Moldova - Second Structural Adjustment Credit Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No. P-7317-MD REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ONA STRUCTURAL ADJUSTMENT CREDIT IN THE AMOUNT OF SDR 29.6 MILLION TO THE REPUBLIC OF MOLDOVA May 28, 1999 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  Republic of Moldova - STRUCTURAL ADJUSTMENT CREDIT Currency Equivalents (Exchange Rate Effective March 2, 1999) Currency Unit = leu (plural lei) (MDL) MDL =USO.12 US$ = MDL $8.73 Government Fiscal Year January 1 to December 31 ARIA - Agency for Restructuring and Enterprise Assistance CAS - Country Assistance Strategy CIS - Comnmonwealth of Independent States DMP - Debt Management Plan EBRD - European Bank for Reconstruction and Development EFF - Extended Fund Facility FSU - Forner Soviet Unlion FY - Fiscal Year GDP - Gross Domestic Product GTZ - German Technical Assistance Agency IDA - International Development Association IBRD - International Bank for Reconstruction and Development IFC - International Financial Corporation IMF - International Monetary Fund INCON - Joint Stock Company - Agricultural Produce (Moldova) JSC - Joint Stock Company LDP - Letter of Development Policy LIBOR - London Inter-Bank Offer Rate MIGA - Multilateral Investment Guarantee Agency PP - Privatization Plan PSD - Private Sector Development PSRC - Public Sector Reform Credit RAO Gazprom - Joint Stock Company - Natural Gas (Russia) SAL - Structural Adjustment Loan (Credit/Loan) SDR - Special Drawing Rights SOE - State-Owned Enterprises SSC - Strategic Studies Center TACIS - Technical Assistance for the CIS (European Union) UNDP - United Nations Development Programme USAID - United States Agency for International Development Vice President: Johannes Linn (ECAVP) Country Director: Roger Grawe (ECC07) Sector Director: Pradeep Mitra (ECSPE) Team Leader: Mark Davis (ECSPE)  REPUBLIC OF MOLDOVA STRUCTURAL ADJUSTMENT CREDIT FOR OFFICIAL USE ONLY Credit Summary Borrower: Republic of Moldova Amount: Credit in the amount of SDR 29.6 million (US$ 40 equivalent) Terms: The credit will be payable in thirty-five years, including ten years of grace, on standard IDA terms. Commitment Fee/ Variable rate between 0.0% - 0.5% of the undisbursed credit Service Charge balance, set annually by the Executive Directors of IDA, and beginning 60 days after signing. Objectives and Description: The proposed credit would support the Govemment's reform program, necessary to create conditions for a resumption of growth and an improvement of the living standards in Moldova. To achieve this goal, the SAC is designed to carry forward the reform program started under SAL II. SAL II focused on four areas: (a) pension reform, (b) land privatization and farm restructuring, (c) unbundling the energy enterprises and starting the process of privatization, and (d) enterprise privatization - particularly small scale. The proposed SAC, will focus on continuing the privatization process in agriculture, energy and the enterprise sector. In agriculture, the focus will be on maintaining momentum for land reform, supporting new private farmers, and laying the foundations for a restructuring of agro- processing. In energy, the SAC will support completion of the privatization process for electricity distribution companies, as well as substantive progress towards privatizing the electricity generation companies and the gas company. It will also initiate a process that should lead to privatizing the district heating companies. Finally, the SAC will support implementation of a new enterprise privatization program covering the years 1999- 2000 which will emphasis the importance of attracting strategic foreign investors to Moldova. Benefits: The credit would provide budgetary support that will help the Govemment in consolidating economic stabilization, bolstering foreign reserves, and servicing external debt. At the same time, the reform program supported by the credit will address key bottlenecks in the privatization of the energy sector, farms, and enterprises and enhance the prospects of long-term growth and improved living standards. This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  Risks: The operation has three major risks. The greatest risk is political. While the current Government has strong ownership of the reform program, it may be hampered by in-fighting within the coalition. Second, the reform efforts may be hampered by weak implementation capacity of Government, especially in the energy sector. Finally, a macro-financial crisis could emerge, caused by new and or reoccurring external shocks and/or by the lack of sufficient external financing in the aftermath of the Russia crisis. The operation seeks to minimize the overall risk by ensuring that a major part of the reform agenda is front-loaded. Most of the core reforns under the program will have already been taken by the Board date. In the case of energy privatization, the process will be well under way. Implementation will be mostly in the hands of an investment bank, and there will be very little political will required until the final stages of the operation. To mitigate political risks, the Government, with support from the Association, has been carrying out an extensive dialogue with many elements of civil society. A public education campaign, including regular roundtable discussions led by the Resident Mission, has helped explain the reform program and build broad- based support for it. To alleviate the risks of the program caused by weak implementation capacity of Government, essential elements of the TA program are in place with the help of bilateral donors, to support key elements of the program (including farm restructuring and electricity privatization). As for macroeconomic risk, the Association will closely monitor the macroeconomic framework, in cooperation with the IMF and continue efforts to work with bilateral and multilateral partners to provide Moldova with sufficient concessional resources. Schedule of Disbursement - SDR 14.8 million (equivalent to US$ 20 million) immediately after effectiveness (expect August, 1999). - SDR 14.8 million (equivalent to US$ 20 million) to be disbursed upon satisfaction of second tranche release conditions (expected about December, 1999). Poverty Category Not applicable. Project ID Number MD-PE-61496 Map IBRD No. 24285R3.  REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED STRUCTURAL ADJUSTMENT CREDIT TO THE REPUBLIC OF MOLDOVA TABLE OF CONTENTS I. ECONOMIC AND POLITICAL CONTEXT 1 A. The Economy 1 B. The Political Economy of Reforms 4 C. Recent Economic Developments 6 H. THE REFORM PROGRAM 8 A. Program Objectives 8 B. Creating a Flexible and Competitive Private Sector in Agriculture 9 C. De-Monopolizing and Privatizing the Energy Sector 11 D. Accelerating Enterprise Privatization and Attracting Strategic Investors 14 III. LINKS WITH BANK PROGRAM AND OTHER PARTNERS 16 A. The Proposed Credit is Central to the Country Assistance Strategy 16 B. Bank Operations 17 C. Benefits and Risks: Political Support, Macro Uncertainty, and Supply Response 18 D. Collaboration with IMF and Other Donors 19 IV. FINANCIAL ARRANGEMENTS 20 V. RECOMMENDATION OF THE PRESIDENT 21  ANNEXES Annex 1: Macroeconomic Framework and Background Table 1: Main Economic Indicators Table 2: Balance of Payments Table 3: Debt Indicators Table 4: Moldova at a Glance Annex 2: Status of Bank Group Operations and Status of IFC Operations Annex 3: Timetable of Key Processing Events and Staffing Annex 4: Letter of Development Policy Annex 5: Matrix of Policy Conditionality BOXES Box 1 Project Risks and Mitigation Measures  May 28, 1999 REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED STRUCTURAL ADJUSTMENT CREDIT TO THIE REPUBLIC OF MOLDOVA 1. I submit for your approval the following report and recommendation on a proposed Structural Adjustment Credit to the Republic of Moldova for SDR 29.6 million (amount equivalent to US$ 40 million) to provide support for the Government's economic reform program. 2. The credit will be on standard IDA terms, with a maturity of 35 years including a grace period of 10 years, and would be disbursed in two tranches: SDR 14.8 million (equivalent to US$ 20 million) immediately after effectiveness, and SDR 14.8 million (equivalent to US$ 20 million) to be disbursed upon satisfaction of second tranche release conditions (expected about December 1999). 3. The Republic of Moldova joined the IBRD on August 12, 1992, MIGA on June 9, 1993, and IDA on June 14, 1994. I. ECONOMIC AND POLITICAL CONTEXT A. THE ECONOMY > Moldova has faced hard economic times in its transition to a market economy-marked by success in economic stabilization, but slow execution of structural reforms. > The implementation of structural reforms in Moldova has followed a cyclical pattern, with intervals of rapid and comprehensive reforms being succeeded by periods ofpolicy stasis. > The Russian crisis in late 1998 undermined the effects of a particularly active and comprehensive period of structural reforms, by deepening Moldova 'sfiscal crisis and lowering its trade-related growth possibilities. 4. Moldova' s independence in 1991 brought with it considerable disruption of traditional trade linkages and payment systems, and a traumatic exposure to world prices. By 1994, the combination of a large terms-of-trade shock (30 percent of GDP' in 1992 prices), a decline in the demand for its exports, and severe weather (droughts, hurricanes and floods) had crippled the country. Almost three-fourths of industry was at a standstill, agriculture was declining, and GDP was just over 40 percent of its 1990 level. Inflation soared, cresting at about 2,200 percent in 1992. l Throughout this report GDP is reported excluding Transnistria.  5. Since 1993, Moldova has rapidly stabilized its economy, and has started structural reforms. Financial stabilization, supported by the IMF (through an STF, two stand-by arrangements and an EFF), had been Moldova's most visible economic policy success until 1998. A new currency was introduced in 1993, and monetary and fiscal policy tightened. Inflation fell to an annual rate of around 15 percent in 1996, then one of the lowest rates in the FSU. The Government's initial round of structural reforms, supported by a Rehabilitation Loan and then by a first Structural Adjustment Loan, focused on three areas: (a) privatizing, restructuring, and demonopolizing enterprises; (b) strengthening the legal and regulatory framework in the financial sector; and (c) liberalizing prices and trade. However, the pace of structural reforms lagged, and GDP continued declining-by about 3 percent in 1995 and 7.5 percent in 1996. The Government's next round of structural reforms, supported by the first two tranches of the Second Structural Adjustment Credit and Loan (SAL II), have been more successful, although much of the progress in implementation came in two bursts-in mid- 1997 and in the second half of 1998. The reforms supported by SAL II aimed to: (a) restore viability to the PAYG pension system through a comprehensive reform; (b) demonopolize and privatize the energy sector-gas and electricity - and improve its financial viability; (c) spur the development of private agriculture through farm restructuring, land titling and the development of a market in land; (d) complete the process of enterprise privatization by moving from mass privatization to systematic privatization for cash. 6. The initial round of these reforms, in 1997, saw some results, as GDP rose by 1.3 percent, the first positive growth since independence. This was spurred by a strong rebound in the agriculture sector, which grew by 11 percent in 1997, recovering from a 12 percent drop in 1996. The situation changed in 1998. The first half of 1998 was dominated by reform inertia (except, to some extent, in agricultural privatization, as collective farms were broken down and land titles issued to private farmers) as policymakers focused on the prologue to, and then aftermath of, critical Parliamentary elections held in March. These watershed elections resulted in a strongly pro-reform ruling Parliamentary coalition and Government. This set the stage for important legislative and Governmental milestones toward structural change in the second half of 1998. During this time, a much-needed (and much-delayed) reform to the PAYG pension system was adopted by Parliament, numerous VAT exemptions were eliminated and increases in excise tax rates were enacted in order to increase revenue collections. Parliament also authorized privatization of the gas sector and numerous other enterprises and associated "objects" which were deemed attractive to foreign investors. 'The beneficial impact of these measures, however, where not realized before the onset of the regional financial crisis. 7. The Russia crisis battered the macroeconomy during the second half of the year. Reduced demand in Russia, along with the inability of the Russian banks to service Moldovan exporters, led to a significant reduction of trade with Russia. Consequently, total foreign trade declined by 19 percent in 1998: exports dropped 24 percent and imports 15.6 percent. The trade deficit reached US$ 398.5 million by end-December, an increase of US$ 14.5 million in 1997. The current account deficit reached 20 percent of GDP for 1998, which led to an external debt to GDP ratio of over 83.5 percent. GDP is estimated to have fallen by over 8 percent in 1998, largely as a result of these trade disruptions. 8. The Russian contagion effect put significant pressure on the leu, which depreciated significantly during 1998. The National Bank of Moldova resisted pressure to depreciate through both direct and indirect intervention - involving market purchases of lei and the implementation of a sharp increase in reserve requirements, money tightening and higher interest rates. However, pressures continued to build and in early November the National Bank 2  announced a ceasing of intervention in support of the leu. In total, net international reserves decreased by almost $100 million in 1998, to less than two months of import cover (from over 3 months), while the exchange rate reached 8.36 lei per US dollar by end-1998, as compared with 4.66 at the beginning of the year and 4.75 just before the Russian crisis. 9. Moldova's debt has grown dramatically since 1992, so that prior to the onset of the Russian Crisis the burden of debt service was already a substantial drag on the State budget and the economy. In 1998, foreign and domestic interest payments from the State budget totaled just over 420 million leu (or 4.7% of GDP), while total external debt service (amortization plus interest, including from the Central Bank and private borrowers) topped $248 million USD. Nevertheless, the debt stock and burden of debt service was made significantly more onerous by the 2-fold exchange rate depreciation of the lei following the collapse of the Russian Ruble. For instance, the IMF estimates that between 1998 and 1999, total external debt (including energy arrears) as a ratio to GDP (excluding Transnistria) will increase from 83 percent to almost 115 percent. At the same time, external debt service for 1999 is projected at $226 million, or roughly 40% of exports of goods and non-factor services. 10. The Russia crisis undercut progress in privatization in 1998, with general instability in the domestic economy and the external markets. The loss of traditional markets and the breakdown of the established trading system-mostly in Russia, but also in neighbors affected by the economic slowdown-has made it more difficult for newly privatized farms and enterprises to find markets for their products. At the same time, the regional financial and macro-economic turmoil has reduced the availability of trade financing and credit. Particularly vulnerable are the newly created private farmers, who face the 1999 agricultural season with relatively little experience as entrepreneurs, and with few resources to weather the transition. In all, GDP fell by 8.6 percent in 1998. 11. The Russia crisis will also leave its legacy in terms of an increased overhang of domestic Government arrears (about half of which are for wages, pensions and energy payments) and increased uncertainty about sufficient external financing to meet Moldova's financing gap. Lack of sufficient reduction in expenditure comiitments led to a renewed buildup of budgetary arrears to 12.3 percent of GDP by end 1998. The IMF estimates the cash deficit to be 3.4 percent of GDP and a commitment deficit of 9.3 percent of GDP in 1998. Moreover, much of recent and potential payments by the State budget are in the form of offsets and in kind, thus providing little cash to either households or enterprises. Wage arrears to education and health workers, already among the lowest paid in the economy, have. been increasing, leading to frequent strikes and protests. Arrears by the Government to the energy sector, although partly reduced by offsets, contribute to the poor financial situation of the enterprises, and lead to the buildup of quasi-fiscal external debt to Gazprom (the monopoly supplier of gas) and electricity suppliers in Ukraine and Romania. At the same time, the shock to investor confidence in late 1998 reduced the Government's ability to raise money externally. Foreign investors almost completely pulled out of the domestic T-bill market, and a plan for a Eurobond issue had to be shelved. The unstable environment also weakened the prospects for significant revenues from large-scale privatization. 12. Finally, the economic slowdown and domestic payment arrears have exacerbated social problems, with poorer households likely to bear the brunt of the shock. There are fewer employment opportunities for entrants to the labor force. Growing unsold inventories have meant that many farms and agro-enterprises have been unable to pay wages in cash to their employees for several months, increasing hardship in rural areas, the poorest parts of Moldova. Public 3  expenditures on the social sectors have been particularly affected, with State Government health and education expenditures, as of end-October 1998, less than 50 percent of that planned for the year. Wage arrears to education and health workers, already among the lowest paid in the economy, have been increasing, leading to frequent strikes and protests. For many households, this is likely to be compounded by the slowdown of remittances from the estimated 100,000 seasonal and temporary Moldovan workers in Russia. B. THE POLITICAL ECONOMY OF REFORMS > Moldova's political economy is complex, and affected greatly by the electoral cycle. Among the tensions are competing pulls between pro-Russia and pro-Romania forces, and between pro-reform factions and those who believe in a more controlled economy. > The political consensus backing the reformers is fragile, and is threatened both by popular discontent at falling living standards and political jockeying before the local elections due in mid-1999. > However, there is a current window of opportunity, with the emergence of a pro-reform coalition, a new class ofyounger, reformist leaders, and an emerging consensus of the inevitability of major economic adjustments. 13. The post-independence political economy of reform in Moldova has been marked by changeovers in the balance of power between competing forces. In the years following independence, Moldova's first President, Mr. Snegur, advocated stronger ties with Romania and a move away from the very close political and economic ties that Moldova had with Russia. Politically, this was counteracted by the dominance of the Agrarian party, which controlled both the Parliament and Government until 1997. Economically, the reality was that Moldova was extremely dependent on Russia-both as a critical supplier of energy and as the largest market for Moldovan agricultural produce. Mr. Snegur lost the Presidential elections in late 1996, to be succeeded by the then Speaker of Parliament, Mr. Petru Lucinschi. In the Parliamentary elections of 1998, the Agrarian party was completely routed, and left without any seats in the new Parliament. On the one hand, the largest party in the new Parliament are the Communists, who hold 40 of the 101 seats. On the other hand, the three other center-right parties in the Parliament joined together to form the Alliance for Democracy and Reform (ADR), which has a controlling majority and a strongly pro-economic reform mandate. 14. The period spanning mid-1998 to mid-1999 presents a remarkable window of opportunity: there is a strong political consensus for reform, and a new, dynamic, group of leaders who believe in the reform process. In 1998, the ruling three-party coalition, the ADR, had incorporated much of the reform program supported by SAL II into its platform, and was diligent in implementing this commitment. The President, Mr. Lucinschi, publicly supported the reform program, and the Government, with a strongly pro-reform cabinet and First Deputy Prime Minister (Mr. Ion Sturza), succeeded in implementing key elements of the program. This included the passage in Parliament of reform to the PAYG pension system, which had been historically perceived as politically difficult in Moldova, as well as a marked ramp-up in the privatization effort. Moreover, after the economic crisis in the latter half of 1998, the Parliament adopted a budget for 1999 that made politically difficult, but necessary, reductions in expenditure commitments. 4  15. The reform impetus is driven by a growing perception that restoring macro-financial equilibrium to the economy is urgent. This became starkly clear in late 1998 when Moldova's vaunted stability in its exchange rate and inflation crumbled at the onslaught of the regional crisis. It is now well understood among the key players in Moldova that the failure to impose hard budget constraints is a contributory factor towards mounting domestic arrears, which is blocking further progress in economic restructuring and causing social unrest. At the same time RAO Gazprom is hardening its attitude towards Moldova's chronic external payments arrears. It reduced the supply of gas to Moldova by half for much of autumn 1998, resulting in massive rolling blackouts throughout the nation. It is clear that the importance of discipline in the energy sector is no longer an issue for debate. 16. Support for farm restructuring and other agricultural reforms is mounting through strong grass-roots support, and general agreement across most political factions, for quickly completing the privatization of farms. As a result, the farm restructuring and privatization program is moving ahead, and the Government has been able to remove much of the implicit and explicit subsidies to the large collective farms. There is an emerging risk, however, that this political consensus will be undermined if the new class of private farmers are unable to access sufficient resources for carrying out their activities, or are unable to effectively market their produce in the wake of the continuing regional crisis. 17. The new Government has strong reformist credentials in its leadership, but weaker support in Parliament. In January 1999, the Prime Minister, Mr. Ciubuc, resigned, and set off a period of political jockeying that caused a partial splinter of the ADR coalition-which otherwise, as members of Moldova's anti-communist bloc, found consensus on economic issues. A new Government, led by Mr. Ion Sturza (Deputy Prime Minister for Economic Reform in the previous cabinet), was approved by Parliament in early march, but by a very slim one vote margin, as the Popular Front, one of the four parties in the governing coalition, refused to vote for the Government. However, the Popular Front leadership subsequently confirmed to the Bank its continued support for the Government's economic reform program. Recent adoption by the Parliament of important reform legislation, including the legal framework for non-state pension funds and the 1999/2000 Privatization program, indicates that the Government has political support for its reform agenda. 18. The new Government is embarking a deep and comprehensive set of reforms. In addition to initiatives outlined below for the SAC program, including privatization in the energy, agricultural and enterprise sectors, the Government is planning a comprehensive reform of the public sector. This will include reform of health, education and social assistance, substantial efforts into reorganizing of the system of government at the local level, reform of Public Administration and the Civil Service, as well as a stated commitment to fight corruption. However, political risks remain on the horizon. There is still the chance that new Parliamentary elections could occur before schedule, while Presidential elections due in 2000 may also serve to polarize the key political figures in Moldova, as was the case during the previous round in 1996- 97. 5  C. RECENT ECONOMIC DEVELOPMENTS > The effects of the Regional crisis on Moldova are severe; they will be felt throughout 1999 and beyond. > The Government is making all efforts to contain the deterioration of the economic situation, while initiating a comprehensive set of structural reforms necessary for a rationalization of the budget and a reorientation of its economy toward non-traditional markets. > The current operation is a key component of this strategy, and represents a strong signal of World Bank support for the new Government. 19. Moldova is arguably the Country most affected by the Russia Crisis. This is due to the fact that Moldova is highly dependent on Russian energy imports, which are nominally priced in dollars, while Russia annually absorbs 60 to 70 percent of Moldova's exports. The combined effect of severely reduced demand for Moldovan products, along with increases in energy costs accompanying the leu's depreciation, substantially impacts real economic performance, raises the cost of inputs, and reduces budget revenues. At the same time, the leu's depreciation makes Moldova's public debt, which is predominantly external, increasingly expensive to service. Economic performance in 1998 was overwhelmed by the regional financial crisis in the second half of the year. After rising by 1.3 percent in 1997, GDP fell by an estimated 8.6 percent in 1998, despite substantial progress in reform during the second half of the year. Moldova's underlying vulnerabilities have not yet changed, while stabilization within the Region is ongoing. As a result, Moldova will continue to face economic hardship throughout 1999. 20. Economic outcomes for the first quarter of 1999 showed that the situation is rapidly deteriorating. An IMF mission visited Moldova in early May to hold discussions for the fourth review under the Extended Fund Facility program (EFF). The mission reported a significant reduction in revenue collection over the first quarter of 1998, and the breaching of performance targets on net domestic assets of the NBM, net credit to the Government from the NBM and the cash deficit of the general government, among others.2 Additionally, the leu has continued o depreciate so that by May 3rd, 1999 it had broken 10 leu per US dollar, while external arrears grew to over $100 million The breaching of quantitative benchmarks combined with slower than expected progress on structural measures, due in part to the impact of the crisis referred to above and also to political turmoil surrounding the formation of the new Government, resulted in a delay of the Fourth Review. An IMF mission will visit Moldova in mid-July to judge, based on a one-month track record of quantitative performance (May 30, 1999 through June 30, 1999), and a two-month track record of performance on structural measures, whether the Fourth Review can be completed at that time. 21. In response to the economic crisis, the Government and the IMF have agreed on a new set of performance targets for the remainder of 1999, as well as an aggressive set of structural measures. With regard to the quantitative measures, the program calls for a loosening of the monetary and cash deficit performance targets during June to help facilitate settlement of external arrears by June 30th, 1999. For the second quarter as a whole, the program calls for a significant 2The end-March targets were not subject to adjustment for delays in World Bank disbursements of the SALII second tranche. This would have substantially reduced, but not eliminated, the breaching of performance targets. 6  realignment of budget expenditures with commitments, including settlement of over 200 million leu of arrears (for external interest), fulfillment of commitments on social sector expenditures and for the Social Fund, and full payment for interest accrued during the quarter. Revenue performance, which slipped substantially in the first four months of the year, is to be the primary focus of remedial measures of a structural nature, and is programmed to increase by more than 50 percent during the second quarter of 1999 relative to the first. Once foreign arrears are settled, the program for the second half of the year calls for a reductioni of net credit to the Government, continued performance of revenue collection and interest service, and the establishment of a track record of eliminating budgetary arrears. 22. On the structural side, the IMF and the Government have agreed to an aggressive set of reform measures which will help to increase tax collections, improve the coordination of monetary andfiscal policy, advance the privatization program and establish a concrete start to the Government's public sector reform process. With respect to tax collections, two important measures are to be carried out by June 15, 1999: (a) strengthening of the Large Taxpayer Unit and (b) implementation of 30 mobile and 17 fixed fiscal posts at the administrative border with the breakaway region of Transnistria. These two measures are important steps toward increasing the tax base, particularly of the shadow economy, improving revenue collection, and thus meeting the quantitative performance program for the first half of the 1999 and beyond. The Government will also take concrete steps toward completing the privatization program - measures which are part and parcel of the actions to be achieved under the SAC project. These include preparatory steps for privatization of Moldtelecom and the energy distribution companies, and registration of the shares of the new Moldovagas joint venture. On the agenda of public sector reform, the Government will prepare an official draft of the new Civil Code and will, in coordination with the IMF, complete a review of the draft Law on Local Public Finance. Among a number of other measures, the Government will, (a) establish a temporary, exceptional, NBM profit transfer mechanism equal to 80 percent of MoF cash payments for 1999 interest due, (b) complete (or reach near completion) of negotiations on external payment arrears with Russia, the national Reserve Bank, commercial suppliers and creditors under State guarantees, (c) initiate restructuring/liquidation programs for firms in default of State guarantees and with substantial arrears to the budget, and (d) approve an appropriate plan for restoration of the financial and operational condition of the State Savings Bank. 23. In the wake of years of economic decline and recently, the regional financial crisis, the Government of Moldova must take bold actions to restore fiscal order, privatize its economy, and reorient its productive capacity for non-traditional markets. With leading reformers at the helm of the new Government, a Parliament with a clear track record of passing legislation for reform, and a substantial window before scheduled election, the remainder of 1999 represents a critical opportunity (potentially the best since independence) for taking the actions necessary to restore economic viability and reduce Moldova' s vulnerability to external shocks. The actions to be achieved under the SAC, including progress in agricultural and land privatization, reform of the energy sector, and an acceleration of enterprise privatization, are critical components of this strategy, and are also necessary for addressing the public sector reform agenda to follow. The operation and supporting actions therefore need to be initiated immediately. In order to maintain the reform momentum, swift approval of the SAC would provide the Government internal support and credibility for achieving its agenda; it would also facilitate optimal timing with respect to weather conditions, the political environment, and the implementation schedule for second tranche release, particularly with respect to energy privatization. 7  24. In order to maintain the momentum of the reform program, as represented by the High Case of the CAS, as well as to ensure that a sustainable macroeconomic framework is in place, the World Bank in agreement with the Government has included an effectiveness condition into the Credit Agreement. The effectiveness condition provides a mechanism to bolster the Government's ability to adopt required and immediate actions which represent very tough political decisions. By the time of the effectiveness date, a strong track record of performance will be in hand. In a'ddition to the effectiveness condition, the IAF also has a set of structural measures, some of which need to be met by June 15th, and the remainder by July 15th, 1999. As the impact of these actions can only be judged with mid-year data in hand, in mid-July, in coordination with an IMF mission, IDA will review progress on the structural measures and Moldova' s macroeconomic performance. In particular, IDA will monitor the following indicators based on end-June numbers: revenue performance, external and domestic arrears reduction, expenditure rationalization, the cash deficit, and net NBM credit to the Government. IDA will also monitor whether an agreement has been reached with the IMF on the Fourth Review of the EFF, and hence that the program is fully financed. Credit effectiveness will depend upon the outcome of the review. II. THE REFORM PROGRAM > The structural adjustment program supported by the proposed SAC is a continuation of the actions supported by the SAL II operation. > The program focuses on promoting ownership change, as a precondition to improved corporate governance, financial discipline and growth through investment. > The principal areas of ownership change are in agriculture and enterprises where the objectives are to increase incentives to restructure and invest, and thus generate greater income and employment; and the energy sector, where the objective is to advance further along the path to improved corporate governance andfinancial discipline. A. PROGRAM OBJECTIVES 25. The Government's program aims at completing the agenda of the structural reforms supported by SAL II-by pushing through ownership change in key sectors, and putting into place measures that advance the reform agenda, while at the same time are difficult to reverse. The SAL 11 program focused on four areas: (a) pension reform, (b) land privatization and farm restructuring, (c) unbundling the energy enterprises and starting the process of privatization, and (d) enterprise privatization - particularly small scale. The proposed SAC, will support the privatization process started under SAL II. In particular, it will focus on continuing in agriculture, energy and privatization. In agriculture the focus will be on maintaining momentum for land reform, supporting new private farmers, and laying the foundations for a restructuring of agro-processing. The SAC will support completion of the privatization process for electricity distribution companies, as well as substantive progress towards privatizing the electricity generation companies and the gas company. It will also initiate a process that should lead to privatizing the district heating companies. Finally, the SAC will support the implementation of a new enterprise privatization program covering the years 1999-2000 which will emphasis the importance of attracting strategic foreign investors to Moldova. 8  26. A strong macroeconomic framework will be needed to ensure that full benefits from structural reforms are achieved. The Government is taking steps, supported the IMF-EFF program to improve budgetary discipline, control inflation and ensure external sustainability. Key elements of the stabilization program include improving tax collection, rationalizing expenditures and maintaining external competitiveness. The structural reforms supported by the proposed SAC aim at helping bring about a supply response to ensure that stabilization is sustainable [See Annex 1, including summary tables, for a more detailed description of the macroeconomic framework]. * Conditions for both tranches: Continued adherence to the agreed fiscal framework, and the maintenance of a satisfactory macroeconomic program. B. CREATING A FLEXIBLE AND COMPETITIVE PRIVATE SECTOR IN AGRICULTURE 27. As the engine for future growth, reforming the agricultural sector is very high in the Government's list of priorities. The process is well under way. The restructuring of collective farms has created a new class of over 200,000 private farmers, most of whom have individual titles to their land. The passage of a law in 1997 allowing, for the first time, trading in land (including agricultural land), together with recent amendments to regulations that lowered the fee on land transactions, is expected to facilitate the process of re-sales and consolidation of farmland. The Government has decided to continue the acceleration of the implementation of agricultural reforms-especially farm restructuring, the de-monopolization and privatization of the grain sector, and the creation of a favorable macro-environment for agricultural growth. 28. The Government has embarked on a significant strategic program for privatization of urban and rural land, and the development of land and real estate markets. The program is supported by the World Bank and USAID through the First Cadastre (Real Estate Registration) Project and the rural Land Project, respectively. This is following the passage of the law on real estate cadastre in the Parliament on February 25, 1998. By establishing a system of clear and enforceable ownership rights, the Government aims to: (a) reduce the transaction costs for property owners at sales, rentals, inheritances, and other forms of property transfers through the availability of needed information; (b) provide confidence to lenders for providing secured credit against real estate; (c) facilitate urban planning and land management through basic information; (d) provide a basis for real estate valuation and property taxation; and (e) facilitate for certain private sectors to develop (surveyors, notaries, valuers). Proposed targets for 1998 have been satisfactorily met on sale and tradability of agriculture land, but the process needs to be continued, with cooperation from the USAID's Land Project. Land titling under a unified parcel basis was completed for 6 percent of private beneficiaries of agriculture land reform. Downward flexibility in the normative price of land under privatization has allowed impressive results on sale of enterprise land, but more needs to be done to increase the incentives for enterprises to buy their land from the municipalities. 29. In farm restructuring, the issue is the removal of obstacles that prevent the extension of the program to all farms. The continuation of this process is aided by recent legislation that establishes the right of peasant farms to have a legal organizational status. A draft law to amend this legislation has been prepared by the Government for subsequent Parliamentary discussion. The draft proposes to permit peasant farm sizes of 5 hectares or more to be registered and function as legal entities. By eliminating a possible source of slowdown in effective farm 9  restructuring, this would clears the way for an increased pace of privatization in the primary agricultural sector. 30. A critical issue that remains is the creation of a legal framework for the expedited settlement of debts at those farms which are ready for restructuring, and to liquidate the traditional (collective or state) farming enterprise. Those farms which do not participate in this project and are insolvent from the financial point of view would become subject to regular bankruptcy procedure immediately. The Government is preparing a draft law that would conform to the following principles: > Extension of the process of settlement of debt to cover the entire debt of the farming sector, including private sector debt. > Clearing farm debts through the transfer of required assets for settling debts to the state, after honoring existing registered liens of creditors. The state would cancel all state and parastatal debts and provide a framework for settling the claims of the private creditors. > Ending the process with the closing of all remaining enterprises, and distribution of any remaining assets after debt settlement to the farm's privatization fund, for distribution to entitled farm members. > Automatic implementation of the process at the level of the farm. > Completion of the process within 12 months, tied to the National Land Program. > A clear notification that the debt-clearing process is an extraordinary, one-time operation and applies only to farms in the National Land Program. Once such a law is adopted, it is likely that most of the over 900 farms in Moldova could be restructured, and land distributed to new owners, by the middle of 2000. * Board condition: The adoption of a satisfactory Law for the Expedited Settlement of Farm Debt. * Board and second tranche conditions: Continued progress towards completion of National Farm Restructuring Program with targets on farm privatization as agreed with the Bank. * Board and second tranche conditions: Continued progress in titling of agricultural land. * Prior to the second tranche release, the Government will review progress in the farm restructuring program, and take any measures necessary to remove identified impediments. 31. Concomitantly, the Government is following up on the market liberalization measures that were started under the program supported by SAL I and SAL II. After the inclusion in the privatization plan of the Fertlitate units, and the adoption of a mechanism to facilitate their sale, the Government is focusing on liberalizing the output market. Two Cereale units were transferred to the management of Lukoil company as part of Moldova's energy debt settlement. The majority of ownership, however, remains with the Government of Moldova. In December 1997 and February 1998 the remaining state shares of four former Cereale enterprises were offered for sale. None of them were sold. There is a plan to offer for sale the remaining state shares of three Cereale enterprises at the stock exchange. Ten former Cereale units had not been included in the 1997-1998 Privatization Program, although it had been agreed with Bank experts that only three units (required to hold the State's emergency grain reserve) would remain in 10  partial state ownership. The 1999/2000 Privatization Program includes the remaining 6Fertilitate and 16 Cereale units. 32. The Government is also determined to support the new class of private farmers, in accordance with the findings of the study of the system of direct and indirect taxation and subsidization of agriculture. The Government has already adopted the key recommendations of the study into the 1999 budget. These measures include: > maintenance of land tax as the primary form of taxing agriculture; > replacement of the collection of taxes in kind by cash payments; > elimination of state guarantees for any credits to enterprises in the agricultural sector; > cancellation of non-cash support through procurement and price support for grain and milk; > cancellation of compensation for national calamities in the form of debt reduction; > reduction of the 1998 level of the water (irrigation) subsidy by 50%; and > cancellation of intervention on the milk market in the form of tax reduction. * Board condition: The taxation and subsidy policy will remain based on the agreements made with the World Bank based on the Agricultural taxation and Subsidy Study. * Board condition: Continued track record of no Government interference on the grain market. 33. The Government is also supporting private farmers by giving them "homestead grants" through the Agricultural Support Fund in time for the spring planting season. These grants are allocated on a per-hectare basis, to private farmers only. They are also be capped so that smaller farmers, who have the least access to credit, can be proportionately larger beneficiaries. * Board and second tranche condition: Proper implementation, according to principles agreed with the Bank, of the Agricultural Support Fund for private farmers. C. DE-MONOPOLIZING AND PRIVATIZING THE ENERGY SECTOR 34. Lack of financial discipline is a particularly serious in the energy sector. Despite the progress during the past two years in demonopolizing, regulating and rationalizing enterprises and preparing them for privatization, the financial condition of the sector remains weak. This is partially because costs recently shot up after the leu lost almost half its nominal value in the wake of the Russian crisis. But the most important reason is low cash collections. Against agreed targets of 100 percent collection and at least 50 percent cash collection, collection was only 43 percent (80 percent excluding gas supplied to electricity sector) during first 9 months of 1998, with less than 30 percent cash collection. In response, the regulatory agency issued decisions, in September 1998, to adjust heat, electricity and gas tariffs to reflect the cost structure. The Government, under the aegis of the National Energy Commission, also took positive steps to improve collections, including the appointment of private collection agents, reduction of tariff privileges and compensations and increased targeting of subsidies to the poor. However, this has not helped the precarious financial condition of the energy enterprises, since the Government has not been able to fully compensate the companies in cash for these privileges. The debt to the energy enterprises compromises their ability to repay foreign creditors for energy imports, and jeopardizes energy supply. RAO Gazprom of Russia has already assumed ownership of half of 11  Moldova's gas transmission sector in exchange for a fraction of past debts. It has also persuaded the Government to assume first $140 million, and then $90 million, in debt owed by the electricity organization, Moldenergo. This increase in sovereign debt, and the continued rise in quasi-fiscal obligations, poses a serious threat to Moldova's creditworthiness. 35. The energy reform program continues the strategy supported by the Bank's SAL II. It features: (i) financial consolidation of the sector through tariff adjustments to ensure cost recovery, improved collections (particularly cash), reduction of arrears, and better targeted subsidies; (ii) restructuring, commercialization, and privatization of the gas and power utilities; (iii) restructuring and decentralization of district heating companies to municipal and local governments; and (iv) the development of a modern legal and regulatory framework. The program has been under implementation for two years, with a mixed success. The power industry has been restructured through unbundling of generation, transmission and distribution functions and creation of joint stock companies in generation and distribution which are now poised for privatization. The controlling portion of shares in the new integrated gas company is being sold to Gazprom of Russia. Electricity and gas laws have been enacted and an independent energy regulatory agency (ANRE) created. 36. The main priority at this stage is to privatize power distribution and generation companies to improve their financial and technical performance and bring in the necessary investment capital. The SAC would support the Government's intensive effort to sell these to strategic investors. The involvement of a reputable investment bank is critical to the success of this process. Its selection is under way and should be completed by end-May. The priority will be given to selling the distribution companies, in Chisinau, Centru, Nord, Nord-Vest, and Sud, all of whose shares would be offered for sale by mid-July 1999. Privatization of controlling shares of the generation companies will closely follow. The privatization of the five distribution companies should be completed this year, and of the three generation companies by end-March, 2000.