Kazakhstan - Rehabilitation Loan Project

Documaat of The World Bank FOR OFICIAL USE ON.Y Rept No. P-6123- REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT T THE EXECUTIVE DIRECTORS ON A PROPOSED REHABILITATION LOAN IN AN AMOUNT EQUIVALENT TO US$180 MII.ION TO THE REPUBLIC OF KAZAKESTAN AUGUST 25, 1993 MICROGRAPHICS Report No: P- 6123/id KK Type: PR 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. CURRENCY EQUIVALENTS Currency Unit = Rublc 1 Ruble 100 kepccks Period Average End of Period 192 Quarter I 102.4 100.0 Quarter I 94.6 100.0 Quarter Iff 177.7 254.4 Quarter IV 396.4 414.5 1993 Quarter 1 580.1 684.0 Quarter U 968.1 1060.0 Quarter HW 1/ 1019.0 987.0 1/ As of August 5, 1993 WEIGHTS AND MEASURES Metric System ABBREVIATIONS AND ACRONYMS CBR Central Bank of Russia CEM Country Economic Memorandum CIS Commonwealth of Independent States CMEA Council for Mutual Economic Assistance FSU Former Soviet Union FXC Foreign Exchange Component GDP Gross Domestic Product IBRD International Bank for Reconstruction and Development ICB International Competitive Bidding IMF International Monetary Fund LC Letter of Credit NBRK National Bank of the Republic of Kazakhstan PIC Pre-identified Imports Component PIU Project Implementation Unit SPC State Property Committee SOE Statement of Expenditures STF Systemic Transformation Facility TA Technical Assistance GOVERNMENT FISCAL YEAR January 1 - December 31 FOR OFFICIAL USE ONLY REPUBUC OF KAZAKHSTAN REHABILITATION LOAN Table of Contents Paee No. LOAN AND PROGRAM SUMMARY ....................................... i I. THE GOVERNMENT'S ECONOMIC PROGRAM ....... .................. 1 A. Recent Economic Developments ............................... 1 B. Economic Reform Policies and Objectives .......................... 4 C. Macroeconomic Stabilization .................................. 5 D. Structural Reforms ........................................ 6 II. THE REHABILITATION LOAN ................................... 13 A. Origin and Objectives .. ..................................... 13 B. Rationale for Bank Involvement ................................. 14 C. Project Description ......................................... 14 D. Implementation Arrangements . ................................ 17 E. Procurement ............................................ 17 F. Disbursement ............................................. 18 G. Project Accounting, Financial Reporting, and Auditing .................. 19 H. Agreements Reached ........................................ 19 I. Environmental Assessment ................................... 20 J. Benefit and Risks .......................................... 20 K. Recommendations .......................................... 21 ANNEXES Annex 1: Memorandum on Structural Reform Policies Annex 2: Selected Economic Indicators: 1990-94 Annex 3: Goods Which Would Not Be Financed Annex 4: Goods to be Financed under the PIC Annex 5: Implementation Arrangements Annex 6: The Foreign Exchange System Annex 7: Key Processing Events Annex 8: Status of Bank Group Operations Map: IBRD No. 23700R This document has a restricted distribution and may be used by recipienb nny in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. REPUBLIC OF KAZAKHSTAN PROPOSED REHABILITATION LOAN LOAN AND PROGRAM SUMMARY Borrower: Republic of Kazakhstan Amount: US$180 million equivalent Terms: 17 years, including 5 years grace period, at the Bank's standard variable interest rate. Objectives: The objectives of the Loan are: (i) to support the Government's reform program which is outlined in a Memorandum of Structural Reform Policies (Annex 1); (ii) to ease the shortage of foreign exchange needed to finance critical knports of inputs, raw materials and spare parts in key sectors, thus minimizing the further contraction of economic activity; and (iii) to support foreign exchange markets and allow the private sector access to foreign exchange. Description: The proposed Loan would finance imports in an amount of US$180 million, consisting of: (i) a foreign exchange market (FXC) component, in an amount of US$94 million, to support the access of enterprises to the foreign exchange auction market for financing imports through normal commercial practices; (ii) a pre-identified imports component (PIC), in an amount of US$86 million, would finance essential imports, procured through existing procurement channels working in accordance with Bank procurement procedures. The latter imports are required for the continued operation of essential public services and a recovery in critical productive sectors. Imports under the FXC are subject to a standard negative list. Benefits: The proposed Loan would allou increased capacity utilization and production in a number of vital sectors. The imports to be financed by the Loan would have direct output and employment effects and would ensure minimum availability of certain essential items, such as medicine and other health supplies. In some cases, critical imports of spare parts could also preserve existing capital assets and prevent a deterioration which would require considerable future investment. In addition, the Loan would increase the access to foreign exchange of companies operated on a commercial basis. Risks: The main risks include: (i) policy slippage or implementation bottlenecks in carrying out the reform program, (ii) further deterioration in the country's external situation due in particular to increased difficulties with trade and payment arrangements within the FSU, or because the external financing requirements would not be met; (iii) the possibility that in view of prevailing conditions, some of the imports financed by the project could end up maintaining activities and enterprises that are fundamentally not viable and should be left to -n- disappear; Pnd (iv) Kazakhstan's lack of familiarity with Bank procurement procedures, which could limit absorptive capacity and lead to significant delays. Close monitoring of economic performance and provision of policy advice and selected technical assistance will aim at alleviating the economic risk. Inexperience with procurement procedures will be mitigated by the establishment of a Project Implementation Unit, which will include procurement advisers. Close attention to procurement and other implementation constraints will be provided during project supervision, and through technical assistance. Cofinancing: Cofinancing on a parallel basis may be provided by the governments of Japan, Belgium and Austria. Financig Plan: FY 94 FY 95 (US$ million equivalent) IBRD 150 30 (foreign cost) Poverty Category: Poverty-focused; supports safety net reform. Map: IBRD 23700R REPORT AND RECOMMENDATION OF TIE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO YHE EXECUTIVE DIRECTORS ON A PROPOSED REHABILITATION LOAN TO THE REPUBLIC OF KAZAKHSTAN 1. I submit for your approval the following report and recommendation on a proposed Rehabilitation Loan (the Loan) to the Government of the Republic of Kazakhstan for the equivalenm of US$180 million in support of a program of macroeconomic stabilization, systemic and structural reforms. The Loan would be at the Bank's standard variable interest rate, with a maturity of 17 years, including five years of giace. Cofinancing on a parallel basis is expected from Japan, Belgium and Austria. 2. The Republic of Kazakhstan joined the IMF on July 15, 1992 and the World Bank on July 23, 1992. An economic mission visited Kazakhstan in April 1992 and a draft Country Economic Memorandum (CEM) was distributed in November 1992. PART I. THE GOVERNMENT'S ECONOMIC PROGRAM A. Recent Economic Developments 3. Polic n The early steps towards economic restructuring in Kazakhstan were initiated before the dissolution of the Soviet Union. Key steps included (i) the larger autonomy extended to state enterprises under the Law on State Enterprises of 1987; (ii) the devolution of substantial fiscal autonomy to the republics of the FSU in 1990; and (iii) the adjustment of administered prices in January and April 1991. But, although initial steps had been taken already , the economic reform process in Kazakhstan was greatly accelerated following the declaration of independence in December 1991 and the widespread price liberalization in January 1992, in the wake of a similar move in Russia. By mid-1993, significant progress had been made on defining and starting the implementation of a comprehensive reform agenda. The centerpiece of this program is the rapid privatization of the economy. In this spirit, a comprehensive privatization program, developed by the State Preperty Committee (SPC), in coordination with the Bank, was approved by the President in March of this year. 4. The Government's program reflects a desire to maintain political sustainability in the transition. Aware that sharply rising unemployment, plant closures and sstained drops in the standard of living could increase political resistance to reform, and could derail the reform agenda, the Government has opted for a pragmatic approach to market transformation. In order to maintain social cohesion and foster the mandate to press ahead with economic reform, the Government recognizes that it must also deliver growth and employment. Increasing attention is therefore being given to eliciting the desired supply response and promoting the emergence of new growth centers as quickly as possible to absorb unemployed resources, particularly labor. 5. tek Rfor . The turning point of the reforms was the liberalization of prices of most goods and services in January 1992, and the parallel adjustment of administered prices (mainly basic food, rents, energy and essential public services, covering about 20 percent of consumer goods) in -2- January, June and October of that year. Petroleum product prices were frrther adjusted in May 1993 to reflect a near doubling in the import price of Russian crude oil. 6. Paralleling price reforms, the state gradually withdrew from trade. In 1992, the country's system of "state order" ("goszakaz"), introduced in late 1991 to replace the dying Union-wide system, still covered the bulk of output. It proved next to impossible to operate however. Therefore, a much less ambitious "state needs" system ("gosnub") was put in place to handle mainly the procurement of goods for the use of the government, the army, defense industries and the fulfillment of bilateral trade agreements. Under this new system, enterprises and individuals are, in principle, free to trade domestically or internationally, and procurement for "state needs" is to take place at freely negotiated prices. 7. The transition process gained momentum through the recognition of private prope:.y. Some initial progress was made towards privatization, albeit slow and lacking in transparency. It is estimated that by the end of 1992, about 20 percent of all enterprises, representing about 12 percent of total employment, had some form of private sector participation and that about half the housing stock had been transferred into private hands at the initiative of local administrations. The development of the private sector is being encouraged through extensive legal reform and institution building. The new Constitution, adopted in January 1993, establishes the legal basis for private ownership and other legislation has been enacted, inter alia, on companies, pledges, leases and bankruptcy. 8. Output and hflon. As in the case of other FSU republics, the transition to a market economy has been accompanied by many difficulties, whic the disruption of trade and payments intensified. Kazakhstan was not insulated from the inflation that swept through the ruble zone. Following decades of price stabiity, consumer prices increased by about 150 percent in 1991, then rose more than 25 times during 1992. Prolonging the trend of the last quarter of 1992, monthly inflation rates increases remained as high as 30 percent during the first four months of 1993, before declining to about 15 percent a month in May-June 1993. Not unexpectedly, price decontrol against the background of a sizable monetary overhang and monopolistic market structures generated a step change in the price level. But the monetization of large budget and quasi-budgetary deficits in Russia, and to some extent in the country itself, was the main fuel to a continuous surge in inflation throughout the ruble area. 9. Over the 1990-92 period, the country suffered a cumulative decline in output that amounted to about 30 percent in real terms. Demand was negatively affected by a steep fall in investment expenditures, depressed consumption levels reflecting the decline in real wages and wealth, and by a cutback in defense outlays throughout the FSU. Furthermore, the collapse in foreign trade which followed the dissolution, first of the Council for Mutual Economic Assistance (CMEA), and then of the Soviet Union, the absence of free transferability of non-cash rubles between republics, and the elimination of state orders, all disrupted the established supply and marketing arrangements. Their effects were magnified by the extreme integration of FSU production. 10. Labor and e. Employment declined less rapidly than output during 1992-93, with unemployment (registered and unregistered) reaching less than 3 percent of the labor force by mid-1993. Labor retention was made possible by (i) real wage cuts caused by the lagged adjustment of wages to -3- acceerating hitflation'; and (i) relatively easy access to bank financing. With the minimum wage reduced at the end-of-1992 to only about 20 percent of its end-of-1991 level in real terms, wage differentials widened considerably. 11. Pun . The government has endeavored to restore its fiscal situation in response to the loss of Union transfers. This restrictive fiscal stance was maintained despite the enormous strains caused by the loss of implicit taxes that accompanied price liberalization, and social pressures to shield some sectors and segments of society from economic hardship. During the last years of the Soviet Union, when fiscal operations were parts of the larger USSR budget, Kazakhstan's fiscal situation deteriorated considerably. Overall deficits rose from 3 percent of GDP in 1985 to over 10 percent of GDP in 1990. These were covered by Union transfers. With national independence, these transfers were lost. Faced with this situation, the authorities succeeded in reducing the overall deficit (excluding grants but including the country's share of the FSU debt) to about 7 percent of GDP in 1992 from 12.4 percent in 1991. This allowed a reduction in domestic bank financirg from 8 percent of GDP in 1991 to 1.1 percent in 1992 (the remainder of the deficit was financed by an accumulation of arrears, mostly domestic). 12. The reduction of the deficit was achieved despite a continuous erosion in fiscal revenues: the latter (including social security contributions) dropped from 30 percent of GDP in 1991 to only 23 percent in 1992 due mainly to a drastic erosion of the tax bases (state enterprise profits, real wages), pressures for tax exemptions and crippling collection difficulties (widespread evasion, including through barter, lack of familiarity with new and constantly changing tax rules). It is hoped, however, that over time measures already taken in 1992, such as the introduction of VAT, excise taxes and customs dutie, as well as the reform of the income taxes, will be instrumental in reversing this trend. 13. Expenditures have therefore had to bear the brunt of the adjustment: they peaked at 41 percent of GDP in 1991, after a new pension system was introduced, than declined precipitously to about 30 percent of GDP in 1992. This reflected (i) cuts in excess of 50 percent in real terms in the investment budget; (ii) the drastic reduction in subsidies; and (iii) severe reductions in civil servants' pay and pensions following the evolution of the minimum wage. 14. MoW and Credit. Monetary developments have been determined by Kazakhstan's continued participation in the ruble zone: the expansion of domestic credit and liquidity has remained largely based on National Bank of Kazakhstan (NBRK) refinancing, itself based on C mtral Bank of Russia (CBR) credit and deliveries of currency.2 Credit expansion was thus restrictive in early 1992 and turned highly expansionary during the second semester of the year and first quarter of 1993. Despite a multiplication of commercial banks, the number of which had reached 180 by now, credit has continued to a large extent to be administratively allocated and channeled through the four largest banks, which make up for 75 percent of bank assets. NBXtK refinance rate, however, was raised to 65 percent in July 1992, as the CBR rate had moved to 80 percent, and was again adjusted to 110 then 140 percent in July 1 In December 1992, averag real wages were about 10 percent higher than a year before, but for the year as a whole, they had fallen by 30 percent compared to 1991. In spite of nominal adjustments, average wages lost about 20 percent in real terms between December 1992 and May 1993. 2 The country has periodically experienced severe currency shortages, when currency deliveries were rationed by CBR, such as in the first part of 1992 and mid-1993. -4- 1993 as the CBR rate was moving to 170 percent. But this rate affected only about 20 percent of its lending, the remainder being extended at preferential rates ranging from zero to 25 percent. Progress was made however towards financial liberalization with, inter alia, (i) the introduction of credit auctions, starting from the last quarter of 1992; (ii) the elimination of restrictions affecting the intermediation margins and the deposit basis of commercial banks; (iii) the adoption of new commercial and central bank and foreign currency legislation; and (iv) the implementation of tighter prudential rules regarding capital adequacy requirements, creditor exposure and credit to shareholders. 15. External Tnsacin. Reflecting the disarray in interstate trade and payment arrangements, Kazakhstan has experienced a contraction in the volumes of external trade since the beginning of the decade, a redirection of transaction towards non-FSU countries and a widening of the current account gap. Ever since the breakup of the FSU, interrepublican trade has been plagued with payment problems, due to crippling difficulties in routing payments through the centralized correspondent accounts of CBR. Until the end of 1992, external trade remained dominated by, and subject to the vicissitudes of, the operation of the "state orders" system with FSU countries. Under this system, imports from FSU countries, primarily Russia, held steadier than exports, causing the FSU current account deficit to widen to over 10 percent of Kazakhstan's GDP in 1992. The deficit was financed in large part through Kazakhstan overdraft on its correspondent account at CBR. Exports also shifted in part to non-FSU markets, illowing a closing of the current account deficit with that area. While access to imports is relatively free, exports remain subject to an intricate system of export licenses and quotas, surrender requirements and export taxes. The external situation is expected to change dramatically in 1993 with the current account deficit with the FSU shrinking as access to CBR resources is reduced, while the non-FSU balance moves into deficit. B. Economic Reform Objectives and Policies 16. Following the euphoria of independence and rush to dismantle the Soviet command system, the authorities were confronted with the realities of the economic and social transition in the second half of 1992. In response to the realization that a market system will not emerge overnight, and the need to redefine the role of the state the authorities began grappling with the complex and difficult task of phasing the transition to a new market-oriented economy. 17. The Government's economic reform program has two key elements. First, the development of a macroeconomic framework which will stabilize the economy, reduce inflation and renew growth in the economy; and second, the implementation of structural and sectoral reforms designed to promote an early supply response. Key elements of the structural reforms include: (a) Enterprise reform, including privatization and better governance of State-owned enterprises expected to remain in state ownership; (b) Creation of an incentive framework to foster private sector development, including promotion of foreign direct investment and dismantling monopolistic markets through increased competition; (c) Reform of the financial sector to support both enterprise restructuring and development of the private sector; and, -5- (d) Establishment of an adequate social safety net to prevent further vulnerable groups from falling below the poverty line, safety net under which spending is targeted to the most vulnerable groups and is consistent with the budget constraints imposed by stabilization needs. 18. The Government's sectoral policies are focused on the development of energy, and mining and metallurgy sectors which are expected to provide a rapid supply response and generate critical export earnings during the early stages of the transition. Given the importance of a steady food supply and the sector's export potential, the 03overmnent is also placing emphasis on the development of the agricultural sector. However, as yet there is no clear and agreed strategy for the development of this sector. Attention is also being given to infrastructure development, particularly telecomr,munications and transportation, to support export expans, And speed integratien into the world economy. C. Macroeconomic Stabilization 19. Kazakhstan's immediate objective has been to reduce inflation and attain macroeconomic stability. Although Kazakhstan authorities and the IMF were engaged in discussions for several months in late 1992 and early 1993, outstanding monetary and, to a lesser extent, fiscal issues prevented the conclusion of a regular stand-by agreement. With the creation of the Fund's Structural Tran.formation Facility, however, it became possible. for Kazakhstan to have access to IMF resources. An STF agreement was approved by the IMF Board on July 23, 1993. It is expected that this STP agreement will lead to a regular Stand-By Agreement. 20. While significant steps have already been taken in the fiscal area, the Government intends to further tighten its control over the budgetary situation. The 1993 budget contains expenditure cuts, as well as measures designed to broaden the tax base and improve collection. Actions are needed to compensate for the elimination of transfers from Russia and also to counteract the revenue erosion ste,nming from the expansion of the informal sector and the increasingly autonomous behavior of state- owned enterprises. The Government must also tackle the difficult question of reducing substantially the large contingent liabilities and implicit subsidies throughout the economy. While reassertion of state property rights and improved corporate governance of state entities should decrease financial demands on the budget and reduce the quasi-fiscal deficit resulting from directed credits for state owned enterprises, policy initiatives in this area will need to be consistent with the overall macroeconomic framework. 21. The STF program agreed with the Fund embodies major steps toward financial stabilization. The primary objectives of the program are to limit the further fall in output in 1993 to about 7 percent and to stabilize output next year while reducing inflation to a 5 percent monthly rate by the end of this year. In addition, the balance of payments is to be strengthened and official external reserves increased. While the focus of the program is on the last half of 1993, the objective is to lay a sound basis for a continuing effort in 1994 which could be supported by an upper credit tranche stand-by arrangement. The program states that, "as a precaution in case financial policies and monetary arrangements in the ruble area fail to restore price stability, the Government will continue preparations for the introduction of a national currency." 22. Restrictive fiscal and monetary policies during the balance of 1993 are designed to support the target for reducing inflation. The overall fiscal deficit in 1993 is targeted at about 6 percent of GDP with domestic bank financing not to exceed 4 percent of GDP. An important element in the fiscal -6- program is the strict limitation of all bdgetary trfnsfers and subsidies (including the social safety net) to about 5.1 percent of GDP. Although th. specific program remains to be worked out, the levels of the deficit, domestic bank deficit financing, and total transfers and subsidies, are all to be further reduced in 1994. The achievement of the fiscal deficit targets for 1994 is to be supported by further reform and streamlining of the tax system, in particular reductions In tax exemptions and the reform of taxes of natural resources. 2j. While recognizing that a necessary condition for stability may be a separate currency and monetary policy, the Government has so far chosen to remain in the ruble zone. This has been motivated primarily by Kazakhstan's political relationship with Russia. Further, this position has been adopted in the hope that credits from Russia continue to be available through these monetary arrangements, even though the terms may be more onerous, as long the country is unable to fully meet its foreign financing needs from other sources. 24. As long as Kazakhstan remains in the ruble area, NBRK will need to align its policies with those of CBR. Although adjustment of the NBRK's refinance rate is expected to follow that of CER with a lag, this will still involve a massive increase in interest rates in Kazakhstan. Consequently, NBRY raised its refinance rate from 65 percent to 140 percent in July 1993, and further increases are expected as the CBR's refinance rate reached 170 percent in mid-July. In addition to the higher refinance rate, an increasing portion of NBRK credit to commercial banks will be auctioned. The proportion of new credit (excluding credit to the Government) to be auctioned will be expanded from 20 percent in the last half of 1993 to 35 percent and 50 percent, respectively, in the first and second quarters of 1994. The overall expansion in the NBRK's net domestic assets is to be held to an average of less than 7 percent monthly during the last quarter of 1993 (compared to the 34 percent monthly average rate of expansion in the first quarter of the year). 25. On the basis of the output, inflation and exchange rate assumptions of the STF program, the external current account deficit would amount to US$1.15 billion (60% of which is with other republics of the FSU), equivalent to 6.4 percent of Kazakhstan's GDP. Kazakhstan and Russia are expected to reach formal agreement on the "zero option" (under which Russia takes over Kazakhstan's share of the international liabilities and assets of the USSR). Consequently Kazakhstan's "inherited" debt burden is small, and the projected 1993 current account deficit, followed by a deficit of a similar dollar magnitude in 1994, should not give rise to balance of payments and debt management problems. As of April 1, 1993, the net official foreign reserves (including gold) of the NBRK were about US$139 million - equivalent to approximately two weeks of estimated imports (including those from the FSU). The STF program calls for increases in net official reserves to US$318 million by December 31, 1993. D. Structural Reforms 26. Kazakhstan's broad approach to structural reform is set forth in the Government's Memorandum on Structural Reform Policies which has been submitted to the Bank, see Annex 1. Specific, time-bound steps to implement this structural reform program have also been agreed and attached to the Mran du. This "Plan of Action for Implementing Selected Structural Reforms" is also shown on the next two pages. The Memorndum focusses on five areas of structural reform: (a) price, subsidy and trade policies; (b) privatization and the reform of state enterprises, (c) developing a competitive private sector, (d) financial sector reform, and (e) social protection. -7- PLAN OF ACTION FOR IMPLEMENTING SELECTED STRUCTURAL REFORMS (Annex to "Memorandum on Structural Reform Policies'] A. Price. Subsid and Trade Policies 1. Adjust administered prices of subsidized goods to reduce subsidies (by beginning of 1994). 2. Price controls on fodder to be eliminated by October 1994. 3. Prices for petroleum and other energy products to be raised to border levels as of the beginning of 1994. 4. Beginning in 1994, the Government inteands to eliminate over a three-year period the remaining subsidies for public utilities consumed by householders: this will be done in parallel with strengthening targeted support for vulnerable groups suffering the negative consequences of the increase in tariffs. 5. Total transfers and subsidies in the State Budget to be limited to 5.1% of GDP in 1993, and farber reduced in 1994. 6. NB1tK to cease providing credit at preferential rates, and any interest rate subsidies to be included in the budget (effective beginning 1994). 7. Reduction of number of commodities under export quotas, and increase of not less than 20% in quotas for those commodities remaining under quotas (by September 1993). 8. A uniform import tariff of 15 percent will be introduced on non-CIS impotts by October 1993, with exemptions limited to basic food items and medicines. 9. State procurement to fulfill bilateral trade agreements to be at freely negotiated or market prices (effective beginning of 1994). B. Privatization and Reform of ta Enterprses 1. All enterprises engaged in retail and wholesale trade, and related trucking and distribution, to be offered for sale before the end of 1994. 2. Distribution of investment coupons for Mass Privatiation to be completed by end of 1993. 3. Conversion of medium and large enterprises included in Mass Privatization Program to joint stock companies by March 1994. 4. Mass Privatization Program targets are for privatization of 30 percent of assets of non-agricultural medium and large enterprises by March 1994 and 70 percent of assets by March 1995. S. Selected very large and special enterprises are to be privatized on a case by case basis, wIth 10 offered for sale by March 1994 and another 10 by March 1995. 6. Government to prepare administrative guidelines, and to submit draft legislation to Parliament at its first session in 1994. on strengthening governance and management of enterprises expected to remain in the public sector. 7. Ministries of Finance and Economy, and the State Propery Committee, to develop an approach to adjustaent assistance for state enterprises, which will be implemented as part of the 1994 State Budget, and which will (as capacities for preparing and reviewing restructuring plans are developed) condition financial assist. to large enterprises on the preparation and implementation of satisfactory resmacturn plans. 8. Effective with the 1994 budget, all forms of direct Government financial assistance (including tax exemptions) to individual enterprises are to be included in the consolidated budget (State Budget and extra-budgetary funds). -8- C. Developing a Competitive Private Sector 1. Anti-Monopoly Committee will prepare revisions to existing legislation, for submission to Parliament at the Fall 1993 and Spring 1994 sessions, to strengthen the legal framework for control of abuses of monopily power, for *fair trade* and for protection of consumer rights. 2. Revised administrative gaidelines for the implementation of the anti-monopoly legislation will be prepared by June 1994. 3. Completion by March 1994 of a review of obstacles faced by private entrepreneurs in commercial and industrial activities, with recommendations ror administrative measures and legislative actions to overcome these obstacles. 4. Take measures, by end June 1994, to improve access to commercial real estate by private firms, including measures to increase the supply of, provide transparent access to, and secure long-term rights on commercial real estate. 5. Complete by June 1994, a study with recommeno.tions for reforms of tax law and administration that would support private sector development (but still be consistent with revenue requirements). 6. Submission to Parliament before December 1993 of a new law on foreign investment which will provide for equal treatment for foreign and domestic investors. D. Financial Sector Reform I. Increase the proportion of new NBRK credit which is auctioned from 20 percent in the last half of 1993 to 35 percent in the first quarter and 50 percent in the second quarter of 1994. 2. Introduce, by end 1993, a strengthened regulatory framework for commercial banks and a tightening of licensing requirements for new banks (so new banks should be able, in time, to meet international banking standards); introduce, by the same date, a revision of capital requirements for all banks (which will at least adjust for inflation). 3. Completion of an audit of the NBRK and in depth financial and operational diagnostic studies of the ten largest banks by March 1994. 4. Completion of studies and recommendations on the development of term lending facilities, and on restructuring the commercial banking system, by June 1994. E. Social Prolection 1. The Government will complete an analysis of the income and expenditures for social protection, for individual funds and for each level of government, under alternative assumptions on employment and unemployment, wage rates, benefit levels (including gradually increasing the retirement age), inflation, and other relevant factors. A preliminary analysis will be available September 30, 1993 (in time to serve as an Input for the 1994 budget); the final report and recommendations will be available by the end of 1993. 2. The Government will undertake a study of the social services now provided by enterprises which, with the commercialization and privatization of enterprises, would in the future be more appropriately provided by local authorities (or other levels of government). Recommendations will be made covering the social services to be transferred and how, in the future, they should be financed. The study and recommendations should be completed by end March 1994. -9- 27. Price. subsidy and trade poliies. Administered prices of petroleum products were doubled in May 1993 to pass through to consumers a similar increase in the price of oil imports from Russia. The authorities envisage further measures to complete the reform of price and trade policies. These would foster both short-term financial stabilization and longer-run reallocation of resources along efficient lines. Such measures involve: (i) adjusting administered prices to reduce subsidies, at the start of 1994; (ii) moving petroleum and other energy prices to the level of border prices at the beginr* g of 1994; (iii) limiting total budgetary transfers and subsidies to 5.1 percent of GDP in 1993; (iv) aboihing NBRK credit at preferential rates and including any interest rate subsidies in the budget; (v) increasing remaining export quotas by no less than 20% by September 1993; and (vi) introducing a uniform import tariff of 15 percent on non-CIS imports by October 1993, with exceptions limitel to basic food items and medicines. 28. Furthermore, the Government indicated that, beginning in 1994, it will eliminate over a three-year period the remaining subsidies for public utilities consumed by householders. This is to be done in parallel with strengthening targeted support for those vulnerable groups that suffer negative consequences from the increases in utility tariffs. It is also understood that, effective in 1994, all state procurement to fulfill bilateral trade agreements will be at freely negotiated or market prices. In addition, price controls on, and the accompanying subsidies for, fodder are to be eliminated by October 1994. With the elimination of price controls on fodder, the only goods that will continue to be under administrative control will be bread, some qualities of flour, baby food, imported medicines, and energy products. In addition to these goods, only public utility and public transport tariffs and housing rents will still remain under administrative controls. 29. Privatisation and Reform of State Enterprises. The privatization program recently approved by the President is expected to accelerate the pace of reform in this field. The program envisages: (i) the rapid sale of small-scale-enterprises such as shops and restaurants, through municipal auctions or tenders of assets, with concurrent measures to ensure competition in wholesale and trucking through segmentation and auctions; (ii) the mass privatization of medium- to large-scale-enterprises after prior corporatization as wholly state-owned enterprises, through the auctioning of the majority of shares to private investment funds, in which Kazakhstan's citizens will invest non-material, points denominated privatization coupons; and (iii) the privatization of very large enterprises on a case-by-case basis, sometimes with prior restructuring and changes in the regulatory framework.Implementation of this program has started. The privatization of very large enterprises began in July 1993 but will be a long process over many years. The mass privatization program was also initiated in July 1993 with establishment of the investment funds in July 1993, opening the way for the distribution to the population of privatization vouchers, starting in September 1993, distribution which should be substantially completed in the second half of 1993; mass privatization could technically be implemented over 2-3 years. As indicated in the Memorandum, the Government's targets for the privatization program are ambitious. All enterprises engaged in retail and wholesale trade, along with related trucking and distribution activities, are to be offered for sale before the end of 1994. Under the Mass Privatization Program, 30 percent of the assets of non-agricultural medium and large enterprises are to be privatized by March 1994, and 70 percent of these assets are to be privatized by March 1995. In parallel to privatization, the Government envisages a three-pronged approach to reform those enterprises which for the time being will remain in the state sector: aimed at improving corporate governance of state enterprises; hardening budget constraints by making subsidies explicit and phasing them down rapidly; and undertaking restructuring. To strengthen governance, medium and large scale state enterprises are to be rapidly corporatized as joint stock companies with proper legal status, property rights and functional boards of directors established. Moreover, the State Property Committee (SPC) envisages introducing a system to monitor, assess, and -10- stimulate the financial performance of state enterprises. The SPC is to exercise the state's remaining ownership rights, and will only delegate effective ownership back to sectoral ministries in cases where important regulations cannot yet be enforced at arms' length. As indicated in the Memorandum, the Government is to prepare administrative guidelines, and to submit draft legislation to Parliament at its first session in 1994, on strengthening governance and management of enterprises expected to remain in the public sector. 30. Reform of the financial sector and the phased reduction in state financial assistance to the enterprise sector is expected to tighten enterprise budget constraints and prompt restructuring. An important provision in the Memorandum is that, effective with the 1994 budget, all forms of direct Government financial assistance (including tax exemptions) to individual enterprises are to be included in the consolidated budget (State Budget plus extrabudgetary funds). The Ministries of Finance and Economy, together with the SPC, are to develop appropriate methodologies to condition financial assistance to large enterprises on the preparation and implementation of satisfactory restructuring plans, which will be initially introduced as part of the 1994 budget. This conditional approach to adjustment assistance to enterprises will be expanded as rapidly as capacities for preparing and reviewing restructuring plans can be developed. The need to increase efficiency and improve lending decisions within banks is expected to restrict credit and accelerate restructuring in loss-makers. Once the legal and institutional framework for contracts, pledges, and bankruptcy becomes functional, the banking sector is expected to exert more financial discipline on the enterprise sector. Enterprises will be forced to adjust away from obtaining working capital relatively easily through the banking system to an envircament in which access to credit is more conditional. 31. In the vast majority of enterprises the necessary restructuring is expected to be undertaken by their future private owners. State induced restructuring of state enterprises prior to privatization is generally to be confined to passive restructuring involving changes in management and staffing. :he separation of social infrastructure, segmentation of businesses, and partial liquidation. To assist in the pre-privatization work, the Government is considering the creation of a special restructuring agency into which the bank loans of a small core of Kazakhstan's most important inefficient enterprises would be transferred. This agency would make debt work-outs and further funding conditional on progress on restructuring and privatization plans, or liquidation. This is expected to be followed after privatization by more comprehensive restructuring and new investment by the new owners. In addition, itflows of foreign capital are expected to prompt adjustment in some of the internationally tradeable sectors of the economy, such as mining and energy. Rapid adjustment in those sectors with foreign involvement is expected to stimulate reform elsewhere in the economy. 32. Developng a Competitive Private Sector. A reduction in the role of the state and promotion of a strong private sector not only requires privatization, but also the elimination of direct controls and subsidies, the strengthening of prices as an allocative mechanism, and the regulation or elimination of monopolies. The Government is adopting a two-pronged approach to the promotion of private enterprises. The first focuses on the development of an institutional and regulatory framework which is conducive towards the private sector, while the second focuses on strengthening the operation of the market through the promotion of increased competition. 33. The Government is well advanced with the development of the necessary institutional and regulatory framework. Legislation on property, companies, pledge, and lease, for instance, has been enacted; improved legislation on foreign investment, natural resource exploitation, and bankruptcy has been prepared; and the civil code - with a framework for contracts - is being overhauled. The -11- Memorandum indicates that the Government will complete, by March 1994, a review of obstacles faced by private entrepreneurs in commercial and industrial activities, with recommendations for administrative measures and legislative action to help entrepreneurs overcome these obstacles. Before next June measures are to be taken to increase the supply of, provide transparent access to, and secure long-term rights on commercial real estate. Recommendations for the reform of tax law and administration, that would support private sector development while still being consistent with revenue requirements, are to be prepared by this same date. 34. The Government has also strengthened the legal basis and enforcement capacity for competition policy. Dominant or monopolistic enterprises will be segmented, prevented from further mergers, monitored to ensure fair market behavior, and exposed to competition through a reduction in entry barriers. As indicated in the Memorandum, the Anti-Monopoly Committee is to prepare revisions to existing legislation, for submission to Parliament at both the Fall 1993 and Spring 1994 sessions, to strengthen the legal framework for control of abuses of monopoly power, for "fair trade," and for protection of consumer rights. Revised administrative guidelines for the implementation of this strengthened legal framework are also to be prepared by next June. 35. The second leg of the Government's strategy focuses on promoting increased competition through improved economic incentives, the adoption and implementation of a more liberal trade regime and the promotion of direct foreign investment. Short term priority will be given to competition in distribution and transport, to the development of a homogenous and relatively open trade regime, the streamlining of enterprise registration and a shift from state orders to competitive public procurement. Complementing this strategy, the Government expects foreign investment to play an important role in the development of the productive base of the private sector and the establishment of autonomous growth centers independent of the economic influence of the FSU. This will be supported by a one-stop system for foreign investment processing and licensing, and the development of a stable macroeconomic environment, and a favorable regime for foreign investment. Before the end of 1993 the Government expects to submit to Parliament a new law on foreign investments which will provide for equal treatment for foreign and domestic investors, which was drafted with assistance from the Bank. 36. Financial Sector Reform. The sector is expected to play a critical role in the restructuring of the economy. in particular, the creation of a modern and efficient banking system is expected to improve the allocation of scarce financial resources, tighten financial discipline on, and force restructuring in the enterprise sector, and also to facilitate Kazakhstan's integration with international trade and financial markets. While the Government's financial sector strategy is still evolving, extensive financial sector reform will be required to achieve these objectives. 37. As indicated earlier, the authorities are now moving subsidies and transfers from the banking system to the budget, and are raising interest rates through both increases in the central bank refinance rate and auctions of an increasing share of central bank credit. Additional measures are needed to address a number of inherited problems from the old system. Not least, a weak payments system, a limited regulatory and supervisory framework, and poor accounting and auditing standards. To transform the sector, and address these weaknesses, the emerging policy framework is focusing on the establishment of a core group of international standard banks, development of an efficient payments system, and the promotion of a rapid transfer of international banking techniques and skills into the sector. An important step was taken in April 1993 with the adoption of a commercial banking law, prepared in consultation with the Bank. In the area of accounting and auditing standards, the Memorandum indicates that an audit -12- of the NBRK, and in depth financial and operational diagnostic studies of the ten largest commercial banks, are to be completed by March 1994. 38. The Government's early focus has been on developing an appropriate policy and institutional framework. New central bank and commercial bank legislation was approved by Parliament in April, credit auctions have been introduced to increase competition in the allocation of funds, and new prudential supervision standards have been established. The design of the new system has focused on establishing international norms in banking, and promoting competition in the provision of financial services. A phased increase to international supervision standards is expected to promote the emergence of a core group of banks which form the basis of the new financial system. Thus the Memoran indicates that, by the end of 1993, a strengthened regulatory framework will be introduced for commercial banks along with a tightening of licensing requirements for new banks (so these new banks should be able, in time, to meet international banking standards). 39. As institutions develop and the economy recovers, the financial market is expected to play the main role in mobilizing savings frorp and allocating investment financing for the private sector. However, the necessary policies and institutional arrangements have not yet been put in place. As indicated in the Memorandum studies and recommendations for the development of term lending facilities are to be completed by June 1994. Although the response to new incentives and prudential standards will take time, extensive institution building in the sector is required to build up expertise, to further improve banking standards, and to tighten prudential requirements. The Memorandum indicates that recommendations on further desirable restructuring of the commercial banking system also are to be prepared by June 1994. 40. Social Protection. The Government's ability to implement, and sustain, such a major economic and social transformation will depend critically on its ability to manage the adverse dislocation costs arising from the adjustment and mitigate the effect on the most vulnerable groups in society. The Government is aware, however, that the reform program necessitates an adjustment in real wages and a short term revision in the standard of living below that underwritten by the Soviet system. While the strong medium term economic outlook suggests that the economy may quickly move to a higher growth path, and thus generate renewed growth in the standard of living, the transitional period is likely to impose increasing costs on some segments of the population. The Government is, therefore, concerned about the welfare of the most vulnerable groups during this transition period, as well as about regional disparities that have existed within the country for some years. 41. With financial resources seriously constrained in the short term, the Government is trying to address the difficult task of redesigning the system of social protection to be consistent with the needs of a market economy and, in particular, to provide a minimum level of social protection during the difficult transition process. To prevent further segments of the population from falling below the poverty line, as was recently observed, the Government is implementing a two-pronged approach: (i) improving the focus and targeting of the social welfare delivery system; and (ii) increasing the efficiency of expenditures and ensuring adequate financial provision for key items of social services. The tightening fiscal position, and expected increase in unemployment (with corresponding implications for additional social protection spending), imply the need for quick action towards both of these objectives. 42. The approach being taken by the Government is to develop a measure of the "subsistence minimum" to which can be related the minimum benefit levels under pension, unemployment and social assistance programs. Given the budget realities, this "subsistence minimum" will have to be estimated -13- parsimoniously. But then its real value should be protected by regular adjustments for price changes. By basing the "subsistence minimum" largely on the costs of a food basket, it can be adjusted for both inflation and regional differences. One objective of the Government's program is to move from universal benefits and subsidies to more targeted assistance to paiticular vulnerable groups. However, to address the emerging problems of unemployment and poverty with more targeted and means tested methods, it will be necessary to strengthen the Government's ability to administer more targeted social protection programs. Attention has also been given to cutting unnecessary or wasteful social spending, and to exploring the potentill for user charges. The local authorities are also likely to have to assume responsibility for the provision of some social services currently provided by enterprises. 43. As indicated in the Memorandum, the Government is now undertaking a analysis of the income and expenditures for social protection, for individual funds and for each level of government. The study will explore likely developments under alternative assumptions on employment and unemployment, wage rates, benefit levels (including gradually increasing the retirement age), inflation, and other relevant factors. It is expected to contribute to an appropriate balance between social protection and budgetary objectives. At least preliminary results are expected to be available in time to be useful in the design of the 1994 budget. A second study, to be completed by March 1994, will concern social services which are now provided by enterprises, but which (with the privatization and commercialization of enterprises) would be more appropriately provided by local authorities (or other levels of government). Recommendations are to be made regarding the social services to be transferred and how, in the future, they might be financed. PART II - THE REHABILITATION LOAN A. Origin and Objectives 44. The Rehabilitation Loan has been prepared in response to the Government's request for support to its economic program. The Bank assisted the authorities in developing the program of systemic reforms in the Memorandum of Structural Reform Policies attached in Annex 1. The Government has translated the policy statement contained in this Memorandum into a Plan of Action indicating the concrete and time-bound measures to be taken (Annex 1). This program lays out a framework for reforms which are necessary for the medium-term restructuring of the economy, and establishes realistic targets and indicators to monitor progress over the coming year. If implemented successfully, the reform program would provide a sound basis for future Bank assistance to Kazakhstan. The macroeconomic framework under which this reform program will be undertaken has been elaborated in cooperation with the IMF and is the object of an arrangement under the Systemic Transformation Facility, approved by the Board of the IMF on July 23, 1993. 45. Agreement on such a macroeconomic framework was a prerequisite for the proposed operation. Substantial progress has also been made by the Government, prior to the finalization of this Loan, in initiating the process of structural reforms. In particular, the Government has implemented the following actions, as agreed with the Bank in the course of the Loan preparation process: (i) adoption (in April 1993) and initial implementation (in July 1993) of the National Privatization Program, with Bank assistance; (ii) adoption of a commercial banking act, prepared with Bank assistance, during the recent session of Parliament in April 1993; (iii) drafting of a new foreign investment law, with Bank assistance, for presentation during the upcoming session of Parliament in the fall of 1993; and (iv) doubling of the -14- administered prices of petroleum products to pass through to consumera a similar increase in the price of oil imports from Russia. 46. Thus, the objectives of die Loan are: (i) to support the Government in its continued implementation of the reform program outlined in the Memorandum of Structural Reform Policies; and (ii) to ease the shortage of foreign exchange needed to finance imports of inputs, raw materials and spare parts in key sectors, thus minimizing the further contraction of economic activity. B. Rationale for Bank Involvement 47. Through the preparation of this operation as well as through other vehicles, the Bank has played a key a key role in the formulation of the Government's reform agenda. The program supported by the proposed Loan represents a coordinated and consistent endeavor to move the country steadily towards the market economy. This program is expected to provide the systemic underpinning for macroeconomic stabilization and the long term development of Kazakhstan along efficient lines. As indicated above, in carrying out this program the country has been severely handicapped by the disruption of its traditional trading patterns, which used to concentrate almost exclusively with the former CMEA and FSU. Furthermore, starting in 1993, the country has experienced a dramatic reduction in foreign financing from Russia, leaving it with a severely constrained external situation. The proposed Loan, together with the expected cofinancing would significantly contribute to closing the resulting external gap, hence help create the macroeconomic conditions under which the reform agenda has a reasonable chance to succeed. C. Project Description 48. To achieve these objectives, the proposed Loan would finance imports in an amount of US$180 million, consisting of: (i) a foreign exchange component (FXC) in an amount of US$94 million, to support access of importers to the foreign exchange auction market for financing imports through established commercial practices; (ii) a pre-identified imports component (PIC), in an amount of US$86 million, to finance essential imports required for the continued delivery of essential public services and a recovery in key productive sectors. 49. The allocation of the proposed Loan between the two above components, as well as within the PIC component will be reviewed from time to time in the light of a rapidly changing situation. In particular, they will be reviewed in the light of monetary developments, the potential availability of funding form other sources and the evolving needs of the economy. Such reallocation will take place by mutual agreement between the Borrower and the Bank. 1. Foreign Exchange Component (FXC). 50. The FXC would increase the amount of foreign exchange available on the market, hence facilitating the access of commercial enterprises to imports on the basis of market mechanisms, rather than through administrative decision. Kazakhstan has already begun foreign exchange auctions. The Foreign Currency Exchange of the Republic of Kazakhstan (the "auction market"), under the National Bank of the Republic of Kazakhstan started its first auction on April, 17, 1992. Auctions are currently held twice a week (see Annex 6: The Foreign Exchange Market). -15- 51. The volume of transactions, however, remains limited. In large part, this reflects (i) the imposition of taxes on foreign exports (payable in foreign currency) to non-CIS countries which encourage barter trade and the non-repatriation or non declaration of export earnings; and (ii) the impact of the unstable monetary environment: with ruble inerest rates substantially lower than inflation, foreign exchange is a ideal store of value, thus encouraging the avoidance of the existing surrender requirement'. Still, foreign exchange is supplied to the auction market only by exporting enterprises. The central bank for its part has so far this year refrained from intervening (sales of foreign exchange by NBRK were only minimal in 1992, amounting to US$16 million). The foreign exchange obtained from the collection of the export tax and through the partial surrender requirement, when enforced, serves to cover government requirements and a gradual build up of reserves in preparation for the possible introduction of a national currency. The exchange rate on the auction market is therefore considerably higher than the official rate, or the Moscow market rate, reflecting transaction costs in the interstate banking system and highlighting the relative scarcity of foreign exchange in Kazakhstan. 52. The authorities intend to foster the expansion the market, as (i) the export tax becomes payable in local currency; and (ii) interest rates are substantially increased. Activities would probably develop even more dramatically if Kazakhstan was to introduce its own currency. 53. Although there no doubt will be state enterprises, as well as private enterprises, purchasing foreign exchange in the auction market, these firms can be expected to operate on basically commercial terms. State enterprises in Kazakhstan are (as part of the program supported by the Rehabilitation Loan) being subjected to greatly increased financial discipline. The central bank has practically ceased providing credits on preferential terms, and will do so completely as of the beginning of 1994. In accordance with the terms of the STF agreement with the Fund, an increasing share of central bank resources are being auctioned and the refinance rate for the balance is being raised in line with market rates. The total of all budgetary subsidies is being narrowly curtailed, and limited to a large extent to agriculture and the social programs. 54. Therefore, in support of this transition from admnistrative to market allocation of foreign exchange and to alleviate import shortages prevailing throughouL the economy, financing will be provided through the FXC to support the expansion of the auction market; the sale of the proceeds of the FXC would also provide non-inflationary financing to the budget. The FXC would reimburse up to the net monthly sales of foreign exchange by the NBRK on the auction market, based on evidence that imports of eligible goods have taken place during the said period.4 The amounts reimbursed would be paid to the account of the Ministry of Finance at the NBRK and become available for further interventions on the auction market. To this effect, a protocol will be signed between these two institution providing for the automatic sale of these proceeds to the NBRK at the official rate of the central bank. 3 Also, residents seeking to purchase or sell foreign exchange on the auction need to present evidence of compliance with foreign exchange regulations, which may deter some potential participants. 4 Non eligible imports include inter alia (i) imports paid in the currency of the borrower or through barter; (ii) goods included on the World Bank's standard negative list; and (iii) goods financed by other donors. -16- 2. Pre-Identified Imports Component (PIC) 55. The second portion of the Loan's proceeds would be used to finance the importation of equipment, materials, spare parts, agricultural inputs, medicines, vehicles and other eligible goods. 56. In the immediate future, the priority objective of the country is to curtail, then arrest the recent drop in output and delivery of public services. While the economy is undergoing a major realignment in relative prices, restructuring of economic institutions and redistribution of income across sectors, it is essential that resources continue to be available for the key priority sectors either because they provide essential services to the population or because they are expected to remain the backbone of the country's productive structures and export earnings. Imports financed under this component would permit the continued operation of these essential public services and a recovery in these critical productive sectors. The focus of the PIC is primarily on critical inputs and rehabilitation of existing capacities. Conversely, current economic uncertainties, particularly with regard to absolute and relative prices, make it difficult to assess investment in new capacities on the basis of sound economic and technical criteria. Therefore, imports for the expansion of existing capacities or the development of new ones would not be eligible under the PIC. 57. In this spirit, the proposed Loan would finance essential import requirements in energy, agriculture, transport, and health, as follows (detailed features are in Annex . (a) Enelgy ($30 million). Following the disruption of trade between the FSU republics, the purchase of critical spare parts and components has been disrupted, which has in turn affected the production of oil, hence export earnings. Critical imports to be funded by the credit would include spare parts and operating equipment for oil production in the Uzen field. (b) ASriculture ($39.0 million). The critical needs of the agricultural sector include (i) agrochemicals to prevent diseases and for weed control; (ii) veterinary medicines; and (iii) materials and spare parts for food processing. These imports are required to maintain basic food production and reduce crop losses due to pests and diseases. (c) Transport ($4.0 million). Although local passenger transport is a stated priority for both local and the republican governments, it suffers from a serious shortage in transport capacity, which is rapidly escalating as an increasing number of buses are taken out of service due to the lack of spare parts or because they have become permanently disabled. The critical imports are targeted to salvtge the existing fleet of buses from deteriorating beyond repair. (d) Health ($5.0 million). Shortages of basic drugs, vaccines, and supplies are causing the deterioration of a health situation which is already bordering on emergency levels. The PIC would cover essential needs for (i) pharmaceuticals and vaccines; (ii) medical equipment; and (iii) raw materials for production of intravenous solutions. 58. All transactions under this component will take place at the official exchange rate. Whenever goods financed by the Loan are for the use of government entities, adequate budget appropriation will be made to cover their cost in domestic currency valued at the official rate. Conversely, when goods are for non governmental entities, be they private or public, they will be sold -17- at the official rate and the proceeds of these sales will be transferred to the account of the budget at the National Bank of the Republic of Kazakhstan. In the exceptional case where such sales would need to be subsidized, specific appropriations will be made in the budget, of which the Bank will be notified. These provisions will be included in the supplemental 1993 and the 1994 budget. It is understood that these operations will be subject to the standard rules regarding the execution of the government's budget and the control of this execution. D. Implementation Arrangements 59. The orwe will be the Republ;c of Kazakhstan, represented by the Ministry of Finance. The Government's legal authority to undertake foreign borrowing and guarantee debt servicing will be documented before effecivjen of the Loan. The Government has appointed the Ministry of Economy as the lead Proiect Implementation Aency for the management of the Loan and the coordination of its implementation. 60. In order to assist in the preparation of the Loan, contribute to its early implementation, and ensure its speedy disbursement, a specific Project Impementation Unit (PIU) has been established within the Ministry of Economy (initially under the TA Loan). Responsibilities of the PIU, detailed in (Annex ), include monitoring the overall progress of implementation, coordinating among the various participating ministries and agencies to ensure a consistent approach in the implementation of the project, advising purchasing entities in all aspects of procurement, administrating the Special account, and preparation of the withdrawal applications, the consolidated progress reports and the Project Completion Report. The Government will provide the PIU with adequate staffing, including a director-level manager and recruit the three foreign experts mentioned below. The PIU will be maintained, with staffing satisfactory to the Bank, at least until the closing date of the Project. 61. For each sector, the Government will appoint one entity, acceptable to the Bank, in charge of (i) purchasing eligible goods for and on behalf of the Government, following Bank procurement procedures; and (ii) ensuring the sale and distribution of such goods, as instructed by the Government. The PIU will advise the said entities in all procurement matters. 62. The PIU will receive the temicalaisn of two foreign procurement advisers and one foreign financial adviser (in charge of disbursement and accountir' - see Annex 5. These experts will be financed under the Technical Assistance Loan to Kazakhstan, aprroved by the Board in August 1993. E. Procurement 63. FtC. As it is expected that the FXC will be used for the import of goods procured by competitive enterprises in the commercial sector, procurement for all contracts under US$1 million will be done directly by the importers using established commercial practices. Contracts larger than US$1 million dollars will be subject to the procedures applicable to the PIC, as described in the next paragraph. In such cases also, the first contract of any importer will be subject to Bank prior approval. 64. E . All procurement of imports under the PIC would be according to Bank Procurement Guidelines and all contracts will be awarded through simplified International Competitive Bidding, following the Bank's Guidelines, except as stated hereinafter. Under certain circumstances, for instance when the early delivery of particular goods or for proprietary parts may justify other methods of contracting, other pro.urement methods in line with the Bank's guidelines, i.e. Limited International -18- Bidding (LIB), International Shopping (IS) with at least three bids from three member countries, or direct contracting may be resorted to; each such procurement would require individual justification and Bank's prior approval. Barring a few exception, contracts under US$ 1 million are not expected to be financed under the PIC. 65. Under both components, commonly traded commodities may be procured through organized international markets or other channel of competitive procurement acceptable to the Bank, in accordance with procedures acceptable to the Bank and with Bank prior approval. F. Disbursement 66. The Loan will finance 100% of the foreign expenditures of goods, imported from World Bank member countries and Taiwan (China). Contracts in the currency of the Borrower are not eligible. Goods imported after June 1, 1993 are eligible for retroactive financing under the Loan up to a maximum amount of US$36 million, equivalent to 20 percent of the Loan amount, in view of the considerable progress already made by the country in implementing the reform program and of its urgent balance of payments needs. The Loan's closing date would be December 31, 1994. 67. FXC. Imports eligible to reimbursement under the FXC will be subject to the Bank's standard negative list (see An 5). Disbursements would be made to the Ministry of Finance on the basis of (i) statements of expenditures (SOEs), prepared by the PIU, following the Bank's simplified documentation requirement for adjustment operations, i.e. prepared from customs certificates, for contracts valued at less than US$1 million, or upon submission of full documentation (contract, supplier's invoice, evidence of shipment, customs certificate and evidence of payment) to the Bank, for larger contracts, respectively; (ii) statement of monthly sales and purchases of foreign exchange by the National Bank of the Republic of Kazakhstan on the Foreign Currency Exchange of the Republic of Kazakhstan ("the auction market") or any successor thereof; and (iii) a statement by the Borrower that the imports presented for reimbursement have not been financed by another loan or grant, or imported through barter arrangements. The net amount of foreign exchange sales by NBRK on the auction market will determine the Monthly Eligible Amount, setting for each month (except during the period of retroactive financing) the maximum amount of eligible amounts of imports that the Bank will reimburse. Any positive difference between the Monthly Eligible Amount of a given month and the amount of eligible imports of that month for which reimbursement has been requested from the Bank can be carried forward. The customs certificates covered by the SOEs will be retained by the PIU for review by Bank supervision missions and auditors. 68. P[C. Disbursements under the PIC will be done through normal Bank procedures (for details, see Annex 5). To accelerate disbursements, a special account will be opened in a foreign commercial bank acceptable to the Bank. The authorized allocation to the Special Account will be US$25 million, equivalent to about four months of disbursem.nts under this component. The Special Account will not be used for imports under the FXC, which, as seen in the previous paragraph, will be disbursed on a reimbursement basis. The account will be opened in the name of the Borrower and will be administered by the authorized representatives of the PIU. Two signatures will be required to make any ' The definition of the "Monthly Eligible Amount- could be subject to review by both parties in the case of substantive changes in the country's foreign exchange regulation, for instance if surrendering requirements could be fuilled by selling export earnings on the auction market. -19- transaction from the account. The PIU will send on a monthly basis, or more frequently, if necessary, requests for replenishment of the Special Account to the World Bank. These requests for replenishment will be accompanied by full documentation for all contracts. G. Project Accounting, Financial Reporting, and Auditing 69. By Loan effectiveness, the PIU is expected to have established an appropriate accounting system, according to generally accepted standards, providing all necessary information on the receipt and use of funds, in accordance with the provisions of the Loan Agreement. The PIU will prepare annual statements of all receipts and payments uer the Loan showing the amounts relating to each component and category detailed in the Loan Agreement. 70. The Borrower will arrange for the auditi of all the abe' financial statements by independent auditors acceptable to the Bank. Project Accounts (including the Special Accounts) will be audited in accordance with the March 1992 "Guidelines for Financial Reporting and Auditing Projects Financed by the World Bank." The Bank will receive these audited statements and audit reports in such scope and detail that it may reasonably request, within six months after the end of each fiscal year of the Borrower. I. Agreements Reached 71. Agreements were reached at Negotiations on: (a) the Government's Memorandum of Economic Policies and its attached plan of action (Annex 1); and (b) the sectoral allocation of pre-identified imports (Annex 3); and 72. The official submission to the Bank of the Government's economic program, as summarized in the Government's Memorandum of Economic Policies was a condition of Board prntaton. Actions included in this memorandum that were prior actions for Board presentation were the following: (a) adoption (in April 1993) and initial implementatior. (in July 1993) of the National Privatization Program, with Bank assistance; (b) adoption of a commercial banking act, prepared with Bank assistance, during the recent session of Parliament in April 1993; (c) drafting of a new foreign investment law, with Bank assistance, for presentation during the next session of Parliament in the fall of 1993; and (d) doubling of the administered prices of petroleum products to pass through to consumers a similar increase in the price of oii imports from Russia. 73. As a condition of disbursement, the Borrower will submit to the Bank a copy of the agreement between the Ministry of Finance and the National Bank of the Republic of Kazakhstan, or an equivalent ministerial resolution, providing for the automatic sales of the proceeds of the FXC from the -20- former to the latter at the official exchange rate. The creation and maintenance of the PIU with adequate staffing and technical assistance, satisfactory to the Bank, are provided for in the Technical Assistance Loan, which parallels this operation. 74. It was also agreed that (i) all transactions under the Loan will take place at the official exchange rate; (i) whenever goods financed by the Loan are for the use of government entities, adequate budget appropriation will be made to cover their costs in domestic currency valued at the official rate; (iii) when goods are for non governmental entities be they private or public, they will be sold at the official rate and the proceeds of these sales will be transferred to the account of the budget at the National Bank of the Republic of Kazakhstan; and (iv) in cases where such sales would be subsidized, specific appropriations will be made in the budget, of which the Bank will be notified. I. Envkramental Assessment 75. The project would be consistent with Bank policy and follow accepted Bank procedures. In conformity with Bank policies for adjustment operations, no environmental rating has been assigned. Nevertheless, in developing procurement procedures for financing imports under the Loan, specific provision will be made to ensure that the inclusion of any toxic or hazardous substances would be under conditions acceptable to the Bank. In particular, agrochemicals would be eligible for financing under the PIC only provided that they meet the requirements of the World Bank's Operational Directive '.03. Also, the question of environmental liability for past pollution will become important during the privatization process. Lack of clarity on this issue could result in unnecessary delays in concluding privatization contracts. Therefore, it is essential to establish clear guidelines on the sharing of the known and potential costs of *emedying problems of past pollution between the State and the prospective new owners. This will require the development of a coherent strategy and the completion of a thorough inventory and an estimate of the least-cost measures for mitigation, with the support of technical assistance financed under the TA Loan. J. Benefits and Risks 76. ] 8. The proposed Loan would maintain and increase capacity utilization, production and consumption in a number of vital sectors of the economy of Kazakhstan. The imports to be financed by the Loan would have direct output and employment effects and would ensure minimum availability of certain essential items, such as medicine and other health supplies. In some cases, critical imports of spare parts could also preserve existing capital assets and prevent a deterioration which would require considerable future investment. In addition, the Loan would increase the access to foreign exchange of companies operated on a commercial basis. 77. Risks. The main risks include: (i) shortfalls in achieving economic goals under the reform program, in particular price stability and the sharp turn-around in foreign trade, and a possible slippage in the momentum of the reform program; (ii) the possibility that in view of prevailing conditions, some of the imports financed by the project could end up maintaining activities and enterprises that are fundamentally not viable and should be left to disappear; (iii) the possibility that the external financing requirements could not be met; and (iv) Kazakhstan's lack of familiarity with Bank procurement and disbursement procedures, which could limit absorptive capacity and lead to significant delays. Close monitoring of economic performance and provision of policy advice and selected technical assistance will aim at alleviating the economic risk. Procurement and disbursement risks will be reduced through close -21- attention to procurement and other implementation constraints during project supervision, and through the provision of technical assistance. K Recommendation 78. I am satisfied that the proposed Loan would comply with the Articles of Agreement of the Bank and I recommend that the Executive Directors approve the proposed Loan. I -wis T. Preston President By Ernest Stern Attachments August 25, 1993 Washington D.C. Page 1 of 12 KA3AKCTAH KABHtET MHIIHCTPOB PECHYBJIHKAClHblR . PECHYVBJIHR MHOCTPJIEP KABHlETI KAAXCTAH Jde ________ eooc WI. Je Sem T.Augu,t 13.1993 M1r.Lewas T.tWruesn President *nternational Dank tor Reconstruction and Development 1816 H Street N.W. Washington.D.C. 20433 Dear Mr.Preston, Tho attachod Momorondum of Structura) jI<rm> is.i' outlin, t.h4 Prgrom of iacreconsui< .las1Jimation and systemic roforrfm of 1.h Repubi1c of Kazakhatan. We requeit. .ho Wrld Buråk to sUppOrt thit prologrom with a ehbili.ies< L<as ån the amount of USs180 snållion uqujvulont. It 1s our intentlon to Implenönt the program coscriled in the att.ached Memorandw. a *et forth in1 a PlCAn of AcoL-n ateneed to this lltk r in order to acbieve b ropid renuti5'on of Oconomic. growth within a auetoinable macrcuonomlic framuwur-k. Give& the coraplexity of t.h trenui t.ji to a re economny. it !u isauviLoble that therc will bo V<Jsfs ucertanty nir.tOntå.d ith Lhe sla nortation& of ti vigras. !703130 ad justm nwti.s ad63 wvrxtvctåvo a t.ions rto l i ke y.< l$e afaquJ 1,d. Wc wil. where appropriate, review th nee.ry cdjuunrjni ' with the World Bank. .Yours såncerely. D.Sembcyev rilulL iDputy Primo ams$• Reputi el an oktntn Atto uh*onit Annex 1 Page 2 of 12 REPUBLIC OF KAZAKHSTAN MEMORANDUM ON STRUCTURAL REFORM POLICIES I. Introduction 1. The Government of Kazakhstan is undertaking a comprehensive program of economic reform. In addition to basic structural reforms and related institution building, this program includes measures for financial stabilization and for the strengthening of key sectors. While up until the present our emphasis has been upon stabilization and structural measures, as progress is made in these areas we will increasingly be able to shift our attention to sectoral policies and investments (including the need for public sector investments in the economic and social infrastructure needed to support the expansion of the increasingly privatized activities in agriculture, manufacturing and commerce). 2. The drop in output between 1990 and 1992 was about 25 percent. Average consumption levels, however, have fallen by less than output, while both investment and military expenditures have declined substantially more than output. A further decline of about 8 percent in output is expected in 1993. In addition, during this year we expect to absorb a large reduction in financing from Russia, with a consequent decline in imports and total resources available to the economy. Although open unemployment has so far been held to modest levels, this has been done only at the cost of a sharp decline in real wages and a deterioration in the financial situation of enterprises. It will be increasingly difficult to sustain support for the economic reform program if output and living standards continue to decline. Consequently halting and then reversing the recent declines in output must be a growing concern. 3. At the same time the Government recognizes that getting inflation under control is a prerequisite for sustained and efficient economic growth. Consequently our monetary and fiscal policies must give a high priority to financial stabilization objectives. Our objective is to reduce the monthly rate of inflation to single digit levels by the end of the year. To support this objective, we have targeted the deficit in the State Budget at 6 percent of GDP, with domestic bank financing not to exceed 4 percent of GDP. The expansion of central bank credit to the commercial banks will have to be severely restricted in order to accomplish our objectives. On the basis of current projections, our target is to reduce the growth in the net domestic assets of the NBRK from an average of 34 percent per month during the first quarter of 1993 to less than 7 percent per month in the fourth quarter. 4. Our economic policies will have to be balanced in such a way as to support both the control of inflation and the recovery of output. Fortunately, many structural reform policies can contribute to both stabilization objectives and also to the recovery of output in the medium-term (if not the short-term). The past declines in output have resulted in large measure from the disruption of the economic ties, between enterprises and between republics of the FSU, that had been maintained under the previous command economy. By accelerating structural reforms, we expect to speed the development of a market economy which will prove both more efficient and more responsive to the needs of the population. Annex I Page 3 of 12 5. The Government continues to attach great importance to the improvement of trade and payments relationships among the states of the Former Soviet Union. We will work actively to find a solution to these problems. As long as Kazakhstan continues to be a part of the ruble area, we intend to coordinate our monetary policies with those of the Russian Federation. The law on foreign currency regulation, along with a specific provision in the central bank statutes, allows for the introduction of a separate currency should this prove desirable. II. The Structural Reform Proga 6. Kazakhstan has embarked upon an ambitious program of structural reforms. We have introduced radical changes in our earlier price, subsidy and trade policies in order to establish a market economy increasingly integrated in the world economy. Our program for the reform of state enterprises involves the privatization of most state enterprises accompanied by strengthening governance and management of those remaining in the public sector. In addition to privatizing state enterprises, we are seeking to create a competitive private economy by encouraging new private sector activities and also through the adoption of pro-competition and anti-monopoly policies. A fundamental restructuring of the banking system will accompany the changes in the enterprise sector. The adjustments required in the move to a market economy, combined with the disruption of economic ties among the republics of the former Soviet Union, have involved heavy transitional burdens. Thus we are strengthening our social protection system so we can meet our population's needs in a manner consistent with our progress towards financial stabilization. The Memorandum outlines, for each of these areas, both our recent accomplishments and the additional measures we intend to undertake in the coming year. A. Price. Subsidy and Trade Policies 7. Prices of most goods and services were liberalized at the beginning of 1992. At the same time substantial increases were made in those prices that remained under administrative regulation. Controls have since been eliminated on many of these items, so at present the only items remaining under control are bread, some qualities of flour, baby food, imported medicines, fodder, housing rents, energy, utility tariffs and public transport tariffs. State orders, involving procurement on a compulsory basis at below market prices, have been completely eliminated; procurement for state needs now takes place at freely negotiated or market prices. 8. The prices of goods and services that are still controlled are being monitored and will be adjusted regularly to avoid any erosion in real terms. By end-1993 the Government will review the list of administered prices and, in order to reduce the budgetary impact, will raise the prices of subsidized goods and services. We expect that price controls on fodder can be eliminated by October 1994. Following recent increases, petroleum prices are now at over 60 percent of world market levels. As of the beginning of 1994, the Government intends to move to world prices for its petroleum products (defined as the border price for imports from Russia plus all domestic processing and distribution costs). The only subsidized petroleum product will be diesel fuel for agricultural uses; this subsidy will be included in the budget. Prior to next January, the Government is willing to negotiate with its FSU trading partners on a phased adjustment of energy prices towards world levels. Any increases in the import costs of energy products will be passed-through in full to end-users. Beginning in 1994, the Government intends to eliminate over a three-year period the remaining subsidies for public utilities Annex 1 Page 4 of 12 consumed by householders; this will be done in parallel with strengthening targeted support for vulnerable groups suffering negative consequences from these increases in tariffs. 9. Subsidy reductions contribute to both financial stabilization and the creation of a system of prices which provides signals to efficiently guide the decisions of producers, financial intermediaries and consumers. In 1993 we intend to limit total transfers and subsidies in the State Budget to no more than 5.1 percent of GDP. (While this figure includes transfers for the social safety net, the vast majority of social protection programs are financed by extra-budgetary receipts earmarked for this purpose.) A further reduction in subsidies and transfers is planned for 1994; we will give particular attention to the replacement of input subsidies for the agriculture by more targeted food subsidies to protect vulnerable groups. Beginning in January 1994, the NBRK will no longer provide credit at preferential interest rates and interest subsidies will be limited to those that are included in the budget. 10. The process of liberalizing foreign trade is being continued. We have already eliminated quantitative restrictions on imports. With current account convertibility for residents, importers can freely purchase foreign exchange at the market determined exchange rate. In February 1993 we substantially reduced the coverage of export licensing and quota arrangements; in parallel with this, we have also reduced interstate bilateral trade arrangements. The next steps, which we expect to take by September 1993, will be a substantial reduction in the number of commodities subject to export quotas accompanied by increases in the remaining quotas by not less than 20 percent. We intend to eliminate these remaining quotas as soon as the situation permits (or in line with similar moves by our CIS trading partners). While we may continue to enter into bilateral trade agreements with other countries, we expect that such trade will be carried out at freely negotiated or market prices; consequently, not later than January 1994, the state will not engage in compulsory procurement at below market prices in order to fulfill bilateral trade agreements. A uniform import tariff of 15 percent will be introduced on non-CIS imports by October 1993, with exemptions limited to basic food items and medicines. 11. We expect to significantly increase our economic efficiency by reforming our price, subsidy and trade policies, and by bringing our relative prices more in line with those in world market. However, in some cases these economic adjustments have undesirable short-term social effects. It is our intention to respond to these adjustment problems by strengthening our system of social protection rather than halting the adjustment process. Our objective is to improve the relative price structure at the same time as we bring inflation under control. Indeed, it is only by doing the latter that we can expect to eliminate the present undervaluation of the ruble and establish a more appropriate economic link between domestic and world prices. B. Privatization and Reform of State Entenrises 12. The centerpiece of the Government's program for the reform of state enterprises is the privatization program for 1993-1995 that was approved by the President in March 1993. This privatization effort is being complemented by strengthening the governance and management of those enterprises that are expected to stay (at least for some time) in the public sector. 13. The privatization program includes three components, relating to (a) small scale, (b) medium and large scale, and (c) very large enterprises. Small scale enterprises are being auctioned for cash and the housing coupons distributed earlier. We expect that all enterprises engaged in retail and Annex 1 Page 5 of 12 wholesale trade, and related trucking and distribution, will be offered for sale during 1993-94. The mass privatization of medium and large enterprises will be based upon the distribution of investment coupons (which should be completed by end 1993) and the conversion of these enterprises to joint stock companies (which should be completed by March 1994). Our targets under this program are to privatize 30 percent 'of the assets of non-agricultural medium and large enterprises by March 1994, and at least 70 percent of these assets by March 1995. In the case of certain very large and special enterprises, the Government has adopted a case by case approach under which it expects to offer for sale at least 10 such firms by March 1994 and to offer for sale at least another 10 such firms by March 1995. Competitive procedures will be used in these case-by-case sales. 14. It is clear that, at least in the short-run, a number of state enterprises will remain under Government control, and some economic infrastructure and defense-related activities are expected to continue as part of the public sector. The Government intends to restructure enterprises that are not expected to be privatized in the foreseeable future, including closing down those enterprises (or parts of enterprises) that are unlikely to be viable. When enterprises are privatized, this will be done at the lowest organizational level practicable (for example, units which maintain separate accounts). We may create holding companies and so-called state joint stock companies (SJSCs) comprising some enterprises of certain economic sectors but generally not those in trucking, distribution/trade, construction, light industry, and agro-processing. For enterprises to be privatized under the mass privatization program, or already earmarked for case-by-case privatization, only those shares that are meant to be retained in the state sector after privatization will be transferred to the holding companies or SJSCs. Privatization or dilution of state sector shares in the holdings and SJSCs, and the enterprises under them, shall not occur other than according to the National Privatization Program for 1993-95. To strengthen governance and management of these continuing state enterprises, the Government will prepare administrative guidelines, and submit draft legislation to Parliament at its first session in 1994 regarding governance and management of state-owned enterprises. These will provide for management accountability, responsibility and operational autonomy through the appointment and responsibilities of boards of directors, incentives for managers, and other appropriate measures. 15. All state enterprises will become subject to increased financial discipline. This will support enterprise restructuring and reconstruction and at the same time contribute to stabilization objectives. However, to help maintain output and avoid major social dislocations, some continuing support will be required while restructuring programs are being prepared and implemented by individual enterprises. The Ministry of Finance, the Ministry of Economy and the State Property Committee will jointly develop an approach to adjustment assistance for enterprises which can begin to be implemented as part of the 1994 State Budget. For larger enterprises, our policy will be to make financial support from the budget conditional upon the preparation and implementation of satisfactory restructuring programs by the enterprises concerned. This approach will be phased in during 1994, as the capacity for preparing and reviewing restructuring plans is developed. In the case of enterprises which are to be privatized, significant new investments in plant, equipment and technology are not expected to take place until after privatization. The initial restructuring to be undertaken while these enterprises are still in government ownership will focus on closure of obsolete facilities, demonopolization, spin-off of social assets, reduction in the labor force, financial restructuring, management training and reorganization. Effective with the 1994 budget year, all forms of financial support to enterprises from government sources will be fully and transparently shown in the budget (State Budget and extrabudgetary funds); Annex 1 Page 6 of 12 individual enterprises will not be given tax exemptions, or other special financial benefits, that are not accounted for in the budget. C. ovelopmng a Competitive Private Sector 16. The benefits of a market economy will be realized only if Kazakhstan can develop a competitive private sector economy. The dominance of existing enterprises, regardless of whether they remain in the public sector, could lead to serious abuse of monopoly (and oligopoly) power. These problems arise in national, regional and local markets. The Government has adopted a four-pronged approach to create more competitive markets. First, demonopolization will accompany privatization. Second, the abuse of monopoly power will be controlled. Third, new private sector activities will be encouraged. Fourth, our liberal trade policies will require domestic producers to compete on the world market. 17. The State Anti-Monopoly Committee and the State Property Committee will pay particular attention to the break-up of local and regional monopolies in wholesale trade, and in related transport and distribution activities. We are, with technical advice from national and international bodies, carrying on a continuing review of existing leg.slation and administrative procedures related to controlling abuse of monopoly power, "fair trade," and protection of consumer rights. We expect to propose to Parliament, during both the Fall 1993 and Spring 1994 sessions, revisions to strengthen existing legislation in these respects. Among other things, these will include rules for horizontal and vertical mergers and acquisitions, and also for the break-up of enterprises and concerns that have abused monopoly power. We will also prepare, by end June 1994, revised administrative guidelines for the implementation of the strengthened legal framework. 18. The legal and regulatory framework for an expanding private sector economy is being put in place. We intend to reduce "profile" restrictions on privatized enterprises. A law on property, recognizing both private and state property, was passed in March of this year. Attention must now be focussed on removing barriers to the establishment and competitive operation of new private enterprises. The Government will complete, by March 1994, a review of obstacles faced by private entrepreneurs, accompanied by recommendations on the administrative measures and legislative action needed to overcome these obstacles. Access to commercial real estate is a particular concern. By June 30, 1994, measures will be introduced to increase the supply of, provide transparent access to, and secure long-term rights on commercial real estate. Tax policy and administration will be the subject of a separate study; by June 1994 we will complete a study with recommendations on reforms in tax law and administration that would support new private sector activities. A new law regarding foreign investment, which provides equal treatment for foreign and domestic investors, will be submitted to Parliament, with approval expected by the end of 1993. Recent and planned measures to promote competition and efficiency through increasing integration in the world economy have been described above as part of the discussion of price, subsidy and trade policies. Annex I Page 7 of 12 D. Financial Sector Reform 19. The Government recognizes that a modem and efficient financial system will be needed to support the transition to a market economy and the resumption of economic growth. We have established a two-tier banking system, including the licensing of private banks and the transformation of state banks into joint stock companies. In April of this year Parliament approved laws on both the National Bank of the Republic of Kazakhstan (NBRK) and commercial banking activities. The NBRK statues strengthened the central bank's independence from government and provided it with the legal basis to conduct monetary and credit policies and to regulate and supervise the banking system. A revised law on foreign currency regulation, also passed in April, establishes a liberal framework for foreign currency transactions and, along with a specific provision in the NBRK statues, allows for the introduction of a national currency. Other recent measures supporting the development of a more market oriented banking sector include the introduction of credit auctions by the NBRK, intreducing competition in the banking sector, and abolition of the limits on margins between the cost of funds and the lending rates of commercial banks. 20. Continuing the move towards using interest rates to allocate central bank credit, we will increase the proportion of new credit (excluding credit to Government) that is auctioned by the NBRK, from 20 percent in the last half of 1993 to 35 percent in the first quarter and 50 percent in the second quarter of 1944. The balance of NBRK credit to commercial banks will be provided at a refinance rate which, as long as Kazakhstan is in the ruble area, will be related to the CBR refinance rate. Our reform of the banking system and the institutional strengthening of the NBRK includes a strengthening of the regulatory framework and a tightening of licensing requirements. We intend to establish a regulatory framework leading, over time, to a core group of banks meeting international banking standards (International Standard Banks or ISBs). As a result of the tighter licensing standards, banks established in the future should be qualified to enter the program to, after a transition period, meet international banking standards. Minimum capital requirements will be revised by end-1993 (taking inflation into account), and subsequently kept under review. Plans are underway to reform the payments system, to enhance accounting standards, to strengthen the legal framework for banking activities, and to develop bank supervision. An audit of NBRK and in-depth financial and operational diagnostic studies of the ten largest banks should be completed by March 1994. Moreover, studies and recommendations will be completed by June 1994 on term lending and also on the further restructuring of the banking sector that may be desirable. All this will lay the groundwork for the continued strengthening of the banking sector. E. Social Protection 21. The Government recognizes that substantial changes in the system of social protection are necessary if needs are to be reasonably met during the economic adjustment period. With the fall in output, and also the decline transfers from the previous Union government, some downward adjustment in the real levels of social benefits and social services has been unavoidable. While unemployment has not yet become a serious problem, as enterprise restructuring takes place, a substantial rise in transitional unemployment seems inevitable. Inflation has drastically reduced the real value of bank deposits that had been the main form of household saving, and thus the ability of households to confront economic difficulties. If we are to accomplish both our social protection and our budgetary control objectives, improvements in the efficiency with which social protection programs are implemented are necessary. Annex 1 Page 8 of 12 22. The Government is giving priority attention to adapting the social protection system to meet present and expected needs. The Government intends to calculate a new "subsistence minimum" to which can be related the minimum benefit levels under pension, unemployment and social assistance programs. This "subsistence minimum" will be based largely upon the cost of a food basket, so its value can easily be adjusted for both inflation and regional differences. We then expect to make changes in our social protection programs based upon the following general principles: (a) continuation of the shift from universal entitlements to more targeted and means tested assistance; (b) minimum pension, unemployment and social assistance benefits that are related to the "subsistence minimum;" (c) regular adjustments in the minimum benefit levels to protect the real values of these benefits; and (d) continued management of unemployment compensation and social assistance programs on a decentralized basis, but with budgetary support from the center to local authorities if the necessary local resources cannot be mobilized; the Pension Fund will continue to be administered by the Government on a national basis. In addition, the Government intends to strengthen programs for the placement and retraining of unemployed workers. We are encouraging the development of non-governmental pension funds and other private retirement savings programs. We are also considering, for the future, an increase in the retirement age. 23. The Government is undertaking two studies related to strengthening social protection and social services. First, we will complete an analysis of the income and expenditures for social protection under alternative assumptions on employment and unemployment, wage rates, benefit levels (including gradually increasing the retirement age), inflation, and other relevant factors. The study will include projections for both republican and regional levels, and for both the earmarked extrabudgetary funds and expenditures included in regular budgets. A preliminary analysis will be available by September 30, 1993 (in time to serve as an input for the 1994 budget); the final report and recommendations will be available by the end of 1993. Second, the Government will undertake a study of the social services now provided by enterprises which, with the commercialization and privatization of enterprises, would in the future be more appropriately provided by local authorities (or other levels of government). The study will include recommendations on the social services to be transferred and how, in the future, they should be financed. This study and recommendations should be completed by end March 1994. F. The Agricultural Sector 24. Structural reform in agriculture is underway and expected to accelerate in the coming year. During 1993, the process of liberalizing prices will continue; this is expected to improve incentives for agricultural production and allow for some reduction in agricultural subsidies. As of early 1993, over 11,000 private farms had been registered, as well as over 400 small businesses engaged in agricultural processing and over 2,000 cooperatives involved in agricultural production and marketing. We plan to move ahead rapidly in privatizing state and collective farms, allowing farmers the legal right to withdraw property from these farms. While private farmers will not be granted full ownership of the land or the right to trade or sell their user-rights, they will be granted long-term (99 year) leases and the right to transfer the leases to their heirs. 25. The Government is preparing a comprehensive strategy for the agricultural sector to further define our approach to structural adjustment, while minimizing disruption of agricultural production. This study will: (a) assess Kazakhstan's capacity to produce key crops and livestock economically and the need for adjustments in the structure and technology of agriculture production; (b) Annex 1 Page 9 of 12 consider the adequacy of producer incentives resulting from existing price and trade policies and make recommendations for ensuring adequate incentives consistent with the objective of reducing agricultural subsidies; (c) refine strategies for privatizing state farms and the development of land tenure policies consistent with the objectives of improving farm productivity; (d) make recommendations for improving the access of farmers, including emerging private farmers, to key inputs including agricultural technical and economic information, credit, agricultural mac inery, fertilizer, seeds and pesticides; and (e) review existing arrangements for marketing, processing and storage of agricultural production and make recommendations for improvement consistent with the objectives of an efficient market economy. The Government has also initiated with the support of a grant from the Government of Japan a study of the irrigation system, which would provide the basis for a long term rehabilitation program. The agriculture strategy is expected to be completed by June 30, 1994 and the irrigation study, by December 31, 1994. Annex 1 Page 10 of 12 PLAN OF ACTION FOR IMPLEMENTING SELECTED STRUCTURAL REFORMS [Annex to "Memorandum on Structural Reform Policies"] A. Price. Subsidy and Trade Policies 1. Adjust administered prices of subsidized goods to reduce subsidies (by beginning of 1994). 2. Price controls on fodder to be eliminated by October 1994. 3. Prices for petroleum and other energy products to be raised to world levels as of the beginning of 1994. (Note 1) 4. Beginning in 1994, the Government intends to eliminate over a three-year period the remaining subsidies for public utilities consumed by householders; this will be done in parallel with strengthening targeted support for vulnerable groups suffering the negative consequences of the increase in tariffs. 5. Total transfers and subsidies in the State Budget to be limited to 5.1% of GDP in 1993, and further reduced in 1994. 6. NBRK to cease providing credit at preferential rates, and any interest rate subsidies to be included in the budget (effective beginning 1994). 7. Reduction of number of commodities under export quotas, and increase of not less than 20% in quotas for those commodities remaining under quotas (by September 1993). 8. A uniform import tariff of 15 percent will be introduced on non-CIS imports by October 1993, with exemptions limited to basic food items and medicines. 9. State procurement to fulfill bilateral trade agreements to be at freely negotiated or market prices (effective beginning of 1994). B. Privatization and Reform of State Enterprises 1. All enterprises engaged in retail and wholesale trade, and related trucking and distribution, to be offered for sale before the end of 1994. 2. Distribution of investment coupons for Mass Privatization to be substantially completed by end of 1993. 3. Conversion of medium and large enterprises included in Mass Privatization Program to joint stock companies by March 1994. Annex 1 Page 11 of 12 4. Mass Privatization Program targets are for privatization of 30 percent of assets of non-agricultural medium and large enterprises by March 1994 and 70 percent of assets by March 1995. 5. Selected very large and special enterprises are to be privatized on a case by case basis, with 10 offered for sale by March 1994 and another 10 by March 1995. 6. Government to prepare administrative guidelines, and to submit draft legislation to Parliament at its first session in 1994, on strengthening governance and management of enterprises expected to remain in the public sector. 7. Ministries of Finance and Economy, and the State Property Committee, to develop an approach to adjustment assistance for state enterprises, which will be implemented as part of the 1994 State Budget, and which will (as capacities for preparing and reviewing restructuring plans are developed) condition financial assistance to large enterprises on the preparation and implementation of satisfactory restructuring plans. 8. Effective with the 1994 budget, all forms of direct Government financial assistance (including tax exemptions) to individual enterprises are to be included in the consolidated budget (State Budget and extra-budgetary funds). C. Developing a Competitive Private Sector 1. Anti-Monopoly Committee will prepare revisions to existing legislation, for submission to Parliament at the Fall 1993 and Spring 1994 sessions, to strengthen the legal framework for control of abuses of monopoly power, for "fair trade" and for protection of consumer rights. 2. Revised administrative guidelines for the implementation of the anti-monopoly legislation will be prepared by June 1994. 3. Completion by March 1994 of a review of obstacles faced by private entrepreneurs in commercial and industrial activities, with recommendations for administrative measures and legislative actions to overcome these obstacles. 4. Take measures, by end June 1994, to improve access to commercial real estate by private firms, including measures to increase the supply of, provide transparent access to, and secure long-term rights on commercial real estate. 5. Complete by June 1994, a study with recommendations for reforms of tax law and administration that would support private sector development (but still be consistent with revenue requirements). 6. Submission to Parliament before December 1993 of a new law on foreign investment which will provide for equal treatment for foreign and domestic investors. Annex 1 Page 12 of 12 D. Financial Sector Reform 1. Increase the proportion of new NBRK credit which is auctioned from 20 percent in the last half of 1993 to 35 percent in the first quarter and 50 percent in the second quarter of 1994. 2. Introduce, by end 1993, a strengthened regulatory framework for commercial banks and a tightening of licensing requirements for new banks (so new banks should be able, in time, to meet international banking standards); introduce, by the same date, a revision of capital requirements for all banks (which will at least adjust for inflation). 3. Completion of an audit of the NBRK and in depth financial and operational diagnostic studies of the ten largest banks by March 1994. 4. Completion of studies and recommendations on the development of term lending facilities, and on restructuring the commercial banking system, by June 1994. E. Social Protection 1. The Government will complete an analysis of the income and expenditures for social protection, for individual funds and for each level of government, under alternative assumptions on employment and unemployment, wage rates, benefit levels (including gradually increasing the retirement age), inflation, and other relevant factors. A preliminary analysis will be available September 30, 1993 (in time to serve as an input for the 1994 budget); the final report and recommendations will be available by the end of 1993. 2. The Government will undertake a study of the social services now provided by enterprises which, with the commercialization and privatization of enterprises, would in the future be more appropriately provided by local authorities (or other levels of government). Recommendations will be made covering the social services to be transferred and how, in the future, they should be financed. The study and recommendations should be completed by end March 1994. Note 1: "World levels" is understood to mean the border price for imports from Russia plus all domestic processing and distribution costs. The subsidy on diesel fuel for agricultural use will be included in the budget. Annex 2 Page 1 of I Ifit.-1. Kazakhstan: Selected Economic Indicators, 1990-94 (Poealage change over sam period one year earlier, unless otherwise specified) 1990 1991 199 Est. Program I/ Program 1/ Nominal GODP (in billions of rubles) St 94 1,593 11,285 35,698 Real GoDP .0.4 -13.0 -14.0 -7.5 1.0 Exchange Rate (rubles per US$t. period average) 0.6 1.75 222 967 1.403 Retail Prices End-of-poriod 147.0 2.567.0 625.0 30.0 Period Average 4.2 91.0 1,381.0 926.0 104.0 Minimum Wage (end-period: rub per month) ... 342 900 10,000 15.500 Percent Change ... ... 163.0 1.011 55 Domestic Petroleum (excl. transport costs, cop). ... 70 8.400 92,00 169,349 As percent of International prices ... 44.0 20.0 65 100 Budget Revenues and Grants2 (percent of GDP) 32.7 25.0 18.7 19.1 19.2 General Government Revenues' (percent of GDP) 22.7 30.0 22.8 ... ... Budget Expenditures (percent of GDP) 31.4 32.9 24.3 25.2 23.4 General Government Expenditutres' (percent of GDP) 31.4 41.0 29.7 ... ... Overall Budget Balance (deficit (-)' a - commitment basis (percent of GDP) (including grants) 1.3 -7.9 -5.6 -6.0 -4.2 (excluding grants) -8.7 -12.3 -6.9 -7.0 -5.6 b - cash basis (including grants, percent of GDP)' 1.3 -7.9 .2.3 -6.1 -4.2 NBRK nt domestic assets ... 32 2,147 807 NBRK liabilities ... 316 1,438 908 .arrent Account Balance (in millions of US$) -2,370 -1,300 -2,080 -1,150 -1,220 (in percent of GODP) (-2.8) (-2.5) (-9.9) (-6.4) (-5.1) Trade Account Balance (in millions of US$) -9.790 -3,160 -1,670 -1,070 .1,190 (in percent of GODP) (-11.3) (-6.0) (-6.9) (-6.1) (-4.9) Sources: Goskomastst, Ministry of Economy, National State Bank of the Republic of Kazakhstan, and IMF staff estimates. 1 Program figures refer to the STIR program agreed with the IMP 2 International prices entering the calculations were converted into domesti currency using the exchange rates shown above. 3 Excluding operations of the Pension Fund. 4 Including operations of the Pension Fund. Annex 3 Page 1 of 1 KAZAKHSTAN - REHABILITATION LOAN Goods Which Would Not Be Financed 1. Notwithstanding other provisions of the Loan agreement, no withdrawal from the loan account shall be made in respect of: (a) Expenditures for goods to be supplied under a contract which a national or international financing institution or any other financing agency shall have financed or agreed to finance; (b) Expenditures for goods intended for a military or para-military purpose or for luxury consumption; and (c) Expenditures for items in the following groups or sub-groups of the United Nations Standard International Trade Classification, Revision 3: Group Sub-group Description 112 Alcoholic beverages 121 Tobacco, unmanufactured, tobacco refuse 122 Tobacco, manufactured (whether or not containing tobacco substitutes) 525 Radioactive and associated materials 667 Pearls, precious and semi-precious stones, unworked or worked 718 718.1 Nuclear reactors and parts thereof, fuel elements (cartridges), non-irradiated for nuclear reactors 728 728.43 Tobacco processing machinery 897 897.3 Jewelry of gold, silver or platinum group metals (except watches and watch cases) and goldsmiths' or silversmiths' wares (including set gems) 971 Gold, non-monetary (excluding gold ores and concentrates) (e) goods procured under barter arrangements; (f) goods supplied from the territory of countries other than World Bank member countries and Taiwan (China). Annex 4 Page 1 of 5 KAZAKHSTAN - REHABLITATION LOAN Goods to Be Financed under the Pre-Identified Imports Component (PIC) 1. Energy 1. The Uzen field is the largest currently producing oil field in Kazakhstan. Its cumulative production since inception of production in 1965, is nearly two billion barrels of oil. Although it is well into its terminal decline curve, the field still produces nearly 100,000 barrels of oil per day, thus making a significant contribution to the country's national income. 2. The field, however, is very badly in need of repair, both in its surface facilities and in its down-hole production equipment. Very little of this equipment is manufactured within Kazakhstan, and must be purchased abroad with foreign exchange. Much of the existing equipment is of Soviet design and manufacture, with specifications which are often substandard to those in use elsewhere. To purchase substitute parts from non-Soviet source requires not only access to hard currency, but access to procurement expertise as well, in the detailing of the required western specifications. 3. The required parts are selected flow lines, tubing strings, valves, and pumps; plus specialized hoisting equipment (workover rigs) which are needed to install these parts. These proposed purchases represent damage control measures only, to be utilized to keep the field producing while the processing for the full field rehabilitation program is underway. 4. Benefits. Under existing conditions, the Uzen oil-field production decline will accelerate, exceeding the minimum economic production threshold within the space of less than two years. Much of this accelerated production decline may be quickly reversed through the selective replacement of faulty downhole pumps, valves and tubing in wells which have previously demonstrated a capacity for high rates of sustained production. The replacement or repair of selected aging surface facilities, to allow the produced oil to be delivered to the point of sale without loss due to line rupture is also required if significant improvements in the level of production are to be realized. 2. Agriculture 5. More than 50% of the critical imports listed for agriculture are for herbicides and pesticides, with the greater portion of herbicides being for use against weeds in wheat fields, with the remainder used for other cereals. Use of agricultural chemicals are widespread with around 10-15 million hectares annually treated with herbicides and pesticides, down from a mid-1980's high of 20 million hectares. While the range of crops produced in Kazakhstan is quite diverse, cereals dominate the cultivated area (60-70%) with wheat representing 60-65% of the cereal area. Pesticides are needed for use against locusts and other pests affecting the production of cotton, fruits and vegetables. Without foreign exchange assistance to procure these chemicals, crop production may fall significantly in 1994. Veterinary medicine included in the list are for the treatment of worms and other internal diseases, and Annex 4 Page 2 of 5 for spraying animals (mainly sheep) against ticks which affect the wool and general health of the sheep. 6. The country also requires other imports for food processing: (i) disinfectants for the cleaning of physical infrastructure, equipment and other processing facilities to protect against diseases; (ii) aluminum cans and sulphide paper for the packaging of cereals and milk powder as baby food. While milk production is adequate, the severe shortage of packaging materials has already caused a shortage of baby food available in the market; (iii) animal fat and palm oil is needed to produce soap thereby avoiding a 50 percent fall in the production of soap next year. While it will be necessary in the longer term to examine the possibility of collecting and processing animal fat locally, without this import, it is expected that the already low level of soap production will fall by 50% during the next year; and (iv) spare parts to replace worn out sections of poultry processing equipment, various agricultural equipment including cutters for fodder production, tractor attachments, cultivation machinery and equipment, farm tractors and other farm related vehicles, equipment for the food industry (refrigerated transport, technical equipment in milk, meat and wool processing) and pumps and other parts required for irrigation equipment. Already, the severe shortage of spare parts renders many equipment inoperative; if the country does not import spare parts, more equipments will be forced out of production quite soon, affecting production at all levels. 7. Benefits. Acquiring the identified critical imports will prevent severe decreases in production, as well as social and economic disruptions. Available supplies of herbicides and pesticides will sustain the production of wheat and other cereals, fruits and vegetables will fall significantly, maintaining both CIS exports and food for domestic needs. Adequate supplies of veterinary medicine will avoid increased mortality rates for animals, thus keeping meat and wool production stable. The lack of disinfectants and the reduced availability of soap could result in health problems. The lack of baby food would result in nutritional problems. Without spares, many aspects of production will significantly reduce, with some areas coming to a complete halt. 3. Transport 8. Road Passenger Transport. Although local passenger transport is a stated priority for both local and the republican governments, it suffers from a serious shortage in transport capacity, which is rapidly escalating as an increasing number of buses are taken out of service due to the lack of spare parts or because they have become permanently disabled. While the World Bank is currently working on a proposed Urban Transport operation with the authorities, this is to focus on the three largest cities - Almaty, Karaganda and Shinikent and does not provide support to the rest of the country. A spare parts component has therefore been included in the proposed Loan to assist sustain the fleet in the remainder of the country outside of the three largest cities. The critical imports are targeted to salvage the existing Annex 4 Page 3 of 5 fleet of Hungarian made Ikarus buses from deteriorating beyond repair. These buses are considered the most modern part of Kazakhstan's bus fleet and provide an essential part of public transport capacity. 9. Benefits. Transport is an essential requirement for improvement of ope. -ons in every segment of the economy. At present, the transport system is severely disrupted, with considerable damaging effects to the economy as a whole. On the other hand, the foreign exchange requirements included represent less than 10% of the regularly required annual repair and maintenance needs. Thus, only the most critical items have been included. These will not be sufficient to clear the already substantial backlog of maintenance and overhaul which has built up over last several years. With these critical imports, a further buildup of backlog cannot be avoided, but at least a serious breakdown of the system can be averted. The benefits derived from these items are significant and the payback can be expected in less than one year. 4. Health 10. The shortages of essential drugs, vaccines and equipment are the most pressing problems facing the health sector. Already the situation is barely tolerable, and a further deterioration will result in much suffering, with the loss of confidence in both the health care system and the Government. The rehabilitation Loan will be used to pay for essential drugs for about $4 million and urgently needed medical equipment for about $1 million. The drugs are basic, essential drugs like: anaesthetic, analgesic, hormones, anti-TB, antiparasitic, anti-asthma, and pharmaceutical chemicals for syrups and intravenous solutions. Instead of supplying intravenous solutions and syrups, the money will be used to buy pharmaceutical grade raw materials, since the solutions can be made at both oblast and hospital pharmacy levels. The supply of raw materials will produce between two and three times as many liters of solutions as would ready-made preparations. All medicines are on WHO's model list of essential drugs. While the analgesic drugs are important symptomatic drugs, the anti-TB drugs and the intravenous drugs are critical in treatment and often life-saving. 11. The drugs and raw materials will be procured either from UNICEF or through international competitive bidding. It is recognized that the regular suppliers will have an advantage, since their products are already been registered in the former Soviet Union and their labels conform to local requirements. The drugs will be supplies to the Ministry of Health's drug organization "Pharmatsia" and distributed from its Central Medical Stores to oblast stores and from there to hospitals, clinics and pharmacies. The drugs are best suited for primary health care, except for the anaesthetic drug. The Bank financed drugs will be priced as all other drugs. A special committee will determine retail prices in line with procurement price and handling. It is recognized that the Ministry of Health may not be able to pass on the full cost of drugs prior to the introduction of an insurance scheme, and thus some targeted subsidy may be required for special groups. Any government subsidy is to be transparent and should appear clearly in the budget. Out-patient patients and future private patients will continue to pay for drugs, but in-patients, invalids, students and pensioners will still be exempted. 12. The list of urgently needed equipment are all basic for primary and secondary health care, including oral health. They are taken from UNICEF's catalogue (1990) and are all of good quality and low-price. The Government wishes to procure these from UNIPAC, since they are unable to procure at lower prices from their usual suppliers. The equipment will come to "Medtekhnica" and be distributed to primary and secondary health care facilities according to need. The price to the institutions have not Annex 4 Page 4 of 5 yet been determined, as the organization is reluctant to operate with the current high market price for drugs. The equipment is very much needed and should contribute to a more efficient operation of a large number of health facilities. 13. Benefits. The proposed support for vital drugs, vaccines, and other medical items, along with other donors' contributions and the national procurement, should contribute to an amelioration of the threatening drug emergency and may also aid in preventing a collapse of the health care system. Most importantly, the improved availability of vital drugs and vaccines will prevent diseases and save lives, including those of infants, small children and pregnant women. The proposed support should also prevent a situation where the government would be forced to appeal for emergency airlifts of drugs. Indirect benefits include lower pressure on the health care system and its providers, and time to formulate a new drug policy and develop improved systems for both financing, procurement, distribution, and the more rational use of drugs and medical equipment. Annex 4 Page 5 of 5 Table A3.1: Sectoral Allocation of the Pre-Identifled Imports Component (PIC) Sector Type of Goods US$ million Energy Uzen Oil-field 30.0 Agriculture Herbicides-Pesticides 30.8 Veterinary Medicine 8.2 Food Industry Raw Material-Packaging Material 8.0 Transport Bus Spare Parts 4.0 Health Drugs and Equipment 5.0 TOTAL 86.0 Annex 5 Page 1 of 7 REPUBLIC OF KAZAKISTAN REHABILITATION LOAN IMPLEMENTATION ARRANGEMENTS 1. The Project Implementation Unit 1. The Project Implementation Unit (PIU), established under the authority of the Ministry of Economy, will be responsible for the overall implementation of the Rehabilitation Loan and the related reporting and accounting activities. Given the wide scope and importance of its assigned finctions, the PIU will be given the authority and stature to deal directly and effectively with the Bank, government ministries and offices as well as the NBRK, commercial and correspondent banks and project beneficiaries. It will also be provided with adequate office space for its staff and facilities for file storage, copying, telecommunications (telephone, telex, and facsimile), information systems (computers and software), transport and adequate staff (see below on organization). It will be required to provide extensive support to sectoral administrations, guidance in procurement procedures new to the country's procurement agencies and other aspects of project implementation. The following is a summary of the main responsibilities of the PIU, which should be read with the Bank's Procurement Guidelines, Disbursement Handbook, and Guidelines for Financial Reporting and Auditing. 2. Overall project implementation responsibilities of the PIU will include the following: (a) to coordinate the activities of concerned ministries, other public entities, trading companies, commercial banks, and NBRK, in order to ensure a consistent and timely implementation of the Loan; (b) to advise the purchasing agencies in all aspects of procurement for the goods purchased through the Loan; (c) to establish and maintain project accounts, prepare all financial reports; (d) to administer the Special Account; (e) to prepare the withdrawal applications to be dispatched to the World Bank; (f) to collect and compile customs certificates for the FXC; maintain files containing all required documentation regarding both components; (g) to provide other management and administration services as may be necessary for the successful implementation of the Loan; and (e) to prepare the Project Completion Report. 3. The PIU shall comprise a full time Manager who shall have overall responsibility for the project. He is assisted by a Financial Manager who is responsible for project finance and accounting and Annex 5 Page 2 of 7 a Procurement Manager who is in charge of advising on all procurement procedures and monitors their implementation. The managerial group will be assisted by a minimum of 5 professional staff (including consultants) as needed to ensure timely decisions and project execution. II. Procurement 4. Pre-dentified IM CoMnent (PI. For each sector, the Government will appoint one entity, acceptable to the Bank, in charge of (i) purchasing eligible goods for and on behalf of the Government, following Bank procurement procedures; and (ii) ensuring the sale and distribution of such goods, as instructed by the Government. The PIU will advise the said entities in all procurement matters. S. For procurement to be conducted according to International Competitive Bidding (ICB) procedures under the PIC, the PIU will provide adequate advice and monitor the following activities by importing agencies: (a) advertising in local and international professional and press media and advising foreign delegations of World Bank member countries, including CIS countries who have become members of the World Bank), and Taiwan (China); (b) preparation of bidding documents using the Sample Bidding Documents issued by the Bank for the prcurement of goods issued by the Bank, based on technical specifications prepared by the relevant technical agencies; (c) distribution/sale of bidding documents to prospective bidders; (d) inviting bids from suppliers in eligible countries; (e) conducting the bid opening process and the evaluation of bids; (f) when designated to do so, preparing contracts; and, (g) when required, arranging and witnessing pre-shipment inspections (PSI). 6. For non-ICB procurement under the PIC, the PIU would provide advice to procurement agencies and monitor that they are following the appropriate procedures specified in the Loan Agreement, including: (a) soliciting written quotations from a list of potential suppliers in eligible countries; (b) soliciting quotation on sole-source basis and negotiating with suppliers for spare parts or other proprietary items; and, (c) placing purchase orders and contracting with selected suppliers. 7. In the area of contract administration services under the PIC, the PIU will closely cooidinate with importing agencies in: Annex 5 Page 3 of 7 (a) collect documentation, such as inspection certificates, certificates of origin/manufacturer, manufacturers'/suppliers' guarantees, bills of lading, beneficiary insurance certificates, and manufacturers' invoices; (b) forward documentation to the clearing agent; and (c) handle insurance claims. 8. In addition, the PIU will review proposals under the PIC for the purchase of imported goods to ensure that they comply with the agreed "pre-identified list", that funds are available in the Loan account to cover their costs and that the local currency equivalents have been deposited by the importers in the borrower's account in the National Bank of the Republic of Kazakhstan (NBRK) (see below). 9. Foreign Exchange Component (FXC). For goods to be procured through ICB under the FXC, the PIU would provide advice to commercial firms in the following areas: (a) advertisi-g in local and international professional and press media and advising foreign delegat, as of World Bank member countries, including CIS countries who have become members of the World Bank), and Taiwan (China); (b) preparing bidding documents using the Sample Bidding Documents issued by the Bank for the procurement of goods issued by the Bank; (c) distributing/selling of bidding documents to prospective bidders; (d) inviting bids from suppliers in eligible countries; (e) if required, conducting the bid opening process and the evaluation of bids; (f) when required, arranging pre-shipment inspections (PSI). 10. In this, the PIU would not be concerned with the items being imported or take any measure restricting their import, apart from ensuring that the FXC imports do not include noneligible items. 11. The PIU will not be involved in the procurement of goods through normal commercial practices under the FXC. 12. Procurement Advisers. In view of the lack of knowledge of the Bank's Procurement Guidelines and procedures amongst the trading companies and enterprises in Kazakhstan on the one hand, and the need to assure fast disbursements of the proposed Loan on the other hand, it was decided to seek the assistance of procurement advisers posted within the PIU, who would advise the PIU on Bank procurement policies, provide standard bidding documents approved by the Bank based on existing sample bidding documents, tram their counterparts in all aspects of the selection of suppliers, awarding of contracts, and monitoring and maintaining records of procurement activities, so as to make them self- Annex 5 Page 4 of 7 sufficient with regards to procurement under subsequent Bank Loans. The advisers will also be expected to provide input to the Country Procurement Assessment Report scheduled for FY94. Ill. Disbursement 13. The PIU will be responsible for the preparation of withdrawal applications and the collection of all supporting documentation. Disbursement will start once the Loan becomes effective. The Disbursement Handbook, which outlines disbursement matters for World Bank Loans, provides additional information on the procedures and should be read in conjunction with this section. 14. Pre-Identified Imports Comonent (PIC). Contracts financed under this component will include payment terms and the PIU will have to ascettain, before approving the contracts, that these payment terms are in line with World Bank disbursement procedures. The following disbursement procedures (or any combination thereof) are acceptable for this component: (a) procedure of special commitments for larger letters of credits (a special commitment is an irrevocable agreement to reimburse commercial banks for payments made (or to be made) under the cover of letter of credit. The special commitment is issued by the World Bank at the request of the PIU and is in favor of the banks of the suppliers); (b) payments of LC's through the special accounts: the paying banks will notify the PIU's of their readiness to pay the suppliers and the PIU will give order to the special account depositary Bank to transfer necessary funds to the banks of the suppliers; and (c) in the case where no LC have been used, direct payments to the suppliers by the PIU through the special account or directly by the Bank (payment terms will have to follow World Bank requirements). 15. Special Account. To facilitate the disbursement of funds, a Special Account (SA) will be opened in a foreign commercial bank acceptable to the World Bank. The SA will be maintained in a fully convertible and stable currency. The SA will be used only for the PIC. The SA will be in the name of the Borrower and will be administered by authorized representatives of the Borrower (preferably staff at the PIU). Two signatures will be required to make any transaction from the account. 16. The SA will be replenished on the basis of withdrawal applications prepared by the PIU. The PIU will submit to the World Bank monthly (or more frequently, if necessary) requests to replenish the SA; these requests will be accompanied by full documentation for all contracts. 17. The PIU will ascertain that adequate provisions have been made in the accounts of the Borrower's budget to record the sales of foreign exchange to importers under the PIU against payment of the equivalent local currency amount, valued at the official rate. The PIU will obtain summary statements of these transactions from the Ministry of Finance and make them available to World Bank supervision missions and external auditors. Annex 5 Page 5 of 7 18. Forein Exchange Component (FXC). Under the FXC, the PIU will for contracts below US$1 million, (a) collect with the Customs Department of the Ministry of Finance, customs certificates reflecting the imports into Kazakhstan of eligible goods and verify their eligibility. The PIU ascertai- that the said imports where not financed by other loans and grants or obtained through barter arrangements; (b) prepare withdrawal applications requesting the reimbursement of the amount of imports reflected in the customs certificates, based on SOEs established under the standard Bank format. The SOEs will summarize key information related to the said customs certificates including number of the certificate, contract amount, description of the goods, country of origin and date of customs clearance. The SOEs will be accompanied by a statement from the relevant authority indicating that the said imports where not financed by other loans and grants or obtained through barter arrangements; for contracts larger than US$1 million (through ICB) (a) collect full documentation regarding each individual transaction; (b) prepare withdrawal applications requesting the reimbursement of the said imports, accompanied by full documentation; Furthermore, the PIU will obtain from NBRK statements of their monthly sales and purchases of foreign exchange on the Foreign Currency Exchange of the Republic of Kazakhstan, or any successor thereof as agreed with the Bank, and forward them to the Bank. The net amount of these sales will determine the Monthly Eligible Amount, setting for each month (except during the period of retroactive financing) the maximum amount of eligible amounts imports that the Bank will reimburse. Any positive difference between the Monthly Eligible Amount of a given month and the amount of eligible imports of that month for which reimbursement has been requested from the Bank can be carried forward. 19. The PIU will ascertain that adequate provisions have been made in the account of the Borrower's budget to record the sales of the proceeds of disbursements under the FXC by the Ministry of Finance to the National Bank of the Republic of Kazakhstan at the official exchange rate. The PIU will obtain summary statements of these transactions from the Ministry of Finance and make them available to World Bank supervision missions and external auditors. IV. Reporting, Accounting and Auditing. Information System 20. The PIU would establish and maintain a Management Information System (MIS) covering all procurement financed by the Loan, as follows: Annex 5 Page 6 of 7 (a) under the PIC, the records would include information received on all procurement transactions, including identity of the user, kind of goods purchased, contract value, identification of the bidders and winning supplier, key dates for the bidding process, and subsequent fulfillment of the contract as well as statements from the Ministry of Finance accounting for the counterpart funds resulting from the sales of goods procured under the PIC to end-users. (b) for the FXC, customs certificates, NBRK statements of sales and purchases of foreign exchange on the auction market, statements from the Ministry of Finance accounting for the counterpart funds resulting form the sales of the proceeds of the FXC. 21. The above information will allow the PIU to monitor Loan implementation and will also provide the basis for the PIU to prepare the Project Completion Report required after the Loan has been disbursed and closed. Ammounting 22. The PIU would establish an appropriate accounting system according to generally accepted standards, in order to provide information on receipt and use of funds, in line with the terms of the Loan Agreement. The system would ensure timely and accurate accounting of all transactions under the Loan, and clear presentation of the financial information. It should enable identification of the use of all funds by components and categories of goods imported. The accounting should reflect the movements of the receipts and payments through the Special Account, with balances agreed with monthly financial statements from the holding commercial bank and with periodic statements from the World Bank. The system should enable identification of the use of funds for the PIC by categories of goods imported by the sector ministries and autonomous public entities. The disbursements on behalf of the sector ministries under the PIC and FXC components would be consolidated monthly by the PIU. 23. The Special Account which will be established under the Loan is intended to assist the Borrower with cash flow and to enable early and more effective project implementation and disbursements. The Borrower will ensure that all the necessary arrangements for proper accounting of receipts and payments (and replenishment) are complete before the start of the Special Account's operations. Financial Reporting 24. Financial reporting for the Loan would follow the specific requirements of the Loan. It would be comprised of a statement of receipts and payments for the reporting period since the beginning of the program. For the PIC the reporting would be in accordance with the disbursements classified and reported by the expenditure categories agreed with the Borrower and spelled out in the legal documents. For the FXC under which disbursements are made subject to a negative list, a summary statement of receipts and payments indicating that items under the negative list are not included should be prepared. A separate report for the Special Account would need to be provided under standard Bank format. A Project Completion Report will be submitted to the Bank by the PIU promptly after the completion of the program that in any event nor later than six months after the Loan closing date. Annex 5 Page 7 of 7 Auditns 25. The accounts, financial statements and reports on the Loan (including the special account) will be audited in accordance with generally accepted auditing standards by independent auditors acceptable to the World Bank, i.e. (i) impartial and independent from the entity to be audited; (ii) well established and reputable; (iii) experienced in the type of assignment to be undertaken; and (iv) able to fulfil the terms of reference required within the specified timetable. In the absence of any satisfactory alternative, the audit of the Loan will be carried out by an international accounting/ auditing firm, recruited at the expense of the Borrower. 26. The audit would cover a review of the supporting documentation including customs documentation. The audit report is to be submitted to the World Bank by the Government within six months of the end of the reporting period, i.e., the fiscal year end or the date of the final disbursement in case the Loan is disbursed in less than 12 months. Finance and Disbursement Adviser 27. In view of the country's lack of familiarity with international accounting and payment practices, the provision of an external finance and disbursement advisor will enable the PIU to: (a) maintain all project accounts in accordance with internationally accepted accounting procedures. (b) arrange payment of goods purchased under PIC; (c) prepare withdrawal applications in the Bank's format; and (d) establish the Project's financial reports in the required format. Annex 6 Page 1 of 3 REPUBLIC OF KAZAKHSTAN REHABILITATION LOAN THE FOREIGN EXCHANGE SYSTEM 28. Kazakhstan has so far remained within the ruble area, though its exchange rates and exchange system deviated from those prevailing in Russia. While Russia introduced in January 1992 a depreciated market exchange rate of around rub 100 to the dollar, the Kazakh banking system as a whole-and the Government-continued for several months to apply the previous commercial exchange rate of around rub 1.7 to the U.S. dollar. Subsequently, while applying this rate (or similarly appreciated rates) for purposes of Republican Hard Currency Fund transactions, the Government adopted the market exchange rate for purposes of foreign currency surrender requirements introduced in April 1992. The appreciated special commercial exchange rate (of around rub 50 per U.S. dollar)-used by Russia during early 1992 for purposes of foreign currency surrender--was never adopted in Kazakhstan. 29. On July 1, 1992, Kazakhstan moved with the Russian Federation to adopt a unified exchange rate system. From this date, the official, market rate of exchange has been defined as the exchange rate of the ruble against the U S. dollar as ascertained by the CBR on the basis of the Moscow interbank foreign currency exchange. The market rate of exchange is applied for all official purposes, including for foreign exchange surrendered to the NBRK and to the banking system, for official external debt service payments, purchases of foreign currency from the Republican Hard Currency Fund, and for accounting purposes by state enterprises. " 30. A second exchange rate also emerges from foreign currency auction held at the Foreign Currency Exchange of the Republic of Kazakhstan under the National Bank.' Subsequent to the first auction on June 17, 1992, auctions have been held on a weekly basis. The rate of exchange established through the auction has typically been more depreciated than that established in the corresponding Moscow auctions.8 Since Russian residents are free to sell foreign currency in Almaty, arbitrage between the two auctions might have been expected to lead to a convergence of the two rates. Remaining 6 The NBRK publishes the exchange rate for the Russian ruble for 25 currencies and the ECU that are quoted by the CBR on the basis of the international cross rate relationship between the U.S. dollar and the currencies concerned. The NBRK is informed twice-weekly of the exchange rates ascertained by the CBR (on Tuesdays and Thursdays), and the market rate, based on these communications, is effective from the start of business the following day. 7 Participation in the auction is limited to the NBRK and authorized banks. The rate of exchange on the auction is independent of the official exchange rate, being set at a level which matches bids with the amount of currency offered for sale. A single fixed rate is applied to all transactions conducted at the auction, the buying and selling rates being the same. Purchasers are subject to a 0.3 percent commission payable to the auction, and to a 1 percent commission payable to the purchasing bank. Residents seeking to sell or purchase foreign currency on the auction (via authorized banks) are required to present documentation establishing compliance with prevailing foreign exchange regulations. Foreign currency purchased on the auction and not used within two months must be re-auctioned. Transactions are limited to the spot exchange of U.S. dollars. 8 In the period June 1992-January 1993, the Alnaty rate was 7.5 percent more depreciated, on average, than that on Moscow auctions, with the margin exceeding 13 percent in the months of December 1992 and January 1993. Annex 6 Page 2 of 3 divergences are believed to reflect costs arising from the use of the interstate banking system. Sales on the Almaty exchange during the second half of 1992 were equivalent to only 8 percent of estimated foreign currency export earnings, possibly reflecting imposition of taxes on foreign export proceeds which encouraged barter trade and the nonrepatriation of foreign currency earnings. Sales peaked at around US$12 million during the month of November 1992, subsequwatly falling to around US$3 million during January 1993 (see Table AS.1). This decline reflected, in par the cessation of foreign currency sales by the NBRK. 31. A third exchange rate emerges from the approved foreign exchange operations of authorized banks with resident enterprises and individuals. This rate is market determined, except that the spread between buying and selling rates must not exceed 10 percent. The interbank market is relatively undeveloped, reflecting the low level of foreign exchange sales to the banking system. Banks may obtain sicenses to operate foreign exchange bureaus. Foreign exchange purchased at the bureaus may be sold only for purposes of business and tourist travel, and is subject to the same 10 percent maximum spread between buying and selling rates. (Source: IMF: Background Paper and Statistical Appendix, Staff Report on the 1993 Article IV Consultation, April 9, 1993) Annex 6 Page 3 of 3 Table AS. 1: Kazakhstan: Foreign Exchange Market Developments. 1992-93 (Rubles per ..S. dollar) Divergence Foreign currency Market exchange rate 1/ from Moscow sales in Daily End- Almaty auction Ahaty auction average period auction rate (In millions Period rate rate rate 2/ (Percent) 3/ of U.S. dollars) January 110.0 110.0 ... February 104.8 90.0 ... ... March 92.3 100.0 ... ... ... April 100.0 100.0 ... ... ... May 95.3 85.0 June 88.5 100.0 144.9 12.0 0.8 July 138.3 161.2 157.4 3.9 2.5 August 167.9 205.0 164.0 1.5 3.5 September 217.4 254.0 246.1 9.6 7.0 OCtober 344.7 398.0 362.6 2.1 10.8 November 423.5 447.0 444.5 3.3 11.8 December 414.6 414.5 475.6 13.9 8.7 January 461.7 572.0 546.6 13.7 5.3 February 572.0 593.0 719.0 24.5 March 658.7 684.0 784.0 18.4 2.5 April 756.3 23.0 870.0 7.1 1.0 May 911.0 1024.0 ... ... ... June 1080.0 1060.0 July 1025.0 987.0 16004/ 51 4/ n.a. Source: Data provided by the National Bank of the Republi. of Kazakhstan. I As determined by the Central Bank of Russia (CBR). The official rate of exchange in Kazakhstan has been pegged to the CBR market rate since July 1992. 2 Average auction exchange rate, weighted by currency turnover. 3 Average percentage depreciation of the exchange rate established on the Almaty auction relative to that established in contemporaneous Moscow auctions. Divergences within each month are weighted by Almaty auction currency turnover. For the period since July 1992, the deviation is equivalent to that between the Almaty auction rate and the official exchange rate of Kazakhstan. 4 On July 13, 1993. Annex 7 Page 1 of 1 REPUBLIC OF KAZAKHSTAN REHABILITATION LOAN KEY PROCESSING EVENTS Time taken to prepare: 14 months Project prepared by: Government with the assistance of IBRD staff and consultants' Pre-Appraisal: June 12-30, 1992 Loan Committee: October 9. 1992 Appraisal: October 19-27, 1992 Post-Appraisal: July, 7-17, 1993 Negotiations: August 11-12, 1993 Board Presentation: September 16, 1993 Expected Effectiveness: October 15, 1993 Closing Date: December 31, 1994 ' This report is based on the findings of the World Bank missions which visited Kazakhstan in April 1992, June 1992, October 1992, February 1993 and July 1993 assisted the Government in identification and preparation of the project, and concurrently appraised it. Mission members included: Messrs./Mmes. Funck, Toureille (Task Managers); Chu (Deputy Task Manager); Guerrero, Loyd, and Holsen (Economists); Andrews (Mining); Somel, Voegele, and Russell (Agriculture); Subbarao (Social Sector); Linder and Yuksel (Procurement); Prefontaine and Renkewitz (Disbursement); and Lauridsen (Health Sector). Mr. Eduardo Abbott has served as counsel for Kazakhstan since June 1992. Additional contributors include: Messrs./Mmes. Mock and Garcia-Garcia (Agriculture); Engelhard, Tirmazi (Procurement); Mills (Social Sector); Lorch (Privatization and Private Sector Development); Saba (Private Sector Development); Polizatto (Financial Sector); Garvey (Environment); and Le Vourc'h (Accounting). Mr. Kadir T. Yarifkoglu and Mr. Russell J. Cheetham are the managing Division Chief and Department Director, respectively, for the operation. Annex 8 Page 1 of 1 REPUBLIC OF KAZAKHSTAN REHABILITATION LOAN STATUS OF BANK GROUP OPERATIONS A. STATEMENT OF BANK LOANS. As of June 30, 1993, Bank lending to the Republic of Kazakhstan had not yet commenced.10 B. STATEMENT OF IFC INVESTMENTS. As of June 30, 1993, Kazakhstan was not yet formally member of IFC, although it applied for membership on January 23, 1992." 10A Technical Assistance Loan in an amount of US$38 million was approved by the Board on August 3, 1993. "A first IFC project, the ABN-AMRO Bank (Kazakhstan] in an amount of US$2 million, is scheduled for Board presentation on September 16, 1993. 方