Moldova - Rural Finance Project

Report No. PID5896 Project Name Moldova-Rural Finance Project (+) Region Europe and Central Asia Sector Agriculture Project ID MDPA35781 Borrower Government of Moldova Implementing Agency Ministry of Finance Rural Finance Project Implementation Unit Mr. Victor Chiriac (Project Director) Tel: 373.2.221142 Fax: 373.2.223106 Environment Category B Date This PID Prepared 12/2/97 Projected Appraisal Date 11/26/97 Projected Board Date 1/9/98 Country and Sector Background 1. Moldova is a small, densely settled country that relies heavily on agriculture. The country produces a variety of agricultural products including wine, fruits and horticulture products. Food and agriculture contributed about 42t of GDP in 1995 and the sector employs about half of the total labor force. Total agriculture output contracted after independence and is expected to continue to contract, although at a much reduced speed. However, a partial recovery of agricultural exports can be observed in recent years. The Government is committed to providing a supportive environment for the emerging private farming sector with the view to developing agriculture as the engine of sustainable growth of the economy. These reforms are supported through the planned Second Structural Adjustment Program (SAL II). 2. Moldova was one of the first former Soviet Union (FSU) countries to take decisive actions to stabilize the economy. In agriculture, GOM introduced a liberal price regime in 1993 - 1995 and only provides limited direct subsidies to agriculture producers and processors. Factors that have hampered the development of agriculture have been Government interventions in the grain sector, high taxation for private farming, and indirect subsidies for some agricultural sub-sectors. This year, GOM has already taken significant steps to liberalize the grain market, complete privatization of agro-processing enterprises in the input supply and grain marketing sector, and reduce the level of indirect subsidization significantly. The encouraging reforms has lead to the approval of the Second Structural Adjustment Loan (SA II) by the Bank's Board in September 97. 3. Land reform and farm restructuring remains controversial in  Moldova, and limited progress has been achieved in this area. The bulk of the land is still used by large-scale former kolkhozes and sovkhozes but about 16t of the land is under full private management. Nevertheless, the number of independent private farmers (about 2-3 ha average) reached about 156,000 in mid-1997 and is increasing rapidly. Private family farms consistently outperform large-scale farms, which is increasingly recognized by GOM and by the agro-industrial sector. Many of the large-scale farms are de facto bankrupt because of debts, lack of capital investments, low worker morale, and deterioration of assets. Simplified farm restructuring and land privatization regulations, combined with pressure created by the increased economic difficulty of the unrestructured farms, has resulted in a new push for farm restructuring to take place. GOM has committed itself to restructure 150 farms in 1997 and 200 farms in 1998. 4. Most of these new private farms that are leaving the kolchozes and newly emerging rural enterprises can not obtain loans from the commercial banks. The major reasons are that the typical loan size are too small to cover the costs of a commercial banks using a classical lending approach. In addition, most of these clients cannot provide sufficient collateral to the banks when starting their business because they often do not have sufficient assets. At the same time, these new farms and rural enterprises have considerable potential for growth and for income-generating investments, they can provide sound business plans and propose bankable investments. Relatively small loans (often between US$ 200 and 1000) enable farmers to buy good quality seeds, fertilizer and machinery services which in turn raise the production and sale of agricultural products significantly. Cooperative banking systems like the Raiffeisen Bank in Germany, the Credit Unions in the United States, or even the Banca Populare that existed before 1940 in Moldova are well suited to provide these services to the rural population based on mutual principles. The principal benefit of such institutions is to lower the costs of financial intermediation sufficiently to make small-scale lending financially profitable. There is scope to re-introduce a similar system into the rural economy of Moldova. 5. The key objective of this project is to introduce a mechanism that would overcome the two most important impediments to financing the rural sector - high transaction costs due to small loan size and lack of traditional collateral. By creating Savings and Credit Associations, this project reduces transaction costs and creates a substitute for traditional collateral. A Pilot Project to test this concept started in March 1997 using grants from Soros Foundation and the Dutch Government of US $190,000. This money was used to establish 10 pilot Savings and Credit Associations in Moldova and to make about 500 short-term seasonal loans (6-9 months) at real positive interest rates (24%). Progress to date under the pilot project shows that the social cohesion within the SCA is necessary to form effective SCAs and ensure full loan repayment. The members are current on all loan installments, and the accounting procedures are well established. -2-  Objectives 6. The objective of the Project is to develop and test a cooperative rural banking system that would efficiently provide financial services to small private farmers and rural entrepreneurs. In order to achieve these objectives, the Project would establish Savings and Credit Associations and train their members with assistance of the Moldova Microfinance Alliance (MMA), create a regulatory body for SCAs, strengthen the Rural Finance Corporation (RFC), and finance a rural credit line to SCAs. Project Description (See 1/) 7. Development of Savings and Credit Associations (category: institution-building). The project would provide technical assistance and training to develop SCAs in the rural areas of Moldova. The Rural Finance Project Implementation Unit (RFPIU), which is under the auspices of the Ministry of Finance, will engage NGOs acceptable to IDA to develop SCAs, train the board and members of the SCA, and provide accounting services to the SCAs. The Moldova Microfinance Alliance (MMA), a local non-governmental organization (NGO) has the necessary skills to provide training to SCAs. These SCAs would mobilize savings from and lend to their members. The MMA would receive an initial grant for the first two years of operations from the Soros Foundation, WWB, and possibly the Gesellschaft fuer Technische Zusammenarbeit (GTZ) to cover the costs of the foreign technical assistance and part of the local operating cost. The other part of the operating cost will be covered through a small fee MMA charges the SCAs. 8. Establishment of a regulatory body of the SCAs (category: institution-building). The project will provide technical assistance and training to the RFPIU to temporarily supervise and regulate SCAs, to develop the framework for a permanent regulatory body of SCAs, and to finance year-end audits of SCAs established under the project. This regulatory body would monitor compliance of SCAs with the prudential rules for SCAs, which have been agreed between the Government and IDA during preparation. The design of the regulatory structure is still under discussion and will be further developed and tested during project implementation. Future regulation is possible through either (a) a government regulatory body for SCAs or through (b) a self-regulatory body created by the SCAs. 9. Establishment of the Rural Finance Corporation (RFC) (category: institution-building). The Project would provide technical assistance and training to the RFC. This is a new wholesale institution to channel a credit line to legally registered SCAs. It will be owned by its member SCAs, registered as a financial joint-stock company under Moldovan law, and licensed as a non-bank financial institution. RFC will operate according to agreed prudential rules and an agreed policy manual, specifying RFC's lending policies. If more than 10. of the credits from SCAs to RFC are overdue by more than 60 days, the Bank may suspend the loan. All SCAs borrowing from the RFC must contribute to the share capital of RFC and become shareholders. -3-  10. Rural Credit Line for SCAs. The Project would provide a credit line to RFC who in turn will extend loans exclusively to SCAs operating in the rural areas. The SCAs will, in turn, onlend these loans to their members. Most of these loans will be small (average US$ 500-700) short-term loans (9 - 12 months) to finance investments for productive purposes like seasonal agricultural inputs, spare parts for equipment, small works, or other small investments. Only SCAs which received training from the MMA, are fully current in their debt service obligations to the RFC, and meet the SCA's prudential rules, would qualify for a loan. For small loans, the SCAs will rely mainly on a mutual guarantee of its members and for larger and medium-term loans the SCAs will require the member- borrowers to provide collateral. All members of the SCA jointly guarantee repayment of the entire loan to the RFC. SCAs will be responsible for evaluating loan applications from members combining them into a single loan application and submitting it to RFC. The RFC's loan assessment will be limited to reviewing the SCAs financial soundness, but without evaluating individual loan applications. Project Financing 11. Total Project Costs are US $6.1 million , as shown in the table below. Project Cost Table Component Category Cost Incl. 9 of Bank W of Contingencies Total Financing Bank- (US$M) (US$M) financing Establishment institution 0.8 14t 0 0t of SCAs building Regulatory institution 0.2 3t 0.2 Body of SCAs building Establishment institution 0.2 3t 0.2 of the RFC building Rural Credit credit 4.9 80 4.6 92t Line for SCAs line Total 6.1 100t 5.0 100t Summary Implementation Arrangements 12. The overall direction and coordination of the agricultural investment program (consisting of the First Agriculture Project, the proposed Rural Finance Project, and the proposed Irrigation Rehabilitation Project) is in the hands of the Project Preparation Committee (PPC). The PPC is chaired by a Deputy Prime Minister, includes representatives of different Ministries, and has been functioning since mid 1996. Project identification and preparation was managed by the RFPIU under the auspices of the Ministry of - 4 -  Finance. The RFPIU was officially created in March 1997, and coordinates all the RFP activities. During implementation, it will be responsible for: (i) coordinating project activities, (ii) managing monitoring & evaluation, procurement and reporting to IDA, (iii) administering disbursements and oversee the collection of funds advanced to the RFC; (iv) engaging NGOs to develop and train SCAs, (v) temporarily supervising the SCAs created under the Project until a regulatory body has been established. For the detailed monitoring and evaluation arrangements, indicators, and responsibilities, compare the Project Design Summary (Annex 1). The staff of the RFPIU will consist of a Director, a regulatory officer, and an administrative assistant Sustainability 13. The project is designed to ensure that over time the rural lending by the participating commercial banks is placed on a self- sustaining basis. The activities of the RFC will initially need to be subsidized, but experience in other countries shows that with increases in loan volumes over time, the RFC will also become self- sustaining. The technical assistance components will ensure that adequate domestic implementation capacity is built through the improvement of Moldova's human resource skills in rural finance. Lessons learned from past operations in the country/sector 14. Whereas microfinance operations are one of the best tools to increase the economic participation, income and assets of the bottom 50- of a countries economic active population, a new start-up operation is difficult to design and risky to implement. Therefore complexity of the project was reduced to only focus on the development of sustainable financial institutions and an appropriate legal and regulatory environment for these institutions. Experience worldwide is available to define the actions needed to build a sustainable microfinance system. Regarding the financial sector policies, the Government and the NBM are encouraging structural change in the financial system, by developing a law for SCAs and setting up a regulatory structure that encourages the entry and growth of SCAs. 15. Key to successful support of the wholesale intermediary (RFC) is strong leadership to establish and enforce high performance standards for financial and operating performance; accountability, autonomy and freedom from political interference, the capability to mobilize funding to build the own sustainability of RFC; intimate knowledge of and competence in assessing the retail institutions (SCAs). These standards include excellent repayments, non- subsidized interest rates that are high enough to finance and part of the operating costs allowing for a limited subsidy to cover operating losses over the first two years, low operating costs, diversity in portfolio between agriculture and rural non- agricultural microentrepreneurs, and an achievable plan to capitalize RFC over time. Sound governance, reduction of political influence, and accountability would be ensured through majority SCA ownership and a stepwise capitalization of RFC. Likewise, RFC will - 5 -  know the SCAs intimately and only wholesale loans to those SCAs that meet similar agreed performance standards and will not attempt to make direct loans to microentrepreneurs. 16. International experience suggests that the development of SCAs needs to be subsidized in the first years. In order to separate the development function from financial service transactions, an NGO, the Microfinance Development Center will provide these services on a separate balance sheet with donor grant financing. The Development Center would also provide training programs and information exchange to SCAs and commercial banks in order to motivate the local banking sector to lend to SCAs. 17. The SCAs need to be in a position to mobilize financial resources locally as a primary source for loan funs and reduce dependence on external grant financing. Therefore, the establishment of the legal and regulatory framework supported by the project would allow SCAs to legally mobilize savings from their members and would set appropriate prudential standards. Poverty Category 18. The Saving and Credit Group sub-component of the Project focuses on providing small loans to small private farmers and rural entrepreneurs. It directly targets the poor and disadvantaged groups in the rural areas and would therefore directly contribute to alleviating poverty. The ongoing poverty assessment, the social assessment of the agriculture sector and similar studies to be published in 1997 will provide detailed information on average household income in the rural areas. However, it is widely assumed that income in the rural areas is predominantly irregular, and significantly below the national average. The Project therefore addresses the most important need named by respondents in surveys - access to small loans and other financial services to finance investments or consumption needs. In addition, a baseline survey of the socio-economic conditions facing small-scale farmers and employees of large agricultural farms is underway to enable the monitoring of farm incomes, demographics of the farming population, and major constraints facing agriculture at the micro-level. Environmental Aspects 19. The Project would be classified as category "B" in the Bank's environmental rating. The credit officers of RFC and the training officers of the Microfinance Alliance will receive a training course on environmental screening of loan applications. In addition, a leaflet on the use of agricultural chemicals will be distributed to the SCAs. Ex-post evaluation of the pilot project will include an evaluation of the exact nature of the activities financed by the credits. If necessary, additional environmental controls will be built in. Pesticides categorized as: 1(a) (extremely hazardous) and 1(b) (very hazardous) under the WHO classification will not be financed under the loan. Program Objective Categories -6-  20. This Project falls into the Program Objective Category of Private Sector Development. 1/ All costs shown in this section are without contingencies. Contact Point Florian Grohs, Task Manager The World Bank 1818 H Street N.W. Washington, DC 20433 Telephone No.: (202) 458-4319 Fax No.: (202) 522-1164 Note: This is information on an evolving project. Certain activities and/or components may not necessarily be included in the final project. Processed by the World Bank InfoShop week ending January 9, 1998. ANNEX 1. Environmental Review 1. There are no environmental impacts expected from the institutional components. The small loans provided under the rural credit line to farmers would be aimed at increasing the agriculture production of smallholder farms from their existing fields. No more than 5t of the outstanding credits would be used to purchase agricultural chemicals (fertilizers or pesticides). Investments in non-agricultural activities are not expected to lead to any negative environmental impacts. 2. The proposed mitigation actions include the implementation of a training course for the credit officers of the RFC, the training officers of the MMA, and the staff of the SCAs on environmental screening of loan applications, including pesticide hazard classification. This training will allow the officials of the RFC and the SCAs to screen and eliminate dangerous pesticides from loan applications. Ex-post evaluation of the pilot project include an evaluation of the exact nature of the activities financed by the credits, and if it is necessary, to build in additional environmental controls. Pesticides categorized as 1(a) and 1(b) under the WHO classification will not be financed under the loan. - 7 -