Armenia - Enterprise Development Project

Document of The World Bank Report No. 15982-AM STAFF APPRAISAL REPORT REPUBLIC OF ARMENIA ENTERPRISE DEVELOPMENT PROJECT November 27, 1996 Enterprise and Finance Division Country Department IV Europe and Central Asia Region  CURRENCY EQUIVALENTS (as of November 21, 1996) Currency Unit = Dram Dram I = US$0.0023 US$1 = Dram 433.83 AVERAGE EXCHANGE RATES Dram per US$1 1995 June 1996 August 1996 October 1996 406.4 409.82 417.00 418.14 WEIGHTS AND MEASURES Metric System ABBREVIATIONS AND ACRONYMS BAU - Banking Advisory Unit CBA - Central Bank of Armenia EBRD - European Bank for Reconstruction and Development EDIPA - Enterprise Development and Foreign Investment Promotion Agency ESAF - Extended Structural Adjustment Facility ESF - Enterprise Support Fund FACC - Foreign Aid Coordination Center FSU - Former Soviet Union GAC - Grant Approval Committee IAS - International Accounting Standards IDA (ITF) - International Development Association (Interim Trust Fund) IF - Investment Fund KFW - Kreditanstalt ftir Wiederaufbau LOC - Line of Credit MOE - Ministry of Economy MOF - Ministry of Finance NBFI - Non Bank Financial Institution NGO - Non-governmental Organization PFI - Participating Financial Institution PHRD - Population and Human Resources Development PIFCA - Private Investment Finance Corporation of Armenia PMU - Project Management Unit SA - Special Account SAC - Structural Adjustment Credit SMS - Securities Market Supervision Unit SRO - Self-regulating Organization YSE - Yerevan Stock Exchange ARMENIA - FISCAL YEAR January I - December 31 Vice President: Johannes Linn, ECAVP Director: Basil G. Kavalsky, EC4DR Division Chief: Paul J. Siegelbaum, EC4EF Task Manager: David A. Phillips, EC4EF  STAFF APPRAISAL REPORT REPUBLIC OF ARMENIA ENTERPRISE DEVELOPMENT PROJECT CONTENTS CREDIT AND PROJECT SUMMARY .............................. i-ii PART I. INTRODUCTION AND BACKGROUND .I Country Background . Recent Economic Developments .I Stabilization and Structural Adjustment ...................................................................3 The Project Background .................................................................3 PART II. THE FINANCIAL SECTOR .4 The Current Situation.4 The Role of the Proposed Project in Financial Sector Institution-Building and Reform .7 The Capital Market.7 The Role of the Proposed Project in Capital Market Reform ,..9 PART III. PRIVATIZATION AND PRIVATE ENTERPRISE DEVELOPMENT .10 State Enterprise Privatization .10 Private Enterprise Development .11 Export Potential.12 The Role of the Proposed Project in Enterprise Development .13 The Enterprise Legal Framework .13 The Demand for Investment Finance .15 PART IV. THE PROJECT .17 Objectives and Scope .17 Summary Project Description and Design Features .17 Survey of Project Demand .18 The Rationale for Bank (IDA) Involvement .18 Bank Group Experience in Credit Lines and Lessons Leared .19 A. Institution Building Component .20 The Project Management Unit (PMU) .20 The Enterprise Support Fund (ESF) .20 Business Advice .22 Financial Institutions and Capital Markets Assistance .22 The Banks and the PIFCA .22 Capital Market Assistance .23 B. The Credit Line Component .24 Overview.24 Participating Financial Institutions .24 The Domestic Commercial Banks .24 The PIFCA.26 Project Costs and Finance .27  PART V. PROJECT MANAGEMENT AND IMPLEMENTATION .............................................. 30 Institutional Arrangements .............................................. 30 The Project Management Unit .............................................. 30 Enterprise Development and Foreign Investment Promotion Agency .............................................. 30 Grant Approval Committee (GAC) .............................................. 31 Supervision .............................................. 3 1 Procurement .............................................. 3 1 Disbursements .............................................. 33 Accounting, Auditing and Reporting ............................................ 34 PART VI. BENEFITS, RISKS AND ECONOMIC ANALYSIS ......................................... 36 Environmental Review ......................................... 36 Economic Analysis ......................................... 36 Project Benefits ......................................... 38 Project Risks and Risk Management ......................................3.......... 39 Monitoring and Evaluation ...................................... 39 PART VII. AGREEMENTS AND RECOMMENDATIONS ...................................... 41 Actions to be Taken ...................................... 41 ANNEXES 1. PMU Terns of Reference 2. ESF Description, OPP 3. Bank Profiles 4. LOC for Domestic Banks 5. Eligibility Conditions (Banks) 6. Project Implementation Plan 7. Supervision Plan 8. Procurement Plan DOCUMENTS IN THE PROJECT FILE Statistics: Banking ESF Terms of Reference EDIPA Charter BAU Terms Of Reference Capital Market Assistance: Terms of Reference PIFCA Business Plan Sub-Loan Agreement Environmental Checklist Private Sector Assessment Synopsis Credit Demand Study Business Adviser: Terms of Reference  TABLES Table I - Major Economic Indicators Table 2 - Reserves and non-performing loans Table 3 - Loans and Reserves in former state banks Table 4 - Privatization process - enterprises under Ministry of Industry Table 5 - Company Registrations Table 6 - Projection of Credit Demand Table 7 - Project cost and financing plan Table 8 - Equipment Budget Table 9 - Financing plan Table 10 - Summary of procurement methods Table 11 - Estimated IDA (ITF) disbursements FIGURES Figure I - Deposits and Credits Figure 2 - Structure of the EDP MAP IBRD23943RI   - i - REPUBLIC OF ARMENIA ENTERPRISE DEVELOPMENT PROJECT Credit and Project Summary Borrower: Republic of Armenia Implementing Agencies: Ministry of Economy, EDIPA, Banks, PIFCA Beneficiaries: Private Enterprises, Banks, PIFCA, EDIPA, SMS, Capital market Institutions Poverty Category: Not applicable Amount: SDR 11.6 million (US$16.75 million equivalent) Terms: IDA terms, payable in thirty-five years, including ten years of grace with 0.75% service charge. Commitment Fee: 0.50% on undisbursed credit balances, beginning 60 days after signing, less any waiver. Onlending Terms: The proceeds of the IDA (ITF) Credit would be passed on by the Government in foreign currency through the Ministry of Economy--Foreign Aid Coordination Center, Project Management Unit (PMU). The PMU would receive a spread of 0.5% on the amount onlent under the investment financing component to the PFIs, to cover its administration costs. The credit would be onlent on the following terms: for investment financing; to eligible financial institutions including the PIFCA and the domestic banks as a subsidiary loan repayable over ten years at a rate of LIBOR plus 2%; for technical assistance; to the EDIPA as a grant, and to the PIFCA for institutional support as a loan at IDA borrowing cost plus 1.25%. The PIFCA and the domestic banks would onlend to subborrower private enterprises at market-determined interest rates and margins, with subloan maturities of up to seven years. The subborrowers would take the exchange risk and the financial intermediaries would take the credit risk. The difference between the cost of the IDA (ITF) credit and the interest rate on subsidiary loans under the credit lines, less an administrative fee for the PMU, would be retained by the Government. Project Costs US$ million equivalent Component Local Foreign Total Financing (Banks, PIFCA) 7.00 25.00 32.00 Project Mgt. Unit 0.10 0.27 0.37 Enterprise Support Fund 1.05 3.50 4.55 k Business Adviser 0.03 0.29 0.32 Banks, capital market 0.40 2.69 3. TOTAL 8.58 31.75 40-33  - ii - Financing Plan US$ million equivalent Local Foreign T.T.l IDA (ITF) 0.00 16.75 .... ...7. USAID 0.00 1.00 ....... .. EBRD 0.00 7.00 ........7 00 KfW 0.00 5.00 5 00 Private Investors 5.00 2.00 7 00 Other cofinancing 1.00 0.00 00 Government 0.58 0.00 0 58. Local Banks 2.00 0.00 .. TOTAL ....:....-'-"" '.5 3L7 :--''' -'''' $ Estimated IDA Disbursements (US$ million equivalent) FY96 FY97 FY98 FY99 FY2000 FY2001 TOTAL Line Of Credit (Banks, PIFCA) 0.00 1.65 2.75 3.50 2.20 0.90 11.00 PMU 0.05 0.22 0.00 0.00 0.00 0.00 0.27 ESF/Business. Adviser 0.07 0.96 1.44 1.33 0.00 0.00 3.79 Banks/ Capital Market 0.00 0.76 0.76 0.17 0.00 0.00 1.691 TOTAL0400000040000000000000000000000t000000000 00. 9.12 3.58 4.95 5.00 2.20 0.90 16.75 CUM. TOTL 0.12 3.70 8.66 13.65 15.85 16.5 Financial/Economic Return to Project: Subprojects financed under the line of credit would earn an expected financial rate of return above their cost of borrowing from the PFIs (PIFCA and the commercial banks). At current rates and spread to the PFIs this rate of return would be at least 15%. Subprojects would assume exchange risk, which would generally necessitate competitive production at world prices. They would produce mainly tradable goods under relatively low prevailing levels of import protection. Economic returns would therefore approximate financial returns. The technical assistance to the banks, the PIFCA, the capital market and the ESF would be expected to earn a satisfactory economic rate of return taking into account likely external benefits associated with creating new markets. Project ID Number: AM-PA-8279  REPUBLIC OF ARMENIA ENTERPRISE DEVELOPMENT PROJECT STAFF APPRAISAL REPORT I. INTRODUCTION AND BACKGROUND Country Background 1.1. Armenia is a landlocked country of 3.7 million people bordered by Azerbaijan, Georgia, Iran and Turkey. It declared its independence formally on September 23, 1991. The Government of President Ter-Petrossian, which has been in power since that time, has been able to create a level of continuity essential to recovery. With few natural resources, Armenia depends for its economic growth on its highly educated population and strong entrepreneurial traditions. While regional political tensions are gradually easing, current economic prospects remain constrained by the legacy of Soviet central planning. Production has been highly dependent on trade with the rest of the Former Soviet Union (FSU) (exports and imports represented over 50% of GDP during the 1980s) and on industry (which constituted about 60% of Net Material Product). In the absence of raw materials and primary processing facilities, Armenia has had to rely heavily on imports of semi-finished goods and critical inputs into domestic industry, particularly of primary energy resources. Armenia was also the location of a disproportionate share of the Soviet military-industrial complex. This high degree of integration into the FSU economy induced economic collapse in Armenia when the intra-FSU trade, payments and financial system broke down. More fundamentally, the elimination of non-market pricing in trade between FSU states imposed a severe terms of trade shock on Armenia, particularly due to the sharp rise in energy import prices. The lack of comparative advantage of significant parts of Armenia's productive base was exposed. 1.2. Progress on reorienting government in the transition to the market economy has accelerated with the improvement in the regional political situation. There have been several recent positive developments in Armenia's relations with its neighbors. The reduction in regional tension has allowed the Govermnent to move away from management of a siege economy under an oil embargo, towards the implementation of a comprehensive stabilization and structural reform program. Recent Economic Developments 1.3. The hyperinflation and major fiscal deficit of 1993, resulting from massive net lending to enterprises and an inflow of rubles withdrawn from circulation elsewhere in the FSU, have been substantially eliminated with the help of currency reform and vigorous measures to bring inflation under control. Public expenditure has been limited to priority items and revenue collection increased, while interest rates on central bank refinancing of commercial bank credit have been allowed to become highly positive in real terms to further restrain monetary growth. Fiscal and monetary restraint was enhanced by abolition of the bread subsidy in 1995. The fiscal deficit declined from 48.2% of GDP in 1993 to 16.4% in 1994, and 8.7% in 1995. For 1996 it is projected to reach 8.2% of GDP. Inflation has fallen sharply, to 1.1% per month in October 1996 compared to 46% per month at its peak in 1994, prior to the stabilization program. This has been accompanied by broad stability in the nominal exchange rate since the Spring of 1994, which has enhanced confidence in the new currency.  -2 - Table 1: Major Economic Indicators Real (~rawth Rite.%..............7 1.4. After an estimated ............ M l_ m _ 60% decline in GDP in GtW ~ ~ ~ ~ ~ ~ ~ +9 6~~~~.....7 . 1991-93, a growth of ,,''..',.'.,','P,'""v;..''.'.......... Pnvat~~~.... ... 5.4% and 6.9% t t-- -...... tt.; - . ..... . t. ............. respectively was recorded .-lnflatat ero) [2