Zambia - Enterprise Development Project

Document of The World Bank Report No. 16524- ZA STAFF APPRAISAL REPORT REPUBLIC OF ZAMBIA ENTERPRISE DEVELOPMENT PROJECT MAY 6, 1997 Economic Management and Social Policy Private Sector and Finance Africa Region  CURRENCY EQUIVALENT (as of March 31, 1996) Currency Unit = Zambia Kwacha (K) US $ = KI,300.00 SDR I = KI,802.44 KI,000 = US$0.77 AVERAGE ANNUAL EXCHANGE RATE Year K per US Dollar 1994 = 699 1995 = 866 1996 = 1229 WEIGHTS AND MEASURES I metric ton (tonne) = 1000 kg or 2,205 pounds I meter (m) = 3.2808 feet I kilometer (km) = 0.6214 miles ABBREVIATIONS AND ACRONYMS BAZ = Bankers Association of Zambia BOZ = Bank of Zambia CAS = Country Assistance Strategy DBZ = Dvelopment Bank of Zambia EBZ Export Board of Zambia EDI' Entcrprise Developutent Projcect EEC Etiropeani Econornic Conminniity EPF = Export Preshipinent Credit GRZ Government of Republic of Zambia IBRD = International Bank for Reconstruction and Development IC = Investment Center ICF = Investment Credit Facility lFC Intemational Finance Corporation IDA = International Development Association IMF = International Monetary Fund LIBOR = London Interbank Offer Rate MCF = Multipurpose Credit Facility MCTI = Ministry of Commerce, Trade and Industry MGS = Matching Grant Scheme MGSC = Matching Grant Supervisory Committee NFU = National Farmers' Union NTE = Non-Traditional Exports PFI = Participating Financial Intermediary RPED = = Regional Program on Enterprise Development SIDO = Small Industries Development Organization TAZ = Tobacco Association of Zambia TPZ = Textile Producers of Zambia UNDP = United Nations Development Programtne ZACCI = Zambia Associationi of Chanibers of Commerce and Industry ZAM = Zambia Association of Manufacturers ZCFG = Zambia Cofree Growvers' Association ZEGA = Zambia Export Growers' Association ZIB = Zambia Institute of Bankers ZNCB = Zambia National Commercial Bank FISCAL YEAR January I to December 31 Vice President: Callisto Madavo Country Director: Phyllis Pomerantz Technical Manager: Thomas W. Allen Task Team Leader: Ahmet 1. Soylemezoglu  REPUBLIC OF ZAMBIA ENTERPRISE DEVELOPMENT PROJECT CREDIT AND PROJECT SUMMARY Borrower: Government of Zambia Implementing Agency: Ministry of Commerce, Trade, and Industry Beneficiaries: Private sector enterprise, participating financial institutions Poverty: Not applicable (not a targeted intervention). The project is expected to offer a significant improvement in poverty alleviation through employment creation. Amount: SDR 32.6 million (US$45 million equivalent) Terms: Standard IDA Terms (40 Year maturity, 10 Years grace, 0.75% service charge) Commitment Fee: 0.50% on undisbursed balances, beginning 60 days after signing, less any waiver On-Lending Terms: * From Apex to Participating Financial Intermediaries at LIBOR plus two percentage points * Rates to final borrowers freely negotiated between PFIs and their clients Financing Plan: See Table 9 Net Present Value: $12.60 million at a discount rate of 13% (economic rate of return 17%) Staff Appraisal Report: 16524 - ZA Map: #26792 Project Identification Number: ZA - 44324   THE REPUBLIC OF ZAMBIA ENTERPRISE DEVELOPMENT PROJECT STAFF APPRAISAL REPORT TABLE OF CONTENTS CREDIT AND PROJECT SUMMARY ..................................................... III 1. INTRODUCTION ......................................................1 2. MACROECONOMIC ENVIRONMENT ......................................................3 3. THE PRIVATE SECTOR ......................................................5 A. Origin and Evolution of The Private Sector .................................................................5 B. Basic Characteristics of the Entrepreneurs .................................................................6 C. The Scope of the Private Sector .................................................................7 D. Enterprise Development Constraints .................................................................8 E. Export Potential and Constraints .................................................................9 F. Business Support Services ................................................................ 12 4. FINANCIAL MARKETS AND THEIR REGULATION ..................................................... 13 A. Structure of the Financial Sector ................................................................ 13 B. Economic Regulation and Monetary Policy ................................................................ 16 C. Prudential Regulation and Supervision ................................................................ 17 5. THE PROJECT ..................................................... 18 A. Origin and Relation with CAS ................................................................ 18 B. Project Objectives ................................................................. 19 C. Lessons Learned ................................................................ 19 D. Project Description ................................................................ 20 E. Project Cost and Financing Plan ................................................................ 27 F. Project Implementation ................................................................ 28 G. Environment ................................................................ 32 H. Project Benefits and Risks ................................................................ 33 6. AGREEMENTS, ASSURANCES, CONDITIONS AND RECOMMENDATION ........................... 35 A. Assurances to be Received During Negotiations ................................................................ 35 B. Condition of Effectiveness ................................................................ 36 C. Condition of Disbursement ................................................................ 36 D. Recommendation ................................................................ 36 Annexes A. Company Registration By Sector ................................................................ 37 B. Summary Employment Statistics ................................................................ 38 C. Business Support Organizations ................................................................ 39 D. Privatization Program Status ................................................................ 40 E. Matching Grant Scheme ................................................................ 41 F. Multi-Purpose Credit Facility ................................................................ 53 G. Institutional Development Component ................................................................. 66 H. Summary of Procurement Arrangements ................................................................ 74 I. Summary of Disbursement Arrangements ................................................................ 75  J. Project Implementation Plan ............................................. 76 K Implementation Support Plan ............................................. 78 L. Economic Analysis and Performance Monitoring Indicators ............................................. 81 M. Financial Sector Overview ............................................. 96  THE REPUBLIC OF ZAMBIA ENTERPRISE DEVELOPMENT PROJECT STAFF APPRAISAL REPORT 1. INTRODUCTION 1.1 Since Zambia's independence in 1964, copper has consistently remained at the center of its economy -- even after copper prices collapsed in 1975, leaving the country heavily indebted and poorer. Several partial attempts at economic reforms during the 1980s not only had little positive impact on growth but also increased the debt burden of the country. Arrears accumulated, and the Bank and IMF suspended lending operation between 1987 and November 1991 (except for a brief period in 1991). Following elections in 1991, and a change in government, these operations resumed. Over the past five years, Zambia has implemented one of the most ambitious and comprehensive economic reform programs on the African continent with considerable support from the donor community. In support of this program, the Bank has implemented five adjustment operations with the sixth one approved in August 1996. The country is also reorganizing and reducing its debt. A Commercial Debt Reduction Operation has been concluded. Zambia also finished a Rights Accumulation Program with the Fund in 1995 and began an ESAF program. 1.2 Significant success in the policy reform area has not, however, yet put the country on a growth path which would reduce dependence on external assistance and be sustainable in the medium to long run. The newly liberalized economic system exposed the inefficiencies inherent in the Zambian industrial sector which was established with the purpose of import-substitution and dominated by parastatals. The obsolete equipment and processing techniques, and outdated product-mix of Zambian firms not only have prevented them from penetrating export markets but also have put these firms in a competitively disadvantageous position with the imported products in the domestic markets. Thus, a significant job loss occurred in the industrial sector with the implementation of the economic reform prograrn. Although some contraction of inefficient operations was inevitable, output and employment losses were exacerbated by the high degree of dependence of manufacturing activities on purchases by the state- owned copper company (ZCCM), which also has shrunk considerably.  2 1.3 Lack of significant supply response has become a major concern for Zambia's reform program. Delays in supply response threaten the economic reform program by contributing to serious political and poverty issues especially in the urban areas where about half of the population live. For a supply response to occur: (i) Zambian firms need to reinvest in their operations by acquiring new technologies and equipment which could make them competitive both in Zambia and abroad; and (ii) Zambian entrepreneurs need to take advantage of the emerging opportunities within the new liberal economic system. 1.4 There are two types of factors accounting for the lack of supply response-- economy-wide and firm-related factors. The economy-wide factors stem from general economic and social problems and include: (i) unstable macroeconomy; (ii) underdeveloped physical infrastructure which causes logistical problems; and (iii) deficiencies in education and in industrial training which constrain labor productivity. The second type of constraining factors arise from the characteristics of Zambian firms and Zambian financial sector: (i) Zambian firms which were established under an import- substitution regime in a highly protective environment have inefficient operations; (ii) Zambian firms have limited capabilities to pro-actively seek out ways and means of transforming their business into viable enterprises in a liberal economy; (ii) Zambia's financial sector does not have sources of funds to provide necessary long term finance for investments, and working capital needs of exporters; and (iii) institutional underpinnings of the newly liberalized financial system are weak and the recent bank failures have undermined public confidence. In addition to these factors, Zambia recently has been hit with an unusual frequency of droughts with two major and one minor drought in the last five years. 1.5 There have significant efforts to address economy-wide and sectoral problems on the part of the donor community. The World Bank/IDA and the IMF have been carrying out macroeconomic dialogue through a series of operations which are closely coordinated. The Bank/IDA also have a portfolio of continuing operations involving infrastructure, agriculture, environment, health and education. The various other donors have been providing assistance directed towards these purposes as well as to some specific industrial sectors (e.g. horticulture, tobacco, coffee) and to certain sections of the society (e.g. micro-scale entrepreneurs). However, there has not been a concerted effort to address firm-related factors. 1.6 Zambia's macroeconomic reform program thus needs to be complemented with micro-level focused projects, and the proposed project is specifically designed for this purpose. It would support firm-level efforts at restructuring by: (i) providing advice through the use of matching grants; (ii) providing long-term credit facility for investment; (iii) providing a short-term credit line for exporters; (iv) providing technical assistance to help strengthen the institutional underpinnings of the financial system--wholesale, retail, and regulatory; and (v) providing technical assistance to create a common and easily accessible information and data base with modern tools for Zambian entrepreneurs, through the Export Board of Zambia.  3 2. MACROECONOMIC ENVIRONMENT 2.1 Inflation. Inflation was unacceptably high during the late 1980s and in the first half of the 1 990s, averaging 44 percent per annum between 1985 - 1987 and increasing to 55 percent in 1988 following the abandonment of the economic reform program. Inflation accelerated to 130 percent in 1989 and stayed at around 100 percent until 1992. In 1992, inflation jumped to 200 percent and continued at these levels until 1994. In 1994, better monetary control was established, and inflation fell to 53 percent in 1994 and to 40 percent level in 1995. Inflation in 1996 was about 35 percent and is currently projected to decline to below 20 percent next year. 2.2 Exchange Rate. The official value of Zambia's currency (Kwacha) appreciated significantly after the mid 1980s when policy focus turned inward. The real exchange rate remained relatively constant in the early 1990s, after a brief depreciation at the beginning of the decade, in spite of trade liberalization. The real rate appreciated sharply for a few months in the late 1993, but that was followed by a sharp depreciation in the same year. A slight downward trend in the index of real exchange rate which had started in the late 1994 continued throughout 1995. The index of real exchange rate depreciated early in 1996 and appreciated back to its 1995 level towards the end of 1996. The tight containment of domestic demand, modest recovery in the price of copper and donor inflows significantly influenced the level of exchange rates. 2.3 Interest Rates. Until March 1993, lending and borrowing rates were administratively determined. Although the rates were supposed to reflect underlying inflation, real interest rates in general were negative. Subsequent to the implementation of Treasury Bill auctions, the real interest rates turned positive. As a matter of fact, the real rates increased sharply with nominal rates. The real rates on treasury instruments which became an important determinant of the interest rates on the other financial instruments in the economy followed a highly volatile path, including becoming negative occasionally, until the middle of 1995 when nominal yields stabilized around 50-60 percent range with inflation staying around 40 percent. The nominal interest rates stayed within the 40 - 55 percent range throughout 1996. 2.4 Privatization. Zambia embarked on a very comprehensive privatization effort with the establishment of Zambia Privatization Agency (ZPA) in September 1992. Upon the approval of PIRC II (Second Privatization and Industrial Reform Credit C25230-ZM) in June 1993, the privatization policy found a necessary momentum. After a slow start, the process has really taken off over the twelve months from June 1995 to June 1996 when about 100 companies out of the total 137 were privatized during this period. The remaining 98 companies/units in the total portfolio of 235 in the program have mostly been prepared for sale or liquidation (see Annex D for a detailed list of these companies). Zambia also showed its determination for privatization program by starting the process for privatization of ZCCM. A separate program for ZCCM privatization aided by the Bank's ERIP TA (Economic Recovery and Investment Promotion Technical Assistance,  4 C28750-ZM) credit is well underway and on schedule. Since the bulk of the privatization occurred very recently, it is difficult to pass a judgment on the current situation of these firms. However, the World Bank findings on the companies that were privatized at the earlier stage (in 1994 and early 1995) indicate that there was a rationalizing of the products and product lines and improvement in the product quality and financial position of these firms. Some of these firms, especially those sold to the foreign investors, also engaged in considerable investments. Based on the World Bank staff interviews, Zambian business people are also happy with the newly privatized companies and they indicated that these companies shifted their procurement to domestic companies where possible and thus created additional business volume for them. 2.5 Trade Policies. Although tariff levels were reduced in the early 1990s, trade policies by and large remained discriminatory for exporters who import substantial amount of inputs until very recently. There were also substantial duties imposed on capital goods. The 1996 reforms addressed these problems by introducing much lower duties on capital goods and inputs. The duty ranges decreased to 5 - 25 percent from 20 - 40 percent, with many raw materials and most capital goods subject to tariff levels 0 and 5 percent, respectively. 2.6 Investment Performance. Investment in Zambia which averaged about 25% of GDP during 1964-1975 era, became stagnant around 14 % of GDP after the collapse of copper prices in 1975, and declined further after 1991. It fell to 9.5% of GDP in 1994. In 1995, investment showed some signs of recovery and increased to 12.5% of GDP which is about the average level of investment in the 1990s. An increased investment demand was observed from recent firm visits and interviews with the commercial banks. It appears that this increase in investment demand is due to three factors: a, investors have begun to discover their competitive edge (especially in activities which add value to local raw materials); b) increased privatization activity (a total of 137 companies were privatized, including some very big parastatals such as Chilanga Cement and Zambia Breweries) and the desire of new owners and potential owners to rehabilitate these companies; and c) the excellent harvest in 1996. 2.7 Recent Performance Under Reform Program. Although Zambia's economic reform program has enjoyed an exceptional level of international support, the events of the last year related to the elections, on top of long-standing good governance concerns, have resulted in a deterioration of relations between Zambia and its bilateral partners. This led to a suspension in June of bilateral balance of payments support. 2.8 Meanwhile, Zambia's performance in meeting the IMF ESAF benchmarks has been by and large satisfactory though, at times, implementation has been uneven. For example, six of the end December 1995 benchmarks were not met due in large part to the poor financial performance of ZCCM. Corrective actions were taken, however, and Zambia has met the revised targets for end-March, end-June and end-September targets. The Bank's newly approved adjustment loan disbursed its first tranche ($45 million) in October, after a joint IMF/Bank mission confirmed that the September targets have also  5 been met. Based on the performance through 1996, the IMF mid-term review of the current ESAF program was approved by the IMF Board on February 28, 1997. The bilateral donors and the Government have also resumed a constructive dialog on governance and economic policy issues. The next Consultative Group meeting is scheduled for July 1997. 3. THE PRIVATE SECTOR A. Origin and Evolution of The Private Sector 3.1 Origin and Early Developments. The presence of private entrepreneurs in Zambia dates back to the pre-independence period. After Independence this private sector, which had extensive foreign interests, was viewed with suspicion -- resulting in the 1968 "Mulungushi Reforms" which nationalized large scale non-mining operations. The "Matero Reforms" of 1969 extended the nationalization process to mines. The private activity which survived was either in the form of minority shareholding in the nationalized companies (e.g. Lonrho, Anglo-American, Tate&Lyle, Dunlop, Duncan Gilbey & Matheson, Shell, etc.) or as multinational corporations (e.g. Coca-Cola, Colgate, Bata Shoe, Barclays, Standard Chartered) or as small/medium enterprises. 3.2 Recent Developments. The recent liberalization program created two major trends in the private sector. First, there is increased activity in informal sector, mainly by small traders and street vendors. Second, there is increased activity in the formation of new companies. Table I below shows that total company registrations averaged about 2250 per year in the 1990s, with a total of over 11,000 new companies created (details are presented in Annex A). Trading sectors (import/export, wholesale and retail grocers) have the biggest share in the newly formed companies. Some new companies have also been created in the sectors where there had not been any significant activity prior to liberalization, such as financial services. Table 1: New Company Registration By Sector 1991 1992 1993 1994 1995 Mining 129 188 72 79 65 Agriculture 143 260 117 128 215 Manufacturing 229 251 236 280 178 Tourism 79 141 106 119 107 Transport/Communication 113 230 124 132 211 Trade 549 627 461 519 529 Financial Services 26 35 56 120 41 Others 697 1012 786 957 857 TOTAL 1965 2744 1958 2334 2203 Source: Zambia Registrar of Companies  6 B. Basic Characteristics of the Entrepreneurs 3.3 The ongoing RPED (Regional Programme for Enterprise Development) Surveyl offers some very valuable insights as to the characteristics of Zambian manufacturing firms as well as perceived handicaps for further business development. As Tables 2 and 3 show, some important conclusions of this survey regarding the basic characteristics of the Zambian firms are that: * Ethnic Africans are very new to the business scene, they are younger than European and Asian origin entrepreneurs, and the vast majority of them have established the businesses they owned; * Even though the general level of education is fairly low, entrepreneurs are typically better educated than the average Zambian and have considerable industry experience. While 66.5 percent of entrepreneurs have no more than high school education, 15.6 percent reached university level while 3.2 percent had undertaken some sort of technical/polytechnical or professional training; * Firms that are established at a small scale, stay small. This is particularly true for firms owned by ethnic Africans. Thus, of the 76 firms in the survey which employed fewer than five people at start up, after a subsequent average 11.7 years in business, only 27.6 percent (21 firms) had more than 10 employees; * Lack of funds appears to be an obstacle both to the establishment and the development of firms. RPED is an ongoing research program in six African Countries (Cote d'lvoire, Ghana, Kenya, Tanzania, Zambia, and Zimbabwe) directed by the World Bank and sponsored by eleven other bi-lateral donor institutions.  7 Table 2: Ethnic Origin of Zambian Entrepreneurs (number of respondents) African Asian European Middle Eastern Number of Owners 102 44 19 3 Age of company 34 37.3 36.5 28.7 founders at year of start-up Average Year of 1980 1974 1971 1990 start-up Business Acquirement: Founded 84 (82.4%) 26 (59.1%) 13 (68.4%) 3 (100%) Bought 8 ( 7.8%) 8 (18.2%) 4 (21.1%) 0 (0.0%) Inherited 8 (7.8%) 7 (15.9%) 2 (10.5%) 0 (0.0%) Others Source : RPED survey (percentages in the last row indicates percent of the total in that group) Table 3. Educational Background of Zambian Entrepreneurs by Ethnic Origin (number of respondents) African Asian European All Employees None 5 (5.0%) 0 ( 0.0%) 0 (0.0 %) 5 (3.0%) 2.1% Primary School 20 (19.8%) 5 (11.4%) 2 (10.5%) 27 (16.2%) 30.8% Secondary 49 (48.5%) 19 (43.2%) 8 (42.1%) 79 (47.3%) 52.0% School University 13 (12.9%) 10 (22.7%) 3 (15.8%) 26 (15.6%) 1.7% Vocational 6 ( 5.9%) 1 (2.3%) 1 ( 5.3%) 8 (4.8%) 8.8% Technical/ 4 (4.0%) 4 (9.1%) 4 (21.1%) 12 (7.2%) 2.7% polytechnical Professional 4 (4.0%) 5 (11.4%) 1 (5.3%) 10 (6.0%) 1.9% Source: RPED Survey (percentages in parenthesis show the percentage in each ethnic group, and percentages of employees falling into each category) C. The Scope of the Private Sector 3.4 It is very difficult to estimate the aggregate size of Zambia's private sector, as the country's national accounts do not decompose changes in output into their public and private components. Employment statistics are, thus, often used as an indication of the size of and the trends in the sector. The most recent available figures (see Annex B) indicate that the total employment loss is about 10 percent since 1991. The parastatal sector has the highest ratio of job loss, with about 15 percent during this period while the private sector employment decreased about 5 percent. 3.5 Composition of Manufacturing Activities. Zambia's portfolio of manufacturing activities has had substantial structural shifts since 1975. However the nature of these shifts are quite different in the pre-1990 era and the post-1990 era. The former is mainly  8 due to stagnant demand, while the latter is attributable to the changes in macroeconomic environment. Table 4: Subsectoral Distribution of Zambia's Manufacturing Percentage of Gross Output Subsector: 1975 1990 1994 Food, beverages and tobacco 27.4 39.3 54.9 Textiles, garments and leather 12.5 12.2 7.7 Wood and Furniture 5.2 2.3 2.3 Paper and printing 5.5 5.4 4.3 Chemical and rubber 20.2 19.0 13.5 Non-metallic minerals 5.0 6.4 4.3 Basic Metals and metal products 23.6 15.1 12.7 Other 0.5 0.3 0.2 Source: CSO The above table needs to be further disaggregated in order to grasp the dynamics of the impact of the recent economic policies. For example, although textiles show a significant decline in the index value, manufacturing of cotton yarn -- which yields significant portion of non-traditional exports -- has been a boom sector for Zambia. The decline in the index is mainly due to closures of the manufacturers of higher end products (such as woven textiles and garments) which could not compete with imports. Similarly, there are significant signs of growth in certain segments of wood related industries even though the index is showing a continuos decline D. Enterprise Development Constraints 3.6 In the RPED survey, Zambian firms of all sizes identified lack of access to credit, competition from imports, insufficient demand, and infra-structural weaknesses as their most difficult constraints -- although there is some variation in perceptions by sector of activity and by firm size. The summary results of these perceived constraints are presented in Table 5. Access to finance is more difficult for smaller firms, while competition from imports threatens more the larger firms. It is interesting to note that Zambian firms do not consider government restrictions to be a handicap for business growth. On the other hand, inflation is perceived to be a significant burden.  9 Table 5: Perceived Business Constraints All Firms Small Firns Large Firms (50+empl) (I -110 employees) Average Among Average Among Average Among Score three Score three Score three biggest biggest biggest problems problems problems (in %) (in %) (in %) Lack of Credit 3.5 52.6 4.0 71.6 3.3 42.0 No demand 2.8 24.2 2.5 24.3 3.2 26.1 Competition from Imports 2.6 22.8 1.8 14.9 3.2 26.1 Lack of Infrastructure 2.8 19.5 3.0 33.8 2.7 13.0 Inflation 2.6 47.4 1.8 33.8 3.2 58.0 Security na 14.9 na 16.2 na 15.9 Lack of Skilled labor na 12.6 na 8.1 na 15.9 Lack of Business Support 2.4 11.2 2.4 16.2 2.2 4.3 Services Taxes 1.8 6.0 1 .0 0.0 1.2 0.0 Government Restrictions 1.1 1.4 1.1 1.4 1.2 2.9 Utility Prices 3.1 23.7 2.3 10.8 3.4 26.1 Source: RPED survey (scores 1: not at all 3: moderate obstacle 5: severe obstacle, percentage figures reflect percent of total companies in each group perceiving a particular item as a constraint) E. Export Potential and Constraints 3.7 Aggregate Exports. Zambian exports are dominated by traditional mining products -- copper, lead, zinc, and cobalt. However, reserves in the existing mines of these metals are rapidly being depleted. Some of these mines are no longer economically viable to operate and have closed--such as Kabwe lead mines--and others are facing closures. Despite increases in non-traditional exports (see below) total exports have declined in tandem with the decline in traditional exports. Table 6: Aggregate Exports 1990 -1995 (in $ million) 1990 1991 1992 1993 1994 1995 Total 1150.6 998 1010.3 849 910.6 1022.2 Exports Copper 1055.0 895.0 867.0 734,0 741.3 852.1 Cobalt 77.0 94.0 135.0 108.0 161.8 161.9 Zinc 17.0 9.0 8.0 7.0 7.2 7.8 Lead 1.6 .. 0.3 .. 0.3 Non- 113 87.4 100.3 99.9 156 175.9 Traditional Exports TOTAL 1263.6 1085.4 1110.6 948.9 1066.6 1198.1 Source: Prospects for Sustainable Growth in Zambia-1995-2005, The World Bank, 1995 3.8 Non- Traditional Exports (NTE). Zambia's NTEs exports, according to preliminary data, has reached to US$215 million in 1996. This figure marks an increase  10 of about 100% since 1990, corresponding to an annual growth rate of about 12%. Their share in total exports has thus continually risen -- reaching about 22% in 1996 from about 10% in 1990. Most of this increase has, however, come from a select few sectors (i.e. textiles, floricultural, processed food). Table 7: Distribution of Non-Traditional Exports 1990 - 1995 (in $ million) 1990 1991 1992 1993 1994 1995 Animal Prod. 2.53 0.85 0.45 0.60 0.37 0.42 Build. Mat 3.98 2.66 3.78 2.97 3.19 3.60 Chemical 3.42 1.84 1.93 0.81 2.36 2.66 Engineering 21.69 20.02 24.42 25.19 36.15 40.76 Floricultural 1.16 1.37 2.94 4.43 9.55 10.77 Garmnents 2.78 1.85 1.34 0.55 0.52 0.59 Handicrafts 0.21 0.07 0.06 0.06 0.09 0.10 Horticultural 5.02 4.18 2.89 1.93 2.54 2.86 Leather 1.15 0.49 0.37 1.01 1.29 1.46 Minerals 1.89 1.31 1.52 1.10 0.86 0.97 Mining equip. 0.41 0.05 0.07 0.02 0.05 0.06 Other man. 1.20 0.65 0.38 0.02 0.03 0.03 Petrol oils 12.32 2.70 1.06 0.14 4.11 4.63 Agri. commo 16.08 16.40 19.64 20.18 10.49 11.83 Processed Food 6.85 3.43 13.95 12.17 23.26 26.22 Gemstones 8.44 7.34 9.78 10.71 9.89 11.15 Textiles 9.49 6.76 13.45 8.91 29.83 33.63 Wood prod. 0.87 0.37 0.64 0.44 0.94 1.06 Electricity 13.49 15.05 1.63 8.66 20.49 23.10 TOTAL 113.00 87.40 100.30 99.90 156.00 175.90 Source: Export Board of Zambia and World Bank estimates 3.9 The recent Bank study on growth prospects for Zambia projects that NTEs will grow at an annual rate of 14.5%, to reach to US$575 million by 2004. By that time, traditional exports are expected to be US$910.2 million. The share of NTEs in total exports is projected to increase to more than one third of total exports in 2004 of estimated US$1.485 billion. The 1996 performance of exports, with about a 30% increase over 1995 level, suggest that these projections are well on target. 3.10 The projected increase in NTE is mainly due to the opening up of new opportunities for Zambia's farmers as a result of the recent liberalization in agriculture. The Growth Prospects study projects significant increases in the production of cotton, soya beans, groundnuts, and sorghum. These industrial crops are likely to encourage down-stream processing. There are already signs: cotton yarn exports have doubled almost every year since 1991; and multinational companies are already targeting oil-seed processing and organizing outgrower schemes to supply their industrial operations.  I1 3.11 Comparative Advantages and Disadvantages. Zambia's major roadways, power, communication facilities, and financial services are in quite good shape when compared to most of the countries in the region. Moreover, Zambian utility prices (excluding international telephone charges) are among the lowest in the region. Table 8: A Summary Assessment of Some Factors of Production in Zambia Factor Zambia's Position Wages About $30/month for skilled labor Power Significant power surplus (exports to region), consistent and about 2 US cents per kwh (planned to be raised to 4 US cents) Water Available, but serious distribution problems especially in the Copperbelt Industrial Culture A tradition of industrial culture exists, especially in the Copperbelt Roads Main routes are in good condition, subsidiary roads need improvement Communication Available, relatively reliable, domestic rates are very low; international rates are very expensive Air Link Daily air transport between Lusaka and major cities in the region. Direct flights to London and Paris (four times and twice a week, respectively) In-land Transport Substantial amount of trucking capacity available, takes very long mainly due to border processings and very expensive to and from regional ports (about $3500 per container round trip) Financial Services Widely available for all transactional purposes. Term finance severely limited. Source: World Bank Staff estimates. Zambia also compares favorably to other countries in terms of wages, and utility costs. Although the current productivity levels are far from levels which would make these cost advantages really attractive, Zambia has a core-industrial culture, especially around the Copperbelt. With the appropriate training and modern management techniques, existing industrial labor force could in time become an asset for foot-loose industries, such as garments -- especially if South Africa's market becomes more open to the subregion. 3.12 Zambia's geographical position is, however, a major constraining factor. In addition to being land-locked, Zambian exporters have to deal with time delays in ground transportation to and from major ports. Significant delays in border crossings create  12 additional financial and logistical problems. The impact of geography is not, however, all negative. Any improvement in South Africa's trade practices will certainly create new opportunities for Zambian manufacturers in the region's single most important market. Zambia also has some potential markets in the North. These markets could in time be attractive, especially for Zambia's engineering product sectors and heavier industries. Some multinationals in the Copperbelt are already trying to establish themselves in countries such as Kenya, Tanzania, and Zaire. This Northern development is, however, constrained by political uncertainties and the pace of economic growth in these countries F. Business Support Services 3.13 Types of Business Support Organizations. Zambia has two categories of business support organizations: public, and private. All public organizations were established by a parliamentary act with a legal mandate. These organizations are intended to serve specific business segments. Some of them were also given a regulatory authority in the sectors in which they operate. The Small Industries Development Organization (SIDO), the Investment Center (IC), and the Export Board of Zambia (EBZ) are among the most prominent of these organizations (A complete list of these organizations is provided in Annex C). These organizations are financed by budget allocations, by fees generated, and through support from some donor funded initiatives. 3.14 Effectiveness of Public Institutions. The effectiveness of the public business support services is quite questionable. SIDO currently employs about 1000 people, but the recovery rate on its lending activity is below 1%. It also operates some industrial estates with tenants paying very low rents. Although the purpose of these estates was to provide facilities for emerging small enterprises, most of the tenants are well established businesses which have occupied the premises for a long time. GRZ recognized these problems and has been trying to restructure SIDO through new legislation. 3.15 The Investment Center was established through donor funded initiatives as an investment promotion agency. However, it also was granted the authority to issue investment licenses with special investment incentives, such as exemptions from customs and duties. In practice, the organization has thus far been pre-occupied with administering the incentive mechanisms, with very little focus on promotion aspects. Recently, in response to a loss of revenues from other sources, the Investment Center increased the fees for processing incentives to very high levels. In the light of the newly announced trade regime, the Center's ability to generate fees from issuing incentive certificates will be severely restricted. 3.16 The Export Board of Zambia (EBZ) is one of the most successful public organizations. EBZ is actively involved in the European Union Export Development Program which targets four sectors: tobacco, coffee, textiles and floricultural products. It  13 is also trying to establish a data base with market information, accessible to Zambian firms. 3.17 Nature of Private Organizations. Most of the private business support organizations are subsidiaries/affiliates of the international audit and consultancy companies. There are also a few local consultancy firms, active mainly in donor funded projects. Some of these firms are also active in providing advisory services for foreign investors and act as an interface between local entrepreneurs and governmental bodies. There are a number of business associations; however, their primary focus has been on political lobbying on behalf of its members, not providing services to promote business restructuring to their members. 4. FINANCIAL MARKETS AND THEIR REGULATION A. Structure of the Financial Sector 4.1 Zambia's financial sector is a shrinking sector with highly conservative and very short-term focused banks. The sector also has a number of new entrants with inadequate capitalization and staffing. The shrinkage and the short-term focus is the direct result of macroeconomic instability over the last few years and large domestic public debt. 4.2 The Size of the Financial Sector. The total size of the financial sector in relation to the size of the economy and the country's population suggests a low level of financial activity. Moreover, a significant demonetization has occurred in Zambia as the ratio of M2 to GDP has decreased to around 12 percent level in 1996 from 22 percent in 1991. The relative size of the financial sector assets to the rest of the economy also declined, as the ratio of total assets of the banking sector to GDP declined to 20 percent in 1995 from 44 percent in 1991. Decline in total assets of the banking sector over the last four years is 58 percent in real terms. (A detailed overview of the financial sector is presented in Annex L). 4.3 Commercial Banks. Zambia's financial sector is dominated by commercial banks, of which the three largest hold more than 10% each of total banking-sector assets. These are the Government- owned Zambia National Commercial Bank (ZNCB) and the foreign-owned Barclays Bank and Standard Chartered Bank. Three medium-size banks hold assets ranging between 5% and 9% each, of the sector total; one is foreign-owned, Stanbic, and two are locally owned, Finance Bank and Union Bank. Out of eleven smaller banks, most are locally owned.  14 4.4 Non-Bank Financial Institutions. Non-bank financial institutions play a small role in the Zambian economy. The Lusaka Stock Exchange (LuSE) is technically operational but relatively inactive as it awaits listing by companies. Leasing activity is largely confined to commercial banks and their leasing subsidiaries. The only building society operating in Zambia, while collecting deposits which by March 31, 1995 amounted to K 10 billion, placed about half of that amount in commercial bank time deposits. New mortgage loans have virtually disappeared because of high nominal interest rates and interest on existing mortgages was capitalized. 4.5 The Securities Market. The securities market is at an early stage of development. Government is issuing Treasury Bills of 28 days or longer and bonds up to 18 months. These GRZ instruments are auctioned weekly by the Bank of Zambia. In volume and impact they dominate the financial sector, having reached 62% of M2 by the end of 1992, reduced to a more manageable 36% over the last 3 years, but were up again to 50% in late 1995. At end-November 1995 Treasury bills outstanding amounted to K 215 billion against total broad money supply of K415 billion and approximately 12% of GDP. As of October 1996, outstanding treasury bills were K248 billion against the total broad money supply of K541 billion. 4.6 Deposits. Total deposits of the banking sector decreased in real terms by 48 percent during the last six years. The composition of these deposits stayed fairly stable over the same period. The new commercial banks started offering higher interest rates and despite the recent bank failures, as explained below, and considerable flight of deposits to bigger banks smaller banks continue to hold a higher share of total deposits than their share in the total assets of the banking sector. 4.7 Lending. Total credit to private sector and parastatals, which is about 29 percent of total banking assets, declined by about 50 percent in real terms since 1990. The composition of the lending portfolio has also changed. Credit to mining decreased by about 90 percent in the same period while decrease in credit to the manufacturing sector is about 73 percent. 4.8 Zambia's commercial banks have been heavily investing in government securities. Current treasury bill holdings of commercial banks are about 44 percent of total deposits. Thus, Government has been the major borrower of the financial markets in the recent years at the expense of the private and parastatal sector. 4.9 Recent Trends. The failure of Meridien Bank in 1995 (and two more smaller banks after that) has precipitated a trend toward concentration of market shares of bigger banks. Depositors moved to the larger, foreign-owned banks for safety, and ZNCB suffered a withdrawal of deposits during the period when a proposal to merge it with Meridien was being aired. The longer-term effects of the Meridien collapse on the structure of the banking market are still unclear. Moreover, the episode has not ended, with two small banks failing shortly after Meridien and several others currently not  15 complying with BOZ minimum-capital requirements. The liquidation of Meridien is still in process. 4.10 After years of realizing losses, state-owned specialized financial intermediaries are being restructured or liquidated. None has played a significant intermediation role over the last two years. These include the Development Bank of Zambia (DBZ), Lima Bank and Exim Bank. 4.11 There is also a significant effort going on to reorganize ZNCB which holds the biggest share of the total banking assets needs to improve its operational guidelines and management information systems. The new management developed a reorganization plan with the help of international consulting companies. The reorganization plan aims to modernize the bank in every respect but requires substantial expenditures. The ultimate objective of the plan is to be able to privatize the bank. The implementation of this plan has already been started. The workforce has been reduced by 30 percent by the end of 1996. GRZ is supporting the management's reorganization efforts and it makes the proceeds from the privatization of parastatal companies available to ZNCB to close and/or to service the outstanding loans to these companies. ZNCB and the government requested the World Bank/IDA support for this plan. Recognizing the importance of ZNCB to the well-being of the financial system and after extensive consultations with the management of ZNCB, BOZ and MOF, the project team decided to support these efforts by incorporating a technical assistance component in the proposed project. 4.12 Disincentives for banks to lend to local businesses can be traced to treasury bill policy, inflation and other symptoms of macroeconomic instability. Since the foreign exchange regime is fully liberalized, commercial banks have been keeping significant deposits with foreign banks offshore. Treasury bills are considered liquid assets for meeting the liquidity requirements of commercial banks. At year-end 1995, total lending to private and parastatal sectors amounted to K237 billion, representing 25% of commercial bank assets. GRZ debt held by banks nearly matched this level, amounting to KI 89 billion. During 1996, a healthier trend was observed with the relative increase in the share of lending to productive sectors in total assets of the banking sector and a decrease in the share of banking sector's claim on GRZ. As of October 1996, total loans and advances to private and parastatal sectors was K390 billion representing about 34% of the total assets of the banking sector and GRZ debt held by banks were about K192 billion. 4.13 All banking activities center on very short-term transactions with interest rates adjusted weekly and subject to large fluctuations. Foreign exchange deposits constitute 18% of all deposits. Commercial bank deposits abroad amount to 130% of the forex deposits of their clients. Loans in forex tend to originate with special sources and amounted to less than 25% of forex deposits, or K 21.7 billion at year-end 1995. The reasons for banks' reluctance to use forex deposits for lending lie mainly in the attitude of the forex deposit holders. Commercial banks indicated that their forex deposit holders  16 frequently instruct them to keep or to transfer their funds overseas for various reasons including suspicions to the continuation of liberal capital account regime. 4.14 Credit Market Failures. Zambia's financial sector offers no reliable long-term finance. Lack of long-term financial resources, and high inflation and interest rates are two reasons for the lack of long-term lending activity. The larger insurance companies and pension funds, traditional sources of long-term funds elsewhere, are illiquid and/or technically insolvent. 4.15 Crowding out by 28-day treasury bill activity in financial markets along with high inflation which raises nominal and real interest rates, are also effecting the financial sector's ability to finance working capital needs for an emerging group of agriculture- based exporters. These exporters which are trying to take advantage of the liberalized economy are transforming Zambia's agriculture scene by organizing outgrower schemes in cash-crops. But, these activities are constrained by the typical need for six to nine months--almost medium-term credit in the Zambian context--financing in line with the crop cycle and on terms approximate to the prevailing interest rates in major financial markets. The kwacha denominated loans are well above world interest rates in real terms and the only solution for these exporters is to borrow in foreign exchange. Zambia's financial system has no access to fixed-term forex for fixed-term lending. B. Economic Regulation and Monetary Policy 4.16 Principles of Monetary Policy. Zambia's economic reform policies relied on tight fiscal and monetary policies. BOZ refrained from financing fiscal needs through money supply expansion and reduced lending to parastatals. GRZ has had to rely on selling treasury bills without BOZ fiscal support. This created significant demand and caused higher interest rates which in turn caused heavier domestic debt service requirements. 4.17 Liquidity Management. BOZ's preference using statutory reserves and core liquidity ratios to manage the liquidity caused further distortions in the financial markets by creating a large spread between deposit and lending rates. BOZ now intends to switch to open market operations as a means to manage liquidity. Some important elements of successful open market operations are far from desired levels. First, accurate and timely financial data is needed. Second, a reliable model of forecasting liquidity requirements needs to be in place. Third, shocks to the system, such as injecting liquidity to the failing financial institutions (in the case of the recent bank failures) must be avoided. BOZ is currently assisted in some of these areas by IMF. 4.18 Foreign Exchange and Capital Account Regulations. Liberal foreign exchange transactions and no restrictions on the capital account transactions create a favorable environment for business development especially in attracting foreign  17 investment. However, Zambia still needs to convince all the economic agents that the changes are permanent. Keeping liberal foreign exchange policies becomes very important to maintain the stability and confidence in the system. Both BOZ and GRZ are committed to this. C. Prudential Regulation and Supervision 4.19 Current Legislation. Under current law, BOZ has the authority to issue prudential regulations for banking institutions. The new Banking and Financial Services Bill has led to introduction of additional regulations. The BOZ is also now able to monitor interim developments in the banking system through monthly and quarterly bank reports, as well as conduct on-site inspections. 4.20 Capacity Building Efforts. Efforts to strengthen the Bank of Zambia's supervisory capacity continue under a comprehensive project to modernize the Bank of Zambia, which is funded by the IMF, UNDP, SIDA, CIDA, and other donors. This project began in 1994 and has included funding for a coordinator, short-term experts, as well as in-country and external training. In November 1995, a tripartite review was completed during which funding was reallocated to reflect changing priorities. 4.21 Among the priorities currently being assigned to this project are capacity building, strengthening off-site and on-site inspection and developing the regulatory framework for implementing the Financial Institutions Act. In view of the failure of Meridien Bank and other banks in 1995, however, the BOZ's enforcement capacity and, equally important, the political will to enforce prudential regulations remain foremost among the constraints impeding effective bank supervision in Zambia. 4.22 With respect to capacity building, under a staff training program managed through the BOZ Personnel Department, courses are being provided by Bank of England staff in Zambia and by South African commercial bank staff in Harare, where a regional training center has been established. Frequent rotation of BOZ staff at all levels and, in some instances, the departure of critical BOZ staff, however, have constrained the effectiveness of long-range planning and have contributed to the currently weak state of bank supervisory capacity. 4.23 The improvement of bank-reporting forms is in process under the BOZ modernization project, as is the drafting of new inspection manuals and reporting forms for non-bank financial intermediaries falling under the BOZ's supervisory authority (notably merchant banks, leasing operations and operations of banks in the securities market). A short-term adviser has reviewed inspection manuals, advised BOZ staff how to prepare for inspection, and is scheduled to train BOZ staff this year in implementing on-site inspection procedures. The improvement in bank reporting forms will also need to take into account information to assess liquidity, interest and currency risk, as well as risks stemming from other operations.  18 4.24 Additional Needs. BOZ will also have to develop procedures for assessing banks' capacity to manage their own financial risks. Such risk management is important in the areas of liquidity, interest rates, currency and other operations, and will be a key criterion in the selection of qualified financial intermediaries to access credit lines under the proposed Enterprise Development Project (EDP). There is also an urgent need to upgrade on-site inspection capabilities of BOZ. It is envisaged that amendments in legislation and the promulgation of regulations will become necessary in due course 5. THE PROJECT A. Origin and Relation with CAS 5.1 CAS Objectives. The Bank's 1994 Poverty Assessment outlined an action plan which was adopted by the government as a focus for Zambia's development objectives. The Bank's CAS is supporting a three-pronged strategy to assist the government in implementing this action plan, specifically: (i) helping to create a stable macroeconomic environment as a prerequisite for growth and employment; (ii) promoting private sector development and greater public sector efficiency to stimulate more rapid and inclusive growth; and (iii) targeting assistance to poor and vulnerable groups directly. The Bank has supported the formulation and implementation of Zambia's economic reform program through a combination of adjustment and project lending, and economic and sector work. Zambia is now moving to a second stage characterized by continued strong support for liberalization and structural policy reform, but with a focus on resuming sustainable growth by putting additional emphasis on stimulating investment, improving efficiency, and increasing direct poverty reduction efforts. 5.2 CAS, Ongoing Programs and the Project. The proposed project would complement both adjustment operations and sectoral investment programs in promoting private sector development. Higher investment levels would also support macro stabilization efforts, and would complement the privatization program by providing assistance to privatized companies. The project would also complement ASIP (Agricultural Sector Integrated Investment Program C26980-ZM)) by supporting agro- businesses. 5.3 Origin of the Project. This project has its origins in work carried out while preparing the Growth Prospects study. An extensive review of the real and monetary sectors was conducted, and the results were used as background papers for that study. Recognizing several significant market failures, the recent Growth Prospects Study by the World Bank recommended "pro-active" initiatives to help Zambian firms reorient their business operations and to enhance their access to finance.  19 B. Project Objectives 5.4 Overall Objective. This project aims to complement and support the ongoing economic reform program by aiding and facilitating investment in internationally competitive economic activities. The current reforms cannot be sustained without the Zambian private sector becoming the locomotive of the economic growth. In order for Zambian firms to assume such a role they need to adapt to the changing macroeconomic environment. For that adaptation to occur, Zambian firms must acquire new technologies and equipment and invest into emerging new opportunities. The project is intended to remove existing obstacles for Zambian firms to accomplish this. It is not, however, intended to prescribe to Zambian firms how to reorient and where to invest. Great care was given to make the project a demand-driven project, with credit priced at market rates and without any implicit subsidies. 5.5 Specific Objectives. The project would support firm-level efforts at restructuring by: (i) enhancing Zambian firms' technical know-how by providing demand-driven technical assistance to Zambian firms in the form of matching grants; (ii) enhancing Zambian firms' access to finance by providing a long-term credit facility for investments and a short-term credit line for exporters; and (iii) strengthening the financial system and availability of information resources in Zambia by providing technical assistance to help strengthen the institutional underpinnings of the financial system--wholesale, retail, and regulatory-- and by providing technical assistance to create a common and easily accessible information and data base with modem tools for Zambian entrepreneurs, through the Export Board of Zambia. C. Lessons Learned 5.6 The project aims to draw on the results of projects, in Zambia and elsewhere, that have sought to support on-lending and to strengthen business services. On-lending projects have often had limited results because: (i) distortionary terms and conditions of onlending led to targeted misallocations of resources; (ii) subsidized credit mechanisms did not have the desired real sector impact; (iii) economic reforms did not precede the supply support programs; and (iv) projects did not provide adequate support for institutional underpinnings of the financial system. The key lessons learned with respect to matching grants and technical assistance are: (i) provision of information and management should be specialized and tailored to the needs of firms -- generalized training and technical assistance should be avoided: (ii) grants to targeted sectors ignored some productive sectors--thus, economy wide coverage is desirable; and (iii) administering the matching grant schemes through independent executors is more efficient and effective. The proposed project design incorporates these lessons.  20 D. Project Description 5.7 Project Components. The proposed project would have the following components. First, the project would have a broad Matching Grant Scheme (MGS) which would be used to stimulate the use of support services to assist firms in their reorientation. Second, a Multi-purpose Credit Facility (MCF) would be provided through the commercial banks to finance investments as well as to stimulate exports. Third, institutional development would be supported through technical assistance for financial institutions and the Export Board of Zambia. 5.8 Project Design Features. The overall project design has the following features: * simple project components so that: (i) they could be easily understood by all the private sector firms: (ii) they could easily be utilized; and (iii) they could be delivered effectively and quickly; * independently manageable project components so that each component can be delivered without being effected negatively by any adverse developments in the other components; * a decentralized implementation structure so that the management of the project components are not burdened with a bureaucracy; * a quick start-up with the only condition of effectiveness requiring the completion of the process of hiring of service contractors for MGS and MCF which was started immediately after the appraisal and was well advanced by negotiations. Disbursement conditions are few, simple, straightforward, and follows automatically from the project implementation; and easy monitoring of a few, key important performance measures which are generated automatically as the project advances and can provide valuable feed-back to policy dialogue and complement other operations. 1. Matching Grant Scheme 5.9 Matching grant schemes have been instrumental and quite effective to induce firms to use specialized services to enhance their capabilities. These schemes were successfully implemented in various countries including: India, Indonesia, Kenya, and Mauritius. Following the success of those projects, projects with similar schemes in Uganda and Zimbabwe have recently been approved. A project with a similar matching grant scheme is being prepared for South Africa.  21 5.10 Purpose and Scope. A Matching Grant Scheme (MGS) will be made available to Zambian firms to promote international competitiveness. MGS is intended to motivate firms to use specialized support services to inject technical and managerial know-how into their operations. It would do so using a combination of three instruments: First, so long as a firm had a written basic development plan, showing the business it wished to become, and the steps in getting there, essentially any use it then made within this plan of external support services would be eligible for 50% grant support towards all fees and travel expenses incurred. * Second, firms would be given free hand-holding assistance on how to go about utilising support services, in order to incorporate skills, know-how and information quickly into their operations [e.g. how to define the tasks, how to find the best supplier for the task, how to use the results]. * Third, although most grants would be "demand-side" grants, as described above, in addition and as a way of reaching very small firms, the scheme would assist private commercial service providers, private-sector associations, and NGOs to develop their capacity to deliver effective services to private firms. It would extend "supply-side" matching grants to any such private or NGO operation wishing to use outside help to develop its service-supply capacity. The grant support would be deliberately temporary. If successful, users of services would have become so convinced of their value that they would continue to utilise them, as appropriate, at full unsupported market prices. 5.11 Design Features. In addition, the MGS will have the following specific design features: * The Scheme would accept applications for the whole project period. With simple and clear eligibility criteria, the available funds would be disbursed on a first-come first- served basis. . The total grant funding available under the proposed project would be US$2.5 million. However, discussions have already been initiated on the possibility of adding to this a further separate fund, under the recently begun Agricultural Sector Investment Program (ASIP). This second fund would be allocated specifically for agricultural/agribusiness activities, but would operate under virtually identical eligibility criteria, with the two funds administered jointly. Further work on this pos- sibility will be undertaken with the ASIP team. * Given the importance of a few larger firms to the impact of such instruments on the Zambian economy, the cap on the maximum grant per firm should be set high. The MGS is intended to motivate even big firms to use more support services, and use them faster than they would without the incentive. This is equally true of firms  22 judged to "be able to afford to do without this help." There would be a cap per firm for grant payment of US$75,000. Each firm is eligible only once and the grants will be given on "first-come first-serve" basis (see Annex E for operational guidelines of the scheme) * The scheme would be run under term contract by a management contractor, providing the services of an internationally-recruited management team capable of gaining the confidence of chief executives in even Zambia's largest private firms. The contract would probably be let to a joint operation, consisting of a local partner able to provide local know-how and contacts, plus office and administrative support, working with a foreign partner providing the services of one full-time internationally-recruited Scheme manager. * Since eligibility criteria would be set deliberately to be simple and transparent, and since the scheme operates first-come first-serve, approvals would not be dependent on "technical evaluation". The approval authority would therefore be delegated to the contractor. The independent management contractor and the economy wide coverage aspects of the design incorporate the lessons of the previous experience elsewhere in the world where some productive sectors were ignored and/or the scheme's efficiency undermined by political and bureaucratic process. The proposed grant instrument for NGOs is the first such instrument included in matching grant schemes. 5.12 Management. The Scheme, and the management contract, would be supervised, on behalf of GRZ, by a specially constituted Matching Grant Supervisory Committee (MGSC), comprised of six representatives from private sector organizations and one representative from the government. This committee has already been appointed by GRZ. GRZ and MGSC would follow the operational guidelines outlined in Annex E. The management contractor would be hired by MCTI on the recommendation of MGSC according to IDA rules prior to the project effectiveness. 5.13 Reaching Very Small Firms. Special efforts have been made in developing the scheme, so as to reach down to very small firms. Such firms would mainly be potential users of standardised or group-oriented services. Usage of such services would be supported. Also, the contractor would be expected to extend promotion and outreach activities to include NGOs, local groupings of very small firms, and localised service suppliers. In addition, NGOs and associations serving such firms would be encouraged to take up "supply-side" grants, to help develop their delivery of support services to very small firms. The scheme would extend "supply-side" matching grants to any private or NGO operation wishing to use outside help to develop its service-supply capacity. The eligibility criteria would be similar to those for demand-side grants, but here the maximum grant per recipient would be set at US$25,000.  23 2. The Credit Component 5.14 Lines of Credit. The project will finance a Multi-Purpose Credit Facility (MCF) which includes two lines of credit - the Investment Credit Facility (ICF) for long- and medium-term loans to finance investments, and the Export Preshipment Credit Facility (EPF) for short-term loans to finance production for exports. MCF funds, denominated in foreign exchange, will be channeled through an Apex (wholesale financial institution) organization to qualified commercial banks and to other financial intermediaries for on- lending. The financial intermediaries will assume the credit risk of all loans. The credit lines will be managed in accordance with the guidelines outlined in Annex F. 5.15 The project proposes an ICF of US$30 million and an EPF of US$10 million. These amounts were estimated on the basis of demand expressed in extensive interviews with the potential participating financial intermediaries (PFI) for credit lines and the potential borrowers from the credit lines. Since the proposed ICF corresponds to only about 2% of the total gross investment over the next three years, it is intended to introduce long-term resources into Zambia. The proposed EPF corresponds to about 6% of NTEs, provided that the facility recycles one and a half times per year. Given the relative size of the credit lines vis a vis existing demand for such credit in Zambia, it is expected that other donors and aid agencies would introduce similar instruments in Zambia. In this respect, KfW of Germany has already agreed to utilize the implementation framework of the project to provide an investment credit line of about US$10 million with terms and conditions identical to the credit lines proposed under this project. 5.16 Eligible Borrowers. The lines of credit will be provided to viable private enterprises by commercial banks and other licensed financial intermediaries. All sectors in the Zambian economy will be eligible to borrow from MCF lines of credit excluding real estate transactions, and pure trading activities. The participating intermediaries will lend the funds to borrowers meeting their own risk criteria and they will be fully responsible for repayment to the Apex lender independent of the final borrowers' performance. 5.17 Eligible Financial Intermediaries. The Apex lending institution will evaluate applications for participation in the program from licensed commercial banks and other financial intermediaries. The Apex will seek IDA's approval for the eligibility of a financial intermediary to participate in the credit lines. An important condition for participation by commercial banks will be compliance with all Bank of Zambia prudential regulations, as well as with the minimum capital requirements which becarne effective at year-end 1996 (see Annex F). For other financial intermediaries (such as investment banks and leasing companies) similar minimum capital requirement and eligibility criteria will be established by the Apex institution.  24 5.18 Limits for Financial Intermediaries. For each participating intermediary maximum amounts from both lines of credit will be established as a percentage of the intermediary's capital as a means to minimize the aggregate financial institution's risk to the Apex. No participating intermediary will be allowed to intermediate more than 25% of the total amount of each line of credit even if qualified for a higher share because of the size of its capital. Limits will be set, nevertheless, so as to generate an aggregate level of eligibility which is much larger than the size of the lines of credit. This excess is intended to promote competition among intermediaries for eligible borrowers. The limits will be revised periodically to reflect the participating intermediaries' performance and capital. During the periodic reviews, additional intermediaries may be approved (new institutions, institutions that now meet criteria for participation which they previously failed), and participating institution will be removed from the list if their performance has deteriorated below the qualifying criteria. For evaluating participating intermediaries the Apex institution will use, to the largest extent possible, the data and analysis of the BOZ Department of Banking Supervision. 5.19 Limits for Final Borrowers. No single borrower (a firm or group of companies) will be allowed to borrow more than 3 million US dollars under ICF and 1 million US dollars under EPF in total from all of the participating intermediaries. These limits on single borrowers are set to facilitate the broader participation in these facilities. No lower limit will be established for loan size, but we expect the banks to set their individual minimum size based on their assessment of administration costs. The interviews with commercial banks indicate a lower limit between US$25,000 - 100,000 for EPF and US$50,000 - 200, 000 for ICF. 5.20 General Terms and Conditions for Final Borrowers. IDA funds for MCF will be provided to the PFIs denominated in US Dollars at a rate of interest which reflects the international rates for US Dollars. The Rate will be equal to 12 month LIBOR plus 2%. This rate will be adjusted annually to the prevailing 12 month LIBOR rate. The PFIs are expected to charge the final borrowers a rate equal to their cost of funds plus a spread to cover their administration costs and credit risk. IDA or the Apex will not dictate or limit their spread, nor is their spread expected to be the same for all their borrowers, as the on- lending rates for each class of borrowers should reflect the PFIs risk in lending to them. The commercial banks interviewed by the mission indicated that their spread will be between 2 - 4 percent. Although all the loans from the Apex to the PFIs and from the PFIs to the final borrowers will be denominated in US Dollars, final borrowers and PFIs will be allowed to make repayments in US Dollars or in Kwacha at the prevailing exchange rate on the day of each payment. This will enable financial intermediaries and final borrowers to assume the exchange rate risk without assuming a foreign exchange availability risk. ICF loans will have a maturity of three to seven years with a grace period of up to 18 months. EPF will have a maturity of up to nine months. Disbursement, and repayment schedules of PFIs to the final borrowers will be exactly reflected into the agreement between the Apex and PFIs.  25 5.21 Sinking Fund. Given the maturity of the IDA credit, the maturity of the loans provided from the MCF allows the MCF to be recycled several times until the IDA credit matures. However, as IDA interest charges are much below international interest rates, it is the intention of IDA and GRZ to make the MCF a perpetual facility of long-term funds for the Zambian private sector by allocating each year part of the Apex interest income to a sinking fund, invested in international debt instruments, which will be sufficient to service the IDA loan repayments. With current international rates, and accounting for the MGS of the EDP credit and for possible depreciation of the US Dollar against the SDRs provided by IDA, the initial annual allocation to the sinking fund will be 3.25% of the amounts disbursed. The sinking fund will be managed by the Apex with BOZ acting as a trustee for the investment portfolio. This sinking fund arrangement would relieve GRZ from any financial burden, provided that the Apex would take the risks of only the viable financial intermediaries and constantly monitor the relation between each PFI's exposure and its financial strength. 3. Institutional Development 5.22 Scope and Components. The project will include technical assistance components which aim to increase institutional capacity in the financial sector and enhance the access and quality of market related information in Zambia. This technical assistance comprises six components: * training for commercial banks for project evaluation and export transactions (EDP- BANK TA); - matching grants to commercial banks to modernize their operations (MGS-BANK); * technical assistance to ZNCB to restructure its operations (EDP-ZNCB TA); * technical assistance to the Apex (EDP-Apex TA) * technical assistance for implementation of MGS (EDP-MGS TA) * technical assistance to BOZ to enhance its supervision capabilities (EDP-BOZ TA) and; * technical assistance to EBZ (EDP-EBZ TA)to establish a global information data base with modern tools. 5.23 Training Courses in Financial Sector (EDP-BANK TA). EDP-BANK TA will be offered in the form of two one-semester training courses, one in investment evaluation and long and medium-term lending, and the other in export financing (for more detail and  26 the framework of terms of reference see Annex G). Each program will be conducted over one three-month period, partly full time (with a component of several residential one week intensive study periods) and partly evening classes. Such courses will be open to all financial institutions to send senior and middle level managers; each of the 2 courses will train between 20 and 30 participants. EDP-BANK TA program will finance the participation of three teachers, with relevant expertise and training experience; one trainer for each course will be a specialist in the specific area of the course, and will be responsible for the course curriculum. The third trainer will teach more general high- level banking subjects in both courses. Local trainers and bankers will provide additional, locally relevant, lectures. The Zambia Institute of Bankers has agreed to take the responsibility for organizing and managing the training program. The local costs of the training program will be financed by tuition fees per participant and paid by the banks. 5.24 Matching Grant Scheme for Commercial Banks (MGS-BANK). A matching grant scheme will be offered to support development efforts of Zambia's locally owned commercial banks (for more detail and the framework of terms of reference see Annex G). Zambia's commercial banking scene has a dualistic nature. On the one hand there are commercial banks owned by multinational banks and on the other there are smaller banks with local ownership. The first set of banks have access to their parents' facilities such as training, expert help, operational manuals , etc. The second set of banks do not have access to such facilities. MGS - BANK is intended to assist the locally owned banks to modernize their operations. MGS - BANK will operate on the same basic principles as the MGS. It will be demand-driven and the interested commercial banks will share the costs. Total funds for MGS would be US$300,000 and the limit per grant is US$75,000. 5.25 Technical Assistance to ZNBC (EDP-ZNCB TA). The project would comply with the request of GRZ and ZNCB management and, by providing technical assistance to this vitally important institution for the Zambian financial markets (for more detail and the framework of terms of reference see Annex G). This technical assistance will be in support of the ongoing reorganization efforts. The project will finance two resident advisors for a year to help the management in their efforts of modernizing and restructuring the bank. 5.26 Technical Assistance to the Apex (EDP-APEX TA). The credit component of the project requires an apex financial institution. At the moment, there is no credible government owned institution to perform as an apex and BOZ rightly considers that executing credit lines creates conflict of interest with its central responsibilities. GRZ is currently trying to establish a new financial institution in Zambia to mobilize concessionary funds and act as a wholesale bank dealing only with eligible financial intermediaries. While GRZ is establishing the new institution which would become a permanent apex, MCF credit lines will be executed by a private contractor who would perform the functions of the Apex (for more detail and the framework of terms of reference see Annex F and G). EDP -APEX TA is intended to cover the cost of such  27 administration should the pace of disbursements and the fee structure of the selected contractor necessitate additional funds. Any remaining funds could be used to assist the new Apex organization at its start-up. The details of costing and limits explained in Annex F and G. 5.27 Technical Assistance for MGS Implementation (EDP-MGS TA). EDP-MGS TA will cover the costs of implementation of MGS and MGS-BANK(for more detail and the framework of terms of reference see Annex E and G). Thus, the costs of MGS Executor and "free hand-holding advice" feature will be covered by this component. 5.28 Technical Assistance for BOZ (EDP - BOZ TA). BOZ requested technical assistance to finance three external advisors to support its institutional strengthening in the areas of regulation and supervision of financial institutions as well as training courses for its own bank supervision staff (for more detail and the framework of terms of reference see Annex G). This technical assistance would provide support for on-site and off-site analysis of information on banks and for the development of regulations and circulars to support the existing prudential legislation and to enforce the existing regulations. 5.29 Technical Assistance to Export Board of Zambia (EDP-EBZ TA). The project will help EBZ to establish an information brokering service to serve all Zambian businesses (for more detail and the framework of terms of reference see Annex G). This service will be provided on a cost-recovery fee-paying basis. EBZ already provides library access and information search services. It is planning the natural extension into information brokering, but has so far lacked the financial resources to fund the required investment in equipment and training. EDP-EBZ TA will support a short-program of specialized training for a new EBZ staff member in a developed country where such services are widely available. The EU has already pledged to provide the hardware which can be used for the planned services. E. Project Cost and Financing Plan 5.30 The proposed IDA credit of US$45 million equivalent would finance about 86% of the total project cost. This figure includes a contingency of US$250,000 --for both IDA and non-IDA funded portions-- in order to accommodate unexpected total project costs for technical assistance and administration of MGS. These cost estimates are based on the figures provided in Section D above and in Annexes E, F, and G. 5.31 Table 9 below provides the project cost financial plan. Private firms are expected to contribute US$7.25 million to the project. Almost all of this contribution would be for the matching grants and credit components of the project. These contributions are estimated based on the ten percent minimum required contribution by the participating enterprises. Potential PFIs expressed that they would normally ask at least 20 percent equity participation for investment projects and finance about 70 percent of export orders.  28 However, they indicated that they would go as low as 10 percent for equity requirement and finance about 90 percent of export orders depending on the borrower and on the project. Table 9: Project Cost and Financing Plan Project Components Local Foreign Total % of Total Total IDA Total Firms Project MGS 0.50 4.50 5.00 9.57% 2.50 2.50 MGS-BANK 0.10 0.50 0.60 1.15% 0.30 0.30 ICF 10.00 23.33 33.33 63.79% 30.00 3.33 EPF 5.56 5.56 11.12 21.28% 10.00 1.12 TOTALTA: 0.80 1.15 1.95 3.73% 1.95 EDP-MGS TA 0.25 0.25 0.50 0.96% 0.50 EDP-BANK TA 0.05 0.15 0.20 0.38% 0.20 EDP-ZNCB TA 0.10 0.30 0.40 0.76% 0.40 EDP-APEX TA 0.20 0.20 0.40 0.76% 0.40 EDP-EBZ TA 0.05 0.05 0.08% 0.05 EDP-BOZ TA 0.20 0.20 0.40 0.76% 0.40 Unallocated 0.25 0.25 0.48% 0.25 TOTAL 16.96 35.29 52.25 100.00% 45.00 7.25 F. Project Implementation 5.32 The project will be implemented in a de-centralized fashion, with each set of beneficiaries responsible for the relevant project component: