Romania - Financial and Enterprise Sector Adjustment Loan Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No. P-6672-RO REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED SINGLE CURRENCY LOAN WITH A US DOLLAR TRANCHE IN AN AMOUNT EQUAL TO US $170 MILLION A DEUTSCHE MARK TRANCHE IN AN AMOUNT EQUAL TO DEM135 MILLION AND A FRENCH FRANC TRANCHE IN AN AMOUNT EQUAL TO FFR100 MILLION TO ROMANIA FOR A FINANCIAL AND ENTERPRISE SECTOR ADJUSTMENT LOAN DECEMBER 6, 1995 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EOUIVALENTS (as of December 6, 1995) Currency Unit = Leu (plural Lei) I Leu = 100 bani lLeu = USS0,0004 US$1 = Lei 2,535 WEIGHTS AND MEASURES Metric System ABBREVIATIONS AND ACRONYMS AR - Agency for Restructuring BA - Banca Agricola BP - Banc Post BPTF - Bank Privatization Task Force BSE - Bucharest Stock Exchange CC - Commercial Company CCSER - Council for Coordination, Strategy and Economic Reform CEC - Savings Bank CIB - Credit Information Bureau CO - Certificate of Ownership DFI - Direct Foreign Investment DSR - Department for Selective Restructuring EBRD - European Bank for Reconstruction and Development EU - European Union FESAL - Financial and Enterprise Sector Adjustment Loan FRF - Financial Recovery Fund FRP - Financial Recovery Program GD - Government Decision GOR - Government of Romania ICB - International Competitive Bidding IDP - Industrial Development Project IPO - Initial Public Offering MEBOs - Management and Employee Buyouts MOF - Ministry of Finance MPP - Mass Privatization Program NAP - National Agency for Privatization NBR - National Bank of Romania NSC - National Securities Commission POFs - Private Ownership Funds PSD - Private Sector Development RA - Regie Autonome RBFT - Romanian Bank for Foreign Trade RBD - Romanian Bank for Development RCB - Romanian Commercial Bank RDA - Romanian Development Agency SAL - Structural Adjustment Loan SOCB - State-Owned Commercial Banks SME - Small and Medium Enterprises SOEs - State-owned Enterprises SOF - State Ownership Fund TA - Technical Assistance VAT - Value Added Tax WOD - Work-Out Department GOVERNMENT OF ROMANIA - FISCAL YEAR January 1 - December 31  FOR OFFICIAL USE ONLY ROMANIA FINANCIAL AND ENTERPRISE SECTOR ADJUSTMENT LOAN (FESAL) Loan and Program Summary Borrower: Romania Implementing Agencies: Ministry of Finance and National Bank of Romania Beneficiary: Not applicable Poverty Category: Not applicable Amount: US$280 million equivalent. The currency composition of the proposed Loan would be the following: - USD 170 million - DEM 135 million (rUS$90 million equivalent) - FFR 100 million (US$20 million equivalent) Terms: Payable in twenty years, including five years of grace, at the Bank's standard interest rate for LIBOR- (PIBOR-) based single currency loans in these currencies. Commitment Fee: .0.75% of undisbursed loan balances, beginning 60 days after signing, less any waiver. Description: The proposed Loan would provide balance of payments support to the Government to help it pursue its stabilization and structural reform program. The principal objectives of the reform program are: (a) a sharp acceleration of the privatization of state-owned enterprises; (b) the enforcement of hard budget constraints and discipline on remaining state- owned enterprises; (c) the elimination of constraints to private sector development; (d) the restructuring and privatization of state-owned banks; (e) the strengthening of the supervisory and surveillance capacity of the National Bank of Romania; and (f) the development of capital markets. The disbursement of the loan will be linked to conditionalities specified for each portion release. Benefits: Implementation of structural reforms in the enterprise and financial sectors under this operation will enhance Romania's prospects for growth and will reinforce the sustainability of its macroeconomic stabilization. Privatization will increase efficiency in the economy as enterprises will be better suited to respond to changes in market conditions and consumer demands. Improved financial discipline and stronger governance will reduce losses and arrears in the State-owned Enterprise sector freeing resources for private sector development. Financial sector reforms would provide the basis for building up a sound and efficient financial intermediation system and the development of a new capital market. The program will also lead to substantially strengthened regulatory and supervisory capabilities of NBR. Economic stability and growth would help Romania achieve creditworthiness and gain easier and cheaper access to external finance. This document has a restricted distribution and may be used by recipients only in the performance of their ofricial duties. Its contents may not othenwise be disclosed widhout World Bank authorization.  Risks: The main risks associated with the proposed Project stem from the complexity and political difficulty of implementing the ambitious Government program. Slippages in the macrostabilization would further complicate the implementation of the program, and would reduce its expected benefits. The local and national elections scheduled for 1996 may increase pressure for the Government to relax its strict policies with respect to financial discipline and budgetary stringency. The complexity of the Mass Privatization Program creates the risk that privatization may be delayed because of implementation problems. However, this risk has been greatly reduced by the large number of privatizations which have already taken place and by the adoption of several market-based mechanisms for privatization, which will be in effect simultaneously with the Mass Privatization Program. Overall, the risks appear manageable and the Government of Romania has demonstrated a strong commitment to reform by implementing many of the policy measures proposed under the FESAL before the approval of the loan. Estimated Disbursement: The proposed Loan would be disbursed in four portions, including a floating portion. The first portion of US$60 million would become available upon loan effectiveness, expected by early 1996, the second portion of US$80 million six to nine months later and the third portion of US$100 a further six to nine months later, upon a review, satisfactory to IBRD, of successful implementation of the adjustment program as a whole and fulfillment of specific portion release conditions. The release of the floating portion of US$40 million would become available as soon as benchmarks, linked to the downsizing of the enterprises included in a surveillance program, are met; such benchmarks are specified in terms of reduction of employment within these enterprises. The Loan would reimburse 100 percent of the foreign exchange costs of eligible imports, with eligibility determined by a small negative list, agreed between the Government and IBRD. Contracts costing less than US$250,000 and goods financed by other donors would not be eligible for financing under the Loan. Financing Plan: Not applicable Map: IBRD 27424 Project ID Number: RO-PA-8773  ROMANIA FINANCIAL AND ENTERPRISE SECTOR ADJUSTMENT LOAN (FESAL) REPORT AND RECOMMENDATION OF THE PRESIDENT TABLE OF CONTENTS Page No. INTRODUCTION ................................... 1 II. THE MACROECONOMIC CONTEXT ..................... 2 A. Recent Economic Developments ....................... 2 B. Need for Structural Change .......................... 3 C. Macroeconomic Prospects ........................... 3 II. THE ENTERPRISE SECTOR .......................... . 5 A. Enterprise Sector Profile ............................ 5 B. Privatization Strategy ............................. 7 C. Strengthening Financial Discipline in the Enterprise Sector ...... 8 D. Fiscal Costs of Enterprise Restructuring and Privatization ....... 10 E. Private Sector Development .......................... 11 IV. THE FINANCIAL SECTOR ............................ 12 A. Overview of the Financial Sector ...................... 12 B. Problems and Challenges Facing the Banking System ......... 13 C. Public Policy Issues .............................. 15 D. Capital Markets Development ......................... 17 V. THE REFORM PROGRAM ............................. 17 A. FESAL Support to Enterprise Sector Development and Reform . .. 17 B. FESAL Support to Financial Sector Policy and Bank Restructuring . 23 VI. THE PROPOSED BANK LOAN ............ .. ............ 26 A. Rationale for Banks' Involvement ...................... 26 B. World Bank Group and IMF Support ................... 27 C. Conditions of Board Presentation and for Release of the Second, Third and Floating Portions ......................... 28 D. Loan Features and Components ....................... 28 E. Procurement and Disbursement ....................... 28 F. Monitoring Arrangements ........................... 29 G. Environmental Assessment Requirements ................. 30 VII. BENEFITS AND RISKS ............................... 30 VIII. RECOMMENDATION ................................ 30  Annexes. Schedules and Map: Annex 1. Letter of Development Policy (LDP) Annex 2. Policy Matrix Annex 3. Status of IMF Operations in Romania Annex 4. Key Economic Indicators Annex 5. External Financing Requirements and Projected Sources of Financing Schedule B. Summary of Proposed Procurement Arrangements Schedule C. Time table of Key Processing Events Schedule D. Status of Bank Group Operations in Romania Map of Romania Documents in Project File 1. Financial Performance of State-Owned Enterprises in 1994 2. Summary Balance Sheets of Main State-Owned Banks, as of December 31, 1994 3. Financial Isolation and Financial Recovery Plans of Regies Autonomes 4. Action Plan for Private Sector Development 5. Ordinance 13/1995 6. Law on Acceleration of Privatization (Law 55/95)  REPORT AND RECOM4ENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED FINANCIAL AND ENTERPRISE SECTOR ADJUSTMENT LOAN TO ROMANIA I. INTRODUCTION 1. I submit the following report and recommendation on a proposed Financial and Enterprise Sector Adjustment Loan (FESAL) to Romania for the equivalent of US$280 million to provide financial support for the Government's adjustment program. The Loan will comprise single currency tranches in US Dollars, Deutsche Marks and French Francs and will be payable in twenty years, including five years of grace, at the Bank's standard interest rate for LIBOR- (PIBOR-) based single currency loans. 2. Romania is a lower-middle income country with a population of about 23 million and a per capita GDP estimated at US$1,280 in 1994. Following the demise of the previous regime in December 1989, Romania faced a daunting agenda of systemic and structural reforms in the transition to a market economy. A large volume of legislation has been passed establishing new institutions and the fundamental statutory framework required to govern public and private economies in a market setting. Following a poor initial performance in the early years of the transition, the macroeconomic policy framework improved in late 1993. Since then the budget deficit has averaged less than 2% of GDP, and inflation abated from about 300 percent in 1993 to about 60 percent in 1994 and to an estimated 35 percent in 1995. Substantial progress was also made since 1993 in implementing systemic and structural reform. Trade liberalization has proceeded swiftly; prices have been largely liberalized; most consumer subsidies have been removed; and the social safety net has been revamped. 3. The proposed adjustment program would build on and complement the reforms already undertaken by the Government since 1990 supported by the World Bank Structural Adjustment Loan (SAL). The Government program, to be supported by the proposed FESAL, would address the main structural issues of the financial and enterprise sectors through an integrated approach that includes: In the Enterprise Sector: (a) an acceleration of state-owned enterprise (SOE) privatization, including a mass privatization program (MPP). This is the cornerstone of the program; (b) enforcement of hard budget constraints on remaining SOEs. The major lossmakers and the enterprises carrying the largest payment arrears have been placed in a special surveillance program, where their management is required to reduce costs, restore financial viability and negotiate agreements with their creditors on the basis of a credible financial recovery plan, failing which they would face liquidation; (c) implementation of an action plan to stimulate private sector development;  -2- In the Financial Sector: (d) gradually raising the soundness of the Romanian banking system by: (i) phasing-in collateralization of the National Bank of Romania (NBR) refinancing by requiring collateralization of its credit lines; (ii) strengthening the supervisory and surveillance capacity of NBR; (iii) enhancing competition and the role of the private sector in the banking system by accelerating the privatization of at least one state-owned bank and downsizing the others; (e) limitation of the recapitalization of banks by the state; (f) introduction of a limited deposit insurance scheme for individual deposits with all banks; and (g) opening of the Bucharest Stock Exchange. II. THE MACROECONOMIC CONTEXT A. Recent Economic Developments 4. From 1989 through 1993, the Romanian economy suffered from major dislocations. Output fell by 32 percent, with industrial output down 54 percent. Unemployment rose to 10 percent of the labor force, while real wages fell by about 30 percent. From a situation of current account balance-of-payments surpluses, large deficits opened, with a corresponding accumulation of foreign debt. To some extent, the continuing deterioration was due to external factors such as the collapse of the CMEA, the Gulf crisis and the ongoing turmoil in Yugoslavia. 5. Romania's initial attempts at stabilizing the economy in 1991 and 1992 were not successful. Inflation remained high. Implementation problems and fiscal and credit policies, including insufficient financial discipline in SOEs, played a major role in creating macro imbalances. Extra budgetary funds, directed credit programs and other quasi-fiscal expenditures added to the formal budget deficit to generate serious macroeconomic problems. 6. However, a major fiscal adjustment took place in 1993. The general government deficit fell by 6 percentage points of GDP. Although the external situation also improved in 1993, it did not fully reflect the gains from the large fiscal deficit reduction because of the remaining high gap between non-government savings and investments, largely attributable to continued SOE losses. The authorities also imposed a significantly tighter monetary policy, raising interest rates sharply. Commercial bank lending rates became positive in real terms for the first time since 1990. 7. The turnaround in macro-stabilization has been broadly maintained: fiscal deficits have been kept under tight control, averaging about 2 percent of GDP in 1993-95; inflation has fallen to an annual rate of 25 percent in mid-1995. Growth has recovered to 3.9 percent in 1994, and is projected to reach at least 5 percent of GDP in 1995. The current account deficit of the balance of payments that fell sharply in 1994, to 1.8 percent of GDP, is likely to widen to nearly 5 percent of GDP in 1995 as a result of strong import demand stemming from high growth in conjunction with a less than full liberalization of the foreign exchange market. The Government has thus demonstrated a strong aund sustained commitment to stabilizing the economy. The stabilization effort has been supported by  -3- the IMF, most recently through an SBA arrangement approved in May 1994, the extension of which to 1996 is presently being considered by the Government and the International Monetary Fund (IMF). B. Need for Structural Change 8. Important successes have also been achieved in structural reforms. In 1991, the Government instituted a land reform program that resulted in 80 percent of agricultural land being privately owned. The housing stock was privatized. Also, the majority of state-owned companies were transformed into commercial entities. Significant progress has been made since mid-1993 in the liberalization of prices, including elimination of price controls on industrial and agricultural products, energy and agricultural products, energy products and consumer goods. A VAT system has been introduced. Also, an open foreign trade regime has been instituted, and a more realistic and liberalized exchange rate established. The social safety net has been strengthened with the establishment of an unemployment benefits scheme and the reform of social assistance and pension systems. These structural reforms have been supported by the SAL and by Bank lending in the relevant sectors. 9. Despite progress in other areas of structural reform, the Government has found it difficult to address the problem of chronic lossmaking enterprises and the associated accumulation of inter-enterprise arrears. The centerpiece of the SAL was support to a Government program to bring greater financial discipline to bear upon enterprises. This program was moderately successful in reducing the volume of arrears through the implementation of a number of actions against delinquent enterprises. Nevertheless, many of the largest enterprises in trouble sectors are still running significant losses and have been building up new arrears to banks and to their suppliers. 10. Continued enterprise losses present a potential threat to macroeconomic stability if the Government is required to absorb them as had happened in January 1992 under the Government's global clearing system. Moreover, the slow pace of enterprise adjustment represents a drag upon economic growth, both through efficiency losses and by crowding out the emerging private sector. il. The lack of financial discipline in state enterprises has had a serious negative effect on the banking system which was forced to provide financing to ailing companies. Bank portfolios have deteriorated requiring repeated "bailout" schemes. Financial sector reform is needed to improve the soundness of the banking system and to enhance its role in the allocation of resources. C. Macroeconomic Prospects 12. In the next few years, Romania's needed internal adjustment is unlikely to come from further reductions in the general government deficit. As economic restructuring advances, demands on expenditure (especially the social safety net) will rise, while there is little scope for revenues to increase or for public investments to be reduced. The main adjustment will thus have to come from an increase in non-government savings, especially from cuts in enterprise losses. Faster progress in enterprise reform is, therefore, essential for a sustainable improvement in macroeconomic balances without sacrificing growth.  -4- Table 1: Macroeconomic Framework (in percent unless otherwise indicated) 1992 1993 1994 1995 1996 1997 1998 1999- 2002- 2001 2004 Growth Rate of GDP -8.8 1.5 3.9 5.0 5.0 5.0 5.0 5.0 5.0 Gross Domestic Investment/GDP 31.4 29.0 26.9 27.5 28.0 29.0 30.0 30.0 30.0 Fixed Investment/GDP 19.2 17.9 19.7 23.0 24.0 25.5 27.0 27.0 27.0 Public Investment/GDP .. .. 5.4 5.9 5.9 5.3 5.3 5.3 5.0 Private Investment/GDP .. .. 14.3 17.1 18.1 20.2 21.7 21.7 22.0 Gross Domestic Savings/GDP 23.0 24.0 24.7 22.9 24.5 26.2 27.5 28.0 28.8 Exports + Imports /GDP 64.0 51.0 49.4 57.0 59.8 60.5 60.8 61.9 63.5 Fiscal Balance/GDP (General -4.6 -0.1 -1.9 -2.7 -2.2 -2.0 -2.0 -2.0 -2.0 Government) Inflation (average) 210.0 256.0 136.0 31.0 20.0 15.0 10.0 10.0 10.0 Real export growth 2.9 10.3 24.3 19.0 11.0 7.0 5.9 5.9 6.0 Real import growth 7.5 2.9 8.9 27.9 5.9 4.5 4.7 5.0 5.0 Current Account Balance/GDP -7.8 -4.7 -1.7 -4.7 -3.7 -2.8 -2.2 -1.4 -0.4 NBR Gross Reserves (in US$ mn), 870 967 1,556 1,347 1,567 1,995 2,546 3,468 4,650 including gold NBR Gross Reserves (in US$ mn), 90 43 591 368 571 972 1,498 2,365 3,465 excluding gold in month of imports 0.2 0.1 0.9 0.4 0.6 0.9 1.3 1.8 2.1 External Debt (US$ million) 3,533 4,456 5,591 6,255 7,383 8,454 9,571 11,000 12,002 External Debt/GDP 18.0 16.9 18.6 18.9 21.1 22.4 23.6 23.5 20.7 External Debt/XGS 69.6 77.4 78.8 72.2 74.8 77.9 81.0 78.4 66.3 Debt Service/XGS 8.8 6.2 9.8 12.6 11.6 10.3 11.1 13.0 12.3 IBRD Debt Guidelines IBRD Debt Service/Public & 1.8 9.5 5.2 5.0 6.4 11.8 16.0 16.1 19.5 Publicly Guaranteed DS IBRD DS/XGS 0.0 0.3 0.4 0.6 0.7 1.2 1.8 2.1 2.4 Preferred Cred./P&PG DS 74.9 40.5 46.3 60.8 61.8 51.0 48.5 39.3 34.0  -5- 13. The projections given in Table 1 above simulate the performance of the economy under a scenario of continued adjustment. Stabilization efforts are expected to be maintained and, under the enterprise reform program supported by the FESAL, greater domestic savings are expected to be released for productive investments. Thus, economic growth is expected to be sustained at a trend rate of 5 percent through the end of the decade. The savings rate is projected to increase from 24.7 percent of GDP to 29.1 percent in 2004. Fixed investment is also expected to increase from 19.7 percent of GDP in 1994 to 27 percent in 2034, with increasing shares of this investment being undertaken by the private sector. 14. Export growth (projected at an average annual rate of 12 percent between 1995 and 1997) should provide the primary stimulus to growth, brought about by maintaining an open trade and exchange system and by the increased access to the European Union (EU) markets, following Romania's signing of the Association Agreement in early 1994. With imports projected to grow somewhat less than exports--albeit still with a high import elasticity--current account deficits are expected to be gradually reduced through the end of the decade to a level of about 1.5 percent of GDP. 15. In the 1990-94 period, Romania found it difficult to borrow from commercial lenders, in part because of credibility problems about its commitment to stabilize and to pursue structural reforms. Early in 1995, however, an international bond issue of US$150 million was oversubscribed, and the Government intends to return to the capital markets. In view of the previous tight capital constraint, most of Romania's borrowings have been from official lenders, particularly the IMF, the World Bank, the European Bank for Reconstruction and Development (EBRD) and the EU. Even though greater access to finance is becoming available, high expected repayments, as well as the need to build up reserves, condition the medium-term outlook. 16. Foreign financing requirements in the 1995-2000 period are high and average US$2.3 billion annually (see Annex 5) reflecting, in part, high repayments to the IMF and the G-24. While official financing will continue to play an important role, as adjustment proceeds, and as companies are privatized, private capital inflows and direct foreign investment (DFI) flows are expected to rise. Initially, the debt burden is expected to rise. The external debt/GDP ratio is expected to increase to 23.9 percent before fallinig to around 19 percent in 2004; debt service payments, reflecting a bulge in repayments, rise sharply in 1999-2000 to an average 13.1 percent, before declining again. These projections do not include follow-up operations to the present IMF standby. Continued IMF operations in Romania should not, however, be ruled out. Moreover, it is possible that Romania will be able to negotiate further bilateral support in 1998-99, to partially offset the sharp increase in debt service in those years. III. THE ENTERPRISE SECTOR A. Enterprise Sector Profile 17. This section describes the present situation in the enterprise sector and discusses the main features of the Government's ambitious reform program. Privatization, strengthening of the hard budget constraint faced by SOEs and improving the governance of enterprises are the main components of this program. Section V describes those elements of the program which are directly linked to the FESAL. 18. The first step in the reform of the enterprise sector was the commercialization of SOEs. This process was completed by mid-1991 resulting in the following two types of enterprises:  -6- Regies Autonomes (RAs): These are "natural monopolies of public interest or essential for national defense and security" which are not intended to be privatized. As of November 1995, there were around 400 RAs. Of these, 44 are public utilities owned by the State. The remaining 350 are "local service" RAs owned by local authorities, municipalities, etc., shortly to be reduced through mergers and reorganization. Commercial Companies (CCs): 6,300 joint-stock companies were corporatized in 1990-91. The capital of each has been split between the State Ownership Fund (SOF), which owns 70 percent, and one of five Private Ownership Funds (POFs) holding the remaining 30 percent. The SOF is a government agency which exercises ownership rights on behalf of the state until the CCs are privatized. Its by-laws require it to sell the shares of all CCs by 1999. The five POFs are formally owned by all Romanian citizens to whom certificates of ownership (COs), representing shares of the POFs, were distributed freely in 1992. The POFs are scheduled to be transformed into private investment funds by early 1996. In the meantime, their directors are appointed by the Parliament, from a list proposed by the Government. 19. In 1994, SOEs (CCs and RAs) accounted for approximately 60 percent of employment and output. CCs account for roughly 75 percent of SOEs output and roughly 90 percent of reported employment. The output of the industrial sector, composed almost fully by SOEs, fell by half between 1989 and 1992 due to the collapse of the CMEA and the drop in trade with the Former Soviet Union. Industrial production increased by an average of about 2 percent per annum in 1993- 1994, and seems to be growing faster in 1995. 20. SOEs' aggregate profitability (before tax) has declined from 15 percent of revenues in 1990 to 5 percent in 1993 and to 0.6 percent in 1994. The actual financial situation of the SOE sector may actually be substantially worse than what is indicated by these ratios. Costs are underestimated, since they are based on historical cost accounting, and depreciation charges are far too low. Also, in 1994, enterprises made very limited provisions against uncollectible accounts receivable, at a time when payment arrears are a major problem. Lastly, revenues are overestimated as they include production to inventory. On a cash flow basis--which gives a more accurate picture of their financial health--the SOE sector has generated an aggregate negative operating cash flow of around 6 percent of GDP. Therefore, many SOEs are cash-starved, even when showing accounting profits. 21. In order to continue operating, the largest lossmakers have been financing their operations by building up arrears with their suppliers, the State Treasury, the banks and, occasionally, with their payroll. The Romanian authorities' initial reaction to the accumulation of arrears, as was the case in other transition economies, was to "net out" the stock of arrears with a "Global Compensation Scheme" (Law 80 of December 1991). Credit was injected into the economy in early 1992 via credits extended by commercial banks to debtors, who were compelled to use the proceeds to pay down their arrears. Soon after, it became clear that arrears would again begin to accumulate unless incentives were created to force enterprise to maintain financial discipline. In fact, some large lossmaking companies have continued to accumulate arrears, in spite of the Government's commitment not to undertake any further compensation schemes. 22. Several measures have been taken to improve financial discipline in the enterprise sector. The legislative basis for enforcing repayment has been strengthened and there is evidence that it is increasingly being applied. The Commercial Code and other relevant legislation is already adequate to enable creditors to establish and realize security, to force borrowers into bankruptcy, to enable creditors to cooperate with the SOF in placing bankrupt companies into liquidation and to use the threat of taking such actions to force borrowers into implementing restructuring and other solutions agreed with their creditors. Since 1992, creditors have begun charging interest penalties on  -7- arrears, presently 0.15 percent per diem, as provided for in Law 76/1992, the passage of which had been agreed under the SAL agreements. Creditors, notably banks, are initiating a growing number of court actions to declare debtors insolvent and to realize their security, if necessary, by public auction of the delinquent debtors' assets. A new Bankruptcy Law has been passed by the Parliament in May 1995. This new law includes a stay on collection actions against a debtor on the initiation of proceedings, provisions for a plan of reorganization and priority in asset claims for post-bankruptcy creditors. Finally, privatization, by improving efficiency and changing governance, is expected to contribute in enhancing financial discipline in the sector. B. Privatization Strate2y 23. In 1991, following passage by the Parliament of Law 58/91 (Privatization Law), the Government adopted a privatization strategy aimed at transferring most of state-owned enterprises to private ownership within seven years. This initial strategy depended on the effectiveness of the SOF in selling the 70 percent of shares of CCs that it holds on behalf of the State. Initially, the SOF was hampered by organizational problems and by the legal requirement to conduct cumbersome evaluations of the enterprises' worth. For the sale of medium CCs (capital between Lei 2.5 billion and Lei 18 billion and staff of between 500 and 3,000 employees) and of large CCs (capital of more than Lei 18 billion and staff of more than 3,000) the SOF relied mostly on direct trade sales to strategic investors. While the shares of CCs held by the SOF must be paid in cash or in installments, the shares held by the POFs are exchangeable against COs. 24. More successful has been the "fast track" approach (based on Management and Employee Buyout -- MEBO) which has been developed for small CCs (less than Lei 2.5 billion capital and less than 500 employees). Under such procedure, the shares held by one of the POFs are typically exchanged against COs held by employees; 15 percent to 20 percent of SOF's shares are purchased by employees in cash and the balance is payable in installments over two to six years. The adoption of Law 77/94, extending the use of MEBO to larger CCs, has resulted in a significant increase in the privatization of medium-size and large CCs in 1995. Table 2 summarizes the results achieved as of November 13, 1995". The target of 1,500 privatizations--which is a condition for Board presentation of the FESAL-- has been met in the second part of November 1995. Table 2: Privatization Total number of CCs to be privatized Privatized by November 13, 1995 | Capital I No. of | Capital 1 No. of Type Number (bln. lei) Employees Number (bin. lei) | Employees Small CCs 3,124 240 497,096 1,073 461 188,264 Medium CCs 2,459 1,824 1,753,828 357 1,992 246,400 Large CCs 708 6,996 1,789,833 54 1,132 147,361 TOTAL 6,291 9,060 4,091,423 1,484 3,585 582,025 25. To accelerate the pace of privatization, in May 1994 the Government decided to introduce MPP. The design of the MPP, which aroused fierce debate within Romania, has been The are the latest detailed data available  -8- approved by the Parliament with the passage, in June 1995, of a Law for Acceleration of Privatization (Law 55/95). The main features of the MPP are as follows: (a) The program will be implemented during 1995 and 1996. (b) Approximately 3,900 CCs of the most profitable CCs are included in the MPP. The list of CCs was published in August 1995. (c) New privatization coupons have been distributed to all adult Romanians in addition to the existing COs. Unlike the old COs, each new privatization coupon will show the name of the citizen to whom it is issued, and will be non-transferable. The existing COs and the new coupons have been given a notional nominal value of Lei 25,000 and Lei 975,000, respectively. (d) All holders of the new coupons and of existing COs will be entitled to bid for shares during a time-bound subscription period. The new coupons plus the existing COs will be exchanged for up to 60 percent of the shares in selected CCs. All shares will have a face value of Lei 25,000. They will be exchanged against COs and vouchers at face value. If the bids for a given company exceed the percentage of the share capital offered for exchange, the shares will be distributed to the bidders in proportion to their bids. (e) Instead of bidding directly for the shares of a specific CC, individuals can entrust their COs and coupons to any of the five POFs, which will bid for blocks of shares on their behalf. Under this second option, Romanian citizens will become shareholders of the POFs. These POFs will be transformed into investment funds by March 31, 1996, in accordance with a new Law being submitted to the Romanian Parliament. (f) The shares of CCs remaining in the ownership of the SOF will concurrently be offered for sale for cash, through all available methods, including auctions, MEBO, trade sales, and Initial Public Offerings (IPOs). In order to facilitate the cash sales, the Government has decided to allow the SOF to grant deferred payment facilities to buyers. These facilities will allow for payment by installments over a period of up to ten years, with a down payment of 20 to 35 percent and a maximum interest rate of 10 percent per annum2'. The effective price that buyers will need to pay is also reduced by the fact that the SOF is required to plow back into the privatized enterprises up to 60 percent of the proceeds of cash sales of shares, to strengthen their financial situation. Finally, if no buyers can be found, the value of the CC will be reassessed and the price of the shares may be discounted. C. Strengthening Financial Discipline in the Enterprise Sector 26. Some of the largest and least profitable CCs are not immediately privatizable and are likely to remain temporarily in the public sector. They will be privatized or liquidated over a period of time extending well beyond 1995. In addition, the 44 RAs of national importance and many of the local ones, mainly mines and public utilities, are slated to remain in the public sector. The Government's strategy is to subject these enterprises to the discipline of the market, to force them to reduce their losses and/or arrears and to maintain or restore a positive cash flow in order to facilitate 2' Ownership of the shares will be transferred in full from the SOF to the new private buyer as soon as the down payment is received by the SOF.  -9- their privatization or to achieve financial autonomy in the case of utilities. For those utilities which still require budgetary subsidies, the Government's objective is to eliminate or reduce to a minimum these claims on the budget. This requires the imposition of a hard budget constraint on all enterprises that remain in the public sector in order to break the vicious circle of losses financed by arrears to suppliers, the budget and the banking sector. 27. An initial positive response by the enterprises is being generated by the increasing severity with which bankruptcy legislation, as well as special legislation against the accumulation of arrears (punitive interest rates; penalties for managers) are being enforced. These measures, however, will only gradually become effective, as the civil courts develop the capacity to deal effectively with bankruptcy cases. In the interim, the state, as the owner of the enterprises, must take a pro-active approach to induce the major lossmaking enterprises to either cut their losses and arrears or face liquidation. 28. Responsibility for the restructuring of CCs that remain in the public sector rests with the SOF as their majority owner. The branch ministries and the Ministry of Finance (MOF) are responsible for restructuring the RAs. The SOF has created a Department for Selective Restructuring (DSR) for the purpose of encouraging and facilitating downsizing and rationalizing ailing enterprises. Its earlier practice of cross-subsidizing enterprises with injections of its own financial resources will be severely constrained with the privatization of the most profitable CCs, which will reduce the SOF's dividend income. The SOF's total expenditures in 1994 were restricted to 0.8 percent of GDP. The Government reform program calls for a similar cap on such expenditure for 1995. 29. In order to strengthen the governance of enterprises, a Law on Management Contracts (Law 66) was passed in October 1993. It provides for a comprehensive framework for performance contracts to be signed with the management of all CCs and RAs in 1994 and 1995. Performance contracts have been revised and signed with most RAs of national importance. 30. The Pilot Isolation Program of a Group of 30 CCs. In July 1993, as part of the program supported under the SAL, the Government took steps to attack the problem of lossmaking enterprises and lack of financial discipline by placing a group of 30 medium and large enterprises in a special program of financial isolation (Government Decision (GD) 301/93). These 30 CCs, which were selected based on their losses and inter-enterprise arrears, were "isolated" from the banking system, which denied them access to new credit unless they could demonstrate the ability to repay. Management of each CC was required to operate on a cash basis and to design a Financial Recovery Program (FRP). The implementation of these FRPs serves as the basis for ascertaining which enterprises can be turned around and be privatized and which enterprises need to be liquidated. The Bank provided technical assistance to support the implementation of the program. 31. The isolation program of this group of 30 CCs has proved to be a useful learning device for Romanian enterprises and government officials. While progress in actual privatizations and liquidations has been limited,' the program has achieved some tangible results: labor has been significantly reduced, underutilized and idle assets have been sold, uneconomic production lines closed and, in several cases, poor management has been replaced. Guidelines and procedures have been established for the design and implementation of FRPs, for conciliation agreements between creditors and debtors, for monitoring of financial performance and for assessment of management. Even more importantly, this program introduced in Romania the concept of enterprise restructuring 3' The liquidation of four of the 30 CCs has been initiated in 1994, with technical assistance financed by the Bank. The process has been hampered by legal challenges, lack of local expertise and its sheer novelty. These legal and institutional difficulties have been overcome. The privatization of other CCs of the group has also been progressing slowly: most of the CCs involved are large, not very attractive and require significant foreign investments.  -10- based on cost cutting and internal cash flow generation, without major investment for expansion and modernization. 32. The New Surveillance Program. Drawing on the experience of the pilot program of the first group of 30 CCs, the Government decided in 1994 to extend the isolation concept as a mechanism for out-of-court conciliation between debtors and creditors. The objective of the expanded program--called thereafter "surveillance program"-is to place with the enterprises and with their creditors--mainly the holders of inter-enterprise arrears and the banks--the responsibility for restoring financial viability to the ailing enterprises to avoid threat of liquidation. CCs designated for the program are given a limited period of time to prepare and implement FRPs. During this period their debt service obligations and their access to the bank credit is suspended. A conciliation with the creditors is then to be negotiated on the basis of the FRPs, if the enterprises can demonstrate that downsizing and cost-cutting measures can generate a positive cash flow before debt service. Failure to agree with the creditors on an acceptable FRP, or failure to implement it and obtain the agreed results, will result in partial or total liquidation of the enterprise. It is expected that the most successful CCs will "graduate" from the surveillance through privatization. 33. The RAs would undergo a similar process as the CCs. However, in the case of the RAs, neither liquidation nor privatization is a realistic option. Instead, the FRPs quantify the budgetary support that is justified to finance these enterprises in the context of their FRPs, within the constraints of the overall budgetary caps established by the stabilization program. The prospect of removal of budgetary contributions, which are not justified in the context of agreed FRPs, is expected to provide adequate incentives to the management of the RAs to vigorously pursue cost cutting, cash flow enhancement, and arrears reduction measures, as well as to seek financial conciliation agreements with their creditors. 34. In January 1995, the Government issued Ordinance 13/95 which provides the legal foundation for the surveillance program. The Government placed 151 SOEs (9 RAs and 142 CCs) under the surveillance regime by GD 212/95. The list of 142 CCs includes the 40 largest lossmakers and holders of payables in arrears, in addition to enterprises in the initial isolation program. The remaining enterprises, about 70, are from the pig and poultry sectors, and the Government placed them in the program to force restructuring in a sector which is one of the largest recipients of subsidies. 35. The Government and the SOF have accepted the Bank's advice to concentrate the limited skills and resources available on the principal lossmakers and accumulators of arrears. As a result, the Government decided to select from the group of enterprises placed under surveillance a subset of 6 RAs and 13 CCs. These 19 enterprises accounted for 19 percent of total SOE losses in 1994 and for 29 percent of the aggregate payment arrears of the SOE sector as of December 31, 1994. The selection of this limited group of RAs and CCs is expected to enhance financial discipline in the entire enterprise sector, not only because these enterprises account for a large percentage of losses and arrears, but also because their creditors will have to share the burden of financial conciliation (i.e., debt restructuring and/or forgiveness). This will convince a very large segment of the enterprise sector that the Government is genuinely committed to put an end to budget-funded bailouts, and will not resort again to arrears compensation exercises. D. Fiscal Costs of Enterprise Restructuring and Privatization 36. The implementation of the privatization and restructuring programs will reduce quasi- fiscal expenditures which, over the medium term, should lead to lower and more predictable fiscal needs. However, in the initial years of the reform, the reduction in quasi-fiscal expenditures will require increased fiscal outlays either directly (e.g., severance pay to laid-off workers in enterprise under surveillance, budgetary subsidies to public utilities to replace directed bank credit) or indirectly  -11- (e.g., increased unemployment compensation, lower tax revenues due to higher provisions in the banks). 37. The reform program has been designed and phased taking into account the need to finance the corresponding increase in the fiscal deficit. It is estimated that in 1995 the fiscal deficit increased by about 0.5 percent of GDP due to the implementation of the reform program. On the other hand, quasi-fiscal expenditures in the industrial enterprise sector are expected to be reduced by 5 percent between 1994 and 1996. The exact fiscal effect of the program is difficult to ascertain because the Government is at the same time adjusting many other expenditures and revenues. The following paragraphs try to quantify the effects of some of the main components of the program affecting the fiscal deficit. 38. The RAs and CCs under the surveillance program currently employ a work force of around 750,000. Based on the experience of restructuring the previous group of 30 CCs in 1993, it can be assumed that about 15 percent of their work force will have to be laid off over the next three years. The unemployed are entitled to receive unemployment benefits at 50-60 percent of the average wage during nine months followed by (means-tested) unemployment benefits for 18 months at 40 percent of the minimum wage. Moreover, Ordinance 13195 introduces the payment -out of a special Financial Recovery Fund (FRF) funded by the budget-- of redundancy payments equal to six months of net wages. Besides these costs, there would be a loss in tax revenues (wage tax, VAT) and in contributions to social security and unemployment funds. The 3,900 enterprises in the MPP are estimated to employ a work force of about 4 million. Once these enterprises are privatized, they may also shed labor, but this is expected to occur only gradually. In this case, increases in payments of unemployment benefits would be partially compensated by increases in profit taxes. Estimates based on these data indicate that the increase in the fiscal deficit linked to privatization and downsizing of SOEs would not exceed an annual average of 0.5 percent of GDP over the next three years. 39. Another source of increased fiscal expenditures linked to the program is the introduction of explicit energy subsidies for some enterprises that until now were financing their energy bills through arrears or directed bank credits. The Government has set aside for this purpose the equivalent of about 0.4 percent of GDP in the FRF. 40. Finally, the main negative fiscal effect from the implementation of the reform program in the financial sector comes from the expected reduction in tax revenues linked to increased loan loss provisions by commercial banks. These provisions, which beginning in 1995 are tax deductible, could lead to a reduction in tax revenues of about 0.45 percent of GDP. 41. Against this direct fiscal cost, there would be gains more difficult to quantify. First, there would be an increase in tax revenues from improved efficiency. For example, the increase in profit tax revenues from each 10 percent increase in profitability in the 151 SOEs placed under surveillance, as well as from those in the MPP, would amount to 0.2 percent of GDP. Moreover, tax arrears from the enterprises under surveillance (2.4 percent of GDP in 1994) should fall as the FRPs are implemented. In addition, as the cost cutting measures contained in the FRPs are implemented, there should be a reduction in the level of budgetary subsidies to the enterprises under surveillance (which will amount to 1.9 percent of GDP in 1995). This should also lead to substantial quasi-fiscal savings as these enterprises account for almost half of non-performing bank loans and inter-enterprise arrears. E. Private Sector Development 42. Since 1989, the number of small private businesses has increased dramatically. The private sector contribution to GDP has risen steadily from 13 percent in 1989 to an estimated 35 percent by early 1995. Altogether, 569,000 private firms --about half of which small family-run  -12- businesses-- have been registered over the last four years. Land restitution and the dismantling of agricultural cooperatives increased the private sector's share in value added in agriculture from about 10 percent in 1989 to 80 percent in 1994. Also, 70 percent of value added in trade, hotels and restaurants now comes from the private sector, as well as a significant contribution in services (40%), construction (25%) and financial services (12%). However, the share of the private sector is only 5 percent in industry and 3 percent in transportation. Presently, about 30 percent of Romania's exports and imports are conducted by private operators. The private sector is the main source of job creation, accounting for about 85 percent of new jobs created in 1994. Private firms now employ 42 percent of the labor force, including 2.4 million private farmers. 43. Although Romania has a liberal foreign investment regime, the cumulative total investment inflow since January 1991 had only reached US$1.521 billion by October 1995. The vast majority of joint ventures are small trading operations; only 163 of them represent an investment of more than US$1 million. 44. Like in most transition economies, the main constraints to private sector development are the concerns of investors about the stability of the macro economic framework, the previously slow pace of privatization and the limited availability of credit. Private entrepreneurs also ask for a simplified procedure for registration of new companies, which is shortly to be established by a new GD. The implementation of the program supported by the FESAL will significantly reduce these problems. IV. THE FINANCIAL SECTOR A. Overview of the Financial Sector 45. Reform of Romania's banking system was initiated early in the process of transformation to a market economy. Entry to the banking sector was liberalized and a two-tier banking system was established in 1990. The commercial activities of NBR were hived off to the Romanian Commercial Bank (RCB), allowing NBR to concentrate on its functions as the monetary authority. Four state banks --namely, RCB, Banca Agricola (BA), the Romanian Bank for Development (RBD), and the Romanian Bank for Foreign Trade (RBFT)-- which previously acted as passive allocators of credit according to the dictates of central plans, were rechartered as universal banks. During the last four years, the banking sector and the accompanying regulatory and supervisory framework have developed rapidly. Following the conversion of NBR into a central bank, prudential regulations and a bank supervisory function have been put in place. Recently, an ordinance has been passed establishing audit and accounting standards, which can be expected to upgrade these critical professions to the direct and indirect benefit of the banking system. 46. By mid-1995 there were over 30 banks operating in Romania. Seven of these banks are state owned, the Savings Bank (CEC), the Romanian EXIM bank, and the five state-owned commercial banks (SOCBs): RCB, BA, RBD, RBFT and Banc Post (BP). In addition, there are 15 private or semi-private banks, five foreign-based Romanian joint-venture banks and four foreign banks. Several new banks owned by domestic and foreign capital are presently being formed, which will be commencing operations in 1995/96. Despite the growth of the new private banks, the state- owned banks continue to dominate the banking system. The CEC, which used to hold a virtual monopoly of household deposits, continues to account for 45 percent of household deposits with the banking system, although its share of the system's aggregate liabilities had fallen to only 7.7 percent by end-1994. The SOCBs accounted for 67 percent of aggregate assets and 82 percent of commercial loans as of December 31, 1994. Market segmentation continues to be evident, with BA concentrating  -13- on production loans for agriculture, RCB on working capital loans for industry and RBFT on trade finance. 47. Diagnostic studies, financial audits and portfolio reviews of the major banks have been completed. Comprehensive institution-building programs are being implemented based on the findings of these diagnostic studies. In this context, the World Bank, EU PHARE and EBRD have supported efforts to strengthen strategic planning, credit assessment, asset/liability management, information systems development and bank training through several initiatives. The programs are geared to realistic strategic business plans and forecasts of future retained earnings, with a view to eventual privatization of several state banks. A loan classification and provisioning system has been promulgated by NBR, similar to the methodology used by the international auditors of the major SOCBs in undertaking their audits, and is now in place in the banks. The banks have begun to take responsibility for dealing with problem loans. Workout departments have been established in the major banks. Legal action is now being used to collect past due debts. Information Technology is being installed to allow the development of meaningful management information and financial accounting. RBD is presently being prepared for privatization. B. Problems and Challenges Facing the Banking System 48. The commercial banks may be broadly classified into four categories: (a) The two largest state-owned banks, BA and RCB, are the weakest financially and institutionally. BA has a large portfolio of loans to state farms and state-owned "integrators" dealing in agricultural input supply, product storage and marketing. RCB has a large portfolio of loans to state-owned industrial enterprises. These banks have been able to continue funding their portfolio of doubtful loans by using their access to unsecured NBR refinancing with little regard to the cost of such liabilities; (b) Two smaller state banks, RBD and BP, which have pursued a prudent policy of finding their loan portfolios mostly from deposits, appear to be the best candidates for successful privatization; (c) RBFT, which has been conservatively managed, but whose loan assets predominantly comprise claims on NBR and MOF in respect of trade transactions undertaken at the behest of the state, which the newly created Eximbank is too small to undertake; and (d) A diverse group of domestic private banks and foreign banks, whose share of the market has grown to around 15 percent of loan assets, but which face difficulties competing with the large SOCBs. 49. The main problems still facing the Romanian banking system are poor quality loan portfolios, an inadequate and volatile capital base, a narrow funding base and consequent over- dependence on NBR refinancing, continuing dominance by the state banks, a high degree of segmentation and a need to improve governance. The relatively weak supervisory capacity of NBR slows progress in all these areas, as banks do not feel enough pressure to change. 50. Loan Portfolio Ouality. During the socialist period, the serious portfolio problems of the SOCBs forced the state to undertake periodic recapitalizations. As most loans had been granted in accordance with the directives of the central plan, the subsequent "bail-outs" were treated as purely administrative exercises. During the last four years, bad loans by SOCBs have been mainly the  -14- consequence of government interference in credit allocations, the lack of credit analysis skills and rapid changes in the profitability of enterprises due to the volatile macroeconomic environment and large changes in relative prices. As of end-1994, the auditors of the five major state-owned banks recommended cumulative loan loss reserves of about 9 percent of the banks' loan portfolios. These provisions exclude loans that are explicitly or implicitly government-guaranteed. Furthermore, loan asset quality has shown a deteriorating trend among some of the major banks. 51. During 1994, the entire banking system experienced a perceptible slowdown in the collection of interest receivables on loans. The five SOCBs reported significant levels of uncollected interest earnings, overdue interest as of June 30, 1994 representing around 35 percent of interest receivable on an accrual basis. Although the banks improved their collection rates in the second half of the year, overdue levels remained high as of end-1994. The debt restructuring and interest forgiveness arising from the conciliation agreement signed in September 19954', will force banks to recognize some of the losses already implicit in their portfolios and will likely affect adversely the results of the major banks in 1995. 52. Capital Base. Owing to the poor quality of loan portfolios, the aggregate capital account of the banking sector has always been weak. Until recently, the capital adequacy ratios of some of the major banks fell well below the indicative requirements of a minimum ratio of capital to risk-weighted assets set by the NBR (along the lines of the Basle guidelines). The problem has been mostly concentrated in RCB and BA. However, there has been considerable progress in this area. During 1994, the major banks earned enough income to be able to make large provisions against loan losses. 53. During the past several years, decapitalization of banks was occurring for several reasons, in addition to the poor lending policies described above. First, because loan-loss provisions were understated, profits were overstated and taxes were out of proportion to the banks' true earnings. Second, the present legislation on the dividends of all state-owned commercial companies requires them to declare a minimum dividend of 40 percent of their after-tax earnings. Hence, this legislation forces the withdrawal of needed capital from the SOCBs. Given the poor quality of earnings in the past and the systemic inadequacy of provisions, SOCBs were, in effect, distributing their capital when dividends were paid out. Third, until recently specific loan loss provisions were not tax deductible. This situation has recently been changed by GD 335/95 of May 16, 1995, which allows for tax deductibility of specific loan loss provisions commencing in the 1995 tax year. 54. The tax-deductibility of specific loan loss provisions will provide a strong incentive for the banks to build up sufficient loan loss reserves. It is also expected that once the new Chart of Accounts for banks is introduced, there will be an increasing convergence between the banks' Romanian statutory accounts and the accounts prepared in accordance with International Accounting Standards, particularly with respect to loan-loss provisions. Furthermore, NBR has recently issued a Circular which requires the major state-owned banks to undertake full loan loss provisions and to retain 50 percent of their net profit after tax until they have reached minimum levels of capital adequacy. This will have the effect of restricting distribution of dividends by state-owned banks to the minimum level of 40 percent established by the law during the period in which they are building up their capital. 4/ Resulting from the implementation of FRPs by the enterprises under the surveillance regime.  -15- 55. The weak capital situation of major SOCBs had previously been exacerbated by the failure of the Government to settle promptly and fully its obligations under Law 7/92 and Ordinance 1/94. However, beginning in September 1994, the Government began settling its overdue obligations and it is now current in all its obligations to the banks. The credibility of GOR's commitment to prompt and unequivocal payment of its obligations to the SOCBs has thus been restored. 56. Narrow Funding Base and Overdependence on NBR Refinancing. On an aggregate basis, the banking sector is characterized by a narrow deposit base. Deposits accounted for less than 50 percent of the five SOCBs' funding liabilities as of end 1994. BA, RCB and RBFT are heavily dependent on NBR refinancing. Notably BA funds around 70 percent of its loan portfolio from NBR and interbank borrowing, and alone accounts for over 60 percent of all NBR refinancing of the banking system. Access to NBR refinancing facilities have enabled BA, RCB and RBFT to forestall a more rapid decline in their market shares. 57. Progress is being made in this area. As of end 1994, the banking system's combined loan/deposit ratio stood at 110 percent, compared to 120 percent as of year-end 1993. BA continued to have the highest loan/deposit ratio of 300 percent (although down from the year-end 1993 high of 470 percent). The medium-term objective of the larger banks is to shrink their assets to better match their resources. 58. Commercial Orientation and the Government's Presence. The SOCBs still have to develop a stronger commercial approach in their operations. The absence of such a focus is a legacy of the past central planning economy and continued dominant government ownership and presence. The performance of BA, RCB and RBFT has been materially affected by lending undertaken under political pressures. Banks have endeavored to pursue greater commercial orientation, which would be facilitated if they were privatized and once there is greater competition in the banking market. 59. Bank Problem Loan Workout Departments (WODs). All SOCBs have established workout departments to deal with problem loans. These units are still inexperienced and understaffed. The units in the major banks are receiving technical assistance provided by foreign workout specialists, funded by EU PHARE, who commenced their work in the first quarter of 1995. C. Public Policy Issues 60. Deposit Insurance. The growth of household deposits in the emerging new banks has been relatively slow. This has delayed their development because these deposits represent the most stable and least expensive funding source. To a large extent, this is due to the fact that household deposits with CEC are covered by an explicit Government guarantee. Moreover, the general perception is that deposits with SOCBs are implicitly guaranteed, whereas deposits with other banks are clearly not guaranteed. 61. In order to create a level playing field for deposit gathering by all commercial banks, including the new private banks, a limited deposit insurance scheme covering deposits at all banks is to be introduced under the supervision of NBR. This would end CEC's privileged status as deposits with it would only be covered to the same extent as deposits with other banks. Such a scheme should cover only a modest maximum amount per account. A legal and institutional framework needs to be in place to ensure timely intervention for dealing with bank insolvencies. 62. Payments System. An important challenge for the development of the banking sector is continued institution-building --both by way of system infrastructure, as well as skills enhancement. For instance, the interbank clearing system has been inadequate to allow prompt settlement of  -16- accounts. Until recently the settlement and clearing system was still based on principles and organization developed under central planning. Small private banks were unable to use the system directly and were, in effect, obliged to buy inefficient and costly payment services from large state- owned banks. The system had a high average float which was especially detrimental in a situation of high inflation. 63. Recent changes in the interbank payments system were initiated by the issuance of NBR Regulation No.10/1994 regarding a paper-based multilateral compensation of interbank payments, which became operational on April 3, 1995. Clearing houses were established in Bucharest and in 41 counties (Judets). A clearing sitting is held daily, under the auspices of the Bank Settlements Department of the NBR. The system operates on a net settlement basis and only covers payments of less than 10 million Lei. In the medium-term, NBR intends to launch a nationwide electronic-based system, which offers same-day clearing and handles large-value payments. 64. Credit Information Bureau (CIB). An effective credit information bureau is needed to strengthen the risk management of banks, the application of the recently introduced prudential regulations, and the quality of financial information on banks, etc. To achieve this objective, NBR and the Romanian Banking Institute have agreed, in principle, on the merits of establishing a CIB. An action plan to establish a CIB will be prepared and implemented. 65. Accounting and Auditing. There is need to: (a) fully implement the new accounting laws; (b) introduce amendments that will enable the current Accounting Law 82/91, drawn up on the basis of EU standards, to fully comply with international standards; (c) develop/implement charts of accounts for enterprises and banks in accordance with international standards; (d) ensure uniform application of accounting/auditing principles and presentation of financial statements based on international standards; and (e) introduce measures that will further develop the accounting and auditing profession. 66. Regulatory and Supervisory Framework. Since 1993, significant policy and regulatory improvements have occurred. The Supervision Department of NBR has established a team of bank examiners to undertake off-site surveillance and on-site examination of banks. Prudential Regulations issued are in line with international standards and cover the minimum initial capital of banking companies, licensing of new banks, large exposures, foreign currency exposures, prohibited business, insider lending/connected lending, loan classification and provisioning and capital adequacy. Additional regulations will be drafted to cover the registration of auditors authorized to undertake bank audits and the external auditing of banks by NBR-approved auditors. 67. Despite the considerable progress made, the supervision framework needs further strengthening. In day-to-day operations, there is a need for greater uniformity of application of norms between the banks. The impediments to effective bank supervision include inadequate staffing, both in terms of the number and experience of staff, and an unwillingness by supervisors to confront banks, which may stem from a lack of supervisory experience. Recognizing the importance of building its supervisory system and skills, NBR has mobilized technical assistance to train and assist senior supervision personnel. The Supervision Department of NBR is presently being assisted by two bank examiners from the Netherlands Bank funded by EU PHARE. Four bank inspection teams of three to four examiners each have been formed. Several on-site inspections took place in 1994 and further on-site examinations are scheduled for 1995 and 1996. Off-site surveillance is also being carried out based on regular returns from banks.  -17- D. Capital Markets Development 68. The Securities and Exchange Law was approved in October 1994, a new National Securities Commission (NSC) has been created and the Bucharest Stock Exchange (BSE) was officially opened in June 1995. The legal, institutional and regulatory framework for the development of capital markets is being finalized by the Government, the NSC and the BSE. 69. Apart from launching the institutions and regulatory framework to promote the capital market, there is a need to provide for a mechanism that will facilitate an active secondary market for shares in connection with the MPP. An adequate framework to handle the technical and legal issues of share trading needs to be put in place. On the technical side, the flow of paper which will occur during and after the MPP has to be accommodated. This relates to: (a) the distribution of the new privatization vouchers; (b) the exchange of vouchers and COs for shares; (c) the initial cash transactions of MPP shares; (d) the delivery of share receipts to shareholders; and (e) the creation and maintenance of share registries. This is a formidable task. The Government, with the assistance of USAID and EU PHARE, is now working on detailed procedures on how securities will be traded once shares are issued under the MPP. 70. Although mechanisms have been established by NBR for trading government debt through open market auctions, secondary trading has not yet commenced because there is virtually no primary market. Starting end-March 1994, the Government commenced issue of 91-day Treasury Bills. The volume issued so far has reached Lei 3,500 billion, with an average level per issue of Lei 200 billion. The frequency of issues changed from quarterly at the beginning to a more frequent but no regular pattern presently. Treasury Bills are mainly bought by the SOCBs, and their price is set at a sitting with the NBR and MOF. The Government, intends to develop the Treasury Bills market into a more open and competitive market by introducing securities of different maturities and offering tax incentives to investors. V. THE REFORM PROGRAM A. FESAL Support to Enterprise Sector Development and Reform 71. The reform program supported by the FESAL builds on measures undertaken within the program supported by the SAL and focuses on implementation of structural reforms at the enterprise level. Policy measures initiated under the SAL, such as development of competitive markets, price and trade liberalization, commercialization of SOEs and early privatization laid down the basis for a market system. FESAL's major thrust would be in privatization and on financial discipline of SOEs that are not yet privatized or will remain in the State's hands. In compliance with the condition for Board presentation. the Government has maintained a macroeconomic framework consistent with the program as determined on the basis of indicators agreed upon with the Bank. and has achieved progress in carrying out the program. It was agreed at negotiation that maintenance of such macroeconomic framework. and progress achieved in carrying out the program would be conditions for second, third and floating portion releases. Privatization 72. Privatization has been proceeding slowly for both political and technical reasons. However, increasingly over the years 1994 and 1995 the Government has made privatization an overriding priority. Starting in October 1995, the Romanian population is able to exchange their COs  -18- and the new coupons for the shares of around 3,900 CCs, either directly or through the intermediation of the POFs acting as investment funds. At the same time, the SOF started selling for cash shares not exchanged for COs and coupons. In order to facilitate the cash sale of shares, the SOF is offering deferred payment facilities to buyers. Lastly, the Government has agreed that whenever shares would not find buyers, their price would be reassessed and lowered. In cases where the discount is more than 30 percent of book value, sale contracts may include standardized clauses, as required by the Law 55/95. 73. The "fast-track" standard MEBO procedure will be maintained for small CCs and has already been extended to larger ones through the adoption of Law 77/94 (MEBO Law). For medium- sized and large CCs, the Government intends to continue the initial public offering program and negotiated sales with strategic investors. Overall, a more active and flexible privatization strategy has been adopted, allowing for additional "bottom-up", market-oriented, methods of privatization and incentives that are conducive to accelerating the privatization process. 74. The Government has complied with the following conditions for Board presentation: (a) the completion of 1.500 cumulative privatizations since the enactment of Law 58/1991: (b) the issuance of an Ordinance, acceptable to the Bank. establishing deferred payment facilities for the sale of shares still held by the SOF after exchange of COs and coupons for shares under the MPP: (c) the formalization and publication of standard contracts. agreed with the Bank. for the cash sale of shares discounted by more than 30%: and (d) the launching of the program of installment sales of 40 percent of the shares of the CCs in the MPP. 75. It was agreed at negotiation that the conditions to be met for the second and the third portion releases would be. respectively: (a) Completion of at least 2.750 cumulative privatizations. since the enactment of Law 58/1991. including at least 400 medium and 50 large CCs: and (b) Completion of at least 3.600 cumulative privatizations. since the enactment of Law 58/1991. including at least 500 medium and 100 large CCs. 76. Companies will be counted towards the privatization targets when they are fully controlled by private owners, as indicated by at least 90 percent of their shares being in private hands. However, a lower percentage of private ownership could be accepted by the Bank, on a case- by-case basis, when the structure and concentration of the ownership and the governance of a privatized firm clearly show that its management has been transferred to private hands. In order to accelerate the process of creating effective ownership structures and corporate governance, the Government will ensure that the shares of CCs in the MPP are registered and tradeable over-the- counter as soon as possible. Share registries will have to be in place as soon as shares begin to be traded for COs and coupons or sold. This is especially important because the shares will be in dematerialized form. The Government has agreed on the measures that need to be taken to facilitate the registration of shares and the development of an orderly over-the-counter market, but the full development of secondary markets in post MPP shares is likely to be a slow process. The conditions  -19- for Board presentation --i.e.. the effective activation of an interim share registry allowing for MPP share registration and the endorsement by the Government of the design of a system. acceptable to the Bank. for the registration and trading of shares-- have been met. It was agreed at negotiation that a condition for second portion release would be the establishment and activation of a system for the registration and trading in shares. Private Sector Development 77. Future growth and employment opportunities lie in the development of a healthy and dynamic private sector. The program supported by the FESAL will improve conditions for private sector development. The FESAL will require the implementation of a Strategy and Action Plan for Private Sector Development, which has been discussed with the Government and which is mentioned in the LDP. This plan will focus on specific actions, such as simplification and streamlining of regulations and procedures for the establishment of new companies, access of private contractors to public sector contracts, and technical support to small and medium enterprises development. Furthermore, a specific condition has been set. In compliance with a condition for Board presentation. the Government has endorsed a simplified procedure. acceptable to the Bank. which would ensure that the registration of new enterprises can be completed in less than a month. It was agreed at negotiation that the establishment of a simplified procedure. agreed with the Bank. for the registration of new enterprises, would be a condition for second portion release. Financial Discipline and Enterprise Restructuring: the Worst Cases under Surveillance 78. The Government program includes measures to impose financial discipline in SOEs that are not yet privatized or will remain with the State for some time to come. This aspect of the Government's program is focused on a surveillance program for enterprises which account for a significant percentage of losses and arrears in the enterprise sector. These enterprises have been required to design FRPs, with a two-year time frame (1995-1996), which specify short-term measures that must be taken to reduce their losses, improve their cash flow from operations and cut their arrears, in cooperation with their economic partners. These FRPs must be acceptable to the Bank and approved by the Government. Consultants financed by Bank-managed Trust Funds and by the EU PHARE program have assisted some of these enterprises in designing these FRPs. To be acceptable to the Bank, an FRP must include: (a) a set of realistic short-term measures to be implemented by the management of the enterprise to reduce costs, enhance revenues and reduce arrears; and (b) credibly projected positive cash flows before debt service. While under surveillance, enterprises are forbidden to undertake new capital investments. Their access to new credit is limited to Government-guaranteed credits explicitly provided for in the approved FRPs. Government guarantees for this purpose must fit under a cap agreed with the Bank. Lastly, their debt service on debt overdue more than 90 days is deferred, pending negotiation of conciliation agreements with their creditors. 79. The scheme provides positive and negative incentives for debt-ridden enterprises and their creditors to reach a conciliation agreement. By reaching an agreement, enterprises obtain debt relief and creditors benefit from the resumption of debt servicing on their frozen credits. Failure to reach an agreement would lead to liquidation which would leave both debtors and creditors worse off.  -20- 80. A core group of 13 CCs, among those placed under surveillance, will receive special attention. They are mostly large lossmakers and/or they have accumulated important payment arrears5'. While, the Government has approved the FRPs prepared by all 151 enterprises subject to the surveillance regime, it has only submitted to the Bank the FRPs for the core group of 13 CCs- which were found acceptable. Moreover, the Government and the Bank have agreed during negotiations on a set of specific and aggregate performance benchmarks to be met by these 13 CCs. By submitting acceptable FRPs to the Bank for the core group of 13 CCs and by agreeing with the Bank on performance benchmarks to be met. the Government has complied with condition for Board presentation. It was agreed at negotiation that a condition for second portion release would be the submission by the Government to the Bank of a report demonstrating. in a manner acceptable to the Bank. that the 13 CCs have made substantial progress in implementing their FRPs. including meeting the aggregate and specific benchmarks agreed with the Bank. The Bank will not monitor directly the implementation of the individual FRPs of the other CCs under surveillance, except in terms of aggregate benchmarks regarding layoffs, liquidations, privatizations and ceilings on financing. The Government and the Bank have agreed during negotiations that, ultimately, all but ten CCs6' placed either in isolation (GD 301/93) or under surveillance (GD 212/95), would have to exit these programs, by achieving one of the following: (a) generation of a positive cash flow after debt service; (b) privatization; and (c) liquidation. Lastly, the Bank will monitor the observance of the aggregate agreed ceilings regarding the Government's and SOF's financial support to these enterprises. 81. The Government has complied with two conditions for Board presentation: (a) the establishment of the legal framework for the surveillance regime. by issuing Ordinance 13/95 in January 1995: and (b) the completion of seven privatizations and liquidations out of the group of CCs placed in isolation under GD 301/93. 82. It was aereed at negotiation that the conditions of second portion release would be: (a) the exit of at least 50 CCs from the surveillance program established by GD 212/95, out of which at least 20 CCs. which have not been placed in isolation under GD 301/93. have been privatized or liguidated. while the remainder of the other 50 CCs have re- established. to the satisfaction of the Government and the Bank, a positive cash flow: and (b) the completion of additional five privatizations or liquidations out of the group of CCs placed in isolation under GD 301/93. 83. It was agreed at negotiation that the conditions of the third portion release would be: (a) the exit of the CCs placed under surveillance from the surveillance program (GD 212/95) except for those referred to below, on account of one of the following: 5/ Five of the 13 CCs are large steel companies (Sidex, Siderurgica, Siderca, Cost, Republica); two are refineries (Petrobrazi, Petrotel); two are from the troubled non-ferrous metal sector (Alum, Ampellutn); one is a fertilizer plant (Turnu); and three are from the metallurgy sector (Tractorul, Turbomecanica, IMGB) 61 The Government and the Bank will agree on a list of up to ten enterprises which would remain in the surveillance program for one year after the third portion release.  -21- - privatization: - re-establishment, to the satisfaction of the Government and of the Bank. of a positive net cash flow: and - liquidation. (b) the completion of additional ten privatizations or liquidations out of the group of CCs placed in isolation under GD 301/93. 84. Nine RAs7' have also been included in the surveillance program. They are required to undergo the same process as the CCs. However, because of their public/strategic nature, the RAs would not face the threat of liquidation and are not subject to privatization. Provision of financial support by the Government, however, are limited to explicitly agreed commitments under approved FRPs, and are subject to an overall cap. The management of the RAs will also focus on cost-cutting measures, improved cash flow generation and reduction of arrears. Should these measures prove insufficient to restore the RAs to financial equilibrium, the FRP will quantify the tariff increases and/or the amount of budgetary financing required to balance revenues and expenditures. While the management of RAs will be fully responsible for the implementation of the restructuring measures that fall within its sphere of responsibility, the Government will be required to take decisions on the pricing of output or services of utilities, public transport and mines8'; on the introduction of a mechanism to curb the building up of arrears; on closures of non-core, uneconomic activities of the RAs; and on budgetary subsidies. New capital investment will be forbidden with the exception of investments already approved under the corresponding FRP9'. 85. In agreement with the Government, a core group of six of these RAs' will receive special attention. They are some of the largest enterprises in the country (the railways, the electricity and gas utilities, and three mining enterprises employing together more than 100,000 workers). They are either large lossmakers and/or they have accumulated important payment arrears. For each of these RAs, the Government and the Bank have agreed during negotiations on a set of performance benchmarks to be met. In compliance with a condition for Board presentation. the Government has submitted to the Bank acceptable FRPs for the core group of six RAs and has agreed with the Bank on performance benchmarks to be met. It was agreed at negotiation that a condition for the second portion release would be the submission by the Government to the Bank of a report demonstrating. in a manner acceptable to the Bank. that the six RAs have made substantial progress in implementing their FRPs. including meeting the aygregate and specific benchmarks agreed with the Bank. A condition for the third portion release would be that the core group of six RAs must have made substantial progress toward phasing out uneconomic activities and improving their cash flows. 7/ The nine selected RAs are RENEL (power), ROMGAZ (gas), SNCFR (railways), RA a Lignitului-Oltenia (lignite), RA a Carbunului-Ploiesti (lignite), RA a Cuprului-Deva (copper mining), Metrorex (Bucharest Metro), RADET (Bucharest district heating) and PETROM (petroleum). 81 In this respect, the Government has already agreed, under the SAL, that prices that are still administered will be based on world prices. Under the FESAL, the Government will be required to continue observing this pricing policy. 9' Four of the eight RAs have investment projects signed or in preparation with the Bank (RENEL, ROMGAZ, PETROM and SNCFR). A new investment project concerning RADET is in the identification stage. IO/ RENEL, ROMGAZ, SNCFR, RAC-Deva, RAL-Oltenia and RAC-Ploiesti.  -22- 86. The above restructuring program for CCs and RAs is likely to have an adverse social impact as a result of the downsizing and labor shedding of these enterprises. This issue is partially addressed by Ordinance 13/95 which introduces redundancy payments and other benefits to employees of enterprises placed in the surveillance program, which may be laid-off as a result of the implementation of restructuring measures. Also, the Employment and Social Protection Project financed by the Bank will complement the FESAL by addressing the issues of unemployment benefits, social insurance and assistance programs and employee retraining. 87. Shrinking of the enterprises' payroll is a major component of their planned downsizing. As labor shedding is a particularly painful exercise, politically as well as socially, special support and specific incentives have been provided. Part of the limited budgetary resources to be allocated to support the reform program has been set aside to compensate enterprises for severance pay (six months salary). An FRF has been created by the MOF with a total budget of Lei 350 billion, of which Lei 100 billion have been set aside for severance pay. The balance is available to support payment of energy bills of chronic defaulters that cannot be cut off from service for social reasons. The severance payment program is mostly based on voluntary separation. It has proven more successful than expected. It was agreed at negotiation that. to encourage the aggressive acceleration of labor retrenchment. the floating portion of US$40 million would be released against a single criterion--in addition. that a satisfactory macro framework be in place--the reduction of employment in enterprises placed under surveillance under GD 212/95. as agreed with the Bank. Enforcement of Hard Budget Constraints: Capping Fiscal Contributions 88. The Government intends to harden the budget constraint faced by all the SOE sector, including enterprises not under isolation. To achieve this objective the Government has set caps for 1995 on the availability of government and SOF financial resources for enterprise restructuring through different channels. The Government will inform the Bank of the caps proposed for 1996 and 1997. Also, arrears to the energy complex are an important source of financing for enterprises in financial distress. In order to close this potentially major loophole in the hard budget constraints which is being imposed on RAs and CCs, the Government has introduced a mechanism to forestall future build up of arrears in the energy sector. RENEL has carried out negotiations with its largest delinquent customers, resulting in partial forgiveness and rescheduling of their debt. These customers have been advised that they will face automatic cut off from supply or progressive reductions in electricity deliveries if they fail to pay their new bill on time. MOF has agreed to pay directly to RENEL the overdue electricity bills of entities which are subsidized by the budget, out of their earmarked budgetary subsidies. Lastly, financial penalties will be applied to the managers of both RENEL and the delinquent customers in case of renewed delays in payment of electricity bills. 89. The Government has complied with the following conditions for Board presentation: (a) the adoption of a mechanism. acceptable to the Bank. to forestall future buildup of arrears in the energy sector. including an agreement on benchmarks to be met: and (b) an agreement on an overall cap on Government and SOF financial support in 1995 to SOEs under the surveillance program established by Ordinance 13/95 for enterprises selected under GD 212/95. including specific caps on: (i) the FRF (Lei 350 billion: 0.5 percent of estimated 1995 GDP): (ii) budgetary subsidies (Lei 1.250 billion: 1.9 percent of estimated 1995 GDP): (iii) Government-guaranteed new bank lending (Lei 280 billion: 0.4 percent of estimated 1995 GDP): and (iv) SOF expenditures (Lei 493 billion: 0.7 percent of estimated 1995 GDP).  -23- 90. It was agreed at negotiation that the conditions for the second and third portion releases would be: (a) substantial progress in implementation of the mechanism to forestall future build up of arrears in the energy sector. as measured against benchmarks agreed upon with the Bank: and (b) observance of the agreed caps on Government and SOF financial support to SOEs. B. FESAL Support to Financial Sector Policy and Bank Restructuring 91. The reform program of the financial sector supported by the FESAL builds on the liberalization and financial development supported by the SAL, and the regulatory reforms supported by the Industrial Development Project, and it complements the reform program in the enterprise sector. Its main objectives are to: gradually raise the soundness of the Romanian banking system; enhance competition and the role of private banks; and accelerate the restructuring, downsizing and privatization of the state-owned banks. Bank Restructuring and Privatization 92. The main objectives of the program are to reduce the state presence in the banking system, and to ensure that the comprehensive institutional development programs currently underway will continue to be implemented effectively. Therefore, the FESAL would seek commitments from the Government relating to, among others: (a) limitation of recapitalization by Government to cases of NBR intervention; (b) timebound plans for clearing all unpaid government guarantees of bank credits; (c) responsibility of the banks' board/management to meet capital adequacy requirements and an appropriate linkage of this principle to management's continuing mandate, performance standards and compensation; and (d) rationalization and downsizing of operations to better manage bankwide risks. 93. The introduction of out-of-court workouts and application of bankruptcy proceedings will be important instruments to enforce loan recovery. Moreover, the conciliation agreements, organized under Ordinance 13/95, will force banks to bear a portion of the cost of the bad loans because they will not be able to recover them fully. This exercise should send a signal that new lending should be based on borrowers' creditworthiness. Limitation of the Govermnent's role in providing financial support to clear the bad loans of banks is one of the principles in the Government program as explained in the attached LDP. 94. The Government acknowledges that maintaining capital adequacy, in accordance with the NBR timetable, should be the responsibility of the banks themselves either by raising their capital (from retained earnings and from new private investors) and/or by reducing assets. [In order to achieve these objectives, specific loan-loss provisions will be deductible from operating profit before tax, and payments of dividends to shareholders from after-tax profits will be restricted until a cushion of adequate provisions has been built up and minimum levels of capital adequacy have been achieved. 95. A condition for Board presentation was that specific loan-loss provisions by banks be rendered tax deductible according to an agreed phased-in schedule during 1995 and 1996. as follows: (a) during 1995--for loans in the loss (100% provision) and doubtful (50% provision) categories: and (b) during 1996 and subsequent years -- for the following categories of impaired credits: loss (100% provision), doubtful (50% provision) and sub-standard (20% provision). This condition has been satisfied by GD 335/95 dated May 16, 1995.  -24- 96. MOF and NBR have made a commitment to ensure that dividends payable by banks to their shareholders are restricted until the said banks have completed full loan-loss provisioning and have achieved minimum capital adequacy requirements. In order to achieve this objective, the following conditions were established: (a) for Board presentation: NBR to issue a circular requiring banks to undertake full loan-loss provisioning and reguiring them to retain 50 percent of net profit after tax as own funds. until they have reached the minimum level of capital adequacy. (b) for the second and third portion releases: Report from NBR on compliance of the banks with the circular and prudential regulations on loan-loss provisioning. cagital adequacy and distribution of net profits. and on measures taken by NBR against non complying banks. The spirit of the Board presentation condition was met by NBR Circular No. 35 dated September 14, 1995. Moreover, the NBR has sent the Bank a letter clarifying: (a) that although the required retention of state owned banks was stated in the Circular to be 'within" 50 percent, in practice, state-owned banks would be obliged to retain the full 50 percent; and (b) that while the shareholders of private banks were given leeway to retain profits or distribute dividends, they would be, de facto, subject to the same requirements placed on state-owned banks. Once the banks have constituted full provisions for loan-losses and have built up their capital ratios at least to minimum acceptable levels (8 % of risk-weighted assets), restrictions on their dividend distribution will be lifted. However, in any subsequent years in which there is a shortfall in provisioning and/or capital adequacy, the banks will be required to reduce their dividends to the extent necessary to restore loan-loss provisioning and capital ratios to adequate levels. 97. As a complement to the banks' ongoing efforts to improve the quality of their credit assessment and approval skills, and in support of the enterprise reform efforts, each of the major banks has created WODs to achieve recovery of bad and doubtful loans previously granted. Each bank's WOD is independent from the rest of the bank's operations, with the head of the unit reporting directly to the President of the bank. In addition, incentives for recovery are being created, such as salary structures based on a percentage of recovery of the bad loans. The banks could restructure credits, grant selective and partial debt forgiveness and/or execute debt/equity swaps to enterprises which present credible restructuring plans, or alternatively sell the debt outright at a discount. The establishment of WODs in each of the major banks was a condition of Board presentation. It has been satisfied. 98. The Government and SOF agreed in January 1994 to commence the bank privatization process with a due diligence exercise involving the RBD. The Government, the regulatory authorities, RBD's shareholders, and bank management remain committed to privatization. Various privatization scenarios are being developed in accordance with a preliminary plan prepared by RBD. EBRD has confirmed its interest in a potential equity investment in RBD. Technical assistance, in  -25- support of bank privatization/restructuring under the FESAL is being provided by USAID/EU PHARE. A draft Bank Privatization Law has been submitted by the Government to Parliament in September 1995. RBD's privatization plan, however, is based on the dilution of SOF's ownership by issuing new shares and selling them to private investors. As a result, the plan can be implemented independently of the passage of the new law, which will regulate the divestiture of state holdings in the share capital of banks. 99. In compliance with a condition for Board presentation. the Government has finalized a privatization action plan for RBD. agreed with the Bank and approved by RBD's shareholders. NBR and the Government. Such privatization plan includes an offer for sale. listing on the Bucharest Stock Exchange (BSE) and sale of at least ten percent of its shares by public offering, over and above those held by the POFs and RBD's employees. It was agreed at negotiation that implementation of the RBD privatization plan. as it may be adjusted in agreement with the Bank. in order to abide by the new Bank Privatization Law, if and when enacted. would be a condition for the second portion release. 100. The selection of a second state-owned bank to be privatized is still being considered by the Government, based on its banking sector strategy. It was agreed at negotiation that the adoption of a privatization action plan for the second bank to be privatized. agreed with the Bank and approved by its General Assembly of Shareholders. the NBR and the Government. would be a condition for second portion release. Such privatization plan is to include an offer for sale. listing on the BSE and sale of at least ten percent of its shares by public offering. over and above those held by the POFs and its employees. Implementation of the privatization plan of the second bank. as it may be adiusted in agreement with the Bank. in order to abide by the new Bank Privatization Law. if and when enacted. would be a condition for the third portion release. 101. The largest SOCBs have continued to expand their lending by borrowing heavily from NBR without collateral. In order to restrict the future growth of these banks, it has been agreed with the Government that there should be no recapitalization by the state, except under exceptional circumstances, and that access by banks to NBR refinancing should be restricted by requiring collateral for all NBR borrowing to be phased in during 1995. The corresponding conditions are: 102. For Board Presentation: (a) an ongoing commitment from the Government that there will be no recapitalization of banks by the state budget. by NBR. or from extra budgetary funds except immediately prior to privatization or as needed upon a bank being intervened by NBR. This condition has been met by a letter to the Bank dated September 25, 1995, signed by the Minister of Finance and the Governor of NBR. (b) NBR to issue a circular for phasing in the collateralization of its refinancing credits to banks, as agreed with the Bank. This condition has been met by NBR Regulation 3/95 issued in August 1995. 103. It was agreed at negotiation that. for the second portion release. NBR would submit to the Bank a report demonstrating progress satisfactory to the Bank in implementing Regulation 3/95 issued by NBR in respect of collateralization of NBR's refinancing credits to banks. For the third portion release. NBR would submit a similar report demonstrating full implementation of Regulation 3/95.  -26- 104. Effective implementation of the prudential regulations recently issued by NBR will require significant strengthening of its supervisory capacity, as well as NBR's powers to enforce the banks' compliance with the new prudential regulations, implementation of an off-site surveillance system, issuance of a new regulation covering the external auditing of banks by NBR-approved auditors, and redefinition of the role, structure and size of NBR's regional branches. In compliance with a condition for Board presentation. NBR has agreed to carry out annual on-site inspections of all banks. Such inspections are to include, where appropriate, a critical assessment of the banks' latest semi-annual portfolio reviews and the associated loan-loss provisioning recommended. It was agreed at negotiation that. for the second portion release. three relevant conditions would have to be met: (a) the stafflng of the Supervision Department of NBR shall be increased to its full complement of around 70 staff: (b) NBR to submit to the Bank a report demonstrating that on-site inspections of banks are being carried out in accordance with the inspection program as agreed with the Bank: and (c) NBR to issue a regulation requiring mandatory independent external audits of banks. A condition for the third portion release would be the submission by NBR to the Bank of a report demonstrating compliance of banks with the mandatory external audit requirements. 105. Deposit Insurance. To enhance all commercial banks' access to household deposits as a stable and low-cost source of funding, the Government will develop a scheme to offer an explicit but limited deposit insurance for household deposits with all banks, subject to prudent limits per individual and/or account. This will create a level playing field for all banks. This will require a strengthening in banking supervision to make explicit deposit insurance safe and secure. It was agreed at negotiation that the adoption by the Government and NBR of a detailed plan for the establishment of a deposit insurance scheme. agreed with the Bank. would be a condition for the second portion release. The implementation of the deposit insurance scheme. would be a condition for the third portion release. 106. Accounting and Auditing. MOF has implemented a new accounting plan for enterprises, and modern accounting and auditing standards have been introduced based on EU directives. As of January 1, 1994, all enterprises applied this new accounting system. There has been some delay in designing a new chart of accounts for banks, despite the fact that many banks have been audited by international accounting firms. However, the Supervision Department of NBR has recently accelerated the process. It plans to introduce a uniform chart of account on January 1, 1997. It was agreed at negotiation that the issuance of a regulation by NBR introducing a uniform chart of accounts for banks, in accordance with internationally accepted accounting standards. would be a condition for the second portion release. 107. Plans to develop capital markets in Romania are now well advanced. A condition for Board presentation was the opening of the BSE. This condition has been met with the official opening of the BSE in June 1995. 108. Although the Government has assumed responsibility for certain past bad loans on the books of the banks, in the past it was tardy in meeting its obligations thereunder. However, the Government is now current in all its obligations to the banks. It was agreed at negotiation that as a condition for the second and third portion releases. the Government would issue reports demonstrating that it is current in all its payment obligations to the banks. including principal and interest due under Law 7/92 and Ordinance 1/94. VI. THE PROPOSE1D BANK LOAN A. Rationale for Bank's Involvement 109. The Government has requested Bank support for the program of structural reforms set out in this Report. This program builds on the macroeconomic and structural adjustment supported by  -27- the SAL. This project is consistent with the Country Assistance Strategy as discussed by the Board of Directors during the presentation of the Petroleum Sector Rehabilitation Project (RO-PA-8777) on April 5, 1994. The strategy specified that a family of projects in support of privatization and private sector development is at the center of the Bank's lending program in Romania, and that the FESAL is the main component of this family of projects. 110. Success in implementing the program supported by the FESAL would imply a massive transfer of SOEs to the private sector and a fundamental restructuring of enterprises, coupled with progress in developing an effective banking system. In this task the FESAL will be complemented by other Bank-financed projects, notably the Industrial Development Project which finances private industry and the Employment and Social Protection Project which will assist workers that may be temporarily displaced as a consequence of the downsizing of the SOE sector. The FESAL has also assisted in setting up the policy framework for several ongoing or planned investment projects in the Oil and Gas, Power and Transportation sectors. Status of Bank Group operations in Romania is attached as Schedule D to this report. B. World Bank Group and IMF Support 111. The center of the IBRD lending program to Romania has been the US$400 million SAL approved on June 2, 1992, which supported the establishment of preconditions for a rapid transition to a market economy: systemic and structural reform measures, price and exchange rate liberalization, macroeconomic stabilization, enterprise reform and social protection. The second portion of US$150 million was released in April 1994. The entire loan had been disbursed in FY95. The SAL was co- financed by the Japanese Export Import Bank for the Yen equivalent of US$100 million, which is also fully disbursed. 112. Romania joined the IFC in 1990. IFC's first investment (telecommunication manufacturing) was approved in April 1992. IFC expects to support investments for the expansion and modernization of existing enterprises through joint ventures designed to bring in foreign capital and know-how and wholly Romanian-owned privatized ventures, provided there is a strong core investor and sound corporate governance. Several missions to Romania have been undertaken in an attempt to assist in the privatization process and develop a project pipeline. The strongest IFC pipeline is in the capital markets area. IFC has invested in Romania's first joint venture leasing company, providing a US$15 million loan. IFC has also received Board approval for an investment in a joint venture commercial bank. 113. Romania signed the MIGA convention on August 6, 1991 and ratified it on June 22, 1992; it became a full member on September 10, 1992. By the end of 1994, MIGA had 12 active registrations for projects in Romania, representing contemplated investments totalling about US$600 million in the agribusiness, banking, manufacturing, and telecommunications industries. MIGA has not yet issued any guarantees for investments in Romania. 114. In May 1992, the IMF approved the second SBA for Romania. This SBA expired in March 1993, when the final purchase was not made due to failure to meet performance criteria for end-December 1992. The third SBA was approved by the IMF on May 11, 1994. It is complemented by an STF which supports structural changes in several policy areas, including the exchange rate regime, and financial discipline. Discussions regarding the completion of the program review with the IMF are continuing. The IMF Board discussion is scheduled to take place in early December 1995. The status of IMF operations in Romania is attached as Annex 3 to this report.  -28- C. Conditions of Board Presentation and for Release of the Second. Third and Floating Portions 115. The proposed conditions for Board presentation, and second, third and floating portion releases have been detailed in Section V and reproduced in the policy program matrix, attached as Annex 2 to this report. This matrix has been used as a basis for policy discussions with the Government. The floating portion may be released at any time after the loan becomes effective, when the aggregate reduction of employment in enterprises placed under surveillance reach the level agreed with the Bank, and as long as satisfactory progress in implementing the reform program set out in the LDP is achieved. However, to ensure that the main objective of the floating portion is fulfilled-i.e., to secure an early reduction of excess labor--the third portion will not be released before the floating portion. D. Loan Features and Components 116. Amount and Tranching. The proposed Loan, comprising single currency loan tranches in US Dollars, Deutsche Marks and French Francs in the amount of US$280 million equivalent, would be made to the Government for 20 years, including a five-year grace period, at the Bank's standard interest rate for LIBOR- (PIBOR-) based single currency loan in these currencies. The LIBOR- (PIBOR-) based single currencv loan terms have been selected by the Government of Romania, based on a review of the structure of the country's foreign trade and its existing foreign debt. It also selected the single currency loan basket to improve its external liability management and reduce its risks. The LIBOR- (PIBOR-) interest rate basis has been selected primarily to preserve the standard country repayment terms of 20 years for LIBOR- (PIBOR-) based single currency loans, compared to the shorter final maturity of fixed rate single currency loans. Given the need to support a strong program of policy reforms, the proposed Loan would be disbursed in four portions: a first portion of US$60 million to become available on credit effectiveness, a second of US$80 million six to nine months later, and a third of US$100 million about six months later. The floating portion of US$40 million would be disbursed as soon as a single specific benchmark is met. Policy measures supported by the Loan are expected to be implemented over the next 12 to 24 months. The Japanese Export Import Bank has indicated its willingness in principle to cofinance FESAL in the Yen equivalent of US$50 million. 117. The utilization of the Loan would be against general imports, except for a negative list of ineligible products such as military and paramilitary items, luxury goods, nuclear reactors and parts, uranium, tobacco and tobacco products, and environmentally hazardous products. E. Procurement and Disbursement 118. Procurement. The proposed Loan of US$280 million will finance 100 percent of the CIF costs of eligible imports needed in the Financial and Enterprise Sector. These imports will be specified through a negative list of categories. 119. Imports made by the Government, public authorities, and private importers for more than US$3 million will be procured under simplified ICB, using the Bank's Standard Bidding Documents for Procurement of Goods, in accordance with the World Bank's Procurement Guidelines (January 1995). This threshold is consistent with the expected size of contracts and the experience of the country with Bank procedures. Contracts in excess of US$10.0 million will be subject to prior review by the Bank. 120. Subject to prior approval of the Bank, commonly traded commodities may be procured through organized international commodity markets or other channels of competitive procurement acceptable to the Bank. Since the Country Procurement Assessment Report for Romania is still in the preparatory stage, it is not known at present if the country's procurement regulations for public  -29- enterprises and commercial procurement practices are adequate and acceptable to the Bank. Thus, contracts for the procurement of goods estimated to cost less than US$3 million may be awarded through international shopping, based on an evaluation and comparison of at least three quotations obtained from suppliers from at least two eligible countries. 121. A procurement unit will be created at NBR to coordinate procurement activities for the operation. The unit's organization, key staff, and procedures should be acceptable to the Bank. The unit will be headed by a procurement specialist with qualifications and terms of reference acceptable to the Bank. The central bank will provide quarterly progress reports of procurement activities to the Bank. 122. A General Procurement Notice will be published in the Development Business. The notice will list the main categories of imports to be financed under the loan, recommend that Bank- eligible exporters contact potential local importers, and invite interested suppliers to establish contact with NBR. 123. Disbursement. Contracts valued at less than US$250,000 will not be eligible for Bank financing. Retroactive financing, not exceeding the equivalent of US$55 million of the Loan for expenditures paid during the four-month period preceding the Loan signature, would be acceptable to the Bank. However, imports shipped prior to the four-month period preceding the Loan signature would not be eligible for Bank financing. 124. Disbursements for contracts below US$10 million will be made against Statements of Expenditure. The relevant documentation will be kept locally for supervision by Bank staff in the field and for auditors whose terms of reference for procurement audits should be acceptable to the Bank. Under the proposed operation, the accounting and auditing procedures of NBR will be upgraded, if required, to be acceptable to the Bank. 125. Acoiunts. NBR will keep the accounts including: (a) a record of drawings on the Loan, with copies of all disbursement requests and underlying documentation; and (b) a record of transactions on the Special Accounts and copies of NBR statements of these accounts. These records will be updated monthly, and quarterly statements of transactions and balances, with the necessary recommendations for disbursements and information on claims in process, will be forwarded to the Bank. 126. Special Accounts. In order to facilitate project implementation, the Borrower will establish three Special Accounts in USD, DEM and FRF, respectively, in NBR to cover eligible expenditures. The authorized allocations will be US$17 million for the USD Special Account, DEM 13.5 million for the DEM Special Account and FRF 10 million for the FRF Special Account. The Special Accounts will be replenished monthly, or whenever one-third of the authorized amount has been withdrawn, whichever occurs earlier. Monthly bank statements of the Special Accounts which have been reconciled by the Borrower will accompany replenishment requests. F. Monitoring Arrangements 127. Audit. All records and accounts of operations under this Loan, including the Special Accounts and Statements of Expenditure will be audited annually by independent auditors satisfactory to the Bank, in accordance with the Bank's Auditing Guidelines. The annual audit reports will be submitted to the Bank not later than six months after the close of each fiscal year. 128. Monitoring. The Government is aware that achieving the ambitious objectives of the FESAL program will require a major implementation effort (including technical assistance support) and close coordination of actions and policies. Therefore, the Government has set up an Inter-  -30- ministerial Task Force to finalize the preparation of the FESAL and serve as the counterpart to the appraisal mission. This task force intends to remain in place after the finalization of the project preparation and to monitor closely its implementation. G. Environmental Assessment Requirements 129. In accordance with the Bank's Operational Directive on Environment Assessment (OD 4.01, Annex E), the FESAL has been placed in category U (unclassified) and does not require an environmental assessment. VII. BENEFITS AND RISKS 130. Benefits. Implementation of structural reforms in the enterprise and financial sectors under this operation will enhance Romania's prospects for growth and will reinforce the sustainability of its macroeconomic stabilization. Privatization will increase efficiency in the economy as enterprises will be better suited to respond to changes in market conditions and consumer demands. Improved financial discipline and stronger governance will reduce losses and arrears in the SOE sector freeing resources for private sector development. Financial sector reforms would provide the basis for building up a sound and efficient financial intermediation system and the development of a new capital market. The program will also lead to substantially strengthened regulatory and supervisory capabilities of NBR. Economic stability and growth would help Romania achieve creditworthiness and gain easier and cheaper access to external finance. 131. Risks. The main risks associated with the proposed Loan stem from the complexity and political difficulty of implementing the ambitious Government program. Slippages in the macrostabilization would further complicate the implementation of the program, and would reduce its expected benefits. The local and national elections scheduled for 1996 may increase pressure for the Government to relax its strict policies with respect to financial discipline and budgetary stringency. 132. The complexity of the MPP creates the risk that privatization may be delayed because of implementation problems. However, this risk has been greatly reduced by the large number of privatizations which have already taken place and by the adoption of several market-based mechanisms for privatization, which will be in effect simultaneously with the MPP. 133. Overall, the risks appear manageable and the Government of Romania has demonstrated a strong commitment to reform by implementing many of the policy measures proposed under the FESAL before the approval of the Loan. VIII. RECOMMENDATION 134. I am satisfied that the proposed Loan would comply with the Articles of Agreement of the International Bank for Reconstruction and Development, and I recommend that the Executive Directors approve it. James D. Wolfensohn President Attachments Washington, D.C. December 6, 1995  -31- Al1N:EX 1 Page 1 of 13 IKOHANIA GOVERNMENT OF ROMANIA NATIONAL BANK STATE OF ROMANIA OWNERSHIP FUND Bucharest November3c, 1995 Mr. James Wolfensohn President The World Bank 1818 H Street, NW Washington, DC 20433 Dear Mr. Wolfensohn, Ref. Financial and Enterprise Sector Adjustment Loan 1. For over five years the Romanian authorities have been implementing reforms aimed at transforming Romania into a dynamic market economy. As in other former planned economies, the transition process has proven to be difficult. But in spite of the difficulties, and as we have shown over the past few years, we are committed to continue and deepen the reforms in all areas. In particular, we have given priority to policy reform in three areas: macroeconomic stabilization; privatization and private sector development; and social protection. The World Bank has provided important support to our program of stabilization and structural reform through the Structural Adjustment Loan and other instruments.  -32- ANNEX 1 Page 2 of 13 Macroeconomic Policy 2. Our main priority since mid 1993 has been to stabilize the economy, which we have significantly achieved. In many aspects we overperformed relative to the programs that we designed with the support of the IMF. In 1993 and 1994, the consolidated general government accounts were in near balance following a substantial reduction in the deficit which exceeded 6% of GDP in 1992. The fiscal deficit in the first half of 1995 is in line with the 2% program target. This was achieved largely by the virtual elimination of consumer subsidies in conjunction with the removal of price controls, and the successful introduction of Value Added Tax. These measures were complemented by a tight monetary policy which has consistently maintained interest rates at levels which are positive in real terms. The foreign exchange market has been further deepened and liberalized in several stages through the establishment of an inter-bank. foreign exchange market. 3. Inflation has abated from 300% in 1993 to about 62% in 1994, and about 25% in 1995. Output began rebounding in 1993, grew by 3.5% in 1994, and is estimated to be growing even faster (by over 5%) in 1995. The trade balance and international reserve position have improved, mainly through a notable export boom. The deficit in the current account of the balance of payments fell from 7.8% of GDP in 1992, to 4.7% in 1993, and to 1.8% in 1994. In 1995, in spite of continued growth in exports, it is likely to show a larger deficit linked to the growth of imports resulting from the very fast growth of the economy. Confidence in the leu has been partly restored as evidenced in the increase in the volume of leu deposits and in the stability of the exchange rate. Flows of direct foreign investment have also increased markedly; the total inflow in 1994 has been equal to the cumulative inflows of the four previous years, and in 1995 inflows may be even larger. 4. In order to maintain this progress and set the basis for sustained growth, we intend to continue policies aimed at reducing inflation and achieving an adequate buildup of foreign exchange reserves. The consolidated government budget deficit is programmed not to exceed 2.9% of GDP in 1995 and 2.2% of GDP in 1996. These deficit targets take into account the expected fiscal costs arising from the implementation of the reforms described in this letter. We intend to continue controlling government expenditure with improvements in the structure of expenditures, including enhanced targeting of social programs and reallocation of expenditures from wages and producer subsidies to infrastructure investments to support the emerging, private sector. Domestic financing of the fiscal deficit will be limited so as to protect private sector access to credit and achieve the targeted inflation reduction. Measures will be taken to ensure a flexible interest rate 2  -33- ANNEX 1 Page 3 of 13 structure which provides incentives for financial savings and efficiency in credit allocation. 5. We also intend to build on progress in structural reforms achieved over the past four years through increased reliance on the price mechanism and on market- determined exchange and interest rates to allocate economic resources. In particular, we intend to maintain the openness of the trade and exchange systems, foster market competition, further reduce availability and access to preferential credits, and ensure the transparency of remaining subsidy schemes (in particular, to the agricultural sector and regies autonomes) which are to be gradually phased out. We regard the price liberalization to be a major achievement during the last four years. We shall continue to uphold our SAL agreements in this regard, which allow for no intervention in price setting except in agreed instances such as natural monopolies. We shall also sustain the SAL agreements on energy pricing. 6. Building on our impressive record in stabilizing the economy, we are now ready for a strongly approach of the actual reform stage, respectively, the privatization, restructuring, the strengthening of financial discipline and other structural reforms in the enterprise sector. These reforms will improve efficiency in the Romanian economy, will lead to faster growth, and ensure the sustainability of our successful stabilization program. Ultimately, we expect that the stability thus achieved and the resumption of economic growth will allow our Government to ensure adequate social protection to the Romanian people. 7. We believe that sustainable growth cannot be achieved without deepening the reform of both the enterprise and the financial sectors. Losses of state-owned enterprises must be curtailed through privatization, restructuring and imposition of severe financial discipline and stronger governance. Private initiative must be freed by creating a stimulating environment allowing private entrepreneurs and privatized firms to grow. At the same time, the banking sector must be strengthened through privatization, the enactment of adequate prudential regulations and the enforcement of commercially-minded lending practices. Lastly, capital markets must be developed in order to ensure adequate reorientation of savings and investment toward the most efficient operators. Therefore, we have decided to deepen enterprise adjustment through acceleration of privatization and imposing stricter financial discipline on enterprises remaining in state hands. This will be complemented by further financial sector reforms. This program, to be supported by the FESAL, is described below. Enterprise Reform Program 3  -34- ANNEX 1 Page 4 of 13 8. Our strategy for improving the financial performance of the enterprise sector is to: (a) accelerate privatization; (b) remove obstacles to private sector development; (c) increase the economic efficiency of the of the large loss-making state-owned enterprises (SOEs); and (d) strengthen the institutional and legal framework for commercial activity. Privatization 9. We are fully aware that privatization and the development of a vibrant private sector are critical to the success of our structural reform efforts. Therefore, our privatization program has been placed on a fast track. Our foremost objective is to complete the privatization of about half of all state-owned enterprises by the end of 1996. By the end of October 1995, we have already privatized around 1,500 commercial companies (CCs), mostly through Management and Employee Buy-Out (MEBO) and, to a lesser degree, through trade sales, public offers, assets sales and liquidation of the non-viable commercial companies. We expect that the Bucharest Stock Exchange, which opened in June 1995, will significantly facilitate public placement of shares, privatization and capital market development. Trade sales of medium-sized and large CCs, including with the participation of foreign buyers, are also increasing. Altogether, we are applying a wide array of market-oriented methods to reach our ambitious privatization objectives. 10. This commitment to privatization is witnessed by our recent launching of a mass privatization program (MPP), which is being implemented within the framework of a new Law for Acceleration of Privatization. Under the MPP, 3,600 enterprises would be privatized, cumulated, over the year 1997. The MPP is based on the distribution of new coupons, to complement the existing Certificates of Ownership (COs) which were distributed in 1992. These new coupons, along with the existing COs, will be exchanged for the shares of participating enterprises. In a first stage, the State Ownership Fund will sell, according to the methods provided by the existing legal framework, shares packages representing at least 40% of the listed CCs social capital and that are not to be privatized through cupons or COs. The State Ownership Fund (SOF) will promptly sell for cash the shares not exchanged for coupons and COs during the MPP. The whole array of privatization methods legally authorized will be applicable to the cash sale of shares. To facilitate such sales, we have issued an Ordinance which authorizes the SOF to grant attractive payment facilities to buyers. To enable the speedy transfer of governance of these enterprises to the private sector, these facilities have been designed in a manner that will transfer ownership over the corresponding package 4  ANNEX 1 -35- Page 5 of 13 of shares as soon as buyers have settled a minimum downpayment of 20% of the value of the shares. 11. Also, the price of unsold shares may be discounted, if warranted, below 70% of their face value. Such shares would then be offered for sale (with limited and widely publicized conditions) under standardized contracts open to any buyer meeting the price and the conditions. Investment funds will be encouraged to participate. Up to 60% of the proceeds due to SOF for the sold shares will remain with the enterprises in order to provide the privatized companies with working capital and to cover their debt service. Lastly, shares remaining unsold as of December 1996 will be redistributed against a second round of vouchers. 12. In order to accelerate the process of creating effective ownership structures and corporate governance, the Governnent will ensure that the shares of CCs are registered and tradable on the secondary market as soon as possible.. Once the MPP is completed, but until the end of 1997, the interim share registry will be replaced by privately managed share registries, opened within the framework of the Romanian Stock Exchange, that will allow for fully fledged trading in dematerialized shares. While the MPP is in progress, we intend to continue accelerating privatization through all other methods available, such as sale of auction and tender of shares, MEBOs, initial public offering and negotiated sales, both to local and to foreign investors. Private Sector Development 13. We recognize that future growth and opportunities lie in the development of a healthy and dynamic private sector. Therefore we shall implement a Strategy and Action Plan for Private Sector Development, which has been agreed with the Bank. We shall focus on specific actions such as simplification and streamlining of regulations and procedures for establishment of new companies by concentrating the operations provided by the law, within the formalities offices that will be established as part of the local and Bucharest Industry and Commerce Chambers. Restructuring of State-Owned Enterprises 14. A limited number of CCs and Regies Autonomes (RAs) accounts for a substantial portion of losses of the enterprise sector. Unable to finance these losses, they have been infecting the whole economy by building up payment arrears with their suppliers, the budget and the banks. Hence, our restructuring program will be targeted at this limited number of large enterprises facing a financial crisis. We 5  -36- ANNEX 1 Page 6 of 13 believe that restructuring of enterprises should be left to new private owners as much as possible. However, RAs are not slated to privatization and large loss- making CCs are unlikely candidates for early privatization. Restructuring will be management-led and will be limited to passive restructuring, including, when imposed by the market conditions, downsizing of some sectors and enterprises, with the objective of reducing losses and arrears and of restoring a positive financial position. 15. In July 1993, we took steps to attack the problem of loss-making enterprises and lack of financial discipline by placing a group of 30 CCs in a special program of financial isolation (Government Decision 301/93). These CCs were "isolated'.' from the banking system, which denied them access to new credit unless they could demonstrate their ability to repay. Management of each CC was required to operate on a cash basis and to design a Financial Recovery Program (FRP). It appears that restructuring is actually happening and a significant group of these CCs is already generating a positive cash flow. The World Bank, EBRD and EC PHARE financed technical assistance for implementation of liquidation, privatization and restructuring. Seven of these CCs have already been privatized or liquidated, and over the next couple of years we plan to liquidate or privatize most of the remaining ones. 16. The isolation program of this first group of 30 CCs has proved to be a useful pilot exercise. It has achieved some tangible results as labor has been significantly reduced, under-utilized and idle assets have been sold, uneconomic production lines closed and, in several cases, uncooperative/poor management has been replaced. Guidelines and procedures have been established for the design and implementation of FRPs, for conciliation agreements with creditors and debtors, liquidation, monitoring -of financial performance and for assessment of management achievements. Even more important, it has introduced in Romania a new concept of enterprise restructuring, based on rationalization, cost cutting and internal cash flow generation, without major investment for expansion and modernization. 17. Drawing from the experience of the pilot isolation program, we have decided to generalize its concept and to develop it further by way of out-of-court conciliation between debtors and creditors. The objective of the expanded program- -called thereafter "surveillance program"- is to place with the enterprises and with their creditors the responsibility of restoring the financial viability of the ailing enterprises to avoid threat of liquidation. We created an Agency for Restructuring (AR) to oversee the implementation of this program. Implementation of the FRPs, however, remains the responsibility of the management of the enterprises under the 6  -37- ANNEX 1 Page 7 of 13 supervision of the Department for Selective Restructuring (DSR) of the State- Ownership Fund (SOF), which acts as the owner. 18. In January 1995, we issued an ordinance (Ordinance 13/95) that provides the legal foundation for the surveillance program and we selected (Decision 212/95) a group of 151 state-owned enterprises (9 RAs and 142 CCs) to be placed under surveillance. CCs designated for the program have been given a limited period of time to implement the FRPs which they have prepared. During this period, their debt service obligations and their access to the bank credit have been suspended. A conciliation with the creditors will then have to be negotiated on the basis of the FRPs, when the enterprises can demonstrate that downsizing and Cost-cutting measures can generate a positive cash flow before debt service. Failure to agree with the creditors on an acceptable FRP, or failure to implement it and obtain the agreed results, will result in liquidation of the enterprise. 19. The RAs would undergo a similar process as the CCs. However, in the case of the RAs, liquidation is not an option. The projected cash flow of some of them may still be insufficient to meet their debt service obligations and to clear their arrears, even after the adoption of realistic cost-cutting measures. Any remaining shortfalls that cannot be covered with tariff adjustments will be provided for with explicit budgetary subsidies (which will be subjected, however, to an overall cap) and will not be financed .with commercial bank credits. The threat of removal of budgetary contributions, if the RA does not adjust, is expected to provide adequate incentives to the management of the RAs to vigorously pursue cost cutting, arrears reduction measures, and to seek financial conciliation agreements with their creditors. We also intend to separate the policy and regulatory functions of ministries from management of RAs and to continue our policy of spinning off and transforming into CCs all activities of a commercial nature presently done by RAs. The liability of the State as owner of the RAs for their commercial activities will also be clearly defined and limited. 20. To concentrate the limited skills and resources available on the principal loss makers and accumulators of arrears, we have decided to select from the group of 151 enterprises placed under surveillance a subset of 6 RAs and 13 CCs, based on the amount of their arrears and/or losses and of their sector of activity. The selection of this limited group of RAs and CCs is expected to enhance financial discipline in the entire enterprise sector, not only because these enterprises account for a large percentage of losses and arrears, but also because their creditors will have to share the burden of financial conciliation (i.e., debt restructuring and/or forgiveness). 7  ANNEX 1 -38- Page 8 of 13 21. The Romanian authorities have undertaken to put an end to budget-funded bailouts, and not resort again to arrears compensation exercises. The strict implementation of the surveillance program should convince a very large segment of the enterprise sector that we are genuinely committed to these objectives. Strengthening the Institutional Framework for Commercial Activity 22. A new, modem Bankruptcy Law has been passed in May 1995. It will enable creditors to enforce their rights. The Competition Law has also been passed. We are now strengthening the appropriate institutional frameworks to enable their effective implementation. 23. Another priority is to develop an orderly market for inter-enterprise credit and to reduce inter-enterprise arrears. New laws governing bills of exchange and promissory notes have been passed. However, the new Ordinance 13/95 will encourage enterprises to evidence their inter-enterprise claims by negotiable instruments. 24. A new accounting system for enterprises and modem accounting and auditing standards have been introduced in 1994, based on EU directives. Eventually, we intend to ensure the full consistency of these standards with international standards. Moreover, in order to implement the new accounting and auditing standards, we have issued an ordinance organizing the profession of accountants and auditors. In parallel, a Romanian Institute of Accounting and Auditing is being established. Social protection 25. Shrinking of the enterprises' payroll is an inevitable component of the restructuring of the state-enterprise sector. However, we must mitigate the social impact of such downsizing. Therefore, part of the limited budgetary resources to be allocated to support the reform program has been set aside to compensate enterprises for severance pay (six months worth of salary). A Financial Recovery Fund (FRF) has been created by the Ministry of Finance with a total budget of Lei 350 billion, in 1995, of which Lei 100 billion have been set aside for severance pay; this fund will be also included in the state budget of 1996. This will complement other forms of social protection financed by our social security system and the Unemployment Fund. 8  -39- ANNEX 1 Page 9 of 13 Financial sector reform 26. Our long-term objective is to enhance the role of the private sector in financial intermediation and to build a competitive banking system complemented by non- bank intermediaries facilitating commerce and investment. To achieve this objective, we will: (a) provide an appropriate framework for financial intermediation and for new entrants; (b) change the system of incentives to state- owned banks so that they improve their financial situation and operational efficiency; and (c) continue to strengthen the supervisory and regulatory framework. Appropriate Framework for Financial Intermediation 27. Our interest rate policy is to maintain market-based positive real rates of interest. To this end, NBR will influence the level and structure of interest rates through its refinancing auction and overdraft facility. Government borrowing from banks will also be set at rates high enough to keep lei-denominated assets attractive. The Public Debt Law has been passed, and the Ministry of Finance (MOF) has reached an agreement with the National Bank of Romania (NBR) on mechanisms for open market operations and initiated pilot auctions of Government debt managed by NBR. As market conditions permit, we shall establish a structured program and timetable for issuing short-term Treasury bills. This should lead, in due course, to the development of a secondary market for government securities. 28. We recognize the importance of developing an effective capital market. The Securities Exchange Act (SEA) has been approved by Parliament and promulgated by the President. The SEA and accompanying regulations will provide a complete legal and regulatory framework for capital market development. The National Securities Commission (NSC) has been established. The Bucharest Stock Exchange has been opened and share trading activities are expected to commence soon. 29. The growth of emerging private banks in the past two years has been significant, but has been constrained by the privileged treatment of the Savings Bank (CEC) which has an explicit government guarantee for its household deposits (which represent the most stable funding source of banks). In order to lift this constraint, a level playing field for deposit gathering by all banks should be secured. To this end, we plan to introduce an explicit deposit insurance for household deposits with all banks, subject to prudent limits per individual and/or account. The possibility of a voluntary scheme is mentioned in the Banking Law, 9  -40- ANNEX 1 Page 10 of 13 but we concur with the introduction and implementation of a limited deposit insurance scheme for the individual deposits of all banks, including CEC. We will introduce any supplementary legislation that is required to achieve this. Simultaneously, the independence and effectiveness of the banking supervision activities of NBR will be strengthened to make explicit deposit insurance safe and secure. 30. Improvement of the inter-bank payment and clearing system aimed at reducing the float (amounts in transit) and reducing inter-enterprise arrears by accelerating payments between customers of different banks is also a high priority. An important prerequisite for developing a modem payment system is by standardizing payment instrumrents, in both paper and electronic form, and the respective codes. NBR and the Romanian Bankers' Association (RBA) will develop and issue such standards by end-1995. RBA has signed a statement of intent with NBR undertaking to set up a National Clearing House for all interbank payments. This opportunity will be used to rationalize the flows in the clearing system and to allow computer technology-based clearing by banks which have appropriate capacity. RBA and NBR will prepare an action plan for a high volume payments system for implementation nationwide and in due course they will prepare a medium term strategic plan for subsequent upgrades. 31. An effective credit information bureau (CIB) is needed to strengthen the risk management of banks, the application of the recently introduced prudential regulations, and the quality of financial information on banks, etc. To achieve this objective, NBR and RBA have agreed, in principle, on the merits of establishing a CIB. An action plan to establish a CIB will be prepared and implemented. Bank Restructuring 32. The Government recognizes that the financial situation of the state-owned banks has to be put on a sound basis, and that the Government's presence in the banking system should be reduced in line with the pace of accelerated enterprise privatization and to encourage the development of the newly emerging private banking system. While the 1993 financial audits of the five state-owned commercial banks indicated that banks could absorb loan losses and attain adequate capital ratios, their interim statements as of June 30, 1994 show a fragile financial position. If future portfolio reviews show a worsening of capital ratios, it is our view that the banks themselves must undertake corrective measures either by raising their capital (from the net profit and from new investments) and/or by reducing assets, and that there should be no additional call on the Government 10  -41- ANNEX 1 Page 11 of 13 budget. In order to provide an incentive to the banks to build up sufficient reserves, we have issued a Government decree to allow tax-deductibility of the specific loan loss provisions mandated in NBR prudential regulation No. 2/1994. Also, NBR will issue a circular which will allow payment of dividends to be restricted by banks unless and until they have undertaken full loan-loss provisioning and have achieved the minimum capital adequacy standards laid down in NBR prudential regulations. 33. Furthermore, securing a market-orientation in the operations of these banks is crucial. To this end, we are committed to the development and implementation of a strategy for the state-owned banks which would ensure their independent management and/or privatization in a phased manner. Therefore, in July 1994 we established a Bank Privatization Task Force (BPTF), chaired by the Council for Coordination, Strategy and Economic Reform (CCSER). The BPTF will develop and guide implementation of the bank privatization and restructuring strategy agreed with the Bank. We have commenced this process with a pilot due diligence exercise involving 'one bank, the Romanian Bank for Development (RBD). We remain committed to its privatization, which will be initiated in 1996. A second bank will be selected in 1996 to commence the privatization process. We do not intend to recapitalize the state-owned banks either by direct equity injection or by exchange of Government bonds for bad assets except, to the extent necessary, to avoid systemic risks, or immediately prior to privatization. 34. At the individual banks' level the five state-ovvned commercial banks have embarked on comprehensive institutional development programs as a result of successive annual rounds of operational audits starting as of end-1991. The programs are geared to realistic strategic business plans and forecasts of future retained earnings, with a view to eventual privatization. Restructuring of those state-owned banks which are not readily privatized will be undertaken based on: (a) agreed restructuring plans; and (b) agreed Policy and Corporate Strategy Statements. In order to restrict the growth of these large state-owned banks, NBR has issued a circular requiring the phasing-in of the collateralization of its refinancing credit lines to banks. 35. In this context, and given the enterprise sector reform objectives, it is imperative that the quality of new lending by the banks be improved. The introduction of out-of-court work-outs and application of bankruptcv proceedings will be important instruments to enforce loan recovery. To this end, each of the major banks has created Work-out Departments (WODs) to enhance recovery of bad and doubtful loans previously granted. These WODs will be made as independent as possible from the rest of the bank's operations, with the head of the 11  -42- ANNEX 1 Page 12 of 13 unit reporting directly to the President of the bank. We envisage that the banks could restructure credits, grant selective and partial debt forgiveness and/or execute debt/equity swaps to enterprises which present credible restructuring plans, or alternatively sell the debt outright at a discount. This exercise, to be started with the enterprises placed in the surveillance program organized under Ordinance 13/95, will force banks to bear a portion of the cost of the bad loans because they will not be able to recover them fully. This should send a signal to banks that new lending should be based on the borrower's ability to repay. Bank Supervision 36. In order to support the reform objectives for the banking system, the Government and NBR plan to strengthen significantly the regulatory and supervisory framework for the banking sector according to an action plan to be drawn up with the assistance of external consultants. This program will include a redefinition of the role of NBR's regional branches. Furthermnore, the staffing of NBR's Supervision Department will be increased to its full complement. This strengthening of NBR supervision is essential given the growing importance of private banks, as well as the need to avoid diversion of bank credit to unviable enterprises. 37. NBR has issued prudential regulations in line with international standards covering licensing, loan exposure limits, currency exposures, insider lending/connected lending, capital adequacy, loan classification and provisioning. Rules relating to ownership of banks by non-banks and equity holdings of banks in non-banks are covered in the basic legislation. A new regulation is to be issued reporting mandatory annual external auditing of all banks by NBR-approved auditors. NBR has already commenced on-site examinations focusing on banks' compliance with the new prudential regulations and has implemented an off-site surveillance system. As from 1995, NBR will undertake annual on-site inspections of all banks. Such' inspections will include, inter alia, a critical assessment of the banks' latest semi-annual loan portfolio reviews and the associated loan-loss provisioning recommended. 38. In order to ensure the effectiveness of these regulations, and as a prerequisite to efficient off-site analysis, a proper accounting framework must provide a sound basis for many of the regulatory reports submitted by banks for supervisory purposes. There has been some delay in designing a new chart of accounts for banks, despite the fact that many banks have been audited by international accounting firms. However, NBR has now requested technical assistance to speed 12  -43- ANNEX 1 Page 13 of 13 up the process and an appropriate action plan will be drawn up shortly to formulate a uniform chart of accounts for banks, harmonized with internationally accepted accounting standards, for introduction as from January 1, 1996. 39. The Government recognizes that there are still gaps in the existing banking law that would impede NBR's ability to provide progressive and effective sanctions against erring banks and act decisively in case of a banking crisis. The banking law will be amended or supplemented with measures to enhance NBR's enforcement powers. In addition, given the recent deterioration in the condition of the banks and the expected adverse impact of the enterprise reform program on the banks, as well as the GOR's position regarding recourse to the budget and the reform program's objectives regarding the role of government in the banking system, urgent solutions to addressing problem banks in the future will be examined and agreed. 40. While we shall implement the various measures and actions listed above, our Government also intends to maintain a close dialogue with the IMF and to continue adhering to the stabilization program which has been agreed under the Stand-by Agreement. NICOLAE VACAROIU PRIME MINISTER GOVERNMETF ROMANIA MUGUR ISARESCU EMIL D,IA GOVERNOR PRESIDENT NATIONAL BANK OF ROMANIA STATE OWNERSHIP FUND 13  ROMANIA Financial And Enterprise Sector Adjustment Loan (FESAL) Proposed Program of Policy Reforms Taken . 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M A C R O E C O N O M I C Policy measures in compliance Maintenance of a macro- Maintenance of a macro- Maintenance of a macro- Maintenance of a macro- POLICY with SAL adjustment economic framework economic framework economic framework economic framework 4 programs. consistent with the program consistent with the program consistent with the program consistent with the program s Establish appropriate macro- as determined on the basis of as determined on the basis of as determined on the basis of as determined on the basis of economic framework in indicators agreed upon by the indicators agreed upon by the indicators agreed upon by the indicators agreed upon by support of consistent trade, Government and the Bank Government and the Bank Government and the Bank the Government and the industrial, monetary and and progress achieved by and progress achieved by and progress achieved by Bank and progress achiwved budgetary policies theGovernment in the theGovernment in the theGovernment in the by theGoverninent in the carrying out of the program. carrying out of the program carrying out of the program carrying out of the program aq (D z 0-zo  :~ ~~~~ .: .: ..... :..:::.:.::. 1 : :: -~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ . :: :-... .. . -:- ves- kllrft, t~~~~Pole P o ..m_ __ _ _ __ _ _ _ y-I UM::1~~Tke ...tti ....o Rles PorionRelaeJ1.i*rto PRIVATIZATION As of 10/30/95, xxx small Completion of 1,500 Completion of at least 2,750 Completion of at least 3,600 CCs privatized out of 3,100; cumulative privatizations cumulative privatizations, cumulative privatizations, Accelerated and effective xxx medium CCs out of 2,500; since the enactment of Law since the enactment of Law since the enactment of Law privatization of major and xx large CCs out of 700. 58/1991. 58/1991, including at least 58/1991, including at least portion of the state-owned 400 medium-sized and 50 500 medium-sized and 100 enterprise sector. Signature of a technical Issue of an Ordinance, large CCs. large CCs. assistance program with EU acceptable to the Bank, A CC is considered Phare to assist in preparing establishingdeferredpayment privatized when at least 90% and implementing the MPP facilffities ior the sale of shares of its shares has been and the initial registration of still held by the SOF after transferred either to entities shares. exchange of COs and coupons which are 90% in private for shares under the MPP. ownership, or to private individuals. Formalization and publication of standard contracts, agreed with the Bank, for the cash sale of shares discounted by more than 30%. Launching of the program of installment sales of 40% of the shares of the CCs in the l _____________________ _______________________ M PP. Establish a market basis for Signature ofa Memorandum of Effective activation of an Establishment and activation accelrating the trading of Understanding with USAJID to interim share registry of a system for the shares issued under the MPP design a system for registration allowing for MPP share registration and trading in and trading of shares. registration and endorsement shares. by the Governmcnt of the design of a system, acceptable to the Bank, for the registration and trading of shares. oQ> CD Z z 0  R : ............................. i ... .. ~ ~ ~ . .. . ,. . . ........ .... . . . .-. -. . - , - . ' ' ' '': ' ' ' ' ' " '""' "E' ' " ' . "' .' "'' ' " . ' ' . '. ' " " "' " ' ""'"' """"'...'. "" ":.''.".-" ' PRIVATE SECTOR Implementation of several Endorsement by the Establishment of a simplified DEVELOPMENT SME development schemes, Government of a simplified procedure, as agreed with the coordinated by NAP, with procedure, acceptable to the Bank, for the registration of To remove constraints to international donors, including Bank, which would ensure new enterprises. PSD and provide incentive consuking services, training, that the registration of new framework and assistance for incubators, loan guarantee and enterprises can be completed economic growth and re investment funds, in less than a month. employment of the state- owned sector. Existing system of enteqxrise registration has been reviewed. The Government has issued two Ordinances providing equal and unconstrained acessc to public sector procurement fDr all private sector suppliers. I-d lb  _ _ _ _ _ _ _ _ _ _ _ _ _ _ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ .. .. . ...pokiy Pro rw..._ _ _ _ _ _ Nie~r Issus & Objeeirra Measun AlreadyBei Actins:T4Jmes Fr Bor toa ro o eod Acin rort hr Acion Prir t Taken Presentation ~~~~~~~Portion Reles oto ase seIaigpartio LOSS-REDUCTION. Law 76 enables creditors to Submission to the Bank of The Government to submit a Exit of CCs placed under Reduction of employment in FINANCIAL DISCIPLINE enforce their rights. (Penalty acceptable FRPs for the core report to the bank surveillance from the enterprises placed under AND GOVERNANCE OF interest rate on arrears of group of 13 CCs. demonstrating, in a manner surveillance program (GD surveillance, as agreed with COMMERCIAL 0.15% per diem.) acceptable to the Bank, that 212195) except for those the Bank COMPANIES the 13 CCs have made referred to below, on account Bankruptcy Law has been substantial progress in of one of the following: Expedite measures to stem passed. implementing their FRPs, enterprise losses. including meeting the (i) privatization; 30 CCs were placed in a aggregate and specific As much as possible, special isolation program (GD benchmarks agreed with the (ii) reestablishment, to the accelerate privatization and 301/93) to prevent further Bank. satisfaction of the leave restructuring to new contamination of banks; Government and of the Bank, owners. recovery programs were Establishment of the legal Exit of at least 50 CCs from of a positive net cash flow; prepared by enterprise frame w o r k f o r t h e the surveillance program and Clarificationandenforecment management with technical surveillance regime established by GD 212/95, of the rights of creditors assistance financed by the (Ordinance 13/95). out of which at least 20 CCs, (iii) liquidation. against delinquent debtors. Bank. which have not been placed in isolation under GD 301/93, The Government and the Protection of debtors against Ordinance 13/95 creates an have been privatized or Bank wiU agree a list of up to creditors while in enablinglegalframeworkfora liquidated, while the 10 enterprises which will reorganization or in the special surveilance progamm, remainder of the other 50 remain in the surveillance process of rehabilitation. which would allow CCs have re-established, to program for up to one year participating SOEs to defer the satisfaction of the after third portion release. Develop an orderly market servicing their debts, pending Governmcnt and the Bank, a for inter-enterprise credit and negotiation of conciliation positive cash flow. reduce inter-enterprise agreements with the banks and arrears. with the other creditors; and Completion of 7 privati- Completion of additional 5 Completion of additional 10 suspension of non-guranteed zations and liquidations out privatizations or liquidations privatizations or liquidations Transparency and new credit. 151 CCs placed of the group of CCs placed in out of the group of CCs out of the group of CCs justification in budget under surveilance by GD isolation under GD 301/93. placed in isolation under GD placed in isolation under GD support. 212/95. SOEs required to 301193. 301/93. prpare FRPs with the objective to reduce losses and arrears and to genezatepositive cash flows. 9) 0 m otD D-,~  P y Isu o Objr k s Ackon: S d A ions FPrior to Third Ao Prior to Taken PrsnainPrinRlaePrtlo Rdels htngNt LOSS - REDUCTION. Boards of Directors fully Submission to the Bank of The Government to submit a Substantial progress by the 6 FINANCIAL DISCIPLINE staffed for most RAs. First acceptable FRPs for the core report to the Bank RAs towards phasing out AND GO-VERNANCE OF series of management contracts group of 6 RAs. demonstrating, in a manner unecomimic activities and REGIES AUTONOMES signed with managements. acceptable to the Bank, that improving their cash flow. New Performance Contracts the 6 RAs have made Reduce losses and arrears of are being designed. Financial substantial progress in regies autonomes. Limit and control and monitoring implementing their FRPs, ultimately reduce budgetary organized by sector ministries, including meeting the financing of their losses and MOF and Court of Account. aggregate and specific arrears. benchmarks agreed with the Major RAs included in the Bank. surveillance program. 00 t21t H X (D  Page 6 of 11 PolCy Is5UisA & bjeWves Measures Alrey Being Actions T.e.: For Boad A ts Por to Scond A:o r t Thirc Po Taken: e :: R - Re ::; Po-ti. : HARD BUDGET Adoption by the Government Substantial progress in Substantial progress in CONSTRAINTS ON RAs of a mechanism, acceptable implementation of the implementation of the AND CCs: CAPPING to the Bank, to forestall mechanism to forestall future mechanism to forestall future FISCAL CONTRIBUTION future build up of arrears in build up of arrears in the build up of arrears in the the energy sector, including energy sector, as measured energy sector, as measured Impose hard budget an agreement on benchmark against benchmarks agreed against benchmarks agreed constraint on the availability to be met. upon with the Bank. upon with the Bank. of budgetary or SOF resources to RAs and CCs An overall cap on Observance of the agreed Observance of the agreed placed in the surveillance Government and SOF caps on Government and SOF caps on Government and SOF program. financial support in 1995 to financial support to state- financial support to state- state-owned enterprises under owned enterprises. owned enterprises. the surveilance program established by Ordinance 13/95 for enterprises selected under GD 212/95, including specific caps consistent with the macro-economic adjustment program, on: (i) the PRF; (ii) budgetary subsidies and investment transfers; (iii) Government guaranteed new bank lending; and (iv) SOF corporate expenditures. Q>> (D Z 0 I-X  rolI'y 'Jam.", ' O s "''' '.' ' ' .t'',,'X..... ..''. .. ... . ..... Prio.Seco*d . .. , ... ,'' . ... __, .di.u. i,. T:Ake ...e ......... hu ~ ttf ies.Thdg rte BANK RESTRUCTURING Successive rounds of Specific loan4oss provisions AND PRIVATIZAT1ON jiagnostic studics, finaial by banks to be rendered tax audits and portfolio reviews by deductible according to an Restrueturing and thernajorbanks, haveresulted agreed phased-in schedule privatizstion of state-owned in detailed institutional dur'eg 1995 and 1996 as commercial banks which, development programs. follows: (a) during 1995-for inter alia, wiU reduce the loans in the loss (100% share of tihe state in the provision) and doubtful (50% banking sector. provision) categories; and (b) during 1996 and subsequent years-for the following categories of impaired credits [i.e., loss (100% provision), doubtful (50% provision) and sub- standard (20% provision)]. I NBR to issue circular Submission to the Bank of a Submission to the Bank of a requiring banks to undertake report from the NBR report from the NBR full loan-loss provisioning demonstrating the compliance denonstrating the compliance and requiring them to retain of the banks under NBR's of the banks under NBR's 50% of the net profit after supervision with the circulars supervision with the circulars tax until they have reached and prudential regulations on and prudential regulations on the minimum level of capital loan-loss provisioning, capital loan-loss provisioning, capital adequacy. adequacy and the distribution adequacy and the distribution of net profits, and describing of net profits, and describing Establishment of WODs in the measures taken by NBR the measures taken by NBR each of the major banks. against non-complying banks. againstnon-comnplying banks. CD' ozl wtZ  1 ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~. : . : ...: :: . .. . _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ .........Poaic Prog . . .... Take: e t Port:on R::ee portion Re: T n :ati:: P:rti-P Privatization of at least one Bank Privatization Task Force Finalization of a privatization Implementation of the RBD state-owned bank and (BPTF) established to develop action plan for RBD agreed privatization plan, as adjusted preparation of a second one and guide implementation of with the Bank and approved in agreement with the Bank, for privatization. the bank privatization strategy. by the shareholders, NBR and in order to reflect the the Government. Such mandatory provisions of the A bank will be considered as privatization plan to iaclude new Bank Privatization Law, privatized when at least 51% an offer for sale, listing on if and when enacted. of its shares has been the BSE and sale of at least transferred either to entities 10% of its shares by public Finalization of a privatization Implementation of the which are 90% in private offering, over and above action plan for the second privatization plan of the ownership, or to private those held by the POFs and bank to be privatized, to be second bank, as adjusted in individuals. its employees. agreed with the Bank, and agreement with the Bank, in approved by its General order to reflect the mandatory Assembly of Shareholders, provisions of the new Bank the NBR. Such privatization Privatization Law, if and plan to include an offer for when enacted. sale, listing on the BSE and sale of at least 10% of its shares by public offering, over and above those held by the POFs and its employees. An ongoing commitment from the Government that there will be no. recapitalization of banks by the state budget, by the NBR, or from extra budgetary funds except immediately prior to privatization or as needed upon a bank being intervened by NBR. z o z I-.  . . . -. , ' i W. E ; i ' ' ' ' t i' ' ' ' i ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ .......... toiyIw &MuisMsyJt Ain uu Bad Aot...... I'M S I FINANCIAL SECTOR Establishment of auction NBR to issue a circular for Submission to the Bank of a Submission to the Bank of a POLICY system for NBR refinancing phasing in the collateral- report prepared by NBR report prepared by NBR, credits. ization of its refinancing demonstrating progres s decmo ns tr at i ng f ull Achieve market-based credits to banks, as agreed satisfactory to the Bank in implementation of Regulationl positive real rates of interest with the World Bank. implementingRegulation3195 3/95 issued by NBR inl to protect value of local issued by NBR in respect of respect of collateralization ofl currency in the light of collateralization of NBR's NBR's refinancing credits tol anticipated inflation and to refinancing credits to banks. banks. rationalize the allocation ofl financial resources forl investment.l Limit banks' utilization of refinancing credits froml NBR without adequatel collateral. Lfl I~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~.. ........ Improve the prudential NBR has issued prudential NBR to have undertaken to The staffing of thel regulation and supervision of regulations covering: carry out annual on-site Supervision Department of banks by NBR. (a) licensing, (b) loan inspections of all banks. NBR shall be ::icreased to its exposure limits, (c) currency Such inspections to include, full complement of around 70 exposures, (d) insider where appropriate, a critical staff. lending/connected lending assessment of the banks' (e) capital adequacy, and latest semi-annual portfolio NBR to submit to the Bank a NBR to submit to the Bank a (f) loan classification and reviews and the associated report demonstrating that on- report demionstrating that the provisioning. Rules relating to loan-loss provisioning site inspections of banks are requiredon-siteinspectionsof ownership of banks by non- recommended, being carried out, banks are takmng place. banks and equity holdings of banks in non-banks are NBR to issue a regulation Submission to the Bank of a covered in the basic requiring mandatory report prepared by NBR legislation. independent external audits demonstrating compliance of of banks. banks with mandatory external audit requirements. ozt H .. ... .........H 1  _ _ _ _ _ _ _ _ _ _ _ _ _i.ogr.&s.... ...-. . T.e . ...........onR haInNrlo Reduce CEC's share of Household savings with CEC Endorsement by the Implementation of the deposit deposit-taking among the included in bank liabilities for Government and NBR of a insurance scheme. population, and provide a which NBR reserve detailed proposal for a level playing field for requirements apply. deposit insurance scheme deposit-taking by all banks. agreed with the Bank. Commercial banks now competing with CEC for household deposits. Improve the speed and NBR Regulation No. 10/1994, efficiency of payments by regarding a paper-based introducing a modern multilateral compensation of payments system. interbank payments, became operational on April 3, 1995. A clearing sitting is held daily, under the auspices of the Bank Setlcments Department of the NBR, in Bucharest and in 41 l Judets. In the medium term, NBR intends to launch a nationwide electronic-based payments system. To establish an effective and Agreement in principle by sustainablecreditinformation NBR and the Bankers bureau to strengthen the risk Association on the merits of management of banks. establishing a credit information bureau (CIB). oz otD  ACCOUNTING AND New accounting standards and Issuance of a regulation by AUDITING an Accounting Law have been the NBR introducing a adopted. The new standards uniform chart of accounts for I m p lem en t s o u n d, are based on EU standards. banks, in accordance with internationally recognized internationally accepted accounting standards in As from January 1, 1994, all accounting standards. enterprises and banks, sup- enterprises required to prepare ported by competent their accounts in accordance accounting and auditing with the new chart of standards. accounts. The Law organizing the profession of accountants and auditors has been passed. Establishment of Romanian Association of Certified Accountants and Auditors. CAPITAL MARKET Ordinances 18 and 24 and Opening of the Bucharest subsequent regulations Stock Exchange Establish Capital Market, adopted. Security Exchange including the BSE and the Act approved by Parliament. National Securities NSC established. Commission (NSC). Settlement of Overdue In December 1994, the The Government to issue a The Government to issue a Government Obligations to Government settled its overdue report stating that it is current report stating that it is current Banks obligations to commercial in all its payment obligations in all its payment obligations banks, as required under Law to the banks, including to the banks, including 7/92. principal and interest due to principal and interest due to banks under Law 7/92 and banks under Law 7/92 and Ordinance 1/94. Ordinance 1/94. m.\pt\rom\fesal\matrix. 195 (D November 8, 1995 otC t.tI  -55- ANNEX 3 ROMANIA: Fund Relations Page 1 of 1 (As of April 30, 1995) I. Membership Status: Joined 12/15/72; Article KIV II. General Resources Account: SDR Millio % Ouota Quota 754.10 100.0 Fund holdings of currency 1,590.69 210.9 III. SDR Department: SDR .illion . Allocatl2n Net cumulative allocation 75.95 100.0 Holdings 24.46 32.2 IV. Outstandinz Purchases and Loans: SDR illion Ouota Stand-by arrangements 524.11 69.5 Contingency and Compensatory 123.95 16.4 Systemic TranAformation 188.53 25.0 V. Financial Arrangements: Expira- Amount Amount Approval tion Approved Drawn Zyp e Date Dare (SDR Million) (SDR Killion) Stand-by 5/11/94 12/10/95 131.97 56.56 Stand-by 5/29/92 3/28/93 314.04 261.70 Stand-by 4/11/91 4/10/92 380.50 318.10 VI. Projected Obligations to Fund (SDR Million; based on existing us- of resources and present holdings of SDRs): Overdue Forthcoming 4/30/95 1995 l2.6 122Z 12.9 12i. Principal -- 175.9 245.4 98.4 92.3 83.1 Charges/Interest -- 38.6 57.0 26.0 20.6 _ 14.7 Total _ 214.5 282.4 124.4 112.9 97.8 Prepared by TRE-AFRP  -56- ANNEX 4 Page 1 of 1 ROMANIA: Key Economic Indicators 1989 1990 1991 1992 1993 1994 1995 NATIONAL ACCOUNTS (as % GDP at Current Market Prices for 1989-1992, and at Factor Cost for 1993-1995) Gross Domestic Product 100 100 100 100 100 100 100 Agriculture and Forestry 14.4 21.8 18.9 19.0 21.0 20.1 20.1 Industry 46.2 40.5 37.9 38.3 32.4 32.3 32.0 Services and Others 26.0 31.9 39.1 45.4 43.6 44.2 43.0 Consumption 70.5 79.2 75.9 77.0 76.0 75.1 77.1 Gross Investment 26.8 30.2 28.0 31.4 29.0 26.9 27.5 Gross Domestic Savings 31.3 20.8 24.1 23.0 24.0 24.9 22.9 Current Account Balance 6.1 -8.6 -4.7 -7.8 -4.7 -1.8 -4.7 Exports GNFS 20.9 16.7 17.6 27.8 23.0 24.9 26.2 Imports GNFS 18.2 26.2 21.5 36.4 28.0 26.9 30.8 Memorandum Items Gross Domestic Product 800 858 2,204 6,029 20,051 49,795 68,493 (in Lei bn, current Prices) Gross Domestic Product 41,347 38,248 28,851 19,579 26,381 20,086 33,108 (in US$ mn, current prices) GDP (Real annual growth -5.8 -5.6 -12.9 -8.8 1.5 3.9 5.0 (rate in %) PUBLIC FINANCE (as % of GDP at Cur. Prices) Total Revenues 51.0 39.8 39.3 37.6 33.6 31.6 34.8 Total Expenditure 42.8 38.7 38.7 42.2 33.7 33.5 37.6 Fiscal Surplus(+)/Deficit(-) 8.2 1.1 0.6 -4.6 -0.1 -1.9 -2.7 MONETARY INDICATORS Broad Money/GDP (%) - 59.9 46.9 31.0 22.7 21.4 20.0 Growth of Broad Money(%) - - 101.2 79.6 141 138 29.0 BALANCE OF PAYMENTS (in US$ mn) Merchandise Exports 10,487 4,266 4,266 4,364 4,882 6,067 7,424 Merchandise Imports 8,437 9,114 5,372 5,784 6,012 6,550 8,881 PRICE INDICES Real Exchange Rate - 102.5 125.9 178.1 131.4 116.7 116.3 (average, Lei/US$ /a) CPI Inflation - 5.1 174.5 210.7 290.3 137.0 31.0 (period average, %) CPI Inflation (e.o.p., %) - - 223.0 199.5 295.6 62.0 25.0 GDP Deflator (%) - 13.6 194.9 200.0 227.7 139.0 31.0 a/ A decrease in Lei/US$ denotes appreciation  -57- ANNEX 5 Page 1 of 1 ROMANIA: External Financing Requirements and Projected Sources of Financing (in US$ million) 1999- 2002- 1994 1995 1996 1997 1998 2001 2004 USES Current Account Deficit 516 1,542 1,295 1,062 878 670 228 of which interest on gap loan 0 0 21 38 74 151 229 Repayment of MLT Loans Public & Publicly Guaranteed 253 372 372 507 651 982 1,430 1. Official Creditors 184 241 230 301 398 552 716 a. Multilateral 13 101 137 195 243 195 310 of which IBRD 0 0 0 31 80 108 191 b. Bilateral 171 140 93 106 155 357 406 2. Private Creditors (1) 69 131 142 206 253 430 714 Private Non-Guaranteed 20 28 35 28 27 31 38 IMF Repurchases 134 387 366 147 138 201 42 Total Repayments 407 787 773 682 816 1,213 1,511 of which gap loan 0 0 0 50 90 299 639 Increase in reserves 1,159 -424 303 506 631 507 520 Total financing requirements 2,082 1,905 2,371 2,249 2,325 2,390 2,259 SOURCES Foreign Direct Investment 341 367 487 497 507 527 560 Disbursements of MLT Loans Public & Publicly Guaranteed 1,016 1,282 1,629 1,687 1,821 1,863 1,700 1. Official Creditors 776 724 1,234 1,072 1,164 1,068 1,066 a. Multilateral 391 422 662 790 844 762 764 of which IBRD 263 182 352 470 484 450 464 b. Bilateral 385 302 572 282 320 306 302 2. Private Creditors (2) 240 558 395 615 657 795 634 Private Non-Guaranteed 99 0 0 0 0 0 0 Total from Long-Term Loans 1,115 1,282 1,629 1,687 1,821 1,863 1,700 Net Short-Tern Capital -9 65 0 0 0 0 0 Total Disbursements (LT+IMF+ST) 1,457 1,403 1,629 1,687 1,821 1,863 1,700 Errors and Omissions (3) 284 135 -15 -1 -3 0 0 Total financing sources 2,082 1,905 2,371 2,249 2,325 2,390 2,259 I/ Includes repayments of gap fill starting in 1997. 2/ Includes gap fill for 1995 to 2004 (0 in 1994, 297 in 1995, and 243 million in 1996). 2/ Includes net credits extended, bilateral clearing agreements and other financing sources m:\pt\rom\fesal\annex5pr.xls  -58- SCHEDULE B Page 1 of I ROMANIA Financial and Enterprise Sector Adjutment Loan SUMMARY OF PROPOSED PROCUREMENT ARRANGEMENTS (US$ million) Procurement Matters' ICB2 Othe,9 Total 200.0 80.0 280.0 m:\ptNrom\fesal\scedb.pr 1/ Estimated amounts. Z/ [CB for contracts of US$ 3 million or more. 3I Minimum contract amount: US$250,000 International shopping for contracts of US$250,000 to US$3 million  -59- SCHEDULE C Page 1 of 1 ROMANIA Financial and Enterprise Sector Adjustment Loan TIMETABLE OP KEY PROCESSING EVENTS 1. Time taken to prepare: 43 months 2. Project prepared by: Government with IBRD assistance 3. Identification mission: January 15, 1992 4. Appraisal mission: October 1994 5. Negotiations: September 19 - 25, 1995 6. Planned Board Presentation: January 11, 1996 7. Planned Effectiveness: January 31, 1996 8. Expected Project Completion: June 1997 9. Relevant SAR: None m:\pt\rom\fesal\schedc.pr  -60- SCHEDULE D THE STATUS OF BANK GROUP OPERATIONS IN ROMANIA Page 1 of I A. STATEMENT OF BANK LOANS (as of September 30, 1995) Amount (S milion) Fiscal (less cancellation) Loan No. Year Bonower Purpose Bank Undisbursed Twenty-sven non-pooled loans and seven pooled loans 2582.22 0.00 were committed fion FY74 to FY82. These loans were fully disbursed by end-FY87 and fully prepaid by FY89. Since then a SAL was approved in FY92; it closed and fully disbursed this FY. 3363-RO 1991 Romania TechnicalAssistance 180.00 4.18 and Critical Imports 3409-RO 1992 Romania Health Rehabilitation 150.00 86.81 3486-RO 1992 Romania Private Farmer Support 100.00 27.89 3593-RO 1993 Romania Transport 120.00 73.35 3723-RO 1994 Romania Petroleum Sector Rehabilitation 175.60 174.61 3724-RO 1994 Romania Education 50.00 49.50 3735-RO 1994 Romania Industrial Development 175.00 175.00 3849-RO 1994 Romania Employment & Social Protection 55.40 55.40 3936-RO 1995 Regia Autonoma Power Sector Rehabiltation 110.00 110.00 de Electricitate Subtotal 1116.00 756.74 TOTAL 3698.22 of which has been repaid 2182.22 TOTAL now outstanding 1516.00 Amount sold of which has been repaid 19.78 TOTAL now held by IBRD 1516.00 TOTAL Undisbursed 756.74 THE STATUS OF BANK GROUP OPERATIONS IN ROMANtA B STATEMENT OF IFC INVESTMENTS (as of September 30, 1995) Amount (Smillion) Date Borrower Purpose Loan Equity T 1992 ALCATEL Communication 5.85 0.69 6.54 1994 ROMLEASE Leasing Companies 0.00 0.45 0.45 Total Gross Commitments Less: CaneUllations, 5.85 1.14 6.99 terminations, exchange, adjustments, repayments, write-offs and sales 5.27 0.00 5.27 Total Commitments now by IFC 0.58 1.14 0.00 Total Undisbursed IFC 0.00 0.16 0.00 Total Outstanding IFC 0.58 0.99 0.00 October 12, 1995 M:\ROM\OTHER\SBGO.XLS  IBRD 27424 22 26 ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~28' :t a .- U K R A IN E - L *RA 48 -- - UKRAINE -mL'ea '~ ROMAN IA 4 T. K.I-e'xn o SELECTED cmEs H U N G A R Y .s t - N .. / @ c T SA'2i S COUNTY (JUDET) CENTERS M A R A AA E - etae6 * NATIONAL. CAPITAL - ~ ~ ' "'[i La laMa re ^ t SUCEARs A >@sv a>.cn. * O -0 EXPRESSWAY - .\ J -TMAJOR ROADS * -\ * 9 t j r , K l s h m TK PORTS ---B.! S t Xf y ~ rDl5Tff!T:_ V _za A t X Q * 7 / -~- RIVERS To Sudopess f - Z a / *- U - - - . / COUNTY (JUDETf BOUNDARIES , S cdea , A 4 v S i8|5,Orno -. - , > / | _ . INTERNATIONAL BOUNDARIES - .t - 2 - / > \ ,~~~~~~~~~~~~~N'Eh'A T Pio Ira- ' * 2<~-' i t , : ' / ( _-.J. / ( T. 8-6p1 6 * M UJ R E. S B.C. adI qtMro7HARC-HITA . - r- C / D. /0 l 20 30 40 50 S 0 / K~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ILDEERS A -- fr:? , 0 0 -0;, , &1 \ -A c o U R ALN Arod ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~46- nnoe~~~~~~~~on,n, ~~~~~~~~~ - ~ ~ ~ ~ ~ ~ ~~-oiN U KRA IN E C ~~~~ HUNEQPAR'A-~ BASOV r, CLnJ \ZAU B( 6 -!Salgtnda sz9ER/N4K / I-' * ~ P>'flO - -_ oARGES - F~~~~~C, A D RAEHPOVFg5tT\trt/i_A.br YUGOSLAVIA _ ~ ,. C..v/occQ ; = /-J/C[UR7Xi ) > T J c_ _ ,~~~~~~~~~~~~~It, n>J * _\j/-, 22 P_I _ _, 0oatate ondEP onyh nobe 'nfrmo,o ,how on 'Buchc/n'e_slVrn ',