Moldova - First Private Sector Development Project

Document of The World Bank Report No. 14555-MD STAFF APPRAISAL REPORT REPUBLIC OF MOLDOVA FIRST PRIVATE SECTOR DEVELOPMENT PROJECT NOVEMBER 17, 1995 Enterprise and Finance Division Country Department IV Europe and Central Asia Region  CURRENCY EQUIVALENTS (November 1995) Currency Unit = Leu US$1 = Lei 4.5 1 Leu = US$ 0.22 WEIGHTS AND MEASURES Metric System ABBREVIATIONS AND ACRONYMS BRU - Bank Resolution Unit BSD - Banking Supervision Department CIS - Commonwealth of Independent States CLRM - Credit Line Regulations Manual EAA - Enterprise Assistance Agency EAP - Enterprise Assistance Program BAFS - Broadly Adapted Financial Statements ESSC - Enterprise Sector Strengthening Component U (TACIS) - European Union Technical Assistance Program for CIS countries IMF - International Monetary Fund FSSC - Financial Sector Strengthening Component FSU - Former Soviet Union GOM - Government of Moldova GTZ - Deutsche Gesellschaft fur Technische Zusammenarbeit IAS - International Accounting Standards MIN - Ministry of Industry MOE - Ministry of Economy MOF - Ministry of Finance NBM - National Bank of Moldova PA - Project Account PFI - Participating Financial Intermediary PIU - Project Implementation Unit PP - Pilot Program SAL - Structural Adjustment Loan SCC - State Creditors Committee SLA - Subsidiary Loan Agreement SME - Small- and Medium-Scale Enterprises SOE - State-Owned Enterprises STA - State Tax Administration STF - Systemic Transformation Facility TA - Technical Assistance TAP - Tax Administration Program TOR - Terms of Reference TU - Technical Unit USAID - United States Agency for International Development VAT - Value Added Tax REPUBLIC OF MOLDOVA - FISCAL YEAR January 1 - December 31  STAFF APPRAISAL REPORT MOLDOVA FIRST PRIVATE SECTOR DEVELOPMENT PROJECT CONTENTS LOAN AND PROJECT SUMMARY ......................... i - iii PART I. BACKGROUND .1 A. Country Context. I B. Stabilization and Structural Reform .1 C. Relations with the International Financial Institutions .3 D. Project Background .3 PART II. SECTOR SETTINGS .4 A. Enterprise Sector Status .4 B. Issues in the Enterprise Sector .7 C. Financial Sector Status .12 D. Issues in the Financial Sector .15 PART III. PROJECT DESCRIPTION .18 A. Objectives and Scope .18 B. Project Structure and Financing .18 C. Enterprise Sector Strengthening Component .18 D. Financial Sector Strengthening Component .21 E. Economic Analysis and Rationale for Bank Involvement .25 F. Detailed Project Costs and Financing Plan .29 PART IV. PROJECT IMPLEMENTATION .32 A. Implementation Arrangements .32 B. Enterprise Sector Strengthening Component .32 C. Financial Sector Strengthening Component .33 D. Procurement .38 E. Disbursements .40 F. Project Accounting, Financial Reporting, Auditing and Supervision .41 PART V. BENEFITS AND RISKS .43 A. Project Benefits .43 B. Project Risks .43 PART VI. AGREEMENTS AND RECOMMENDATIONS .44 A. Agreements .44 B. Recommendations .45  ANNEXES A. Out-of-Court Restructuring-Sample Memoranda B. Eligibility Criteria for Commercial Banks C. Automation of the National Bank of Moldova D. Payments System Development: Technical Specifications E. Computerization Plan for Tax Inspectorate F. Project Implementation Schedule G. Project Supervision Plan H. Technical Assistance: Estimated Costs, Financing Plan and Procurement Methods MAP IBRD No. 24285R2 TABLES Table 1 - New Business in Moldova Table 2 - Production Indicators in 1993 and 1994 Table 3 - Unpaid Wages and Salaries, October 1993-July 1994 Table 4 - Summary of Proposed Procurement Arrangements FIGURES Figure 1 - Large Enterprises are the Dominant Employers in Moldova Figure 2 - Bank Credits Overdue Figure 3 - Arrears for Sample of 12 Enterprises Figure 4 - Changes in Regulatory Capital in the Moldovan Commercial Banks BOXES Box 1 - Privatization Programs for 1993/94 and 1995/96 Box 2 - Performance of Selected Enterprises Box 3 - Obstacles to the Development of SMEs Box 4 - Improvements in the Banking Sector CHARTS Chart 1 - The Creditor-led Enterprise Adjustment Program Chart 2 - Organizational Chart of the Technical Unit This report is based on the findings of an Appraisaldmission that visited Moldova in May 1995. Members of the team included Messrs./Mmes. Kreacic (Task Manager), Brandsma,; Fleming, Jedrzejczak, Miklin, Pardo, Sutch, and Vandehoeck. EMessrs. Lamdany and.Pepper are the peer reviewers. Messrs. Siegelbaum and Kavalsky. are the managing Division Chief and Department Director respectively for the operation..  MOLDOVA FIRST PRIVATE SECTOR DEVELOPMENT PROJECT Loan and Project Summary Borrower: Republic of Moldova Beneficiary: Ministry of Finance (MOF), National Bank of Moldova (NBM), Ministry of Economy (MOE), participating financial intermediaries (PFIs), and private enterprises. Poverty Category: N/A Amount: US$25 million equivalent and DEM14 million equivalent (about US$10 million). Terms: A single currency loan repayable over twenty years, including a five year grace period and in two tranches: a US dollar tranche in an amount of US$25 million and a deutsche mark tranche in an amount of DEM14 million equivalent at the Bank's standard US dollar and DEM Libor-based rates, respectively. Onlending Terms: Bank funds under the credit component will be onlent by the MOF to PFIs in US dollars or deutsche marks; from the PFIs to final borrowers in the same currency at freely determined interest rates. The cost to PFIs will reflect the cost of Bank funds, the administrative cost of the Technical Unit (TU) in the MOF, part of administrative costs of the Project Implementation Unit (PIU), and a premium to cover the credit risk associated with the PFIs. Depending on subproject requirements, the maturity of subloans granted to finance capital formation would vary from 1 to 5 years; working capital subloans would be for a maximum of 18 months. Objectives: The principal objective of the project is to support and help accelerate the Government's reform program in the enterprise and financial sectors, focusing especially on measures enhancing the links between commercial banks and enterprises. In particular, the project will: (a) accelerate the emergence and growth of small- and medium-scale enterprises (SMEs); (b) streamline larger enterprises and release assets into the market, thus creating smaller, focused companies; and (c) increase the efficiency of resource mobilization and credit allocation through the provision of assistance to restructure the banking system, strengthen the infrastructure for banking activity, and provide institutional development support for solvent banks. Description: The Project comprises two components: an enterprise sector strengthening component and a financial sector strengthening component. The enterprise sector strengthening component would support enterprise adjustment by providing post- privatization assistance, through a new Enterprise Assistance Agency (EAA), to selected large enterprises and would finance the automation of the Tax Administration in the MOF. Thefinancial sector strengthening component would  ii provide resources, through qualified participating banks, for medium-term loans to private and privatized enterprises. This component would also assist in the development of banking skills in the PFIs, the automation of the NBM, and the further development of the payments system. Benefits: Anticipated benefits of the proposed project are: (a) strengthening the supply response to the Government's reform program through the introduction of a comprehensive program of support for the development of SMEs and the turnaround of troubled enterprises; (b) strengthening the financial infrastructure by upgrading the payments system, automating the Tax Administration and the NBM; (c) improving the quality of banks by strengthening the regulatory and supervisory environment in which banks operate; and (d) enabling privatized and new private enterprises to obtain financing at competitive rates for investments. Risks: Risks include: (a) increasing pressure on the Government to reverse the reform measures if and to the extent that the lack of supply response continues-dealing with this risk is the fundamental purpose of this operation; (b) possible backsliding by the Government that will lead to (i) the SCC not sending enterprises into bankruptcy that cannot be restructured successfully under the EAA, and (ii) future budgetary contributions being made to enterprises under EAA's care; (c) institutional weakness of the NBM and PFIs which would lead to a slow disbursement of the credit component-technical assistance has been incorporated into the project design specifically to address this risk; (d) afurther deterioration of the econonty could lead to a significant build-up of non-performing loans which would have a debilitating effect on the already weak financial sector; and (e) slow disbursement of the credit line due to possible competition from directed subsidized credits that might be reintroduced for political reasons. This risk is addressed through an agreement with the Government that a significant part of funds from the budget (earmarked for private enterprise assistance) be channeled through the project-supported TU on market terms. Project Costs: US$ Million Equivalent LOCAL FOREIGN TOTAL Financial Sector Strengthening Credit Line 5.00 27.45 32.45 Payments, Clearing System -- 0.68 0.68 NBM Automation 0.45 1.55 2.00 TA, Financial Sector 1.05 3.50 4.55 Enterprise Sector Strengthening Enterprise Assistance Program 0.50 6.90 7.40 MOF/Tax Administration -- 1.92 1.92 Total Project Cost 7.00 42.00 49.00  iii Financing Plan: US$ Million Equivalent LOCAL FOREIGN TOTAL Government 6.5 -- 6.5 IBRD -- 35.0 35.0 Netherlands -- 2.1 2.1 Germany -- 2.0 2.0 EU (TACIS) -- 1.5 1.5 USAID -- 1.4 1.4 Enterprises 0.5 -- 0.5 Total 7.0 42.0 49.0 Economic Rate of Return: N/A Estimated Disbursements (in US$ Million Equivalent): FY96 FY97 FY98 FY99 FY00 Annual 3 8 14 7 3 Cumulative 3 11 25 32 35 Closing Date: July 31, 2000 Map: IBRD 24285R2 Project ID: MD-PA-8561   I. BACKGROUND A. Country Context 1.1 Moldova is a landlocked country situated between Romania and Ukraine, with a territory of 33,700 square kilometers. It became independent on August 27, 1991. With a population of 4.3 million, Moldova is the most densely populated country of the former Soviet Union (FSU). The population is 67 percent ethnic Moldovan, 14 percent Ukrainian, 13 percent Russian, 4 percent Gagauz (a Christian Turkish people), and 2 percent Bulgarian. 1.2 During Moldova's transition to independence, intense conflict arose due to ethnic factors and differences in approach to economic reform and restructuring. The armed conflict, which ended in a cease fire in July 1992, resulted in the de facto partition of the country, with the Transnistria region remaining under separate control. A new Government took over after the parliamentary election in February 1994 and the Parliament adopted a new Constitution, which establishes a framework for recognizing ethnic differences and provides democratic mechanisms for solving conflicts. The population decided by referendum in March 1994 that the country would remain independent of its powerful neighbors. This decision lowered tensions in Transnistria's relations with the rest of the country. Moldova's efforts to reduce the risk of conflict through peaceful and constitutionally-based negotiations as well as through rebuilding economic relations have so far been productive. Moldova has entered into trade agreements with the CIS and a number of countries, including Romania and Germany. 1.3 Moldova's rich soil and moderate climate are advantageous for agricultural production. During the Soviet period, Moldova developed as a producer of raw and processed foodstuffs (primarily grapes, grains, wines, fruit, vegetables and livestock). Agriculture (about 40%) and the agro-processing industry (about 20%) accounted for most of the National Material Product (NMP) while the industrial sector (household appliances, wood processing, high technology electrical goods and inputs for defense industries) accounted for an additional 20 percent of NMP. 1.4 The Soviet economy was designed as a centrally-planned production line spreading over eleven time zones, in which Moldovan enterprises played a fully integrated role. Most large industries in Moldova were controlled from Moscow. As a result, Moldova was, and still is highly interdependent with other FSU economies. Its small, open economy has therefore been extremely vulnerable to the disruption of trade and payments as well as falling demand for its traditional products that has followed the disintegration of the FSU. In addition, Moldova has suffered a series of climatic disasters that have reinforced the sharp fall in GDP, now at an estimated 40 percent of its level in 1990. B. Stabilization and Structural Reform 1.5 Stabilization. Moldova suffered one of the largest terms of trade shocks of any FSU country. Its dependence on imported energy, and the movement of energy prices to market levels, have lowered real incomes and created an external balance of payments deficit which continues to pose financing problems. Foreign exchange reserves, as of November 1995, were estimated at over four months of imports. Moldova's position as a small member of the ruble area meant that its role in determining domestic monetary policy in the early years of the transition was essentially passive. Inflation approached 2,000 percent in 1992. In November 1993, the NBM officially introduced the new national currency, the leu, supported by firm financial policies, including a ceiling on credit to Government. Over eighty percent of credit is now made available through refinancing auctions; almost all remaining credit is offered at the auction-determined monthly interest rate. Inflation has been reduced from monthly rates of 30-40 percent for most of 1993 to 1.0 percent in the third quarter of 1995. The interest rate on loans peaked at 31 percent per month in early 1  1994, and then followed inflation down to eventually reach about 4 percent in November 1994. The central bank auction rate was 1.7 percent per month in October 1995. Commercial interest rates are, however, much higher, at about 5 percent per month on average, but these too are on a downward trend. Fiscal tightening reinforced monetary firmness during 1993 and early 1994. Budget transfers to enterprises were cut to about one percent of public expenditures in 1993, from 21 percent in 1992, and the largest consumer subsidies, on bread and milk prices, were eliminated in May 1994. The fiscal deficit was narrowed from over 23 percent of GDP in 1992 to 8 percent in 1994, and is expected to be 4 percent in 1995. 1.6 Structural Reform. As early as 1990 the Government took the first steps towards the creation of a market economy. However, progress was hampered by divergences between Government and Parliament on the course of reform and the inertia associated with centrally planned practices and expectations. Significant change began in March 1993, when Parliament adopted the Government's Action Program for the stabilization and recovery of the economy, supported by the IMF and the World Bank. Structural reforms began in earnest, with substantial liberalization of trade and prices, the abolition of preferential credit, and initial steps to reform agricultural policies and improve social protection. 1.7 The new Government which took office in March 1994 has deepened structural reforms. In the financial sector, it is committed to promoting the development of a modem commercial banking system overseen by an autonomous central bank. The NBM has started to build the regulatory and supervisory framework to improve the safety and soundness of the banking system and is committed to a thorough restructuring of the sector. The NBM is beginning to extend its scope of responsibility and competence from the conduct of monetary policy into other central banking areas by tightening prudential regulations, and by introducing loan classification and provisioning requirements. A new Banking Law adopted by Parliament in July 1995 strengthened the NBM's powers of supervision and enforcement of safety standards in commercial banks. The former branches of the Soviet specialized banks were turned into Moldovan state banks before being nominally privatized. More than 20 new private banks have entered the system. 1.8 Parliament approved the Privatization Law in July 1991, but implementation was delayed, initially by the outbreak of conflict over the status of Transnistria and continuing debate on methods of privatization. Significant progress was made from June 1994 onwards, although there is still resistance to small-scale privatization from local authorities and line Ministries. As of end of June 1995, 741 medium- and large-scale enterprises had been auctioned and 563 small-scale objects had been privatized through public auctions. The Government intends to transfer roughly 80 percent of state assets, which includes the large majority of productive enterprises, into private forms of ownership. 1.9 The Government is delivering a strong signal on payments discipline through initiation of a program of enterprise restructuring, with pilot liquidations of several loss-makers. The Government has made significant progress towards creating a supportive business environment by removing all export restrictions. All price and margin controls have been removed-with the exception of a short list of socially sensitive goods from which margin controls will be removed by end-1995-and the maximum tariff is being reduced in stages to 20 percent by December 31, 1995. The Government has removed all export taxes and has started with the implementation of a more rational tax structure, through the introduction of a new corporate profit tax, excise taxes and VAT. 1.10 Competition in the agricultural sector is being enhanced by the dismantling of the large parastatals which dominated grain procurement and agricultural input supply and by the audit and reorganization of Moldcoop, the cooperative which controls rural retail trade. 1.11 Pensions and other benefits have been de-linked from the minimum wage, and benefits will be increased through targeted, flat-rate cost-of-living adjustments within the limits set by the overall fiscal stance. 2  The pension age is to be raised and the Government has agreed to take over severance pay obligations of liquidated enterprises to assist enterprise adjustment and provide for displaced workers. C. Relations with the International Financial Institutions 1.12 Moldova became a member of the World Bank in August 1992. The first Bank loan to the country, the Emergency Drought Recovery Loan (3569-MD) of US$26 million, was approved by the Board on October 21, 1993, with the objective of financing critically needed agricultural imports after the severe drought of 1992. The IMF supported the Government's stabilization efforts through a Compensatory and Contingency Financing Facility-CCFF (March 1993); a Systemic Transformation Facility in September 1993; and a Stand-by arrangement (approved in December 1993). In October 1993 the Bank extended a second loan to Moldova, the Rehabilitation Loan (3653-MD) of US$60 million, to support the initial stage of structural reform and finance critically needed imports such as oil and gas. The Structural Adjustment Loan-SAL (3815-MD), also of US$60 million, was approved on December 8, 1994, and is designed to deepen the stability and reform efforts and support the Government budget. The second tranche of the SAL was released in October 1995. The IMF granted a second CCFF in December 1994 and approved a second Stand-by in March 1995. The Pre-Export Guarantee Facility (3851-MD) of US$30 million, effective since October 1995, has the objective of stimulating viable production for export and building bridges with foreign financiers, traders, and ultimately investors by mitigating the risk of changes in the policy environment. D. Project Background 1.13 The Bank has supported structural reforms which have resulted in trade and price liberalization, the development by the NBM of the functions appropriate to a central bank, and a substantial shift in ownership from the public to the private sector. Other donors are supporting the implementation of complementary reforms which will enhance the prospects of this project's success. The US Government is giving substantial support to the privatization process and the development of capital markets. Other donors are assisting with the development of the legal framework for business, formulation of the public investment program, review of social sector programs, and numerous programs in the agriculture sector. The emphasis of the Bank's own operations is now shifting from support for the policy framework necessary for the transition to a market economy towards the promotion of adjustment in the economy. Bank operations being prepared in parallel in the agriculture and energy sectors will address constraints to supply response in those sectors. The proposed project will build on and consolidate existing policy reforms in the enterprise and financial sectors by continuing the dialogue and providing the institutional development and incentives needed to make those reforms effective. 1.14 To allow the economy to recover, resources will need to be freed from the old economic structures and channeled through market mechanisms to help fuel new private sector growth. A disproportionate share of credit available in the economy is absorbed by old, inefficient industries, which also hold a major share of assets and commercial space, crowding out the nascent private sector. The proposed project aims to help free these resources and facilitate the emergence of market-based links between enterprises and banks, thus promoting private sector investment and growth. The project is composed of mutually- reinforcing components designed to foster new business development, promote privatization and rationalization of the old industrial and agro-processing enterprises, and provide incentives for efficient resource allocation through the supply of credit on market criteria to private and privatized enterprises. 3  II. SECTOR SErTINGS A. Enterprise Sector Status 2.1 Moldovan enterprises today are constrained by a number of factors inherited from the Soviet era: too many resources located in large loss-making enterprises; outdated equipment with almost no process or product flexibility; and inadequate management skills to cope with market-induced changes. In 1994, industrial production decreased 27.7 percent compared to the previous year. Contraction in the enterprise sector continued steadily from 1990, but appears to have bottomed out in mid-1995. Industrial output has grown from 35.6 percent in May 1995 (1990 = 100) to 43.4 percent in September 1995'. At the same time, there is little evidence at the enterprise level of activities which could lead to the development of new products and markets, higher efficiency and better design and quality of products. The very slow pace of ownership change until mid 1994, Moldova's relative isolation from competitive pressures, and a negligible inflow of foreign investment have all contributed to a lack of enteiprise adjustment. 2.2 Enterprise Sector Structure. Data for the distribution of employment shows (Fig. 1) that in spite of Figure 1. Large Enterprises are the Dominant reductions in employment in the former military complex, Employers in Moldova and smaller but continuous labor reductions in the rest of the sector, large enterprises remain the dominant employers. As in the other republics of the FSU, industrial enterprises are grossly oversized. The virtual 17% 12% 42% 29% non-existence of supportive, industrial SMEs is a I _ __ particularly acute problem for Moldova, with its small 0 100-500 domestic market and traditional agricultural and agro- processing specialization. Over-sized enterprises are still heavily dependent on cooperation with the producers and traders from other republics of the FSU. With the breakdown of the USSR, and delay in re-establishing Source: Government of Moldova (1994) trade lines with the FSU, many production links and markets were lost. 2.3 These lost links and deteriorating terms of trade resulted in extraordinary pressure to adjust quickly. Yet, significant adjustment has not materialized at the enterprise level. Few relationships have been forged with enterprises in non-FSU markets and the new situation has not stimulated much development of local supportive industries (SMEs) to offset the loss of traditional suppliers. Enterprises have yet to assume full responsibility for design, marketing, purchasing, sales decisions, and the development of strong links with local suppliers. Regulations in force until recently explicitly forbade state-owned enterprises (SOEs) to subcontract work to the local private sector. Macroeconomic incentives introduced by the Government are not understood fully or are treated as temporary-all in the expectation that "relations from the past will be reintroduced." Thus, the structure of the enterprise sector, by firm size and product range, has not changed for the most part nor has the behavior of much of enterprise management. iSource: Government of Moldova. Official statistics do not yet capture fully the private sector, while quantification of prevailing barter transactions leaves a broad margin for error. 4  2.4 Ownership structure has, however, begun to change significantly during the last year with the acceleration of mass privatization. The state sector of the economy has been progressively reduced and organizational forms have become more diversified due to the emergence of a small SME sector (see Table 1). Table 1. New business in Moldova* 2.5 Privatization Experience. In July 1991, Legal Form 01/93 07195 the Parliament approved the Privatization Law. (# of registered businesses) The slow pace of privatization, up to 1994, was due to conflicting legal provisions, weak coordination between different governmental Limited Liability 7,470 16,479 institutions involved in the privatization process, Individual Company 5,110 29,376 the complexity of the privatization procedures, and Jin SW k ComFany 206 2,323 the highly politicized environment prior to the Production Cooperatives 2,227 2,436 elections in February 1994. Leaseholds 486 337 Total 15,980 64,908 2.6 The first privatization program was adopted for 1993-1994 and covered 1,555 objects: *Theactualnumberofoperatingeompaniesmaybe 995 medium- and large-scale enterprises and 560 lower, Many would-be entrepreneurs register to keep the SMEs (see Box 1). This represents approximately option of developing a private business while maintaining 35 percent of the overall value of state assets and their job in SOBs or the Government. Also, private about 50 percent of the total net value of the state ernployers often require employees to register as individual owned enterprises (excluding agriculture and entrepreneurs to avoid excessive wage taxes. housing which have been privatized under separate Source: Government of Moldova laws). The enterprises located in Transnistria have since been removed from the list (as unavailable for privatization) and some enterprises, especially small objects, were liquidated, merged or leased. By the end of June 1995, 741 medium- and large-scale enterprises had been auctioned for patrimonial bonds. In August 1994, the open outcry auctions were resumed for small-scale units, and by the end of June 1995, 563 small-scale objects had been privatized. 2.7 Upon completion of the mass privatization program for 1995/96, it is expected that roughly 80 percent of state productive assets will have been transferred to private ownership. In addition, the Box 1. Privatization Programs for 93/94 and 95/96 The 93/94 Privatization Program is a mass privatization approach with patrimonial bonds (vouchers) as an exclusive payment instrument. Patrimonial bonds were issued to Moldovan citizens in accordance with their number of years of work. The share allocation mechanism is based on a competitive auction mechanism. Employees have the right to buy up to 20 percent of shares of their company at a nominal price for patrimonial bonds. In the case of agro-processing enterprises, 50 percent of shares have to be given to suppliers free of charge. A national auction system allows the simultaneous privatization of hundreds of medium- and large-scale enterprises, and open outcry auctions are used for small-scale units. In the case of oversubscription-demand greater than 3 times the supply-the allocation of shares is made in a second round of the auction. If there is still an oversubscription in the second round, the allocation of shares i5 made in a third round, on a pro rata basis. The 95/96 Privatization Program includes 800 enterprises to be privatized for patrimonial bonds, 400 enterprises to be privatized for bonds and/or cash and 240 units (including 90 unfinished construction sites) to be privatized for cash. It is likely that only a small fraction of the best enterprises can be sold for cash. 5  Government intends to encourage local and foreign strategic investors to participate in privatization on a case-by-case basis. The list of enterprises to be privatized by different methods consists primarily of state-owned enterprises not included in the 93/94 Program. The Government also intends to privatize some of the so-called "strategic" enterprises, such as the national airline, through trade sales to strategic investors-preferably western-while developing its capacity for regulation and arms-length supervision. 2.8 Corporate Governance. The secondary market for shares of privatized companies and an efficient banking system are important mechanisms to enhance corporate governance and to promote the restructuring of companies. A formal secondary market for trading shares was established recently when the Moldovan stock exchange launched its first operations in July 1995. A government bond market is also just starting in Moldova. The Moldovan financial sector faces a number of immediate structural and infrastructural issues that need to be cleared in order to be an efficient tool to promote corporate governance. Newly created collective investment vehicles-investment funds, trust companies and citizens' associations (voucher clubs)-assist the privatization process and introduce a new form of collective, indirect ownership which can facilitate corporate governance through the accumulation of larger blocks of voting power. By July 1995, 41 close-ended investment funds and 10 trust companies had been established. 2.9 Enterprise Sector Performance. The Moldovan economy continued to shrink in 1994 for Table 2. Production indicators in 1994 and 1995 the fourth consecutive year until mid-1995 when it started showing slight improvement (see Table 2). Indicator 1994 1995(est.) This was the result of both adverse climatic conditions in 1994 and unsolved systemic issues GDP 3.8: 40.1 (discussed in the next section). From the Volue ofIndustrial Production 47.0 423: perspective of medium term viability, Moldovan Gross Agricultural Production 60.7 66.7 industrial enterprises, excluding newly registered Fixed Capital Investments 14.0 9.0 SMEs, can provisionally be divided into three or i ffiie groups, each with specific limitations and restructuring needs: *Solvent enterprises with salable products and local markets. This group is small, employing 4-5 % of the work force, and includes almost all enterprises with a cost advantage over equivalent imports, like: basic foodstuffs, certain brands of alcohol, and furniture. There are also some enterprises-textiles, perfumery-where solvency appears achievable given proper management. *Large enterprises of electro-technical and specialized equipment sectors, formerly producing mainly for the military complex of the USSR and employing about 6% of the work force. These enterprises were managed centrally from Moscow and were highly specialized units of an integrated technological process dispersed all over the FSU2. Recession and economic conversion in the FSU have made their products obsolete. These enterprises often have highly qualified staff. Their conversion would require fundamental changes-reorientation of production and substantial long-term financing. 2According to the manager of one defense enterprise, 95% of its production went to other republics of the FSU; the remaining 5% was used locally but only by another defense enterprise. 6  *Enterprises coping with one or more major constraints: specifically, a decline of purchasing power domestically and in the FSU generally; a shortage of short-term financing for working capital; the loss of markets to better quality products. These are the vast majority of enterprises and employ about 90% of the workforce. B. Issues in the Enterprise Sector 2.10 The major issue affecting the transition of the industrial sector to market-based behavior is insufficient adjustment at the enterprise level. This lack of adjustment is primarily due to a complex set of interdependent infrastructural, institutional, and capability deficiencies: * In the infrastructure area these include: an inadequate accounting system; an inherited enterprise sector structure with excessive labor and capital resources concentrated in medium and large enterprises; narrow, yet high volume product range (with the local market occupying only a fraction of installed capacity); and excessive dependence on imports. * On the institutional side, in addition to deficient laws-relating for instance to collateral and bankruptcy-and a weak commercial court system, the main obstacle to enterprise adjustment is the interlocked non-market relationship between the Government, enterprises and the former state banks which preserves the command economy approach to economic activity. - In the capabilities area the major constraint remains an overall lack of market oriented management skills-including lack of skills to prepare "bankable" projects for financing. 2.11 The above deficiencies all contribute to low competitiveness. Reluctance to privatize SMEs immediately and support the entry of private SMEs (both through spin-offs of larger SOEs as well as establishment of new SMEs) has only aggravated the current structural weaknesses and insufficient competitiveness. The interlocking relationships noted above are making the enforcement of rmancial discipline difficult. The negative impact of these problems is magnified by demonetization of the economy and a shortage of medium- and long-term finance-even for the most promising of exporters. While the above are characteristic of other small former republics of the FSU, Moldovan conditions are more severe due to a less advantageous geographical position, weaker traditional links with European economies, and a reluctance of foreign investors to invest-in part due to the unresolved political situation in Transnistria. Low Competitiveness 2.12 Enterprises aiming to shift to more competitive markets encounter major problems. The organization of production has been such that existing companies have little, if any, process or product flexibility. Most Moldovan industrial enterprises perform poorly at present according to common performance indicators. The result is low working capital productivity, high energy dependence, and very high costs. Improved production methods demand close consultation with the customer and good relationships with a range of complementary enterprises. All too often, the lack of orders has contributed to the preservation of production systems that lack the design, engineering, and organizational capabilities to succeed in a market economy. Instead, the production system combines the low productivity of short runs with the lack of flexibility of batch production systems. Product flexibility is very limited due to a severe lack of industrial design capacity. Consumer goods enterprises are facing a decline in sales due to declining purchasing power in the FSU and increased 7  competition from firms outside the FSU. The firms visited during project preparation have been trying to compete by lowering prices but are finding this difficult due to the need to allocate large overheads across a low volume of output. Even if these enterprises were able to lower significantly the costs of production, it is unlikely that, with their present quality and design, they could increase market share. 2.13 Managerial skills required to address the deficiencies and achieve the necessary restructuring are scarce and there is a lack of determination to manage the adjustment process through radical changes in operations, methods, and structure. Managers of already privatized companies-lacking basic business skills-remain driven by volumes of production and see restructuring as contingent on: (a) the purchase of new equipment; (b) the reintroduction of soft long-term financing; and (c) the renegotiation of preferential trade agreements with FSU countries. Substantial managerial energy is spent on pressuring the Government to secure the above-even after the firms are privatized-thus putting pressure on the Government to soften hard budget constraints. 2.14 Lack of adjustment is also heavily related to inadequate accounting systems and weak motivation to change them. Accounting and financial statements are still oriented outward to feed "the center" with window-dressed historical data rather than inward, to support managers in their decision- making process (see Box 2). The lack of motivation was seen clearly during recent pilot liquidations when the existing accounting procedures presented a misleadingly positive enterprise picture, and gave managers an argument not to proceed with liquidation. There is also a fundamental disparity between international auditors and bank managements in the assessment of commercial banks due mainly to different accounting practices. Box 2. Performance of selected enterprises ... . ....... In October 1994, the performance of eight enterprises with different ownership forms. was comparedwith that in 1991. The volume of production had decreaseda2-5 times while costs of production increased 7-10 times du to energy and rawf material prie rises and increases in wages. However, all etedrprises reported a positive operating margin (operating income less total -costs). : i ........ Such high profitability ratios are mainly due to inadequate accountting: .. .. . . 6* The definitioni of revenues is excessively liberal. -In addition:to production sold it includes goods sentto: clients with little prospect of being. paid on time-if at all and inventories with very: limited prospect of being sold; -:' * Costs are counted on the FIFO basis which in an inflationary environment creates:a false impression of weCUbeing and does not provide incentives to build up the necessary working capital; and * Barter transactions allow manipulation of cost and revenue figures. Slow Entry of SMEs 2.15 There is a lack of understanding in Moldova about the importance of a growing, vibrant SME sector for achieving a more efficient enterprise structure. The main obstacles to the growth of existing SMEs are summarized in Box 3. The main reasons for the very slow entry of new, especially production-related, businesses are: * Slow pace of small-scale privatization due to the resistance to privatization of units at the level of employees, municipalities and branch ministries. 8  * Input markets dominated by the state and strongly linked to FSU economies. Virtually all of raw material input comes from either the domestic market (42 percent) or FSU markets (50 percent); the majority of domestic input is supplied by state-owned firms. Twenty percent of all companies use barter for over 25 percent of their raw material purchases; about a quarter of manufacturers use barter for over 50 percent of their inputs. * New private firms having limited access to productive assets. New equipment for many types of activities is not produced in Moldova; second-hand and therefore cheaper equipment is still locked up in state enterprises unwilling to sell. Box 3, Obstacles to the Development of SMEs A Private Sector Study covered about 100 SMEs in mid-1994. Most of the private firns pursued a mix of activities: trade and services or manufacturing and trade. The firms-which were on average 2 years old-employed on average 17 people. About 44 percent of firns increased turnover in the first 6 months of 1994 compared to the same period in 1993. However, 15 percent reported losses, 16 percent broke even, and 69 percent had only small profits. Over 30 percent of the firms exported: 2/3 of exports went to FSU, and about 114 to Central Europe. Three types of obstacles to growth were identified: * Financing. The main sources of start-up capital were own savings (59 percent) followed by loans from friends and/or family. Almost all entrepreneurs need additional finance for working capital and for investment capital: 60 percent prefer a bank loan, over 30 percent would consider venture capital, preferring a foreign partner. At present, working capital is financed out of profits (46 percent), own savings (19 percent), customer advances (12 percent), and bank loans (6 percent). Few entrepreneurs use loan funds to finance investment capital. High interest rates are quoted as the major problem associated with bank loans, followed by demanding collateral requirements. * Reporting requirements for SMEs. Small and large businesses have identical filing requirements. Although simplified, a small business spends, on average. one staff-week a month while a medium to large business spends two staff-weeks per month fulfilling the following reporting requirements: Taxes- Road, Transport, Land, Conversion, Social Fund contribution, Water, Profit, Value Added, excise and income tax: Financial: Balance Sheet, Financial Results, Production and sales, Labor and wages, Cash Flow, Overview of fixed assets; Social: Social Security, Pension. * Company registration. In order to register a company, an entrepreneur has to get permits or licenses from: the National Company Registrar or one of its branch offices; the National Statistical Office; the registration office of the local municipality in which the company operates; a ministry relevant for the envisaged activities, such as the Department of Trade for import or export activities, the Ministry of Agriculture for agro-processing activities; the fiscal authorities to register as a taxpayer; and the local mayor's office for a license, if the entrepreneur intends to begin retail activity. Weak Financial Discipline 2.16 As in other FSU economies, weak financial discipline (soft budget constraint or soft financing) is the result of a number of causes: weaknesses in banks' lending policies, weak enforcement of tax obligations, activities of functional and branch ministries lobbying for different forms of subsidies, poor payment discipline of enterprises and lack of credible threats allowing efficient collection of overdue payments. It is also a consequence of temporary solutions available to enterprises, such as postponed payment for energy, wages and salaries or utilization and sale of previously accumulated stocks of inputs. 9  2.17 Inappropriate bank financing is reflected in overdue and uncollected loans. The situation is worsening (see Figure 2). Audits of the four Figure 2. Bank Credits Overdue biggest banks confirmed that revolving loans, new 160 loans to pay old ones, payment postponement and 160 rescheduling, as well as acceptance of 120 questionable collateral are the principal techniques . 100 81 used by the banks to hide the poor quality of their o80 6 60 portfolio. Anecdotal evidence suggests that banks 40 continue to lend to loss-makers and recognize 20 - them as trustworthy clients. Also banks' 0 shareholders excessively use their privileged Jun 94 Oct 94 Dec 94 position to borrow. Source: Government figures 2.18 Governmental subsidies granted to enterprises or price subsidies for selected products-while far from being a major source of soft financing as in the past-are still present. Direct subsidies to enterprises during the first six months of 1994 totaled Lei 52.7 million (US$12.3 million). Principal indirect subsidies approved include governent credit guarantees, which on October 1, 1994 equaled Lei 20.9 million (US$4.6 million) and restructuring of commercial debts as government debt-toward the end of June 1994 the arrears of Lei 36.7 million (US$8.5 million) of Cereale at Agroindbanc were taken over by the NBM. 2.19 Tax arrears are one of the most important sources of soft financing and at the same time the most direct threat to the macro-economic stability of Figure 3. Arrears for Sample of 12 Enterprises the country. Tax arrears are growing constantly. By (Micn ix in Nartxr 19) October 1, 1994, enterprises owed the Government a total of Lei 278 million (US$64.7 million): Lei 86 20 million (US$20 million) in excise taxes, Lei 74 million 15. -(US$17.2 million) in VAT, Lei 75 million (US$17.4 10- million) in profit taxes, Lei 26 million (US$6 million) in road taxes. By December 1, this total amounted to Lei 331 million (US$77 million). As of December 1, o 1994 the wage arrears to the Budget amounted to Lei Taxtsm BDv Vh VmW 42 million (US$9.8 million). Concentration of arrears ard in the 12 enterprises with the largest arrears is presented in Figure 3. 2.20 Inter-enterprise arrears amounted on October 1, 1994 to Lei 1.2 billion (US$280 million). Mutual arrears were set off in May 1993 but only about 20% of the inter-enterprise arrears were canceled as a result. These limited results are due mainly to the fact that the arrears are from the "down-stream" enterprises to the "up-stream" ones which, in many cases, are outside the republic. In mid-December 1994, consumers of oil products owed Lei 260 million (US$60.5 million) to the State Fuel Association. Without downsizing through sale of assets-or in extreme cases liquidation-to satisfy creditors, dealing with arrears only through clearance sends the wrong signal to the enterprises that weak payment discipline would not be penalized and that the Government would bail out enterprises again and again. Since mid 1994, pressure on debtors has increased to satisfy creditors from previously undeclared accounts or through enforced sale of assets. The threat of liquidation or action under the bankruptcy law is gradually starting to became a reality as the first liquidations have taken place and some external debts, wages and pensions have been paid that would not otherwise have been. 10  2.21 Unpaid wages and salaries are another source Table 3. Unpaid Wages and Salaries, Oct. 93-Jul. 94 of soft financing. Laying-off a redundant work force is difficult in the present political environment. Month Level at the end ote month Employees prefer to work unpaid for months, accept Million Lei % of wagfes paid payment in products, or accept forced unpaid leave October 1993 11.1 17.1 rather than be made redundant, as there are few January 1994 40.4 74.3 opportunities for new employment. The formal rate of March 1994 80.6 113.2 unemployment is still low-the latest figures in mid- May 1994 83.4 - 77.1 1995 show only 25,000 registered as unemployed and July 1994 5.6 72.0 only 7,000 qualified for unemployment benefits. The Source: Market Insttute Chisiau level of unpaid wages and salaries through July 1994 is presented in Table 3. 2.22 Using previously accumulated stocks of raw materials and components was until recently an important buffer against hard budget constraints. Traditionally, state enterprises hoarded stocks. They have allowed enterprises to keep production going and to be competitive in FSU markets by avoiding payment of new higher prices for input components. Postponing necessary adjustment was encouraged by the adoption of FIFO cost accounting rules. For example, in wine and brandy production-where the technological (aging) process takes many years-prices of input components are presently 3-5 times higher than three years ago. In 1991-1993 state enterprises could buy materials at below market price and sell them at significant profits. 2.23 Deficient and untested laws and administrative procedures to liquidate and restructure enterprises are also an impediment to the efficient implementation of enterprise adjustment measures. Seven pilot liquidations have been initiated under the SAL to streamline the administrative procedures, send a strong demonstration signal to other enterprises, and open the process of selling unused assets to entrepreneurs. These pilots highlighted deficiencies in the existing regulations and the Government is preparing a new version to facilitate the process of liquidation and asset sales. A further 15 liquidations are planned for mid-1995. 2.24 There are powerful incentives for all the parties not to enforce hard budget constraints. For the Government, most of the enterprises are seen as "too big to fail." For creditors, which are often distressed enterprises themselves, there may be value in waiting. Suppliers are reluctant to provoke a closure of major customers. A creditor's position may give it additional control over its debtor's behavior. Enterprises which are individually not "too big to fail" tend to create a network of inter- enterprise payments and, therefore, disperse the potential costs of liquidation around a web of enterprises. For banks, taking action against an undisciplined borrower may reveal the extent of the non-performing debts in the bank's loan portfolio. For all creditors the cost of liquidation, combined with the obligatory payments to the budget and employees, may be higher than the liquidation value of the assets. As a result, even an improved bankruptcy law and the growth of debts may not be enough to expand the use of bankruptcy proceedings significantly. 2.25 An adequate institutional response following the privatization and deregulation of the economy is a prerequisite for enterprise level adjustment. The successful examples of such adjustment in Central and Eastern Europe are based on a mix of internally-driven break-up of privatized and state-owned medium and large enterprises and bottom-up growth of small and medium sized private businesses. These two processes are closely related and their success depends upon the development of specific 11  institutions and skills. The streamlining of existing institutions will require the skills to turn around insolvent and overstaffed entities. It will also require clear regulations to deal with redundancy and with the divestiture of social assets. Downsizing and restructuring in the absence of strategic investors is difficult. The best way to tighten financial discipline in the initial period of transition is to identify and isolate companies requiring major adjustment, to promote their commercial revitalization and, when necessary, liquidation. The establishment of new private businesses will require the introduction of growth oriented skills, deregulation and easier procedures for establishing new businesses. The last few years have shown that a quick response will not be possible without substantial external assistance in terms of financing and skills-transfer. C. Financial Sector Status 2.26 Banking Structure. As of July 1, 1995 there were 22 commercial banks in Moldova: four large, former state commercial banks, 17 new local, mainly privately owned banks, and one Romanian bank. The banking sector is dominated by the four former state banks, the Social Bank, Moldindconbank, the Savings Bank, and Agroindbank, jointly accounting for 67 percent of the total credit in the banking system. They were created with a divested portfolio and liabilities and were established in 1991 as joint-stock commercial banks, taking over the activities of Moldovan branches of specialized FSU banks. The Social Bank focuses on small businesses, Moldindconbank on industry and construction, while Agroindbank specializes in the agriculture and agro-industry sector. The Savings Bank, with over 1,000 sub-branches, is the primary depository for household savings, and carries an explicit deposit guarantee from the Government. It has begun to develop as a retail lender. A core of new private banks has begun to emerge, some of which are growing very quickly in terms of both capital and assets. Seven of these banks are of significant size (Bancosind, Exim, Interprinz, Mobias, Oguz, Petrol, and Victoria) accounting for 29% of total bank credit, 35% of total regulatory capital, 21 % of total assets, and 31 % of household deposits. 2.27. Financial Condition of Banks. The four former state banks were audited in accordance with International Accounting Standards (IAS) for the period ending December 31, 1993, with a follow-up review of the June 30, 1994 loan portfolios. The objective was to determine the banks' credit condition, capital adequacy, and their overall strengths and weaknesses. The audit findings reveal a severely undercapitalized banking system: loss provisioning in three former state banks eliminated their 1993 profits and reduced their equity to negative amounts. The exception was Agroindbank, where equity remained positive but inadequate under NBM standards. Other weaknesses confirmed by the audit included: inadequate credit appraisal and monitoring as well as the absence of risk management procedures; excessive lending to shareholders and loss-making state enterprises; poor internal financial controls and outdated management information systems; lack of experienced banking staff; and excessive branch autonomy. Loan portfolio quality may have deteriorated further since the audit was completed due to further lending to loss-making enterprises, excessive bank taxation, worsening terms of trade, the further decline of trade with Russia, and recent droughts and floods. The audit showed that the four banks needed considerable strengthening. A high percentage of non- performing loans and excessive credit risk concentration appear prevalent in the system. There is inadequate provisioning for non-performing loans while the GOSBANK accounting standards fail to provide a true picture of the underlying financial health of banks. 2.28 Accounting and Auditing Framework. The international accounting firms audited the four former state banks under the IAS. The Moldovan banks, however, continue to use the GOSBANK accounting system, and have little incentive to convert. An extensive program of support and technical 12  assistance would be required to bring Moldovan accounting standards to internationally accepted standards. The NBM has established a working committee with representatives of the commercial banks to assist in reforming the accounting practices. Banks will be required to prepare and present financial reports in compliance with Broadly Adopted Financial Statements (BAFS) format by the end of 1995. One of element of this approach includes the utilization of BAFS as a minimum reporting requirement in the transition to IAS. These efforts are now supported by TA provided by USAID. However, several of the commercial banks are already currently preparing financial statements more compatible with IAS using BAFS. Figure 4. Changes in the Regulatory Capital of the Moldovan Commercial Banks (000 Lei) 90,000 80,000 70,000 60,000 50,000 .. 01/01/95 40,000 0L7/01/95 30,000 20,000 10,000- *- - - l- . - 2 Lo C Eo DDgXDmDDc D2 E 2 t. mo-X- X 0 > 5c 2.29 National Bank of Moldova. The NBM was established by the Law of the Republic of Moldova as the central bank in 1991. The objectives of the NBM are: ensuring the stability of the national currency, issuing money, safeguarding the nation's currency reserves, implementing monetary and credit policy, and supervising the activities of the commercial banking system. The National Bank Law passed by Parliament in July 1995 refines the role of NBM and strengthens its supervision function. The operation of banks in Moldova is also governed by the Law on Financial Institutions which was passed by Parliament in July 1995. This law sets out the powers and responsibilities of the NBM regarding commercial banking activities. With the support of the IMF and the Bank, the NBM is rapidly strengthening its capacity to supervise the commercial banking system according to the provisions of the new Law. 2.30 Regulatory and Supervisory Framework. Banking supervision is addressed in both of the above laws. Although neither the regulatory nor the supervisory framework is well established, the 13  NBM does have limited regulatory powers. These include issuance of banking licenses and supervision of commercial banks in accordance with prudential regulations. Although the NBM can exclude commercial banks which are not in compliance with its prudential standards from the credit auction, and can restrict access to securities market, these are not a practical deterrent for the four former state banks. The NBM also has the power to limit the amount of household deposits to the level of bank capital for banks which are not in compliance with prudential standards. The NBM has no right to demand or enforce a change in management of a commercial bank which is not complying with prudential standards; it only has the right to recommend to shareholders that they replace a bank's management. Nor can the NBM restrict or limit the dividends paid by commercial banks, and it can apply monetary penalties to commercial banks after agreement of the Commercial Court. 2.31 The NBM has taken several regulatory initiatives in recent years. Prudential ratios governing capital adequacy, legal lending limits, liquidity and reserves were introduced in June 1993. Supported by the Bank's SAL, allowable capital, classification and provisioning guidelines were introduced in December 1994. A new law provides for the mandatory creation of adequate reserves, encouraged by favorable tax treatment of provisioning. A bank will not be in compliance with capital regulations until the bank has evidence of adequate capital after setting aside sufficient provisions for possible loan losses. Bank licensing regulations and bank auditing guidelines have also been introduced. The NBM has adopted several additional regulatory initiatives including the introduction of risk-based capital adequacy guidelines after the banks reach solvency. Other SAL-supported regulations include: risk- weighted capital standards, reinstatement of regulations restraining insider lending to directors, officers, shareholders and related interested parties; enforcement of the limit on exposure to single borrowers of 30% of capital; and enforcement of the regulation to form an adequate allowance for loan losses. On-site supervision was introduced in the sunmmer of 1995. 2.32 Bank restructuring. As a first step in implementing a bank restructuring strategy, NBM has required all commercial banks to submit a statement of their capital position as of year-end 1994, adjusted for adequate reserves and conforming to the new Credit Classification and Provisioning Guidelines. Initial results indicate that four banks have capital deficiencies, with some banks close to insolvency. As a result, the NBM signed Memoranda of Understanding with 11 problem banks setting out measures necessary to reach a positive capital position by July 1, 1995. A comprehensive exercise assisting banks in formulating "Capital Building Programs," initiated by the Bank, is in process. All banks were advised how to prepare detailed data on their capital and financial positions as well as their strategy for the coming two years, including a forecast for growth, plans to raise capital, and problem areas that will need to be corrected to realize the strategy. Data will be analyzed by the project- supported Bank Resolution Unit (BRU) located in the NBM supervision department. BRU is assisted by USAID funded advisors. The BRU will work with problem banks to address weak points and possible restructuring or recapitalization. 2.33 Legal framework for bank operations. The legal framework relating to collateral for bank lending was established in December 1993. It has many deficiencies, however. There are, for instance, deficiencies in the registration of titles, and other property rights, and a lack of a developed commercial court system for enforcement. Financial institutions encounter difficulties in the valuation of collateral. They are not allowed to own foreclosed property and are forced to set up separate legal entities to dispose of foreclosed collateral. The new but weak secondary securities market impedes valuation of financial collateral while the Law on Securities Circulation and the Stock Exchange of May 18, 1993 (the Securities Law) covers only certain types of securities and excludes, among others, treasury bonds, bank certificates of deposits, and promissory notes. 14  2.34 The laws on the National Bank, financial institutions and taxation of banks have been adopted by Parliament. In addition, the Securities law was amended in June 1995. A comprehensive public debt law, which also establishes the legal foundation for book-entry government securities, is expected to be passed by Parliament soon. Further, a revised law on bankruptcy was submitted to Parliament in June 1995. The court system and enforcement of existing laws, such as the laws of collateral and bankruptcy, is being strengthened. 2.35 Payments, clearing and settlement system. The bank payments system has over the last year improved in terms of the speed and efficiency of completing the payments process. Payments that used to take several weeks to clear and settle can now be completed within a week. This improvement has been facilitated in part by the adoption of an E-mail electronic delivery system which is used to deliver a range of documents. However, only six banks are connected to NBM's electronic payment system, and not all the branches of these banks are connected to the system. D. Issues in the Financial Sector 2.36 In order to support the development of the real sector of the economy it is vital that the financial sector be restructured so financial intermediation resumes. The volume of financial intermediation in relation to the size of the Moldovan economy is well below that of a Western economy of equivalent size. The Government is faced, therefore, with a number of immediate structural and infrastructural issues in the financial sector. 2.37 Banking sector structure. To the extent possible, the restructuring of the banking sector should take place in tandem with the restructuring of the enterprise sector. Without strong banks that are prepared to lend to the emerging private sector on market-based principles the effective restructuring of enterprises may not be possible. The main challenges in the banking sector at this juncture are: a) attracting capital to back new, truly commercial financial institutions; b) regaining confidence of the population in the banking system; and c) the restructuring and strengthening of commercial banks. NBM has initiated a restructuring process (see para. 2.32 above) that will entail some 11 problem banks-including three of the four large, former state banks-presenting to NBM an acceptable recapitalization plan. The Bank and the IMF are jointly working on the preparation of a restructuring strategy in support of NBM. The challenge for the NBM will be to precipitate the restructuring, merger, or liquidation of insolvent banks, but to do it in a way that will not undermine confidence in the banking system as a whole. The strong message that such a proactive approach to restructuring will inject into the banking system will create a more disciplined approach to banking operations in the system at large. The banks emerging from the restructuring process will be stronger and more able to play a central role in financial intermediation. 2.38 Bank practices. Moldova's banking sector has been nominally privatized. The four large former state banks remain, however, sensitive to pressure from the government, as well as from industrial shareholders, in making loans. This ambiguity in ownership and control undermines market discipline in granting loans. One major reason is that a significant portion of banking shares is owned by large enterprises that continue to be heavy borrowers from these banks. In addition, government pressure to make loans based on non-market criteria also adversely affect the loan portfolios. Banks still rely on the GOSBANK accounting system, which contains inconsistencies in accounting practices, clouding accurate assessment of the Banks' financial strength. However, by the end of 1995, banks will be required to prepare and present financial reports in compliance with BAFS format with full 15  conversion to the new chart of accounts and IAS reporting required for all banks in Moldova by the end of 1996. 2.39 Skills Development. There is a need for technical assistance both in the NBM and in the commercial banks to improve a wide range of banking skills. The banks need to develop expertise, among others, in project finance structuring and analysis, risk analysis, credit initiation, credit appraisal and loan monitoring. There is also need for on-the-job assistance for commercial banks in bank strategic management, human resources development, operations, treasury management and trade finance products and services. Other weaknesses include the lack of experience in, trade finance techniques, foreign exchange trading and its risks, and internal audit and controls. USAID has begun a program to raise professional standards by training local bankers, while several banks have resident Western advisors. However, more technical assistance is requiree, to expand the professional level of the commercial bankers and NBM supervisors to reach a level competitive with their western counterparts. 2.40 Regulatory and supervisory framework. A sound regulatory framework and strong mechanism for banking supervision are vital prerequisites for a well functioning, solvent banking system. The NBM, in collaboration with the IMF and in consultation with the Bankers Association in Moldova, assisted in the drafting of the National Bank and Financial Institution Laws which have been enacted by Parliament. The Supervision Department of the NBM has increased its staff over the last few months but needs considerable reinforcement. While the NBM's capacity to understand, regulate and supervise the banking system has grown recently-reinforced by the two new laws-the supervision function needs to improve its skills in techniques of bank supervision, both on- and off-site. To support NBM's strategy for restructuring the banking sector it will be important to develop skills within the department of Banking Supervision for the resolution of problems associated with bank insolvency. 2.41 Credit Channeling Mechanism. There is a need to strengthen Moldovan banks-through tailored programs of institutional development-to a point where they are able to channel medium-term credit to private enterprises from multilateral international organizations, and other donors. In this way banks would be able to finance the new investment needed to support the economic transition. In recent years a number of new private banks have developed that are well capitalized and are lending on market-based principles. These banks, which may become the core of the banking system in due course, have the ability to absorb new skills, including those needed to channel medium-term credit. 2.42 Infrastructure Development. The infrastructure for the banking system requires significant strengthening. The introduction of internationally accepted accounting and auditing principles, for instance, would provide the necessary foundation for banks and their clients to function in a market economy. The payments system should be further upgraded if it is to support the enhanced volume of transactions expected as economic activity increases. The NBM is at the center of the payments and clearing system and it will require extensive investment in computer hardware and software to support the upgrading of that system. The legal, regulatory and supervisory framework for banks should also be upgraded by improving and implementing existing laws, especially in the field of bankruptcy, collateral, and property rights. More generally, there is a need to improve the computing and management information infrastructure in those institutions-the NBM and the Tax Authority-that interface with the banking system and the enterprise sector. 2.42 Capital Market Development. The legal framework for a well-functioning capital market should be developed to support the current acceleration in the privatization process and the resulting demand for 16  an efficient securities trading mechanism. As the focal point for secondary market trading-the stock market-develops, the parallel development of capital market infrastructure such as a share depository, a system for clearing and settlement of shares, and a system of share registry and share ownership transfer is required. There is also a need for a Securities and Exchange Commission, or its equivalent, to safeguard the investing public's interests. Furthermore, it is imperative that adequate regulations regarding investment funds are drafted to safeguard small investors. 2.43 A formal secondary market for trading shares of privatized and private companies is taking its first steps with strong logistical support from USAID. The stock exchange-established as a joint-stock company by a group of market operators-began operations in July 1995 while the State Securities Commission (SSC) was appointed in mid-1995. Both institutions are at their nascent stage and require further institutional development and staffing to create a secure and efficient secondary market. The first priority is to create an effective supervision system for investment funds. These play a critical role in privatization and will likely play an equally important role in the corporate governance of privatized companies. The Capital Market Monitoring Unit, created under the auspices of USAID, is a valuable first step in this direction and should be accommodated by the SSC. There is also an urgent need to create a sound environment for secondary trading-reliable registrars and share depositories and a system for the clearing and settlement of securities and related payments. The SSC should also develop and implement licensing requirements for professional market operators: broker/dealers, investment advisors, portfolio managers. These requirements in turn should then lead to the development of adequate and efficient safeguards for small, unsophisticated investors who dominate the Moldovan market. 17  III. PROJECT DESCRIPTION A. Objectives and Scope 3.1 The project is part of a broader program of support for the reform of the enterprise and financial sectors. It was conceived because of the limited supply response to date to the stabilization and structural reform measures being implemented under the Government's economic reform program. The project would be supported by a proposed World Bank loan of US$35 million equivalent, and funding from other donors, including EU (TACIS), Germany, Netherlands, and USAID, totaling US$7 million. 3.2 The principal objective of the project is to support and help accelerate the Government reform program in the enterprise and financial sectors, focusing especially on measures enhancing the links between commercial banks and enterprises. In particular, the project will: (a) accelerate the emergence and growth of SMEs; (b) streamline larger enterprises and release currently unproductive assets into the market, thus creating smaller, focused companies; (c) increase the efficiency of resource mobilization and credit allocation through the provision of assistance to restructure the banking systs -n; and (d) strengthen the infrastructure for banking activity, and provide institutional development si pk irt for solvent banks. The project will have a strong demonstration effect on the whole enterprise s -crr by showing the benefits of firm-level adjustment, and by reinforcing financial discipline through facilitating the exit of non-viable parts of enterprises and releasing their assets into the market. In the financial sector the project will increase the efficiency of resource mobilization and credit allocation through the provision of assistance to restmicture the banking system, strengthen the infrastructure for banking activity, and provide institutional development support for solvent banks. B. Project Structure 3.3 The project will comprise two components: an enterprise sector strengthening component (ESSC); and a financial sector strengthening component (FSSC). The ESSC will facilitate the growth of a population of viable and competitive enterprises by providing technical assistance (TA) for rationalizing selected larger enterprises and by providing private SMEs with the technical assistance necessary to prepare bankable investment projects. A Bank survey of SMEs indicates that taxes and tax administration are significant obstacles to private sector development. The ESSC will provide computer hardware and software to assist in strengthening the ability of the Tax Administration within the MOF to collect taxes in a timely fashion and lower transaction costs. The FSSC will provide resources-a credit line-through qualified participating banks, for medium-term loans to private and privatized enterprises. This component will also: (a) assist with the development of banking skills in the participating banks; (b) strengthen the payments system through the provision of computer software and hardware for the Clearing Center at the NBM; and (c) support further institutional development- including automation-for NBM as a whole. C. Enterprise Sector Strengthening Component 3.4 The enterprise sector strengthening component totals US$9.32 million, of which 53% would be financed by the proposed Bank loan. It consists of (a) an Enterprise Assistance Program (EAP) for US$7.4 million and (b) a Tax Administration Program (TAP) for US$1.92 million to finance the automation of the Tax Administration in the MOF. The ESSC has the following objectives: 18  * freeing assets presently locked in large- and medium-sized enterprises and making such assets available for private SMEs while preserving the core businesses of streamlined enterprises; * stimulating decentralized, out-of-court, creditor-led action aimed at imposing financial discipline on enterprises through rehabilitation of their businesses and debt restructuring voluntarily agreed between owners and creditors; * serving as a demonstration of the positive after-effects of privatization; and * preparing bankable investment projects. 3.5 Enterprise Assistance Program. The EAP would assist the Government in the initiation of market oriented adjustment of selected enterprises through the tightening of financial discipline and the provision of supporting expertise and technical skills. Streamlining in enterprises will be achieved through the introduction of an out-of-court, creditor-led adjustment of selected enterprises, aided by an Enterprise Assistance Agency (EAA) established on June 21, 1995 (for details on the EAA see Chapter IV). 3.6 Most of the activities leading to tighter financial discipline through the implementation of the EAP would be left to a decentralized process operated by market agents including: (i) owners and management of enterprises to be restructured; and (ii) commercial (individuals, other enterprises and commercial banks) and public creditors (the State Budget, the Social Fund, energy suppliers and wages). They would be advised in this process by local and foreigrf consultants. 3.7 Only private or privatized enterprises, provided they have had a general meeting of shareholders and a Board of Directors, are eligible to participate in the EAP. 3.8 To encourage enterprises to undertake sometimes painful adjustment measures, a variety of incentives are foreseen, including the restructuring of arrears and penalties due to public creditors and commercial creditors (including banks). This entails a temporary moratorium on these claims and the possibility of their restructuring, and technical assistance from international and local consultants for which some financial contribution would be required from enterprises. Furthermore, management may sell assets or divisions of the enterprise in a transparent and competitive way-within the general limits pre-approved by owners. 3.9 At the same time, enterprises entering the EAP are restricted in their access to external financing for the duration of the agreed moratorium. New credits from third parties (banks, suppliers) will not normally be allowed during this period. This, however, does not prevent a private commercial bank from lending money at its own risk and on its own terms to enterprises in the programs in well documented cases (signed delivery contracts, invoices) and only for operational short-term financing of working capital. To remain in the program, an enterprise would have to pay ongoing operational expenses including tax as wages and energy. 3.10 Rights and Obligations of Owners. The owners of an enterprise notified by the Creditors Committee (see 3.12) must decide whether or not (i) to accept measures negotiated with creditors or (ii) to voluntarily initiate liquidation of the enterprise by filing for bankruptcy. The Board of Directors of a company undertaking the EAP should include representation of external shareholders and internal ones (managers and employees). The Board of Directors should be authorized by the owners to hire and dismiss a chief executive officer (CEO) of the company, sign a management contract and authorize the 19  CEO to implement restructuring measures, including downsizing. Management contracts would set post-restructuring targets and define incentives for managers that achieve the targets. 3.11 Rights and Obligations of Creditors. The proposed EAP is a voluntary alternative to the bankruptcy procedures envisaged by the Bankruptcy Law-creditors may refuse to accept the restructuring as proposed by a company's Board of Directors, and file for bankruptcy. Creditors act through a Meeting of Creditors. Measures accepted at the Meeting of Creditors are binding for all creditors. 3.12 Selection Criteria. Cawt 1: The Creditor-led Enterprise A4ustment Progam Entry into the EAP is to be Tire Schedle initiated by the State Creditors Committee (SCC) Crditors Tirm Line Enterprise representing public creditors, established by the Government's decree of May 4 T C cks 15, 1995 (see Chart 1). The SCC will prepare a list of The SCC serds enterprises with debt to the erTKorandum c2 v*Jmks public creditors focusing on The mandum particular cases where there is a high probability that 4 weeks entry in the EAP would result in fast recovery of a < The G/Meetirg of Shareholders: authorizes the Board of Directors company. Hence, the cases 4 weeks to irite credtors to negtiate chosen should promise the highest potential return from The hrst Cieditars an invested dollar of TA, in Meeting t d terms of fast and substantial 6 wks improvement of financial The Second Creditors MBeting solvency and potential growth appoves the Adjustment Ran and o opportunities. To participate the debt restructuring agreemNnt A in the EAP enterprises will up to 9 nahs have to satisfy the following criteria: (i) medium- to large-scale enterprise, (ii) willingness of management and owners to participate, (iii) export asagreed orientation, (iv) well defined _ products and markets, (v) Loan application sound operational capacity, and (vi) ability and willingness to cover a part of the costs for the TA received. The donors (Germany, USAID, EU (TACIS)) will choose enterprises whose probability of successful adjustment they estimate to be high. 20  3.13 Initiation of the Program. The SCC will begin the process of notifying Boards of Directors of selected enterprises of the need to start a process of legal compliance with the Program (Annex A: Sample Memorandum). Such a memorandum will have to be countersigned by the enterprise director and returned to the SCC, indicating whether the enterprise agrees to call a general shareholders meeting. Successful completion of this step would empower the enterprise's Board of Directors how best to work out an Adjustment Plan that would have to be acceptable to enterprise's private and public creditors. If such authorization is granted, the Board of Directors wili notify and seek the creditor's approval for preparation of the Adjustment Plan (the First Creditor's Meeting). 3.14 The First Creditor's Meeting will decide whether to support an enterprise's attempt to prepare an Adjustment Plan, which will imply a moratorium on the payments due to each creditor during the preparation of the Adjustment Plan. An Adjustment Plan would include: a conservative projection of cash flow, including one-time revenues from selling assets. It should also contain a short-term survival plan, including: cutting costs related to energy consumption, employment, materials and components, transportation, marketing, and overnead; collection of receivables; selling assets and/or separable ongoing businesses; other measures J,eading to strengthening the operational cash flow; a debt restructuring plan and assistance in the reconciliation of debts with creditors; and a three- to five-year business plan and an investment loan application when necessary. 3.15 Work-out Phase. Once creditors have approved the preparation of the Adjustment Plan, the Second Creditor's Meeting will vote on whether the proposed Plan is acceptable. This plan shall be approved by a qualified majority of the creditors registered at the First Creditors' Meeting (2/3 of creditors present at the first meeting). As a part of the approved Adjustment Plan, the creditors will sign a debt restructuring agreement with the enterprise. Pursuant to this, the creditors will agree that during the work-out period proposed in the Adjustment Plan (not to exceed 9 months) a moratorium on payments on non-current debts will apply. The enterprises that successfully emerge from the Program will begin repayment to each of the creditors in accordance with the provisions of the debt restructuring agreement. 3.16 Conclusion of the Prcgram. After the period of adjustment, the enterprise should graduate as a financially viable entity. If it cannot satisfactorily adjust, public and/or private creditors may undertake measures leading to the termination of the company. The SCC will be obliged to initiate a bankruptcy proceeding on behalf of the public creditors against enterprises (i) that reject entry into the Program; (ii) whose creditors reject the preparation of an Adjustment Plan; (iii) whose creditors reject the proposed Adjustment Plan or (iv) that fail to successfully implement the Adjustment Plan. D. Financial Sector Strengthening Component 3.17 The objectives of this component are fourfold. The first is to provide medium-term financing for newly privatized and other private sector enterprises. The second is to establish a robust channel for credit lines in the context of a strengthened regulatory and supervisory environment for banks. The third objective is to provide an incentive for participating banks to strengthen themselves to become core banks in the Moldovan banking system. The final objective is to support the institutional development of those parts of the NBM that interface closely with the private banking system. 3.18 The FSSC consists of the following sub-components: (i) financial support for the Credit Program, including an SME window; (ii) institutional strengthening and technical support for the TU, 21  the Bank Resolution Unit and participating financial intermediaries (PFIs); (iii) strengthening of the Payments, Clearing and Settlement System; and (iv) automation of the NBM. 3.19 To become a PFI, private commercial banks would have to meet a set of stringent financial and management criteria and have signed a Subsidiary Loan Agreement (SLA) with the TU. Potential PFIs would have to be individually appraised by the TU and be satisfactory to the Bank. A precondition for any bank to become eligible would be to have its financial statements audited by external auditors acceptable to the Bank. The evaluation of a PFI would focus on five main areas: (i) capital adequacy, (ii) asset quality, (iii) management effectiveness, (iv) earnings performance, and (v) liquidity. The specific eligibility criteria were confirmed at negotiations (see Annex B). As a condition of loan effectiveness, two Subsidiary Loan Agreements satisfactory to the Bank must have been signed. While the banking sector of Moldova is in need of serious restructuring, at least one large and two smaller banks are expected to meet the eligibility criteria immediately. Temporary deviations from the eligibility criteria could be allowed as long as the SLA to be entered into between the TU and PFI includes a custom-made program of recapitalization and/or institutional development. Such programs would include a negotiated timetable for implementation, and could be supported by the technical assistance sub-component for the banking system. 3.20 The demand for medium-term credit. As Moldova's economy stabilizes, privatized enterprises and new entrepreneurs will require access to medium-term financing to support the investment needed to restructure the economy. In the context of a Bank survey of SMEs, virtually all entrepreneurs (92%) cited the lack of longer-term financing as a constraint on their operations, and expressed interest in drawing on the proposed line of credit. T'he survey estimates the pipeline for the SME borrowing to be in the order of US$40 million. This estimate may be at the high end of the demand range and may not reflect the actual numbers of sub-projects that are "bankable." However, the investment needs of the restructured larger enterprises may, in addition, boost the demand estimate. Accordingly, the US$27 million credit line should be adequately sized to meet a significant proportion of demand in the project pipeline, taking into account the limited availability of foreign exchange facilities in Moldova. The binding constraint in defining the size of the credit component has been the estimated absorptive capacity of the banks- -i.e., their ability to channel additional loan funds without violating prudential regulations. The regulatory capital of the banksI determines the additional funds banks can channel. The NBM's prudential regulations limit the maximum loan size to a single borrower to 30% of this regulatory capital. At present the absorptive capacity of Moldovan banks appears limited due to the insolvency of a number of banks caused by their need for extensive provisioning. However, some banks-the initial focus of the proposed credit line-have had success in issuing new shares. Experience in other FSU countries shows that bank capital has the potential to grow quite quickly in some instances. See Box 4. NBM Regulation of May 31, 1995 on Risk Weighted Capital Adequacy defines regulatory capital as Tier I + Tier II capital minus loan loss provisioning and investments into other banks, and capital adequacy as regulatory capital divided by risk- weighted assets. 22  Box 4. Improvements in the Banking Sector In the auturn of 1994, the Bank screened some of the smaller banks in Moldova for their eligibility to become a possible intermediary for SME lending. The Bman* discussed the criteria for eligibility and the required performance and financial structure improvements with two possible candidates, Both banks successfully followed up on the Bank's recomnendations for improvement. One bank has significantly diluted its concentrated ownership (and connected lending portfolio) by issuing shares to private individuals, increasing shares in the hands of private individuals from 6 to 47 percent and decreasing the share of the 10 major shareholders (SOEs and former SOEs) from 70 to 39 percent. The second bank has undertaken steps to reduce its bad debt by: the initiation of bankruptcy proceedings against clients, cutting costs of administration to increase its profit margin, and proposing to shareholders deferral of dividend payments and measures to raise additional capital The commercial eligibility of these banks was confinned in a subsequent, November 1995 mission. 3.21 Credit mechanism and bank eligibility: The credit line will be channeled through a TU in NBM and then on to PFIs. PFIs would on-lend the proceeds to private enterprises using market-based principles. The PFI would carry the risks associated with the on-lending. The project will seek to strengthen incentives for sound institutional development of newly formed commercial banks by establishing strong criteria for participation in the line of credit. 3.22 Regulatory and Supervisory Frarnework: As a backdrop to the proposed credit line, Bank preparation missions have discussed extensively with the NBM the legal, regulatory, and supervisory environment for the banks. The NBM has made considerable efforts to strengthen prudential supervision of banks and is supported by a comprehensive program of technical assistance coordinated by the IMF. To ensure that the regulatory environment is sound enough for the channeling of the proposed credit line, an implementation program for a number of measures to strengthen the supervisory framework-noted below-was agreed with the Governrment during project preparation. 3.23 The amended Central Bank and Financial Institutions Laws accord the NBM additional enforcement authority. The NBM needs to develop the capacity to use these powers effectively. Although the growth in the capacity of the NBM to supervise the banking system has improved recently, the Supervision Department needs to develop a sound institution building program. This program would include the development of the structure and staffing of the Supervision Department as well as a plan for the expansion of off-site and on-site supervisory capacities. As a condition for Board presentation, banking regulations satisfactory to the Bank have been put in place, satisfactory progress has been nade in the enactment of an Institutional Development and Action Plan for the Banking Supervisory Department of the NBM. As a condition of effectiveness, the new Financial Institutions Law has come into force. 3.24 If more banks are to become strong intermediaries capable of intermediating external medium- term foreign currency credit, a major restructuring of the banking sector must be initiated. However, to develop and enact such a strategy NBM will need significant assistance from the Bank and other donors. With the support of a Bank preparatory mission, NBM agreed to form a Bank Resolutions Unit (BRU) in its Supervision Department in June 1995. The objectives of the unit are threefold: (a) to follow-up on deficiencies identified during the bank examination process; (b) to formulate market-based resolutions prior to liquidation and; (c) to intervene in the conservatorship of troubled banks. The main role of the BRU would be the compliance function. It would act upon findings of deficiencies from on- site examinations and off-site surveillance. The BRU would intensively scrutinize the problem areas in troubled banks. The compliance function would also intensify the scope and frequency of reporting 23  requirements for troubled banks. Its major role would bc to formulate corrective programmatic measures in collaboration with the banks' management, the goal being to rehabilitate troubled banks by correcting their underlying deficiencies. The scope of the work would include review and evaluation of management's strategic plans, a.nd assessment of their feasibility. The objectives of these corrective action plans would be qualitative and quantitative, designed to remedy identified weaknesses. BRU would sell, merge or liquidate banks that fail to recapitalize. USAID is providing assistance (US$1 million) in the form of bank resolutions experts to advise the BRU. The structuring and financing of BRU was agreed with the NBM during project preparation. 3.25 The Supervision Department is receiving additional assistance from the Bank preparatory team in formulating remedial action plans for the banks. These action plans-structured jointly by the banks and NBM guidelines-will cover qualitative and quantitative steps designed to improve the banks' performance. Completion of the remedial action plans by the banks will allow the NBM to assess the condition of the banks and monitor their remedial progress. 3.26 Institutional strengthening of the Technical Unit, the Bank Resolution Unit and the commercial banks. The Technical Unit will be supported by TA cofinanced by the Government of Netherlands (US$1.1 million to finance two foreign specialists for 2-3 years, local staff training, and office equipment). PFIs will be eligible for two types of technical assistance. Banks that meet specific eligibility criteria established by the TU will be able to participate in a special "Windows Program." The selected banks will be expected to establish special-preferably independent-small business lending units (the "windows"). The loan officers will receive training from experienced small business bankers from the West who will be seconded to the intermediaries for at least one year. They will assist the banks with setting up loan screening and monitoring systems and will be members of the banks' loan committees. The design of the program is based on world-wide experience with conditions for successful and sustainable small business credit lines. Tranches of US$500,000 will be made available for eligible banks to on-lend to SMEs. The Government of the Netherlands will support this program with US$1 million. Banks not eligible or not interested in taking part in the Windows Program, will be able to avail themselves of alternative technical assistance made available through the TU. Such technical assistance would comprise help in areas such as credit analysis, financial management, planning and budgeting, internal audit, and management information systems. The latter technical assistance will be financed by an allocation of US$0.4 million under the proposed Loan. 3.27 Development of the Payments. Clearing and Settlement System. Another important area where NBM interfaces with the commercial banking system is through its role at the heart of the payments, clearing and settlement system. The payments system in Moldova needs to be upgraded if it is to support the expected increase in economic activity in the emerging private sector (see Annex D). Only six banks are connected to the payments system of the NBM. A study financed by EU (TACIS) on the payments system concluded that the existing Email-based system does not, at present, provide sufficient security, recovery capability, or operational reliability to be used as the electronic delivery mechanism for a modern payments system. The study contains a number of recommendations to improve, for the short-term, the reliability and security of the existing system. Longer-term recommendations were also put forward for improving both electronic payments delivery and banks' internal payments processing. It is estimated that hardware and software, valued at US$0.68 million is needed for an immediate upgrade of the Clearing Center in the NBM and the computer interfaces in commercial banks. As a condition of loan disbursement under this subcomponent, the NBM has agreed to present to the Bank a fully-costed plan for payments system automation. 24  3.28 Automation of the National Bank of Moldova. The NBM is the key state institution that interfaces with the commercial banking system. Its function as supervisor of the banks and as the implementor of monetary policy means that it has a significant impact on the evolving structure of, and liquidity in the banking system. It is important that NBM be provided with institutional development support so that it can increase the efficiency with which it handles its key functions. The NBM is currently constrained in its ability to conduct monetary policy and oversee the functioning of the banking system by weaknesses in its data bases, analytical capabilities, management information systems, and other aspects of its computer environment. The NBM has therefore embarked on a program of development of its hardware and software capabilities. The existing computers break down often, and local support is not available. In the Banking Supervision area, enforcement of the new prudential regulation standards will require a redesign of the NBM systems to provide better capacity for regulatory reporting and off-site supervisory analysis. An IMF Mission has been working with the NBM to determine system requirements and implementation costs. The NBM's information technology plan calls for the acquisition of networked workstations, and accompanying application software: operating systems, data bases, analytical systems and accounting systems. Annex C presents the information technology plan, and budget. The automation program is estimated to cost US$2.0 million, of which the Bank loan will finance US$1.55 million. The balance will be financed by the NBM. As a condition of loan disbursement under this subcomponent the NBM has agreed to present to the Bank a fully-costed plan for the automation of the NBM. E. Economic Analysis and Rationale for Bank Involvement 3.29 Policy Environment. Moldova is one of the most disciplined and successful countries of the FSU in introducing and maintaining severe macroeconomic stabilization measures. Its budget deficit has been reduced to 4.0% of GDP in 1995 while the annual inflation rate is below 10%. Stabilization of the domestic currency vis-a-vis the US dollar has substantially increased the transparency of enterprise activities in the industrial sector as well as their competitiveness in domestic and foreign markets. Export taxes and quantitative import restrictions have been removed, and the maximum import tariff reduced to 20%. Budget subsidies to the industrial sector have been limited to relatively insignificant levels and their procedures have become more transparent. 3.30 Price distortions have been largely eliminated. Interest rates are determined at auction; over eighty percent of credit is made available through refinancing auctions and the remaining credit is offered at the auction-determined monthly interest rate. The exchange rate has been unified and foreign exchange is purchased at regular inter-bank auctions. Commodity prices in both domestic and foreign trade have been liberalized with only a very few exceptions (due to be removed in December 1995). Consequently, the risk of a downward shift in rates of return on particular projects due to the removal of policy related advantages is low. 3.31 Core Economic Objective. The main objective of the project is to shift enterprise adjustment and credit allocation decisions to market forces. The fast pace of privatization, with an exclusive use of the mass privatization approach, has left behind unsolved problems. These include an excessive concentration of resources in existing, mostly inefficient and uneconomic industrial structures and the continued operation of the remnants of a collapsed central planning system. The purpose of the Project is to jump-start the country's emergence from this growih-inhibiting and market-hostile situation. This will be done by providing a balance of incentives and penalties together with the required information and expertise to assist market participants to make good economic and financial decisions and create a self-sustaining market process. To achieve this objective, the Project will build the institutional and 25  regulatory capacity to carry out creditor-led restructuring, free assets, and create financing opportunities. 3.32 Achievement of Core Economic Objective. The proposed creditor-led restructuring of privatized enterprises is designed to free assets to help increase the number of small enterprises (the supply side). Publicly sponsored promotion, including an SME small-banking loan window, will support the small enterprise sector, building on approaches used successfully in Poland and Russia. The need to increase financing opportunities available to SMEs is addressed in a twofold way: strengthening commercial banks in their capacity to lend and making technical assistance available to emerging private businesses to prepare bankable projects. At present, commercial banks are not only short of resources to lend, they also have difficulty in articulating their long-term lending policy and in assessing the available lending projects. The lack of these capacities in the banks often results in (i) excessively risky lending to projects promising unrealistically high rates of re-turn (mostly in trade) or (ii) offering "rescue lending" to selected enterprises with little concern about the enterprise's or the bank's future-at the expense of sound projects in manufacturing and services. 3.33 The Project has already had a visible impact on policy-establishing new relations between the Government and enterprises through a newly created conimittee of public creditors and the promotion of a non-governmental agency supporting enterprise efforts to become more competitive and market oriented. By facilitating the streamlining and downsizing, opening the channel for asset sales, introducing voluntary liquidations and supporting leaner bankruptcy procedures, the Project builds a strong base for the growth of new, smaller and better focused enterprises and has increased the demand for credit for bankable projects, part of which would be met by the proposed PSD credit line component. 3.34 Institutional Capacity and Regulatory Framework. The Project has initiated and is supporting a network of non-governmental institutions and related supporting activities: the EAA, business centers, consulting firms oriented to small and medium enterprises, and training programs for the enterprise and banking sectors. In addition, the judicial system is being strengthened in its capacity to deal with commercial cases (bankruptcy and restructuring). The project is also supporting the development of an appropriate legal and regulations framework. 3.35 New institutions and a regulatory framework will be of little use if there are no commercial entities sufficiently motivated to use them. The proposed TA to enterprises, available through the EAA, will facilitate the process of creditor-led restructuring by decreasing the level of information asymmetry between the management of a company and its creditors -- thereby balancing the bargaining power of the two parties. Presently, managers of former state enterprises grossly overvalue the assets of their companies as well as their ability to generate positive cash flows. This is mostly due to their valuation of production capacity based on historical costs of investments in fixed capital, and too optimistic an assessment of potential markets. On the other hand, creditors are at a significant disadvantage as market verification of the assertions of managers is not available. In this case, a sound assessment of the potential gains or losses available from keeping a business going, versus liquidation (or substantial streamlining), is difficult if not impossible to determine; often the outcome is deadlock, and both sides lose. TA will lead to a narrowing of this information gap. 3.36 To accelerate the positive demonstration effects of this pilot program and increase the number of financially eligible projects, the preparatory costs of credit applications and evaluation would be supported by grant-funded TA. Such TA will also promote the development of expertise in the 26  qualifying commercial banks to evaluate credit applications better, deal with debt restructuring, and lower the level of risk in the lending portfolio. 3.37 Fiscal Impact. The line of credit will be fully self-sustaining. Expected on-lending margins will cover the costs the Technical Unit incurs while it operates and supervises the loan disbursement, as well as the risk of a default of PFIs. In addition, the technical assistance available to enterprises will create new value-added to be allocated between both sides of a contract-the enterprise and its creditors-including the State budget. Early results from the pilot stage of the project indicate that tax revenue from participating enterprises has already risen significantly. In this sense, the budget can expect positive net fiscal results over the medium term and therefore treat the financing of TA as an investment. The state budget is usually one of the biggest creditors. Money spent on TA will be recouped by collecting overdue and current taxes, which otherwise would not be collectable. The successful implementation of the restructuring programs will result in the broadening of the tax base- through restructured companies, new businesses spun-off from downsized companies, and commercial creditors who, in many instances are currently unable to pay taxes themselves. Jobs will be generated in the core businesses of restructured companies and interrelated networks of companies, yielding additional tax revenue and limiting budgetary and quasi-budgetary severance payments and unemployment benefits. 3.38 Analysis of Alternatives. During project preparation, an in-depth analysis of four possible channels for medium- and long-term funds was undertaken. In addition to a credit line, these included the creation of a venture capital fund, a credit cooperative, and a leasing company. The research showed that the credit line was the best and most operational option at this stage; the other alternatives also generated significant benefits but required further institutional and regulatory development before the risks and costs they entailed could be well managed and reduced to reasonable levels. Specifically, the strengthening of private commercial banks to manage risk, as required to support the credit line, is the most cost-effective way of mitigating risk in the short-term while still making medium to long-tern fmance available. Once current efforts to strengthen property rights to land and fixed assets, to improve registration and to increase enforcement of collateral and bankruptcy procedures are further advanced, and the appropriate legislation has been passed, with specialists trained in the new procedures, then the ability to reduce risk and enable repossession of on-lent funds will be enhanced to the stage where the other options will become attractive. 3.39 Cost-benefit Analysis. A study of small businesses completed during project preparation, along with interviews with managers of a number of privatized enterprises, indicate that financial rates of return to the line of credit sub-projects will exceed the borrowing costs of the PFIs. Available business proposals show that existing and new ventures in manufacturing and services wouid be able to afford an annual interest rate around 16% (in US dollar terms). 3.40 On average, financial rates of return correctly reflect expected economic rates of return; there are no major distortions which could result in a systematically biased allocation of capital or in quasi- rents for some borrowers. Financial rates of return are likely to remain higher than economic rates of return because of the large number of investment opportunities in new products and services and the persistent scarcity of available capital. As foreign trade has already been liberalized, Moldovan enterprises are already facing competitive prices and will not be able to benefit from protection under the current trade regime. Growing competitiveness and openness of markets will reduce costs through: rationalization of employment and energy use, removing the inefficiencies of barter transactions, shortening investment cycles, and improving the quality and availability of information. 27  3.41 Analysis of the sensitivity of the estimated rates of return to possible policy changes and sovereign risks can only be tentative. However, the continuing progress in improving the policy environment and implementing strict macroeconomic measures, and the growing geopolitical stabilization, strongly indicate that the number of opportunities for profitable business will grow. The proposed line of credit can easily be topped up if it proves successful. 3.42 The project is expected to generate substantial positive externalities through its demonstration effects, and by increasing the demand for credit (the number of potentially bankable projects prepared in the rapidly growing private sector) and matching it with an efficient supply of credit (the number of PFIs graduating from the Bank's rehabilitation program and approving sub-loans solely on the basis of market criteria). While the total value of the project is relatively small in relation to the overall investment needs of the economy, it is expected these demonstration effects will accelerate the mobilization of investor interests through follow-up credits and investments into more competitive and better, structurally-adjusted enterprise and banking sectors. 3.43 Rationale for Bank Involvement. The Bank is committed to assist Moldova in pursuing its program of economic reforms and its efforts to launch a sustainable economic recovery. Notwithstanding the introduction of macro-stabilization and significant structural reforms, the response of the enterprise and financial sectors has been slow. Given the central role these two sectors will play in transforming the economy in the direction of positive growth, it is now vital to focus efforts on their simultaneous restructuring. 3.44 In the enterprise sector, the Bank is supporting the Government in its efforts to increase the role of the private sector, both through the acceleration of the privatization process and by facilitating the development and growth of new private firms. In the context of the recent SAL, the Bank supported the Government in its efforts to create a competitive environment and tighten financial discipline throughout the economy, thus inducing faster adjustment at the enterprise level. The pilot liquidation of seven SOEs has helped the private sector gain access to unused state assets and has sent a strong signal through the enterprise sector about the Govermnent's resolve to enforce a hard budget constraint. The Government's degree of May 15, 1995 on "Critical Measures for Improving the Financial-Economic Standing of Industrial Enterprises," drafted with the Bank's support during project preparation, introduces a decentralized, creditor-led debt reconciliation and restructuring program. The Bank is supporting, also through project preparation, the development of SMEs by removing constraints that have impeded their growth and by mobilizing grant resources to finance the acquisition of key business skills. 3.45 In the financial sector, the Bank has had a continuing dialogue with the NBM, the financial institutions and the Governrment. The Bank is providing assistance in developing a restructuring strategy for the Moldovan banking sector. The objective is to develop a robust financial system that can effectively mobilize domestic and foreign resources and on-lend them to viable enterprises. The Bank is working very closely with the IMF on issues of financial sector strategy in Moldova. A common approach is being adopted on the key reform issues which is having a powerful positive influence on the NBM. The proposed project would also enhance the scope for using the Pre-Export Guarantee Facility, as local banks' capacity would be developed allowing them to assume their normal role in working capital financing. 28  3.46 The Bank has played the leading role in coordinating major donors involved in post- privatization restructuring of the economy. It is the only institution currently active in Moldova which is able to maintain a policy debate with the Government on essential framework reforms across differing sectors while also orchestrating specific technical interventions designed to support the reform process in practical ways. 3.47 The Bank's Country Assistance Strategy envisions that the primary impetus to growth will come from unleashing the private sector. The proposed project, with its emphasis on creating a supportive policy environment and through its support of simultaneous restructuring of the enterprise and financial sectors, will play a major role in stimulating the private sector. 3.48 This project is not intended to have a poverty focus, nor is it expected to have any negative environmental effects. F. Detailed Project Costs and Financing Plan 3.49 The total project cost is US$49 million of which US$35 million equivalent will be financed by a two tranche US dollar and DEM Single Currency Loan. The Enterprise Sector Strengthening component totals US$9.32 million of which US$4.92 million will be financed by the IBRD loan. US$7.40 (US$3 million from IBRD) will assist the Government in the initiation of market oriented adjustment of selected enterprises through the tightening of financial discipline and the provision of supporting expertise and technical skills. In addition, US$1.92 million (IBRD) will finance automation of the Tax Administration in the Ministry of Finance. The Financial Sector Strengthening component is dimensioned as US$39.68 (US$30.08 million IBRD), of which US$4.55 million (US$0.4 million IBRD) will be for technical assistance to selected commercial banks and a TU which will channel US$27.45 million equivalent of credit lines from the loan and US$5 million of Government counterpart funds. In addition, US$2.5 million (US$1.55 million, IBRD) will finance computer equipment for the automation of an information system crucial to NBM's ability to monitor participating banks, and US$0.68 million (IBRD) will finance the upgrading of the Payments, Clearing and Settlement System. 3.50 The total project cost for the Enterprise Assistance Program (EAP) is estimated at US$7.4 million. TA will be used to support enterprises in their restructuring efforts through the provision of restructuring professionals. The amount and costs of technical assistance will vary depending on the individual enterprise size, its organizational complexity, financial and market situation, as well as the abilities of its management and staff to adjust. Minimal resources will be designated for the overall coordination and administration of the process by the EAA. It is envisaged that a substantial, and growing part of the resources would be used to finance local experts. 3.51 The technical assistance part of the project constitutes part of the broader effort by the Bank, the Government and the international donor community to support the implementation of the Government's reform program in the Enterprise and Financial Sectors. EU (TACIS) has agreed to support the EAA with ECU 1 million, the German Government has positively responded to the request of the Moldovan Government to commit at least US$0.5 million for the implementation of the Pilot Program and indicated a likelihood to support further implementation of the Program. Domestic financing (US$0.5 million equivalent) is envisaged from cash privatization proceeds, allocated from the state budget and cost-sharing by participating enterprises. The main merit of this source is that it demonstrates the Government's commitment to the Program and its objectives. The Government is also expected to support the EAA by in-kind grants such as office space, office equipment, and 29  telephone lines. In the financial sector, the Government of the Netherlands has positively responded to the request of the Moldovan Government to support the TU with US$1. I million and SME advisors in commercial banks with US$1 million, while USAID is assisting the BRU with US$1 million. 3.52 Eligible subborrowers are all private enterprises or newly-privatized enterprises, and therefore are independent of the government. These enterprises are responsible for managing their own foreign exchange risk. Moreover, participating banks will take the full credit risk of the subloans, and will have full autonomy in selecting subprojects ex ante, subject to the credit line guidelines. It is expected that funds available under the single currency loan (SCL) component will be onlent to borrowers which have a need for a foreign currency loan because they earn revenues in foreign exchange. Surveys conducted by potential participating banks indicate that a substantial number of existing borrowers generate revenues in foreign exchange, virtually all of which is in US dollars. As part of the eligibility criteria of subborrowers and projects, participating banks will be expected to include in their credit appraisals a demonstration that the currency and terms of the subloans are appropriate given the projected revenues of the subborrowers. 3.53 The Government is proposing to use US$5 million equivalent in domestic currency to cofinance with the Bank's credit line. The funds will be channeled through the TU to PFIs on market terms. It is expected that henceforth the Government will use the TU as its primary mechanism for channeling credit from the budget to enterprises. Detailed Project Costs US$ million equivalent FOREIGN COSTS COMPONENT PROJECT COMPONENT COSTS AS% OF TOTAL COSTS AS %TOTAL LOCAL FOREIGN TOTAL COST PROJECT COST ENTERPRISE SECTOR STRENGTHENING EAP .50 6.90 7.40 93 % 15% MOFlTax Admin. 1.92 1.92 100 % 4% FINANCIAL SECTOR STRENGTHENING Credit Funds 5.00 27.45 32.45 85 % 65 % SME Windows 1.00 1.00 100 % 2% PIU .15 .15 0% 0% TU .70 1.50 2.20 68% 5% BRU .20 1.00 1.20 83 % 3% Payments,/Clearing .68 .68 100% 1% NBM Automation .45 1.55 2.00 78 % 4% TOTAL PROJECT COSTS 7.00 42.00 49.00 86 % 100.0 % 30  Detailed Financing Plan US$ million equivalent Project Component Local Foreign TOTAL % IBRD MOF/ Firms IBRD Netherlands EU Germany USAID Finance NBM JTACIS) ENTERPRISE SECTOR STRENGTHENING EAP .50 3.00 1.50 2.00 .40 7.40 41 % MOF/Tax Admin. 1.92 1.92 100% FINANCIAL SECTOR STRENGTHENtNG Credit Funds 5.00 27.45 32.45 85 % SME Windows 1.00 1.00 0 TU .70 .40 1.10 2.20 18 % PIU .15 .15 0 Bank Resolution Unit .20 1.00 1.20 0 Payments,/Clearing .68 .68 100 % NBM Automation .45 1.55 2.00 78 % TOTAL PROJECT COSTS 6.50 0.50 35.00 2.10 1.50 2.00 1.40 49.00 71% 31  IV. PROJECT IMPLEMENTA TION A. Implementation Arrangements 4.1 The Executing Agency for the Borrower (the Republic of Moldova) would be the MOF, within which there would be a Project Implementation Unit (PIU) responsible for overseeing and coordinating the implementation of the two components of the Project. The PIU would coordinate with the governrnent entities in charge of each component of the Project. Furthermore, the PIU would liaise with the World Bank and, once the Bank loan becomes effective, would be authorized to request disbursements from the Loan Account and be in charge of opening and administering the associated Special Account. The organizational structure, staffing needs and the basic budgeting requirements for the PIU have been agreed with the Government of Moldova. The PIU would be part of the External Financing Department of the MOF and would require the budgeting of two additional professional staff members, who would be in charge of the day-to-day functions of the PIU. The Director of the PIU would be a senior member of the External Financing Department who would work part-time on this assignment. B. Enterprise Sector Strengthening Component 4.2 Enterprise Assistance Program (EAP). The Enterprise Assistance Agency (EAA) would be the managing and coordinating unit for the technical assistance to be supplied from international and domestic sources for the EAP. Funding for this US$7.4 million subcomponent cost would be channeled through the PIU to the EAA in the form of non-reimbursable allocations from the Governmeent. Efforts would be made to fund the bulk of this component with foreign grants. Several grant sources have already been identified and discussed with the Authorities. Nonetheless, about US$3 million is expected to require financing from the Bank loan. Financial arrangements for this subcomponent would be formalized under a Funds Transfer Agreement to be entered between the MOF, on behalf of the Republic, and the EAA. The guidelines for such a Funds Transfer Agreement were reviewed with the Authorities during project preparation, and it was agreed that a satisfactory version of such an Agreement will be signed by the parties and delivered to the Bank prior to effectiveness. 4.3 The EAA is a non-governmental, not-for-profit, independent legal entity, supervised by the Supervisory Board, consisting of three members appointed by the Government (including an ex-officio chairman of the Board), 2 representatives of local entrepreneurs, and 2 appointed by donors financially supporting the Agency. The daily operations of the EAA are managed by the Executive Director-a Moldovan citizen with relevant professional qualifications. EAA was established on July 15, 1995. The supervisory Board of EAA had its first meeting on July 26, 1995 and appointed the Executive Director. 4.4 The objective of the EAA will be to manage the technical assistance necessary for the EAP, recruitment of local consultants to participate in teams working in enterprises, facilitation of contacts of particular donors and restructuring teams with the administration, and quality control of the work of consultant's teams. The original scope of the activity may be extended into other areas related to post- privatization reforms e.g., capital markets and real estate reform. 32  4.5 The State Creditors' Committee (SCC) will prepare the list of enterprises eligible for isolation on the basis of information on debt levels from the Monitoring Unit in the MOF. The SCC will also recommend actions on behalf of public creditors. The Ministry of Finance will monitor arrears of individual enterprises to public creditors and timely payment of current obligations. During the Program, the MOF will provide assurances that there is no soft financing flowing in a non-transparent manner from the budget or the capital markets. The NBM will supervise the isolation from the banking sector. 4.6 To facilitate a fast start-up of the project a pilot program has been initiated during project preparation. In this pilot, 10 SOEs are being restructured as a SAL second tranche condition to facilitate development of local restructuring skills and allow fine-tuning of the procedures. 4.7 State Tax Administration (STA). Under this sub-component US$2 million would be allocated to cover expenditures associated with the implementation of a four-phase program over two years covering the purchase of computer equipment (hardware and software), its installation, associated start- up costs and the training of local staff to operate the system. This automation program supports broader reforms in tax policy and administration designed to achieve the Government's stabilization objectives and provide a broad-based tax system appropriate to a modern decentralized economy. At the adniinistrative level, all taxpayers will receive taxpayer identification numbers, audit and inspection practices will become specialized and targeted only at evasion, forms will be simplified and data requirements reduced, and filing requirements will be streamlined and reduced. Computerization will be introduced in stages based on simplified procedures and experience with pilots. Assessment processes will be automated and information sources will be electronically linked to other relevant authorities including Customs and the Treasury system in the MOF. Businesses will be able to file by electronic means. The executing agency for this sub-component will be the STA at the MOF. The implementation program is described in detail in Annex E. The Minister of Finance has asked the IMF to review the program and to supervise its implementation. Presentation of the fully costed implementation plan, satisfactory to the Bank, will be a condition of disbursement under this sub- component. It is also expected that the IMF will oversee all stages of implementation to ensure that the program adheres to the standards agreed. C. Financial Sector Strengthening Component 4.8 The Credit Line. The credit line would be managed by a TU established at the NBM. The NBM would act only as a fiscal agent and would not take any of the credit risks involved in the intermediation of funds to the private sector. The role of the NBM in the intermediation of the credit line would be defined in a Fiscal Agency Agreement to be entered into between the Government and the NBM. The TU would channel funds to participating financial intermediaries, which would on-lend the credit line resources to their private sector clients. Credit line resources would be available from two sources: (i) US$27.45 million equivalent from the 20-year maturity Bank loan, and (ii) a Government-funded Leu co-financing facility of up to US$5 million equivalent, to be funded by allotments in the National Budget over a three-year period. These sources were confirmed at negotiations. Also, a Fiscal Agency Agreement, satisfactory to the Bank, would have to be signed as a condition of loan effectiveness. 4.9 The Technical Unit. The TU would be a newly-created Apex within the NBM, under the direction of an NBM official with a solid academic background and preferably with practical lending 33  experience. Its purpose would be to manage the credit line of the proposed Project. The TU would have four main functions: (i) the selection of participating banks and the monitoring of their continued eligibility for the intermediation of the credit line resources; (ii) the development and implementation of the credit line regulations, including on-going supervision of their compliance by PFIs and final borrowers; (iii) the day-to-day management of, and access to, the credit line by PFIs for onlending to final borrowers; and (iv) the management of the TA needed to develop in Moldovan banks the skills required for lending to private investment projects. Decisions by the TU would be made following a two-step approach. The director of the TU, in charge of the day-to-day affairs, would make formal recommnendations to the TU Committee, which would include representatives of the MOF and the MOE, in addition to the NBM. The TU's work would be guided by two basic documents each of which must be acceptable to the Bank: (i) the Operational Procedures of the TU, and (ii) the Credit Line Regulations Manual (CLRM). The organizational chart for the TU, already agreed with the Moldovan Authorities, is shown in Chart 1. Two Western banking experts would be recruited to staff the senior technical positions reporting to the director. A preliminary version of the Statutes of the TU were discussed with the authorities at the MOF and the NBM during appraisal. 4.10 In order to cover Chart 2: Organizational Chart of the Technical Unit its operational costs, the TU would be allowed to charge a fee which TU Committee would be part of the (six members representing MoF, MoE & NBM) lending rate charged to a PFI for subsidiary loans. The NBM has agreed to Managing Director cover in full the start-up (locS staff from NBM) costs and the expected initial operating cash deficits of the TU. The Banks Manager Operations Manager I Legal Counsel appointment of the (foreign expert) (foreign expert) (^ocal expert) Managing Director of the TU by the President of the NBM was a condition of negotiations. 4.11 Additional services provided by the NBM. The NBM's Operations Department would open an account-the Project Account (PA)-on behalf of the Republic that would be maintained for the life of the credit line. The PA would have the dual purpose of receiving deposits-originating in withdrawals from the Bank loan and the servicing of subsidiary loans by PFIs-and making disbursements that would go to the servicing of the Bank loan by the Republic, the granting of subsidiary loans to PFIs, or covering the costs of operating the credit line. Besides being a depository account for liquid balances, the PA would serve the purpose of keeping full and detailed accounting of the transactions being financed out of the proceeds of the credit line. 4.12 Access to Credit Line Resources by a PFI. To access these financial resources, a PFI that has entered into a Subsidiary Loan Agreement would be able to request from the TU a commitment of credit line funds for a specified period of time, up to 4 years, which could be extended by the TU once 34  the PFI has demonstrated a capacity to engage in successful term lending. In general, such commitments would be contingent on the PFIs ability to remain eligible for credit line use throughout the commitment period. Initial commitmnents would be for a lump-sum of US$1 million equivalent per PFI, with future increments of up to US$3 million. However, a PFI would be able to secure additional commitments only after it has itself committed no less than US$500,000 in eligible subloans (properly documented according to the CLRM). has completed an agreed trial period and is in full compliance with the performance criteria agreed upon with the TU in the Subsidiary Loan Agreement. Prior to committing additional funds from the credit line to a PFI, the TU would have to seek the consent of the Bank. 4.13 The TU would stand ready to authorize subsidiary loans financed with the Bank loan in US dollars or deutsche mark for onlending in the same currency to eligible subborrowers. The TU would also be able to offer financing in Moldovan lei from the co-financing facility to be made available through Governmental budgetary appropriations. The US dollar and deutsche mark subloans would have to go to subborrowers that have revenues in the same currencies or have other ways of hedging the foreign exchange exposure associated with a liability denominated in hard currency. Debt servicing by PFIs and subborrowers would always be in the same currency in which the loan was originally denominated. 4.14 Each subloan would be documented by a Subloan Agreement to be entered into between a PFI and its subborrower. This agreement would include a tentative disbursement schedule for the subloan and the conditions agreed for disbursement. The minimum requirements to be included in every Subloan Agreement would be listed in the Subsidiary Loan Agreement to be entered into between the TU and each PFI. 4.15 The Credit Authorization Process. The credit risk associated with a specific subloan would rest entirely with the PFI granting such credit. Thus, neither the Bank nor the TU are expected to duplicate the credit or project analysis done by the PFI. Rather, the role of the TU would be to concentrate on performing ex-post quality control reviews to determine whether credit regulations have been met by the PFI granting the subloan. This notwithstanding, the TU would hlave the flexibility to conduct ex-ante reviews of subloan documentation in those cases when a specific PFI establishes a record of non-compliance with credit regulations. Also, there would be an ex-ante review of subloan documentation when a given subloan is above a specified free-limit level and for the first two subloans granted by a PFI just starting to operate with the credit line. 4.16 Eligibility of Subborrowers and Subprojects. The proposed credit line is geared to offer medium-term financing (one- to five-year maturities for capital investments and up to 18 months for working capital) for a wide range of private investment activities in Moldova. A corporate borrower is private if more than 50 % of its ownership is in private hands. Newly privatized and other emerging private sector enterprises would be able to obtain subloans from PFIs to finance their fixed capital needs and working capital requirements. Since the credit line would be non-sector specific, subproject eligibility would be based entirely on its technical, financial, economic and enviromnental soundness. Minimum eligibility requirements for subloans, based on subproject and subborrower eligibility, would be defined in the CLRM. PFIs would be required to appraise project risks, including an evaluation that the currency of onlending is appropriate for the subborrower. This last evaluation criterion is likely to make the credit line better suited and particularly relevant for the financing of export-oriented projects. Since the credit risk associated with a subloan is taken by the PFI granting the credit, the final decision 35  on the credit risks to be assumed, and the subloans to be granted, would be made entirely by the PFIs, following its own credit screening criteria. The minimum subloan size would be the equivalent of US$30,000 for investment projects and US$10,000 for working capital lending. The aggregate maximum subloans outstanding to any individual subborrower would be the equivalent of US$2.5 million-whether they are granted by one or more PFIs. 4.17 The SME window. At least two of the PFIs are expected to apply and participate in the intermediation of credit line resources through the so-called SME window. Lending to these subborrowers would follow the guidelines contained in the CLRM, with no differential treatment for this sub-set, save for the fact that the maximum amount of subloans per subborrower would be US$100,000, with no minimum subloan size. In order to secure adequate credit practices on the part of PFIs engaged in SME lending, the Project contemplates a special program of technical assistance geared to providing in-house western banking expertise to two of the PFIs involved with SME lending-to be financed by foreign grants to be provided directly to the selected banks. Other PFIs wishing to access the window would have to provide strong evidence to the TU-satisfactory to the Bank-that they have the outside support or in-house knowledge required to implement a facility able to provide small scale loans customized to SMEs. Furthernore, the TU would make separate credit line commitments, in tranches of US$500,000, to those PFIs eligible for this kind of lending. These commitments would be in addition to any others that the TU would normally grant to a PFI. 4.18 Eligible expenditures. In addition to financing investments in plant and equipment and working capital, the PFI would be able to finance the cost of patents, licenses, and franchises needed for the subproject's production process. Bank funds would not be used to refinance already existing subborrowers' liabilities. 4.19 Interest rates on subsidiary loans. At present there is an absence of medium-term funding for banks in the Moldovan market, given that deposits are scarce and practically all short-term. Thus, there are no useful market indicators that could be used for guidance when trying to determine a market rate at which Bank funding could be onlent to PFIs. Short-term interest rates are volatile, so they also are of little help when trying to determine an appropriate level for a sustainable medium-term rate for investment project financing. Faced with this dilemrna, the Government would like to avoid setting credit line interest rates to PFIs in an arbitrary fashion, which could result in a misallocation of resources or subsidies on the rate. As a second best option, they would be willing to charge PFIs a rate that captures the cost of funds for the Government. In the case of Bank provided resources, it has been agreed that the cost of funds would include the following components in addition to the IBRD lending rate: (i) the cost of supervising the credit line subcomponent by the MOF; (ii) the cost of setting up and operating the TU and the cost of other services to be provided by the NBM; and (iii) the cost of establishing a credit risk fund to insure the Republic against potential losses that could result from poor servicing of the credit line by some PFIs. These three costs would be incorporated in a spread over the Bank rate which would be fixed once a subsidiary loan is granted. However, in order to reflect changes in the relevant Bank lending rate, the interest rates charged on future subsidiary loans would be reviewed semi-annually. Changes in the value of any of the components of the spread would require the consent of the Bank. The detailed formula to determine the interest rate to be charged on subsidiary loans would be included in the CLRM. As the number of PFIs increases, consideration will be given to establishing a bidding mechanism for pricing subsidiary loans and allocating credit line resources among competing PFIs. The interest rate to be charged to PFIs on the counterpart funds in local currency to be made available by the Government through the TU will never be lower than that 36  charged on US dollar funding originating from the Bank loan. Actual Leu rates will be set from time to time by the TU based on an assessment of the cost to the Government of funds raised in the local market. Prior to their implementation, all interest rates to be charged by the TU will be reviewed by the Bank. 4.20 Interest Rates on Subloans. The interest rate on subloans would be negotiated freely between each PFI and its client, taking into account market conditions and the risks involved. Every effort would be made by the TU to create transparency in the rate setting process. The formula used to calculate the rate would be incorporated into each Subloan Agreement and it would includc a mechanism to adjust it semi-annually to reflect changes in the PFI's subsidiary loan rate. 4.21 Subloan Maturities. Depending on subproject requirements, the maturity for subioans granted to finance capital formation, such as investment in plant and equipment, would vary from 1 to 5 years. Working capital subloans would vary from 9 months to 18 months. 4.22 Environmental Requirements. A manual on environmental review procedures for individual subprojects will be prepared by the Government and reviewed by the Bank. It will become an annex of the CLRM. The manual will provide the guidelines to classify, from an environmental point of view, each sub-project to be financed by the credit line, allowing the development of a process under which local environmental laws and regulations will be applied by appropriate institutions i.e., environmental authorities and loan beneficiaries. Such a process will reduce the Bank's direct involvement in the implementation of a particular sub-project while still allowing it to carry out its supervisory function efficiently. The manual will be reviewed with the borrower prior to effectiveniess and it vill be approved as part of the CLRM. 4.23 Technical Assistance for Financial Intermediaries and Support for TU. Support to financial intermediaries would be critical for the success of the credit line and for the implementation of badly needed restructuring and overhauling of the banking system. Technical assistance requirements under the financial sector strengthening component would comprise the following subcomponents: (a) staffing of the TU with two experts in western-style banking for a period of two years each and start-up and incremental recurring costs required for the operation of the TU (US$1.6 million); (b) consulting services to implement a two-year technical assistance program to support the credit line-related lending activities of PFI and the development of western banking practices in the banking industry in general (US$0.4 million); (c) two years of consulting services by western experts who would do in-house work on developing SMEs' lending skills in selected PFIs participating in the SME window of the credit line (US$1 million); and (d) technical assistance to be provided by foreign consultants plus start-up and operational costs for the establishment of the BRU at the NBM (US$1 million). Efforts were made to finance as much as possible of the US$4 million estimated to be required for this subcomponent with foreign grant funding. During project preparation US$3.1 million was mobilized from the donors, the NBU agreed to support the incremental operating costs of the TU with US$0.5 million, while US$0.4 million is budgeted as a part of the loan to the Republic. Grants and Bank resources would be channeled through the PIU to the TU, BSD and BRU at the NBM. The costs associated with this subcomponent would be assumed entirely by the Republic. The NBM would manage this technical assistance program and act as fiscal agent of the Government. 4.24 Strengthening of NBM and Payments, Clearing and Settlement System. Under this component US$2.23 million would be used to cover expenditures associated with the purchasing of 37  computer equipment, its installation (hardware and software), associated start-up costs and training of local staff. The executing agency for this subcomponent will be the NBM, which will use US$2.23 million in the implementation of its own information system (US$1.55 million) and the upgrading of the banks' Payments, Clearing and Settlement System (US$0.68 million), which operates under the umbrella of the NBM. Funds from the Bank loan would be deployed and the funding would be channeled through the PIU to the NBM. The NBM would receive Bank funds as onlending from the Republic under the same terms and conditions as those in the Bank Loan Agreement, except for a small annual administration fee to be charged by the MOF. The onlending would be formalized under an NBM Sub-Loan Agreement to be entered into by the MOF, on behalf of the Republic, and the NBM. It was agreed that a satisfactory NBM Sub-Loan Agreement will be entered into prior to disbursement from this subcomponent of the Bank loan. Also, it was agreed with the authorities that pior to disbursement from the Bank loan under this subcomponent the NBM will present for the Bank 's review fully costed plans for its automation and that of the clearing center. The implementation plans for the two subcomponents of this component are described in Annexes C and D. D. Procurement 4.25 Procurement will be done in accordance with World Bank Guidelines for Procurement dated January, 1995. In the procurement of goods through ICB, domestic manufactured goods may be awarded preference in accordance with Articles 2.54 and 2.55 of the World Bank Guidelines for Procurement. In anticipation of a formal Country Procurement Assessment Report scheduled for FY96, an extensive survey of 30 private enterprises regarding their current procurement practices was conducted. 4.26 Procurement of Goods. Under both the NBM's and the STA's institution building subcomponents most of the Bank financing (US$4.15 million) would be used to buy computer software and hardware. Three different contracts are anticipated: the automation of the Tax Administration in the MOF (Annex E); the development of the Payments, Clearing and Settlement System (see Annex D); and the automation of the NBM (see Annex C). These contracts will all be procured by ICB. 4.27 Procurement in Loans to Financial Intermediaries. For subprojects financed under the credit line (US$27.45 million equivalent in total, with a maximum subloan size of US$2.5 million equivalent) and executed by subborrowers, procurement would take place in accordance with World Bank guidelines according to the following thresholds: (i) contracts valued up to US$1 million equivalent in the case of goods would be procured using local commercial practice in combination with multiple quotes from multiple countries; and (ii) all contracts above US$1 million equivalent would be procured by ICB. For ICB contracts, the Bank's Standard Bidding Documents for Goods (January 1995) would be used. The US$1 million threshold for ICB was determined on the basis of the results of an extensive survey conducted in May 1995 (Moldovan companies operating with the credit line would procure goods and equipment on the basis of multiple bids from a range of countries). In some special cases, Direct Contracting might be used, but only if it meets standards and procedures acceptable to the Bank, following the directives contained in paragraph 3.7 of the Procurement Guidelines (January 1995). For easy reference the Procurement and Consultant Guidelines and relevant provisions in the Loan Agreement, concerning procurement, consultant selection and contracts, will be annexed to the CLRM. The CLRM will be subject to prior review and clearance by the Bank. Technical assistance will be given to PFIs to strengthen their capabilities in procurement. 38  4.28 Procurement of Technical Assistance. Under both the Enterprise Assistance Program (US$3.0 million) and the Technical Assistance (US$0.4 million) for the FSSC the Bank will finance short-term consulting services for the credit line and TU. Technical assistance is expected to require several different contracts, a number of them for small amounts. The Guidelines on the Use of Consultants (August 1981) will be applied. It is expected that some of the Bank financing would be used to procure large consulting contracts. Contracts for consulting services of more than US$50,000 in the case of individuals and more than US$100,000 in the case of companies will be subject to prior review by the Bank. Review by the Bank of the terns of reference would be carried out for all procurement of consultant services. It is expected that almost all the technical assistance packages will be procured on the basis of short-listing. In cases of small individual consultant short term assignments contracts, these packages will be procured through individual contracts. A list of TA packages and the procurement method for each package is described in Annex H. 4.29 Prior review by the World Bank of procurement documentation would be carried out for: (i) all contracts procured through ICB; (ii) the first contract financed by each PFI; (iii) the first contract under all other subcomponents of the Project and; (iv) all contracts procured through direct contracting. Contracts for consulting services of more than US$50,000 in the case of individuals and more than US$100,000 in the case of companies will be subject to prior review by the Bank. Procurement procedures and documents for other contracts would be subject to random review by the Bank during project supervision. 4.30 All subloan applications would include a discussion of procurement procedures used and criteria for selection of suppliers of goods, and ensure that these conform with the Bank's Guidelines. PFIs and sub-borrowers are expected to keep records on quotations requested. Evidence of those quotations will be required for ex-post review during project supervision. The TU (in the case of the credit line subcomponent) and the PIU will monitor adherence to the Procurement Guidelines and furnish quarterly progress reports on procurement activities to the Bank. 39  Table 4. Summary of Proposed Procurement Arrangements (US$49 million equivalent)' Not Bank Total Loan Subcomponent ICB LCB Other Financed Costs Computers 4.15 0.95 5.10 (4.15) (4.15) Credit line 2.50 24.952 5.00 32.45 (2.50) (24.95) (27.45) Technical Assistance 3.403 8.05 11.45 (3.40) (3.40) TOTALS 6.65 0.00 28.35 14.00 49.00 1 (0.00) I Figures in parentheses are the respective amounts financed by the Bank loan. 2 Local Commercial Practice is expected to be used as procurement method for subloans under US$I million equivalent. 3 For technical assistance, services will be procured according to the Bank's Guidelines on the Use of Consultants (1981). E. Disbursements 4.31 To facilitate project implementation, the Borrower would establish two Special Accounts (one in dollars, another one in DEM) in one of the major foreign commercial banks on terms and conditions satisfactory to the Bank to cover the Bank's share of expenditures. The Authorized Allocation to a Dollar Special Account would be US$1,000,000 representing about four months of average expenditures made through the Dollar Special Account. The Authorized Allocation to a DEM Special Account would be DEM 600,000 representing about four months of average expenditures made through the DEM Special Account. During the early stage of the Project, the initial allocation to the Dollar Special Account would be limited to US$500,000, and the initial allocation to the DEM Special Account would be limited to DEM 400,000. However, when the aggregate disbursements under the Dollar Tranche of the Loan have reached the level of US$4,000,000 and the aggregate disbursements under the DEM Tranche of the Loan have reached the level of DEM 2,000,000, the initial allocation may be increased up to the Authorized Allocation of US$1,000,000 and DEM 600,000 respectively by submitting the relevant Application for withdrawal. Applications for replenishment of the Special Accounts would be submitted monthly or when one-third of the amount has been withdrawn, whichever occurs earlier. Documentation requirements for replenishment would follow the standard Bank procedure as described in Disbursement Handbook, Chapter 6. Monthly bank statements of the Special Account which have been reconciled by the Borrower would accompany all replenishment requests. The minimum size of application for the payment directly from the Loan accounts would amount to 20% of the amount of authorized allocation to the Special Accounts for each Tranche of the Loan. 40  4.32 Under the credit line, the Bank would finance up to 100% of foreign expenditures (C.I.F.), 100% of local expenditures (ex-factory costs) and 80% of local expenditures for other items procured locally. All expenditures under the credit line will be for financing of goods. Bank reimbursements would be related to eligible expenditures made not more than 120 days prior to submission of the application by the PFI to the TU. Expenditures for individual contracts valued at under US$1 million equivalent financed by subloans would be disbursed against Statements of Expenditures (SOEs) certified by the TU. The TU would ensure that all supporting documentation is adequately maintained and is available for review at the Bank's request. Disbursements for all contracts valued at or above US$1 million would be made against fully documented withdrawal applications. These disbursement arrangements would be incorporated in the CLRM. 4.33 Disbursements in connection with the subcomponents that provide technical assistance for PFIs and the EAA including consulting services required directly for the TU and the EAA would be disbursed against Statements of Expenditures for contracts below US$100,000 for consultant firms and bellow US$50,000 for individual consultants. All disbursements above a threshold of US$100,000 for firms and above US$50,000 for individual consultants would be made against fully documented withdrawal applications. Statement ox Expenditure Procedure cannot be used for purchase of equipment for automation of the NBM, payment system and Tax Administration. 4.34 Retroactive financing will be possible for an aggregate amount not to exceed the equivalent of US$3.4 million for the following expenditures: purchase of computer equipment for the NBM, the payments, clearance and settlement system and the Tax Administration. Strategies for institutional strengthening in these key areas have already been agreed with the Bank and implementation is about to begin. Retroactive Financing is needed if the momentum behind reform in these areas is not to be slowed. ICB will be used for procurement and retroactive financing will apply to eligible expenditures after September 1, 1995. 4.35 The project is expected to be completed by January 31, 2000. The proposed closing date is July 31, 2000. F. Project Accounting, Financial Reporting, Auditing and Supervision 4.36 Accounting. The Borrower will have responsibiZity for the appropriate accounting for the funds provided by the Bank under the Loan, for reporting on the use of these funds, and for ensuring that audits of the financial statements or reports are submitted to the Bank. The PIU, on behalf of the Borrower, will establish an appropriate accounting system to provide information on the proper receipt and use of funds in accordance with the Loan Agreement. The system should ensure timely and accurate accounting of all transactions under the Loan and clear presentation of the financial information. 4.37 Financial Reporting. Financial reporting for the different Project components would be carried out by the PIU, TU and EAA for their respective components, and it would closely reflect the specific requirements of the Loan. It would comprise a statement of receipts and payments for the reporting period since the beginning of the Project. The reporting would be in accordance with the disbursements classified and reported by the expenditure categories agreed with the Borrower and spelled out in the legal documents. Bi-annual progress reports would be submitted by the PIU, which would act as coordinator for all financial reporting. The PIU's quarterly reporting would include a 41  separate report with respect to the Special Account. A Implementation Completion Report will be submitted to the Bank by the PIU promptly after the completion of the program, not later than six months after the loan closing date. 4.38 Auditing. Financial statements and reports on the Loan (including the Special Account) would be audited by an auditor acceptable to the Bank and the audit reports would be submitted to the Bank within six months of the end of the fiscal year. Selected auditors must be: (i) impartial and independent from the entity to be audited; (ii) well-established and reputable; (iii) experienced in the type of assignment to be undertaken; and (iv) able to fulfill the terms of reference required within the specific timetable. 4.39 Project Supervision. The proposed project is complex in nature given that it straddles two sectors (the enterprise and financial sectors). Furthermore with limited human resources in the public sector in Moldova there would need to be a strong emphasis on supervision. Program supervision input by Bank staff is therefore expected to be above average, particularly at the early stage of project implementation. The establishment of a PIU will help facilitate smooth project implementation and supervision. 42  V. BENEFITS AND RISKS A. Project Benefits 5.1 Anticipated benefits of the proposed Project are: (i) strengthening the supply response to the Government's reform program through the introduction of a comprehensive program for supporting the development of SMEs and an isolation program for restructuring troubled enterprises to create a pipeline of bankable projects; (ii) strengthening of the financial infrastructure by upgrading the payments, clearing and settlement system, automation of the State Tax Administration and the NBM; (iii) improvement in the quality of bank intermediation by strengthening the regulatory and supervisory environment in which banks operate; (iv) enabling privatized and new private enterprises to obtain financing at competitive rates for export-oriented investments; and B. Project Risks 5.2 The project also faces a number of risks: (i) increasing pressuire on the Government to reverse the reform measures if the lack of supply response continues-this risk is addressed by the positive demonstration effect of successful enterprise turnaround and export perfornr.ance; (ii) possible backsliding by the Government that will lead to (a) the SCC not sending enterprises into bankruptcy that cannot be restructured successfully under the EAA, and (b) future budgetary contributions being made to enterprises under EAA's care; (iii) institutional weakness of the NBM and PFIs which would lead to a slow disbursement of the credit component-technical assistance has been incorporated into the project design specifically to address this risk; (iv) a further deterioration of the econonmy could lead to a significant build-up of non- performing loans which will have a weakening effect on the already feeble financial sector; and (v) slow disbursement of the credit line due to possible competition from directed subsidized credits that might be reintroduced for political reasons. The risk is reduced through an agreement with the Government that a significant part of funds from the budget-earmarked for the enterprises-be channeled at market determined rates through the project-supported TU. 43  VI. AGREEMENTS AND RECOMMENDATIONS A. Agreements 6.1 During negotiations, agreements were reached on all Loan documentation including the provision of: (i) a regulatory framework enabling implementation of the EAP and establishment of the EAA. (para. 3.5) [Loan Agreement (LA) Section 1.02 (f) and Schedule 5 (5)]; (ii) adoption of an Institutional Development and Action Plan of the Banking Supervisory Department of the NBM (para. 3.23); (iii) establishment and appropriate staffing of the BRU within the NBM. (para. 3.24); (iv) final agreement on the balance between loan and grant financing for the TA, taking into account the availability of grants from donors (paras. 3.26 and 3.51); (v) confirmation of specific set of eligibility criteria for private commercial banks (para. 3.19); (vi) confirmation of additional eligibility criteria for commercial banks to participate in SME window program (para. 4.17); and (vii) confirmation of sources for the credit line: (a) US$27.45 million equivalent from the 20-year maturity Bank loan and (b) US$5 million equivalent to be funded by allotments in the National Budget over a three-year period. [LA Schedule 5(2) (g)] 6.2 Prior to the Board the following actions were taken by the Borrower: PIU Director has been appointed. (para. 4.1) Banking regulations satisfactory to the Bank have been stubmitted and satisfactory progress has been made with the implementation of an Institutional Development and Action Plan for the Banking Supervision Department of the NBM. (para. 3.23) Substantial progress has been made with the pilot program, inc:uding appropriate regulatory changes and progress satisfactory to the Bank with the restructuring of 3-5 pilot enterprises. (para. 4.6) Two banks, acceptable to the Bank, have expressed their willingness to participate, and have demonstrated their capacity to qualify as participating financial institutions. (para. 3.19) 6.3 As effectiveness conditions: The new Financial Institutions Law has come into force. (para. 3.23) [LA Section 6.01 (f)] Conclusion of a Grant Agreement satisfactory to the Bank for the establishment and staffing of the TU. (para. 4.10) [LA Section 6.01 (d)] At least two Subsidiary Loan Agreements satisfactory to the Bank will be signed. (para. 3.19) [LA Section 6.01 (b)] A Funds Transfer Agreement satisfactory to the Bank to be signed between the Ministry of Finance and the EAA. (para. 4.2) [LA Section 6.01 (c)] 44  Conclusion of a Fiscal Agency agreement satisfactory for the Bank between the MOF and the NBM. (para. 4.8) [LA Section 6.01 (a)] Finalization and adoption of a Credit Line Regulation Manual (CLRM) with an Annex of environmental review procedures for individual sub-projects (para. 4.22) [LA Annex to Schedule 5, Section I(B)(2)(e) and LA Section 6.01 (e)] 6.4 Conditions under specific disbursement categories: NBM to present to the Bank a fully costed plan for the automation of the payments and clearing center. (para. 3.27) [LA Schedule 1 (3)(c)] NBM to present to the Bank a fully costed plan for its automation. (para. 3.28) [LA Schedule 1 (3)(b)] MOF to present to the Bank a fully costed phased implementation plan for the automation of the State Tax Administration. (para. 4.7) [LA Schedule 1 (3)(d)] A NBM Sub Loan Agreement to be signed between the Ministry of Finance and the NBM. (para. 4.24) [LA Schedule 5 (3)(a)] B. Recommendations 6.5 The proposed Project provides a suitable basis for a Bank Loan to the Republic of Moldova. The loan will be a two tranche, US$25 million and DEM14 million (equivalent of US$10 million), LIBOR-based single currency loan with floating interest rates, for a period of 20 years, including a grace period of 5 years. 45   ANNEX A Page 1 of 3 SAMPLE MEMORANDUM TO BE SENT BY THE SCC TO THE ENTERPRISES To: Chairman of the Enterprise Board/Enterprise Director Enterprise Name & Address RE: Memorandum concerning measures to be taken in connection with debt due to the State in the amount of Lei_ Dear Sir/Madam: Pursuant to Resolution No. of the Council of Ministers, the undersigned State Creditor's Council (the SCC) has been formed by the Government to represent the Government's interests as the creditor of the enterprises indebted to the Government in the amount exceeding Lei (the Debtor Enterprise). The said Resolution empowered the SCC, inter alia, to take measures aimed at reversing the mounting financial problems of the enterprise sector by actively encouraging the Debtor Enterprises to undergo a meaningful rehabilitation, which shall include restructuring of the enterprise's existing debt to the Government and private creditors (the Restructuring). In accordance with the said Resolution, the SCC has determined that the total amount of present indebtedness of Enterprise to the Government is Lei , which includes Lei _ in tax arrears, Lei in wages arrears, Lei in arrears to the Social Fund and Lei in energy arrears (each of the amounts includes principal, interest, penalties and other applicable charges). In order to deal with this debt in a productive manner, the SCC hereby requests the Enterprise to seek a voluntary rehabilitation through isolation. Specifically, the SCC requests that Enterprise (i) hold a general meeting of its shareholders in which the management shall ask the shareholders to empower the Board of Directors to prepare and implement the Restructuring Plan, (ii) notify all its creditors of the First Creditors' Meeting to be held by the Enterprise , in which it will seek their approval for the preparation of the Restructuring Plan acceptable to creditors; (iii) prepare such Restructuring Plan within 6 weeks from the date of the First Creditors' Meeting; (iv) hold the Second Creditors' Meeting in which it will seek the creditors' approval for the Restructuring Plan and the conclusion of a Debt Restructuring Agreement regarding the rpstructuring of the enterprise's existing debt as proposed in the Restructuring Plan; (v) implement the Restructuring Plan while in isolation; and (vi) resume the payment of its debts in accordance with the terms of the Debt Restructuring Agreement upon successful completion of the Restructuring Plan and emergence from the isolation program. Please note that you may incorpora&e into the Restructuring Plan the appropriate incentives made available by the Government under Resolution No. . Please also note that in preparing and implementing the Restructuring Plan, assistance may be sought from the Post-privatization Agency, a non-profit organization established and operating pursuant to Resolution No. If you agree to seek restructuring through implementation of measures listed above, please countersign this memorandum-agreement with the SCC by signing two copies of the attached "Plan of Action" Form and return one signed copy to the SCC by _ _ _ Please take notice that if the SCC does not receive the countersigned memorandum agreement by the date specified, the SCC will initiate bankruptcy proceedings against Enterprise in a court of proper jurisdiction in accordance with the Bankruptcy Law of the Republic of Moldova. State Creditors' Council by Chairman  ANNEX A Page 2 of 3 PLAN OF ACTION Enterprise _, hereby agrees to seek the Restructuring in accordance with the principles set out in the Resolution No. _ . For this purpose, Enterprise _ hereby agrees to enter into this Memorandum Agreement with the State Creditors' Committee (the SCC) pursuant to which it shall seek a meaningful rehabilitation, including the restructuring of its debts with its creditors (public and private) (the Restructuring). In order to achieve such restructuring, Enterprise shall: 1. By _ _ [insert date not later than 30 days from the date of this memorandum] have its management hold a general shareholders' meeting, at which the management shall request the shareholders to empower the Board of Directors to prepare and implement the Restructuring Plan; 2. If the shareholders' meeting so empowers the Board, draw a list of creditors of Enterprise _ and by [insert date not later than 30 days from the date of the general meeting of shareholders referred to in I above] send by registered mail invitation letters to each of the creditors on the list at their last known address and publish a notice in at least two newspapers of wide circulation concerning the holding of the First Creditors' Meeting. Such invitation letters will be prepared in accordance with the model form attached thereto and shall inform the creditors that the First Creditors Meeting will be called in order to get the creditors' approval for preparation of the Restructuring Plan acceptable to the creditors. 3. If the First Shareholders' Meeting agrees through a double majority (i.e., the majority of total claims among the creditors appearing at the First Creditors' Meeting and the number majority of creditors so present) to allow Enterprise - to prepare the Restructuring Plan, prepare the Restructuring Plan within a period not exceeding six weeks and immediately deliver the said Plan to each creditor for review by speediest means available, together with a notice of the Second Shareholders' Meeting, to be held within two weeks of the date of such notice. 4. Hold the Second Shareholders' Meeting at which the Restructuring Plan will be explained and discussed and a vote of creditors held on whether to support the adoption of the said Plan. If the Restruzturing Plan is adopted by creditors through a double majority vote, sign a debt restructuring agreement with each creditor present which will govern the debt payment obligation of the enterprise to each of the creditors once it emerges from the restructuring. 5. Implement the restructuring plan through isolation with due diligence and efficiency in accordance with appropriate business, financial, accounting and managerial practices in accordance with the provisions of the said Plan so as to achieve its objectives in full. 6. Upon successful implementation of the restructuring plan and emergence from isolation, commence and continue payment of its debt obligations to each creditor in accordance with the provisions of the debt restructuring agreement. Enterprise _ hereby acknowledges its understanding that should it fail to secure the necessary consents or approvals at any of the steps 1-4 above or should it fail to comply with any one of its obligations in accordance with steps 1-5 above, the SCC, as the representative of the Public Creditor will commence bankruptcy proceedings against the Enterprise in a court of competent jurisdiction in accordance with the bankruptcy law of Moldova. Enterprise through its authorized representative (Director or Chairman of the Board)  ANNEX A Page 3 of 3 SAMPLE LETTER OF INVITATION TO CREDITORS TO ATTEND THE FIRST CREDITORS' MEETING Dear Creditor: On [insert date] Enterprise _ signed a memorandum agreement with the State Creditor's Committee (the SCC), established pursuant to Resolution No. _ of the Council of Ministers to represent the Govermnent in its capacity as the Public Creditor of Moldovan enterprises. Pursuant to the said memorandum agreement (a copy of which is attached hereto), Enterprise undertook to seek a meaningful restructuring acceptable to and supported by its creditors, which shall include restructuring of its debt obligations. On [insert datel, pursuant to paragraph I of the said memorandum agreement, the general shareholders' meeting empowered the Board of Enterprise to seek such restructuring. In order to proceed with the preparation of the said restructuring plan, on _ [insert date] Enterprise _ will be holding the First Creditors' Meeting at _ [insert address] in order to seek the consent of its creditors to prepare the restructuring plan acceptable to creditors within six weeks of the date of such meeting. We strongly encourage you to attend the First Creditors' Meeting through your authorized representative and are hoping for your support in allowing Enterprise - to prepare a meaningful restructuring plan which will help it to resolve its financial difficulties and resume its payment obligations to you in accordance with the debt restructuring agreement to be agreed upon as part of the restructuring plan. Sincerely, Director or Chainnan of the Board of Enterprise   ANNEX B Page 1 of 3 Eligibility Criteria and Procedures to Select and Monitor Participating Financial Intermediaries 1. In order to be a Participating Financial Intermediary (PFI), commercial banks have to meet at all time a set of stringent financial and management criteria and have signed a Subsidiary Loan Agreement (SLA) with the Technical Unit (TU) established at the National Bank of Moldova (NBM). These SLA are negotiated separately by each PFI with the technical staff of the TU, which has to seek the final approval of the TU's Committee prior to the signing of each Agreement by the Managing Director. In the case of the first five (5) SLA, prior to their review by the Committee, the Managing Director shall submit each SLA to a review by the World Bank (WB). All other SLA, after their signing, shall be submitted to the WB for an ex-post review and their acceptance on a non-objection basis. 2. Potential PFIs must be individually appraised by the staff of the TU, with particular attention given to their overall lending capabilities and financial and portfolio performance. The same standards shall be used by the staff of the TU to constantly monitor the continued eligibility of currently operating PF1. The staff of the TU shall base its recommendations for action in the case of each PFI on a comprehensive assessment of its creditworthiness. That is, the PFI must have a satisfactory financial and management structure, a satisfactory risk-based capital adequacy, an acceptable asset quality and lending performance, a comfortable liquidity position, and the organization, management, technical staff and other resources required for the efficient carrying out of its operations. The TU's assessment reports must include an evaluation of all these areas, for which the TU shall define a set of eligibility criteria or minimum standards, which shall include the following: A. General Standards: i) The bank must undergo an in-depth annual audit that is conducted in accordance with international accounting and auditing standards. ti) The bank must be in compliance with all banking laws and regulations or, if not, the bank: (a) shall have entered into a time bound agreement with the NBM to come into compliance; or (b) shall be in the process of reaching such agreement to the satisfaction of the NBM. iii) The bank shall be operating pursuant to regulatory and investment requirements and procedures which the WB and the NBM have judged acceptable. Outstanding prudential regulations issued by the NBM shall have to conform to international standards and be satisfactory to the WB at all times during effectiveness of the WB Loan. B. Financial Standards: iv) The bank's "net worth" must equal at least 8% of the bank's risk weighted assets and off- balance sheet exposures (as defined by the NBM), or any higher percentage that the NBM may specify in the future.  ANNEX B Page 2 of 3 v) The bank must have a "net worth" of no less than 4 million lei, or any higher figure that the NBM may specify in the future as the minimum "net worth" requirement for banks operating in Moldova. vi) The bank must maintain a level of loan less provisions at all times at least equal to the minimum required according to the prudential regulations issued by the NBM under the new Banking Institutions Law. vii) The bank must have a positive "net income" for the most recent financial year, as reflected in externally audited financial statements. viii) The bank must be in compliance with the legal reserve requirements of the NBM. ix) The bank must limit the funding it receives from the Government or the NBM to no more than 25% of the bank's "total funding," which comprises deposits (including inter-bank deposits), and funding from the Government or NBM. This percentage will be reviewed anually and mutually agreed between the Bank and the NBM. x) The bank must limit its exposure to a single borrower; "related" and "connected" parties (as defined by the NBM) must be in compliance with the NBM's prudential regulations. xi) The bank must have an open foreign exchange position (as defined by the prudential regulations of the NBM) for each single foreign currency equivalent to less than 10% of the bank's "net worth", and for the total open position for all foreign currencies equivalent to less than 25% of the bank's "net worth"; or any lower percentages that the NBM's prudential regulations permit banks in the future. C. Managerial Standards: 1 The bank's Board of Directors sets overall bank policy and performs appropriate oversight of the bank's operations. 2 The bank has a sound business plan and has appropriate budgeting procedures. 3 The bank has sound lending policies and procedures. 4 The bank has satisfactory internal controls and audit procedures. 5 The bank is not exposed to undue interest rate risk. 6 The bank's management information system provides sufficient information to the staff responsible for managing the bank's risks and financial performance.  ANNEX B Page 3 of 3 D. Other Standards: The bank has established a unit for term-lending and has designated a capable professional, trained in project financing, to act as the counterpart to the TU. E. Additional Standards for PFI in the SME Window: In order to qualify for intensive technical assistance to develop a sustainable and profitable small business lending program, each PFI will have to meet an additional set of criteria to be agreed upon in individual SLAs: i) Clear commitment from tOD management to successful SME lending. ii) Establishment of a special unit for small business lending. iii) Allocation of dedicated staff to this unit and payment of staff based on performance measured as a combination of loans disbursed and repayments obtained. iv) Implementation of small business lending technology consisting of (cash flow based) loan screening and monitoring systems as well as client tracking systems. v) Willingness to accept (over time) more flexible collateral such as inventories and receivables. 3. Side Agreements: The banking sector of Moldova is in need of serious restructuring, so few commercial banks, if any, are expected immediately to meet the eligibility criteria established in paragraph 2. Thus, some adjustment of the eligibility criteria could be allowed temporarily by the TU provided that the SLA of the relevant bank includes provisions whereby the PFI agrees to implement a customized program of capitalization, risk reduction and/or institutional development, as the case might be. The agreed program, to be formalized in a Side Agreement to the SLA, shall set specific targets to be achieved over time, making the continued participation of the bank in the intermediation of the Credit Line conditional on its timely compliance with the programmed improvements. Also, (as shall be specified in the Side Agreement) during the transition period the access of a given bank to the Credit Line might be restricted by the TU in any way it sees necessary to protect Credit Line resources from excessive risks. In particular, the "free limit" ailowance for a bank with a current Side Agreement cannot be more than half that allowed to banks complying fully with the eligibility criteria. At the end of the transition period banks with a Side Agreement are also expected to comply fully with all the eligibility criteria, so that the standard norms of the Credit Line Regulations Manuai will apply.   ANNEX C Page 1 of 5 Automation of the National Bank of Moliova 1. Background The modernization program in progress at the National Bank of Moldova (NBM) has resulted in the assumption of new functions and procedural changes in many of its activities. In order to facilitate the smooth transition to these new functions NBM has chosen automation solutions for its daily functions. Responding to these underlying requirements, the NBM developed automation solutions for building systems that are both efficient and cost-effective, an environment for sharing information, and telecommunications capabilities. The proposed automation strategy is based on interconnected local area networks, which are, in turn, composed of multiple microcomputers. The basic elements of the architecture are: (1) the network-transmission media for exchanging information; (2) workstations-user's personal computer; (3) servers-devices for more powerful data processing that support a network of workstations and other servers. Witliin this automation environment as many automation needs as possible will be met with microcomputers, connecting them to networks and adding to these networks, software, shared microcomputer-based data storage, printing, and specialized processors. This technology environment will be cost-effective, modular, expandable, and easily maintained. When implemented, this environment will offer the NBM an efficient and flexible computing environment that can be easily expanded to accommodate the growing requirements. 2. Project Description Support for automation of NBM under the PSD loan is being provided in the context of a broader project-comprising a number of subprojects-which the NBM is financing in part (in the order of US$0.95 million). a. Prototype Local Area Network (LAN) Subproject-This project was set up by NBM to learn, develop, and test standards for LAN, workstations, servers and applications before LAN can be installed in the user departments. Specification of the user requirements which describes applications that will run on the LAN was developed. This, in turn, was based on the specification and technical platform that was developed with assistance from a local contractual firm. The network which is being installed and implemented is 1OBaseT, in a star configuration, with each workstation or server directly attached to its hub via twisted-pair wire. Several hubs may be configured in a line and interconnected which provides an easy growth path for expansion. The prototype LAN is installed in the Computer Technology Department. It has twenty four workstations, two 586 Pentium servers and one UNIX database server. This project has been funded fully by the NBM and the project was installed during the first week of May 1995. b. Local Area Network for NBM Subproject-This subproject will involve the installation and implementation of a local area network for user departments. The first user department LAN will be installed in four departments: the Banking Supervision department, the Economic Analysis and Research department, the Foreign Operations department, and the Balance of Payments department to support the central economic database for NBM. Data specification procedures have already begun and actual development of the software system and the installation and inplementation of the LAN will start during the fourth quarter of 1995. The next LAN installation is planned for the Credit Resource  ANNEX C Page 2 of 5 department, Accounting department and Clearing and Settlement department. The Administration department LAN will be introduced toward the end of 1996. c. Office Automation Subproject-With the implementation of the LAN project, an office automation project was introduced. NBM evaluated the MicroSoft Office Software and the decision was made to adapt MicroSoft Office as the standard office automation software for NBM and introduce Access Software for the database development tool. INFORMIX has been selected for the new NBM- wide database platform. d. Development of the new Accounting System-NBM is in the process of converting from the old Gosbank accounting system to the new chart of accounts on July 1, 1995. A decision has been taken to modify the existing FOXPRO computer programs to accept the new chart of accounts. The system should be developed on the new database platform in the near future. It is planned that systems development efforts should start in mid 1996 and have the system completed by the first quarter of 1997. e. The Book Entry System-The first Goveniment Securities auction has held in March 1995 and it is decided that auction will take place every five (5) weeks. Initial programs were written in FOXPRO and a more comprehensive system should be developed to repiace the current one. The new system will be implemented during the fourth quarter of 1996. f. The Administrative Systems-NBM initially developed a payroll system on a stand alone PC using FOXPRO. Now, however, a comprehensive Administrative System will be developed on the new automation platform to address personnel, payroll, procurement requisitions, inventory and other administrative functions. 3. Hardware and Software Configurations a. Hardware Configuration Database Server: Pentium - 90 Mhz Tower 64MB RAM 5GB Hard Drive 3.5" 1.44MB Diskette Drive 17" Monitor(1280 x 768 Color) Ethernet Card Network Card and Disk Controller UPS 1250W American Power Smart 220V/50 cycle Engli.sh/Russian keyboard and mouse  ANNEX C Page 3 of 5 Conmuunications Server: Pentium - 90MHz Tower 64MB RAM1GB Hard Drive 3.5" 1.44MB Diskette Drive 17" Monitor(1280 x 768 Color) Ethernet Card Network Card and Disk Controller UPS 1250W American Power Smart 220V/50 cycle English /Russian keyboard and mouse Applications Server: Pentium - 90MHz Tower 64MB RAM IGB Hard Drive 3.5" 1.44MB Diskette Drive 17" Monitor(1280 x 768 Color) Ethernet Card PC/TCP/IP English/Russian keyboard and mouse Departmental Server: Pentium - 90MHz Tower 16MB RAM 2GB Hard Drive 3.5" 1.44MB Diskette Drive 17" Monitor(1280 x 768 Color) Ethernet Card PC/TCP/IP English/Russian keyboard and mouse Workstations: 486DX40 based PC 8MB RAM 240MB Hard Drive 3.5" 1.44MB Diskette Drive 14" Monitor (1280 x 768 Color) Ethernet Card English/Russian keyboard and mouse Terminals: 486DX40 based PC 4MB RAM SVGA screen and video adapter Ethernet Card English/Russian keyboard and mouse Laptop: Laptop 486DX 75MHz 240MB Hard Drive 9.5" Monitor 8MB RAM expandable to 16MB VL Local-Bus Video Expansion Bus for Smart Station Modem  ANNEX C Page 4 of 5 3.5" 1.44MB Disk Drive Power Management System b. Software Requirements Following software will be used as standard software syster.s: o -Network Operating Systems -Novell Netware -SCO UNIX o Widows Operating System o Microsoft Office which includes Word for document creation, Excel for spreadsheet applications, Access for database and Power Point for the production of quality publications. o MicroSoft Project for managing the development effort and monitoring the project progress. o INFORMIX for database software. 4. Hardware Requirements Hardware # of Units Price/Unit Total Cost Power Server 3 $20,000 $60,000 - communications - processing - database Dept. Servers 15 $14,000 $210,000 Workstations 200 $3,000 $600,000 Terminals 40 $700 $28,000 Copying Machine 15 $900 $13,500 External Modem 20 $250 $5,000 Hubs-24 port 20 $1,700 $34,000 Ethernet cards 300 $140 $42,000 U P S _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _  ANNEX C Page 5 of 5 Hardware # of Units Price,Unit Total Cost - 600VA 200 $250 $50,000 - 900VA 22 $300 $6,600 - 1250VA 3 $350 $1,050 Laptops 10 $4,000 $40,000 Printer 10 $2,000 $20,000 FAX machines 12 $300 $3,600 CD ROM 30 $400 $12,000 Scanners 15 $750 $11,250 Contingency 57,750 Total $1,250,000 5. Funds Allocation and Requirement Schedule The following table summarizes the plan for allocating and required schedule for the disbursement of funds: Hardware $1,250,000 Software $ 225,000 Training and Other $ 75,000 Total $1,550,000 January 1996 $ 825,000 June 1996 $ 725,000   ANNEX D Page 1 of 1 Payments System Development: Technical Specifications 1. Background The project for supporting the development of the payments system in Moldova is aimed at strengthening: * Intra-bank delivery of payment messages * Inter-bank delivery of payment messages (submissions) * Submission processing and settlement in the NBM1Settlement Confirmation. 2. Project Description Under this project there are two sub-projects: a. Implementation of an integrated, Automated Interbank Payments System (AIPS). This will include 30 site EDS, NBM Submissions Processing and Settlement Applications, including Nominal Ledger facilities as standard. The cost estimate is $500,000 including software and customization. No hardware is included as it is likely that the applications will utilize either the DEC/SWIFT platform, or the NBM Local Area Network, both of which are separately costed. b. Implementation of backup / disaster recovery site for NBM systems. Cost estimate $150,000 including hardware and communication lines. An integrated AIPS approach has been chosen for the following reasons: * sharing of computer platform capacity with the SWIFT implementation, * standardized built in operational procedures and record / file formats, * provides a nominal ledger soiution for the Accounts Department of the NBM, * has high standards of system and operational documentation, * adequate technical support / software maintenance. Project Costs Implementation of AIPS $500,000 Implementation of backup disaster recovery site $150,000 Contingency $30,000 Total $680,000 Funds Requirement Schedule January 1996 $400,000 June 1996 $280,000   ANNEX E Page 1 of 11 Computerization Plan for the Moldovan Tax Inspectorate Introduction The business and economic environment in Moldova is going through a significant restructuring. A modernized, well-functioning tax system is an essential element in achieving macroeconomic stabilization, developing a clear set of the "rules of the game" needed for a market economy, and in facilitating the business investment needed in Moldova. The Government is committed to this process through a comprehensive review and reform of the tax system. The result will be a system which is simpler to cope with, fairer and competitive with its trading partners. In response to advice and recommendations from the IMF and the World Bank, and with the assistance of USAID-financed long-term resident technical advisers, the Ministry of Finance is undertaking three major initiatives that will: * Reform the structure of the tax laws in Moldova, e Restructure the tax administration, and * Computerize many of the functions of the Tax Inspectorate. Each of these elements of reform is dependent upon the others for the success of reform as a whole. Reform of tax policy mechanisms will create a broadly-based tax structure with low rates, giving investors a secure framework in which to work. Reform of the tax administration processes and procedures will help in clarifying rights and obligations, and will enable business to comply more easily and at lower administrative cost with the tax system. Finally, computerization of the Tax Inspectorate will allow business to devote a smaller share of their time and expenses to the tax collection process and for the Government to improve the efficiency of the administration. This Annex explains the inter-linked reforms in tax policy, administration, and computerization and describes the four-phased implementation program for which the PSD Loan would finance the hardware, software and related training, at an estimated cost of $US 1.9 million. The computerization plan is divided in 9 sections as follows: 1 . Overview of the current tax system 2. Tax policy objectives 3. Recent developments 4. Tax administration objectives 5. Computerization objectives 6. Organization of the Tax Inspectorate 7. Computerization of the Tax Inspectorate 8. Design and Implementation Schedule 9. Funds Allocation  ANNEX E Page 2 of 11 1. Overview of the current tax system To ensure financial stability for the government, the tax system in Moldova should raise the necessary revenues to finance government programs and services and service public debt, while reducing its reliance on credit. The system is far from meeting these objectives at present. Currently the situation is as follows: * Nominal GDP in Moldova was 7.8 bn lei in 1994, and is expected to increase to 8.65 bn lei (I 1 per cent) in 1995. * Government revenues were 1,317 m lei in 1994. Of this amount, 953 m lei (12.2% of GDP) was from taxation. This compares to expenditures in the same year of 1,837 m lei. * The largest source of tax revenue is the Corporate Profit Tax (35.3%), followed by the Value Added Tax (29.0%), Excise Tax (15.1%) and Pcrsonal Income Tax (13.6%), most of it being collected through withholding at source by employers. These taxes contributed a total of 93 percent of total tax revenue for 1994. 2. Tax policy objectives To meet the economic and financial needs of the country, the following objectives have been developed and will guide the government in modernizing its tax system: * The revenue level generated by the tax system should be roughly sufficient to finance the programs and services of government, and to do so in a way that is reliable and predictable over time. * The tax system should not limit the growth capacity of the economy. This is vital for domestic producers operating in world markets and to attract foreign investment in Moldova. The tax burden must be and remain competitive with its trading partners -- both in the former Soviet Union and in other countries. While every tax system must be competitive with its trading partners, there is an even stronger case for small countries such as Moldova, which can significantly improve its economy by being competitive and expanding its markets. As part of the tax reform exercise, the overall tax burden faced by enterprises is being examined. 3. Recent developments In this context, the Government has already taken a number of steps to improve the tax system and improve the economic climate: * Business income tax rates have been significantly reduced, from 50 per cent (70 per cent for certain corporations) to 32 per cent; * A new income tax law for banks has been prepared and has passed first reading in Parliament and is expected to be enacted in a few weeks. This law will significantly improve the tax system for banks  ANNEX E Page 3 of 11 by gradually reducing the tax rate from 40 per cent to 32 per cent and introducing a deductible reserve provision for loan losses (in line with agreements under the Structural Adjustment Loan). * New proposals are being developed to modernize the real estate tax law and the resource sector tax laws. * A new consolidated tax code is in preparation which will combine the existing set of income tax laws (currently over 15). * The system will be made simpler to cope with. For example, the current method for depreciation calculation is being reviewed and simplified. * Rather than requiring a separate amortization schedule for each good, a declining balance method with five categories of depreciation rate is being considered. * The method for determining allowable business expenses and the accounting method are also being reviewed with the aim of harmonizing them with market economy norms. * A discussion paper is in preparation that will explain the main objectives that the Government intends to follow with tax reform, present the major issues that it is considering, and outline next steps. The Government has also begun taking steps to modernize the tax administration: 4. Tax Administration Objectives Tax administration is currently very labor intensive and imposes substantial costs of compliance on business. Therefore, a process has already begun to consolidate its structure, modernize its facilities and computerize its facilities, improve the quality of the human resources working in the Tax Inspectorate, and improve compliance and collection techniques. * Various provisions have been introduced to improve the effectiveness of the Tax Inspectorate; * A new Chief of the Tax Inspectorate has been appointed and three senior positions have been created which will permit senior officials of the Tax Administration to plan and structure the new administration. Further steps are under way to improve tax administration: * The tax filing requirement is being reviewed in order to reduce and simplify the number of forms and amount of data required. * The tax filer identification system is being updated to be consistent with computer processing requirements. * The auditing of returns is being specialized. Currently, auditors have no specialization. They must deal with all types of tax and they are required to review each tax return every two years. In future, audit criteria will be changed to target cases where there is a high probability of evasion or fraud.  ANNEX E Page 4 of I1 The Tax Inspectorate is improving its communication capacities with the business community to discuss and inform them of proposed changes and to better explain changes that have been adopted. (A newsletter was recently issued). 5. Computerization Objectives To ensure that the fiscal reform project is successful, modernization of the current computer hardware and software is essential. With the shift from a small number of taxpayers under central planning to a decentralized economy covering a much large number of enterprises and individuals responsible for their own tax returns, the quantity of transactions to be processed will soon become unmanageable through existing means. Without the aid of a well designed and well integrated automated data processing system, the Tax Inspectorate will not be able to fulfill its responsibilities effectively. This system will also serve to lessen the administrative burden the business community faces when it deals with the tax system. To develop and implement this plan, a software information engineering group that will concentrate their efforts on designing and implementing systems that will change the current way of doing business. This group will work closely with the advisors and key users to develop computer applications for the Tax Inspectorate. The Tax Inspectorate has already begun identifying the personnel that will be part of this group. In designing and implementing a computerized tax system, a number of goals will be pursued: I. Simplify data entry by using electronic information transfer as much as possible between computers within the Tax Inspectorate and from other external sources (banks, Customs, etc.) 2. Generate benefits to the Tax Inspectorate quickly, even if many parts of the system remain to be completed. Careful planning and phasing in of essential components at intervals throughout the development process will allow parts of the system to be successfully implemented in production prior to its completion. 3. Create a set of inter-networked, distributed computers, working in the framework of a comprehensive systems design, that will continue to provide benefits as further expansion of the system continues. 4. Provide taxpayer service on tax information. 5. Generate taxpayer identification numbers (TIN) for a broad base of taxpayers. 6. Centralize control of taxpayers for auditing and tax evasion purposes. 7. Maintain a central data base for taxpayers. 6. Organization of the Tax Inspectorate There are presently 39 local Tax Inspectorate offices in Moldova. The capital, Chisanau, contains the largest office as well as 5 district offices. The other local Tax Inspectorate offices are scattered throughout the country. All heads of the local Tax Inspectorate office report directly to the Chief of the  ANNEX E Page 5 of 11 Tax Inspectorate. The local offices employ 1800 tax inspectors, of whom a minimal number have computer expertise. Currently, each local office is responsible for administering every tax base in their district. This includes processing, verification and collection of VAT, corporate income tax, personal income tax for self- employed, withholding tax for employees and the real estate and land tax. 7. Computerization of the Tax Inspectorate Volume of information processed To assess the machinery required for computerization, it is necessary to calculate the volume of information to be processed. The volume of data the Tax Inspectorate is currently processing is estimated by multiplying the number of taxpayers by the number of blanks required to be completed on each tax form. Adding up all the taxpayers for each different tax base gives a figure of 2 million tax records in Moldova. The amount of information required from the taxpayers can be expressed as about 50 million fields, or 150 megabytes of information. At present, the great majority of taxpayers are existing enterprises. With the introduction of a broad- based income tax on employees, and the inclusion of new businesses in the tax net, the number of tax records is expected to rise to 6 million by 1997. This and other changes will result in the volume of fields processed by the Tax Inspectorate to increase by a factor of 10, to about 500 million fields. Storage of this information will require about 1.5 gigabytes of computer space. The number of taxpayers now and in 1997 along with the amount of space required to store the tax filer information is available in Table 1. The taxpayer number identification system will also generate a large volume of data to be processed and stored. Currently there are 50,000 filers in the system, requiring 2 megabytes of storage space. This will expand to 3 million filers in 1997, requiring 200 megabytes of storage space. Current state of computerization Computerization of the Tax Inspectorate is in its infancy. The bulk of the hardware is in the capital, Chisinau, with the remainder scattered around the country. Each of the 39 local Tax Inspectorate offices is currently equipped with at least one 486 chip desktop computer, in addition to an older 286 machine. There are a total of 134 machines operating around the country. Of these, 47 are 486 machines, 24 are 386 machines and the remainder 286 machines or older. A detailed list of the computers currently available to the Tax Inspectorate appears in Table 2. The machines are not being used to their full capacity at the moment. Only the computers in the Chisinau district (the main Chisinau site and 5 other offices in tota!) are linked in a network and transmit information via modem. There are plans to create a network in other offices, but these have not been implemented as of now. Also, many of the existing machines are obsolete. Given the need for development of a standard software platform (Windows based), the existing 286 machines (and some XT/8088s) will not be able to be used in the future as part of a large, integrated network. Furthermore, the 386 machines will need to be upgraded to meet the minimum needs of the new system.  ANNEX E Page 6 of 11 The functions these machines are providing is also linmited at the moment. The assignment of Taxpayer Identification Numbers (TIN) is done by computer. However, because there are no communications links between offices, this means that the TIN registration form is handed over to a local Tax Inspectorate office, then delivered to the Computer Center at the Ministry of Finance for processing. Then a certificate is returned back to the local office and the taxpayer. The treasury function in the Tax Inspectorate is computerized to a limited extent. Taxpayers go to their assigned bank and make a payment to a prespecified account set up by the Treasury specifically to handle taxpayer payments. The bank sends a paper report to the Tax Inspectorate each month listing the payments received. The Tax Inspectorate then uses this information to check that the amount that has been paid is equal to the amount it has calculated as the liability. The only tax bases this process applies to are the corporate income tax and the value added tax. There are no treasury functions computerized for the employee withholding system, the self-employed income tax, or the land or real estate tax. Presently, the only local Tax Inspectorate office with the ability to communicate electronically with the central site is in Belti. Once again, this only applies to tax payment records, not processing or report generating or other functions. No other electronic transfer of information is possible between offices outside of the capital and the Computer Center or the Central Tax Inspectorate. All document tracking, analysis and report generation is currently done by hand in the local offices and then sent to the Central Tax Inspectorate as needed. Tax processing for each tax is still done by hand in each Tax Inspectorate office. Corporate taxpayers are required to submit a balance sheet and income statement along with their statement of tax liability. The Tax Inspectorate checks the calculations by hand for each tax return and notifies the taxpayer in case of a discrepancy. Tax processing by hand is also done for the other major taxes: personal income tax (self-employed as well as employee withholding) or the land and property taxes. In addition, property valuation for buildings is done manually by the Biurtau of Technical Inventory (BTI). Valuation for land is done by the Ministry of Agriculture. Currently, thev are partly computerized, having available only obsolete equipment. This is a serious impediment to maintaining up-to-date, accurate values. The valuation process should be updated to utilize modern methods of valuation, mass appraisal, spatial analysis, and increasingly, market information. With the computerization of the Tax Inspectorate, Moldova will be modernizing its tax system. This will mean that document tracking, processing, verification, collection, transfer of information are all done on computer. Report generation and an on-line information system will allow the government to monitor its finances and conduct tax policy with much greater efficiency than ever before.  ANNEX E Page 7 of I 1 8. Design and Implementation Schedule Four phases of implementation The computerization program is divided into four phases. Phase One, May 1995 to January 1996, is being devoted to the creating the underlying infrastructure of the system and the development of prototypes. During this phase, the new, simplified forms and procedures will be designed, and the systems development team will be writing the software to be used for tax calculation, document tracking, record keeping, and report generation for each tax base. Using a small sample of taxpayers, they will test this system, making changes if needed based on input received from the users (the Tax Inspectorate), the tax advisers and the taxpayers. Specialized software for property valuation will be installed. This will be done either at a central cite or at multiple locations. This policy decision and administrative arrangement has not yet been made by the government. This software will be used to collect, maintain and manage market data and conduct highly technical research of the real estate and land tax bases. The data and research will enable a much more accurate valuation of property. Use of valuation standards approximating market values will facilitate collection of required taxes. Computerization of valuation will allow up-to-date, accurate property values to be maintained in the system as the market economy continues to evolve. The resulting property tax system will be much fairer and socially equitable than before, and will have the potential of generating high levels of revenue. The resident advisers are supplying the Tax Inspectorate with a Pentium style server computer to be used as the hub of the systems design efforts. In addition, the Tax Inspectorate has seven 486 desktop machines allocated to the systems design team. Phase Two, from January through June 1996, is the beginning of the implementation of the system at the central site in Chisinau. The prototypes will be expanded into a full scale system using real data. The Value Added Tax will be the first tax base to be computerized. It is an ideal candidate since the VAT is one of the largest tax bases, and will be the easiest to computerize. During this phase, real data will be collected from VAT payments. The system will be used to calculate liabilities, monitor payments, and general reports. The aim is to continue testing the system using real data for one tax, then spread the system throughout Moldova by region and by tax base. At this time, the centralized database, containing complete information on all taxpayers, will be created. It will be maintained at the Computer Center in Chisinau. Communication links will be established with each of the nine regional Tax Inspectorate offices. External sources (i.e. Treasury, National Bank, commercial Banks, Customs, Financial Guard) will be able to send information to the Tax Inspectorate electronically, greatly increasing compliance capabilities. The Central Tax Inspectorate computer system will also be linked to this central system. Phase Three will last from July 1996 through the erd of the year. The new system design will be installed in a small number of satellite regions. Each of these will be linked electronically with the Central Tax Inspectorate. The excise tax and income tax are planned to be computerized during this time as weil. At this point, the broad based income tax system will be introduced, replacing the current employee withholding system. The Central Tax Inspectorate will have the capacity to retrieve information about the tax system in a much more timely fashion than ever before.  ANNEX E Page 8 of 11 The final phase, Phase Four, will be the implementation in the regional Tax Inspectorate offices throughout Moldova. This is expected to take another five months, from January through May 1997. Each of the nine regional offices will establish direct links with the central office. The remaining local Tax Inspectorate offices will be clustered into networks around the nine regional offices. The remaining tax bases, primarily the land and real estate taxes, are expected to be computerized during this stage. Following full implementation, the systems development team will become the Systems Design Center. Its function will be to continually adapt the computer system to the changing tax system in Moldova. This includes updating software as the tax code changes, maintaining a secure database of taxpayer information, and responding to information requests from the Tax Policy office within the Ministry of Finance. 9. Funds allocation The following table summarizes the plan for allocating the proceeds of the loan: Hardware $1,342,145 Software $ 400,000 Facilities $ 75,000 Contingencies $ 100,000 Total $1,917,145 Hardware At the heart of the system will be three extra powerful computer servers, equipped with a Pentium chip. Each will have a specialized function, and therefore a specialized configuration. The data base server will have an extra large (5 GB) hard drive. The returns processing server will have expanded (64 MB) memory and a large (2 GB) hard drive. The communications server will have a standard I GB hard drive. The Development team, the Taxpayer Identification Number center and the Chisinau territorial Tax Inspectorates will also have Pentium machines, though not as powerful as the previous ones. Each local Tax Inspectorate office will use a 486 machine as the center of its processing facility. All the machines will be linked into a two-stage network. Smaller local offices will communicate via modem with a nearby regional center. Each of the nine regional centers will, in turn, communicate with the central site in Chisinau. In essence, this will be one large, tenritory-wide network. This will enable the local offices to communicate more effectively with the central office by transmitting information electronically, rather than on paper. The Computer Center will be able to archive taxpayer records, and provide the Ministry of Finance with information it requires to do tax policy analysis. The Ministry, through the Central Tax Inspectorate office, will be able to quickly access information summarizing the tax collection activities of the local offices.  ANNEX E Page 9 of 11 The land and property tax valuation system will require four dedicated computers to properly run the system. The research and valuation will be conducted from the central site, with the billing and collection functions performed by the local Tax Inspectorate offices. Taxpayers' payments will be made at local banks. The data entry process is the most labor-intensive one, but it requires the least sophisticated computer. The data typed in will automatically flow into a larger machine, either a central machine within a local Tax Inspectorate office, or to the date base server at the Computer Center. Therefore, these computers can be purchased without a hard drive and will function simply as a "dumb terminal". In addition, there will be approximately 50 other dumb terminals around the country for on-line access to information stored elsewhere. The remainder of the money spent on equipment will be devoted to printers, network cards, tape backup systems, power backup systems, and miscellaneous supplies. Details of the computer equipment configuration are listed in the appendix as Table 3. A summary of which offices will be receiving which type of equipment is contained as Table 4 in the Appendix. Several different types of software will need to be purchased for the computerization of the Tax Inspectorate and land valuation system. * Computer Aided Software Engineering (CASE) tool: This is a development tool for an analyst or programmer which will be used to assist in the design stages of the system. A multi-user license for 14 application developers will be installed in the LAN system. * Microsoft Project This is a tool for managing the development effort, which provides an automated capability to follow the progress of the project. Delays and / or deviations can be identified and corrected immediately. The use of this tool is essential for completing the project on time and within budget. * Novell Netware This will be the software used to run the computer network. Local users will be able to send and retrieve data and communicate with other local offices and the Data Processing center electronically. * Windows This is the operating system selected for the computerization plan. * Unix This is a multi-tasking software that permits several users to simultaneously access the central data base. * Microsoft Office This is a package of integrated, office automation software which includes: Word, Excel, Access and Powerpoint. Specialized software will be needed for the land and property valuation system. This system will provide an integrated valuation environment that supports the major approaches to market value  ANNEX E Page I0oflI estimation. The valuation subsystem will allow for generation of values by the income approach for income producing properties (including properties where imputed rent can be applied), cost approach for land and/or buildings and the comparables approach for land and/or buildings. The system will also support the adaptive estimation procedure as well as multiple regression analysis and descriptive statistics. The system will provide basic data maintenance and report generation. The spatial analysis subsystem will support automated mapping, including land value maps, multiple layers of spatial and attribute records, polygon buffering and overlays, and land suitability analysis. The system will allow data porting from one subsystem to another as well as to generic software such as spreadsheets and word processors. Facilities The Ministry of Finance has committed space to the Application Development team. This will be in a site apart from the Central Tax Inspectorate. The 14 person team will work here temporarily until a new building! for the Tax Inspectorate is completed. This temporary space will need office firniture, wall partitions, wiring for a local area network (LAN) and telephone lines. A conference room and secure data s-w-ge will also be provided. The central tax data base will be located in the new Tax Inspectorate building. Facilities for data storage and offices for the development team have been taken into consideration during the planning stage for this building. Nine regional sites have been selected to provide connectivity to the central system. Extra telephone lines will be provided at the sites for the modems which will be used to transmit and receive data. In the five Chisinau Tax Inspectorate district offices and the regional offices, terminals will be installed to provide tax filer services, such as document and payment tracking. 10. Development and training Through a technical assistance project in Moldova, USAID is funding several aspects of the modernization of the Moldovan Tax Inspectorate. The primary measure of assistance has been the financing of KPMG Barents Group advisers, including a full-time Computerization Adviser who will work on the project for a period of two years. He will be supported as required by short-term advisers in areas such as database design, network administration and computer-aided software engineering. He has been working closely with the Tax Inspectorate to evaluate the current state of computerization and draw up a plan for computerization. During the next two years, he will be overseeing the implementation of the computerization plan. Development The Tax Inspectorate has committed to putting together an Application Development team. Over the course of the two year project, this team will work in consultation with the Computerization Adviser and the system users to design and implement the system. The Application Development team will consist of the following: * Local hires by the Tax Inspectorate I Database Administrator I Network Specialist  ANNEX E Page 11 of 11 I Computer Assisted Systems Engineering (CASE) tool specialist I Analyst / Programmers 4 Programmers * Transfers from the Computer Center 4 Analyst / Programmers (Taxpayer Identification Number system) Training Training will proceed in several stages: * First, the Applications Development team will be trained using specialized software for system design and management such as CASE tool and Microsoft Project. They will also be trained in using office automation software (Microsoft Office), networking software (Novell Netware) and database management software (Unix). * As the system spreads throughout Moldova, users of the system will receive training in the applications developed, on-line communications, information retrieval and office automation software, as needed. Both classroom style and on-the-job training will be utilized. In addition, customized courses will be offered by short-term advisors on specific topics.   1995 FY96 1996 FY97 1997 FY97 D J F M A M J J A S O N D J F M A M J J A S O N D J F M A M J J A S O N D Project negotiations X Loan signature X Project effectiveness x Project completion Project closing Fisca gency Agreement signed X > |Set up TU unit with BOL i Advisor to TU: Banks Manager (long-term) appointment (w/option to extend) < >: Advisor to TU:Operations (short-term) P appointment/training S^C Two advisors to banks : for SME lending ; Key TU staff appointment X i TU's annual audits and semi-annual full 1 C progress reports ! 1 (additional banks enrollead, iasthey qualify First set of subsidiary loan agreements signed (subsequent agreements signed, as they X -s occur) Continued checking of compliance by the * participating banks with the eligibiliy requirements (IAS audits) Development of Environmental Compliance Manual Environmental Compliance seminar X| MOF to open Special Account XI EAA Director appointment/training (w/option x to extend)X3 Implementation agreement signed X EAA's annual audits and semi-annual full J ,,,1 progress reports - Evaluate speed of disbursement of TA. 3 component g EAA to open account <'X>  1998 FY99 1999 FYO 2000 FY01 2001 J F M A M J J A S O N D J F M A M J J A S O N D J F M A M J J A S O N D J F M A M J Project negotiations Loan signature Project effectiveness Project completion X Project closing r Fiscal Agency Agreement signed Set up TU unit with BOL C Advisor to TU: Banks Manager (long-term) appointment (w(option to extend) Advisor to TU:Operations (short-term) _ appointment/training Two advisors to banks: for SME lending Key TU staff appointment f TU's annual audits and semi-annual full progress reports Pre-qualify first set of participating banks (additional banks enro!led, as they qualify) First set of subsidiary loan agreements signed (subsequent agreements signed, as they -_-_ occur) Continued checking of compliance by the participating banks with the eligibiliy requirements (IAS audits) Development of Environmental Compliance Manual Environmental Compliance seminar MOF to open Special Account ll _m _ EAA Director appointment/training (w/option to extend) Key EAA staff, appointment Implementation agreement signed EAA's annual audits and semi-annual full progress reports Evaluate speed of disbursement of TA component X EAA to open account  ANNEX G Page 1 of I MOLDOVA Private Sector Development Project Supervision Plan APPROXIMATE DATES ACTIVITY STAFF COMPOSITION STAFF WEEKS 2/96 Supervision Task Manager 8 Procurement Disbursement Bank Specialist Enterprise Specialist Lawyer 6/96 Supervision Task Manager 6 Enterprise Specialist Bank Specialist Environment 10/96 Supervision Task Manager 6 Enterprise Specialist Bank Specialist 1/97 Supervision Task Manager 5 Enterprise Specialist Bank Specialist 4/97 Mid-term Review Task Manager 6 Enterprise Specialist Bank Specialist Lawyer 9/97 Supervision Task Manager 5 Enterprise Specialist Bank Specialist 1/98 Supervision Task Manager 5 Enterprise Specialist Bank Specialist 12/98 Supervision Task Manager 5 Enterprise Specialist Bank Specialist 10/99 Supervision Task Manager 5 Enterprise Specialist Bank Specialist 6/2000 Final Supervision Task Manager 6 Enterprise Specialist Bank Specialist Lawyer   ANNEX H Page I of I Private Sector Development Loan Technical Assistance: Esitmated Costs, Financing Plan and Procurement Methods (US$000) Procurement Sub-Components Govt Govt Govt EU US .BRD IBRD Total of of of AID Procurement Method _______________________ zMot Neth Gem _ PIU r 5O 150 EAP Foreign consultants 1600 1200 300 2600 Short listing 5700 Local Consultants 500 400 300 100 400 Short listing 1700 TU Banks Manager (24 months) 600 600 Operations Advisor (24 months) 500 500 Short-term Consultants 200 400 Short listing 600 SME Specialist (24 months) 500 500 SME Specialist (24 months) 500 500 BRI1_U Chief Advisor (24 months) 500 500 Short-term Consultants 200 500 700 TOTAL |1050 2100 200 1500 | 1400 3400 11450   MAP SECTION   iBRD 24285R2 gtT.Nemiro M O L D O VA - M\_< ogiiv- U K R A I N E T. 1o s yV mni-f-