Romania - Industrial Development Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 11542-RO STAFF APPRAISAL REPORT ROMANIA INDUSTRIAL DEVELOPMENT PROJECT APRIL 26, 1994 MICroGHAPHiICS Report No: 11b42 RC Type: SAR Country Operations Division Country Department I Europe and Central Asia Regional Office This document has a restricted distribution and may be used by reipiens only In the perfonnace of their official duties. Its contents may not othenwise be disclosed wihout World Bank authoradon.  CURRENCY EQUIVALENTS Currency Unit Romania Leu (L) US$1.00 - lei 450.00 on January 1, 1993 US$1.00 = lei 735.00 on July 1, 1993 US$1.00 = lei 1276 on December 31, 1993 US$1.00 - lei 1680 on April 15, 1994 ABBREVIATIONS AND ACRONYMS BA Bank for Agriculture CBF Chemical Bank CC Commercial Companies CCB Cooperative Credit Bank CEC Savings Bank CO Certificates of Ownership DFB Dacia-Felix Bank EFF Export Finance Fund EIB European Investment Bank EXIM Export Import Bank of Romania FX Foreign Exchange GDP Gross Domestic Product IDP Industrial Development Project IRR Internal Rate of Return LC Letter of Credit LIBOR London Inter-Bank Offered Rate MIND Bank for Small Industry and Private Initiative MOE Ministry of Environment MOI Ministry of Industry MOF Ministry of Finance NAP National Agency for Privatization NBR National Bank of Romania PFI Participating Financial Institution PHARE EC-Phare TA Program for Eastern Europe PO Purchase Order POF Private Ownership Fund PSD Private Sector Development RA Regie Autonomes RBFT Romanian Bank for Foreign Trade RC Restructuring Committee RCB Romanian Commercial Bank RDB Romanian Bank for Development SAL Structural Adjustment Loan SCL Single Currency Loan SGF Societe General SME Small and Medium Scale Enterprises SOE Statement of Expenditures SOF State Ownership Fund TA Technical Assistance TCB Ion Tiriac Commercial Bank TD/MOF Treasury Department of the Ministry of Finance UCECOM Central Union of Cooperatives ROMANIA - FISCAL YEAR January 1 - December 31  FOR OFFICIAL USE ONLY ROMANIA INDUSTRIAL DEVELOPMENT PROJECT STAFF APPRAISAL REPORT Table of Contents Page No. LOAN AND PROJECT SUMMARY . . . . . . . . . . . . . . . . . . . . . . . . . I. INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . ... . . A. Background .1... . . . . . . . . . . . . . . . . . . . . . . . . II. INDUSTRIAL RESTRUCTURING AND PRIVATIZATION PROGRAM . . . . . . . . . . . . 2 A. The Industrial Sector.. 2 (a) Industrial Structure. 2 (b) Economic Environment and Impact of Recent Policy Reforms . . 3 B. Enterprise Reform . . . . . . . . . . . . . . . . . . . . . . . . . 4 C. Privatization.. 5 (a) Privatization Program. 6 (b) Institutional Framework. 6 (c) Privatization to Date. 7 (d) Measures to Speed-up Privatization . . . . . . . . . . . . . 8 D. Restructuring . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 (a) Government's Industrial Strategy . . . . . . . . . . . . . . 9 (b) Institutional Framework and Recent Developments . . . . . . . 11 E. Private Sector Development ...... . ............ . 12 (a) Small Scale Private Sector (SME) . . . . . . . . . . . . . . 12 III. FINANCIAL SECTOR . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 A. Current Structure of the Financial Sector . . . . . . . . . . . . . 14 B. Financial Sector Reform ...... . . .. . . .. . . .. . . . . 15 C. Financial Markets ....... .. .. .. .. .. .. .. .. . . 16 IV. PROJECT RATIONALE ......... .. ............. ... . 19 A. The Bank Group Strategy for Assistance . . . . . . . . . . . . . . 19 B. Rationale for Bank Involvement ..... . . . . . . . . . . . . . 20 V. THE PROJECT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 A. Objectives and Scope of the Proposed Project . . . . . . . . . . . 22 B. Financing Component ........... .... .... .... . 23 C. Technical Assistance Component ...... . .. . .. . .. . . . 25 D. Project Cost and Financing Plan . . . . . . . . . . . . . . . . . . 26 E. Environmental Impact . . . . . . . . . . . . . . . . . . . . . . . 27 This document has a resticted distnbution and may be- usd by redpiens ondy Inthe pebmnsY of tber offidcaldutes.Itscontentsmaynototherwisebedisclosedwitd WoddBankaMtoraiat  VI. PROJECT IMPLEMENTATION AND ONLENDING ARRANGEMENTS . . . . . . . . . . . . 27 A. Loan Terms and Conditions ... . . . . . . . . . . . . . . . . . . 27 B. Lending Arrangements .... . . . . . . . . . . . . . . . . . . . 29 C. Loan Administration . . . . . . . . . . . . . . . . . . . . . . . . 33 VII. BENEFITS AND RISKS . . . . . . . . . . . . . . . . . . . . . . . . . . . 35 A. Benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35 B. Risks .36 VIII. AGREEMENTS REACHED AND RECOMMENDATIONS .37 List of Tables Table 3.1 Non-Government Credit Volume in Real Terms . . . . . . . . . . . 17 Table 4.1 Policy-Related Measures and Objectives Accomplished During Project Preparation . . . . . . . . . . . . . . . . . . . . . . . 21 Table 5.1 Technical Assistance for Privatization and Restructuring . . . . . 25 Table 5.2 Estimated Total Project Cost .... . . . . . . . . . . . . . . . 26 Table 5.3 Proposed Financing Plan . . . . . . . . . . . . . . . . . . . . . . 26 Table 6.1 Participating Financial Institutiorns with Romanian Capital . . . . 31 Table 6.2 Conditions of Effectiveness . . . . . . . . . . . . . . . . . . . . 32 List of Annexes Annex 1 Technical Assistance Component Specification . . . . . . . . . . . 38 Annex 2 The Banking Sector . . . . . . . . . . . . . . . . . . . . . . . . 42 Annex 3 Participating Banks ..51 Annex 4 Foreign Trade and Export Credit Demand . . . . . . . . . . . . . . 66 Annex 5 Criteria and Procedure for PFI Qualification and Accreditation ..71 Annex 6 Foreign Exchange Market and Foreign Exchange Credit Market . . . . 77 Annex 7 Estimated Disbursement Schedule of the Proposed Loan . . . . . . . 83 Annex 8 Supervision Plan ..84 Annex 9 List of Documents in Project File . . . . . . . . . . . . . . . . . 87 This report was prepared by Ms. S. Brajovic-Bratanovic (EClCO), Mr. P. Van der Veen (IENIM), and Mr. A Goldschmidt (Consultant). Peer review was conducted by Messrs. M. Hinds (EMTDR), J. Nellis (PSD) and Ms. I. Zurayk (EC2CO). The following individuals have also contributed to project preparation: R. Heath, R. Chalk, H. Bhattacharya, E. Mangan (IENIM); S. Sattar (MNEPH), R. Roberts, L. Ponzio, C. Calcopietro (Consultants).  ROMAN-IA INDUSTRIAL DEVELOPMENT PROJECT LOAN AND PROJECT SUMMARY Borrower: Romania Loan Amount: US$175 million Beneficiaries: Private enterprises and exporters, Ministry of Industry (MOI), National Bank of Romania (NBR), participating financial intermediaries. Loan Terms: Single currency loan (SCL) in US dollars for twenty years, including five years grace period, at Bank's standard variable rate for SCLs denominated in US dollars. Onlending Terms: The Government will onlend funds to the participating financial intermediaries (PFI) in US dollars at the prevailing six-months LIBOR plus a margin of 30 basis points to be charged by the Ministry of Finance (MOF). The PFI subsidiary loans will be extended on a first-come first-served basis, back-to-back to PFI subloans to final beneficiaries and vith the same maturities. The PFIs subloans to the beneficiaries will be denominated in US dollars at LIBOR plus the MOF margin and a market-based PFI spread. The subloans for investment finance will be provided at variable market-based interest rates with 3-17 year maturities and 1-5 years grace; the subloans for export finance will be provided at fixed market- based interest rates and up to one year maturities. For both credit components, the final sub-borrowers will bear the exchange risk. The PFIs will bear the full credit risk of their subloans. Proiect Descrigtion: The Project will finance (a) investment of private enterprises to improve international competitive- ness and/or expand exports; (b) exDorts by providing partial to full coverage of exporters' pre-shipment finance needs for imported inputs; and (c) technical assistance to help in designing and implementing policies and strategies for privatization and restructuring, and for strengthening institutional capacity of the individual PFIs.  - ii - Benefits and Risks: The expected benefits include: (a) improved conditions for effective supply response; (b) increased export potential, efficiency and profitability of private industrial enterprises; (c) improved capacity of the financial sector to provide export and restructuring related finance; (d) increased competition and integration of Romanian financial markets; and (e) further advance in building policy and institutional framework to speed up ownership transformation and restructuring and to stimulate the private sector growth. The mechanisms developed and the technical assistance put in place should yield significant demonstration effects. Institutional weaknesses and skill deficiencies of banks, enterprise managements and government agencies is the main risk. It is addressed through TA covering all aspects where skill deficiencies may jeopardize successful implementation, and through increased Project supervision. There is also a risk concerning PFI intermediation capacity -- macroeconomic volatility and uncertain prospects may adversely affect the PFIs' willingness to engage in invc-tment lending or decrease their risk exposure capacity. This is addressed through the proposed Project conditionalities, by increasing the capacity of banks to take and sustain risk through mandatory loan classification and provisioning and by increasing the level of general loan loss reserves; through TA to improve the PFI's capacity to assess and manage risk; by keeping open access to eligible PFIs; and by maintaining flexibility in the allocation of funds to the export and investment finance components. The PFI credit risk and the foreign exchange risk of final beneficiaries have also been decreased by extending a single currency loan. The macroeconomic instability is a major risk, which is addressed by the SAL and through ongoing policy dialogue with the IMF and the Bank. In addition, the Bank will review project implementation one year after loan effectiveness with an option not to extend further commitments in case of adverse developments. Estimated Cost: (US$ Million) Local Foreign Total Investment Credit 55.0 102.0 157.0 Export Credit 104.0 70.0 174.0 Technical Assistance 0.0 3.0 3.0 TOTAL 159.0 175.0 334.0  - iii - Financinf Plan: (US$ Million) local Foreien Total IBRD 0.0 175.0 175.0 Sub-borrowers 40.0 0.0 40.0 Financial Intermediaries 119.0 0.O 119.0 TOTAL 159.0 175.0 334.0 Estimated Disbursement: (US$ Million) 95 FY97 FY98 Annual 53.0 61.0 35.0 21.0 5.0 Cumulative 53.0 114.0 149.0 170.0 175.0  ROMANIA INDUSTRIAL DEVELOPMENT PROJECT I. INTRODUCTION A. Background 1.01 In the period since the 1989 revolution, the Government of Romania has formulated and started implementation of far-reaching reform programs to stabilize the macroeconomic situation and to move towards an efficient market economy. A new legal and institutional framework has been established, and the policy framework has been substantially liberalized. Commercialization and corporatization of the state enterprise sector has been completed, and enterprise management has been freed from direct government intervention in production and investment decisions. Recognizing the difficulty of achieving an adequate supply response and efficiency gains in enterprises owned and operated by the public sector, the Government plans to divest 6,300 state-owned enterprises. Thirty percent of the state's equity in commercial enterprises has already been divested through allocation to five Private Ownership Fund^ and mass distribution of their shares. By end-1993, about 490 small and medium-size companies have been privatized and another 500 are in active preparation. A program is being developed to provide a variety of options for the full privatization of a large number of enterprises, while at the same time motivating and assisting the remaining viable enterprises to adjust effectively to the new market-oriented environment during the transition to eventual privatization. 1.02 The ownership reform of the state sector is supplemented by a broad program to support growth of indigenous private sector enterprises. About 546,000 new private firms were registered by end-1993, of which about 30 percent were in manufacturing and trade, and about 78 percent have already opened for business. About 29,000 joint ventures have been formed by end-1993, of which about 100 involve large state enterprises. In the 1991-1993 period, the private sector has productively absorbed over one million employees and its participation in GDP has grown from less than one percent in 1989 to about ten percent in 1991 and an estimated 30 percent in 1993. 1.03 There are, however, some areas where progress has been rather slow. The enterprises' response to systemic and policy changes has been largely reactive, such as stopping production and laying off labor; actual restructuring has barely started. The volume of foreign investments has been low, often because of expected difficulties to obtain finance for post-privatization restructuring. The growth of private firms has also been inhibited by crowding out from access to capital, raw materials, and infrastructure. Both the Covernment and most enterprise managers, however, have come to realize the need for an energetic proactive approach to restructuring and/or privatizing their enterprises and to attracting foreign partners. 1.04 The proposed Industrial Development Project will assist the Government to speed up the process of transition by creating conditions for faster and more efficient supply response and by supporting the establishment of enabling policies and institutions. While the restructuring needs of Romanian enterprises, especially in industry, are considerably greater than what can be  - 2 - addressed through a single operation, it is anticipated that the proposed Project will have a broad impact on the overall transition process through: (a) promoting development of the private sector enterprises by providing financial support to private enterprise restructuring and investment programs and to exploiting the export potential of Romanian industry; (b) assistance in the desigr. of the institutional and policy framework for privatization and restructuring, and in creating an enabling environment to increase private sector share of the economy; and (c) supporting the banking sector reform by improving prudential regulations and bank supervision, strengthening individual banks and encouraging restructuring and privatization of state-owned banks. By generating growth and employment in the private sector, the proposed Project would facilitate reforms in the state sector by mitigating the cost of those reforms. 1.05 To support the proposed Project, the Government is requesting a Bank loan of US$175 million. The proposed Loan would include: (a) a financing component of US$172.0 million, including US$102 million for restructuring investments in private industrial enterprises and US$70.0 million for export financing to help realize Romania's export potential; and (b) a technical assistance comRonent of US$3.0 million to support institution building and training of staff in key government agencies and in the banking sector. II. INDUSTRIAL RESTRUCTURING AND PRIVATIZATION PROGRAM A. The Industrial Sector (a) Industrial Structure 2.01 By standards of most market economies, Romania has a la.ge industrial sector, which in 1989 accounted for 58 percent of net material product and 38 percent cf total employment. In the traditional pattern of socialist industrialization, Romania has promoted producer goods industries. In 1989, these accounted for 56 percent of the total industrial output, while the share of consumer goods subsectors (i.e., textiles, garments, food processing, electronics and consumer durables) declined during the 1980s to only 24.5 percent of the output. 2.02 Among the producer goods industries, machine building had a dominant position, accounting for about 28 percent of gross output in 1989 and about 36 percent of the net material product by industry. This specialization was strongly influenced by Romania's position in the CMEA markets. The second largest subsector was chemicals, including oil refining and petrochemicals. It accounted for about 21 percent of the total industrial output in 1989. This subsector oiiginally derived its importance from the domestic endowment in oil and natural gas resources. These resources have been badly depleted by the 1980s, however, and must now be supplemented by oil and natural gas imports. Metallurgy, the third largest subsector, kept its share at about 9.8 percent of industrial output throughout the 1980s.  2.03 High energy intensity and obsolete and worn-out capital stock are common characteristics of Romanian manufacturing technology. Priority given to new investments rather than modernization of the existing capital stock during the 1980s, combined witk the decline in equipment imports from OECD countries and the stagnation of imports from the CMEA, resulted in the growing obsolescence of Romanian industry. Whi? obscure depreciation rules make realistic estimates rather difficult, it appears that by 1990 about half of the fixed capital of Romanian industry had already been fully depreciated. The particular situation varies by sector. (b) Economic Environment and Impact of Recent Policy Reforms 2.04 At the start of the reform in 1990, large sections of Romanian industry were inefficient at international market prices. Historically, the inefficiencies persisted due to the price distortions in e. ptive domestic markets, an indiscriminate flow of funds from the Government, a certain degree of cross-subsidization between domestic and international markets and an orientation toward CMEA markets. The industrial performance in the past has been also constrained by the lack of micro level incentives fcr improving enterprise performance and the constrained mobility of resources. 2.05 The regulatory, institutional and business environment of the enterprise sector has significantly changed since the reform started. The policy reform started in 1991. Measures aiming toward correcting relative prices, imposing hard-budget constraints, limiting access to credit and increasing competition, have put the enterprise sector under enormous stress. With higher prices of inputs and limited scope for increasing output, due to the drastically falling demand in domestic and in the CMEA markets and increasing international competition, many enterprises have faced sharp declines in their sales. Industrial output fell by about 18 percent in 1990 and 20 percent in 1991 (a two- year drop of about 36 percent); in 1992, industrial production was about 22 percent lower than in 1991 (or about 52 percent of its 1989 level). The output decline leveled off in 1993; the total industrial production volume registered an increase of about one percent. There were, however, marked adjustments in the output of specific subsectors. For example, food and beverages, wood, pulp and paper, and textiles sector produced 10-15 percent less than in the same period in 1992; various branches of chemical industry (e.g., artificial fibers, plastic, rubber) increased output 2-5 percent, as have varioui branches of machine building; electrical machines and metallurgy increased output by 8 percent; most successful were the furniture, consumer electronics, and road transport vehicles branch, with 20-29 percent output increases. 2.06 The foreign trade performance was negatively affected by the decline of CMEA markets and by the confusion accompanying systemic collapse. In addition, in 1991 and 1992, Romania lost two prominent trading partners (Iraq and Yugoslavia) due to the UN embargo. In 1990, the convertible currency exports fell to about 56 percent of their 1989 level, and declined by another 4 percent in 1991. In 1992, the export decline was successfully arrested mostly due to the significantly improved policy environment, including trade liberalization, open entry policies, rationalization and lowering of tariffs, improved management of the foreign exchange regime and leave the full retention policy. The convertible  - 4 - currency exports grew by about 22 percent compared to their 1991 volume and remained at about the same level in 1993. The industrial sector still accounts for the bulk of exports, with a share of about 85 percent in 1993, a decrease from about 95 percent in 1989. More detailed analysis of export performance is provided in Annex 4. The participation of the private sector in export activities has substantially increased; in 1993, the private sector accounted for about 27 percent of total exports. 2.07 The restructuring programs in Romania have been left almost entirely to the initiative of enterprise management. The most prominent element of the enterprise adjustment so far has been labor retrenchment. This has been more pronounced in labor-intensive sectors, where the cost of labor represents a higher percentage of the variable cost of production and the skill level is lower. In capital-intensive industries, the labor retrenchment is smaller, since the loss of skilled labor could become an unsurmountable problem if the enterprises' prospects improved. In the aggregate, in 1991, the retrenchment of labor led to an 11 percent decline in the total industrial employment as compared to 1989. The trend continued in 1992, with the total industrial employment falling to about 76 percent of its 1989 level. The manufacturing sector witnessed the most significant employment decline; in 1992, the employment stood at about 85 percent of its 1991 level and 77 percent of its 1990 level. Nonetheless, the slow pace of retrenchment relative to output contraction in industry gcnerated an 11 percent reduction in the average labor productivity in 1991, and further 17 percent decline in 1992. In 1993, however, this trend reversed, showing an increase in labor productivity of about 7 percent. B. EnterRrise Reform 2.08 About 6,300 enterprises in public ownership dominate the Romanian corporate sector. In 1989, they accounted for about 92 percent of the total economic establishments; the industrial sector comprised 2,102 public enterprises. By the end of 1990, essential elements of the new regulatory framework were in place to start the enterprise reform: Law No. 54, on Free Initiative and Small Business Establishment, legalized small-scale private initiative; Law No. 96 on Foreign Capital Investments opened Romania to foreign investors; and Law No. 31 on Corporations provided a regulatory framework for the establishment and management of commercial companies. Law 31 established a two- tier governance structure comprised of an Administration Council, elected by the general shareholders meeting to exercise ownership interest in a commercial company, and a Management Board, appointed by the Administration Council for operational management of a company. For companies in state ownership, the role of a general shareholders meeting is played by the Council of State Representatives. 2.09 Law No.15 on Restructuring of State Economic Unit has initiated a full-scale commercialization and corporatization of the Romanian state-owned enterprises, except for a number of designated strategic sectors (e.g., military, power, mining, oil and gas exploration and exploitation, telecommunications). Enterprises have been converted into state-owned autonomous companies (RA, regie autonomes) and commercial companies (CC, joint-stock limited liability). Allowing for full managerial autonomy, the Government's objectives were to impose  . 5 - hard budget constraints and managerial accountability on both categories and to privatize the commercial companies. The National Agency for Privatization has been established to lead the conversion and the subsequent privatization process. 2.10 By mid-1991, the commercialization of the corporate sector was completed. Of the total number of about 6,700 companies, about 600 regie autonomes1 and about 6,300 commercial companies were established. Of about 2,140 enterprises under the manufacturing arm of the MOI, about 20 were classified as RAs and the rest are now operating as commercial companies. Through the conversion of enterprises into CCs, property rights were intended to be concentrated in a corporate board (i.e., the Administration Council) appointed by the owners: initially the parent ministries, then the State and tne Private Ownership Funds and eventually the new private shareholders. The introduction of the corporate governance framework, under Law No. 31, was accomplished rather quickly, but decision-making continued to be hampered by unclear ownership rights and responsibilities. 2.11 A numbsr of ownership and management issues critical for implementation were addressed during Project preparation, as otherwise they could have slowed privatization, negatively affected access to Bank credit lines, and complicated decisions related to enterprise borrowing and subproject implementation. Specifically, the Government has: (a) streamlined the structure and clarified the responsibilities of the Council of State Representatives, which acts as a general shareholders meeting for CCs in state ownership, and of the Administration Council, with an objective to enhance the decision-making process concerning enterprise privatization and restructuring;2 and (b) introduced management contracts for enterprises in (majority) state ownership aiming to clearly establish managerial accountability and performance-based management incentives.3 C. Privatizationl 2.12 The Government considers privatization to be the most effective way to improve enterprise efficiency by providing better incentives to capital, management and labor. The privatization policy has been gradually developed through extensive discussions with the Bank and through consulting assistance provided by the EC-PHARE. The Privatization Law was promulgated in mid-1991 with the principal objective of transferring all Romanian CCs to private hands within seven years. Besides speed, the other major concerns of the Government have been the transparency and fairness of the process, and the amelioration of its social costs. I/ Subsequent review mandated by the SAL reduced this number to about 430 at end-1993. 2/ Respective amendments to Law 31 were a condition for negotiations. 0/ Submission of Law on Management contracts to the Parliament was a condition for Board presentation.  *6- (a) Privatization Program 2.13 The privatization program concerns about 6,300 enterprises with about 4 million employees. It stipulates the distribution of 30 percent of state patrimony to Romanian citizens in the form of Certificates of Ownership (CO) in five Private Ownership Funds (POF). Each citizen holds COs of all five funds, and the COs may be exchanged for shares of commercial companies in the process of privatization. The POFs, with portfolios of about equal values, hold 30 percent of the shares of virtually all Romanian CCs and are expected to manage their portfolios so as to advance the privatization process, and to raise the value of the outstanding COs. The 70 percent balance of the CCs shares have been allocated to the State Ownership Fund (SOF). The SOF mandate is to sell its portfolio of shares or liquidate enterprises or their components in annual programs, each comprising at least 10 percent of the initial SOF portfolio, until the CCs are completely privatized (in maximum seven years). 2.14 In addition, the Privatizarion Law has initiated early privatization of about 30 medium to large enterprises and a process of small asset sales. For the early enterprise privatization, the objective of the program has been to gain hands-on experience in various modes of privatization, including private placements, public floating of shares and employee or management buy-outs. For the sale of assets, where the enterprises themselves decide to offer an asset for sale and enjoy the sale proceeds, the objectives have been to: provide an immediate means to start restructuring enterprise balance sheets; allow more efficient use of assets by the private sector; and gain experience in competitive bidding processes. (b) Institutional Framework 2.15 The institutional framework for large-scale privatization in Romania assigns the major roles to the SOF and the five POFs. These institutions are placed under the auspices of the Perliament. The SOF by-laws were enacted in June 1992.4 They define the SOF as the public agency responsible for privatization, for restructuring including liquidations, and for providing corporate guidance to all Romanian companies. The SOF is expected to divest its ownership share of enterprises within a period of seven years; its first privatization program was presented to the Parliament in January 1993.5 Since its establishment in October 1992, the SOF has focused on attaining institutional capacity to privatize small and medium-size companies; its capacity to address restructuring and liquidation will be addressed only in 1994. Given the multitude of responsibilities and the size of its portfolio, the SOF must continue to devote a massive effort to building its capacity, and its institutional culture and skills. Success of this effort will be one of the critical factors in the transition. 4/ Finalization of the SOF by-laws, establishment of its Board and initial sw.affing were conditions for appraisal of the proposed Project. If Formulation of 1993 Privatization Program, its submission to the Parliament and subsequent approval was a condition of project effectiveness.  - 7 - 2.16 The POF by-laws were adopted by the Parliament in July 1992. The POFs are defined as comr.mercial companies, which are a hybrid between a holding company and a mutual fund. They have a number of objectives: to improve the value of their portfolios and of underlying COs; to provide for orderly exchange of COs for CCs shares; and to speed up the privatization process by sharing with the SOF the responsibility for privatization. The POFs' headquarters are placed in five different towns to bring direct exposure to experiences of market economy to local environments. Since the POFs are smaller and more dynamic agents than the SOF, the portfolio allocation and the resulting portfolio management policies will substantially influence the speed and success of privatization and the course of restructuring in Romania. The proposed Project assisted in finalizing the design of the POFs.6 2.17 The next step in the privatization program is the development of methodologies, procedures and programs for large-scale privatization, including detailed quantitative targets and implementation plans for the various privatization schemes. The manner by which the state exercises its ownership rights is of utmost importance for privatization, as well as in critical cases of enterprises being restructured. Therefore, the formulation of a comprehensive package of instruments to exercise ownership rights and provide corporate guidance to CCs is also on the agenda. Constraints which may inhibit the pace of implementation would also have to be addressed, such as the occasional conflicting roles of the various agencies involved in the process; the inadequacy of the financial sector; and the lack of managerial and/or institutional capacity in many CCs to turn them around and make them profitable and attractive to private investors. (c) Privatization to Date 2.18 Considerable privatization has already taken place in Romania. The principal path to private ownership, in terms of private capital commitment, has been through joint ventures with a foreign partner. Since the enactment of the Law on Foreign Investments in 1990, over 29,000 joint ventures, with committed capital of about US$760 million, have been formed. Similar to experiences elsewhere in Eastern Europe, foreign investments have initially involved a large number of ventures with small capital commitments; in 1992, the investors' philosophy changed, and new joint ventures involved larger companies (about 103 joint ventures so far) and higher capital commitments. Another major path to privatization has been through leasing assets to a private company or through management contracts (an estimated 50,000 contracts). Both mentioned routes to privatization have largely been initiated and managed by the enterprises themselves. Finally, there has been a spectacular growth of indigenous private sector enterprises (further elaborated in Section E). 2.19 The early grivatization program was completed in early 1993. About 2,900 assets, mostly shops, warehouses, smaller production facilities and, to a lesser extent, underutilized production equipment, have been sold from the li Finalization of POF by-laws, POP portfolio allocations and registration of POTs, and establishment of their Boards were a condition for appraisal of the proposed Project.  - 8 - initial list of about 7,800 assets. About 22 small and medium companies have been privatized. Shares of two of these companies were successfully floated on the market by the domestic banks; employee and management buyouts have been used in about 18 cases; and about five cases involved private placements with foreign investors. 2.20 The enactment of the small enterprises privatization methodology (para. 2.22), a fast-track standard procedure, has substantially advanced privatization of small companies. By March 1994, about 400 had been sold mostly through management and employee buyouts. The SOF, with the responsibility to prepare enterprise evaluation and lead negotiations, estimates that it would take another two years to privatize all enterprises in the "small" category, the major obstacle being the lack of institutional capacity to prepare evaluations and negotiate deals. The SOF is currently able to privatize about 60-80 enterprises per month. Of the medium size companies, about 100 have been targeted for privatization, and 39 have been privatized; of the large companies, three have been privatized. (d) Measures to Speed-up Privatization 2.21 In order to meet the ambitious privatization targets, specific measures are needed to speed up the process by proceeding on parallel tracks and by employing new innovative approaches, including mass privatization. The recently elaborated privatization program for 1994 recognizes this need and, as detailed below, the Government is committed to taking steps to introduce other measures to speed up the privatization process. 2.22 The aggregate CC portfolio has been classified in three categories, according to the size of the CCs. Privatization is now proceeding on parallel tracks; for each category, specific measures have been or will be introduced to speed up privatization. Small companies are to be privatized through a simple competitive bidding procedure, similar to the one used for the sale of assets. It is managed by a committee, including SOF/POF and NAP representatives.7 Of the total of about 6,300 CCs to be privatized by the SOF, about 3,100 have been classified in the "small" category. Likely investors targeted for this group of CCs include enterprise managers and employees; private entrepreneurs whose companies have successfully grown or who are integrating backwards from the trade business; and small foreign investors. 2.23 For the medium-size companies, a group of about 2,500 CCs, the responsibility to manage privatization is assigned to the POFs. The POF portfolio distribution allows POPs to specialize by industrial sectors or by geographical regions. In mid-1993, to encourage the privatization of the medium- size CCs, the SOF issued instructions empowering management of CCs in a financially viable condition and operating in competitive markets (i.e., there are more than three domestic producers) to seek private investors (targeting foreign companies). The SOF also issued methodological norms for the preparation 7/ The procedure was enacted in January 1993, originally being a condition for effectiveness of the proposed Project, and is in implementation since May 1993.  of the privatization prospectus. Once an investor has been found, the management is asked to contact the SOF and to formally initiate the privatization process. To accelerate the privatization of medium-size CCs, a number of new innovative mass privatization schemes are being designed and will be introduced through selected pilot exercises, evaluated and then fully implemented on a large scale. 2.24 These include: a) Rrivatization funds, in the form of privately- managed investment companies which would bid for a majority of shares of CCs of their choice. A number of investment companies is currently under preparation and one (Capital SA) has already been established. The founders of investment companies are typically Romanian banks (e.g., Tiriac and RBFT in the case of Capital SA) or other non-bank financial institutions, and one or more foreign financial institutions (e.g., EBRD and Wasserstein Perella in the case of Capital SA); b) privatization through the use of success-fee-based privatization management contracts. The SOF plans to retain reputable foreign consultants to find foreign investors for a batch of companies in a sector and would reimburse consultants with a percentage of the sales price once the privatization deal is completed. The sector-based privatization will be initiated for textiles, garments, detergents, wood-based industries, and a number of other sectors; c) real estate investment funds are being discussed; and d) an additional mass privatization scheme or an improvement of the existing scheme allowing COs to be used to purchase the SOF shares is being actively considered. 2.25 The large companies, including about 700 CCs, are to be privatized on a case-by-case basis. The SOF will take the responsibility of preparing the company, in terms of downsizing and shaping up the operations, and actively seeking foreign investors. For certain very large companies, typically in capital-intensive sectors, foreign investors are few and can easily be identified from a small number of international conglomerates. The privatization of such sectors (e.g., steel, non-ferrous metallurgy, fertilizers, refineries, cement) would be approached on a sectoral basis and through specific sector restructuring and privatization strategies. D. Restructuring (a) Government's Industrial Strategy 2.26 The Government's approach to industrial restructuring distinguishes between two types of enterprises and subsectors: a) enterprises in capital- intensive sectors, where the restructuring should be introduced in the context of sector rationalization strategy and where the size of enterprises and their importance in local and national economy justify a more direct government involvement; b) enterprises in sectors which already operate in commercial market conditions and where the restructuring could be left to market forces and to enterprise management initiative. The first type of government-engineered restructuring notably includes sectors with the largest number of lossmakers (i.e., metallurgy, chemicals and machine building) and subsectors characterized by gross overcapacity comprising a number of production units with virtually identical technology and undifferentiated products (such as fertilizers and refineries).  - 10 - 2.27 The short-term program specifically targets large lossmakers that need urgent intervention and support to cut the operating losses that will eventually be either liquidated, merged with others, or downsized to the point where resulting units may become viable. In almost all cases, it involves enterprises where liquidation or restructuring will have significant socio- political implications. About 100 large enterprises, mostly from metallurgy, chemicals and machine building sectors, have already been identified, including some of the 30 enterprises with the largest interenterprise arrears followed by the SAL, enterprises with the largest arrears with the banking system and with the largest overdue tax liabilities. In June 1993, the Government started implementation of an emergency program by selecting 30 enterprises in critical financial condition, isolating them from other economic agents and placing them under surveillance of a restructuring committee. 2.28 The medium-term adjustment program, beyond 1996, has a "constructive restructuring" dimension. It is intended for industrial branches and individual enterprises that are considered viable and with growth potential, even if they are not presently profitable. The targeted industrial subsectors include: light machine building, food industry, small-tonnage chemical industry, and traditional export-oriented light industries. In order to support the restructuring process, the Government plans to finance investment projects, guarantee commercial credits, reschedule debts, bring in private financing together with state funding, and provide moderate protection for the subsectors deemed to be in the national interest. 2.29 Both the short- and the medium-term industrial adjustment program give high priority to the closure of economically non-viable enterprises. However, the method of selecting such enterprises is still unclear and their access to finance seems to leave too much room for discretion. It is crucial that large state-financed restructuring be confined to a few vital RAs and to a limited number of CCs that are expected to remain in state ownership in the near future and that cannot be closed down, and to demonopolization that needs to be implemented prior to privatization. 2.30 The Government's exact role and the rationale for its involvement in the industrial restructuring process has still not been well defined. According to the Privatization Law, the SOF, being the majority shareholder of CCs, is responsible for their restructuring, while the responsibility for restructuring of RAs remains with branch ministries. The branch ministries are also responsible for industrial sector strategies. The MOI has launched extensive sector studies covering 85 subsectors, of which 52 have been completed. On the basis of these studies, the MOI plans to devise a comprehensive industrial policy, including restructuring and privatization, that will be forwarded to the SOF to serve as a guideline for enterprise restructuring strategies. The Government is currently refocusing the responsibilities of the MOI, including support to establishment of an enabling environment for the private sector. The proposed Project would support this effort in a number of ways: (a) by helping the MOI to define its new role and how it would be exercised; (b) by assisting the MOI to develop sector restructuring strategies; and (c) by providing technical assistance to the MOI to develop the necessary institutional capacity (Annex 1).  - 11 - 2.31 In view, however, of the heavy competing demands on fiscal and external resources, the Government's direct role in enterprise restructuring can only be modest. It should be restricted to helping with labor retrenchment, and disposal of all peripheral activities and assets. Most restructuring is best left to new private owners. The provision of money for new investment can only be highly exceptional, and even then can most prudently be organized between the banks and their clients in enterprise workouts. To facilitate this restructuring, the Government should clearly signal to the enterprises that they must focus on reducing costs and that they should plan the rationalization of their activities without expecting state financial assistance. 2.32 Parallel to the Government-managed programs, there will be a restructuring process initiated and managed by enterprises themselves, which will be financed by enterprises' own funds and by the banking sector. This will include viable enterprises, which already operate in competitive markets, and enterprises subject to post-privatization restructuring. Restructuring of the latter will be supported by the investment component of the proposed Project. (b) Institutional Framework and Recent Developments 2.33 According to Law 58, the SOF bears the responsibility for corporate governance and restructuring of CCs. Since its establishment, the SOF has been primarily concerned with building institutional capacity for privatization and with privatizing small companies. To get ahead with the restructuring of the 30 isolated enterprises, the Government has created a provisional Rescructuring Committee (RC). International experts were retained, with Bank's help, to assess financial recovery programs prepared by managements of isolated companies and to recommend a course of action. In December 1993, the Restructuring Committee proposed and the Government endorsed an action plan to downsize 21, to liquidate six, and to privatize three enterprises. 2.34 The first isolation exercise having proved to be a promising approach in addressing the issue of enterprise restructuring and of enforcing financial discipline, the Government is planning to extend it to a second and larger group of troubled enterprises, including some RAs. In January 1994, the Government established another list of 30 enterprises (5 RAs and 25 CCs) which, on aggregate, represent 50 percent of the losses and 45 percent of the inter- enterprise arrears of the state-enterprise sector. In order to eventually return to profitability and to settle their arrears, these enterprises must undergo a drastic exercise in loss-reduction and downsizing. Some debt-relief measures and recapitalization may be inescapable. Eventually, some of them will be either liquidated, merged with others, spun off as separate units, or privatized. In almost all these cases, the restructuring will have significant socio-political implications. 2.35 A more permanent institutional arrangement has also been implemented in 1994. An independent SOF subsidiary, called the Directorate for Selective Restructuring, with a separate balance sheet, has been created to manage restructuring, including liquidation of large loss-making enterprises. It took over the implementation of the RC decisions and would eventually consider all 80 to 120 firms deemed critical to the stabilization process. The RC has been  - 12 - dismantled, but the Government has institutionalized its functions in the form of a department called the Restructuring Agency, under the Council for Coordination, Strategy and Economic Reform. The most important immediate challenges are: a) to efficiently implement restructuring decisions regarding the first 30 problem enterprises; b) to clearly define rules that would help select the next group of enterprises that should be put in isolation; and c) to ensure that the new SOF subsidiary does not create an open-ended subsidy system with little or no incentive. to effectively force either exit or privatization. A strong signal must continuously be sent to loss-making and other enterprises that they must adjust or face liquidation. 2.36 Industrial Technology Infrastructure. Over the long run, the Government intends to develop a comprehensive industrial technology infrastructure to help enterprise managements to improve their business and technical practices. A study, financed by the proposed Project (Annex 1), would review the existing 140 institutes, which were a basis of the industrial technology infrastructure ir the old regime, aiming to conceptualize and develop a practical implementation program for a new market and service-oriented framework. Consideration would be given to streamlining and strengthening part of the existing structures, including changing the ownership of the institutes to transform them into private, specialized, services-oriented facilities. E. Private Sector Development (a) Small Scale Private Sector (SME) 2.37 A large number of private sector enterprises have been established since the revolution. By end-1993, about 546,000 firms were registered, of which 29 percent as family establishments under Law No. 54, and the rest as partnerships and joint-stock companies under Law No. 31. About 78 percent of these companies have opened for business. A breakdown of registered SMEs by area of economic activity indicates that about 30 percent are active in manufacturing and trade and the rest in the agriculture and services sector. There is relatively equal participation by family associations and commercial companies in manufacturing and trade; in the services sector, commercial companies dominate strongly, accounting for over 76 percent of SMEs. 2.38 Romania looks to the emerging private sector to provide a major impetus for economic expansion, employment, innovation and growth during the transition. Indigenous small and medium enterprises would likely be the only agents capable of absorbing the excess labor certain to be cast off from restructured or liquidated state enterprises. Despite the lack of proper institutional framework, difficulties with access to finance and "red-tape" in many other areas, the SME growth has been remarkable. In the 1991-1993 period, the SME sector (excluding agriculture) productively absorbed over one million people. By 1993, over 5,000 of these new private companies employed between 21 and 50 employees, and about 800 had more than 50 employees. Their output grew from less than one percent of GDP in 1989 to about ten percent in 1991, and an estimated 30 percent in 1993. The markets for larger production-oriented SMEs are mostly domestic; only about nine percent of their output is exported. They mostly operate in the final goods markets.  - 13 - 2.39 As part of an effort to develop a viable and coherent PSD strategy, the Department for Private Small and Medium Enterprises of the National Agency for Privatization (DPSME/NAP) conducted a national survey on the impact of the social and economic environment on private sector development in Romania. The sample was composed of 1,500 small and medium enterprises. In a separate effort funded by the EC-PHARE, a consultant surveyed 200 newly-established SMEs. The survey findings raise concerns, as they indicate that the current environment does not allow the SME sector to utilize its full potential. The Government is aware of these problems and intends to create a more favorable environment and a supportive institutional framework for SME development, including actions to: (a) create a supportive institutional framework, including government agencies and non-governmental entities run by entrepreneurs, operating at the national and the regional levels; (b) improve coordination, eliminate overlaps, improve targeting and reLevance of programs and activities for SME support and increase the quality of SME-related services; (c) provide SME-related services, including direct advice and training of entrepreneurs on legal provisions, accounting and bookkeeping, financial management, loan applications and other banking matters, marketing, business planning, production management, financial planning, etc; (d) improve SME access to financing; and (e) address the most urgent problems related to SME operations and to remove red tape. 2.40 Progress has alread, been made on some of the programs agreed on in the course of the proposed Project preparation. At the regional level, the Government is playing a catalytic role to encourage formation of various associations of entrepreneurs. A study concerning options to provide the SME credit guarantees has been completed, and an SME Credit Guarantee Fund has been established.8 The SME Credit Guarantee Fund is owned by the Government, by the banks which intend to use its services and by a number of private investors, and will be operated on a commercial basis. From the twelve-point action program, the barriers to private sector access to the social safety net and other social services have been removed; a program for promotion of entrepreneurship through mass media has been finalized and its implementation started; two pilot incubation centers have been established; and agreements with a number of universities were signed allowing entrepreneurs access to their facilities and training. 8/ This was a condition for negotiations of the proposed Project.  - 14 - III. FINANCIAL SECTOR A. Curgent Structure of the Financial Sector 3.01 Until December 1989, the Romanian financial system operated under the central planning mechanism. Financial flows were controlled administratively, leaving little role for central or commercial banking functions. The National Bank of Romania (NBR) issued notes but had little responsibility for the money, credit, or interest rate policy. Savings were mobilized through the Savings Bank (CEC), which lent out a small portion of its resources in the form of housing loans and passed the remainder to the NBR. The Romanian Bank for Foreign Trade (RBFT), the Investment Bank (now the Romanian Bank for Development, RDB) and the Bank for Agriculture and Food Industry (now Bank Agricola, BA), respectively, were responsible for lending to the trade sector, the state enterprise sector and agriculture. All risks were absorbed by the Government. Consequently, the banks' capitalization was extremely low. Funds were mostly borrowed from the NBR and supplemented by deposits from clients in their respective sectors. The NBR also had quasi-commercial banking functions, taking deposits of state enterprises and making short-term loans, mostly for working capital. 3.02 Reform of the banking system has been initiated early in the process of transition to a market economy. Entry to the banking sector was liberalized as soon as the new Government took office. A two-tier banking system was established by late 1990, and formally legislated in April 1991 with the passage of the Law on Banking Activity and the Law Concerning the Status of the National Bank of Romania. The Banking Law endows commercial banks with universal banking powers, and the NBR is given a high degree of formal independence. 3.03 By the end of 1990 a number of private banks was established, including the Bank for Small Industry and Private Initiative (MIND), the Cooperative Credit Bank (CCB) and the Ion Tiriac Bank for Commerce (TCB). Limits of the types of customers and financial services that could be provided by foreign banks were lifted, and entry for new foreign or mixed ownership banks was liberalized. This group currently includes the Chemical Bank (CBF), the Societe Generale (SGF), the Frankfurt-Bucharest and the MISR Bank. There were also new entries by banks in state ownership, including the Romanian Commercial Bank (RCB), which was formed in late 1990 by carving out the commercial portfolio from the balance sheet of the NBR; and the Export-Import Bank of Romania (EXIM), which was established in 1991 to strengthen financial services to the foreign trade- oriented industrial and services sectors. By late 1991, the private bank, Dacia Felix (DFB, based in Cluj), the Banca Creditului Romanesc S.A. (Credit Bank) and the Bank Post, S.A. were created. The Romanian commercial banking sector now comprises six state-owned banks, six private banks (with Romanian capital and joint ventures) and the Bucharest branches of four foreign banks. Another seven private banks have passed registration and are preparing to open for business. More detailed analysis of the Romanian banking sector is provided in Annex 2.  - 15 - B. Financial Sector Reform 3.04 Substantial strengthening of the financial sector is required for it to be able to support the process of transition, especially privatization and industrial restructuring. The banking system is characterized by high market concentration, weak funding base, rigid and unsophisticated structure of funding and lending instruments, and high nominal growth (Annex 2). Open access and the universal banking principle have yielded a multitude of new private banks and the emergence of competition. Bank capitalization has been substantially improved. At end-1991, the capitalization of the commercial banking sector was about 2 percent. By end-1992, the capitalization improved to about 8 percent and in 1993 only two banks were below the international capital adequacy standard. 3.05 The NBR is increasingly using indirect instruments to manage monetary and credit policies, and interest rates have been fully liberalized.9 It has enacted prudential regulations concerning new bank licensing; ownership of banks and qualification of its management; branching; credit risk exposure to a single client and affiliated groups; and currency risk exposure rules. The Supervision Department has been reorganized and strengthened and has already started on-site supervision. Donor TA and direct assistance by the NB of Holland has been and will continue to be readily available to the NBR. 3.06 The current business environment is still not fully conducive to the development of healthy financial intermediaries. The macroeconomic environment is volatile, and a level playing field for all economic agents has not been fully implemented. This creates problems in appraising and pricing credit, interest rate and currency risks. The current level of (tax deductible) general loan loss reserves mandated at 0.5 percent of banks' asset portfolio, taxes banks' capacity to sustain risk. Income is reported on accrual basis which inflates banks' profitability and profits are taxed on nominal rather than inflation-adjusted bases. Specific measures are urgently needed to increase banks' capacity to take and sustain risk, and to make sure that reported financial position reflects banks' business reality. This includes: (a) introduction of rules for risk- based capital adequacy; (b) rules on asset classification and provisioning; and (c) increase in (tax deductible) general loan loss reserves to a level commensurate to financial risk inherent in the current business environment.10 3.07 The proposed Project would also contribute to strengthening of the banking system by improving business practices for appraisal of projects and clients and by providing technical assistance to strengthen individual banks' appraisal capacities; by introducing new instruments and financial services related to export finance; and by stimulating competition and assisting the small private banks to penetrate corporate credit markets. Assistance would also be provided to the NBR to facilitate the implementation of prudential regulations, 9/ The interest rates liberalization is not fully effective in Romanian financial markets, especially in the deposit market. This is due to the inherited structural rigidities (see Annex 2). 10/ Conditions for loan effectiveness of the proposed Project.  - 16 - to improve banks' capacities to manage their risks and asset/liability portfolios; and to improve banks' internal controls and audits (Annex 1). C. Financial Markets 3.08 Financial intermediation in Romania is performed almost exclusively by the banking system. Credit markets have traditionally been characterized by strong segmentation. This segmentation was both logical (e.g., different credit conditions and access rules) and institutional (i.e., access was provided only through assigned banks). Due to the market segmentation, economic agents have faced different conditions of access and different marginal pricing, depending on their identity, economic activity, ownership, size, etc. The new Banking Law (i.e., free entry and branching, universal banking) and the change of rules allowing economic agents to select their bank addressed some of the main issues of the credit markets in Romania. The investment credit markets are, however, still dominated by the two state-owned banks (RDB and BA), which hold about 80 percent shares in the respective markets for industry and agriculture lending, and by the RCB, which dominates the short-term end of the corporate credit markets. The RBFT and the new private banks are successfully challenging their dominance. Moreover, these new banks are also playing an extremely positive role in contributing to the integration of the traditionally segmented credit markets in Romania. 3.09 While interest rate deregulation measures and the abolishment of direct credit controls have provided more scope for the working of market forces in banking and finance, other measures are also needed aimed at: (a) unifying the market; (b) strengthening the competitive structure of the banking system; (c) improving the competitiveness of financial institutions; and (d) improving the capacity of the banks to analyze risk and to price loans accordingly. The proposed Project, by opening access to all qualified banks and providing technical assistance to strengthen their capacities, aims to address operational aspects of the noted issues. 3.10 Since the revolution, the total credit has substantially contracted in real terms (Table 3.1). At end-1993, the volume of credit in real terms was only about 34 percent of that in 1989. The maturity structure has also changed. While the long-term end of the credit market accounted for 28 percent of the total market in 1989, its share declined to about 8 percent in 1993 and the volume to about 10 percent of that in 1989. Another important structural change is a much larger number of market participants. On the supply side, the number of banks has roughly doubled, although the newcomers still accounted for about 12 percent of the total domestic credit market at end-1993. There was also a substantial increase on the demand side. Due to the enterprise commercialization and the new private sector entrants, the number of credit transactions has increased by more than ten times. 3.11 Investment Credit Market. Bank credit has traditionally had only a limited role in the industrial investment finance. In the state enterprise sector, about 55 to 60 percent of investment has been financed directly by the budget, another 25 to 30 percent by the retained earnings and depreciation funds, and only 9 to 12 percent by the banks. For investments in modernization,  - 17 - rehabilitation or expansion, up to 80 percent has been financed from depreciation and retained earnings. Credit control has traditionally been maintained through credit ceilings determined by the type of credit and industrial activity. The financial sector reform has formally replaced this mechanism with discretionary contractual relations based on bank assessments of projects' viability and clients' creditworthiness. The industrial credit market currently accounts for about 20-25 percent of total credit in Romania, a significant fall from the over 45-50 share traditionally held in the last two decades. The market is dominated by public enterprises. Table 3.1: Non-Government Credit Volume in Real Terms Domestic Credit | Foreign Exchange l Total Credit Credit 1/ Notn-goverrnment bil. Lei ;/ Short-Term Long-Term l___________LX' a/ A/ A/ v/ a/ 1989 810 100 100 70 100 28 100 2 1990 683 80 74 64 94 33 42 3 1991 1,375 58 28 77 34 19 24 4 1992 1,915 40 43 75 20 _ 14 56 11 1993 4,555 34 38 77 10 8 67 15 Source: NBR Annual Inflation: 1990 - 105; 1991 - 279; 1992 - 200; 1993 - 280 Deflator Coefficients in Relation to 1989: 1990 W 1.05; 1991 - 2.93; 1992 - 5.86; 1993 16.41 1/ Volume in real terms in percentages of 1989 volume a' Term structure in percentages of total credit 3/ Converted at official NBR reference rates: 1989 - 12; 1990 - 35; 1991 - 186; 1992 - 430; 1993 - 1250 3.12 Term-credit has severely contracted since the revolution. In 1991, its volume in real terms was a mere 34 percent of that in 1989; by end-1992, the market further contracted in real terms to about 20 percent and by end-1993 to about 10 percent of its 1989 volume. The foreign exchange non-government credit market in Romania initially took an even larger dip. In 1990, it contracted to 68 percent and, in 1991, to a mere 8 percent of its 1989 volume. In 1992, however, this market started to recover, due to the funds provided by international development banks and to suppliers credit. By end-1993, the volume increased to about 67 percent of that in 1989, and its share in the total credit market in Romania increased to 15 percent. In terms of demand/supply characteristics and instruments, this market is very different from the one that existed before and immediately after the revolution. 3.13 The transformation of banks into joint-stock companies brought more conservative lending practices. Due to high inflation, the maturities of available credits have shortened to well below two years, access to foreign exchange is difficult and credit for capital investments involving imports is  - 18 - practically not available (Annex 6). The small and medium-size enterprises, including export-oriented enterprises and the new private enterprises which have grown to employ over 20 people, are most negatively affected by the lack of term- finance. This is particularly problematic because the supply response from these types of enterprises holds a potential for reversing Romania's current economic decline. 3.14 Based on the MOI surveys, the investment demand of viable export- oriented enterprises which operate in a competitive market environment totals about US$0.5 billion annually. It originates in export sectors such as textiles, garments and leather, wood, pulp and paper, building materials, light engineering and chemicals industries. Companies seek credit to improve international competitiveness and profitability, to consolidate theit export positions, or to facilitate privatization or joint ventures with foreign private investors. The NAP estimates that the SME investment demand currently amounts to about US$150 million annually. Neither estimate includes incremental permanent working capital demand, which would increase the estimates by US$200 million and US$50 million, respectively. 3.15 The volume of the proposed Project's investment credit component was determined based on intermediation capacity of t financially viable part of the Romanian banking sector, excluding the state-owned banks that were not financially viable and the branches of foreign banks. The assumption that the real growth of aggregate balance sheet size for such banks will be kept at about 20 percent annually, gives an estimated US$200 million incremental intermediation capacity."1 The existence of a pipeline of viable projects was confirmed by screening a number of investment proposals from various sectors, including textiles/leather, machine building, metallurgy, electronics and machine tools. The reviewed investment proposals amount to approximately US$55 million, of which about half are with IRRs of over 20 percent; these were presented by viable enterprises with a proven record as successful exporters. 3.16 Working Capital Finance. Access to working capital finance is of key importance for a successful supply response in Romania. As part of the tight control mechanism, enterprises in the central planning system were typically severely undercapitalized as compared to similar enterprises in a market economy. The conversion process to commercial companies in Romania did not take care of this problem, as the enterprises were not properly capitalized before they were converted. Furthermore, a large number of enterprises were participating in barter arrangements with the CMEA, which lowered their working capital needs. Once the CMEA disintegrated, working capital needed to be increased. Another reason has been a significant devaluation of national currency, which required a corresponding increase in working capital for enterprises which use imported inputs and spare parts. Increases in wages and prices of domestic inputs, combined with the general lengthening of collection periods, have also required an increase in working capital. 11/ However, this operation will remain within limits set by the Government's credit policy and is not incremental in this respect.  - 19 - 3.17 Exacerbating increased working capital needs of the corporate sector is the lack of capacity of the financial sector to deliver, in terms of volume, timing and instruments. This has been reinforced by the NBR policy of credit restraint introduced as a part of the stabilization program. For initially viable enterprises, the limited access to working capital often has been a reason for the decline in capacity utilization and/or the loss of markets. For example, a few enterprises in the textiles and garments sector, which are successful exporters, operate at about 50 percent of capacity. Their effective capacity utilization has been determined not by their opportunity to sell, but by their access to working capital. The access to finance somewhat improved by 1993, and the volume of short-term finance recovered, in real terms, to about 38 percent of that in 1989. This was mostly due to the large spreads in the range of 20 to 30 percentage points which the banks considered adequate to accommcdate their credit risk concerns. 3.18 The lack of working capital finance combined with uncertainties in the terms of access to foreign exchange market and the ability to timely buy the foreign exchange has been especially detrimental to exporters. Unless an exporter has his own source of foreign exchange, he would normally obtain a foreign suppliers' credit, or a credit in domestic currency and then exchange lei for convertible currency in the foreign exchange (FX) market. (Foreign exchange credit markets and foreign exchange markets are analyzed in Annex 6). The FX market supply was typically 8-15 percent of the demand in the 1991-1992 period and about 2-5 percent of the demand in 1993, making access to foreign exchange by particular exporters haphazard and dependent on the FX position of the exporter's bank on any particular day. Potential exporters who need foreign exchange typically wait one to three months to satisfy their demand, hence they are not able to transact if an export order entails strict delivery schedules. 3.19 The proposed Project's demand estimates for export finance were derived based on the assumption that the export credit line under the Project should be able to finance major categories of positive value-added Romanian exports, taking 1993 as a base year. This yields a demand estimate of about US$630 million for export finance (Details are provided in Annex 4). This estimate was cross-checked by a detailed survey, by sectors and enterprises, of export potential unrealized due to the lack of adequate foreign exchange financing. The survey was conducted by the MOI in October 1992. Within sectors, enterprises were screened based on profitability and export experience. For the electronics, chemical/petrochemical, machine building and textile sectors, a potential incremental export volume in 1993 was estimated at US$1.36 billion, requiring an estimated US$443 million in foreign exchange financing. IV. PROJECT RATIONALE A. The Bank Group Strategy for Assistance 4.01 The reform strategy in Romania has been rather steady. The Government remains committed to moving decisively and coherently across a broad front to sustain the reform effort. The reform priorities include: (a) macroeconomic stabilization as a prerequisite for the success of the reform program; (b) accelerating the transformation of ownership; (c) rationalization  - 20 - of productive sectors to make them efficient and ilternationally competitive; and (d) providing social protection to the affected segments of the population. 4.02 In intensive dialogues over the past three years, the Government and the Bank have found considerable agreement on the priorities for adjustment and development. The Bank's medium-term country strategy comprises several strategic themes as reference points for guiding the overall program in support of Romania's reform effort. The Bank aims to: (a) facilitate and support Romania's structural reform and its transformation to a market economy; (b) contribute to financing its balance-of-payments requirements, and help establish its creditworthiness; (c) support sectoral adjustment and development efforts; and (d) help mobilize resources from both official and private sources. - 4.03 The centerpiece of the Bank's current operations in Romania has been the SAL, which was approved in July 1992. The SAL program, along with the Fund stand-by arrangement, provided a macroeconomic framework for the transition. It supports stabilization efforts, including fiscal reform, price and trade liberalization; introduces measures to further policy reforms of the enterprise sector and to strengthen financial discipline; and aims to improve the affordability and effectiveness of the social safety net. Continued support to enterprise reform is critical for the success of the transition. The Bank intends to deliver this support through the proposed Project and the future adjustment operations. 4.04 The proposed Project is fully consistent with the Bank's assistance strategy for Romania and supports all its major elements. In the November 1991 to September 1992 period, the proposed Project was the main vehicle to assist the Government to conceptualize and develop a regulatory, institutional and procedural framework for privatization. Table 4.1 summarizes policy-related measures and the associated objectives which have been accomplished during Project preparation. The intention was to ensure that the overall environment is conducive to privatization and to the successful growth of the private sector. 4.05 Other related Bank projects include the Private Farmer and Enterprise Support Project and the Employment and Social Services Project. The former aims to stimulate transformation and development of the private agricultural sector in Romania, including its distribution and food processing aspects, while the latter aims to improve services associated with the social safety net, helping to ease the exit of non-viable firms and accommodate workers' retrenchment. B. Rationale for Bank Involvement 4.06 In the period since the revolution, the Government has successfully established the legal and institutional framework necessary for a market economy. The role of the state in both macro and microeconomic management has changed. On the macro-level, the new policies have emphasized liberalization (e.g., price, foreign trade, interest rates, entry and exit policies), decentralization and competition (e.g., in banking, industry, agriculture), and market and private sector orientation. At the micro level, the Government has already disengaged from involvement in operational management of enterprises; it has commercialized virtually all enterprises in trade and manufacturing sector and started to  - 21 - enforce their financial discipline; and plans to fully divest its holdings in the next seven years. Financial policies and entry to the banking sector and markets have been liberalized, resulting in emergence of the new private institutions and in changes of financial market structure and availability and quality of financial services. Table 4.1: Policy-Related Measures and Objectives Accomplished During Project Preparation Macro Objective Measure sProjet Objective Completed Privatization