Moldova - Structural Adjustment Loan

Z _IV dS/S - 14'1) Do_mmt of The World Bank FO M o CaL USE ONlY Rbpt No. P-6444-MD REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED STRUCTURAL ADJUSTHMENT LOAN IN AN AMOUNT EQUIVALENT TO US$60 MILLION TO THE REPUBLIC OF MOLDOVA NOVEMBER 15, 1994 Thi document has a rstricted distibution and may be ued by reipients only in the performance of their official duties. Its contents way not odtwise be disclosed without World Bank authorization.  CURRENCY EOUIVALENTS (November 1994) US$ 1.00 = Lei 4.3 FISCAL YEAR January 1 - December 31 METRIC EOUIVALENTS 1 meter (m) = 3.28 feet 1 square meter (sq.m) = 10.76 square feet 1 Idlometer (Ian) = 0.62 miles 1 square kilometer (sq.km) = 0.386 square miles ABBREVIATIONS AND ACRONYMS CCFF Contingency and Compensatory Fmancing Facilitv CIFCE Chisinau Interbank Foreign Currency Exchange CIS Commonwealth of Independent State CPAR Country Procurement Assessment Review FSU Former Soviet Union EU European Union GDP Gross Domestic Product ICB International Competitive Bidding NFN Most Favored Nation NBN National Bank of Moldova NMP Net Material Product PSD Private Sector Development STF Systemic Transformation Facility USAJI) United States Agency for International Developmeat  FOR OFFICIAL USE ONLY REPUBLIC OF MOLDOVA STRUCTURAL ADJUSTMENT LOAN Loan Summary Borrower: Republic of Moldova Amount: US$60 nillion Terms: Payable over 20 years, including 5 years of grace, at standard variable interest rate Objectives and Description: T'he proposed two-tranched loan would provide fast-disbursing balance of payments assistance for the Government in the implementation of its structural adjustment program. Disbursements would be designed so as to provide non-inflationary budget fnacing. The program supported by the Loan comprises a set of key measures needed to induce a quick response in the real economy to macroeconomic tightening and sharp relative price movements. The program is thus designed to produce the reallocation of resources needed to promote a recovery in sustainable export-led growth, while providing for the most vulnerable groups. The main foci of the program are: privatization; hardening the budget constraint on enterprises; creating a competitive environment; and better targeting of social benefits within fiscal constraints. The programn supported by the loan is also intended as a catalyst for balance of payments support and provision of technical assistance by other donors. Such support would be sought in the framework of a Consultative Group meeting on Moldova. Poverty cateaory: Poverty-focused. The loan would support improved targeting of the social safety net through a reorientation of public expenditures towards minimum benefits for pensioners and other beneficiaries without other income from employment; a freeze on earnings-related and mmnimum- wage related benefit entitlements; and Government provision of severance pay and unemployment benefit for unemployed workers in bankrupt or liquidated enterprises. Benefits: The proposed operation would support the development of a competitive private market-based economy that promotes the efficient allocation of resources for economic growth and improvement in living standards. Such a response is essential in order to reverse the output decline and induce structural change. TMis document has a rbcted distniton and may be ucd by recipients *y in the d atbot offi duies. Its contens may not otheise be disclosed wiot World Book autboriatoiL  The main risks attached to the program are (i) potenztial divisions within the Government and Parliament on the speed and depth of politically sensitive reforms (the Government has a track record on reform and now also has a majority in the Parliament; however, the deepening of the refonn process may revive this risk); (ii) the disjunction jetween progress on stabilization and the delay in the restoration of growth (this risk wil be addressed through the loan program); (iii) capacity within the admiistion may not be reinforced quickly enough to petmit timdly implementation of the program (technical assistance is being mobilized agaimst this risk); (iv) sufficient balance of payments support may not be forthcoming to sustain the program, forcing a lower level of imnwjrts, aggravating the fall in output and living standards, and risking a return to inflation (further assistance will be sought from the international community to reduce this risk); and (v) continued protectonism especially in Western Europe and/or delayed recovery in the rest of the FSU could constrain Moldova's export-led recovery and the restoration of its creditworthiness. This report is based on the findigs of preparation and apprsal mimions which visited Moldova between April and Setembr 1994, comprising Messrs./Mmes. Helen Sutch (senior country economist, mision leader), Gregory Jedrzejczak (PSD specit), Staney Johnson (consultant agricultural specialist), Vladimir Kreacic (senior enteprise reform specialist), Deborah Mabbett (social sector and labor market consultant), Jo Ann Paulson (senior financial economist), Onno Ruhl (coury officer), Theodor Stolojan prvoizaton specialist), and Jonathan Walters (country economist). Brian Beman Csaba Csald and Philip Golkman provided support in Washingon and participated in negotiations. Tamara Kanteman provided secretarui support. Documents were reviewed by Alan Gelb and Shahid Yusuf. Basil Kavalsky and Wafik Grais are, respectively, the Director of dte Country Deparm, and Division Cbief of the Country Operations Division, responsible for Moldova in the Europe and Central Asia region.  MEMORANDUM AND RECOM[MENDATION OF THE PRESIDENT OF THE IBRD TO THE EXECUTVE DIRECTORS ON A PROPOSED S7?2UCTURAL ADJUSTMENT LOAN TO THE REPUBLIC OF MOLDOVA TABLE OF CONTENTS PART I. COUNTRY CONTEXT AND POLICIES ........................... I I. THE RECENT PAST AND PROSPECTS FOR THE FUTURE . . A. Background: A Fledgling New Order .I B. Stabilization: Successful but Fragile .3 C. Experience with Structural Adjustment. 4 D. The Road Ahead .5 E. External Financing, Debt and Creditwonhiness. 7 II. HOW TO ACHIEVE ECONOMIC GROWTH BASED ON THE MARKET ... 8 A. Strengfhening the Macroeconomic Framework .................... 8 B. Ownership Change .......... ........................... 8 C. Hardening the Budget Constraint ............................. 10 D. Creaing a Competitive Environment ......................... 14 E. Providing Social Protection within Fiscal Constraints ...... I ......... 16 F. Achieving a Supply Response: Complementary Measures .... ......... 18 PART II. BANK STRATEGY AND THE PROPOSED STRUCTURAL ADJUSTMENT LOAN .......................... .................... 18 A. Support from the World Bank, IME, and Other Agencies: the Record So Far . ........................................... 18 B. Bank Strategy ............ ............................ 19 C. Program Implementation and Proposed Tranche Conditions .... ........ 20 D. The Financing Package .................................. 23 E. Benefits and Risks .......... ........................... 25 PART M. RECOMMdENDATION .26 Amnex I Table 1: Key Economic Indicators Table 2: Key Exposure Indicators Table 3: Balance of Payments Annex 2 Leter of Development Policy Annex 3 Policy Matrix  MEMORANDUM AND RECOMMENDATION OF T3E PRESIDENr OF THE IBRD TO THE EXECUMVE DIRECTORS ON A PROPOSED STRUCTURAL ADJUSTMENT LOAN TO THE REPUBLIC OF MOLDOVA 1. I submit for your approval the following memorandum and recommendation on a proposed loan to the Republic of Moldova for the equivalent of US $60 million to provide support for the Government's Structural Adjustment Program. The loan would be at the Bank's standrd variable interest rate, with a maturity of 20 years including a grace period of five years. Co-financing or parallel financing for quick-disbursing balance of payments assistance is being sought, and financing for technical assistance to support a number of measures in the Goverunent's reform program has been obtained or is being sought from various donors. 2. The Republic of Moldova joined the IBRD on August 12, 1992, MIGA on June 9, 1993, and IDA on June 14, 1994. It is in the process of joining IFC. The country's per capita GNP is estimated at $1,180 in 1993, placing it in Operational Category II. 3. Moldova is at a critical point in its adjustment. Now that inflation has been sharply reduced and the exchange rate is stable, the country needs to ensure that available resources are channelled to the highest yielding activities in order to support a sustainable recovery of output. Only rapid and determined implementation of structural reforms will permit such an outcome and avoid furiher declines in incomes as well as the unraveling of the stabilization obtained at high cost. Support for a large advance in structural reforms is the objective of the Strucural Adjustment Loan (SAL). PART }. COUNTRY CONTEXT AND POLICIES i. T1E RECENT PAST AND PROSPECTS FOR THE FUTURE A. Backgrowmd: A Fledging New Order 4. A recently indeendent country. Moldova is a landlocked country situated between Romania and Ukraine. It became independent on August 27, 1991, as the Soviet Union disintegrated. With a population of 4.3 million and a land area of 33,700 square kilometers, Moldova is the most densely populated country of the former Soviet Union. 5. Progress in achievina political identit and stability. The path to Independence unleashed intense conflict in which ethnic factors combined with differences in approach to economic reform and restucturing. The armed conflict, which ended in a cease fire in July 1992, resulted in the de j.do partition of the country, with the Transnistria region remaining under separate control. Negotiations are taking place with the aim of finding a constittional soludon. A new Government took charge after Parliamentary elections in February 1994. The parliament adopted a new constitution on Juty 27, 1994, which establishes a framework for recognizing differences and provides democratic mechanisms for resolving conflicts. Lately an initial agreement was reached with Russia on the witdrawal of its 14th Army over a three-year period. These developments combine to reduce the risk of renewed conflict over the status of Transnistria.  2 6. Since the breakup of the former Soviet Union (FSU), Moldova has found itself on shifting ground as it tries to find a new basis for its links with FSU countries while aeso seeling to expand relations with countries to the west. In a referendum in March 1994, the population decisively affirmed the country's independence, thereby rejecting the option of unification with Romania. In April 1994, the Parliament confirmed Moldova's membership of the CIS, allowing it to enter the CIS free trade area. The country also shares a free trade area with Romania. 7. An innmorenndent. ener'v-intensive economy. 1a egy mrrallv based. In the USSR economy, Moldova was a producer of raw and processed foodstuffs (primarily grapes, grains, wines, fruit, vegetables and livestock). The coutry derives its comparative advantage from the fertile soil and temperate climate. Agrculture accounted for about 40 percent of Net Material Product (NMP); agro-industry contributed approximately half of the almost 40 percent of NMP accounted for by the industria sector, along with household appliances and high-technology electrical goods (in part, for the defense industry, where production has now virtually ceased). The economy was designed to be highly interdependent with other FSU countries, and trade contiues to be a significant proportion of GDP (see Annex 1 Tables). In particular, Moldova is 99 percent dependent on imports for primary energy resources. Characteristic of the FSU, the economy is extremely energy-intensive. The ratio of dollar GDP to kilograms of oil equivalent used is 0.8, similar to that in Russia and Belarus (both 0.7), but much lower than that in Germany (5.5). 8. Severe external shocks. As a result of the price hlbrization which accompanied the breakup of the FSU and exposue to world prices, Moldova experienced a large terms of trade shock accoundng for 30 percent of GDP in 1992 prices. Its economy was also hit by the disruption in payments and declining trade within the FSU. In addition, Moldova was afflicted by severe drought in 1992. In 1994, the sharp decline in FSU aggregate demand has brought almost 70 percent of industry to a standstill, while another severe drought, followed by hurricas and floods, inflicted significant losses of crops, herds, and infrastructure, compounding Moldova's economic problems. Inital estimates of losses amount to $345 million, close to the esmated level of total current public expenditure in 1994 of $374 million. 9. Wrenchinj economic co on. The cumulative decline in GDP since 1990 is over 60 percent. Living standards have fallen sharply, with a fal in real average wages of 53 percent between December 1992 and Janay 1994, and further declines since then. The fall in output has not been reflected in significant open unemployment, but the use of forced vacations is widespread, and wage arrears for tme actually worked are estmated at around one-third of wages due for the economy as a whole; wage arrears are much higher in agriculure. 10. A ratid macroeconomic stabiliatio. Prices rose on average 1276 percent in 1992, and in 1993 iftion averaged about 21 percent a month, surging from mid-year umil the new currency, the leu, was introduced in November, 1993. Year on year, infation in 1993 was 788 percent. Since the introduction of the new currency and the introduction of the stabilizaion program, monetary and fiscal policy are being tghtened (as descnrbed in paragraphs 12-16 below). Inflation has declined sharply to monthly rates of under 2 perent, and the fiscal deficit has been narrowed to 8 percent of GDP for the first part of 1994. 11. Slweguchanges. Adjustment in the real economy is occurring at a slower pace. than stabilization. There are an increasing number of small private firms as well as some large exportng ao-enrprs with foreign parters. SOEs predomiate, however, and continue to claim the larger  3 share of credit and other resources, crowding out the nascent private sector. The Government now realizes that the effects of tighter credit, high real interest rates and sharply increased energy prices have been diluted by widespread rollover of non-performing loans, capitalization of interest, and an expansion of arrears. Reallocation of resources in response to macroeconomic tightening and relative prce movements has therefore been muted. The result is coninuing output decline and little structual change. B. StabiLzation: Successful but Fragile 12. Since late 1993, Moldova has been following a tight monetary policy supn-rted by an STF and a Stand-by arrangement. The Fund program includes market allocation of credit, subsial declines in the rate of expansion in base money and in net domestic assets, and strict ceilings on credit to Government from the NBM and the banking system. Monthly rates of inflation are targeted to fall below 3 percent by December 1994. The overall fiscal deficit was programmed to decline from over 23 percent of GDP in 1992 to 3.7 percent of GDP in 1994. The program allows for an increase in government expenditure on the social sectors, but requires large savings in subsidies, together with increases in tax revenue, derived from removal of tax exemptions and better compliance. 13. Iflation has fallen even faster than targeted, from a monthly average of 20.5 percent in 1993 to 2.2 percent in the three months from May to July 1994, and zero in August. In response, nominal average interest rates set at refiancing auctions have decreased from a peak of 377 percent in March to 79 percent in July (monthly rate 6.6 percent). The real credit crunch is severe and inte rates have been high in real terms for nine months. Short-term lending predominates. 14. Fiscal tightening reinforced monetary firmess during 1993 and early 1994. Budget transfers to enterprises were cut to about 1 percent of public expendiure in 1993, and the largest subsidies, on bread and nilk prices, were eliminated in May 1994. Capital expendtu was reduced to 3 percent of GDP. Education and health expenditures are the largest remaining items in the budget at 6 percet and 3.8 percent respectively of GDP. The authorities have introduced new taxes (see paragraph 19), removed some exemptions, and extended the scope of excise taxes. However, exemptions from the VAT and profits tax remain a source of distortions and revenue foregone, especially in the agricultural sector. 15. Fiscal firmness is proving hard to sustain. Public sector wage arrears have emerged, together with arrears on payments for fuel. At the same time, the fiscal stance is thetened by increasing tax arrears (reaching 150 m lei by March 1994), delayed payments by enterprises to the budget for extrnally-financed imports, and the transfer to the budget account of overdue government-guarateed loans to SOEs. In addition, enterprises are shifting to barter deals, whih undennines tax payments and debt servicing. Recorded GDP is lower than projected. Most recently, the need to replace housing and repair roads and other infastuctu destroyed by the senes of naural disasters has added subsntially to claims on the budget. These factors indicate that the budget deficit is likely to reach 6.8 percent of GDP in 1994. Slow commitment by donors of pledged external finmcing designed to provide budget support has worsened these already substantial fiscal pressures. 16. The Government is now under pressure to lend from the budget for seasonal agricultual finmce, as banks, affected by tight credit ceilings, non-performing loans, and shrinking use of dte banig system by enterprises, will not extend furher credit for these purposes. The xistig  4 inefficient allocation of credit and productive resources - in both banks and enterprises - is now directly threatening the stabilization program. C. Expemience with Stuctrl Adjustment 17. Parliament adopted the concept and main principles of transition to a market economy in successive sessions during 1990 and 1991. Since then, the Government has set out its objectives and strategy for comprehensive econonuc reform in documents presented to Parliament each year and. since late 1992, has made considerable progress in creating the conditions for structural change. Under the program supported by the Bank's Rehabilitation Loan, the Government removed all export taxes and almost all quantitative restrictions on exports', introduced a new import tariff, eliminated direct price controls with few exceptions', and raised margin controls. A new currency, the leu, was introduced in November 1993 and the exchange rate is freely determined at regular inter-bank auctions held by the Chisinau Interbank Foreign Currency Exchange (CIFCE). The autonomy of the National Bank of Moldova (NBM) has been strengthened; the authorities have tightened banking laws and prudential regulations, and are starting on a program of institutional development for the NBM and the commercial banks. 18. Since 1992 a series of laws has been passed, including laws on collateral and bankruptcy, putting in place the legal framework for business. The bankruptcy law has been invoked to deal with over 40 bankrupt private enterprises. In March 1994, the President issued a decree permitting SOEs to dispose of surplus assets in the market, helping the emergence of new businesses. State orders have diminished in importance and are now largely confined to counterpart trade for energy imports from Russia. During 1993 and 1994, the Goverment has moved to eliminate regulations circumscribing labor market flexibility and private sector wage determnation. Privaization of agriculture started in 1992, with distribution of individual plots and the gradual conversion of large State and collective farms into joint stock and other corporate forms. A small but growing number of individuals are leaving these companies, taking their shares in the form of land, and seting up as private farmers. 19. The stucture of taxation was reformed in successive moves during 1992. Progressive rates of personal and corporate income tax were introduced; VAT (now at a basic rate of 20 percent) replaced the turnover tax, and the payroll tax rate on agricultural enterprises was raised and unified (at 38 percent) with the rate in the rest of the economy. Excise taxes were introduced on a wide range of both imported and domestic products3. Prices for energy have been adjusted upwards substialy for most consumer groups and will be adjusted further to reflect the higher cost of imported energy products. jResriczions still remain on exports of grain, leather, and energy products. Z,The exceptons are public tansport tar, charges for communal services, housing rents, and the Ste procurement price for grain. I/Pesona income tax rates range from 10 to 70 percent, with the bulk of axpayers in the lower part of the range (10-20 pent). Ihe top raze of corporate incom tax is 32 percen. Excise taxes range from 10 to 80 percent on ad valoem basis.  5 20. The authorities have enhanced the environment for private sector development through the improvements noted above in the trade and price regime and regulatory framework. Progress has been less imnptessive in some other aspects of the program. Privatization of small scale businesses began in October 1993, but the program was initially subject to delay for both political and technical reasons, and measures to strengthen public enterprise governance are also lagging. The Government has made efforts towards better targeting of social protection, but further work is needed to restructure the social safety net within existing fiscal liniits. Despite the NBM's leadership in reforn, the commercW banks are slow to adjust, and existing credit allocations to traditional clients have shown litde change. 21. On the other hand, there has been substantial progress in hardening the budget constraint on enterprises, with extremely tight conditions for new credit and the withdrawal of almost all government subsidies to enterprises. However, with the success of the stabilization efforts, pressures broke out through other channels. Financial constraints on enterprises were relieved through loan rollover and capitalization of interest owed, through an outgrowth of arrears - to suppliers, employees, banks, and the budget - and through default on government guaranteed loans. Political pressures exerted by enterprises for trade protection also resulted in the imposition of excessive import tariffs on sensitive products including wine and carpets. The combination of evasion of the hard budget constraint and slow ownership change has tended to perpetuate past pattems of resource allocation and output, with the result that change in the real economy is as yet limited. 22. Some of the delays in program implementation can be ascribed to the suspension of normal government business during the election campaign leading up to the Parliamentary elections on February 27, 1994, and the subsequent formation of the new Govermnent; and to the emergence of opposition to reform from vested interests. Since it took office, however, the Govermment has demonstrated renewed commitment to the program, with the establishment of the Republican Commission to put more teeth into enterprise financial discipline and of a new Ministry of Privatization and State Property, responsible for acceleration of the privatization program. The Government has also decided to eliminate margin controls, adopt a timetable for reducing the maximum import tariff to 20 percent by end-November 1995, and submit legislation to Parliament for a phased increase of the retirement age. D. Mh Road Ahead 23. The path of reform so far has been difficult, especially in the face of a series of natural disasters, the tension over the status of Transnistria, and the growing impoverishment of the population. The notable stabilization success is fragile in the absence of quick movement in the real economy. Realizing this, the Government has elaborated a program for the next stage of reform that is focused on the policies needed to spur movement in the real economy. This program is described in Part I. 24. The authorities realize that decisiveness and determination will be needed in the adoption of critical measures to accelerate privatization of the economy, harden the budget constaint on enterprises, create a cormpetitive environment, and ensure minimum protection for those who suffer in the process. The growth and adjustment path projected in the following is based on the implementaion of this program. Certainly the path projected can unfold only under these conditions, which are also the ones the Strctural Adjustment Loan would support.  6 25. Condnuing progress with export and price V" zralization is already enabling a recovery in exps from their depressed levels in 1992 and 1J93. Strong export growth to both FSU and non- FSU markets was emerging in 1994 before the natural disasters struck. The export pull should conte, responding to trade liberalization, enterprise restructuring, de-monopolization in agriculture, and the elimination of restrictions on private market activity. Foreign investment has already taken place in the wine and fruit concentrate industries and further foreign investment is expected, helping ivesuntet to revive and production become better attuned to market demand. Under these conditions, GDP would start to grow by 1995, arresting the decline in private consumption during 1996. In the absen of external shocks or of policy reversal, GDP growth would rise gradually thereafter. Real output would recover its 1991 level only by the end of the decade, however. 26. Growth in production and exports should come from small dynmic private firms (both new starts and privatized entities), together with large enterprises responding to the new environment in both agricultwe and industry. This response has already started, to a large extent through joint venures wih Russian. and Westem European partners. A larger penetration of Moldova's ex'ons in CIS markets can be expected with better product quality, increased marketing efforts and improved relations with the CIS countries. In parallel, the shift in the composition and direction of trade towards non-CIS markets is likely to continue (exports to the non-FSU had already reached 39 percent of total exports in 1993). However, this redirection of trade could over time be constrained by proom, particularly in the large Western European market. MOOVA - Main Ma bundcta (in percent) 1994 1995 1997 20_0 2002 GDP Growth Rate -6.0 0.5 3.5 5.5 6.0 Exports (GNFS) Growth Rae 5.0 4.8 6.1 6.4 6.5 Impotts (GNFS) Growth Rate 4.0 1.0 3.1 3.9 4.2 wnvesotUtIGOP 8.7 11.0 15.0 18.0 18.0 SavwgIGDP -6.7 -3.1 3.5 10.4 12.4 RPcal DeflOcGDP -6.8 .4.6 .0.3 -1.0 40.8 Resource 8alanco/GDP .16.4 -14.1 -11.5 -7.6 -5.6 27. Ihe coing pass-through to domestic users of world energ prces and the enforcement of budt constraint on them wil promote a reduction over tme in the energy ntesity of the economy. Firms would undertake new investments that embody greater energy efficiency while the product m would shift away from energy-intensive products. A reduction in the share of energy prodt in total imports would follow, leaving room for capital goods imports. These trends would induce a reducdon in the share of imports to GDP while the export to GDP ratio rises, trmslating into a steady narrowing of the trade deficit.  7 28. The financing of investments will require a sustained increase in domestic savins; initially from a reduction of the public sector cuarent deficit, but later from the effort of the private sector. responding to price stability, finacial sector reform, and the expanded opportunities for private sector investment. In addition, the economy will have to cominue to rely on external savings to complement the domestic effort, in the form of a rising flow of foreign direct investment as well as balance of payments assistance. External financing for investment is needed to orient production in response to market demand and spur efficiency improvemens, which will require energy-efficient investment in all sectors. A small number of large food-processing plants are equipped to Westem standards, but most of the machinery and equipment in agriculture and industiy is obsolete (and, in agricllture, ill- adapted to the growing Tnber of smaller-sized farms). These add up to significant investment requirements. E. Extena Fnancing, Debt and Creditworhness 29. As noted above, there is a pressing need for extern finae for balance of payments support as well as for investment purposes. Moldova's dependence on imports, and especially imported energy, combined with the massive terms of trade shock, mean that production is likely to fal furither unless financing is available to sustain imports in the near term while adjustmnm takes place. This need is particularly glarng in the energy sector, where the country has large arrears. 30. Burden-sharing is an issue. The World Bank and the IMP, together with Russia, have supplied the bulk of exernal assistance to date. Bilateral assistance has also been etended by the United States, Japan, China, the Netherlands and Romania, and will soon be forthcoming from the European Union. The Bank plans to convene a Consultative Group in early 1995 with the aim of mobilizing contining and broader support. 31. Moldova agreed to the zero option with the Russian Federation so has no responsibility for the external debt of the FSU. Debt to Russia incldes consolidated debt of $89 m plus a further loan of 50 billion rubles, and arrears in mid-June to Russian energy suppliers of over 800 m lei (including exchange losses). There is $78 m of other bilateral debt, and $86 m in IBRD loans; and there will be debt of $150 m to the IMF when the Stand-by is fully disbursed. Bilateral financing from the United States, China, the Netherlands and Romania is in grant form or is concessional, but Moldova faces market rates on credits from the EU, Japan and Russia. 32. Moldova's deficit on current account can be expected to narrow from 15.4 percent of GDP in 1994 to around 7 percent in 2005; and the ratio of debt service to exports would begin falling in 2005, havig risen to around 20 percent by the end of the decade and nearly 30 percen in 2004. The IBRD's share of total debt service declines after 2003. Debt to GDP would fall from a peak of 67.5 percent in the year 2002, and then decline steadily. While these indicators remain below those for middle income coutries as a whole, they are high for the FSU in general, and paricularly given the low startng point. They raise serious questions for the long term and suggest at least a portion of future official assistance to Moldova should contme to be on concessional terms.  8 II. HOW TO ACHEVE ECONOMIC GROWTH BASED ON THE MARKET A. S heg the Macroeconomic Framework 33. To achieve sustainable growth based on the market, the authorities recognize that the first requiremnent is a sound macroeconomic framework in which clear signals are provided to economic agents. The objective for mnacroeconomic policy is to attain a level of absorption in the domestic economy and real exports that will'be consistent with sustainable domestic and foreign balances. Monetary, fiscal and exchange rate policy will need to be hamessed to this end. Then, to ensure the econcany adjusts to this framework, a mutually reinforcing set of structural measures is needed to achieve ownership change, harden the budget constrain. on enterprises, create a competitive environment, and improve the targeting of social protection within fiscal constraints, as set out in Sections B to E below. 34. fIMoty. pg1jW. In late 1993, the authorities introduced policies for macroeconornic stabilization (supported by an IMF program, as described in paragraphs 12-13) that have forced a sharp drop in inflation and produced stability in the exchange rate. They are cormmitted to continuing these policies so as to create conditions for non-inflationary growth. Further measures required to nake the progress achieved so far sustainable, and allow real interest rates to fall from their present higt levels, will include restraints on the informal growth of credit that is now occurring through arrears and accumulating interest on bad loans. These practices mean that demand for credit is inflated by demand from clients who do not expect to repay. As credit supply is strictly limited under the stabilization program, this inflated demand pushes interest rates higher than they would otherwise be if payment discipline were imposed. Viable firms that intend to repay are penalized in these conditions. Measures to restrain these practices, thus assisting a market-based fall in nominal interest rata, are addressed in Section C (paragraphs 43-60) on hardening the budget constraint on enterprises and developing the strategy for the banking sector. 35. Strengthening fiscal policy. At the same time, the Govermnent intends to enforce fiscal discipline in a sustainable way, recognizing that too much reliance is currently being placed on payment arrears to achieve cash deficit targets. However, overall, arrears to the budget exceed arrears from the budget, (although they do not necessarily involve the same enterprises) so the cash deficit could be lowered furdter if arrears in both directions were fully paid. Their inmmediate priority is to improve collection of taxes and other enterprise arrears to the budget, in order to protect deficit reduction gains and allow credit to Government to remain within ceiling. Without such measures, credit to Government is soon likely to exceed the limits consistent with stabilization objectives. To this end, the Government has imposed severe penalties on late tax payments, and is seeking external assistance to re-orient the tax administration from a centralized to a decentralized private economy and to raise capacity for tax registration, collection and audit. Other measures currently underway include the introduction of a Treasury function and a public investment program, which will permit improved expenditure programming and control. D. Ownership Change 36. As part of the development of a dynamic private sector, the Government's objective is to transfer ftom public to private ownership the great nmjority of State-owned enterprises (SOEs). The main elements of the strategy are to:  9 o implement the 1993/1994pnavaouonprogrwn as fast as techicaily possible; o define, adopt and implement a new priatizaon pnrgram for 1995/1996. Privatization - bckround and methods 37. The Parliament approved the Privadzation Law in July 1991, but implementation was delayed by the outbreak of conflict over the status of Transnstria and continuing debate on methods of privatization. The approach finally chosen was mass privatization through patrimonial bonds (vouchers) using a national computerized system, with cash sales limited to a small nber of construction sites and a very few enterprises. This reflected the wish that only Moldovan citizens should participate directly in the program and the fear that purchasers holding rubles from outside the country would outbid nationals if cash sales were permited. 38. The patrimonial bonds are non-tradeable. The nominal value of the bond varies according to the number of years worked, together with a base amount equivalent to five work-years assigned to all Moldovan citizens including children. Employees have the right to use their bonds to buy up to 20 percent of the enterprises they work in, and suppliers to agro-processing enterprises are entitled to 50 percent of the stock of these enterprises free. These arrangements reflect the political balance in Moldova between the agricultural and industral lobbies. Overal, the privatization methods chosen lead to wide diffusion of ownership of individual enterprises. Recognizing that post-privatzation share-trading after the initial round of privatization will be crucial if efficiency gains are to be realized, the Govermment has ensured that shares are ttadeable; it has also passed the necessary legislation to enable the establishment of private financial intenediaries such as Investment Funds, Trust Companies and citizens' associations, which are al in the early stages of creation. An independent Stock Exchange is being set up to facilitate post-privatiaon share trading, and the authorities are also establishing the equivalent of a Sewcides Exchange Commission. 39. The original 1993/94 Privatization Program covered 955 enterprises and 500 smaU-scale firms (shops, coffee houses). They represent the majority of Stateowned firms, though only about 35 percent of the total value of State assets including hospitals, schools, and railways. The list of enterprises for privatization under this program is now being updated as it includes enterprises in Transistia controlled by the authorities there and enterprises whicb have closed or disappeared through mergers and acquisitions since the list was compilod. Acceleration of drivatzatioL 40. The implementation of the 1993/94 Privatization Program was initially very slow, and came to a virua stop as elections approached and the agencies involved becme highly politicized. However, the Govenunent elected in Febnrary 1994 set up a new Ministty of Privatization and State Property Administration over the previously waring agencies, streamlined the regulatory framework, and mobilized broader support to prepare enterprises for privatization by using other Ministries and the private sector. Enterprises are also being required to prepare their own pdvatization plans. In mid-1994, the national auction system was tested through pilot auctions and is now working well, with an increasing number of enteprises being privatized each month. 41. Completion of the 1993/94 Privadzation alm. No technical obstacles now remain and the Government is making a determined effort to complete in sbstane the 1993194 Pdivatization  1(1 Program by the end of 1994. Voucher auctions were held for over 154 large enterprises and around 70 small-scale enterprises were auctioned by end-October. The Government is seeking to raise the numbers of enterprises prepared and auctioned every month. While it will not be possible to meet the original target of completion of privatization of 500 small-scale and approximately 600 remaining mediun-to-large enterprises by end-Decenber, 1994, the remainder will be announced in December for susbsequent auction at a specified date. This will represent a significant transformation of the ownership structure of the economy and will create a large private sector. 42. The new grivatization strategy and 1995/96 Drogram, A new privatization strategy will be incorporated in the 1995/96 Privatization Program to be submitted to Parliament in November 1994, which will cover the remaining SOEs slated for privatization. The Government realizes that mass privatization of larger enterprises by patrimonial bonds does not, in the short run, produce the concentration of ownersip, new management. or new capital necesary for efficiency improvements. Oppornunities for strategic investors can occur only in second and following rounds of share trading. Hence, to improve efficiency, the new strategy will provide for cash auctions and negotiated direct sales to domestic and foreign core investors. To prevent delay and de-capitalization of enterprises which remain in the public portfolio and cannot be sold by other methods, the new program will contain an updated mass privatization component using indexed savings. In recognition of the large number of financiaUy troubled enterprises and those which have already shut down, the program will also provide for asset spin-off, liquidations, and sales of assets at open auctions. (Such actions are already occurring in parallel under the enterprise financial discipline component but were not previously envisaged under the privatization progran). C. Hardeing the Budget Constraint 43. The authorities recognize that it is essential to harden the budget constraint on enterprises if the incentives created by liberalized prices and ownership change are to be effective in producing changes in economic behavior. Efforts to corporatize SOEs and introduce improved corporate governance mechanisms are under way but are slow to implement; productive results from this process are even slower. These efforts will continue, and should yield in the medium-term a more efficient allocation of resources and more market-oriented composition of prodehction. But tougher payments discipline is needed immediately if enterprises, whether public or private, are to be constrained to respond to market signals now, forcing the switch in resources needed to underpin stabilization efforts and permit growth to emerge. 44. Using a multi-pronged approach to strengthen financial discipline throughout the economy and induce enterprise adjustment to market conditions, the Government plans to: o strengthenfiscal disdpline especially through withdrawal of subsidies, improved tax collection, and recovery of debts to the budget; o strengthen credior and payments discpline through a range of instruments including use of the collateral law and bankruptcy laws; o send a strong signal by liquidatng a number of enterprises that have no fiture and in less extreme cases force managerial and financial restructuring including spinning off assets;  11 o strengthen baiing discipline within the context of a strategy to improve bank safety and develop a modern banking sector. 45. StrenFthening fiscal discipline. As noted in paragraph 35, the Governent plans to impose fiscal discipline. The Ministry of Finance is playing the primary role. The largest budget leakages occur through tax arrears, where broadly based taxes have declined even more than GDP; through overdue Government guaranteed loans falling on the budget account; and through late payments by SOEs for goods received under official external financing. The Ministry has aready collected a large proportion of the money on overdue loans assumed by the budget, and the issue of fiurther Governnent guarantees has now been severely restricted to a small number of loans where collateral is not available. Efforts are also being made to collect payments for extemally fimanced imports, but some will have to be written off. The Government has received technical advice on strengthening the tax administration and resrwctig it to match the emerging private and decentralized economy, but the task will be difficult and time-consuming. In the meantime, the authorities are trying to improve collections by removing tax exemptions. 46. StrenSILeninn creditor discipline. The Governnent will clrify and publicize existing legal rights of all creditors. These rights include the ability to start bankruptcy procedures, enforce collateral agreements on all economic agents including SOEs, and negotiate debt settlements. The Government will also enhance court capacity to enable more active use of the collateral, bankruptcy and liquidation laws. To reduce the high costs of enforcing payments discipline, the Government will review the high fees charged for registering collateral, initiating bankruptcy proceedings, and other financial procedures. 47. These measures follow on from a nationwide exercise to net enterprise arrears and enforce SOE payments discipline that took place in early 1994, steered by a Republican Commission set up for the purpose. As a result of this exercise, the authorities now have a database on the composition of arrears and the worst net debtors and will maintain it on a regular basis. The enterprises in arrears have been screened to identify the worst loss-makers. The Govermment refised pressure to clear the remaining net debt with an infusion of new credit; instead, it is dealing with the worst cases (see paragraphs 49-53 below) and is considering inroduction of a scheme to securitize inter-enterprise debt and allow a secondary market to develop. The Government is also playing a role in payments discipline t1rough the Ministry of Finance. The budget as creditor will continue to pursue its claims on ente-,nse debtors for tax arrears and for goods procured under externally financed loans. 48. Enterprise arrears to energy utilities are large and consequently the f&iancial situation of these utilities is a major concern. In addition to continuing the policy of adjusting the energy tariffs to reflect the increased price of imported energy, mechanisms have been introduced for dealing with these arrears and to improve payment discipline on new bills. These mechanisms include cutting services to non-paying customers and imposition of fines at or above commercial interest rates. A number of enterprises have already been cut off and pre-payment is being demanded for new supplies. 49. Sending a strong signal. Although many enterprises are technically bankrupt they continue to survive through sharing wage cuts and compulsory vacations among workers, not paying taxes or debts, and accmlaing arears to other enterprises or udlities. Thus the skills, machinery and fixed assets remain tied up in these unproductive enterprises and are not made available for new, more efficient uses. In order to deal with this problem, formal legal mechanisms will be used to close entprises and auction their assets. Severance pay will be financed by the Employment Fund in cases  12 where bankrupt enterprises cannot cover their obligations to workers (see also paragraph 74: promoting labor market adjustment). In less extreme cases, productive ownership change in SOEs is to be achieved by rationalizing businesses and selling off assets and accumulated stocks. In effect, these other methods will occur in parallel with privatization through the patrimonial bond program, getting assets into the market quickly in cases where it would not be possible to sell the enterprise to the population as a viable going concern. 50. In the near term, with market mechanisms for creditor discipline as yet untested, the Government has decided to signal the tightening of financial discipline by administrative means. It initiated in November 1994 the liquidation of the worst five loss-making SOEs identified during the recent arrears-netting exercise. At the samne time another five SOEs with some prospects for recovery were selected for "clinical" control. Financial discipline will be imposed on these enterprises through nanagerial and financial restructuring, including the privatization of specific production lines, sale of assets, changes in pricing policy and other measures. Fresh resources from the budget will not be used. Further liquidations of non-viable SOEs (including, if appropriate, some listed in the 1993/94 privatization program) are envisaged as enterprise adjustment proceeds and through the appropriate track of the 1995/96 privatization program. 51. After these initial pilot liquidations and restructuring measures, actions to impose financial discipline will be extended to a further group of at least 10-20 loss-making SOEs during the first part of 1995. The Government as owner will force the enterprises to sell assets and stocks to clear debts. It will subject serious loss-makers to strict limits on future borrowing and the worst loss-makers will not have access to new funds. Organizational changes will also be required, including brealdng SOEs up into smaller units, without injecting new capital from the state budget. 52. However, the Goverunent does not want enterprise restructuring to rest solely on its own administrative decisions. For this reason, it is taking the steps to strengthen generalized creditor discipline outlined above and is promoting financial sector discipline as noted below. It also wishes enterprises to take their own initiative in rationalizing their activities and clearing debts. To this end, a decree enabling enterprises to sell assets and equipment was issued in March 1994 and the requirement for prior approvals for such sales was lifted in October 1994. 53. The Government as owner will continue to have restructuring responsibilities. Once implementation capacity is better developed, the Govermnent intends to deepen the process through liquidation and passive restructuring programs in cases where financial discipline on SOEs is not being exerted sufficiently by independent creditors or through early privatization. Supported by the PSD operation now being prepared, the Government plans to develop an isolation exercise for troubled enterprises, under which isolation from outside financing would be triggered by the size and duration of their debt. The enterprise would then enter a moratorium phase in which two initial routes would be available to it: voluntary liquidation or rehabilitation. If rehabilitation (including asset spin-off, cost-cutting, labor shedding and debt settlements) did not work within a specified period, the enterprise would enter bankruptcy proceedings or be liquidated. 54. Financial sector objectives and strategy. The authorities' objectives are to promote the development of an autonomous central bank and modem commercial banking sector, together with an appropriately regulated insurance industry. The National Bank of Moldova (NBM) is now relatively independent, is well able to conduct monetary policy, and is tightening prudential requirements on the commercial banling sector, which consists of the four main ex-Soviet banks together with a dozen  13 small new banks. With the exception of the Savings Bank, which continues to be majority State- owned, the former State banks have been nominally privatized, although a large proportion of their shares is held by SOEs. Once these SOEs are privatized, the banking sector will also become fully privatized. The NBM should keep a close watch on competitive conditions, given the possibility that one or two of the former State banks could dominate this sector. 55. However, the banking sector is not yet in a position to take a leading part in the needed rationalization and restructuring of the enterprise sector. Neither the accounting and other banking infrastructure nor the human capacity is yet in place to make the informed judgements necessary for efficient credit allocation. Lending decisions are too often swayed by large shareholders. And the capital position of most of the biggest banks is severely compromised by poor lending decisions. which have resulted in a concentration of non- or poorly-performning loans to a relatively small number of enterprises, few of which may survive the transition. 56. In this situation, the strategy is to create a small but powerful set of rewards and penalties that will create immediate incentives for commercial banks to seek profitable lending opportunities and rebuild their capital position, while moving as quickly as possible to foster institutional development in parallel. The first part of the strategy (paragraphs 57-59) is designed to produce greater efficiency in credit allocation while improving bank safety. The main emnphasis is on loan classification and provisioning, strengthening the capital base, and enforcement of prudential regulations. Fees and bank taxation will be reviewed to support the strategy. The second part concerns institutional development (paragraph 60). 57. Since January 1994, the NBM has required commercial banks to classify loans as having normal, doubtful or bad repayment prospects, and to establish reserve funds. This practice will now be strengthened and formalized on the basis of the information from the audits of the four main commercial banks which were carried out during 1994. The NBM issued regulations in November 1994, requiring banks to classify their portfolios, identify non-performing loans, and establish provisions against expected losses; these regulations will apply to all loans made after March 1, 1995. The NBM will announce a timetable starting in April 1995 and leading to full provisioning by March 1996. New standards for allowable capital will be introduced before end-1994. In early 1995, regulations for simple risk-weighted capital standards will be introduced, as the next step in a timetable for moving into line with international practice. Banks will also be required to implement the prudential regulation limiting exposure to single large borrowers to less than 30 percent of capital, with exceptions for five named utilities. The restriction on connected lending will be reinstated, with the same exceptions. At present, the NBM has few instruments at its disposal to deal with non- compliance. Under the new Banking Law, to be submitted to Parliament by mid 1995, a range of penalties and sanctions will be developed in line with normal banking practice. At the same time, banks will be given incentives to expand their deposit-taking business and extend their lending in other directions. In recognition that higher capital and provisioning standards will raise costs, the Government will propose to Parliament a new taxation policy phasing in tax deductibility of amounts set aside for capital and risk reserves for all commercial banks as from April 1995. 58. The new focus on limniting exposure to bad loans and building up capital will help reduce the practice of automatic loan rollover and interest capitalization. Together with the requirements to restrict connected lending and limit exposure relative to capital to single large borrowers, these measures will force banks to confront the excessive credit demand of large inefficien. SOE clients.  14 At the same time, the banks should be encouraged to collateralize loans and use the bankruptcy and collateral laws as appropriate. 59. The requirement that the commercial banks adopt safer banking practices will be matched with efforts from other parts of the Government to establish a safe and stable bankdng system and enforce financial discipline. As a first step, the NBM will collect information on connected SOE lending and large exposure loans to SOEs, and share this information with the Ministry of Finance, so that appropriate steps can be taken within the Govenmnent tc prevent enterprises from running up excessive debt burdens before privatization. 60. Institutional development. The NBM is starting to coordinate and supervise a program of instiutinal stnthening for the fiacial sector. With external assistance, the NBM's accounting systems are being modenized and capacity for banking supervision will be enhanced. In the comnmercial sector, the audits on the four main banks will be followed by diagnostic studies; after that stage, development of twinning arrangements with Western banks is being considered. The NBM is drafting a new banking law. It has also established a working committee with representatives of the commercial banks to reform accounting practices, with the objective of developing an action plan and timetable for conversion to a new standard. Training for commercial bankers has recently started with assistance from USAID. Training programs will also be developed, with external support, to enable the introduction of the new classification and provisioning standards, and to raise capacity in normal conmmercial banking functions including credit and risk evaluation. D. Creating a Compeitive Environment 61. To promote sustainable growth, the authorities need to ensure that price signals correspond as closely as possible to real resource costs, that restraints on competition are removed, and that enterprises respond efficiently to market incentives and constraints. The program supported by the Rehabilitation Loan made substantial progress in establishing an enabling environment for private sector development (see Part I, Section C: Experience with Structural Adjustment, paragraphs 17-22 and paragraph 62 below). To complement these advances, the next stage of the program will tackle the major remaining constraints to private sector development through the policies described in this section on trade, prices and foreign exchange; State procurement; and demonopolization and privatization in the agricultural sector. At the same time, the acceleration of privatization and the imposidon of a hard budget constraint on enterprises (Sections B and C above) will promote the supply of assets and access to credit needed to promote growth in the private sector. 62. Trade, prices and forei8 exchanee. The Government has already made considerable progress in removing restrictions on trade, priing and foreign exchange allocaton (paragraphs 17-19). Most export and price restrictions have been eliminated and the exchange rate is freely determined at foreign exchange auctions. In a further round of liberalization in mid-1994, minmium reference prices for exports were removed, as were the prohibition on barter exports to convertible currency countries and the import tariff surcharge on barter. In addition, on November 1, 1994 the Government submitted legislation to Parliament to eliminate margin controls as from January 1, 1995, with the exception of a short list of essential goods, from which margin controls will be removed in the first half of 1995; and applied Most Favored Nation (MFN) tariff rates to a limited number of countries (by end-1995, MFN rates will apply to all countries of origin, except where free trade agreements apply).  1S 63. The objective of increasing productive efficiency and technological innovation through external competition will be pursued through a low and relatively uniform import tariff. The maximum tariff rate will be reduced in stages, according to a schedule submitted to Parliament as part of the budget submission for 1995. According to this schedule, the maximum tariff will be reduced to 50 percent as of January 1, 1995, to 30 percent as of April 1, 1995, and to 20 percent by December 1, 1995.4 Duty exemptions for foreign investors and small businesses will be minimized to avoid fiscal revenue losses and to provide equal treaunent to all forms of business. Subsidies on imports implicit in the arrangements for distribution of products financed by external credits will be eliminated; wherever possible foreign currency or goods supplied by extenal credits will be auctioned, and all credit to the distributors or recipients of such goods will be on market terms. The surrender requirement for foreign exchange (which is now at the market rate) will be abolished entirely by end-Deember 1994. 64. State procurement will be put on a competitive basis. Valuable experience was gained under the Bank's Rehabilitation Loan with competitive tendering and international shopping, with the result, inter alia, that the authorities were able to procure a large quantity of fuel for the 1993/94 winter at below world market prices. As a result of this experience, both domestic and foreign suppliers will be invited to tender for fulfillment of the state's requirements in future. Technical assistance from the World Bank through an IDF is being utilized to prepare the necessary legislation and design the system. No preferences in allocation of inputs or credit will be given to those who supply state needs, in order not to undermine their competitors. Competition will be allowed in all products where the state is involved in supplying inputs or marketing outputs. 65. Demononolization in aricudture. As agriculture is the dominant sector of the economy, reform in that sector is essential for recovery in growth and exports. Improvement in the efficiency of input and output markets is the identified priority in the reform of agriculture. The Government has therefore decided to break up and privatize the large agricultural parastatals, starting with the conglomerates Cereale (grain procurement and processing) and Fertilitatea (ferilizers and other input supplies). Based on experience with these two dominant parastatals, a general policy will be developed for restrucaring and privatizing all the agricultural parastatals. The Govermnent has already abolished Cereale as an independent entity, and taken it temporarily into the Ministry of Agriculture. The commercial enterprises that existed under the Cereale umbrella will be separated and privatized as independent commercial units during 1995 and 1996, following Parliamentary approval of their inclusion in the 1995/96 Privatization Program. As a result of this split-up, the functional monopoly in many areas (storage, milling, bakeries) will cease to exist. The Ministry of Agrculture will retain regulatory and other public service functions. The same model will be used for Fertilitatea, starting in late 1994. The privatization of Cereale and Fertlitatea is likely to create several hundred competing new fims, with varying levels of viability, which will impel a process of wholesale adjustnent in resource use in agriculture. 66. In parallel, the Government will remove obstacles to competition in the markets that were served by the two conglomerates. Efforts to develop improved agricultural markets will be guided by the idea that Moldova is a small nation and must be fuy integrated with the international economy if I/For a small number of luxury goods, a tarf of 30 percent will be maiamined in order to coordinate wih tariffs of those goods in other CIS counties. The tariff for alcoholic beverages will be harmonized with the prevailing triff in Russia. The import tariff for guns and ammunition will be 70 percent.  16 agriculture is to grow and prosper. Participation in these international markets will be increased by the removal of the restriction on grain exports by mid-1995. Efforts will also be made to develop information systems for international markets that will permit the restructured private agricultural enterprises to participate more effectively in international commerce. 67. Demonopolization in rural retail trade. The highly centralized - and highly inefficient - Union of Consumer Cooperatives of Moldova (Moldcoop) dominates rural retail trade and owns almost all retail storage facilties and outlets in rural areas. Sales have decreased significantly and Moldcoop is a large net debtor, according to the evidence collected by the Republican Commission. Because of its legal status as a private cooperative, it cannot be treated like an SOE. However, the Government has decided to move swiftly to deal with the costs Moldcoop is currently imposing on the economy. In September 1994 it arrived at an agreement with the management of Moldcoop that it would be subject to a full organizational and financial audit followed by restructuring, with the aim of adjustment to the new economic environment. At the same time, directed credit to Moldcoop has been eliinnated, and creditors throughout the economy will be encouraged to pursue legal measures to recover outstanding debts from Moldcoop. These pressures will help impel asset spin-off and i'Tster decentralization of Moldcoop's operations. At the same time, formal and informal barriers to entry of new firms into rural food and retail trade will be eliminated. 68. Efficient land and rural credit markets. The corporatization and privatization of former state and collective farms is proceeding, together with the distribution of individual plots of land. In July 1994, the Government issued a decision determining that two thirds of the land is subject to privatization and setting a November 1994 deadline for local authorities to issue land titles for all stock-holders and private snall plot owners. The implementation of the decree will help the development of markets in rural assets and credit. For that purpose, the Government plans to set up land titling and registration procedures, but it should be recognized that these will take some time to put in place. At present, there is a moratorium on land sales until the year 2001. With the objective of ending the moratorium, as a first step the Govermnent has already submitted legislation to Parliament to legalize the sale of land in urban areas and provide for leasing, for up to 99 years, of land in rural areas. Once this measure is implemented, the Government intends, as the second step, to remove the ban on sales of agricultural land. Fanners and commercial banks will also be encouraged to use leases as collateral, to aid in raising needed finance. The resulting opportunities to trade land and to finance production will increase incentives within the joint stock companies to define property rights for land more clearly. E. Providing Social Protection within Fiscal Constrants 69. The Government wishes to ensure that social protection is available for vulnerable groups and also to provide unemployment benefits for the rising numbers of people who will be dismissed as a result of enterprise adjustment. Some progress has been made in targeting the worst-off through the Social Support Fund, but much remains to be done to make social protection more effective within existing fiscal limits. 70. Pensions and unemployment benefits: the financing problem. Pensions and unemployment benefits in Moldova are calculated with reference to the minimum wage, with supplements above the minimum based on past earnings. They are financed by a payroll tax of 38 percent on wages paid. Changes in early 1994 in the minimum-wage based formula for calculating pensions raised the total cost of pension provision. At the same time, collections of payroll tax went into serious decline in  17 parallel with the fall in output and shift to barter transactions. In June, when the minimum wage was raised to 18 lei per month, only 60 percent of pensions could be paid. 71. Targeted compensation for price increases. It was already clear that the formula linking pensions to the minimum wage was doing little to secure pensioner incomes (and that those receiving the minimum wage-based pension were actually falling behind in real terms). More had been achieved to protect vulnerable groups from poverty by the use, in 1993 and early 1994, of targeted price compensations financed by the budget for pensioners, families with children and other vulnerable groups to help compensate for the staged removal of subsidies on bread and milk. The Government has now decided to de-link pensions and other benefits from the minimum wage. Instead, a system of targeted price adjustments is being introduced. Under the new system, all qualifying beneficiaries will receive the same nominal amount in comipensation for price increases. This compensation will occur only to the extent permitted in the context of the overall fiscal adjustment. The new system was announced on November 10, 1994, for implementation in January, 1995. The next announcement will be made in January for implementation early in 1995. 72. Introduction of the new system will offer better protection to the poorest beneficiaries. Together with the gradual increase in the pension age, for which the Govermnent will subnit legislation to Parliament in the fall of 1994, the new compensation mechanism will provide considerable savings to the Social Fund and release resources for increased unemployment benefits. This is because, under the new system, the earnings-related component of the pension will effectively be frozen at current nominal levels. As only non-working pensioners will be entitled to compensation for price increases, pensioners who are still in employment will find their benefit incomes erode in real terms with time. Along with the phased increase in the pension age, the new price compensation system will help to improve the financial position of the Pension and Employment Fund; the cost- sharing arrangement between the Pension and Employment Fund and the budget will be kept under regular review. In the longer run, the Government hopes to assist enterprise adjustment by reducing the level of payroll tax, recognizing that it creates a disincetive to employment and places a burden on enterprises. As a first step, it plans to reduce the rate of payroll tax from 38 percent to 35 percent on January 1, 1995. The Government also intends to enable other savings and pension instruments to be created. This will stimulate resource mobilization and enable people to generate income for old age over and above the basic pension. 73. To assist the establishment of the new system, the Government will postpone further increases in the minimum wage (the Minister of Finance has already announced that no increases are envisaged in calendar 1995), and is considering whether to abandon the minimum-wage based system of wage determination altogether. This would aid reduction of inflationary pressures in the economy. It would also necessitate another system of deternining incomes that have previously been defined in terms of multiples of the minimum wage (notably within the Government administration - wages elsewhere in the economy are already deregulated). The Government plans to work on an alternative mechanism for wage-fixing for Government employees that would be related to labor market conditions. 74. Promo labor market adjustment: severance pav. At present, many enterprises cannot afford to pay workers, yet cannot afford to dismiss them, because they lack funds to cover severance pay. The Govemment has decided that both labor market and enterprise adjustment would be promoted by amending severance pay requirements. Specifically, in cases of liquidation or bankruptcy where the enterprise cannot cover its severance obligations, the Employment Fund would  18 finance severance pay to dismissed workers. A formal Government decision was issued in November 1994 for implementation from January 1995. 75. Capaciqt to cover increasing claims for Imemployment benefit. The rate of recorded unemployment remains very low, at 1 percent in the first half of 1994, of whom only about 25 percent received unemployment benefit. These rates will rise as a result of enterprise retrenchment, bringing into question capacity to pay benefits. However, the rate of claim would have to rise from the present 0.25 percent to 5 percent before the financing assigned to the Employment Fund came under pressure. Beyond that point, it would be necessary either to increase the share of payroll tax assigned to the Employment Fund (which would become more feasible once the relative amount required for pension claims began to fall as a result of pension reform); or to transfer fumds from the Goverrnent budget. An analysis of replacement rates and unemployment benefit flows, on the assumption that job loss rates reach 10,000 per month by March 1995 and continue at that rate through 1995 and 1996, indicates that unemployment benefit claims would level off at 6.9 percent. This increase in claims is within the range of the fiscally tolerable, especially if the authorities also review and reduce the rate and duraion (presently nine months) of unemployment benefit if financing is stretched, which they have committed to do. F. Acdeving a Supply Respoe: Com Meures 76. The measures outlined above should provide the basis for the projected turnaround in the decline of output in Moldova. Given the steepness of the decline however, the government cannot rely only on a correct structure of incentives and the removal of obstacles to private sector activity to insure that the pick-up in growth is sufficient for the political and economic sustainability of the program. For this reason a number of additional steps are being considered to promote increased production and exports. Some of these are being supported by other World Bank operations as explained in the Bank Strategy section below (paragraphs 81-84). A new facility wil be established so that Moldovan exporters will have access to pre-shipment financing, enabling them to obtain imported inputs into the production process. An equity fund is being prepared to promote new private investment in developing Moldova's agro-industrial and light industry potential. This will be supplemented by lines of credit for private industrial and agricultural enterprises that will support investments to improve the quality of processing and packaging of Moldova's export products. Training in marketing and m gement skills is being provided through technical assistance. Transport obstacles to trade are currenly being studied and investment programs are being developed to lower the currently high level of transportation costs, which represent a substantial barrier to increased exports. PART H. BANK STRATEGY AND THE PROPOSED SMTUCTURAL ADJUSTMEN LOAN A. Support from the World Bank, DMF, and Other Agencies: the Record So Far 77. The proposed Structural Adjustnent Loan would be the third World Bank loan to Moldova. The first loan, an Emergency Drought Recovery Lon (US $26 million, Ln. 3569-MD), was approved by the Board on March 11, 1993 and financed critical inputs for the 1993 agricultural season. The second loan was the Rehabilitation Loan (US $60 million, Ln. 3653-MD), approved by the Board on October 21, 1993. It promoted reforms in privadzation and enterprise governance, the financial sector, agricultural policy, trade and pricing, and the social sector.  19 78. The initial focus of both the World Bank and the IMF was to provide speedy assistance in the face of the severe drought of 1992. The need for emergency imports created urgent financing requirements which were met through the Bank's Emergency Drought Recovery Loan and the Fund's CCFF. This prompt response established a good working relationship between Moldova and the Bretton Woods institutions. 79. During the sunmer of 1993, agreement was reached on stmctural refom and stablizaion prograns to be supported by a Rehabilitation Loan and an STF program. A Stand-by Agreement was put in place in December 1993 covering the period from the last quarter of 1993 to the end of 1994. A first Consultative Group meeting was held in Paris on October 26, 1993, followed by a pledging session in Washington on December 15, 1993. Counting assistance from all sources including the Bank and the Fund, a financing package of approximately $300 million was put together in balance of payments support for calendar year 1994. The fourth purchase under the Stand-by was released based on review of the end-June 1994 performance criteria, and the stabilization program supported by the Fund continues to be on track. 80. Bank disbursements have been rapid (the Emergency Loan of $26 million is 99 percent disbursed and closed, while $53 million of the $60 million Rehabilitation Loan has been disbursed), but other donors have been very slow to follow through on commitments for essentially bueucratic reasons. This has seriously undermined economic management during 1994; it has also substantially reduced the authorities' confidence in external support and increased their apprehension of the short- run costs of further liberalization measures. Additional fast-disbursing finac assistance from a wide range of sources will be important to the sustanability of the program; to this end, the Bank plans to convene a second Consultative Group on Moldova early in 1995. D. Bank Strate 81. The Bank's objectives are to support the rapid adjustnent of the Moldovan economy to the severe extenal shocks recently experienced, including its exposure to a radicaly different set of relative prices from that obtaining in the past, and to promote a recovery of sustainable growth. A limited CAS was discussed by the Board when it approved the Rehabilitation Loan in October 1993, under which two cases were envisaged. Moldova's performance conforms with the high case as set out at that time, involving a rapid transition to a market economy through the sustained implementation of the reform program, leading to enhanced creditwortiness of the country in the medium term. In the light of Moldova's rapidly changing circumstances, a full CAS will be submitted for Board consideration with the first investment operation. 82. Given the small size of Moldova's domestic market, the strategy to achieve the growth objectives focuses on export development, at the same time promoting adjustment to the energy price shock. Moldova's principal exports are based on agriculture and agro-processing, but there have also been significant industrial exports in the past. While Moldova is already a trading nation, retention and growth of its existng markets and expansion into new markets will require quanm leaps in productivity and efficiency, and re-orientation of production to market demand. It will also require an accelerated shift from public to private ownership and the creation of an enabling environment for a growing private sector based on the narket. At present, an excessive amount of resources are ded up in unsaleable products and activides. If sustainable, export-led growth is to be achieved, it will be necessary to switch resources into activities that are competitive on world markets.  20 83. The first stage of the Government's economic reform program (supported by the Bank's Rehabilitation Loan) is creating the environment needed to spur this adjustment towards export competitiveness and growth. As yet the response in terms of the reallocation of resources is limited. The program to be supported by the proposed SAL will deepen the systemic reforms needed to promote such a reallocation of resources and underpin the forthcoming sector operations that are being prepared in parallel. These operations are designed to promote a recovery in exports and sustainable growth through a rapid supply response to the framework structural reforms. In addition, a loan is being planned whose aim is to stimulate viable production for export and build bridges with foreign financiers, traders. and ultimately investors by mitigating the risk of changes in the policy envirorunent. Sector operations are being mounted in energy and environment, agriculture, and private sector development, as explained in paragraph 84 below. These operations fall within the program described in the limited CAS discussed in October 1993, with the exception of the planned export promotion operation, which had not been defined at that stage. 84. A mix of adjustment and investment operations at the sector level are designed to deepen the reforms and provide the basis for an efficient supply response through reducing energy intensity and reallocating resources in the industrial, trade and agriculture sectors towards internationally competitive activities. Given Moldova's energy dependence and the waste and environmental damage associated with its present patterns of energy distribution and use, an early operation is planned in that sector. An agricultural operation will help promote the new investment and the market environment needed to reallocate resources towards efficient production and export markets, while the first private sector development operation will promote a competitive environment in the enterprise sector, strengthen financial discipline on the remaining SOEs, and underpin institutional development in the fimnacial sector. Subsequent operations will address housing needs, provision of improved irrigation systems in agriculture, and training in labor market skills needed in the new market environment. C. Program Implemeon and Proposed Tranche Conditions 85. The Government has set up a Council on Economic Reform to oversee and coordinate the implementation of the adjustment program. The Council is chaired by the Deputy Prime Minister in charge of Economic Reform and consists of all the Ministers concerned, including those for Finance, Economy, Privatization, Labor and Social Protection, Agriculture and Industry. The Governor of the National Bank of Moldova is also a member. Under the Council is a Committee for Economic Reform chaired by the Deputy Minister of Economy which supervises the implementation of reform program at working level. Both Council and Committee meet weekly. In addition, there is the Republican Commission, also chaired by the Deputy Prime Minister in charge of Economic Reform, which was set up to conduct the arrears identification and clearance exercise. Under the stewardship of the Commission, potential enterprise candidates for liquidation and defensive restructuring are being identified. 86. Although the Governent administration in Moldova is generally competent, many of the tasks involved in the implementation of the reform program are unfamiliar and require expertise that is not available domestically. Technical assistance is already in place to support privatization, the development of capital markets, the drafting of economic legislation, the introduction of a Treasury fimction and public investment program, to help develop the financial sector and train personnel, to assist in enterprise liquidations and asset auctions, and in the social sector. Further technical assistance will be sought as necessary to support implementation of the reform progran.  21 87. The following outlines the measures that preceded Board presentation and those identified for the release of the second tranche. The underlying presumption is the continuation of the required macroeconomic policies, as reflected in satisfactory performance under the IMF Stand-by Agreemnent. 88. The following pre4bewd cond*ions for the SAL have been met: o all regulations, institutional capacity and the computerized bidding system for implementing the 1993194 privatization program are in place and functioning, such that auctions have been held for 50 medium and large enterprises and 100 small scale enterprises; and a proportionate numier of both large and small-scale enterprises are being privatized per month so as to permit substantial completion of the full 1993/94 program by end-December 1994; o submission to the Parliament in November 1994 of the 1995/96 program, as agreed with the Bank, specifying the new privatization stegy and the list of SOEs to be privadzed; HIardenin the Budaet Constraint: o establishment of the institutional framework and initiation of the liquidation procedures of five loss-making SOEs; o adoption of restructuring plans satisfactory to the Bank for another five highly indebted SOEs and the start of implementation. These plans include the privatization of production lines, the sale of assets and other measures to impose financial discipline, and exclude use of budget resources; o elimination of the regulations requinng prior approvals from the Ministry of Privatization and State Property and the Branch Ministry concerned for SOE asset sales through publicly announced auctions and tenders; o introduction of mechanisms to deal with the arrears to energy utilides, including cutting services to non-paying customers. Payment conditions and criteria for termination of services are bing publicized; o the introduction by the NBM of regulations governing the classification and provisioning of the loan portfolio for commercial banks, as well as the formulation of regulations satisfatory to the Banlk governing the definition of allowable capital for commercial banks; Creating a CQomnetitie Environent: o (i) inclusion of the privaization of the commercial enterprises belonging to Cereale and Fertilitatea in the 1995/96 privatization program; together with (ii) the preparation of a privatization plan assuring the separation of operating units and the development of competitive domestic markets boti regionally and nationally;  22 o submission to Parliament in November 1994 of legislation removing margin controls in January 1995, with the exception of a small group of socially important commodities, from which margin controls would be removed by mid-1995; Providing Social Protection within Fiscal Constraints: o de-linking of increases in all pension and social assistance benefits from the minimum wage. Adjustment of benefits for all qualifying beneficiaries by identical nominal increases based on the changes in prices in the previous period; the new system was announced in November 1994, to become effective on January 1, 1995. The level of future increases is to be consistent with the overall fiscal adjustment. The earnings- related component of pension income would thus be frozen; working pensioners would not qualify for these price compensations. 89. Proposed second truche condidons are as follows: Ownership change: o achievement of satisfactory progress in implementing the 1995/96 privatization program, as evidenced by the establishment of the regulatory framework and insdtutional capacity, followed by monthly auctions and advertisements for auction, in accordance with a timetable agreed with the Bank; Hardenine the Budget Constraint: o achievement of satisfactory progress in the sales of assets of seven enterprises under liquidation; o initiation of the managerial, organizational and ownership restrucmtng for a further group of 10-20 highly indebted SOEs. The restructuring should include the privatization of production lines, the sale of assets and other measures to impose financial discipline without injection of new capital from the budget; o introduction of regulations on simple risk-weighted capital standards for commercial banks, as part of a timetable for moving into line with innational practice; reinstatemt of the regulation limiting loans to any shareholder of a bank who owns or controls 10 percent or more of the bank's total shares to an amount not exceeding 20 percent of the bank's capital (with the exception of five named utilities as agreed with the Bank); and enforcement of the requirement that all commercial banks make provision for possible loan losses on loans extended after Mach 1, 1995; CrEat a Cometitive Enviromnent: o (i) revision of the reognization and privatization plans for Cereale and Fertilitatea in a mamer satisfactory to the Bank, with the aim of creating competitive markets and a start to implementation of these privatization plans in conformity with a tmetable that will ensure completion by end-1996; this plan to include early disposal of excess storage, transport and milling capacity, either tbrough sale or medium term lease  23 arrangements; (ii) transfer of their regulatory functions to the Ministry of Agriculture and other Ministries as appropriate; and (iii) de-monopolization of the traditional markets of Cereale and Fertilitatea, including through competitive procurement of the State grain reserve; o timely implementation of the timetable as agreed with the Bank for reducing the maximum import tariff to 20 percent by end-November 1995; providing Social Proeconin Fisal Canstrains O submission to Parliament of the phased increase in the pension age by six months per year for men and six months per year for women beginning in mid-1995, until the pension age reaches 65 for men and 60 for women; the increase to occur in all pension categories including early retirement and special pensions; o implementation of the new system of increases in pensions and benefits to apply during 1995 and following years, whereby benefit increases are de-linked from the minimum wage and all qualifying beneficiaries receive a flat nominal increase based upon the price changes in the previous period and the overall fiscal context. D. Ie Fnacng Packge 90. Loan amount and borrower. The proposed loan of US $60 million would be made to the Republic of Moldova represented by the Ministry of Finance as Borrower. Disbursements would be made to the National Bank of Moldova (NBM) and an account of the Ministry of Finance at the NBM will be credited with the leu equivalent at the official exchange rate of the day"; the Govermnent will thereby receive non-inflationary budget support. The foreign exchange proceeds of the loan will be sold by the NBM or will be held in reserves, in accordance with the objectives of monetary policy.6 The loan would have a maturity of 20 years including a five year grace perod, at the Bank's standard variable interest rate. 91. Project manazement. Overall coordination of project activities and general loan administtion will be the responsibility of the Department of Foreign Economic Relations in the Ministry of Economy. The Director of this Departent, as project manager, will be responsible for preparng applications for disbursement, mninSing project accounts and arranging for their timely audit, and monitoring overall loan implem on. On the basis of the information from the various agencies involved in the implementation of this loan, the project manager will prepare the Borrower's contribution to the Project Completion Report within six months of the closing date. The project manager has obtained experience in this work in her function as head of the Project Coordination Unit for the Bank's Rehabilitation Loan. I/ The oficia exchagetate is defied in Moldova astbe rate demined at the atest auction in the Chisinau linrbank oEign Cureny Exchange (CIFCB).