Morocco - Financial Sector Development Project (Vol. 1 of 2) : Main report

(a 6 6 4t Document of 3 $6-7 ..44oA 5 $ (08~ -to mThe World Bank !$ FOR OFFICIAL USE ONLY 5370- 337Z2- ,- 3373 - Afo0 . Report No. P-5553 MOR REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON 4 PROPOSED PACKAGE OF LOANS TO THE KINGDOM OF MOROCCO AND EIGHT MOROCCAN BANKS IN AN AGGREGATE AMOUNT EQUIVALENT TO US$235 MILLON FOR A FINANCIAL SECTOR DEVELOPMENT PROJECT PART I: THE MAIN REPORT June 3, 1991 This document has a restricted distribution and may be used !y recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY ,OUIVALENTS Currency Unit - Dirham (DH) DH per USS 1984 1985 1986 1987 L9&t 1989 1990 Year Average 8.81 10.06 9.10 8.36 8.21 8.48 8.02 Year End 9.55 9.62 8.71 7.80 8.21 8.12 8.04 FISCAL YEAR January 1 - December 31 LIST OF ABBREVIATIONS BCM Banque Commerciale du Maroc BCP Banque Centrale Populaire BMCE Banque Marocaine du Commerce Exterieur BMCI Banque Marocaine pour le Commerce et l'Industrie BNDE Banque Nationale pour le D6veloppement Economique COG Caisse Centrale de Garantie CDG Caisse de Dep6t et de Gestion CDM Credit du Maroc CIH Credit Immobilier et H6telier CNCA Caisse Nationale de Credit Agricole CPM Cr6dit Populaire du Maroc EC European Community EMI Electrical and Mechanical Industry ERR Economic Rate of Return FI Financial Intermediary GDP Gross Domestic Product GOM Government of Morocco IS Corporate Income Tax ITFA Industrial and Trade Policy Adj'tstment MCI Ministry of Commerce and Indu. MTR Medium-Term Rediscountable ODI Office pour le Developpement Industriel PB Participating Bank PCB Participating Commercial Bank PE Public Enterprise PERL Public Enterprise Rationalization Loan SAL Structural Adjustment Loan SGMB Soci6te G6nerale Marocaiae de Banque SOE Statement of Expenditures SSI Small Scale Industry UNDP United Nations Development Pzogram UN/ISO United Nations/International Standardization Program VAT Value Added Tax  FOR OMCIUL USE ONLY KINGDOM QF MOROCCO FINANCIAL SECTOR DEVE-LOPMENNT PROJECT LOAN AND PROJECT SUMMARY Ekftgagwg: The Kingdom of Morocco and eight Moroccan banks. An.pun: US$235 million equivalent, of which adjustment component: "S$125 million equivalent; investment component: US$110 million equivalent. Guara ZoThe Kingdom of Morocco (investment component). Ibnns: 20 years, including 5 years of grace, at standard variable interest rates. .QInancQi: Investment Comgonent: An IFC-led syndicated loan for a total of US$10.0 million equivalent. Adiustment Component: Arrangements with multilateral and bilateral agencies being pursued. PIag The proposed project is a hybrid consisting of a financial DIWiR1Ion: sector adjustment component and an investment component. The adJuatment component would support a program of reforms in the financial sector. The specific policy measures would concern: (i) the transition towards indirect monetary control; (ii) the development of domestic financial markets, in particular for Government securities; (iii) the liberation of interest rates and the elimination of directed credit policies; and (iv) the strengthening of the regulatory and supervision framework for the banking system. The investment component will provide medium- and long-term financing to eligible firms for investment sub-projects, mainly in private, export-oriented industries. It consists of a package of eight loans totalling $110 million to Banque Nationale pour le D6veloppement Economique (BNDE) and seven commercial banks. The loan to BNDE would include a component to finance a technical assistance program aimed at ensuring BNDE's long-term viability in a market determined envirotnment. This document has a restricted distribution and may be used by recipients oilly in it.e performance of their official duties. Its contents may not otherwise be disclosed without - '* srank authorization.  * ii - ilensft and The project's main benefits are (i) the establishment of a Rlsks: market-oriented financial sector, consisting ef sound financial institutions, with renewed access to international capital markets, operating in a strengthened prudential and regulatory framework; and (ii) the provision of long-term resources to finance private investment in a competitive and outward oriented environment. Through a hybrid operation, the Bank will be able to provide institutional support and advice to the participating banks (PBs) and facilitate their transition to the new financial sector environment. The IFC-led syndication represents a critical step to increase Moroccan financial intermediaries' (FIs) reliance on market sources, and is part of the Government strategy of reestablishing normal access to international financial markets. Two main risks can affect the success of the project. The first risk relates to the consolidation of the macroeconomic progress already achieved, a necessary condition for the successful implementation of the financial sector reforms. While the fiscal deficit has been reduced very substantially over the last decade, further progress is required at a time when foreign financing of the deficit through rescheduling is going to disappear. The Government is committed to further fiscal efforts which will be finalized as part of the next budget law in the fall of 1992. A second area of potential concern is that of the development of excessive risk exposure in the banking system, because of increased competition and reduced mandatory placements in risk-free Government securities. This risk is limited in view of the generally sound financial condition of the banking system and the strengthening of prudential regulations and supervision by the Central Bank. Esimted IBRD Fiscal Year FY92 FY93 FY94 FY95 FY96 FY97 Disbursements: --(US$ million)----------- Adjustment Component 125 Investment Component Annual 7 20 25 22 17 19 Cumulative 7 27 52 74 91 110 AppMlsalgenon: This report and the associated technical annex constitute the Zoard documentation for this project. There is no separate Staff Appraisal Report.  KINGDOM OF MQROCCO FINANCIAL SECTOR DVLOPMgENT PRECT Table of Contents PARTI->EM^IBEPO EM I - THE MAIN REPORT I. INTIODCTiQ . . . . . . . . . . . . . . . . . . . . . . . 1 II. ECONOMIC REFORMS AND PERFORMANCE IN THE 1980s . . . . . . . . . . 1 A. The Program of Reforms . . . . . . . . . . . . . . . . . . 1 B. The Response to Reforms . . . . . . . . . . . . . . . . . . 3 C. Prospects and Challenges . . . . . . . . . . . . . . . . . 6 III. BANK STRATEGY FOR THE NINETIES . . . . . . . . . . . . . . . . . 10 IV. THE FINANCIAL SECTOR DEVELOPMENT PROJECT . . . . . . . . . . . . 13 A. The Adjustment Component. . . . . . . . . . . . . . . . . . 13 1. Overview of the Financial Sector . . . . . . . . . . 13 2. Financial Sector Reforms . . . . . . . . . . . . . . 15 B. The Line of Credit Component . . . . . . . . . . . . . . . 21 C. Monitoring and Loan Administration . . . . . . . . . . . . 23 1. Adjustment Component .23 2. Line of Credit Component . . . . . . . . . . . . . . 25 V. PROJECT RISKS . . . . . . . . . . . . . . . . . . . . . . 25 VI. OTHER BANK GROUP OPERATIONS . . . . . . . . . . . . . . . . . . . 26 VII. AGREEMENTS REACHED . . . . . . . . . . . . . . . . . . . . . . . 26 VIII. RECOMMENDATION . . . . . . . . . . . . . . . . . . . . . . . 27 ANNEXFS Annex 1: Letter of Developinent Policy and Associated Matrix . . . . . 28 Annex 2: Macroeconomic Ine.cators .40 Annex 3: Consolidated Balance Sheet of Commercial Banks, 1986-1989 44 Annex 4: Consolidated Balance Sheet of Specialized Financial Institutions, 1986-1989 .45 Annex 5: Distribution of Credit to the Economy, 1986-1989 .46 Annex 6: Merchandise Exports, 1980-1989 .47 Annex 7: Investment, Employment, and Value Added in Manufacturing . . 48 Annex 8: Distribution of Exports in Industry, 1984-1988 .49 Annex 9: Status of Bank Operations . . . . . . . . . . . . . . . . . . 50  W2~ Table of Contents fCont.1 PART II- T1CHNICAL ANNEX ON THE UNES OF CREDT I. THE PARTICIPATING BANKS . . . . . . . . . . . . . . . . . . . . . 1 A. Banque Nationale pour Is Developpement Economique (BNDE) 1 B. Banque Marocaine du Commerce Ext6rieur (BMCE) . . . . . . . 7 C. Banque Commerciale du Maroc (BCM) . . . . . . . . . . . . . 10 D. Wafabank (WAFA) ..12 E. Banque Marocaine pour le Commerce at l'Industrie (BMCI) . . 15 F. Banque Centrale Populaire (Cr6dit Populaire du Maroc) . . . 17 G. Societe Generale Marocaine de Banque (SGMB) . . . . . . . . 20 H. Credit du Maroc (CDM) ..21 II. THE LINES OF CREDIT .23 ANNE3ES Annex 1: BNDE Financial Statements .29 Annex 2: BMCE Financial Statements . . . . . . . . . . . . . . . . . 33 Annex 3: BCM Financial Statements . . . . . . . . . . . . . . . . . 35 Annex 4: WAFA Financial Statements .37 Annex 5: BMCI Financial Statements . . . . . . . . . . . . . . . . . 39 Annex 6: BCP Financial Statements . . . . . . . . . . . . . . . . . 41 Annex 7: SGMB Financial Statements . . . . . . . . . . . . . . . . . 43 Annex 8: CDM Financial Statements . . . . . . . . . . . . . . . . . 45 Annex 9: Estimated Disbursement Schedule . . . . . . . . . . . . . . 47  - I - I. INTIRQDfCTIQN 1.01 I submit the following report and recommendation on a proposed package of loans to the Kingdom of Morocco and eight Moroccan banks in an amount equivalent to US$235 million, for a Fin&ncial Sector Development Project. The project is a hybrid operation, consisting of an adjustment and an investment component. A two-tranche policy based loan to the Kingdom of Morocco for the equivalent of US$125 million would support the Government's program of reforms in the financial sector. In addition, lines of credit to eight Moroccan financial intermediaries (FIs), totalling the equivalent of US$110 million, would provide medium- and long-term financing for the expansion and modernization of the private, mostly industrial, export-oriented sector. In parallel with the investment component, an IFC-led syndicated loan for the equivalent of US$100 million would provide additional financing to four or five of the eight participating banks (PBs). For the adjustment component, cofinancing arrangements are being actively pursued with other bilateral and multilateral agencies. 1.02 The project's central objective is to increase the supply of long- term capital to private entrepreneurs, while supporting financial sector reforms that will encourage efficient allocation of investment and broader participation by the various segments of a potentially very dynamic private sector. Supporting strong long-term private investment activity is important at a time of continued need for macroeconomic stabilization and rationalization efforts in the public sector. It is private investment performance that will sustain growth, allow an increase in exports and create employment so that stability can go in hand with an expanding economy that meets the social challenges of the 1990s. It is desirable, therefore, that a substantial portion of total World Bank Group intermediated capital, that helps finance Morocco's development, be directly available to the private sector. It is also desirable that, in line with Morocco's strategy of renewed access to international financial markets, World Bank lending become increasingly instrumental in attracting foreign private capital. With financing from IFC and private commercial lenders, representing 48X of the total resources made available to the PBs in the context of this operation, the project contributes to the implementation of this strategy. 11. ECONOMIC REFORMS AND PERFORMANCE IN THE lOSOs A. The Program of Reforms 2.01 In 1983, faced with a severe economic and financial crisis, Morocco turned its back on twenty years of inward-looking, public sector-led economic development and adopted a strategy of outward-oriented, private sector-led growth. The Government implemented a set of extensive stabilization and adjustment polici -s, supported by a series of IMF stand-by arrangements and World Bank sectoral and structural adjustment loans. The Government program consisted of four main components: (i) fiscal and monetary restraint and exchange rate realignment to redress macroeconomic imbalances; (ii) the reform of the price and incentive framework to promote competition and efficiency in the domestic  - 2 - productive sectors; (iii) rationalization of the financial and management controls of the public enterprise sector; and (iv) initial reforms in the domestic regulatory framework and in the financial sector to encourage private investment and supply response to the policy measures. 2.02 Stabilization. By 1983, Morocco's external debt and fiscal deficit had risen to unsustainable levels. The Government's stabilization program aimed at reducing the public deficit by cutting government expenditures, and improving the balance of payments through active exchange rate management and the initial steps of a sweeping trade reform. The program was supported by the Bank and the IMF and by Morocco's official and commercial bank creditors, who repeatedly rescheduled the country's outstanding external debt. More recently, in 1988, the Bank approved a structural adjustment loan (SAL) which aimed primarily at facilitating the transition from stabilization to growth and at restoring Morocco's access to international markets by the mid-1990s V. 2.03 Trade Reform. The trade liberalization program was supported by two Industrial Trade and Policy Adjustment Loans, in 1984 and 1986, and by the first SAL. It consisted in lowering the maximum tariff rate (from 400X in 1983 to 45X in 1988), simplifying the tariff structure, reducing the share of manufacturing output protected by import restrictions (from 60X in 1983 to 20% in 1989), and lowering the special import tax (from 251 to 12.52). Further reforms are being prepared by the Government to harmonize and lower the levels of effective protection. The measures envisaged include the reduction of the number of tariff rates and of the maximum custom duty, the elimination of remaining quantitative restrictions and the rationalization of the system of reference prices. Completion of the trade reform is expected to be supported by a second SAL. 2.04 Public Enterprise Reform. By the early 1980s, Morocco's public enterprises (PE) had become very large, accounting for 201 of GDP and 301 of all investment. When their economic performance deteriorated, they became a large financial drain on public finances. In the mid-eighties, with the support of the Bank V, the Government initiated a major reform of the PE sector which consisted of: (i) financial restructuring of some of the key public sector monopolies and utilities; (ii) establishing a management and performance system for monopolies or regulated public service enterprises to enhance efficiency and productivity; and (iii) initiating divestiture programs to privatize a significant number of PEs. In addition, the financing of PEs was put on a sounder basis, by cutting operating subsidies ana limiting the role of the State to equity contributions. The reform of the PE sector was consistent with the reduction of the role of the State in economic activity, and was an important step towards allowing private and public enterprises to compete under a system of equal economic and financial opportunities. 1/ President's Report, SAL-I, Report No. P-4857-MOR, November 8, 1988. ZI President's Report, Public Enterprise Rationalization Loan, Report No. 4545, April 30, 1987.  - 3 - 2.05 reform of the Domestic Administrative Framework. To accompany the overall adjustment program, the Government took complementary measures to reduce rigidities in the economy. For example, administrative delays in obtaining investment approvals were reduced by a Royal Letter of 1989, which limited administrative processing to a maximum of two months. An external trade simplification program was launched in 1989, with UNDP financing and the Bank as executing agency. This program aims at simplifying foreign trade procedtres through the normalization of customs forms and procedures, and the integration of data processing on foreign trade transactions handled by Moroccan exporters and importers with that of their foroign counterparts V. 2.06 The Financial Sector. Beginning in the mid-eighties, the Government undertook the initial steps of a program to imp.ove policies and introduce greater competition in the financial sector. Among the measures taken were: raising interest rates to positive real levels; eliminating most interest rate subsidies to specialized financial institutions (SFIs); allowing the SPIs to take deposits and to lend for werking capital; creating a commercial paper market; and introducing an auction market for Treasury bills. Nevertheless, to meet high borrowing requirements, the Treasury continued to rely on non-mark6t mechanisms, such as mandatory placements of a fixed portion of commercial banks' deposits in Treasury bonds, which represented on average 1.11 of GDP during 1984-89. This, combined with other directed credit policies as well as Morocco's inability to tap international capital markets, resulted in a shortage of term resources to finance private investment. Consequently, during the 1980s, the World Bank continued to be the principal external source for such resources. 2.07 In the early eighties, the Bank financed the agricultural, housing and industrial sectors, mainly through lines of credit to the SFIs (CNCA, CIH and BNDE). In 1985, the Bank approved the Electrical and Mechanical Industries (EKI) project, which channelled investment funds through five commercial banks and the Office pour le Developpement Industriel (ODI). The growing role of cemmercial banks in the provision of investment financing was further reflected by their expanded participation in two further World Bank operations. In May 1987, the Bank approved a US$70 million package of loans for an Industrial Export Finance Project, and in December 1989, a US$170 million package for an Industrial Finance Project to eight banks, including BNDE. B. The Resonse to Reforms 2.08 Stabilizatior and Growth. Looking back on the 1980s, it is clear that the main objectives of Morocco's macroeconomic stabilization efforts were achieved (Table 2.1). In terms of fiscal balance, the budget deficit was reduced from 11 in 1983 to around 4% of GDP in 1988-1990. Government investment was cut in half but, with the support of SAL I, minimum levels of public investment were maintained; the Government's Target Investment Program (TIP) met its objective of a 3% share of GDP for 1987-1990. The sharp improvement in the fiscal balance contributed to low and stable inflation, which remained in the 3 to 7% range throughout the second half of the decade. 2/ UNDP Trade Procedures Simplification Project No. UNDP/MOR/88/006.  - 4 - 2.09 Considerable progress was also made towards balance of la_ments ydability. Starting with a deficit of almost 8X of GDP in 1984, the current account strengthened considerably, showing a su-.plus in 1987 and 1988, and an average deficit of about 3X of GDP in 1989 and 1990, despite a contractual problem with phosphate exports in 1989 and the temporary surge of oil prices in 1990. Several factors contributed to the impruvement in the current account. The falling trend in oil prices, and only moderate increases in absorption as a consequence of the stabilization policies, limited the growth of imports. At the same time, there was vigorous export growth, particularly of manufactured goods (para. 2.11). Lower current account deficits have improved debt inidicators and the country's creditworthiness. Debt outstanding as a share of GDP dropped from 105X in 1986 to 85X in 1990, and debt service dropped from 372 to 242 of exports of goods and services. Between 1986 and 1990, Bank Al-Maghrib's net foreign reserves increased from US$0.2 to US$2.0 billion. TABLE 2.1: MROCCO_ - SELECTED MACROCMO1WOIC INDICATORS 1981-90 . ...........-*---actual-t --. ----------- 1981-85 1986 1987 19911 1989 199019 Real GOP Growth 3.4 8.4 -2.5 10.3 1.3 3.4 Current Aecount/GDP/g -9.0 -1.3 0.9 2.1 -3.6 -2.0 Budget Det icit/GDP /A /k -9.2 -4.8 -4.9 -4.8 -4.5 -3.3 Gross Fixed Capital Formation/GDP 26.1 22.7 20.0 20.6 23.0 22.0 Debt Outstanding/GOP 107.3 105.5 108.2 92.5 93.1 84.8 Debt Outstandfng/XGS 336.6 337.4 328.3 282.7 325.5 252.7 Debt Service/XGS 35.3 37.0 31.3 26.4 31.9 24.2 Not Foreign Assets (US$ mililon) 144 176 359 500 463 2038 Real Import Growth (Goods & NFS) -0.4 7.7 7.9 6.5 3.1 10.8 Real Export Growth (Goods & UPS) 4.0 2.2 10.1 18.6 -14.1 26.0 Real Nanuf. Export Growth/2 10.5 14.5 27.4 14.0 13.1 22.1 /_ Before grants. The grants amount to 3X of GOP in 1990 /b Cash basis /I Excludes Phosphates and phosphate derivatives, includes re-exports /d Preliminary 2.10 The above achievements were accompanied by an acceleration in the rate of overall economic growth, although performance on the external account from year to year remained vulnerable to rainfall and to fluctuations in the international phosphate market. Growth averaged 4.42 per annum in the second half of the eighties, versus 3.42 during the period 1981-1985. All sectors of the economy contributed to this performance. The manufacturing sector responded particularly well to the new set of policies and incentives. Manufacturing value added increased annually by 132 during the 1985-88 period, and the share of manufactured goods in total industrial production increased from 152 in 1982 to 24.52 in 1988. Employment in manufacturing has grown at an average rate of 92 p.a. since 1984, with total employment in the manufacturing sector reaching approximately 410,000 in 1989. Investment in manufacturing grew by approximately 11.52 p.a. in real terms during the period 1986-1990 (Annex 7). Investment in  - 5 - export-oriented sectors grew even faster, doubling its share from 24X in 1984 to 51X in 1988. 2.11 Export Growth and Diversification. Following the opening up of the economy and the stabilization program, export volumes increased steadily, the composition of exports showed signs of diversification, and the manufacturing sector in particular grew increasingly outward-oriented (Table 2.2). In SDR terms, total exports grew by 6.8% per annum in 1985-90. During the same period, the share of manufactured exports in total exports increased from 45% to 57%. rirms in the textile industry, in particular, posted a strong export performance, with nearly 50% of their output sold abroad in 1988, as compared to 20% in 1984 (Annex 8). Tabte 2.2: EVOLUTION OF MOROCCAN EXP0RTS. 1980-1990. SELECTED YEARS SgR million Percentage of Total 1980 1985 19901! 1980 1985 199011 :ion-Mwnufactured Exports 1269 t1 1327 7 55 Food Stuffs 376 520 714 20X 25X 23X Phrsphates & Other ores 588 S38 433 31X 26X 14X Other 305 80 180 16X 4% 6X Manufacturedxports 614 919 1768 332 452 5 Phosphate Derivatives 185 296 561 102 14X 182 Processed foods 132 54 60 72 3X 22 Other manufactures 205 228 - 102 72 finished products 297 363 919 162 182 302 of which: Garments 58 123 n.e. 32 62 n.a. Knitwear 56 44 n.a. 32 2X n.a. Other 80 129 n.e. 42 62 n.a. I~IAi. 1D~ 2057 M 100X 100X lQ9 1/ prelm:inary Source: Sank Al-Mghrib. 2.12 In sum, the economy has responded favorably to the program of reforms implemented in the eighties. A measure of the success of the adjustment program is the recent evolution of the set of macroeconomic indicators that the Government and the Bank manitored under SAL 1. As detailed in Table 2.3, these indicators have beet. largely met. Any deviations, such as the temporary drop in foreign exchange earnings in 1989, were discussed with the Government and remedial action was taken (a 9.5% devaluation in May 1990). Despite this clear improving trend, the balance of payments remains vulnerable to external shocks, reserve levels are still unstable for an open economy that wants to access international financial markets and attract private capital, and exports need to be further diversified.  - 6 - labte 2.3. MOROCCO - MACROECONICINDICATORS SPECIFICALLY DISCUSSED AND MONITORED UNDER SAL-I 1988 1989 192 Total Gross Fixed Capital Formation/GOP *SAL-I 19.0X 19.5X ZO.0X - Actual 20.6% 23.0% 22.0% Gross Public and Publicly-Guaranteed External Debt/Total Foreign Exchange Earnings .SAL-I 2.8 2.6 2.4 - Actual 2.8 3.0 2.5 Real Groith Rate of Manufactured Exports - SAL-I 12.0% 10.0% 10.0% - Actual 14.0% 13.1% 22.1% Net Foreign Assets of Bank Al-Maghrib (US$ million) - SAL-1 450 850 1.050 - Actual 500 463 2,038 Source: President96 Report SAL-I, Report No. P-48S7-M. C. Prosoects and Challenges 2.13 Consolidating Macroeaconomic Progress. The first challenge for Morocco in the 1990s is the consolidation of the macroeconomic progress already achieved. This will require a strong macroeconomic program with three key components: steady and high rates of growth, a sustainable budget deficit, and balance of payments viability. Steady growth of over 5% p.a. in the nineties -compared to the relatively high (4.4% p.a. on average) but somewhat irregular rates of growth of the second half of the eighties- will rely on productivity gains resulting from the reforms, and an increase in private sector investment. A government investment program of around 4% of GDP would provide the basic physical and social infrastructure to sustain this growth. The resulting expansion of national income would lead to per capita consumption growth of around 1.7% p.a. by the mid-nineties, thus contributing to the alleviation of social pressures. 2.14 Balance of payments viability by 1993 is another cornerstone of macroeconomic stability, actively pursued by the authorities through a two- pronged approach. First, the resource gap would be reduced from 5% of GDP in 1990 to 2% by 1995, as exports grow and diversify following the completion of the trade reform and as the public deficit is reduced. Second, the capital account would improve as foreign investment expands and voluntary project- related financing resumes in line with improved creditworthiness. Balance of payments viability should lead to full convertibility of the dirham by the middle of the decade, further strengthening confidence in the economy.  2.15 Following the temporary disruption caused by the Gulf crisis, Moroccan policy makers have renewed their efforts to implement the last phase of macroeconomic adjustments. The crisis has had a strong impact on the economy, through higher oil prices, increased social demands, and lower tourism revenues. Policy-makers have been resourceful in balancing the need to be flexible to the unforeseen political developments, while at the same time maintaining the economic course to achieve the medium-term objectives. 2.16 The macroeconomic management agenda includes the reduction of the budget deficit to levels consistent with balance of payments viability and private sector expansion, and the consolidation of current account deficits compatible with projected financing. An IMF stand-by, a second SAL and a second PERL are expected to support this program. Detailed macroeconomic projections for 1941-95 are presented in Annex 2. 2.17 In order to allow for the financing of additional social and infrastructure expenditures necessary for balanced medium-term growth, the reduction in the budget deficit will need to be achieved through medium-term revenue measures which will ensure the continuation of the minimum public investment program supported under SAL I. The 1992 Finance Bill should be an important step in this direction through the approval of medium-term revenue- generating measures. The public expenditures program, which would be monitored under SAL II, would in particular include non-salary social expenditures on health, basic education, and non-irrigated agriculture. 2.18 Morocco is one of the countries that has been most severely impacted by the Gulf crisis. The initial impact of the crisis was in terms of the increased cost of oil imports, on which Morocco depends for most of its energy requirements. As part of the international effort to help the countries most impacted by the Gulf crisis, Morocco received special support in the second half of 1990 to help compensate for the higher cost of oil imports. In the event, world oil prices fell back to precrisis levels faster than anticipated. As a result, and helped by the substantial increase in Morocco's exports earlier in the year, the country was able to use these capital transfers to achieve a significant buildup in its external reserves, which rose to cover three months of imports by the end of 1990. The Gulf crisis continues to have an impact on Morocco's economy during 1991. Although oil prices are projected to remain low, the effect on tourism is turning out to be more protracted. The preliminary indications are that foreign exchange earnings from tourism will fall by about 50% in 1991. The slowdown in the world economy coupled with a possible slowdown in foreign investment constitutes an additional source of lower foreign exchange inflows for this calendar year. Taking all these factors into account, the total impact on the balance of payments could be as high as 3% of GDP in 1991. 2.19 The Moroccan Government will seek a final round of Paris Club negotiations to reschedule part of its official debt obligations. A last rescheduling agreement covering 1991 and 1992 would allow the authorities to manage this temporary shock without slowing the adjustment and liberalization process. Given the temporary nature of the shock, the economy should be able to resume its medium-term path in a relatively short period of time. 2.20 The achievement of balance of payments viability by 1993 remains attainable. Furthermore, the convertibility of the dirham could follow once  - 8 - the trade liberalization program has been completed and voluntary financial flows have resumed. The unpredictabillty of future shocks and the initial vulnerabilities faced following convertibility require the continued buildup of foreign exchange reserves up to a minimum of 4 months of imports by the mid- nineties. The experience of other countries which have gone through similar processes shows the importance of a reserve cushion in supporting the sustainability of trade liberalization and of opening up the capital account 2.21 Beyond 1993, the financing of the capital account should be within the limits of what Morocco can expect from official and private sources without any additional recourse to exceptional financing. Following the completion of adjustment measures to be supported by SAL II, direct foreign investment should reach US$300 million per year, private sector projects should attract new commercial financing, and manufactured exports should increasingly finance additional import requirements. 2.22 Private Sector Development. The last decade of the twentieth century provides Morocco's private sector with the opportunity to become the engine of rapid growth. Morocco has already progressed significantly in setting up a framework for efficient resource allocation and economic management. However, further strides towards private sector development are required in terms of the strengthening of the supporting infrastructure and in regard to export diversification. 2.23 Infrastructure constitutes an essential support to private sector activity. To be effective, this support necessitates: (i) a regulatory framework conducive to efficiency while preserving adequate standards of quality; and (ii) a minimum core investment program for new and maintenance projects. On both fronts, Morocco has lagged behind. In transport, despite a fairly sophisticated network, the sector is highly regulated, leaving little choice to consumers in the selection of their transport mode. As much as 60X of tertiary roads, accounting for over 45X of the total road network, were deemed in bad condition in 1988, compared to 40X five years earlier. The accumulated delays in maintenance have been so serious, that most of these roads now need extensive rehabilitation before regular maintenance can be applied. Telecommunications, a prerequisite to the development of a modern, outward oriented economy, remains a constraint. Although the number of telephone lines has almost doubled between 1984 and 1990, overall density remains low at 1.7 line/100 pop., compared to 9.4 in Turkey and 17.8 in Portugal; and 32% of expressed demand remains unsatisfied. 2.24 Moroccan industry is increasingly outward oriented, and signs of diversification have emerged. Exports, however, remain concentrated, both in terms of products and markets. Phosphates and phosphate derivatives, sensitive to commodity price fluctuations, continue to represent nearly 402 of all exports. Products with relatively low value added, such as food stuffs and garments, account for another 35%. A major challenge for Morocco's export industries is to move into products of higher value added. Success in exporting such products requires high and consistent quality, quick response to changing demand, and strong integration into world distribution systems. This will, in turn, require access to more advanced levels of technology and improvement in labor productivity, through (i) an improved policy and institutional framework for technology promotion, standards and quality certification; and (ii) the training of skilled labor, both at the technical and managerial levels. In terms of  -9 - market diversification, the EC remains the dominant market, with over 65% of all exports in 1989, with France alone accounting for 30C. The concentration on EC markets reflects both geographical proximity and preferential trade agreements granted to Moroccan exporters. However, Morocco's preferential treatment in the EC has eroded in relative terms as a result of general reductions in tariff rates. In addition, future quota allotments, and for textiles in particular, are becoming increasingly difficult in view of the enlarged Community. A recently completed study, jointly prepared by UNDP and the Bank V, makes detailed proposals to further the diversification of Morocco's export markets, in particular towards the North American market which remains largely untapped. 2.25 SocLal Dimension of Growth. During the last twenty years, as a result of GDP growth and the provision of social services, significant improvements occurred in all social indicators. Life expectancy rose from 49 to 61 years, the death rate fell from 18 to 10 per thousand, and infant mortality dropped from 145 to 73 per thousand. Female literacy increased from 101 in 1970 to 22% in 1985. Despite these improvements, several social indicators still compare unfavorably with other countries having similar income levels (Table 2.4). The number of physicians is under half of the average in comparable lower middle-income countries. The child death rate is significantly above the levels observed in comparable countries, and only 57% of the population (27% in rural areas) has access to safe water. Illiteracy remains a critical issue, with 552 of males and 78X of females illiterate. Quite apart from equity considerations, this constitutes a major handicap to the labor requirements of an expanding modern private sector. Moreover, high labor force growth and accelerating internal migration have spilled over into high unemployment in the modern sector and eroding real wages and unstable occupations outside it. This has exacerbated strains on existing social services and exposed the fragility of the social safety net and the inadequacies of the education system. Table 2.4: COMPARATIVE SOCIAL INDICATORS NOROCCO TUNISIA EPILIPPINES THAILAND GNP per capita (1987) 610 1180 590 850 (in US# Life Expectancy (years) (1987) 61 65 63 64 Crude Death Rate/1000 (1987) 10 7 8 7 tIllteracy (X) (1987) 67 46 14 9 Populetfon/Physicisn (1984) 15610 2150 6700 6290 Population/Nursing Person (1984) 920 370 2740 710 Daity Caloric Supply/Capita (1986) 2915 2994 2372 2331 Access to Safe Water (X of Popul.) 57 89 64 70 Rural Population (X) 27 79 43 63 Chitd Death Rate per 1000 10 8 4 3 Health as X of Total Soverunnt Expenditures 3.0 5.9 6.0 6.2 w/ "Morocco 2000 - An Open and Competitive Economy, UNDP Trade Expansion Program - Country Report" dated November 7, 1990.  - 10 - 2.26 A recent social sector report analyzes the characteristics and causes of poverty and outlines the key areas to be addressed to tackle the social dimension of adjustment as Morocco enters the nineties W. In particular, in view of Morocco's continued tight budgetary situation, the authorities will have to be more selective in allocating social expenditures and emphasize strategies that simultaneously affect more than one dimension of poverty. Almost a third of total government expenditures is already allocated to social spending, and it is unlikely that the social budget will be able to outpace overall budget growth in the medium-and-long term. Failing large intersectoral shifts, it will become necessary to redouble efforts to direct the internal allocation of the social budget in favor of actions that maximize the integration of the poor into the economy. Efforts to reduce illiteracy through improved primary education quality and other incentives for school attendance, preschool child development programs (especially targeted nutrition asrtstance), and improved family planning services should receive much higher priority. These three areas of intervention have major linkages to earnings potential, improved health, and nutrition. 2.27 ln sum, Morocco has achieved considerable progress since independence, but great potential remains for improving the living standards and productivity of the poor. Morocco's return to a sustained growth pattern in recent years and good prospects for a continuation of this trend represent an unprecedented opportunity to tackle the social dimension of growth. This opportunity is also an immense challenge. Lack of appropriate response to the legitimate aspirations of a large share of the population living below the poverty line might threaten further economic progress and what remains a rather fragile social fabric. 111. BANK STRATEGY FOR THE NINETIES 3.01 The Bank's country assistance strategy for the nineties aims to help Morocco meet the three challenges described above: (i) to complete the remaining phases of the adjustment reforms (1991-93); (ii) to develop the private sector and its role in the economy as the driving force; and, (iii) to strengthen the social dimension of growth. Given the constraints on the number and volume of loans which the Bank can prudently process while maintaining a reasonable exposure, selectivity of intervention and an emphasis on seeking cofinancing will be key criteria in the design of the Bank's program. Continued close coordination with the IMF in the area of macroeconomic analysis and policy advice, and with the IFC in regard to support for the Moroccan private sector, are essential. 3.02 The Adjustment Program. The Bank Group has played an important role in supporting Morocco's adjustment program through extensive policy advice and 5,1 "Reaching the Disadvantaged: Social Expenditure Priorities in the 1990s", World Bank Report No. 7903-MOR.  - 11 - considerable financial support. The forthcoming adjustment program, of which the proposed project is one element, would include two additional operations currently under preparation: (i) A Second Structural Adjustment Loan (SAL-2), with two major objectives: first, a rationalization program of public expenditures, with priority given to expenditures in basic education, health and agriculture, within the framework of a comprehensive action program on social and poverty issues; second, completion of the trade liberalization program to remove all quotas, lower effective protection, and improve efficiency through trade facilitation measures. (ii) A Second Public Enterprises Rationalization Loan (PERL-2) which aims at: restructuring key sectors (including mining and sugar, where the State holds an important portfolio), assisting the Government in the setting up of the regulatory framework for its privatization program, and supporting further institutional measures to improve the efficiency of enterprises remaining in the public sector. Cofinancing discussions with the African Development Bank, the Japanese Ex-Im bank and the EC are at an advanced stage for these quick- disbursing adjustment operations. By 1993-94, the adjustment phase of Morocco's program should be completed. At that time, Morocco should be able to renew normal financial relations with the international financial community. Direct borrowings in external markets, as well as foreign equity capital, should become major sources of external capital. 3.03 The Macroeconomic Framework. The Bank and the Government have agreed on a medium term macroeconomic framework within which this project, as well as the above mentioneC adjustment operations, will be inscribed. The main elements of the framework are summarized in Table 3.1 and the detailed projections are presented in Annex 2. The numbers reflect the discussions with Moroccan authorities on SAL II and PERL II as well as consultations with the IMF. 3.04 Progress on the debt front allows the Government to pursue three objectives in the next years. First, getting out of the rescheduling phase after the last Paris Club round. Second, regaining normal access to international financial markets. Third, maintaining price stability while accelerating growth. If these objectives can be reached by the mid-nineties, Morocco will have overcome the debt crisis, will no longer need rescheduling, and will have the reserve cushion to support external shocks without backtracking on the liberalization program.  - 12 - Table 3.1: OMQOCC0 - NACRO2CONOHIC FRAMEWORK 1991-96 Medium-Toer indicators 1221:2? 1993-94 199S9 Real GDP Growth 4.4 4.7 5.3 Current Account/GDPL -1.9 -0.6 0.9 Budget Deficit/GDP E1 -2.4 -1.7 -1.4 Total Gross Fixed Capitat Formation/GOP 22.6 23.5 24.0 Debt Outstanding/GDP 82.0 75.0 65.0 Debt Outstanding/XGS 252.0 220.0 185.0 Debt Service/XGS 27.0 28.9 25.9 Reserves (months of imports) 3.4 4.1 4.5 Real Manuf. Export Growth I/ 9.0 10.0 10.0 / After debt relief k/ Payment order basis, before debt relief S/ Excludes phosphates and phosphate derivatives, includes re-exports 3.05 SuDDort to the Private Sector has been essentially provided in the past through lines of credit to industry, housing, tourism and agriculture (para. 2.07). Future assistance to the private sector will be direct and indirect. Operations are planned to support the private sector directly, through projects to enhance industrial technology, and to provide further long-term resources to the financial sector in the form of multi-sector lines of credit. The private sector will benefit indirectly from operations, such as the proposed Second Telecommunication Loan (FY93), which would promote the subcontracting of telecommunication services to private firms, from projects in transport, water supply, and power generation, and from the development of municipal finance, which will have a strong private sector focus. 3.06 In the social sector, Bank support in the past was directed towards the development of health facilities, employment (through two Vocational Training projects), and basic education. The emphasis now will be on broadening this involvement in the context of a concerted nationwide social action program. Under SAL-2, the Government is expected to adopt social sector performance indicators in key areas of development. The Bank program will be assisted by a number of sector studies in health, education, and employment, including a comprehensive UNDP/Bank-financed Living Standards Measurement Study. Projects in education, health, nutrition and labor market intermediation are planned, and will fall in place within a framework where policy and institutional issues will have already been addressed. Several Bank infrastructure operations, such as water supply projects in rural areas, are having a direct impact on social development. These efforts address a challenge that is immense and must work within tight budgetary constraints. While progress is at hand in the macroeconomy, and the private sector shows encouraging signs of vitality, a decisive victory over poverty remains an elusive goal. 3.07 IFC Strategy and Lending Progra". IFC has a healthy and diversified portfolio of projects in the following sectors: banking, cement, shipping, fishing, fruit processing, textiles, and mining. Total outstanding IFC investments as of December 31, 1990 amounted to US$139.6 million equivalent  - 13 - (loans of US$132.7 million and equity participations of US$6.9 million). During FY90, IFC syndicated a US$92 million loan to Cr6dit Immobilier et H6telier which represented the first injection of non-Government guaranteed long-term commercial bank funding in the Moroccan economy in the past four years. In addition to its lending and investment transactions, IFC has been advising the Government on the implementation of its privatization program. IFC has helped the Ministry of Economic Affairs and Privatization to estimate manpower requirements and has prepared a document outlining the cost of the operation which the Ministry has distributed to potential donors. IFC has also just prepared a technical assistance proposal relating to one of two of the initial large privatization transactions. 3.08 IFC's priority in Morocco will continue to be the promotion of foreign exchange-generating projects in tourism, textile, fishing and transportation sectors. IFC will also continue to seek opportunities to improve Morocco's access to international financial markets through syndicated loans. Parallel financing of the proposed project through the IFC-led commercial syndication, will be instrumental in achieving this objective. Finally, IFC plans to continue playing a leading role in the implementation of the country's privatization program, both as advisor and as investor. IV. THE FINANCIAL SECTOR DEVELOPMENT PROJECT 4.01 The proposed project is a hybrid operation consisting of two distinct components: a two-tranche policy based loan of US$125 million to the Kingdom of Morocco in support of a program of reforms in the financial sector; and an investment component consisting of a package of lines of credit to eight Moroccan FIs for a total of US$110 million. IFC will cofinance the investment component through an IFC commercial syndication to four or five FIs for a total of about US$100 million. The proposed project will support the completion of the financial sector liberalization undertaken by the Government, and will also provide the foreign exchange and long-term financing needed for private sector investment, in particular industry, to sustain a supply response to the ongoing process of economic adjustment. A. The Adiustment ComRonont 1. Overvew of the Finanoal Secor 4.02 Institutional Framework. Morocco's financial system includes Bank Al-Maghrib (the Central Bank), 15 commercial banks, and five specialized credit institutions. Other financial institutions include the Treasury, the postal checking system, the National Savings Bank, and the Caisse Centrale de Garantie (CCG). There are also six leasing companies, mostly owned by the banks, and a number of insurance companies. Capital markets are still in their infancy, and the Casablanca stock exchange has, so far, played a limited role in mobilizing equity finance.  - 14 - 4.03 Most banks have significant foreign participaticn in their capital. Foreign shareholders typically own 20 to 40X of the stock These are large banking groups, predominantly French - e.g. Credit Lyonnais in CDM, Banque Nationale de Paris in BMCI - but also from other, mainly European, countries such as Italy, Spain and Scandinavia. The banks have historically focused on short- term lending but, as the financial system has been progressively liberalized, they have become increasingly active in longer term financing, mainly for industry. The banking system encompasses approximately 900 branches. In addition to the commercial banks, there are five Government-controlled specialized credit institutions: the Banque Nationale pour le Developpement Economique (BNDE), lending for industrial projects; the Caisse Nationale de Credit Agricole (CNCA), lending to the agricultural sector; the Caisse de Ddp6r et de Gestion (CDG), mobilizing public sector savings and lending to local governments and to the money market; the Credit Immobilier et H6telier (CIH), lending for housing and tourism projects; and the Caisse Marocaine des Marches (CMM), lending to private companies engaged in public works. Furthermore, through its many branches, the postal checking system (Bureaux de Ch6ques Postaux) is able to receive deposits from the public throughout the country. The National Savings Bank, also operating within the postal sy;tem, collects small savings from the public. Finally, the CCG, a public agency, guarantees domestic and external loans to public or private enterprises. 4.04 The Treasury mobilizes domestic resources directly from non- financial agents, particularly in the form of deposits into the postal checking system, and Treasury deposits. Other sources of Treasury financing have been: (i) mandatory placements of 35X of sight deposits that banks are required to hold in T-bills at below market rates of 4.25X (which account for about 20X of the Treasury's domestic financing); and (ii) bonds issued to the public and institutional investors, at administered rates. An auction-based system for placing T-bonds on the money market has been operating since early 1989 and has developed significantly. 4.05 The main policymaking body on monetary and credit matters is the Credit and Financial Market Committee. Originally established in 1954, the committee was substantially reformed with the introduction of the 1967 Banking Law, which constitutes the legal foundation for the Moroccan banking and financial system. The Committee has the Minister of Finance as its President, the Governor of the Central Bank as Vice President, and also includes representatives from Morocco's banking and financial community. It meets several times a year to review matters related to money and credit. 4.06 Distribution of Credit. The distribution of outstanding credit by term among different types of banking institutions during 1986-1990, is detailed in Annex 5 and summarized in Table 4.1. The distribution indicates a gradual shift towards medium- and long-term credit which accounted for about 41X of total outstanding credit to the economy in 1990, as opposed to 36X in 1986. Commercial banks have increased their share of medium and long-term financing, while specialized institutions have become more actively involved in short-term lending. The share of export credits in short-term lending increased and reflects the expansion of exports relative to the whole economy.  - 15 - Tgble 4.1: IMROCCO - DISTRILUTIOM OF CREDIT TO THE ECONOMY IN 1986-1990 Percentaaes at end of erfod Average annual growth rate 1986 19i7 1988 198Q 1990'/ 1986-1989 Shortterm credit 64.0 OA 62.3 Au 59.3 L8 Central lank 11.4 12.3 11.3 11.0 11.0 9.8 Commerciat benks 47.9 45.8 44.8 43.6 43.7 7.5 (of which export credits) (8.0) (7.9) (8.2) (9.0) n.a. Specialized banks 4.8 5.5 6.2 5.7 4.6 17.6 Medium & ton-term credit 36.0 MAZ 37 39.7 40,7 1i.5 Commercial banks 7.6 7.6 8.8 10.3 11.2 23.0 Specialized banks 28.4 28.9 28.9 29.4 29.4 12.1 TOTAL 100.0 100.0 Au 100.0 100.0 10.9 I end of June Source: Bank AI-Maghrib 2. FinancIal Sector Reforms 4.07 During the past decade, monetary and financial policies were aimed at preserving thies stability of the financial system and a low rate of inflation, in a context of high Treasury borrowing requirements. Although this objective was generally met, its pursuit, through quantitative credit restrictions, interest rate controls and selective credit policies, created distortions in the mobilization of savings and inefficiencies in the allocation of credit to the economy. Beginning in the mid-eighties, the authorities undertook a program of progressive elimination of direct monetary controls, with a view to increasing the efficiency and responsiveness of financial intermediation (para. 2.06). In the late eighties, improved macroeconomic stability and the projected decline in the needs for domestic financing of the budget deficit encouraged the authorities to move to a second phase of reforms. 4.08 The adjustment component of the proposed operation would support this second phase of liberalization. The program includes reforms in four main areas: (i) the transition towards indirect instruments of monetary management; (ii) the development of financial markets, in particular for Government- securities; (iii) the liberalization of most interest rates and the elimination of directed credit policies; and (iv) the strengthening of bank supervision and prudential regulations. 4.09 Transition to Indirect Control of Credit and Money. The macroeconomic progress already achieved (Chapter II) makes the early 1990s an opportune time to abandon quantitative rationing of credit for a system of indirect control by the Central Bank. It is important that these indirect controls operate effectively. Maintaining low inflation has been a key achievement for Moroccan policy makers. The liberalization of the financial sector must not inadvertently lead to a loss of monetary control. Reinforcing indirect control instruments and the role of the Central Bank in managing the  - 16 . liquidity is thus the desirabie and prudent strategy. The Government's program includes (i) the elimination of all credit ceilings, thus promoting competition in the banking system; and (ii) the strengthening of the Central Bank's indirect control instruments. Indirect monetary control will be reinforced through three sets of measures. First, the Central Bank's monetary control capacity will be enhanced through a more effective use of reserve requirements. The reserve requirement ratio currently applies to sight deposits only. Under the program, the Central Bank will have the authority to extend the base to include time deposits and the ceiling on the ratio will be increased from 15X to 25X on sight deposits, and set at 10 on time deposits. This will enable the Central Bank to control the total size of the banks' balance sheet, and influence interest rates more effectively. In addition, the Central Bank will control reserve requirements on a weekly and monthly basis. This will facilitate a more rigorous control of the banks' reserves. Second, the control of the monetary base through banks' refinancing at the Central Bank will be enhanced by limiting the eligibility to fixed rate rediscounting on direct medium-term investment loans to small scale enterprises. Third, a single (seven-day) interest rate will be applied on all advances at variable rate.W This measure will increase the transparency of monetary policy as changes in the advances rate will give financial markets a clear signal from the monetary authorities on liquidity. In the medium-term, the Central Bank intends to develop open market operations, as the auction market deepens and Bank Al-Maghrib develops its capacity to manage a sizeable portfolio of Treasury bonds. 4.10 Developing the Domestic Financial Markets. The authorities rightly consider that developing the market for Government securities is the first critical step towards the development of domestic financial markets. With a stock of domestic government debt reaching DH50 billion (25X of GDP) at the end of 1989, the Treasury is by far the largest borrower on the domestic market. The authorities have been increasingly relying on market mechanisms to meet Government borrowing requirements on the domestic market. In 1988, an auction market was organized for 3-month, 6-month and 12-month bills. Since 1990, maturities of one, three and five weeks are also offered. Still, the market for government debt remains very imperfect. First, about 801 of the Treasury's domestic financing is secured at administered interest rates, mostly below market. The banking system has been required to invest 351 of sight deposits in Treasury bonds at 4.25X per year, thus constraining the development of a market for Government securities. Second, the market for Treasury instruments remains largely segmented both in terms of clients and prices, which tends to perpetuate a distorted structure of interest rates and to hamper the development of a secondary market. The further development of domestic financial markets is constrained by the fiscal exemptions granted to most Treasury instruments and jk Four maturities are offered at present: one-day, three-day, seven-day and one month. 2/ Auction of government bonds with one-week to 12-month maturities is limited to the banking system. Maturities of 6 months, 1, 2, 3 and 5 years are issued to the non-bank private sector. Special bonds of 2, 3, 5 and 15 years are placed with the Banque Centrale Populaire (BCP); 10-year bonds with the Caisse de Dep6t et Gestion (CDG); 15-year bonds are reserved for institutional investors.  - 17 - rigid financial placement rules imposed on institutional investors, such as CDG and the insurance companies, which are required to maintain a substantial share of their portfolio in Government securities. As a result, potential issuers such as enterprises or financial institutions cannot significantly enter the bond market. 4.11 The Government program aims at (i) encouraging the development of an efficient market for government securities; and (ii) implementing the fiscal and regulatory measures needed to deepen the domestic financial markets. The proposed adjustment component would support the following measures. First, mandatory placements in Treasury bills will be gradually reduced and replaced by funding through the auction market. As a first step, the ratio of sight deposits to be placed in such T-bills has been reduced to 32X in 1991 and will be further reduced to 251 in 1992. This measure should improve the banks' flexibility in asset management and deepen the T-bill market. Second, the Treasury will take regulatory measures in order to expand the auction market to insurance companies and other enterprises; allow banks to underwrite Treasury bond issues; and place long-term bonds through public offerings as opposed to the current system of bilateral placements with institutional investors. Third, the Government will prepare a program of measures to harmonize the tax treatment of all financial instruments on the basis of a study to be carried out by the Ministry of Finance. Fourth and finally, a program to reform the Stock Exchange and to create mutual equity funds will be discussed with the Bank. 4.12 Interest Rates and Directed Credit Policies. The removal of credit ceilings represents a decisive step towards a more competitive environment that will allow a competitive determination of interest rates, in an open environment. Over the recent years, interest rates have been kept positive in real terms. However, extensive controls have reduced the scope for competition and efficiency in bank lending and deposit mobilization. In addition, the absence of variable rate instruments provides no protection against d&mestic inflation, reduces the scope for efficient interest rate risk management, and limits term transformation. Selective credit policies have also limited the scope for competition and contribute to the segmentation of the credit market. These include specific advantages granted to SFIs, such as special accounting procedures and tax treatment, and mandatory purchase of their bonds by commercial banks. The adjustment component would support the freeing of most interest rates, the elimination of remaining selective credit policies, and the implementation of a transparent and market-based foreign exchange risk coverage system. 4.13 Interest Rate Policy. The Government program includes (i) the liberation of interest ratas on bank deposits above three months V; (ii) the liberation of all lending rates, with the exception of export financing and rediscountable medium-term investment loans to small scale industries, which would continue to have regulated rates at 8X and 12% respectively 1; and (iii) L/ A minimum rate of 8.5X applies to 3-month deposits. 2/ Export credits represent about 101, and rediscountable medium-term credit to SSIs about 31 of total bank credit to the economy.  - 18 - the revision of the ceiling on lending rates I which will be based on the cost of banks' resources. This ceiling will be set at 1 1/3 times the weighted average rate on six and twelve-month bank deposits and adjusted every six months. This rate has the advantage of being determined by a market which is large in volume WI. In addition, emphasis will be given to encouraging variable interest rates. Variable interest rate contracts (that is at rates which can be altered during the life of a loan in relation to movements of a pre-set reference m.Arket rate) will allow lenders and borrowers to deal in a more efficient way with the uncertainty on the future level of real interest rates. The diffusion of such instruments will be supported by the Central Bank through the issuance of operational guidelines on the technical implementation of deposit and loan contracts at variable rates. Most of the funds provided under the credit lines of the proposed project are expected to be onlent at variable rates, thus encouraging banks and corporate borrowers to become more comfortable with the new system. 4.14 Selective Credit Policies. The gradual elimination of selective credit policies aims at eliminating any subsidies resulting from preferential treatment granted to SFIs. Banks will have more flexibility in their lending decisions and will increasingly compete directly with SFIs. Any remaining subsidies, such as on interest rate for low-income housing loans, will be clearly identified and covered by the Government budget. The program includes: (a) Banks are currently required to place 5.5% of their deposits in rediscountable medium-term loans or in BNDE notes and 6% in loans to the housing sector or in CIH notes. These two ratios will be reduced to 5% in 1991 and further to 2.5% in 1992. (b) The liberalization of medium-term domestic bond issuances by the SFIs through the elimination of the mandatory Government guarantee and control over interest rates. (c) The Government guarantee on CIH's loans to finance hotel projects will be eliminated, and ex-ante administrative controls exercised by the Ministry of Finance on the budget expenditures of a single SFI (the CNCA) will be eliminated and replaced by approved annual budgets by 1992. 4.15 ImRlementing the Foreign Exchange Coverage System. The Moroccan authorities have developed a new foreign exchange risk coverage system, which can be expected to be self-financing and ensure equalization of the cost of foreign resources with the cost of domestic capital to the banking system. This scheme covers external long-term borrowing undertaken by financial institutions for financing long-term credit. Banks and SFIs would pay into an exchange lQ The ceiling is currently set at one-third above the average interest rate on the one-year Treasury bonds, auctioned during the previous semester. 11/ Commercial banks' 6 and 12-month deposits represent about 75% of total term deposits (Annex 3).  - 19 - guarantee fund the difference between the interest rate on foreign borrowings and the market-decermined cost of resources in the domestic market, plus a 1X front-end fee charged to the enduser. Financial institutions would onlend to final borrowers at free market rates. Hence, both financial intermediaries and final borrowers would be indifferent to whether funds are domestically or externally borrowed. 4.16 The new foreign exchange risk coverage system will be implemented under the proposed project. A market-determined reference rate will be introduced and used to equate the cost of domestic and foreign capital. This rate will be the weighted average cost of commercial banks' 6 and 12-month deposits as declared to Bank Al-Maghrib during the previous semester (plus a 0.75X margin to reflect the administrative cost normally attached to the collection of term deposits). It will be adjusted every six months. Such a rate has the advantage of being market-determined is a good indication of the cost of domestic term resources to the banking system (para. 4.13). The proposed system should be viewed as a practical approach to the pooling of foreign exchange risk during the transition from a controlled financial system with strict exchange controls, to an open and competitive system with full convertibility. Once this goal is achieved, in two or three years, the financial institutions and final private borrowers themselves, will be able to choose freely the denomination of loans and use various forms of cover. At that stage, the Government should be able to withdraw entirely without having to fear an undesirable negative impact on private sector long-term investment activity. 4.17 Regulation and Supervision of thg Banking System. As financial liberalization proceeds, the prudential regulatory and supervisory framework will require further strengthening in order to minimize the risks associated with greater latitude for bank lending. A number of reforms have already been undertaken to strengthen the prudential regulatory framework and the supervision of banks. They include: (i) the modific tion in 1986 of the Banking Law establishing the legal framework for the banking system, including a uniform accounting system; (ii) instituting a uniform bank accounting plan, which requires detailed balance sheet data; (iii) instituting accounting standards for line items in the accounting plan; (iv) setting up an off-site surveillance system requiring detailed monthly reporting of all balance sheet operations and income statement flows; (v) setting up a comprehensive on-site examination system, although its full implementation remains hampered by understaffing; and (vi) instituting prudential ratios requiring: maintenance of a solvency ratio of 5.25X of net worth to sight and term deposits, minimum capital and net equity of 100 million DH; provisioning against doubtful loans; and risk concentration limited to lOX of net equity to any single borrower. This framework is complemented by internal controls of major banks which reflect a high level of professional management. 4.18 With the implementation of new liberalization reforms, further strengthening of the framework is deemed necessary to preserve the stability of the banking system in an open, competitive environment. This will be achieved through the following measures: (i) preparation of a new Banking Law which will provide more independence and flexibility to the Central Bank in conducting its regulatory and supervisory functions; (ii) external audits will be required to follow International Auditing Standards; the Central Bank will approve a list of firms experienced in comprehensive bank auditing and receive their reports,  - 20 - which will complement its own inspection activity; (iii) capital adequacy standards will be established, in line with the 81 capital to risk-weighted assets ratio of tho Basel Committee of Banking Supervision, which all banks will have to comply with by January 1993; (iv) prudential ratios and accounting standards will be revised so that, by 1991, loans to a single beneficiary will be limited to 7X of net equity of the bank, and by 1992 loans to a single corporate group limited to 15X of the bank's net equity; a more rigorous definition of net equity, in particular excluding loans to related entities, will be implemented; (v) a new loan classification and provisioning system will be introduced. Loan classification will be defined with a greater degree of objectivity, based on aging of arrears, and on the financial situation of borrowers. This will allow for earlier identification of problem loans, cessation of interest accrual, and related provisioning, particularly on past due overdraft accounts; and (v) accounting policies and procedures between banks and the three major SFIs (BNDE, CIH ans CNCA) will be harmonized. 4.19 Impact of Reforms. In sum. the objective of the reform program, to be supported by the project is to establish the polity and regulatory frameVork which will enable the Moroccan financial system to operate according to internationally accepted norms and standards in an open, competitive and liberalized environment. Moreover, the program also supports the putt..ng into place of rules and safeguards which should ensure that this move to a liberalized financial framework does not come at the expense of the financial stability and institutional soundness which are the hard won gains of Morocco's cautious financial sector management in the 1980s. 4.20 As detailed in Table 4.2 below, the budgetary impact of the financial sector reforms during the implementation period of the program is minimal (0.03X of GDP in 1991-92), and therefore consistent with stabilization objectives and balance of payment viability. Table 4.2: MOROCCO - FISCAL IMPACT OF FINANCIAL SECTOR REFORMS (in millions of Dirhame) Measure 1221 1921 Reduction fn mandatory placements in T-bonds: Net incrementaljost to the Treasury (17) (98) 1/ Asstming that the shortfall in financing out of mandatory placements is offset by bonds sold at an auction rate of 12X; and that the increase in revenues generated by the banks is taxed at 40X.  - 21 - B. The Line of Credit ComRonent 4.21 The line of credit component of the Project will encourage the broad participation of Moroccan financial institutions which operate on a sound, commercial basis and meet the Bank's creditworthiness criteria. A package of lines of credit will be made available to seven commercial banks and BNDE, amounting to a total of US$110 million equivalent. The project will also support investment financing by a large and diversified base of private firms. There will be no sectoral targeting of Bank funds. The maximum size of individual loans will be US$6 million and approvals of eligible subprojects W, will be entirely delegated to PBs for loans of US$2 million or less. The PBs will use the lines of credit over a 2-year commitment period. Under the project, BNDE will prepare, with the assistance of international consultants, a program aimed at ensuring its long-term viability in a market-determined environment and will take necessary steps towards its effective implementation. BNDE's program will be furnished to the Bank by December 31, 1991, and discussed thereafter with the Bank. Each of the PCBs will prepare a report by March 31, 1992, detailing the impact of the reform program on their activities and performance. The reports of the PCBs will also be discussed with the Bank. 4.22 The eight banks participating in the proposed Project accounted for 74% and 57% of total bank deposits and loans in Morocco at the end of 1989 (Table 4.3). The two largest commercial banks, BCP and BMCE, are majority owned by public entities. The other banks are majority private-owned. These banks have been appraised by the Bank. IFC has carried out its analysis jointly with the Bank, and appraisal findings (detailed in Part II of this Report), will be shared with foreign banks participating in the commercial syndication led by IFC. The financial condition of the PBs is generally sound and they are considered to be creditworthy borrowers. Prudential ratios are closely monitored by the Central Bank. As detailed in Part II, several of the PCBs already meet the prudential ratios which will be introduced under the project. Five of the PCBs were estimated to comply with the 8% capital to risk-weighted assets ratio at the end of 1990, and another bank is expected to meet the ratio by end-1991, following a planned capital increase. For one of the PCBs (Wafa), compliance with the regulatory minimum capital ratio, is expected to require a capital increase. Wafa's management plans to take appropriate steps towards meeting the ratio by end-1992. Most of the PCBs were also estimated to comply with the single beneficiary exposure limit (7% of net equity) at the end of 1990. The three main SFIs (BNDE, CIH and CNCA), which have had longstdnding relations with the Bank, are considered sound and financially viable institutions. In consultation with the Bank, they have each adopted policy statements which include prudent financial guidelines. Accounting policies and procedures of the SFIs will be harmonized by end-1992 (para. 4.18), as a first necessary step towards the harmonization of their prudential guidelines with commercial banks. BNDE, the only SFI borrowing under the proposed operation, has recently exceeded IV The subprojects eligible for Bank financing will be those undertaken by private enterprises (or public enterprises, in the industry and tourism sectors, slated for privatization), with an internal rate of return of a least 12%, a structure of financing including at least 30% equity, and demonstrating acceptable impact on the environment.  - 22 - its single project exposure limit set at 25X of equity in its policy statement. Under the project, agreement was reached that BNDE will reduce this limit to 20X. The management of all tht banks is generally good and free to act without government interference in day-to-day operations. Their project appraisal capability is satisfactory and their performance has improved steadily under the Bank's SSI, EMI, Industrial Export Finance and Industrial Finance projects. Under the last two projects, the PBs have committed their credit allocations faster than originally anticipated. Table 4.2: THE PARTICIPATING BANKS (As of December 31, 1989) Total Moroccan BCP BNDE BO Bt mm m AM oA &ai t Deposits (DH billion) 23.2 0.2 7.1 10.0 4.3 3.9 3.8 5.4 57.9 78.4 Loans (DH billion) 7.1 3.3 4.6 6.0 3.0 2.7 3.3 3.3 33.3 58.7 Equity (DH million) 2,115 248 938 793 298 455 412 529 5784 10,093 Total Assets (DM billion) 29.1 5.7 11.6 23.1 6.5 5.9 6.9 8.3 97.1 120.56 o/ Comercial banks and SFIs Source: Bank Al-Ma8hrib 4.23 In parallel and as a complement to Bank lending, IFC will syndicate a commercial loan amounting to US$100 million equivalent for four or five of the PBs. The complementarity of IFC and IBRD funds played out fully through the process of allocating the funds. The banks that are going to be the recipients of IFC funds were chosen because of their market shares, their own institutional strategy of access to international financial markets, and interest in participating in the commercial syndication led by IFC. In the allocation of IBRD funds, the amount of financing from IFC was taken into account, and a bank that only receives IBRD funds, will receive a larger share of these funds relative to its market share (and relative to its share in past credit lines) than one that also receives IFC funds. This complementary allocation mechanism, as well as the joint appraisal of the participating banks, is possible due to the close coordination in time of the IBRD and IFC projects. 4.24 Total Demand for Investment Credit. Private industrial investments registered by the Ministry of Commerce and Industry (MCI) increased substantially in 1990, projected to trartwlate into a demand for credit of about DH 6.5 billion (about US$800 million) per year during 1991-93. According to the financing plans submitted by investors in recent credit lines, on average about 70X of the investment costs are covered by self-financing, capital increases, suppliers' credits and leasing. Medium-and long-term loans from commercial banks and BNDE account for the remaining 30% of the financing. This would translate to a demand for industrial credit of about DH 4.0 billion (US$500 million) during the two- year commitment period under the Project. About 80% of the Bank loans are expected to finance industrial investment, and the rest for tourism and other projects. The propos'd package of IBRD loans, amounting to a total of US$110 million, would thus cover about 18% of the projected demand for industrial  - 23 - investment credit during the commitment period of the Bank loans. Combined with the IFC-led parallel commercial syndication for a total of US$210 million, the project will cover about 34% of projected credit demand for industrial investment, during the 1991-93 period. It would thus represent a major contribution by the World Bank roup to support private investment in Morocco, by making Bank group intermediated capital available in a market environment and at market rates, but with maturities and volumes which could not be mobilized without its support. C. Monitorlna and Loan Administraton 1. Adjustment Component 4.25 Release of Funds and Tranching. A comprehensive macroeconomic review with particular emphasis on the 1990 outcome took place in April 1991 (for a detailed presentation of 1990 numbers, see Annex 2). As noted in Table 2.3 above, the macroeconomic indicators set for 1990 in SAL I have all been substantially met or surpassed. The proceeds of the quick-disbursing component will be made available in two tranches. The first tranche, of US$75 million, will be released upon loan effectiveness. Intensive preparatory work on the financial sector has been carried out by the Ministry of Finance and the Central Bank, in consultation with the Bank since mid-1990. As a result of this cooperation, some important measures have been implemented in late 1990 and early 1991. These measures, detailed in Annex 1, concern: (i) the removal of credit ceilings; (ii) the strengthening of the reserve requirement instrument; (iii) the reduction of the availability of automatic rediscounting at preferential rates by Bank Al-Maghrib, as well as the implementation of a unique rate on all advances at variable rates; (iv) the opening of the T-bill auction market to insurance companies and enterprises; (v) the liberation of most lending and deposit rates; (vi) the adoption of a program for the elimination of mandatory bank placements in rediscountable medium- and long-term loans and loans to the housing sector, and the implementation of the first step in such reductions; and (vii) the increase of the minimum amount of banks' equity capital to DH 100 million. 4.26 Additional policy measures have been implemented, as a condition of Board presentation. They include: (i) limitation of the eligibility for rediscountable medium-term investment loans to SSIs as defined by Bank Al-Maghrib; (ii) adoption of a program for the elimination of mandatory bank placements in Treasury bonds as well as the implementation of the first step of the program; (iii) introduction of the foreign exchange risk coverage system; and (iv) issuance of a circular by Bank Al-Maghrib providing directives to the banks for the implementation of variable deposit and lending rates.  24 - 4.27 Release of the second ranche, of US$50 million, expected in early 1992, would be predicated upon continued satisfactory overall macroeconomic performance, with particular reference to progress towards achieving the key indicators agreed with the Government and set out in Table 3.1 above. To this end, a comprehensive macroeconomic review, emphasizing the 1991 outcome and the 1992 objectives, will be undertaken in close consultation and cooperation with the INF prior to second tranche release. Satisfactory completion of this review will be a condition of tranche release. As regards the financial sector itself, the second tranche release conditions will comprise (a) satisfactory progress in terms of the Government's overall financial sector reform program as set out in the policy matrix attached to the letter of development policy; and (b) achievement of the following specific conditions laid out in the legal documents: (i) reduction in the required level of mandatory placements in Treasury bonds to 25% of sight deposits; (ii) reduction in the required level of mandatory placements in rediscountable medium- term loans and in housing loans to 2.5% of deposits each; (iii) submission to the Council of Government of the new draft Banking Law; (iv) issuance of a circular requiring domestic banks to maintain a minimum ratio of 8% between capital and risk-weighted assets and (v) total risks exposure limit on a single group of related beneficiaries set at 15% of banks' net equity. 4.28 Procurement and Disbursements. The Government will be the Borrower for the quick-disbursing component. The Ministry of Finance and Bank Al-Maghrib will be responsible for the relevant policy-related aspects of the proposed loan while Bank Al-Maghrib alone will be responsible for procurement, disbursements, and the maintenance of the loan account. Proceeds of the loan will be used to finance the full foreign exchange costs (CIF) of eligible imports, procured after International Competitive Bidding (ICB) or other procedures in accordance with Bank guidelines. Ineligible items would be set out in a negative list and would include those already financed from other sources, those intended for military or paramilitary use, and luxury items. Commodities would be procured under shopping procedures based on quotes from more than one supplier. Both public and private imports would be eligible for financing. Simplified ICB would be required for contracts of US$5 million or more, in accordance with Bank guidelines for procurement under SALs. For public sector imports of less than $5 million, local competitive bidding (LCB) procedures modified to be acceptable to the Bank would be followed. Private sector imports of less than $5 million would be procured following usual commercial practices of the purchaser which involve quotations from prospective suppliers from at least two countries. For procurement through ICB, bids, bid evaluation reports, and certified copies of contracts would be presented to the Bank prior to the submission of the first application for withdrawal of funds. For other procurement, prior to submission of the related withdrawal application, the Borrower will furnish all information and documentation that the Bank may reasonably request in respect of such procurement. The closing date of the quick disbursing loan will be December 31, 1992. 4.29 Audit. Bank Al-Maghrib would be responsible for the maintenance of all records of transactions under the loan in accordance with sound accounting practices. All accounts would be audited within six months after the end of the Borrower's fiscal year by independent auditors acceptable to the Bank. Certified  - 25 - copies of the audit would be submitted to the Bank and would include a separate opinion with regard to claims submitted to the Bank on the basis of Statements of Expenditures (SOEs). 2. Une sf Credit Component 4.30 IM21emengation. Bank loans are expected to be committed on a two- year period. The final date for submission of investment sub-projects to the Bank will be December 31, 1993. Ex ante reviews by the Bank will be required for sub-projects with sub-loan proposals above the free-limit of US$2 million. Sub-loans under the free-lmit 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. A suspension remedy under the lines of credit in the event the reform program is not carried out, is provided for. 4.31 Procurement and disbursements. Procurement and disbursements will follow the guidelines normally applied to financial intermediation loans. These guidelines are detailed in Part II of the report. Most loans to the PBs urnder the Industrial Finance Project were fully committed by June 30, 1990 and are being disbursed at a faster pace than anticipated. Since the PBs have been participating in several previous Bank projects and have consistently applied sound project selection criteria, in order to avoid delays in implementing sub- projects, retroactive financing will be allowed up to an aggregate amount representing 10 of each line of credit for payments made since September 30, 1990. The closing date of the loans will be December 31, 1997. 4.32 Audit. The financial intermediaries participating in the project will have their financial statements audited by independent auditors acceptable to the Bank. In addition, each PB will maintain separate as well as consolidated accounts on the use of its Bank loan. These accounts and the statements of expenditures (SOEs) will also be audited. The PBs will submit annually to the Bank, the reports of these auditors within the six months following the end of each fiscal year. V.