Morocco - First Municipal Finance Project

Document of The World Bank FOR OFFICIAL USE ONLY -A/ $/Z6 /- AL 2-Al3J /7 Al U12 Report No. 11562-(R STAFF APPRISAL REPORT KINGDOM OF MROCCO FIT MCIPAL FflIANC PROJT NAY 21, 1993 Infrastructure Operations Division Magbreb Department Middle East and North Africa Region I This docum has a resiucted dhltibu md may be used by recdputs o y in the performanoe of their oficud duties. Its contents may ot otherwie be dcdosed whot Wold Bsnk aorlzo.  CURRENCY EOU-VALENTS US$1 - DH 8.50 (as of January 1, 1993) DH 1 - US$0.12 FISCAL YEAR January 1 - December 31 ABRO2IXS BM Banque Al-Maghrib (Central Bank) CDG Caisse de D6p8t et de Gestion (Administrator of Insurance and Pension Funds) CL Collectivit6s Locales (Local authorities) FEC Fonda d'Equipement Communal (Communal Infrastructure Fund) GT General Treasury of the Kingdom ICB International Competitive Bidding LCB Local Competitive Bidding MOF Ministry of Finance MOI Ministry of Interior TDMI Training Directorate of the Ministry of the Interior USAID United States Agency for International Development VAT Value-Added Tax  FOR OMFFCIL Use ONLY KINgDOOF MQRCCQO FIRST MUNICIPAL FINANCE PROJECT STAFF APPRAISAL REPORT CONTNS LOAN AD PROJECT SnMMA R Y . . . . . . . . . . . . . . . . . . . . . . . . SU Y I. INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 II. THES ECTOR OVERVIEW AND ISSUES .................. 2 A. Local Sarvices . . . . . . . . * . . . . . . . . . . . . . 2 B. Sector Tnstitutions and Manageme:it Systsu1s . . . . . . . . . . 2 C. Municir.L Finance . . . . . . . . ..... .. . . . . . . . 5 D. Main t,.;tor Issues . . . . . . . . . . .. . . 7 III. SECTOR REFORMM PROSPECT8 . . . . . . . . . . . . . . . . . . .. 9 A. Actions to Improve the Sector . .............. . 9 S. Forecast of Flow of Funds of the Local Sector . . . . . . . . 11 C. Bank Role and Sector Lending Strategy . . . . . . . . . . . . 12 IV. THE BORROWER AND PRIMAMY PROJECT EXECUTING AGENCY . . . . . . . . . 13 A. Institutional Profile ................. . 13 B. Credit and Financial Policieg .............. 15 C. FEC's Finances . . . . . . . . ... . . . . . . . . 16 V. THE PROJECT . . . . . . . . . . . . . . . . . .... . 19 A. Origin . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19 B. Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . 19 C. Rationale for Bank Involvement 9.. . . . . . .*.. . . . .. . . 20 D. Project Description . . . . . .. . . . . . .. . . . . .. 20 E. Project Cost and Financing... ........ . . ..... 22 F. Implementation . . . . . . . . . . . . . . . . . . . . . . . . 24 G. Procurement and Disbursements 25 H. Monitoring . * . .. .* *. 27 I. Benefits and Risks . . . . . . . . . * . . . . . . 28 VI. AGRhEMENTS AND RECOMMENDATIONS . . ... . . . . . . . . . . . 29 This document has a sticted distibuton nd ay be used by eipents on Int pfomance of tir offcia dutes Its ctets may not oQthwie be discloe without Wold Bank autoiaton.  Table 2.1s Local governments' revenues and expenditures . . . . . . . . 5 Table 3.1s Forecast of flow of funds of the local sector . . . . . . . . 12 Table 4.1: FEC's summary financial statement . . . . . . . . . . . . . . 18 Table 5.1: Summary of costs . . . . . . . . . . . . . . . . . . . . . . 23 Table 5.2: Project's summary financing plan . . . . . . . . . . . . . . 23 Table 5.3: Procurement arrangement . . . . . . . . a.. . . . . . . . . 26 ANNEXS ANNEX As Local government finance in Morocco . . . . . . . . . . . . . 31 ANNEX B: Program to develop and introduce a new VAT distribution system 57 ANNEX C: Plan of action to improve local sector management and intevgoverrAment finances . . . . . . . . . . . . . . . . . . 58 ANNEX Ds Terms of reference for study on local and intergovernmental finances . . . . . . . . . . . . . . . . . . . . . . . . . . 59 ANNEX Es Terms of reference for study to develop the local sector manu ageentinformation systems . . . . . .... 62 aNNEX Fs Training component ........... ......... 68 ANNEX 0: Procedures for processing and administering loans . . . . . . 78 ANNEX H: Action plan for the institutional improvement of FEC . . . . 82 Attachments Computation of FEC's Targets of Performance . . . . . . . . . . . . . . . . . . 83 ANNEX I: FEC's policy statement ................... 84 Attachments Evaluation Criteria . . . . . . . . . . . . . . 91 ANNEX Js Notes to FEC'o financial statements . . . . . . . . . . . . 103 ANNEX K s etailn of project costs ... . . ...... 109 AEX Ls Disbursement schedule . . . . . .......... 110 ANNEX M: Allocation of proceeds ..... . .. . .111 ANNEX Ns Monitoring ystemsystem............ . 112 ANNEX O Documents and data available in the project file . . . . . . 118 This report is based mainly on the findings of missions which visited Morocco in October-November 1991, January 1992, May 1992. and October-November 1992 (appraisal). The appraisal team was composed of Messrs. Julio Linares (task manager), Claude Hovnanian, Charles Sterling, Sherif Arif (ENTEN), and Frangois Vaillancourt (consultant - Professor of the University of Montreal). Earlier contributions pertain to Messrs. Alberto Antonini (INV04). Alain Tobelem (LATPS). Mrasa Fernandez-Palacios (P8DCP). Antoine Sylvain (consultant, official of the Government of Quebec) and Noe Assia Khellaf (consultant). The following Bank professionals advised the mission: Mr. Jacques Coudol on restructuring the municipal finance agency; and Mr. Richard Bird (Professor of the University of Toronto--visiting consultant to the Bank) on intergovernmental finances. Mrs. Nicolette DeWitt advised the mission on legal aspects and prepared the project legal documents. Messrs. Tim Campbell (LATAD) and Jam Hicks (TWURD) were peer reviewers. M4essrs. Amir Al-Khafaji (Division Chief. M111IN) and Harinder Kohli (Director, MNI) approved the report. Ms. Michelle Detwiler edited the report. Mrs. Jocelyne Simmonds produced the report.  KINGDOM OF SBMORCC FIRS! MUNICIPAL rINANCZ PRGJECT OAN AND PROJECT S8MMARY Borrowers Kingdom of Morocco and Fonds d'Nquipement Communal (FEC) AmounI RKingdo.a of Morocco: US$ 4 million equivalent FBCs US$100 million equivalent Tomes Repayable in 20 years, including five of grace, at the Sank's standard variable interest rate. Onlendig la. s FEC will onlend to the beneficiaries US$100 million equivalent in dirhams with a margin of about 4 percentage points to cover the foreign exchange risk plus 2 0 - 2 S percentage points to cover tho cocmmercial and interest risks, and management costs. Maturities will be up to 1S years with a grace period on principal of up to two years. The Kingdom will assume exchange losses on FEC's loan in excess of the exchange margin. DsecrlRtigns The project aims at improving the efficiency of local investments, distribution of the local share of the value-added tax (VAT) among local governments, availability and delivery of local services, and management of the local sector. It includes the following: (a) Funding for local investments in roads, water and seworage, solid waste, and productive and recreational facllities (US$176.5 million - 96.8 percent of total project cost). (b) Technical assistance, training, and equlpment to improve FEC's institutional capabilities, (US$0.8 million - 0.4 percent of total project cost). (c) Training for local governmente' staff, including the construction of a training center, training of trainers, and related consultant services (US$2.3 million - 1.3 percent of total project cost). (d) Technical assistance, training and equipment to improve int rgovernmental finance, and the central government management systems related to the local sector (US$2.7 million - 1.5 percent of total project cost).  - ii - Benefits: The project would benefit about two million people living in urban and rural agglomerations, including a large number of poor. All financed Investments wiill have high priority and meet stringent quality criteria. Subprojects will have an economic rate of return of at least ten percent. Further, project benefits are expected well beyond those of financed investments on three additional counts. First, policy reforms and conditionality are designed to increase the efficiency of investments--regardless of sources of financing-- through the local sector. Second, actions to Improve mar.agement systems of local governments and central authorities dealing with the local sector are designed to improve services aad the financial performance in the local entities. Third, the restructuring of FEC (agency in charge of financing local investments) and the reform of the distribution of the local share of the VAT among local governments are designed to enhance the discipline of local governments and thus increase their savings. Risks Ind safeguards: Improving local services and sector management countrywide is an ambitious undertaking which will require sustained effort for many years. The project addresses key sector issues, and it involves many agencies, some institutionally and operationally weak. Three main risks have been identified. The first is that limited project preparation capacity at the local level compounded by a st.l' untested FEC might result in a slow pipeline of quality subprojects and thus delay project execution. The present backlog of projects--a good number of them potentially eligible--will mitigate this risk at the beginning of project execution. The training component and technical assistance to FEC will reduce this risk in the longer term. The second main project risk is that FEC's management might fail to apply its demanding policy framework. Government and Bank collaboration in designing the new FEC have already reduced this risk. The third is that political pressures might undermine the Government's resolve to carry through and maintain the reform in the distribution of the local share of the VAT. Intensive discussion of sector issues throughout project preparation have already considerably reduced this risk. The annual reviews of project performance including a major one in 1995 should further reduce all risks.  - iii - USS MILLION LOCAL FOREIGN TOTAL (ESTIMATED COSTS | Local projects Infrastructure 109.6 63.4 173.0 Studies and designs 2.0 0.5 2.5 Institutional development 0.5 _0. 1.0 112.1 64.4 176.5 Institutional improvement of PEC 0.0 0.8 0.8 Training for local governments 1.1 1.2 2.3 Institutional improvement of Central Government units 0.9 2.7 TOTAL PROJECT COST1 114L1 182.3 lFINANCING PLA Subborrowers' resources 35.3 0.0 35.3 FEC 42.0 0.0 42.0 Government 1.0 0.0 1.0 Bank 3S.8 ,6.2 104.0 TOTAL FINANCING AuM L ILOAI DISBURSEMENT SCHEDULE Bank Finecal Year A 2* U 2 A 22 Annual 8 31 33 23 8 1 C2tulative 8 39 72 95 103 104 ECONOMIC RATE OF RETURN Min. 10% when applicable J/ Includes about US$25 million for taxes and duties.  FIRST MUNICIPAL FINANCE PROJECT STAF APPRAIA IMPORT I. IjY.2MDgIL.QJ 1.1 This report appraises Morocco's First Municipal Finance Project, which involves two interrelated loans: one to the Communal Infrastructure Fund (FEC), the municipal finance agency; and one to the Kingdom of Morocco. Given the importance of the Government's obligations under its Loan Agreement to the FEC component, failure by the Government to carry out its obligation under its Loan Agreement would give rise to a suspension remedy under the FEC loan. Tne effectiveness of the FEC loan, moreover, will be conditional upon the effectiveness of the Kingdom loan. The project's objective is to support loans to FEC and the Ringdom, mainly for financing municipal inveitments and institutional improvement components, respectively. 1.2 The performance of the local sector significantly affects the Moroccan economy. In spite of low investment levels caused by limited funds, the local sector's share of gross domestic product has been around 5 percent in the last few years and local sector investments amount to about 25 percent of those of the Central Government. About 12 percent of total fiscal revenues accrue to local governments as local taxes or transfers from the Central Government. Upgrading the local sector, therefore, is a priority policy initiative for which the Government has requested Bank assistance. 1.3 The proposed project has three major development goals. The first is to improve the efficiency of local government investments. To achieve this, the Government is restructuring FEC. This restructuring entails the adoption of a clear investment financing policy framework, which would regulate the investment eligibility, project quality standards, operating norms, and financial conditions of loans. The second is to improve intergovernmental finances. The most urgent measure to achieve this will be the introduction of a more rational system -- based on social and economic criteria -- for distributing the local share of the value-added tax (VAT) among local governments. This system will replace discretionary capital transfers and current transfers based on the estimated current budget deficits of each local government, with single transfers out of the local share of the VAT distributed among local governments on the basis of objective criteria. The Moroccan authorities, moreover, would review and revise local taxes, as needed, as well as develop a long-term strategy to improve intergovernmental finances. The third major development goal is to increase the availability and improve the delivery of urban and rural infrastructure services, as well as upgrade the management of local governments. 1.4 In keeping with project goals, the project would finance urban and rural infrastructure, and training and technical assistance for the Central Government departments concerned, local governments, and FEC. Two loans in the aggregate of US$104 million are proposed. They would be disbursed for components--including partial funding of FEC subloans which in turn would partially finance local investments--with a total cost of some US$182.3 million in current prices. FEC, in parallel, is expected to finance another US$350 million of investments during the project execution period (1994-1998), for a total lending program of over US$S500 million. All projects financed by FEC, including subprojects financed with the Bank loan, would fulfill the same eligibility criteria and conditionaliti^ outlined in PEC's Policy Statement.  -2- II. THE SECTOR: OYERVIEW AND ISSUES A. Local Serviceg 2.1 The level of coverage for local services in Morocco is low compared with countries of similar development. About 60 percent of the non-dispersed population have access to piped water, compared with over 70 percent in many other developing countries. Only some S5 percent of the population have electric service, and streets and rural road. are generally deficient. Facilities and services are worse in medium- and small-size towns (10,000-50,000 inhabitants). Overall conditions could further deteriorate as the population is growing fastest in those towns, thus str,'ining their limited organizational and financial arrangements to carry out investments. 2.2 Insufficient investment largely accounts for Morocco's low level of local services. In 1986, the Central Government and the local governments reviewed potential investments required to satisfy strictly local needs, screened out the investments that appeared to be non-essential or non-urgent, and prepared a list of priority investments totalling US$3,700 million equivalent in 1986 prices. This, in addition to investments needed to accommodate population growth (about 4 percent p.a. for the non-dispersed population and about 2.5 for the country's current total population of 27 million) and replace decaying facilities, would call for an annual investment level in the order of US$600 million over a period of ten years. Yet, the historical investment level has been only about US$300 million p.a. This translates into US$ll per capita, a meager amount considering that present services are highly deficient. Achieving a much higher level of investment could strain the limited management capabilities of most local governments. But over the medium term, the paucity of funds is the main binding constraint to achieving investment levels more commensurate with service requirements (para. 2.18). Potential for quality investments by local governments is further discussed int para. 5.6 within the context of the project description. B. Sector Institutions aad Manacement Systems 2.3 The Moroccan public administration is divided among the Central Government, provinces, prefectures (i.e., major metropolitan agglomerations), and communes. There are 47 provinces and 13 prefectu-re, each with an assembly and a governor. These authorities are responsible for implementing provincial and metropolitan investments approved by the Central Government, which allocates funds to the provinces and prefectures from the fiscal resources earmarked for local governments. Governors are appointed by the King and seport to the Minister of the Interior. Provinces and prefectures, in turn, are divided into some 1,550 urban and rural communes (about 900 before 1992). Primarily urban communes, 250 at present, are called "municipalities*. The other 1,300 communes, groups of villages and areas with dispersed population, are considered rural. Larger municipalities own quasi-autonomous agencies called "R6gies," which specialize in the provision or distribution of one or more services, such as water, power, and local transportation. In the smaller communes, the RMgies are self-contained operating units within those communes. 2.4 Communes. The communes, which will be the main project beneficiaries, are the base level of local government. They are mainly responsible for constructing and maintaining local roads and streets, as well as for providing sewerage, solid waste disposal, slaughterhouses, and market services. An elected President and elected Council govern each commune. The  - 3 - Council ie empowered to formulate the communal budget, select investments, and set rates on several local taxes and fees (which account for a small fraction of the resources of most communes). Two committees of council members, the investment and the finance committees, develop investment ideas and propose investwr it to the Council, respectively. The President, as the commune's chief executii j officer, manages local services, implements investment projects, and oversees the R6gies. Notwithstanding the powers of local authorities, the Ministries of Finance (MOF) and Interior (MO0) must approve commu"*l budgets. 4X0 also approves the submission of local government projects co lending agencies. The General Treasury of the Zingdom (GT) within MOF, moreover, receives all commune resources for deposit in government central accounts and, upon review for legal and accounting adequacy, pays suppliers on behalf of the communes. 2.5 Human Resources. In the last few years, communeas have significantly increased their institutional capacity, but still have a long way to go before constituting a modern local sector. In 1991, total communal staff reached 103,000, or four staff per 1,000 inhabitants (three in 1990), a low level compared with about six observed in efficient local sectors of other countries. Communes, moreover, managed to increase the percentage of professional and managerial staff from four in 1990 to five in 1991. Most medium-size communes already have she capacity to program and implement their investment proiects, with assistance from external architects and other eAperts supervised by communes' professional staff. Rural communes, especially the smallest ones and those furthest from urban areas, generally need the support of professionals from provincial governments to plan for and even carry out investment projects. Starting in early 1992, MO was hiring the key staff for the communes created later that year. still, to be able to manage the increased number of communes, government plans call for increasing communes' staffing ratios from the present four per 1,000 inhabitants to five in 1993 and six by 1995. Becau.e9 the compensation of local officials is now generally adequate, communes should be able to continue upgrading the quality of their ranks by retaining and hiring qualified staff for -hich, in the future, communes will rely mainly on a major training componenx included in the present project (para. 5.4). 2.6 The Communes' financial information systems are adequate enough to prepare clear budgets and account for their execution, but they need improvement to permit better financial management by commune officials and better oversight by the Central Government. The standardized accounting records required by NO0 clearly reflect commune transactions. Each investment has its own account, so that it would be relatively easy to audit investments financed by FEC. Still, communes' accounting systems do not show the status of receivables; they only produce administrative accounts showing sources on an accrual basis and expenses on a cash basis, failing to produce statements of revenues and expenses, cash flow, and financial condition. Technical assistance under the project will help the Moroccan authorities further improve the communes' financial information systems (para. 5.4). 2.7 The Regies. The R6gies, even those that are separate legal entities, have little autonomy. 1O0 appoints the R6gies' Director General and main line managers. Although the R6gies operate similarly to business enterprises, they, like the communes, are subject to tight central supervision. MOI reviews and approves the R6gies' budgets, specific investments, and user charges. For lack of timely approval of adequate tariffs and other fees, the R6gies' financial performance in generally poor, which is why they frequently neglect to rehabilitate and maintain their facilities. Sank-assisted water and sewerage  projects currently under preparation, rather than this project, will more appropriately address the development issues and financlal needs of the major self-standing Regles with which the Government will start the process of reform. FEC may even finance the investments of self-standing R6gies with Bank funds, but stringent borrower eligibility criteria and conditions for loc.;i governments to guarantee R6gie debt will severely limit such financing. Overcoming that constraint ought not come from relaxing FEC's financial standards, but from the Government's fostering R6gies, finaneial viability. 2.8 Private Sectar's Role. Private sector participation is increasing in several local services, most notably in urban transportation and solid waste collection. Still, some local services that appear amenable to privatization-- such as marketplaces and slaughterhouses--overwhelmingly remain public services provided by local gove-nments. Local authorities do not prohibit or tax away private sector partici;ation in those activities, but national laws and other regulatory practices may affect such participation. A national law requires that wholesale markets managed by local governments--official exchanges for fruit and vegetables--must be public. Anyone can open an establishment to sell to retailers, but not with the character of an exchange where wholesale prices are officially determined. Anyone can also open a retail business, but basic food stuffs are subject to maximum markups imposed by the Ministry of Economy under the Prime Minister, MOI, or the provincial governors acting as Central Government agents. Enforcing these price controls is easier in municipal markets, as violators can lose their moderately priced tenancies. Private enterprises can open slaughterhouses, as long as they comply with strict sanitary regulations. In practice, public slaughterhouses predominate, but legal private and clandestine private slaughterhouses also exist. The main issue is price controls. Addressing this issue is well beyond the scope of this project, which already has ambitious policy objectives. Still, increasing private sector participation is a legitimate policy objective, which requires further study. The means to lay the groundwork for enhancing that participation are discussed in para. 5.4. 2.9 Role of the Central Government. At the central level, the main actors for the local sector are MOI and MOF. MO! oversees local governments as well as FEC, through its General Directorate of Local Governments. This directorate comprises the Directorate of Investments, which reviews and helps prepare local investments, and the Directorate of Local Finance, which reviews the budget of local governments. ROl, moreover, has a Training Directorate (TDMI), which serves not only the Ministry but the local sector as a whole. MOl also has a Court of Accounts, empowered to audit the accounting documents, facilities, and project sites of all local governments. While senior officials and professionals in the above units are highly competent, they lack both an adequate data base to monitor local government performance and adequate formats for the information they review to screen whether the proposed local investments address priorities and conform with appropriate standards. Nor, for its part, also has highly qualified officials and professionals in charge of the local sector. Its GT controls expenditures by approving payments with appropriate legal and accounting support. MOF's Division of Local Governments, dependent on the Department of the Budget, reviews local budgets and monitors local taxation. The Division of Banking and Finance, under the Department of the Treasury of MOF, in addition to MOl, oversees FEC. 2.10 MIg. Mainly because of the communes' and R4gies' limited autonomy and lack of access to commercial bank loans (para. 4.1), the Government has had to rely entirely on FEC to provide loan funds for local government and R6gie  - 5 - investments. Unti_ December 1991, FEC was a government agency responsible for appraising communal investment projects and channeling fiscal resources to them under the management of the Calse de D6p6t et do Gestion (CDG, which is a public institution responsible for managing pension funds and Some fiscal resources) and the general supervision of (X0 and NOV. Since this arrangement contributed to an unsatisfactory lending performance, FEC was restructured In December 1991 with the pasesage of an organic law (promulgated in August 1992) giving FEC the autonomy of a publicly-owned specialized financial institution. Issues related to FEC are discussed in paras. 2.19 and 2.20; FEC's organization and management are discussed in paras. 4.1 - 4.9. C. lunicival Finance 2.11 Ovedgiew. The following table shows revenues and expenditures of local governments for 1990-1992. In 1990, for example, the GT not only received revenues for local governments, but also paid local government expenditures of DH 6,600 million (US$780 million equivalent), as those govarnments do not manage their own funds (para. 2.4). A similar parity between revenues accrued by, and received on behalf of, local governments during the bud cit period, and actual expenditures of local governmerbs during such period, are estimated for 1991 and 1992. Information on assets and liabilities to match those flois is generally unavailable, as local governments in Morocco, as in most countries, still do not prepare balance' sheets, a matter that the proposed project will address (para. 5.4). FEC's financial statements, however, show that local governments have an aggregate debt of about DH 2,600 million (US$300 million equivalent), a modest burden compared with total flows. Tabl 2.1s LOCAL GOVERIUENTS' REVENUES AND EXPENDITURES (DH billion) CONCEPTS ACTUAL BUDGET 1990 1991 1992 Revenues l - % Local taxes and 2.7 41 3.3 01 3.6 40 other VAT 3.4 51 4.2 52 4.4 49 Loans 0.5 8 0.6 7 0.9 11 Total resources 6.6 100 8.1 100 8.9 100 Expenditures Operating costs 2.7 42 3.4 42 4.S 50 Debt service 0.3 S 0.4 5 0.5 6 Investments2 3.6 53 4.3 53 3.9 44 Total expenditures 6.6 100 8.1 100 8.9 1i0O Source: 501's Directorate of Locat Finance, ith some adjustments and reclassiffeation. 21/ Includes investments In education, health and agriculture carried out by the line ministries.  - 6 - 2.12 Local Sect2r Agcountina. The table above excludes current account surpluses and unused investment credits at the beginning and at the end of the period, which combined have remained about equal to some DH 2.700 million. Those accounts legally permit the GT to pay for local investments early in the budget period, while waiting for established current surpluses and actual collection of the VAT to permit local governments to tender and the GT to pay investment expenditures charging them to the present period's VAT. The current account surplus of DH 700 million--excess of local taxes plus VAT allocated to non- investment expenditures, over operating costs and debt service--is largely planned, and justifies early investment expenditures the following year. The remaining DH 2,000 million are a float of unused investment credits largely resulting from requiring prior receipt of VAT resources before tendering investments. Essentially, MOF makes the planning and execution of investments lag behind the accrued local share of the VAT, as a means to foster the GT's cash balances, contain public sector expenditures, and avert local arrears. The non- transparent, complex accounting practices are the result of MOP policy and Central Government management of local funds. Since these are the cornerstone of intergovernmental finance in Morocco and the Government will be improving the distribution of the local share of the VAT, reforming the present system in the near future is unlikely and unwarranted. Annex A provides details on local finance, including this complex matter. 2.13 ReveUi. Local taxes, a current account revenue item, are about equally divided into taxes managed by the Central Government and taxes managed by the local governments. There are 35 taxes in total. The higher yielding ones are two on real estate rental values and one on the maintenance of a business license; the other are miscellaneous taxes and fees. A largely completed reform, started in 1990, substituted some new taxes for old ones, changed some rates, left the total number of ta%es unchanged, and increased total yield by about 15 percent that year. An evaluation of the results of this reform should be carried out around 1994. Loans, mostly from FEC, make up capital revenue. The local share of the VAT is about equally divided into a current component, earmarked to cover operating costs aad debt service, and a capital component, earmarked to cover investment expenditures. 2.14 The Local Share of the VAT. According to a law implemented in 1988, 30 percent of the proceeds of the VAT belong to local governments. In 1990, total VAT accruals for local governments amounted to DH 3,400 million (US$400 million equivalent). Nonetheless, a large share of local government VAT accruals were unavailable to carry out local expenditures because they were used either to finance centrally controlled and administered local expenditures or to increase public sector cash (paras. 2.15 - 2.17). 2.15 The Distribution of the VAT amonc Local Governments. With MOP concurrence, MOI distributes the larger part of the local share of VAT proceeds among local governments. To contain total public spending, MOP recovers part of the local share of the VAT by financing out of that share certain investments In education, health, and agriculture made by the line ministries; this part was about 16 percent of VAT accruals in 1990. Then, at its discretion, MOI distributes a part of the remaining VAT resources to pay for local governments' common expenditures and another part to finance so-called "national integrated investments" (mainly in water and power), which mostly benefit provinces and metropolitan areas. In 1990, the remaining VAT resources of DR 1,600 million (about US$200 million equivalent - 47 percent of the local share of VAT and 16 percent of total VAT) were fully allocated to operating subsidies in accordance with the competitive demands of the local governments' forecast deficits. The residual item, following the precedent of 1989, might have been an allocation for  -7- investmente to be distributed among local governments on the basis of population and used for investments freely chosen by those governments. But, in 1990, that residual was nil. 2.16 Exenditures. Expenditures include the following: operating costs (42 percent of total), of which about half are for personnels debt service (5 percent); and investments (53 percent). operating costs, particularly for personnel, are growing rapidly mainly to overcome staff shortages (para. 2.5). Investments, totalling some DH 3,400 million (US$400 million equivalent in 1990), mainly comprise installations for the various services managed by local governments. About two-thirds of that amount were spent on health, education, and agricul.ure by the line ministries, as well as on local services under NOl national programs and on specific investments financed by MOI-earmarked VAT allocations. In 1990, some DH 700 million worth of investments were local, fully chosen and managed by local governments and paid for by the GT with current VAT cash on the legal basis of past operating surpluses (para. 2.12). 2.17 Investment Decisions. To a large extent, the scrutiny of investments depends upon their source of funding. Each communal council freely decides to undertake local investments financed with current surplus on the basis of analysis by consultants and staff, review of alternatives by its investment committee, and recommendation of its financial committee (para. 2.4). Citizens may, but seldom, attend council meetings. MOl reviews those investments on the basis of a summary description in the proposed budget and requests additional information when a proposed investment appears to be unsound. It has stopped grossly unjustified investments even to communes with ample own funds. For local Investments financed with specific allocations from the VAT, MOI determines priority investments among communes' competitive proposals, but for each commune it generally follows the ranking of priorities of the respective communal council; communes, under a free format, must submit a technical brief for each proposal. NOI tends to choose Lnvestments concerning several local governments on the basis of national and regional benefits. Investments proposed for FEC financing, as described in Chapter IV, undergo the highest degree of scrutiny. D. Main Sector Issues 2.18 The previous section introduces a number of substantive issues. A major one is the paucity of funds, which funding for local investments under the project will address. Another issue is the limited capabilitLes of the local sector, a substantLal constraLnt to sector development, which project technical assistance and training components will seek to overcome. Yet, another iesue, at least in the short run, is the inconsistency of the VAT allocation (to local governments) with macroeconomic balance. To maintain Lts target of international reserves or other competing policy objectives, the Central Government may need to recover part of the VAT for its expenditures and lag payments under the local share of the VAT behind legal accruals. In the short run, the Government will have to strike a balance between fostering those objectives at the expense of the local sector and providing this sector with reasonable means to finance investments. This is further discussed in the context of the forecast of local sector flow of funds within the framework of the present project design. The issues of whether local governments should be more accountable to their constituencies than to the Central Government and manage their own resources-- matters of political and macroeconomic choice--cannot be resolved within the time frame of the present project. Other shorter-term issues should be resolved or studied first. These issues are discussed below.  2.19 The Interaction of transfers and Credit to Local Governments. The most critical concern in local finance is that the manner in which the local share of the VAT is distributed among communes along with FEC's credit practices encourage those communes to finance low-priority investments with debt. As noted above, MOI, with the intention of encouraging savings, allocates almost half of the local share of the VAT among communes on the basis of forecasted current budget deficits that include debt repayment. Because MOI makes sure that communes have earmarked budget resources to repay FEC's loans, FEC has traditionally granted loans to the communes regardless of their capacity to service debt out of their own funds. These conditions have resulted in many communes' managing to negotiate the acceptance by the Government of their projected budget deficits, obtaining loans to finance low-priority investments, and ensuring future subsidies out of the local share of the vW.e to service their excessive debt. Tightening of FEC's credit standards would reduce but not eliminate this problem, as the mechanics of justifying future subsidies with debt would persist until the borderline debt service ratio established by FEC precludes contracting of further debt (para. 4.12). Thus, both the system to distribute the local share of the VAT and FEC's credit policies must pursue the efficiency of investments and the soundness of debt service coverage ratios among communes. 2.20 Still, FEC had yet to put in place a sound system for channeling its government-guaranteed resources to the communes. As further explained in Chapter IV, FEC's lending policies and practices have been lax. FEC's institutional arrangement has largely accounted for this. When CDG controlled FEC, it was neither responsible for, nor had an interest in the best use and protection of FEC funds. FEC's credit committee, in which MOF, as guarantor of FEC, was represented, made credit recommendations but not decisions. Thus, under this institutional setup, there were virtually no links between authority to take action, real responsibility for, and interest in the results of those actions. FEC, moreover, still lacked mandatory lending policies. FEC's restructuring will overcome these shortcomings (Chapter IV). 2.21 Lona-Term Outlook. over the longer term, Morocco's system of intergovernmental finance poses three questions that cannot yet be answered. The first is how to allocate powers and responsibilities among the Central Government, the local governments, and other agencies. For example, local government responsibility for providing some health and education services (not only funding investments of government departments) requires further study. The Government is already considering assigning to the communes of the beneficiary areas responsibility for executing health and education facilities financed with the VAT resources recovered to balance the national budget. A firm assignment of responsibilities could only come after close observation of how local governments and the Central Government jointly manage some projects and a critical assessment of the experience of other countries (e.g., Tunisia, Canada, Colombia). Furthermore, providing certain services (e.g., slaughterhouses, water and power distribution) through the private sector might be the best solution. The second question, partly derived from the first, is what would be the appropriate transfer level and mechanisms. For example, although tradition favors the VAT system, a reflection on the alternatives of an allocation out of total current revenues or program-specific transfers may be useful. The third question, as discussed above (para. 2.13) is how to finetune, or restructure, the system of local taxes. These, and other related questions, will be the subject of studies financed under the project (para. 5.4).  - 9 - SSS. *ECTOR PEFORM AND PROSPECTS A. Actions to !mrove the Sector 3.1 The Moroccan authorities are undertaking major reforms to local finances and other actions to improve sector performance. The following paragraphs summarize these reforms. 3.2 Distribution of the L,cal SharQ of the VAT. The Immediate and most important reform to local finances is that of the system to distribute the local share of the VAT among local governments, reform which the Government will introduce in Fiscal Year 1995. Under the new system, at least 50 percent of the VAT revenues earmarked for local governments will be distributed among them on the basis of objective criteria. These criteria will include: (a) the size of population, as a proxy for needs; (b) fiscal endowment (measured by assessments of local taxes managed by the Central Government), as an equity corrector to the population criteria; and (c) fiscal effort (measured by collection of taxes managed by local governments), as an incentive to self-reliance of local governments. Local governments will use VAT resources allocated on the basis of those criteria either to cover operating costs and service debt, or to carry out investments. Annex A describes the details of the envisaged system which the Moroccan authorities will reassess with the Bank and adjust as needed in October 1994, on the basis of information on local taxes of the full 1993--first year for which the number of local governments almost doubled--and the fL.,at semester of 1994. It is anticipated that the Government will allocate up to 30 percent of the local share of the VAT to expenditures in health and education managed by the related line ministries, common expenditures of local governments, and funding to gradually phase out operating subsidies and complete previously authorized investments with financing from earmarked VAT funds. It is also anticipated that MO! will distribute about 20 percent of the local share of the VAT among local governments on a discretionary basis. Annex B describes the minimum Government commitment-what now can be reliably expected--concerning the new system to distribute the local share of the VAT among local governments. 3.3 Although under the new system earmarking of VAT funds for current and investment xpenditures is not expected to apply, local budgets will continue to be subjected to the approval of NOI, which will enforce repayment of debt first. Under the new system, MO! will coane allocating operating subsidies on the basis of forecast deficits including debt service. FEC, moreover, will have maximum debt service ratios as eligibility criteria for local governments' borrowers. Thus, under the new system there will be little or no incentive to incur excessive debt to finance lower priority investments. The objective criteria to distribute the VAT should foster the efficiency of investments and the responsibility of elected officials to their constituencies. 3.4 Durin neoot.ations, the Government agreed to introduce an acceptable system for distributlng the local share of the VAT on the basis of the criteria described above. To introduce the above system by January 1, 1995, understandings were reached during negotiations that the Government would carry out the following actions: (a) by October 31, 1993, prepare and issue a circular to the local governments outlining the objectlves and main principles of the new system; (b) during 1994, develop the details of that system; and (c) by October 31, 1994, prepare and issue instructions to the local governments, describing the details of the new system. Also, the Government would expect to distribute about 15 percent of the local share of the VAT on the basis of population in 1994, as it started doing in 1993. Furthermore, by October 31 of each year after 1994,  - 10 - the Government will review with the Bank its experience with the new system and make adjustments the following year, as agreed, during such reviews. 3.5 Restructurina FEC. The Moroccan authorities have already begun restructuring FEC. The first step was the promulgation of FEC's new organic law and the passage of a decree implementing the law (paras. 2.10 and 4.3). The secondi step was the organization of the Board, the establishment of a credit committee, and the appointment of an acting General Director with full powers by the Board and the Government. The Ring is expected to make a final appointment of the Director General in late 1993, but such a decision is not essential for FEC to conduct its business now. The credit committee is composed entirely of government representatives and a management committee--to be created at Board discretion--would include a minimal representation of local governments. The third step was the approval of a policy statement, with clear financial and credit policies, by FEC's Board. The statement, as agreed between the Moroccan authorities and the Bank, is summarized in Chapter IV and fully presented in Annex I. As a fourth step, the Directors for the main line units--project evaluation, supervision, finance and administration-should be in place bv the time the Bank declares the FEC loan effective (para. 4.9 and Annex N). Furthermore, as discussed in Chapter IV, FEC, throughout project execution, will improve its organization, staffing, management systems, facilities, equipment, and finances. 3.6 Other Actions to Imorove the Local Sector. To support the above reforms and further upgrade intergovernmental finances and local sector management, the Government, during 1994-1996, will discuss with the Bank the results of certain studies (Chapter V), and during 1996-1997, will undertake the actions agreed upon during such discussions, as follows (schedule of actions in Annex C)t (a) develop a program to improve local and intergovernmental finances including assessments of the results of the reform of local taxes and prospects for privatizing local services; (b) introduction of an improved accounting system for the local sector; (c) implementation of measures to improve the formulation and implementation of local budgets; (d) adoption of improved formats for review of local investments by the Central Government; and (e) establishment of a data base to produce and disseminate information on local governments. The Government, moreover, will carry out a training program for local officials and officials of the Central Government who deal with local governments (Chapter V). The Government gave assurances durina nenotiations that it would implement a plan of institutional improvement of the local sector including those actions (Annex C). Paragraph 5.4 further discusses technical assistance and training. Terms of reference for the study on local and intergovernmental finances, as well as local sector management information systems, are presented in Annexes D and Z, respectively. The local sector training program is presented in Annex F. 3.7 Improvina the Efficiencv of Investments. As already mentioned and further discussed below (paras. 1.3 and 5.2), the project aims to improve the efficiency of investments by local governments. Thus, it is legitimate to ask whether the proposed measures to improve sector performance are adequate enough to achieve that objective, or additional measures are called for. The present project will pursue the efficiency of investments mainly through the following: (a) introduction of a system to distribute the local share of the VAT on the basis of more objective criteria, which will reduce the risk that some local governments wlll negotiate the financing of low-priority investments, and will permit all local governments to better plan their investments with more predictable resources; (b) establlshment of eligibility criteria of projects as well as of local governments, which will include maximum debt service coverage ratios to discourage some local governments from undertaking lower prinrity  - 11 - investments financed by debt; (c) requirement that FEC borrowers gradually contribute at least 20 percent (zero at present) out of own funds to the financing of investment projects, which should foster prudent investment and borrowing decisional (d) implementation of a training program, which will enable managerial and technical staff of local governments to make better decisions or recommendations; and (e) introduction of a standardized system of information for local governments to clear investments with the Central Government on the basis of their viability. On balance, these arrangements, comprising a system of checks and incentives, would go a long way toward improving the efficiency of investments. one alternative to tighten further investment selection would be for MOl to clear local investments on the basis not only of viability but also according to a schedule of priorities and set of rules. But this would undermine the already limited autonomy of local governments and any possible progress in making local authorities accountable to their constituencies. Likewise VWC, as a financial agency, ought not engage in ranking priorities for the local governments, but essentially restrict itself to applying its lending eligibility criteria. Thus, the above arrangements are considered adequate to enhance the efficiency of investments by local governments. B. Forecast of Flow of Funds of the Local Sector 3.8 The table below presents a preliminary forecast flow of funds of the local sector for 1993-1995. Local taxes have been estimated on the basis of past trends. Local VAT resources reflect Treasury projections of total VAT revenues. it is assumed that the Central Government, to balance its budget, will recover DH 1.0 billion of the local share of the VAT (by funding expenditures of the line ministries in health and education out of this share), the best estimate of Moroccan officials at present. It is also assumed that reforms affecting VAT distribution are in place as scheduled (para. 3.2). FEC loans (wbose outstanding balance would increase from US$350 million in 1992 to USS550 million by 1997) are similar to projections in Chapter IV, projections which are compatible with FEC's potential resources. No substantial changes in local taxes and intergovernmental finances--other than the distribution of the local share of the VAT--are assumed in this projected flow of funds, as possible changes for 1995 deriving from studies under the project cannot be anticipated now. Local investments would increase to DH 5 billion in 199S. This is predicated on the Government's not needing to recover more than DR 1 billion to balance its budget, at times an overriding priority. As a framework for the project, that projection will be reviewed and updated after each year of project execution.  - 12 - Table 3.1s FORECAST 0 FLOW OF FUNDS OF THE LOCAL SECTOR (DR blllon) FORECAST OONCEPTS 1993 1994 1995 Resources Local taxes and others* 4.3 4.8 S.3 VAT* 4.9 5.3 5.9 Loans 0.7 0.9 0.9 Total resources - Total expendltures 9.9 11.0 12.1 Hxganditunes Current expenditures 4.8 5.1 5.3 Debt service 0.7 0.7 0.8 Investments 3.4 4.2 5.0 VAT recovery by the Central Government 1.0 1.0 1.0 * Estimated to grow in tandem with inflation and GDP growth. Source: Bank estimates based on unoff ic1at preliminary budgets prepared by the Directorate of local finance in NOF. C. Bank Role and Sector LeAna Stratecrv 3.9 Past Bank involvement in the sector includes the Pilot Project for the Communal Infrastructure Fund (Loan 2272-NOR), completed ln 1989, and a sector report on local finance, completed in 1990. The project completion report for the Pilot Project (No. 10075) made two main recommendations. The first one was that FEC monitor the execution of projects lt financed more closely. This recommendation, as discussed ln Chapter IV, has been incorporated into the present project design. The second recommendation, also incorporated into the project design, was that FEC become a more autonomous financlal agent of the Government and be supervlsed ln much the same way as a financlal instltution. The Bank sector report (No. 8782-MOR) helped shape Bank vLews or. the dietribution of the local share of the VAT among local governments as well as other local and intergovernmental finance Lisues. These views pervade project condltionality. 3.10 In the past, the Bank had concentrated on helping Norocco stabilize its economy, while deferring action in the local sector. Yet, a local sector with its present problems might jeopardize macroeconomic stability. A Bank report on lssues and prospects ln the publlc sector (No. 10157-MOR) shows that publlc Lnvestment has been Lncreasingly decentrallzed from the Central Government to the local governments and public enterprises in the course of Xorocco's stabilizatLon, which began in 1983. Publlc savings, however, have not risen commensurately outeide the C :ntral Government. For the local governmnts in particular, that report concludes that the exlsting VAT allocatlon system has been an important element preventing better savings performance by the local governments. Therefore, Bank strategy for Morocco places hlgh priority on upgradlng the local sector as a means of improving the consistency of the local sector wlth sound tax policies and macroeconomic balance as well as the  - 13 - efficiency of local investments. The proposed project, as explained mal.n.y in Chapter V, has been designed with these objectives in mind. IV. THE BORROWER AND PRIMARY PROJCT EXh'CUTING AGENCY A. Institutional Profile 4.1 As explained in Chapter V, carrying out the project will require the involvement of many agencies: local governments, NOI and MOF units, and FEC. Although the institutional profile and capabilities of these entities have been discussed earlier (Chapter III), FEC, as the main borrower and primary project executing agency, requires a detailed evaluation. For the foreseeable future, moreover, the communes will rely on FEC as their main financier. FEC's mission will remain essential until industries and banks in Morocco operate in a fully competitive environment, and until local governments assess and collect most of their taxes, and manage their cash (which could serve as security and compensatory balances for loans). This will go well beyond the time frame of this project. Thus, the Government has taken a number of important steps to transform FEC into an autonomous and creditworthy financial institution cepable of fostering the efficiency of local investments and financial discipline of local governments. The following paragraphs, with that perspective, assess FEC's status and prospects. 4.2 Institutional Arranaements. With Bank assistance under the proposed project, FEC is undergoing a full restructuring, including major changes in institutional arrangements, as well as in organization, staffing, credit policies, and financial structure. Although FEC's ful' restructuring will take about two years, the new institutional arrangements are completed and most organizational, staffing and accounting arrangements will be completed between late 1993 and early 1994 (para. 4.4). 4.3 Under FEC's new law, FEC is both a Public Establishment subject to the control of MOF and an entity with the status of a financial institution subject to the supervision of the Central Bank (Bank Al-Maghrib - BN). A Board of 18 members, under the oversight of MOI and MOF, governs FEC. The members of the Board include: one representative of the Prime Minister, who chairs the Board; one representative each of the ministries of the Interior, Finance, Education, Public Health, Public Works, Energy and Mines, and Tourism; one representative of BMs one representative of CDG; and eight representatives of the local governments, appointed by MOl. The Board is empowered to approve FEC's budget, borrowing operations, personnel policies, lending and financial policies, and the lending program. The annual lending program is also subject to MO? and MOI approval. The Board may delegate any of its powers to a management committee organised at the Board's discretion. This committee would include a minimum representation of local governments, if any. Furthermore, the law establishes a credit committee composed only of government officials (representatives of MOI, MOF, BM, CDG, and FEC's Director General). This committee approves or rejects loans without recourse. The Director General, appointed by the King, is FEC's chief executive officer (para. 3.5). These arrangements are balanced to permit local representatives to influence FEC activities, while precluding them from making banking decisions. 4.4 9ganizatLga. FEC's organization--as not&F by consultants under French Government and USAID grants--requires some changes. Currently, it still comprises four divisions, subdivided into 11 units or services: the appraisal  - 14 - division, including sites and services, water supply, sewerage, and urban transport unitst the project execution division, including supervision and loan administration units; the financial division, including financial management and accounting units; and the research division, which supports the technical or credit committee, including planning and study units. In the absence of an administration division, this organization falls short of adequately supporting a self-sufficient agency charged with fostering the development of the local sector. FEC now has to administer its human and physical resources, and control its own operations, as CDG no longer sustains these functions. It also has to carry out various functions required by autonomous lending Institutions. FEC's organization is being modified and is expected to be composed of the following: (a) An office of the Director General. (b) Five line divisions or departments, including: (i) projects, comprising the present units of the appraisal division, plus a new project development unit charged with building a pipeline of projects; (li) the three project execution, financial, and research divisions, essentially as at present; and (iiI) administration. (c) Two small regional offices (each including a few engineers) for the follow-up of project preparation and supervision, directly under the Director General, but reporting to both projects and project execution. (d) Offices of the Secretary, Legal Counsel, and Public Relations under the Director General. (e) A emall Financial and Operational Internal Audit Office staffed mainly with accounting/financial staff and at least one engineer. 4.5 Staffina. FEC's present staff of 44, including 32 professionals, is generally qualified, but insufficient to appraise and supervise projects adequately. The main shortage is in competent engineers and financial analysts. rEC also lacks professionals competent to assess environmental issues. FEC is expected to fill key positions in those areas with highly qualified professionals and increase its total staff to about 55 by the beginning of 1994, and to no fewer than 65 by the beginning of 1995. These staffing levels should be sufficient for the scope of FEC operations during project execution, as gauged by annual disbursements of US$90 - 140 million. As an autonomous entity, FEC should be able to raise salaries moderately from the CDG's present somewhat low scale, and thus hire and retain qualified staff at all levels. 4.6 Although FEC's management information systems account for transactions and provide basic information to monitor operatiLns, they need improvement. For example, FEC's chart of accounts and format of financial statements are adequate, but the accounting system fails to provide a breakdown of individual loans for each borrower. This is done through a separate loan operations system, which requires frequent and sometimes laborious reconciliation with the accounting system file. Insufficient and outdated micro-computer software and hardware largely account for this and other shortcomings in all management systems. At present, FEC has fewer than one micro-computer for every four staff; the micro-computers as well as spreadsheet and word processing software that FEC uses for most applications have been off the market for almost five years. FEC, moreover, lacks a centralized system to permit its staff to share data expeditiously. USAID consultants have formulated a plan to overcome  - 15 - those constraints. It calls for increasing the micro-computer/staff ratio to about 0.5 mainly with state-of-the-art equipment coupled with similarly advanced general and application-specific software. USAID will finance those acquisitions as well as the continued assistance of consultants through complete implementation of the plan in early 1994. 4.7 FEC's Procedures. FEC-also needs to improve its operating practices. Staff of the project evaluation division, on the basis of an adequate methodology introduced under the Bank-assisted Pilot Project (Annex 0), issue well structured evaluation reports. Yet, partly because of the heavy workload and partly because of budget constraints, they generally fail to visit the borrower and the project site. For the same season, physical inspections through project execution are virtually nonexistent. The additional staff as well as improvements to systems will help tighten evaluation and supervision procedures. 4.8 As mentioned in Chapter V, FtC's credit practices have historically been lax. The main problem liez not in analysing projects as such, but in approving, disproportionately, projects requiring a loan debt service well in excess of communes' and R6gies' own resources to service their debt. FEC's practice of consistently financing 100 percent of project costs has further undermined the financial discipline of its borrowers. The reform of the system to distribute the local share of the VAT and the institutional restructuring of FEC will go a long way towards correcting those problems. FEC now has introduced an articulate system of borrower eligibility criteria. FEC also has started charging loan losses in accordance with time in arrears, in a manner consistent with policies that SB is introducing in the financial sector under the Bank- assisted financial sector development loan. These conditions, relevant both to the financial discipline of the local sector and FtC's own financial performance, are included in FEC's Policy Statement (para. 4.10). 4.9 To enhance FEC's institutional capabilities, during neacotlations FEC agreed that it will: (a) implement an acceptable organizational plan with five divisions responsible for project appraisal, project supervision, finances, administration and research (para. 4.4); (b) carry out an acceptable action plan to become adequately staffed; (c) carry out a training program agreed upon with the Bank; and (d) implement an adequate accounting system (including subaccounts for each loan to each borrower). Furthermore, as a condition of effectiveness of the FEC loan, FEC should have appointed its four main line managers (department directors for project evaluation, project supervision, finance and administration) and two environmental specialists. Annex H contains an action plan for FEC's institutional development. B. Credit and Financial Policies 4.10 Of special importance in establishing FEC's managerial independence, FEC's Board has approved a precise Policy Statement including particularly credit and financial policies, which, with Bank staff assistance, government authorities already developed during project preparation (Annex I). Credit policies, particularly eligibility criteria for borrowers and projects, and lending conditions will be applicable to all FEC operations, including those refinanced under the Bank-assisted project. purina n2gotiations, assurances were obtained that FEC will carry out its operations in accordance with the Statement of Policy. The following paragraphs highlight main policies in that statement. 4.11 FEC Policy Statement has the following objectivess (a) induce local governments and R6gies to undertake priority investments; (b) improve the  - 16 - financial performance of local governments and R4gies; (c) optimize the economic use of scarce resources and help communes balance their budget and R6gies maintain financial viability; and (d) maintain FEC's viability through sound policies and protection of the value of its equity. To fulfill those developmental objectives, FEC's main activity will be to fund financially and economically viable investments by provinces, metropolitan agglomerations, urban and rural communes, and R6gies. FEC will allocate its resources in the order in which projects are approved and funds become available; i.e., the allocation of funds will be entirely demand-driven. 4.12 The statement comprises the following policiess (a) fterational cuidelines. Substantive requirements for the appraioal and supervision of projects includs, amonj otherss (i) visit the project area at least once during project preparation or appraisal; and (ii) visit the project area at least once during the project period--three times for major projects--to supervise execution of works and installation of equipment. (b) Eliaibilitv criteria. Criteria applied to borrowers and projects requires compliance with certain financial indicators including the followings (i) borrowing local governments should maintain a ratio of debt service/ordinary resources of no more than 0.40; (ii) in general, by 1998, borrowers should finance about 20 percent of investment costs with their own resources. (c) Financial policies. Financial targets, revenue policies, and accounting rules, including: (i) gradual achievement of a minimum return of 1.2 percent on the average value of total assets; (ii) a minimum intermediation margin of 2 percentage points in variable- rate loans and 2.5 in fixed-rate loans; and (iii) a provision equal to 30 percent of the total balance of loans which have been in arrears for one annual installment (see Annex I, Attachment 2 for provisioning of loans with arrears above one year). Given the responsibility placed by the Government, at its request, on the Bank to support FEC's initial development, the Bank will review the consistency of implementation of the Policy Statement (applicable to all of FEC's loans, regardless of sources of financing). This will be done mainly during Bank supervision missions through a review of a random sample of FEC's appraisal reports and project files of loans financed by FEC without Bank refinancing. This understanding has been confirmed durinc neactiations (Annex N). C. FEC's Finances 4.13 Financial Performance. While FEC's finances were, as seen in the table below and Annex J, fragile, they have begun to improve. In 1990, for example, FEC's debt-to-equity ratio before a reasonable allowance for loan losses was about 20 to 1. Yet, an external audit carried out on the basis of prudential accounting policies has determined that FEC should charge to equity DH 76 million (US$9 million equivalent) for Bogies' arrears and thus increase its debt-to- equity ratio to about 70 by the end of that year. Mainly because of an historically slim financial margin of 0.0-0.5 percent, FEC has had virtually no profits before loan losses and thus steadily eroded its modest equity in real terms. The 1,5 percent minimum margin adopted for new loans this year and the 2.0-2.5 percent minimum margins to be adopted under the project (para. 4.16) will  - 17 - gradually increase the return on assets and start supporting the real value of FEC's equity. 4.14 FEC has also had to struggle with a compromised short-term liquidity. In 1991, it approved loans beyond assured sources of financing, giving rise to DU 1,500 million (US$180 million equivalent) in undisbursed loan balances, about double the hiscorical amount. FEC is however expected to finance this backlog by the end of 1993, mainly using the recovery on its outstanding loan balances. 4.15 The Government and FEC have taken several important actions to improve FEC's debt-to-equity ratio, which, together wita undertakings given under this project, confirm that FEC can be construed as a financially viable and autonomous municipal financier. The Government, by the end of May 1993, will contribute DH 75 million to FECse equity. The Ministry of the Interior--which through the approval of municipal budgets and transfers has leverage over municipal councils--has required these councils to assume the total balance of their Rsgios debts in arrears with FEC. Implementing such an assumption is a condition of effectiveness of the FEC loan. With these actions, FEC will attain a debt-to-equity ratio of not more than 1S to 1 in 1993, ratio which is similar to that of established financial institutions in Morocco and acceptable in accordance with international standards. 4.16 Financial Pros2ects. On the basis of the financial policies agreed during negotiations, a tentative, summary projection of FEC's financial statements for a six-year project execution period (including the end of 1993 with no disbursements and the beginning of 1999 with minimal disbursements) is also shown In table 4.1 (details in Annex J). After 1994, FEC's loans are expected to grow in tandem with inflation (4-6 percent p.a.) and GDP growth (assumed 4 percent p.a.). Issue of government-guaranteed obligations, albeit limited because of both budgetary constraints and the financial sector liberalization envisaged by the Government, would still permit that growth of loans. With total external rerources including the proposed Bank loan, FEC should be able to lend an annual average of about US$115 million to local governments and agencies, almost double the historical level. With interest rates on new operations reflecting market conditions, FEC's return on assets would gradually grow to about 2 percent (consistent with a financial, gross margin of at least 2 percent on new varLable-rate loans and 2. 5 percent on fixed- rate loans) by the end of this decade. Since costs are about 0.6 percent of assets, that would leave over one percent above management costs available to support the value of FEC's equity. This, plus additional Government equity contributions of DH 60 million (US$7 million equivalent), would lower FEC*s debt- to-equity ratio to about 12 to 1 by 1997. The Government will assume the foreign exchange risk on the Bank loan to FEC, with FEC covering the cost of such risk within the framework agreed upon under the Bank-assisted financial sector adjustment operation. Similar to practices by financial institutions borrowing from abroad, FEC should charge to operations the so-called reference cost (i.e., average rate paid for six-month and one-year deposits in commercial banks plus 0.75 percent), the normal excess of which over the Bank rate should cover most realized conversion losses, any remainder not consumed by losses would accrue to the Government which would assume losses beyond that excess. FEC will cover its interest rate risk by lending at appropriate variable and fixed rates tied to its cost of funds (para. 5.13).  - 18 - Tab-le 4. s PEC'S SUNMARY FINANCIAL STATNENIT'S (DH million caurront)" 1990 1991 lm 1993 1994 1995 1996 199 1998 INCOME Interest ernea t 208 250 308 379 453 536 622 713 810 Interest expense 190 234 290 354 392 453 517 581 646 Other expense' 1? 13 86 (79) z7 31 40 45 51 met income 1 3 (68) 101 20 31 39 S2 68 FUNDS Sources: operations II 10 11 8 10 18 26 38 53 Recovery of loansr 202 235 260 319 360 417 475 537 603 Government guaranteed bonds' 394 592 634 650 500 475 525 500 600 Bank project loan 0 0 0 0 193 289 288 104 39 Other loans 76 0 8 78 89 40 50 250 350 Government contribution 0 0 0 75 0 0 0 60 0 Total sources 682 837 913 1,130 1,152 1,239 1,363 1,489 1,645 uses: Loans disbursec 503 631 814 650 850 923 1,014 1,114 1,222 Loan repayment 101 126 172 460 296 318 337 359 432 Others 5 1 12 13 1 1 1 1 1 Change In funds 74 79 (85) 7 4 (3) 11 15 (10) BALAICE Assets 2,113 2,603 2,999 3,411 3,938 4,481 5,072 5,709 6,365 Equity 111 114 39 215 236 267 305 418 486 RATIOS Income from loans (X) 12.0 12.1 12.2 12.8 13.4 13.8 14.1 14.4 14.6 Interest expense on 11.3 10.4 10.6 11.5 11.4 11.5 11.5 11.5 11.6 liabilities (X) Debt to Equity ratio (M) 16.4 20.4 72.4 14.1 15.0 15.0 14.9 12.0 11.5 A/ Inflation rates in the 42 - 6X range; exchange rates between DO 8.5 and D0 10.00 per USS1. kY Average lending rate--atbeit varfable--estimsted at about 14.5. g/ Average cost of resources--albeft variable--estimated at about 122. 9y Includes loan losses of DH 76 million In 1992 and recovery of loan losses of DO 93 million in 1993. I/ Average repayment period of 9 years. fX Average amortization period of 10 years. a/ Since 1994, growing in tandem with inflatfon, plus the ,:rowth rate of GDP, which Is asusued to be 4 percent per year.  - 19 - 4.17 To foster FECWs financial performance, assurances were obtained during necotiations that FEC will maintain: (a) a ratio of administrative expenses (inoluding depreciation) to assets of not more than 0.75 percent; and (b) a rate of return on total assets of not less than 0.5 percent in 1994, 0.8 percent in 1995, 1.0 percent in 1996, and 1.2 percent in 1997 and thereafter. To start FEC off oan a reasonable financial footing as a Bank borrower, the Government has contributed DH 75 million (US$9.0 million) and, as a condition of :.-fectLUUMese, is causing local governments, to assume their RMgies' debts in arrears, bringing FEC's debt-to-equity ratio down to 15 to 1 in 1993 (para. 4.15). Furthermore, assurances were obtained during neotigations, from FEC, that it will maintain a debt-to-equity ratio of no more than 15 to 1 auring 1993-1996 and no more than 12 to 1 in 1997 and thereafter. The Government has also generally acred to take all measures as may be required on its part to enable FEC to comply with its obligations under this loan; understandings were reached that this would include taking, by July 1, 1997, measures to enable FEC to meet its 1997 debt-to-equity ratio requirements (including, if needed, an additional increase in FEC's equity by up to DH 60 million). Under these conditions, FEC should be able to operate as an independent financial institution with significant managerial and financial independence, an institution for which, therefore, a full guarantee of performance from the Government is not required. It should serve as a viable financier of local governments and agencies until these entities and the banking system can successfully enter the financial marketplace without the need for directed credit. Annex R explains how to compute the above covenanted indicators of FEC's performance. 'J. THE PROJECT A. Oriain 5.1 As far back as the processing of the Pilot Project in the early 1980s, the Government and the Bank have envisaged a major follow-on operation to finance municipal infrastructure and underpin a comprehensive development strategy for the local sector. Nainly through sector work and supervision of the Pilot Project, the Government and the Bank identified major sector issues and potential actions to resolve them. In May 1991, following completion of the Pilot Project and Government's request for the new operation, a Bank mission agreed in principle with the Government on the main lines of a sector development strategy and identified the project. During subsequent preparation missions, appraisal and negotiations, the Government and the Bank further developed ane. confirmed such a strategy (para. 3.1). The project, as described below, is designed in accordance with that strategy. I B. Obiectives 5.2 The objectives of the proposed project are to: (a) enhance the quality of communal infrastructure projects mainly by, first, restructuring FEC, including the introduction of consistent economic, financial, and technical criteria for project selection, and, second, upgrading the institutional capacity of local governments; (b) improve the procedures and criteria for allocating the local share of the VAT amon7 local governments and lay the basis for further improving local and intergovernmental finance;  - 20 - (c) expand and rehabilitate urban and rural communal infrastructure and relted services throughout the country} (d) improve the financial discipline of local governments so that in the long run they may be able to borrow from commercial banks; and (e) improve management systems in the local sector. C. Rationale for Bank Involvement 5.3 Rationale for Bank Involvement. The project supports the main pillars of the Bank's country assistance strategy for Morocco, as discussed in the Board in February 1993. First, the project is designed to enhance the efficiency of the public sector management. This is expected to be achieved through the reform of the system to distribute the local share of the VAT among local governments, and through the restructuring of FEC. Second, improved local sector performance will necessarily help consolidate and deepen macroeconomic adjustment by extending the reform beyond the Central Government level. Third, the project will help alleviate poverty and improve social i$dicators, as it will improve the coverage and quality of essential services for the poor. Fourth, the project, mainly by increasing local transport infrastructure and the reliability of water and power services in many municipalities, will help the private sector achieve its potential as an engine of growth. Finally, the project specifically aims to improve water resource and environmental management, as project eligibility criteria include conditionalities to foster cost recovery -- notably to reduce the wastage of water -- control any adverse environmental impact, and enhance FEIC's environmental competence and improve its coordination of environmental management with the central and local governments. D. Proiect Description 5.4 The project would include the following componentss (a) Fundina for Communal Infrastructure Development. Under this component, FEC will make subloans to local governments for about 250 subprojects aimed at rehabilitating and expanding urban and rural infrastructure and services. Except for investments involving resettlement (FEC-financed investments involving resettlement will have appropriate conditionalities, including adequate compensation of persons subject to involuntary resettlement), all investments eligib:- for FEC financing in accordance with FEC's policy statement and related project eligibility criteria agreed with the Bank will be eligible for Bank refinancing. These investments includes (i) street and traffic lighting and roads and bridges; (ii) water supply, sewerage, drainage, and solid waste facilities and equipment; (iii) transportation equipment and facilities; (iv) productive facilities such as markets and slaughterhouses; (v) parks and recreational facilities; and (vi) electrical power networks. Studies to prepare subprojects will also be eligible. (b) Institutional Improvement of FEC. This component will consist of some training (mainly visits to similar institutions abroad), as well as expert services, vehicles and equipment, to assist INC in further developing and improving its operational procedures, and in procuring equipment financed under the loan (Annex H). To better define training, FEC, with the assistance of consultants, will  - 21 - develop a comprehens ive training program for a three-year period, program which it should submit for Bank review by April 1, 1994 (Annex H). Services and equipment will complement staff training provided under the project and follow up on assistance provided by French and US bilateral aid agencies for developing mAnagement information systems. Detailed needs will be assessed in late 1994, when bilateral aid is phased out. (c) Trainint for the Local Sector. This component, to be carried out by the Government, will support a comprehensive training program for local governments and R6gies, as well as central government departments and agencies that oversee and assist the local public sector (Annex F). Although the program concentrates heavlly on upgrading managerial competence in all aspects of municipal infrastructure development and maintenance, it also addresses clerical workers, skill gaps, particularly those of bookkeepers. The program includes training to improve the choice of investments, and environmental reviews. The component will includes (i) trainer fees for in-country training of central, local, R6gie, and occasionally FEC staff, consisting of introductory courses, workshops, and seminars; besides imparting new knowledge, understanding, and skills, seminars would draw up on participation from various regions of the country and emphasize the transfer of technology and experience; (ii) external courses and study tours, both overseas and domestic, for TDMI staff, CL staff, and trainers; and (iii) technical assistance consisting of about 30 staff-months of consultancy to be provided by municipal engineers, specialists in training trainers, experts in municipal investments, specialists in management systems, lawyers, accountants, and auditors. Consultants would help develop curricula, train TDNI staff, and lead workshops and seminars. (d) imnrovement of Local Sector Management. This component will include computer equipment and software as well as studies with the following objectives (Annexes C, D, and E): (i) development of a program to continue improving local and intergovernmental finances, including an assessment of the recent reform of local taxes; (ii) exploration of the potential for privatizing local services; (iii) introduction of an improved accounting system for the local sector; (iv) improvements to the preparation and execution of local budgets; (v) improvements to the review of investments by the local governments and the Central Government; and (vi) introduction of a system to produce, collect, and disseminate information on local governments within the framework of a centralized data base. Annexes D and E describe the terms of reference for these studies. 5.5 Financina of Investments. FEC will allocate its resources, including onlent Bank loan proceeds, to the financing of priority investments. such investments will be defined as those which: (a) fit eligible categories in FEC's policy statement; (b) pass FEC's test of project eligibilLty upon appraisal; and (c) local governments insist on carrying forward, after FEC discusses their investment programs with them and explains the effect of the related loan on debt service and on their flexibility for financing other investments. Although FEC's Board might assign priorities in the preparation effort to PEC staff, the allocation of onlent funds by region, borrower, and sector will be essentially demand-driven and follow the order in which priority projects--as defined above-- are approved and funds become available (para. 4.11). The Bank will finance a  - 22 - time slice of FEC's loans by specifically funding certain subprojects submitted by FEC. Under the project, the maximum sublcan amount for a single subproject will be US$10 million, as projects requiring larger loans could be better supported within the framework of Bank aector-specific operations. Yet, the only limil on the use of funds by a local government entity will be that determined by its capacity to carry out the project and service its debt. FEC will have the same project standards, lending conditions, and financial policies for all of its operations, irrespective of the sources of financing. The Bank, prior to financing, will review the appraisal of all subprojects with loans of US$1 million equivalent or more, and the appraisal of the first two subprojects with a lesser loan amount in each subsector (e.g., solid waste collection, social facilities, communal roads), submitted for Bank financing. The Bank, moreover, should be permitted to review FEC's records for any loan financed with other sources, as well as conduct surveys for projects financed by local governments with own funds. The total loan amount, as shown below, is being set to support a viable investment program according to investment needs, the execution capabilities of the local governments and agencies, the status of local finances and the pipeline of subprojects. 5.6 By and large, the institutional capabilities of local governments and FEC support the investment forecasts for the local sector, FEC's lending level over the project execution period (US$115 annual average), and the proposed project. In the recent past, local governments have spent about US$400 million annually for about 4,000 investment, projects. Most municipalities and a good number of rural communes maintain portfolios of priority projects to be carried out over three to five years. The provincial governments help the other communes prepare projects. The Directorate of Investments of MOl also helps with the more substantial projects. Preparing projects for execution and financing usually takes one to two years. In 1991, PEC appraised and approved 140 projects for financing for a total loan amount of almost US$100 million, commensurate with FEC's estimated loan level during project execution. These projects included funds for financing consultants to prepare investments, loans for which FEC, with insignificant losses, agreed to recover by making corresponding investment loans. An analysis of FEC's loan portfolio of the recent past reveals frequent deviations from the just-approved Policy Statement mainly in terms of processing standards and procurement, but also reveals substantial compliance in inherent project quality. This indicates that FEC can reasonably attain the envisaged volume of business in quality subprojects and in the process, foster project quality for all municipal investments. Yet, this also indicates that expecting communes to adjust to the Policy Statement and FEC to process a substantial number of eligible projects, as per that Policy Statement, will take some time. FEC, moreover, lacks a track record as a lender under demanding banking standards. For this reason the commitment period should be three years maximum. Thus, the commitment deadline has been set at December 31, 1996 which, with a maximum subproject investment period of three years, raises the project execution (including disbursement) period to six years. Project design is still one year short of the standard disbursement profile of urban sector investment projects for Morocco, mainly on account of the moderate loan amount (para. 5.8). If FEC satisfactorily applies its policy statement and rapidly commits loan funds, the Bank, in about two years, should be prepared to consider another operation to continue funding local investments and help upgrade local sector management. The development of subprojects is further discussed in para. 5.11. B. Proiect Cost and Financina 5.7 gCct. Total project cost is estimated at US$182.3 million (equivalent to about 30 percent of total FEC loans and about 10 percent of the  - 23 - investment program of local governments) in 1994-98 current prices. Foreign costs account for about 37 percent of total; taxes for about 15 percent. Most project expenditures comprioe part of an investment program with a pre- established limit, so that neither physical nor price contingencies apply. Detailed costs, particularly for components other than Bank-financed local projects, are in Annex R. A summary of costs is shown below. Table 5.1s SUMMARY OF COSTS (US$ million) Percentage Percentage foreign Foreign Locat Totat of totat Cost Part A. Bank-financed local projects 64.4 112.1 176.5 96.8 36.5 Infrastructure 63.4 109.6 173.0 94.8 36.7 Studies and designs 0.5 2.0 2.5 1.4 20.0 Institutional development 0.5 0.5 1.0 0.6 50.0 Part B. Institutional improvement of FEC* 0.8 0.0 0.8 0.4 100.0 Part C. Training for local goverrnents 1.2 1.1 2.3 1.3 52.2 Part D. Institutional fiprovement of Central Government units 1.8 0.9 2.7 1.5 66.7 TOTAL PROJECT COST 68.2 114.1 182.3 100.0 37.4 * Includes equipment, technical assistance, and training. 5.8 Financing Plan. The proposed Bank loans totalling US$104 million (US$100 million for FEC and US$4 million for the Kingdom), a modest amount considering sector financing needs, would finance 57 percent of the total project cost. FEC, in turn, would finance 23 percent of the project cost from fiscal resources (bonds guaranteed by the Government), the Government 0.6 percent, and the beneficiaries 19.4 percent from fiscal resources or internal cash generation. The total amount of FEC subloans under the project will be about US$160 million, equivalent to 35 percent of total FEC loans during the project period. A summary project financing plan is shown below. TXakl .2s PROJECT'S SUMMARY FINANCING PLAN (US$ million) Financing Amount Percentage Sub-borrowe&s' resources 35.3 19.4 FEC 42.0 23.0 Government 1.0 0.6 Bank 104.0 57.0 TOTAL 182.3 100.0  - 24 - F. Implementation 5.9 The project will comprise two loanss one of US$100 million to FEC for funding communal investments and FEC's institution building; the other of US$4 million to the Kingdom for funding local sector training and the improvement of the Central Government management systems for the local sector. FEC wi' 1, therefore, be the executing agency for the communal infrastructure development component, as well as for its own technical assistance and training. MOI, in coordination with MOF, will carry out the studies to improve intergovernmental finance and local sector management, the purchases of equipment for the local sector data base, and the training component. 5.10 Beneficiarv Entities. Subproject entities eligible for Bank financing will include all local governments and Regies eligible for FEC financing. FEC will lend only to those local governments and agencies that fully comply with the evaluation and eligibility criteria established in FEC's Policy Statement agreed with the Bank (paras. 3.5 and 4.10, and Annex I, Attachment 1). Most borrowers will be communes. As indicated above, R6gies are expected to have problems meeting eligibility criteria and getting communes, constrained by their own debt service ratio targets, to guarantee the R5giesg debt. 5.11 Develooment of Eliaible Suboroiects. As already discussed, FEC has far more potential volume of business than its potential resources could realistically match (para. 5. 6). But most subprojects already appraised by FEC-- mainly for procecural or procurement shortcomings--fail to comply fully with FEC's Policy Statement which FEC has just introduced. Still, FEC has established its capability to generate projects by, among other things, appraising some subprojects which fully comply with that Policy Statement just a few weeks after such a statement was confirmed during negotiations. On this basis, FEC should have no problem to rapidly generate a pipeline of eligible subprojects to start substantial loan disbursements in early 1994 as now expected. 5.12 Eliaibilitv Criteria for Suboroiects. Irrespective of the sources of funds, FEC will finance subprojects meeting project-related eligibility criteria, which are detailed in Annex I (Attachment 1) and highlighted as follows: (a) the subproject has been considered a priority as defined above (para. 5.5); (b) the proposed technical solution is that of least cost for the benefits intended; (c) the technical standards of that solution are commensurate with the population's capacity to pay fees or the local government's capacity to generate resources; (d) the subproject will be environmentally sound; (e) adequate arrangements will be in place to manage the implementation and operation. of the subprojects; and (f) subprojects generally should have a minimum economic rate of return of 10 percent and those of revenue-earning enterprises a financial rate of return at least two percentage points above FEC's lending rate. Except for subprojects involving involuntary resettlement, all subprojects eligible for FEC's financing in accordance with its policy statement will be eligible for Bank financing. 5.13 Lendina Conditions. Consistent with Government policies agreed under the Bank-assisted Financial Sector Development Project, FEC's Policy Statement establishes that FEC will lend at both variable and fixed rates. Loans at variable rates over its life will bear an interest rate of at least two percentage points above FEC's marginal cost of borrowed funds. Loans at a fixed rate will bear an interest rate of at least 2.5 percentage points above such cost. To set rates at loan inception, FEC, at the end of each month, will compute the marginal cost as the weighed average rate paid on long-term borrowed funds obtained during the one-year period ended that month. Still, FEC will  - 25 - adjust rates on each variable rate loan only once a year, within a two-percentage points annual cap and seven percentage poLnts life cap, as established by SM. FeC will apply similar rates to loans regardless of the sources of its financing and the type of its borrower. Grace periods on principal will be up to two years; the maximum term will be 15 years. No interest will be financed. Total loans to the beneficiaries, as per FEC's Policy Statement, will generally not exceed 80-90 percent of investment costs. G. Procurment and isbursements 5.14 Prgcurement. Responsibility for procurement would be as followas (a) MOT, in coordination with MO4, for parts C (local sector training) and 0 (improvement of central management); (b) FEC for part B (institutional building)S and (c) the local governments or their designated agencies, such as the R6gies, for part A (local investment projects and institutional development). If needed, the local governments will be assisted by the regional directorates of central ministries and technical assistance will be available from MO!. Since the pipeline of subprojects would be dispersed over many cities across the country, committed separately for each category of civil works over a period of three years, and executed and administered by different local governments or agencies over a five- to six-year period, it would not be feasible to aggregate the contracts into packages large enough to attract international contractors or suppliers through ICB; moreover, local contractors are efficient and the market is very competitive. However, interested foreign bidders would be eligible to participate. Although no large civil works contracts are expected, any civil works contracts exceeding US$2 million equivalent would be procured through international competitive bidding (ICD). Civil work contracts with cost exceeding US$150,000 and up to US$2 million will be awarded through local competitive bidding (LCB), under local procedures acceptable to the Bank. Supply of goods and equipment (mainly solid waste collection trucks) will be awarded through ICB for contracts with total costs over U8$S00,000, and through LCD for contracts with total costs over US$150,000 and up to US$500,000. Works and goods costing US$150,000 or le may be procured through local shopping from at least three suppliers or contractors. The works and goods covered by local shopping procedures comprise: (i) works--basic infrastructure such as street upgrading, improv emnt of banks and limited drainage works; and (ii) goods-mall trucks and office equipment. The majority are to be provided in dispersed communities where packaging is unfeasible. All awards would be made to the lowest evaluated bidder upon review by the beneficiary and FEC. Consultants financed with Bank funds would ba recruited according to the mGuidelines on the Use of Consultants by World Dank Dorrowers." Prior review by the Bank would be required for contracts valued above US$1 millIon equivalent for civil works and US$250,000 for goods. Prior Dank review of all documentation would also be required for consultant contracts valued at US$100,000 and above; prlor review of terms of reference only would be required for consultant contracts valued at less than US$100,000, all single source contracts, and amendments that raise the total contract value above US$100,000. To help FEC and the sub-borrowers comply with Bank guidelines, moreover, the Bank would make an ex-post review for all documents related to Bank-financed subprojects (goods and works) for the first two contracts procured under LCs for each type of investment descrLbed in Annex I (eight subsectors or a total of 16 contracts). Furthermore, during supervision missions, the Bank would review subprojects committed under the free-limit threshold, focusing on procuremnt arrangements. All other procurement would be reviewed ex-post on a selective basisl thus, MO?, FEC, and local governments would be required to retain all procurement documentatLon. Because most contracts would be small, the prior review process would cover about 40 percent of total contract values procured under the project but in view of the arrangements, described above to  - 26 - review the first two contracts in each subsector this percentage is considered acceptable. During neaotiations, agreement was reached on all procurement arrangements. Table 5.3 below summarizes the procurement arrangements for the project. Table 5.3: PROCUREMNT ARRANGEMENT (US$ million equivalent) PROCUREMENT METHOD* PROJECT ELEMENT TOTAL COST ICe LCB Shopping Other 1. Works 1.1 Infrastructure under FEC 4.6 143.4 148.0 subprojects (2.8) (79.4) (82.2) 2. Goods 2.1 Under FEC subprojects 2.4 3.0 20.0 25.4 (1.5) (1.7) (11.7) (14.9) 2.2 Equipment for HOI, NOF and FEC 1.4 1.4 (1.2) (1.2) 2.3 Equipuent and materials for LC 1.0 1.0 training (0.8) (0.8) 3. Consuttancies 3.1 oesign/Supervision 2.5 2.5 (1.5) (1.5) 3.2 Technicat assistance. training 3.5 3.5 (2.9) (2.9) 3.3 External courses 0.5 0.5 (0.5) (0.5) TOTAL 7.0 146.4. 22.4 6.5 182.3 (4.3) (81.1) (13.7) 4.9) (104.0) * Figures in parentheses are the respective amounts fifnced by the Bank loan. 5.15 Disbursements. Consistent with the project financing plan, the Dank will disburse against: (a) 70 percent of the FEC subloan amount for eligible subloans to the local governments; (b) 100 percent of foreign and 80 percent of local expenditures for equipment and materials for FEC's institution building and local sector management; (c) 100 percent of technical assistance and training for FEC's institution building and local sector management; and (d) 80 percent of technical assistance and training for local sector management. Disbursements for technical assistance would be fully documented. Disbursements for contracts related to civil works, equipment, and materials would be made on the basis of statements of expenditures (SOEs) except for those requiring prior review by the Bank (para. 5.14). Supporting documentation would be retained by PEC and the sub-borrowers, and made available for review by Bank staff and auditors. To facilitate project implementation, special accounts would be established with an authorized allocation of US$6 million for the FEC loan and US$250,000 for the Government loan representing about four months. of estimated expenditures. Accounts would be replenished upon presentation of documents as stated above. Modalities concerning the operation of the special accounts and SOEs have been confirmed during negotiations. Although the proposed disbursement period is six years, the project is expected to be substantially completed with most disbursements made by early 1998, the fifth year of project execution. Nevertheless, the closing date is being set at June 30, l9S9 and commitment  - 27 - deadline at December 31, 1996. The dijburuement schedule and disbursement categories are In Annexes L and M, respectively. B. Nonitorina 5.16 Criteria for project success include the followings (a) maintenance and further upgrading of the reform in the distribution of the local share of the VAT among local governments; (b) compliance with lending criteria in the FEC's Policy Statement, which should be similar for Bank-assisted and other FEC- financed subprojects; (c) achievement of FEC's loan targets, which grow approximately with inflation and GDPI (d) achievement of loan commitment and disbursement targets; and (e) substantial compliance with covenants and meeting of monitoring indicators by FEC and the Government. Because of the importance of the undertakings of the Kingdom in its Loan Agreement in the overall success of the FEC component, effectiveness of the latter is conditional on the effectiveness of the former. However, the reverse would not necessarily be true. 5.17 To monitor project implementation and sector performance, an understanding was obtained durina neaotiations that the authorities under the project would report to the Bank as follows (Annex N): (a) FEC is to report on progress in project implementation and the performance of the beneficiaries by February 28 and August 31, for the semesters ending December 31 and June 30, respectively. (b) Starting in 1994, FEC is to submit reports by external auditors acceptable to the Bank by June 30 of each year, with opinions on FEC financial statements of the preceding year, progress in project implementation by category and component (for both the financial year and cumulative), compliance with financial covenants including those applicable to beneficiaries, the special account, and statements of expenditure. Auditors will apply international auditing standards and accounting principles. For the provision of loan losses, auditors will apply, in particular, provisions of the FEC's Policy Statement agreed with the Bank (Annex I, Attachment 2). Considering that FEC's restructuring has delayed the appointment of auditors, the audited report for the 1992 financial statements will be submitted by September 30, 1993. (c) The Government is to submit a financial report for the local sector by June 30 of each year for the fiscal exercise ending December 31 the preceding year. (d) Both the Government (with representatives of HOI and MOF) and FEC are to carry out formal reviews of project and sector performance with the Bank by October 31 of each year. 5.18 Supervising the project will require: (a) two two-week missions p.a. comprising a financial analyst and a municipal engineer; and (b) a mid-term three-week mission by a multi-disciplinary team of some five professionals. Total staff-weeks needed to supervise the project is estimated at 110 (average 18 per year). Total travel expenses are estimated at US$350,000. A detailed budget for project supervision is presented in Annex N.  - 28 - I. Benefits and Risks 5.19 Benefitsa. The project, with improved services, would benefit about 2 million people living in urban and rural agglomerations, including a large number of poor. All investments financed under the loan will have high priority and meet stringent quality criteria. Still, project benefits will go well beyond Bank-financed investments on at least three additional counts. First, as. explained above, policy reforms and project conditionalities are designed to increase the efficiency of all investments--regardless of sources of financing-- through the local sector. Second, actions to improve management systems of local governments and central authorities dealing with the local sector are designed to improve local services and the financial performance in the local entities. Third, the restructuring of FEC and the reform of the distribution of the local share of the VAT, in particular, are designed to enhance the financial discipline of local governments and thus increase their savings. These, albeit leaving the local sector largely accountable to the Central Government, amount to a major reform in terms of economic public sector management. 5.20 Environmental Asnecte. Many subprojects, particularly those in water, sewerage, and solid waste collection and disposal, will have a positive environmental impact. Any possible adverse environmental impact will be screened, assessed, and mitigated as needed &.ad consistent with the project environmental category of rB". FEC will approve subprojects for sewerage systems, solid waste collection and disposal, marketplaces, and slaughterhouses only when such a subproject to be assisted or another by the same beneficiary addresses all significantly adverse environmental aspects. FEC will employ two environmental specialists who will be responsible for environmental impact assessment reviews and project appraisal procedures. The Bank will assist FEC in designing detailed and comprehensive job descriptions and project appraisal procedures. For projects that generate or deal with hazardous wastes, full environmental impact statements will be obligatory. When the Envi,:onmental Secretariat of M01--with Bank assistance--becomes operational, FEC will comply with the guidelines of such secretariat and clear complex subprojects with it, as needed. 5.21 Risks and Safeauards. Improving local services and sector management countrywide is an ambitious undertaking which will require a sustained effort for many years. The project is complex, addresses key sector issues, and involves many agencies, some of which are institutionally and operationally weak or untested. Three major risks match the project's ambitions and complexity. The first is that limited project preparation capacity at the local level compounded by a still untested restructured FEC may result in a slow pipeline of quality subprojects and thus slow project execution. Submission of some subprojects complying with the proposed FEC Policy Statement has already mitigated this risk. The training component and FEC's upgraded organization and systems will reduce this risk in the longer term. 5.22 The second major project risk is that FEC's managiment and governing bodies could fail to maintain their demanding Policy Statement. Government and Bank collaboration in designing the new FEC have already reduced this risk. Covenants on FEC's financial performance should help further reduce such a risk (para. 4.17). 5.23 The third major project risk is that the Government may be unable or unwilling to carry through and maintain the reform in the distribution of the local share of the VAT. Political interests at times may call strongly for tight control on local authorities and their constituents, and thus for central  - 29 - discretion in distributing the local share of the VAT. Intense discussion of the VAT issue throughout project preparation has already reduced the risk that the Government may fail to distribute the local share of the VAT appropriately. Implementing the reform of the distribution of the local share of the VAT early during project execution will also substantialiy reduce that risk. The entire process of VAT transfer reform makes a return to the old system extremely difficult. The annual reviews of sector progress conducted during implementation should further minimise the risk that the Government fails to maintain the reform (para. S.17). 5.24 Project financial risk, for its part, is minor. FEC's recovery of all loans to local governments is virtually ensured by the earmarking of budgets making repayment to FEC a priority. Local taxes, the local share of the VAT and minimal FEC bond issues would provide the needed counterpart resources to fund the project investments. VI. AG}5SfMENTS AM OOIMEIDATZI 6. 1 Duging neaotiations, assurances were obtained from the Government that it will: (a) by May 31, 1993, contribute DU 75 million to FEC's equity (para. 415); (b) by January 1, 199S, introduce an improved system to distribute the local share of the VAT among local governments (paras. 3.2 and 3.4); (c) implement a plan, acceptable to the Bank, to improve local sector management (para. 3.6)1 and (d) take all measures as may be required on its part to enable FEC to comply with its obligations under its Loan Agreement. 6.2 Durian neaotiatigns, assurances were obtained from FEC that it will: (a) carry out its operations in accordance with the agreed Policy Statement (para. 4.10); (b) onlend Bank funds for local government projects only in accordance with the above statement and the eligibility criteria agreed upon with the Bank (paras. 4.10 and 5.12); (C) earn a net financial return on total assets of at least 0.5 percent in 1994, 0.8 percent in 199S, 1.0 percent in 1996, and 1.2 percent in 1997 and thereafter (para. 4.17); (d) maintain total administrative expenses at not more than 0.75 percent of the value of total assets (para. 4.17); (e) maintain a debt-to-equity ratio of no more than 15 to 1 during 1993- 1996 and 12 to 1 in 1997 and thereafter (para. 4.17); and (f) implement an institutional improvement plan as agreed with the Bank (para. 4.9).  - 30 - 6.3 The conditions of effectiveness of the loan to FEC are as follows: (a) local governments sholid have assumed or guaranteed the total balance of their R6gies" loans from FEC in arrears for one year or more as of June 1, 1993 (pera. 4.15); and (b) FEC should have appointed its four main line managers and two environmental specialists (para. 4.9). 6.4 With the above assurances, agreements and conditions, the proposed project is suitable for Bank loans totalling US$104 million--US$4 million to the Kingdom of Morocco and US$100 to FEC with the guarantee of the Kingdom--at the BankIs standard variable interest rate, to be repaid over 20 years including five of grace.  - 31 - anns Page 1 of 15 1IRSf UMIICIPAL FINANCE PROJECT LOCAL GOVERNIIENN FINANCE IN MOROCCO XllffODUC!TQIO 1. This annex presents an overview of local and intergovernmental finance in Morocco, examines the allocation of the value-added tax (VAT) revenues to local governments, and provides Information on local taxes and revenues. It contains the fol:;wing sections: (a) local administration and services; (b) local budgeting and accountingi (c) current and capital revenues; (d) central government transfer.a ant (e) local taxes. This analysis of local government finance only concerns those services provided directly by local governments and financed from their resources; therefore, it will niot discuss the finances of public utility companies (Rfgies), concessions, or other services provided through contractual arrangements. OCAL AMINISTRATION AND SERVICES 2. The Moroccan subnational admanistration consists of two levels of governments the provinces and the communes. The communes are subdivided into rural and urban communes, the latter called "municipalities." Local government councils have authority over most local public servicer and decide on the form of arrangements for their provision. In the country's larger urban agglomerations, water supply, urban transport, distribution of electricity, and in a few cases sewerage services are provided by quasi-autonomous public utility RMgies, which have been created by the councils. In some smaller municipalities and in rural areas, water supply and distribution of electricity are provided by the national water and electricity agencies, ONEP and ONS, respectively, under contractual arrangement. In exceptional cases, transportation and water supply services are provided through concessions. Local public services provided directly by local government consist of garbage collection, construction, and maintenance of streets and roads, recreational areas, street lighting, traffic management, wholesale and rood markets, and sewerage services. The level of activity in these services varies significantly among local governments. Local government investments in 1990 by type and sub-sector are shown In Attachment 1, Tables 1-4. LOCAL 3UDaEmTNG AND ACCOUNT 3. This section explains intricacies of centrally mar.nged local budgets and how the lnter-budgetary flow of funds from one year to the next generates surpluses that tend to obfuscate the financial resources available for local governments' operating and investment expenditures. in 1990, local governments, in the aggregate, accrued some US$1,250 million equivalent of revenues and spent only about US$800 million (which includes about US$400 million for investments). This resulted in an apparent surplus of US$450 million which, on the surface, ouggests that their resources exceeded their needs or capacity. Yet local governments generally have resources substantially below their needs and execution capacity. Most of that apparent surplus is unreals it results from local government accounting practices, which in turn necessarily follow from the financial controls the Central Government imposes on local government funding and expenditures. Although those controls slow down investments and blur local sector's finances, their proximate dismantl1ng is unwarranted, as they aim to  -32 - Annex A Page 2 of 15 master public sector funds and constrain publio expenditures amid local dependency on transfers and shortage of public funds. The flow of funds must be interpreted within this context. A summary table is presented belows Table Is Local Government Revenues and Expenditures, by Source, 1990 (DH million) REVNUES Local Taxes 2,672 Collected by the Central Government 1,205 Collected by Local Governments 1,467 VAT Transfera1 3,449 Subsidies to Balance Current Budgets 1,155 Earmarked for Investments Expenditures 2,294 Borrowing 500 Total Revenues 6J21 Surpluses From Previous Years2 2,800 Total Available Sources 9,421 EX?-XNDIX=RS Current Expenditures (debt service excluded) 2,740 Debt service 340 Investments 3,583 National Programs Rural programs, water, electricity 1,349 Education, Health, Agriculture 405 Others 1,828 Total Expenditures 6663 Surpluses (Deficit) 2,758 Source: Calculations based on statistics from the Ministry of the Interior. 'VAT transfers earmarked for fnvestment exenditures for the year 1990 are entirely alloeated to nationat prograum elnfstered by the Central Goverument. Local governaents have altost no fnvolvement in thes proGram. 2 Surpluses from prevfous years are af lable for investment expenditures only. These lare surpluses are caused by delys In the fupletentation of lnvestment expenditures and should not be interpreted as an excess of resources (for a detailed explanation, see pars. 3).  - 33 - annexA Page 3 of 15 4. The cornerstone of the system of local finance is the General Treasury's collecting and maintaining all local funds, and paying for all expenditures on behalf of lecal governments. To monitor this, the closed local budgets show revenues on an accrual basis and expenditures on a cash basis. One form of the revenue that flows into the budget is the cumulative surplus (current eurplue plus transferred investment credits) from previous years. On the closing date, it increases with the surplus of the current year (Figure 1). Furthermore, as seen below, revenues are not necessarily disposable. Fig3&zt.lt INTiRSUDGUTARY FLOW OF FUNDSs SURPLUSES Year N-I Year N Year N+1 Rsu LpE Re.. Egm am I. midget ;dget Budget - cu t and Capi Sfuusr te prebous Budtet supUs_ gear ao remded as apltl rewemes In the faftwbIq gear budget. S. Both revenues and expenditures are divided between current and capital (Attachment 1, Table S). Current revenues include operating subsidies and current expenses debt service. Although the Central Government approves the local governments' current and capital budgets at the beginning of the fiscal year, MOP makes budget credits available for disbursement against investments only gradually through the year as the General Treasury receives cash. Because local governments can only tender for investments on the basis of available credits, that system results in the accumulation of local funds as consolidated public sector cash, in investment slippage, and in unused open credits accumulating at year end. Both committed and uncommitted credits remain open to support the following year's investments. Purthermore, local expenditures on health, education, and certain agricultural programs apparing on the local government budgets are financed by them out of transfers, but are managed exclusively by the Central Government. Any delay in those expenditures increases the open investment credits. 6. The above budgetary process together with the Ministry of the Interior's allocation of operating subsidies to each local government on the basis of their forecast current deficits has resulted in an incentive for local governments to overestimate expenditures and underestimate revenues in their budgets. The inflated forecast deficits foster transfers. The resultant surplus current budgets of the present year will become disposable financial resources for  - 34 - AnnexA Page 4 of 15 the following year's investments, once that surplus is determined. This current surplus, plus available investment credits at year end, are usually presented as a source item (cumulative surplus of previous year) for the following fiscal year. 7. The total system, thus, results in delaying investments (which are a lagged function of past surpluses) and in showing largely unreal accounting surpluses. A rough approximation to having revenues and expenditures on a more similar basis would be to acknowledge that the cumulative surplus is merely an accounting entry, but that the amount of disposable budgeted transfers is equivalent to that cumulative surplus. The surplus, thus, would be nearly cut in half, but still inflated by that of delayed expenditures of the Central Government and planned current surpluses of the local governments. The delayed opening of investment credits would still induce real surpluses of disposable over spent resources, as it constrains local governments' planning and execution efforts. Only the local authorities' accounting all transactions on either an accrual or a cash basis, and managing local funds, would reveal a fully transparent financial picture of the local sector. Still, those anomalies would substantially subside if, first, MOI were to cease granting operating subsidies on the basis of forecast current budget deficits, and second, if HOF were to open all investment credits at the beginning of the year. Under the First Municipal Finance Project, the Government will cease granting operating subsidies on the basis of forecast current budget deficits. Earlier opening of investment credits is being considered amid some concern that it might result either in government funding of local expenditures before receipt of local resources, or in the accumulation of local arrears. Financially and politically, Morocco is not yet ready for major decentralization of local financial management to the local governments. Yet, distributing the local share of the VAT among local governments on the basis of more objective criteria, which will foster elected local authorities' autonomy to choose investments, will be a substantial step in that direction. CURRENT AND CAPITAL RE ENUES overview 8. Local governments have three types of revenues to finance their operations and investments: (a) local fiscal resources and other local revenues (33 percent of total revenues excluding prior surpluses in 1990); (ii) transfers from the Central Government which come from the proceeds of the Value-Added Tax (59 percent of' total revenues in 1990), and (c) credits (5 percent). Transfers take two forms: an allocation for local governments' operating expenditures, and allocations for their it-estments. Current revenues 9. Local governments' current revenues include all tax resources aa well as transfers from the Central Government to their current budget. There are two types of local tax fiscal resources: Local taxes that are administered by the Central Government and those administered directly by local governments. These three categories of revenues represent the core of the local government resources. Each anounts to about a third of their current revenues as in Table 2 below.  - 35 - Annex A Page 5 of 1S Tablo 2L Local Goverament Current Revenues, 1990 (DR million) Local Taxes Collected by Central Government 1,205 31% Local Taxes & Other Revenues Collected by Local Governments 1,467 38% VAT Transfers (Deficit Subsidy) 1,155 30% Total Current Revenues 3,l27 100% Sources Calculations based on statistics from the Ministry of the Interior 10. Local taxes that are administered by the Central Government include two property taxes, the urban tax, and the "taxe d'6dilit6," and a business tax or "patente." These are major revenue sources for local governments (DR 1.2 billion in 1990). They are administered by the state because of the relative comple-ity of the assessment and collection procedures (paras. 28-34). Local taxes that are administered directly by local governments consist in a series of small taxes and fees raised from several economic sectors. Although each yields limited revenues, on the aggregate they provide a significant amount of revenue to local governments (DH 1.3 million in 1990). They were the subject of a recent reform in 1990 which, once fully implemented, will certainly increase local government revenues, albeit moderately (paras. 36-38). Transfers to local governments' current budgets are aimed at financing their operating deficits. These transfers are called the "deficit subsidy" and are the focus of much criticism because they create a series of negative incentives to local governments' financial management. They have increased continuously in nominal terms in the last decade and in particular between 1989 and 1990 (from DR 833 million to DH 1.2 billion). Capital Revenues 11. Local government investments are financed by capital revenues which are resources strictly earmarked for investment financing. They consist ofs (a) transfers from VAT proceeds; (b) credits; and (c) local governments' own resources or surpluses from the current budget (Table 2). Transfers for Investments appear to be the most important source of revenue for local governmento (DE 3,500 million in 1990). It should be clear, however, that most of these transfers (about 73 percent in 1989 and 100 percent in 1990) are earmarked for investments administered by the Central Government. Local governments' involvement in these investments is very limited. They appear, nevertheless, on local governments' accounting documents because they are financed by local funds. These investments are centrally-managed government expenditures and national programs, many of which are for rural development. Local governments receive a small allocation from the VAT resources to finance their own investments which, in practice, has never exceeded DH 600 million. Since 1990, these transfers, specifically earmarked for local government investments, have been temporarily eliminated because the VAT resources were insufficient to finance all programs for which they were allocated (paxa. 19). 12. Credits come primarily from the Communal Infrastructure Fund (Ponds d'Squipement Communal - PEC), an institdtion responsible for channeling fiscal resources to local governments. These credits provide limited revenues and are irregularly distributed among them. The management of these loans is inadequate, nd the FEC in its current institutional setting is unable to introduce a better  - 36- Annx A Page 6 of 15 management of the lending system. The major drawbacks of this system can be summarized as follows: (a) FEC does not have mandatory lending policies, particularly concerning the financial performance of borroweral thus FEC does not pay attention to local government finances. Loans are granted independently from local governments' capacity to reimburse their loans as all loan reimbursements are guaranteed by the Central Government through the deficit subsidyg (b) loans cover 100 percent of the investment costs; (c) FEC lacks qualified staff to appraise and supervise projects. On-site visits are not made before loans are granted or during the project implementation. FEC's analyses prior to lending are cursory and are based on limited information; and (d) no substantive conditions are imposed on loan disbursements. 13. Local government current expenditures are dominated by their personnel costs, which took up about one-third of their total operating expenditures in 1990 (DH 1 billion). Investments are primarily made in street and road constructions and in various types of buildings (Tables 3 and 4). Tahlae as Urban Commune investments, 1990 (DDH million) New Construction Streets and sidewalks 176 Sewers 76 Electricity 77 Water 23 Other Infrastructure 8 Administrative Buildings S1 Markets 57 Housing 16 Other Buildings 146 Other New Construction 92 Integrated Investments 281 Real Estate 25 Cars, Trucks, Furniture, etc Subsidies, Other Budgets & Fond de Concours Total Sources Ministry of the Interior  37- AnngxA Page 7 of 15 Table 4Ls Local Government Investments, 1990 (DH million) New Construction 1,740 Integrated Investments 439 Land and Other Real Estate 40 Cars, Trucks, Furniture, etc. 404 Subsides to annex budgets (other services) 268 Others 641 TOTAL 3,583 Sources Ministry of the Interior CENTRAL GR92RNMENT TRANSFERS Increasina Central Government Transfers to the Local Sector 14. Central Government transfers to local governments have been increasing continuously since the 1976 local government reform. The sharpest increase occurred in 1985 when the law allocating at least 30 percent of the VAT revenues to the local sector was implemented for the first time in 1988. Table 5 below shows that in one year, between 1987 and 1988, these transfers increased 71 percent. Table 5s Central Governaent Transfers to Local Governments, 1984-1990 (DH million) 1984 1985 1986 1987 1988 1989 1990 Total Transfers 1.377 1.492 1.680 1,600 2.870 3.012 3.449 Deficit Subsidy SOO 613 674 629 690 833 1,155 Investments 877 879 1,006 971 2,180 2,179 2,294 Source: Ministry of the Interior 15. This increase in the resources allocated to the local sectors did not necessarily translate into a proportional increase in local government revenues. Only a part of VAT resources are transferred to the local governments for their own activities. The rest are used to finance several other programs, some of which benefit small rural localities and require centralized management for efficiency. But a large portion of these programs are closer to Central Government expenditures financed through what should be the local share of the VAT resources. These programs are growing in numbers, primarily as a consequence of Central Government budget constraints. VAT resources allocated to the local sector are thus rapidly becoming insufficient. In brief, VAT resources serve the following purposes: (a) to balance local government current budgets; (b) to finance national programs such as rural development programs and other Central Government expenditures that are identified as priority investments; and (c) to provide local governments with investment subsidies (Tables 6 and 7 and Attachment 1, Table 6).  -38 - AnneUA Page a of 15 Table 6* Allocation of VAT Resources, 1988-1990 (DH million) 1988 1989 1990 TRANSFERS TO LOCAL 2ER 1 1, 1.41 1.153 To Current Budgets (Balance Subsidies) 691 833 1,153 To Capltal Budgets 512 578 0 NATIONAL PROGRAMS2 1.212 1.162 14755 Special Endowment 978 633 803 Rural Development Programs 0 281 157 New Responaibilitieu 0 0 406 Others 235 248 389 SHARED EXPENDITURES3 455 4Iii Common to All Local Governments 9 138 30 Contribution to C.G. Expenditures 446 301 511 TOTAL I&= Z Table 7s Allocation of VAT Resources, 1988-1991 (percentages) 1988 1989 1990 TRANSFERS TO LOCAL 0OVERSMENTS la AZ 1 To Current Budgets (Balance Subsidies) 24 28 33 Ta Capital Budgets 18 19 0 NATIONAL PROGRAMS 22 5 Special Endowment 34 21 23 Rural Development Programs 0 9 5 New Reuponaibilities 0 0 12 others 8 8 11 SHARED EXPENDITURES 15 16 Coamon to All Local Governments 0 5 1 ContrLbutlon to C.a. Expenditures 16 10 15 TOTAL Q Q Note: 1991 projetfions revised In October; only OH 2.790.64 miltion more disbursed at that time. Transfers to local govermants are used freely by local govermmnts. 2 National program are bynagg b the Control Gowerment. Thse lnvestmnts appear on local goerrmnts' budgets. ' Shared Expenditures are maad by the kinistrV of Interior.  - 39 - Annex A Page 9 of 15 The Deficit Subsidy 16. The defiett subsidy is allocated to local governments to finance their operating or current budget deficit. It is based on local governments Q own evaluation of their revenues and expenditures, i.e., on their own projected deficit, which is then negotiated with the officials of KOl. This allocation system has significant drawbacks. It creates incentives for local governments to underestimate revenues and overestimate expenditures to obtain more revenues. It rewards politically-active local officials at the expense of those more concerned with raising their own revenues. It finally creates a perverse management of local government debts as all debt repayments are automatically guaranteed by the Central Government through the deficit subsidy. It pushes local governments into requesting loans above their real capacity to borrow, as a way of raising revenues. It is a system that is not conducive to the efficient use of financial resources nor to good financial management. Despite efforts from MOI to control pressure from local government officials and to limit the deficit subsidies, these transfers have been growing steadily through the years. 17. These problems have been recognized by the Government, which has recently developed the main concept of a reform. The proposed allocation system is designed to elimlnate the deficit subsidy and introduce relevant criteria for distributing VAT resources among local governments. This reform is reviewed in more detail in paras. 24-27. CaDital Subsidies or Tronsfers for Local Government Investment 18. Capital subsidies are allocated to local governments' capital budgets, on the basis of population, to finance their investments. These transfers have always been relatively modest (less than DU 600 million) despite the original objectives to promote local government investments defined in 1986, at the time of the allocation of VAT resources to the local sector. 19. In 1986, 10I required that each local government identify its investment needs and submit a list of priority projects. This survey served to establish a " project bank." It was estimated that DR 31 billion of investments would be needed by the communes, and that these investments could be implemented within the next few years. In reality, they never had a chance to be implemented because the allocation to local government capital budgets from the VAT resources remained modest. it is only after all other allocations of the transfer system have been satisf ed that the amount of capital subsidies to be allocated to local governments can achieve their own investments is determined. With the continuing growth of the deficit subsidy and the increasing number of national programs in the last two years, the VAT has increasingly become insufficient for satisfying all these programs. Capital subsidies for local governments* own investments have been the most affected by these trends. Communes have to finance their investments through their own resources and through borrowing. some communes may have been able to use VAT resources allocated under the deficit subsidy to finance part of their investments, but the extent of these investments could only be limited. 20. The treat&ient of the capital subsidy as a residual of all other allocations explains why the amounts transferred remained small. It has also made  - 40 -AnnexA Page 10 of 15 such transfers irregular and unpredictable, restricting local governments' capacity to budget their investments. National Proarame 21. National programs use up an increasing share of the VAT resources allocated to the local sector (51 percent in 1990 compared with 39 percent in 1989). Most of these programs are managed entirely by the Central Government, local government participation limited to the implementation of some minor tasks. These programa include large rural development projects--irrigation, water supply, afforestation, and rural electrification projects-- which are centrally managed. They also include special programs (special endowments) that are large projects and expenditures conducted by NOI. Finally, they include expenditures common to all local governments (for printing administrative materials and for conferences) and other Central Government expenditures related to police services and to some urban rehabilitation or renewal work. Newly Transferred Responsibilities 22. In 1990, some responsibilities in education, health, and agriculture were transferred to local governments. It is not yet clear whether this reform is permanent or temporary. These transferred responsibilities do not represent real transfers of authority but transfers of charges, i.e, of some investment expenditures to the local sector to be financed from VAT resources. These investments are administered entirely by relevant ministries and are part of the ministries' investment plans. For education, they are small projects for primary schools in urban and rural areas. For agriculture, they include equipment purchases and construction of facilities. For the health sector, they include the participation in the construction of a large hospital project in Casablanca and the construction of small health facilities and equipment purchases. 23. These transfer of charges used 12 percent (DH 406 million) of VAT resources allocated to the local sector in 1990. They have increased the amount of resources allocated to national programs at the expense of capital subsidies for local governments' own investments. REFORM OF THE VAT DISTRIBUTION SYSTEM 24. The reform of the allocation of the system of VAT resources will bring significant improvements not only to the transfer system but also to the management of local government finances. It will eliminate the deficit subsidy, replacing it with a systematic allocation to the current budgets of local governments. The main principles of the reform can be summarized as follows. 25. Out of the local share of the VAT established by law, the Treasury would first recover, over the next few years, about DH 1.5 billion per year by transferring to the local budgets certain expenditures of the health and education ministries. During a transitory period of three years, part of the local share of the VAT will be allocated gradually to phase out operating subsidies and finance previously authorized VAT-funded investments which take several years to complete. Then, at the macro level, the remainder (most of the local share of the VAT in the fourth year) will be allocated 50 percent to the rural sub-sector and SO percent to the urban sub-sector, largely reflecting the historical allocation. At the micro-level, this allocation will be distributed among local governments according to the following criteria:  - 41 - Annex A Page 11 of 15 (a) an amount equally distributed (5 percent of the allocation), to replace the phased-out operating subsidies; (b) an amount distributed on a per-capita basis, corrected for social equity in accordance with fiscal endowment as measured by assessments of local taxes managed by the Central Government (50 percent); (c) an amount distributed in accordance with per-capita fiscal effort, as measured by collection of taxes managed by local governments (20 percent); (d) an amount equally dlitributed to provincial capitals, to cover the associated costs of managlng provincial affairs (5 percent); and (e) an amount distributed at MOlls discretion, mainly to subsidize local governments adversely affected by the system, as well as to cover emergencies and common expenditures (20 percent). 26. Local governments will use the VAT allocated on the basis of the above criteria either to cover operating costs and service debt or to carry out investments. Although earmarking will not epply, local budgets will continue to be subjected to the approval of MOI, whic' will enforce debt repayment first. Under the new system, MOI will cease alloe ting operating subsidies on the basis of forecast deficits that include debt service. FEC, moreover, will impose maximum debt service ratios as eligibility criteria for borrowing local governments. Thus, under the new system, the inducement to incur excessive debt to finance lower priority investments will disappear. The objective criterla to distribute the VAT should foster the efficiency of investments and the accountability of elected officials to their constituencles. 27. The system will be in place for 1995. An MOl resolution establishing the system will be cleared by MOP and circulated among local governments by October 1994. LOCAL TAXES Local Taxes Administered bv the Central Government 28. The urban tax, the "taxe dwedilit6," and the "patents" or business tax are summarized in Attachment 2, Table 1. These are by far the most important of all local taxes. They generate one-third of all local government current revenues and 15 percent of its total revenues (DH 1.2 bilLon) in 1990. 29. The urban tax is an old property tax modified several times since its inception in 1992. It is based on the rental value of buildings and the land as well as on any equipment and capital investment made on this land. The rates vary between properties used for businesses and those used for housing, and they also vary with the rental value of properties. Exemptions and deductions are applied in some cases; e.g., owner-occupied units receive a 75 percent deduction. Since the lntroduction of the general income tax in Morocco in 1990, owners of income- generating properties have not been subjected to the urban tax. To compensate for this loss in revenue, local governments have been receiving, since 1990, all the proceeds from the "patente." Before the general income tax reform, they used to receive only 10 percent of the revenues from this tax. These changes will be very beneficial to local governments once the procedures are well established as the potential revenues from the "patente" tax appear to exceed the lost revenues from the urban tax (Tables 8 and 9).  - 42 - Annex A Page 12 of 15 30. The "taxe d'6dilit6u is also based on the rental value of the buildings and the land. The rates are 6 percent and 10 percent depending on whether the property is located at the center or the periphery of the city. No exemptions or deductions are applied. This tax was introduced initially to cover the costs of street construction and maintenance, though it is not earmarked for any particular expenditure. 31. The "patente" is an old business tax based on physical elements rather than accounting information. It is based on the rental value of the buildings and the land used for business activities. In addition, it includes a levy specific to the type of business. Despite the fact that this tax is not based on business activities or profits, it provides important local government revenues. It has the advantage of being well known and accepted by the population and can potentially reach businesses that are not subjected to other taxes. Any reform of this outdated tax should first consider its relevance in relation to other taxes, and the costs and difficulties involved in setting a new tax. Table 8s Revenues from Local Taxes Administered by the Central Government, 1989-90 (DH million) 1989 1990 Urban Taxl 530 459 Taxe d'Rdilit6 680 652 Patente2 5 94 TOTAL , ! 2 Source: Ministry of the Interior, General Directorate of Local Governments Table 9s Assessments of Revenues from Local Taxes Administered by the Central Government, 1989-90 (DH million) 1989 1990 Urban Tax 627 285 Taxe d'Edilite 826 832 Patente 826 863 Sources Ministry of Finance, Tax Department 32. The urban tax, the "taxe d'6dilit6," and the "patentes are wholly administered by the Central Government. Like all property taxes, both the urban tax and the Otaxe d'6dilit6" are costly and difficult to manage. They mobilize I The urban tax was reformed In 1990, after the introduction of the general income tax. This explafns the lower figures for 1990 and 1991 coqpared with those of 1989. 2 Only 105 of the "patenteO proceeds were allocated to local goverrnments in 1989. Sinre 1990, 100l of these tax proceeds have been allocated to local governments. Low revenues in 1990 are due to delays in the luplementatfon of this reform.  -43- annex A Page 13 of 15 most of the resources of the Tax Department (Direction des Imp8ts) of MOp. The assessments are carried out every five years by commissions formed by a representative of MOF and local representatives. Before the Introduction of the general income tax (GIT), these assessment were updated yearly. Today, the information gathered for the GIT helps trace rented properties and those used for businesses and helps update the urban tax and the "taxe d'4dilite" record. Updating records for new owner-occupied units is still a problem, however, particularly in the rapidly growing urban peripheries. Rental values are established, by comparison, based on the rents charged within identified locations and based on the type and the size of the property. 33. Collections are hindered by disputes of assessments which are frequent as well as costly to administer. The Tax Department is particularly sensitive to social problems caused by these taxes. A typical example mentioned is that of an owner-occupied unit where the rental value increases without creating any income for the owner. 34. There seem to be frequent delays in the collection of these taxes. The arrears that build up (Tables 8 and 9) are due to disputes mentioned above and delays in assessments and collection procedures. These arrears are problems Insofar as they create anomalies in local government revenues which hinder their capacity to plan and budget their revenues and expenditures accurately. Local Taxes Administered by -ocal governments 35. Local taxes administered by local governments are summarized in Attachment 2, Table 2. These represent about one-third of their current revenues and 11 percent of total revenues. They are important sources of revenue for local governmen*s because local officials have authority over the rates for about 40 percent of these taxes and fees, and are responsible for most of their collection. 36. The 2gforLm. In an effort to improve these revenues and provide more autonomy to local governments, the Central Government has introduced a fiscal reform. The reform law was enacted in 1989, and implementation began as early as 1990. The latest tax to be introduced, the tax on "unbuilt" land, will be implemented in 1992. The objectives of this reform were to: (a) increase local government revenues by introducing new local taxes; (b) simplify and rationalize existing taxes by modifying their rates and bases to improve their assessment and collection procedures and to increase their yield; and (c) increase and fix the rates of about 60 percent of the taxes and fees, which effectively took away some of the authority on local taxes from local governments. This was judged necessary, however, because local officials had not introduced any changes in their tax rates for many years. 37. Many new taxes were introduced by the reform and only one tax was eliminated. Out of the 34 local taxes, only 12 remained unchanged. The other are either new taxes or old ones that have been substantially modified. 38. The fiscal reform touched many sectors. The urban development sector was particularly targeted because that sector had been very active and profitable in the last decade. Two new fees were created, consisting of the land development fee and the obreakup of estates" fee, and the existing construction fee was  44 AnnexA Page 14 of 15 reformed. The tax on ounbuilt' land was finally introduced after a decade of debate. The reform lso itntroduced transport licenses, most of which would he administered by the Ministry of Transport. Both the transportation and the urban development sectors are primary beneficiaries of the services provided by local governments and, therefore, can be qualified as appropriate sectors subject to taxation. The reform further introduced a new hotel tax which raised some protests from the already stagnant tourism induetry. Other newly created taxes were applied to fishing, education, artisanal activities, and the production and sale of beverages. 39. Preliminary Evaluation of the Reform. Tt is still too early to draw final conclusions on the outcome of the reform. The latest figures of local government revenues of 1990 show some preliminary results which should be interpreted with caution. Figures show an Increase in local tax revenues between 1989 and 1990, but no dramatic changes in the amounts of these revenues (Table 10). Table 10' Local Governments' Own Revenues, 1989-90 (DH million) 1989 1990 Taxes 252 347 Fees 639 836 TOTAL 891 1,183 Sources Ministry of the Interior 40. The reform allocated to provinces and prefectures a series of fees, which have increased substantially their tax revenues, from DH 3 million in 1989 to DR S-i million in 1990. Most of these revenues can be attributed to a drivers' license fee and a hunting fee (Table 11). 41. Urban communes benefitted from the rehabilitation and extension of existing taxes which already provided them with important revenues before the reforms the construction fees and the wholesale and market fees, which were extended to the fishing sector. Taxes on beverages were radically transformed and doubled their yield after the reform. Their revenues were, however. relatively modest. 42. Revenues from forests continue to be the primary resources for a small number of rural communes. Overall, rural communes have also benefitted from the reform of their fee system. Their revenues from fees have increased in the same proportion as those of urban communes. 43. At thli early stage of the reform, local government revenues from local taxes and fees have already increased. Most of the increases can be attributed to existing taxes that have been rehabilitated and extended. It is also these taxes that generate the highest revenues (Table 11). New taxes produced limited revenues, as some require more time to be fully implemented and efficiently administered. It is, nevertheless, clear that the reform did not introduce any major taxes into the local government revenue system.  - 45- Annex A Page 15 of 15 a .l* U oal Taxea an fees adminIstered by Local Goveramets,, 1990 Prefctrs Nd mnicipal- Rl Tax"s an Fe Provinces ities Coauno Total X (a) R8evene frm Forest 248 248 21X cm) Rote Tax 5 5 ox (R) Tax an Beveramg 7 7 1X CU) U",erI a t Tax 12 12 1t (M) Tax mn sS tim Evfts 1 I 01 (I) Tax an Prvate Udscatin 2 2 OX (N) Oriver*s Lice FPes 20 20 2X cm) Few for Vehicle Visits 5 5 0O (N) Nuwting Fee 15 1S 1X Otbw Taxe 32 32 3X Total Tuns hQ 22 Z at 29X X ot Total 12X 17X 711 1001 (U) Market Fe"s 77 77 6 (R) WHolesaleo Markets 156 156 13X CM) Ffsh Markets 22 22 2X (a) Constfutin 115 115 101 (N) Len evlopment Fes 2 2 0o (N) Breakp of Esttes 3 3 OX other Fee 12 118 130 11X Local TaXe of Rural Coinm 331 331 2ex Total Fees Ii 121 D I X ot Total 1X 59X 401 1001 Total LOal Tae ad FeU a1 0 lOOX X of Total 4X 471 49X 1001 Souroes Miuistry of the Xaterior notes Transformation introduced by the reforms (N)-New, (R)wRtformed, (U)-Unchanged. 'Othwr ta inelud tan cowmwrcial dspltay of, inter alls, goads (or wndows), pons, end transport 'Other fes iclude fee for, iner ells, mni slaughter, eivil rgistry, esbulence, d certifiattion  - 46 - ANNEX A Attachment 1 Tables 1 - 2 Table-s LOCAL ZNV3STNNS, 1990 Prefectures NuIc- Rural & Provines ipslitles Cafunes Total New Construction S83 22 434 1,740 49X Integrated Investments 9 281 149 439 12% L and oth gReal Estate 6 25 8 40 1l Cars, Trucks, furnmtur., etc. 83 216 105 404 11X Susidies to wrmex buxgets 16 15S 98 268 8X Others 641 641 1n total .9 199^ 310 latet zm~~~~~~~~~~2 UL 100% 4t 6w0K 22X 100% Source: Ninistry of the Interior. Table 2s SMEsSSMANNS WA FUND8 ALOCA!RD 5O LOCAL *BY SBSCOR, 1990 (Oi million) Communal Development 336 19% Social Facilities 212 12% Klectrification 161 9% Administrative Buildings 179 10A Specialized Uquipment 185 11l Potable Water 279 16% oommunal Roads 145 8a sewers 158 9% Garbage Collection 101 6% TOTAL 1,755 100% Source- Ministry of the Interior.  - 47 - ANNEX Attac.1ment 1 Table 3-4 Table NYUSN o0 TVA VUD ALL0CRED TO LOCAL BJY 5XCMO, AGoREGATED 1988-1990 (Dli mllliQn) Communal Development 1,257 19% Social FaclIltles 794 12% ZlectrifLcation 601 9% Administrative buildLngs 671 10% specLalLsed squipment 694 11% Potable Water 1,045 16% Communal Roads 542 8a sewers 592 9% Garbage Collection 378 6% TOTAL 6.573 100% Sources nlistry of the Interior. Table 4s LOCAL INVUSII I3UT 1TS1r FINANCED BY LOAN8, 1990 (DU thousand) Coaaun