Mozambique - Industrial Enterprise Restructuring Project

Document of The World Bank FOR OFFICIAL USE ONLY C#e R F/ Report No.7826-MOZ STAFF APPRAISAL REPORT MOZAMBIQUE INDUSTRIAL ENTERPRISE RESTRUCTURING PROJECT NOVEMBER 21, 1989 Industry and Energy Operations Southern Africa Department This document has a restricted distribotion and may be used by recipients only in the performaaoce of their offciil duties. Its contents may not otherwise be disclosed without World Bank aothorization.  CURRENCY EQUIVALENTS US$1 - 813 Niticais (MT) - October 1989 US$1 . 682 Meticais (MnT) - at tine of Appraisal (March 1989) MT 1000 - US$1.47 ABBJIVIATIONS AND ACRONYMS ADL Arthur D. Little BE Beneficiary Enterprise BM Bank of Mozambique BES Business Environment Study BPD Banco Popular de Desenvolvimento BSTM Banco Standard Totta de Mocambique CCADR Caixa de Credito Agrario e Desenvolvimento Rural CDC Commonwealth Development Corporation CNP Commissao Nacional de Planeamento (National Planning Commission) CREE Commissao de Relacoes Economicas Externas (Commission for External Economic Relations) ERC Enterprise Rehabilitation Component ERP Economic Rehabilitation Program ERTU Enterprise Restructuring Technical Unit GOM Government of Hozambique GPIE Gabinete de Promocao do Investimento Estrangeiro (Office of Foreign Investment Promotion) IDIL Instituto Nacional de Desenvolvimento de Industria Local National Institute for Light Industry Development IFC International Finance Corporation MA Ministry of Agriculture MCW Ministry of Construction and Water MOF Ministry of Finance MIE Ministry of Industry and Energy ML Ministry of Labor MTC Ministry of Transport and Communications PETROMOC Empresa Nacional de Petroleos de Mocambique (National Petroleum Company) PFI Participating Financial Institutions PPF Project Preparation Facility RP Rehabilitation Plan SARL Sociedades Anonimas de Responsabilidade Limitada (Public Limited Liability Companies) SNAAD System for Non-Administrative Allocation of Foreign Exchange SEILA Secretariat of State for Light Industry SETEP Secretariat of State for Vocational and Professional Education SQRL Sociedades por Quotas de Responsabilidad Limitada (Private Limited Liability Companies) UNIDO United Nations Industrial Development Organization FISCAL YEAR Government and Public Enterprises: Calendar Year  , , AL_ I MOZAMBIQUE INDUSTRIAL ENTERPRISE RESTRUCTURING PROJECT TABLE OF CONTENTS Page No. CREDIT AND PROJECT SUIARY . . . . . . . . . . . . . . . . . . . .i-iii 1. THE ECONOMY . . . . . . . . . . . . . . . . . . . . . . . . . . 1 Background ........................... . 1 The Economic Rehabilitation Progranm and The Industrial Sector ............................ . 2 II. INDUSTRIAL SECTOR BACKGROUND .................. . 3 A. The Structure of Industrial Production, 1973-1987 ..... . 3 B. Institutional Framework ............. ... 6 C. Financial Sector .................. ... 7 D. Sector Issues and Constraints . . . . . . . . . . . . . . . . 9 E. Government Objectives and Priorities . . . . . . . . . . . . 14 F. Status of Enterprise Review ............... . 15 G. IDA Assistance .... . . . . . . . . . . . . . . . . .. 15 Past Bank Involvement ................ . 15 IDA's Role in the Sector . . . . . . . . . . . . . . . . 16 III. THE PROJECT ......................... . 16 A. Project Rationale .16 B. Objectives .17 C. Project Description . . . . . . . . . . . . . . . . . . . . 17 Enterprise Rehabilitation Component (ERC) . . . . . . . 17 Technical Assistance Component (TAC) . . . . . . . . . . 18 D. Project Cost and Financing .19 IV. MAIN FEATURES OF THE CREDIT .23 A. Credit and Onlending Terms and Conditions . . . . . . . . . 23 B. Selection of Potential Beneficiary Enterprise (BEs) . . . . . . . . . . . . . . . . . . . . . 24 C. Sample Enterprise Profiles .25 D. Enterprise (Subproject) Eligibility Criteria under the ERC . . . . . . . . . . . . . . . . . . . . . . 27 E. Subloan Processing and Administration . . . . . . . . . . . 28 This document has a restricted distribution and may be used by recipients only in the performance of their offitial duties. Its contents may not otherwise be disclosed without World Bank authorization.  MOZAKIQUE INDUSTRIAL ZNTERPRISE RESTRUCTURING PROJECT TABLE OF CONTENTS V. PROJECT IMPLDKNTATION . . . . . . . . . . . . . . . . . . . . . 29 A. Institutional Setting and Management . . . . . . . . . . . . 29 B. Status of Project Preparation and Implementation Schedule . . . . . . . . . . . . . . . . . . . . . . . . . 32 C. Project Preparation Facility . . . . . . . . . . . . . . . . 33 D. Procurement . . . . . . . . . . . . . . . . . . . . . . . . 33 E. Disbursement . . . . . . . . . . . . . . . . . . . . . . . 36 F. Special Account . . . . . . . . . . . . . . . . . . . . . . 38 G. Accounting and Auditing Requirements . . . . . . . . . . . . 38 H. Monitoring and Reporting Requirements . . . . . . . . . . . 39 VI. PROJECT BENEFITS AND RISKS . . . . . . . . . . . . . . . . . . . 39 A. Benefits . . . . . . . . . . . . . . . . . . . . . . . . . . 39 B. Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 VII. SSM#ARY OF AGREEMNTS AND RECONEND&TIONS . . . . . . . . . . . 40  | MOZ^M~~~~~~IWBIQUE INDUSTRIAL ENTERPRISE RESTRUCTURING PROJECT LIST OF ANNEXES 2-1 Structure of Manufacturing Industry, 1973-1987 2-2 Geographical Distribution of Industrial Enterprises - 1973 2-3 "Tutelage of Manufacturing Industry 2-4 Structure of Interest Rates 2-5 Sectoral Distribution of Credit 2-6 Evolution of Bank Credit to Enterprises by Bank and Activity 2-7 Suzmmary Data on 40 Major Enterprises 3-1 Technical Assistance Costs to the Enterprise Restructuring Unit Restructuring Technical Unit (ERTU) 3-2 Human Resources and Training Institutions in the Industrial Sector 3-3 Draft Scope of Packaging Sub-sector Study 3-4 Cost Estimates for 15 likely Project Beneficiaries 4-1 Data Sheet on Probable Rehabilitation/Restructuring Enterprises 4-2 Guidelines for ERTU Operations, Subproject Eligibility Criteria and Subloan Administration 5-1 Project Implementation Organization Chart 5-2 Bank of Mozambique-Summary Accounts, 1980-87 5-3 Monetary and Credit Developments, 1980-87 5-4 Terms of Reference for the ERTU 5-5 Enterprise Restructuring Technical Unit - Jos Descriptions 5-6 Estimated Disbursement Schedule for the IDA Credit 5-7 PCR Preparation Arrangements 6-1 Selected Documents and Data Available on Project File  I1OZAMBIQU INDUSTRIAL ENTERPRISE RESTRUCTURING PROJECT CREDIT AND PROJECT SUMMARY . Borrower: People's Republic of Mozambique Beneficiaries: Ministry of Finance (MOF); Bank of Mozambique (BM); Ministry of Industry and Energy (MIE); and selected major beneficiary enterprises (BEs). Amount: SDR 40 million (US$50.1 million equivalent) Terms: Standard IDA terms, with 40 years maturity Onlending Terms: Government will pass on US$50.1 million equivalent of the IDA credit to the BM to: (a) channel US$39.9 million to BEs under the Enterprise Restructuring Component (ERC); and (b) retain US$10.2 million equivalent for technical assistance to strengthen the Enterprise Restructuring Technical Unit (ERTU) and other agencies involved in the Project, for consultancies to BEs for subproject preparation, and for training. The ERC would be channelled to BEs primarily as loans through BM. However, in appropriate cases, the Government could use this component to make direct equity investments in BEs in combination with loans according to their assessed needs for fitancial restructuring. The BM would onlend the credit proceeds under the ERC in local currency to eligible BEs at adjustable interest rates based on the structure of rates prevailing in Mozambique. The credit risk on onlending would be borne by the BM who would receive an appropriate spread as determined by the banking system. The foreign exchange risk would be borne by the Government and would be covered by the interest yield on funds onlent, net of the service charge on the IDA credit, and the onlending spread of the BM. The Government would bear the risk on any equity investments. Subloans under the ERC would have maturities of up to 15 years, including up to a 5-year grace period. Project Description: The Project's overall objective, which is in support of the Government's strategy, is to restore production and efficiency in a selected group of major industrial and agro-industrial enterprises. More specifically, the Project aims to: (a) introduce a framework and criteria for selecting enterprises for rehabilitation, based on potential economic, financial and technical viability, and on management capacity to operate efficiently and profitably; (b) finance the rehabilitation, financial restructuring and operational support to selected enterprises. The restructuring process would, where appropriate, include rationalization of capacity, privatization, technical partnership arrangements, or, if necessary, closure of nonviable operations; (c) protect the environment and worker safety; (d) strengthen Government's capacity to implement the rehabilitation  - ii - program; and (e) support policy reforms and subsector reviews designed to strengthen enterprise operations in a market-oriented environment. Project Benefits and Risks:. Rehabilitation of selected major enterprises will yield high economic returns through restoration of employment and higher levels of production and incomes. Improvements in the institutional and policy framework, plus increased enterprise autonomy and competition, with more private sector involvement through joint ventures and divestiture, should enhance enterprise efficiency and profitability. The rehabilitation, financial restructuring, privatization and technical management approaches developed for enterprises under the Project will serve as demonstration cases for the design and implementation of similar programs in other enterprises. Further, the Project will aim to increase the market orientation of enterprises through improvements in financial and management information systems, with emphasis on accurate record keeping, cost controls and related training of enterprise personnel. The major risks associated with the Project stem from: (a) the economy's fragility and therefore the possibility that political and social opposition may weaken Government's commitment to the ERP reform program during Project implementation, particularly the more sensitive changes (e.g. price liberalization and state enterprise divestiture or liquidations) whb"i represent a significant departure from past policies; (b) limited Government and enterprise experience in implementing rehabilitation plans; and (c) the security situation, which might adversely affect project implementation. To mitigate these risks: (a) the Project would provide assistance in training a.nd financing tools and equipment for laid-off staff in order to alleviate the social costs and therefore, reduce the risk of resistance on the part of the public; and (b) BEs will be selected primarily on the basis: of their potential economic, technical and financial viability; that they possess a capable management team or plans are made to secure such a team; and that their operations are not seriously affected by the security situations. The ERTU is being strengthened through the services of an experienced consulting firm and enterprise management will also be strengthened and, where necessary, assisted in formulating and implementing their rehabilitation plans. Close supervision during Project implementation will be maintained to deal with problems as they arise to ensure that the environment is not adversely affected by the operations of BEs. Government commitment to, and progress so far in, implementing the reform program has been encouraging and no evidence exists of flagging Government resolve.  - iii - NOWKBIOQUE INDUSTRIAL lNTRPRISF RESTRUCTURING PROJECT PROJECT COSTS AND FINANCING PLAN Local Foreign Total A. Estimated Project Costs 1/ (US$ Million Equivalent) Project Components 1. Enterprise Rehabilitation Components (Fixed investments, spares, working capital & TA) 33.5 62.4 95.9 2. Technical Assistance Component: 2.0 8.8 10.8 TOTAL COSTS 35.5 71.2 106.7 B. Financing Plan Government and enterprises 34.1 0.0 34.1 Co-financing 2/ 0.0 22.5 22.5 IDA 1.4 48.7 50.1 TOTAL 35.5 71.2 106.7 C. Estimated Disbursements: 3/ IDA Fiscal Year: FY90* FY91 FY92 FY93 FY94 FY95 FY96 Annual 1.8 6.8 11.4 15.5 8.1 4.0 2.5 Cumulative 1.8 8.6 20.0 35.5 43.6 47.6 50.1 Z of Total 3.5Z 17.02 40.0Z 71.8Z 87.0? 95.02 100.02 Estimated ComPletion Dates December 31, 1996 *Including the Repayment of PPF advance. 1/ Project Cost Estimates exclude taxes and duties. 2/ Interest to co-finance has been expressed by Italy (US$22.5 million equivalent). In addition, several bilateral and multilateral agencies may co-finance specific enterprise rehabilitation, including IFC, CDC, Caisse Central. 3/ Based on standard World Bank, Africa-Region disbursement profiles and recent disbursement experience in Mozambique.  MOZAMBIQUE INDUSTRIAL ENTERPRISE RESTRUCTURING PROJECT / STAFF APPRAISAL REPORT I. THE ECONOMY Background 1.01 Pre-Independence. Despite its considerable natural resource base, Mozambique's principal foreign exchange earnings during colonial times derived from transit trade services and mine workers' remittances, principally from South Africa and Zimbabwe. A variety of agricultural products (including prawns, cashew nuts, tea, cotton, copra, sugar and thyme, mostly from the settler-dominated estate sector) were also exported. Industry consisted of agro-processing operations closely linked to the agricultural estate sector and import substitution activities, which were concentrated in Maputo and Beira and depended on imported raw materials, equipment, and spare parts. 1.02 The 1973-86 Economic Decline. Between 1974 and 1976, the mass exodus (approximately 90%) of the Portuguese settlers and instability in the region, which spread into Mozambique, created major disruptions throughout the economy. Industrial enterprises and agricultural estate operations were abandoned by owners, managers and skilled technicians. Industrial production, which accounted for 12% of GDP in 1973, declined by almost 50% between 1973 and 1976. Destruction of production facilities and infrastructure by armed bandits intensified after 1980, and the deteriorating security situation in rural areas had a severe impact on agro-industries. After recovering somewhat between 1976 and 1980, industrial production continued to decline thereafter and in 1986, was estimated to be about one- third of the 1973 level. Effective production capacity declined sharply to about 10-40% of rated capacity because of obsolescence, mechanical breakdowns, shortages of replacements and spare parts, and war-related damage. 1.03 Other key economic indicators have also been in decline. Between 1980 and 1986 exports fell by nearly 75%; imports decreased by more than one- third from 1980 to 1985, before recovering somewhat in 1986. Since 1980, external imbalances, aggravated by the increasingly overvalued exchange rate, have led to the rapid accumulation of external debt service arrears. Internally, difficulties attributable to inappropriate economic policies were aggravated by the deteriorating rural security situation, which even now seriously disrupts agricultural export production. / Detailed information and analysis on the economy and the sector are available in several Bank reports, including (a) Country Economic Memorandum (June 6, 1985); (b) Memorandum of the President for the 3rd Rehabilitation Credit (April 24, 1989): and (c) the green cover industrial sector "Business Environment Study" (June 20, 1989).  -2- 1.04 Government efforts to reverse the decline began in 1984-86 with the introduction of the Economic Action Program. Liberalization measures introduced in the program included a foreign exchange retention scheme for selected export enterprises and a new investment code to promote foreign direct investment. These measures were not sufficient to stimulate any significant turnaround in economic performance. The economy was isolated from international and domestic market forces by centralized economic management and control. The Economic Rehabilitation Protram and the Industrial Sector 1.05 In response to the continuing economic crisis, in 1987 the Government of Mozambique (GOM) with Bank and IMP assistance, launched a far- reaching Economic Rehabilitation Program (ERP). 1.06 In addition to major macroeconomic adjustment measures, which included progressive devaluations of an extremely overvalued metical, the GOM initiated major reforms in economic management. The reforms were intended to (a) progressively reduce centralized administrative controls and encourage private sector participation; (b) encourage improved resource allocation through indirect methods such as market determined prices and credit policies rather than administrative intervention; and (c) establish more direct links between economic performance and financial results. 1.07 Industrial sector objectives included in the ERP were to: (a) restore production, (b) improve efficiency of resource use, (c) increase enterprise autonkomy and accountability, and (d) encourage a comercial business environment. Efficiency in resource allocation is being promoted by a combination of measures, including: (i) a revised foreign exchange allocation system, which became operative in 1987; (ii) more restrictive credit policies and reduced subsidies; (iii) increased freedom to adjust employment in response to economic signals; (iv) progressive decontrol of input and output prices; and (v) greater enterprise-level authority with respect to procurement and marketing. As a result of these measures, two and one half years after initiation of the ERP, enterprises are operating in a more market-influenced environment rather than under the heavily administered system of the past. To assist industrial enterprises in adjusting to this more open environment and to restore efficient production, the GOM requested the International Development Association (IDA) to help design and finance the proposed Industrial Enterprise Rehabilitation Project (IERP).  -3- II. IUMJSTRUIL SWGTOR IACIGROUND A. The Structure of Industrial Production. 1973. 1987 2.01 Annex 2-1 presents the structure of manufacturing industry. Data presented are from the last couprehensive pre-independence survey and from preliminary estimates for 1987. In 1973, 1,409 registered industrial enterprises employed 98,868 workers. Manufacturing value added was estimated at 12? of GDP. Numerically, the largest group of enterprises were the 331 (mostly village-level) flour mills (average employment 5.75) and the 285 small bakeries (average employment 15). The largest operations in terms of employment were six sugar mills (5,298 workers) and 15 cashew processing operations (20,850 workers, or 212 of total employment). The food, beverage, and tobacco sub-sectors were the largest contributors to value added (44Z), followed by textiles, garments, and leather (16X), metals fabrication and engineering (13.5Z), and wood, paper, and printing (102). Several recent estimates of industrial employment and composition have been prepared from a variety of sources, but the results have been considerably divergent. A reconciliation of the latest data available from the Ministry of Labor (ML) and from the Ministry of Industry and Energy (MIE) shows an estimated industrial employment level for 1988 of 80-100,000 versus 98,868 reported in 1973. For 1984, a United Nations Industrial and Development Organization (UNIDO) study team estimated 100,000 employees for the formal sector and 50,000 for the informal sector, but these estimates appear optimistic. A 1987 ML survey, covering all enterprises, estimates for 1987 show that there were 66,500 in the manufacturing sector, 17,700 in construction, and 3,700 in public utilities. The National Planning Commission (CNP) estimates for 1987 show that there were 87.800 employed in nationally registered manufacturing enterprises. 2.02 Table 2.1 2/ traces the decline of industrial output from 1973 through 1987. Table 2.1s MOZAMBIQUE - INDEX OF INDUSTRIAL PRODUCTION, 1973-87 Al (1980 - 100) 1973 1975 1980 1981 1982 1983 1984 1985 1986 1987 Total manufac- turing output 139 87 100 103 90 70 56 43 42 45 aI/ 1980 - Base Year, 100 Source: National Planning Commission (CNP), Informacao Estatistica, 1987. 2/ Based on gross output data for nationally registered enterprises only (over 50 employees).  -4- The index indicates that output for 1987 was about 72 higher than in 1986, the first increase for 7 years. The modest improvement appeared to be mainly due to donor import support programs, including the IDA First Rehabilitation Credit (Cr. 1610-MOZ), which allocated about US$35 million to industry. The recovery, however, was uneven. Major improvements in production were recorded in textiles (212), wood products (462), chemicals and plastics (16Z), and basic metals (1362). Tobacco and leather production registered declines. Preliminary indications are that industrial production increased by a further 72 in 1988. 2.03 Recent mission field surveys confirm that the composition of registered enterprises is relatively unchanged since the colonial period. due to the extremely low level of post-independence investment. Shutdowns have been numerous, and production by establishments that continue to function has substantially declined because of obsolescence and breakdowns. 2.04 Ownership Structure of Industry. In 1975, following independence, the State's decision to 'intervene' in abandoned or commercially sabotaged enterprises radically changed the operating structure of industry. After an initial "intervention' in about 300 enterprises, the 1977 law (D-L 16-75 of February 13, 1975) permitted chaniges, including full state ownership or reversion to private ownership. By 1984, the structure of ownership of 575 nationally registered enterprises was as follows: state - 114; intervened - 140; private - 294; mixed and cooperative - 27. 2.05 As a result of many restrictions placed on market-based private operation, there was little interest in, or movement towards, privatization of "interveneds or mixed enterprises until the start of the ERP. Recently, the situation is beginning to change. The Government has begun to rationalize the status of some "intervened, enterprises by grouping those within the same subsector and converting them into state enterprises. Some of those already formed are SOVESTE, E.E. (garments - 5 factories); IMOCAL, E.E. (shoes and leatherwear - 5 factories); EMPLAMA E.E. (plastics - 5 factories); and COMETAL (railroad cars and heavy steel fabrication). Other "intervened* firms have either been sold to private investors or returned to the original owners. To date, decisions related to enterprise ownership have been on a case-by-case basis. It is expected however, that the pace of divestiture will significantly increase and will take place in a more systematic fashion, through the proposed IERP. Company asset valuations and the structuring of sales agreements have been carried out by working groups within the MIE. At the larger enterprise level, a number of "intervened" companies have been sold, usually to Mozambican entrepreneurs, who are starting to become interested in purchasing assets at current devalued prices. 2.06 Industrial Location. In 1973, 412 of industrial employment and 51Z of sector value added were located in Maputo Province (Annex 2-2). If Beira were included in the ccelculations, employment and value added estimates were 572 and 712, respectively. Manufacturing activities such as rubber, plastics, chemicals, paints, metal fabrication and engineering were heavily concentrated in these two cities. Agro-based activities such as cereals milling, cotton ginning, sisal and tea production, and forestry operations were more widely dispersed. By 1987, the pattern became further concentrated  because of the decline in agro-processing and an increase in the share of total production accounted for by Haputo province. This may reflect, in- part, under-reporting elsewhere. Nevertheless, reported absolute employment in manufacturing and processing in Maputo Province increased from 34,800 in 1973 to 46,400 in 1987. 2.07 Current Investment Climate. The business climate in 1987-88 has improved as a result of the ERP. Principal policy reforms have included: (a) devaluation and an increase in the relative price of internationally traded goods and lower real wages in the organized sector; (b) decontrol of pricing, distribution, and procurement; (c) movement towards non-administered foreign exchange allocation; and (d) increased efforts by the Government to stimulate local and foreign private investment through, inter alia, privatization efforts, investment incentives, and recognition of the role of the private banking sector. The increased availability of imports financed by donor aid has also been a positive factor. Nevertheless, the investment climate continues to be adversely affected by security problems, the generally poor condition of infrastructure and industrial plant, and the potential contraction of demand resulting from lower real wages. 2.08 The few indicators which are available show an upturn in activity. Foreign investment proposals to the Office of Foreign Investment Promotion (GPIE), which was established in 1985, have increased from a total of 15 for the 3-year 1985-87 period to 20 for the first 11 months of 1988. The majority of proposals in the pipeline are tourism and trade related; processing industry proposals included fish, cashew nuts, and tobacco. 2.09 Demand for Industrial Sector Production. Increased foreign exchange availability and market liberalization have created a short-term resurgence of industrial activity and consumer demand. Sustainability is uncertain until the security situation is resolved and rural areas can be reintegrated .nto the formal sector of the economy. In urban areas, the severe drop in real incomes, which has accompanied exchange rate adjustment, has eroded purchasing power at the lower levels of the economic pyramid. The Business Environment Study (BES) survey of 62 enterprises indicated that food processing activities continued to experience strong demand, but some softness was beginning to appear in sectors such as textiles, garments, shoes, and condensed milk. Soft demand for local manufactures may be due in part to a preference for newly available, higher-quality imports, particularly for shoes and apparel. Products whose principal markets are rural, such as bicycles and agricultural implements, continue to experience lagging sales and inventory buildup because of security problems that constrain access to markets. 2.10 Industrial EfficiencS. A survey of industrial efficiency based on a domestic resource cost analysis of a 40-enterprise sample has recently been completed as part of the Business Environment Study. The objective was to identify and rank industrial subsectors in terms of operational efficiency and production cost structure relative to international competition. Given the deficiencies of most enterprise balance sheets, cost accounting practices, and other data shortcomings, the results should be interpreted as only indicative. The analysis indicated that, at the ERP adjusted exchange rates, a fairly wide cross-section of import-substitution industries and some  - 6 - agricultural export operations have efficient short-run marginal production costs. This is in sharp contrast to the pre-ERP prevalence of negative value added operations. The long-run efficiency of industries was less clear, emphasizing the need for detailed enterprise-by-enterprise studies before embarking on major rehabilitation investments. 2.11 Preliminary as they are, study results indicate that potential exists for development of low-capital, labor-intensive export oriented operations in the Maputo area. These operations could take advantage of a relative abundance of idle factory capacity and (by Sub-Saharan Africa standards) a relatively industrialized work force. The study also indicates that local resource-based industries such as sugar and edible oil processing and textile manufacturing are currently burdened with high input and operating costs, resulting in part from security-related uncertainty of raw material supply and subsequent low capacity utilization. B. Institutional Framework 2.12 The organization of the industrial sector reflects vestiges of a centrally planned economy. Enterprises deemed to be of national importance --whether state owned, mintervened,o or private--come under the administrative "tutelage, of central ministries. Local enterprises are under the tutelage of the provincial directorates of the MIE. Approximately 580 registered national enterprises (not all in an operative state) are under the tutelage of eleven central ministries. Areas of administrative responsibility are given in Annex 2-3. As of March 1989, SEILA was dissolved as a Secretariat, but its functions were retained in a Light Industry Department created within the MIE. 2.13 Unidades de direccao (Coordination Units) are responsible for supervision. There are a total of 11 unidades under the Light Industry Department (formerly SEILA) and 7 under the MIE, excluding energy production. Each unidade supervises a set of industrial subsectors, each containing between 10 and 30 individual enterprises. In some cases larger enterprises such as SOGERE (beverages) and ELECTROMOC (electrical services) act as the unidades for the rest of the particular subsector. SEILA was also responsible for the Directorate of Local Industries; this directorate is now the Institute for Local Industry Development (IDIL). 2.14 Until 1988, the unidades linked the enterprises with the central planning process. Their main responsibility in practice was the coordination of data for planners, based on data received from compulsory company reporting. The unidades were also responsible for price authorization, foreign exchange allocation, technical assistance, training coordination, and industry studies. 2.15 In practice, unidades varied considerably in terms of the functions they performed. More important, the level of autonomy permitted individual enterprises varied widely, especially with respect to foreign exchange allocation. In some unidades, enterprises could procure and import diractly, whereas in others all such activity was carried out by the unidade's management, and individual enterprises were charged fees for the unidade's services.  - 7 - 2.16 Consistent with the rapidly changing sector environment, both de Jure and de facto relationships between unidades and individual enterprises are in a state of flux. In general, enterprises enjoy greater managerial autonomy than in the recent past. An important indicator is that many enterprises are now permitted to trade directly with each other, rather than through wholesaling intermediaries, both in domestic and international trade. C. Financial Sector 2.17 The present financial system came into being when the banking system was restructured in 1978. There are three banks, one of which, Bank of Mozambique (BM), is legally responsible for carrying out the dual functions of both a central and a commercial bank. Both BM and the second bank, the Banco Popular de Desenvolvimento (BPD), are 10O? state-owned. The third bank, Banco Standard Totta de Mocambique (BSTM), is a (largely foreign-owned) private bank. In addition, an Agricultural Development Credit Fund (CCADR) was established in 1988. 3/ 2.18 For the first decade after independence, the banking system operated mostly as a passive conduit of funds to finance p-oduction plans for the various sectors of the economy. In keeping with the Government's new economic policy, considerable changes are now under way in Mozambique's financial sector, including introduction of competition in resource allocation within the banking system. For example, while BM has held a monopoly on foreign exchange operations, a limited foreign exchange operations license was recently granted to BSTM. 2.19 Structure of Interest Rates. The structure of both lending and deposit rates of interest in Mozambique is shown in Annex 2-4 (including a translation of the Ministerial Order of 1989 which sets the most recent rates). As the Annex shows, the rates for 1981 and 1987 were very low in nominal terms, ranging from 0 to 6Z for deposits, and 3 to 102 for lending. In real terms these rates were negative because inflation levels averaged in excess of 1OZ over the period. The structure of interest rates was revised (with increased interest rates on demand and time deposits) effective January 1987, as part of Mozambique's agreements with the IMF for a Structural Adjustment Facility (SAF). Effective January 1989, the number of lending rates was reduced to 16, ranging from 14Z to 352. The number of term (over one year) lending rates has declined from 27 to 7, and the range contracted from 18-35Z to 22-34Z, with rates for most categories increasing by 4-6Z. 2.20 Interest rates are still negative in real terms, although less so now that inflation has started to decline. Under the terms of Mozambique's agreement with the IMF, interest rates would continue to be reviewed and be progressively revised to achieve positive real interest rates by 1990. 3/ A more complete discussion of the financial sector is contained in paragraphs 3.01 - 3.47 of the SMEDP (Small and Medium Enterprise Development Project) SAR (Report No. 7987-MOZ).  - 8 - 2.21 Credit Allocation Policy and Sectoral Distribution. Mozambique had no active formal credit allocation policy until 1987, when a ceiling on domestic credit expansion was introduced in the context of the SAF agreements with the IMF. Under the terms of the agreements, additional credit expansion is allowed to the extent of the countervalue in meticais of certain foreign exchange resources, such as IDA Credit loans. 2.22 Credit Ceilings. For 1988, the ceiling on domestic credit expansion was Mt 74 billion, of which Mt 20 billion was for lending to the State and Mt 54 billion for lending to the economy. The level of bank finance available to the State declined significantly in real terms. This shift partly reflects changes in the channelling of financial resources to State enterprises, in the context of rationalization of their operations, as well as increasingly tight controls on the Government's budget and the desire to make adequate funds available to the economy to stimulate growth. 2.23 Provisional figures for 1986 show an actual expansion in domestic credit of Mt 64.9 billion. In 1986, BM accounted for 792 of total bank lending, BPD for about 182, and BSTM for about 32. By year-end 1988, these figures were 69.52, 23.62, and 4.32, respectively, with the remaining 2.62 lent by the newly established CCADR. More significant perhaps are the various institutions' shares in incremental lending in 1988: BM lent less than 482, BPD accounted for about 37Z, BSTM for about 72. and CCADR for about 92. 2.24 Sectoral Distribution. In recent years, agriculture has accounted for around half of total bank lending; of the remainder, industry accounts for about 172 (39-422 if primary transformation of agricultural products is included), construction for about 5-72, transport and communications for around 12-14Z, domestic trade for some 7-92 and foreign trade for 62. Data for BM (Annex 2-5), which are fairly indicative since BM has accounted for 852 of industrial lending, suggest that manufacturing receives only about 112 of total lending. As of year-end 1988, BM accounted for 702 of total lending to industry, down from 852 in 1986, and BPD and BSTM accounted for 13.52 and 12.92, respectively. The newly established CCADR accounted for 3.5Z. BPD does not at present lend to the construction and trade sectors and only recently has it lent to the transport sector; BSTM has less than a 32 share in lending to construction and transport but an 11-132 share in lending to the domestic trade sector (Annex 2-6). ,.25 Banking System Arrears and Capital Base. The banking system faces a serious arrears problem, which has arisen from several sources. A significant portion of the arrears dates back to independence, when many Portuguese owners of firms left the country. Another portion stems from directed lending by the state-owned banks (mainly BM and BPD), largely to state enterprises and intervened firms. Much of this lending covered operating deficits. Total figures for this type of lending, and for arrears arising from it are not currently available. Since 1987, the Government has covered enterprise operating deficits through direct fiscal subsidies. The level of subsidy has been reduced substantially from Mt 9.1 billion in 1987 (most of which went to the agricultural sector) to Mt 6.8 billion in 1988.  - 9 - 2.26 The Government has begun to address the arrears problem in negotiations with BH, which holds most of the arrears (about Mt 40 billion). This amount represents only the principal in arrears, since BH does not accrue interest on doubtful loans. The proportion of these arrears in BM's overall portfolio is declining. In 1986, the proportion of arrears stood at 41Z; by December 1987, they had declined to 34Z and by December 1988, they were only about 152. Other arrears deemed reprogrammable have declined from 42Z of the total portfolio to 212 over the same two years. Reprogrammed amounts now constitute 25Z of the portfolio and doubtful debts have remained fairly stable at about 6?. In the meantime, BM's healthy portfolio has increased from 132 to 332 (or to 58Z if rescheduled amounts are included, and to 732 if the amounts the state has agreed to assume are also included). BH's equity and reserves also increased substantially in the last quarter of 1987, to Mt 25.9 billion; the adequacy (or degree of inadequacy) of this figure is quite difficult to judge because the extent of unrealized foreign exchange losses that may be allocated to the commercial banking function of BH is uncertain. The other two banks have begun similar negotiations with the Government. The total amount of debt the state will assume has not yet been decided. If the banks had to recognize the full extent of their current arrears as losses, they would have negative net worth, given the banks' narrow capital base. The capital-to-assets ratio was about 42 for BH in December 1987 (after an 82? capital increase), 2.32 for BPD, and 1.1Z for BSTM. Assurances about timetables for clearing the commercial banks' lending arrears, and overall rehabilitation of the banking system, are being sought in the context of the Small and Medium Enterprise Development Project (SMEDP). D. Sector Issues and Constraints 2.27 The constraints facing the industrial sector, which include antiquated plant and equipment, often unclear ownership, deficient financial structure, and underqualified management will clearly affect its capacity to respond to the expanded market opportunities that the new policy environment has made possible. 2.28 Initial supply response difficulties since the ERP began have highlighted a series of macro and enterprise-level constraints that must be addressed if the industrial sector is to respond fully to the opportunities inherent in Hozambique's changing circumstances. The following summarizes the latest developments and/or recent policy changes relevant to the industrial sector and areas where further work is needed. 2.29 Exchange Rate Adjustment. The ERP-induced devaluations have helped to rationalize the structure of domestic resource costs vis-a-vis foreign equivalents. Mozambique has become, in international terms, a low-labor-cost producer (in terms of salary, if not as yet in terms of unit cost). The policy of flexible exchange rate adjustment will be maintained, with quarterly reviews in light of actual price developments in Mozambique and abroad, and with a view towards narrowing the gap between the official and parallel market rates. 2.30 Foreign Exchange Allocation. The heavy reliance on external assistance, much of which is provided only on a tied basis, requires the  - 10 - continued use of a system for centrally administered direct allocation of foreign exchange. While such a system is necessary, the Government will seek to enhance the operation and efficiency of the allocative mechanisms. As devaluation reduces the level of excess demand for foreign currency, a staged opening up of access to foreign exchange is becoming feasible. The Government has initiated liberalization of the foreign exchange allocation process by setting up two funds. The "Market Fund' provides foreign exchange for the purchase of inventory for trading companies, and the 'Small Enterprise Fund" finances inputs for a short list of 180 designated enterprises. In 1988, a total of US$6.0 million was disbursed from both funds. The fund allocation for 1989 is expected to total US$25 million. With the objective of progressively moving toward a more open trade regime, in 1989, a System for Non-administrative Allocation of Foreign Exchange (SNAAD) is being introduced through the Third Rehabilitation Credit (Cr. 2021-MOZ). In the first year of operation, foreign exchange and import licenses will, on request, be automatically granted for a narrow range of imported inputs (spare parts for cargo and collective transport, and key inputs to the garment and shoe industries). These products will not be subject to domestic price control regulation. The estimated value of foreign exchange to be dedicated to the SNAAD is US$25 million, or about 20 percent of projected "free' exchange for imports during 1989. 2.31 Regulations require that a metical-denominated countervalue of the foreign exchange requested mist be deposited in the BM before the foreign exchange can be utilized. Mission conversations with individual enterprises indicate that a metical scarcity--a result of devaluation and inflation--is impeding some firms from solicitiag foreign exchange. Access to metical countervalue through the local banking system by BEs to be rehabilitated will be an essential part of the IEPP. Operational sustainability of rehabilitated enterprises at satisfactory levels of capacity utilization will require that they have assured access to foreign exchange for the procurement of recurrent imported raw materials and spare parts. 2.32 The Foreign Exchante Retention Scheme, introduced in 1984, entitles exporters to hold a proportion of their sales proceeds at the BM in a convertible account. The proportion retained is variable, with a current average of about 50X. The retention account is normally denominated in meticais and is therefore convertible only at the prevailing exchange rate. Import licenses are granted only after the Ministry of Trade checks for possible local supply availability. A further issue concerns the mechanism for transfer of import entitlements to enterprises supplying the export sector. Refinement of this system in the short run would be beneficial; in the long run, the implications of this system to the economy-wide allocation of foreign exchange merit closer examination. The Government will seek to reduce the export retention rates as the scope of the SNAAD expand, and, with this objective, will review the rate structure in 1989. 2.33 Tariff and Taxation Policy. Before the ERP, fiscal and tariff structures were complex, with a system of turnover taxes and tariffs that had a cascade effect, acting as a disincentive for the use of domestic intermediaries in the absence of quantitative restrictions. The realignment of the currency and the progressive opening of foreign exchange allocation will r.ow permit the price of foreign exchange to play a more important  - 11 - allocative role. In line with the Policy Framework Paper (PFP), which has been agreed to with the Bank and IMF, the Government is implementing a two- stage reform of the tax and tariff structure. The first stage, completed in early 1989, concentrated on converting specific rates to ad valorem rates and simplifying rate structures through the consolidation of product categories and reduction in the number and range of rates. 2.34 The legislation also: (a) established a duty drawback scheme for export production with at least 35? local value added; (b) provided exemption for one-half of import duties for raw materials, equipment, and spare parts for import substitution projects with at least 45? local value added; (c) established the possibility of full tariff exemption for raw materials, equipment, and spare parts for export expansion projects; and (d) revoked all existing regulations pertaining to customs tariff exemptions. Measures were also initiated to strengthen the administrative capacity of the Customs Administration. During the second stage of tariff reform, to be completed by end-1989 under the Third Rehabilitation Credit, progress will continue in simplifying the system and harmonizing the tariff nomenclature with international conventions. 2.35 Pricint Policy. Reduction of the incidence of fixed pricing and replacement of ex ante authorization for price changes with ex post review have been key improvements in the industrial sector's operating environment. Those industrial products still subject to fixed pricing are cigarettes, beer, soap, wheat and corn flour, sugar, and cooking oil. All others are subject to price controls. Fixed prices are being periodically adjusted in relation to international prices. As supply conditions and competition improve, the GOM plans to adopt a more flexible pricing policy. 2.36 Distribution Policy. All industrial products except sugar are now freed from trading through monopoly trading corporations. All enterprises are now permitted to trade directly; state trading companies are expected to compete with the private sector. Control over foreign procurement is still exercised through the foreign exchange allocation system and import licensing. Administrative control over allocation of some essential industrial goods (e.g. flour) will be continued through rationing in Beira and Maputo and through priority rural distribution. 2.37 Enterprise Debt, Asset Revaluation, and Financial Restructuring. During the pre-ERP period many enterprises--state-owned, 'intervened," and private--accumulated large debts from sustained operating iosses, often due to price controls, which were subsidized by virtually unlimited credit from the BM. The combination of sustained operating losses, excessive debt, depreciated currency, and now-unrealistic depreciation allowances and understated asset values renders many enterprise balance sheets virtually meaningless. Financial restructuring will therefore be a central element of enterprise rehabilitation contemplated under the IERP. Decree 13/88 requires revaluation of all assets by enterprises, beginning with the balance sheets for fiscal 1988. To simplify the process, the revaluations will be carried out in accordance with a series of monetary correction coefficients issued in January 1989.  - 12 - 2.38 The Government has so far taken steps to transfer about Mt. 8.0 billion of the debt of ten State and *intervened" companies to the Central Budget, where revised terms and conditions of repayment will be worked out (para. 2.26). However, the Government has not considered the possibility of restructuring private company debt in this manner. Some individual debt reschedulings have also been arranged through the BM. The BM and Ministry of Finance (MOF) have begun to deal with the resolution of pre-ERP internal debts on a case-by-case basis for parastatal and "intervened' enterprises. Restoration of financial stability for each enterprise will be a subloan condition for enterprises supported under the IERP Credit (para. 4.13). 2.39 Accounting, Auditing and Financial Management Practices. A review of auditing, accounting, and financial management practices of both public and private enterprises was carried out by the World Bank's Internal Auditing Department (IAD) in 1987. The review team found that: (a) a system of standard accounts had been instituted in 1984; (b) because of a scarcity of trained accountants, the accounts of many state enterprises were in arrears; and (c) internal auditing quite often was deficient. Enterprises are currently required to submit annual financial statements to the MOF within four months of the end of the fiscal year. External udit of enterprise accounts is not required in Mozambique, and there is almost no independent accountancy profession. In fact, until recently, there were no public accounting firms in the country and there were only several dozen individual accountants with private practices. Some auditing for tax purposes is undertaken by a small unit in the Ministry of Finance (the Department of Audit and Tax, DAT), and some accounting firms are now showing interest in setting up offices. One local firm is carrying out company valuations on behalf of the Office of Foreign Investment Promotion. The recently promulgated decree requiring updated asset revaluation of all enterprises, though urgently needed, will impose an additional demand for expertise that is in very short supply in Mozambique. Larger firms often contract expatriate accountants. As a response to the shortage of accounting and auditing expertise, the MOF has already authorized a mixed ventu-e with an international firm of chartered accountants and will soon authorize a second. Several large international accounting firms are also considering establishing offices in Maputo. The Commercial Institute of Maputo (CIM), a Government entity, is the only commercial training institute in Mozambique. It offers a concentration in accounting, approximately equivalent to the U.S. Bachelors degree. The lack of affordable and competent financial management expertise is a major constraint to expeditious preparation of plans for the financial restructuring of enterprises. 2.40 Incentive System. Between 1984 and 1986 a variety of measures with the stated objective of promoting private investment in productive activities was introduced. Their cumulative impact was marginal in the face of the fundamental policy, regulatory, and security barriers to most private investment activity. Since initiation of the ERP, considerable progress has been made in policy and regulatory areas to encourage private sector activity, but not much more than a modest recovery of investment activity can be expected regardless of the nature of the incentive system, until the security situation improves.  - 13 - 2.41 The Foreign Investment Law of 1984 and the domestic investment law of 1987 established modest systems of incentives including tax holidays, accelerated depreciation allowances and investment credits, and exemption from payroll and turnover taxes and import and export duties. All exemptions are usually negotiated on a case-by-case basis. Export operations are also able to negotiate foreign exchange retention schemes in order to procure imported inputs directly. Recent legislation has established a duty drawback scheme and a partial customs duty exemption for qualifying import substitution operations. Legislation to permit debt-equity swaps, through which foreign investors could acquire Mozambican assets in return for assumption of external debt, was promulgated in January 1989, but as of April 1989 had not yet been utilized. The legislation requires investment in fixed assets, technology, or foreign currency that is complementary to the swap. The legislation protects foreign investors against exchange rate risk but also contains restrictions on repatriation of capital and acquisition of cleat _.tle to "intervened" enterprises. 2.42 Legal and Regulatory Framework. The overall question of company formation and ownership has been partially addressed by the Government through legislation relating to 'intervened" enterprises. The Government has sold off assets abandoned by previous owners and has come to specific agreements with new owners. Conditions of sale have been that the company is retained for its original purpose (otherwise a new license is required) and that labor is retained in acccrdance with the labor protection laws. Sales are negotiated case by case; however, no general clarification of the legal position of "intervened" enterprises has been made (Decree Law No. 16- 75 dated February 13, 1975). The Government has expressed the intention to determine the legal position of intervened enterprises and, in general, to deal with the question of company formation and ownership for the benefit of attracting new investors. Agreement was reached at negotiations that, with IDA support, the Government shall, not later than December 31, 1990, prepare and complete an action plan to determine the legal ownership status of enterprises under Government intervention, and promptly thereafter, take all legal and administrative measures necessary to implement the Plan. Not later than June 30, 1993, the Government would, jointly with IDA, undertake a major review of progress in implementation of the Plan. Progress would also continue to be monitored as part of the normal Annual Project Implementation Review. 2.43 Labor Laws. Until January 1987, employment was governed by Law 4/80 of 1980, which set out 4 basic occupational categories. This system was inflexible and detracted from efficient use of labor. In 1985, a considerable amount of labor shedding took place, and in January 1987 Decree 5/87 implemented a new labor law setting 20 grade ranges in industry, specifying new pay levels, and allowing supplementary payments such as performance-linked and seniority bonuses. During implementation, a series of interim increases were permitted to offset part of the effects of devaluation-induced price increases. The aim was to permit more flexibility in employment by rewarding efficiency and allowing enterprises to lay off workers. It is intended that these measures will allow wage costs to reflect operating conditions more accurately. The prevailing base minimum irdustrial wage in March 1989 was Mt 16,000/month. The prevailing range is Mt 20-30,000  - 14 - per month for production workers. Total employer costs are approximately twice the base salary. 2.44 Enterprise ManaRemet. A certain level of competent management (most often found in privately owned import substitution industries--e.g., food processing, light metal fabrication, etc.) does exist, but quality varies widely among enterprises. The situation in the parastatal, and especially "intervened' enterprises is critical. Typically, management is not sufficiently qualified in technical, marketing, and financial management skills and has matured in an essentially non-competitive environment where most allocation decisions were made at unidade levels. In many 'intervenedo enterprises, the skills required to identify markets, prepare financial and physical rehabilitation programs, and obtain term finance simply do not exist. Skilled supervisory and engineering personnel are also in short supply. Shortages of managerial and technical skills must be regarded as a principal constraint to sector rehabilitation. E. Government Objectives and Priorities 2.45 Government objectives for the industrial sector are to restore production and efficiency and to develop a commercial business environment. To achieve these goals, Government has assigned high priority to: (a) selective investments for rehabilitation, financial restructuring, and privatization of potentially viable major enterprises; (b) improving the policy and incentives system; (c) allocating sufficient resources to manpower development; (d) support for the development of small and medium-scale enterprises (SMEs). The proposed IERP supports strategies (a) - (c). In 1987, the Government undertook the ERP, a far-reaching reform program, which incorporates this strategy and has resulted in some supply response (paras.1.05 - 1.07). However, it will take some time for most of the recent reforms to work through the system, for the shift and reallocation of resources to take place, and, thus, for restructuring to be accomplished. The Government has begun to address some outstanding issues in the sector by: (a) setting up an Enterprise Restructuring Technical Unit (ERTU) in the MOF in 1988 to provide the institutional framework to coordinate the overall rehabilitation program (para. 5.09); (b) preparing rehabilitation and restructuring plans (which may include privatization where necessary) for priority enterprises on a case-by-case basis; (c) initiating studies that will be the basis for reforming the corporate legal framework; and (d) carrying out subsector studies, which may include recommendations on the rationalization of capacity or closure of non-viable enterprises (para. 3.10). Given the large magnitudes, it is unlikely that the Government can raise enough resources in the short term to rehabilitate the entire enterprise sector and restore production to its pre-1975 peak. Moreover, rehabilitation of some production capacity may not be economically justified. Sectoral strategy is, therefore, viewed as essentially a two-phase process: first, cost-effective rehabilitation of selected enterprises to restore production over the short run, and second, a higher level of capital investment to sustain modernization,and rationalization over the medium and long term.  - 1S - F. Status of &nterprise Review 2.46 The Industrial and Agro-industrial Enterprise Review of 40 enterprises, completed early in 1988, formed the basis for the design of the IERP. The international consulting firm of Arthur D. Little was contracted to undertake this review, which was carried out at two levels. First, a sample of 40 enterprises, with characteristics representative of the large scale enterprise sector, were selected for the initial sectoral review. Subsequently, 15 enterprises were selected for prefeasibility level review. The prefeasibility studies for all fifteen enterprises have been completed. 2.47 According to the Review, most problems that enterprises face center around four issues: (a) impaired production capacity due to lack of foreign exchange; (b) inappropriate policy environment; (c) scarcity of managerial and technical skills; and (d) security. Donor balance of payments support is assisting Government to address (a) and (b) within the framework of the ERP. The study recomuended that given the delicate economic and security situation, priority be given to rehabilitatior. of enterprises with high marginal returns, especially those that can either save or generate foreign exchange, those with basic managerial competence and those located in relatively secure zones. This strategy was followed in selecting the 15 enterprises for prefeasibility review and in designing the proposed project. The prefeasibility studies and subsequent feasibility studies will be used to prepare each enterprise's rehabilitation plan, which will include plans for physical rehabilitation, financial restructuring, and strengthening operational capacity (para. 4.10). If they meet the eligibility criteria, the 15 firms would form the core group of BEs for the IERP foreign exchange credit line. Annex 2-7 provides a snapshot view of the 40 enterprises. G. IDA Assistance 1. Past Bank Involvement 2.48 IDA has so far made eight credits to Mozambique, both general balance of payments support and several project-based investment credits in various sector operations. At the macroeconomic level, IDA has already provided imported inputs and spare parts to the industrial sector through the First and Second Rehabilitation Credits, approved in 1985 and 1986, respectively, and will continue this type of balance of payments support under the Third Rehabilitation Credit approved in 1989. At the operations level, project investment aims to support restoration of production (and increased productivity), efficiency, and competitiveness. In parallel with the IERP, a project is being prepared to assist smaller enterprises via provision of an APEX credit line for foreign exchange requirements, technical assistance for the SME sector, and training in project and credit analyses for selected staff of participating banks (BM, BPD, BSTM). The Small and Medium Enterprise Development Project (SMEDP) will emphasize support for the emerging private sector entrepreneurs. In addition, the proposed Economic and Financial Management Technical Assistance Project was recently negotiated. Through the project, IDA would help finance institutional support to strengthen the capacity of key economic decision making agencies involved in the implementation of the ERP. IDA's program of sectoral support  - 16 - will benefit from the Business Environment Study, which will enable the Bank to advise the Government on industrial strategy 4nd policies beyond rehabilitation and recovery. IDA's dialogue with the Government, together with recent Government policy initiatives, suggests a strong determination to come to grips with the constraints in the enterprise sector, and a convergence of views is emerging on how to resolve some of these issues. Continued Bank involvement over the medium term is important to support and assist in deepening the reform process and in maintaining the momentum of economic recovery. 2. IDA's Role in the Sector 2.49 IDA's assistance strategy to Mozambique is consistent with the ERP and aims to provide: fast-disbursing support for the Government's broad policy initiatives to rehabilitate and restructure the economy by reducing or eliminating macroeconomic distortions and addressing structural constraints to economic growth; and project-based investment lending to facilitate the resumption nf production, employment, and incomes in the productive sectors. The IERP would complement the Government's efforts by emphasizing: (a) enterprise rehabilitation to restore output or increase the rate of capacity utilization from the current low levels (10-30Z) within existing production capacity; (b) restructuring of enterprises to restore financial stability; and (c) strengthening management and operations to improve competitiveness. The strategy views rehabilitation as having two levels. In the short term the objective is to restore production in those facilities that are still usable and that require relatively small investment in spare parts and upgraded equipment; over the medium and long term, much higher levels of investment in modernized plant and equipment will be required to sustain sector recovery in a more competitive external and liberalized internal environment. III. THE PROJECT A. Project Rationale 3.01 The IERP is an integral part of Government's strategy to resuscitate production and growth in Mozambique and complements the ERP's medium-term policy framework for economic recovery. The Project would aim to rehabilitate and restructure about 15 key enterprises that are considered important for a supply response and growth in the sector. The Project aims to build an institutional framework and approach to enterprise rehabilitation and restructuring that could form the basis for a continuing rehabilitation program. Review of the legal ownership status of enterprises under Government intervention under the Project is supportive of the move towards greater private sector involvement and a more market-oriented economy. IDA's involvement--through general policy dialogue, three rehabilitation credits and several project-based investment credits--has contributed significantly in shaping the Government's strategy and priority setting under the ERP. IDA's further involvement through this Project will help broaden and deepen the recovery program and is viewed by the Government as necessary to sustain the momentum of reform, to generate an adequate supply response, and to  - 17 - encourage other donors (many of whom have already given strong support to the ERP) to support these efforts in a well-coordinated manner. B. Obiectives 3.02 The IERP is designed to: (a) introduce a framework and criteria for selecting enterprises for rehabilitation that is based on each enterprise's potential economic, financial, and technical viability and on its management capacity to operate efficiently and profitably and that they undertake to introduce measures to protect the environment; (b) finance rehabilitation, financial restructuring and operational support to preselected and potentially efficient major enterprises. The rehabilitation and restructuring process would, where appropriate, include rationalization of capacity, privatization, technical partnership arrangements, or, if necessary, closure of operations; (c) require that each BE institute measures to protect the environment and worker safety; (d) strengthen Government's capacity to implement the rehabilitation program; and (e) support policy reforms and subsector reviews designed to strengthen enterprise operations in a more liberalized, market-oriented environment. The project is conceived as a pilot effort that would develop an approach that could be replicated in other large-scale enterprise rehabilitation, restructuring, or privatization efforts. C. Project Description 3.03 The Project, with a total cost of US$106.7 million (including IDA credit of US$50.1 million equivalent), would consist of two components: an Enterprise Rehabilitation Component and a Technical Assistance Component. A brief description of each is given below. 1. Enterprise Rehabilitation Component (ERC) 3.04 The ERC would assist the rehabilitation and financial restructuring of about 15 selected enterprises. Funds allocated for rehabilitation would finance fixed investments (the repair, replacement, or modernization of obsolete or damaged assets; elimination of uneconomic lines and activities; consultancy services, operational support and training to strengthen management) and incremental permanent working capital needs for the selected enterprises. The project would assist the financial restructuring of enterprises that have good rehabilitation prospects but face financial difficulties because of past policy distortions and operating inefficiencies. Restructuring would be achieved through recapitalization; conversions of debt into equity or quasi-equity; and injection of fresh equity through (where appropriate) divestiture, joint venture, or technical partnership arrangements with foreign or local private investors. The eligibility of BEs would be based on: confirmation (through appraisal) of their efficiency, economic and financial viability, and potential to earn or save foreign exchange; review and approval of their rehabilitation plans; and an undertaking to institute measures to protect the environment.  - 18 - 3.05 Subloans and investments under this component will finance: (a) rehabilitation or replacement of fixed assets (machinery, equipment, factory buildings and related civil works); (b) permanent working capital (increases in stocks of imported raw materials, spare parts, and components required to sustain production for the initial period following rehabilitation); and (c) operational support services (including expatriate staff, personnel training, and advisory services on environmental protection) to upgrade BEs' technical, financial, marketing, and general management capacity. 2. Technical Assistance Coponent (TAC) 3.06 The TAC would support institutional development in the following areas. 3.07 Assistance to ERTU. The Credit would finance the services of experts to strengthen the ERTU's (and other institutions) capabilities to implement the rehabilitation program and provide operational technical assistance to enterprises. These advisers would also provide training to local staff in project appraisal, enterprise rehabilitation and restructuring techniques and methodology. A detailed breakdown of technical assistance costs to the ERTU is given in Annex 3-1. The Project also makes provision for additional short-term consultants to assist ERTU in specialized areas. 3.08 Assistance to Enterprises. Most of the BEs will need outside expertise to develop satisfactory business or rehabilitation pians. The Project would, through the ERTU, support the hiring (on a reimbursable basis) of short-term consultant services for the preparation of prefeasibility studies, rehabilitation plans, and/or liquidation, privatization, or joint venture arrangements. Financing would be provided for the preparation of a further 10 enterprise rehabilitation plans, beyond those for the 15 enterprises already identified, whose implementation could be financed under parallel or subsequent projects. To assist enterprises to comply with reporting requirements, financing would be made available for external audits. 3.09 Training of Laid-off Staff. To alleviate the social costs of possible personnel reductions, the IDA Credit would include an allocation of US$1.4 million under the TAC to assist Government in the preparation of training programs for staff laid-off in the course of enterprise restructuring or liquidation. Since staff retrenchment could only be accurately identified after the completion of enterprise reviews and inclusion in the rehabilitation plans, the Government would, in consultation with enterprise managers, design specific training programs for re-deployed staff. The programs would include, inter alia, provisions for financing of skills training and (in some cases) of related tools and equipment for employees seeking to start up in trade or commerce on their own. Since many of the workers laid off are likely to be those with little formal education who may not immediately benefit from the training offered by existing institutions such as the Secretariat of State for Vocational and Professional Education (SETEP), skills training would aim to equip such staff with a practical trade or skill for redeployment or starting up on their own. Programs will be initiated by Government, which will submit them to the ERTU for review and transmission to IDA for approval. Implementation will be  - 19 - overseen by the Ministry of Labor (ML). and will be supervised by the ERTU (which would be responsible for coordinating the program). Training will be provided at existing technical institutions in Mozambique. The Government is in the process of initiating changes in the education system that will strengthen the provision of technical training. A profile of some Le the institutions in the country is provided in Annex 3-2. Some of these institutions are to receive technical assistance to strengthen their institutional capacity through a UNDP/UNIDO project. Most training programs would be carried out by local trainers, and the bulk of the costs involved would be local costs. Disbursement of IDA funds for training would be conditional on each concerned BE furnishing to IDA, through Government, the plan for implementing training. 3.10 Subsector Studies. The TAC would finance subsector and policy studies, which will be implemented by the MIE. On the basis of preliminary findings of the Business Environment Study, the subsectors that require further review include edible oils, textiles and garments, transportation, sugar, and public sector enterprise management. During appraisal, an understanding was reached with Government that four subsectors--packaging, metal-working, textiles and edible oils--would be studied initially. The scope of the studies is attached in Annex 3-3. At negotiations, the Government requested, and a decision was made, to undertake a fifth study for the construction and building materials subsector. The TOR fl this study are expected from Government before end of FY90. The five stu_.es will be initiated before end of FY89 through PPF financing and are expected to be completed by September 30, 1990. Provision has been made to finance several other sectoral and subsector studies in the course of Project implementation. Agreement was reached at negotiations that the Government shall: not later than April 30, 1991, submit to IDA acceptable terms of reference for all subsector studies in addition to the original five to be undertaken and completed under the Project Preparation Facility; not later than December 31, 1991, the Government shall carry out and submit to IDA the recommendations of all subsector studies: not later than June 30, 1992, the Government shall exchange views with the Association on the recommendations and agree on an action program; and not later than March 30, 1993, carry out the action program. It was agreed that Government will make efforts to initiate implementation of the recommendations for the original five studies before September 30, 1991. D. Prolect Cost and Financing 3.11 Justification of Project Cost. Aggregate investment costs for the rehabilitation of all large-scale enterprises (UNIDO estimate for 130 large scale enterprises) in Mozambique over the next five years are estimated at about US$1.0 billion of which US$500 million would represent foreign exchange expenditures (equipment investment and spare parts, US$ 400 million; technical assistance, US$100 million). This amount would be divided about equally between fixed investments and increases in permanent working capital. Preliminary estimates of rehabilitation requirements for the 15 potential BEs are provided in Annex 3-4. The Project cost estimates and financing plan for the 15 BEs are szumarized in Table 3.1. Total Project cost is estimated at  - 20 - US$106.7 million equivalent, including US$71.2 million in foreign currency. The IDA Credit of approximately US$50.1 million equivalent would finance 47S of total Project costs and 70Z of foreign exchange requirements. The balance is being sought from co-financiers. About US$34.1 million equivalent would be financed from local sourcess Bls, Government, and local banks (paras. 3.12 - 3.14). The cost estimates under the ERC assume hat rehabilitation of two enterprises (CIH and IMA) would be phased and exclude financing requirements for three enterprises (CELMOQUE, CAJU and CARMOC) that are being considered under separate operations. Should financing from those sources not materialize, these enterprises would be eligible for financing under the IERP. If they were to be included in the estimates (and if CIM's and IMA's rehabilitation were not phased), total ERC costs would be US$107.9 million ($74.4 million in foreign currency). Detailed project costs for these enterprises are on Project file.  - 21 - Table 3.1: MOZAMBIQUE - PROJECT COST ESTIM&TES AND FINANCING PLAN Local Toreign Total (USS million) l Enterprise Rehabilitation Component (ERC) Fixed Investments 4.8 36.6 41.4 Spare Parts 1.2 2.8 4.0 Working Capital (incremental) 27.2 18.2 45.4 Technical Assistance 0.3 4.8 5.1 Subtotal 33.5 62.4 95.9 Technical Assistance Component (TAC) ERTU operations 0.6 3.5 4.1 Other institutions - 1.0 1.0 Technical assistance to enterprises - 3.8 3.8 Other studies - 0.5 0.5 Staff training 1.4 0.0 1.4 Subtotal 2.0 8.8 10.8 Total project cost 35.5 71.2 106.7 FINANCING PLAN: IDA 1.4 48.7 50.1 Govermnent/Project Entities 34.1 - 34.1 Co-financing: Not yet finalized - 22.5 22.5 Total Project Finance 35.5 71.2 106.7 3.12 Co-financing. In view of the large foreign currency requirements of the sector, co-financing from other donors is being sought to fill the financing gap. IDA's involvement in providing untied long-term financing of the foreign exchange component is important in coordinating and attracting further co-financing for enterprise rehabilitation. The other donors look to IDA to assure the technical and financial viability of the BEs and their economic contributions to Mozambique. Discussions have taken place, and official solicitations of interest were sent to several potential co- financiers for a financing gap of US$22.5 million equivalent. The Government of Italy has agreed in principle to co-finance the project through bilateral  - 22 - agreement with the Government of Mozambique. The IFC and Commonwealth Development Corporation (CDC) have also indicated their interest in co- financing the Project. Prefeasibility studies for some of the fifteen enterprises have been sent to CDC. Participation by both institutions would be on an enterprise-by-enterprise basis, contingent on viability of the enterprise. Caisse Central de Cooperation Economique may also participate on a case-by-case basis. To encourage full use of cofinancing, IDA financing of individual subprojects will be limited to US$8 million. For enterprises with financing requirements exceeding US$8 million (4 out of the 15 enterprises may fall into this categoryw Annex 3-4), Government will be required to seek other sources of financing to complement the IDA credit. 3.13 Local Currency FinancinR. The BEs would finance about 23Z of the physical rehabilitation and related working capital expenditure in local currency. This will, to the extent feasible, be financed by: enterprise net profits, new shareholders through cash purchases of newly issued enterprise shares, and new borrowing from the local financial markets. 3.414 Government contribution to Project financing will be limited by the tight foreign exchange and fiscal budget constraints prevailing in Mozambique. The Government would finance 52 of overall Project costs, mostly in the form of the recapitalization of enterprises through equity contributions and the local operating costs for the ERTU. A lOZ cost contingency has been included in the rehabilitation cost estimates. A reliable estimate of the financial needs of each enterprise to be rehabilitated will only emerge from the final feasibility studies, which will provide a basis for adjusting the scope of the project during implementation. Should financing be insufficient to cover all 15 enterprises, Government (with agreement from IDA) may delete some of these enterprises from the Project. Conversely, if funds available exceed the requirements of these enterprises, additional enterprises could be selected jointly by IDA and Government for prospective rehabilitation according to the process established under the Project. 3.15. Technical Assistance Requirements. The foreign exchange requirements of the TAC would total US$8.8 million over the Project period for: (a) consultancy services to prepare prefeasibility studies and rehabilitation plans; (b) Project management and ERTU training; and (c) sectoral and subsector studies. The cost is estimated on the basis of actual costs for those contracts already concluded and similar experience in the region. The magnitude of this technical assistance is explained by the complex nature of this Project in the Mozambican environment; the multiplicity of enterprises in a wide range of subsectors to be assisted, each requiring specialized expertise currently unavailable in the country; and the need to have appropriate quality control and to strengthen management skills within the ERTU and the BEs. Valuable transfer of know-how is expected to be derived from the presence of external experts, in sector management as well as in the technical aspects relating to enterprise operations. In view of limits on Government expenditure as part of its recent agreements with both the Bank and the IMF, IDA would allocate the equivalent of US$1.4 million in local currency to help finance the local costs of retraining laid-off workers.  - 23 - IV. MAIN FEATURES OF THE CREDIT A. Credit and Onlending Terus and Conditions 4.01 The proposed IDA Credit of US$50.1 million equivalent will be made to the People's Republic of Mozambique on standard IDA terms. The Government will pass total credit proceeds to BMH to: (a) channel $39.9 million equivalent to BE's primarily as loans. However, in appropriate cases the Government could use the ERC to make direct equity investments (US$5 million shoulld be initially allocated for this purpose) in BEs in combination with loans according to their assessed needs for financial restructuring as identified in the Rehabilitation Plan (RP); and (b) US$10.2 million would be retained for the TAC, to be administered by the ERTU. The ERC amount will be passed on by the Government to the BM under a subsidiary administration agreement on terms and conditions acceptable to IDA. The onlending arrangements as well as the eligibility criteria for BEs, subloan processing and administration, and onlending terms and conditions are briefly outlined below. 4.02 Financial restructuring would be a major issue for almost all the enterprises assisted under the proposed Project. BM is the commercial bank with which most of the targeted enterprises have operated and, therefore, which holds most of their debt. BM is also an interested party, in its capacity as Central Bank, in all programs to help clear the banking system's loan portfolio arrears. For this reason, BM would be the financial intermediary for the ERC under the proposed Project. Once the initial subloan is made, it would be possible for subloans to be sold by BM to the other commercial banks, either in entirety or through syndication, with BM acting as the lead manager. BM would be acting in its commercial banking function when making subloans, for which it would bear the normal banking risk. The signing of a subsidiary administration agreement between the Government and BM, transferring the funds to BM and defining the functions and responsibilities of the latter, shall be a condition of Credit effectiveness. 4.03 With respect to the lending portion of the ERC, the BM would make the Credit proceeds available to the BEs at variable interest rates in accordance with the interest rate structure prevailing in Hozambique. That structure has been established in consultation with the IMF, and it has been agreed that the level of interest rates will evolve so that they become positive in real terms by 1990. The revised interest rate structure (para. 2.19) introduced in January 1989 raised lending rates for loans with maturities of over one year to between 22? and 35? and was also considerably simplified. Annual reviews of the interest rates charged on subloans under the Project will be undertaken jointly by the Government and IDA. 4.04 The subloans or investments in BEs would be denominated in meticais converted at the exchange rate prevailing on the date of disbursement from the Special Account. The BM would retain, out of the interest payments due from the BEs, an annual administration fee (about 0.5? of the outstanding subloan amounts) to cover its costs in administering the Credit plus a margin  - 24 - not to exceed 452 of the annual interest rate charged by the BM to the BE to cover the credit risk. The foreign exchange risk would be borne by the Government and would be covered by the interest yield on funds onlent, net of the service charge on the IDA credit, and the onlending spread of the EM. The Government would bear the risk on any equity investments. 4.05 Subloans for financing fixed assets, spare parts, and the aLsociated increase in permanent working capital, and for the preparation of rehabilitation plans would have maturities of up to 15 years, including grace periods of up to 5 years. Onlending to BEs will be under subloan agreements on terms and conditions acceptable to IDA. Repayment of each subloan by a BE to the EM would be on the basis of a fixed amortization schedule. 4.06 The Government could use up to US$5 million of the Credit to make equity investments in enterprises where this is necessary for financial restructuring. The proceeds of the investment would also finance fixed assets, spare parts and permanent working capital. All such equity investments, including the respective Investment Agreement between BM on behalf of Government and the respective BEs, would require prior approval by IDA. Whenever equity investments are made, a divestiture policy satisfactory to IDA would be adopted. When a divestiture takes place, the Government's equity investment under the proposed Project could be repaid either at once or on the basis of a fixed amortization schedule. The funds repaid by the BEs to the BM could be used by the Government to finance enterprise rehabilitation and restructuring in a manner consistent with the objectives and financing arrangements under the Project. Eligibility criteria for subprojects, and onlending terms and conditions under the Project will be reviewed at least once annually to identify changes needed to ensure successful Project implementation. B. Selection of Potential Beneficiary Enterprises (BEs) 4.07 During Project preparation, the Government in consultation with IDA selected 15 enterprises, from a sample of 40 enterprises studied by a team of consultants, as potential Project BEs. The 15 prospective BEs were selected on the basis of their potential technical, economic and financial viability and on their ability to adjust to or operate under the new incentive system. Viability would be confirmed through prefeasibility studies to evaluate market potential as well as technical and managerial capacity. The status of studies undertaken so far is summarized in para. 5.12. Other enterprises may be added depending on the availability of finance (para 3.14). The enterprises that were selected fall into three broad categories: agro-industry, as represented by processing of cashew nuts (Caju de Mocambique) and edible oils and soaps (Grupo Madal and FASOL/SABOREL), timber (Madeiras de Cabo Delgado), citrus fruit (Citrinos de Manica), and grain milling (Compagnhia Industria de Matola); light manufacturing industry, represented by metal working (Metal Box and ECOME), cables (CELMOQUE), paper cartons (CARMOC), pipes and roofing material (IMA), steel drums (Van Leer), construction material (PROSUL), plastics, and rubber products (FACOBOL); and heavy industry (Cimentos de Mocambique-Dondo). As a group the selected enterprises have: (a) a significant impact on the performance of the subsectors they represent; (b) a substantial impact on foreign exchange savings through efficient import substitution or generation  - 25 - through exports; (c) important links to other enterprises; and (d) important potential as generators of employment and incomes. 4.08 To overcome security constraints, only those projects located in fairly safe zones were initially selected. The maximum amount of ERC proceeds that could be used for investments or subloans to a single enterprise would be US$8 million. This ceiling would enable the Credit proceeds to be spread equitably among the 15 BEs. For subprojects with large rehabilitation requirements, Government would make efforts to secure additional financing above the US$8 million from other sources, especially to meet the enterprise's working capital requirements (allocations for this purpose could come from the import support programs). The Government would actively seek the involvement of institutions such as IFC and CDC to supplement the IDA funds. Specific eligibility criteria for BEs are summarized in paras. 4.10 4.13. C. Sample Enterprise Profiles 4.09 Summary details of the 15 beneficiaries enterprises are provided below in Table 4.1, and more complete profiles are provided in Annex 4-1.  1le 4.1t H2EBW - PEE; M S ENWII MUWIMT urN IML DENE MLFG I SAM Nb. E- AMTfY - FDWaN P s S EMN( ME= rr UIMErLIDN 1986) a/ J fc.) !5 b/ k E; RN ~I W IUrL Caju de 1tx aq Ca ns ts State 8.53 0.00 8.53 12.3 6,500 E kmn b * .ww. Me= do 400 4pn, t x.q Co D11 7lne State 3.00 0.00 3.00 1.2 Cl z ,s de Ctiriws State 4.05 0.00 4.05 5.3 1050 irr.g. rdtib.Ie 2din >kii Qu4 Oopm & edib oil Ptiwate 8.43 3.42 11.85 3.5 3600 TO ,B defi.d (e 4p. zmhb. & aq;szt) able E"Tiit }nterwnmd 6.46 5.03 11.49 4.4 485 RMub./fkru&ia restr. CxutC at lb be deflild (zeub. In mulvJcnfc