Zambia - Third Development Bank of Zambia Project

Doculment of The World Bank FOR OFFICIAL USE ONLY cR. i?S3-27 Report No. P-4384-ZA REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED CREDIT OF SDR 8.3 MILLION TO THE REPUBLIC OF ZAMBIA FOR A THIRD DEVELOPMENT BANK OF ZAMBIA PROJECT November 17, 1986 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS Currency Unit Kwacha US$1 - K 6.87 US$0.1456 = K 1.00 The US Dollar/Zambian Kwacha exchange rate is determined by weekly auction. The exchange rate shown above is the result of the auction held on August 30, 1986. IEEIGUTS AND MEASURES 1 meter (m) = 3.28 feet (ft) 1 kilometer (km) = 0.62 miles 1 sq kilometer (km2) = 0.386 sq miles I metric ton (tonne) = 1,000 kg = 2,204.6 pounds 1 liter = 1.057 US quarts = 0.22 Imp. ga]ton ACRONYMS AND ABBREVILAIONS BOZ Bank of Zambia DBZ Development Bank of Zambia DEG Deutsche Gesellschaft fur Wirtschaftliche Zusammenarbeit Entwicklungsgesellschaft (German Finance Company for Economic Cooperation) DRA Debt Recovery Action Plan EIB European Investment Bank FMo = Nederlandse Financierings Maatschappij Voor Ontwikkelingslanden N.V. (Netherlarnds Finance Company for Developing Countries) INDECO Industrial Development Corporation MIS Management Information System SOE Statement of Expenditures T-Bili = Treasury Bill ZIMCO Zambia Industrial and Mining Corporation FISCAL YEAR April 1 - March 31  FOR OFFIACIL USE ONLY REPUBLIC OF ZAMBIA THIRD DEVELOPMENT BANK OF ZAMBIA PROJECT CREDIT AND PROJECT SUMMARY Borrower: Republic of Zambia Beneficiary: Development Bank of Zambia (DBZ) Amount: SDR 8.3 million (US$10 million equivalent) Terms: Standard Terms of Relending: The Borrower would onlend the US$8.9 million investment component of the credit to DBZ at 8.23 percent interest for subloans denominated in foreign currency, and at a variable rate equal to the Treasury Bill (T-bill) rate plus 2 percent for subloans denominated in Kwacha. DBZ would rspay the credit to the Borrower in accordance with the aggregate of the repayment schedules for subloans. Subloans would not exceed 15 years with grace periods not to exceed 4 years. DBZ would provide sub-borrowers with the option of denominating the subloan (i) in US dollars, at a fixed annual interest rate of 8.23 percent plus a 4 percent spread; (ii) in Kwacha, at a variable interest rate equal to the T-bill rate plus a 2 percent foreign exchange risk premium plus a spread of not less than 4 percent. The Borrower would pass on the US$1.1 million technical assistance portion of the credit to DBZ as a long-term subordinated loan (quasi-equity). Project Description: The credit would finance the long-term foreign exchange portion of the capital investment requirements of productive sector subprojects approved by DBZ, for modernization, expansion or restructuring of existing enterprises, and to a lesser degree for new investment subprojects. The credit would also finance the establishment of a computerized financial and management information system at DBZ, technical assistance to implement the new system and train staff in its use, as well as staff training in project evaluation and supervision, both in Zambia and abroad. 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.  - ii - Project lenefits and Risks: The proposed project would provide term resources to the productive sectors in Zambia to rehabilitate industrial and agro-industrial enterprises, and increase production and exports in all productive sectors. It would thus help accelerate growth and increase employment in Zambia and would complement the positive Impact of the policy reforms already taken by the Government and supported by IDA through a policy-based Industrial Reorientation Project and a Recovery Credit. The investment component of US$8.9 million is expected to support productive investments totalling about US$20 million. The project would also enable IDA to help DBZ, the main term-lending institution in Zambia, to increase its efficiency by mobilizing additional resources, upgrading the quality of its portfolio, and increasing the effectiveness of financial and management decision-making. Continued IDA support would enhance DBZ's capability to mobilize additional foreign capital and other resources from bilateral institutions and would enable it to play a more significant role in assisting the recovery of Zambial's productive sectors. There are two risks to this project. One is the possible deterioration of Zambia's economic situation. Such a risk is, however, limited, as long as Zambia continues to follow the stabilization program supported by the lMP and the policy reforms and actions envisaged by IDA and other donors to increase the resource transfer and accelerate economic growth in Zambia. A second risk is a continued deterioration of DBZ's arrears position. This risk is being reduced as DBZ takes the actions supported by the proposed credit to improve loan collections and to resolve its portfolio problems. These should ensure that DBZ will remain an ef:ective term-lending institution that promotes economically sound investment projects.  - iii - Financing Plan: (DBZ Investment Program FY1986 to FY1991) Amount z (USS million) Comercial Banks 16.0 15.4 Non-Bank Financial Institutions 18.0 17.3 DBZ-Share Capital 7.3 7.0 DBZ-Retained Earnings 4.7 4.5 IFC 6.0 5.8 FMO 5.0 4.8 IDA (DBZ III) 10.0 9.6 EIB 8.0 7.7 Total DBZ Financing 75.0. 72.1 Beneficiaries" Own Funds 29.0 27.9 Total Investment Program 104.0 100.0 Estimated Disbursements: IDA Fiscal Year 1987 1988 1989 1990 1991 1992 - (US$ million) Annual 0.5 2.5 3.0 2.0 1.5 0.5 Cumulative 0.5 3.0 6.0 8.0 9.5 10.0 Appraisal Report: Report No. 6310-ZA, dated November 17, 1986.  INTERNATIONAL DEVELOPMENT ASSOCIATION REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECIUTIVE DIRECTORS ON A PROPOSED CREDIT TO THE REPUBLIC OF ZAMBIA FOR A TRIRD DEVELOPMENT BANK OF ZAMBIA PROJECT 1. I submit the following report and recommendation on a proposed credit to the Republic of Zambia of SDR 8.9 million (approximately US$10.0 million) on standard terms to finance a third line of credit for the Development Bank of Zambia (DBZ). The proceeds of the credit (except US$1.1 million equivalent for technical assistance) would be on-lent to DBZ under arrangements whose terms depend on the currency that subborrowers may choose. DBZ would on-lend the funds in turn to qualified subborrowers under the same terms marked up by four percent per annum. Details of the on-lending terms are in paragraphs 37 to 39 below. The interest rates are expected to be positive in real terms. PART I - THE ECONOMY 2. A Country Economic Memorandum on Zambia (Report No. 5000-ZA) was distributed to the Executive Directors on April 24, 1984. A new CE1 and a Public Expenditure Review will be issued shortly. The analysis presented here is based on these reports' findings and on subsequent information received from the Zambian authorities. Country data sheets are attached as Annex I. 3. Zambia's economy is heavily dependent on external trade and on government activity. Imports and exports each range between 30 and 40 percent of GDP. Government expenditures amount to about 35 percent of GDP, and the Government owns a majority share of mining and most manufacturing enterprises. Mining, mainly copper, provides about 90 percent of foreign exchange earnings and 10 percent of gross value added. Much economic activity is dependent on expatriate technical, managerial, and administrative skills. Current Economic Situation 4. For the past decade, the Zambian economy has been in a state of contraction and the country is presently in the midst of an acute economic and financial crisis. Relying on a single primary commodity for the bulk of its export earnings and with an industrial sector highly dependent on imported inputs, the economy was vulnerable to the combination of deteriorating export prices, increasing costs for imported goods and raw materials, and regional unrest which occured over the past decade. Since 1975, when the economy's problems began with a sharp drop in the copper price, Zambia's terms of trade have deteriorated steadily aad by 1985 were  -2- more than 70 percent below the average for the early 1970s. Although the Government initially managed to slow the decline in economic activity by extensive foreign borrowing, contributing to the serious debt-servicing problem that constrains the country's current options, real CDP has been on a general downward trend since 1975, falling on average by about 1.5 percent per year. With population growing by 3.1 percent per annum during this period, real GDP per capita is now about 25 percent below the 1974 level. Following the World Bank Atlas methodology, GNP per capita was estimated at US$470 in 1984, but it is much lower now as a result of the substantial depreciation of the Kwacha in the past two years. 5. The balance of payments has been in chronic disequilibrium since 1975, with current account deficits climbing to an average of 19 percent of GDP in 1980-82, before dropping to an average of about 10 percent of GDP in the past three years. Nevertheless, the volume of imports declined steadily and is now about 60 percent of the level in 1980 and 45 percent of the level in 1974. This has resulted in an economy-wide problem of severe underutilization of capacity and, especially in the mining sector, a large backlog of maintenance and rehabilitation expenditure that has contributed directly to a declining trend in copper production and exports. In 1985, copper exports fell to their lowest level (475,000 tonnes) since Zambia's independence. The current level of imports, supported by external aid, is now only barely adequate to sustain copper production and to provide e critical minimum of inputs for the rest of the economy. The large current account deficits have also led directly to Zambia's high level of external indebtedness. At the end of 1985, Zambia's total external liabilities stood at US$5.4 billion, including drawings from the ItF (US$640 million) and overdue commercial payments of about US$600 million. By comparison, merchandise exports amounted to only about US$715 million in 1985. 6. The decline in copper prices also severely affected Zambia's fiscal and monetary positions. Prior to 1976, mineral taxes provided a large share of government revenue, but because of the losses incurred by tiue mining company in that and subsequent years, they became an insignificant source of funding for the government. A new mineral export tax was introduced in 1983, however, which now contributes about 10 percent of Government's revenue. Deficit financing absorbed a large share of net domestic credit and contributed to a sharp rise in consumer prices, averaging 20 percent per annum during 1976-78 and 12 percent per annum in 1979-82. Price increases have accelerated in 1983 and 1984 to about 20 pprcent per annum, reflecting the decontrol of prices in December 1982 and the devaluations of the Kwacha during the past two vears. Currently, inflation is running at an annual rate of about 30-40 percent due largely to the sharp depreciation of the Kwacha from 2.2 per US$1 in October 1985, just prior to the introduction of the foreign exchange auction, to over 10 per US$1 at present. 7. There is no doubt that external factors have been an important cause of Zambia's present economic difficulties. Apart from low copper prices, severe droughts over 1982-84 have necessitated substantial food imports. Nevertheless, inappropriate policies and shortcomings in economic management have exacerbated the economic difficulties. The main  -3- deficiencies in economic policies were that: (i) pricing and subsidy policies favored the urban consumer at the expense of the agricultural producer; also, controlled industrial prices led to low profitability in the manufacturing sector; (ii) tax incentives and low interest ratas led to a pattern of capital intensive investment; (iii) exchange rate and tariff policies encouraged the use of artificially cheap imported raw materials and other inputs. Strategy for Economic Restructuring 8. Zambia' s economically exploitable ore reserves are only sufficient to maintain present levels of copper production for another 15 years or so, after which production can be expected to decline sharply. In the absence of new sources of income, employment and foreign exchange, Zambia may expect a drastic fall in living standards and social well-being by the turn of the century. However, Zambia has the potential to develop alternative sources of income, employment, and exports. The greatest potential is in agriculture, where there are opportunities for import substitution (cotton, oilseeds, livestock, grains, forestry products, and fish) and for exports (beef, cotton, coffee, tobacco, groundnuts, and sugar). Once a good start is made with agricultural development, possibilities should be created for agro-based industries. 9. The Government's development strate3y, then, is to restore copper production to the 530,000 tonne level, the economically sustainable level given the technical and other constraints on the irdustry in Zambia, while at the same time accelerating development of the agricultural and industrial sectors, with a heavy emphasis on production for export. This strategy is designed to maximize foreign exchange earnings from mining over the medium term, while efforts are made to diversify production and exports through growth in the other sectors of the economy. This will require a susbstantial restructuring of production and employment, which can only be accomplished in the long run. The Government initiated this effort in 1983 with the introduction of a far-reaching program of economic reforms that has received the full support of the international donor community. The authorities also introduced, with support from the IMP, a comprehensive stabilitzation program designed to restore the country's financial viability. 10. The main content of the economic restructuring package may be suz-arized as follows: - Providing a system of incentives to producers and exporters of agricultural and industrial products in which production is responsive to market forces; - Ensuring the competitiveness of exports through an active exchange rate policy; - Using tariffs and interest rate policies to reverse past trends of import dependence and capital intensity;  - 4 - -- Liberalizing administrative restrictions on foreign trade and the licensing of production, in order to improve the allocation of resources and to encourage investment in productive activities; -- Reducing the Government's deficit and recourse to domestic bank borrowing by reducing expenditure on personnel costs, subsidies and other non-development related activities; -- Improving planning and budgetary procedures to shift resources to productive uses and economic investments; - Allowing greater competition in the procurement and selling of food crops. The National Agricultural Marketing Board (NAMBOARD), the Government's agricultural marketing agency, will move towards the role of buyer and seller of last resort, using a system of floor and ceiling prices for agricultural produce and inputs, respectively; - Strengthening the technical and managerial capacity of Zambia Industrial and Mining Corporation (ZIMCO), which is the holding company of most state-controlled enterprises; = Restructuring the energy sector to bring about lesser dependence on imported oil. 11. In the past two years, the Government has made significant progress in translating the above policies into tangible action. Stand-by arrangements were agreed with the IME in 1983, and again in 1984. Under these programs, the Kwacha was first linkea to a basket of currencies and was depreciated in a gradual manner through October 1985 when a foreign exchange auction was introduced, resulting in a further substantial reduction in the value of the Kwacha. Because the Government has been successful in holding wage increases to considerably less than rises in the cost of living, it has maintained the benefits of devaluation in real terms, which has improved the competitiveness of exports. Debt rescheduling with members of the Paris Club, commercial banks and non-OECD governments covering obligations due in 1983 and 1984 was also obtained. In early 19B6, following appro:al of a two year IMF standby arrangement, the Paris Club agreed to reschedule Zambia's 1985 arrears to the Club members, plus all obligations falling due in 1986. 12. In terms of improving conditions for longer-term growth, the most significant of the above financial measures was no doubt the exchange rate adjustments. But other measures with significant long-term impact have been introduced as well. Since December 1982, the Government has abolished the control of all wholesale and retail prices except for maize flour used in the production of roller meal, the basic staple consumed by the lower income segments of society. Over the last three years, producer prices for most agricultural crops have been increased considerably in real terms, and they now approximate border prices. The Government has also improved the incentives affecting foreign trade by introducing a foreign exchange  -5- retention scheme and concessional tax rates for non-traditional exports, and by imposing a minimum tariff on many non-dutiable imports which should reduce the high rates of effective protection afforded to import-intensive industries. 13. The Government's efforts over the past two years represent a major reformulation of economic policies and incentives. This progress is currently in danger of being set back, however, due to insufficient foreign exchange to maintain production (and exports) and to honor external debt obligations. On one hand, the Government wishes to improve the supply of essential consumer goods by providing inputs to the productive sectors and thus show some benefits from the considerable sacrifices its policies have required of the population. In particular, a rapid increase in the consumer price of maize (resulting from higher producer prices, drought induced imports and lower subsidies) has heightened the political sensitivity of further reforms that may result in higher prices for other goods and services. On the other hand, the Government must allocate considerable foreign exchange to debt service that cannot be rescheduled. 14. Along with the new exchange rate system, the Government introduced last October a wide range of supporting measures, including decontrol of interest rates, conversion of the import licensing system to one of import registration, and further measures to reduce government expenditure and borrowing from the banking system. There remains, however, a major requirement for the success of the economic reform program. The Government's capacity for policy analysis and formulation, for adminis- tering development programs and for mobilizing and monitoring the flow of domestic and external resources needs to strengthened considerably. The Government will need to focus on this crucial issue in the context of a long-term program of training and institutional development, while also giving top priority to improving immediately the policy formulation and implementation capacities of such key agencies as the Ministry of Finance and Planning and Bank of Zambia which are essential to the success of the whole reform program. Growth Prospects 15. Zambia's external payments situation deteriorated further in 1986 and the worsened prospects for mineral exports in the near term have worked to delay the recovery process. on the other hand, however, more rapid growth than was anticipated has occured in industry and agriculture in response to favorable weather conditions and the reform measures, and the response of non-treaditional exports to the improved incentives and exchange rate has been quite promising. It seems reasonable to expect, therefore, modestly positive growth in 1987 and 198B, followed by somewhat more rapid growth in ensuing years. The main obstacle to more rapid growth continues to be the excessive amount of debt service falling due in the medium term, which prevents imports from reaching the levels required for faster growth. Resolution of this problem will require a high and sustained level of commitments and disbursements from the donor community, on cox.cessional terms and in quick-disbursing form, preferably in support of the auction. It will also require continued access to IMF resources.  -6- But most signifleantly, it will require an extraordinary restructuring of Zambia's external debt to bring about a large reduction in the debt service ratio. The amount of restructuring provided by the annual rescheduling exercises of past years although helpful will simply not suffice, since imports will not be able to reach the necessary levels. 16. For the five year period, 1986-90, the Zamblan economy should be able to achieve GDP growth (at market prices) of about 3.6 percent per annum on average, which would only maintain per capita income at current levels. Because of the difficulties facing the economy in the next couple of years, especially ln the mining sector, the rate of growth is not likely to exceed 2.5 percent per annum on average, but as productive efficiency rises and the confidence of the private sector is restored by the reform program, there should be an upturn in economic activity in the later years of this period. To achieve this level of GDP growth, gross investment would have to increase by about 10 percent per annum in real terms, reaching 16 percent of GDP by 1990 from 12 percent in 1985. At this level, the investment ratio is still low. However, it is the most that is achievable given the external constraints on the economy. On the other hand, a good part of the gains in GDP over the next few years are expected to come from increased productivity of investment due to Improved resource allocation and greater selectivity in capital projects by the public sector. While a major effort is required to generate domestically the savings needed to support this level of investment, a substantial part of the investment will have to be financed from abroad. 17. There is no question but that the social cost of adjustment in Zambia will be heavy, particularly for the next five years and perhaps for the next decade. Coming on top of the large drop in living standards that has already occurred, this will be an especially difficult period for the Zambian people. However, it is equally certain that without these adjust- ments living standards would decline even further and there would be little or no prospects for improvement in the future. With the adjustment program per capita income will be stabilized in the medium term and rise in the longer run, which would not be the case without the program. Steps are being taken to soften the impact of these measures on the lowest income segments of society, e.g., the maize subsidy is being retained for this group, assistance is being provided for resettlement to rural areas, incen- tives are being given for investment in lower income areas, etc. Most importantly, the adjustment program itself will ensure increasing supplies of basic consumer goods at reasonable prices, which would not be the case otherwise. Creditworthiness 18. Scheduled service on public and publicly guaranteed (PPG) external debt will remain over US$400 million per annum for the next three years, or about 40 percent of export earnings at today's copper prices. Of this amount, about US$65 million per annum is due to the World Bank Group, including the IFC. (The Bank currently holds US$467 million, or 15 percent of Zambia's US$3.2 billion PPG debt disbursed and outstanding). In addition, about US$200 million per annum in payments is due to the IMF and  -7- another US$50-70 million per annum on Zambia's pipeline of commercial payment arrears and short-term borrowings. In total, scheduled debt service will amount to over US$700 million per annum for the next three years, and it will thus be necessary for the Government to continue its financial stabilization policies ln cooperation with the IMF and to seek debt relief through further rescheduling. Even with maximum debt relief under rescheduling arrangement similar to those of the past, however, Zambia will continue to owe over US$400 million per annum in debt service that cannot be rescheduled. The Government should, therefore, avoid as much ss possible borrowing on commercial terms, and additlonal borrowing should carry sufficiently long grace periods and maturities. 19. In the longer term, the restoration of Zambia's creditworthiness depends on the vigor with which the Government continues to pursue its economic cestructuring policies. The Government is Well underway in adjusting its economic policies and is fully committed to take further steps towards economic reform and the restructuring of Zambia's productive industries. Assuming successful economic policies, careful financial management and adequate external assistance, Zambia will be able to achieve a sufficient measure of export growth and diversification within the next decade to allow the country to resume normal debt servicing. II. BANK GROUP OPERATIONS IN ZAMBIA 20. Since 1956, the Bank Group has made 28 loans and 14 credits to Zambia, totalling about U$780 million 'net of cancellations). Two additional Bank loans were made to Zambia and Zimbabwe jointly to finance shared power facilities on the Zambezi River. Fourteen loans and six credits have financed energy, transportation, communications and rural water supply projects. Four loans and one credit for education have helped expand Zambia's secondary and higher education systems, teacher training, and commercial, agricultural and technical education systems. Two program loan1 have helped Zanbia maintain its development program in periods of severe economic dislocation. In agriculture, forestry and fisheries, six loans and six credits have been for 'ndustrial forest plantations, livestock, commercial crops, integrated family farming, coffee production, smallbolder dairy development and fisheries development. Agricultural projects in the Eastern and Southern Provinces are assisting smallholder farmers, and an Agricultural Rehabilitation Project is providing inputs to the sector in support of policy reforms. Other loans have assisted Zambia's urban development program, copper mining and, through the Development of Bank of Zambia, its manufacturing, agricultural and industrial sectors. A technical assistance credit is helping the Government improve its planning and project preparation. An engineering credit is supporting a project to assess the rehabilitation requirements of the TAZAM&-- oil pipeline. 21. The International Finance Corporation (IFC) has invested about US$87 million in 11 projects in Zambia since 1972. Two investments each were in shoe manufacturing, in a packaging materials plant and in textiles  8 and fiber production, and one eazh in the Development Bank of Zambia, tourism development, food production and processing, cobalt production, and copper production. 22. The implementation of Bank-assisted projects in Zambia has deteriorated significantly in recent years, and serious delays have been experienced in the execution of a number of these projects. There are several reasons for this, the main one being the lack of budgetary resources with which to finance local counterpart expenditures and to prefinance local expenditures which are subsequently to be reimbursed by the Bank loan. Most seriously affected have been the Bank's agricultural projects for which funds, although budgeted, have not been released to the executing agencies for several months. Other reasons for the lagging implementation of projects are ineffective project management and inadequate inter-agency coordination. The Bank-assisted agricultural projects, which require careful management and effective coordination have suffered from these problems, as has the Third Highway Project. 23. The deterioration of project implementation has, as expected, substantially reduced the rate of disbursements on Bank Group loans and credits. As of September 30, 1985 a total of US$87 million of loans and -US$128 million of credits remained undisbursed. To alleviate the problem, provision is being made for technical assistance in projects to strengthen implementing agencies and increased use is being made of the Resident Mission in monitoring project execution. Revolving funds are being established under new and ongoing projects which should ease the Government's financial burdeu and accelerate disbursements. In addition, estimates of co;:.terpart ftunds required and when the tunds should be made available are being prepared by Bank/IDA staff well in advance of their need to allow implementing agencies as much lead time as possible to plan for these expenditures. As of December 1984, IBRD loans disbursed and outstanding were about 12 percent of Zambia's total medium and long-term debt disbursed and outstandilg. 24. The Bank Group's strategy in Zambia is to support the country's efforts to diversify and increase economic efficiency. Raising the efficiency of the mining industry through the Export Rehabilitation and Diversification loan so that the industry may contribute resources to diversification programs was the first step in carrying out this strategy. Subsequent operations, such as the Agricultural Rehabilitation Project and the Industrial Reorientation Project are focusing on improving sector policies in agriculture and industry, which are the sectors with the best potential for production and export growth and for employment creation. The Group's strategy also gives priority to programs to increase the use of indigenous energy resources and to raise the efficiency of transportation services. Emphasis will be given to rehabilitation and maintenance, rather than expansion, of infrastructure and Bank Group assistance is expected to include a significant propurtion of quick-disbursing resources. Support for addressing the longer term development constraints, e.g., improving economic management, education, population, health, etc., is also part of the strategy. Policy and institutional reform programs in each of the sectors, as well as on the macroeconomic level, are being agreed with the Government. Through organizing and chairing the regular meetings of the  - 9 - Consultative Group for Zambia, the Bank is assisting the Government in coorainating the country's economic rehabilitation program and investment needs with the international donor community. At its last meeting, which was convened on an emergency basis in December 1985, the Consultative Group endorsed the Government's recent economic measures, in particular the foreign exchange auction system, and announced substantial multi- and bilateral financial support for the Government's program. PART III - THE INDUSTRIAL AND FINANCIAL SECTORS The Industrial Sector 25. Zambia's manufacturing sector is relatively large compared to other sub-Saharan African countries, contributing over US$600 million to GDP in 1983, and employing nearly 60,000 workers (16 percent of employment) in the modem sector. The 20 percent share of manufacturing in Zambia's GDP is second only to Zimbabwe, and only Zimbabwe and the Ivory Coast in sub-Saharan Africa have higher levels of manufacturing GDP per capita. 26. Manufacturing was the fastest growing sector of the economy in the first decade after independence. From 1965 to 1974, manufacturing value added grew at 10 percent per annum in real terms while total GDP was growing at about 3.3 percent p.a. due to: (i) growing demand for consumer goods because of growing incomes; (ii) increased demand for equipment and metal fabrication linked to the mining sector; and (iii) the Government's policy of accelerated industrialization through import substitution and public sector investments in manufacturing. However, between 1975 and 1980, industrial output fell dramatically by 15 percent in real terms in response to the sharp fall in copper earnings and the resulting economic recession. In the 1980s, industrial output continued to decline, with manufacturing value added in 1985 about 75 percent of the 1976 level. 27. It was difficult for the industrial sector to respond to the changed environment, because Government policies with respect to licensing, tariffs and investment incentives had created an environment in which competition was limited and industry grew as an import-substituting activity behind high protective barriers. In addition, the choice of public sector investments coupled with distortions in factor prices combined to create a highly capital and import-intensive structure. In addition, Zambian manufacturing is highly dependent on imported inputs (representirg about 20 percent of total imports), while manufactured exports represent no more than 1 perceat of the country's total exports. Declining output, value added, wages and productivity was the result. The parastatals, which account for 69 percent of -he sector's assets, 66 percent of value added and 54 percent of employment, were particularly hard-hit, because their problems are also the result of weak management, politically-based hiring policies and uneconomic size plants. 28. The economic reform of 1985, including the liberalization of the import licenoing system and the elimination of all remaining import prohibitions, which accompanied the foreign exchange auction, have  - 10 - substantially opened Zambia's formerly protected industrial sector to international competition. Other reforms recently enacted or in progress include the establishment of a minimum 10 percent tariff on mDat imports, reduction of maximum tariff rates from 150 to 100 percent , and the establishment of a Tariff Commission to undertake a comprehensive tariff reform. The Industrial Development Corporation (INDECO), the holding company for parastatal manufacturing enterprises, has established an economic evaluation unit to review the group's investment projects and the economic viability of its industrial firms. INDECO is also preparing an action program for restructuring or closing down inefficient enterprises. An Investment Act was enacted in April 1986. This legislation is designed to encourage private investment in enterprises which have export potential, make heavy use of locally-produced inputs, or are located in rural areas. Finally, an Export Promotion Board has been established to assist enter- prises with export potential to develop or expand the markets for Zambian goods. These reforms are already having a positive impact on industry and increases are beginning to take place in capacity utilization, productivity of capital and labor, efficiency of foreign exchange use and exports. The Financial Sector 29. The Bank of Zambia (BOZ), was established as a Central Bank in 1965 to Issue currency, regulate commercial banks, and establish and administer national monetary and credit policies through the use of the discount rate and reserve requirements. BOZ also manages Zambia's interna- tional reserves and is in charge of the country's foreign exchange control system, which it administers in cooperation with the commercial banks. Zambia has a well developed financial system which includes, in addition to the Central Bank, nine commercial banks and six specialized parastatal financial institutions. The latter are under the control of the Zambia Industrial and Mining Corporation (ZIMCO)-the Apex holding company for all state-controlled enterprises. 30. During the 1980s, monetary policy has largely met the requirements of the Government's fiscal policy. Between 1980-82, monetary and credit policy accommodated the growing needs of an expansionary budget policy and an attempted recovery in the productive sectors. Budgetary restraint in 1983 led to a sharp decline in the rate of growth of net banking system assets, the monev supply, and banking system credit to both the Government and private sector. Credit growth expanded in 1984, but inflation grew even faster and the kwacha suffered its first major depreciation. With the opening up of the economy in 1985, a substantial monetary expansion occurred. At the same time, the rate of inflation continued to rise, fueled by major price increases in a whole range of goods and services following the substantial devaluation of the kwacha in October-November of that year. Monetary expansion has continued at a high rate in 1986, accompanied by a doubling in the rate of inflation. 31. Between 1982-85, BOZ raised interest rates in a series of gradually larger steps, until in 1985, rates were completely freed and rates are now set by market forces. The removal of all ceilings on interest rates in September 1985 resulted in almost a doubling of rates within a two-month period. An auction of treasury bills was also  - 11 - introduced, which more than doubled the T-bill rate over the same period. Under the new system, the Banks in practice establish a prime rate which is close to the T-bill rate. The basic market option for the banks is to (i) invest deposits in T-bills, or (ii) make loans at rates reflecting the return on T-bills plus their own loan administration costs of about 1 percent plus an additional profit margin. In practice, the prime rate charged is about 2 percent above the T-bill rate, which provides the banks with a 6 percent spread over the average cost of deposits. In effect, the T-bill auction established a market-oriented cost structure not only for government borrowing, but also for setting lending rates throughout the banking system. 32. When the T-bill stabilized at about 24 percent, some borrowers had to pay as high as 33 percent, and the average lending rate was about 30 percent. As a result, even though real interest rates remained negative following the 1985 devaluation and subsequent price inflation, they have recently become marginally positive as the rate of inflation slowed during the course of 1986. The prospects for the future trends in interest rates and inflation depend largely on the Government's success in controlling the latter. Assuming that the Government's economic program, including a market-oriented interest rate policy, will be maintained, the outlook is for a return to an equilibrium situation resulting from a decline in the rate of inflation. Consequently, the market-determined interest rates are expected to become substantially positive over the medium term. Bank Group Experience in Lending to Industry 33. The Bank Group's lending to industry has been channelled through the Development Bank of Zambia (DBZ). Its relationship with DBZ began in 1971 when, at the request of the Government, the Bank reviewed the need for a development bank in Zambia and recommended the establishment of DBZ to fulfill the functions of mobilizing term resources and promoting and financing viable projects in the productive sectors. DBZ was subsequently established in December 1972 and began operations in January 1974. The Bank Group has helped DBZ to mobilize foreign exchange resources through an IFC equity investment and providing lines of credit to finance its opera- tions. DBZ received a Bank loan (No. 1210-ZA) of US$15.0 million and an IFC equity investment of K 350,000 in FY76. The objectives of. the first Bank loan and the IFC investment were to (a) provide investment financing for productive projects which met sound economic, financial and technical criteria, and (b) to build DBZ into an effective development financial institution. A project completion report (PCR), prepared in 1982, found that these objectives were substantially met. Proceeds of the first Bank loan financed 47 small- and medium-size projects mainly in the manufac- turing, agricultural and transport sectors, and generated 1,500 new jobs at an average investment cost per job of K 20,400 (US$16,000 in 1981). DBZ had established sound operating policies and steadily improved its project appraisal, implementation and supervision procedures, while maintaining a healthy financial condition and an increasing profitability. A second Bank loan, (No. 1923-ZA) of US$15.0 million was granted in FY80, whose main objective was to assist in the efficient development of the industrial, agro-industrial and agricultural activities. The loan was effectively fully disbursed by June 30, 1986, about one year ahead of schedule.  - 12 - Nevertheless, an increasingly difficult macroeconomic environment began tc affect the performance of a substantial number of DBZ's clients, and this situation, in turn, was affecting DBZ's own performance. While DBZ remained a sound institution, the difficult economic situation of the past several years led to a deterioration in the quality of DBZ's portfolio, an increase in the level of arrears and a decline in profitability. The proposed project would aim inter alia at helping DBZ improve the quality of its portfolio and financial condition and performance. PART IV - THE PROJECT 34. The project was appraised in April-May 1986 and negotiations were held in washington, D.C., in October 1986. The Zambian delegation was led by Hr. Fred Siame, Senior UnderSecretary, Ministry of Finance, Government of Zambia. A Staff Appraisal Report (No. 6310-ZA, dated November 17, 1986) is being distributed separately to the Executive Directors. A credit and project summary is presented at the beginning of this report and a supplementary project data sheet is included in Annex III. Project Objectives 35. The main objectives cf the project are to complement the policy reform package by helping productive enterprises to expand, modernize or rehabilitate their existing capacity or to establish new productive facilities. The project would also help DBZ to improve its performance and its ability to mobilize resources through (i) a major capital increase; (ii) the upgrading of the quality of DBZ's portfolio, and (iii) increasing the efficiency of financial and management decision-making by establishing an MIS and training DBZ staff in its use. Project Description 36. The proposed IDA credit of US$10.0 million equivalent consists of a credit component (US$8.9 million) which would provide resources to DBZ to finance the long-term foreign exchange requirements of its planned invest- ment financing activities over a three-year period within its five-year (FY86/91) program, and a technical assistance component (US$1.1 million) which would provide DBZ with resources to train its staff, computerize its accounting and financial management procedures and establish a Management Information System (MIS). The credit would be made to the Government on standard IDA terms. A US$1.5 million advance, equal to four months anticipated disbursements, would be made from IDA's credit account to establish a special account operated by DBZ. In order to prevent any delay in the implementation of the MIS sub-component, an amount not exceeding SDR 250,000 would be made available for retroactive financing of related expenditures made before the date of credit signing, but after October 31, 1986. The final date for submitting subprojects to the Association for approval is March 31, 1990. The Project is expected to be completed by December 31, 1991, and the Closing Date is June 30, 1992.  - 13 - Credit Component 37. Because both foreign exchange and local currency can be freely obtained at interest rates established by the market and at an exchange rate also determined by the market, sub-borrowers would have the option of selecting subloans denominated either in dollars or kwacha. The Government would onlend the funds for the credit component to DBZ at a fixed annual interest rate of 8.23 percent for subloans denominated in US dollars, and at a variable interest rate equal to the auction-determined Treasury Bill rate plus two percentage points for subloans denominated in Kwachas. The price differential between the two currencies would reflect the relative risks and costs involved. The proDosed lending rate structure from DBZ to the individual borrowers would be as follows: (i) subloans denominated in dollars: fixed interest rate equal to the Bank's lending rate at the time of negotiations, plus a 4 percent spread (i.e., 8.23 + 4.0 = 12.23 percent per annum); (ii) subloans denominated in kwacha: BOZ's variable T-bill rate plus a 2 percent premium for the foreign exchange risk, plus a 4 percent spread (i.e., presently 23 + 2 + 4 = 29 percent). 38. The proposed onlending arrangements are based on the market determined interest and exchange rate systems currently in place. Should these systems, which rely on market forces, be changed, the normal legal remedies would be available to the Association. 39. DBZ would relend the funds for maturities of up to 15 years including appropriate grace periods not to exceed 4 years. DBZ would repay the Government in accordance with an amortization schedule conforming to the aggregate amortization schedules of subloans. DBZ would keep its present free limit of US$400,000 for individual subprojects and aggregate free limit of US$5 million. The maximum amount that could be financed for individual subprojects would be US$2 million. By December 31, 1986, DBZ would introduce a system to calculate economic rates of return for all projects requiring DBZ financing of more than US$250,000. Proceeds of the credit component would finance capital investment am' permanent working capital requirements of viable subprojects which meet the criteria set out in DBZ's Policy Statement and have been satisfactorily appraised by DBZ. According to the Policy Statement, which may not be amended without IDA approval, DBZ's exposure to any single borrower would be limited to 20 percent of its own equity, and DBZ's financing woud not normally exceed 75 percent of the total cost of any individual subproject. Technical Assistance Component 40. The Government would provide US$1.1 million to DBZ, from the proceeds of the technical assistance component of the proposed project, as a subordinated loan to DBZ, which would represent a quasi-equity contribution, and would strengthen DBZ's financial condition. The terms and conditions of such financing would be spelled out in a Financing Agreement approved by IDA. These funds would be used to finance the total cost of the following: (i) training DBZ professional staff especially in  - 14 - the areas of financial management and project appraisal and supervision (US$200,000); (ii) employing an MIS advisory service to install and implement a computerized accounting, financial and management information system and to train DBZ staff in its use (US$300,000); (iii) obtaining the necessary computer hardware and software (S$400,000); (iv) employ for a term of three years, a Financial Advisor to help DBZ improve its accounting and financial management functions and train staff in the Finance Division (US$200,000). DBZ is presently negotiating a contract for the hiring of MIS advisory services. The Financial Advisor would be hired prior to March 31, 1987. DBZ would, not later than June 30, 1987, submit a detailed staff training program to IDA for its review and comment. The Development Bank of Zambia 41. Ownership. DBZ is responsible for implementing the proposed project. DBZ was established in 1972 with an initial authorized share capital of K 10 million consisting of 600 'Class AR shares and 400 "Class B" shares of K 10,000 each. IFC subscribed 35 shares of the latter. "Class A" shares are reserved for the Government and its agencies and "Class B" shares are reserved for private local and international banks or instituticns. As of March 31, 1986, DBZ's total paid-in capital amounted to K 18,950,000. A capitalization plan to raise an additional K 51 million in share capital, which would be required to finance DBZ operations and maintain a prudent debt/equity ratio during the coming years, was accepted by DBZ's shareholders during its July 1986 Board Meeting. After being briefed on the results of IDA's appraisal, DEG, FR0, EIB and IFC have undertaken a joint appraisal of DBZ and wili present proposals to their respective Boards to subscribe a substantial portion of the new "Class B" shares, which are expected to result in these institutions holding about 25-35 percent of DBZ's total share capital. Among the local shareholders, parastatal financial institutions have indicated their willingness to subscribe additional capital. The Government, however, is presently unable to provide additional capital because of fiscal constraints. However, DBZ has reached agreement with the Government for channelling a K 9 million portion of a grant from the Dutch Government, to DBZ as part of the Govern- ment's "Class A" share contribution. The proposed IFC equity investment is expected to fill the gap, and to effectively reduce the Government's ownership below 60 percent. An appropriate five-year capitalization plan acceptable to IDA would be prepared by DBZ by September 30, 1987, and implemented thereafter. 42. Organization and Management. Overall, DBZ's management is dedicated and effective. DBZ's organizational structure comprises six divisions responsible for project promotion, appraisal, supervision, personnel and administration, finance and internal audit. All the divisions are adequately managed. The Finance division needs to be strengthened by recruiting an experienced Financial Advisor which will be financed from the proceeds of the technical assistance component of the proposed project (para. 40). Except for a one-man office in the Northwestern Province, all DBZ's staff are located in Lusaka. The appraisal, implementation and supervision of projects financed by DBZ entail extensive travel by DBZ staff, and the distances involved make it difficult for DBZ to supervise effectively some of these projects. DBZ is,  - 15 - therefore, establishing a regional office in Ndola to handle projects in the Copperbelt, Northwestern, Northern and Luapula Provinces, which account for 40 percent cf DBX loans. 43. Quality of Portfolio. DBZ's loan portfolio has increased from K 65.7 million at year end 1982, to K 177.2 million, distributed among 288 borrowers, as of March 31, 1986. DBZ also had a total equity portfolio of K 5.1 million in 23 firms. DBZ's portfolio has been traditionally of high quality, but it started to deteriorate when the Zambian economic crisis accelerated in the early 1980s. As a result, arrears Increased from 2.8 percent of total loan portfolio in 1982, to 15.8 percent by December 31, 1985, while the collection ratio was low (60-80 percent). However, during project preparation, DBZ intensified its collection efforts, and the collection ratio increased sharply to 144 percent for the quarter ended March 31, 1986. A recently received annual audit report for March 31, 1986 indicates that these efforts have been a success with arrears falling to 11.1 percent of portfolio, substantially below the target agreed upon at negotiations (see below). With IDA's assistance, DBZ prepared a two-phase Debt Recovery Action Plan (DRA). Phase one focused on reducing arrears from the 40 clients covering 73 percent of its portfolio in arrears as of December 31, 1985. By the end of September 1986, seven firms had repaid in Nfu and 23 firms were in the process of repayment. The arrears of three other firms had been rescheduled because they required additional tile to repay, and legal action had been taken against seven other firms which had not reached agreement with DBZ. During negotiations, it was agreed that phase two of the DRA would commence on December 31, 1986. As a meams of establishing a imnitorable basis for assessing DB' s collection perfor- sance, DBZ agreed at negotiations to set semestral targets to include a collection ratio that would result in arrears declining to 12 percent of total loan portfolio in December 31, 1986, 10 percent by June 30, 1987 and 9 percent by December 31, 1987. 44. Financial Performance. In 1985, DBZ substantially increased its provisions against bad loans, in response to the deteriorating arrears situation, to K 4 million from K 0.4 million in FY84. The implementation of a new provisions policy in FY86 has resulted in total provisions of K 7.1 million (4 percent of total loan portfolio). Such a level of provi- sions reflects adequately DBZ's portfolio risk at this time. During nego- tiations, agreement was reached with DBZ not to distribute dividends unless provisions for bad or doubtful loans constitute at least 4 percent of total loan portfolio. DBZ's liquidity position is bezlthy and its fiuancial structure remains sound. The term debt-to-equity ratio for the period FY82-84 remained below DBZ's 4:1 limit. By early 1986, however, the debt-to-equity ratio juwped to 4.9:1 because of a substantial revaluation of the foreign excbange component of its loan portfolio in that ynar, and because sbare capital increases did not keep pace with borrowed resources in meeting the reeds of DBZ's clients. However, the ratio declined subsequently, to 4.4:1 as of October 31, 1986, as additional capital was paid In. Given DXZ's sound financial and liquidity position, under the proposed credit, DBZs maximum debt:equity ratio would be increased to 5:1, in line with its operational growth projections.  - 16 - Project Cost and Financing 45. DBZ's operational forecast is based on a firm pipeline and a cautious optimism that the recent economic policy measures undertaken by the Government, with strong support from the International Monetary Fund and the World Bank, will provide a timely stimulus to the economy and gene- rate a growth in demand for investment financing. Total loan approvals expressed in current US dollars are expected to grow in nominal terms by 4 percent in FY87 increasing to 10 percent in FY91. To meet this expected growth in operations, DBZ will require new resources in an amount of US$75 million equivalent for the five-year period FY86-91. The direct and indi- rect foreign exchange component of this amount is estimated to be US$45 million, of which about US$30 million would be required during the three- year commitment period of the proposed credit (April 1987 to March 1990). Financing Plan FY86/91 (US$ million) Amount Z Commercial banks $ 16.0 15.4 Parastatal non-banks 18.0 17.3 DBZ-share capital 7.3 7.0 DBZ-retained earnings 4.7 4.5 IFC 6.0 5.8 FRO 5.0 4.8 IDA (DBZ III) 10.0 9.6 EIB 8.0 7.7 Total DBZ financing $ 75.0 71.8 Beneficiaries own funds 29.0 8.2 Total Project Cost $104.0 100.0 Project Implementation 46. Reporting Requirements. DBZ would submit quarterly reports to IDA, including interim balance sheets and profit and loss statements, a resource position statement, arrears, loan repayments billed and collections received, and the status of subproject processing. On an annual basis, DBZ would submit, not later than six months after the end of the current fiscal year, and four months after the end of subsequent fiscal years, a full annual audit report, prepared by accountants acceptable to IDA, in accordance with the Bank Group's 'Illustrative Form of Audit Reports for Development Finance Companies". 47. Procurement and Disbursement. Procurement for DBZ-financed projects is made following regular commercial practices in Zambia. DBZ policies require that clients obtain at least three quotations from three different suppliers or contractors. To be comparable, each quotation must include a complete itemization of the total price or cost, including suppliers' standard term of sale. Selection of the winning quote is based on adherence to the following: (i) price/cost competitiveness; (ii) previous performance of the supplier/contractor; (iii) availability of  - 17 - maintenance services in Zambia; (iv) availability of technical assistance services (i.e., training and installation); and (v) provision of warranties and performance guarantees. Under the proposed project, DBZ will also require each sub-borrower to submit a detailed written comparison of the quotations received. Consultants would be selected in accordance with "Guidelines for the Use of Consultants by World Bank Borrowers and by the World Bank as Executing Agency" (August 1981). Disbursements are expected to conform to regional and IDA-wide profiles for lending to industrial development finance institutions. The proceeds of the credit would be disbursed as follows: (a) Credit Component: 100 percent of foreign expenditures and 75 percent of local expenditures for goods and services, except for civil works for which disbursements would be made against 40 percent of local expenditures; (b) Technical Assistance Component: 100 percent of expenditures for consultants' services arn training, and 100 percent of foreign expenditures for equipment. 48. Special Account. In order to expedite disbursement, a special account would be set up by DBZ, into which IDA would make an initial deposit of US$1.5 million, representing four months estimated disbursements immediately following credit effectiveness. Replenishment of the Special Account for expenditures under S25,000 would be made on the basis of Statements of Expenditures (SOE), and the documentation for withdrawals made would be retained by DBZ to be reviewed by IDA supervision missions. Expenditures against contracts or orders in excess of $25,000 would be fully documented. Applications for replenishment would be submitted to IDA on a monthly basis or whenever funds fell below US$1 million. An audit of the Special Account would be included in the annual audit of DBZ's accounts, and the auditor's opinion would include a separate paragraph with respect to amounts withdrawn on the basis of SOE's. Project Benefits and Risks 49. The proposed project would provide term resources to the produc- tive sectors in Zambia to rehabilitate industrial and agro-industrial enterprises, develop manufactured exports, and increase agricultural production. It would thus help accelerate growth and increase employment in Zambia and would complement the positive impact of the policy reforms already undertaken by the Government and supported by IDA. The investment component of $US8.9 million is expected to support productive investments totalling about US$20 million. The project would enable IDA to help DBZ, the main term-lending institution in Zambia, to increase its effectiveness by mobilizing additional resources, upgrading the quality of its portfolio, and increasing the effectiveness of financial and management decision-making. Continued IDA support would enhance DBZ's capability to mobilize substantial fcreign capital and other resources from bilateral institutions arid would enable it to play a more significant role in assisting the recovery of Zambia's productive sectors.  - 18 - 50. There are two major risks to this project. One is the possible deterioration of Zambia's economic situation. Such a risk is, however, limited, so long as Zambia continues to comply with the IMF stabilization program and the policy reforms and actions agreed upon with IDA and other donors, to increase the resource transfer and accelerate economic growth in Zambia. A second risk is a continued deterioration of DBZ's arrears posi- tion. This risk is being reduced as DBZ takes strong action to improve loan collections and to resolve its portfolio problems, in the context of Debt Recovery Action Plan, which will be closely monitored by IDA. These should insure that DBZ will remain an effective term-lending institution that promotes economically sound investment ptojects. PART V. RECOMMENDATION 51. I am satisfied that the proposed credit would comply with the Articles of Agreement of the Association and recommend that the Executive Directors approve the proposed credit. Barber Conable President Attachments Washington, D.C. November 17, 1986  - 19 - AM I Roge I of 2 ZANN[M 1:OOI DIICA1 Papulation: 6.678 Iion (md-1985) GNP Ir Cpa: US$400 (1985)1/ 1985 US$ Permt Amu Grwth RNoew (Z) at Costant Prices lodicator ud.Jix. of QP 1975-0 1981 1982 1983 1984 1985 GlP, ator Coast 2055 88 -0.7 2.7 -2.1 -0 1.5 4.8 (NP, l1zIret Pdric 2345 ID -1.1 6.2 -2.8 -2.0 -0.4 3.4 A