Morocco - Industrial Finance Project

Document of The World Bank FOR OFFICIAL USE ONLY A,V 3/ 3, a tfA 7 Report No. 7458-MOR STAFF APPRAISAL PEPORT MOROCCO INDUSTRIAL FINANCE PROJECT OCTOBER 26, 1989 Europe, Middle East and North Africa Regional Office Country Department II Industry and Energy Operations Division 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 = Dirham (Da) 1982 1983 1084 1985 1986 1987 1988 DH per US$ Year Average 6.02 7.11 8.81 10.06 9.10 8.36 8.21 Year End 6.27 8.06 9.55 9.62 8.71 7.80 8.21 DH per SDR Year Average b.65 7.60 9.03 iO.22 10.68 10.81 11.03 Year End 6.91 8.44 9.36 10.57 10.66 11.07 11.05 FISCAL YEAR January 1 - December 31 LIST OF ABBREVIATIONS BCM Banque Commerciale du Maroc BCP Banque Centrale Populaire BMCE Banque Marocaine du Commerce Ext6rieur BMCI Banque Marocaine pour le Commerce et l'Industrie BNDE Banque Nationale pour le D6veloppement Economique CDM Credit du Maroc CIH Credit Immobilier et Hotelier CMPE Centre Marocain de Promotion des Exportations CNCA Caisse Nationale de Credit Agricole EEC European Economic Community EMI Electrical and Mechanical Industry ERR Economic Rate of Return GDP Gross Domestic Product IS Corporate Income Tax ITC International Trade Center ITPA Industrial and Trade Policy Adjustment MCI Ministry of Commerce and Industry MTR Medium-term Rediscountable ODI Ofice pour le Developpement Industriel PB Participating Bank SAL Structural Adjustment Loan SGMB Societe G6nerale Marocaine de Banque SMAEX Societe Marocaine d'Assurance a l'Exportation SOE Statement of Expenditures SSI Small Scale Industry UNDP United Nations Development Program UN/ISO United Nations/Initernational Standardizat-ion Organization VAT Value Added Tax  FOR OFFICIAL USE ONLY MOROCCO INDUSTRIAL FINANCE PROJECT STAFF APPRAISAL REPORT Table of Contents Page No. LOANS AND PROJECT SUMMARY ............................... (i) Chapter I. INTRODUCTION ........................................., 1 Chapter II. THE INDUSTRIAL SECTOR A. The Macroeconomic Background ........... 2 B. The Industrial Policy Reforms ...... ........... 2 (i) Trade Liberalization ...... ............... 3 (ii) Investment Promotion ...... ............... 5 (iii) Institutional Support to Exporters. 6 C. Performance 7 (i) Performance in Manufactt.ring. 7 (ii) Evolution of Moroccan Exports. 9 D. The Bank's Role in the Industrial Sector .12 Cthapter III. THE FINANCIAL SECTOR A. Overview. . 14 B. Recent Developments and Future Prospects ...... 15 C. Distribution of Credit ...... .................. 17 D. Coverage of Foreign Exchange Risk .... ......... 18 E. The Participating Commercial Banks .... ........ 20 F. Banque Nationale pour le D6veloppement Economique ..... .............. 24 Chapter IV. THE PROJECT A. Rationale, Objectives and Components .... ....... 26 B. Evaluation of Demand for Investment Credit ..... 27 C. Features of the Lines of Credit ..... ........... 28 D. Export Promotion ....... ........................ 31 Chapter V. PROJECT BENEFITS AND RISKS ....... ....................... 32 Chapter VI. AGREEMENTS TO BE REACHED AND RECOMMENDATIONS .33 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.  Table of Contents (continued) Page No. TABLES Table 2.1: Investment Approvals in Manufacturing, 1984-89 ............ 8 Table 2.2: Evolution of Moroccan Exports during 1980-88 .......... .... 9 Table 2.3: Destination of Moroccan Exports in 1987 and 1988 .... ...... 10 Table 3.1: Distribution of Credit to the Economy in 1986-88 .... ...... 18 Table 3.2: Financial Indicators of the Participating Commercial Banks, as of December 31, 1988 ............. .. 20 Table 3.3: BNDE's Financial Indicators in 1984-88 .25 ANNEXES Annex 1: Investment Approvals uader the Industrial Investments Code, 1984-88 .. . 34 Annex 2: The Manufacturing Sector in 1980 and 1987 .35 Annex 3: Merchandise Exports, 1980-88 .36 Annex 4: List of Sub-projects Committed under the Industrial Export Finance Project, as of September 30, 1989 .37 Annex 5: Structure of Key Interest Rates, 1985-88 .38 Annex 6: Finanicial Statements of the Participating Commercial Banks, 1986-88 .39 Annex 7: Banque Nationale pour le Developpement Economique .... ..... 41 Annex 8: Estimated Disbursement Schedule ........................... 52 Annex 9: Documents in the Project File ............................. 53 This report is based on the findings of a June-July 1988 appraisal mission and a July 1989 post-appraisal mission. The appraisal mission consisted of Messrs. C. Basterra (Mission Leader), B. Horton, M. Mitchell and Ms. D. Pham, and Messrs. Fromageot, G. Johnson and J. Raven (consultants). The post appraisal mission included Mr. E. Forestier (Mission Leader) and Ms. B. Lewis.  MOROCCO INDUSTRIAL FINANCE PROJECT Loans and Project Summary Borrowers: Eight Moroccan banks: seven commercial banks -- Banque Centrale Populaire (BCP), Banque Commerciale du Maroc (BCM), Banque Marocaine du Commerce Ext6rieur (BMCE), Banque Marocaine pour le Commerce et l'Industrie (BMCI), Cr6dit du Maroc (CDM), Societe G6nerale Marocaine de Banque (SGMB) and Wafabank --- and Banque Nationale pour le Developpement Economique (BNDE). Guarantor: The Kingdom of Mero- .o. Amount: US$ 170 million equivalent in aggregate. Terms: 20 years, including a five-year grace period, at the Bank's standard variable interest rate. F-oiect Description: The Project will support the supply response of industry to the new set of incentives and policies introduced under the Government's adjustment program. It will also contribute to increased competition and efficiency in the financial sector. The Project consists of eight lines of credit to financial intermediaries, amounting to a total of US$ 170 million, to be on-lent to eligible firms for investment sub-projects. Bank funds will support enterprises which are adapting well to the new industrial incentives environment and are financially sound with equity representing at least 30% of each sub-project investment cost. In accordance with the Government's policy to encourage export development, at least 60% of the Bank funds will be allocated to export-oriented sub-projects. In line with Government policy of fostering private investment, no more than 15% of Bank funds will be allocated to public sector projects. Up to 20% of the Bank funds could be used to finance tourism projects and up to 10% to finance projects developed by leasing companies. Tourism projects will be considered as export-oriented projects. These limits represent a progressive liberalization in the allocation of credit by the Moroccan financial system, and under Bank operations to the country. Under the Project, measures will be taken to: (a) strengthen the financial intermediaries and Morocco's institutional capabilities in relation to export promotion activities; and (b) ensure prompt and regular payment by the Treasury of foreign exchange losses due to the participating banks.  On-lending Terms: The funds will be on-lent by the financial intermediaries to industrial and industry-related firms and to tourism enterprises. The amount allocated to each financial intermedisry reflects the demand from its clients and its perforu,:nce in investment lending in the past. Bank funds are expected to be committed over a two and a half year period. Sub-loans made by the financial intermediaries will be denominated in local currency. On-lending interest rates will reflect domestic market rates and will be significantly positive in real terms. The foreign exchange and interest rate risks will be covered by the Foreign Exchange Risk Fund, against payment of premia by the participating banks and the final borrowers. The repayment terms of investment sub-loans will reflect the economic life of the sub-projects; the maximum maturity will be twelve years, including a maximum grace period of five years. Benefits and Risks: Morocco has embarked on a widespread program of economic liberalization and reform whose continued success depends critically on the ability of Moroccan industry to expand the production and exports of products in which the country has a comparative advantage. This growth will in turn depend upon the continued improvement in the incentives and policy framework governing industry (which has been supported through a number of Bank operations), and upon access by industry to adequate medium- and long-term financing. The Project will contribute to the expansion and modernization of the industrial sector, employment creation in industry and increasing manufacturing exports. It will promote competition in the fir.ncial sector and contribute to the institutional strengthening of financial intermediaries as well as other institutions involved in the development of exports. The main external risk under the Project is that, as a result of increased economic protection in the countries which are Morocco's major export markets, the expected demand for investment credit may not materialize or investment sub-projects may encounter difficulties daring implementation. However, many Moroccan enterprises are already developing plans, with the support of the PBs and the Centre Marocain de Promotion des Exportations (CMPE), for diversifying their products and mn.rkets to guard against potential restrictions in access to traditional export markets. Domestically, the major risk is that the Government may not commit itself fully to continued policy and administrative reforms, notably the gradual liberalization of the financial sector. This is unlikely as implementation of such reforms is continuing, and the Government is seeking further IMF and Bank support to the adjustment process.  - iii - Estimated Disbursements: IBRD Fiscal Year FY91 FY92 FY93 FY94 FY95 FY96 (US$ million) Annual: 10.2 30.6 39.1 34.0 25.5 30.6 Cumulative: 10.2 40.8 79.9 113.9 139.4 170.0 EconomicZ Rate of Return: Minimum of 12% for each sub-project.  I. INTRODUCTION 1.01 This report appraises a project designed to (i) provide financing for Morocco's industrial sector, with a special emphasis on support to export-oriented investment, and (ii) improve the efficiency of the financial system by promoting the development of competitive, market-based financial institutions. It includes a package of eight loans, totalling US$ 170 million, to seven commercial banks and the Banque Nationale pour le D6veloppement Economique (BNDE). At least 60% of the Project's funds will be allocated to export-oriented firms. Under the Project, measures will be taken to strengthen participating banks (PBs) and to ensure regular payment of foreign exchange losses due to participating banks by the Treasury, in addition to measures already underway to strengthen the export promotion capabilities of the Centre Marocain de Promotion des Exportations (CMPE). A study on administrative requirements constraining industrial investment in Morocco is being carried out by the Ministry of Commerce and Industry (MCI) and efforts to update Morocco's long-term export strategy in light of its changing external environment are also underway, with UNDP/IBRD assistance. 1.02 The Project complements the macroeconomic and policy framework agreed to in the context of the ongoing Structural Adjustment Loan (SAL) and IMF stand-by arrangement. These operations support the Government's stabilization and structural adjustment program, on-going since 1983, which consists of a flexible exchange rate policy, liberalized trade through reduced tariff and non-tariff protection, gradual liberalization of the financial sector, strengthened domestic resource mobilization, increased efficiency of public investment, export promotion and simplification of administrative proceditres for international trade. At the macroeconomic level, the Moroccan economy is in a period of recovery. The average real GDP growth rate reached 5.6% p.a. in 1985-88. The budget deficit has been reduced significantly, and in 1987 and 1988, the current account registered small surpluses. Further efforts, however, are required to restore economic growth and the country's international creditworthiness. The proposed Project will provide the medium- and long-term financing crucial to generate a supply response from the industrial sector, particularly from export-oriented firms, to the new set of economic policies and incentives, and will contribute to the development of a competitive market-based financial system. Finally, the project will also support export promotion and complement on-going Government programs in trade facilitation, with a view to ensuring that these are consistent with and respond to Morocco's changing external markets in light of the recent declaration of the Union of Maghreb Countries and of prospects presented by the 1992 EEC unification program.  - 2 - 11. THE INDUSTRIAL SECTOR A. The Macroeconomic Background 2.01 The sudden reversal in the terms of trade in the late 1970s, as a result of lower prices for phosphates, the country's major export commodity, and the second jil shock, prompted Morocco to resort increasingly to external capital markets in order to maintain a high rate of public investment. During this period, Morocco's external debt grew exponentially from US$1.8 billion in 1975 to US$13.9 billion ia 1983, at which point it represented nearly 120% of GDP and 355% of foreign exchange earnings. The unanticipated rise in international interest rates in the early 1980s, compounded by the declining productivity of public investment and a severe and prolovged drought in 1980-84, proved more than Morocco's balance of payments could endure. Bereft of foreign exchange reserves and access to external funds, Morocco was unable to shoulder its debt service burden--the debt service ratio reached 53% in 1983, with interest payments alone accounting for 20% of exports. By that time, it had become clear that the solution to Morocco's financial distress lay in a comprehensive program of economic reform. A set of extensive stabilization and adjustment policies was evolved by the Government and supported by a series of IMF standby arrangements and World Bank sectoral and structural. adjustment loans. 2.02 As a result of the introduction of these adjustment programs coupled with favorable international developments, Morocco's economy is recovering while maintaining a low level of inflation. The fiscal and current account deficits have declined significantly and Morocco has maintained a GDP growth rate of 5.6% on an average annual basis during 1984-88. The overall budget deficit declined from 11.2% of GDP in 1984 to 4.2% in 1988, and the current account deficit fell from 7.8% of GDP to small surpluses in 1987 and 1988. Total external debt in 1988 decreased to 91% of GDP and 303% of all foreign exchange earnings. Inflation averaged only 5.4% in 1985-88. Average annual real GDP growth is currently expected to be at least 3.5% over the medium-term as a prerequisite to ensuring the maintenance of per capita living standards, as well as the generation of resources required to reestablish creditworthiness. The planned growth in GDP in turn requires continued expansion of manufactured exports at a real annual rate of about 6%. This level of export growth is feasible, but is proving more difficult and more expensive to achieve because capacity utilization of export indust.ries is already high and further production growth will need more investment. Therefore, competitive export-oriented firms need access to investment financing, on appropriate terms, to fuel the supply response to the policy measures. B. The Industrial Policy Reforms 2.03 Until the 1983 financial crisis, Morocco's industrial development was based primarily on a policy of import-substitution pursded through heavy protection for imports and a significant role for public enterprises. Although this policy permitted the attainment of reasonable growth in the sector in the 1970s, its mounting costs in terms of efficiency and balance of trade disequilibrium becar.ie increasingly evident. The growth of manufacturing  -3- value-added declined from 7% p.a. in real terms in 1973-77, to 1.62 p.a. in 1978-82, and manufacturing exports stagnated at 8 to 10% of ma.iufacturing output in the 1970s. This, combined with the general economic deterioration in the early 1980s, prompted the Government to reassess its industrial strategy. In the framework of its program of economic reforms supported by the Bank and the IMF, the Government has, since 1983, implemented comprehensive reforms of the incentives and policy framework in the industrial sector in support of Morocco's export-led growth strategy. Policy reforms have been undertaken in the areas of: (i) trade liberalization; (ii) investment promotion; and (iii) institutional support to exporters. The Bank has supported these reforms through two ITPA loans approved in 1983 and 1985 and the SAL approved in 1988 1'. The proposed Industrial Finance Project will help finance the expansion and modernization of the industrial sector with special emphasis on export-oriented private enterprise. (i) Trade Liberalization 1. Import Policies 2.04 Since 1983, the Government of Morocco has reduced tariff and non-tariff protection, progressively compressed a previously wide range of trade taxes, and gradually replaced quantitative restrictions by tariffs. As a result, about 90% of the total value of Morocco's imports is now not subject to licensing, compared to 38% at the end of 1983. The share of domestic manufacturing protected by quotas has also declined from 60% to 35%. Moreover, the Government has progressively reduced the maximum customs duty, which currently is 45% 2/. The import-weighted mean tariff for manufactured products fell from 30.6% in 1983 to 21.6% in 1987. 2.05 Under the SAL further progress is being made in reducing the level and dispersion of effective protection. By the end of 1990, no more than 15% of domestic production should be protected by import licensing requirements. The liberalization of remaining products would cor.tinue thereafter in accordance with the Government's objective to limit the use of quantitative restrictions to exceptional and duly justified cases. By adopting the International Harmonized System and the progressive aggregation of categories from the eight to the six digit level, the Government is simplifying the existing tariff nomenclature, which has been unduly driven by firm-specific considerations. The Government recently introduced floor prices for certain imports to offset apparent unfair trade practices. Under the SAL, the Government plans to substitute reference prices by a more formal safeguard procedure that is transparent and non-discretionary. 2. Export Policies 2.06 Since 1983, the Government has introduced several important reforms to eliminate barriers to exports, reduce existing disparities I' See Morocco: Industrial Trade Policy Adjustment Loans I and II, PPAR No. 7938, June 30, 1989; and Structural Adjustment Loan (SAL), No. P-4867-MOR, November 8, 1988. 2' In addition to the customs duty, there is a 12.5% levy on all imports.  - 4 - between exporting and import-substituting activities, and simplify administrative procedures for external trade. Export licensing was abolished on virtually all industrial, agricultural and mining products. Furthermore, the Government abolished the monopoly of the Office de Commercialisation et d'Exportatior on the commercialization of fresh and processed food exports and repealed the statistical tax on exports, which had been applied at a rate of 0.5%. 2.07 Central to Morocco's export promotion policy is the "temporary admission" procedure which has beer expanded and made more effective. According to this procedure, direct and indirect exporters (i.e. local suppliers to exporters) are now allowed to import most inputs duty-free without prior authorization -'. Imports under temporary admission have grown quite rapidly, from DH 2.3 billion or 9.1% of total imports in 1983 to DH 7.7 billion or 19.0% of total imports in 1988. Some measures taken since 1983 to improve the temporary admission scheme include: self-declaration of the wastage rate; on-site customs clearance for imported inputs and exported products; and the introduction of global and mutual guarantees to cover possible payment of duties on temporary admission imports, in the case where goods are not re-exported. 2.08 F.nancing arrangements for exporting activities have been streamlined and made more effective. Ceilings on pre-shipment export credits have been raised to between one and two months of exports. The maturities of post-shipment financing have been extended up to 180 days. Also, exporters are authorized to rediscount export bills abroad in foreign currency to pay for imports and service these borrowings directly from export proceeds. In addition, the Central Bank rediscounts, up to five years, medium-term suppliers' credits for exports of capital goods, and offers forward foreign exchange contracts of up to one year to exporters for covering their foreign exchange risk. Such export financing facilities have not yet been extended to indirect exporters however, due primarily to inherent difficulties in monitoring the contribution of indirect exporters to final exports. 2.09 The .973 Export Code and its subsequent extensions and modifications grant certain fiscal incentives to exporters. Since 1988, new enterprises are exempt from corporate income tax (IS) on their export earnings for five years, starting the year in which the enterprise begins to export. After that period, the enterprises retain a 50% exemption from the IS. Furthermore, the turnover threshold for trading companies to receive the same fiscal benefits is now DH 2 million of exports compared to DH 10 million before modification of the Export Code. Some agricultural and fishing products are still subjected to prior administrative authorization.  -5- 3. International Trade Procedures 2.10 In 1986, the Government established a National Commission for the Simplification of International Trade Procedures. The Commission's main tasks include the reduction of delays in handling of goods, the standardization of documents and procedures, the improvement of port efficiency and the promotion of new information handling techniques (using UN/ISO data-interchange standards). Chaired by the Minister of Economic Affairs, the Commission includes representatives from the various ministries and government offices concerned with foreign trade. It has delegated day-to-day activities to a Task Force representing all Commission members as well as the chambers of commerce and industry, professional associations, forwarders and banks. A working group has prepared an analysis of the various procedures required for imports, exports, and trade under temporary admission, and has identified principal causes for delays. 2.11 To accelerate the Commission's work in streamlining and simplifying trade procedures, UNDP financing for a program of foreign technical assistance has been provided. A formal project document, under which the Bank is designated executing agency, was prepared and signed in January, 1989. The objective of the project is to reduce current delays in handling of goods (e.g. about 20 days on average for entry of containers through the Port of Casablanca) by at least 50%. The project includes a detailed review of the status of computerization for trade transactions in Morocco, and the presentation to the Moroccan administration and businesses of the most recent international trade facilitation aevelopments, including the electronic data-interchange system being developed in the European Economic Community (EEC). The project envisages the recruitment by November, 1989 of a resident expert to assist the Commission full-time for a two-year period. (ii) Investment Promotion 2.12 A new Industrial Investment Code was approved in 1983 and certain aspects have been revised subsequently. The Industrial Investment Code mainly provides customs duties exemption on imported equipment to new and extension projects. It also gives limited tax rebates to small-size firms that are labor intensive and to firms located in the least-developed regions of Morocco. The corporate income tax rate has been reduced from 48% to 40% as an added investment incentive, and controls on the entry of firms, except in the case of a few basic foodstuff industries (i.e. flour, oil and sugar) have been removed. In order to promote foreign investment in the country, the Industrial Investment Code made foreign firms eligible for the incentives. It further guaranteed the transfer of dividends abroad and the repatriation of capital plus accummulated profits. More recently, Moroccan banks were authorized to transfer funds abroad to foreign investors without prior authorization from Office des Changes. Partly as a result of these changes, foreign investment in manufacturing has increased from less than 8% of the total in 1982 to 20% in 1988 (see Annex 1).  - 6 - 2.13 The Moroccanization Law of 1973 still requires majority Moroccai. ownership for some industrial activities if they sell part of their production in the domestic market (i.e. leather tanning, refrigerators, radios and TV sets, vehicles, steel, vegetable oil, beverages, tobacco, soaps and detergents, fertilizers and fish canning). This is a politically sensitive issue which also affects many other economic activities besides industry. The Ministry of Commerce and Industry (MCI) has however begun to address this issue. A study on administrative requirements constraining industrial investment in Morocco is being carried out, and a general move towards a consensus on the neea to revise the Moroccanization Law in order to stimulate growth appears to be evolving. (iii) Institutional Support to Exporters 2.14 A variety of public, semi-public and private institutions have programs to assist exporters and promote the growth and diversification of Moroccan exports. These include CMPE, a public institution created for that specific purpose (para. 2.16), the Direction de l'Artisanat, the professional association of exporters, the chambers of commerce, the Office pour le D6veloppement Industriel (ODI) and the banks. Many of these institutions receive financial and technical assistance from multilateral and bilateral cooperation programs (UNDP, USAID, France, Germany, etc.). Some of these programs also assist individual exporting firms directly. 2.15 Moroccan exporters however continue to be poorly represented by Moroccan institutions abroad, and there are still only a few trading companies marketing Moroccan products internationally. Some recent initiatives attempt to correct this situation. A Moroccan bank, Societe Marocaine de D6p6t et Credit, recently created a trading company with USAID assistance. The Moroccan banks are opening more branches abroad thus providing additional support to exporters. In addition, banks, government agencies, and industrialists are increasingly collaborating to undertake promotional campaigns abroad. A UNDP funded export strategy study (para. 2.27) and a CMPE study (para. 2.17) would result in the development of a long-run program to ensure adequate overseas representation of Moroccan exporters. 2.16 Centre Marocain de Promotion des Exportations. CMPE is a publicly financed institution, under the authority of the MCI, created to promote the diversification and growth of Moroccan exports. It is located in Casablanca and began operating in 1980. The private sector is well-represented in CMPE's Board through the chambers of commerce and professional associations. CMPE has a staff of 60, including 30 professionals. It provides information on regulations and business opportunities in foreign markets and organizes seminars and trade missions for exporters.  2.17 CMPE receives support from both multilateral and bilateral sources, including the Federal Republic of Germany, France, and USAID. Also, UNDP is financing an extensive program of technical assistance to CMPE. Under the three-year program completed in 1988 (US$ 780,000), the International Trade Center (ITC) assisted CMPE in preparing studies of ten Moroccan sectors with export potential, organizing business missions and seminars for exporters and staff training. A new three-year program (US$ 860,000), also financed by UNDP, was started in 1989 and includes: (a) a study on the rationalization and strengthening of the institutional set-up for export promotion in Morocco, including the review of CMPE's statutes; (b) additional sector studies and elaboration of sectoral programs for the development of exports; and (c) direct technical assistance to selected exporters for implementing export development programs. 2.18 The need to diversify export markets in the medium-term (para. 2.27) highlights the relative importance of continuing support of CMPE in the short-term to render its export promotion activities more effective. Specifically, in addition to the undertaking of the UNDP program described above, government budgetary support to CMPE has more than doubled since 1987 (to US$1.2 million equivalent in 1989) and is expected to be increased further in 1990. 2.19 Societe Marocaine d'Assurance a l'Exportation. SMAEX was created by the Government, in the context of its trade reform program, to take over the previous export insurance system which was run for the State by Banque Marocaine du Commerce Exterieur (BMCE). SMAEX's shareholders are insurance companies, the State, and commercial banks. SMAEX covers commercial and political risks, natural disasters, and is expected to participate in trade fairs and advertising/promotion campaigns. USAID has financed technical assistance to the new company. There are plans to extend the system in the future to cover risks of order cancellation by foreign buyers, guarantees to commercial banks on credits extended to exporters, and performance guarantees needed by construction and public works companies. C. Performance (i) Performance in Manufacturing 2.20 The manufacturing sector has responded favorably to the new set of incentives and policies. Manufacturing value-added increased at an average annual rate of 4.6% during 1984-88 compared to 3.6% during 1980-83. Overall, a large part of the growth in manufacturing came from exports which increased from about 13% of manufacturing production in 1980 to about 20% in 1987. The share of manufacturing value-added in GDP remained constant at about 17% during the 1984-88 period. The evolution of manufacturing by subsectors between 1980 and 1987 is presented in Annex 2. Food industries grew at the highest rate during the period. Textiles and leatber, as well as engineering,  - 8 - maintained their relative shares. The share of chemicals and related industries in manufacturing value-added declined during the period, although growth in this subsector appears to have resumed since 1987. 2.21 The economic reform program and the new set of industrial incentives have generated strong investment demand from the private sector. Industrial investment projects approved by the Ministry of Commerce and Industry (MCI) "' have increased substantially since 1985 (see Annex 1 and Table 2.1). During 1984-85, the amount of these investments stagnated around DH 2.7 billion per year. Subsequently, they grew at an annual average rate of 16.5% in real terms to DH 4.1 billion in 1988. The surge of industrial investment has also been reflected in the rapid commitment of funds under the Bank's Industrial Export Finance Project approved in May 1987. Preliminary indications for the first seven months of 1989 show a continued increase of investment, at 7.5% in real terms relative to the same period in 1988. The on-going study on administrative requirements constraining industrial investment carried out by the MCI (para. 2.13) is expected to identify barriers to entry and efficient operations of industrial firms and to propose corrective actions. Moreover, a Royal Letter recently issued (June 14, 1989) aims at simplifying investment approval procedures through, inter alia, limiting the time period for their administrative approval to two months. To support the continued increase in investment approvals, the Government plans to dis8tss the results of the NCI study and the impact of the simplification measures recently taken to facilitate private investment, with the Bank, by December 31, 1990. Table 2.1: INVESTMENT APPROVALS IN MANUFACTURING. 1984 1989 (Constant 1984 prices, millions of DH) 1984 1985 1986 1987 1988 1989 / Amount _Q Amount ! Amount _I Amount -s Amount __ AmountZ Food Industries 811 29 869 33 1,038 35 1.073 28 812 20 430 16 Textiles & Leather 717 26 712 28 802 27 1,527 40 1,693 41 1083 40 Engineering 583 21 360 14 434 1S 467 12 445 11 281 10 Chemicals & Others 667 24 642 25 669 23 792 21 1,130 28 913 34 TOTAL 2.778 100 2.583 2.943 100 3.859 0 4. 100 2.707 100 JOBS CREATED. 27,948 30.573 34,768 54,158 59,581 33.318 a/ January to July Source: Ministry of Commerce and Industry The majority of industrial investments are presented for review to the MCI in order to benefit from the various advantages granted under the Industrial Investment Code (para. 2.12).  2.22 Until recently, most of the increase in industrial investment came from the textile sector and was linked directly or indirectlv to production for export. In parallel, the average investment cost per job decreased from SDR 11,000 equivalent in 1984 to SDR 8,800 in 1988, showing a concentration of investments in more labor-intensive (particularly textile) activities where Morocco has a comparative advantage. Since 1984, public sector firms ha';e represented about 4% of industrial investment, and foreign investment has represented about 19% of the total. About 33% of the total investment during the period was for the creation of new firms. (ii) Evolution of Moroccan Exports 2.23 Structure. The trade policy reforms initiated in 1983 helped Morocco increase and diversify its export babe. As summarized in Table 2.2 below, and detailed in Annex 3, overall, between 1980 and 1988, total exports increased at an average annual rate of 4.6% with the fastest growth oc"uring post-1983, and manufacturing exports by 12.5%. Preliminary figures for the first half of 1989 indicate that manufacturing exports rose at a somewhat lower pace of 3% compared to the same per4od of 1988, illustrating, among other factors, the need to continue to adhere to flexible exchange rate policies. The share of manufactured exports in total exports increased regularly from 33% in 1980 to 58% in 1988. Withini manufacturing, the share of non-traditional exports (other than processed foods and phosphate derivatives) rose from 41% in 1984 to 46% in 1988. Table 2.2: EVOLUTION OF MOROCCAN EXPORTS DURING 1980-88 SDR million* Percentage of Total 1980 1984 1988 1980 1984 1988 Non-Manufactured Exports 1,269 1,087 1,128 67.4 51.4 41.8 Food stuffs 376 342 503 20.0 16.2 18.6 Phosphate Rock 588 511 377 31.2 24.2 1l.0 Others 305 234 248 16.2 11.1 9.2 Manufactured Exports 614 1,029 1,571 32.6 48.6 58.2 Phosphate Derivatives 185 473 663 9.8 22.4 24.6 Processed Foods 132 132 179 7.0 6.2 6.6 Other manufactures 297 423 729 15.8 20.0 27.0 of which: Garments 58 114 222 3.1 5.4 8.2 Knitwear 22 36 108 1.2 1.7 4.0 Carpets 56 44 50 3.0 2.1 1.9 Shoes & leather 27 30 52 1.5 1.4 1.9 Other interm. goods 80 94 121 4.3 4.4 4.5 Other finished goods 55 105 176 2.9 5.0 6.5 TOTAL 1,883 2,116 2,699 100.0 100.0 100.0 * SDR equivalents reflect better the currency composition of exports. Source: Office des Chat.ges and mission estimates.  - 10 - 2.24 The growth in the share of manufactured exports in total exports represents an important change in the structure of Moroccan exports. The policy to increase the local processing of phosphates led to substantial increases in phosphoric acid and fertilizer exports since 1980, which has helped to offset Morocco's vulnerability to world market conditions for phosphate rock exports. Also, the most impressive growth had been in non-traditional manufactures, which until 1988 nearly doubled their share in total exports (from 15.8% in 1980, to 31.3% in 1987). Within this category, the share of garment and knitwear manufactures more than tripled, from 4.2% of total exports in 1980 to 14.7% in 1987. Due, in part, to a marked recovery of the world phosphate market, and to limitations imposed on the growth of Moroccan textile exports by EEC quotas and by increasing competition from other countries (i.e. the East-Asian NICs, Portugal, Spain, and Turkey), the share of non-traditional manufactures in total exports declined by about 4.3 percentage points during 1988. 2.25 The above figures only cover exports recorded in Morocco's external trade statistics and thus omit re-export of foreign-owned goods sent to Morocco for processing (mainly garments, knitwear and electronics). Exporters in this activity only bill for their services (i.e. value-added in Morocco), and the amount billed is recorded in the current account as a "non-factor service". Subcontracting exports of this type have increased dramatically from SDR 7.6 miliion equivalent in 1980 to SDR 60.6 million in 1987, and further to SDR 83.0 million in 1988. For garments and knitwear, in particular, subcontracting exports currently represent, in tonnage terms, over 40% of the volume shown in the trade statistics. For the electronics sector, most exports take place under subcontracting arrangements. 2.26 Markets. Moroccan exports have traditionally mainly been oriented towards European countries. The EEC remains the dominant market with over 56% of total 1988 exports, and France in particular (26%). Table 2.3: DESTINATION OF MOROCCAN EXPORTS IN 1987 AND 1988 (in percent) Minerals & Phosphate Foods and Other Total Derivatives Live Animals Exports Exports 1987 1988 1987 1988 1987 1988 1987 1988 Europe 62.9 54.3 74.1 68.6 80.6 80.9 72.6 66.7 Africa 0.5 1.7 7.2 8.8 12.8 12.8 6.9 7.2 America 10.9 8.9 2.7 2.9 2.8 2.4 5.6 5.2 Asia 23.8 32.8 16.0 19.7 3.6 3.7 14.1 19.9 Australia/Oceania 1.9 2.3 - - 0.2 0.2 0.8 1.0 TOTAL 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0  - li - During 1987-88 however, there have been some signs of improved regional diversification due, in part, to the opening up of the unified Maghreb market to Moroccan exports. The combined shares of Africa and Asia have grown by about 6%. The shares of the Americas and Australia'Oceania in Moroccan exports have however remained low, with the United States and Canada continuing to represent only about 2% of total Moroccan exports. 2.27 Morocco must further diversify its export markets. Excessive reliance on the EEC, France in particular, may prove costly over time. First, Morocco's preferential tariff treatment in the EEC has eroded in relative terms as a result of general reduction in tariff rates under the current round of multilateral trade negotiations. Second, although Morocco has benefited from preferential quota treatment, future allotments, in particular for textiles, may become more difficult in view of the recent enlargement of the EEC. A market with enormous potential for Moroccan exports is the United States, where Morocco t,ces very low tariff and non-tariff barriers under the Generalized System of Preferences. Penetration of the US market, however, requires large volumes of timely supplies, good quality control, and adequate distribution systems. Expansion towards the North American market, combined with diversification in Europe and in the Maghreb countries, and strengthening of the Asian market, is an important objective of Morocco's current export strategy. In support of this objective, the Government is undertaking (with UNDP funding and the Bank as executing agency), a study which will determine concrete measures to ensure the diversification of Morocco's export markets in the medium to long-run, in a manner coherent with other trade-related studies and activities (para. 2.17). Preliminary results of the study should be available by the end of 1989. 2.28 Tourism. Tourism is expected to play an important role in Morocco's export diversification strategy. Tourism receipts constitute a vital source of foreign exchange earnings for Morocco. In 1988, tourism receipts amounted to about DH 8.7 billion (US$ 1.06 billion), corresponding to about one-ti.ird of total export receipts and 50% of manufactured exports. Yet, tourism potential remains largely unexploited and it has not so far played the catalytic role that characterizes its expansionL in other countries. Growth of tourism receipts in 1985-88 slowed to an annual average of 12.5%, less than one-third the rate of the previous three years, due largely to limited capacity. The number of beds in Morocco remains below 75,000, and has been growing sluggishly at 5% a year since 1984, far below the 8,000 beds per year called for by the Government's 1988-92 Plan, and comparing very unfavorably with countries with similar tourism potential, such as Spain, Portugal or Tunisia. At the same time, demand is strong from European countries, and is increasing rapidly from other Arab countries. To promote investment in the sector, the Government has recently lifted price controls on three- and four-star hotels. In addition, to foster competition between commercial banks and Credit Immobilier et H6telier (CIH), the authorities have exempted medium- and long-term loans to hotel investments from the Central Bank's credit ceilings. While CIH, which enjoys a quasi-monopoly in tourism financing, has access to long-term financing notably from foreign lines of credit, this is not the case of commercial banks. As a result, commercial banks would be unable to compete with CIH unless they have access to long-term financing. Therefore, to enhance competition in the financing of tourism activities, and  - 12 - in line with the Government's objectives to expand tourism capacity and diversify foreign exchange earnings, the proposed project would provide limited financing for tourism investments (para. 4.07). D. The Bank's Role in the Industrial Sector 2.29 As of September 30, 1989, the Bank had approved 16 operations in the industrial sector in Morocco, for a total of US$ 601.6 million. Of these operations, 13 were credit lines through financial intermediaries, two loans for processing phosphates and one loan to a cement factory. The Bank has also supported industrial, trade and financial policy reforms through two Industrial and Trade Policy Adjustment (ITPA) Loans in 1984 and 1985 (US$ 150, and US$ 200 million, respectively) and through the ongoing US$ 200 million SAL approved in 1988. IFC had financed 11 projects for a total of US$ 228.4 million, of which US$ 215.6 million in loans and US$ 12.8 million in equity. IFC lending to Morocco includes US$ 80 million in syndicated loans to BNDE; US$ 50 million to CIH; US$ 71 million to various industrial enterprises; and US $6.3 million for a transport venture. 2.30 Initially, the Bank supported the development of investment lending to industry through the establishment and strengthening of BNDE. The Bank made nine such loans to BNDE between 1962 and 1981. In 1979, Bank projects supported the Government's focus on the development of the small-scale industrial (SSI) sector. In order to be able to reach a large number of SSI firms, the Bank used the commercial banks as intermediaries and BNDE, which mainly focusses its lending in medium and large firms, as the apex institution. Two SSI loans were made in 1979 1-' and 1981 respectively. The two SSIs projects were successful in terms of job creation, at a lower cost than the industrial average. While the first SSI loan was committed faster than anticipated, the second one experienced delays in implementation, mainly due to the impact of the economic crisis on industrial investment in the early 1980s. As a result, about 60% of the original loan amount was cancelled. In 1985, the Bank supported the expansion of Morocco's industrial base by focussing on the relatively underdeveloped electrical and mechanical industries (EMI) sector. A US$ 25.1 million loan was made to the Treasury for distribution among ODI and five commercial banks, which were placed for the first time in direct competition with BNDE. As a result of the economic difficulties during the intitial stages of project implementation and of the changes in policies and incentives, the demand for credit in the EMI sector developed more slowly than anticipated, and only 73% of the loan was committed by July, 1989. Beginning with the second ITPA Loan in 1985, the Bank has supported the diversification of the development banks -- including BNDE -- into deposit taking and lending for working capital. 2.31 In May 1987, the Bank approved a US$ 70 million package of loans for an Industrial Export Finance Project in support of the Government's program to increase manufactured exports. In addition to providing financing to export-oriented firms, the project contributed to the: institutional strengthening of banks; increased access to working capital financing and lo Morocco, Integrated Project for Small-Scale Industrial Development, PPAR, No. 6063, February 11, 1966.  - 13 - foreign exchange for exporters; improvements in international trade, customs, and value-added tax procedures; completion of sector studies; and strengthening support to export promotion activities. In order to promote competition and improve access to investment financing, the Bank loans were distributed between BNDE (40%) and seven commercial banks (60% in aggregate) which had shown their capacity to evaluate and monitor nvestment sub-projects. Each participating bank (PB) signed a seearate loan agreement with the Bank and submitted the sub-project appraisa' reports directly to the Bank for review and approval. 2.32 Commitments under the Industrial Export Finance Project developed much faster than originally expected. In the aggregate, by just eight months after loan effectiveness, commitments had reached 90% of the total loan amount. By September, 1989 total commitments had reached 96%, and 61% of the total loan amount had been disbursed. Of the eighty-two sub-projects already authorized, the textile sector by far represents the major share. Spinning and weaving have accounted for the major part of the investments, and clothes manufacturing for the largest part of jobs created. Among the sixteen non-textile sub-projects authorized, nine are for food processing and the rest are for miscellaneous industries. Many of the sub-projects are for expansion of existing firms and include replacement of old equipment and productivity improvements. 2.33 Many of the lessons learned from the experience of past Bank lines of credit have been incorporated into the design of the proposed project. The proposed project will further promote competi.ior in the banking sector and will continue to increase the role of the commercial banks in investment lending to industry and tourism. The Bank loans will be made directly to each of the PBs which will bear the commitment charges and will be solely responsible for the administration of their respective loan. The amount allocated to each PB takes into account its performance under previous Bank credit lines. Additional improvements relate to: more flexibility as regards eligibility criteria for individual sub-projects; increase of maximum size of sub-loans and of free-limit; simplified documentation requirements and disbursement procedures; and reduced reliance on directed financing.  - 14 - mII. THE FINANCIAL SECTOR A. Overview 3.01 Morocco's financial system includes Bank Al-Maghrib (the Central Bank), 15 commercial banks, and five specialized banks controlled by the public sector. There is also a stock market in Casablanca with a rather limited role, a relatively active inter-bank market, two public sector savings banks, six leasing companies mostly owned by the banks and a number of insurance and installment finance companies. Financial intermediation is relatively well-developed in Morocco and the ratio of M2 to GDP was 0.47 at end-1988. However, the r2latively underdeveloped state of the capital market restricts the range of financial instruments available. The Treasury only began issuing bonds to the public in 1985, and in 1988, an auction-based system for placing Treasury bonds on the money market was introduced. 3.02 Banking activities are firmly controlled by the Central Bank, which fixes ceilings on credit by the commercial banks and imposes prudential regulations. The Central Bank monitors the commercial banks' reserve requirements (8% of sight deposits), minimum equity (5.5% of deposits) and maximum exposure to individual clients (10% of own equity). Commercial banks are also required to hold (a) 35% of sight deposits in treasury instruments, and (b) 15% of deposits in selective credits and bonds of the specialized banks ' The Central Bank rediscounts credit for exports, and to a lesser extent for crop marketing at preferential rates. The subsidies (between 1.5 and 2.5%) are however limited and the Government plans to review the justification for preferential rediscount facilities in the context of the on-going liberalization of the financial sector (para 3.07). Actual rediscounting of preferential credit at the end of 1988 amounted to 12% of total credit by the commercial banks, and over 90% of the rediscounted credit was for exports. 3.03 Most interest rates are still determined administratively. The Central Bank reviews interest rates periodically to adjust to changing economic conditions (Annex 5). Current interest rates on time deposits. ranging from 8.5% to 11%, are positive in real terms, and lending rates of 12% to 14% on medium- and long-term loans provide a sufficient spread to cover the costs of intermediation, including normal profit. After the 1985 reform, nominal rates increased by about 2% on average, and the adopcion of floors and ceilings on borrowing and lending rates introduced an element of competition in the financial system. In 1988, some nominal interest rates were adjusted downwards and interest rates on convertible Dirhams deposits were freed. Owing to the sharp decrease in the inflation rate, real interest rates have increased steadily from 1986 to 1988. In the context of its macroeconomic l~ With at least 3.5% in CNCA bonds, 6.0% in housing loans (or CIH bonds) and 5.5% in medium-term rediscountable (MTR) loans to industry (or BNDE bonds). Only MTR loans over the minimun 5.5% are actually rediscountable with the Central Bank.  - 15 - dialogue with the Government on financial sector issues, further liberalization of the interest rate structure is being sought, particularly through the introduction of variable rate instruments (para 3.09). B. Recent Developments and Future Prospects 3.04 The Government is firmly committed to a gradual liberalization of the financial system. Although some constraints still prevent the financial sector from playing an optimal role in the resource mobilization and allocation process, recent developments illustrate the Government's determination to improve the efficiency of the system. 3.05 The main distortion in the financial sector has been created by the ceiling on credit to the economy "' imposed by the Government to control credit expansion and preempt a major share of resources of the banking sector to finance the fiscal deficits. Credit ceilings were increased by only 7% for 1988 (compared to a real GDP growth rate of 10%). Moreover, distribution of credit ceilings among the financial intermediaries is uneven. While credit ceilings apply to about 80% of the portfolios of commercial banks, specialized institutions are exempted. Credit ceilings have been effective in keeping monetary control and macroeconomic stability while financing a relatively large fiscal deficit. However, they may have introduced substantial crowding out of the private sector by the Government. Also, an undesirable side effect of the credit containment policy has been to reduce the level of competition among the banks, including the development banks. Commercial banks have little incentive to compete for deposits with maturities of more than six months that can only be invested at the margin at moderate rates in Treasury bills, if the banks are to stay within their credit ceilings. They tend, therefore, to concentrate their loans on better risks and to discriminate against small and risky businesses. As detailed in para. 3.08, as the Government's fiscal situation improves, credit ceilings are being phased out and should be eliminated by the end of 1990. 3.06 Another constraint relates to the importance of directed credit. As a result of the captive market created for Treasury bonds by the imposition of credit ceilings and the 35% mandatory placement of demand deposits that banks must hold in Government paper, the Treasury accounts for a large share of lending by commercial banks (52% of total lending at the end of 1988, up from 42% in 1985). In addition, commercial banks are required to hold 15% of their demand deposits in preferential credits or bonds of specialized institutions, at low to moderate interest rates. The importance of directed credit combined with the existence of credit ceilings reduces competition among financial institutions and can lead to the crowding out of private sector investment. The planned removal of credit ceilings is expected to alleviate this problem. Includes credit to the private sector and to public sector firms, but excludes credit to the Treasury.  - 16 - 3.07 Financial Sector Liberalization. The Government has already embarked on a program of gradual liberalizacion of the financial system, supported by both the IMF and the Bank. The first financial sector reforms were supported by the second ITPA loan of the Bank in 1985. They included: maintaining positive real interest rates and elimination of interest rate rebates; elimination of obligatory placements and reserve requirements on time deposits; mobilization of savings through public issues of treasury bonds; fixing ceilings on credit by individual banks based on their performance in mobilizing savings; reform of the taxation system affecting the financial sector; diversification of the specialized banks into deposit taking and lending for working capital; and creation of a commercial paper market as an alternative to bank credit. Moreover, under the recent stand-by arrangement with the IMF, the Government proposes to continue reducing fiscal deficits and Treasury arrears, and limit growth of treasury borrowings from the banks. In 1988, an auction-based system for placing treasury bonds on the money market was introduced. 3.08 More recently, the Government has taken steps to eliminate the use of direct credit containment policies, notably by reducing the scope of directed credit. In March 1989, the Government removed credit ceilings on medium- and long-term loans for hotel projects as a new step towards their complete elimination (para. 2.28), expected to be effective by mid-1990. The Government also indicated that it intends to foster competition between commercial banks and specialized institutions by: (i) increasing the ceiling above which medium-term loans to industry by commercial banks must be approved by BNDE; and (ii) providing incentives to commercial banks to finance tourism projects by removing credit ceilings on hotel loans, traditionally financed almost exclusively by CIH. These reforms, once fully implemented, would remove some of the main constraints currently limiting the efficiency of the financial sector. 3.09 Bank Strategy in the Financial Sector. The Bank's strategy in the financial sector aims at furthering the liberalization of Morocco's financial system while continuing to provide term financing, channelled by efficient, market-oriented financial intermediaries to priority sectors such as agriculture, housing and industry. The dialogue with the Government is being deepened on a selected number of financial sector issues where potential for further reform exists and is consistent with other macroeconomic priorities (such as the reduction of the budget deficit). There are currently three main areas where further financial sector reform, with Bank support, is envisaged. First, directed credit policies could be further reduced. While substantial progress has already been achieved by breaking the quasi-monopoly of specialized institutions in financing such sectors as tourism (para 2.28) or industry (para 3.11), specialized institutions still enjoy a limited number of privileges such as preferential access to domestic resources (para 3.02), or special tax treatment which should be abolished over time. In line with this objective, the proposed lines of credit would be available to seven commercial banks and one specialized financial institution, BNDE, which would compete under the same terms and conditions for Bank funds. Likewise, in the framework of the proposed project, predetermined  - 17 - allocations of Bank funds are less stringent than in the case of previous operations where Bank funds were allocated for specific end-users, such as the EMI project or the on-going Export Finance project (para 4.07). Secondly, there is scope for further interest rate liberalization, notably through the introduction of variable rate instruments which would better reflect domestic inflation changes, and respond more quickly to international exchange and interest rate movements. Sequencing of reforms in this area, however, should be closely linked to progress achieved by the Government in limiting the fiscal deficits and the resultant Treasury borrowing requirements. Finally, in the framework of its continued support to priority sectors through intermediation lending I/ , the Bank would further support the institutional strengthening of Moroccan financial institutions, specifically in the important areas of credit risk assessment, accounting and provisions policies, and audit quality. C. Distribution of Credit 3.10 The distribution of outstanding credit by term and among different types of banking institutions during 1986-88 is summarized in Table 3.1. On a term basis, the distribution of credit was fairly stable during the period, with short-term credit representing about 63% and medium-and long-term credit about 37% of total lending. The share of the commercial banks in short-term credit declined due to credit ceiling consi.raints as well as increased competition from specialized banks. Short-term lending by specialized banks increased at an average annual rate of 26% during the period, compared to 9% for all short-term credit. The share of export credit increased from 16.72 of short-term credit offered by commercial banks at year-end 1986, to 18.3% at year-end 1988. This change reflects the dynamic performance of exports, as well as the exemption of export credit from the credit ceilings imposed on the commercial banks. 3.11 Medium- and long-term credit is available principally from three of the specialized banks -- Caisse Nationale de Credit Agricole (CNCA), Banque Nationale pour le Developpement Economique (BNDE), and Credit Immobilier et H6telier (CIH) -- which specialize in agriculture, industry, and housing/tourism development, respectively. Commercial banks play an increasingly active role in medium- and long-term lending and their share in total term credit increased in 1988 to 23.3%, from 21.1% in 1986. The share of BNDE, the main source of investment lending to industry, declined during the period due mainly to increased competition from commercial banks. Investment lending to industry by the commercial banks consists of direct medium- and long-term credit, five-year medium-term rediscountable loans (MTR), and loans financed by the Bank lines of credit. Until 1987, BNDE enjoyed a quasi-monopoly in See Morocco: National Agricultural Credit Project No. 7453-MOR, May 24, 1989; and Second lhousing Finance Project, No. 4731-MOR, July 31, 1989.  - 18 - this type of lending as only BNDE loans could qualify for interest rate rebates under the Industrial Investment Code; these have since been eliminated. Also, commercial banks and investors were discouraged from using MTR loans for investment due to the requirement that such loans had to be reviewed and approved by BNDE. Since then, the limit above which medium- and long-term loans to industry by commercial banks have to be approved by BNDE has been increased '', and commercial bank credit of this type increased by 69% between 1987 and 1988. Finally, the Bank lines of credit, which are available to commercial banks and BNDE under the same terms, have significantly contributed to the increased role of commercial banks in industrial investment financing. Table 3.1: DISTRIBUTION OF CREDIT TO THE ECONOMY IN 1986-88 (percentages at end of period) Average Annual Growth rates 1986 1987 1988 1986-1988 Short-term credit 64.0 63.6 62.3 8.7 Central Bank 11.3 12.2 11.3 9.9 Commercial banks 47.9 46.4 44.8 6.6 (of which export credits) (8.0) (7.9) (8.2) 11.2 Specialized banks 4.8 5.0 6.2 25.8 Medium & long-term credit 36.0 36.4 37.7 1.9 Commercial banks 7.6 7.6 8.8 18.8 Specialized banks 28.4 28.8 28.9 11.2 (of which BNDE) (5.9) (5.5) (5.2) 3.0 TOTAL 100.0 100.0 100.0 10.2 Source: Bank Al-Maghrib D. Coverage of Foreign Exchange Risk 3.12 Until 1985, the Moroccan Treasury assumed the foreign exchange risk on foreign borrowings by the specialized banks. This foreign exchange risk coverage was revised in 1985 in the context of the Bank's IPTA II loan. Under the ITPA system, a minimal share of 2% of foreign exchange losses (or profits) was to be absorbed by the financial intermediaries, and the remaining 98% was to be covered by a Foreign Exchange Risk Fund, maintained in the name of the Treasury in each "X Beginning in 1988, review by BNDE has not been required for MTR loans to SSIs: (i) total balance sheet of the firm before the project not to exceed DH 10 million; (ii) project cost not in excess of DH 5 million; and (iii) maximum credit of 70% of the project cost.  - 19 - institution's books. The financial intermediaries contributed to the Fund a risk premium, consisting of: (a) a flat fee of 1% on withdraiwals of foreign loans charged to the final borrower; and (b) an annual fee comprised of the difference between the fina cial intermediary's lending rate in local currency and the interest rate on the foreign loans, minus a spread, generally 3%, for the financial intermediary. In case of insufficient funds, additional losses were to be supported by the Treasury. Due to the rapid devaluation of the DH in the eaily eighties, substantial foreign exchange losses occured, and the Fund's resources proved insufficient to cover the losses. As a result of its own tight liquidity situation, the Treasury was unable to reimburse the financial intermediaries on time, and sizeable arrears accumulated. 3.13 The Government therefore decided to revise the foreign exchange coverage system in consultation with the Bank and the IMF. A new scheme was recently developed which would markedly improve the current system. Under the new system, the cost of loans to financial intermediaries, financed from external sources, will be equal to the cost of funds of equivalent maturities in the domestic market. The difference between that rate and the foreign borrowing rate would be passed on as insurance premium to the Foreign Exchange Risk Fund. Financial institutions would onlend at market rates to final borrowers, with a spread that would be voluntarily determined by the institutions themselves in each case. Hence both financial intermediaries and final borrowers will be indifferent as to whether funds are domestically or externally borrowed. The new scheme is expected to allow the Foreign Exchange Pisk Fund to be financially self-sufficient over the medium-term. The modalities of the new foreign exchange risk coverage system are still being worked out: the revised scheme is expected to be operational in 1990. 3.14 In the meantime, for this proposed operation, a transitional scheme has been devised, which would increase the resources of the Foreign Exchange Risk Fund, but would not necessarily equalize the cost of foreign borrowings with the cost of domestic resources of equivalent maturities to financial intermediaries. Also, the interim scheme would set the spread available to the PBs at 2%, as opposed to a voluntary margin under the new system. In this respect, the transitional arrangement is acceptable, though less satisfactory than the new permanent scheme described above. Under the temporary scheme, the PBs' spread will be reduced from 3% to 2%, but the Treasury will assume the initial 2% of the foreign exchange losses. In addition, in the case of BNDE, the Treasury has stipulated that the IPTA II foreign exchange risk coverage scheme be extended to the outstanding balance of all BNDE existing foreign borrowings, including those contracted prior to 1985. These arrangements are spelled out in letters dated June 1989 from the Minister of Finance to the Presidents of the participating commercial banks and of BNDE. The assumption by BNDE of a greater share of exchange losses on borrowings contracted prior to 1985 has a relatively moderate impact on BNDE's profitability, as most of these borrowings will be paid off by 1992 (Annex 7, para. 12). Past and present arrangements also require that the financial institutions repay their debt in full directly to foreign lenders, with the Treasury reimbursing its share of foreign exchange losses accrued within three months following the end of each  - 20 - semester. Payment of Government arrears owed to BNDE on the account of foreign exchange losses as of end-1988 has been made. Assurances were obtained during negotiations that reimbursement of the Treasury's share of foreign exchange losses accrued each semester, would be made regularly to all PBs within three months following the end of each semester. The foreign exchange risk of future operations is planned to be covered by the new scheme described in para. 3.13. In the event that the modalities of that inew scheme are worked out rapidly between the Government and tie financial institutions concerned, efforts would be made to examine if the proposed operation should be covered by it. E. The Participating Commrercial Banks 3.15 The seven commercial banks participating in the proposed Project (para. 4.04) account for more than 80% of total commercial bank deposits and loans in Morocco. The two largest banks, BCP and BMCE, are majority owned by public entities; the other banks are majority private-owned. The management of all the banks is generally good and free to act without government interference in day-to-day operations. Prudential ratios are closely monitored by the Central Bank (para 3.02) and the seven participating commercial banks are considered to be sound, creditworthy borrowers. Their performance under the Bank's SSI, EMI and Industrial Export Finance projects has been satisfactory. Specifically, under the Industrial Export Finance Project, the participating banks have generally committed their credit allocations faster than originally anticipated (para. 2.32). 3.16 The financial statements of the participating commercial banks in 1986-88 are presented in Annex 6, and a summary of main financial indicators for 1988 is shown in Table 3.2 below. Table 3.2: FINANCIAL INDICATORS OF THE PARTICIPATING COMMERCIAL BANKS (as of December 31, 1988) BCP BCM BMCE BMCI CDM SGMB WAFA Deposits (DH billion) 21.6 6.2 9.5 3.8 3.6 3.2 4.8 Loans (DH billion) 6.9 3.9 5.1 2.9 2.6 2.7 3.1 Equity (DH million) 1,812 468 611 275 331 288 385 --------------------(percentages)-------- Loans/Deposits 32.1 62.5 53.5 76.4 71.9 85.6 64.1 Equity/Deposits 8.4 7.6 6.5 7.2 9.3 9.1 8.0 Equity/Loans 26.2 12.2 12.1 9.5 12.9 10.6 12.5 Doubtful Loans/Loans 5.3 1.6 4.6 10.2 2.2 5.2 5.1 Provisions/Loans 1.3 1.4 2.2 4.8 2.4 3.3 4.7 Net Profit/Total Assets 0.4 1.2 0.7 0.4 1.2 1.2 1.0 Net Profit/Equity 6.5 24.5 21.4 9.1 21.5 24.7 20.8 Source: Commercial banks and mission estimates.  - 21 - The financial condition of the participating banks is p'nerally sound. They are very liquid as a result of the restrictions on lending and the requirement to hold 35% of sight deposits in Treasury instruments. Doubtful loan accounts of the banks varies from 1.6% for BCM to 10.2% for BMCI (para. 3.22). Guidelines from the Central Bank allow great latitude for identifying doubtful loans and encourage over-provisioning. Actual provisions range from 1.3% of loans for BCP (para. 3.19) to 4.8% for BMCI (para. 3.21 and 3.22). Capitalization is adequate by international standards. Despite relatively high administrative expenses (2.2% to 3.9% of average total assets) profitability ratios remain high. This is in part due to the dictated interest rate envirownent, which results in high interest spreads. The average spreads range from 6.5% to 8.7% (Annex 6), except for BCP, which has a relatively low spread of 2.1% due to a high concentration of Treasury securities in its loan portfolio. 3.17 In addition to the monitoring and control exercised by the Central Bank over commercial bank activities (para. 3.02), all of the banks accounts are subjected to stringent internal audits, and external audits I/ are undertaken by official auditors (Commissaires aux comptes) of the Ministry of Finance and are reflected in the banks' annual reports. Under the Bank's PERL operation (Loan 2820-MOR), a draft law has been prepared and submitted to Parliament requiring high, internationally acceptable minimum qualifications of Commissaires aux comptes, generally in Morocco. This notwithstanding, in addition to the audits by the Commissaires aux comptes, the accounts of several 2/ of the commercial banks participating in this operation are also audited or reviewed by fully qualified, independent, commercial auditors, a practice whose use is becoming increasingly widespread as financial sector reforms gain in momentum. During negotiations of the proposed loans, assurances were obtained that the accounts of all of the PBs would be audited annually by independent external auditors satisfactory to the Bank, and that these audits would be submitted to the Bank within six months following the end of each fiscal year (para. 4.15 (a)). Finally, the accounting standards applied by the banks are governed by Morocco's 1982 Plan Comprable Bancaire, which is based on the currently effective French banking law, and which reflects generally accepted accounting standards and practices. 3.18 Project appraisal capability of the commercial banks is generally satisfactory. Substantial experience has been gained in this area (initially with the help of BNDE), through the implementation of the Bank-financed SSI, EMI and Industrial Export Finance projects. Project appraisal has been carried out in accordance with guidelines satisfactory to the Bank, and economic rates of return (ERR) are estimated. Investors, and occasionally the banks themselves, hire external consultants to prepare and appraise investment projects. All of the banks have made special efforts to recruit and train staff with appropriate qualifications to ensure continued improvement in project appraisal and supervision. BNDE's accounts are audited regularly by external commercial auditors, as agreed under past operations with the Bank. i.e. BCM, WAFABANK  - 22 - 3.19 Banque Centrale Populaire (BCP). This is the largest of the commercial banks. It is very active in collecting deposits from Moroccan workers abroad and in lending for housing and to small firms. BCP has more than 40 professionals assigned to appraise and supervise investment projects. Projects financed by BCP accounted for more than 50% of the sub-projects financed under the two Bank's SSI projects. BCP's financial structure is substantially different than that of the other commercial banks. Its deposit base has grown very rapidly in recent years and, under current lending constraints imposed by credit ceilings, its loans to deposits ratio only reached 32.1% at end-1988. Thus, a large part of its deposits is invested ia treasury securities. Given its distribution of assets and liabilities, BCP's interest spread and profitability are now lower than those of the other commercial banks. Specifically, a large share of BCP's resources traditionally came from deposits of Moroccans living abroad, which, according to existing policies, are remunerated at relatively high rates. The higher costs of these resources, combined with the loss, in 1988, of BCP's tax exempt status, meant that its net profits dropped, and its return on equity declined to 6.5% in 1988 from 18.8% in 1987. To address this situation, BCP has embarked on a program to diversify its resource base. It has also begun to develop its international trade financing activities, particularly export financing, which had previously represented a relatively small share of its banking operations. BCP's participation in the ongoing Export Finance operation and in the proposed operation is consistent with this strategy. BCP is also sending staff abroad for training in these areas. 3.20 Banque Commerciale du Maroc (BCM). This is the third largest commercial bank in Morocco and the largest fully private bank. The quality of BMC's loan portfolio is good (1.6% in doubtful loans), and the bank's profitability is high (net profits of 1.2% of average total assets in 1988). Its return on equity is among the highest, at 24.5%. Management is competent and dynamic, and the staff is well qualified. Its Investment Projects Department, created in 1978, now has a staff of nine professionals, of whom four are engineers. The Department has made efforts to improve its project appraisal capability and regularly supervises the portfolio in collaboration with the staff of the branch offices. BCM has taken the initiative to create an "Export Club" to inform and assist exporters. BCM was the most active bank under the Bank-financed EMI Project, approved in 1985, and has also been very active under the recent Industrial Export Finance Project. 3.21 Banque Marocaine du Commerce Exterieur (BMCE). This is Morocco's second largest commetcial bank in terms of assets, and it has been the largest user of Bank funds under the Industrial Export Finance project. It is the leader in international trade finance. BMCE, which has subsidiaries in Paris and in the Tangiers free-trade zone, is planning shortly to open representative offices in Brussels and Madrid. BMCE's liquidity is high (loans to deposits ratio of 53.5% at end-1988). Under new management, appointed in 1986, BMCE's financial condition has improved. In 1988, its equity base grew stronger by the incorporaLion of a large part of its 1987 net profits into reserves. The ratio of equity to loans increased to 12.1% from 9.2% in 1987. The quality of its loan portfolio also improved. Doubtful loans dropped to 4.6% of loans from 6.3% in 1987. However, BMCE remains weaker than the other banks in terms of equity and net retturn on total assets. BMCE has a Projects Division comprised of six professional staff and has added another engineer in 1989.  - 23 - 3.22 Banque Marocaine pour le Commerce et l'Industrie (BMCI). Among the commercial banks, BMCI was one of the first to establish a department for investment lending and to set up a special program to finance new entrepreneurs. Its Projects Department includes 14 professionals, of whom four are engineers. For several years, BMCI faced a deterioration in the quality of its portfolio, a situation which became more urgent in 1988. Doubtful loans increased to 10.2% from 7.2% in 1987, and are high relative to the other banks. This performance resulted from the ineffectiveness of a regionally centralized management approach, which did not adapt well to project appraisal and supervision of small and medium-sized projects, scattered outside of the Casablanca area. To address the deteriorated condition of its portfolio, BMCI increased, in 1988, its provisions, and its administrative costs rose as collection and supervision efforts were intensified. While these actions impaired BMCI's profits in 1988 (return on equity fell to 9.1% from 23.2% in 1987 and net return on total assets was also relatively low, at 0.4%), this should be considered an exceptional year, despite which BMCI's profits remained respectable relative to other banks. Since then, BMCI's operations have been decentralized, and it has now become more selective in its new lending activities. It has strengthened its Finance and Marketing departments through the recruitment of two senior staff from its French affiliate. Moreover, during the preparation of the proposed project, discussions were held with BMCI's management on further measures which could be taken to improve its financial performance. 3.23 Credit du Maroc (CDM). This bank appears to have one of the most conservative lending policies and its financial condition is very sound. The quality of the loan portfolio is good (2.2% of doubtful loans in 1988), and it has high equity (9.3% of deposits) and profitability (net return on average total assets of 1.2%). CDM has not been very active in investment lending and its participation in the SSI and the Industrial Export Finance projects of the Bank was relatively modest. CDM has a Credit Department with seven professionals, including one engineer, who evaluate credit applications for both investment and working capital purposes. CDM is building up its investment lending activities progressively, particularly for export-oriented projects. While its participation in the ongoing Industrial Export Finance Project has been modest, its performance in terms of disbursement against commitments made has been above average, reflecting its highly selective lending policies. 3.24 Societe Gen6rale Marocaine des Banque (SGMB). Th_s bank shows a high return on equity (24.7% in 1988) partly due to a low-cost deposit base (average interest paid on deposits of 5.0%) and a relatively high loans to deposits ratio (85.6% at end-1988). Its financial condition in terms of equity, doubtful loans and provisions is at about the average for the PBs. Its participation in investment lending under the Bank-financed SSI and Industrial Export Finance projects has been limited. The Specialized Finance Department now has five professional staff. Compared to the other banks, SGMB relies more heavily on the investors and its own branch offices for the preparation of appraisal reports, which are then reviewed and completed at the headquarters. Outside consultants are occasionally used to complete the appraisal of investment projects. Under the EMI and Industrial Export Finance  - 24 - projects, SGMB mainly participated as a member of consortia of oanks, delegating the major responsibility for project appraisal tco the lead banks of the consortia. 3.25 Wafabank. This bank is one of the most innovative and dynamic of the commercial banks, with a particular interest in export financing, its main growth area. Its overall performance, compared to the other banks. can be considered average. In 1988 the quality of its loan portfolio improved however, and Wafabank maintained high coverage of its doubtful loans through provisions. Wafabank is the second largest commercial bank (after BMCE) in export financing and as participant in the Bank-financed Industrial Export Finance Project, where its performance has been excellent. Supported by USAID, Wafabank has a special line of credit for short-term financing (in foreign currency) of SSIs. Its Credit Department is organized in six sectoral units which evaluate credit applications for both investment and working capital. Each unit has one engineer with a sector specialty. Wafabank recently created a small unit to assist exporters and facilitate their contacts with potential foreign clients. F. Banque Nationale pour le Developpement Economigue (BNDE) 3.26 BNDE, Morocco's industrial development bank, has been the country's central institution for medium- and long-term industrial lending. In light of the extensive involvement of the Bank with BNDE, a detailed discussion of its past performance and prospects is provided in Annex 7. BNDE is generally a sound institution, but like most development banks, it has encountered difficulties in redefining its role as selective credit policies are being reduced and competition from commercial banks increases (para. 3.08). The Moroccan Government directly controls 34% of BNDE's capital and an additional 15% through other publicly-controlled financial institutions. The rest of the capital is distributed among the Moroccan private sector (27%) and foreign institutions (24%), including IFC. About half of BNDE's loans are to manufacturing firms and the rest to energy, mining, transportation, services and leasing companies. 3.27 BNDE received nine direct loans from the Bank between 1962 and 1981, and two loans from syndicates of foreign banks led by IFC in 1983 and 1985 respectively. It has been the apex institution for the two Bank-financed SSI projects in which commercial banks participated. Under the 1987 Industrial Export Finance Project, BNDE received a loan of US$ 28 million, equivalent to 40% of the overall facility, which has been fully committed. BNDE coordinates disbursements under that project. 3.28 A summary of BNDE's financial indicators for 1984-88 is presented in Table 3.3. BNDE's loan portfolio hardly grew during the 1983-87 period, but increased in 1988 in line with the surge of its direct loans approvals. BNDE's profitability is adequate (net profits of 11.4% of equity in 1988), but remains constrained by delays in the reimbursement by the Trensury of foreign exchange losses covered by agreements with the Government. BNDE borrowed to finance these receivables which amounted to DH 340 million or 11.3% of its  - 25 - loan portfolio at end-1988. Treasury arrears to BNDE have now been settled. Table 3.3: BNDE'S FINANCIAL INDICATORS IN 1984-88 (End of period) 1984 1985 1986 1987 1988 Loans Outstanding (DH million) 2,849 2,766 2,871 2,878 3,044 Loans Affected by Arrears (%) 19.9 14.0 18.8 29.8 15.9 Arrears over 3 Months/Loans (%) 12.6 10.2 10.7 12.2 9.4 Provisions for Losses/Loans (X) 7.7 8.3 9.1 10.1 9.5 Long-Term Debt/Equity 10.0 10.6 9.4 8.0 8.2 Net Profit/EquiLy (%) 7.6 8.6 6.8 8.0 11.4 Source: BNDE 3.29 The quality of BNDE's loan portfolio has improved regularly since 1984. Arrears over three months decreased from 12.6% to 9.4% of outstanding loans between 1984 and 1988, and loans affected by arrears from 19.9% to 15.9%. Significant amounts of arrears from companies going through restructuring programs have been rescheduled during this period; these companies still require close follow-up. As many of BNDE's problem loans stemmed from state-owned enterprises, BNDE's policy statement was amended in 1983 and now sets the maximum share of loans to public enterprises at 25%. During the last few years, BNDE has followed a policy of making large allocations to provisions for portfolio losses; at end-1988, BNDE's provisions for losses exceeded the amount of arrears over three months. BNDE has recently reorganized and strengthened its Supervision Department in order to improve portfolin management. 3.30 In line with the Government policy to gradually liberalize the financial system, BNDE is focusing on improving its competitiveness and its ability to mobilize domestic resources, so that it can operate in a market-determined financial environment. To this end, BNDE has already started to take on term deposits and to make short-term loans. In order to further develop these activities, BNDE is considering opening two small commercial banking branches, in Rabat and Casablanca respectively, and is beginning to recruit and train staff for this purpose. Promotion activities have also been reinforced, particularly among exporters, and efforts to diversify into investment lending for tourism and agriculture projects are under way. BNDE is still, however, dependant on Government approval for all of its borrowings and is facing more competition from the commercial banks in its traditional business of industrial investment lending. As a result of these changes, as well as of pressure from its shareholders, BNDE's management has become more concerned about the definition and implementation of its future strategy as a financial institution. It is therefore defining a detailed medium-term plan which will be discussed with the Bank by September 30, 1990 (Annex 7, para. 10). Assurances to this effect were obtained at negotiations.  - 26 - W. THE PROJECT A. Rationale, Objectives and Components 4.01 Rationale. The Project will complement the Government's ongoing program of macroeconomic adjustment, trade and financial policy reforms supported by the Bank's Structural Adjustment Loan. It will provide the foreign exchange and long-term financing needed to stimulate a strong supply response from Morocco's industrial private sector to the new set of institutions and incentives. The assessment of the alternative sources of term finance currently available in the financial system indicate that the Bank loans would provide about 27% of the demand for investment credit during the 2.5 year commitment period under the project (para. 4.06). This demand is unlikely to be met by existing sources of financing for several reasons. First, until the Treasury plays a more neutral role in the financial system, the banking system will continue to channel a large share of domestic resources to finance the budget deficit (para. 3.06). While budget deficit and fiscal policy issues are being addressed by the Government with Bank support under the Structural Adjustment Loan, in the short-term, the Treasury will continue to rely on sizeable domestic bond financing, which could lead to significant crowding out of private investment. Second, because of lingering credit ceiling limits, commercial banks have had little incentive to attract term deposits and long-term resources are not readily available in the domestic market. This, however, is changing. Commercial banks anticipate gradually increasing the share of term deposits in their resources following the elimination of credit ceilings, which is underway. Finally, capital markets remain relatively underdeveloped and few substitutes to investment credit, such as bonds or various types of securities, exist. Legislatien and institutional improvements to strengthen the role of capital markets are being introduced by the Government, with support under the PERL Bank loan; in the meantime however, financial intermediation will continue to meet most of the demand for long-term resources. Investment financing provided by Bank funds through financial intermediaries would therefore meet an otherwise unsatisfied demand. 4.02 The Project will also improve the efficiency of the iinancial system. It will foster competition in the banking system and increase the effectiveness of financial sector intermediation. The participating banks (PBs), which will act as intermediaries of the Bank funds, are in good financial condition and are competent to evaluate projects and administer sub-loans. Under the project, commercial banks and BNDE would compete, on equal footing, to finance various industrial and tourism projects. In addition, the project itself reflects a move away from directed credit in that the share of financing to be provided for specific activities is far below that required under previous operations. The Project also complements IFC's activities in Morocco's industrial and financial sectors. IFC directly promotes and takes equity participations in individual firms, and attracts additional foreign commercial lending to the country through the syndication in the international financial markets of loans to Moroccan banks.  - 27 - 4.03 Objectives. The Project will contribute toward widening the base of Moroccan exprerts and alleviating piessure on the balance of payments by financing export-oriented industries, efficient import-substitution activities, as well as a limited number of tourism projects. The Project will support the development of competitive, market-based financial institutions. In particular, it will promote an incrcasing role for the commercial banks in the economy by encouraging their participation in industrial investment and tourism lending, thus enhancing competition among financial intermediaries. It will also contribute to the institutional strengthening of the financial intermediaries and Morocco's export promotion capabilities. 4.04 Components. The Project will consist of a package of lines of credit amounting to a total of US$ 170 million equivalent, to seven commercial banks and BNDE. The individual allocations to each of the PBs will be as follows: BNDE: US$ 50 million; BMCE: US$ 40 million; BCM: US$ 25 million; Wafabank: US$ 17 million; BCP and BMCI: US$ 12 million each; SGMB: US$ 9 million; and CDM: US$ 5 million. The PBs will use the lines of credit, over a commitment period of 2.5 years, to finance eligible investment sub-projects of financially sound firms. Sub-projects will include development, upgrading and expansion of facilities of industrial enterprises, enterprises supporting the industrial sector, and tourism enterprises. They will also include provision of equipment to leasing companies for use by industrial enterprises. The PBs will allocate at least 60% of the funds to export-oriented investments. Under the Project, measures will be taken to strengthen the financial intermediaries and to render Morocco's export promotion capabilities more effective. B. Evaluation of Demand for Investment Credit 4.05 Industrial investments approved by the MCI increased substantially in 1987 and 1988 (para. 2.21). Conservative estimates for future growth of 10% p.a. in nominal terms, suggest an average level of investment approvals in the order of DH 7.7 billion per year during 1990-92. The annual surveys of the MCI indicate that, on average, about 80% of approved investments are actually implemented. On that basis, actual industrial investment during the 1990-92 period may average about DH 6.2 billion (US$ 730 million equivalent) per year. 4.06 According to the financing plans submitted by investors, on average about 70% of the investment costs are covered by self-financing, capital increases, suppliers' credits and leasing. Medium and long-term loans from the commercial banks and BNDE account for the remaining 30% of the financing. This would amount to a minimum demand for industrial investment credit of DH 4.7 billion (US$ 550 million equivalent) during the 2.5-year commitment period under the Project. About 90% of the Bank loans are expected to finance industrial investment, and about 10% tourism projects (i.e. somewhat lower than the maximum 20% provided for under the loans). The proposed lines of credit, amounting to a total of US$ 170 million, wouid thus cover about 27% of the projected demand for industrial investment credit during the commitment period of the Bank  - 28 - loans. The rest of the demand will be covered mainly by MTR loans from the commercial banks and BNDE loans funded from other sources. C. Features of the Lines of Credit 4.07 Eligibility criteria. The proposed lines of credit would finance investment sub-projects meeting the following criteria: a. enterprises supported by Bank funds must be financially sound. Equity should represent at least 30% of total investment cost for each industrial and tourism project; b. they should have financial and economic raLts of return of at least 12%. In addition, each proposed line of credit would meet the following requirements: a. in line with the Government macroeconomic priorities, at least 60% of each of the credit lines wili be used to finance export-oriented sub-projects, i.e. those from which, within five years of completion, at least 40% of the additional production attributable to the investment is expected to be exported, either directly by the enterprise itself or by some of its clients; b. in line with Government policy of fostering private investment, the total amount of financing for projects with majority public shareholding will be limited to 15% of each of the credit lines; c. the total amount of financing for tourism sector projects will be limited to 20% of each of the credit lines. Tourism projects will be considered as export-oriented projects; d. the total amount of financing for projects developed by leasing firms will be limited to 10% of each of the credit lines. 4.08 Lending arrangements. The Bank will extend loans to the eight PBs under separate Loan Agreements. The maturity of the loans will be 20 years, including five years of grace. The amounts of the loans (para. 4.04) are based on the demand anticipated by the PBs and on their respective performance under the Industrial Export Finance Project. Each PB will be fully responsible for the administration of its loan account. 4.09 Sub-project financing. Each Bank loan will finance the foreign exchange component of investments of eligible sub-projects. On average, the foreign exchange component of industrial investments in Morocco is estimated at about 70% of total costs. For admin.strative simplicity, Bank financing under each line of credit for any given sub-project will be limited to a maximum of 70% of the total investment costs (including permanent working capital but excluding the cost of land) of the sub-project. In order to maximize the catalytic impact of the Bank  - 29 - credit lines, the maximum sub-loan size for a single investment sub-project and a single sub-borrower will be US$ 5 million. It is estimated that the Project will finance about 130 sub-projects. 4.10 The PBs will on-lend Bank funds at fixed rates in local currency. The on-lending interest rates will be equal to the higher of the then applicable Bank rate or BNDE's medium or long-term rates (or CIH's rates, in the case of tourism projects), depending on the maturity of the sub-loans. Currently, BNDE's rates are 12% for loans with maturities of two to seven years, and 13% for loans with maturities beyond seven years. Since the BNDE and CIH interest rates are fixed by the Government, this arrangement will ensure that the same on-lending terms apply to all PBs. The sub-loans financed by the Bank would be exempt from the credit ceilings of the commercial banks. The foreign exchange risk will be covered by the Foreign Exchange Risk Fund (para. 3.14). The amortization schedule of individual sub-loans will follow the PBs' lending practices and will be in line with the economic life of the sub-projects and the expected financial performance of the sub-borrowers. Sub-loan maturities will not exceed 12 years, including a grace period of up to five years. Sub-loan repayments will be recycled for similar activities until they are needed to repay the Bank loans. The Bank loans will be repaid according to a fixed amortization schedule. 4.11 Sub-project appraisal requirements. The PBs have established a record of solid assessment of credit risk under several recent Bank operations. Under the proposed project, flexible eligibility criteria (para. 4.07) and appraisal requirements should permit the PBs to tailor financial packages more closely to the needs of their individual clients while ensuring that Bank funds are on-lent on the basis of sound business decisions. The PBs will submit the appraisal reports in respect of non free-limit sub-loans to the Bank for approval. The free-limit would be US$ 2 million except for sub-loans to Lourism enterprises and leasing companies, for which there will be no free-limit. Sub-loans under the free-limit are expected to represent about two-thirds of the Bank funds. Under the Project, the PBs will pay special attention to the environmental impact of sub-projects, which will be designed and implemented in accordance with appropriate safety, health and environmental standards satisfactory to the Bank. Appraisal reports will include the assessment of the environmental impact of sub-projects according to guidelines satisfactory to the Bank. 4.12 Procurement. Based on the experience under the Industrial Export Finance Project of 1987 and under other Bank lines of credit for industry in Morocco, the average sub-project size is expected to be about US$ 2 million equivalent. Individual contracts for procurement of goods and services will generally be of less than US$ 500,000. Under the proposed Project, procurement will normally take place under the supervision of the PBs through existing local channels according to normal commercial practices in Morocco, where the inherent self-interest of the entrepreneurs has led to efficient procurement under the Bank credit lines. Industrial promoters may also have some construction capability and find it more efficient to execute civil works themselves. The PBs, which have sufficient experience in local construction costs,  - 30 - will be able to verify that these works reflect market conditions. 4.13 Disbursements. The Bank will disburse 100% of amounts paid by the PB under a sub-loan, up to the approved sub-loan amount (para. 4.09). Disbursements will be made on the basis of statements of expenditures (SOEs), with the supporting documentation being retained by each PB and made available for review by Bank supervision missions. Where construction works are executed directly by the investor concerned, this docwuentationi may consist of an independent technical report with a valuation of the works executed. The minimu. size of withdrawal applications to the Bank are planned to be US$ 100,000.. Modalities concerning use of SOEs were confirmed during negotiations. 4.14 In order to avoid delays in implementing sub-projects submitted to the PBs, and to make up for the early commitment of the Industrial Export Finance Project and the lack of alternative sources of funds, retroactive financing will be allowed up to an aggregate of US$ 17 million (or 10% of the Bank loans) for expenditures incurred since January 1, 1989. This allowance will be distributed among PBs in proportion to the amounts of their individual lines of credit. The estimated disbursement schedule for the package of loans, based on the standard disbursement profile for the EMENA/IDF sector, is given in Annex 8. The final date for submission of investment sub-projects to the Bank will be June 30, 1992, and the Closing Date of the loans will be June 30, 1996. 4.15 Institutional Development of Financial Intermediaries. Consistent with the increasing market orientation and gradual liberalization of the financial system (para. 3.07), the proposed project would reinforce the PBs' ability to assess credit risks and BNDE's ability to develop an institutional strategy well-adapted to a more competitive environment. To that end, the financial intermediaries participating in the project will take the following actions: a. Each PB will submit to the Barnk two types of reports. First, they will submit annual progress reports on the status of implementation of sub-projects and their operations during the first three years following the completion of the investment. These reports will compare the actual performance of individual sub-projects against the estimates made at the time of appraisal (e.g., investment costs, implementation period, volume of production, annual sales and exports, and financial condition and performance of the firms). The reports also will summarize problems encountered by the sub-projects and the measures taken, or to be taken, to try to solve these problems. Thus, the PBs will not only better serve the needs of their clients, but also sharpen their ability to identify problem projects at an early stage and take corrective actions on time. This would in turn contribute to maintaining the sound quality of their portfolios. Second, and in addition to general audited financial statements of each PB (para. 3.17), each PB will maintain separate as well as consolidated accounts on the use of its Bank loan.  - 31 - These accounts and the statements of expenditures (SOEs) will be reviewed by independent auditors acceptable to the Bank. The PBs will submit annually, to the Bank, the reports of these auditors within the six months following the end of each fiscal year; b. As detailed in Annex 7, BNDE is preparing a medium-term plan which will outline its divers-fication strategy in a more competitive environment. TV s would include, in particular, measures to broadea i's resource base, notably by increasing the share of stable dom.estic resources, and diversify the range of financial services available to its clients. BNDE's plan will be discussed with the Bank by September 30, 1990. D. Export Promotion 4.16 Morocco's current export strategy calls for a diversification of products and markets. In order to be effective, the manufacturing firms and export trading companies will largely have to launch this effort themselves. To support the efforts of these firms, the Government is reviewing, with technical assistance financed by UNDP, the current institutional set-up for export promotion (para. 2.15). Moreover, actions to improve the effectiveness of the CMPE, including the establishment of a planning and evaluation unit within it, are being undertaken. This unit, under the control of the Managing Director, prepares detailed annual programs of activities for the Center with definition of responsibilities, time schedules and budget allocations, and follows-up on the implementation and actual effectiveness of these activities. In addition, CMPE's salary scales are being reviewed to allow for more flexibility in hiring and retraining experienced staff. Assurances were obtained at negotiations that the Government will strengthen its institutional capabilities in relation to export promotion activities. In the short-term, in order to ensure that CMPE will have adequate resources to carry out its ongoing programs pending the longer-run recommendations to be derived from the Export Strategy Study (para. 2.27), the Government has confirmed its intention to maintain an adequate budgetary allocation for CMPE in 1990, in an amount at least equal to that of 1989.  - 32 - V. PROJECT BENEFITS AND RISKS 5.01 This Project complements and builds upon Morocco's ongoing macroeconomic adjustment program by: (i) providing essential long-term credit for the expansion and modernization of the industrial sector; and (ii) supporting the development of competitive market-based financial institutions which would serve as catalysts to the broadening and deepening of the financial system. By emphasizing export-oriented enterprises, which are labor intensive, the Project will promote the creation of employment. It will also promote competition and efficiency in the financial, sector and contribute to the institutional strengthening of the financial intermediaries as well as other institutions involved in the development of exports. The expected increase in industrial production and employment will help generate sustainable growth in Morocco, thereby reinforcing the momentum for continuing the implementation of the adjustment process. Moreover, the expected increase of exports will relieve the pressure on the balance of payments and improve Morocco's debt-servicing capability and creditworthiness. 5.02 There are two risks associated with this project. First, as a result of increased economic protection in Morocco's major export markets, the expected demand for investment credit may not materialize or investment sub-projects may encounter difficulties during implementation. This may slow down the utilization of the credit lines, but many enterprises are already developing programs for diversifying their products and markets to guard against potential restrictions in access to export markets. Assistance to firms by the PBs and CMPE, as well as from foreign technical assistance programs, would also contribute to the successful implementation of the diversification of exports. The second risk is a slowdown in the continued implementation of industrial, trade and financial policy reforms. The Government has reaffirmed its determination to broaden the liberalization reforms engaged in the industrial sector, with Bank support under the recently approved SAL. The long-term competitiveness of manufactured exports is an essential component of this program. A slowdown in the liberalization of the financial system already initiated by the Government, in particular the phased elimination of the credit ceilings, would reduce the incentive of the banking system to mobilize domestic, particularly long-term resources, and would tend to perpetuate market segmentation in the financial system. While this risk may materialize in case of resurgence of inflation pressures, the probability is low, as the Government, in the context of the Standby Arrangement with the IMF, is committed to rely on indirect instruments to control monetary expansion. An important step in that direction was taken in December 1988 by establishing an auction-based system for placing Treasury bonds on the money market. Furthermore, the Central Bank already uses reserve requirements and loan portfolio to equity ratios as tools to manage the liquidity of the economy, and to control credit expansion.  - 33 - VI. AGREEMENTS REACHED AND RECOMMENDATION 6.01 During negotiations, agreements were reached on the following points and recorded in the loan documents: With the participating banks: (a) Eligibility cri.teria of sub-projects, appraisal requirements, on-lending terms, procurement and disbursement procedures (paras. 4.0:' to 4.14); (b) Reporting and auditing requirements (paras. 3.17 and 4.15). With BNDE: (a) Preparation of a plan detailing BNDE's diversification strategy to be discussed with the Bank by September 30, 1990 (para. 4.15). With the Government: (a) The Treasury will reimburse the PBs its share of foreign exchange losses accrued each semester, within three months following the end of each semester (para. 3.14); (b) Strengthening of institutional capabilities for export promotion activities (para. 4.16). 6.02 In view of the above agreements, the project is suitable for a package of loans to eight Moroccan banks, each with the Guarantee of the Kingdom of Morocco, for a total of US$ 170 million equivalent, with terms of 20 years, including a five-year grace period.  - 34 - ANNEX 1 MOROCCQ Investment ApDrovals under the Industrial Investment Code. 1984-88 (Amounts in DH million) 1984 1985 1986 1987 1988 No. Amount No. Amount No. Amount No. Amount No. Amount Food Processing Grains, baking & sugar 114 206 110 99 94 245 127 181 131 259 Other food products 86 303 101 509 115 641 113 417 137 556 Beverages & tobacco 8 44 11 63 15 84 8 51 15 256 Subtotal 208 553 222 672 224 970 248 649 283 1071 Textile & Leather Spinning, weaving & knitting 160 566 147 514 207 652 228 1,091 279 1072 Clothing 61 67 120 182 145 248 332 663 378 732 Leather & footware 49 84 59 85 46 66 59 103 81 429 Subtotal 270 717 326 781 400 966 619 1,857 738 2223 Chemical P Related Industries Wood & wood products 27 42 37 87 29 48 22 30 44 92 Paper, cardboard & printing 63 108 68 123 54 115 86 193 89 238 Non-metalic mineral products 55 322 43 275 44 165 54 325 71 642 Chemicals 56 102 41 92 56 310 55 218 74 292 Rubber & plastics 53 82 64 121 83 152 84 196 89 223 Other 6 11 3 6 4 15 3 - 8 4 Subtotal 260 667 256 704 270 805 304 962 375 1491 Enaineering Industries Metallurgy 14 43 13 46 4 4 66 13 12 30 Metalworking 86 157 76 150 92 226 99 251 79 184 Machinery & equipment 44 116 34 66 40 159 43 58 54 65 Transportation equipment 21 51 17 36 23 29 23 135 25 57 Electrical & electronics 31 194 37 91 41 77 48 87 59 246 Other 5 22 6 6 9 28 9 23 5 4 Subtotal 201 583 183 395 209 523 228 567 234 586 Industry-related services1l 94 258 152 280 151 282 204 655 182 402 TOTAL 1.033 2.778 1.139 2.832 1.254 546 1.603 4.692 1809 5783 of which: Public sector 215 105 108 364 135 Moroccan private 2,042 2,276 2,557 3,554 4509 Foreign 52, 451 881 774 1139 of which: Creation 313 1,002 335 759 397 1,252 541 1,700 603 1706 Extension 720 1,776 804 2,072 857 2,294 1,062 2,992 1206 4077 ,f which: SMIs 640 703 697 773 731 792 972 1,143 1122 1481 COST PER JOB (DH '000) 99 93 102 87 97 1/ Includes mainly cold storage facilities. Source: Ministry of Commerce and Industry  ANN'X 2 MOROCCO The Manufacturing Sector in 1980 and 19871/ (Amounts in DH million) Capaci ty No. of Firms No. of Workers Value Added Total Sales Exports Utilization Investment2/ 1980 1987 1980 1987 1980 1987 1980 1987 1980 1987 1984 1987 1980 1987 M(% (M Food Processing Grains, baking & sugar 409 899 15,719 20,597 510 1,636 3,709 9,965 46 151 70 70 154 224 Other food products 254 422 14,969 22,675 685 2,287 4,246 11,455 836 2,714 60 55 198 444 Beverages & tobacco 37 33 7,276 7.055 391 3.571 2.275 5224 55 65 75 74 88 141 Subtotal 700 1,354 37,964 50,327 1,586 7,494 10,230 26,644 937 2,930 na na 440 809 Textile & Leather Spinning, weaving & knitting 352 464 41,913 46,961 793 2,276 3,153 7,508 421 2,396 67 60 231 469 Clothing 266 473 18,524 41,680 127 944 438 3,274 247 2,754 61 49 14 228 Leather & footwa-e 169 248 8.268 12.346 152 450 570 1.608 123 670 60 41 24 85 Subtotal 787 1,185 68,705 100,987 1,072 3,670 4,161 12,390 790 5,820 na na 269 782 Chemical & Related Industries Wood & wood prnducts 126 194 7,274 8,971 196 481 826 1,601 204 330 59 60 34 46 Paper, cardboard & printing 238 336 8,182 10,475 353 958 1,311 3,855 168 431 69 68 42 130 w Non-metalic mineral products 215 305 15,334 22,234 670 1,873 2,315 5,007 44 71 59 66 217 198 Chemicals 131 241 13,959 19,485 882 2,245 4,514 12,961 1,544 4,719 76 60 102 970 Rubber & plastics 98 195 6,030 7,503 213 600 825 1,943 8 105 60 66 28 91 Other 16 26 326 421 7 15 16 30 - 3 41 58 - _4 Subtotal 824 1,297 51,105 69,089 2,321 6,172 9,807 25,397 1,967 5,659 na na 423 1,435 Engineering Industries Metallurgy 41 26 1,506 2,599 61 712 213 2,498 6 372 39 62 10 129 Metalworking 224 329 13, SS 14,651 434 949 1,583 3,658 13 49 50 46 73 123 Machinery & equipment 107 202 3,997 5,990 116 432 554 1,740 - 1 46 54 20 45 Transportation equipment 66 99 6,383 6,729 244 734 1,287 2,915 65 249 39 42 22 81 Electrical & electronics 59 110 6,994 9,232 241 713 898 2,274 38 249 49 46 52 107 Other 10 22 219 857 5 52 21 142 - _ 38 52 1 17 Subtotal 507 788 32,854 40,058 1,101 3,592 4,556 13,227 121 925 na na 178 502 TOTAL 2.818 4.624 190,628 260.461 6.080 20.928 28.754 77.658 3.818 15.334 65 60 1.310 3.528 1J Includes only firms with more than 10 workers or with annua' sales over DH 100,000. They represent about one-quarter of employment and three-quarters of value added in manufacturing; the rest Are mostly artisanal firms. 2/ Includes actual investments. Source: Ministry of Commerce and Indurtry, 1980 and 1987 surveys.  - 36 - ANNEX 3 MOROCCO Merchandise ExRorts. 1980-88 (SDR million) Average A.inual Growth Rate (%) 1980 1984 1985 1986 1987 1988 1980-84 1984-88 Food and Beverages 507 474 538 611 587 682 -1.7 9.5 Citrus Fruits 226 117 146 162 135 146 -15.2 5.7 Tomatoes 48 32 32 36 42 36 -9.7 3.0 Other Fresh Vegetables 28 26 28 38 38 35 -2.0 7.7 Canned Fruits & Vegetables 52 48 55 57 57 60 -1.7 5.7 Fruit & Vegetable Juices 6 18 25 13 8 33 33.2 16.4 Fresh Fish 15 136 146 179 203 226 73.5 13.5 Canned Fish 67 61 71 82 73 82 -2.0 7.7 Wine 8 5 4 4 5 4 -12.1 -5.4 Others 58 32 32 40 26 60 -14.3 17.0 Agricultural Raw Materials 78 l 76 103 -10.1 19.2 Paper Pulp 24 22 14 23 31 46 -1.7 20.2 Others 54 29 42 41 45 57 -14.4 18.4 Fuels and Lubricants 91 84 Al 53 60 55 -2.1 =3.