Document of The World Bank FOR OFFICIAL USE ONLY MICROFICHE COPY Report No. 10458-RO Report No. 10458-RO Type: (SAR) LUCCA, F. / X32642 / H5 067/ EClAG STAFF APPRAISAL REPORT ROMANIA PRIVATE FARMER AND ENTERPRISE SUPPORT PPOJECT MAY 18, 1992 Agriculture Operations Division Country Department I Europe and Central Asia Region This document has a restricted distribution and may be used by recpients only in the performance of thefr oflicial duties. Its contents may not otherwise be disclosed without World Bank authorization. CURRENCY EOUIVALENTS Currency Unit = Leu (plural Lei) US$1 = Lei 200 Leu 1 US$0.0050 Lei ger US Dollar Official Rate Market Rate 1990 November 20 35 1991 April 60 200 (Interbank)' 1991 November 180 300 1992 March 200 350 FISCAL YEAR January 1 - December 31 ABBREVIATIONS AND ACRONYMS AB - Agricultural Bank CAP - Agricultural Production Cooperatives CB - Romanian Commercial Bank CEC - National Savings Bank DB - Romanian Development Bank EC-PHARE - European Economic Commission/Economic Assistance for the Restructuring of Poland, Hungary and Romania FESAL - Financial and Enterprise Sector Adjustment Loan FI - Financial Intermediaries AB and DB FTC - Foreign Trade Company GOR - Government of Romania IMF - International Monetary Fund Judet - Administrative District LIB - Limited International Bidding MAFI - Ministry of Agriculture and Food Industry MEF - Ministry of Economy and Finance MOT - Ministry of Trade NBR - National Bank of Romania OED - Operations Evaluation Department (of the World Bank) PFESP - Private Farmer and Enterprise Support Project RBFT - Romanian Bank for Foreign Trade SAL - Structural Adjustment Loan SME - Small and Medium Enterprise TA - Technical Assiatance 1 The interbank rate applies to other foreign exchange transactions. The interbank market for foreign exchange was establ.ished in April 1991. FOR OFFICIAL USE ONLY STAFF APPRAISAL REPORT ROMANIA PRIVATE FARMER AND ENTERPRISE SUPPORT PROJECT Table of Contents Page No. LOAN AND PROJ=CT SUMMARY i-i i I. INTRODUCTION ............... 1 II. AGRICULTURAL SECTOR .2 A. Background. 2 B. Irrigation . . . . . . . . . . . . . . . . . . . . . . . . 4 C. Mechanization . . . . . . . . . . . . . . . . . . . . . . 4 D. Research and Extension. 5 E. Agroprocessing .6 F. Marketing, Prices and Foreign Trade . . . . . . . . . . . 6 G. Sectoral Adjustment Policies . . . . . . . . . . . . . . . 10 H. Future Prospects .10 I. Bank's Strategy and Role .13 III. LAND REFORM AND FARMER ASSOCIATIONS . . . . . . . . . . . . . 14 A. Background .14 B. Dismantling of CAPs and Reorganization of the Land . . . . 15 C. The Impact of the February 1991 Land Law . . . . . . . . . 16 D. Government Strategy and EC-PHARE Assistance .17 IV. THE FINANCIAL SECTOR .18 A. Background .18 B. The BankiTig System .19 C. The Role of The National Bank of Romania (NBR) . . . . . . 22 D. Major Romanian Banks . . . . . . . . . . . . . . . . . . . 23 E. Other Domestic Banks .25 F. Financial Intermediaries under the Project . . . . . . . . 26 V. THE PROJECT .27 A. Project Objectives and Rationale for Bank Involvement . . 27 B. Summary Project Description . . . . . . . . . . . . . . . 29 C. Detailed Features .29 D. Project Cost and Financing .30 E. Procurement .32 F. Disbursements .32 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. Table of Contents (cont'd) Pace Ng. VI. PROJECT ZMPLEMENTATION . . . . . . . . . . . . . . . . . . . . 33 A. Overview . . . .. . .33 B. Credit Operations ...... . . . . . . . 34 C. Reporting and Evaluation ... . . .... 38 D. Accounts and Audit ....... . . . . . . . . . . . . 39 E. Bank Supervision . . . . . . . . . . . . . . . 40 F. Environment . . . . . . . . . ....... . .... 40 VII. PROJECT LENEFITS, RISKS, AND ENVIRONMENTAL IMPACT . . . . . . 40 A. Benefits . . . . . . . . . . . . . . . . . . . . . . . . . 40 B. Risks . . . . . . . . . . . . . . . . . . . . 42 C. Environmental Impact ..... .. . ....... .. . . 43 VIII. AGREEMENTS REACHED AND RECOMMENDATION . . . . . . . . . . . . 43 A. Assurances . . . . . . . . . . . . . . . . . . . . . . . . 43 B. Conditions ........ . .............. . 44 C. Recommendation.. . . . . . . . . ... .. . . 44 1. Financial Intermediaries 2. Institutional Development Activities by Other Agencies 3. The Economics of Agricultural Production in Romania and Proposals for an Initial Negative List of Production Subsectors to be Excluded from Project Investment 4. Estimated Disburement Schedule 5. Reform of the Agricultural Information System 6. Selected Documents Available in the Project File ME IBRD No. 23664 Thie report is based on the findings of a Bank appraisal mission to Romania in January 1992 comprising Messrs. F. Lucca (task manager), J. Yaron, W. Zijp (Bank), M. Borish, R.P. Harrison, J. Intrator, R. Lacroix (Bank consultants), and E. Caputo (Italian Cooperative Association). Contributions in assuring the EC-PHARE program of technical assistance were made by Ms. V. Alliata. Peer reviewers were Mr. C. Ceaki, Mr. J. DUster and Ms. M. Bromhead. - i- SAFF APPRAISAL REPORT ROMANIA PR! VATS FASMZR Atm EBITERPRISE SUPPOb..j2MQJEQt LOAX AND PROJECT SUM=ARY 1err.w rZ'Romania henIU iclariews Private farmers, food processing and marketing enterprises AmounU US$100 million equivalent Z3l3 tnanl A.Mcl23 Ministry of Economy and Finance (MEF), and Agricultural Dank (AD) and Romanian Development Bank (DB) as Financial Intermediaries (Flu). Rolendino Terms: (i) From the Government to the financial intermediartes (FI) in either domestic currency (lei) at the then- prevailing National Bank of Romania (NDR) discount rate, or in dollars at LIBOR plus a margin to be determined by the Ministry of Economy and Finance (NFF). (ii) From the Flo to the beneficiaries in either lei at the NIR discount rate (variable) plus a spread to be decided by the FIs, or in dollars at LIBOR plus the NSF margin and the FI spread. Project ObilctLvest The objective of the project is to support private sector development in rural areas and through this, raise agricultural output, increase efficiency of production, generate employment and improve living standards. The project aims to achieve this through financing credit to private farmers and other private businesses for (a) the establishment and expansLon of rura. enterprlses in order to improve input supply and marketing services and increase business activity, and (b) on-farm investment ln order to increase production. The project has close policy links with both the proposed Structural Adjustment Loan (SAL) and the proposed Financial and EnterprLse Sector Adjustment Loan (FESAL). - ii - 3roiect DeucrLatlon: The loan would finance private investment in viable agricultural and other rural buuinesses through a credit line expected to take five years to disburse. It is intended to be wide ranging and demand led excluding those ineligible subsectore which are assessed not to be economically viable. It would cover both investmert items and incremental working capital for: (a) agricultural production including certain types of livestock agricultural machinery and related services; (b) processing of agricultural products, particularly small- and medium-scale investment to increase value added in the rural areas; (c) marketing and trade of agricultural products, especially for transport, wholesaling and rCZAling of both agricultural outputs and inputs; and (d) other rural businesses. PrSeect Benefits: The main benefit of the project would be increased private rural sector business activity and improved rural institutions. The credit provided by the project would support both (a) private on firm investment which would contribute significantly to agricultural production and efficiency; and (b) much needed private investaent in iri.xt distribution, agricultural services and product marketing. Enhanced competition in the rural banking syste-. and broader access to credit threugh the support c new business entrants would contribute to creatA - x competitive economic environment. The pro4-.t, indirectly, would support the Government's economic reform program by creating additional employment and new sources of income in rural areas. Finally, because of its positive overall effect on agricultural production and efficiency, the project would make the country more competitive in international markets, resulting in a favorable impact on its balance of payments. Proeect Rlsks The main project risk is that subloans would not be fully or promptly repaid. This could occur primarily because there is little experience with lending to private farmers and small businesses in a free market environment, entailing higher than usual financial risk for borrowers as well as Fla. To address this, the project provides for application by the FIs of sound lending criteria. Assistance in the preparation of the lending operations manual and associated training currently being provided by the Dank will help implement this. A more minor risk is that because businesses may be reluctant to borrow for goods which appear expensive on a historical basis, the drawdown of project funds could be slower than anticipated. This risk would be mitigated once the effects of macroeconomic reform are seen to be working, and borrowers understand the rationale of the new price relationships. - iii - Xstimated Proiset Cost.:l Local EogigA Total -------- US$ million -------- On-Farm Investment 16.5 16.5 33.0 Agricultural Processing 22.2 35.5 57.7 Marketing, Distribution and Services 26.0 48.0 74.0 Total 64.7 100.0 164.7 la Based on total investment costs plus incremental investment in working capital. Financing Plant Local reign Total -------- USS million --------- IBRD 100.0 100.0 Participating Banks 20.0 20.0 Subborrowers 44,7 44.7 Total 64.7 100.0 164.7 Estiuated Disbursements: Bank FY: 93 94 95 96 97 98 ------------ USS million ------------ Annual 15 32 35 8 8 2 Cumulative 15 47 82 90 98 100 Closina Date: June 30, 1998 ERR - Minimum of 15% for subproject FRR - Minimum of 15% for subproject MR: IBRD No. 23664 S TAFF APPRAISAL REPORT ROMANIA PRIVATE FARMER AND ENTERPRISE SUPPORT PROJECT I. INTRODUCTION 1.01 Romania has a population (1990) of 23.4 million including a work force of 11.7 million. Its economy" grew rapidly from 1948 to 1979, but stagnated during the 1980s. Since the revolution in 1989 there has been an economic decline. Overall GDP fell about 7% in 1990 and the general consensus is that in 1991 --al GDP fell by 10%, exports by 30%, and imports by 45% from their 1990 levels. Per capita income is now estimated at about US$1,300. Agriculture together with agroindustries account for about 20% of GDP and about 35% of the total labor force. The country with its continental climate and some of the most uniformly fertile soils in south eastern Europe has sound K - conditions for a flourishing agriculture. Unti. the 1980s Romanian agriculture met domestic food consumption requirements for temperate products and ws8 a large net exporter. However, output and productivity which had increated steadily between 1950 and 1980 fell alarmingly between 1980 and 1989 due main'.y to the inability of the centrally planned system to deliver cr. _cal inputs. 1.Z:2 At the time of the 1989 revclution the state presence was pervasive in ajriculture. Of the ha 10 million of cultivated land, including ha 3 million under irrigation, 29% was operated by state farms and 59% by centrally ma._ged production cooperatives (CAPs). The small private sector comprising about. 1 million peasants had access to about 12% of the poorest cultivated land as well as to grazing areas for livestock. The bulk of the food processing and distribution system was run by state companies which were generally technically inefficient and in poor Zinancial condition. 1.03 Since the revolution the government has embarked on an ambitious program of system reforms to liberalize the economy. The principal elements of these reforms which apply to the agricultural sector include: (a) the decollectivization of the CAPs; (b) the redistribution of lands to private farmers as a consequence of the recently enacted land legislation,Z involving privatization of over ha 8 million; (c) permission for non-state units to market their production through non-state channels; and (d) producer price liberalization in three different stages in November 1990, April 1991 and July 1991 for all but a few strategic products. This liberalization appears to have already generated a positive supply response from private sector agriculture, particularly for products which can easily be marketed privately. 1/ For a detailed analysis of the Romanian economy, see Report No. 9497-RO dated September 13, 1991. V Land Fund Act - reported in Official Gazette of Romania III year - No. 37, February 20, 1991. -2- 1.04 The project was identified following Bank economic and sector work including the findings of the Country Economic Memorandum Mission of November 1990 and the rechnical Assistance and Critical Imports Project Appraisal Mission. Following closely behind the proposed Structural Adjustment Loan (SAL) through which the Bank is assisting Romania in broad macroeconomic reform, this project is designed specifically to further support the agricultural privatization process by the timely provision of much needed credit to newly privatized farmers and other rural businesses. Ongoing financial and management audits of likely participating banks, which are being undertaken as part of the preparation of the proposed Financial and Enterprise Sector Adjustment Loan (FESAL) is helping to ensure the strengthening of the rural credit system so that it can effectively deliver the much needed finance for investment. The preparation work undertaken by the Bank in bringing the project to fruition has initiated important actions funded by other donors which would (a) strengthen the policy making capacity of the Ministry of Agriculture and Food Industry (MAFI) to assist in the refocussing of its role from a centrcl planning agency controlling production to a support agency concerned with creating a policy environment which enables market led growth to take place; (b) assist in reorienting agricultural research and extension towards supporting the changed agricultural structure; and (c) substantially improve market information availability. The project would be implemented through the Ministr! of Economy and Finance (MEF) and selected financial intermediaries (FIs). The bulk of project disbursement (86%) would span a three-year period (late 1992 to late 1995). 1.05 The total cost of the project is estimated at US$165 million, of which US$100 million (61%) is foreign exchange. The Bank loan of US$100 million to Government would finance part of the PIs' lending to the private rural sector during the project period. The remaining investment resources would be provided by the Flo themselves and Investors. II. AGRICULTURAL SECTOR A. Background 2.01 Land and Climate. Romania has a land area of 237,000 km2 of which ha 10.1 million (43%) is under crops and ha 4.7 million (20%) is in meadows and pastures. Forestry is also important and covers about ha 6.5 million, or about 28% of the country's total land area. The climate in Romania is generally continental with hot summers and cold winters. Rainfall in the areas of better soils, which are situated in the Danube plain, is typically about 500 mm annually; it is distributed throughout the year but is erratic. irrigation is important in some areas for high value crops (horticulture, potatoes, sugar beet) and desirable, but not essential, for cereals. 2.02 Prior to the 1989 revolution primary production was undertaken by about 365 state farms, 3,784 state production cooperatives (CAPs), and one million private farm houssholds, mainly livestock keepers. The breakdown of the ownership of land in 1990 was as follows: - 3 - Table 2.1: LAND OWNERSHIP BY SUBSECTOR AND TYPE OF UWk (19900 State Private Units CAPs Famp Total --- million hectares --------- Annually Cultivated Land 2.1 6.6 0.8 9.5 Vineyards & Orchards 0.2 0.3 0.1 0.6 Subtotal Cropped Land 2.3 6.9 0.9 LQ- Pastures & Meadows 2.2 1.5 1.0 4.7 Total Agricultural Land 458.4 1.9 14.8 2.03 As a result of the 1991 land law, about ha 6.9 million of cropped land and ha 1.5 million of pastures and meadows belonging to the former CAPS are being privatized,!/ bringing the total area of agricultural land under private control to ha 10.3 million. 2.04 Past Performance. Between 1950 and 1980 the agricultural sector was massively mechanized and soils were intensively fertilized. Gross agricultural output increased at an aiverage annual rate of 4.5% - more than trebling over the period, largely as a result of improved yields for both crops and litestock. In parallel, the proportion of the labor force in agriculture fell from 74% to 29% as more than 3 million peopl.e moved out of agriculture to provide manpower for industrial development. As a result of this growth, Romanian agriculture met domestic food consumption requirements for temperate products and was a large net exporter of agricultural products. By the early 1980s, agric"ltare exports, of which about 50% were to the EC, accounted for about 23% of tctal exports. Between 1985 and 1989, however, agricultural production declined at an estimated annual average rate of about 4% for crops and 5% for livestock. This resulted from decreasing factor productivity which was partly due to shortages of imported inputs and partly to the deterioration of the irrigation systems and of the agricultural machinery park. 2.05 The overall decline in crop production has continued through 1990 and 1991, with est'mated falls in production between 1989 and 1991 of 12% for oilseeds, 31n f.-r sugarbeet, 51% for potatoes and vegetables and 37% for fruit being part; .ompensated by a 4% increase in cereal (mainly maize) production. Livestock >,duction increased overall between 1989 and 1991. Meat and wool production increased by 12% and 13% respectively, which in value terms more than offset falls in milk and egg production (1% and 5% respectively). Lack of necessary critical inputs continued to be a major reason for declining productivity. For example, mainly because of the allocation of domestically Y Although this land is now outside public sector control, the process of identifying its ownership and allocating it to particular individuals is still at an early stage (see para 3.05). manufactured fertilizer for export, fertilizer used for the 1991 crops was far too low.1 For agrochemicals and livestock production there have also been serious shortages, due to lack of foreign exchange for importo.V 8. irrgatila 2.06 Over the past 30 yeirs, a massive Irrigation program has taken place in Romania, and currently about ha 3.2 million have been equipped with irrigat.ion facilities. Most of the irrigated land is in the plains and about half of it is on state farms. However, the absence of an effective system to collect user fees and shortages of foreign exchange in recent years have resulted in inadequate maintenance and non-replacement of essential spare parts. As a result there has been a drastic decrease in irrigation efficiency. Drainage work is now requir-4 cver ha 1 million. Furthermore, much of the irrigation system as it is , tly operated is extremely energy intensive and not cost effective. Basic deci-ions need to be made on which crops and areas to irrigate on the basis of their financial and economic viability and on how to restructure the whole system to introduce efficiency and ensure sustainability. A study to review this has been commissioned under the Bank's Critical Imports and Technical Assistance loan (Loan 3363-RO). C. Mechanization &.07 In 1990 the agricu?"ural sector in Romania was servad by 127,000 tractors, down about 17% from 1989, 41,500 cereal combine harvesters, about 17,000 maize combine harvesters, and 5,500 self propelled forage harvesters. The present ratio of approximately 1 tractor per ha 75 of cultivated land is one of the lowest in Europe and substantially below the ratio Romania experienced in the early eighties (1 tractor per ha 53). It is estimated that availability of tractors in Romania iE currently about 40% below the optimum level. Furthermore, the age structure of * machines is poor (e.g. 70% of 45 hp tractors are over six years old) and theg proportion in good working order is low. There are similar problems with other agricultural equipment, particularly with combine harvesters and balers. 2.08 This unhealthy situation has been caused by lack of replacement of agricultural machinery, due both to a policy of virtually no imports having been made and ali- to the diminishing performance of Romanian agricultural machinery factories. Because of low controlled sales prices, Romanian factories have been unable to earn sufficient revenue to modernize and restructure their plants and coneequently are operatizag at 30-40% of capacity. Thus, the.4 has been considerable queuing for tractors. For example, in 1990 1J It was estimated by MAFI to have been only 24% of the technical requirements. J Imports of agrochemicals in 1991 were about half of those in 1990, and 41% below the level initially planned, while imports of protein meal in 1991 were only about 370,000 tons soybean meal equivalent compared with actual imports of about 900,000 tons in 1990 and a planned figure for 1991 of about 950,000 tons. -5- private farmers received 2,969 (30-45 hp) tractors as again&lz a rsgstered demand of 30,000 - less than 30%. The level of unsatisfied demand eased somewhat in 1991 as domestic prices for tractors were substantially increased1V &nd some 7,000 tractors were sold to private individuals (about 80% for cash and 20% on credit). There in still some overhang o0 demand, and this, together with new demand from the private sector which is likely to be generated as a result of price liberalization and the corresponding increase in farm profitability, may not be met solely by existing local manufacturers. However, the trade and exchange rate liberalization measures being introduced are starting to result in competitive supply of A variety of foreign machinery in the Romanian market, thereby alleviating this physical bottleneck.V D. Research and Extension 2.09 Agricultural research in Romania is entirely undertaken by the public sector. The largest of the crop research institutes is the Cereal and Technical Plant Research Institute (ICCPT) located in Fundulea, near Bucharest. It has its own network of 13 regional agriultural research stations, none of which, however, conducts serious agricultural economic research. There is also no formal agricultural extension system charged with the responsibility of disseminating information among farmers in a permanent systematic manner. There is a need for an agricultural research policy to. serve the new market economy. There are major gaps in technological and economic information in areas pertaining to small farmer production including production and marketing economics, the role of sociology, the role of productivity and the use of small farm machinery. In the field of specialized livestock research, technological advances are required in farm management economics, animal huebandry, disease control and epidemiology, and grassland management and conservation. Much of this te-hnology can be effectively transferred from developed countries which have accumulated a large body of technical and practical knowledge about lives;ock production. Nevertheless, domestic research capability is needed to identify potentially useful technologies and management techniques. The absence of an extension system in Romania is typical of all Eastern European countries. The creation of a more effective system of agricultural information oriented to the needs of the private sector needs to be put in place, especially now that several hundr3ds of thousands of additional farm operators will need direct technical assistance. A thorough review of the research and information services needed to spur private agricultural development is warranted. A study on this subject will be undertaken in parallel to the project (Annex 2, para 4(d)). 1/ Prices in January 1992 are about lei 1.4 million for a 45 hp tractor, or about $7,000 at the official exchange rate. This is equivalent to export parity. v The Technical Assistance and Critical Imports Loan (No. 3363-RO) has had a modest input in alleviating this bottleneck through financing US$7 million worth of spare parts as against a possible annual need for foreign exchange in the mechanization sub-sector of over US$100 million annually. - 6 - S. AaroDrocessna 2.10 Agroindustry in Romania comprLses the following major processing sectorst meat, milk, edible oil, fruit and vegetables, bakery and fish. Food processing is mainly undertaken by state enterprises. There are about 400 major industrial units in the agroprocessing sector, employing some 300,000 people, which genezate about 10% of all industrial production. Following the new privatization laws recently approved by parliament, and the consequent privatization of the land, the numbers of farmers and middlemen interested in participating in value added operations in the food processing area are increasing rapidly. However, they are in great need of technical and financial assistance. Although substantial foreign exchange has been generated in recent years by the export of processed foods, very little capital has been plowed back into restructuring or modernization of plants. The renult is that their technical and economic status has severely deteriorated. The extent to which it will be economically and technically feasible to restructure state-owned processing enterprises is presently unclear. fowever, new private sector processors deriving from the new reform system are entering the marketplace especially in the fields of bakeries, beer and meat processing. An agroindustry study, originally introduced under the Bank's Technical Assistance and Critical Imports Loan, is now being undertaken and financed by EC-PHARE. The study is expected to claseify agroindustries in the state sector by standards of technical, economic and financial viability and to identify the types of units worth restructuring, indicative levels of investment, and to makF broad proposals for the disposal of those operations which are not potentially viable. F. Marketing. Prices and Foreign Trade 2.11 Marketina System. The provision of food products is organized through three channele: sales through the state managed distribution system (the organized channels); informal free markets; and consumption out of own production. Distribution through organized channels in 1990 accounted for about 60% of total food expenditures. Commodity groups where the state's share in marketing is smallest are milk and dairy products (27%) and fruits and vegetables (35%). In general, the state control over agricultural inputs and the use of strong measures to encourage private operators to deliver a substantial part of their output to state units has tended to keep the share of government procurement high. Private food processing to date has been a cottage industry with units operated mostly from farmers' homes. Although peasant markets are the main outlet for private food sales, farmers do not own marketing facilities but rent stalls daily in designated areas. With the lack of permanent sales outlets in these markets, the absence ot wholesale distribution systems, and deficient transport, private farmers face difficulties in marketing their products. The relatively high prices in peasant markets partially reflect farmers' high unit marketing costs which are largely caused by low daily sales volume. There is a need for substantial changes in marketing and distribution of agricultural products. The increased fragmentation of production brought about by land reform means that for perishable products, such as fruit and vegetables, marketing facilities need to be developed in the production areas. This will require substantial -7- private investment ln wholesale and retall markets, facilities, cold stores, trucks, etc., which could be financed under this project. 2.12 Three major thrusts of the new food marketina 2olicv promoted by the authorities are decentralization; elimination of state intermediaries; and the privatization of outlets. Rationing and the state's effective monopoly have now been abolished, with the exception of some basic goods currently in short supply.]' For all other commodities, it is intended that procurement contracts in the future will be executed voluntarily between wholesalers, retailers and agricultural producers. However, there has not yet been a substantial influx of private commercial wholesalers and commission agents within the food distribution system. The new emphasis on elimination of state intermediaries is directed at reducing the state's influence on procurement and distribution. In particular, the controls exercised by state agencies are to be phased out in an effort to encourage formation of private sector marketing and trading concerns. 2.13 Through the privatization laws, it is intended that all state enterprises presently engaged in wholesale and retail trade will be converted to commercial companies and eventually privatized. This process has already started for example, 14 previously state-owned flour mills have recently been sold to private bidders. Through this ongoing reform process, the entire food distribution system could be fully commercialized in the medium term and operated largely by the private sector. Nevertheless, if private initiative is to succeed, it must secure finance for investment and working capital. 2.14 Prices. Romania has recognized that the system of administered prices used in the past ofte.. gave wrong economic signals and has now embarked on moving towards a market economy within which supply and demand determine prices. This process is not yet completed. Over the past two years, there has been a significant move towards liberalizing prices. Controls on retail prices of agricultural products were substantially removed by the July 1991 price liberalization. Now only certain types of basic food products, sold through state-owned channels, such as bread, liquid milk, butter, vegetable oil, sugar, chicken and certain inexpensive meat cuts have fixed (and subsidized) prices at the retail level (para 2.12). Fixed procurement prices, often in the form of a contract between the state farm and the procurement agency continue to be the norm for state farms. Until recently, these were determined centrally on an historical 'cost plus' basis which in times of inflation set prices too low for sustainable production. Now Government has indicated a willingness to move away from this price setting methodology and I, Commodities of agricultural origin which are still subject to price control when processed by state owned companies account for about 20% of food expenditure. In January 1992 explicit levels of subsidy at the retail level, which are paid to state owned companies selling goods at controlled prices are 55% for bread, 68% for edible oil, 67% for sugar, 71% for liquid milk and 80% for butter, 71% for chicken and 22%-46% for various inexpensive meat cuts. Government views these subsidies as a short term transition measure and is planning to eliminate them over the next two years, with the first reduction (by 25%) on May 1 1992. - 8 - proposes to uet transfer prices between state-owned commercial agencies at levels based on 'border prices.' This change will be an important step towards removing distortions in the sector. Private producers, both individual farmers and farmers, associations, can sell to state units at procurement prices and sometimes at negotiated prices. Products that can be marketed directly, such as fruit and vegetables, livestock products or items ior inter farm use (seed, livestock, etc.) are not subject to controls but are naturally constrained by farmers' physical ability to transport and market their goods. Nevertheless, because the state sector still handles a large proportion of traded agricultural products (e.g. about 60% of wheat, 90% of oilseeds, 60% of meat but only 30% of maize), the levels of 'procurement prices' have an important influence on prices in the private sector. 2.15 Although, following initial liberalization, free market farm gate prices were reported as not being very different from controlled price levels, it appears that, with the impact of inflation and the devaluation of the lei, a substantial price gap soon developed, particularly with cereals, small livestock and livestock products for which there is a strong demand from other farmers or households. Price differentials vary by commodity but, typically, private market prices for these types of products as of the end of October 1991, were 30-70% above official procurement prices.2' 2.16 The levels of official prices at the farm gate at end October 1991 for both inputs (fertilizer, concentrates, mechanical services) and outputs roughly corresponded to 'border prices', when calculated at the old official exchange rate of lei 60 per US$. Compared with the unified exchange rate introduced in November 1991, initially of lei 180 per USS, they were therefore very low - about a third of world prices. Although official farm prices were increased by an average of about 60% on December 17, 1991, they were still well below 'border' levels at.the official exchange rate in January 1992. The main impact of the low overall real level of aaricultural prices is that the 'terms of trade' are weighted heavily against the sector, thereby depressing output. The distortion between official and orivate market Prices has had a further deleterious effect in that state distribution agencies have found it increasingly difficult to procure adequate cereal and other basic food supplies domestically. During autumn 1991 it became substantially more profitable for small scale producers either to feed grain to pigs or chicken, which could be sold later on the private market or to withhold grain and wait for its price to be lncreased, rather than to sell it to the state agencies at the procurement price. Furthermore, because state importers of key inputs - protein for animal feed, intermediate products for fertilizer or pesticide manufacture, parts for tractors and equipment - have had severely rationed quantities of foreign exchange available to them, allocation of inputs which are also at low (subsidized) real prices is still effectively administered by MAFI. This results in their being allocated according to the Ministry's objectives rather than being subject to market demand, and so being purchased by end users with the highest marginal return to these factors of production. 1/ Following unification of the exchange rate (see para 2.17) and adjustment of official prices in November and December 1991, the differentials appear to have fallen. -9- Clearly, all of the.e distortions - low absolute prices, differentials between private market and official prices and rationing of subsidized imported inputs - need to be minimized and preferably eliminated altogether for the market to function efficiently. Further, a sustainable interest rate and rate of exchange policy needs to be established. 2.17 To achieve the vital goal of 'getting agricultural prices right' in Romania, and thereby setting the stage for agricultural growth, the ongoing procees of liberalizing internal and external trade needs to be carried through especially now that the exchange rates for public and private sector businesses have been unified. Through SAL preparation, preparation of this project and parallel sector work, intensive dialogue on this subject has taken place between the Bank and Government. There is now broad agreement that the aims should be (i) both agricultural and input and output prices should approximate to border prices at the farm gate level for most products and that key imported inputs should be freely available and not subsidized; (ii) consumer subsidies which may be necessary to keep certain key foods affordable should be transparent, impact only at the retail level and be reduced over time; and (iii) the sales volume of price controlled items should gradually be reduced. 2.18 Romanian foreian trade in agricultural products is dominated by state-owned Foreign Trade Companies (FTCs). Before the Government placed a ban on agricultural export in 1989, agricultural exports were running at about $0.5 billion annually. Close to half of agricultural exports were livestock products, mainly frozen pork, mutton and beef, canned beef, butter and cheese. Fruit and vegetables followed with about 20% of export earnings. The remainder wgas mainly cereals to the Soviet Union. About 70% of agricultural export in 1989 was in convertible currency, about half of which went to EC countries (mainly live sheep, butter, cheese, canned meat, fresh fruit, wine and seeds). Almost all vegetable exports went to Austria, Switzerland and Sweden. The removal of the export bans,11 and the liberalization of agricultural trade, together with the recent unification of the exchange rate, aro all important elements of the macroeconomic reform process which are expected to be supported by the proposed SAL. With the resultant development of economic incentives and the ongoing relaxation of price controls, thereby increasing the influence of market forces, the product mix and location of Romanian agricultural activity is likely to change significantly. The export mix is also expected to change, possibly towards higher value products as the export market focus moves increasingly to convertible currency markets. These changes will take place gradually as producers and traders use their new autonomy and the most profitable use of resources in individual cases becomes clearer. To facilitate these market-driven changes and encourage enhanced productivity, it will be important to support the necessary capitalization of the new private farmers, processors and traders. 3/ Some of the restriction on exports, notably pig meat, had been removed by January 1992. - 10 - G. Sectoral Adiustment Policies 2.19 The broad policy aim within the agricultural sector is that it should be competitive, both domestically and internationally, and that prices of and international trade in agricultural commodities, including key inputs, should be liberalized in the medium term. The sector would thus grow in a way dotermined by comparative advantage which could be expected to lead to a growth in agricultural exports once this policy becomes operational. To foster the ongoing privatization in the agricultural sector and hasten the more complete introduction of market forces and financial discipline, the need for additional major adjustments in marketing and investment policies is recognized. Necessary adjustments include: (a) the introduction of viable competition in marketing and service activities which are presently largely undertaken by state-owned commercial production and distribution companies; (b) the progressive reorientation of state-owned companies, including state farms, towards more commercial operation; (c) the institutional strengthening of governmental policy-making and farmer support agencies; (d) the extension of financial sector reforms to rural and farmer support agencies and to rural financial markets; and (e) a broad upgrading of the technological basis for production (applied research), both at the farm level and in the processing and input supply industries. This proposed project would make a major contribution to (a) above by expanding credit and foreign exchange availability to SMEs starting up in this subsector. The institution building activities, developed during project preparation and now being programmed by EC-PHARE (Annex 2), would address (c) above. H. Future Prosoects 2.20 Romania has sound economic potential for agriculture. Traditional crops and livestock (cereals, oilseeds, pig meat) can be produced at costs well below border prices (see Annex 3) and it is likely that better returns still would be obtained from more intensive products such as fruits and vegetables. Nevertheless, although agriculture will certainly be an important sector of the Romanian economy, its growth rate in the medium-term is open to conjecture. Tentative projections are for real growth of between 3% and 4% p.a. between 1993 and 2000.-I Technically, this is feasible; indeed, provided the land ownership/organization issue can be rapidly clarified, and necessary inputs made available at economic prices, considerably higher growth rates could be expected given the low base.>/ However, there are other factors which also influence projections. With undistorted pricing of energy, the area irrigated is likely to fall significantly, with a consequent negative effect on production. Additionally, agricultural growth may be constrained by the market for some products (para 2.22). 2.21 In the short term (1992) prospects for agricultural production appear grim. Partly because of shortages of fuel and equipment, and partly 1/ Romania: Draft SAL Initiating Memorandum, February 1992. 3/ Agricultural output in 1992 is probably going to be 25% below the 1988 figure. - 11 - because of the reorganization of land ownership, both wheat planting and the area of land plowed in autumn 1991 (for other 1992 crops) was substantially below normal. D'Even with a massive effort in spring 1992, it is likely that (i) total planted area will be below normal; and (ii) some plantings will be late or seed beds will be prepared hurriedly thereby causing yields to fall. 2.22 Because of conflicting distortions in the past - subsidized prices for food but rationed supply, it is difficult to determine whether aggregate domestic demand for food will rise or fall in response to liberalization. In the longer run, increasing population estimated to grow at about 0.5% p.a. coupled with a projected growth in GDP per capita averaging about 3% between 1992 and 2000 would generate substantial aggregate increased domestic demand for agricultural products, although the product mix and relative prices could be expected to change. 2.23 On the export front, Romania already has niche markets for some items while the liberalization of the economy could be expected to result in private initiatives which would give impetus for further development of specialty export products. In the longer run, the prospects of reduced trade barriers to Europe and the restoration of demand from the Eastern Europe and Central Asia Republics should give rise to a modest increase in the potential for expansion of meat and grain exports. 2.24 Credit demand in the sector, both from producers and emergent marketing/processing enterprises, is strong. This is not surprising given the negative real interest rates which existed in 1991. The rate of private credit uptake in 1991 and projections for 1992 indicate a demand far in excess of the proposed disbursements under this project, even against the background of rapidly increasing nominal interest rates. 2.25 Provisional results from a survey of demard by the main banks lending to agriculture suggest agroindustrial private sector borrowing requirements for 1992 of about US$70 million for a range of investments, including bakeries, breweries, milling, meat processing, and fruit processing. In the private agriculture production subsector, there is strong demand for credit for agricultural machinery (including tractors), livestock, greenhouses and the establishment of orchards and vineyards. There is a considerable shortage of agricultural machinery on offer and, as in the past, sales are likely to be determined by availability. It is estimated that in total about US$200 million worth of domestically manufactured tractors (improved by the inclusion of foreign components) and other agricultural machinery will be available for delivery in 1992, of which 75% is expected to go to the private sector. Assuming half of this is financed through loans, credit demand for Romanian agricultural equipment by the private sector would be about US$75 million in 1992. Besides equipment from domestic sources, there will also be significant demand for imported specialist equipment. M1/ Winter wheat plantings in autumn 1991 were ha 1.56 million compared with an average of ha 2.32 million in the previous three years, while the area of plowed land as at December 31 was about ha 1 million compared with a norm of ha 5 million. - 12 - 2.26 The further liberalization of prices, together with a policy of setting official prices at levels close to border prices (see paras 2.14 to 2.17), should result in a significant improvement in the agricultural terms of trade compared with the recent past. For example, in March 1991, the time of spring planting decisions, official prices of wheat, maize and sunflower were lei 2.00, 2.40 and 4.00 per kg respectively. By early 1992, border prices for the same commodities, converted to lei at the official exchange rate, were lei 25.0, 17.6 and 59.6 per kg respectively (Annex 3, Table 3). These figures are higher than the year earlier financial prices, by factors of 12, 7 and 15 respectively, which is far greater than the increases over the same period of either consumer prices or wages. On the same basis, there would also be a substantial, but in total lesser, increase J.n the price of variable agricultural inputs (seeds, fertilizer, chemicals, mechanization), the cost of which typically represents 50-65% of crop output value at border prices (but a lower figure if, as in the past, availability of inputs is restricted). Profit per hectare under border price conditions for most crops would be substantially higher in real terms than under the past system of low fixed prices and subsidized inputs. Movement towards border prices would clearly strengthen the financial viability of operations in this sector, thereby increasing credit demand. Even _n the short run, the investment credit needs of agriculture and the associated processing and marketing sector are likely to exceed US$200 million of disbursements annually. 2.27 A broad brush estimate of agriculture's 'balance sheet, puts the aggregate value of total assets in agriculture and agroindustries, part of which would normally be financed by credit, at about US$10 billion, excluding the value of land. More thaa half of this is already in private hands, yet the present (end 1991) outstanding balance of formal credit to the private sector is under US$100 million. As assets change handb, and real investment and reinvestment is made at a rate likely to be about US$1 billion annually, under stabilized conditions a strong demand for investment credit will be generated provided that both inflation and interest rates are below 10-15%. If high interest rates continue over the next year or so and suppress long term investment credit demand, there will still be strong demand for short term credit. In particular, seasonal credit will be required for production by new agricultural entities and there will also be continued demand by emergent marketing firms in subsectors such as cereals/bread or oilseed processing which buy seasonal crops at harvest time but market their products year round. 2.28 Recent visits to bank branches and discussions with private borrowers revealed that while there is a shortage of private equity capital, as would be expected after 40 years of communism, there were still many examples of profitable emergent firms which were creditworthy bank customers. Particular areas of profitable private activity reviewed included agricultural produce transport, bakeries, meat processing, brewing, sheep production for export and greenhouse production of flowers. Given the rapid expansion of the number of clients being served, however, and the increasing volume of credit extended, the banks will need to be cautious in assessing the soundness of potential borrowers and the viability of the proposed investments. - 13 - I. Bank's Strateav and Role 2.29 The Bank's lending strategy in agriculture is to support the jovernment effort to establish a stable macroeconomic environment conducive to a gradual development of market-driven private agriculture. This strategy is in line with the aims of the structural adjustment loan (SAL) recently appraised by the Bank. More specifically, the Bank strategy and its role in agriculture is conceived within a medium-term strategy aimed at providing support to privatization via (a) implementation of the land privatization act; (b) gradual elimination of state monopolies operating in processing and distribution; (c) strengthening of (i) the rural financial intermediation system, (ii) the research and extension servicee, and (iii) the government policy- and strategy-making capacity; and (d) providing credit for both investment and incremental working capital to private farmers and other rural based private businesses. While (a) and (b) above fall within the framework of the proposed SAL, (c)(i) would be pursued under both thie project and the proposed FESAL and (d) would be directly addressed by the project. 2.30 The proposed project is the first agricultural operation conceived within the above-mentioned agricultural strategy to support the emerging rural private sector. It would help channel vital capital and, in particular, convertible currency resources directly to the emergent private sector. Because of this clear need for resources, and the potential for private sector development, the project could be implemented in parallel to other more comprehensive agricultural eector studies. Over the next eighteen months, findings from the project-related sector studies under preparation may provide the basis for a more comprehensive Bank operation to support further development of a market economy in the agricultural sector. The Bank is presently conducting regional studies in East Europe on land reform and agricultural pricing and is contemplating a major study on agricultural trade. Further work on agricultural incentives and cooperatives is now under consideration; an irrigation study is under way, and a forestry review has been initiated. 2.31 Relationshils with Other Aoencies. The Bank has also been instrumental in coordinating external assistance from multilateral (EC-PHARE) and bilateral agencies in support of the agricultural sector. Specific activities which will facilitate the effective implementation of this Project and which have been fostered by the Bank but will be financed by other agencies, mainly EC-PHARE, would include strengthening of: (a) the banking system's capability to provide credit efficiently to rural borrowers; (b) policy and strategy formulation capacity within MAFI; (c) technical assistance services to rural undertakings; (d) the Agricultural Information System - education, research, extension; (e) the agroindustry subsector through undertaking a detailed study; - 14 - (f) market information for agricultural products; and (g) cadastral services. A detailed description of these institutional development activities and the implementation arrangements for them is provided in Annex 2. 2.32 Lessons Learned. The most relevant lessons learned with regard to agricultural projects from OED reviews and the most recent financial sector operations are (i) macroeconomic stability and sector sustainability are basic prerequisites for investment; (ii) the banking system needs to be cleared of uncollectible arrears and establish capital and provisions adequacy; and (iii) appropriate accounting systems need to be established in the corporate sector to achieve financial tran.parency and accountability. All previous Bank lending to the agricultural sector in Romania was made prior to 1985. By 19P' Romania had ceased borrowing from the Bank and by 1989 had fully repaid all outstanding Bank loans, many ahead of schedule. Previous agricultural loans were all planned investments with funds passing through the Agricultural Bank (AB). The main lessons to be learned from the several loans for intensive livestock (pigs, poultry and dairy cows) were that, although individual subprojects generally performed adequately, the severely restricted availability of key imported inputs - in that case protein feed - meant that the overall impact of the livestock projects on the economy was probably negative. Massive financing of irrigation projects, all of which are energy intensive, resulted in operations which were not financially and economically viable. This is one of the reasons that an irrigation study (para 2.06) has been commissioned. Clearly, the system of centrally chosen projects, controlled prices, physical allocation of resources and unavailability of foreign exchange to agriculture, despite the fact that it was a key exporting sector, has resulted in unsatisfactory performance. This project takes account of these lessons: firstly, subprojects will result from effective credit demand and not be administratively selected; and, secondly, because of the movements towards (a) freeing up prices, and (b) a liberalized agricultural trade regime, which would permit key inputs to be imported and to be freely available in the market with financial prices close to economic prices, the types of investment made are likely to be economically viable. III. LAND REFORM AND FARMER ASSOCIATIONS A. Backoround 3.01 Following World War II, the country's existing agricultural and consumer cooperatives were incorporated into the centralized planning approach of the communist government. Private agricultural lands we-e expropriated and reorganized into collectives (called agricultural production 'cooperatives' (CAPs)) and state farms. The collectives were structured into a country-wide system of 41 regional unions, one for each Judet (administrative district), under the control of a national union headquartered in Bucharest. Party officials were often appointed to the key positions at the national and regional levels. At the local level, the CAPs were required to supply state - 15 - factories and retail outlets with a portion of their output and pay a tax to the government based on their profits. The system left little incentive for either individual or group initiative, although it did serve as an important means of providing employment. 3.02 After the revolution of December 1989, in February 1990, a new law on agricultural associations provided for the independent development of the cooperatives. This initial step toward privatization of the cooperatives was given an important impetus with the promulgation of the new land law in February 1991, which provided for the return of much of the expropriated farm land to its original owners or their descendants. On the basis of these two laws, the CAPs are in the process of being dismantled. B. Dismantlina of CAPs and Reoraanization of the Larnd 3.03 Under the new law, n. ssets of the CAPs are being distributed to their members; 60% on the basis e work contribution over the past decade and 40% on the basis of previous land ownership. In all, it is reckoned that there will be about 6 million individual land owners or laborers resulting from the breakup of the CAPs. Many of these are city dwellers who have hereditary title to land but are not actively involved in agriculture. Three broad types of organization are resulting from the reorganization of CAPs. These include legally constituted associations which have the right to borrow, family associations which are normally looser groupings and are not a 'legal' entity and so must borrow through their members and individual farmers operating independently. Included in the legally formed associations are both associations growing out of part of the original CAPs and a?so associations growing out of the old inter-cooperative economic associatiLns which were normally specialized units e.g. pig farms, dairy farms, etc. This latter group have generally formed into private joint stock companies rather than farmer associations. 3.04 As of January 1992, Romania had 2,250 legally constituted farmers' associations with ha 1.1 million (ha 489/association) and embracing 390,293 families (173 families/association). An additional 1,597 associations were being processed which, using the same average area, would mean that in total about ha 1.9 million, or 23% of the old (1990) CAP land area was likely to be operated through legally constituted farmers associations in 1992. At the same time, newly organized family associations numbered 8,338 and occupied ha 1.2 million (ha 144/family association). An additional 1,814 family associations were being processed, which would bring the total to 10,152 and area farmed to about ha 1.5 million, or 18% of former CAP land. Combined, legally constituted and family associations are likely to operate about 41% of former CAP land in 1992. 3.05 Parallel with the breakup of the CAPs, the Government has a program to give title to the 6 million beneficiaries of decollectivization. This is indeed a massive task. The number of parcels of land involved has been estimated at anything from 13 to 24 million. Progress has been rapid in terms of broadly identifying the land areas involved. At the commune level, the local commissions have established 99% of the land to be distributed and at the Judet (district) level, 91% of commune proposals have been approved. - 16 - Despite progress on this front, the cadastral survey process has been slower than expected, creating delay. in the issuance of ownership claims and full land title and registration. This process is reported to ba constrained by insufficient technicians assigned to the task (5,500), inadequate coordination and planning among the interrelated phases (adjudication, demarcation, registration, title distribution, and ongoing training), and lack of required information systems (hardware and software). As of early January 1992, only 43,556 titles had been issued against 4.5 million ownership claims. An additional 1.7 million ownership claims are expected to be issued in the next two to three months. The immediate consequence of these delays is reduced investment and production in agriculture. Unless these problems are soon resolved, medium- and long-term impact will also include reduced collatera availability among private farmers and associations for bank loans. One of the main tasks of MAFI in the coming months will be to ensure acceleration of the cadastral survey. They could begin by deploying underutilized technicians and specialists, which are estimated to number 14,000, and working closely with EC-PHARE consultants and Dutch consultants to implement more efficient processing and planning standards. 3.06 Technical assistance comprising both experts and equipment for surveying to support the cadastral service is already in place and being funded by EC-PHARE. Additional support specifically for lank.. registration is being provided using Bank Dutch Trust Fund resources. The rate at which full title to land can be distributed is presently unnlear and would be heavily dependent on the amount of resources committed to the program. However, it would be unreasonable to expect that the millions of plots involved could be identified, mapped in detail and registered on behalf of 6 million beneficiaries in less than about 5 years. Therefore, in the short- and medium-terms many farmers will have to rely on the common understanding that they are entitled to a certain area of land within a large block rather than specifically owning an individual parcel. C. The Impact of the February 1991 Land Law 3.07 In the summer of 1991, the Bank and MAFI recruited 40 agricultural university students to carry out a random sample survey of farmers who were beneficiaries of the Land Privatization Law of February 1991 and had inherited land formerly operated by the CAPs. Survey teams interviewed 1,243 households and 210 farmer associations. The major findings of the survey are that within the sample cover, most (65%) farmers have elected, for the time being, to cultivate land in associations. On average, these new associations (which are larger than the national average) cover less area (500 ha) and have fewer members than the former CAPs. These smaller sized units are likely to be more manageable by the new emerging private farmers than the old CAPs and could provide a foundation for the formation of smaller commercial farms. Those farming in associations indicated that they have chosen to do so because they have more access to machinery and equipment and to technical assistance. Individual farmers, on the other hand, indicated a high inclination to farm independently and also to undertake processing and marketing activities of agricultural products on their own. All farmers, whether farming collectively or individually, indicated a need for capital investment and stated that they would be willing to finance it with long-term credit i' it were avatlable - 17 - through the banking system. Specific items which they felt they would need credit for were agricultural machinery, livestock, small-scale processing equipment for bakeries, dairy plants, and butcheries. 3.08 In the expectation that the trend towards smaller associations and individual private farms will continue, technical assistance is now needed for the development of new more intensive cropping systems and of appropriate processing and marketing services, with the aim of adding value to agricultural production. Because of the perishability of many agricultural products, the linking of processing and marketing with production can lead to greater rural incomes and improved efficiency. As a result, there is a strong demand among producers for the financing of small- and medium-size agricultural enterprises. However, because of lack of experience, technical assistance to support such processing and marketing activities would be required. 3.09 Various other information important for understanding the emerging social and production structure of newly formed groups was derived from the survey. With regard to age the survey indicated that about half of the individual farmers are more than 51 years old, while in the farmers associations, about 35% of the farmers are over 55. Most of the young people living on the farms increase family incGme through off-farm employment. With 65% of the persons in primary production, processing or marketing being female, it is clear that women are playing a prominent role in the evolution and development of the new market oriented rural sector. 3.10 In contrast to the CAPs which were managed at the local level by only a few trained technicians, and in which management's primary role was to meet centrally-determined production targets, the members of the no- associations are active participants in decision making at all levels from production to marketing. The survey also indicates that most association members are remunerated by the association for the use of their land by receiving a combination of shares of the output and part of the net earnings. 3.11 The new managers of the associations are elected by the members. While most of the managers interviewed expressed a high degree of optimism about the potential of their associations and described plans for expanding operations and entering into new economic activities, many lack the management and business skills necessary to improve operational efficiency and evaluate the feasibility of new ventures. Training is required in such areas as farm management, including cash-flow analysis, cost-benefit analysis, processing and marketing skills, and maintenance of agricultural machinery and equipment. D. Government Strateov and EC-PHARE Assistance 3.12 Government agricultural policy looks upon the new land ownership structure as an essential element in the privatization and growth of the agricultural sector. It is the expressed intent of the Government to give the farmers full control over their own production and marketing operations. Nevertheless, the physical nature of the land (large, flat fields, with villageB far from the land) in some of the more productive regions of the country means that there will be a strong economic reason for carrying out - l8 - much of the field work on the land using large scale equipment. Creating the right kind of organization to ensure compatibility between individual control on the one hand and the potential benefit from economies of scale on the other will be a major challenge within the sector. 3.13 The transition from CAPs to individual units or voluntary associations requireie a tuajor restructuring of the country's agricultural institutions, including those providing inputs, extension services, marketing information and credit; some significant changes have already taken place. There is an evident danger that the farmer associations will not evolve beyond the joint farm management/production stage and will simply functtan as smaller collective farms. At present, no real guidance or support is being provided to aseist the associations with planning, improving operations, or equipping the members with managerial, financial, organizational and technical skills. EC-PHARE is planning to implement an interim support and training service which would be an important step in assisting the associations through this transition period, and enable them to expand their operations and develop their husiness activities on a sound financial basis. This type of assistance could make a strong contribution to the promotion of private sector development. Many of the farmers have already taken action to establish their own primary level associations ard restructure their production activities. To move through this transition phase successfully, the new farmer organizations and the institutions providing them with agricultural services will require specific technical assistance and training. A series of initiatives are being undertaken by the Bank to assist EC-PHARE to define an appropriate technical assistance program in this area (Annex 2). 3.14 In the - -dium- to long-term, it :. expected that initial land allotments will r r,onsolidated through sale and leasing. Markets in inputs and servicee 'rr %..tall private farmers will improve and the capital stock inherited from the Ci.Ps will be replaced by buildings and machinery more appropriate for smaller scale production, and that the producer associations will eventually evolve into traditional marketing cooperatives. During the transition stage, however, these newly formed associations will need to make important adjustments in order to survive in the new market environment. At the same time, Government will need to ensure that the privatization of agricultural services and inputs supply proceeds rapidly and that markets for outputs operate more freely. IV. THE FINANCIAL SECTOR A. Background 4.01 The objective of the Government of Romania is to establish an efficient and broadly-based financial sector, as a fundamental component of a competitive market economy. In order to achieve this objective, an extensive program is being introduced to transform the financial system, based on three principal elements: (1) efficient monetary and credic policies; (2) strengthening of the banking syste.1.; and (3) deepening of the financial system through the development of capital markets. - 19 - 4.02 Support for this program of financial sector reforiki is being provided mainly by multilateral agencies, such as the IMF, the Bank, and the European Community (under its PHARE program). The strategy of the Bank is to assist the overall reform of the financial system while addressing through a number of operations also the specific needs of the industrial, agricultural and service sectors of the economy. The first such operation in the new lending program for Romania was the Technical Assistance and Critical Imports Loan (Loan 3363-RO) for US$180 million equivalent which was submitted to the Board in June 1991. The second is the proposed (SAL) to support the Government's program of macroeconomic reforms. Also in the pipeline are two interlinked sectoral projects to promote private sector development and transition to a market economy as follows: (a) this project, the Private Farmer and Enterprise Support Project (PF.SP); and (b) the Financial and Enterprise Sector Adjustment .oan (FESAL;, scheduled to be appraised in September 1992. 4.03 The reform of the financial sector will have an important impact on the Agricultural Bank (AB) and the Romanian Development Bank (DB), the two banks which, after agreement on a satisfactory restructuring program and the initiation of its implementation, are expected to play the major rcle in carrying out the credit program of the project. B. The Bankina System 4.04 Until December 1989, the Romanian financial system existed to implement the central plan; flows of funds were controlled administratively, leaving little role for central baa..cing or commercial banking functions. The National hank of Romania (NBR) was charged with note issue, but had limited responsibility for money, credit, or interest rate policy. As risks were assumed by the government, banks maintained little or no capital, and no agency existed to supervise financial institutions. Banks provided limited services to their clients and had scant authority to allocate credit. Savings were mobilized through the Savings Bank (CEC), which lent out a small portion of its resources in the form of housing loans and passed the remainder to the NBR which used these funds to refinance loans made by the banking system. The Romanian Bank for Foreign Trade (RBFT), DB and AB, respectively, were responsible for lending to the trade sector, the state enterprise sector and agriculture, mostly with funds borrowed from the NBR. In effect most of the money onlent was never recovered and written off both sides of the balance sheet with the authorization of the MEF. In addition to serving as the bank of issue, the NBR also had quasi-commercial banking functions, taking deposits from state enterprises and cooperatives and making short-term direct loans. 4.05 The post-revolutionary governments are dedicated to moving towards a market economy. In the financial sector a two-tier banking system was created in December 1990 by spinning off all the commercial banking transactions from the NBR to create the Romanian Commercial Bank (CB). The CB and three other state-owned banks (RBFT, DB and AB) all became commercial banks, registered as joint stock companies and operating under the authority - 20 - of two banking laws approved by the Romanian Parliament in April 1991. The government increased the capital of the banks somewhat but still left them undercapitalized. Several private banks were licensed and have begun operating (Mindbank, Bank Tiriac, the Cooperative Credit Bank, Banca Renasterea Creditului Romanesc and Dacia Felix). The Romanian commercial banking sector now comprises six state-owned banks, five private or mixed capital banks and the Bucharest branches of five foreign banks, making a total of 16 in all. The system io completed by several insurance companies (of which the two largest were formed by splitting ADAS, the state insurance monopoly), about 850 credit cooperatives and several hundred small credit unions set up by the trade unions. 4.06 In terms of deposit mobilization CEC still enjoys a dominant position, lending most of its funds either to the NBR or through the interbank market to the commercial banks. However, in 1991 the four major state-owned commercial banks have been permitted to compete more actively for deposits and to diversify their lending business in line with their new freedom to function as universal banks. The AB has begun to finance activities outside agriculture, while other banks are starting to compete in the agricultural sector. The banks have set up departments to lend to the private sector, and credit extended to this sector accounted for as much as 10% of credit flows in the first six months of 1991 (paxa 4.07). However, the low level of deposit and lending interest rates, far below inflation, and the absence of adequate collateral remain serious constraints on the growth of this market. 4.07 In general, banks have been left free to determine their lending and deposit-taking activities. Each of the state-owned banks ultimately reports to a 5-person committee, which includes representatives of the NBR, NEF, and the National Privatization Agency (NAP). However, this committee approves broad policy, meets infrequently, and shows no signs of interfering with bank business decisions. The state-owned banks appear to be devoting limited resources to the credit evaluation process, and are mainly lending to the state-owned enterprises (Regie Autonome) sector with explicit, signed guarantees from the MEF. Their lending in 1991 has been concentrated among state-owned commercial companies, regie autonome, newly created private sector firms, and individuals. The NBR has not intervened in specific lending decisions nor has it provided any guarantee. 4.08 Structure of the Banking System. The present financial system in Romania is structurally imbalanced and underbanked, specially in terms of customer choice. The savings bank, CEC, holds around 63% of aggregate bank deposits, yet lends very little to customers, placing most of its funds with NBR and the Romanian commercial banks. On the other hand, the four main commercial banks have modest customer deposits but account for over 90% of aggregate domestic lending. To improve the efficiency of intermediation in the system it would be desirable for the main commercial banks in Romania to progress towards a structure waereby their loan portfolios were funded mainly from customer savings and other deposits. One way this could be achieved would be through the gradual assimilation of CEC branch offices to the commercial banks. The future role of CEC within the banking system is currently being reviewed by Government. All four commercial banks together have 385 branches and only CEC has an extensive network (2,300 branches and, - 21 - until recently, 3,000 post offices acting as agents). CEC's monopoly on household deposits will be partially broken by the new Post Office Bank, which will take on the deposits placed through the post offices, but more radical measures are probably needed to reshape the system. The new private banks have very small networks, except for Bankcoop which intends to establish at least one branch and two agencies in each of Romania's 41 districts (judets). 4.09 Institutional Development of the Banks. The banks in Romania need a massive program of institutional development covering the following areas: * training at all levels covering especially basic banking skills, credit assessment, foreign exchange dealing, treasury management, customer calling and marketing skills, securities trading, accounting and modern administrative techniques; * full financial audits and portfolio reviews to GAAS standards; * computerization and systems development to provide general ledger accounts and accurate management information; and * strategic diagnostic studies to examine each bank's market position, financial performance and management, to review options for the future and to prepare detailed strategic and business plans with a view to getting the banks ready for eventual privatization; * the appointment of experienced credit advisors to each of the main banks to establish credit policies and design appropriate loan authorization and review procedures. Most of this institutional development is being provided under the preparation of the FESAL with EC-PHARE financing. Part of it is being provided with funds made available in the context of the preparation of this project using Japanese Trust Fund resources. AB and DB, expected to be the project FIs, will initiate a restructuring program before they become eligible as conduit for project funds (para 6.06). 4.10 Present Finanicial Condition. The Romanian banking system is fundamentally undercapitalized. On September 30, 1991, capital and reserves for all Romanian banks (excluding the National Bank) totalled lei 55.4 billion compared with total liabilities of lei 1,265 billion, or a leverage ratio of 22.8 to 1. The total capital and reserves of lei 55.4 billion represented 6.58% of the system's lei 842.5 billion in total loans (which include loans of lei 93.1 billion to the government). Although final figures for December 31, 1991 are not yet available for all the banks, the problem of under- capitalization has probably become more severe, because a surge in lending activity in the last quarter, after NBR lifted the restrictions on credit expansion (para 4.13), was not matched by a proportionate increase in equity. 4.11 At present it is extremely difficult to assess the collectibility of the banks' risk assets, the great majority of which (probably as much as 90% or more) consists of loans to state enterprises. The operational audit of t!, major banks as at December 31, 1991, carried out by international - 22 - auditors, has commenced in February 1992 and will assist in quantifying the size of the problem. The Government is committed to taking whatever steps are necessary to ensure that possible losses to banks from non-performing loans to state enterprises do not result in the insolvency of the banking system. Between 1988 and September 1990 losses exceeding lei 250 billion were written off using budSatary funds. In 1991 Government has assumed the responsibility for 95% of bad and doubtful loans to state enterprises totalling around lei 150 billion which were identified in July 1991 (Government Decision 447/91), with the banks absorbing the remaining 5% over a period of several years. It is evident that before real progress can be achieved in the restructuring - let alone the privatization - of the Romanian banking system, it is necessary to quantify the uncollectible state enterprise loan portfolios of the banks and determine Government's role in relieving the banks of this burden. At the same time, appropriate measures need to be taken to improve and strengthen the banks' lending, credit analysis and risk assessment procedures, to reduce the level of future losses and to ensure that no state pressure is applied to grant loans to non-creditworthy public (or private) enterprises or for non- viable economic activities. Steps are being taken in this regard for Fla (para 6.06). C. The Role of the National Bank of Romania (NBRI 4.12 Bank Supervision and Reaulation. The banking laws adopted on April 1, 1991 endowed NBR with sole supervisory authority over banking companies, with very broad authority to write regulations. NBR's Banking Regulation and Supervision Department, supported by the IMF and its consultants, has made considerable progress in developing policy recommendations and prudential rules, which will serve as a foundation for both off-site analysis and on- site inspections. In January 1992 the Department commenced its first detailed on-site inspection of a bank. 4.13 Imolementation of Monetary and Credit Policy. During the first nine months of 1991 NBR applied strict credit ceilings as was recommended by the IMF, using bank by bank ceilings to limit the growth of money supply to about 15% annually with the intent to curb inflation, which in this period was over 100%. As a result of this tight monetary policy, the total domestic bank credit (excluding credit to Government) stood at lei 49.4 billion in September 1991, only 9.6% over the December 1990 amount. Enterprises, unable to obtai.n credit from the banks, stopped paying their suppliers; consequently, inter-enterprise arrears which at the beginning of 1991 had been estimated at lei 100 billion rose to lei 1.2 trillion, almost 40% of GDP, by the end of November 1991. Alarmed by the growth of arrears NBR abolished credit ceilings during the fourth quarter and banks were once more allowed to lend. Total bank credit grew to lei 898.8 billion at the end of November 1991, a growth of 19.9% in just two months, and further growth was experienced in December 1991. AB was one of the banks that substantially increased lending in the last quarter of 1991, its net balance of outstanding credit growing by 50%, equivalent to lei 134 billion, in the three-month period. These figures on growth do not include loans made in January 1992, but recorded in December 1991, under the Global Compensation Scheme (Law 80 dated December 23, 1991). This scheme is an attempt to reduce the inter-enterprise arrears which have had a highly negative effect on the real sectors of the economy. Preliminary - 23 - estimates, made in mid-January 1992, indicated that the net credit injected into the banking system would be around lei 400 billion. D. Maior Romanian Banks 4.14 Agricultural Bank. AB, first established in 1948, underwent several organizational and structural changes over time and was converted, in December 1990, into a joint stock company, still fully owned by the state, and a universal bank. Based on total assets it is the fourth largest bank in the system with about 18% of total bank assets. In total lending it is the second largest bank with a portfolio equivalent to 25% of total credit from the banking system. The provisional 1991 balance sheet indicates that the AB sourcea of funds were as follows: CEC (30%), NBR (40%), sight deposits (27%), and equity (3%). Until recently, AB has specialized in lending to agricultural producers and to the food processing industry, and its major customers were state farms, state-organized agricultural cooperatives and state-owned processing plants. Since 1990, AB has given increasing emphasis to previding banking services and credit to the private sector, including individual farmers, private small-scale enterpri3es and the newly formed farmers, associations, successors to the former agricultural production cooperatives; AB is also expanding its lending and banking services to other sectors of the economy. As AB is expected to play the leading role in project implementation more detailed information on its organization, financial position, lending operations, interest rates and its involvement in the private sector is provided in Annex 1. 4.15 Provisional financial statements for AS (prepared at end-January 1992) for the year ending December 31, 1991 show total assets of lei 329.1 billion (US$1.6 billion), comprising a loan portfolio of lei 306.2 billion (93%) and other assets of lei 22.9 billion. Gross income, was lei 3.7 billion. Refinancing facilities from NBR of lei 135.8 billion and loans and deposits from CEC of lei 97 billion financed over 76% of AD's outstanding loan portfolio, the balance being financed from customers' current account deposits and AB's equity of lei 9.3 billion, which was equivalent to 2.8% of total assets on December 31, 1991. Although AS only partially (60%) meets the Basel convention recommended capital equity requirements, the return on equity (40%) and the return on assets (1%) are to be considered satisfactory. Its capital structure shows an adequate long-term debt to equity ratio of 10:1. The Government has raised the statutory capital from lei 6 billion to lei 9 billion in March 1992. Its accounts and the 1991 financial statements are being audited by external auditors in accordance with GAAS. A manual of lending guidelines for agricultural credit in accordance with Bank requirements is being prepared. AB has a small core of adequately qualified staff and is undergoing a specialized training program for management and staff financed by EC-PHARE. 4.16 Romanian Dank for Develooment. DB was established in 1948 as the successor to ~he National Society for Industrial Credit, and specialized in medium- and long-term credit for industrial development and short-term advances to industries for working capital. It is state-owned and holds only about 10% of the banking system's total assets, making it the fifth largest bank. In terms of lending DD is the fourth largest, with 14.1% of total bank - 24 - credit. DB has 41 branches (one in each district like the other major banks), 35 sub-branches and 66 agencies, and a total staff of about 3,000. 4.17 As of December 31, 1991, the total assets of DB stood at lei 245 billion, comprising a loan portfolio of lei 198 billion and non-performing loans of about lei 21 billion for which Government has agreed to take responsibility. (In 1990, Government funded the writing off of bad loans amounting to lei 15 billion.) DB's liabilities, as of above date, comprised lei 110 billion or about 50% in sight and time deposits, including deposits from the State Insurance Company; another 31% (lei 76 billion) was refinancing provided by NBR, borrowing from other banks, mainly CEC, was equivalent to 15% (lei 36 billion), and Government deposits equalled 4% of total liabilities. 4.18 Romanian Commercial Bank S.A. CB was established in December 1990 when the commercial banking activities of the National Bank were restructured and transferred to a separate bank. CB is state owned and has inherited a large portfolio of loans to state enterprises. It is the second largest bank in the system, with 24.5% of the total assets, but by far the largest lender with about 33% of the total lending by the Romanian banking system. The bank has 41 branches, one in each judet (district) of Romania, and 112 sub-branches. and agencies. CB intends to open an additional 10 to 15 sub-branches in 1992. Total staff number about 8,750, of whom about 1,150 are in the headquarters. 4.19 As of November 29, 1991, the total assets of CB stood at lei 410.8 billion, comprising a loan portfolio of lei 301.8 billion and loans to government of lei 35.7 billion. At present, lending activities are concentrated on the industrial and service sectors; CB intends to widen its portfolio and expand activities to other sectors of the economy, including the agriculture sector. 4.20 Of CB's liabilities, lei 117.6 billion or 28.6% came from sight and time deposits from the public, deposits of investment funds of enterprises and cooperatives, and the State Insurance Company. Another 12.8% were deposits of Government and the remaining liabilities consisted of refinancing from the NBR (5.8%) and borrowing from other banks, primarily CEC (35.1%). 4.21 Romanian Bank for Foreian Trade S.A. RBFT was established in 1968 to take over the activities previously handled by the International Division of NBR. In the past it had a virtual monopoly on all Romanian foreign exchange transactions and its lending operations financed import and export activities. In January 1990, RBFT obtained approval to widen the scope of its activities and operate as a commercial bank, whilst other banks were authorized to carry out foreign exchange transactions. The bank is state- owned and, from January 1, 1991, its legal status has changed to that of a joint stock company. Its total assets of lei 428.6 billion at November 30, 1991, or 25.6% of the commercial banks' total assets, make it the largest bank in the system, but it ranks only third in domestic lending, with a portfolio of 18.9% of total credit from the banking system. RBFT's total assets of lei 428.6 billion comprised a loan portfolio of lei 170.1 billion (of which lei 54.4 billion in foreign exchange include non-performing loans of about lei 25 billion) and deposits with NBR of lei 137.5 billion. Liabilities included time and sight deposits of lei 105.4 billion (25% of total), foreign currency - 25 ^ deposits of residents - lei 24.1 billion (6%) and foreign liabilities of lei 133.1 billion (31%) - lei 44.0 billion in convertible and lei 89.1 billion in non-convertible currencies. 4.22 Currently, RBFT has six branches and plans to open about 10 new branches in the medium term. Its total staff numbers around 1,025 employees. RBFT has entered into five joint ventures with foreign banks/financial institutions, three of which have branches in Bucharest. The objective of R8FT is to continue to exploit its position as the bank specialized in foreign exchange transactions while diversifying into other banking services. 4.23 Romanian Savings Bank. CEC, established in 1864, is a state-owned savings bank, mobilizing deposits from the population and channelling the bulk of its resources to other banks to finance their lending operations. Total assets, at as November 30, 1991 amounted to lei 326.7 billion, making it the third largest bank in Romania. However, about 84% of its assets consisted of interbank loans (lei 275.3 billion), whilst CEC's loan portfolio stood at lei 45.4 billion, consisting of housing loans only. CEC is a major source of fui:ds for AB financing about one-third of AB's loans as of above date. CEC liabilities consisted of sight and time deposits of lei 241.3 billion and a Government pension fund of lei 58.8 billion. Given the highly negative interest rates in real terms paid on deposits in 1991, CEC's deposits steadily decreased, from lei 268.5 billion at the beginning of 1991 to lei 241.3 billion at the end of November 1991. 4.24 CEC total staff numbers about 13,000 and it has the most extensive branch network, with a total of about 2,600 branches. In addition, until recently 2,800 post officws and 776 credit cooperatives have also served as proxy branches of CEC. However, following the establishment of the new Post Bank, which opened for business in January 1992, post offices will no longer serve CRC and the Post Bank could become a strong competitor in mobilizing savings from the general public and providing credit for consumer goods and housing. E. Other Domestic Banks 4.25 The Coolperative Credit Bank (Bankcoon). In 1990 the Union of Consumer Cooperatives and the Union of Credit Cooperatives decided to set up Bankcoop, a private commercial bank to be owned partially by the Romanian consumer and credit cooperatives and partially by private shareholders. The bank was officially registered in September 1990 and opened for business in December 1990. The shareholders are 1,200 consumer cooperatives (52%), around 600 credit cooperatives (20%), the State Insurance Company (ADAS) (4%) and private individuals (24%). The Bucharest branch of Bankcoop was opened in December 1990; it currently has 41 branches and 50 sub-branches, planning to open an additional 40 sub-branches by June 1992. Bankcoop's staff numbers approximately 2,000. 4.26 Bankcoop intends to operate as a full service commercial bank. It accepts deposits although its principal depositing customers will be the consumer and credit cooperatives which are its main shareholders, but Bankcoop will also serve private individuals and provide current and savings accounts - 26 - services. On the lending side Bankcoop will concentrate on supporting small businesses throughout Romania in the agricultural, service and light industry sectors, competing with AB and CB. The future prospects for Bankcoop appear promising although the new bank is likely to find itself constrained in its ambitious expansion plans by the scarcity of trained banking staff. 4.27 At the end of November 1991, Bankcoop's total assets amounted to lei 30.2 billion and its total loan portfolio stood at lei 23.5 billion. Liabilities comprised sight and time deposits of lei 11.6 billion and borrowing from NBR - lei 14.6 billion. In the medium term Bankcoop could develop sufficiently to become an intermediary for Bank funds, although at present it is too small and weak to fulfill that role. 4.28 The Romanian Credit Cooperatives. In Romania there are around 835 small 'credit cooperatives' which function as mutual funds for the benefit of their members. Each is independently constituted, with its own funds provided from members' contributions as part of its capital and by deposits, has its own balance sheet and management. On average each credit cooperative has around 5,000 members, of whom approximately one-third are borrowers. Loans are granted mostly to meet the personal needs of members (consumer durables, weddings, etc.) although in the countryside some loans are also made to purchase livestock, seeds, etc. Loan collections of the credit cooperatives have been good, as members' loan repayments are usually deducted from their monthly salaries and community pressure within the villages ensure that tardy borrowers pay up. Up to now the lending capacity of any credit cooperative has been limited strictly to its own mutual fund, with no borrowing permitted from external sources. This has effectively restricted lending to any individual member to a low multiple of his contribution (up to 3.5 times) and inevitably leads to lengthy waiting lists of potential borrowers. The Romanian credit cooperative system comprises around 4,500,000 individual members, of whom around 1,600,000 are borrowers. Total assets of the system were lei 10.7 billion at December 31, 1990 of which lei 8.7 billion comprised loans to cooperative members and lei 1.2 billion deposits with banks. Most of the bank deposits were with AB, CEC and CB, but as Bankcoop extends its network some of the deposits of the credit cooperatives are likely to be transferred to the new institution. In the long run it would probably be beneficial for the Romanian banking system if many of the credit cooperatives were absorbed by Bankcoop. However, initially, Bankcoop does not want to force the pace. The management of Bankcoop feels that if the bank grows successfully, some of the credit cooperatives may seek to merge, whilst others will prefer to remain independent. F. Financial Intermediaries under the Prolect 4.29 At present, three of the commercial banks (AB, DB, CB) are actively involved in financing investments in agriculture and agroindustries and have expressed interest in participating in the proposed project. Because of their present financial statue, only two of these banks, AB and DB, will act as Financial Intermediaries (FIs) under the project (para 6.06). At present, financial plans are being prepared to improve the capital structure and operational efficiency of these institutions. In this regard the Bank is prcviding Institutional support on lending operations to AB and DB under - 27 - preparatory facilities with Japanese Trust Fund financing while auditing training and computerization is being financed by EC-Phare. If, in the course of the next three years, before the cutoff date for commitments expires, another bank becomes qualified for project participation, the Bank will consider amending the loan documents to allow its participation. V. THE PROJECT A. Proiect Obiectives and Rationale for Bank Involvement 5.01 Proiect Obiectives. The objective of this project is to support private sector development in rural areas and through this, raise agricultural output, increase efficiency of production, generate employment and improve standards of living. The project aims to achieve this through financing credit to private farmers and other private businesses for (i) on farm investment in order to increase production; and (ii) the establishment and expansion of private rural SMEs in order to improve input supply and marketing services and increase business activity. The project has close policy links to two other Bank operations, the SAL which has been recently appraised and the proposed FESAL, currently under preparation. 5.02 Major problems in agriculture result from (i) the lack of investment over the past decade; and (ii) the total upheaval of the structure of the sector into units for which much of the present equipment and technology is inappropriate. Because of these, both substantial investment and radical changes in support systems will be required to get the sector 'on track.' This project addresses the critical investment constraint. Through provision of credit and associated foreign exchange directly to private agriculture and other private rural SMEs the project will help alleviate the financial resource bottleneck. As indicated earlier (paras 2.19 and 3.13), technical assistance activities designed to address the second of these problems are being undertaken mainly by EC-PHARE and cover (i) strengthening of the key FIs to ensure sound appraisal of agricultural and related projects; (ii) policy analysis within MAFI, thereby keeping in focus the need for liberalized prices and unrestricted access to key inputs; (iii) the need for specific management advice within the new farmers associations thereby helping ensure well-directed investments; (iv) the framework for an improved agricultural information system for the long run benefit of the whole sector; and (v) improved market information by introduction of a system within the Ministry of Trade which would benefit producers, intermediaries and consumers by making prices transparent and so increasing market efficiency. 5.03 Regardless of its precise level of growth, the agriculture sector will remain a vital and major part of the Romanian economy. Given that there is very little practicable opportunity for substitution of labor for capital in many agricultural tasks, substantial reinvestment will be needed annually to maintain an acceptable level of mechanization. The sector will also require investment to respond to the changes in unit size resulting from decollectivization. Furthermore, the removal of restrictions on private investment and the set of market based incentives now facing small and medium - 28 - sized enterprises (SMEs) in the rural areas is likely to generate substantial investment demand by emerging businesses in marketing, services and processing. Because of the high value added in this latter group of activities, the bulk of project resources would be oriented towards them. This proposed project recognizes the likely investment needs of the rural sector and the challenges to be met in the successful implementation of the reform process in Romania. 5.04 Rationale for Bank Involvement. The country economic memorandum (CEM) and subsequent sector work as well as the preparation and appraisal of this project have confirmed that agriculture is likely to remain an important sector in Romania in the long run, and in the short term it has tl potential to be an important engine for growth. Key areas for early action t.o rehabilitate agriculture include (i) the strengthening of the rural financial intermediation system; (ii) the elimination of agricultural production and marketing monopolies; (iii) price and agricultural trade liberalization; and (iv) the prompt implementation of the land privatization law. Bank intervention in these areas is proposed within the framework of a medium-term strategy aimed at continuing privatization of the sector and at promoting stability, production efficiency and profitability. Policy and institutional issues in most of these areas are being addressed by the proposed S*L, particularly with regard to fiscal and agricultural trade liberalization, demand management, reforming of enterprises, and completion of the land reform. In addition, the Technical Assistance and Critical Imports Project, the preparation activities under the proposed FESAL and EC-PHARE are providing support for the implementation of the medium-term agricultural strategy in the areas of restructuring and strengthening of the commercial banking system. 5.05 Government is deeply committed to developing the agricultural sector and is keenly aware of its economic potential. However, as a result of the liberalizations of prices over the past eighteen months and unification of the exchange rate and the concern for the impact of these on the cost of living, a system of low fixed consumer prices and corresponding subsidies has been introduced as a transition measure. Partly as a result of this, it is not practicable to expect an immediate movement towards fully liberalized trade and consequently distortions in financial prices and signals are expected to continue in the short term. In the longer term, Government is fully wedded to the goal of stable undistorted financial prices, and the SAL Letter of Intent indicates this. Specific SAL goals are to gradually eliminate subsidies by 1993 which should allow the liberalization of farm gate prices. In thio regard, within the framework of the SAL, Government has undertaken to carry out a study of prices and subsidies and has Invited the Bank to participate in a study of the agricultural sector with a view to coming up with policies which would lead to continued sectoral growth. Against this background, it can be expected that in the medium term, financial prices will become close to economic prices. In the meantime however, some distortions can be expected. The project would address this by initially excluding investments in likely nonviable subsectors (para 5.08). 5.06 The PFESP will be the first important Bank operation to assist the Government to implement a strategy for agricultural and rural development aimed at transforming the sector into a predominantly private and market-based - 29 - economy. Through the PFESP, the Bank would help the privatization process by directly supporting financial assistance to the beneficiaries of the new Land Law and other newly formed private businesses. B. Summary Proiect Description 5.07 To achieve the above objectives (para 5.01) the project would support the following activity: Credit Proaram. The project would provide credit (proceeds of US$100 million equivalent Bank loan plus internally generated funds) for much needed investment and incremental working capital in viable private rural enterprises within subsectors for which the broad economic viability has been predetarmined. C. Detailed Features 5.08 The loan would finance Private investment in viable agricultural and cther rural businesses. At least 80% of the loan proceeds would E:inance private agroprocessing and agricultural marketing activities while no more than 20% would be available to finance primary produ_tion. It can be justified by considering that under present inflation and in the process of gradually dismantling public agricultural enterprises there is higher profitability and there are more active entrepreneurs in these commercial activities than in primary production. As regards primary production, it is intended to be wide ranging and demand-led within those broad subsectors which are currently assessed to be economically viable. Investment in ineligible subsectors identified to be nonviable because of poor potential economic returns or problems of long gestation period at a time of high interest rates, would not be eligible under the project. Investment in ineligible subsectors which would be reviewed semiannually by the Bank and the borrower, provides for exclusion of lending in sugar beet, tobacco, orchards, vineyards, large- scale intensive poultry production, certain types of pig production, and large-scale intensive milk and beef production (see Annex 3 for details of ineligible subsectors). The loan would cover both investment items and incremental working capital ($10 million). Financing of the latter would cover working capital needs associated with and deriving from the financing of investment under the loan. It is estimated that incremental working capital financing would require about 10% of the loan proceeds. Funds would be made available to partially finance expenditures by private individuals, farmer associations or private companies in the following indicative categories: (a) processina of acricultural Products, particularly small- and medium-scale investment to increase value-added in the rural areas; (b) marketina and trade of aaricultural oroducts, especially for transport, wholesaling and retailing of both agricultural outputs and inputs including inter alia pickup trucks, cold storage and freezer facilities, holding & handling equipment, shop fitting and other facilities for food and agricultural product retailing; - 30 - (c) other rural businesges such as transport, agrotourism and other activities or services which contribute to the development of private initiative in rural areas; and (d) aaricultural production covering a wide range of products, but excluding those in ineligible subsectors predetermined as unlikely to be economically viable (Annex 3). Subsectors financed would include certain types of livestock, most types of crop production, and the provision of agricultural machinery and related services, including tractors and corresponding ancillary equipment. Aggregate lending under this component will be 20%. D. Proiect Cost and Financina 5.09 The estimates of investments to be supported by credit under the project are only indicative and based on Fla' estimated demand. Actual lending would vary in response to real market demand. Preliminary Bank estimates which have been agreed to by the Flo expected to participate under the project indicate a loan amount of US$100 million equivalent to be disbursed over a five year period. The loan would support an aggregate investment1/ of about US$165 million. Of this, about US$33 million is assumed to be on-farm investment with an estimated foreign exchange cost of 50%. The cost of the agroprocessing component of the project is estimated at US$58 million with US$35 million (61%) foreign exchange. The cost of the marketing, distribution and services component is estimated at US$74 million of which US$48 million (65%) is foreign exchange. The relatively small allocation for agricultural production investment credit is justified by the likelihood that it may take some time for inflation and interest rates to fall, thereby reducing the attractiveness of production investment relative to investments in marketing and services which typically have shorter pay back periods. The total investment financed under this project is likely to be only a small part of the country's agricultural investment needs, estimated at US$3 billion over the next four to six years. 1V Defined as total medium and long-term investment plus incremental working capital investment over the five-year main project period. - 31 - Table 5.1: ESTIMATED PROJECT COSTS /i Loai Forein frai Lkcal Foref an Totlat Percent CoMonent ---- Lef MilLionLt ----- - US$ Milion v. - Base Cost On-Farm Investment 3,300 3,300 6.600 16.5 16.5 33.0 50 20 Agricultural Processing 4,440 7,100 11,540 22.2 35.5 57.7 61 35 Marketing, Distribution and Services 5.200 9.6D0 14.800 2.0 48.0 74.0 6 Total 12.9J4 2.00 3.9.40 64.7 61 140 /a Based on total investment costs plus incremental fnvestment in working capital. Lb Based on lei 200 u USS1.00. Table 5.2s PROPOSED FINANCING PLAN (USS Mil
World Bank Group · Staff Appraisal Report
Romania - Private Farmer and Enterprise Support Project
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World Bank Group
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Staff Appraisal Report
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Romania
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World Bank