Moldova - Country assistance strategy

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 15499-ND MEMORANDUM OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORES ON A COUNTRY ASSISTANCE STRATEGY OF THE WORLD BANK GROUP FOR THE REPUBLIC OF MOLDOVA April 5, 1996 Country Department IV Europe and Central Asia Region 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.  DATE OF LAST CAS September 30, 1993 (limited) CURRENCY EQUIVALENTS (April 1996) US$1.00 = Lei 4.5 FISCAL YEAR January - December 31 METRIC EQUIVALENTS I meter (m) = 3.28 feet I square meter (sq.m) = 10.76 square feet 1 kilometer (km) = 0.62 miles I square kilometer = 0.386 square miles ABBREVIATIONS AND ACRONYMS CIS - Commonwealth of Independent States CEM - Country Economic Memorandum DAC - Development Assistance Committee (OECD) EBRD - European Bank for Reconstruction and Development EFF - Extended Fund Facility ESW - Economic and Sector Work FSU - Former Soviet Union GDP - Gross Domestic Product IBRD - International Bank for Reconstruction and Development ICR - Implementation Completion Report IDF - Institutional Development Fund IFC - International Finance Corporation IFI - International Financial Institution IMF - International Monetary Fund MIGA - Multilateral Investment Guarantee Agency NBM - National Bank of Moldova NGO - Non Government Organization OECD - Organization for Economic Cooperation & Development SAL - Structural Adjustment Loan SECAL - Sector Adjustment Loan STF - Systemic Transformation Facility UNDP - United Nations Development Program USAID - United States Agency for International Development WTO - World Trade Organization  FOR OFFICIAL USE ONLY MEMORANDUM OF THE PRESIDENT OF THE IBRD TO THE EXECUTIVE DIRECTORS ON A COUNTRY ASSISTANCE STRATEGY OF THE WORD BANK GROUP FOR MOLDOVA Table of Contents A. RECENT DEVELOPMENTS ........................................................... 1 B. THE REFORM AGENDA ..........................................................3 Macroeconomic Stabilization ...........................................................3 Private Sector Development ..........................................................4 Public Sector Restructuring and Improvement of Financial Discipline .........................................7 Poverty Alleviation, Social Protection and Human Resource Development .................................. 8 C. ECONOMIC PROSPECTS AND CREDITWORTHINESS .......................................................... 10 Strong Reform Scenario .......................................................... 10 Muddling Through .......................................................... 13 D. BANK GROUP ASSISTANCE STRATEGY ........................................................... 14 A Three-Pronged Assistance Program .......................................................... 16 Portfolio Implementation .......................................................... . 19 Box - The Situation in Transnistria and the Bank's Program ..................................................... 20 Risks and IDA Eligibility ........................................................... 22 E. AGENDA FOR BOARD CONSIDERATION .......................................................... 22 ATTACHMENTS Table: Framework for the Country Assistance Strategy Annexes Annex Al Moldova - Selected Indicators of Bank Portfolio Performance and Management Annex A2 Moldova - Bank Group Fact Sheet FY 1993-1999 Annex A3 Moldova - Summary of Economic and Sector Work Annex A4 Moldova - Priority Poverty Indicators, Resources and Expenditures Annex A5 Moldova - Key Indicators Annex A6 Moldova - Key Exposure Indicators Annex A7 Status of Bank Group Operations in Moldova Annex C l Moldova - National Accounts Annex C2 Moldova - Exports and Imports Annex C3 Moldova - Balance of Payments Annex C4 Moldova - External Debt Stocks and Flows Annex C5 Moldova - Public Finance Annex C6 Moldova - Monetary Survey Annex C7 Projected Arrears, Rescheduling, and Reductions in Debt and Debt Service 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 Word Bank authorization.   MEMORANDUM OF THE PRESIDENT OF THE IBRD TO THE EXECUTIVE DIRECTORS ON A COUNTRY ASSISTANCE STRATEGY OF THE WORD BANK GROUP FOR MOLDOVA A. RECENT DEVELOPMENTS 1. A limited Country Assistance Strategy (CAS) was presented to the Board with the Rehabilitation Loan (3653-MD) in October 1993. The Bank's initial assistance for Moldova aimed at providing balance of payments financing in support of the Government's reform effort, and helping the country overcome the consequences of two severe droughts in 1992 and 1994. 2. Moldova is a small, densely populated country with great agricultural potential. It is situated on the western edge of the former Soviet Union (FSU), bordered by Ukraine and Romania. Over 50 percent of the ethnically diverse population of 4.4 million lives in rural areas. Two-thirds are ethnic Moldovans, 14 percent Ukrainian, 13 percent Russian, 4 percent Gagauz (a Christian Turkic people), and 2 percent Bulgarian. Endowed with rich agricultural land and a temperate climate, Moldova's role in the FSU was that of a producer of raw and processed foodstuffs (primarily grapes, grains, wines, fruit, vegetables and livestock). Agriculture and agro-processing represent about 60 percent of GDP. The country is almost wholly dependent on imports for its primary energy requirements and inputs for its manufacturing industries. 3. Moldova's independence was followed by a period of political instability. In early 1992, the year following independence, disagreements over economic policies, together with ethnic factors. resulted in an armed conflict between the regions on the right and left (Transnistria) banks of the Nistru river. Since the cease-fire in July 1992, the Moldovan Government has made notable efforts to solve differences by peaceful and constitutional means, in both Transnistria and in the Gagauz region in the south. The production, trade and transport links between the different regions are functioning well, and progress has been made on the political front. Gagauz identity has been accommodated by partial self-government within the constitution and, aided by an agreement to withdraw Russia's 14th army from Transnistria over a three year period, intensive talks have taken place on the reintegration of this region into Moldova. On July 5. 1995, the President of the National Bank of Moldova and the head of the Transnistrian central bank signed an agreement on the parallel circulation for non-cash transactions of the Moldovan Leu and local coupons on the left bank of the Nistru river. This appeared to be an important first step towards the adoption of economic reforms in Transnistnra. However, the situation started changing in late 1995. Due to increased political uncertainty, resulting from the Russian Duma's refusal to ratify the agreement to withdraw the 14th Armny, the momentum towards a settlement of the Transnistria problem has slowed.  Real GDP Growth 20 1990 1 991 19 19 ~~99O~99~~ ~9194 199 4. The economy also suffered from a series of shocks that caused a precipitous decline in living standards. Moldova experienced one of the greatest terms of trade shocks--estimated as equivalent to a 30 percent decline in 1992 income--in the FSU. This was due to the move towards world prices in intra-FSU trade, especially for energy. The balance of payments position deteriorated sharply, as energy rose from 16 percent of total imports in 1991 to 40 percent in 1994. As a result, the current account deficit increased from US $39 million in 1992 to US $94 million (almost 5 percent of GDP) in 1994. The budget deficit also increased rapidly to 22 percent of GDP in 1992 and inflation accelerated. reaching 1,200 percent a year. Natural calamities--floods, hurricanes and droughts in 1992 and 1994--further exacerbated the situation. Between 1991 and 1994, output and real wages fell by 60 percent. Total employment decreased from over 2 million people in 1991 to around 1.3 million in 1994, although open unemployment remained low at less than 2 percent. Living standards fell sharply, poverty increased and the quality of social services declined. 5. Moldova was one of the first FSU governments to take decisive action to stabilize the economy. The drought of 1992 and the armed conflict with Transnistria delayed the implementation of stabilization policies up to 1993. At that time, however, the Government moved quickly, supported by the IMF, and important progress was achieved. The budget deficit was reduced from more than 23 percent of GDP in 1992 to around 8 percent of GDP in 1994, mainly by cutting government spending and transfers to public enterprises from 44 percent of GDP in 1992 to 25 percent in 1994. Monetary policy was tightened and a new currency (the leu) was introduced on November 29, 1993. These policies led to a reduction in inflation from a monthly rate of 37 percent in January of 1993 to less than 1 percent in April of 1995. However, in October and November 1995, inflation showed a sudden surge with monthly rates of 3.2 and 6 percent respectively. This can be only partly explained by seasonal factors and administered price increases. Another factor might have been over-estimation of the demand for the leu in Transnistria. The National Bank of Moldova has since tightened monetary policy, and inflation declined to 2.9 percent in December, and is now expected to fall to its previous levels. -2-  Annual Inflation Rate 1400 ... .. .. .. .. . 1200 1000 . . . ... 800 6 0 0 .. .............. .. 400 ............ . o . - . . U I -.,..:-:.~~~~~~ .... .. . .... 200W 1992 1993 1994 1995 6. The Government is also implementing structural reforms, and is achieving good results. Enterprise privatization is proceeding at a pace that should ensure that all industrial and commercial enterprises will be in private hands within two years. Prices are being liberalized and the legal and regulatory frameworks for a market economy are being put in place. Given the small size of its economy and domestic markets, the Government assigns high priority to integrating Moldova into the global economy and opening up the trade regime. In addition to working very actively with the Bretton Woods institutions, Moldova was the first FSU country to be admitted to the Council of Europe, it is pursuing WTO membership. and it has signed a trade and political cooperation agreement with the European Union. These policies are starting to yield results. After falling by more than 22 percent in 1994, GDP stopped declining in 1995. Helped by a good harvest, agricultural production has turned around in the last quarter, growing by 4 percent overall in 1995. Industrial production is estimated to have fallen by about 7 percent in 1995. But there are signs of a tumaround as industrial output in October and November was 7 and 15 percent higher than in the same months of 1994. Moreover. exports are estimated to have increased by 7 percent in real terms in 1995. with the share of exports to non-CIS countries reaching 40 percent. B. THE REFORM AGENDA 7. The Government's overall objective is to re-establish sustainable economic growth. This will be achieved by allowing the private sector to expand. based on exports and services. The reform agenda to support this objective covers four broad areas: macroeconomic stabilization; private sector development; public sector restructuring and improvement of financial discipline; and social protection and human resource development. While substantial progress has been made in these areas (paras. 5 and 6), further steps are still required to move the economy onto a path of sustainable growth. Macroeconomic Stabilization 8. Moldova has successfully implemented IMF programs beginning with an STF in September of 1993, followed by two Standby programs. While this reflects the Government's commitment to stabilizing the economy, the success achieved remains fragile. The sudden surge of inflation at the end of 1995 indicates that Government must remain very vigilant in this area. Control of the money supply and the reduction of inflation were accompanied by the build-up of domestic payment arrears. The fiscal deficit was financed, in part, through the accumulation of arrears, equivalent to nearly 1.4 percent of GDP in 1994: due to public workers, utilities, suppliers - 3 -  of capital goods. and to the Social Fund. Similarly. Moldova has had difficulties remaining current on its payments for energy imports. especially for natural gas. 9. Efforts are underway to strengthen the stabilization program, and the preparation of a three year EFF is very advanced. The National Bank of Moldova is committed to a monetary policy framework that is consistent with the objective of bringing inflation back to less than one percent a month during 1996. This framework will be supported by appropriate fiscal policies. The Government's fiscal program requires limiting the deficit to around 4 percent of GDP in 1996; it was estimated to be around 5 percent in 1995. The level anid composition of public expenditures are being reviewed. Initial spending cuts were achieved by the near elimination of net lending to enterprises, which was at subsidized interest rates. Now there is a need to examine other expenditure items, in order to improve drastically their targeting. Government revenue also needs to be raised from its currenit low level of 17 percent of GDP. Therefore, the Government is reducing tax exemptions, for example the personal use exemptions for imports. Moreover, a number of legislative and administrative iitiatives are undenvay to provide the basis for a modern tax administration, including: requirements for filing returns and for providing relevant information when requested, an authorization for the tax authorities to assess penalties, and the imposition of criminal sanctions for tax evasion. 10. In order to ensure that stabilization is durable it is also necessary to deal with the arrears problem and to harden the budget constraint facing enterprises. There has been substantial progress in hardening the budget constraint on enterprises, with tight conditions for new credit and the withdrawal of subsidies. In the absence of a significant real output response, the pressure resulting from the monetary and fiscal efforts has been translated into an outbreak of arrears. Foreign debt for energy supplies has accumulated; the financial position of the energy utilities continues to deteriorate; (receivables fall short of payables by over $120m, and many receivables are not recoverable), the Government budget has become payer of last resort for energy used but not paid for by households, farms anid enterprises, and is consequently squeezed in its abilitv to pav wages, pensions and other benefits; bank portfolios carry too many loans in arrears to slow-adjusting enterprises so that profitable activities are crowded out; enterprise competitiveness suffers from too high a level of energy intensity in production. The response to this problem needs to be multi-faceted. Efforts to promote payments discipline and introduce meters for principal consumlers in the energy sector need to continue. At the same time, the underlying problem of enterprise adjustment, needs to be tackled through restructuring or closure. Positive efforts are also needed to promote the adjustment of Moldovan enterprises through technical assistanice and dissemination of best practice. Private Sector Development 11. The Government realizes that growth can be achieved only by unleashing a dynamic private sector that can respond to the new market signals. This requires (i) privatization; (ii) establishing a legal and regulatorv framework conducive to pnvate sector development; (iii) liberalization of markets; and (iv) developing the financial sector. 12. Accelerating enterprise privatization is a Government priority. Initially the implementation of the 1993/94 Privatization Program was slow and came to a virtual halt at the beginning of 1994 as parliamentary elections approached and the agencies involved became highly politicized. However, after the elections, the new Government set up a Ministry of Privatization and State Property Administration, streamlined the regulatory framework, and mobilized broader - 4 -  public support for the program. Enterprises were required to prepare their own privatization plans. As a result, the pace of privatization picked up and the 1993/94 program was completed by mid- 1995. This was accomplished through mass privatization, using patrimonial bonds (vouchers). The new 1995/96 Privatization Program was adopted by Parliament in March 1995. The implementation of this program would result in virtual completion of privatization of Moldovan industry and retail within two years. The first part of this program completed the voucher privatization in November 1995, transferring over 70% of industrial enterprises into private hands. The Govemment realizes, however, that mass privatization of larger enterprises does not, in the short run, produce the concentration of ownership, new management, or new capital necessary for efficiency improvements. Hence, the new Program provides also for cash auctions and negotiated direct sales to domestic and foreign core investors. The first international tender, for privatization of the tobacco industry, was initiated in December 1995. 13 Land privatization is critical to the growth of the agricultural sector and the whole economy. Land reform and restructuring of farms has proceeded fairly slowly. The first stage of land refonm, now substantially complete, distributed land for household plots (average size 0.3 ha) to the rural population. The second stage consists of farm privatization. It began in 1992 but was suspended in 1994 in the face of political opposition. It was resumed in mid-1955 after Parliament amended the Land Code to extend the circle of eligible people for free land entitlements, limit the minimum size of land allowed to be taken out of a collective fanm, and require that only a "qualified fanner" certified by local authorities can manage any of the newly formed fanms. Those .amendments seriously compromised the rights of individuals to exit from a large-scale fanm and to establish a new private fanm. As a result, true private fanming--defined as individual fanms and fanmer associations--only covers 3.7 percent of agricultural land in Moldova. 14. Positive steps have been recently taken in the area of land refonr. The Land Code introduced post-independence established a moratorium on selling any land received under privatization and land reform measures until 2001. The moratorium for urban land, as well as household plots and orchards was lifted on January 1. 1995. This measure has already created a limited land market in Moldova. Selling of land shares inside the large-scale farming structures has recently become possible. and the Govenmment has decided to support the President's proposal to Parliament to pennit immediate trading of rural land parcels. It is now the Govenmment's stated policy that fanr land should be treated under law as any other tradable commodity. Moreover, the Constitutional court has declared, in January 1996, the restrictions on exit from the ex-collective farms unconstitutional. The Government and Parliament have given assurances that the Court's decision will be respected. However, the modalities for implementing this decision still need to be developed. 15. Efforts are being taken to strengthen the legal and regulatory framework for private sector development. New entrants, foreign as well as domestic, are expected to contribute as much or more to private sector development as privatization. This is particularly true in the service sector, which is beginning to show its potential as a source of growth and employment. New entry has, however, been slow due to: (i) difficult access to urban real estate; (ii) lack of a market for capital equipment (held by larger enterprises even if unused); (iii) non-transparent and complex government regulations at entry, as well as complicated requirements for tax administration. The Govenmment is starting to address these problems. It is improving the transparency and simplicity of company registration and licensing, adopting a new streamlined bankruptcy law and reviewing the collateral law. - 5 -  16. Price liberalization for the vast majority of goods and services has been essentially completed. Prices for a small number of public services, electricity and gas remain controlled and margin controls remain on some basic goods. Export quo-as, licensing requirements and minimum reference prices have been removed. Similarly, import licenses were abolished, except in the cases of goods affecting national securitv and goods subject to medical or cultural regulations. Import tariffs have been frequently modified since November 1993, which created an atmnosphere of uncertainty and discouraged the expansion of trade. The Government is now committed to maintaining the new tariff schedule. as introduced on December 1. 1995. This schedule has a maximum tariff of 20 percent except for a small number of luxury goods (audio and video equipment, and luxury cars). The foreign exchange market was also liberalized and Moldova accepted in July, 1995. the obligations under Article VIII of the Articles of Agreement of the IMF, resulting in current account convertibility of the Leu. 17. Liberalization is particularly important for agricultural development. Although necessary, price liberalization alone has not resulted in market and competitive forces that provide efficient-pressures for sector restructuring. In order to increase international competitiveness and efficiency in agriculture. short- to medium-term strategies will also focus on creating a working market both for agricultural products and inputs. Important steps toward liberalizing the supply and distribution of inputs and outputs were taken with the break-up and inclusion in the 1995-1996 privatization program of Cereale and Fertilitatea, the former state trading monopolies for grains and grain products and fertilizers and agro-chemicals. 18. An efficient and sound financial sector is necessary for private sector development in agriculture and industry. Important strides have been made in this area. The Government eliminated directed and preferential credit in mid-1993, leaving allocation of credit and setting of interest rate levels to the credit auction. Gradually, new and improved prudential banking regulations are being introduced, the most important one being the regulation on risk-weighted capital adequacy. The introduction of the "Law on the National Bank of Moldova" and the "Law on Financial Institutions" enhances the autonomv and the enforcement powers of the National Bank. These steps have brought first signs of adjustment in the financial sector. Some banks have widened their owvnership structure and increased capital bv attracting small private investors. efforts to strengthen the capital base are evident in a number of other banks. 19. However, the balance sheets of many commercial banks continue to have an overhang of non-performing loans, reflecting weak financial discipline and rising inter-enterprise arrears which were around lei 1.7 billion in mid-1995. This may explain why the spread between bank deposit and lending rates have remained high, around 10 percentage points a month in mid-1995. The National Bank is responding to this situation by strengthening the banking supervision department both in terms of staffing and training programs. At the same time, new loan quality classification guidelines have been implemented and banks are now required to publish a monthly statement of their capital balances. Agreements with under-capitalized banks have been concluded under which these banks are subject to restrictions on their acceptance of deposits, loan activities and payments of wages and dividends. Further steps now being implemented in this area include: the introduction of internationally recognized bank accounting standards; the introduction of improved reporting requirements and inspection procedures and the development of plans to strengthen the banks' capital base. -6 -  Public Sector Restructuring and Improvement of Financial Discipline 20. Private sector development muist be accompanied by the restructuring of the public sector and the redefinition of its role to that of supplying key physical and social infrastructure. In the present context of Moldova priority needs to be given to the reallocation of government spending, energy sector adjustment, and re-orienting (he role of the public sector. 21. The Government has embarked, with Bank support, on a comprehensive review of public expenditures, with the aim of identifying the macroeconomic constraints on the size of public expenditure and the deficit; to review the allocation of expenditures; and to improve the budget process and cost control. On the macroeconomic front, the objective is to identify the fiscal stance consistent with sustained creditworthiness and low inflation. On the structural side, the aim is to support adjustment by identifying and analyzing the structural shifts that need to take place to make the pattern of Govermiient expenditure appropriate for. and supportive of, a market economy. This will include reconmiendations on the reallocation of expenditures across sectors and also by type. Finally, the Government is considering institutional reforms needed to implement its priorities and ensure that fiscal policy becomes a more effective instrument. This will mean establishing the institutions, criteria and mechanisms needed to ensure that Government expenditure is appropriately defined and allocated and effectively controlled. Institutional reforms would also imply greater transparency, which is an important objective in view of the disquieting rumors of official corruption. 22. The financial crisis in the energy sector has escalated into the most serious macroeconomic problem currently facing Moldova. The crisis manifests itself most obviously in the growth of external borrowing for energy consumption, in particular from external fuel suppliers and international anid domestic banks. Total net debt for the gas and power subsectors is estimated at US$ 413 million by end- 1995, making Moldova one of the largest energy debtors per unit of GDP in the FSU. The energy debt arises from a complex number of financial issues, but can be simplified into two main problems: growth of "covered" debt representing non-payment of energy bills by consumers, and growth of "uncovered" debt representing financial losses due to inadequate tariffs, unmetered energy, theft, and exchange rate losses. Unless all tariffs, including residential ones, are raised uncovered debt could reach US$ 212 million by the end of 1996 even after taking into account US$ 52 million of debt relief which Russia's Gazprom has agreed to give in exchange for 51 percent of Moldova's gas transmission assets. This level of uncovered debt will continue to be a drain on economic recovery in Moldova, requiring either substantially higher tarffs in the future to pay off the debt or additional transfers of prime assets. Moreover, the energy debt problem has led to frequent energy supply disruptions and higher costs for energy, thus penalizing viable enterprises as well. 23. The Moldovan authorities and the Bank worked closely to develop a comprehensive framework for financial rehabilitation of the energy sector. This resulted in an action plan that would concentrate first on ensuring that the energy companies can cover their current costs and then on resolving issues related to prior debts. To limit the growth of "covered" debt the Government aims during 1996 at increasing collection to 100 percent of billing, with cash collection amounting to at least 70 percent of total collection. Concomitantly, the problem of increasing "uncovered" debt will be dealt with by setting electricity, gas and heat tariffs during 1996 at levels that would cover all cash operating costs, and by end-1997 to cover all costs of operation including the costs of production, operations and maintenance, depreciation, interest charges, a bad debt reserve, and a contribution to profit. Ultimately the Moldovan energy sector -7 -  will benefit from substantial restructuring, commercialization, corporatization and regulatory reform. In order to set the stage for such far-reaching reforms, the Government has embarked. with Bank support, on a program to upgrade the sector's accounting and information systems. 24. Energy sector refontis have implications for social policies and the public investment program. The strict enforcemilent of payment discipline and higher tariffs is bound to affect poorer households. Therefore, the Goverrnent will need to introduce a mechanism to ensure supply of a life-line level of energy to vulnerable groups. This could be done through a cash benefit, if a proper targeting mechanism could be developed, or by a life-line tariff for all households. The sector's poor financial position has also limited the companies' ability to finance necessary maintenance, which has caused a serious deterioration of assets, increasing costs to the energy companies. and thus further worsening their financial situation. Therefore, limited public investment in the sector at this stage is critical in order to avoid far more serious problems later which would require more substantial investmenit. 25. The agriculture sector's progress also requires a transformation of its public institutions and services. The development of rural land markets needs complementary government rural services for land-title registration and transfer. The provision of physical infrastructure is key to the sector's future development. Hence, it is necessary to improve irrigation, rural roads, rural electrification, telecommunications and rural water supplies. The Government is also considering a better prioritization and rationalization of the public-sector agricultural research system, and wa's to develop private sector funding and participation in agricultural research. Moreover, the institutions responsible for determining sectoral policies. regulation and public administration require modernization. This would include reviewing: the overall functions and staffing of the Ministry of Agriculture and Food: the grains' strategic stocks policy; the wine sector development strategy: food quality standards and inspection, and environment standards for agriculture and agro-processing activities. Poverty Alleviation, Social Protection and Human Resource Development 26. The decline in GDP has led to a sharp fall in living standards. Fiscal shortfalls have resulted in non-payment or late payment of budget sector wages, pensions and other benefits. Many enterprises are unable to pay Social Fund contributions or wages -- around one-third of the workforce is on forced leave, or restricted work. For many families, household plots and relatives in the countryside have been the real social safety net. Enterprises undergoing restructuring are divesting health clinics, kindergartens and other social services to local authorities, who rarely have the resources to continue operating them. 27. Poverty alleviation is a key objective of Moldova's economic reform program. Work on a ''Poverty Assessment" is starting shortly, with Bank support. This should provide the necessary information and analysis for policy reforms that aim at helping the poor and protecting vulnerable groups. Economic growth and job creation are necessary for poverty reduction, but more needs to be done for those who may be left behind. That is why the Government is now moving to redesign social policies, and specificallv to improve the targeting of expenditures. Moreover, the health and education systems are being reformed so as to maintain critical human capital investments during the transition period  28. Reform of social protection is under way. The financing of pensions and other benefits is particularly worrisome. There were 730,000 people of pension age in 1994 compared to employment of around 1.300,000, a dependency ratio of 56%. In an attempt to make the social protection system more affordable, the Goveniment replaced generalized subsidies on consumer goods with flat rate cash payments targeted to pensioners and families with children to compensate for increases in the prices of basic necessities. It also disqualified working pensioners from further pension increases, and proposed legislation to Parliament to increase the pension age gradually over time to age 65 for both men and women. The Govermnent also unified the rate of payroll tax between sectors and lowered it, In an effort to lower the costs of employing labor. At the same time it is seeking to improve payroll tax collections so as to reduce the high level of arrears to the Social Fund and enable further decreases in payroll tax rates. Despite these measures, more fundamental reforms will be needed. The Governmenlt is currently reviewing the pension and social benefit system and is developing the regulatory framework for a private savings and social insurance scheme, which will complement the increasinglv flat rate state pension and social protection system. 29. Moldova's health care sector needs fundamental reform. The sharp decrease in public resources available for health care, from around 8 percent of GDP in 1990 to 2.6 percent in 1995, will inevitably lead to a deterioration of the health care system. Health indicators and life expectancy are already showing some decline. Disniption of senrices has led to sporadic outbreaks of parasitic diseases and diseases preventable by inmmunization. Cholera has re-emerged. The new Health Law, adopted in June 1995. recognizes the relative importance of primary health care, and addresses a broad spectrum of issues, from private sector participation in provision of medical services to the development of health insurance. The la,. however, does not set out a clear health care reform strategy. In order to stem the continuilig decline of the health care system, the Governmenit intends to follow up the law by defining a strategy to rationalize sector expenditure and to develop the basic benefits package which will be financed from public resources. 30. The move to a market economy puts new demands on the education system. The Government has adopted an education sector reform strategy that is designed to match the prevailing structure in most Western European countries. This involves: (i) introductioni of a new four tier pre-university structure; (ii) a complete overhaul of the education program, curriculum and teaching materials at all levels: (iii) reform of teachers' training and retraining of teachers in the new curricula, and (iv) the introduction of educational standards and standardized assessments. These reforms have been adopted by Parliament and the development of curricula has started for primary education. The Government now needs to initiate a reform of financing and resource allocation in education. At present. private sources of funds are being mobilized only on an ad hoc basis, and the allocation of resources among the different levels of education is biased in favor of vocational and higher education. In addition, spending on educational inputs is not well-balanced resulting. inter alia. in a low student-teacher ratio of around 11 (compared to an OECD average of around 18). but, at the same time. severe shortages of text books and other teaching materials. -9-  C. ECONOMIC PROSPECTS AND CREDITWORTHINESS 31. Moldova's medium-term economic prospects will depend greatly upon the Government's economic policies. Growth will come from private sector activity and, in particular, investment. For that to happen, macroeconomic stability, a liberal economy with transparent rules and effective protection of property rights and contract enforcement are critical. The expansion and consolidation of the policies described above should produce a sustainable growth rate of 5 percent per year. On the other hand, a scenario of "muddling through", which avoids deepening of reforms. would lead to slow economic growth, essentially stabilizing the economy at its present low level of output. This scenario would leave serious doubts about the country's creditworthiness. Strong Reform Scenario 32. With strong reforms, output, income and living standards could start rising at an annual rate of 5-7 percent. Continued strong stabilization would imply a gradual reduction of the fiscal deficit to less thani 3 percent of GDP by 1998. This would be consistent with a rigorous monetary stance and a decline in inflation to 5 percent per year starting in 1998. Macro-economic stability. together with liberalization, privatization and institution building will encourage private entrepreneurs to begin investing. Thus the investment rate, which is currently around 5-6 percent of GDP, would at least double and could reach comparable levels to Poland (16 percent in 1993), the Czech Republic (17 percent in 1993), or Slovenia (20 percent in 1993). Initially, growth is likely to be in services, such as retail trade and transportation, where the legacy of central planning has left a great deal of unfulfilled demand and where the required investment is typically small. The sector could grow at 10-15% a year, and its share in GDP could increase from around 30 percent in 1995 to around 50 percent- the share of services in GDP is around 58% in Slovenia, 55% in Poland and 54 % in the Czech Republic. Such an expansion in services will require that the private sector be able to purchase or lease real assets (land and office space) and that a stable legal and institutional framework for doing business is in place. Land reform, free markets for inputs and outputs, and adequate support services for private farmers would be critical to the expansion of agriculture. The sector could grow at around 2-3% a year over the medium-term. Industry, especially export-oriented agro-processing, would pick up in tandem, growing at more or less the satne rate as agriculture. The relatively small size of Moldova's market implies that this rapid growth could only be achieved through greater outward orientation. Annual growth rate of exports would be around 6-7 percent over the medium-term. Maintaining a liberal trade regime is key to this export expansion. The social situation would improve dramatically. The unemployed will benefit from the expansion in job opportunities, mainly in the service sector. As the labor market tightens, real wages would begin rising to reach their 1991 level in 5-7 years. 33. This scenario shows significant financing needs over the medium term. The current account deficit will come down steadily, but will still be around 4% of GDP till the year 2000, due partly to the rise in investment to improve competitiveness, both in existing and new production. Thus, the stock of debt would reach a peak of nearly 40% of GDP by 1998, with the debt service ratio exceeding 20% in 2002 and 2003. These creditworthiness indicators are acceptable, but do indicate risks. It is important to realize that Moldova is presently only $5 per capita over the operational cut-off for IDA. Since economic growth is expected to resume, Moldova will remain an IBRD-only country, which is justified by the debt indicators mentioned above. However, Moldova's creditworthiness remains highly vulnerable to further adverse external shocks. If. in spite of a liberal reform stance due to shocks, growth does not materialize as expected and - 10-  Moldova remains below the IDA eligibility threshold for a number of years, the issue of creditworthiness and access to IDA would be reviewed separately. ThbI~ 1. Maui E~on~mk In4kators5. . * . :9 - Rap . : ......l.. .~~ ~ .. . . .. . . .. . . .. . .. 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2()04 205 G:rowvth rate ot (;I)E' (mp) -22.2 0.0 5.0 7.0) 7.0 6.5 6.0 6.0 5.5 5.0 5.0 5.()0 I)omestic Investment / (' 6.4 5.4 7.6 10.4 13.0 15.8 17.9 19.2 19.4 19.4 19.4 19.5 l overnen.t 1.5 2.4 3.9 4.9 4.8 4.7 4.7 4.4 4.4 3.9 3.9 3.9. Non-govenunlent 4.9 3.0 3.7 5.5 8.2 11.1 13.2 14.9 15.0 15.5 15.5 15.6l Natio.al Savin.gs /.(l)' 1.3 . .1 1.9 4.9 8.3 11.4 13.8 15.4 16.1 16.7 17.2 17.4 Fiscal Balanlce /(iI)1' -8.1 -5.1 -4.1 -3.1 -2.9 -2.8 -2.8 -2.3 -1.7 -1.2 -1.4 -1.6l G;rowvth rate of Real per capita C onsulmptionl -0).5 2.4 3.1) 2.5 1.9 2.3 3.2 3.9 3.4 3.5 3.6l Inflationl (period average) 369.5 24.4 10.0 7.5 5.0 5.0) 5.0 5.0 5.0 5.0 5.() 5.0l Real Export (;rowth 7.0 6.6 7.2 7.6 7.3 7.0) 6.5 6.4 6.3 6.1 5.9l Real hnport G;rowvth 3.3 6.7 5.6 5.1 5.0 5.1 4.9 4.1 3.5 3.5 3.6l Currenlt Accolunt Balanlce / (;I)E -5.1 -5.3 -5.6 -5.4 -4.8 -4.4 -4.1 -3.8 -3.3 -2.7 -2.3 -2.1l Foreign Exchanlge Reservesl (I.S$ millions) . 179 197 143 154 164 176 189 203 215 228 241 257l (In Months oflhnports) 2.9 3.0 2.0 2.0 2.0 2.0 2.0 2.0 2.0 2.0 2.0 2.1)l Ext. I)ebt (IJS$ mlillionis) 493 588 808 953 1073 1137 1177 1212 1226 1223 121() 1198l Ext. I)ebt / (:;)E 25.7 27.4 35.2 38.1 39.3 38.2 36.5 34.7 32.6 3(1.3 27.9 25.8l Ext. I)ebt /X(:S 7').3 87.3 110.7 120.6 125.6 122.7 117.1 111.8 105.0 97.3 89.6 82.8l I)ebtService/X(:S 3.9 14.1 10.8 13.7 18.3 17.6 17.7 19.6 20.1 20).1 18.6 16.5l 34. Economic growth, export expansion and increases in savings are key to the improvement in debt indicators that could occur at the turn of the century. As GDP growth rises from 0 percent in 1995 to 6 percent in year 2000, exports grow at 7 percent a year in real terms, and the savings rate increases from 0.1 percent in 1995 to 16 percent in the year 2002, Moldova's creditworthiness would improve dramatically. Under those conditions, the current account deficit could decline to 2 percent of GDP by 2005. Moldova would be able to attract sufficient private capital in the form of direct or portfolio investment to finance its deficit. As a result, the stock of foreign debt would stabilize in nominal terms and decline as a proportion of GDP. Finally, the fiscal performance will be key to raising savings and improving creditworthiness. The Government is undertaking strong efforts to improve revenues, which will support the effect of expenditure cuts through sharper setting of priorities. A positive sign is that the experience in the sale of Government bonds since the first offering in July 1995 shows that the Government is able to raise domestic resources to finance part of its deficit. -.I. I  Table 2. Burden Sharing Assumptions and Exposure Indicators 1995 1996 1997 1998 2004 Gross Flows (S million) Bank 48.0 38.3 43.5 50.8 54.0 IMF 65.0 71.0 68.0 68.0 00.( EBRD 6.0 19.0 19.0 13.0 20.0 Bilaterals 39.3 68.0 46.0 45.1 34.4 Other 0.0 53.3 16.3 17.7 13.6 Total 158.3 249.5 192.9 194.6 122.0 Exposure Indicators (%) IBRD DS/ public DS 8.5 13.3 13.4 13.6 30.2 Preferred DS/ public DS 60.2 49.1 60.0 84.2 61.8 IBRD DS/ exports 1.2 1.4 1.8 2.4 5.3 35. The Bank and other preferred creditors would be taking an extraordinarily high share of the financing burden, especially in the initial years. This reflects the fact that Moldova, as a non-DAC cotntry with marginal creditworthiness has very limited financing sources available. The responsibility of the intemational community to provide the Government with the necessary support to implement its ambitious reform program falls largely on the shoulders of the preferred creditors: the Bank, the IMF and EBRD. Russia has been a major source of bilateral funding, by end 1994 it had disbursed more than $100 million in credits to Moldova. Japan (JEXIM) co- finaniced the Rehabilitation Loan in the amount of $40 million, and the EU has supplied two quick disbursing loans (ECU 25 million and 20 million), in addition to technical assistance. Other support has been forthcoming from the United States, China, Germany, the Netherlands and Romania. The Bank has made significant efforts to raise other resources (see the section on donor coordination), and will continue to do so. This will be done both by seeking co-financing for Bank projects, and bv using innovative approaches. like the Pre-export Guarantee Facility. Even with those efforts, however, the prospects for attracting alternative financing in the short term are modest. 36. As table 2 indicates, the guideline on the share of preferred creditors' debt service in public debt service is already exceeded by a wide margin. Under a base case lending assumption (see section D). the Bank's share in total debt service would exceed guidelines around the year 2000. On the other hand, overall creditworthiness indicators and the ratio of IBRD debt service to exports remain acceptable. The initial effort by the preferred creditors is justified because the reforms should allow Moldova to reach a sustainable growth path, enabling it to attract private sources of financing and foreign direct investment. A reduction in IBRD lending, to remain within exposure guidelines, would imply a serious cost to Moldova and a reduction in its growth prospects. This would be particularly unfortunate at a time when the country is implementing a strong reform program. 37. A strong reform program is necessary for Moldova to achieve the growth rates described here, but there is a risk that the desired growth rate may not be reached despite good policies. Factors beyond the Government's control could lead to lower than expected growth. For example, Moldovan products could be subject to protectionist policies in importing countries. In this case the export expansion that is necessary to sustain Moldova's growth may not materialize. Or, foreign financing may not be forthcoming, which could result in lower investment - 12-  and growth than envisaged here. The timing and magnitude of the private sector response to the new policy framework are difficult to predict. In some countries private activities have expanded rapidly in response to reforms, but in others uncertainties about economic or political factors have slowed private investment. Thus the mere implementation of a strong economic reform programn cannot guarantee that Moldova will achieve the 5-7 percent sustainable growth rates achieved by other reforming countries. On the other hand, failure to reform will undoubtedly lead to a disastrous economic outcome. Muddling Through 38. The situation changes dramatically if reforms are not implemented. Without addressing the main remaining obstacles to economic growth, the economy would continue to be too energy intensive and production structures would be too inflexible to adjust to market signals, stifling private sector initiative, and making competitiveness on export markets an elusive goal. The result of this scenario could be stagnation at a low level of output, comparable to that of today. This might even be too optimistic, because Moldova would have great difficulties financing the large extemal deficits that would occur under such a scenario, so output may continue to decline. In either case, Moldova would drop to the ranks of the lower income countries for a significant period of time. 39. In the absence of structural reforms the needed expansion in investment would not occur, as the environment would not be conducive to private sector activity. Under this scenario the investment rate is unlikely to rise above 3 percent of GDP. Growth would remain low at 0.5- 1.5 percent a year. Moreover, as competitiveness would not be enhanced, export growth would be sluggish, around 1.5 percent a year, and the required change in the structure of the economy would not take place. Living standards would not improve. Real private consumption would grow at less than I percent a year, and may even decline over the medium term. Poverty would continue and probably deepen. The human cost of not carrying out structural reforms could be very high, as education and health standards would continue to decline. 40. Moldova's creditworthiness under this scenario would be weak, as it will be difficult to keep a stabilization program on track. The current account deficit would remain at around 5.0 percent of GDP. The debt to GDP and debt service ratios would grow to 50 percent and 30 percent respectively by 2005. This implies that muddling through may not be a real option. It is extremely doubtful whether Moldova would be able to attract sufficient external resources to finance its import needs. Without reforms, the current account deficit would not be financed. Preferred creditors typically require a coherent economic framework prior to lending, and private entities would not have sufficient confidence to invest in Moldova or lend to it. Hence, although Moldova might become IDA eligible under this scenario, poor policy performance would likely result in its IDA allocation being very low. The pressures would be very high on government to resort to deficit spending and on the Central Bank to print money. In this case even stabilization and creditworthiness gains would not be sustained, leading to a return of hyperinflation and negative growth. - 13 -  19)94 1')9)5 1'996 1997 199S 1999 2000)( 200(1 200{2 200(3 200(4 200(5 GTrowth) rate ot(:;l)l' (mlp) -22.2 0().( I.5 I.8 1.7 1.5 1.0) 0.8 ().5 0).5 0.5 0.5 D)omestic Investmenit / (:il)l' (6.4 5.4 3.(1 2.9 2.9) 3.0) 2.2 1.4 1 .8 I .X 1.8 I.8 Fixed hivestinent 6.4 5.4 3.01 2.9 2.9 3.0) 2.2 1.4 1.8 1.8 1.8 1.8 (Aovenunlent 1.5 2.4 2.4 2.3 2.0) 1.9) 1.7 1.3 1.4 1.3 1.3 1.3 Non-g:ovenunenit 4.9 3.11 0.7 (.6S 0).9 1.1 0. 4 0.1 0.4 (1.4 0.4 0.4 National Savings / (;I)P 1.3 (1.7 -I1.8 -1.8 -1.8 -2.1 -2.5 -2.9 -2.8 -2.9 -3.1 -3.4 Fiscal Balance /(:;)1' -8.1 -5.1l -5.3 -4.3 -4.1 -4.9) -6.4 -8.1 -8.5 -10).2 -13.6 -17.6 G;rowth rate of Real per capita -(1.5 2.7 1.3 1.3 0).9 (1.9 11.5 -(1.2 -(1.1 -0).1 -(1.2 C'onsumilptionz Inlflation (period average) 369.5 24.4 15.() IS.(1 15.0 15.0 2().(1 25.1) 28.0) 3(1(1) 4().() 40).0) Real Export(:;rowth 7.1) 1.9 1.9) 1.4 1.4 1.3 I1.3 1.3 1.1 1.2 1.2 Real Imiport (:rowth 3.3 -().5 1 .() 1.2 1.1I -11.5 -11.7 1.1 0(.3 0.2 -0.1 Currenit Account Balanice / (;I)I' -5.1 -4.7 -4.8 -4.6 -4.7 -5.1 -4.7 -4.3 -4.6 -4.7 -4.9 -5.2 Foreign Exchlange Reserves (1.JS$ millionis) 179 257 2()() 190 1811 15() 100( lOt)0 10)0 10l) 1()0 101) (hiMontblsofimports) 2.9 3.9 3q.0 2.8 2.6 2.1 1.3 1.3 1.3 1.3 1.2 1.2 Ext. I)ebt (IIS$ millionis) 493 588 783 893 100l 10:51 10:70 1132 12()2 1280 137() 1475 Ext. I)ebt I (;1)1' 25.7 27.4 35.2 38.9 41.9 42.4 41.9 43.() 44.4 46,1 48.() 5(1.3 Ext. I)ebt / X(;S 79.3 87.4 111.9 124.2 136.5 14(.1.) 138.8 143.5 148.5 154.4 161.4 169.9 I)ebt Service /X(:;S 3.9 14.1 11.3 14.3 19).4 20).2 21.7 24.8 27.1 28.5 29.1 30.2 D. BANK GROUP ASSISTANCE STRATEGY 41. The Bank Group assistance strategy aims at supporting the implementation of the reform agenda outlined in section B. This agenda will establish a firm basis for sustainable private sector- led growth based on (i) increased competitiveness, notably in the exports of agricultural goods and in agro-processing, (ii) improved energy efficiency, (iii) the rapid emergence of a service sector. and (iv) quality investment in the country's human resource base. 42. While Moldova's track record in implementing reforms is solid, the momentum of the reform process is one of pragmatism rather than idealism. This reflects the realities of the political economy in Moldova: the Government has consistently pursued a strategy of consensus building and balancing of different forces, both internally and externally. With the upcoming presidential elections in the Fall of 1996, less consensus is likely in the immediate fluture, but expectations are that it will re-emerge quickly after the elections. The Bank strategy will therefore aim at providing a constant push to making progress in critical reform areas, while recognizing the need to balance competing interests. An important element in that strategy will be "constructive engagement" through small projects in key sectors in order to provide momentum to the dialogue at sectoral level. - 14 -  43. The base case for Bank assistance in the CAS is therefore one of continued strong commitment to reforms and a high level of support. Since in practice the speed of reforn in different sectors will vary, this base case is designed to respond flexibly to developments on the ground. The Government anid the Bank would work on the preparation of a lending program for FY96-98 of 11 projects totaling US $290. The actual implementation of specific investment projects, however, would depend on satisfactory progress in each sector. Delays in meeting individual project conditions could lead to corresponding delays in project processing, thus lowering the total lending voluime for the CAS period. 44. Agreement on a program for a second Structural Adjustment Loan (SAL 11) and its implementation are the triggers for the base case. The key measures to sustain the momentum of the reform agenda and justify the level of support envisaged in the base case. would be supported bv SAL 11. While the precise SAL 1I program still needs to be defined, its main components would be as follows: * maintaining a stabilization program supported by the IMF; * completing enterprise privatization: * carrying out land reform. particularly: implementing the Constitutional Court's decision removing restrictions on exiting large-scale farms, and fully liberalizing the land market: * maintaining a liberal trade anid price regime. particularlv: abolishing remaining margin controls and keeping the maximum tariff at 20 percent (except for a small number of luxury goods); e improving financial discipline in the energy sector by increasing tariffs to cover full operating costs. raising cash collections to comparable international levels, and maintaining "lifeline" energy supplies to vulnerable groups; * improving safety and supervision standards in the banking sector and withdrawing Government guarantees on commercial loans, * hardening the budget constraint for enterprises, and promoting enterprise adjustment including voluntary liquidation of unviable enterprises remaining in State ownership: and e improving targeting of social benefits, eliminating arrears on benefits payments and setting priorities in spending for health and education. 45. Without these measures, grovth would not be sustainable and creditworthiness would be limited--see the description of the muddle through scenario in section C. The Bank's program would move to a low case. The lending program would not exceed $75 million for the three year period, divided over five projects. These projects would support a limited core program in the areas of private sector development, agriculture and land reform, energy, and education. For each project to go ahead. the Bank would still have to be satisfied that the policy framework in the relevant sector would allow the expected benefits of the project to materialize. The Private Sector Development Loan has already been approved by the Board. Satisfactory implementation of enterprise privatization was an important trigger for this operation. The key sectoral triggers for the other lending operations in the low case are as follows: * energy: agreement on a new tariff structure to improve cost recoverv and on collections targets, * agriculture: agreement on an agricultural research program and on reforms of institutions responsible for carrying it out: * education: agreement on programs for curriculum development and teacher retraining: and * cadastre: agreement on reforms of the land market. - 15 -  Table 4: FY96-FY98 Lending Program Base Case Low Case FY96 FY96 Private Sector Development $35 iln Private Sector Development $35 mln Energy (aiid Environment) $10 nln Agriculture I $10 miln FY97 FY97 SAL II $50 Tln Energy (and Environmenet) $10 mlni Cadastre $10 mndn Agriculture $10 mln Education $10 nln Agriculture II $45 muin FY98 FY98 Energy $40 mln Education $10 mln Tramsport/Export $40 ni Cadastre $10 mil Promotion Irtrigation $40 inii A Three-Pronged Assistance Program 46. Moldova's past and present performances indicate that the base case is the most likely scenario. Under the circumstances, the Bank group will support the implementation of all three elements of the Government's reform agenda with projects, programs and activities covering: private sector development; public sector restructuring and improvement of financial discipline; and social protection and human resource development. 47. The Bank will support the Government's program for private sector development. Now that the privatization of enterprises is largely completed, the Bank group's assistance program wili focus on: strengthening of the legal and regulatory environment for the private sector, the provision of financing for investment and working capital for viable activities, and the facilitation of the flow of external private financing. An area of special attention will be the agriculture sector, the key sector in the economy, where private sector development is not yet very advanced. 48. The second Structural Adjustment Loan (SAL IT, will be the main instrument to support the strengthening of the legal and regulatory framework for the private sector. The progranm will focus on improving the transparency and simplicity of company registration and licensing, establishing a functioning mechanism for bankruptcy, and implementing the court reform which provides for inclusion of the economic courts (the "arbitraj" courts) as specialized courts within a unified court system with a single supreme court. In addition, assistance will be provided, together with USAID, for the conversion of enterprise and commercial bank accounting to international standards. 49. The Private Sector Development loan has created the basis for strengthening the financial sector and putting in place financing for investment and working capital. This program is also supported by EBRD, which has put in place lines of credit through two different commercial banks (Victoria Bank and Agroind Bank). The Bank and the Government are discussing the possibility of follow-up PSD operations if progress in implementing reforms warrants them. The possible - 16 -  establishment. by IFC, of a leasing company will reinforce these efforts. In addition, supervision and prudential regulation of the banking system has made significant progress, supported by both the SAL, and IMF programs and technical assistance. These efforts will be continued under SAL II. focusing on creating a baniking system that can play its full role in allocating resources, allowing the Government to phase out its guarantees for commercial loans. 50. An area of specific concern is the facilitation of the flow of external private financing. Moldova is not very well-known to potential investors. Actual paid-in foreign direct investment was only around $30 million by October 1995. Nevertheless, profitable opportunities for private investors do exist and are being enhanced, as the Government puts in place the appropriate policy and regulatory framework. The Pre-export Guarantee Facility is an attempt to attract private foreign financing in an area, the foreign exchange and trade regime, where regulatory reforms are already in place. As other such areas emerge, the Bank will continue to pursue opportunities for attracting foreign financing through use of the Bank's guarantee instrument and co-financing techniques. The policy dialogue in different sectors will be focused on building the foundation for such interventions by improving financial discipline and the regulatory framework allowing private participation and operation. In addition, the Bank is actively supporting the Government in marketing Moldova to foreign investors, for example through its participation in a major investor's conference in Chisinau in September 1995, and Moldova's participation in the Pilot Program of Seminars at the 1995 Bank/Fund Annual Meetings. 5 1. Over time. IFC and MIGA will play an increasingly important role in attracting foreign private financing to Moldova. Neither MIGA guarantees nor IFC investments have been made to date. Recent IFC raissions have identified a number of prospects, including small investments in agro-business and the expansion of a metal treatment and processing plant. Privatization of the telecommunications network could provide good opportunities at a later stage. In the technical assistance area, IFC has approached a number of prospective donors for support to establish a Romania-Moldova Enterprise Facility that would provide business management advice and assistance in raising financing for small and medium-sized projects in both Romania and Moldova. Since Moldova joined IFC early in 1995, IFC has worked closely with the Bank in its efforts to develop a successful program. The demand for MIGA guarantees has been limited until now, only one preliminary application has been received, but demand is expected to pick up with foreign investments in the medium term. 52. Private sector development in the agriculture and agro-business sector is especially important, as this sector is likely to play a major role in the development of exports. The objective of the Bank's three year agricultural investment program is to promote rural land reform and farm restructuring, improve post-privatization services to agro-enterprises, initiate rural finance reform, and strengthen human resources and institutions in the sector. In this context, the First Agricultural Project would concentrate otn supporting agricultural research for key export commodities as well as the related research institutions' farmers outreach programs, promoting agro-enterprise restructuring and investment plauling, and assisting the Government in sectoral strategic plairing. analysis of sector refonns, and the preparation of further public investments for the sector. The proposed Second Agricultural Project would provide support to the agricultural service sector, including commercial seed production; technology transfer for farm equipment and post-harvest crop-handling, a "Rural Entrepreneurs' Fund" for farm recapitalization post- restructuring: the design and capitalization of a crop insurance system, and export promotion. The proposed Irrigation Project would rehabilitate and complete selected irrigation schemes to reduce the risk of drought in the southern part of Moldova, and further strengthen the agricultural - 17 -  research, education and extension system. Support will also be provided for the development of the cadastre system to help develop a market for land. 53. Supporting the development and strengthening of public institutions needed in the management of a market economy is an important element of the Bank group's assistance strategy. The main instrumients for this purpose will be Economic and Sector Work (ESW). and coordination of institution building technical assistance. The Bank will finance the rehabilitation of essential infrastructure. and the revamping of public institutions for their new role in a market economy. and for new areas of attention. the most important of whiclh is the environment. Finally. the program will support the Government's efforts to improve financial discipline throughout the economv, as the key to accomplishing structural adjustmnent. 54. The central piece of ESW will be the Public Expenditure Review (PER), which is currently underway. The main themes of the PEh are (i) macroeconomic sustainabilitvy (ii) structural shifts in expenditures reflecting the changing role of the Govenunent during and after the transition: and (iii) institutions, criteria and mechan-ismiis for effective expenditure decisions and cost control, including continued work on improving Public Investment Progranrriing. To complement this effort, the Bank will provide targeted technical assistance financed from the Institutioiial Development Fund (IDF). Examples are the IDF grants for institutional strengtheninig of the Department of Energy, for Accounting Reform, and for Public Procurement legislation. which are under implementation. Further IDF grants will be proposed to help the Government develop a Real Estate strategy and to support Health Care reform. Finally, Sector Work will help the Government redefine its role in specific sectors, and identify priorities for public investments. The Bank recently completed an Agriculture Sector Review, and a Transport Sector Review. Before embarking on the second energy project a fonnal sector review will be undertaken, and work is planned in the social sectors as well. 55. The Bank will support badly needed capital preservation and investment in the energy sector. This would include upgrading of existing facilities to stem the deterioration of these assets: technical assistance for institution building and regulatory' reform; improvement of financial information and management systemns for the energy utilities: and investments in metering, techlical control and dispatching of electricity and gas. As it will take some time to improve the finanlcial situation of the energy enterprises, the Bank will start with a small project to address the most urgenit capital preservation needs, and to build the institutional capacitv for environment and for energy audits of enterprises, to be followed by a larger project once the financial positioin of the utilities xere improved enough to justify a higher volume of lendilg. It will also finanice public investmiients and support institutionial reforms in the transport sector, based upon the conclusions of the Transport Sector Reviexv. This xvould be complemenited by investments developing the institutional capacity for export promotionl. 56. The National Environmental Action Plan. has identified wvater and soil pollution and the energy intensitv of the economn as key priorities for action. These will be addressed in the context of specific projects. Support for integrated pest managemiient in the first agriculture project, and the support of quality monitorinig of agricultural products. would help monitor and eventuallv address the problem of pesticide residues in those products. A water use master plan is being prepared in the context of the irrigationi project. and eniergy audits of industrial enterprises will be done in the enlergy and environmient project. -18  57. The Bank will work with the Government to improve financial discipline. mainly in the context of SAL II and the PER. The energy sector will receive special attention. Lending in this sector will be contingent on improvement of financial discipline, as evidenced by the implementation of the action plan for the energy utilities agreed betweeni the Government and the Bank. The key element of this plan is disconnectioni of services to non-payers. In order to minimize the social impact of higher energy prices, this plan provides for a life-line energy supply at subsidized prices. Above that, the cross-subsidy from commercial customers to households w-ill be phased out. 58. The Bank will support the Government in putting a meaningful social safety net in place, maintaining essential social services, and restructuring the education and health systems to be sustainable and affordable in the medium term. The structural reform programs supported by the Rehabilitation Loan and the first Structural Adjustment Loan included important first steps toward improved targeting of the social benefits and pension svstem. The program supported by SAL II will deepen these measures, aiming to put in place the key elements leading towards an affordable benefits system. This work will be reinforced by the Poverty Assessment, which will help the Government and the Bank assess the effects of econoiic policies on the most vulnerable groups. 59. In education, where the Government is more advanced in defining its oxNn strategy, the Education Project will support curriculum development, teacher retraining, assessment system development and procurement of textbooks and teaching materials, all for general education. The Bank's intention is to use the preparation of this first education project to initiate a long-term dialogue, and to reach agreement on a comprehensive sector reform "road map." focusing on a medium term human resource development strategy to support private sector development and export promotion, and on improvement of financing and resource allocation mechanisms in the sector. This dialogue will also focus on the issue of gender equality, as there is some evidence that the economic decline ma' have had a bigger negative impact on girl's enrollment, especially in the countryside. 60. In the case of health care, as noted above, the Bank will provide technical assistance financed from an IDF grant. The overall objective would be to help the Government target its expenditures so as to maintain access to critical services and protect the poor. Work in this area might lead to a small project toward the end of the CAS period. Portfolio Implementation 61. While the Government's commitment to the transition to a private sector led market economy is solid, it has proved difficult to generate strong ownership of specific project interventions. Until very recentlv, the Bank's operations have been emergency or fast-disbursing. They were prepared much more quickly than is possible for an investment project in a new institutional environment. The expectations generated by this early experience, together with unfamiliarity with Bank project implementation, meant that the need for active Government participation, including commitments to maintaining counterpart staff and budget funds. was not initially internalized. Both sides are now working to correct this. In CAS discussions. the Government agreed to set up clearly defined counterpart groups at the working level for each project, and to involve the Ministr' of Finance and the Parliament early on to avoid delays in the process of budget allocation for Government contributions and ratification of legal documents. In - 19 -  addition, the design of Bank projects is being simplified to reflect the limited institutional capacity for project preparation and implementation. Action to strengthen procurement is taking place with assistance from an IDF grant, and there will be further attention to strengthening procurement functions in each forthcoming Bank operation. Box: The Situation in Transnistria and the Bank's Program Motivated by notably differing approaches to economic reform, the region on the left bank of the Nistria river, known as Transnistria, attempted to secede in 1991. A brief anned conflict was followed by a signed cease-fire in July 1992. Since then both parties have tried to find a constitutional solution unider the aegis of the OSCE. The Moldovan Govenunent has offered Transnistria regional autonomy uider a fonnula similar to that agreed with the Turkish- speaking GTagauz region in the south; the authorities in Transniistria support a confederationi of two sovereign states. Developments in Russia appear to influence the tenor of the continuing dialogue. The region accounlts for about 16 percent of Moldova's territory aid 17 percent of its popuilationi, with a higher percentage of Russians and Ukrainiians than in the population at large. hi the past, its industrial production accounted for 28 percent of the total. More significantly, Transnistria produces almost all of Moldova's electricity and all of its steel aid is an important source of water. Trade routes to Ukraine traverse the region, including the main route to the Black Sea port of Odessa. Moldova is nearly 100 percent dependent oni imported energy, aLmost all of which comes tlhrough Transnistria, including three natural gas pipelines from Gazpromn Russia; petroleum products and coal are imported by rail from Russia and IJkraine. Since the cease-fire, econiomic cooperation via these trade anid transit routes has continued amid strengtlLened. hi July 1995 the two parties signed an agreement to avoid the use of military force, to seek conflict mediation, and to use the Moldovan leu for non-cash tranisactions (there has been some dispute about the continuation of the monetary part of the agreemenit), They have also agreed to participate in a joint venture with Gazprom Russia. World Bank lending to date has been to the Republic of Moldova; however, none has been explicitly targeted to the Tranisnistria region, although Transnistria has benefited from a share of the fuel imports puirchased umder the Rehabilitation and Structural Adjustment Loanis: A planned Bank mission to assess the economic situation in the region had to be postponed because of lack of agreement with the authorities there, but cooperation at the technical level resulted in successful collection of data. Future lendinig which explicitly included Transnistria would need to respond to two key factors: (i) the need to move to a market economy in the region and (ii) its severe econiomic decline amid poverty. Oii both counts, its situation differs markedly from that in the rest of Moldova. The different political sensitivities and starting point would raise real questions about the nature, speed and sequencing of operations that wouid be appropriate there. As triggers fDr lending, a constitutional resolution to the Transnistria status would have to be in place, and the commnitment to undertake econiomic refonns in line with those being undertakien in the rest of Moldova.: Poverty alleviation would be a high priority in Transnistria. 62. The importance of supervision is increasing in the Bank's work program. Most lending to date in Moldova has been to support the Government's adjustment program. Supervision of this portfolio has been part and parcel of the policy dialogue. While clearly more is needed to broaden and deepen this adjustment program, the focus of the Bank's efforts is shifting to investment lending, starting with small loans in key sectors. The wider scope of the lending program and domestic institutions involved requires a quantum change in supervision, with coefficients that are above the Bank-wide average. The Bank's supervision strategy for Moldova includes: * keeping initial loans small to build understanding and capacity with counterpart agencies before embarking on more ambitious operations, * carrying out broad capacity building efforts through judicious use of IDFs, for example on public procurement, legal, real estate and accounting reforms; - 20 -  * organizing training in key aspects of project management, including procurement. disbursement and financial management: * holding weekly meetings between the Bank's Resident Representative and the Deputy Prime Minister to discuss issues affecting the lending program, including implementation (the possibility of transferring greater responsibility for supervision to the field will be reviewed after more experience with a portfolio of 2-3 investment projects), and * holding regular country team meetings at headquarters, and with Departmental Management, to review progress in the Moldova portfolio, including feedback from supervision missions and the Resident Representative's weekly meetings with the Deputy Prime Minister. 63. The civil society and the NGO community in Moldova are still weak, given the fledgling democratic tradition. However, the process of nation building and the strong democratization effort are leading to a flurry of activity in the press, academic community, political parties and grass roots organizations. The Resident Mission which was established in 1994 is playing an important role, both in terms of monitoring these developments and making sure that Bank missions are aware of them, so that they can benefit from interaction with these groups, and in an outreach and public education program on economic reform. In addition, the Bank is pursuing active involvement of stakeholders in project preparation. For example, under the First Cadastre Project local land committees will play a critical role in preparing land distribution plans for rural regions. 64. Coordination between donor organizations is good. Regular meetings between the local representatives of donor agencies in Chisinau have proven useful. The Bank's efforts focused initially on raising balance of payments support in the Consultative Group process. Consultative Group meetings took place in October 1993 and March 1995, leading to substantial support from the donor community, co-financing with Japan. the United States and the Netherlands, and support from the European Union. A Consultative Group meeting to discuss the PER is envisioned for the Fall of 1996. While the Bank will continue these efforts, they are not likely to yield a level of financing that would eliminate the burdensharing problem for preferred creditors. 65. Cooperation with the other IFI's is very active. Close cooperation with the IMF--which includes Bank participation in kev IMF missions--continues to be critical, as macroeconomic stabilization will not be sustainable without structural reformn. The structural reform framework supporting the EFF has been prepared in parallel with this CAS. With EBRD. frequent consultation and coordination on the work program has been very important to divide the work and avoid duplication. This has been particularly effective in the energy and financial sectors. Apart from these sectors, EBRD's program consists of a major investment in bottling capacity for the wine industry, a road pioject and a potential oil terminal project on the Danube, and possibly a number of smaller investments in agro-business. 66. The Government's capacity for donor coordination is improving but still quite weak. Technical assistance funded bv UNDP and the Governnent of the Netherlands is expected to help address this problem. As other donors often are willing to provide significant amounts of technical assistance on a grant basis, the Bank aims to assist the Government in designing projects that provide an umbrella for TA activities from different donors. The cooperation with a large number of donors in the technical assistance for the Enterprise Restructuring Agency in the context of the Private Sector Development Project is a case in point. In this manner, crucial institution building assistance can be provided at lower cost. - 21 -  Risks and IDA Eligibility 67 It is likelv that Moldova will continue its good policy performance and will achieve relatively high growth as of 1996- The Bank would then be in the high case, although it is recognized that the proposed levels of IBRD financing raise some burden-sharing concerns. There are two types of risks that may stop this scenario from materializing. The first is that the Govenmieit will fail to implemilent key parts of the reformn program due to political pressures or instittitional weaknesses and corruption. Growth would not be achieved and the Bank would be in the low case. If growth remained poor for a sustained period of time. Moldova might, in fact, become IDA eligible. But in that case. poor policv perfornance would likely result in Moldova's IDA allocation being veryv low. The second risk is that grow-th would be low, despite good policy performnance. Such a scenario might materialize, for example, if there is a permanent deterioration in tenns of trade, or if extemal financinig for the program is insufficient, or if access to export snarkets is limited. The Bank would still be in the high case and would continue supporting M4oldova, but creditworthiness may; be weak. Hence, it would consider seeking some IDA financing as a blend with IBRD. E. AGENDA FOR BOARD CONSIDERATION 68. Executive Directors mav wish to consider the following questions: * Do Directors consider the proposed Bank share in total finanicinig under the base case acceptable? e Do Directors agree with the steps included in the Agenda for Reform outlined in the CAS and our assessment of their critical role in economic recovery? Jamnes D. Wolfensohn President Attachments Waslington. D.C. April 5. 1996 - 22 -  MOLDOVA Attachment Table: Framework for the Country Assistance Strategy COUNTRY OBJECTIVES MONITORABLE ACTIONS AND BANK SERVICES TASKS PERFORMANCE INDICATORS Macro-economic stability and growth * Achieve a GDP growth rate of around 5% Adjustment Lending SAL 11 (FY97) per year * Reduce inflation to single digits Non-lending services Consultative Group (FY97) * Reduce fiscal deficit to around 3 % of GDP Public Expenditure Review (FY96) * Maintain a viable external position and at CEM (FY98) least a 2 month reserve cover Transnistria Report (FY97) Private Sector Development * Complete enterprise privatization Adjustment lending SAL 11 (FY97) * Agreement on a land reform program and satisfactory implementation Investment Lending PSD I (FY96) * improve PSD environment and maintain Agriculture I (FY96) liberal trade and price regimes Cadastre I (FY97) * Strengthen banking system and withdraw Agriculture 11 (FY97) Government guarantees on commercial Irrigation (FY98) loans Non-lending Services Private Sector Assessment (FY97) Agriculture Sector Update (FY97) Financial Sector Note (FY98) Public Sector Restructuring * Improve financial discipline in energy Adjustment Lending SAL 11 (FY97) sector; including increasing cost recovery and improving collections Investment Lending Energy (FY96) * Rationalize public expenditures and develop Energy II (FY98) a Public Investment Program Transport/Export promotion (FY98) * Hardening of budget constraints for public Agriculture I (FY96) enterprises, including liquidation of Agriculture 11 (FY97) unviable enterprises Irrigation (FY98) Non-lending Services Public Expenditure Review (FY96) Transport Sector Rcview (FY96) Energy Sector Review (FY97) Municipal Sector Note (FY97) CEM (FY97) rD NQ)  COUNTRY OBJECTIVES MONITORABLE ACTIONS AND BANK SERVICES TASKS PERFORMANCE INDICATORS Ensuring Social and Environmental * Improve targeting of social benefits and Adjustment Lending SAL 11 (FY97) Sustainability eliminate arears on benefits payments * Start reforms in health and education Investment Lending Energy (FY96) * Reduce energy intensity of economy Education (FY97) * Build capacity for environmental Energy 11 (FY98) management Non-lending Services National Environmental Action Plan (FY96) Public Expenditure Review (FY96) Poverty Assessment (FY97) CEM (FY98) (D N.) a N.  Annex Al Page I of 1 Moldova - Selected Indicators of Bank Portfolio Performance and Management FY93 FY94 FY95 FY96 Planned Portfolio Performance Number of projects under implementation 1.00 2.00 3.00 4.00 Average implementation period (years)' 0.31 1.01 0.86 1.10 Percent of problem projects rated U or HLI (for past years, rated 3 or 4) Development objectives' S S S lmplementation progress (or overall S S S status for past years)d Canceled during FY in USSm 0.00 0.00 0.00 0.00 Disbursement ratio (%)' N/A 603.41 100.00 N/A Disbursement lag (%)r -358.29 -0.18 14.01 0.00 Memorandum item: % completed projects 0.00 0.00 0.00 0.00 rated unsatisfactory by OED' Portfolio Management Supervision resources (total USS thousands) N/A 161.20 188.70 305.80 Average supervision (lJSS thousands/project) N/A 80.60 62.90 61.16 Supervision resources by location (in %) Percent headquarters N/A 71.81 77.47 67.52 Percent ficid N/A 28.19 22.53 32.48 Supervision resources by rating category (USS thousands/project) Projects rated HS or S 0.00 80.60 62.90 37.86 Projects rated U or HIU 0.00 0.00 0.00 0.00 Memorandum item: date of last/next CPPR a. Average age of projects in the Bank's country portfolio. b. Rating scale: "HS" denotes "Highly Satisfactory", "S" denotes "Satisfactory". "U" denotes "Unsatisfactory", and "HU" denotes "Highly Unsatisfactory". c. Extent to which the project will meet its development objectives (see OD 13.05. Annex D2, Preparation of Implementation Summary /Form 590]). d. Assessment of overall performance ofthe project based on the ratings given to individual aspects of project implementation (e.g., management, availability of funds, compliance with legal covenants) and to development objectives (see OD 13.05, Annex D2, Preparation ofhlnplemenriatzon Summary [Forn 590]). The overall status is not given a better rating than that given to project development objectives. e. Ratio of disbursements during the year to the undisbursed balance of the Bank's portfolio at the beginning of the year: investment projects only. f For all projects comprising the Bank's country portfolio, the percentage difference between actual cumulative disbursements and the cumulative disbursement estimates as given in the "Original SARIPR Forecast" or, ifthe loan amounts have been modified, in the "Revised Forecast." The country portfolio disbursement lag is effectively the weighted average of disbursement lags for projects comprising the Bank's country portfolio, where the weights used are the respective project shares in the total cumulative disbursement estimates. g, OED data, available in the statistical appendix to the most recent ARPP reports. Note: Disbursement data is updated at the end ofthe first week ofthe month. Supervision resources include Salaries, Benefits, and Travel for "'BB" source of funds but excludes FAO staff and PCR task costs.  Annex A2 Page I of 2 Moldova - Bank Group Fact Sheet FY 1993-1999 IBRD/IDA Lending Program, FY 1993-1999 Past Current Planned' Category FY93 FY94 FY95 FY96 FY97 FY98 FY99 Comnmitnenrts (USSmt) 26.0 60.0 90.0 55.0 115.0 120.0 100.0 Sector (%)5 Agriculturc 100.0 0.0 0.0 18.0 48.0 33.3 40.0 Education 0.0 0.0 0.0 0.0 9.0 0.0 0.0 Social 0.0 0.0 0.0 0.0 0.0 0.0 40.0 Energy 0.0 0.0 0.0 18.0 0.0 33.3 0.0 Non-sector 0.0 100.0 100.0 0.0 43.0 0.0 0.0 Power 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Private Sector Development 0.0 0.0 0.0 64.0 0.0 0.0 10.0 Transportation 0.0 0.0 0.0 0.0 0.0 33.4 0.0 Urban 0.0 0.0 0.0 0.0 0.0 0.0 10.0 TO',r< 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Lending instrument (