Document of

The World Bank

FOR OFFICIAL USE ONLY

Report No. 12773-PB

STAFF APPRAISAL REPORT

PHILIPPINES

SUBIC BAY FREEPORT PROJECT

MAY 10, 1994

Industry and Energy Operations DivisionCountry Department IEast Asia and Pacific Regional Office

This document has a restricted distribution and may be used by recipients only in the performance oftheir official duties. Its contents may not otherwise be disclosed without World Bank authorization.

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

CURRENCY EQUIVALENTS(as of December 31, 1993)

Currency Unit = Pesoi 1 = US$0.035US$1 = P 28.4

WEIGHTS AND MEASURES

ha hectarekm kilometerm meterm2 square meterm3 cubic meterMGD million gallons per dayMW megawatt

ABBREVIATIONS AND ACRONYMS

ADB - Asian Development BankASEAN - Association of South East Asian NationsBCDA - Bases Conversion and Development AuthorityBOT - Build-Operate-TransferCDA - Comprehensive Development AreaCIF - Cost, Insurance and FreightCOA - Commission on AuditDBM - Department of Budget and ManagementDENR - Department of Environment and Natural ResourcesDFI - Direct Foreign InvestrnentDOJ - Department of JusticeEPZ - Export Processing ZoneGEF - Global Environment FacilityGOCC - Government Owned and Controlled CorporationGOP - Government of PhilippinesIRR - Implementing Rules and RegulationsJV - Joint VentureMOA - Memorandum of AgreementNPC - National Power CorporationPWC - Public Works CenterSBF - Subic Bay FreeportSBMA - Subic Bay Metropolitan AuthoritySEZ - Special Economic ZoneUS - United States

FISCAL YEAR

January 1 to December 31

FOR OFFICIAL USE ONLYPHILIPPINES

SUBIC BAY FREEPORT PROJECT

STAFF APPRAISAL REPORT

CONTENTS

Page No.

Loan and Project Summary ............................

I. BACKGROUND: THE BASE CONVERSION PROCESS ........... 1

A. The Freeport Concept ............................. 2B. The Conversion Planning Process ...................... 2

II. THE SUBIC BAY FREEPORT ............................ 5

A. Endowments and Existing Facilities ..................... 5B. The SBF's Competitiveness and Development Prospects 7C. The Conversion Strategy. 9D. Status of SBF Development and Privatization .12E. Off-SBF Development Program and Priorities .14F. Lessons from Previous Bank Involvement .14G. Rationale for Bank Involvement .15

III. THE PROJECT .16

A. Objective .16B. Description .16C. Cost and Financing .18D. Implementation .19E. Environmental Aspects .22

IV. THE BORROWER .23

A. Background .23B. Organizational Structure .24C. Financial Management and Control .25D. Environmental Management .26E. Training and Technical Assistance Needs .28

This project was prepared by Messrs./Mme. Shilpa Patel (Task Manager), John Arnold (TransportEconomist-Consultant), Aldo Baietti (Financial Analyst), Jack Fritz (Environmental Specialist), KishoreRao (Institutional Consultant) and Leonard Schiffman (Transport Engineer). Mrs. Merle Mendis-Dennisprocessed the report. Peer reviewers were Messrs. Peter Long and Hoon Mok Chung. The project wascleared by Mr. Vineet Nayyar, Chief, EAIIE and Mr. Callisto E. Madavo, Director, EAI.

This document has a rctricted 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.l

Page No.

V. FINANCIAL ASPECTS .................................. 29

A. Overview of Past and Current Performance ................... 29B. Investment Program and Financing Plan ..................... 31C. Future Financial Performance ........................... 32

VI. PROJECT BENEFITS AND RISKS ............ .. ............ 34

A. Benefits ......................................... 34B. Risks .......................................... 35

VII. AGREEMENTS AND RECOMMENDATION . .36

A. Agreements .36B. Recommendation .37

ANNEXES

Annex 1 Description of Infrastructure Components .................... 38Annex 2 Indicative Timetable of TA Activities ...................... 40Annex 3 Merchandise Control System ............................ 41Annex 4 Zoning Regulations and Design Code ...................... 44Annex 5 Automated Financial Management and Accounting System ......... 46Annex 6 Privatizations Transactions Assistance ...................... 48Annex 7 Enhancing SBMA's Institutional Capabilities .................. 50Annex 8 Facilities Management Support .......................... 55Annex 9 Environmental Baseline Survey .......................... 57Annex 10 Institutional Support to the Ecology Center .64Annex 11 Environmental Management Plan (EMP) .66Annex 12 Total Project Cost .72Annex 13 Disbursement Schedule .74Annex 14 Project Supervision Plan .75Annex 15 Implementation Schedule .76Annex 16 SBMA's Financial Statements .78Annex 17 Assumptions for Financial Projections .81Annex 18 Economic Analysis .92Annex 19 Selected Documents Available in the Project File .94

Organization Chart

Map: IBRD No. 25499 and 25500R

PHILIPPINES

SUBIC BAY FREEPORT PROJECT

Loan and Project Summary

Borrower: The Subic Bay Metropolitan Authority (SBMA)

Guarantor: Republic of Philippines

Amount: US$40 million equivalent

Terms: 20 years, including 5 years of grace, at the Bank's standard variable interestrate.

Proiect Objectives: The objective of the project is to attract private investors to the Subic BayFreeport (SBF). This will be achieved by: (a) improving existing infrastructure;(b) improving access to the area for industrial, commercial and passenger traffic;(c) maintaining the SBF asset base, including protection of the environment; and(d) strengthening the capacity of the SBMA to manage and administer thefacility.

Project Description:The project consists of three components. The first is site improvement, whichincludes improvement of land access (road, bridge and entry gates); airportimprovements (runway repair, strengthening of aprons and taxiway, airportcommunications and navigation equipment, and conversion of an existingbuilding into a passenger terminal); port repairs; a pilot standard factorybuilding development (6 buildings); and the provision of miscellaneousequipment for security and maintenance purposes. The second component istechnical assistance and training to strengthen the institutional capacity of theSBMA and to provide appropriate systems for the implementation of freeportpolicies. The third is environmental protection, which includes the carrying outof an environmental baseline survey, the provision of monitoring equipment andinstitutional support to establish a sound environmental infrastructure at the SBF.

Benefits and Risks: The major project benefits are: (a) economic benefits arising from increasedeconomic activity and employment in the region, estimated to reach US$750million over the next decade; (b) environmental benefits arising from increasedprotection of the forest lands and the bay; and (c) financial benefits to theSBMA arising from increased rental and other income from the SBF. Inaddition, institutional strengthening at the SBMA will result in significant humancapital development.

The major risks are political in nature. A policy reversal regarding the SBF'sfreeport status would nullify its competitive advantages, and inflows of foreigninvestment would likely diminish. To mitigate this risk, assurances wereobtained that the SBF's freeport status will be maintained, and appropriateremedies against a potential policy reversal are be included in the proposed loan.Another risk relates to the relative lack of experience in freeport management at

the SBMA. To address this concern, the project will provide long-termntechnical assistance to provide the expertise required while training SBMApersonnel on-the-job so that they gain the necessary experience. The risk ofdelays in project implementation has been minimized through intensive projectpreparation activity. The project itself is not expected to have adverseenvironmental impacts. There is a risk of future environmental degradation ifsatisfactory maintenance practices are not followed. The project will addressthis concern.

Project Cost:

Local Foreign Total------------------ US$ million

Site Improvement 9.3 26.9 36.2Institutional Support 0.2 4.8 4.9Environmental Protection 0.0 1.0 1.0

Taxes and Duties 1.0 0.0 1.0

Total Cost 10.5 32.6 43.1Physical Contingencies 1.5 4.6 6.0Price Contingencies 1.0 1.9 2.9

Total Cost with Contingencies 12.9 39.1 52.0Interest During Construction 0.6 1.5 2.1Total Financing Required 13.5 40.6 54.1

FSinancng Plan:Local Foreign Total

-------- US$ million -------IBRD 0.9 39.1 40.0SBMA's Internal Cash 12.6 1.5 14.1

TOTAL 13.5 40.6 54.1

Estimated Disbursement:

IBRD Fiscal Year 1995 1996 1997 1998 1999--------------------US$ million-------------

Annual 7.2 17.6 11.2 2.4 1.6Cumulative 7.2 24.8 36.0 38.4 40.0

Economic Rateof Return: 12% to 37% depending on project component.

Map: IBRD 25499 and 25500R.

I. BACKGROUND: THE BASE CONVERSION PROCESS

1.1 The Subic Naval Base was the largest U.S. military facility operating outside the UnitedStates. Located 80 km northwest of Manila (see Map IBRD 25499), the baselands covered 15,130 ha,within the territorial jurisdiction of the City of Olongapo, the town of Subic in Zanbales, and the townsof Moron and Hermosa in Bataan. Approximately 6,700 ha housed the area formerly leased by the U.S.Navy. Given its strategic location, and its role as the primary support for the U.S. Seventh Fleetoperating in the Westem Pacific and Indian Ocean, the U.S. had invested heavily in the Base. Estimatesof the replacement value of the facilities range from US$8-10 billion.

1.2 The earliest predecessor to the base was an unfinished Spanish Naval Station, acquiredby the U.S. in 1898 following the Spanish American War. Following World War II and the achievementof Philippines independence, a decision was made to establish a U.S. Naval Base at Subic. Much of thearea occupied by the U.S. was previously occupied by the City of Olongapo. The control of thebaselands was governed by the 1947 Military Bases Agreement between the Philippines and the UnitedStates. Following the expiration of that agreement and the failure to negotiate a longer withdrawalschedule, a 1 -year termination notice was served on the U.S. Navy to evacuate the premises by December31, 1992. The Navy evacuated the premises in two phases, turning over the central base area and relatedfacilities on September 30, 1992, and the remaining facilities on November 24, 1992. During thetransition period, most of the moveable assets were removed by the Navy.

1.3 The major concern of the Government was the economic dislocation that would ensueupon the Navy's withdrawal. The Subic Base directly employed over 37,000 Filipinos, and the nearbycommunities were almost exclusively dependent on the Base for their economic livelihood. ThePresidential Task Force for the Bases Conversion Program was set up in January 1992 to implement abase conversion and redevelopment program. The creation of a freeport at Subic was an idea originallyespoused by the local leadership and citizens of Olongapo City as far back as 1971. The idea wasconcretized through the introduction of three articles in the Bases Conversion and Development Act(Republic Act 7227), signed in March, 1992; these articles established the Subic Special Economic andFreeport Zone, and created the Subic Bay Metropolitan Authority (SBMA) to operate, administer andmanage it.

1.4 In early 1992, the Government requested assistance from the World Bank to help developa strategy for the conversion of the baselands to civilian use. This assistance was provided in two phases.An initial Bank mission, fielded in March 1992, confirmed the basic feasibility of the redevelopment ofthe site as a mixed-use industrial, commercial and tourism facility under the favorable economicincentives accorded to it as a freeport. It also identified a number of areas where technical assistance(TA) was required to implement the freeport regime, including formulating the implementing rules andregulations for the SBMA; physical planning and formulation of a land and facilities use plan; andtransportation facilities planning. This TA was provided over the August 1992-January 1993 period.'The Government subsequently requested Bank assistance in financing the critical infrastructure andequipment needs, as well as further TA for institutional strengthening and environmental protection, tojump-start the freeport and attract private investors. This assistance is described in the present report.

The TA was financed by a grant from the PHRD Fund (Japan), and approximately 80 person-months of assistance wasprovided to the SBMA. A report entitled Philippines: Strategv for Conversion of the Subic Naval Base into a SpecialEconomic Zone and Freeport, January 1993, contains the various analyses and studies undertaken as part of this TA.

-2-

The remainder of this chapter discusses the general principles guiding the conversion, followed by adescription of the facilities and proposed conversion strategy for the area in Chapter II. The proposedproject is described in Chapter III. Chapters IV and V present an assessment of the borrower from bothan organizational and financial viewpoint. Chapter VI analyzes the benefits and risks associated with theproposed project, and Chapter VII contains a summary of actions to be agreed between the borrower andthe Bank in connection with the proposed project.

A. The Freeport Concept

1.5 The International Convention on the Simplification and Harmonization of CustomsProcedures of 1979 (Kyoto Convention) defines free zones as being "part of the territory of a State whereany goods introduced are generally regarded, insofar as import duties and taxes are concerned, as beingoutside the Customs territory and are not subject to the usual Customs control. " Export Processing Zones(EPZ) and Special Economic Zones (SEZ) are recent variants of the traditional freeport or free zoneconcept, the earliest example of which was Gibraltar (1704). Free zones were established to encouragetrade between harbors among international trade routes and can play an important role in attractingforeign investment. All free zones share certain basic elements. First, they are limited to a physicallydefined area, which in the case of an EPZ is usually an industrial estate, and in the case of a freeport,could be ports, cities, islands (Bataam Indonesia or Labuan, Malaysia) or even entire countries (HongKong or Singapore). Second, they are considered to be extra-territorial, physically or administrativelylocated outside the national customs territory. Third, merchandise may be freely stored indefinitelywithin the zones, re-exported or imported into the host country's customs territory upon payment ofapplicable taxes and duties. However, free zones differ in the extent of the area covered by the zone;the activities and processes that are allowed to take place; and the end-user markets where free zoneproducts may be sold.

1.6 Freeports differ in several regards from EPZs. First, they tend to cover larger areas, andtherefore offer greater flexibility to firms in terms of the location of their plants. Second, the range ofpermissible activities in a freeport tends to be broader than in an export processing zone (EPZ): firmscan undertake any legal activity, and individuals can reside within it. Third, registered enterprises andresidents can freely import all types of merchandise and are not restricted to those used directly in themanufacturing process, as in an EPZ. Fourth, duty- and tax-free merchandise can be sold at thewholesale or retail level and/or consumed freely within the freeport area, unlike in an EPZ where retailsales or on-site consumption of duty- and tax-free products are not allowed. Finally, freeport enterprisesare not required to export a certain percentage of their production, and are free to sell to the local marketupon payment of any applicable duties and taxes by the importing party.

B. The Conversion Planning Process

1.7 In contrast to a traditional physical facilities development, where facilities are designedto meet the desired use, an infrastructure conversion process changes the use of existing space based onan analysis of the highest use of the space. Military bases are examples of infrastructure that has beendeveloped to meet the highly specialized requirements of military applications, and whose uniquecharacteristics pose several challenges to the process of conversion. They are generally located in remoteareas, away from major population centers and transportation hubs. However, these disadvantages areoften offset by the fact that base complexes tend to be self-contained, with most components of supportinfrastructure already on-site. They generally contain special purpose buildings and structures which aremore difficult to adapt to new uses. Older bases have often not observed the highest standards ofenvironmental practices, and clean-up efforts are an important consideration. They are usually highly

-3-

secured facilities, with limited points for entry and exit. Furthermore, since bases are not configured foruse by individual companies, their layout may not be conducive to immediate civilian use.

1.8 Freeport Regime Requirements. Converting the former U.S. Naval Base into a freeporthas several implications on physical planning. A freeport needs to be highly secure in order to preventthe leakage of duty-free goods into the national economy. This translates into the need to separate trafficfor industry from traffic related to residents and visitors; provide additional entry/exit points to easetraffic flow; and allow for additional security inspection procedures required for effective control. Theexisting road network and transportation facilities need to be enhanced to permit rapid processing ofimport and export shipments. The layout of the complex needs to be flexible enough to accommodatediverse activities as they locate in the freeport.

1.9 Community Goals. Community goals and objectives are an important consideration inthe base conversion strategy. Studies of successful military base conversion in the United States haveclearly indicated the fundamental and critical role played by the local community in determining basereuse plans. The issues of most concern to community and regional leaders in the Subic area were: (i)replacing jobs lost by the Filipino base workers, as well as the indirect jobs in activities providing goodsand support services to base employees; (ii) utilizing the conversion process as a catalyst for the economicdiversification and re-development of the region; (iii) integrating the base with Olongapo City to reducethe disparities between base and off-base facilities and infrastructure; (iv) protecting the unique naturalenvironment and resources of the base; (v) operating the freeport as a self-sustaining, profitable entity,without the need for continuing support from the national Government; and (vi) maximizing the role ofthe private sector in operating and managing the freeport's facilities, without giving any one privatecompany disproportionate control over freeport operations.

1.10 Tarzet Industries. A clear understanding of industry sectors likely to locate within thefreeport is equally important for planning the conversion. The potential market response to the Subicfreeport was developed through an overall assessment of the competitiveness of various industries in thePhilippines relative to its ASEAN neighbors, an evaluation of the competitiveness of the freeport conceptrelative to competing export processing zones, special economic zones and freeports elsewhere in EastAsia, and an assessment of investment patterns in the Philippines.2' This analysis indicated that a diversegroup of industrial and service activities would be potentially attracted to the freeport (see para. 2.13).The needs of the target market would, in turn, dictate the physical, administrative and promotion planningprocess.

1.11 Physical Facility and Infrastructure. A survey of the existing facilities to determine theircondition, quality and reuse potential was then undertaken. This evaluation indicated that: (i) the base'sgeneral-purpose buildings are suitable for use by light manufacturing, non-polluting operations, or forstorage and warehousing purposes; (ii) special-use facilities are less suitable for immediate conversion,and may require more extensive renovation and modification; (iii) most of the officers' quarters areadaptable for use as a hotel/motel or office space with minor modifications; (iv) raw land parcels aresuitable for the development of industrial estates; (v) electricity and water supply are sufficient for theshort-term, but will need to be augmented as demand increases; individual meters will have to be installedto each building for appropriate billing; (vi) sewage treatment facilities are inadequate and additional

This analysis was undertaken as part of the Bank's initial mission (Philippines: Subic's Industrial and Tourism ConversionStrateey and Action Proeram, May 1992, Informal Bank Report), and followed up through the subsequent technicalassistance provided to the authorities. The tight timeframe of the U.S. withdrawal meant that a very short transitionperiod was available to the authorities to define and implement the conversion strategy. The resulting time pressureprecluded the carrying out of a detailed market survey to identify the potential market response to the SBF.

-4-

liquid and solid waste disposal facilities are needed; (vii) the airport facilities need to be upgraded; portfacilities need some repair but do not need to be developed in the near-term; and (viii) existing roadsconnecting Subic to Manila are sufficient up to volumes of a few thousand tons per day, but criticalportions of the road need to be improved to accommodate container trailer and tourist vehicular traffic.

1.12 Alternative Development Scenarios. There are a number of trade-offs and potentialconflicts between the various objectives and possibilities of the conversion. For example, limiting thefreeport area to a small, secured area to reduce the potential leakage of duty-free goods into the nationalcustoms territory goes against one of the major stated interests of commnunity leaders, which is tointegrate the freeport with the adjoining community and ensure maximum access to freeport benefits.A set of redevelopment principles against which to assess alternative conversion strategies was thendeveloped, based on the various findings, objectives and requirements discussed above. Threedevelopment concepts were evaluated and ranked according to how well they fulfilled these redevelopmentobjectives:

* maritime industry. This is the most obvious reuse concept given the site's former useas a naval facility. The advantage of this approach would be the utilization of existingbuildings and facilities immediately, with minor modifications. The skilled workforcepreviously employed in the former U.S. Naval Base's ship repair and maritime-relatedactivities would be absorbed by like industries. However, this approach would notmaximize the long-term potential of the complex, and would not meet the objective ofdiversification of activity. The potential adverse environmental impact would be a threat.

- tourism and recreational complex. This concept capitalizes on Subic's attractivelocation and scenic beauty. The advantage would be the high employment generationpotential of tourism, and the revitalization of Olongapo's entertainment industry. Thedisadvantage would be the potentially limited impact of tourism as a means to upgradethe capabilities and long-term potential of the workforce; in addition, this concept wouldnot meet the objective of economic diversification. Tourism demand would also be anissue, given the attractiveness of other sites in the Philippines. Finally, existing facilitieswould require considerable upgrading in this scenario.

3 multi-sectoral growth pole. This concept meets the requirements for economic diversityand flexibility, and maximum use of existing structures. This approach would targetcompatible, non-polluting industries with a capacity to generate high levels ofemployment, as well as warehousing and logistics, tourism, recreation and conventioncenter activities, and offshore financial services. The drawback would be theadministrative complexity of promoting, regulating and securing the complex.

1.13 Selected Approach. Clearly, no one approach is likely to meet all the objectives and goalsof different interest groups. The redevelopment approach selected was that of a multi-sectoral growthpole, since this concept best met the various redevelopment objectives retained. Recognizing theadministrative complexity of applying the freeport regime over the large physical area of the freeport (asallowed for in R.A. 7227), a phased implementation is foreseen. At present, the freeport regime is tobe implemented in the former base area, and the conversion strategy accordingly targets this area. Thefocus of the TA activities to date has been on defining a physical facilities and infrastructure plan whichmeets the requirements of target industries and which represents the best and highest use of existingassets, and a comprehensive policy and institutional framework for streamlined implementation of thefreeport regime.

-5-

H. THE SUBIC BAY FREEPORT

A. Endowments and Existing Facilides

2.1 Physical Characteristics. The Subic Bay Special Economic and Freeport Zone, asestablished by R.A. 7227 (former U.S. Naval Base and surrounding municipalities) covers an estimatedtotal land area of 60,000 ha, and water area of 9,525 ha. However, in the initial phase, the freeportconcept is limited to the area occupied by the former U.S. base (referred to as the Subic Bay Freeport -SBF). The SBF covers an area of around 15,000 ha, of which 6,658 ha house the former Naval Base,

and is situated in the northwestern corner of Bataan Peninsula, sandwiched between the area's two majornatural features: the Zambales Mountain Range and Subic Bay. The mountain range separates the SBFfrom the Central Luzon Plain, and protects the base from the monsoons and trade winds from thenortheast. Subic Bay provides an excellent, well-protected harbor which opens up to the South ChinaSea. The terrain around the SBF is mountainous, with relatively steep slopes extending almost to thewater's edge. The developed areas have been carved out of hills or created by filling in low areas.

2.2 The broad-leafed evergreen rain forest in the SBF (3,500 ha) represents the only relativelylarge area of undisturbed forest in Central Luzon. This type of forest, identified as Diptocarp, is themost commercially valuable of the forests in the Philippines. The most common species is the Lauanfamily, which includes the famous Philippine mahogany, although U.S. Navy records indicate that thereare many representatives of the more than 3,000 varieties of trees that have been identified in thePhilippines. There are also mangrove swamps along low-lying waterfront areas. Many of the more than10,000 species of flowering plants and ferns that have been identified in the Philippines are also said tobe found in the SBF area. The areas off-base are generally coarse wild grasslands, mostly the result ofslash-and-burn agriculture. There are about 760 different species of birds in the Philippines; rodents arenumerous, including over 50 known species of rats. Several varieties of poisonous snakes exist.Saltwater fish are abundant, and mollusks occur in large numbers. However, an inventory of the floraand fauna found in the Subic forest is not available. Threatened or endangered species in the Subic areainclude the green sea turtle and the hawksbill turtle. In addition to its international ecologicalsignificance, the forest is also the lifeblood of the SBF in terms of water availability, since it covers fivewater catchment areas.

2.3 Historical Sites. Few pre-World War II structures remain in the SBF. The Spanish Gate,located in the Central Area, once guarded the western approaches to the old Spanish Naval Station, anddates from the 19th Century. A museum/memorial in a 19th Century Philippine-Spanish theme is housedin a restored Spanish storage facility. Remnants of the earliest American construction are a coalingstation and bunkers that housed an anti-aircraft battery prior to World War II. The Chapel in the CentralArea was originally known as the St. Roques Parish Church of Olongapo, and occupies a site that hasbeen used for religious purposes since 1885. No sites of archaeological significance have been discovereddespite intensive construction efforts in areas most likely to support human settlements.

2.4 Existing Buildings and Structures. The facilities at the former Subic Naval Base complexwere developed and operated to meet the unique needs of the military: the storage of large volumes ofpetroleum products and ammunition; specialized facilities for the needs of a largely transient population;and tightly secured and limited access to adjoining Olongapo City. The Base had nearly 2,000 buildingswith a total covered area of around 970,000 m2 . These buildings include industrial structures forworkshops and storage, commercial-type buildings for office and retail activities, special areas/buildingsfor the airport, ammunition and fuel storage, residential areas for family housing and bacheloraccommodation, as well as community facilities for education, health care and recreation. The vastmajority of the buildings in the complex are less than 50 years old, and were designed and maintainedin accordance with U.S. Navy standards. Many of the buildings and structures require a high level ofmaintenance, and with the exception of certain special buildings such as hangars, warehouses and recently

-6-

built housing units, the projected remaining life of the structures is 10-15 years. Table 2.1 presents asummary of the existing facilities in the complex.

Table 2.1: Inventory of Eidsting facilities and Previous Use

Activity No. of Gross Land Previous UsesBldgs. Floor Area

Area (ha)(m2)

Naval Station 473 213,760 326 administration, housing, commercial,recreation, temporary camps

Ship Repair 68 92,940 27 drydocks, ship repair and conversionFacility

Naval Supply 72 102,230 224 petroleum, oil, lubricant storage facility,Depot warehouses

Public Works 900 343,866 1,161 administrative, housingCenter

Naval Air 261 167,300 800 2.744 km runway, 260,000 ml apronStation parking

Naval Magazine 116 37,175 3,300 193 magazines and 50,186 m2 of open pads

Naval Hospital 29 13,940 322 90 hospital beds

Grande Island - - 47 integrated hotel and recreational facility

Other - - 451 recreational facilities, miscellaneous

Total 1,919 971,211 6,658

2.5 Utilities. Electrical power for the SBF is purchased from the National Power Corporation(NPC). A private company operates the existing on-base generation plant (26 MW) which it has leasedfrom the SBMA. The same private operator is constructing another, larger plant (108 MW) on a BOTbasis, expected to be commissioned in early 1994. The main supply of potable water is from theBinictican, Boton, Malawaan, Triboa and Binanga rivers, filtered and chemically treated in an on-basewater treatment plant, with a capacity of 12 million gallons per day (MGD). The water distributionsystem is comprised of antiquated clearwell pumps with a maximum capacity of 10 MGD, and severalinter-connected sub-systems located throughout the complex. The sewage collection and disposal for thecomplex consists of four separate systems, of which three provide primary and limited secondarytreatment prior to discharge in rivers or the bay. The former U.S. Naval base produced some 23 to 27million liters of domestic effluent per day, of which around 20 million liters were discharged as untreatedsewage directly into the bay. Sewage from adjoining Olongapo City is also discharged without treatmentinto Subic Bay. These practices are unsatisfactory, and are currently under review by the SBMA witha view to defining adequate solutions for the future. Solid waste was disposed off in a landfill on-base;however, this landfill was closed in 1992 and the SBF's present solid waste is disposed off in OlongapoCity's landfill, which is reportedly adequate for the next 10-15 years. Nonetheless, the SBMA intendsto review solid waste management practices and future needs in light of the anticipated economic activity

-7-

in the SBF. The former Naval base had a sophisticated network of telecommunications facilities forinternational and domestic voice and data communications. The complex's local area network of fiberoptic and copper cable provided a total subscriber line capacity of over 13,000 lines. However, most ofthe telecommunications equipment was removed by the U.S. Navy upon evacuation. The two remainingPABXs have a total capacity of 1,400 lines, which is adequate for the SBF's very limited needs atpresent. Capacity will, however, have to be increased to keep pace with SBF development.

2.6 TransRort Infrastructure. The SBF port facilities are configured to handle a mix ofcontainer and breakbulk cargo. The layout of the facilities dates from the early 1960s and does not lenditself to modern cargo handling operations. In addition, repairs are required at several wharves. Theairport has a single runway and requires weight limits on wide-bodied planes both landing and taking off;the runway, taxiway and aprons require strengthening in view of the anticipated activity. Passengerterminal facilities are inadequate: the present terminal building can accommodate only 79 passengers,based on the gross floor area per passenger used in the Civil Aviation Master Plan of the Philippines.The most convenient route from Manila to the SBF is via the North Luzon Expressway to San Fernando(57 kIn, 4-lane, good surface condition); from San Fernando to the Layac junction in Dinalupihan (48Ian, 2-lane, fair surface condition); and, finally, the Bataan-Zambales national road (24 Iam, of which 12km is a zig-zag portion with a maximum grade of 6%, 3-lane sections on critical curves, good surfacecondition). The Mabayo-Tala-Mabiga-Naparing road is an alternative road, currently under construction,starting near the Layac junction in Dinalupihan and ending near the southern gate of the SBF. Trafficforecasts indicate that an additional road connecting the SBF to Metro Manila will be required in the next10-15 years.

2.7 There are three main vehicular entry routes to the SBF. The first is through the MainGate and Magsaysay Bridge, connecting the SBF to Olongapo City. The second is through the KalaklanGate, which connects with the national road to the left of Olongapo City. The third is the Kalayaan Gate,connecting the SBF to the national road at the outskirts of Olongapo City. These access points areinadequate for the increased traffic flows into the SBF, and even with the limited activity taking placein the SBF at present, cause traffic back-ups during rush hour and on weekends. Within the SBF, thereare 92 road sections with a total length of 79.6 kmn. All the roads are in good condition with theexception of the perimeter road going to Kalayaan Gate, and are not likely to require major investmentfor the next 5 years. There are 66 parking lots, all in good condition, distributed throughout the SBF;aggregate parking areas are capable of handling 11,300 cars, which is adequate for the anticipated activityover the next 5-10 years.

B. The SBFs Competiiveness and Development Prospects

2.8 Over the last decade, the Philippines has captured a very small part of the boom in directforeign investment (DFI) compared to its ASEAN neighbors: around 5 % in 1990 and 1991. DFI has alsoaccounted for a very small percentage of total private investment in the country. In contrast to themarked export orientation of DFI in most other ASEAN countries, about 75 % of DFI in the Filipinomanufacturing sector is in domestic market oriented industries. A noteworthy aspect of DFI is theincreasing importance assumed by Newly Industrializing Countries of Asia as a source of foreigninvestment. The share of foreign investment from Hong Kong, Taiwan, South Korea and Singapore havebeen rising, particularly in the last few years.

2.9 The low private investor response to the reformed incentive structure in the Philippinescan be traced to the negative investor perception regarding sustainability of reform efforts and, morerecently, poor conditions of infrastructural services. Although the accumulated impact of reforms takenso far (relating, inter alia, to the financial sector, trade policy, the tax system and investment incentives)has been significant, slow and piecemeal implementation, at times aggravated by the judiciary, has createda persistent perception among potential investors that reforms in the Philippines might not have beenowned by the GOP and thus could not be effectively implemented and might even be reversed. Foreign

-8-

investor confidence has been further eroded by recent short-falls in electricity supply, crumblingtransportation and telecommunications infrastructure, and continuing concerns over the personal securityof foreign executives. Many of these problems are well on their way to resolution. Nonetheless, thePhilippines faces strong competition in the region. In the Asian region, lower-end import-dependentoperations, reliant on attractive and stable policies, and productive and stable workforces, are increasinglylocating in emerging investment locations such as China, Indonesia and now Viet Nam. Higher-endactivities, requiring critical basic infrastructure and support services, educated workforce and competitiveintermediate goods industries, are choosing Malaysia, Thailand and Singapore.

2.10 The SBF Incentives Regime. The freeport concept holds the potential to offset many ofthe competitive disadvantages of manufacturing in the Philippines. It can offer world class infrastructurein a secure and self-contained environment. The SBF also provides a number of attractive incentives forbusiness:

* no restriction on foreign or local ownership of enterprises;

* duty-free imports and exports of raw materials, intermediate and finished goods;

* ability to import, store, process, manipulate, consume or re-export merchandise duty- andtax-free;

* no foreign exchange controls, and free markets for gold, securities and futures;

i unlimited sales to the domestic economy, subject to payment of applicable import dutiesand other charges;

* no taxes except for a 5 % corporate tax on gross income; and

* ability for the SBMA to issue work permits, with permanent resident visa provided fora minimum investment of US$250,000.

2.11 The SBF's Competitive Position. The market potential of the SBF depends on its abilityto successfully compete for international investment with the large and increasing number of SEZs, EPZsand freeports in the East Asian region. There are currently 62 operational EPZs or industrial estates andanother 40 under various stages of development in the region. Within the highly successful SEZdevelopment in China, export-oriented, high technology bonded industrial parks and commercial freetrade zones are being established along the coast and in Hainan island. In addition to the long-establishedfreeports of Hong Kong and Singapore, Malaysia and Indonesia have designated a number of islands asfreeports. The SBF will directly compete with these locations as well as the large number of free zonesin Mexico and Latin America in attracting private investment. In addition, the liberalization of Viet Namposes a strong and immediate competitive threat.

2.12 The SBF offers several potential advantages over EPZs, and its incentives regime iscomparable to that of the many freeport and commercial free zone projects under development. Theadvantage of the SBF lies less in its incentives framework, and more in the ready availability of worldclass infrastructure, facilities and other amenities. Unlike freeports that are being developed fromscratch, the SBF requires limited financing and time for commercialization. The primary advantage tothe prospective manufacturer of locating in the SBF is that operations can begin almost immediately. TheSBF can also offer financial advantages, derived from the fact that the carrying cost of the facilities isvery low: the fixed assets turned over to the SBMA at virtually zero cost create a huge capital base withminimal corresponding outlays of either equity or borrowed funds. Offsetting these strategic advantagesare certain constraining factors, such as the present lack of commercialized airport and port facilities.

_ ---- ---- _ ---

-9-

However, the SBMA is in a sound position to contract debt for facilities improvements and many of theconstraining factors can be alleviated.

2.13 Potential Investors. In light of the SBF's incentives framework, and the benefits andconstraints of location in the SBF, several industrial and service activities were identified as potentiallocators in the SBF. These are:

* light manufacturing/assembly, including apparel, footwear, toys, textiles, jewelry,leather products, sporting goods, electronic components, electrical appliances andequipment, electro-mechanical devices. The SBF's comparative advantage is theavailability of unskilled labor and under-roof space at competitive prices.

* light engineering, such as industrial and analytical instruments, industrial equipment andgeneral components. The SBF's comparative advantage is the good (but diminishing)technical and industrial skill availability and several specialized buildings that would besuitable with minor modifications.

* information services, including data entry, image processing, voice center operations,multi-media and software development. The SBF's comparative advantage is theavailability of basic literacy and keyboarding skills, telecommunications potential, andsuitable buildings, including the availability of good housing.

- warehousing and distribution. The SBF's basic transportation facilities are well suitedfor cargo operations; significant warehouse space is available as-is; andtelecommunications potential exists.

* tourism and recreation, including accommodation, duty-free shopping, retirementhousing, business conventions and marina and other recreation. The SBF's majoradvantage is the natural beauty and clean environment of the site. Several recreationalfacilities exist and are easily upgradeable.

3 fimancial services, such as offshore banking and other services, as well as offshorecorporate registry. These activities are expected to develop in the medium-term, oncemanufacturing activity picks up in the SBF, and as the telecommunications potential isdeveloped.

2.14 In terms of the source and nationality of investment, the largest number of initialinvestments in the SBF is likely to come from Filipino firms, investing primarily in light manufacturingor tourism and retail trade projects of small size. Foreign investment will tend to concentrate on largerprojects. Investment from the East Asian NICs is expected to increase. In particular, the SBF is likelyto attract significant investment from Taiwan (Taiwanese investors are reportedly seeking to diversifytheir holdings away from China), once SBMA finalizes its negotiations with a Taiwanese company todevelop and manage an industrial estate within the SBF. The Export-Import Bank of Taiwan has alreadyprovided a loan on soft terms for site and services improvements for this green field site.

C. The Conversn Strtegy

2.15 The strategy for the conversion of the Subic Bay Naval Base complex, and developmentof the SBF, is based upon careful consideration of various factors (described in Chapter I). The strategyis predicated on the maximum utilization of existing buildings and structures by private locatorsimmediately, and the development of new buildings and facilities by predominantly private developersin the medium-term. This approach was chosen because it capitalized on the SBF's fundamental costadvantages: since buildings and facilities were turned over to the SBMA at no cost, the SBMA has the

-10-

unique advantage of being able to under-cut the competition in terms of lease rates for buildings andfacilities, thereby achieving rapid occupancy. The role of the SBMA is seen to be that of a facilitating,promotional, and regulatory authority, with limited involvement in the development and operation offacilities. This notwithstanding, it is recognized that the SBMA may have to operate certain facilities andundertake the renovation and construction of certain buildings to catalyze private sector interest andparticipation; however, this is viewed as an interim arrangement to be turned over to private operatorsas soon as possible. The privatization approach distinguishes between the SBF's "core productive assets"(assets such as land and existing buildings for use by private locators directly, thereby generating incomefor the SBMA), and "support facilities" (facilities such as the port and airport, demand for which isderived from users of core assets). The privatization strategy also differentiates between areas for thedevelopment of private "business complexes" and other areas reserved for the development of individualbuildings by individual locators. In order of priority, the privatization of core assets would precedeprivatization of support facilities, which would require a certain mass of economic activity to be in placeprior to privatization.

2.16 Land Use Plan. The focus of SBMA's land use plan is a multi-use complex at a centrallocation on the waterfront (see Map IBRD 25500). The revitalized Central Area will house commercial,trading, tourism-related and light industrial activities, while ensuring the conservation of importantmonuments and historic landmarks. An allocation of 284 ha of land has been made for light and mediumindustry development in several pockets, including larger land parcels for the development of integratedindustrial estates. Housing occupies 358 ha, encompassing existing areas and densification orredevelopment of selected pockets for a planned increase of approximately 6,000 dwelling units. Around2,000 ha of the Naval Magazine area is reserved as a Nature Park; however, detailed, environmentally-friendly land use proposals could be developed for this area. The conversion of the military airport intoa civilian international airport requires 285 ha. An area of 29 ha is reserved for the future developmentof a cargo port in the former Naval Supply Depot. An allocation of 263 ha has been made forcommunity facilities. Special areas, such as the tank farm and areas reserved for the Philippines ArmedForces, occupy 193 ha. Some 146 ha are designated as green buffers, while the remainder are LandReserves to provide flexibility in time and space. The 3,500 ha of intact tropical forest are scheduledfor inclusion in the Global Environment Facility (GEF) Conservation of Priority Protected Areas project,negotiated recently (see para. 4.22). The publication of SBMA's land use plan is a condition ofeffectiveness of the proposed project. Agreements were reached at negotiations that this land use planwill be implemented.

2.17 Privatization. The SBF conversion strategy foresees an important role for the privatesector in the future development and operation of the SBF. The outright lease of the entire facility to aprivate operator was rejected as a privatization mechanism by the authorities at the very outset.3' Theprivatization approach distinguishes between different categories of assets. Existing assets can basicallybe classified into two basic categories: core productive assets and facilities which will generate incomefor the SBMA, and support facilities, which will provide services to support the income generatingactivities. In addition, a differentiation must be made between areas zoned for general industrial,commercial or tourism use, and areas specifically designated as Comprehensive Development Areas(CDA). Existing buildings within a CDA are expected to be levelled or significantly modified in themedium-term, to allow for the development of the CDA. This implies that they can only be leased ona short-term, non-renewable basis.

2.18 Several privatization mechanisms are available to the SBMA. These range from outrightdivestiture; simple or capital leases for land and buildings; joint ventures for the operation of utilities orin the form of property development companies; build-operate-transfer (BOT) arrangements (whereby aprivate entity would develop a project, operate it for a fixed period and then transfer the asset to SBMA);

This would have amounted to replacing one dominant controlling presence with another, which would have beenpolitically unacceptable.

-11-

management contracting (where a private company is hired by the SBMA to operate certain facilities fora fee); and public or private offering of shares. Given the diversity of SBF assets, a single privatizationapproach is not feasible. Thus, different mechanisms have been developed for each major category ofasset, as summarized in Table 2.2. In most cases, with the exception of standardized building leases, theassistance of privatization and financial advisors would be required.

Table 2.2: SBMA's Privatization Approach

Type of Property Privatization Mode Procedures

Comprehensive Development Areas

General Use Buildings short-term, fixed lease with fixed lease term on first-come, first-servedlimited renewal basis

Business Complexes long-term lease, JV or revenue bidding processsharing

Non-Comprehensive Development Areas

Raw Land long-term lease or JV bidding processdevelopment

Developed Land long-term lease; lessee must fixed lease term on first-come, first-servedconstruct building to SBMA basisstandards

General Use Buildings long-term lease fixed lease term on first-come, first-servedbasis

Special Use Buildings long-term lease with technical bidding procedureprovisions

Support and Specialized Facilities

Airport operating agreement negotiate with local or foreign operators

Port management agreement bid and negotiation with local or foreignoperators

Power long-term lease, management negotiation with NPC or private companyagreement or JV

Water/Sewerage BOT, JV or operating bidding process or negotiation with privateagreement operator

Telecommunications iV bidding process

Specialized Facilities long-term lease, JV or revenue financial advisor on a commission basissharing

-12-

2.19 Institutional Aspects. The SBF's conversion strategy has significant institutionalimplications. The freeport regime is administratively complex to implement; this complexity is compoundedby the fact that the legislative base of the freeport is contained in only three articles of R.A. 7227, incontrast to the detailed and comprehensive legislation typically associated with freeport regimes. As a result,the SBMA has had and continues to expend much effort in clarifying some of the ambiguities of thelegislation. Appropriate systems are required to implement the freeport regime, including adequate customsprocedures and monitoring of SBF purchases and sales for Treasury revenue purposes. The SBMA is a veryyoung organization whose focus and work program are evolving. In the early days of the U.S. withdrawal,its primary preoccupation was the orderly transition from U.S. Navy to civilian use. Having secured thepremises, it has begun to implement the broad conversion strategy outlined above. However, it will needmore experienced staff in freeport management to undertake many of the tasks it has set for itself. TheSBMA will continue to require multi-disciplinary technical assistance to refine its conversion strategy,implement its privatization agenda, and develop its own institutional capabilities.

2.20 The conversion strategy also has significant implications on the SBMA's environmentalmanagement function. One of the major objectives of the SBMA is the protection of the environment. Thisimplies that future industrial, commercial and tourism activity must be carefully vetted to ensure that it isenvironmentally benign. The presently good environmental conditions of the SBF must be preserved; thisimplies that a baseline of information has to be developed on existing conditions, appropriate standards haveto be established, and compliance on the part of SBF locators monitored on a regular basis. The SBMA willneed to urgently build up a sound environmental management infrastructure within its institution. Here, too,technical assistance and other institutional support is required.

D. Status of SBF Development and Privatization

2.21 Getting the SBF off the ground will involve efforts in three broad areas. The first is tooperationalize the freeport regime. This involves defining the SBF policy regime and regulatory proceduresand implementing an appropriate institutional framework to administer the SBF. These aspects are discussedin Chapter IV. The second is to implement the physical conversion strategy. In addition to privatization,this involves identifying critical areas for continued SBMA investment and management. The third is toundertake strategic planning for future SBF growth. This translates into the definition of a multi-yeardevelopment program, including regular fine-tuning of the conversion strategy. As can be expected,effecting the SBF conversion will take time, and must be viewed as an on-going process. Quite apart fromthe time required to structure SBF development and privatization deals, the SBMA itself is in a start-upphase. Nonetheless, much progress has been achieved in these areas in the one year that the SBMA hasbeen operational, as described in the paragraphs below.

2.22 As of November, 1993, the SBMA had received over 500 expressions of interest fromprospective investors. Of these, 32 proposals had been accepted and are presently being implemented. Ofthe remainder, 16 proposals are under contract negotiations and 42 are under active review. In terms ofsectoral breakdown, commercial activities (including retailing and banking) take the lead at 50%, followedby 22% for manufacturing, 12% for hotels and restaurants, with the balance for support services andinfrastructure, such as telecommunications and power. As expected, the vast majority of these initialinvestors are Filipino (over 75%). However, the number of foreign investors is expected to increase as theindustrial estate (para. 2.23) is developed. Total employment created as of November, 1993, is 5,195employees. The projected investment of these 32 firms at full development (in most cases, over the next1-2 years) is over US$350 million; employment projections stand at 12,800. In terms of value, over 90%of the investment commitments are from foreign investors. The projected investment of the 58 proposalscurrently being negotiated or actively reviewed is around US$125 million, whereas the projected employmentis close to 4,000. Here, too, the vast majority of interested investors is Filipino (or Filipino subsidiariesof foreign firms). A significant event has been the recent agreement between the SBMA and a major airfreight and courier service to establish a regional hub at the Subic International Airport. A large, world

-13-

class tenant such as this one provides an anchor for promotional activity, and holds the potential to attracthigher-value, air freight-dependent activities to the SBF.

2.23 Industrial Development. The areas slated for industrial development in the land use plancover both green field sites and existing developed sites. For the former, the SBMA has been in activediscussion with a Taiwanese company as well as the Taiwanese Government. A 262 ha site will bedeveloped in three phases. The Export-Import Bank of Taiwan has provided a loan on concessional termsto finance the site development costs of the first phase. The SBMA expects to enter into an agreement witha private Taiwanese company to develop, manage and promote the estate, and some 75 firms have reportedlyexpressed an interest in locating in the estate in the first phase. The first phase development (approximately120 ha) is expected to be completed in 1997. For the latter, the SBMA has entered into leases on existingbuildings with 8 firms (as of November, 1993). The problem now is that the SBF is rapidly running outof buildings that would be suitable for small-scale industrial activities. The buildings available requireextensive reconfiguration and conversion; alternatively, new buildings need to be constructed in thedesignated industrial areas of the land use plan. The SBMA's experience is that small investors, who aremainly local Filipino firms, are interested in immediate occupancy and are unwilling, or unable financially,to undertake the necessary renovations or construction.

2.24 Commercial Development. The commercial development to date has concerned the leasingof existing buildings to operators providing support services to SBF residents and tourists. Amongst suchservices are banks and shops. Other activities include gas trading, message handling services and alaboratory. Warehousing and transhipment services are also taking place.

2.25 Tourism Development. Hotel development, including one casino resort, has been quitespectacular in the SBF, attesting to the high interest in the site on the part of tourists. There has also beensubstantial interest in restaurant and retail trade activities. Local tourism tends to be concentrated on week-ends, whereas foreign tourists (mainly from Taiwan) seem to be mainly of the package tour variety.Considering that the SBF has not actively promoted the site to the tourism industry, the growth in tourism(some 440,000 visitors since January 1993) is remarkable. In addition to these private-sector financedactivities, the SBMA has been involved in the provision of tourism-related services (operating some of therecreational facilities, for example) pending their privatization. These services have been provided primarilythrough ex-Base employees in a volunteer capacity. Facilities slated for privatization in the 1994-95 periodinclude the golf course and the marina.

2.26 Svecial Use Areas. One of the early and notable successes of the SBMA has concerned theprivatization of the petroleum, oil and lubricant facility, a 181 ha complex of underground storage tanks anddedicated pier. This facility has been leased to a U.S. company on a 25-year, renewable lease. Theprivatization arrangement was undertaken with the help of financial advisors.

2.27 Utilities. The existing 26 MW power plant has been leased to a private operator, whooperates the plant under an arrangement with the National Power Company (NPC). The same operator isalso constructing a 108 MW plant on a BOT basis on land that has been leased by the NPC from the SBMA.SBMA purchases power from NPC and is responsible for power distribution within the SBF; however,power distribution is high on the list of SBMA's privatization priorities. SBMA's agreement with NPCprovides for satisfaction of SBF power needs from these plants in priority over provision of power to thenational grid.

2.28 A Memorandum of Agreement with the National Telecommunications Commission providesthe SBMA with a great deal of flexibility to issue telecommunications franchises within the SBF. Moresignificantly, the SBMA can enter into arrangements with any local or foreign entity, and is not restrictedto dealing with existing franchise owners. With the assistance of privatization advisors, the SBMA iscurrently in the process of evaluating bids for the creation of a joint venture for the provision oftelecommunications services within the SBF. SBMA's stake in the joint venture would be between 20% and

-14-

30%, subscribed to through the provision of existing telecommunications equipment and the franchise. Inthe initial phase, 2,000 new lines will be added to the SBF by mid-1994.

2.29 Transport Infrastructure. At present, the airport is being operated by SBMA employees withassistance from staff seconded from the Air Transportation Office. SBMA's strategy is to retain ownershipand control of the airport in the short- to medium-term, but to enter into a management contract with aqualified operator. Several improvements to the airport are required in terms of terminal facilities,navigational aids and air traffic control equipment, as well as repairs to the runway, taxiway and aprons.These improvements are needed urgently, in view of a recent agreement between the SBMA and an airfreight service that intends to establish a regional hub at the Subic International Airport. Generalmaintenance of the port facilities is undertaken by SBMA staff, who also operate the facilities on anoccasional, as-needed basis. Full privatization of the port is not foreseen in the near-term, but the SBMAintends to enter into a management contract for port operations. In order to maintain the extensive portinfrastructure, several repairs to the wharves and piers are required. The road network in the SBF is ingood condition, and no major rehabilitation is required at this stage.

2.30 Residential. Although there has been substantial interest on the part of investors in someof the housing units in the SBF, no units have yet been leased on a long-term basis. The SBMA is currentlyin the process of devising a housing privatization strategy. The basic approach is to package the housingunits in lots, which would be offered to real estate management companies for management and individualleasing. It is expected that the first lots will be bid out by mid-1994.

E. Off-SBF Development Program and Priorities

2.31 The conversion strategy to date has focussed on redevelopment of the former U.S. NavalBase, which represents the first phase of freeport implementation. The Zone, however, is considerablylarger (see para. 2.1) and encompasses surrounding municipalities. The SBF will not remain a restrictedenclave in the long-term, and indeed, should not be viewed as such for planning purposes. It is linked toOlongapo City and is an integral part of the sub-region. An urban master planning exercise for thesurrounding municipalities is currently underway, financed by a TA grant from the Asian Development bank(ADB). This study is expected to provide: (i) an urban development strategy for the area; (ii) infrastructuraldevelopment plans for transportation, water supply, power and telecommunications, drainage and sanitation,and housing; and (iii) prefeasibility studies for critical infrastructural development projects required tosupport SBF development in the next five years. One such priority would be the improvement of thehighway infrastructure connecting the SBF to Metro Manila.

2.32 The long-term vision for the development of the Central Luzon (one of the objectives ofR.A. 7227) is the establishment of 50-100 ha industrial estates along highways in the Central Luzonprovinces, and shipping the manufactured goods through the SBF port. This strategy is guided by the factthat the land available for industrial development is limited in the SBF, whereas it possesses a good, naturalharbor where port operations can be developed. The development of the Central Luzon provinces willprovide livelihood for lahar-devastated areas (as a result of the Mt. Pinatubo eruption) and ease thedemographic and industrial congestion in Manila. This strategy is also consistent with the development ofthe Clark Air Field as a SEZ (per R.A. 7227). The infrastructural requirements of translating this visioninto reality are many: the existing road network in the region will have to be improved in order to facilitatethe trucking of goods into the SBF; industrial estates will have to be developed off-base; and the SBF portwill have to be improved to handle modern cargo operations.

F. Lesons from Previous Bank Involvement

2.33 The Bank has played a major role in the Philippines through a lending program involvingsome 140 operations, but has no direct experience in freeport or EPZ development in the country.

-15-

Experience from Bank involvement in similar activities in other countries4' indicates that EPZs are mostsuccessful when they are part of a coherent incentives and trade policy regime; further, that key factors forsuccess include appropriate location, the availability of suitable physical trade infrastructure, sitedevelopment consistent with investor demand, and a policy environment that fosters private sectordevelopment. The country's trade, investment and foreign exchange regimes are now at par with those ofits more dynamic East Asian neighbors; furthermore, the SBF's incentives package is comparable to thatoffered by its competitors in the region. The SBF's proposed regulatory framework, its location andphysical infrastructure are consistent with the success factors commonly cited for EPZs. Projectinterventions are designed to fill in the gaps in the regulatory framework, particularly with respect to theenvironment, and to ensure a phased development of the SBF.

G. Rationai for Bank Involvement

2.34 As described in the Country Assistance Strategy, discussed by the Bank's Board onFebruary 3, 1994, the Philippines is at a critical juncture in its economic history, and needs to seize theopportunity to break out of its low economic growth cycle. Foreign direct investment will be very importantif the Philippines is to catch up with its more affluent neighbors. The SBF has the potential to kick-startthis process. Improving the business environment for private enterprises is a key element of the GOPdevelopment agenda. The SBF provides a model base for the implementation of concerted and soundbusiness-friendly policies. The SBF has already attracted considerable investor interest; however, certaininstitutional and infrastructural bottlenecks prevent the SBMA from realizing the full potential of the SBF'sconsiderable asset base. In a competitive environment such as that facing the SBF, rapid accommodationof interested investors is essential: a lack of adequate facilities or administrative delays can create negativeperceptions, dampen investor confidence, and generally undermine the SBF development strategy. At thesame time, the SBMA must avoid a haphazard development of the SBF, guided by short-term financialconsiderations rather than the long-term maximization of economic, financial and environmental benefits,if it is to effectively act as the custodian of this important asset.

2.35 The Bank can play a catalytic role in helping the GOP and the SBMA effect an orderlyconversion of the facility, and its presence provides a measure of comfort to private investors. The proposedproject touches on a multiplicity of sectors. The Bank has considerable experience in and is well-equippedto deal with the issues related to all these sectors. The bulk of the proposed financing concernsinfrastructure, for which the terms of Bank funds are more appropriate than the shorter maturity finance thatwould be available commercially. The overall financial needs of the SBF are large, and the availablecommercial funding would be more effectively channeled if it supports commercial ventures. Finally, theBank has already been involved in the provision of technical assistance to the SBMA to help strengthen thepolicy, regulatory and institutional framework and define a conversion strategy for the baselands. TheBank's continued involvement will help implement this conversion strategy, and, in particular, ensure thatthe emphasis on environmental protection and institutional strengthening is maintained.

Export Processing Zones, Policy and Research Series 20. As discussed in Chapter I, a freeport can be considered an EPZwith free trade and other equal footing export policies.

-16-

m. THE PROJECT

A. Objecive

3.1 The objective of the project is to attract private investors to the Subic Bay Freeport (SBF).This will be achieved by: (a) improving infrastructure and access to the area for industrial, commercial andpassenger traffic; (b) maintaining the SBF asset base, including protection of the environment; and(c) strengthening the capacity of the SBMA to manage and administer the facility.

B. Description

3.2 The project consists of three components:

(a) Site Improvement. Several infrastructural improvements are required at the SBF, consistingof new construction, conversion of existing facilities for civilian use, selected repairs toexisting facilities, and replacement of critical equipment that was removed by the U.S. Navyupon evacuation. Detailed engineering studies and construction supervision for thesecomponents will also be included. A detailed description of the improvements is containedin Annex 1.

Land access to the SBF will be improved through: (i) the construction of a 4 Iam, two-laneaccess road from Kalalake Bridge to Kalayaan Gate (see Map IBRD 25499). This road willlink the main industrial area of the SBF (presently being developed) to the outskirts ofOlongapo City and the national highway, thereby diverting heavy traffic away from thetourism and commercial areas of the SBF as well as the narrow streets of Olongapo City;(ii) the construction of an 82 m, two-lane bridge with pedestrian walkway linking RizalAvenue in Olongapo to the SBF. This bridge will be used for incoming traffic to the SBF;outgoing traffic will pass through the existing Magsaysay Bridge. This system will improvetraffic flows in Olongapo City as well as in the SBF; and (iii) construction of security plazasat the Main Gate Complex (Rizal and Magsaysay Bridges) as well as at Kalayaan Gate toprocess incoming and outgoing traffic.

Air traffic access to the SBF will be improved through: (i) strengthening of the runway inorder to accommodate the size of aircraft which are forecast for the next 10 years. Thestudy and mitigation of a subsidence problem at the northeast end of the runway are alsoincluded; (ii) the reconstruction of the southeast taxiway, including its strengthening andwidening, in order to accommodate aircraft expected to be used by the freight hubbingoperation; (iii) apron strengthening at both the passenger and freight operations areas toaccommodate the forecast aircraft sizes; (iv) providing adequate airport communicationsequipment and air traffic control equipment suitable to provide a minimum Category 1control; and (v) converting one of the existing hangars into a passenger terminal to createadequate passenger handling capacity. An existing building will also be converted to afreight warehouse for freight carried on passenger aircraft.

In order to prevent further rapid deterioration of the underdeck structure at the Alava,Rivera and Bravo Wharves and at Pier 1010 (see Map IBRD 25499), and to ensure theircontinued availability for operations or commercial activities, existing cracks and damageto the concrete piles and deck structure will be repaired and sealed. A cathodic protectionsystem will be installed to protect the steel components at Pier 1010 and Bravo Wharf.

A pilot standard factory building development will be undertaken on a 10 ha site in theformer PWC area (see Map IBRD 25499). Site development will include the basicinfrastructure (roadways, water, electrical and sewer line connections). The initial phasewill cover an approximate land area of 6 ha for 20,000 m2 of covered floor area. Three

-17-

basic configurations, providing multiples of 1,000 m2 space, have been designed. Sixbuildings will be constructed in total.

Miscellaneous equipment will be provided for security and maintenance purposes.Communications equipment and vehicles will be provided for security services. Electricityand water meters will be installed in existing buildings to permit appropriate billing forutilities to the tenants. Emergency equipment (generators, emergency pumps, etc.) will alsobe provided.

(b) Institutional Support. Several actions are foreseen to strengthen the institutional capacity ofthe SBMA and to provide the appropriate systems for the implementation of freeportpolicies. Agreements were reached at negotiations that for all the technical assistanceactivities, the SBMA will retain consultants according to terms of reference and a selectionprocedure acceptable to the Bank. It was also agreed that the timeframe for the carrying outof the studies and the implementation of the agreed recommendations would follow thetimetable shown in Annex 2.

In order to monitor duty-free purchases such that the appropriate taxes can be collected,5'a merchandise control system will be designed and implemented. This computerized systemwill link each duty-free retail outlet to a central database. SBF visitors will be issued a passcard in which purchases will be recorded. Any purchases above the prescribed limit willbe assessed the appropriate duties. The project will finance the design and implementationof the system, including hardware, software and training to SBMA staff in its use. Termsof reference are contained in Annex 3.

Technical assistance will be provided to define appropriate zoning regulations and a buildingdesign code for the SBF. This will ensure a coherent future development, consistent withthe agreed land use plan. Terms of reference are contained in Annex 4.

The SBMA's present billing system is largely manual. In the future, with increased activity,an automated system will be required in order to accurately track SBMA revenues andensure that billing takes place on a timely basis. The project will finance the design andimplementation of this system. Terms of reference are contained in Annex 5.

Several SBMA facilities are slated to be privatized within the next 2-3 years. The projectwill include a privatization assistance fund for the provision of specialized advice on specifictransactions. Among the major items foreseen at present are water and sewerage servicesand solid waste management. In the case of water and sewerage services, a technicalconsultant has already been hired to define the basic technical parameters, and projectinterventions will concern assistance in the actual bidding process and negotiation with thechosen supplier. For solid waste management, terms of reference for the necessary servicesare being prepared by the SBMA. A tentative description of the services required is inAnnex 6. Agreements were reached at negotiations that an action plan and timetable for theadequate provision of water and sewerage and solid waste management in the SBF wouldbe provided to the Bank by December 31, 1994.

In order to strengthen the SBMA's institutional capabilities and improve SBF administration,a team of 3 senior advisors will be provided under the project. The role of this team willbe two-fold: first, to provide the necessary technical skills and experience currently missingfrom SBMA staff and second, to provide on-the-job training to SBMA counterparts. The

Executive Order 97A, issued subsequent to R.A. 7227, sets duty-free purchase limits for Filipinos residing outside theSBF. Any purchases beyond the prescribed limits are subject to applicable taxes and duties.

-18-

areas to be covered include planning and property development, customs and taxation policyand investment promotion. Terms of reference are contained in Annex 7.

Short-Term Training: The project will provide short-term consultancies as required fortraining and workshops in freeport-related topics. Terms of reference for this assistance arecontained in Annex 7.

Given the sheer size of the SBF and the various facilities contained in it, and in light of theSBMA's key role as custodian of these assets, the facilities management function needs tobe strengthened. The project will provide critical equipment required to operate andmaintain utilities and other services until such time as they are privatized. It will alsoprovide institutional support to adequately organize and structure the facilities managementfunction at the SBMA. Terms of reference for this support are in Annex 8.

(c) Environmental Protection. An Environmental Baseline Survey will be carried out toestablish the basic environmental conditions within the SBF and develop a baseline ofinformation on the forest lands and the bay. Terms of reference are in Annex 9. Theproject will also provide environmental monitoring equipment for the newly-establishedEcology Center in the SBF, as well as institutional support to assist in establishing a soundenvironmental management infrastructure in the SBF (Annex 10 contains terms ofreference). An Environmental Management Plan covering the organization and work planfor the SBMA's Ecology Center (terms of reference are in Annex 11) has been submittedto the Bank for review. The adoption of an agreed Plan by the SBMA's Board and itspublication is a condition of effectiveness.

C. Cost and Financing

Projet Cost

3.3 The base project cost is P 1,207 million (US$43.1 million equivalent), and total project costincluding contingencies is P 1,596 million (US$52.0 million), with a foreign exchange component of about75%, or US$39.1 million. Physical contingencies represent around 14% of the base cost, while pricecontingencies represent 18%. Table 3.1 sunumarizes the cost estimates; details are presented in Annex 12.Base costs are in December 1993 prices, and are derived from the most recent equipment, material and laborcost data available. A relatively higher level of physical contingency has been included to allow for possiblecost overruns on certain items for which detailed engineering has yet to be finalized. Price contingenciesare estimated on the basis of escalation factors of 7% for local costs and 2.5% for foreign costs.

Flnancing Plan

3.4 Table 3.2 summarizes the proposed financing plan for the project. Bank financing willaccount for about 74% of the total requirements of US$54.1 million, including interest during construction.The proposed Bank loan of US$40 will finance 100% of the estimated foreign exchange cost and will be atthe standard variable interest rate for a 20-year term, including a five-year grace period. The SBMA willbear the foreign exchange and interest risks for the loan. The loan will be guaranteed by the GOP.Agreement was reached at negotiations that the GOP will provide this guarantee.

-19-

Table 3.1: Summary of Project Costs

-Million Pesos--- -Million USS---Component % of %

Local Foreign Total Base Cost Local Foreign Total Foreign

Site Improvement 259 753 1012 84 9.3 26.9 36.2 74lnsniutonal Support 5 133 138 12 0.2 4.8 4.9 97Environiental Protecdon 0 28 28 2 0.0 1.0 1.0 100

Taxes and Duties 29 0 29 2 1.0 0.0 1.0 0

Total Cost 293 914 1,207 100 10.5 32.6 43.1 76Physical Condngencies 41 128 169 14 1.5 4.6 6.0 76Price Condngencies 66 154 220 18 1.0 1.9 2.9 70

Total Cost with Contingencies 400 1,196 1,596 132 12.9 39.1 52.0 75Tomls may not Add up due to rounding.

Table 3.2: Financing Plan(US$ million)

% of

1994 1995 1996 1997 Total Total

Tobi Project Cost 11.8 27.0 8.5 4.8 52.0 96.1

Interest During 0.3 1.2 0.5 0.1 2.1 3.9Construction

12.1 28.2 9.0 4.9 54.1 100.0Toatl to be Ibm_cod

FUmd 1W:4.7 23.3 7.6 4.4 40.0 73.9

World Bank 7.5 4.9 1.4 0.5 14.1 26.1SBMA's Internal Cash

12.1 28.2 9.0 4.9 54.1 100.0Total Ybhaancgtotals may not add up due to rounding.

D. Imple an

Projed aggement

3.5 SBMA is fully responsible for implementing the project. The Deputy Administrator forAdministration has been appointed as the project manager for SBMA; he is assisted by a team of SBMA staffdrawn from the engineering, finance and corporate planning departments. This team has participated inproject preparation and is therefore fully cognizant of detailed project content. The team of resident, long-tenn advisors will also be available to assist the project management team as appropriate.

3.6 SBMA has currently hired consultants who have assisted with the preparation of the physicalcomponents of the proposed project. To avoid implementation delays, the same consultants will continueto assist with final designs and procurement. Agreements were reached at negotiations that appropriatelyqualified consultants would be hired for the supervision of civil works. The SBMA's engineering staffwould handle the procurement of goods and equipment; however, specialized assistance for the finalizationof technical specifications for the communications equipment would be provided by appropriateconsultants.§' These proposed arrangements are acceptable to the Bank.

Such assistance is foreseen in the existing grant from the PHRD Fund (Japan).

-20-

3.7 Procurement arrangements for the project are summarized in Table 3.3. The cost of eachitem includes its pro rata share of physical and price contingencies. The portion of the project not financedby the Bank loan (NBF) would follow SBMA's procurement procedures. These follow COA rules andguidelines, and are satisfactory to the Bank.

Table 3.3: Procurement Arrangements(US$ million)

Component --------------------------Procurement Method----------------------ICB LCB Other NBF Total

Works

Land Access 4.6 1.7 0.4 6.7(4.0) (1.5) (0.0) (5.5)

Airport Improvements 14.4 14.4(12.4) (12.4)

Port Repairs 2.3 0.1 2.4(2.0) (0.0) (2.0)

Standard Factory Buildings 7.0 0.4 7.4(6.0) (0.0) (6.0)

Goods

Airport Navigational Aids 6.5 6.5(0.0) (0-0)

Communications Equipment 2.5 2.5(2.5) (2.5)

Vehicles 0.7 0.7(0.7) (0.7)

Miscellaneous 2.9 0.5 0.1 3.5(2.9) (0.3) (0.0) (3.2)

Consultants

Advisors 2.8 2.8(2.8) (2.8)

Studies 4.9 0.1 5.0(4.9) (0.0) (4.9)

Total 34.4 1.7 8.2 7.6 52.0(30.5) (1.5) (8.0) (0.0) (40.0)

Figures in parentheses represent amounts financed by the Bank loan.NBF: Not Bank Financed includes taxes and duties.Other: local and international shopping; consultant services.

-21-

3.8 About US$34 million equivalent of goods and works to be financed by the Bank under theproposed project would be suitable for procurement through international competitive bidding (ICB)according to the Bank's procurement guidelines and using the Bank's standard bidding documents. Contractsfor goods valued at US$200,000 equivalent or more, amounting to US$6.1 million in the aggregate, wouldbe procured on the basis of ICB. A margin of preference equal to 15% of the CIF bid price of importedgoods, or the actual customs duty, whichever is lower, will be allowed for domestic manufacturers. Off-the-shelf, readily available goods, having a per item value of no more than US$200,000, would be eligible forprocurement through local and international shopping with a minimum of three quotations, in an aggregateamount not to exceed US$500,000. Civil works contracts valued at US$2 million equivalent or more,amounting to US$28.3 million, would be procured on the basis of ICB. Minor civil works contracts valuedat less than US$2 million equivalent, amounting to US$1.7 million in the aggregate, would be procuredthrough local competitive bidding following procedures acceptable to the Bank. While it is unlikely thatforeign contractors would be interested in such small contracts, there will be no restriction on their biddingon these contracts. Consulting services, amounting to US$7.7 million, will be awarded according to Bankguidelines. It is expected that some 350 person-months of consulting services will be required for thevarious activities of the project. Prior review of procurement documents will be required for consultingservices which will result in contracts with an estimated value of US$100,000 or more for the engagementof firms and US$50,000 or more for the engagement of individuals. Prior review of bid documents andapproval of contract awards will be mandatory for all contracts expected to cost the equivalent ofUS$200,000 or more, which will cover 90% of total contract value.

Disbursement

3.9 The estimated disbursement of the Bank loan is shown in Annex 13 and summarized inTable 3.4. This assumes that the loan will become effective by July, 1994. The project is expected to becompleted by June 30, 1998. A loan closing date of June 30, 1999 has been established to allow for latepayments. The scheduled disbursement follows the Bank's standard profile for industrial developmentprojects in the Philippines. Retroactive financing not exceeding US$4 million equivalent of the proposedloan is recommended for eligible payments made prior to the date of loan signing, but after December 6,1993. These expenditures would concern primarily consultant services for detailed engineering andinstitutional support.

Table 3.4: Estimated Loan Disbursement(US$ Millions)

-------------------------------Bank Fiscal Year-------------------------------

1995 1996 1997 1998 1999

Annual 7.2 17.6 11.2 2.4 1.6

Cumulative 7.2 24.8 36.0 38.4 40.0

3.10 The Bank loan will be disbursed against: (i) 100% of foreign expenditures for importedequipment and materials; (ii) 100% of local expenditures (ex-factory) for locally manufactured items;(iii) 90% of civil works; (iv) 70% of other locally procured goods and services; and (v) 100% of totalexpenditures for consulting services.

-22-

3.11 Disbursements for all expenditures would be based on full documentation, except for:(i) contracts for works and equipment that cost less than US$200,000 equivalent; and (ii) contracts forconsulting services for US$100,000 equivalent for firms and US$50,000 equivalent for individuals.Supporting documents for disbursements based on statements of expenditure (SOEs) would be kept by SBMAfor review by external auditors and Bank supervision missions. SBMA will open a US$ Special Accountin a commercial bank and an initial deposit of US$1 million (representing an average of about two months'small disbursements) would be made to facilitate payments for eligible expenditures.

Monitoring, Reporting and Supervision

3.12 The Bank will monitor the physical progress of the proposed project as well as theborrower's financial and institutional performance. For this purpose, an average of two supervision missionswill be fielded per year during the active project phase. The missions will review implementation of theproject in addition to the more general freeport conversion strategy. SBMA's institutional development andfinancial situation will also be an important part of such reviews. To measure the success of the conversionstrategy, and SBMA/SBF performance, the following monitoring indicators would be used: (i) number andamounts of private investment proposals pending approval; (ii) number and amounts of investment proposalsbeing implemented; and (iii) total employment created. The project manager in SBMA will serve as the keyliaison between the Bank and the borrower, and will provide periodic progress reports on projectimplementation, to include the monitoring indicators. SBMA will also provide the Bank with its annualfinancial and auditor's reports.

3.13 Project supervision by the Bank will follow the supervision plan presented in Annex 14.Bank supervision will require an estimated 60 staffweeks over the life of the project, of which around 15weeks will be at headquarters (to review, inter alia, procurement actions and progress reports) and 45 weeksin the field. Supervision would be carried out by Bank staff and consultants with expertise in infrastructuredevelopment (road engineer, port specialist), privatization support (privatization of utilities), institutionalissues, and environmental management. SBMA will supervise the project on an on-going basis through theproject manager, assisted by technical and financial staff within the institution as required. The plannedimpleme