Madagascar - Financial Sector and Private Enterprise Development (APEX) Credit Project

Document of S The World Bank FOR OMCUIL USE ONLY Rqpt No. P-5076-MAG MEMORANDUM AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED CREDIT OF SDR 36.4 MILLION TO THE DEMOCRATIC REPUBLIC OF MADAGASCAR FOR A FINANCIAL SECTOR AND PRIVATE ENTERPRISE DEVELOPMENT (APEX) PROJECT FEBRUARY 23, 1990 . This docme h a restricted distributon and may be used by recpients only in the performane of the offiec dutes. Its contents may not otherwise be diclostd without Wodd Bank authodzation.  y.~~ ~ ~ ~ ~ 1 CURRENCY EQUIVALENTS Currency Unit - Malagasy Francs (PMG) US$1.00 G PMG 1,580 (March 1989) WEIGHT AND MEASURES Metric System ABBREVIATIONS 3FV - Bank for Commerce BII - Bank for InTdustry BTM - Bank for Agriculture CB - Central Bank of Madagascar CCI - Chamber of Commerce & Tndustry CNFPB - National Banking Training Center GDP - Gross Domestic Product IRP - Investment Rediscount Fund JCEM - Association of Young Entrepreneurs MEP - Ministry of Economy and Plan MFB - Ministry of Pinance ar4 Budget PSAC - Public Sector Adjustment Credit SHE - Small and Medium Enterprise FISCAL YEAR January 1 - December 31  FOR OMCUL USE ONLY MADAGASCAR FINANCIAL SECTOR AND PRIVATE ENTERPRISE DEVELOPMENT (APEX) CREDIT CREDIT AND PROJECT SUMMARY Borrowert Democratic Republic of Madagascar. Beneficiaries: Central Bank of Madagascar (CB), participating financial intermediaries, the Small and Medium Enterprise (SHE, Assistance Unit at the Ministry of Economy and Plan, Chamber of Commerce and Industry, Association of Young Entrepreneurs, local training institutions and cunsulting firms. Amount: SDR 36.4 million (US$48.0 million). Terms: Standard IDA, 40 years. Relending Terms: (i) The borrower would onlend US$45.0 million equivalent in local currency to CB at CB's regular reference rate (currently 12.0 percent p.a.) minus an administrative fee of 0.5 percent (to cover the operating cost of the Project Bureau within CB) for 30 years, including a grace period of 10 years. CB would onlend the funds to qualified participating financial intermediaries at its regular reference rate with a flexible amortization schedule reflecting the aggregate maturity of subloans extended by intermediaries. The onlending and final lending rates would be flexible and adjusted periodically. The spread which participating intermediaries could charge to beneficiary enterprises would initially be limited to a maximum of 7 percentage points. Prior to release of the Credit's second portion, this cap would be removed. The Government will assume the foreign exchange risk. With real interest rates 'n local currency roughly equivalent to real interest rates in international markets, and as the exchange rate and interest rate policies are broadly based on a market-clearance approach, domestic interest rates would adequately reflect the expectations of devaluation. The project would include provisions to ensure the continued adequacy over time of the onlending arrangements, i.e., that they continue to reflect the economic cost of capital, including the implicit foreign exchange risk. (ii) The US$3.0 million equivalent in local currency allocated for Technical Assistance would be made available to implementing agencies by Government on a grant basis. This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be discloe. _;.bout World Bank authorization.  - iL. linanclni Plant ml lions IDA 4000 Subborromrs 16. 8US Abistance Unlt 0.2 TOTAL 66.5 Economic Rate of Returs Not app1Lcable Staff A#raisal R-uorts Report No.7712-MAG Malps Not applicable  MEMORANDUM AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED CREDIT TO THE DEMOCRATIC REPUBLIC OF MADAGASCAR FOR A FINANCIAL SECTOR AND PRIVATE ENTERPRISE DEVELOPMENT (APEX) CREDIT 1. The following memorandum and recommendation on a proposed IDA Credit to the Democratic Republic of Madagascar for SDR 36.4 million (US$48.0 million equivalent) are submitted for approval. The proposed Credit would be on standard IDA terms and. through a combination of investment credit and technical assistance, would provide term resources, through the country's financial intermediaries, for investments in all productive sectors, except housing. 2. Economic and Sector Background. With a population of 11.6 million growing at 3? per year and a per capita income of about US$200 in 1987, Madagascar remains one of the poorest countries in the world. Its economic record is mixed, characterized by stagnation from 1972 to 1980, sharp deterioration between 1980 and 1982 and limited economic growth since 1983, which appears to have picked up in 1989. Agriculture (42Z of GDP) is the mainstay of the economy, employing 801 of the population and generating over 8OX of export earnings. Inappropriate economic policies, emphasizing the public sector and industrialization relegated agriculture to a supporting role and led to natinnalization of foreign-owned enterpr-ses, axtene!v. consumwer subsidies, and controls over private sector activity. The Government embarked on a poorly coordinated policy of massive public investment between 1978 and 1980, financed mainly with external borrowing on commercial terms. This policy produced a fiscal deficit of 14S of gross domestic product (GDP) in 1980, an annual inflation rate of 302, and a large increase in the external debt burden. 3. IMF-supported stabilization and adjustment policies implemented during 1980-88 resulted in a substantial reduction in the fiscal deficit (from 142 to 4.51 of GDP in 1988). Largely as a result of these developments, credit expansion fell sharply and inflation dropped from about 302 in 1981-82 to about 13? in 1983-86. The current account deficit was cut almost in half from its level of about US$425 million in 1981. Imports dropped by more than half in real terms since 1982. Real GDP, which had contracted by 101 between 1980 and 1982, started growing again slowly in 1983, reaching over 4S in 1989, based on preliminary estimates. 4. After pursuing a cautious reform strategy to address structural distortions sector by sector, the Government moved decisively, with support from IDA's PSAC (approved by the Executive Directors in June 1988), to reform public and banking sectors. With regard to industry in particular, the Government, in 1985, eliminated most ex-factory price and profit margin controls. It also improved the quality of public investment in manufacturing, eliminated most export taxes and promulgated a new investment code. IDA supported this effort with an Industrial Sector Adjustment Credit (ISAC) in FY86. In 1987, banks tightened crLiit to unprofitable public enterprises, some of which were closed.  - 2 - 5. In 1987, the Government moved to establish a trade and foreign exchange allocation regime broadly based on market forces. The measures included# (l) a large devaluation totaling 462 In foreign currency terms (May.June 1987). (ii) replacement of quantitative import restrictions with a simplified tariff structure (January 1988)g and (tll) Implementation of a market-determined allocation system for foreign exchange for Imports (July 1988). IDA supported these reforms with the Industry and Trade Policy Adjustment Credit (ITPAC) in 7Y87. More recently, and in carrying the above sector specific changes further, IDA approved the Public Sector Adjustment Credit (PSAC) in 1Y88, which centered ons ti) refoming the budgetary proceas, (ii) streamlining the parastatal sector, (iii) introducing a first set of reforms in the coumercial banking system, and (iv) removing administrative obstacles to the expansion and dlversification of exports, including elimination of the state monopolies hver traditional export crops. 6. The financial sector, which consisted of the Central Bank and three state-owned commercial banks also underment major changes. Until the mid. 19809, the banking system functioned as an extension of the public sector and had been implementing public policy decisions through a monopoly on credit allocation. In particular, the banks provided equity and loan financing to non-creditworthy public enterprises. In addition, administratively controlled interest rates did not cover overhead costs and provisions for bad debts. As a result, the Government began taking corre,:tive actions by deregulating most interest rates in 1985. In an effort to restore commercial autonomy and accountability, separate boards of directors were created for each bank in 1986. A first step was taken in 1987 at restructuring the banks' portfolios, through increased provisioning and write-oiff; ceilings were also established for credit to risky public enterprises. In 1988 a new Banking Law was issued, providing a new regulatory framework and opening, for ths first time, the sector to private capital. A fully private bank vas thus accredited and started operations in mid-1989. 7. These structural reforms are complex and it will take two to three years to implement them effectively. During this period, GDP growth is expected to continue improving gradually. To implement the program successfully requires further changes in macroeconomic management, including reform and in some cases sale of state-owned enterprises to the private sector, further changes in the financial sector and greater availability of credit for investment. Recognizing these needs, the Government has decided to improve the availability of term financing through a banking system which is in the process of being partially privatized and through accompanying policy changes in the financial and private enterprise sector. The proposed credit would support the implementation of these objectives. Specific financial sector policies relate to monetary policy and consist of modifying authorization requirements, money market and rediscount systems, credit ceilings and reserve requirements. These conditions have been discussed with Government in full consultation with the IMF, including a technical assistance mission of the IMF Central Department (CBD) that took place in August 1989 (para. 14). 8. Rationale for IDA Involvement. IDA's involvement in the proposed financial sector/APEX operation would provide impetus to ongoing reforms in the financial sector and would encourage more private sector initiatives. Efficient functioning of the financial sector constitutes an essential condition for the growth ,bjectives pursued by the Government; the policy  - 3 - and institutional development measures supported by the project would substantially contribute to this process. 9. Prolect Obiectives. The proposed project would complement the above mentioned structural adjustment programs and would provide funding for the investments in rehabilitation and new projects, including joint ventures, needed to foster growth in all productive sectors of the economy. The project supports Government efforts to promote financing of private enterprises of all sizes with a special attention to development of eaall-scale enterprises througe technical assistance. 10. Proiect Description. The project would consist of (a) a US$45.0 million APEX credit line divided into two portions (first portion of US$18.0 million, second portion of US$27.0 million) to finance investments by viable private and mixed enterprises in all sectors including agriculture and commerce, and (b) a technical assistance and training component of US$3.0 million. The project would support policy measures primarily concerning the financial sector, but also supporting private enterprise sector development. These policy measures would, inter alia, help expand resource mobilization and improve allocation in the financial sector as well as support improvements in the private enterprise environment, build on and continue to increase competition and portfolio restructuring in order to reduce ban.. spreads, suppress the Central Bank's prior credit authorization prerogative and increase the efficiency of the system of reserve requirements. Satisfactory implementation of policy reforms would be a condition of disbursement of the second portion of the Credit (para. 14). 11. The credit component would finance: (i) fixed assets and associated permanent working capital of new investment, rehabilitation and expansion projects and (ii) free standing permanent working capital for existing viable enterprises in the productive sectors. The credit component would be made available under an apex arrangement to all sound existing and future financial institutions accredited by the Central Bank. Funds under the Credit would be channelled through the Central Bank to the comnercial banks, which would in turn grant loans to the final beneficiaries of the project. An apex arrange- ment is the most suitable for financing numerous majority private projects in the productive sectors, due to the number of financial institutions that would participate. As more =termediaries enter the sector, entrepreneurs would have better accessibility to term credit on a more competitive basis. Eligible financial intermediaries in good standing would be able to participate on a first-come first-served basis, provided they have entered into a participation agreement with the Central Bank. 12. A multi-faceted technical assistance component of US$3.0 million equivalent would finance a program to Mi) carry out training and extension service programs for SNEs, financial intermediaries and other recipients, (ii) strengthen the Central Bank supervision and monetary management capacity, and (iii) support the SHE Assistance Unit in the Minist:ry of Economy and Plan, the restructuring of the Chamber of Commerce and Industry and the estallishment of a one-stop Investment Promotion Center. 13. The total cost of the project is e&timated at US$66.3 million equivalent, of which US$46.0 million would be in foreign exchange. A break- down of costs and the financing plan are shown in Schedule A. Amounts and methods of procurement and disbursement, as well as a disbursement schedule,  - 4 - are in Schedule B. A timetable of key project peccessing events and the status of Bank Group operations in Madagascar are given in Schedules C and D, respectively. The Staff Appraisal Report, No. 7712-MAG, dated February 16, 1990, is being distributed separately. 14. htead Actions. The Government and the Central Bank have agreed on the followings A) APEX component (i) signing of a subsidiary Loan Agreement and establishment and staffing of the Project Unit in the Central Bank, as a condition of effectiveness; and (ii) content of the draft participating agreements to be signed (as a condition of disbursement to each intermediary) between participating intermediaries and the Central Bankt B) Sector Policy Contents (M) modification of the systems of reserve requirements and individual credit ceilings by banks, as conditions of effectiveness; (Li) reorganization of the money market and rediscount mechanisms of the CD, by October 15, 1990; and (iii) abolition of the Central Bank's prior authorization prerogative and of individual credit ceilings by banks, as conditions of disbursement of the second portion of funds. 15. Benefits. The proposed APEX Credit would help maintain the momentum of the reform process in the financial sector, and support increased competition by allowing equal access to term resources by all financial intermediaries, including the first new private commercial bank. Improved private sector resource mobilization and allocation are expected from the financial sector policy measures supported by the project, which are a logical continuation of the procese initiated under PSAC. Broader access to credit by the private sector, throuah 'he APEX component, wovld encourage increased supp1y respono. in the form of Invegtment and reconotitut inn of permanpnt working capital within a further deregulated and more competitive, partly privatized financial system. In addition, the project would generate employment opportunities thus helping absorb expected unemployment as a result of possible Public Enterprises closures in the future. Finally, through targeted SHE assistance, services for this high-potential subsector will be improved. 16. Risks. Madagascar is undergoing substantial changes in its banking sector not only through portfolio restructuring of existing banks but also through allowing private capital to re-enter the sector for the first time since 1972. While the project aims at reinforcing and carrying forward these reforms, thire remains a risk that the political will to continue with this process might falter, especially in implementing expected privatization efforts of financial institutions. The Government's commitment to reform and achievements during the last five years suggest that the risk is not excessive. 17. Recommendation. I am satisfied that the proposed credit would comply with the Articles of Agreement of the Association and recommend that the Executive Directors approve the proposed Credit. Barber B. Conable President Attachments by Washington, D.C. Ernest Stern February 23, 1990  -5- SCHEDULE A Page I of 1 DEDOCRATIC REPUBLIC O MADAoASCAR FINANCIAL SECTOR AND PRIVATE ENTERPRISE DEVELOPMENT (APEX) CREDIT ESTDIATED COSTS AND FINANCING PLAN Local Foreimn Total S _----US$ rillion equivalent----- Estimated Costs Investments 18.5 44.0 62.5 94.3 Technical Assistance and Training 1.6 1.9 3.5 5.3 SMlt Assistance Unit 0.2 0.1 0.3 0.5 TOTAL 20.3 46.0 66.3 100.0 Financins Plans Subborrovers 18.1 - 18.1 27.3 SME Assistance Unit 0.2 - 0.2 0.3 Proposed IDA Credit 2.0 46.0 48.0 72.4 TOTAL 20.3 46.0 66.3 100.0  SCNEDUIE B Pagm I of 2 DEMOCRATIC REPUBLIC OF MADAGASCAR FINANCIAL SECTOR AND PRIVATE ENTERPRISE DEVELOPMENT (APEX) CREDIT PROCUREMENT METHOD AND DISBURSEMENTS Project Element Procurement Method Total ICB LCB Other Cost ------------ (U8 million)