Economic development and the private sector: Market factors in large industrial development projects - Whether in the public or private sector, such projects must meet the strict financial criteria of the Bank
Author: Chauncey F. Dewey and Harinder S. Kohli
Publication Date:
01 Jun 1982
eISBN:
9781616353490
ISBN:
9781616353490
Language:
English
Keywords:
FD; F&D; country; exchange rate; government; developing country; IDA operations; bank financing; government involvement; bank appraisal report; Agroindustries; Project loans; Public sector; Asia and Pacific
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Large industrial projects in developing countries, whether publicly or privately owned, should be both economically and financially viable and subject to market discipline.

Abstract

Large industrial projects in developing countries, whether publicly or privately owned, should be both economically and financially viable and subject to market discipline.

Chauncey F. Dewey and Harinder S. Kohli

Large industrial projects are an important element in the development programs of most developing countries. For many years, the Bank has helped finance such projects, whether government-owned or private, with a host-country guarantee. This article reviews some aspects of the Bank’s experience with these projects.

The term “large” industrial project usually refers to new projects or expansions of existing projects whose investment requirements, including plant and related infrastructure, exceed US$100 million. Many of them are in heavy, capital-intensive basic industries such as steel and fertilizer production; others may be large projects in industries such as textiles or chemicals. Often included in the category are smaller projects such as projects for cement mills, which may not be considered large in a developed country but are large in terms of the total investment budget of a developing country.

The benefits of large industrial projects are usually great. Such projects can lead to important improvements in the balance of payments, increased fiscal revenues, more inputs being available to local farmers and other producers, the generation of employment opportunities, the creation of industrial centers, and so on. For example, after achieving full production in the mid-1980s, the Jordan Arab Potash Project will generate about $200 million a year in net export earnings, about $100 million a year in additional government revenues, and also create about 800 new jobs—thus creating an important industrial growth center in a remote region of the country. (See box.)

Because large industrial projects are often seen as vital to a country’s growth and represent a large share of its budget, governments frequently take an active interest in them. The degree to which such projects are publicly or privately owned and managed is likely to be affected by their size in relation to the capabilities of the country’s private sector, by the country’s reluctance to allow what it sees as a strategically vital activity to be controlled by foreign businessmen, or by ideology. Often, however, the distinction between “public” and “private” is less than obvious. Some wholly government-owned parastatals (for example, PETROQUISA in Brazil)—and many with mixed ownership—are run like businesses and have substantial autonomy; some private businesses (such as Indian Explosives’ fertilizer operation) are so closely regulated that they have relatively little room for discretion. With or without ownership, governments can control enterprises and determine their profitability through regulatory policies, taxes, and their power to affect the prices of inputs and outputs.

Irrespective of ownership, experience indicates that the contribution to economic development of these large and highly visible undertakings is best assured if the signals of the market, adjusted as necessary to offset distortions, are followed at every stage of the project cycle. Such projects should be initiated only when there is a clear, sufficient, and continuing international or domestic demand for the product. And their design and subsequent operations should be such that they are financially viable—without protection or subsidy—as well as economically sound. For the World Bank, the technicalities of ownership are of less concern than the soundness of a project and the efficiency with which it is managed. Whether a large industrial project is public or private or has mixed ownership, sponsors and lenders should be guided, in their analysis, by relevant market factors and should emphasize the need, in the project’s operations, for maximum feasible autonomy and financial discipline.

Creating sound, well-managed projects in developing countries is no small challenge, given the constraints that usually exist. These may include any or all of the following: (1) a scarcity of experienced business managers; (2) an environment not conducive to entrepreneurship; (3) a lack of trained labor and low labor productivity; (4) a deficiency in or absence of supporting services; (5) an inadequate or inefficient physical infrastructure; and (6) government policies, including subsidies, tariffs, and tax and labor regulations that impede rather than support efficient development.

The Bank finances only those industrial projects which it believes to be economically, technically, and financially viable. It is not interested in creating profit without economic benefit—for example, where the profit results from subsidy; nor, in its experience, are efficient management and sustained economic benefits likely to result from an industrial project that does not have to pay its own way. Beyond having them operate effectively and as efficiently as possible, it is important—for broader reasons—to ensure that large industrial projects make good use of existing infrastructure, do not have a serious adverse impact on the environment, and, insofar as possible, are effective vehicles for the transfer of technology through project design, training of local personnel, and the strengthening of local institutions.

Large industrial projects financed by the Bank have often been good vehicles for private sector involvement through equity participation and through cofinancing (although where private ownership predominates, the Bank’s affiliate, the International Finance Corporation, has usually been the source of the loan). But cofinancing, of course, is not limited to private sources. Counting official sources, supplier credits, and private sources, the total cofinancing associated with the 31 Bank-financed large industrial projects that had some form of foreign cofinancing during 1977–81 amounted to about $2.8 billion, compared with Bank financing for these projects of $2.1 billion. Total financing for the projects exceeded $12.8 billion. (See Tables 1 and 2.)

Table 1

Financing of Large Industrial projects by the World Bank, fiscal years 1977–81

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Source: World Bank, Industrial Projects Department.

Including projects without foreign cofinancing.

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Apart from financial involvement, private companies play an important role in the conception, management, and implementation of most large industrial projects. They are normally responsible for supplying the needed equipment and technology and the necessary design, engineering, procurement, erection, staff training, and project implementation services—usually, when Bank financing is involved, on the basis of international competition. The multifaceted relationship between large industrial projects and the private sector is expected to continue and become even more important in the future—as the capabilities of local business communities increase, international trade and financial flows grow, and developing country governments become increasingly aware of their limitations in the industrial sector.

Efficiency, financial discipline

Understanding the constraints facing large industrial projects and the interdependent, sometimes conflicting, factors that dictate success or failure is one thing; being able to achieve success in a particular social and political context is another. Success with large industrial projects requires the marriage of sound economic policies, good administration, and market forces. That this is well known has not, however, prevented costly, and sometimes grandiose, failures. For example, a fertilizer project in East Africa was abandoned after practically all the equipment was delivered and substantial site work completed, when the government realized the project was not economically viable and would require a substantial subsidy to run, which it could not afford to pay. Some failures of this sort have been caused by unanticipated national or international events, but many were simple failures of judgment that could have been prevented by rigorous evaluation and proper planning of the type recommended and practiced by the Bank.

Ammonia/Urea project in Pakistan

One of the first major fertilizer projects financed by the Bank and the International Finance Corporation (IFC), this large complex supplies urea for the domestic market and utilizes natural gas, the preferred feedstock for nitrogen fertilizer production, available from a nearby gas field.

The local private owners provided an intimate knowledge of local business environment, while the partner from the United States lent technical know-how of the fertilizer industry and was responsible for project management, staff training, and initial plant operations. The plant design was supplied by a reputed international chemical engineering firm and the plant was engineered and constructed by an experienced contractor. Both firms were based in the United States and well known to the technical partner. Most of the equipment and services were procured from private suppliers in the United States, the United Kingdom, France, Japan, and the Federal Republic of Germany.

The Bank and the IFC participated actively as an “honest broker” in the design, evaluation, and negotiations of the project concept and subsequent supervision of its implementation. The Government and the private partners looked to the Bank for help in ensuring that the division of benefits between the economy as a whole and the project as well as between the two major partners was appropriate, and that the regulatory environment would be such as to give the project sponsors the opportunity to earn a satisfactory profit. This was accomplished through a critical review of the joint venture agreements, implementation and procurement arrangements, and specific agreements on a financing plan and government fertilizer pricing policies.

The project was successfully completed in 1975 within schedule estimates and close to the original cost budget. The project provides Pakistan with urea at a production cost subsequently lower than that of imported fertilizer. The project’s economic rate of return calculated before the recent increases in international fertilizer prices was 18 per cent, compared to the 10 per cent estimated on the basis of assumptions used at the time of the approval of the project in 1968 by the Bank’s Board. The project has been operating at or above nominal design capacity. The Project Performance Audit prepared after project completion by the Bank’s independent Operations Evaluation Department found the project to be an economic, technical, and managerial success.

Potash project in Jordan

In 1977, the Bank approved a US$35 million loan for a $430 million project in Jordan to produce potash fertilizer from the Dead Sea brines. The largest project ever implemented in the country, it will substantially increase and diversify Jordan’s exports. It will also provide the world with another much needed source of potash closer to major market areas in Asia and Oceania, which have no major local source of potash exploitable yet.

The Bank assisted the company and the Government in obtaining $190 million in debt financing from a large number of multilateral (Kuwait Fund, Organization of Petroleum Exporting Countries Fund), bilateral (United States Agency for International Development (USAID), the United Kingdom Overseas Development Ministry, Iraqi Fund), suppliers credits (Austria), and commercial (European, Jordanian) sources. The project was designed and engineered by a major U.S. engineering firm, which is also responsible for managing its implementation. The firm has signed a separate contract, with a provision for substantial profit sharing, to operate the project for the first five years, during which period local staff will gradually assume responsibility. The plant facilities are being built by contractors from the United Kingdom, Austria, the Federal Republic of Germany, the United States, and Korea. Equipment supplies are coming from all major developed countries. The company management is being assisted by technical advisors from the Netherlands, and management and financial consultants from the United Kingdom and the Philippines. This assistance from experienced foreign firms is helping the company to develop and operate on a sound commercial basis.

The project was inaugurated on March 18, 1982. It was completed within the original schedule and close to cost budget. The company has already signed long-term contracts for the sale of all its production to potash marketing companies in Europe, Japan, and the United States.

The Bank and USAID have played a major role in the design, preparation, appraisal, financing, and implementation of this project. As part of this assistance, the two institutions financed a $10 million engineering project in 1975 to develop the technology and design options for the project and recommend marketing, organizational, implementation, and financing arrangements. The Bank appraisal report was used by the non-Jordanian shareholders and other lenders as a basis for their financing decisions.

Table 2

Financing pattern of a few large Industrial projects financed by the World Bank, fiscal years 1979–81

(In millions of U.S. dollars)

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Source: World Bank, Industrial Projects Department.

Projects with substantial private sector participation in ownership.

To ensure that projects use resources efficiently, both an economic and financial analysis are required. When designing a project, to ensure its economic efficiency it is essential to use “economic” prices for inputs and outputs—that is, prices which do not reflect subsidies or other distortions. At the same time, the project should be structured to permit financial viability during operations, based on the actual prices of inputs and outputs.

Prices, however, are often subject to non-market pressures. The products of projects in basic industries, for example, are frequently sold to politically vocal and important consumers who press for artificially low prices, such as farmers with respect to fertilizer and businessmen with respect to steel and cement. Similarly, project sponsors and management seek to ensure high output prices and protected, preferably noncompetitive, markets. If these pressures are allowed to distort the pricing of the project’s inputs and outputs, financial discipline and management accountability will likely suffer and economic efficiency will decline as a result.

Ideally, domestic prices of inputs and outputs should be in line with long-term international market prices. Similarly, the project ideally should be charged market rates for its financing. Otherwise, because of price distortions, the project’s financial results may not reflect its economic costs, and inefficiencies may be hidden. A project (one, for example, to produce automobiles) may be profitable, due to subsidies, but be wasteful for the economy; or, more commonly, an economically beneficial project (to produce fertilizer, for example) may show losses—and have its financial accountability and management hampered—if output prices are held down by government regulation.

In its continuing dialogues with country governments, the World. Bank consistently favors the elimination of most direct and indirect subsidies to local industry—in order to restore to the market its valuable role as indicator/enforcer of economic efficiency. In its lending for large industrial projects—even under long-term International Development Association (IDA) credits, which carry minimal charges—the Bank requires the borrowing government to relend the proceeds to the beneficiary organization at or close to market interest rates and with a maturity period of 12 to 15 years.

Every World Bank loan agreement for an industrial project includes financial covenants to help ensure that the borrower will follow prudent financial policies, maintain a sound financial structure, and meet its financial obligations promptly. Such covenants commonly pertain, for example, to liquidity and debt service ratios, the financial rate of returns (where state government sets key prices), and debt/equity requirements. Projects, whether state or privately owned, should have sufficient initial equity in proportion to their debt to permit further financing on reasonable terms, as necessary, and to provide a cushion for debt service in times of adversity.

Having an economically efficient project—that is, one which produces a needed product at an appropriate quality level and at a true cost which is internationally competitive—requires, in addition to the usual financial analysis to establish the enterprise’s amenability to efficient and accountable management, a careful analysis of all the significant economic costs and benefits. The cost of the investment should include the costs of new infrastructure needed for the project to operate efficiently. While appraising a proposal for a chemical plant, for example, one should review not only all factors influencing the viability of the plant itself but also the plant’s impact on the need for related physical and social infrastructure in the country, such as housing, railway, port, road, power, water, warehousing, and distribution facilities. For the cost/benefit analysis, internal transfers in the economy that are not economic costs or benefits (such as duties and some taxes) should be disregarded, and appropriate adjustments in the prices of inputs and outputs should be made in order to eliminate distortions caused by market imperfections and local regulations controlling trade, currency, and prices. Based on such an analysis, the return on investment should be above the opportunity cost of capital—that is, above the returns from available alternative investments.

In performing an economic analysis, various alternatives are usually tested and “trade-offs” illuminated. There are likely to be trade-offs, for example, between, on the one hand, the duration and predictability of the time required to implement a large industrial project (which sometimes exceeds five years) and, on the other hand, the amount of capital and foreign expertise used. Balancing these elements requires substantial judgment, and local aspirations to develop indigenous know-how sometimes have to be taken into consideration together with economic factors including the cost of time and delay. Delays can be more expensive than commonly realized. Imported capital goods and equipment may lay idle and require storage. Implementation costs may increase more rapidly than the prices that can be charged for the project’s output. Additional interest or management expense may be incurred. A need for additional foreign exchange may arise because the country must continue importing products that will eventually be produced locally by the project or because the export earnings anticipated from the project are postponed. In addition, expensive delays can destroy the close communication, cooperation, and confidence among owners, consulting firms, and contractors that are usually essential to good project implementation.

After an evaluation of the economic costs and benefits of a proposed investment, it sometimes becomes evident that the project is not justified as conceived. This may result in its abandonment—as happened recently with a large steel complex and an aluminum project proposed to the Bank by two Middle Eastern countries. More frequently, it results in drastic changes in the scope, size, and timing of a project to make it economically attractive.

Government involvement

Large industrial projects often severely tax the limited financial and human resources of a developing country. Since many projects—those, for example, that exploit natural resources and are remote from their markets—have to be very large if they are to be economic, their capital costs can account for a substantial proportion of the development budget of a small- or medium-sized country. The potash fertilizer project in Jordan mentioned earlier required almost one third, and a paper pulp project in Tanzania absorbed approximately one quarter of these countries’ total public investment budget for industry over a five-year period. The success or failure of projects of this size often has a significant impact on the country’s balance of payments, its operating budget, the availability and prices of key products needed by other domestic undertakings, and the health of the industrial sector as a whole. Consequently, it is not hard to understand the reasons for government concern.

The degree of government involvement and ownership in such projects varies widely. Government involvement, depending partly on the proportion of government ownership, can range from the provision of fiscal and tax incentives and the supply of utility services and inputs of infrastructure facilities to the assurance of local markets for project output, the control of prices, and the provision of financing. Often—particularly in the case of projects in the mining and petroleum sector and projects providing basic industrial commodities such as steel, cement, and fertilizer—governments also become actively involved in corporate policies, especially those related to pricing, product distribution, procurement, management, and labor practices.

Governments with major financial participation often also exercise control over the nomination of key managers and staff salaries. In fully state-owned companies, which are often run as government departments, trusted civil servants, though inadequately trained to run a business, are sometimes nominated as key managers, and staff salaries are set low to correspond to civil service levels.

Strong government interest, with its likely concomitant political considerations and resulting lack of objective analysis, sometimes leads to poorly conceived and inefficient large industrial projects—some of which, if executed, become “white elephants.” The Bank’s experience with over 100 large industrial projects appraised during the past decade has confirmed that careful planning, good management, and substantial autonomy are normally the most important factors in making a project successful. Governments should allow even parastatal agencies maximum possible autonomy and they should judge the performance of their managers mainly on the basis of normal business and financial indicators. Before lending for large industrial projects, it is important, therefore, to assess the quality of management and the degree of autonomy that will be allowed.

In Egypt and Turkey, for example, where most parastatals have traditionally been subject to extensive government control, it has been the Bank’s practice to lend only to those state-owned industrial companies that in effect operate as commercial entities. In countries where “corporation laws” exist, the Bank has sought to have the projects brought under them, or, failing this, has sought to have countries foster efficient, motivated, and sufficiently independent management through administrative measures.

The private contribution

In addition to obtaining the necessary business, marketing, financial, and management skills often possessed by the private sector, large industrial projects need to have access to appropriate technology. This is normally best obtained through involvement of private sector companies as project sponsors and managers or, if that is not feasible, as technical partners or advisors. Beyond the large industrial project itself, even where it is in the public sector, many private sector “upstream” and “downstream” activities are likely to be stimulated—such as subcontracting for components and materials; local construction; mechanical, fabrication, and manufacturing industries; and distribution.

In brief, while some governments wish to exercise complete control over the promotion, implementation, and operation of large industrial projects, there is evidence that government officials and procedures are usually not well suited to managing large businesses effectively. Potential sponsors from the private sector, on the other hand, because of their limited financial and human resources and their perceptions of higher business risks in the large industrial projects in developing countries, are often unable or unwilling to promote and finance them without active government participation. The challenge is how to mesh effectively the provision of needed resources controlled by the government with the discipline of the market and the capabilities and knowledge of the private sector within and outside the country.

In the case of two Bank-assisted fertilizer projects, the box on page 27 illustrates many aspects of the multifaceted inter-relationship between the public and private sector. Not detailed in the box, but as important as ownership, is the careful application of disciplined economic and financial analysis to large industrial projects and the effort to increase the influence on them of market forces.

That approach not only fosters sound investments but also helps the Bank earn the cooperation and trust of cofinanciers—as does its emphasis on managerial competence and autonomy, comprehensive agreements with governments and borrowers, and close monitoring during project implementation. Irrespective of ownership, it is important to bring to bear every means available to ensure the financial viability, the economic efficiency, and the technical soundness of these complex and important projects.

World Bank cofinancing with the private sector

The Bank’s cofinancing program aims to encourage private financial institutions to direct their lending in developing countries to high priority projects in different sectors, to introduce new lenders to developing countries, to bring new entities in borrowing countries to the market, and, more generally, to encourage the Bank’s borrowers to broaden their sources of external finance and diversify the instruments of borrowing.

Through cofinancing, the World Bank’s role as a catalyst in attracting development finance for high priority programs within developing countries has increased significantly in recent years. Between fiscal years 1977 and 1981, cofinancing reached a yearly average of nearly $3.7 billion in around 90 projects per year. It has been a feature in about 37 per cent of Bank/IDA operations, and the volume of funds mobilized from other sources external to borrowing countries has been equivalent to more than 36 per cent of the total volume of World Bank lending. Historically, the major source of cofinancing has been official bilateral and multilateral aid agencies. However, in fiscal year 1981, cofinancing with commercial banks became the single most important source for the first time, contributing about $1.7 billion to project financing in approximately 18 operations.

The Bank is placing increased emphasis on cofinancing with private financial institutions and is taking a number of measures to expand its association with private lenders, including a more active promotional program vis-à-vis the private banking community and new techniques of cofinancing that could make it more attractive to some borrowers and private lenders.

World Bank cofinancing operations by region, fiscal year 19811

(In millions of U.S. dollars)

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Source: Information extracted from President’s Reports and Appraisal Reports. World Bank—Signifies zero.

Ending June 30, 1981.

The number of individual operations with cofinancing by source is greater than the total number of projects with cofinancing since there are projects cofinanced with more than one source.

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Cover Finance & Development
Finance & Development, June 1982
Author: International Monetary Fund. External Relations Dept.
Volume/Issue:
Volume 19: Issue 002
Publisher:
International Monetary Fund
ISBN:
9781616353490
ISSN:
0015-1947
Pages:
48
DOI:
https://doi.org/10.5089/9781616353490.022