Uzbekistan - Rehabilitation Loan Project

Document of The World Bank FOR OFICIAL USE ONLY Report No. P-6525-UZ REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED REHABILITATION LOAN IN THE AMOUNT EQUIVALENT TO US$160 MILLION TO THE REPUBLIC OF UZBEKISTAN MARCH 3, 1995 FILE COPY This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS Currency Unit = Sum I Sum = 100Tins Period Average* 1993 December 441 1994 August 11 January 546 September 15 February 587 October 21 March 621 November 23 April 1,287 December 25 May 1,477 1995 June 4,836 January 25 July 9 February *1993-June 1994 in sum coupons. A new currency, the sum (1 sum= 1,000 sum coupons), was introduced on July 1, 1994. WEIGHTS AND MEASURES Metric System ABBREVIATIONS AND ACRONYMS CBU Central Bank of Uzbekistan DCEEA Department of Coordination of External Activity FSU Former Soviet Union FXC Foreign Exchange Component GDP Gross Domestic Product IBL Institution Building/Technical Assistance Loan IBRD International Bank for Reconstruction and Development IMF International Monetary Fund LDP Letter of Development Policy MFER Ministry of Foreign Economic Relations MOF Ministry of Finance PIU Project Implementation Unit PSAD Price Setting and Anti-Monopoly Department SIF Social Insurance Fund SOEs State-Owned Enterprises SPC State Property Committee STF Systemic Transformation Facility TA Technical Assistance GOVERNMENT FISCAL YEAR January 1 - December 31  FOR OFFICIAL ISE ONLY REPUBLIC OF UZBEKISTAN REHABILITATION LOAN CONTENTS Page No. LOAN AND PROGRAM SUMMARY ....................... i I. THE GOVERNMENT'S ECONOMIC REFORM PROGRAM .1 A. Recent Economic Developments ...... ........................... 2 B. Macroeconomic Stabilization. 3 C. Structural Reforms. 4 Incentive Framework. 4 Enterprise Reform. 6 Links Between Enterprise Reform and Financial Sector. 9 Poverty Concerns ....... ................................. 10 II. THE REHABILITATION LOAN .11 A. Objectives .11 B. Rationale for Bank Involvement .12 C. Project Description .12 D. Implementation Arrangements .12 E. Procurement .13 F. Disbursement .14 G. Retroactive Financing .14 H. Project Accounting, Financial Reporting, and Auditing .14 -. Agreements Reached .15 J. Environmental Assessment .16 K. Benefit and Risks .16 L. Recommendation .17 ANNEXES ANNEX 1 Letter of Development Policy ANNEX 2 Matrix of Policy Conditions ANNEX 3 Selected Economic Indicators ANNEX 4 Goods Ineligible for Financing ANNEX 5 The Foreign Exchange System ANNEX 6 Status of Bank Group Operations ANNEX 7 Timetable of Key Processing Events MAP: IBRD No. 25454 | This document has a restricted distribution and may be used by recipients only in the performance of their |of icial duties. Its contents may not otherwise be disclosed without World Bank authorization._   REPUBLIC OF UZBEKISTAN REHABILITATION LOAN LOAN AND PROGRAM SUMMARY Borrower: Republic of Uzbekistan Amount: US$160 million equivalent Terms: 20 years, including 5 years grace period, at the Bank's standard variable interest rate. Objectives: The main objectives of the proposed Rehabilitation Loan are to: (i) support the Government in the design and implementation of its structural reform program; (ii) ease the shortage of foreign exchange needed to finance critical imports and minimize the transition's negative impact on the level of economic activity stemming from delay of reform and transitional disruption, and (iii) deepen the existing foreign exchange market to improve private sector access. Description: The proposed Loan would finance imports in an amount of US$160 million. The Loan will provide foreign exchange with the objective of strengthening the development of Uzbekistan's incipient foreign exchange market and of increasing access to foreign exchange by privatized and commercialized firms that rely on market institutions for their import needs. Loan proceeds will be channeled by the Ministry of Finance through the Central Bank's weekly foreign exchange auctions. Eligible imports are subject to a standard negative list. Retroactive financing is available to finance goods imported after November 30, 1994. Benefits: The proposed Rehabilitation Loan supports and helps accelerate the Government's implementation of a comprehensive structural reform program in the transition to a market-based economy, thus avoiding sustained economic decline which inevitably would have a negative impact on the poor. The Loan also provides the framework for donor support, helps supports the national currency, deepens the foreign exchange market while increasing access to it for the private sector.  -ii- Risks: The main risk relate to policy slippage in implementation of stabilization and structural reform measures. It may result from: (i) the Government's insufficient understanding of the key macroeconomic linkages that will determine the success of the program; (ii) increase in inter-enterprise arrears as a result of higher interest rates that may jeopardize monetary and fiscal targets; (iii) the Government's structure and very limited institutional capacity, which makes it difficult to implement complex policy measures that require coordinating policy decisions by various institutions to achieve comprehensive reform; and (iv) a possible lack of popular support caused by declines in output and employment. The policy package included in the Rehabilitation Loan supports measures that will help to mitigate these risks. Close monitoring of economic performance and provision of policy advice and selected technical assistance will aim at alleviating the economic risk. The Bank's efforts in mobilizing external donor support will also help to mitigate implementation risks. Rate of Return: Not applicable Poverty Category: Poverty focussed; supports social safety net reform. Appraisal Report: Not applicable Estimated Disbursement: US$32 million (20 percent of the proposed loan) could be used to finance retroactively eligible imports procured in the four months preceding Loan signing. Effectiveness is expected by April 1, 1995. In addition, up to 10 percent of the Loan amount (US$16 million) per month will be available for disbursement upon signing up. From July 1, 1995 on the monthly disbursements will increase up to 12.5 percent of the Loan amount (US$20 million). Map: IBRD No. 25454  REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED REHABILITATION LOAN TO THE REPUBLIC OF UZBEKISTAN 1. I submit for your approval the following report and recomnmendation on a proposed Rehabilitation Loan to the Republic of Uzbekistan for the equivalent of US$160 million to provide support for the Government's economic reform program. The Loan would be at the Bank's standard variable interest rate, with a maturity of 20 years including a grace period of 5 years. This operation is consistent with the Country Assistance Strategy, presented to the Board under separate cover. 2. Uzbekistan became a member of the IBRD in September 1992, IFC in October 1993, and MIGA in November 1993. The first country economic memorandum (Report No. 11683-UZ) was distributed to the Board in September 1993 and an economic report on Subsidies and Transfers (No. 12934-UZ) was distributed in June 1994. I. THE GOVERNMENT'S ECONOMIC REFORM PROGRAM 3. For the first two years after independence, the Government of Uzbekistan was very cautious in its approach to economic reform. Although prices were partially liberalized, small shops and housing privatized and preliminary legislation enacted, the Government retained central control of most economic activities. 4. In late 1993, as the economic situation deteriorated, Uzbekistan withdrew from the ruble zone and the Government decided to consider comprehensive economic reforms. In December 1993, the Government issued a "Statement on Systemic and Macroeconomic Policy" that set forth the framework for a reform programn for 1994 and beyond. Specifically, the Statement announced the Government's intention to liberalize prices, limit the budget deficit, tighten credit, remove credit subsidies, create a foreign exchange market, strengthen the Central Bank and banking system, expand the privatization program to medium and large-scale enterprises and target social assistance--all positive steps toward transforming Uzbekistan into a market-based economy. 5. On January 22, 1994, a Presidential Decree called for accelerating privatization of medium and large-scale enterprises, promoting participation of the public in privatization, promoting enterprise reform programs, encouraging private sector activities, establishing property rights, reducing reliance on state orders and liberalizing foreign exchange controls. The Decree and related resolutions reduced the number of goods subject to export licensing requirements; established uniform treatment for the Former Soviet Union (FSU) and non-FSU trade; eliminated all import tariffs until July 1995, when a new system would be put in place. Specific measures for currency convertibility and opening the capital account of the balance of payments, including removing the foreign exchange proceeds tax and creating an interbank market for foreign exchange (implemented in April 1994) were also introduced. 6. Recent policy measures signal a significant shift toward accelerating implementation of a reform program. During 1994, the Government started to translate its broad reform and stabilization objectives into a comprehensive set of economic policies. In November 1994, the  Government reached agreement with the IMF on a program to be supported by the Systemic Transformation Facility (STF) which was approved by the IMF Board on January 25. 1995. Details of priority structural reform measures have been or are being worked out in the context of a medium- term program. Implementing this comprehensive policy agenda will require considerable effort b) the Government, as well as financial and technical assistance from the international community. 7. The proposed Rehabilitation Loan is designed to assist the Government in advancing and implementing its economic reform agenda. Particular emphasis is placed on privatization, the deepening of the existing foreign exchange market to increase private sector participation and help stem the economic disruption resulting from breakdown of the payment system and intra-FSU trade. A. Recent Economic Developments 8. Like many other FSU countries, Uzbekistan has suffered serious macro-economic instability and output declines since 1991. Uzbekistan suffered a cumulative decline of Gross Domestic Product (GDP) of around 15 percent during 1992-1994 compared with an average of 40 percent for the rest of the FSU. Disruption in the availability of imports particularly has hampered manufacturing output, which fell by over 15 percent in 1993 and declined further in 1994. The largest drop occurred in the heavy industrial sectors most closely linked to other FSU republics, with whom trade and payments were disrupted. In contrast, agriculture, which accounts for over 35 percent of GDP, expanded moderately during 1993-1994. Domestic oil and natural gas production also expanded significantly over the last two years. Uzbekistan's ability to diversify export markets away from FSU trade, and growing oil and gas production, were the main factors that cushioned output contraction. Nevertheless, despite the disruptions in interrepublic trade caused by lack of adequate payments arrangements and shortages of foreign exchange, Uzbekistan's current account deficit increased from $240 million in 1992 to about $400 million in 1993 and 1994. In addition to large macroeconomic imbalances, the trade deficit has been negatively affected by the rising unit cost of energy imports. 9. In 1993, the consolidated budget deficit was estimated to be about 12 percent of GDP. Real interest rates remained highly negative, and enterprises continued to show no financial discipline. As the Government accelerated its reform efforts, it significantly tightened fiscal and monetary policy. According to IMF estimates, the overall budget deficit remained below 4 percent during 1994. The Central Bank discount rate has been increased to 250 percent, and a three-month fixed term deposit has been introduced in the Savings Bank, with a quarterly interest rate of 30 percent. Notwithstanding the removal of profit margins and elimination of rationed food stuff, inflation fell dramatically during the second half of 1994, to a monthly average of 4 percent from over 20 percent a month in the first half of 1994. 10. The dramatic improvement in the 1994 fiscal position resulted from expenditure reductions, mainly from eliminating discretionary budgetary transfers to enterprises and sharply reducing consumer subsidies. In 1993, direct consumer subsidies amounted to around 9 percent of GDP, mainly for bread, flour, sugar, vegetable oil, residential gas, heating and public transportation. Direct subsidies were reinforced by sizeable indirect subsidies. Foreign exchange was provided at preferential rates for grain, sugar, meat, milk and pharmaceutical imports. Energy imports, arranged mainly through bilateral trade agreements, were also supplied at below world market prices.  -3-I 11. Prices of bread and flour, while still administered, were sharply raised in September and November 1994. During 1994, prices for bread and flour were adjusted 30 - 40 fold. Remaining direct subsidies represented about 4 percent of GDP in 1994. Indirect subsidies remained for purchasing domestic grain at below international prices through the state order system. 12. The reduction in direct consumer subsidies in 1994 was accompanied by a monthly flat allowance of 150 sums to workers, pensioners, students, the unemployed and mothers with young children. This replaced the previous practice of proportional and frequent wage and pension increases, which sheltered real wages from inflationary erosion. As a result of the previous indexation practice, real wages fell only between 5 to 10 percent both in 1993 and 1994. Similarly, since 1991, pension expenditures had doubled as a proportion of GDP. The new practice is more progressive and less expensive. The switch from proportional to flat indexation alone is estimated to reduce pension costs by one third. Furthermore, inflation will rapidly erode the allowance, since it is fixed in nominal terms, which will result in additional savings over time. Although this represents a step in the right direction, transfers need to be still better targeted in the future. Social expenditures including pensions, child allowances, compensation payments, consumer subsidies, and unemployment benefits, remain large in Uzbekistan - about 19.7 percent of GDP in 1994. 13. Uzbekistan withdrew from the ruble zone in November 1993 and introduced its interim currency, the Sum coupon. In the absence of complementary fiscal and monetary measures, the market value of the sum coupon rapidly depreciated in the first half of 1994. As the Government continued to maintain an unrealistic official exchange rate, the black market premium on foreign exchange reached a peak of 10:1 in March 1994. Starting in April 1994, the Government introduced an interbank weekly foreign exchange auction to determine the exchange rate. The introduction of the Sum, Uzbekistan's national currency, on July 1, 1994 has been accompanied by a shift away from expansionary fiscal and monetary policy and by institutional changes in the foreign exchange market. A dual exchange rate system, which consisted of an auction for non-cash transactions and a commercial rate for cash transactions, was eliminated in October 1994. B. Macroeconomic Stabilization 14. The Government's stabilization program, supported by an STF arrangement with the IMF, seeks to reduce inflation to an average 2 percent per month by end 1995. To attain this objective, the consolidated budget deficit is to be limited to 3.5 percent of GDP during 1995 and domestic bank financing of the budget is to be limited to 2 percent of GDP. All financial subsidies will be made explicit and channelled through the budget. Support to enterprises will be limited to passive restructuring and liquidation and will decline over time. An increasing share of central bank credit to the commercial banks will be auctioned, reaching 50 percent by the end of June 1995. Meanwhile, beginning in January 1995, the refinance rate will be adjusted monthly on the basis of past and targeted inflation. 15. Under the STF, the Government is committed to maintaining the recent unification of the exchange rate, substantially expanding the availability of foreign exchange through the inter-bank foreign exchange market, reducing the surrender requirement, and ensuring current account convertibility. The auction-determined exchange rate is now used for all foreign exchange transactions by individuals, enterprises, banks and the Government. Intervention in the foreign exchange market will be limited to smoothing out sharp fluctuations, rather than attempting to target a particular exchange rate.  -4- C. Structural Reforns 16. Structural reform is essential to transform Uzbekistan into a market-based economy. To promote reform, the Government intends to: (i) establish an appropriate incentive framework; (ii) support continued privatization, passive restructuring and establishment of corporate governance for enterprises remaining in the public sector; (iii) develop a sound financial system that can channel funds to private enterprises and facilitate settlement of trade payments; and (iv) strengthen the social safety net for individuals severely affected by enterprise reform. Incentive Framework 17. Uzbekistan's incentive structure is now mainly distorted by indirect subsidies, state orders on cotton and grain, monopolies and quantitative restrictions on exports. The Government, after realizing that subsidies had generated unsustainable budgetary pressure, began to implement a program to eliminate consumer, producer and credit subsidies. In addition, existing import subsidies on grain, energy products and agricultural inputs will be phased out in 1995 as all trade becomes channelled through foreign exchange auctions. 18. For the 1995 crop, state orders on cotton will be reduced to 60 percent of the average 1993-1995 output. Moreover, the procurement price for cotton under state order will be raised to 50 percent of the intemational price (including transport costs). The Government has also agreed to phase out cotton state orders by 1998. 19. The Govermment has already made significant progress in reforming universal consumer subsidies and eliminating direct food subsidies (including, recently, bread and flour). The Government intends to further accelerate cost recovery for public transport and household utilities so that the differential between household and industrial tariffs can be narrowed by 50 percent for heat by mid-1995 and for gas and electricity by end-1995. 20. For grain, state orders will also be eliminated and procurement prices raised to world market level during the transition period. The Government agreed to reduce the state order to 50 percent in 1995, 25 percent in 1996 and to completely discontinue state orders on grain by 1997. The price on grain procured under the state order system will be raised to 50 percent of world prices (excluding transport costs) in 1995, to 75 percent in 1996. This will bring immediate efficiency gains and increases in production, and demonstrates the Government's commitment to the new policy. 21. In order to fulfill inter-republican agreements that are still pending, the Government will maintain a system of state purchases during 1995. Those state purchases will be carried out through competitive tendering, with voluntary participation. Initially, purchases for Government needs may be centralized; ministries and local authorities will gradually shift to do their own tendering, subject to minimum regulation of procedures. 22. The Government has started to revise Uzbekistan's trade regime. It wants to align domestic and world prices of tradable commodities, expand trade, raise fiscal revenues during the transition, and diminish the role of centralized trade. It has already unified treatment of FSU and non-FSU trade. Import tariffs have been removed until July 1, 1995 when the Govermment will consider putting in place a homogenous import tariff structure. The number of goods subject to export licenses has been reduced from 74 to 11 (including cotton fiber, oil, gas, ferrous and non-ferrous  metals), as of December 31, 1994. Cotton sold through the Commodity Exchange is now exempt from export licensing. However, the quantities of cotton trade in the Exchange are still very limited. A 30 percent surrender requirement at the market exchange rate for all exports was introduced in april 1994. The Government intends to eventually eliminate the surrender requirement. 23. The Government intends to reduce further the number of items subject to export licenses, to simplify the procedure of granting cotton export licenses and to start implementing a system of auctions for export licenses on products other than cotton in 1995. Export licenses have become an obstacle for increasing exports and for foreign market access to private traders and farmers. In addition, commodities and goods subject to centralized trade are subject to export quotas. At present, a single license is granted by the Ministry of Foreign Economic Relations for each export contract. The Government has agreed with the Bank to introduce a simplified procedure for granting cotton export licenses for cotton not sold through the exchange. Under such system, a license will be granted within 10 days after receipt by the Ministry of Foreign Economic Relations of a duly prepared contract, a certificate from the Goskomprognozstat confirning the existence of the free cotton, and a certificate of origin. 24. Domestic trade will be demonopolized and opened up to import competition. Rapid demonopolization followed by privatization of dominant enterprises in the warehousing, wholesale trade, and road freight transportation sectors, as well as removal of barriers to entry in these sectors by new private enterprises, are essential to assure the introduction of essential requirement for the successful operation of a market economy. To achieve this objective, the Government has announced its commitment to prepare a concrete, detailed and timebound action plan for: (i) the demonopolization of dominant entities in the warehouse, wholesale trade and transport sectors, including Uzbeksavdo, Uzautotrans, Uzbekberlyashu and Uznefteproduct; and (ii) the removal of barriers to entry by new private enterprises in these sectors. Implementation will start by June 30, 1995. 25. The Government's anti-monopoly efforts will be conducted by a general Competition Agency that will not be empowered to control prices. Instead, this agency will monitor monopoly power, collusion and collective dominance, entry barriers, takeovers and mergers, and a limited number of vertical trade restraints that restrict access to scarce inputs and distribution outlets. The Competition Agency will have a clear legal mandate to investigate and break up monopolistic enterprises and levy heavy fines--an important change, since at present, fines are small and the Price Setting and Anti-Monopoly Department (PSAD) appears extremely reluctant to impose them. In certain sectors of the economy (energy, telecommunications, water), however, problems of natural monopoly will remain and some form of price regulation will be inevitable. To deal with the administration of these prices, the Government will establish an Office of Public Utility Regulation. The monitoring of these institutions will be complemented by the demonopolization of trade and the resulting opening up to import competition.  -6- Enterprise Reform 26. The Government has made reforming state owned enterprises (SOEs) a priority. SOEs absorb a large share of the country's financial resources through their demands on the budget and the banking system. Uzbekistan now recognizes that growth depends on relatively fast privatization and isolating large loss makers to improve performance and attract needed foreign investment. The Government's program for enterprise reforn has evolved in two stages. Stage 1, which was only started in 1992 and was completed in October 1994, focused on privatization of small scale objects' and housing. Stage II, introduced by Presidential Decree in January 1994 and announced in March 1994, was intended to accelerate and broaden privatization and attract foreign investment. 27. Stage I. Stage I included privatization of housing and small enterprises, primarily in consumer trade and services and local industry. State Property Committee (SPC) records show that by the end of 1994, privatization of over 96 percent of housing (approximately 4.5 million units) had been accomplished and the privatization process had begun for an estimated 82 percent (9,634 enterprises) of the total 11,765 enterprises subject to privatization2. 28. The Stage I privatization program had many shortcomings. Almost all of the privatization of small scale entities was through direct transfer or sale to staff. Very limited numbers of small scale enterprises were sold to the public through auctions. While approximately 600 medium scale enterprises were corporatized, this was done in closed stock form, including share allocation to the staff and Government, with the Government generally continuing to hold the majority share. Finally, approximately 400 large scale enterprises were also corporatized (generally closed form) with the Government holding the majority share. Shares in these enterprises were generally issued only to labor collectives. Ownership rights in closed companies were not freely transferable. Medium and large scale enterprises have been reorganized as "concerns" which have tended to continue the sectors' pyramid structures through cross ownership of SOE shares and allocating management of state shares to concerns that maintain the same production/sales/distribution chain. While not excluded, foreign investors have been largely uninvolved, except for tobacco and valuable mineral and metal extraction. Transfers carried contractual obligations to preserve product and employment profiles for 3-5 years. 29. Stage II. Stage II, which began in March 1994, was designed to overcome Stage I's shortcomings but it fell short of addressing all of the critical issues. Over 40 legislative and administrative acts were prepared and the Republican Stock Exchange, the National Share Depository and the National Investment Fund created to implement this second stage of the privatization program. The Government committed as part of Stage II to privatize all enterprises, except large public utilities and services relating to defence, security and safety. Stage II also provided for transferring land rights to new owners, including homeowners and farmers. 'Uzbekistan's privatization program figures refer to "objects" which may include one or more enterprises. For simplicity, this text uses "objects" and "enterprises" interchangeably. 2The total number of enterprises has been estimated at 18,717. Of these, 6,952 entities (hospitals, schools, security installations, etc.) have been exempted from privatization.  -7I- 30. Small Scale Privatization. The first group of small enterprises and assets selected for Stage II privatization by local authorities consisted of those that had not already been transferred to staff, which existing staff were not interested in purchasing or which were unfinished construction projects. These enterprises and assets were being competitively sold through auctions and tenders. Since March 1994, 450 enterprises or assets have been sold (out of 800 identified) through approximately 94 auctions. 31. Large and Mediun Enterprises. In Stage II, most large (over 2,000 employees) and medium (150-2,000 employees) enterprises are being converted to open stock companies. By the end of January, 1995, several hundred medium and large-scale enterprises were converted to open joint stock companies with blocks of shares transferred to employees, the state, the public (through the Stock Exchange or directly), or foreigners. 32. Until December 1994, the program granted SPC wide discretion in allotting shares to each shareholder category. Until they are sold, the SPC is the residual shareholder of shares designated for sale to the general public and foreigners. Thus far, the Stock Exchange has sold minority share blocks of approximately 30 firms, primarily to related enterprises. Foreigners can purchase shares above a certain percentage that varies across sectors. The SPC was simultaneously equity holder in the Stock Exchange, the National Share Depository and the National Investment Fund and owner and seller of state property. The National Share Depository was 37.5 percent SPC owned. The Republican Stock Exchange was 51 percent SPC owned, with the minority held by member brokers. Until January 1995, the National Investment Fund was 37.5 percent SPC owned. 33. Joint Venture Privatization. Under Stage II, SPC was to offer foreign investors majority or entire ownership in about 100 selected enterprises. The state was to retain a majority interest in some sectors, such as energy and fuel, mining and processing of ferrous metals, precious and semi-precious stones, and radioactive and rare-earth elements. In these sectors, foreign investors would be able to participate through minority shareholding or contractual arrangements. This form of privatization is referred to in Uzbekistan as "joint venture" privatization and more commonly elsewhere as "case-by-case" privatization, with the Government continuing to exercise a central role in determining the level of outside ownership. However, the criteria, sequence, and methods for case-by-case privatization were not defined in Stage II program. 34. Program for Strengthening Stage II Privatization. While the Stage II program as outlined by the Government and implemented to date has many positive features, significant problems remain concerning the program's scope, approach, timing and institutional arrangements. First, the program did not make clear (i) which enterprises would remain under majority state ownership, nor (ii) under which timing and method privatization would take place. Second, the program did not specify targets and had no other means to monitor progress. Third, the transfer process was slow and followed ad hoc procedures that made prediction and assessment of privatization difficult. Fourth, the imposition of profile restrictions undermined the quality of privatization. Fifth, the program lacked clear procedures for transferring shares of medium and large-scale enterprises. 35. The Stage II program as it is being implemented fails to meet the Governnent's objectives in terms of quantitative targets, speed, governance improvements and equity in the privatization process. These deficiencies can be surmounted only through a privatization program that is extensive and potentially involves broad participation by the population, i.e. a mass privatization  -8- program.- SPC share offerings should be public and transparent. Case-by-case discretion should be eliminated and the general public should be given ample opportunity to participate. Profile requirements would need to be eliminated in order not to prevent the efficienc) gains resulting from market incentives. The program's institutional arrangements would also need to be improved through the divestiture of state ownership in the Republican Stock Exchange, National Share Depository and National Investment Fund. 36. The Government has become aware of the need to address the remaining deficiencies of the privatization program. As a result, the Government recently announced revisions in the program and has finalized an Action Plan which extends the scope of privatization, improves its speed, clarifies procedures and expands public participation through allowing the creation of private investment funds. 37. The Government has already announced the removal of all existing profile restrictions (on type of activity and employment) on privatized enterprises and prohibits such profile restrictions from being included in any privatization contract in the future. A Cabinet of Ministers' Resolution decreased SPC's ownership position as of January 1, 1995 in the Republican Stock Exchange from 51 percent to 35 percent, in the National Share Depository from 38 to 24 percent and in the National Investment Fund from 39 to 20 percent. Furthermore, SPC is committed to completely eliminating its ownership position in the Republican Stock Exchange and National Investment Fund, and reduce its share in the Share Depository to 10 percent by January 1, 1996. 38. The Government will guarantee that a minimum of 30 percent of shares ("reserved shares" currently held by the Government) of medium and large scale enterprises is made available to newly established private investment funds at their nominal price. The investment funds, in turn, will issue their own shares to the general public. Regulations on the operation of the investment funds will be developed to promote widespread public subscription. Investment funds will be able to exercise their option to purchase reserved shares during a period of time that will be agreed with the Bank. Unsold shares, out of the 30 percent, will be offered for sale through the stock exchange at the end of the period. Investment funds will also be allowed, like any other investors, to purchase additional shares through auction and the stock exchange if they so desire. 39. The action plan includes specific measures (some of which have already been taken) to: (i) set target dates for enterprises to be corporatized and offered for sale to the public. Targets for the 1995 program include privatization of 1,796 objects, including 1,494 small scale, 150 medium and 152 large. It is expected that during the course of 1995, corporatization and segmentation of some medium and large enterprises as well as demonopolization efforts will yield a much larger number of objects for the program, in particular in the small-scale category; (ii) define the scope and conditions of the initial offering of shares, limiting the control of the Government and insiders over privatized or corporatized medium and large-scale 3Hereafter mass privatization will refer to a program that is extensive; it may or it may not include a voucher scheme.  -9- enterprises as well as opening the capital enterprises already corporatized in a closed form. The plan will include the following: (a) minimum percentage to be offered for sale to the general public (51 percent); (b) minimum percentage of the shares to be offered to investment funds (at least 30 percent of those for sale); (c) maximum percentage that can be sold to insiders (25 percent); (d) maximum percentage. that the Government is allowed to retain (26 percent); (e) that the Government and insider shares together will never exceed 49 percent; (f) investment funds will be able to either purchase beyond the 30 percent minimum shares or not invest at all, if they so decide; and (g) remaining state shares will become available for sale to the public; (iii) define rules for transparent and competitive tendering of all lead shareholding positions in medium and large-scale enterprises that will be privatized on a case-by- case basis; (iv) determine the information that needs to be widely circulated to the general public before selling medium and large-scale SOE shares through the stock exchange. In addition, ensure that the Ministry of Finance prohibits the public issue of shares unless an emission prospectus is published in the press; (v) provide for all licensed brokerage houses to have equal rights to promote the sale of shares offered by SPC in the stock exchange; 40. Important mechanisms, including the pricing mechanism to ensure fast market clearing when there is excess demand or excess supply for an enterprise's shares, and minimum prudential regulation for investment funds are being prepared. The revised privatization program, including the implementation arrangements for the investment funds is expected to be adopted by May 31, 1995. links Between Enterprise Reform and Financial Sector 41. Enterprise and financial sector reforms must be jointly addressed because banks are the major creditors of SOEs and claims on SOEs dominate banks' asset portfolios. Prior to the adoption of the stabilization program, banks were the main channel for transferring subsidies to SOEs and taxing depositors, via highly negative real interest rates. Banks in Uzbekistan have directed large subsidies to the sectors and enterprises selected by the Government without concern for the recipients' creditworthiness. While most credit to the enterprise sector comes from the banking system, the progressive decline of the banks' real deposit base has increased their reliance on Central Bank of Uzbekistan (CBU) financing, further fuelling inflation. CBU refinance credits have been almost exclusively allocated to the two state owned banks for agriculture and industry; only a small fraction was left for the small private and joint venture banks. 42. The stabilization program supported by the IMF, which involves a rapid increase in interest rates to positive real levels, credit tightening and credit auctions, will significantly affect SOEs' borrowing from the banking system and banks' access to CBU facilities. The reduction and eventual elimination of implicit credit subsidies to enterprises will highlight the bad financial condition of many SOEs, affect cash-flows, and could result in substantially increased enterprise arrears.  -10- 43. The Government has denied credit and financial assistance to about 600 bankrupt enterprises and transferred from the banking system to the budget temporary interest rate subsidies to approximately 1,000 enterprises that produce essential goods and services and that cannot service their debt obligations to commercial banks under the new interest rate policy. Experimental restructuring has been started in a few SOEs in the building material sector where performance agreements have been signed between the Government and management teams to document mutual objectives and financial obligations. 44. In January 1995, the Government took important steps to introduce financial discipline in SOEs and to prevent an increase in commercial banks' doubtful loans. It established a Credit Bureau at the CBU which will (i) build a data base on aggregate and enterprise level arrears; and (ii) report on outstanding arrears to major creditors including composition, length of time they have been overdue, and causes of arrears. The Central Bank will instruct all commercial banks to provide, in the agreed format, the information on SOE arrears requested by the Credit Bureau. The Government will issue a sirnilar instruction to all concerned state agencies and organizations (tax authorities, Goskomprognosztat, Social Fund). The Government has also decided to isolate the 30 to 50 SOEs with the largest arrears and to exclude them from access to commercial bank credit. A working group with representatives from the Ministry of Finance and CBU has been set up to analyze and provide recommendations to the Cabinet of Ministers about the enterprises to be isolated from the banking system. Selection will be based on: (i) high levels of arrears to all creditors (banks, enterprises, taxes, and workers' unpaid claims); (ii) the level of non-recoverable arrears; (iii) present and prospective level of losses; and (iv) an overall assessment of the financial and operational viability of the worst-perforning SOEs. 45. The Government will then identify, from the SOEs in the isolation exercise, a limited number of SOEs (a sub-set of 10 to 15 large enterprises with the largest total arrears) and assess their potential operational and financial viability. Based on these results and using specific criteria to be developed, liquidation or passive restructuring plans will be prepared for these enterprises. Options will include full liquidation, closing non-viable components and product lines, spinning-off services unrelated to the enterprise's core business, divesting the Government's participation in social assets of those SOEs and rearranging the remaining potentially profitable components into new commercial entities that would resume relations with the banking sector on fully commercial terms and be immediately offered for sale under the government's privatization program. The new relative price structure that will emerge in a market environment might reveal that a large group of SOEs is financially non-viable. Poverty Concerns 46. As has occurred in some other countries of the Former Soviet Union, inaction on structural reforms in Uzbekistan would lead to economic decline and inevitably will result in a larger proportion of the population sliding into poverty. Falling output and inflation would adversely affect the welfare of Uzbekistan's population. Structural reform will be essential to sustained economic growth, and, thus, support to the start of this reform process is an investment which sets the stage for reducing future poverty. A degree of hardship is inevitable during the transition from open unemployment associated with enterprise restructuring and severe fiscal constraints which will hinder the social protection system and delivery of basic social services. The program being supported by this operation has been designed with consideration to the need to protect vulnerable groups during this transition. Other components of the Bank's assistance strategy will ensure and expand access to  - I 1- basic social services with a significant poverty focus, such as in health and rural water supply and sanitation. 47. One major element for protection of the most vulnerable groups is support for families. Recent changes in social assistance have improved targeting. Assistance to low income families, introduced pursuant to decree in August 1994 and administered locally has a budgetary allocation of about one percent of GDP (1.5 billion sum). By October 1994, over 200,000 low income families were receiving support through the social protection scheme. The system of farnily allowances has been rationalized to a single benefit linked to the minimum wage. 48. A second major element of social protection is to reform the pension system without jeopardizing the benefits going to the most vulnerable pensioners. Given that Uzbekistan's pension expenditures are too large relative to demographic structure and GDP, almost doubling since 1991 to about 10 percent in 1994 and forcing a reliance on budget transfers and Central Bank credits, it is necessary to reform pension benefit rules. To limit entitlement of groups that are less vulnerable, proposals are being developed to cut benefits to pensioners who continue to work and to reduce the number of categories entitled to early pensions. In spite of the necessity to decrease benefit levels, lower benefits will be protected to maintain pensioners on lower benefits above the poverty line. The Government announced in February 1995 and plans to introduce in June 1995 a revised system for adjusting pensions whereby the minimum pensions will be protected by adjusting them quarterly according to changes in consumer prices while other types of pensions will be increased by the fixed amount determined for the minimum pension, consistent with fiscal constraints. ll. THE REHABILITATION LOAN A. Objectives 49. The main objectives of the proposed Rehabilitation Loan are to: (i) support the Government in the design and implementation of its structural reform program; (ii) ease the shortage of foreign exchange needed to finance critical imports and minimize the negative impact on the level of economic activity stemming from delay of reform and transition disruption; and (iii) deepen the existing foreign exchange market to improve private sector access. 50. In light of the experience of other Bank rehabilitation loans to FSU countries, the proposed policy package concentrates on key issues with significant up-front action. The core requirements for the Loan consist of phasing-out of state orders; designing and implementing a privatization program for medium and large-scale enterprises; initiating the isolation of a selected group of distressed SOE from the financial sector; and deepening the foreign exchange market. 51. The policy conditions specified under the proposed Rehabilitation Loan constitute a subset of the Government's medium term agenda which are outlined in its Letter of Development Policy (LDP) (Annex 1). Annex 2 presents the policy conditions for Board presentation and monitorable medium-term actions. The latter are time-bound performance benchmarks that extend beyond the proposed loan's disbursement period and are included in the LDP. Since the loan is a one-tranche operation, they have been designed to serve as a continuous evaluation instrument to be used in the macroeconomic and sectoral dialogue and the Bank's sectoral and subsequent lending operations in Uzbekistan.  -12- B. Rationale for Bank Involvement 52. The program supported by the proposed Loan represents a significant effort towards the implementation of a comprehensive structural reform program. The program provides the structural underpinnings for macroeconomic stabilization, the policy changes required for successful transformation to a market based economy, and represents the framework for future Bank operations. The proposed Loan will also contribute to fill the external financing gap, and create the macroecornomic conditions to facilitate the success of the reform agenda. C. Project Description 53. The proposed Loan, in an amount of US$160 million, provides foreign exchange to strengthen the development of Uzbekistan's incipient foreign exchange market. Since the Government introduced its new currency in July 1994, this component is fundamental to support the development of an interbank auction market for foreign exchange. It will increase access to foreign exchange by privatized and commercialized firms that rely on market institutions for their import needs. 54. Loan proceeds will be channeled by the Ministry of Finance through the Central Bank's weekly foreign exchange auctions. Interbank weekly foreign exchange auctions were established in April 1994 and a single unified exchange rate applies to all official and commercial foreign exchange transactions. A dual exchange rate system, which consisted of an auction for non- cash transactions and a commercial rate for cash transactions, was eliminated in October 1994. At present, there are 13 banks authorized to deal in foreign exchange. There is a 30 percent surrender requirement on non-centralized exports. All the proceeds from centralized exports are channelled through the auctions, as of January 1, 1995. D. Implementation Arrangements 55. The Borrower will be Republic of Uzbekistan as represented by the Ministry of Finance. The proceeds of the Loan will be channeled to the Central Bank for supplying funds to the foreign exchange auction market. The Loan will be managed in Uzbekistan by the Project Implementation Unit (PIU) which is part of the Department of Coordination of External Economic Activity (DCEEA) at the Cabinet of Ministers and was established under the Bank's Institution Building/Technical Assistance Loan (IBL). 56. The Central Bank will continue holding weekly interbank foreign exchange auctions to provide funding for importers, and the Customs Committee will monitor imports to support reimbursement of eligible imports. 57. The PIU will have main responsibility for implementation and providing the World Bank with information on the progress on Loan implementation both relating to policy actions and utilization of loan proceeds. For this purpose, it will: (i) liaise with Central Bank staff to ensure efficiency in the auction process and progress reporting, and (ii) communicate regularly with the Customs Committee to ensure imports are recognized by Standard Customs Declaration Forms, and that goods included in the "Negative List" and other prohibited goods are not included for reimbursement purposes. PIU staff will also be responsible to furnish periodic reports and to make arrangements for implementation reviews, and a final project audit of Customs Form presentations and Central Bank cash auction activities. PIU staff will be available, if needed, to advise importers  -13- regarding ineligible items, typical procurement procedures. advertising and market search techniques. and developing appropriate documentation. In order to prepare the PIU to perform the above functions, additional staff is required. The appointment of two additional qualified PIU staff is a condition of Board presentation. The Ministry of Finance and Central Bank staff will have primary responsibility in the budgeting and transferring of funds between two institutions. 58. The PIU will be responsible for the collection of customs forms from the Customs Comnmittee, checking them for goods eligibility and consolidating them into the periodic reimbursement requests. The PIU will also be responsible for reviewing foreign exchange sales data from the Central Bank in order to monitor the channeling of Loan proceeds to the foreign exchange market. The PIU will also prepare the withdrawal application for reimbursement requests, including supporting documentation as indicated in the Bank's Disbursement Handbook, and submit them to the Bank. 59. The PIU will ensure that adequate provisions have been made within the Central Bank and accounts of the Borrower's budget to accurately record sales of the proceeds of foreign exchange provided under the Loan. The PIU will obtain summary statements of these transactions from the Central Bank and the Ministry of Finance for its reporting and will make them available to World Bank supervision missions and the project's designated external auditors. E. Procurement 60. As part of the ongoing economic reforms, the Government of Uzbekistan is considering the development and introduction of the legislative framework and the subsequent establishment of institutional requirements for public procurement in the country. A Country Procurement Assessment Report (CPAR) has not been prepared, but we are planning to initiate, in early FY1996, the preparation of a Country Procurement Strategy Paper (CPSP), in lieu of CPAR. 61. The proposed Loan will finance 100 percent of delivered costs of general imports in to the Country, except the items contained in the standard negative list (Annex 4). The public and private enterprises in Uzbekistan generally conclude import contracts through competitive quotations from different countries and these practices are acceptable for procurement under the proposed operation. Since Uzbekistan has no customs duties on imported goods, it has no requirement for preshipment inspection. However, the possibility of introducing the preshipment inspection for imports will be discussed in the context of CPSP. The PIU will have the oversight responsibility for procurement under the proposed operation, under the guidance of an expatriate procurement adviser, retained by PIU under IBTA, particularly on procurement actions under International Competitive Bidding (ICB). 62. The imports by the Government Ministries, Public Enterprises and Private Importers exceeding US $2.0 million per contract will be procured through simplified ICB, except commonly traded commodities, which will be procured through organized international commodity markets or through other channels of competitive procurement acceptable to the Bank. The standard bidding documents of the Bank will be used for simplified ICB, in accordance with Bank's Procurement Guidelines. Imports not exceeding US $2.0 million equivalent per contract will be procured in accordance with standard commercial practices being followed by the Public Sector and private enterprises.  -14- F. Disbursement 63. The Loan will finance 100 percent of the foreign expenditures on goods imported from Bank member countries. Contracts denominated in Sums will not be eligible. Loan disbursement provisions have been designed to facilitate the development of a market-based auction and to ensure a smooth flow of funds into that market. In addition to the retroactive financing provisions (para. 65), loan proceeds of up to $16 million per month will be available for disbursement upon signing of the Loan Agreement. From July 1, 1995 on, up to $20 million per month will be available for disbursement. The Loan's closing date is June 30, 1996 64. Import eligible for financing under the Loan are subject to a standard negative list. Disbursements for imports that are under contracts US$2.0 million each will be made on the basis of Statements of Expenditure, based on summaries of Customs certificate data. Such information will include: certificate number, description of the goods, landed cost, country of origin and date of Customs clearance. The customs certificates covered by the Statement of Expenditures will be retained by the Borrower for review by Bank supervision missions and auditors. Disbursement for imports above US$2 mnillion would need full documentation as described in the Bank's Disbursement Handbook and specified in the Disbursement Letter. G. Retroactive Financing 65. In view of the progress already made with structural reforms, eligible goods imported after November 30, 1994 will be eligible for retroactive financing, up to a maximum amount of US$32 million, equivalent to 20 percent of the Loan amount. H. Project Accounting, Financial Reporting, and Auditing 66. The PIU will establish and maintain a Management Information System (MIS) to track activities under the foreign exchange auctions and import actions during the designated reporting period. The Central Bank would report to the PIU on auction transactions and the proceeds of the Loan it received from the Ministry of Finance; the Customs Committee would provide data on imports via summaries of its standard customs documents. The information system should also enable the PIU to determine that only eligible imports are included in the Government's reimbursement requests. The Borrower will prepare annual statements of all receipts and payments under the Loan. 67. The PIU will arrange for auditing at the Borrower's expense of the above financial statements by independent auditors acceptable to the Bank. Project accounts will be audited in accordance with the March 1992 "Guidelines for Financial Reporting and Auditing Projects Financed by the World Bank." In the absence of any satisfactory alternative, the audit of the Loan will be carried out by an international accounting/audit firm. The Bank will receive these audited statements and audit reports in such scope and detail that it may reasonably request within six months after the end of each of the Borrower's fiscal years.  -15- I. Agreements Reached 68. Agreements was reached at Negotiations on: (i) the attached Letter of Development Policy, outlining the Government's reform program and the timing of implementation; (ii) the functions of the Project Implementation Unit, Ministry of Finance, Central Bank and Customs Commnittee; (iii) the standard negative list of goods precluded from financing under the proposed loan; and (iv) accounting and auditing arrangements. 69. The following measures were implemented prior to Negotiations: (i) A Presidential Decree was issued on January 19, 1995, announcing the reduction of state orders on cotton-fiber to 60 percent of the 1995 output and that on grain to 50 percent of the 1995 crop. (ii) A Presidential Decree was issued on February 8, 1995, announcing an increase in the procurement price for grain and cotton remaining under state order to 50 percent of world prices for the 1995 crop. (iii) Cabinet of Ministers' Resolutions were issued on December 2, 1994 and January 31, 1995, announcing a specific mechanism for the automatic granting of cotton export licenses. (iv) A Cabinet of Ministers' Resolution was issued on February 6, 1995, announcing the preparation of a detailed and timebound action plan for the (a) demonopolization of dominant entities in the transport, warehouse and wholesale trade sectors (including Uzbeksavdo, Uzautotrans, Uzbekberlyashu, Uznefteproduct) and (b) removal of entry barriers to new private enterprises in these sectors. (v) The State Property Comrnittee (SPC) finalized on February 16,1995, a privatization action-plan specifying: (a) the scope of privatization including number of eligible enterprises by size and sector, and the minimum and/or maximum percentage of ownership shares to be offered for sale to staff, the investment funds, and the public (in the case of medium and large-scale enterprises); (b) the approach to privatization, including the means, methods and procedures for divestment in each category and the institutional arrangements. The program includes a mass privatization scheme, using investment funds acceptable to the Bank, which is capable of promoting speed, equity and corporate governance in the privatization process; and (c) a timetable for each element of the plan and each enterprise category, indicating target dates for specific numbers of enterprises to be corporatized. The SPC has issued Resolution announcing the content of the program on February 24, 1995. (vi) Selection criteria were established to determine which enterprises should stop receiving new bank credits. Identification of the debt and arrears of the largest 30 users of credit in 1994-95 has been carried out. (vii) Operating principles for a pilot scheme for passive restructuring of the largest loss- makers were announced on February 9,1995.  -16- (viii) A Cabinet of Ministers Resolution issued on Februarv 8, 1995 announced a revised system for adjusting pension benefits under which the minimum pension will be adjusted quarterly. The Resolution was submitted to the Parliament. It has already been endorsed by the Economic, Social and Legal Committees of the Parliament. Parliamentary approval is expected by April/May 1995 when the Parliament resumes formal sessions. 70. The following measures were implemented prior to the presentation of the proposed Loan to the Board: (i) An SPC Resolution was issued on February 23, 1995 specifying procedures for medium and large scale privatization to be conducted through transparent, competitive sales including rules to govern domestic and international tenders for lead shareholdings in medium- and large-scale enterprises privatized through a case-by-case approach. (ii) Selection criteria were determined and announced on February 23, 1995 for selecting enterprises to be put under the proposed pilot restructuring scheme. (iii) Two additional staff members have been appointed for the Project Implementation Unit (PIU). J. Environmental Assessment 71. The project is consistent with Bank policy and follows accepted Bank procedures. In conformity with Bank policies for adjustment operations, this project has been assigned to Category U (unrated), which does not require an environmental assessment. K. Benefits and Risks 72. Benefits. The proposed Rehabilitation Loan supports and helps accelerate the Government's implementation of a comprehensive structural reform program in the transition to a market-based economy, thus avoiding sustained economic decline which inevitably would have a negative impact on the poor. The imports to be financed by the Loan will have direct effects on output and will facilitate the availability of critical imports. The Loan also provides the framework for donor support, helps supports the national currency, deepens the foreign exchange market while increasing access to it for the private sector. 73. Risks. Uzbekistan faces substantial internal and external risks. While recent developments are encouraging, it is not yet clear how quickly the Government will be able to move to implement the wide array of policy measures in the programs under discussion with the Bank and the Fund. Policy slippage on the stabilization and structural reform program may result from: (i) possible ineffective implementation of key macroeconomic policies critical to the success of the program; (ii) increases in inter-enterprise arrears that may jeopardize monetary and fiscal targets; (iii) limited institutional capacity, which makes it difficult to implement complex policy measures that require coordinating policy decisions by various institutions to achieve comprehensive reform; and (iv) a possible erosion of popular support caused by declines in output and employment. The policy  -17- package included in the Rehabilitation Loan supports measures that will help mitigate these risks. This will be achieved notably by limiting further output declines and implementing an adequate social protection program. 74. In addition, Uzbekistan faces external risks: (i) vulnerability to relative price shifts in the markets for its export commodities -- cotton, energy products and gold, (ii) supplv bottlenecks in the FSU as some of the traditional import links are broken, and (iii) lack of sufficient external financing. If Uzbekistan cannot mobilize sufficient external financing in the short term, the economy will be exposed to a binding foreign-exchange constraint on trade and the country will be forced to rely more heavily on gold sales to generate foreign exchange and/or to lower imports thus reducing the growth potential of the economy. Reducing imports will also constrain Uzbekistan's ability to import capital goods and slow the rate of investment and technological transfer. L. Recommendation 75. 1 am satisfied that the proposed Loan will comply with the Articles of Agreement of the World Bank and recommend that the Executive Directors approve it. Lewis T. Preston President by Sven Sandstrom Washington, D.C. March 3, 1995 Attachments   Annex i Page I of 11 LETTER OF DEVELOPMENT POLICY' Mr. Lewis T. Preston President The World Bank Dear Mr. Preston: 1. Uzbekistan is undertaking a comprehensive program of economic reform aimed at moving toward a market-based economy. In addition to key structural reforms and related institutional building, this program includes measures for financial stabilization and for the strengthening of key sectors particularly agriculture and energy. In particular, we expect to focus our attention toward deepening structural reforms, strengthening the domestic currency, implementing sectoral policies and carrying out a public investment prograrn that will support the development of the private sector. 2. Uzbekistan has suffered from serious macro-economic instability and output declines since 1991. The decline in output over the period 1991-94 (about 15 percent) has been less than the average of the rest of the FSU (40 percent). The important factors in cushioning the reduction were the economy's specialization in agriculture and energy, which are relatively stable sectors, the strength of Uzbekistan's exports, notably non-ferrous metals and cotton, the diversification away from FSU trade, and the country's growing oil and gas production. 3. Both consumption and investment have declined substantially since 1991. Disruption in the availability of imports particularly hampered manufacturing output, which fell by about 15 percent over the period 1991-94. The largest drop occurred in the industrial sectors that were most closely linked to other FSU republics because of the break-up of economic relations and payment mechanisms. The agriculture sector expanded moderately during 1993-1994. Oil and natural gas production has also expanded significantly during the last two years (90 and 16 percent, respectively). 4. We recognize that getting inflation under control is a prerequisite for sustained and efficient economic growth. Consequently our monetary and fiscal policies give a high priority to financial stabilization objectives. Inflation came down sharply in the second half of 1994 and the fiscal deficit declined to about 4 percent of GDP. During 1994, we significantly tightened fiscal policy which has resulted in a dramatic improvement of our fiscal position. This was due to the elimination of the enterprise sector's access to the special budgetary transfers which were responsible for a large part of the fiscal deficit in 1993, and the curtailment of direct budgetary consumer subsidies. In July 1994, a new domestic currency, the sum, was introduced and monetary and credit policy were made progressively more restrictive. Preferential credits to enterprises were reduced, and Central Bank reserve requirements were increased. The discount rate was increased to 225 percent by the end of 1994 and three-month fixed term deposits were introduced at the Saving Bank, with a quarterly interest rate of 30 percent. 5. Our stabilization programn, to be supported under the IMF's Systemic Transformation Facility (STF), is expected to reduce inflation to an average 2 percent per month by the end of 1995. To attain this objective, the consolidated budget deficit will be limited to 3.5 percent of GDP during 1995 and domestic bank financing of the budget will be limited to 2 percent of GDP. All financial  Annex 1 Page 2 of 1 1 subsidies have been made explicit and channeled through the 1995 budget. Support to enterprises will be limited to passiv e restructuring and liquidation and wAill decline over time. An increasing share of Central Banlk credit to commercial banks will be auctioned, reaching 50 percent by the end of June 1995. Beginning in January 1995, the refinance rate is adjusted monthly on the basis of past and targeted inflation. 6. We are commnitted to maintaining the unified exchange rate, thus substantially expanding the availability of foreign exchange through the inter-bank foreign exchange market, and ensuring current account convertibility. Interbank foreign exchange auctions to determine the exchange rate were started on April 15, 1994. In recent months, additional progress has been made toward institutionalizing weekly auctions of foreign exchange. We unified the exchange rate in October 1994, and are committed to maintaining a market-based exchange rate in the future. The Structural Reform Program 7. We have embarked on an ambitious program of structural reforms. We have begun to introduce significant changes in price, subsidy and trade policy in order to establish a market-based economy increasingly integrated into the world economy. To promote and deepen reforms, we will: (i) establish an appropriate incentive framework; (ii) support continued privatization, restructuring and establishment of corporate governance of medium and large scale enterprises; (iii) develop a sound financial system capable of channeling funds to private enterprises and facilitate settlement of trade payments; and (iv) strengthen the social safety net. This letter outlines our recent accomplishments and the additional measures we intend to undertake in 1995 toward these goals. Price, Subsidy and Trade Policies 8. In recognition of the unsustainable budgetary pressure generated by subsidies, we have introduced a program to eliminate consumer, producer and credit subsidies. In addition, existing import subsidies on grain, energy products and agricultural inputs will be phased out in 1995 as all trade is channelled through foreign exchange auctions. Complementing progress toward completing price liberalization, reforming the foreign exchange regime and removing most direct budget subsidies for consumer goods, we have begun to phase out the state order system. 9. The principal agency for implementing the state order system was dismantled in March 1994 and has been replaced by Uzoptbirzhetorg, which will initially conduct state procurement and organize wholesale trading markets and will evolve to purchase only goods needed for the state's own use. In order to fulfill pending inter-republican trade agreements, we will maintain a system of state purchases during 1995. Those state purchases will be carried out through competitive tendering, with voluntary participation. Initially, purchases for government needs may be centralized; ministries and local authorities will gradually shift to do their own tendering subject to minimum regulation of procedures. A system of state procurement will be established by April 30, 1995, to make purchases for central and other branches of government on a contractual basis at minimum cost since such agency will not make profits nor pay dividends. We will request the World Bank's assistance to reform the public procurement system and procedures.  Annex I Page 3 of 11 10. Industrial and agricultural state orders for all conmmodities except cotton and grain, have been eliminated. Apart from cotton and grain, state purchases are limited to petrol, diesel coal and a small number of consumer items, such as salt and vegetable oil for distribution in hospitals and schools. For the 1995 crop, state orders on cotton will be reduced to 60 percent of the 1995 output and reduced thereafter in approximately equal installments until elimination in 1998. Moreover, the procurement price for cotton under state order will be raised to 50 percent of the international price and will reach world prices by 1998. Since January 1, 1995, the staple foodstuff rationing system has been completely abolished. 1I. For grain, state orders will be reduced to 50 percent in 1995, 25 percent in 1996 and completely eliminated by 1997. Procurement prices for grain will be raised during the transition to 50 percent of world levels in 1995 and to world levels in 1997. This should bring immediate efficiency gains and increases in production while allowing for a gradual adjustment of prices at the consumer level. Such a phased reduction of state orders will prevent a negative shock to the budget and allow time for establishing a system of agricultural taxation, and for cost recovery of agricultural inputs. We will revise by June 30, 1995, and start implementing by end of the year, an agricultural taxation system equitable with other sectors which would eliminate the need for state orders or the imposition of explicit export taxes, notably on cotton. In addition, we will introduce water charges on irrigation by December 31, 1995, which can be expected to cover at least 50 percent operating costs. 12. We have started to revise Uzbekistan's trade regime, to align domestic and world prices of tradable commodities, expand trade, raise fiscal revenues during the transition, and diminish the role of centralized trade. We have already unified treatment of FSU and non-FSU trade. Import tariffs have been removed until July 1, 1995, when we will consider a uniform import tariff structure. The number of goods subject to export licenses has been reduced from 74 to 11, as of December 1994. In addition, the tax on foreign exchange proceeds and the surrender requirement at the official exchange rate were removed. Instead a 30 percent surrender requirement at the market exchange rate for all exports (including centralized trade) was introduced. We intend to eventually eliminate the surrender requirement in order to ensure current account convertibility. 13. We intend to further reduce the number of items subject to export licensing in 1995. Cotton sold through the commodity exchange is exempt from export licensing. For cotton not sold through the exchange, we have introduced a simplified procedure for granting cotton export licenses, under which a license is granted within 10 days after receipt by the Ministry of Foreign Economic Relations of a duly prepared contract, a certificate from the Goskomprognozstat confirming the existence of the free cotton, and a certificate of origin. We also intend to begin implementing a system of auctions for export licenses on products other than cotton by June, 1995. 14. We recognize the need to increase prices for crude oil to provide incentives for oil production, and intends to raise (as reflected in the program supported by the STF) the wholesale price for oil to at least 75 percent of the world price by March 31, 1995, and to 100 percent of the world price by October 1, 1995. Simultaneously, we will put in place a suitable fiscal scheme for capturing additional profits which will accrue to oil producers from these price increases. We also plan to raise wholesale prices of petroleum products to world prices in line with the increase in crude oil prices.  Annex I Pat2e 4 of 11 15. We recognize that a realistic pricing structure which reflects the true economic cost of supply is the most effective means of providing incentives to consumers to use energy efficiently. At present, prices of electricity, natural gas, heat and hot water to end-users do not reflect the economic costs of supply. We have taken measures to raise prices to industrial users substantially, although in many cases even these remain below economic cost. Prices to residential users are far below those to industrial users, even though the economics of energy supply mean that residential users should pay several times the tariff charged to large industrial consumers. 16. While recognizing the urgency of energy price reform, we are of the view that an immediate increase of energy prices to residential consumers to economic levels would place an insupportable burden on family budgets at a time of economic stringency. Therefore, as a first step we intend to reduce the differential between the prices charged to industry and to households for heating by 50 percent by June 30, 1995 and for electricity and gas by 25 percent by July 1, 1995 and by another 25 percent by December 31, 1995. We intend to eliminate all of these differentials by 2000. Energy prices for industrial consumption are expected to at least remain constant in real terms during this period, and utilities will be permitted to pass on costs in energy inputs (natural gas, oil and coal) to industrial consumers. During 1995 we intend to carry out, with financing from international donors, studies to establish economically efficient tariff systems for network energy utilities (electricity, natural gas and heating), and the recommendations of these studies will be implemented in a phased manner from June 1996 onward. 17. Rapid demonopolization, followed by privatization, of dominant enterprises in the warehousing, wholesale trade and road freight transportation sectors, as well as removal of barriers to entry in these sectors by new private enterprises, are essential to assure the introduction of competition. To achieve this objective, we have announced on February 8, 1995, through a Cabinet of Ministers' Resolution, its commitment to prepare a concrete, detailed and timebound action plan for: (i) the demonopolization of dominant entities in the warehouse, wholesale trade and transport sectors, including Uzbeksavdo, Uzautotrans, Uzbekberlyashu and Uznefteproduct; and (ii) the removal of barriers to entry for new private enterprises in these sectors. The action plan will be submitted to the Bank, for review and comments, no later than March 31, 1995, and implementation will start by June 30, 1995. 18. Our anti-monopoly actions will be implemented by a general Competition Agency that will not be empowered to control prices. Instead, this agency will monitor monopoly power, collusion and collective dominance, entry barriers, takeovers and mergers and a limited number of vertical trade restraints that restrict access to scarce inputs and distribution outlets. The Competition Agency will have a clear legal mandate to investigate and break up monopolistic enterprises and levy heavy fines- an important change, since at present, fines are small. In certain sectors of the economy (energy, telecommunications, water), however, natural monopolies will remain and some form of price regulation will be inevitable. The antimonopoly law will be amended by June 30, 1995 to establish new institutional arrangements described above and to set criteria for anti-competitive behavior and corresponding sanctions.  Annex 1 Page 5 of 11 Enterprise Reform and Privatization 19. In 1992, we began to implement an economic reform program designed to establish a competitive market economy. To this end, we have designed and introduced a number of structural reforms and enacted laws and created new institutions to implement them. Our enterprise reform policy has evolved in stages toward broader, deeper and quicker organizational and ownership transformnation. The program through 1994, has focused primarily on housing and small scale privatization of retail shops, trade and service enterprises. To date, over 96 percent of the housing has been privatized and approximately 82 percent of the privatization of the targeted small scale objects (one or more enterprises) has begun. 20. In 1994, we introduced significant new measures to expand reforms to medium and large enterprises and to introduce increased competition and openness in the transfer processes. Originally, the formns of privatization had been limited to closed companies and transfers to staff. In January 1994, a decree was issued requiring transformation of established joint-stock companies into open-end companies. Privatized enterprises were often subject to profile restrictions that limited the desired reallocation of resources. Until March, 1994, there was little opportunity for the public to participate. There were no uniform criteria for allocation of shares among workers, the state and the public and the state retained a significant percentage in the authorized capital of enterprises. The absence of rules for tendering shares for large enterprise created delays and a lack of transparency and predictability. The dominant role of the State in the Stock Exchange, Investment Fund and National Depository have held back capital market development. 21. A new Privatization Program was issued in March, complemented by over 40 legislative and administrative acts. Since March, progress has been substantial. Over 94 competitive auctions have been held resulting in over 450 sales. Over 200 medium and large enterprises have been converted to corporations with registered, transferable shares eligible for sale on the stock exchange. A Real Estate Exchange was established. A National Share Depository was created and became active in registering the shares of the newly formed corporations. Two investment funds were created. The Stock Exchange has begun to function and several auctions have taken place. 22. In November 1994 we removed profile restrictions on privatized objects, decided to reduce state ownership to a minority equity position in the objects subject to privatization and in the enterprises that have gone through the privatization process, in the Stock Exchange, Investment Fund, and the National Depository. We also confirmed equal access by brokers to securities operations in the Stock Exchange. We will intensify reforms during 1995, as reflected in the Action Plan, the major aspects of which include: (i) development of specific targets for corporatization and privatization of medium and large enterprises (categorized by employment); the targets will include specification of the methods of privatization (i.e., whether auction of assets, "free sale" of shares through the stock exchange, case-by-case sales to lead shareholders or strategic buyers); (ii) development and publication of rules for speedy corporatization, registration and allocation of shares in enterprises, such rules to provide that:  Annex 1 Page 6 of 11 (a) the workers' are to receive up to 25 percent and the state may retain up to 26 percent of the shares of any one enterprise, with the additional rule that the maximum percentages will not be applied simultaneously in any one case, so that in no case will the combined worker/state equity percentage exceed 49 percent; and the 51 percent will go for free sale. Provisions will be made for future sales of state holdings; (b) at least 30 percent of the shares of each corporatized enterprise in the privatization program will be made available for sale to privately owned investment funds. (iii) development and announcement of rules for transparent and competitive tendering of all lead shareholding positions (strategic investors) in medium and large enterprises that will be privatized on a case-by-case basis; (iv) establishment of rules for infornation that must be provided to the public in connection with share sales through the stock exchange and rules to require that such information, as well as announcement of the offering, is made public prior to sale; (v) establishment of pricing and mechanisms for shares to ensure fast market clearing, whether in conditions of excess supply or demand; (vi) development and issuance of prudential regulation for investment funds; and (vii) elimination of the state's equity in the stock exchange and the National Fund and reduction to 10 percent its equity in the National Depository. Links between Enterprise and Financial Sector Reformns 23. We are aware that without stricter financial discipline in the enterprise and banking sectors, the stabilization program will not be sustainable. Similarly, we believe that financial discipline can only be imposed if actions are accompanied by mutually reinforcing structural reformns adopted over the medium term. The latter includes as essential components: faster privatization of enterprises; the rapid liquidation of non-viable SOEs and the operational and financial restructuring of loss-making but viable enterprises. The latter group includes enterprises which will be restructured either prior to their privatization but without new investment or, for those enterprises which will remain in the domain of public sector, as part of the public sector reforms directed at stopping the drain of budgetary resources. 24. Our stabilization program, which involves rapid increase in interest rates to positive real levels, credit tightening and credit auctions, will significantly affect SOEs' borrowing from the banking system and banks' access to CBU facilities. The reduction and eventual elimination of implicit credit subsidies to enterprises will highlight the bad financial condition of many SOEs, affect cash-flows, and increase enterprise arrears very substantially (i.e. tax arrears, social security arrears, inter-enterprises arrears, arrears to banks, workers and other creditors). As a temporary measure, we will have to subsidize, directly from the budget, a number of enterprises which, although being financially viable and solvent, are unable to afford the new, much higher interest rates. These temporary transparent subsidies will be phased out as essentially sound enterprises are restructured. We are aware that such policies need to be very selective and of limited duration to preclude the misallocation of public funds.  Annex 1 Page 7 of 11 25. Enterprise debt and bank restructuring must be jointly addressed because banks are the major creditors of SOEs and claims on SOEs dominate commercial banks' asset portfolios. Prior to the adoption of the stabilization program, banks were the main channel for transferring subsidies to SOEs and taxing depositors, via highly negative real interest rates. Banks in Uzbekistan have directed large subsidies to the sectors and enterprises selected by the government without concern for their creditworthiness. While most credit to enterprises comes from the banks, the progressive decline of the real deposit base has increased their reliance on CBU financing. In the process not only inflation has been exacerbated but also the direction of credit has crowded out bank financing for the private sector. 26. We have already taken important steps to introduce financial discipline in SOEs and to prevent an increase in commercial banks' doubtful loans. Specifically, we have: (i) collected initial data on SOE arrears, (ii) denied credit and financial assistance to about 600 bankrupt enterprises (iii) transferred from the banking system to the budget temporary interest rate subsidies to approximately 1,000 enterprises that produce essential goods and services and that cannot service their debt obligations to commercial banks under the new interest rate policy, and (iv) established a working group with representatives from MOF and Central Bank to develop further recommendations. Finally, experimental restructuring has been started in a few SOEs in the building material sector, where performance agreements have been signed between the government and management teams that document mutual objectives and financial obligations. 27. To further impose financial discipline, we will select the largest non-performing SOEs and exclude approximately 30-50 with the largest amount of arrears from access to commercial bank credit. Selection will be based on: (i) high levels of arrears with all creditors (banks, enterprises, taxes, and workers' unpaid claims); (ii) the level of non-recoverable arrears; (iii) present and prospective level of losses; and (iv) an overall assessment of the financial and operational viability of the worst-performing SOEs. Selection will be based on: (i) high levels of arrears with all creditors (banks, enterprises, taxes, and workers' unpaid claims); (ii) the level of non-recoverable arrears; (iii) present and prospective level of losses; and (iv) an overall assessment of the financial and operational viability of the worst-performing SOEs. 28. From the SOEs in the isolation exercise, we will select a limited number of SOEs with the largest total arrears (a sub-set of 10-15 enterprises) and assess their potential operational and financial viability. Based on these results, liquidation or passive restructuring plans will be prepared. Options will include: closing non-viable components and product lines; spinning-off services unrelated to the enterprise's core business; divesting the Government's participation in social assets of those SOEs; and rearranging the remaining potentially profitable components into new commercial entities that would resume relations with the banking sector on fully commercial terms. These could then be immediately offered for sale under the government's privatization program. 29. To implement the above program, we have established a Credit Bureau at the Central Bank. The Credit Bureau will: (i) build a database on aggregate and enterprise level arrears; (ii) report on outstanding arrears to major creditors --particularly banks-- including at least for how long they have been overdue and type of currency; and (iii) provide information, analysis and recommendations to the Cabinet of Ministers to inform their credit and restructuring decisions. The Central Bank will instruct all commercial banks to provide, in the agreed format with the World Bank, the information  Annex 1 Pace 8 of 11 on SOE arrears requested by the Credit Bureau. We will issue a similar instruction to all concerned state agencies and organizations (tax authorities, Goskomprognosztat, Social Fund ). By February 1, 1995, the Credit Bureau has generated data on debt arrears for at least the largest 30 credit users during 1994. We have agreed with the Bank on specific criteria for selecting non- commercially bankable SOEs to be isolated from new commercial bank credit and we will agree on specific criteria for selecting a subset of enterprises to participate in a passive future restructuring scheme. 30. Finally, in order to assist and new private enterprises in their restructuring decisions we intend to design a post-privatization financing facility by mid-1995 and link it to the provision of credit by qualified financial intermediaries. Implementation will be expected to follow on a reduced number of enterprises. Bankdng Sector Reform 31. We initiated the establishment of a two-tier banking system, but we are aware of the need to prepare a broader financial sector strategy including a bank restructuring program concomitant with the reforms being undertaken in the enterprise sector. We are committed to strengthening the banking sector, enhancing competition and expanding the market share of non-State banks. 32. Banking reform comprises the development of Uzbekistan's financial infrastructure and a set of institution building measures. We are prepared to develop the legal framework required for the safe and sound operation of financial intermediaries. The latter includes the drafting, issuance and implementation of an ambitious legal agenda which includes a new CBU Law (as agreed with the IMF, Parliament will promulgate this Law before June, 1995), a Law on Banks and Banking, and the amendment or drafting of new legislation on secured lending, collateral and bankruptcy, giving banks the incentives and protection for collecting and granting loans in a safer environment. The CBU is committed to continuing implementation of a new accounting system and to increase the disclosure of the banks' financial data. With World Bank assistance, the CBU will carry out diagnostic studies of the three major banks, continue its efforts to modernize the payment system and improve CBU's capabilities to regulate and supervise financial intermediaries. Attention will be paid to the drafting of a Licensing Manual, On site and Off Site Supervision Manuals and Guidelines, the adoption of risk- based loan portfolio classification and provisioning systems. Significant attention will be given to the training of CBU staff in this area and to the training of commercial bankers, accountants and auditors. 33. We are aware of the needs to strengthen not only the CBU, but also the State banks. To that effect we are undertaking a program to audit their loan portfolios and draft action plans to address their main organizational, operational and financial weaknesses. We will need to rely on technical assistance and external financial support to foster the development of the financial sector and enhance its capacity to mobilize and allocate in a more efficient manner the country's financial savings.  Annex 1 Page 9 of 11 Private Sector Development 34. We recognize that the foundation of a successful transition is the development of an environment which encourages the private sector, both new private enterprises and privatized state property. Specifically, such an environment exists when there is recognition, protection and encouragement for private parties to acquire, use, transfer and leverage property, without legal or bureaucratic interference. In creating a favorable environment, we will be guided by the following principles: (i) private persons and enterprises will be free and secure to take all actions in their economic interest which are not specifically and clearly prohibited by published laws, without the need to refer to or seek the approval of state or municipal administration; where administration is specified by law, procedures will be clear, the guiding principle being facilitation, not ex ante prevention or discretionary approval; and (ii) the allocation of property rights among different parties, including owners (whether state or private), creditors and debtors,shall be without preference to the state or entities with state ownership; and allocation of rights shall be clear and predictable; and (iii) foreign investors will be encouraged by clear, administratively predictable rules and legal assurances which will make Uzbekistan competitive with other nations seeking investment. 35. To implement the above principles, a decree "On Initiation and Encouragement of Private Entrepreneurship" was issued on January 5, 1995 which provides equal rights for the private sector and SOEs. The decree also provides tax incentives to entrepreneurs, allows for the sale of houses and land on which they are located to foreign legal entities and private individuals, and additional measures to promote private sector development. 36. Any remaining restrictions on the transfer of housing will be eliminated in 1995. The use and easy transfer of land under commercial establishments will be permitted and included in the privatization program in 1995. In 1995, we will design and begin to implement a program for long term lease of land. Accessible registries for companies, shares, land and mortgages are being established and will be strengthened in 1995. 37. A bankruptcy law to improve the clarity of property rights and facilitate easy and quick transfer and use of property to secure credit and establish creditors' rights in property has been prepared and approved by the Parliament in September 1994. We have issued a decree in January 1995 to remove the bias against private property, preferences for state property, and facilitate private contracts. The Civil Code will be duly amended to reflect these changes. Provisions to be used as collateral for all types of property (movables, immovable and intangibles) will be provided. 38. The Law on Foreign Investments and Guarantees for Activities by Foreign Investors" enacted in May 1994 provides investment guarantees in accordance with generally accepted norms, creates foreseeable conditions for repatriation of capital, profit, salaries, interest, license fees and necessary licenses for entry, operations and exit. Any additional regulations necessary to achieve these guarantees and conditions will be issued in 1995. We recognize the importance of creating a suitable  Annex 1 Page 1O of 11 legal framework for the energy sector. Priority has been given to drafting a Petroleum Law, which will also assist in attracting foreign investment for petroleum exploration and production. Social Protection 39. We face significant challenges in adjusting the system of social protection inherited from the Soviet Union, and ensuring access and delivery of basic social services to the population. Falling real wages throughout most sectors of the economy have imposed pressure on living standards. Assistance to the poor has been limited despite high overall levels of social expenditure. As enterprises and collective farms shed the burden of social service financing and provision, such responsibilities will fall increasingly upon local authorities that may lack the necessary financial and administrative capacity. Such developments would aggravate an already serious poverty problem, especially in the context of fast population and labor force growth, high inflation, falling output and worsening fiscal constraints. 40. We are aware that implementation of the ongoing reform program will result in higher unemployment. While the pace of labor shedding to date has been slow, we have put in place a framework for dealing with rising unemployment through the introduction of unemployment benefits, establishment of the Employment Service, and the creation of the Employment Fund to finance unemployment benefits and training, and creation of new jobs. 41. In order to adjust the system of social protection and social services in ways that are consistent with the shift towards a market-oriented economy, we plan to improve targeting in the system of social protection. This is particularly important given the significant reductions in universal subsidies on consumer goods and services. Given the difficulties related to reduction of benefits for various categories of the population, we are pursuing alternative targeting approaches. Assistance for low income families, introduced in late 1994 and administered by local authorities will be monitored so as to ensure that the neediest families are receiving support and budgetary allocations are adequate across localities . Likewise, family allowances have been simplified and increased in real terms. We are planning to review the role of family allowances as an instrument for assistance to low-income families, with the intent to strengthen the role of local low income assistance program. 42. We recognize the need to address large and rising expenditure on pensions, which exceed what would be expected given Uzbekistan's level of national income and demographic structure. The 1995 budget provides for the reduction of the budget transfers to the Social Insurance Fund that had occurred during 1994. At the same time, we will give priority to protecting the real benefits of elderly people receiving the minimum benefit. We will prepare and introduce in June 1995 a revised system for indexing pensions whereby the minimum pensions will be protected by adjusting them quarterly according to the changes in consumer prices and other types of pensions will be increased by the fixed amount determined for the minimum pension. Further measures that would increase the effectiveness and fairness of the pension system will be implemented in 1995, including reduced benefits for working pensioners, reassessment of the occupational categories entitled to early retirement, expansion of the payroll tax base to include enterprises outside the state sector and reduction of administrative costs related to pensions delivery.  Annex I Page II of 11 43. To support the program of economic reform laid out in this letter and the country's balance of payments needs, the Government of Uzbekistan requests a Rehabilitation Loan from the World Bank in an amount of US$160 million. Sincerely yours. Bakhtiyar Hamidov Deputy Prime Minister Republic of Uzbekistan February 16, 1995.  Ann11ex 2 ligC I Of 7 UZBEKISTAN REIIABILITATION LOAN - POLICY CONDITIONS Objectives Actions Already Fulfilled Before Board Medium Term Institution;d Taken Presentation Actions Requireuniciuw A. INCENTIVE Uzconlractorg has been Reduction in the state order on cotton Cabinet of Ministcrs STRUCTURE dismantled by Decree to 60 percent for the 1995 crop was Resolutions. 1. State Orders (March 1, 1994). announced on Jan. 19, 1995* by Phase out state order Presidential Decree. system. Uzoptbirzhelong has been Establish a system of state Technical Assisuiiu&c created to: (i) temporarily Increase in the procurement prices procurement by competitive tender of from the Bank w ill hc conduct state procurement, and for cotton remaining under state basic goods and services for state souighit to reformin the (ii) organize wholesale trading orders to 50 percent of world prices needs (hospitals, army, etc.) by procureinent sysCtlT ;11(1 markets. for the 1995 crop was announced on April 30, 1995. proceduires. February 8, 1995 by Presidential State order on cotton for 1994 Decree. crop and on grain for 1995 crop have been reduced from 75 to By June 30, 1995 develop a plan, to D)ecrec/('abinct ol 67 percent. Reduction in the state order on grain be agreed with the Bank, to phase out Ministers Resolutimv | to 50 percent for the 1995 crop was the wedge between procurement and(l State orders (except cotton and announced on Jan.19, 1995* by world prices for grain and cotton grain) have been eliminated by Presidential Decree. subject to state orders within the next Presidential decree from August two and three years, respectively. 22, 1994 (including meat, poultry and milk). Increase in the procurement price for Reduce state order on grain to 25 grain remaining under state order to percent for the 1996 crop. 50 percent of world prices for the 1995 crop was announced on February 8, 1995 by Presidential Decree. Eliminate the state order on grain by 1997 and the state order on cotton by 1998. *Denote actions fulfilled for IMF's Board approval of STF.  Amiex 2 Pa;wc 2 of 7 Objectives Actions Already Fulfilled Before Board Medium Term i1stimitional Taken Presentation Actions Rcqm i emcnts 2. Trade Tax on foreign exchange A specific mechanism for the Start implementing agreed auction Diminish role of proceeds removed on automatic granting of cotton export mechanism for export licensing by centralized exports and April 11, 1994, by Presidential licenses acceptable to the Bank, was June 30, 1995. imports and implicit tax Decree. announced on January 31, 1995 distortion. through a Cabinet of Ministers' By June 30, 1995, develop an Ministry of Finance Number of goods subject to Resolution. agricultural taxation system, (MOF), Ministry of export licensing reduced (11 acceptable to the Bank, whichi woul(d IForeign Fconomic goods remain). eliminate need for state orders or Rtelations (M FUR), and export taxes, notably on cotton. Start Goskomprogno7stlat Import duties were abolished in implementing by December 31, (implementation). Feb. 1994 until July 1, 1995. 1995. Responsibility for customs control transferred to Taxation Committee. Improve access and allocation of foreign New currency introduced (Sum exchange. in July 1994). Organized forex market. A weekly auction mechanism established on April 15, 1994. A dual exchange rate system has been implemented from April - September 1994. In October the system was unified. Overall surrender requirements to interbank foreign exchange auctions increased to 30 percent of forex receipts, extended to centralized exports and to be Central Bank channelled through the auction (inpleni;tti(0 as of Nov.15, 1994. As of January 1, 1995 100% of centralized export proceeds are to be channeled through the auction. Authorized banks and dealers increased to thirteen.  Annex 2 Page 3 of 7 Objectives Actions Already Fulfilled Before Board Medium Term Institutional Taken Presentation Actions Requiirements 3. Subsidies Direct food subsidies have been Reduce the differential between Cabinet of Minister's Eliminate subsidies that recently removed and price household tariffs and industrial tariffs Resolution /MOF have distortionary effect on controls eliminated, except for for heat by 50 percent by June 30, implementation. the incentive structure. administered prices for bread 1995, for gas and electricity by 25 and flour. percent by July 1, 1995 and by another 25 percent by Dec. 31, 1995. Technical Assistance Rationing of staple food stuff needed on energy pricing has been eliminated. and tariff structures. Full pass-through on industrial Ministry of l'inance tariffs for gas, electricity and (implementation) heat has been implemented. 4. Antimonopolv Policy Promote competition in Antimonopoly law enacted in A Cabinet of Minister's Resolution Submit to the Bank for review by Technical assistance wholesale and retail trade 1992. was issued on February 6, 1995 April 1,1995, the action plan for required to prepare the and related storage and announcing the preparation of a demonopolization and removal of action plan and revise transport services. Department of Implementation detailed and timebound action plan barriers to entry in the warehousing, antimonopoly law. of Antimonopoly and Price for the (i) demonopolization of wholesale trade and transport sectors. Policy established within the dominant entities in the transport, Implementation to start by Establish by decree, an Improve control over abuse MOF. warehouse and wholesale trade June 30, 1995. independent Competition of monopoly power. sectors (including Uzbeksavdo, Authority and Office of Uzbeksavdo (largest trade Uzautotrans, Uzbekberlyashu, Amend antimonopoly law by Utility Regulation. monopoly) has privatized about Uznefteproduct), and (ii) removal of June 30, 1995 to: establish an 11,000 trade and retail outlets. barriers to entry by new private independent competition authority, enterprises in these sectors. (The regulate natural monopolies, establish Action Plan to be prepared by an office of Utility Regulation; and March 31, 1995. set criteria for anti-competitive behavior and corresponding sanctions. Liberalize entry iito auto freight transport by March 31, 1995, by replacing licensing with registration requirement.  Annex 2 Page 4 of 7 Objectives Actions Already Fulfilled Before Board Medium Term Institutional Taken Presentation Actions Requirements B. ENTERPRISE REFORM 1. Privatization January 21, 1994 Presidential The State Property Committee (SPC), Design, approve and announce Cabinet of Ministers' ani( Develop a coherent, Decree calls for measures to prepared and announced an action- detailed, time-bound implementation State Property consistent privatization broaden privatization, including plan acceptable to the Bank arrangements, acceptable to the Bank, Cotnmitice Resolitions program aiming at broad participation of private specifying:* for the mass privatization scheme participation and a individuals, the purchase of land using investment funds by May 31, primarily private, non- where enterprises are located, (1) the scope of privatization: 1995.** Substantial strem!ethening monopolistic economy. and the creation of a stock number by size and sector; and the and training of SP' exchange. minimum and /or maximum (foreign partner scarch/ percentage of ownership to be offered negotiation, Over the last 24 months, regular for sale to staff, the investment auction/bidding privatization has begun, funds, and the public, for medium procedures, new involving about 10,000 SOEs and large scale enterprises; privatization tcchnbiqiies, (mostly small to medium sizes), regulatory framework for mainly through transfers to their (2) the approach for privatization, investmcnt funds). staff. including the means, methods and procedures for divestment in each I)evelop skills and 1993 Resolutions of the Cabinet category and the institutional procedures for rccnikt of Ministers urged rapid arrangements. Such action includes a created Stock Fxch.lu,,c privatization. privatization scheme, using with specialized exterial investment funds, able to promote assistance. Auctions of state assets and speed, equity and corporate small enterprises have begun in governance in the privatization March 1994. process; and Privatization proceeds (3) a timetable for each element of transferred to the central budget the plan and each enterprise category, in August, 1994. indicating dates for specific numbers of enterprises to be corporatized. * Denote actions fulfilled for IMF's Board approval of STF. ** Denote structural benchmarks of IMF's STF.  Annex 2 I'age 5 of 7 Objectives Actions Already Fulfilled Before Board Medium Tern Institutional Taken Presentation Actions Rc(1uirinccwlS_*_l Privatization (continued) The SPC issued on February 24, Prepare a comprehensive legislative 1995. Additional procedures for and institutional framework for open, Remove privatization Business profile restraints have medium and large scale privatizations transparent process in the initial andl constraints in order to been removed. to be conducted through transparent, secondary offerings of enterprise promote equity and competitive sales; including rules to shares, other securities and debt efficiency. govern domestic and international instruments, including independent tenders for lead shareholdings in share clearing facilities and share On January 5, 1995 a medium- and large-scale enterprises registry and depositories by June 30, Presidential Decree was issued privatized through a case-by-case 1995. to strongly support Private approach. Sector Development. 2. Governance of State- Owned Enterprises (SOEs) Clarify ownership, property All State property has been By June 30, 1995**, transform 50 and management rights of clearly identified as Republican percent of closed medium and large- Strengtlicn calacity ( l SOEs. Separate SOE's or Municipal Property. scale SOEs into open joint stock State Privatization ownership and management company form. Shares to be Conimuiltce (SP'() functions; establish Presidential Decree of Jan. 1994 registered at the Ministry of Finance throuighi tecinical conmmercial objectives and provides for (i) Concerns to be and fully transferable. assistance to iniplenp wri! permit management dissolved or changed into corporatIatitio l autonomy while holding it Associations; (ii) Closed accountable for meeting companies to be transformed Technical assi stalclc commercial objectives into open companies. niecdc(l in dlvelol)iTw according to market-based complnly law, and t,, performance criteria. The process of registration of assist in financial shares of open joint-stock report1ing of S01's companies at the Ministry of accordine v) intern;i Finance formed as of October accotinting stand(r(k 1, 1994 has been completed. * Denote actions fulfilled for IMF's Board approval of STF. ** Denote structural benchmarks of IMF's STF.  Anicx ) P:age 6 (i 7 Objectives Actions Already Fulfilled Before Board Medium Terin Inst initi,u:ll Taken Presentation Actions Rcquiie1nww, Governance of State- Methods to improve financial Owned Enterprises discipline of enterprises, including (continued) 1991 and 1992 Resolutions the operating principles of a pilot Select a group of enterprises among abhinet of Nlini,t s' broadly define relations between scheme for passive restructuring of the largest loss-makers to participate Resolution Impose discipline on the Concerns and SOEs. the largest loss-makers have been in the pilot restructuring scheme hy use and flow of financial established.** June 30, 1995. ('Central Banl< Ni TTr\ resources to enterprises, August 1993 Decree urged of F:innice, CojInCIJ; particularly the largest loss improved performance or rapid A criteria, acceptable to the Bank, banks and Cabinet ot makers. elimination of identified loss- for selecting enterprises to be put Nlinisters' dirftt making SOEs. under the proposed pilot restructuring participatioin. scheme has been determined and announced. ** Government has established a The Credit Bureau developed The Credit Bureau will report to thc Credit Bureau under the Central selection criteria, acceptable to the Government on a quarterly basis, Bank to operate a centralized Bank, to determine which enterprises enterprises arrears to the budget, to information and monitoring should stop receiving new bank the bank, and to other enterprises and system of enterprises arrears to credits.** creditors. the Government (loans from the Budget, taxes and social The Credit Bureau identified debt and security contributions), to the arrears for the largest 30 users of banks and to other enterprises credit in 1994 and provided the and creditors.* information to the Bank in the agreed format. * Denote actions fulfilled for IMF's Board approval of STF. ** Denote structural benchmarks of IMF's STF.  Annex 2 Page 7 of 7 Objectives Actions Already Fulfilled Before Board Medium Term Institutional Taken Presentation Actions Requirements C. SOCIAL SAFETY NET 1. Pensions Rationalize current pension Pension Law, effective 1994, Cabinet of Ministers has submitted Implement the revised scheme of Cabinet of Ministers' structure to contain costs and a decree of April 15, 1994 Resolution to the Parliament on pension adjustment by July 1, 1995. resolution/decrees. and ensure adequacy. reduced number of groups February 8, 1995 with a revised entitled to early pensions. system for adjusting pension benefits. Strengthen enforcement of payroll tax collection. Daily penalty for late payment reduced to 0.2 percent in Jan. 1994.  Annex 3 Page 1 of 2 UZBEKISTAN REHABILITATION LOAN SELECTED ECONOMIC INDICATORS 1. Key Indicators 1993 1994 1995 1996 1997 1998 (Estimated) (Projected) Growth Rates GDP -4.5 -6.2 -1.7 2.4 4.4 Consumption / Capita Growth Rate 2.2 -5 -0.7 2.7 3.2 Total DOD (mln. US$) 1,492 1,758 2,279 2,681 2,966 3,060 DOD / IGS 45.8 47 55.8 62.5 66.1 65.7 DOD / GDP 6.5 14.2 19.7 23.6 25.5 25.2 Debt Service (mln. US$) 72 651 446 596 515 571 Debt Service / IGS 2.2 17.4 10.9 13.9 11.5 12.3 Debt Service / GDP 0.3 5.3 3.9 5.2 4.4 4.7 Gross Investment/GDP 29.4 24.5 23.8 22.4 21.2 20.9 Export Growth Rate 2.6 0.8 2.5 4.2 4.3 Exports/GDP 12.3 13.3 14.3 14.9 15.1 15.1 Import Growth Rate 7.4 5.4 2 1.6 1.4 Imports/GDP 14 15.8 17.8 18.4 18.3 17.8 Sources: Uzbek Authorities and Staff Erim  Annex 3 Page 2 of 2 UZBEKISTAN REHABILITATION LOAN SELECTED ECONOMIC INDICATORS 2. Balance of Payments 1993 1994 1995 1996 1997 1998 (Estimated) (Projected) Exports of GNFS 2,838 3,235 3,365 3,583 3,893 4,224 Imports of GNFS 3,229 3,621 3,954 4,116 4,272 4,422 Resources balance -391 -386 -589 -533 -379 -198 Net Factor Income -14 -26 -40 -78 -121 -137 Current Balance -405 -412 -629 -611 -500 -335 Long-term Capital Inflows 1,001 418 500 550 481 308 Direct Investment 30 120 198 218 240 254 Net LT Borrowing 971 298 302 332 242 54 a. Disbursements 1,025 872 660 814 586 403 b. Repayments 54 574 358 482 344 349 Other LT Inflow (net) . Total Other Items (net) 20 30 39 51 66 86 Overall Balance 617 39 -90 -11 48 59 Meno Item Reserve Stock 1,300 1,336 1,387 1,376 1,400 1,412 Change in Net Reserves -617 -36 90 11 -48 -59 Reserve / Imports 4.83 4.43 4.21 4.01 3.93 3.83 GDP (billion of current US$) 22,999 12,338 11,570 11,374 11,650 12,162 Sources: Uzbek Authorties and Staff Estimatcs  Annex 4 Page I of 1 UZBEKISTAN REHABILITATION LOAN GOODS INELIGIBLE FOR FINANCING 1. expenditures for goods included in the following SITC groups or subgroups, or any successor groups or subgroups under future revisions to the SITC, as designated by the Bank by notice to the Borrower: Group Subgroup Description of Items 112 .. Alcoholic beverages 121 .. Tobacco, unmanufactured, tobacco refuse 122 .. Tobacco, manufactured (whether or not containing tobacco substitutes) 525 .. Radioactive and associated materials 667 .. Pearls, precious and semi-precious stones, worked or unworked 718 718.1 Nuclear reactors and parts thereof, fuel elements (cartridges), nonirradiated for nuclear reactors 728 728.43 Tobacco processing machinery 897 897.3 Jewelry of gold, silver or platinum group metals (except watches and watch cases) and goldsmiths' or silversmiths' wares (including set gems) 971 .. Gold, nonmonetary (excluding gold ores and concentrates) 2. expenditures in the currency of the Borrower or for goods or services supplied from the territory of the Borrower; 3. payments made for goods imported prior to the date of signing, except that withdrawals in an aggregate amount not exceeding the equivalent of $32,000,000 may be made on account of payments made for such goods imported before that date but after November 30, 1994; 4. expenditures for goods supplied under a contract which any national or international financing institution or agency, other than the Bank shall have financed or agreed to finance; 5. expenditures for goods intended for a military or paramilitary purpose or for luxury consumption; and  Annex 5 UZBEKISTAN Page 1 of 3 REHABILITATION LOAN THE FOREIGN EXCHANGE SYSTEM 1. Uzbekistan left the ruble zone and introduced an interim currency, the sum coupon, on November 15, 1993. Regular weekly interbank foreign currency auctions began on April 15, 1994. The auction-determined exchange rate was used for all official transactions. Uzbekistan introduced its national currency, the sum, on July 1, 1994. The sum was introduced at a conversion rate of 1,000 sum coupons per sum and at an exchange rate of 7 sums per US dollar. The auction to determine the official rate coexists with a parallel or "black market" in foreign exchange. 2. On August 1, 1994, a dual exchange rate was temporarily established by the Central Bank. The official exchange rate was used for non-cash transactions and customs payments, while the commercial exchange rate was used for cash transactions. Individuals were granted the right to buy limited amounts of foreign currency at the cash rate. The limit was initially set at US$250, and subsequently increased to US$1,000 in September, when the Cabinet of Ministers also gave the Central Bank control over decisions on the amount of foreign currency that individuals can buy from currency offices and other regulations on currency exchange transactions. The Central Bank decreased the limit on annual purchases of individuals to US$300 in late November, 1994, but plans to increase it to at least US$1,000 for 1995. In October 1994, after the currency turmoil in Russia, a Cabinet of Ministers resolution mandated that all payments and settlements in Uzbekistan be effected in sum. 3. In the period immediately following the introduction of the currency in July 1994, the sum depreciated steadily, but the parallel market rate appreciated as enterprises and individuals moved out of the sum coupon and access to bank credit and cash deposits was restricted. During August the official exchange rate was relatively stable at about 11-12 sums per US$, but the sum depreciated further in September, so that the difference between the official, cash, and parallel market rates narrowed. The commercial and cash rates were unified in the first week of October at the rate of 22 sums per US dollar. The sum has depreciated slightly since then (see Figure 1). Figure 1 Official Exrange Rate 27 - - 25-- 23-- 21 17 15 13 @ 0 e oU t 8 0 z  Annex 5 Page 2 of 3 4. In the foreign currency auction, the Central Bank acts as seller and the participating banks as buyers. Initially, 4-6 banks participated in the auctions, but the number has increased to 13. The Central Bank is considering applications from two more banks. The first step in the auction procedures is to collect the applications of participating banks. If demand based on these applications exceeds the amount of foreign exchange offered, then the price of foreign exchange is increased and banks resubmit their orders. The new rate is set when the amount requested equals the amount offered. All banks pay the same rate at the end of the auction. Participating banks deposit the sum equivalents of their bids before the auction. The foreign currency offered by the Central Bank is frozen in foreign banks until after the auction. Foreign exchange is transferred to winning bidders one day later. 5. The amount of foreign currency exchanged in the auction was initially rather low, at about US$ 1 million per week. The small amount transacted and the small number of banks participating indicated that an efficient currency auction market was probably not yet in place, but beginning in September 1994 the volume of transactions began to expand and reached about US$ 10 million the first week in January, 1995. Both the increase in the volume of transactions and the greater number of participating banks (Figure 2) pave the way for use of the auction as an indicator of underlying market conditions. The official exchange rate for the sum will continue to be determined by the auction. Figure 2 AverageVolume of ForexTraded (min. USS) 9.5 8.5 7.5 6.5 5.5 4.5 3.5 2.5 1.5 0.5. June July Aug Sept Oct Nov Dec. J. 6. One of the sources of increased volume in the foreign currency auction is the 30 percent surrender requirement for all foreign exchange receipts. Since November 1994, the proceeds from the 30 percent surrender requirement on both centralized and noncentalized exports has been channeled through the auction. From January 1, 1995, all foreign exchange earnings from centralized trade (except gold) are being channeled through the auction.  Annex 5 Page 3 of 3 7. Since November 1994, the spread between the auction and parallel market rates has widened. The market has now become very fragmented and thin. The parallel market has become a less reliable indicator of market conditions since the Government took measures in late November 1994 to restrain activities in this market. The quoted exchange rate incorporates a considerable risk premium. New rules and foreign exchange regulations will be issued in March 1995 with assistance from the IMF. The situation in the foreign exchange market will need to be followed up carefully in the coming weeks.  Annex 6 Page I of 1 UZBEKISTAN REHABILITATION LOAN STATUS OF BANK GROUP OPERATIONS A. Statement of Bank Loans and IDA Credits As of December 31, 1994 (US $ million) Loan No. Fiscal Purpose Amount in USS million Last ARPP Supervision Year (less cancellations) Ratings IBRD Undisbursed Development Implementation Objectives Progress 3650-UZ 1994 Institution Building 21.0 20.2 - U U: Unsatisfactory; S: Satisfactory; HS: Highly Satisfactory. B. Statement of IFC Investments As of January 12, 1995 (JS $ million) Fiscal Year Obligator Type of EFC Loan IF Equity Participants cl Total Business 1994 Amantaytau Gold 0.0 1.0 4.0 5.0 Gold Fields Mining Co. Total Gross 1.0 4.0 5.0 Conmnitment a/ Less Cancellations, Terminations, 1.0 4.0 5.0 Repayment and Sales Total Commitment Now Held b/ 1.0 4.0 5.0 a/ Gross comnitments consist of approved and signed projects. b/ Held commnitments consist of disbursed and undisbursed investments. c/ The participants in the joint venture, which to date has undertaken a feasibility study of the gold mines are: Government of Uzbekistan, Lonhro Co. (UK), and the IFC.  Annex 7 Page 1 of 1 UZBEKISTAN REHABILITATION LOAN TIMETABLE OF KEY PROCESSING EVENTS 1. Time taken to prepare: 14 months 2. Project prepared by: Governrnent of Uzbekistan, with assistance of IBRD staff1. 3. Preparation/Pre-Appraisal: April 11- 28, 1994 June 28 - July 14, 1994 November 2 - 14, 1994 4. Appraisal: January 4 - 13, 1995 5. Negotiations: February 14-17, 1995 6. Board presentation: March 28, 1995 7. Expected effectiveness: April 1, 1995 8. Expected program completion: June 30, 1996 1/ This report is based on the work of the World Bank missions which visited Uzbekistan in October 1993, February, April, June, and November 1994 and January 1995, and assisted the Government in the preparation of the program and concurrently appraised it. The core team included: Messrs. /Mmes. Vatnick (Task Manager); Brefort, Saba (Enterprise Reformn/Privatization); Montes-Negret (Financial Sector); Klugman (Social Safety Net); Kennefick, Rajagopalan (Implementation Arrangements); Demars (Disbursement). Other contributors include: Messrs./ Mmes. Connolly, Seabright, Takacs (Incentive Framework); Amodeo, Cramer, Kopicki, Vellutini (Enterprise Sector); Bouton, Frascati, Honohan (Financial Sector); Lowry (Real Estate Market); Green, (Energy); Folb (Pharmaceuticals Needs); Denizer, Mena, Montes (Implementation Arrangements); Barlas (LEGEC); Guerrero, Bertozzi, Uruefia and Gomez (EC3C1). Messrs. Kadir T. Yurukoglu and Yukon Huang are the managing Division Chief and Department Director, respectively, for this operation.  6~~~~~~~ 4~~~~~~USSIAN 60 ~~~~~~~~~~~~FED. __AERBAIJAN \A/AKH0IAr1 , ,,, Nct .a . 1 X A, e e YR;) 7ol ea J' j \ \ t~~~~~~~~~~~~ ~ ~~~~~~~~~~SLAMIC REP '' ' Fr KAZAKHSTAN |\ OF IRAN It '-l(AKSA, s \ ~~~Mu nokt ( >s I + I t \ / ~~~~~~~~~~~~~~~~~~~~~~~AFGFHANISTAN d *-q2"'s" N _ ISLMI REP |' 'u K A Z A K H KSTA F IRN U Z B E K I S T A N KYRGY Caspian Sea h l L(kuduk EREPUJBLIC The boundories, colors,\ Noai 1/ 1 f otenr informaio ond ho-n T U R K M E N I S T A N / , _Q QI on this map do not \r imply oon the part of u< Guhra d '! ony judgment on the legal \Srir Stotus of any territory,-R y ) \\ o=/ n j ril s s - I or any ondorsement Chordzho \\ / / boundories. . .... mh)\XKos T A J I K I S T A N J ..JISLAMIC REP?\/ ' 1eo<1 , 0......, - OF IRAN A w9,PaZ 9> - > Shu>hKZ STAN U Z B E K I S T A N DhrIl0 ,' t r ' ~~~~~~~~~~~~~~Terme' r1',- * National Capital _ { rM-, zSh-lf O Selected Cities R - Railroads A F G H A N I S T A N - Main Roads 40 Ioshkent ~Rivers MILE50 lro 200 P' 1 he bndar Internationel Boundaries K ILOMEcERl o r0 implI on th po, o I :    FILE COPY (C(I 3CI Report No: P- 6525 UZ Type: PR