at foreign central banks. * Study Tour No. 1 (first year of the program). A group of 5 staff from the relevant research areas will participate in a 3-week study tour to study the various instruments of mone- tary policv available to other central banks, particularly the policy and operational aspects of setting required reserve ratios, the use of the central bank discount rate (direct provision of reserve deposits through the discount window or through rediscounting or purchase of financial assets) and open-market operations (purchase/sale typically of government securities). Participants will also be exposed to different organizational "models" of the research and statistics functions of the host central banks. Visits would include three central banks, probably from the follow- ing countries, depending on absorptive capacity: US (Fed- eral Reserve Bank of New York), Italy.(Bank of Italy), Mexico (Banco de Mexico), and the United Kingdom (Bank of England). At the end of their mission, the participants will be responsible for writing a report of their learning experience, highlighting their relevance for the PBC. * Study Tour No. 2 (second year of the program). A group of 5 staff from the relevant research areas will participate in a 3-week study tour to study the use/design of income and expenditure surveys useful in designing a system of national and regional leading indicators to assess and anticipate economic fluctuations. Visits will include the University of Michigan, the NBER (Boston), one regional Reserve Bank (possibly the Federal Reserve Bank of Richmond or Philadelphia to study, for example, the experience with the Industrial Production Index) with a follow up visit to the Federal Reserve Board in Washington to study how the various regional indices are consolidated at the national level. Finally, the participants would visit the U.S. Commerce Department to study the Index of Leading Indicators. At the end of their mission, the participants will be responsible for writing a report of their learning experience, high- lighting their relevance for the PBC. * Study Tour No. 3 (third year of the program). A group of five staff from the relevant research areas will participate in a three-week study tour which is intended to revisit some of the topics covered in Study No. 1 (instruments of mone- tary policy), with some emphasis in other central banks' experience in integrating analytical tools with practical day-to-day policy decisions. The participants will look at practical applications of demand for money models, flow of funds, financial models and/or business cycles models devel- oped during the first two years of the program. (Relevant - 156 - &WX 16 central banks and research institutions will be identified at a later stage). * Secondments. Subject to the constraint imposed by the absorptive capacity of the host institutions (central banks) and the number of staff with the required language skills, it is proposed to finance under the program the secondment of up to four (4) staff per year from the relevant research and statistics areas of the PBC (headquarters and provincial branches) for 4-month secondments (hands-on training). The central banks of the following countries will be approacheds Australia, New Zealand, Canada, Japan, Malaysia, Ireland, and Mexico. (b) Research Proiects. Responding to PBC's aim of strengthening its policy research agenda in areas such as money, credit, financial sector reform, savings and enterprise behavior, and business cycles, the Financial Sector Technical Assistance Project will finance vis- its by high-level consultants to assist PBC in developing new ana- lytical tools and strengthening its empirical and analytical work. A description of the objectives and proposed organization of the various research activities financed under the program, as well as preliminary terms of reference for the consultants, are contained in Attachment 1. (c) Automation. As part of the project, the automation needs of the different departments of PBC involved in research and statistics and/or in implementing credit and monetary policies were examined, with the aim of financing their more pressing software and hardware needs. - 157 - ANNEX 16 At.tachment 1 CHINA FINANCIAL SECTOR TECHNICAL ASSISTANCE PROJECT People's Bank of China Preliminary Terms of Reference for Research Projects Research Proiects 1. Hands-On Training and Policy Orientation of the Research Activities. The research activities financed under the credit are heavily training ori- ented: all the activities would be preceded by careful ex-ante preparation of relevant training material (sent well in advance of the consultant(s)' visit to PBC). In addition, the consultant(s)' work in the field (Beijing) will begin, in all cases, with at least two days of formal lectures (on the rele- vant research topic). The development/perfecting of the proposed research tools will be carried out Jointly (by the foreign expert(s) and a core coun- terpart team of PBC researchers/staff (see below). All the research activi- ties financed under this component of the credit attempt to improve PBC's policy research capabilities, emphasizing the development of quantitative tools and strengthening PBC's informational and forecasting capabilities. 2. Organization. PBC's departments directly involved in research and statistics will designate for each activity small counterpart teams (4-5) which would work (full time) closely with the consultant(s), developing the proposed activity (although the lectures and further diffusion of the research outputs will be addressed/open to larger groups). PBC's core teams should be responsible for using and maintaining the various tools develon.d jointly wit the consultant(s). Activity 1R: Survey Research 1. Obiectives. The Research and Statistics Department of the PBC is conducting at present two surveys: (i) one semi-annual survey of household savings; and (ii) a survey to monitor major enterprises. The objective of the first survey is to assess households' savings and expenditure decisions in order to identify and forecast the determinants and future behavior of bank savings deposits. Based on the survey's results, PBC tries to infer infla- tionary expectations, which are taken into account in deciding changes in the level of controlled interest rates. The second survey attempts to assess the financial condition of major state-owned enterprises and their potential demand for working capital and bank credit. In addition, PBC's questionnaire surveys the enterprise managers' expectations regarding future prospects of the economy. The consultants will assess the methodology being used at pre- cent to conduct the two surveys--including the adequacy and representativeness of the present random sample of 10,000 households in 20 cities, the sample and indicators examined in the enterprise survey (in view of the limitations imposed by present distortions in the price structure and the accounting system), and the adequacy of the questionnaires and statistical and analytical - 158 - ANNEX 16 Attachment 1 methods being used. Given the .heoretical and practical relevance of expecta- tions held by economic agents in determining their decisions, an accurate assessment of them can be vital for policy decisions. The consultants will discuss with PBC's staff the experience of other countries in this area, advising PBC on the development of a sound system of leading indicators, for- mulating specific technical recommendations to improve PBC's surveys and their usefulness for policy-making purposes. Nctice that participation of the coun- terpart team of this group in the Stuidy Tour 2 (see above) would be highly desirable. 2. Preparatory Work Previous to Mission. The consultants should send to PBC (in advance of their visit) all the relevant background literature which will be used for instructional purposes at the beginning of the mission (no less than two days of lectures previous to the start of the empirical work), and upon which the proposed research activity will build upon. Detailed data requests and work programs should also be sent prior to arrival in Beijing. 3. Characteristics of the Consultants. The two consultants envisaged should have strong academic credentials (economics and statistics) and wide practical experience in conducting large opinion/census-type surveys. ([ote: consultants' profile: senior researchers (with experience in business cycles, leading indicators and expectations analysis), possibly from agencies like the US Commerce Department, the Consumer Research Center of the University of Michigan or the NBER. One option to deliver this TA would be to contract with one of the last two institutions, simplifying the unavoidable coordination work.) 4. Outputs to be Prepared by the Consultants. The consultants will be responsible for assessing the quality/usefulness of the present two surveys conducted by PBC, formulating specific recommendations for upgrading the representativeness/usefulness of the surveys and suggesting ways to develop indicators and reporting formats useful for policy-making purposes. 5. Timing. Length, and Frequency of the Visits. The two consultants will initiate their field work during the first year of the program, visiting China for a length of two months each. Their initial work will be conducted in Beijing, but they should visit one or two provinces to advise PBC on data collection and processing. Each consultant will assume responsibility for one of the two surveys. The two consultants should be available for (mail/phone) consultation after their initial mission and be available for a one-month follow up visit to China during the second year of the program. Activitv 2R: Estimation of the Demand for Money 1. Obiecitives. The objective is to develop and transfer an econometric model to estimate, on a quarterly basis, money demand in China, using as explanatory variable real national income, interest rates (on government bonds, bank deposits and secondary market debt instruments) and expected inflation (beyond the adaptive expectations and perfect foresight models used in earlier works). Attention should be given to identifying the determinants - 159 - NNEX 16 Attachment I of consumer expectations (possibly linking this worK with the outcome of Activities I (survey research) and 5 (savings behavior). The consultant should also attempt to estimate a vector-autoregressive model of money demand for short-term projections, testing the stability of the different demand for money specifications. The econometric model will be increasingly important for monetary programming purposes, particularly once PBC develops open-market operations. 2. Prenaratory Work Previous to Mission. The consultants should send to PBC (in advance of his visit) all the relevant background literature which will be used for instructional purposes at the beginning of his mission (two days of lectures previous to the start of the empirical work) and upon which the proposed application will build. Detailed data requests and work program should also be sent prior to arrival. 3. Ontputs to be Prepared by the Consultants. The various econometric applications developed by the consultant should be entirely operational and well documented by the end of the assignment. The tools developed by the consultant should be readily usable by the PBC staff and should be able to run in PC-type of computers using commercial econometric packages. The consultant should demonstrate ways of integrating the results of the model within the PBC's monetary programming framework. 4. Length and Date of the Visit. The consultant should visit Chins during the first year of the program for a one-month visit. 5. Characteristics of the Consultant. Strong academic background in monetary theory and policy and econometrics. Familiarity with China's finan- cial system and data. Activity 3R: Flow of Funds 1. Oblectives. The objective is to initiate the development of a social accounting matrix (SAM) for Ch'na, in order to provide detailed sectoral information on savings and the allocation of investment funds. The consultants should develop a SAM framework for collecting and organizing China's economic and social information. In a second phase, they would attempt to develop SAM models of China's economy to simulate the effects of policy interventions. 2. PreDaratory Work Previous to the Main Mission. The consultant should have a preliminary preparatory mission to China, to assess the existing information at PBC and other government agencies required to start a flow of funds system. The consultant should draw a work plan and hold preliminary discussion with PBC of the support (human and otherwise) to initiate the development of this research activity. The consultant should prepare in the field an aide-memoire for discussion with the authorities. Prior to the first mission, the consultant should send to PBC all the relevant background literature which will be used for instructional purposes at the beginning of the mission (two days of lectures previous to the start of the empirical work), and upon which the proposed application will build. Detailed data - 160 - ANNEX 16 Attachment 1 requests and work program should also be discussed and agreed prior to the second mission in the first year of the program. The consultant(s) should advise and oversee the progress of the work with annual visits during the three years of the program. Detailed work plans and terms of reference should be developed based on the initial and subsequent revisions of the overall program. 3. Outputs to be PreRared by the Consultantls). During the first visit to China, the consultant would discuss with PBC's staff the analytical basis of the SAM framework--bringing comparative experiences from other developed and developing countries--and its links with the system of national accounts (SNA) and input-output tables. The consultant should assess the informational requirements of a basic, but expandable, SAM model, discussing and recommend- ing a suitable sectorization. It is important to maintain sufficient flexi- bility for future expansion of the SAM, progressively broadening the num- ber/type of enterprises/operations/sectors and the level of disaggregation. The consultant should draw with PBC an action plan in which the various activ- ities to be carried out are clearly defined, including formats for data col- lection and processing, as well as a timetable to follow the progress of the research work. After the first year identification mission, the consultant(s) should plan and agree with PBC the scope and timing of the main mission in the remaining part of the first year of the program. During the second and third years of the program, the consultants would return to China to _.ontinue their work (each time for two month visits). In the interim period between the various missions, the consultants should be available for consultation and advice to PBC. Given the long-term nature of the proposed activity, the con- sultant should identify further TA needs (and possibly additional sources of financing), as well as the interface of the flow of funds work with the new SNA. 4. Length. Date, and Freauercv of the Visits. The length of the iden- tification mission will be four weeks, followed by three two-month missions over the three years of the program. 5. Characteristics of the Consultants. Strong academic background in national accounts, accounting, and statistics. Familiarity with the SAM framework and extensive practical experience. Activity 4R: Financial Models 1. Objectives. PBC is responsible for overseeing, supervising, and regulating all financial intermediaries in China. The objective of this activity is to foster PBC capabilities to assess the microeconomic/financial implications upon the (specialized and comprehensive) banks of changes in policy parameters and preferences of the public. The consultant(s) should convey to PBC's research staff the various models of the banking firm dis- cussed in the literature, drawing upon examples from their previous work in this area, and should develop computer models for at least two banks (possibly one specialized bank and one comprehensive bank). Such models should be able to answer questions such as the impact on bank profits/interest spreads resulting from changes in policy parameters (ex. changes in regulatory - 161 - ANNEX 16 Attachment 1 constraints) such as reserve requirements, interest rates on loans and depo- sits, changes in provisions, rising loan delinquency, etc., as well as changes in the public's preferences for bank inputs. Finally, the consultant(s) should address and model efficiency issues in the operation of Chinese banks by showing the outcome of using international comparators (ex. operational costs) on banks' profitability. 2. Preparatory Work Previous to Mission. The consultant(s) should send to PBC'u counterpart team (in advance of the visit) all the relevant back- ground literature which will be used for instructional purposes at the begin- ning of the mission (two days of lectures on the subject--bank modelling-- previous to the start of the empirical work) upon which the proposed applica- tion will be build. Detailed data requests, questionnaires, and work programs should also be sent prior to arrival. 3. Outputs to be Prepared by the Consultant(s). The consultant(s) should apply a common methodology (probably adapting existing asset/liability management models) and adapt/develop models for no less than two Chinese banks (specialized and comprehensive). By the end of their mission the models should be entirely operational and well documented. Particular attention should be given to transfer their know-how to PBC staff, which should allow them to amend/expand the computer models jointly developed. PBC's staff should be able to adapt the models developed to the rest of banking institu- tions in the system. Such models should be able to run in PC computers and should allow PBC's staff to simulate and forecast the implications of changes in policy parameters or exogenous factors on the financial conditions of the banks. The models should be primarily used by the research and statistics areas of PBC in support of policymaking in the financial sector, but they should also be useful in guiding PBC's supervisory functions (off-site pruden- tial regulation). The consultants should be aware and liaise with consultants responsible for drawing the new chart of accounts for the banks and the revamping of PBC's supervisory functions financed under other components of the credit. One of the consultants (financial analyst) will return to Beijing during the second year of the program, in order to provide advice/review the models developed in the meantime by PBC's staff. 4. Length. Date. and Freguencv of the Visits. The two consultants should visit China during the first year of the program for a five-week visit, and one of them should go back on an updating/follow up three-week mission in the second year of the program. 5. Characteristics of the Consultants. One of the consultants should have strong background in bank and cost accounting and finance. The second consultant should have extensive and demonstrated experience in commercial banking and financial analysis and moaelling. Activity 5Re Analvsis of Savint Behavior 1. China's domestic savings rate has been among the highest in the developing countries, at about 30 percent of GDP in the last three decades. Household savings rose rapidly during the decade of economic reforms - 162 - ANNRX 16 Attachment 1 increasing substantially its share over both, household assets, and GNP. Continuous increases in households' financial savings and the limited avail- ability and "short-termism" of financial assets raises concern about the stability of bank deposits, raising the specter of large and destabilizing demand shocks. Building upon the existing literature, the consultant will estimate life-cycle/permanent income models, using quarterly and disaggregated data (CASS Household Consumption and Savings Survey). One important objective is to estimate the interest elasticity of savings, the elasticity of substitu- tion between bank deposits and other financial assets (bonds and T-Bills traded in secondary markets) and to determine whether or not inflationary expectations have an effect on private savings. In addition, the consultant should explore the connection between a potential monetary overhang and savings. 2. PreRaratorv Work Previous to Mission. The consultant should send to PBC (in advance of the mission) all the relevant background literature which will be used for instructional purposes previous to the start of the empirical work (two days of lectures covering the main approaches to savings analysis, illustrated with comparative experiences from other countries). Detailed data requests and work programs should also be sent prior to arrival. 3. Outputs to be Prenared by the Consultant. The research project should be policy-oriented, suitable to advise policymakers on the likely con- sequences of changes in interest rates, changes in inflationary expectations, changes in current and permanent income, etc., as well as investigate longer- term factors (like age profiles and preferences of urban/rural households) which will affect saving patterns. 4. Length. Date. and Frequency of the Visits. Pending on PBC's absorp- tive capacity this research activity could start during the second year of the program. It is envisaged that one consultant should visit Beijing twice over a two-year period, for stays of two months and one month, respectively. 5. Characteristics of the Consultant. Strong academic background in economics and econometrics. Experience in national accounts and savings anal- ysis. Activity 6R: Business Cycle Analysis 1. Obiectlvee. The objective is to develop a quarterly real business cycle model that connects inventory changes with fluctuations in CDP, enabling PBC to anticipate turning points in China's economic activity. The 1989/90 experience clearly indicated that a better understanding of inventory behavior Is easential to achieving a better understanding not only of the macro- economics of business cycles, but also the microeconomics of the firm. The consultant will examine, in a disaggregated form (ex., finished goods, work proces., materials, and supplies) the changes in inventory investment in China'" manufacturing and retail sectors (wholesale and retail trade), explor- ing the applicability of microeconomic models of inventory behavior (ex., production smoothing and (S,s) models) and Metzler-type of inventory-accelera- tor mechanisms. Progreso under this research activity should be closely - 163 - ANNEX 16 Attachment I linked to the survey research project (Activity IR), in particular the devel- opment of leading indicators. 2. Preparatorv Work Previous to Mission. The consultant should send to PBC (in advance of the mission) all the relevant background theoretical liter- ature and comparative experiences from other countries which will be used for instructional purposes previous at the beginning of the mission (two days of lectures) previous to the start of the empirical work. Detailed data requests and work programs should also be sent prior to arrival. 3. Outputs to be Prepared by the Consultant. The consultant should develop clear guidelines for data collection. The consultant should develop PC-compatible micro and macroeconomic models of inventory behavior useful analytical purposes in support of policy formulation. 4. Length. Date. and Frequency of the Visits. The consultant should visit China twice over a two-year period, for missions of two and one month, respectively. S. Characteristics of the Consultant. Strong academic background in economics and statistics. Practical experience in mounting statistical sur- veys and in business cycles analysis. tNote: This component cou3d be contracted with a researcher from an institu- tion like the NBER, Brookings, or a well-known researcher in this area like Alan S. Blinder (Princeton). Some interesting work in this area has been carried out for other socialist economies (ex., see A. Chikan and M.C. Lovell, editors, The Economics of Inventory Management, North Holland, 1988)). ctiity 7R: BackRround Research Studies 1. Obiectives. As indicated above, the increasing role played by mar- ket forces in China's economy calls for PBC to respond to new challenges by developing appropriate analysis and research activities to provide a sound foundation for policy decisions. It is envisaged under the program to invited two senior consultants/academicians per year, starting the second year of the program to advise PBC on background research studies on commonly egreed rele- vant areas. Research areas and specific terms of reference would be identi- fied and agreed between PBC and the IMF at a later stage. The consultants will provide substantial training on the topics selected during the initial phase of their visite and will develop, jointly with PBC researchers (particu- larly from the Financial Research Institute), a thorough research proposal, providing advice durivg the initial phase and consultation as the task pro- gresses. 2. PreDaratorv Work Previous to Mission. The consultant(s) should send to PBC's counterpart team (in advance of the visit) all the relevant back- ground literature which will be used for instructional purposes at the begin- ning of his miesion (two daye of lectures previous to the start of the empiri- cal %iork)p and upon which the proposed application will build upon. Detailed data requests and work programs should also be sert prior to arrival. - 164 - ANNEX 16 Attachment 1 3. Outputs to be Prepared by the Consultant(s). The consultants will produce a fully-fledged policy-oriented research proposal, examining the rele- vant literature and international experiences, proposing a specific methodol- ogy. They will assess the quality and data requirements and provide advice during the initial phase, as well as some consultation until the completion of the task. 4. Length. Date. and Freguency of the Visits. One-month visits to China by two foreign experts per year over a three-year period. 5. Characteristics of the Consultant. Strong academic background in the areas to be addressed under the particular research topic selected. Familiarity with Chinese statistics and economic system. - 165 - ANNEX 17 CHINA FINANCIAL SECTOR TECHNICAL ASSISTANCE PROJECT MOP Debt Management and PBC Fiscal Agent/Monetarv Policy Component Terms of Reference 1. Expert Assistance on Development of Government Securities Market (19.5 staff-months. of which 7.5 to PBC and 12 to MOF) 1.1 The main responsibility of the expert will be to provide advice on all matters relating to setting up and operating a systematic mechanism for the sale of government securities and PBC short term paper. During the prepa- %atory stage, the expert will assist MOF and PBC in establishing the technical and operational arrangements for underwr ting and auction procedures. Once the operational arrangements have been determined, the expert will assist in developing a regular schedule of bill and bond issues, and a strategy to introduce new maturities and technical features, and new selling techniques. The expert assistance is in line with recommendations 5, 10, 13, 15, 18, 21, 23 and 27 of the IMF (CBD) advisory report. 1.2 The specific tasks to be Performed by the expert include: (a) During the preparatory stage, the expert will make recommendations on and discuss with the authorities the appropriate division of labor in government securities market regulations and supervision. (b) Also during the preparatory stage, brief the authorities on under- writing and auction regulations and other operational arrangements for selling government securities in major countries, and recommend appropriate arrangements in China.l/ (c) Help the MOF and PBC develop appropriate procedures for introducing and implementing auctions of treasury/PBC bills. Among the issues that need to be addressed are the timing and volume of tenders, based on both budgetary and monetary policy considerations. This may require advice on specific organizational units and other opera- tional arrangements for coordination that ma- need to be set up or strengthened at MOF and PBC to carry out operations in treasury/PBC bills. The oxpert should advise on specific procedures for conduct- ing auctions (i.e., necessary manuals, forms, publicity techniques, printing, issuance, distribution and safekeeping of securities, arrangements for implementing and supervising sales). The advhor will also organize and conduct a seminar, for the benefit of MO1, PBC and other concerned entities on auction techniques and proce- dures. l/ This stage could coincide with the study tour of selling techniques and auction procedures in selected industrialized countries. - 166 - ANNEX 17 (d) Advine on the technical features and selling techniques for a non- marketable long-term saving bond targeted for households, and on the operational arrangements for the distribution of such bonds. The expert should also assist in preparing a seminar for the authorities on these topics. (e) Review the role and function of the PBC Quotation Center in order to evaluate the feasibility of setting up auction arrangements on a national basis using information exchange facilities of the center. The expert should also examine the role and functions of MOF's moni- toring center and make recommendations as needed. (f) Advice on operational arrangements for dealers in government securi- ties (i.e., eligibility criteria, how appointed). The expert should also organize a short securities market training program for the dealers; (g) Advice on the necessary adaptations to accommodate a regular sched- ule of auctions as well as auctions of an expanded range of maturi- ties; (h) Coordinate the work closely with advisors on debt programming, trea- sury cash management, and open market operations. Mi) Advise on the drafting of government securities laws and the required regulations for :arrying out sales of PBC's short term paper. Timing 1.3 An expert (or team of experts) will be required for a period of 19.5 staff-months in total, over a three-year period. During the first year, a total of 7 staff-months will be required to carry out the preparatory stage of introducing an auction system for treasury bills and developing underwriting procedures, advise on the features and distribution of a long term savings bond and conduct a seminar on this topic, review the role, functions and equipment needs of MOF's monitoring center and advise on operational arrange- ments for securities dealers. The expert will also advise on government secu- rities regulations. The expert will advise PBC in the legal, regulatory and operational aspects of developing new market-based monetary policy instruments (including auctions of short term PBC and/or Treasury bills). During year two, a total of 10.5 staff-months of expert assistance will be required to implement the auctions and streamline underwriting procedures and expand the range of eligible participants in treasury bill auctions. The expert will also conduct a seminar for MOP and PBC on auction3. During years two and three a total of 4 staff-months of expert assistance will be required to investigate the possibility of using the Quotation Center to facilitate auc- tions on a national basis. 0-uwlifications an Experience of Expert 1.4 The expert(s) should have served in an advisory/decioion making capacity in the area of managing government debt sales and interacting with - 167 - ANNEX 1t market participants. The expert should also have background in the area of monetary policy formulation and implementation and its coordination with gov- ernment debt management, as well as regulatory and legal aspects. The expert(s) could be a current or retired staff member from a Central Bank of an industrialized country, or a Finance Ministry. 2. ExDert on Establishing Operational Arrangements for Short-Term Reserve Money Forecasting (16 staff-months to PBC) 2.1 The main responsibility of the expert would be to advise on the design of an appropriate framework for reserve money programming, including short-term forecasting and monitoring of bank reserves. The expert assistance is in line with recommendation 11 of the IMF (CBD) advisory report. 2.2 The specific tasks to be Rerformed by the exRert include: (a) Assess PBC's capacity to make forecasts of the liquidity of the banking system on a regular basis (reserve money programming). In particular, assess PBC's capacity to generate the required informa- tion from PBC itself, from the specialized banks, from MOP, and from other relevant agencies, and make recommendations for improvement as appropriate. Assist in developing new information and in coordinat- ing the flow of information between the above agencies in order to facilitate short-term forecasts for managing bank reserves. (b) Assist PBC staff in setting up an initial database of monetary and money market statistics, analyzing key tactors affecting money mar- ket liquidity, designing a framework for reserve money forecasting, and conducting initial forecasting exercises.2/ (c) Advise on the requisite database and computer facilities for reserve money programming. This includes advising on the appropriate com- puter hardware and software for PBC.3/A/ (d) Assist in arranging requisite training for PBC staff in the area of short-term reserve forecasting and monitoring. 2I The advisor should work closely with the advisor ror the research and statistices component of the Financial Sector Technical Assistance Proj- ect. / >The Technical Assistance Program includes an allocation of 4 personal computers for this component, plus networking. This may be amended as necessary. l This component may require a separate expert in systems development to generate necessary software in coordination with overall automation stra- tegy for the PBC. - 168 - ANNEX 17 Timing 2.3 An expert (or team of experts) will be required for a period of 16 staff-months in total, over a three-year period. Assessment of the data capacity, coordinating the flow of information and advising on the requisite computer needs will take 8 staff-months. Designing and implementing a program for reserve money forecasting will take 4 staff-months, while training will require an additional 4 staff-months. Qualifications and Exiterience of Expert 2.4 The expert should be a current or retired staff member of a research or monetary operations department of a central bank with experience in manag- ing all aspects of reserve money forecasting and monitoring. 3. Expert on Debt Programming and Treasury Cash Management (14 staff-months to MOF) 3.1 The main responsibility of the consultant will be to strengthen the capacity of MOF to forecast and monitor the Government's cash balances (and borrowing requirements). This is required for debt management planning, set- ting auction schedules, as well as for general budget forecasting. The expert assistance is in line with recommendation 19 of the IMP (CBD) advisory report. 3.2 The specific tasks to be performed by the expert include: (a) Assess MOF's capacity to make monthly/weekly/daily cash balance forecasts. Also assess capacity for Government debt progrAmming. In particular, assess MOP's capacity to generate the required infor- mation from appropriate agencies. The expert should assess the related organizational structure of MOF and make recommendations for change as needed. (b) Assist in developing techniques for Treasury cash balance forecast- ing and debt programming, including setting up the initial database of fiscal statistics on daily/weekly/monthly basis (as required for OMO and auctions), and conduct initial forecasting exercises. (c) Organize short training seminar on treasury cash management for selected MOF staff and other relevant agencies, by developing format and materials as appropriate. td) Advise on computer hardware and software needs for cash balance forecasting and debt probramming. 5/6/ 5/ Technical Assistance Program includes allocation of 10 personal comput- ers, plus networking and software. This may be amended as necessary. 6/ This component may require a separate expert in systems development. - 169 - ANNEX 17 Timing 3.3 An expert (or team of experts) will be required for a period of 14 staff-months, covering a 3-year period. The initial stage of assessing MOP's data capacity and computer needs and setting up initial database will take 6 staff-months. Setting up debt programming and treasury cash balance forecast- ing techniques will take 4 staff-months, while staff training will take an additional 4 staff-months. The expert will allocate 4 staff-months in year one of the program, 6 in year two of the program and 4 in year three of the program. Qualifications and Experience of Exvert 3.4 The expert should be recruited from a Finance Ministry with exten- sive experience in managing all aspects of treasury cash forecasting and moni- toring. 4. Expert Assistance on Money Market DeveloDment and ften Market Operations (10 staff-months to PBC) 4.1 The main responsibility of the expert on money market development and open market operations will be to assist in reviewing the current struc- ture of money markets in China, with a view to modifying the structure as appropriate, as well as advising on the eventual Introduction of open market operations. The expert will also advise on establishing national regulations governing money market transactions. The expert assistance is in line with recommendations 7, 12, 14 and 26 of the advisory report. 4.2 The specific tasks to be performed by the expert (or team of experts) include: (a) Review the draft regulations and accounts settlement arrangements governing interbank markets, and regional regulations governing other money market transactions, and make recommendations for revi- sion, including the adoption of national regulations; advise on the need for revisions in the legal framework. The recommended changes should also draw on the experience of other countries with emerging money markets, on which the expert should present findings to the appropriate authorities.7/ (b) Review the organizational structure of PBC relating to monetary operations and make recommendations as needed. (c) Review the current range of institutions involved in money market trading, and the range of instruments in use, and recommend improve- ments that would stimulate competition among banks, ensure greater transparency in the market, and impart greater flexibility in the 7/ A separate legal expert to review the necessary legal framework for the money market, and assist in establishing or amending commercial codes, bill of exchange laws, etc., may be required. A brief visit by a cen- tral bank accounting expert may also be needed. - 170 - ANNEX 17 interbank rate. The expert should work closely with the advisor on government securities. (d) Advise PBC on technical details of developing open market operations in government securities in both primary and secondary markets. The expert should advise on the use of auctions of treasury bills, refi- nance auctions, and other instruments, and their coordinated use to implement monetary policy. The expert will also advise on specific arrangements for conducting repurchase and reverse repurchase agree- ments, as well as other possible intervention techniques. (e) In order to develop intervention techniques, the expert should advise on the introduction of regular auctions of short-term PBC relending. This would include advising on the rules of access to various PBC relending facilities, collateral requirements, and intsrest rate structure. The expert should also advise on technical aspects of conducting auctions of PBC relending, including eligibil- ity criteria for bidding (i.e., banks and/or NBFIs), bidding format, frequency of auctions, etc. The expert will advise on determining auction volumes in line with the reserve money forecasts, and coor- dinating the timing of these auctions with treasury bill auctions. (f) The expert should advise on the necessary changes to reserve accounting practices.8/ (g) The expert should brief the authorities on money market intervention techniques, including refinance auctions, in major countries that have undertaken monetary management reform. The expert should also brief the authorities on open market techniques in other countries, and make recommendations for China. The expert should also assist in training staff in conducting open market operations in coordina- tion with the work of the expert on short-term reserve forecast- ing.9/ Ch) The expert should advise on the financial/accounting arrangements between PBC and MOF for conducting open market operations, if and when a decision is taken to issue short-term Treasury bills. Timing 4.3 An expert (or team of experts) will be required for a total period of 12 staff-months over a 3 year period. Recommendations on regulations gov- erning money markets and revisions to the current structure of money market. require 3 staff-months, of which 2 in year one and one in year two. Advice on introducing auctions of PBC relending will take place in year two, and consist g/ The expert should work closely with the advisor for the central bank accounting component of the Financial Sector Technical Assistance Proj- ect. 9/ This advise should coincide with the study tour of money market interven- tion techniques in major countries. - 171 - ANNEX 17 of 3 staff-months, while preparations for open market operations will require 1 staff-month in year two and two in year three. Qualifications and Experience of Expert 4.4 The expert(s) should have served in an advisory/decision-making capacity in the area of managing all aspects of money market intervention, including open market operations, and on related regulatory aspects. The expert(s) should also have a background in government debt management and its coordination with monetary management. The expert(s) could be a current or retired staff member from a central bank of an industrialized country. 5. Expert Assistance on Book-Entry Securities System (20 staff-months to PBC) 5.1 The main responsibility of the expert(s) will be to design a book- entry system which will serve initially for holdings, clearing, and settlement of PBC paper, and have the flexibility to be expanded to include a wider range of securities. The expert(s) will also advise on the implementation of the design. Because of the close linkage of the book-entry system with the pay- ments system and PBC's overall automation strategy, the expert should liaise with the advisors in these areas. After an intensive initial period for design, the expert should also consult during the implementation phase. The expert assistance is in line with recommendations 9, 24 and 31 of the IME (CBD) advisory report. 5.2 The specific tasks to be performed by the expert include: (a) Review with the authorities their plans for the government securi- ties market, with particular attention to the participants, amounts and frequencies of issues. To what extent will the market be cen- tralized or decentralized? What types of transactions should be supported? Repurchase agreements, for example? Determine the level of business that will need to be supported by the book-entry system over an initial 5-year period, under different assumptions regarding PBC's role as fiscal agent for the MHO. (b) Assess the current operational capabilities and automation plans of the PBC and of the likely participants in the security market. The expert should consult with staff at the PBC and with likely partici- pants to integrate the book-entry system with the overall automation strategy. (c) Determine, in consultation with authorities, which functions should be performed by the system; transfers, payments of interest, redemp- cion, primary and secondary mark-et trades, and reporting require- ments. (d) Design an automated system that will meet the business requirements in (i) above and that will interface with the developing payments system. The design should take into account the following: -172- ANNEX 17 (i) Current and upcoming technology and costs of purchasing versus leasing equipment; architecture of the system. (ii) Co=unications and transmission technology. (i4i) Flexibility of the system to accommodate further changes. (iv) Safety and security, to reduce the chance of fraud or acciden- tal errors. (v) Risk management, for credit, liquidity and systemic risks. (vi) Operating capabilities of participants. (e) Advise on the sequencing of implementation if the authorities decide to go ahead with the plan. Advise on what work should be done internally and what should be put out for bid. Recommend procedures to acquire (or lease) hardware and software. Set selection criteria for bidding for hardware, if appropriate. (f) Expert will cooperate with other advisors in related areas, such as payments systems, government securities markets, money markets, and open market operations. (g) The advisor will consult with appropriate authorities concerning the legal and regulatory framework for securities transactions to ensure that the book-entry system will be in line with the framework. (h) The expert should also arrange for training of the appropriate staff once the book-entry system is operational, and assist in the actual implementation of the system. Timing 5.3 An expert will be required for a period of 20 staff-months over a 3- year period. Because of the close linkage of the book-entry system with other elements of PBC's overall automation strategy, particularly the payments sys- tem, it is essential that the work begin as soon as possible in order to coor- dinate it with the automation strategy. The design stage of the system will require a total of 6 staff-months over the first and second years of the program. Software development will require 6 staff-months. The actual imple- mentation of the system during year three will require 8 staff-months of tech- nical assistance, including 2 staff-months for training. _ualifications and Experience of Expert 5.4 The above assignment will require a multi-disciplinary team with expertise in the conceptual, technical and operational aspects of book entry systems development and the linkages with payments and clearing systems. -173- ANNEX 17 6. Study Tours Study Tour on Government Securities Markets and Selling Technigues 6.1 During the first year of the program, one study tour will be con- ducted to introduce PBC and MOF staff to operational arrangements of auction systems for government securities in other countries, as well as to study variations in selling techniques to meet the needs of different investor groups. At the same time, the study touir will observe institutional struc- tures of government securities markets, as well as institutional arrangements and information systems used by certral banks and finance ministries for moni- toring these markets. The study tour will include six staff and one inter- preter. The staff should be senior personnel (Division Chief level) with responsibilities for the issuance of treasury securities. It would be advan- tageous to have staff from both PBC and MOF on the same study tour, so as to encourage discussion of coordination issues with the host authorities. The group would visit two to three industrialized countries. The study will last approximately three weeks, including travel time. Study Tour on Money Market Operations 6.2 During the third year of the program, one study tour will be con- ducted to acquaint senior staff of PBC with institutional arrangements for conducting open market operations in other countries, as well as other money market intervention techniques. The study tour should also observe treasury cash forecasting and reserve money programming techniques in the selected countries. The study tour shciuld also review the regulations governing money markets in these countries. The study tour will include five staff and one interpreter. The staff should be senior personnel (Division Chief level) responsible for managing money market intervention. The group -ould visit two to three industrialized countries. The study tour will last approximately three weeks, including travel time. - 174 - ANNEX 18 CHIA FINANCIAL SECTOR TECHNICAL ASSISTANCE PROJECT Summary of Technical Assistance to Legal Department The technical assistance to be provided under the Project would be comprised of three parts: development and implementation of a financial legislation database; provision of expert advJce; and undertaking two seminars on banking legislation. The financial legislation database would provide access to all rele- vant laws and regulations for all participants in the financial sector. Its development would take place in three steps. Firet, a database would be developed to include all the nationwide financial legislation promulgated or approved for promulgation by the State Council and all the financial regula- tions issued by the People's Bank of China (PBC) since 1949. This step would be completed in the first half of 1993. Second, a database would be estab- lished to include all the internal rules and regulations issued by the specialized banks (Agricultural Batik of China, Bank of China, Bank of Communications, China Investment Bank, CITIC Industrial Bank, Industrial and Commercial Bank of China and People's Construction Bank of China, etc.). this second step would be completed in the second half of 1993. Third, a local financial legislation database would be established, to include the financial rules and regulations issued by the local branches of PBC and the specialized banks. This third step would be completed in the second half of 1993. In view of the importance of the revision and promulgation of a nationwide comprehensive banking law, expert advice would be provided to the Legal Department of PBC in comparative banking law and banking law drafting. The expert advice would commence in the fall of 1992 or early 1993, and would continue thereafter on an ae needed basis. Two seminars would be organized on banking legislation. The first would be held in early 1993, and potential topics would include: design of the banking law, the independence of the central bank and the objectives of monetary policy, separate administration of the banking, securities and insur- ance sectors, "enterprization" of operation and functions of the specialized banks, legal questions of banx risk management and other legal questions related to banking operations, such as bank secrecy. The second seminar would take place late in 1993 and would include relevant topics, depending on the status of banking legislation at that time. Under the Project, international expert participants would be invited to participate in the seminars. - 175 - ANNEX 19 CHINA FINANCIAL SECTOR TECHNICAL ASSISTANCE PROJECT FBC Graduate School Terms of Reference for Adviser Introduction 1. The PBC Graduate School was established in 1981. The School is cofundee by the People's Bank of China (PBC), the four specialized banks and the People's Insurrance Company of China (PICC). The Graduate School offers master anti doctoral programs to students who are then absorbed by PBC or one of the other banks supporting the School. The School provides students with both a thaoretical as well au practical foandation in economics and interna- tional finiance and banking. Current enrollment in the school is 120. of which 18 are doctoral candidates. The School has some 9 full time professors and associate professors; these are supplemented by part time professors drawn from other universities, PBC and banks. 2. Despite impressive achievements to date, the Graduate School need. further strengthening, both in terms of physical resources and the quality of education provided. Therefore, under the World Bank Financial Sector Techni- cal Assistance Project, PBC would engage, for a two year period, a foreign expert, with at least 5 to 10 years experience as a graduate school professor. Scope of Work 3. The responsibilities of the expert would be tot (a) assist the School to elaborate a revised curriculum for macters ard doctoral students, including a core program for all students and supplemental programs for students specializing in different areas (to be completed within six months of the start of the assignment); (b) assist the School to outline the appropriate content for the various courses defined in the proposed curriculum (to be completed within 12 months of the start of the assignment); (c) teach two courses each semester on subjects to be agreed with PBC and the World Bank; (d) advise the School on recruitment of full and part-time professors and assist in evaluating the performance of professors recruited; (e) advise the School on purchase of books and other training materials; (f) assist in developing training materials for selected courses; and - 176 - ANNEX 19 (g) undertake other reasonable tasks requested by the management of the Graduate School. Reportina 4. The expert would be required to produce quarterly reports on his/her activities. The expert would also be required to produce a draft final report in month 23 and a final report four weeks later. This report inter alia should aseess remaining deficiencies and constraints hampering the future development of the Graduate School and outline further steps to achieve aca- demic excellency. - 177 - ANNEX 20 CHINA FINANCIAL SECTOR TECHNICAL ASSISTANICE PROJECT PBC Graduate School: Equipm%nt List Foreign Name of equipment Quantity cost (set) ($) Main Apparatus 51,200 Main controller WE-7810 1 Main tape recorder WE-6310 2 Tape recorder for student use WE-6610 48 Student insulating desk WE-8031A 24 Earphone WE-5950 49 Collateral Aparatus 43,000 Other Equipment Analyzer WE-7950 1 l Slide projector WE-9080C 1 1 7,700 Microphone WS-1250 2 Wire Collateral Teacher's monitor WV-Cm 100 1 1,700 Students' monitor WV-CH 1000 6 9,800 Airhead project TV SHARP 1002M 1 4,700 Video cassette recorder J-700 2 2,300 Hi-Pi B5000 1 2,770 Power AC Adaptor 1 2,300 Air conditioner Mitsubishi PsH-SG6 1 5,770 Information locket 2 300 Shoe locket 4 600 Humidity moderator 2 1,200 Pickup camera Panasonic M8000 1 2,300 Cassette & video type 1,000 Total 93.660 - 178 - ANNEX 21 CHINA FINANCIAL SECTOR TECHNICAL ASSISTANCE PROJECT People's Bank of China Terms of Reference for Automation Strategy Study Introduction 1. The World Bank is preparing a financial sector technical assistance project aimed at strengthening a number of aspects of management and opera- tions in China's financial sector. Aspects under consideration include the strengthening of accounting, bank supervision, payment systems, research and statistics, legal framework for financial operations, and others. The People's Bank of China (PBC), being the Central Bank, plays the leading role in the strengthening the macro regulatory functions, the control of capital and money supply. In order to achieve these objectives, PBC needs to estab- lish a systematic approach to office automation (OA) and a management informa- tion system (HIS). PBC has realised that piece-meal development in electronic data processing cannot satisfy the needs of the management and decision making functions of the central bank .ole. The purpose of this proposed study is to develop a comprehensive perspective plan to satisfy the Headquarters require- ments in office automation and management information system, in order to guide developments in these critical areas over the next five yea:s. 2. Automation in PBC at this time is very limited. For example, the Research and Statistics Department has only four 286/386-class microcomputers and several older IBM/XT microcomputers. By way of a 3Com server, some 250 million characters of data are being maintained for analysis. This capability and capacity satisfies only a very small fraction of the needs of performing the research and statistical functions of that department. In the case of the Supervision Department, there are only three personal computers in the HQ and a total of seven personal computers in the field for some 6,000 bank examin- ers. Other Departments are at a similar level of very limited automation. There are two small minicomputeres an M240 and an M150, at Headquarters. Currently, requests from various departments for computer technologies are increasing and are varied. As the perceived requirements for automation are evolving and specific applications are being identified, there is an urgent need to define a technological infrastructure to avoid fragmentation and to guide automation development as requirements become mature. 3. Two recent developments provide an opportunity for installing a cost-effective infrastructure for automation. One is the implementation of the Payment System by PBC, with the establishment of a satellite-based comu- nications system, currently linking 40 branch offices, and expanding later to some 600 other branch offices. This system has the capacity to provide addi- tional data communications especially during non-peak hours for other systems needs. The other significant development is the recent completion of the new PBC Headquarters building (with no equipment installed as yet). - 179 - ANNEX 21 Oblective of the Study 4. The objective of the study is to develop a comprehensive plan to install a basic set of facilities to be used as a platform for automation, in order to aid the management and operation of PBC and its branch offices. Not all management and operations functions are suited for automation, nor are all suited applications are ready for automation. Therefore, the study will develop a plan for the deployment of facilities and equipment, the implement- ation of automated systems, and the provision of staff training. The plan should cover the requirements of the next five-year period, and in accordance with the priorities set by PBC. Scope of Work 5. To achieve the above objective the scope of the study will include: (a) Identify and articulate the automation needs over the next five years of key PBC functional areas such as (i) Funds Management; (ii) Currency Issues (iii) Research and Statistics; (iv) Accounting; (v) State Treasury; (vi) Supervision; (vii) Financial Administration; and (viii) Internal Audit. The consultant will be required to iden- tify these needs based on a quick analysis of the broad areas, on conceptual and design work already undertaken in some of these application areas, and also on experience of other similar institu- tions elsewhere. (b) Determine the needs for additional workstations (personal computers) by PBC Headquarter staff on the basis of rapid inventory, with an objective to provide appropriate technology for each staff who has the need for workstations over the five-year period. (c) Taking into consideration the existing equipment, and based on the needs defined in (a) and (b), as well as the information that PBC Headquarters would require from the branches, the specialized banks and other government organizations, plan the office automation and management information system requirements for Headquarters depart- ments and the three levels of branch offices (40 first level, 300+ second level, and some 2,000+ third level), for the period of five years. (d) Recommend a computer topology and type of wiring for the Headquar- ters building, in support of the projected automation. The topology and the wiring scheme should be multipurpose and the gateways should cater to the needs of satellite and ground communications. Consid- ering the long life span of the building, the wiring plan needs to be sufficiently versatile to accommodate evolving technology for at least the next Iv years. (e) Assist in determining the appropriate staffing pattern over the five-year period to support the facilities to be deployed and to develop applications identified. - 180 - ANNEX 21 (f) Determine training needs for technical staff as well as end-usero, consistent with the projected buildup of technology and applica- tions. (g) Develop cost estimates over the five-year period, inclusive of needs in the PBC Headquarters and that of the branch offices, dividing the cost estimates between local and foreign currencies. (h) PBC currently is completing a satellite-based communications facil- ity in support of the intercity Payment System. Although the system is installed to primarily support the Payment System, there is how- ever spare capacities especially during nonpeak hours for other applications. In addltion, a parallel study is in progress to develop a more robust communications system for broader applica- tions. This study, therefore, should assume the availability of such a private network connecting all second level branches and some of the county branches over the next five years. In this connec- tion, estimate the traffic load on the system, during peak houro and nonpeak hours. (i) Design a framework for a decision support system on the basis of a relational data base, supported by modelling analytical techniques, such as currency supply model, a credit model and a interest rate regulatory model. Study OutDut 6. At regular intervals during the study and at its completion, the consultant is expected to produce written reports, diagrams, and tables as applicable for each of the tasks identified in the Scope of Work above. The consultant should take into consideration the feedbacks and comments of PBC and modify the work program for the remaining period accordingly. Each report will include the data collected, analysis performed, alternatives explored, and basis for the conclusions/estimates/recommendations. As delineated above, eight documents will be provided, addressing each topic individually. Schedule and Envisioned Level of Effort 7. It is envisioned that the following level of effort is requiredt (a) The study is to complete within four months, after signing of agree- ment, with one month of preparation and three months of work. The study is to be completed no later than December 1992. (b) It is estimated to require 9 staff-months of professional time in several applicable disciplines. (c) The atudy is expected to be carried out to a large extent in Beijing, China, with some field visits to branch offices outside of Beijing. - 181 - ANNEX 21 Selection Criteria 8. The selection of the Consultant will be based on the following cri- terias (a) Experience in conducting strategic and perspective studies of office automation and computerization (25 percent). (b) Experience in office automation and management information systems in a Central Bank context (15 percent). (c) Experience in the field of office automation and computerization in China or other developing countries (25 percent). (d) Professional skills in the areas of office technology, large-scale computer operations, communications (satellite communications know- ledge not required), operating system, and application systems requirements definition,and implementation (35 percent). Proiect Management 9. The study will be directed by a Steering Committee established within PBC, chaired by the Deputy Governor, with several department directors as committee members. The Steering Committee will decide on all recommenda- tions and issues and will approve the results of the study. 10. The day-to-day supervision will be provided by a Working Committee, chaired by a senior PBC staff, with members comprised of major user groups. 11. Working Groups will be established within PBC to act as counterpart teams to facilitate the work of the consultants during the design, develop- ment, implementation and operational phases. - 182 - ANNEX 22 CHINA FINANCIAL SECTOR TECHNICAL ASSISTANCE PROJECT Terms of Reference for Study on Directed Credit Background 1. Reforms in the financial sector were initiated in the late 19708 and began to accelerate in the mid-1980s. The reforms included the establishment of banks as independent entities from the central bank with some measure of independent decision making and responsibility for their profit and losses. Stated intentions are to have banks operate increasingly as commercial enti- ties. Nevertheless, juxtaposed against this objective is the contradictory stance that banks have a role to play in allocation of credit to sectors and enterprises considered as priorities by the Government, and concomitantly, the interdiction that banks should not lend to some enterprises or sectors consid- ered as lesser priorities. During the period of the rectification program, directed credit appears to have increased. Similarly, the Government has in recent years introduced priority loans which benefit from reduced interest rates. Such loans cover both fixed asset and working capital loans. It is estimated that priority loans account for 30 percent of fixed asset t.&nancing. 2. Experience worldwide has indicated that directed and subsidized credit seldom achieve their stated objectives. Credit is often diverted to purposes other than intended, there is excess demand for credit requiring rationing from which the powerful (but not necessarily the most efficient) benefit, and subsidies are given indiscriminantly to all enterprises in a designated priority sector irrespective of need. More importantly, directed and subsidized lending tends to have critical detrimental implications for banks' financial performance, ultimately requiring support from the budget to salvage insolvent banks. The budgetary outflows in turn have the obvious con- sequences for overall macroeconomic stability. 3. There is a need in China to progressively reduce and eventually eliminate government intervention in credit allocation and subsidized lending. In the interim, ideally all lending which does not conform to banks' objective commercial lending criteria should be handled by the banks on a maniaged fund basis with all profits and losses accruing to the State. Even in so far as budgetary implications lead the authorities to consider this impossible in the short term, it will be important to take actions to clearly segregate such lending so that its impact is transparent and eventually the losses can be compensated. Alternatively, all directed and subsidized lending could be concentrated in one institution, leaving the rest of the financial system clean. Both alternatives have their advantages and disadvantages and their complexities. Sco.e of AssiQnment 4. On the basis of the above considerations, under the World Bank financed Financial Sector Technical Assistance Project, the People's Bank of - 183 - ANNEX 22 China (PBC) wishes to undertake a study to determine an approach for treatment of directed and subsidized credit. The proposed study would undertake the following: (a) define what constitutes directed credit and determine, with the help of the specialized banks, the volume of such lending (broken down into working capital and longer term lending) in the specialized banks' outstanding portfolios; (b) determine the amount of directed credit (broken down into working capital and longer term lending) which is expected to be allocated by the specialized banks in the coming years; (c) determine the volume of subsidized lending in the banks' portfolios and the amounts expected to be allocated in the coming years; (d) review the feasibility and desirability of making one financial institution responsible for all such lending in China, analyzing financial implications; (e) review the feasibility and desirability of instead having the spe- cialized banks continue to handle such lending with the accounting for such lending clearly segregated; (f) recommend which among alternatives (d) and (e) is preferable or recommend another alternative; (g) if alternative (d) is selected, recommend a strategy for implement- ing the alternative, including whether outstanding directed loans should be transferred to the designated institutions or only new directed lending; (h) if alternative (e) is selected, recommend a strategy for implement- ing the alternative, including the process for allocating loans as directed or commercial, the means and formats for maintaining sepa- rate accounts for directed and commercial lending, etc. (i) if another alternative is selected, map out a strategy for its implementation; and (j) determine the timetable for implementing the recommended alterna- tive. Oreanization of the Study 5. The study would be undertaken by PBC, with the support possible of a few man-months of external experts. The study should be completed by the end of the first year of the project (that is, from credit effectiveness). - 184 - ANNEX 23 CHINA FINANCIAL SECTOR TECHNICAL ASSISTANCE PROJECT Estimated Disbursements ($ million) Year/Semester Amount Cumulative FY93 II 3.0 3.0 FY94 I 0.8 3.8 II 1.9 5.7 FY95 I 2.0 7.7 II 2.4 10.1 FY96 I 3.6 103.7 II 6.0 1.9.7 FY97 I 6.0 25.7 II 6.0 31.7 FY98 I 8.4 40.1 II 8.4 48.*5 FY99 I 6.0 4. II 3.0 57.5 FY2000 I 2.5 60.0 Based on standard disbursement profile for technical assistance loans, Asia Region, adjusted for Special Account. - 185 - ANNEX 24 CHINA FINANCIAL SECTOR TECHNICAL ASSISTANCE PROJECT Key Monitoring Indicators Indicators Target Dates A. General Credit effectiveness December 1992 B. Utilization of Credit Proceeds Closing date September 30, 1999 C. Project Implementation 2. PBC ComDonents 1. Payments System Development - PBC Appointment of consultants for master design study September 1991 Consultant cmmences work October 1991 Stocktaking report January 1991 Interim enhancement report March 1992 Vision report March 1992 Conceptual design March 1992 Detailed design - first draft June 1992 final draft September 1992 Request for information July 1992 Request for proposal--to Bank Group October 1992 --finalized December 1992 Selection of vendor July 1993 Implementation July 1993 onwards First meeting International Advisory Panel November 1991 Second meeting International Advisory Panel February 1992 Third meeting International Advisory Panel July 1992 Fourth meeting International Advisory Panel November 1992 2. Regulation and Supervision - PBC la Appointment of consultants December 1992 Start of work January 1993 Completion of BOCOM Pilot Exam. October 1993 Completion of organizational study June 1994 Completion of on-site examination procedures and off- site surveillance methodologies March 1995 Completion of prudential regulations June 1994 Provision to Bank Group of timetable for enactment of prudential regulations October 1994 Supervision training plan June 1995 Completion of special asset reviews of ABC branches December 1994 Completion of special asset reviews of branches of ICBC and BOC December 1995 Special asset reviews of all specialized banks by PEC 1994-98 - 186 - ANNEX 24 Indicators Target Dates 3. Accounting Appointment of consultant December 1992 Start of work January 1993 Completion of inventory of accounting standards/practices and proposed implementation plan August 1993 Completion of Accounting Standards January 1996 Organizational study February 1994 PBC and financial sector accounting MIS system report August 1994 Charts of Account/Manuals June 1995 Training plan, curricula and materials July 1094 Final report January 1996 4. Internal Audit Start of work February 1993 Completion of organizational study March 1994 Internal audit procedures/practices/programs March 1994 Internal audit manual March 1995 Training plan, curricula and materials August 1994 Final report February 1996 5. Research and Statistics Refresher courses 1993 Research projects/studies Demand for money 1993-94 Flow of funds 1993-95 Analysis of savings behavior 1994-95 Survey research 1993-94 Business cycle models 1993-9t Financial models 1993-94 Background research studies 1993-95 6. Fiscal agent/monetarY Rolicv Development of auctions and open market operations 1993-95 Strengthening comprehensive cash planning 1993-95 Auction and other regulations 1993-94 Complete design study of book-entry system 1994 7. Legal Complete banking law April 1993 8. PBC Graduate School Expert Advisor 1993-95 9. Study on Directed Credit December 1993 10. Automation Strategy Study August 1993 - 187 - ANNEX 24 Indicators Target Dates II. MOP Components 1. Accounting Draft of framework (concepts) for new accounting standards November 1991 Promulgation of framework End 1992 Appointment of Special Advisor December 1992 Appointment of consultants to DAAA D&camber 1992 Start of work January 1993 Work plan for developing new standards Narch 1993 Strategy for implementing new standards July 1993 Completion of 25 basic standards January 1995 Completion of remaining basic standards January 1996 Final Report January 1996 Completion of CPE study December 1993 2. Government Domestic Debt Management Strengthening debt programming and treasury cash management 1993-95 Regulations governing deelers and auctions 1994-96 New product development 1993-94 Developing auction and urderwriting techniques 1993-95 III. AAPRC Appointment of consultants January 1993 Start of work February 1993 Completion of Auditing Standards July 1993 Promulgation of new standards End 1993 La Indicative target dates; they will be firmed up upon receipt of consultants' proposals. SAR217.A251CH& S&R/Kafka108-08-92javtIdg2jmjd ANEU 25 Page 1 CHINA FINANCIAL SECTOR TECHNICAL ASSISTANCE PROJECT Matrix of Monitorable Indicators Activity Year-One Indicators Year-Two Indicators Year-Three Indicators 'Year-Four Indicators A. PROJECT IMPLEMENTATION 1. PBC (a) Strengthening PBC * Completion of BOCOM e Finalization of Pruden- Regulation & Pilot Examination tial Regulations & Plan Supervision of for Their Implementa- FinanciAl Insti- tion tutions * Implementation of Pru- * Implementation of Pru- 0 Implementation of Pru- dential Regulations dential Regulttions dential Regulations * Finalization of Organi- * Implementation of Rec- zational Study (Super- onmendations of Organi- vision function) zational Study * Finalization of On-Site * Implementation of on- oo Examination Procedures Site ExamKnation Proce- & Off-Site Survelslance dures and Automated Methodologies Off-Site Surve.llAnce * Development of Curricu- * Finalization of Super- * Implementation of lum for Training Bank vision Training Plan & Training Supervisors Materials * Asset Reviews of ABC 0 Asset Reviews of Branches with Iuterna- Branches of ICBC, BOC, tional Consultant Input PCBC, with Interna- tional Consultant Input * Asset Reviews by PBC of * Asset Reviews by PBC of * Asset Reviews by PBC of Specialized Bank Specialized Banks Specialized Banks (b) Payments System * Completion of Master * Selection of Vendor L * Implementation * Implementation Development Design Study & Request Implementation for Proposals SAR217.425CE& ShBKsfaI10$-08-921avtldg'1mjd AM= is Page 2 Activity Year-One Indicators Year-Two Indicators Year-Three Indicators Year-rour Indicators (c) Accouatlng Mod. * Progress in Developing * Progress in Developing * Finalization of * Implementation of nev ernizatiou New accounting Stan- Nev Accounting Stan- Accounting Standards Accounting Standarda dards for Financial dards for Financial for Financl.aI Institu- Institutions in line Institutions in line tions in line with vith International with laternational International Practice Practice Practice o Completion of Organiz&- * Implementation of Rec- tion Study of PBC ormendationa of Organi- Accounting Function zation Study * Completion of Financial * Implementation of MIS * Implementation HIS System for PBC & for PBC & FSRS for Financial Sector Financial Inbtitutions Reporting syatem (FSRS) * Completion of Account- for Financial Institu- ing Manual tions * Charts of Accounts for PBC i other rinancial Institutions (d) Strengthening * Completion of Internal * Implementation of New * hIplementation of New * Implementarion of New F-' lIternal Audlt Audit Procedures Internal Audit Proce- Internal Audit Manual i Internal Audit Manual CO dures New Internal Audit Pro- & New Internal Audit * Completion of Internal cedures Procedures Audit Manual * Completion of Organiza- * lmplementation of Rec- tional Study of PBC ommendations of Organi- Internal Audit Function zational Study (e) Research & Sta- * Progress Report: * Progress Report: * Progress Report: * Assess Use of Training tistics Training & Research Training & Research Training & Research & Research Projects Projects Projects Projects for Policy-Making Pur- poses (f) PBC Fiscal Agency * Progress Report: * Progress Report: * Progress Report: Com- I Monetary Policy Reserve Money Forecast- Reserve Accounting, PBC prehensive Cash Plan- ing Money harket Devel- Lending through Auc- ning (Reserve Account- opment & Open Market tions, Money Market ing) Operations Development * lmplementation of PBC * IUplementation of PBC a Implementation ef PBC Open Market Operations Open Market Operations Open Market Operations * Book-Entry System: * Book-Entry System * Implementation of PFC's e Lmplementation of Design Study Development: Design Book-Entry System PbC'a Book-Entry Sys- Study & Software tem S*217J251WC 8AKafka10I1-08-921vtIdgIjnjd 2S Page 3 Activity Year-ne Indicators Year-Two indicators Year-Three Indicators Year-Your Indicators (a) leal Comonent * Draft BanIing Law * Promulgation & Inpie- mutatiou of Banking Law * Legal Database Develop- * Banking Legislation mont Seminar * Banking Legislation S#ainar (h) PBC's Graduata * Pro&ress Report: * Progress Report: School Expert Assistance, Cur- Expert Assistance, Cur- riculsm, Language Lab & riculus, Language Lab I Teaching Material Teaching Material (M) Study on Directed * Completion of Study ' Discussion of Study & * Implementation of Study * Implementation of Credit Implementation of Study R',comenndationa Study Recoamendations Recommendations (J) Automation Strat- e Completion of Study egy Study 0 * Discussion & implemen- * Implementation of Study * lmplementation of Study * Implementation of tation of Study Recom- Recommendations Recomnendations Study Recommendations mendations 2. MHF (a) Modernization of * Promulgation of Frame- Accounting Stan- work for Nev Accounting dards Standards * Elaboration & Adoption F Finalization of at * Finalization of an * Enactment of New Basic of Plan for Development least 25 Basic Stan- Additional 3-5 Basic Standards of Basic Standards in dards in Harmony with Standards in Harmony Harmony with Interna- International Practice with International tional Practice & Ini- Practlce tiati Work SAR217.A2SICH& SARIKifka108-0B-92IavtIdgj/ajd ANNEX 25 Page 4 Activity Year-One Indicators Year-Two Indicators Year-Three ldic-ators Year-Four Idleators * Approval of Financial * Approval of Financila * Approval of Financial Sector Standards Devel- Sector Standards Devel- Sector Standards Devel- oped by PBC oped by PBC oped by PBC * Elaboration of Strategy * Enactment of New Stan- * Enactment of New Stan- * Enactment of New Stan- for Enacting the New dards, as relevant, in dards, as relevant, in dards, as relevant, in Standards accordance with Strat- accordance with Strat- accordance with Strat- egy egy egy * Completion of Feasibil- * Implementation of CPE * Implementation of CPE * Implementation of CPE lty Study on Program of Program Program Program Continuing Professional Education (CPE) & In- troduction of Program * Design & Implementation * Design & Implementation * Design & Implementation * Design & Implementa- of Advisory & Publicity of Advisory & Publicity of Advisory & Publicity tion of Advisory & a Campaigns to Dissemi- Campaigns to Dissemi- Campaigns to Dissemi- Publicity Campaigns to nate New Standards nate New Standards nate New Standards Disseminate New Stan- q dards * Design & Implementation * Design & Implementation * Design & Implementation * Design L Implementa- of Training Plan/ of Training Plan! of Training Plan/ tion of Training Plan/ Materials Materials Materials Materials (b) Strengthening * Progress in Delegation c Progress in Delegation Domestic Debt from the State Council from the State Council Managemenr to HOP Power to Deter- to HOF Power to Deter- mine Timing & Condl- mine Timing & Condi- ti4e. of Goverrment tions of Goverement Sedurities Issues. Securities Issues. Corsistency of HO1 and Consistency of NOF and FEC interest rates. PBC interest rates. SAR217.A251CHA SARIKafkAIO8-08-92javtldg2lmjd ANNEX 25 Page 5 Activity Year-One Indicators Year-Two Indicators Year-Three Indicators Year-Four Indicators * Development of Debt * Development of Debt Programming & Treasury Programming & Treasury Cash management Tech- Cash management Tech- niques niques * Draft Government Secu- * Draft Government Secu- rities Regulations L rities Regulations & Advise on Operational Advise on Operational Procedures for Govern- Procedures for Govern- ment Securities Dealers ment Securities Dealers * Development of Tech- * Development of Tecn- niques & Procedur a for niques & Procedures for Conducting Auctions & Conducting Auctions & Underwritiug of Govern- Underwriting of Govern- ment Securities ment Securities * Development of New Long-Term Savings Bonds for 3ouseholds - 193 - ANNEX 26 CHINA FINANCIAL SECTOR TECHNICAL ASSISTANCE PROJECT Supervision Plan Bank GrOuR Supervision Input 1. This project would be staff-intensive in its supervision, as the various technical assistance components would require close monitoring. In addition to the regular supervision for the review of progress reports estimated at 5 staff-weeks during the first year, and 4 each during the next two project years, the following staff input is needed. Tndicative Activity Specialization Staff Date Weeks 11/92 MOP - Financial 5 review progress in: Analysis(Accounting) appointment of con- economics (macro-) sultants for economics (payment) accounting, auditing legal components; PBC - review progress in: -appointment of con- sultants for regulat- ion and supervision components; -review progress in the design of Pay- ment system; -drafting of banking legislation; -preparation of the research & statistics and Graduate School component; 4/93 MOF - financial analysis 6 review progress in: (account. & audit.) -workprogram for financial sector accounting component; (regulation) -workprogram for economics (macro-) auditing component; economics (payment) -appointment of con- information technol. sultants for debt management component - 194 - Indicative Activitv Specialization staff PBC - review progress in: -workprogram for regulation & super- vision component; -workprogram for fin. sector acct'g & PBC acct'g system component; -workprogram for int. audit component; -appointment of con- sultants for fiscal agency/monetary policy component; -research & statistics -Graduate School; -appointment of t.a. for automation study; -directed study; -Payment system; 11/93 MOF/PBC - economics (macro-) 7 -annual review of economics/financial progress in financial sector sector reform, and economics (payment) project implement. economics (debt) HOF - financial analysis Review progress in: (account'g & audit.) -accounting component; legal -auditing component; information technol. -debt management; PBC - Review progress in: -regulation & supervision (BOCOH); -fin. sector acct'IS. -PBC acct'g system; -fiscal agency/moaet. policy; -research & statls;tLs -automation study -directed credit; -payment system; -banking sector legis- lation; .~ ~ ~~~~~~~~~~~~~~~~----- .-.. - 195 -A X 26 Indicative Activity Specialization Staff Date Weeks 04/94 MOF - financial analysis 6 Review progress in: (account'g & audit.) -accounting component; economics (macro) -auditing component; economics (payment) -debt management; economics/financial -training; sector PBC - training Review progress in: economics (debt) -regulation & superv. (BOC/ABC/ICBC); -accounting; -internal audit; -training; -payment; -fiscal agency/monet. policy; -Graduate School; 11/94 annual review - same as in 10/93 7 activities analogous to 10/93 segment 04/95 activities analogous same as in 03/94 6 to 03/94 segment 11/95 annual review - same as in 10/94 7 activities analogous to 10/94 segment 04/96 activities analogous same as in 03/95 6 to 03/95 segment 11/96 annual review - same as in 10/95 5 activities analogous to 10/95 04/97 MOP - debt management economics 3 PBC - supervision; fiscal agency; ree. & stat.; 11/97 annual review economics 4 financial analysis/ accounting legal 04/98 same as in 03/97 same as in 03/97 3 11/98 annual review - same as in 10/98 4 same as in 10/97 - 196- ANNEX 26 Indicative Activity Sfecialization Staff Date Weeks 04/99 Project completion economica, 12 review financial analysis/ accou.nting legal training MOF and PBC Contribution to SuDervision 2. During project implementation, MOP, PBC, and AAPRC will provide semi-annual progress reports (March and September) using as comparator the agreed implementation timetable and monitoring indicators (Annex 24 and 25, respectively). The scope of the report will include implementation of tech- nical assistance and training, progress in the preparation and enactment of various regulations, procedures, and standards, as well as procurement and disbursement information. - 197 - ANNEX 27 CHINA FINANCIAL SECTOR TECHNICAL ASSISTANCE PROJECT Selected Document and Data Available in the Prolect File Formal Bank Group Reports 1. "Chinat Financial Sector Review: Financial Policies and Institutional Development," June 29, 1990. Formal IMF Reports 1. "China: Issues in Developing Government Securities Market, Domestic Public Debt Management and Monetary Policy Techniques," Central Banking Department, International Monetary Fund, Washington, D.C., August 26, 1991. Staff and Consultants' ReDort 1. Coumentary on Banking, Law Plan and Monetary System Legislation Plan, Ainum Saaid, Legal Department, September 11, 1991. 2. Report on Accounting and Auditing Components, Preparation Mission, Howard Keefe (Consultant), February 7, 1991. 3. Reports on People's Bank of China (PBC) Accounting and Internal Audit Component and Audit Administration of the People's Republic of China (AAPRC) Audit Component, Pre-appraisal Mission, Howard Reefe (Consultant), April 19, 1991 and May 22, 1991. 4. "Electronic Inter-Branch System Overview," informal note, Andrew Sheng, November 1990. Legal Documents 1. Signed contract for payments system master design study between Bank Group and PA Consulting, dated October 17, 1991. 2. Japanese Grant Agreement (FINANCIAL SECTOR TECHNICAL ASSISTANCE PROJECT) between People's Republic of China and International Bank for Reconstruction and Development, dated March 4, 1991. Working Papers 1. Details on project cost estimates. -198 - CLRA I CHINA FINANCIAL SECTOR TECHNICAL ASSISTANCE PROJECT The People's Bank of China PEBC) Organization Chart Policy Research OffD ce Ilnterest RStes r Savings Daeagement Department Planning & Tundy ManaDertment La RFienacal Admialt tratio Department /b Accounting Department D t o r( Supervnsion & Audit Department_ |iTreaeury Department Research d Statistics DepartmeCntrol GoLdegaSil Rer ulad itory pat mepntGovernor, SEducation Department - Intersational Department Currency Issuing Department Retucial System Ren orm Department Iuternational Fiauce Organization Depart t I nitaFcial Technology DepartmeStde I State Adenisotration of Exchange ofnreit IGold c gilver Admlinistrtion Departmcuttu c Supervisupervision Department o ci | ~~Personnel Department |Administration Department } ~~Retirement Department Capital Construction Department_ ltute of Financial Studies laIn charge of Annual Credit Plan aud Allocation of Credit. 7tIn charge of llcensinig of new institutions and authorizing issues of primary securities. ZiSupervises compltauce of financial institutions with state policies. -199 - CHAT 2 UINANC!AL SECTOR TECHNICAL ASSISTACE PROJECT The Ministry of Finance (MOF) Oraanization Chart Office General Planniag Department Budgeting Department r Xl~Ealtor |_ Reglon41 Budgeting Department vice Ministers (4)::_E Tax Polion Department CoDnercnal, Foreig Trade and -1 naAdcial lnsta tuti ono Department = Indus:tria1 and Communicatlons Department -- Fom.agn Exchange aud Foreign Affairs Departmn Cultural Education and Admilnltratiou DeparTtme=nt| + ~~~Agricultural Department| + ~~National Debt Manaa8ement Department -----I ~World Bank Department | ~~Regulations and Laws Department77 7 == 2 ~Supervision Departmeat - 7 + Publlcnnauace and Tax System Ref orm DestmaI ~~~~Bureau of Foreign Affairs < ~~Agrlcul.ural Tax Collection Department Personnel Department| + ~~~~Education Department| Department of Accouatiug Affairs Administration| Administration Department - 200 - Q FINACIAL SI!C4R TECHNICAL ASSISTACE PROJECT Audit Admintstration of the Peoyle'e Renublic of China (AAPRC) OrRanization Chart Genoral Office Coordinating Department | Auditor General - Industry an d Communlcatlou Audit Department | Vice Auditor Generale -Monetary Audit Department Commerce and Trade Audit Department Agriculture Forestry & Education Audit Departmean Capital Construction Audit Department __ _l Non-Profit Units and National Defense | l ~~~~Department 0 ]l Forelgn Investment Audit Department -- J PlFnance Audit Department| Foreign Affairs Departmen| ~~~Audit System Directing Department| --F+ Administration Department| ----r ~Audit Training Centres Audit Research Institution China Audit Publishing Bouse - 201 - 4 FILA1CIAL SIECTOR TECHICA-L ASSIMCE PRO:ECT Projct gmlementation and Sugervision Schedule Activiry 1991 1992 1993 1994 1995 Activ' 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 I. Proiect Implementation Schedule A. Genera credit effectiveness x B. Project co tNoneno P (1) eaulaton sup arsion (PC Appointment or consul.rats x BOCOM Pilot Examination ... Organizational study .......... ._ P.udential regulations ... ... . On-site proceurei . .... ._._........ ..... Off-site surveillance Training Special asset reviews with .......... ............ ... consultants Special asset reviews by PBC .......... ............ .......... tll) Pavments_ Sv tem -(PBCI oatimn o consultants x Dosaign study . .__ Bidding and vendor selection ........ implementation _ _ _ _ __ (iii) Accounting/external audit IPBC. HOP! - 6PRC) Appointment or consultantu (PBC MOF)I x Appolutment of consultants (AAPC)I x Development of accounting standarda (MOF, PBC) ----- ------------ ______ ___._ _ _ Organization study (PBC) ........ __ PBC and financial sector reporting system .___.... ..... Audit standards (iv) Intenal Audit (PBC) eve opment o procedurea, manuals, training plan ____ __ ------------__ (v) Research and Statistics (PEC) ae resher courses Research projects ____ _______. ______...> (vi) Automation Strategy Study (PBC) .___ (vii) Directed Credit Study (PBC) ---------- (viii) PBC Gr.'duate School (ix) Strengthening Public Debt Management, PBC Fiscal Agency and Monetary Policy Roles (MOP. P30) _._ __ ___........._______ Stron thoning debt proramnn Strengthening regulations (MOF,PBC) Developing auctions and open market operation ---.---- ------ -- -------- Strengthening comprehensive cash planning (PBC) ------------ ------------ ----------- Book-entry system design and implementation __ ______ ----- ----------- New product development and selling techniques -__________ _ II. Prolect Supervision Schedule x x x x x x x