Moldova - Second Structural Adjustment Loan and Structural Adjustment Credit Project

Document of The World Bank FOR OFFICIAL USE ONLY ReportNo. P 7139 MD REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT AND THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN IN AN AMOUNT EQUAL TO US$ 55 MILLION AND ON A PROPOSED CREDIT IN AN AMOUNT EQUIVALENT TO SDR 33 MILLION TO THE REPUBLIC OF MOLDOVA FOR THE SECOND STRUCTURAL ADJUSTMENT LOAN AND CREDIT August 18, 1997 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.  REPUBLIC OF MOLDOVA SECOND STRUCTURAL ADJUSTMENT CREDIT AND LOAN CURRENCY EQUIVALENTS (as of July 30, 1997) Currency Unit = Lei US$ I = Lei 4.6 WEIGHTS AND MEASURES Metric System ABBREVIATIONS AND ACRONYMS ARA - Agricultural Restructuring Agency ARIA - Agency for Restructuring and Enterprise Assistance CAS - Country Assistance Strategy CIS - Commonwealth of Independent States DMP - Debt Management Plan EBRD - European Bank for Reconstruction and Development EFF - Extended Fund Facility ESW - Economic and Sector Work FSU - Former Soviet Union FY - Fiscal Year GDP - Gross Domestic Product GTZ - German Technical Assistance Agency IDA - International Development Association IBRD - International Bank for Reconstruction and Development IFC - International Financial Corporation IMF - International Monetary Fund INCON - Joint Stock Company - Agricultural Produce (Moldova) JSC - Joint Stock Company LDP - Letter of Development Policy LIBOR - London Inter-Bank Offer Rate LPG - Liquid Petroleum Gas MIGA - Multilateral Investment Guarantee Agency PP - Privatization Plan PSD - Private Sector Development RAO Gazprom - Joint Stock Company - Natural Gas (Russia) SAL - Structural Adjustment Loan (Credit/Loan) SDR - Special Drawing Rights SOE - State-Owned Enterprises SSC - Strategic Studies Center STF - Systemic Transformation Facility TACIS - Technical Assistance for the CIS (European Union) UNDP - United Nations Development Programme USAID - United States Agency for International Development VAT - Value Added Tax MOLDOVA - FISCAL YEAR January I - December 31 Vice President: Johannes F. Linn (ECAVP) Country Director: Roger W. Grawe (ECC07) Unit Director: Pradeep K. Mitra (ECSPE) Task Team Leaders: Arup Banerji, Hafez Ghanem (ECSPE)  FOR OFFICIAL USE ONLY REPUBLIC OF MOLDOVA SECOND STRUCTURAL ADJUSTMENT CREDIT AND LOAN Credit/Loan Summary Borrower: Republic of Moldova Amount: US$ 100 million equivalent, consisting of credit of SDR 32.6 million (equivalent to US$ 45 million), and loan of US$ 55 million. Terms: The credit will be payable in thirty-five years, including ten years of grace, on standard IDA terms. The loan will be payable in twenty years, including five years of grace, at the standard interest rate for LIBOR-based US dollar single currency loans. Commitment Fee/ Variable rate between 0.00% - 0.50% (set annually by the Service Charge: Executive Directors of IDA) on undisbursed credit balance, beginning 60 days after signing, less any waiver. 0.75% on undisbursed loan balances, beginning 60 days after signing, less any waiver. Objectives and Description: The proposed three-tranche credit and loan would support the Government's reforms, necessary to create conditions for a resumption of growth and an improvement in living standards in Moldova. To achieve this goal, critical reforms need to be undertaken in: (i) improving financial discipline; (ii) privatizing the energy sector; (iii) accelerating land reform and land privatization; (iv) reforming the pension system; and (v) completing enterprise privatization, especially for small-scale. Benefits: The credit and loan would provide the Moldovan Government with short-term budgetary support essential for maintaining the level of basic public services at a time of fiscal transition. It will also provide necessary foreign exchange to purchase imports critical for Moldova's economic activity. The availability of low cost, non-inflationary budgetary financing will help consolidate Moldova's economic stabilization and maintain its short-term creditworthiness. At the same time, the reform program supported by the credit and loan will address key bottlenecks and enhance the prospects of long-term growth and improved living standards. Risks: The operation has three major risks. The greatest risk is political. With Parliamentary elections due within the next year, it is possible that the reform process may be slowed or stalled. 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.  i. Second, the Government may be hampered by weak institutional capacity for effective implementation, especially in the areas of farm restructuring and energy sector privatization. Finally, there is the risk that the much needed economic expansion, the aim of the reform program, will be delayed and thus push Moldova into a less sustainable economic path. This may be due to slow reform implementation, or an exogenous shock to production or income that lowers growth. The operation seeks to minimize the overall risk by ensuring that a major part of the reform agenda is front-loaded, and will be implemented before Board presentation. To mitigate the political risks, the Government and Bank have been carrying out a wide dialogue with diverse elements of civil society, so as to build broad-based support for the reform program. To alleviate the risks to the program caused by weak implementation capacity, the Bank is working with two non-Governmental agencies specifically created to implement reform programs in agriculture and enterprise restructuring, and helping the Government to mobilize external technical assistance for implementation. The program includes social mitigation efforts, in its fiscal, pension reform, and energy sector reform components. Schedule of Disbursement - SDR 25.4 million (equivalent to US$ 35 million) immediately after credit effectiveness (expected in September 1997); - SDR 7.2 million (equivalent to US$ 10 million) and US$ 25 million upon satisfaction of second tranche release conditions (expected about June 1998); - US$ 30 million upon satisfaction of third tranche release conditions (expected about March 1999). Poverty Category Not applicable Project ID Number MD-PE-44 147 Map IBRD No. 24285R3  REPORT AND RECOMMENDATION OF THE PRESIDENT OF IBRD AND IDA TO THE EXECUTIVE DIRECTORS ON A PROPOSED SECOND STRUCTURAL ADJUSTMENT LOAN AND CREDIT TO THE REPUBLIC OF MOLDOVA TABLE OF CONTENTS PART 1. THE ECONOMY ............................................... I A. Moldova's Transition Challenge .................................................... I B. Political Consensus on Economic Reforms ................ .................................... 2 C. Reducing Arrears is a Clear Priority .................................................... 3 D. Extending the Privatization Program is Necessary for Growth ............................................ 4 E. Towards Achieving Moldova 's Economic Goals .................................................... 4 PART 11. MOLDOVA'S ADJUSTMENT PROGRAM ................................................ 6 A. Program Objectives .................................................... 6 B. Promoting Macroeconomic Stability .................................................... 7 C. Creating a Fair and Affordable Pensions System ............................ ........................ 9 D. De-Monopolizing and Privatizing the Energy Sector .................................................... 10 E. Creating a Competitive, Private Agricultural Sector .................................................... 12 F. Completing Enterprise Privatization .................................................... 14 PART 111. THE PROPOSED LOAN ....................R. 1 6 A. The Proposed Loan is Central to the Country Assistance Strategy ..................................... 16 B. Benefits and Risks .................................................. 17 C. Bank Operations .................................................. 20 D. Financial Arrangements .................................................. 20 E. Collaboration With IMF And Other Donors ................. ................................. 21 PART IV. RECOMMENDATION OF THE PRESIDENT ............................................... 22  ii ANNEXES Annex I Table 1: Main Economic Indicators Table 2: Balance of Payments Table 3: Debt Indicators Table 4: Moldova at a Glance Annex 2 Status of Bank Group Operations and Status of IFC Operations Annex 3 Timetable of key processing events and Staffing Annex 4 Letter of Development Policy Annex 5 Matrix of Policy Conditionality BOXES Box l Government Expenditure Arrears 8 Box 2 Farm Restructuring 13 Box 3 Project Risks and Mitigation Measures 17 Box 4 Measures Already Taken Under the Program 19  REPORT AND RECOMMENDATION OF THE PRESIDENT OF IBRD AND IDA TO THE EXECUTIVE DIRECTORS ON A PROPOSED SECOND STRUCTURAL ADJUSTMENT LOAN AND CREDIT TO THE REPUBLIC OF MOLDOVA 1. I submit for your approval the following report and recommendation on a proposed Structural Adjustment Credit to the Republic of Moldova in the amount of SDR 32.6 million (amount equivalent to US$ 45 million), and a proposed Structural Adjustment Loan to the Republic of Moldova in the amount of US$ 55 million, to provide support for the Government's economic reform program. The credit and loan (collectively SAL 1) will be disbursed in a total of three tranches. 2. The credit would be on IDA terms, with a maturity of 35 years including a grace period of 10 years, and would be disbursed in two tranches: SDR 25.36 million (equivalent to US$ 35 million) immediately after effectiveness, and SDR 7.24 million (equivalent to US$ 10 million) to be disbursed upon satisfaction of second tranche release conditions (expected about June 1998). 3. The loan would be made for 20 years, including a grace period of 5 years, at the standard interest rate for LIBOR-based US Dollar single currency loans with an expected disbursement period of 0-3 years, and would be disbursed in two tranches: US$ 25 million to be disbursed upon satisfaction of second tranche release conditions (expected about June 1998), and US$ 30 million to be disbursed upon satisfaction of third tranche release conditions (expected about March 1999). 4. The Republic of Moldova joined the IBRD on August 12, 1992, MIGA on June 9, 1993, and IDA on June 14, 1994. PART I. THE ECONOMY A. Moldova's Transition Challenge 5. Moldova's independence in 1991 brought with it considerable economic disruptions. There was a significant breakdown of traditional trade linkages and payment systems and a traumatic exposure to world prices. The combination of a large terms-of- trade shock (30 percent of GDP in 1992 prices), a decline in the demand for its exports, and severe weather (droughts, hurricanes and floods) nearly crippled the country's economy. Inflation soared, cresting at about 2,200 percent in 1992. By 1994, almost three-fourths of industry was at a standstill, agriculture was declining and GDP was just over 40 percent of its 1990 level.  2 6. Independence was also followed by a period of political instability. In the armed conflict between the Moldovan regions on the east (Transnistria) and west banks of the Nistru, discord over economic policies was aggravated by ethnic tensions. A cease-fire was declared in 1992. Since then, there has been slow progress towards a mutually acceptable resolution to the problem, with the resumption of trade and transport, and some production, between the two regions. In May 1997, the Moldovan President signed a memorandum with Transnistrian representatives on settling the conflict, but the details of the eventual accord are yet to be worked out. 7. Since 1993, Moldova has rapidly stabilized its economy, and has started structural reforms. Moldova's most visible economic policy success has been financial stabilization, supported by the IMF (through an STF, two stand-by arrangements and an EFF). A new currency was introduced in 1993, and monetary and fiscal policy tightened. Inflation fell to an annual rate of around 15 percent in 1996, one of the lowest rates in the FSU. The Government's initial round of structural reforms, supported by a Rehabilitation Loan (approved in 1993) and a first Structural Adjustment Loan (approved in 1994) focused on three areas: (i) privatizing, restructuring, and demonopolizing enterprises; (ii) strengthening the legal and regulatory framework in the financial sector; and (iii) liberalizing prices and trade. 8. The reforms have moved Moldova's economy towards improved efficiency and responsiveness, but the agenda is yet incomplete. The situation became particularly difficult in 1996, when economic and political factors converged to slow the pace of reforms. Adverse weather conditions contributed to a drop in GDP by 10 percent. At the same time, a volatile election season resulted in some slippage in the reform program. The new Government in Moldova is now working to combine progress in financial stabilization with a second generation of structural reforms aimed at revitalizing the economy through imposing payments discipline and promoting private sector led growth. B. Political Consensus on Economic Reforms 9. Building consensus on economic reforms in Moldova has not been easy. Presidential elections were held in late 1996. The new President, Mr. Petru Lucinschi, immediately announced his determination to continue, and even accelerate, the reform program. One of his first actions was to issue a decree on urgent measures which stressed action in two key areas: (i) improving financial discipline, particularly payment of budgetary arrears to workers and pensioners, and (ii) accelerating privatization (especially small-scale privatization), land reform, and the development of urban and rural land markets. Unfortunately, valuable time was lost in bargaining with Parliament: first, over the composition of the new government; and second, over Parliamentary adoption of key elements of the reform program. Legislation on the tradability of agricultural land was passed only in July 1997, after the President intervened decisively and pointed out that  3 failure of the Parliament to support the reforms would logically lead to resignation of the Government and early Parliamentary elections. 10. The period of political change is not over. Parliamentary elections are due in the Spring of 1998, and the various political parties are already maneuvering for position. It is possible that Parliament will postpone adoption of politically difficult reforms in the run up to the elections. The Parliament has already postponed further consideration of the Government's proposed increase in the pension age until October, recommending that this be discussed as part of the overall reform in the pension system expected to be implemented in 1998. It is possible that the present Government will change after the elections, and that the next Government will be less committed to reform. The President and Prime Minister have responded to political uncertainty by front-loading the reform program and taking the case for reform directly to the public. Much of the key legislation needed for the program has already been adopted by Parliament, with three important exceptions: the law on pensions, the legal framework for demonopolization of the energy sector, and the detailed plans for privatization of the energy utilities, as well as, possibly, further amendments to the land tradability law to promote the land market. Work over the coming months will focus on the implementation of reforms that have already been widely discussed in the country and formally adopted by Parliament, and on developing the consensus required to put the remaining measures in place. C. Reducing Arrears is a Clear Priority 11. There is a consensus on the need to improve payments discipline. It is now generally agreed that that the failure to impose hard budget constraints is jeopardizing the gains of stabilization and blocking further progress in economic restructuring. The energy sector is increasingly being singled out as a key problem. 12. Moldova's success at stabilizing the economy could be compromised by the failure to carry out structural fiscal reforms. As in other FSU countries, tax revenues to the State Budget have been falling, and reached a low of 18.3 percent of GDP in 1996. Difficult decisions on restructuring and reducing expenditure commitments were postponed. At the same time, the cash deficit was reduced in order to combat inflation. Arrears from the Government have been the result. By end-1996, budgetary arrears of the consolidated Government (State and local, including the Social Fund) were estimated at 964 million lei, or 11.8 percent of GDP. The Government owed 213 million lei to energy enterprises, 112 million lei in wages to budgetary employees, and 121 million lei to the Social Fund. This further reduced the Social Fund's already limited ability to pay pensioners-it, in turn, owed 315 million lei in pensions. Failure to pay the elderly their pensions in a timely fashion resulted in a great deal of suffering and had serious social consequences. The situation has improved over the first half of 1997, with the Government acting aggressively to reduce the stock of pension arrears by two thirds.  4 13. Financial discipline throughout the economy is weak. This is a particularly serious problem in the energy sector where collection rates are very low-at the end of April 1997, the receivables of Moldenergo (the power utility) accounted for US$ 98 million, or some 4.7 percent of GDP. The debt to the energy enterprises compromises their ability to repay foreign creditors for energy imports. The stock of Moldovagas's arrears to RAO Gazprom of Russia was US$ 212 million, including almost US$ 45 million in penalties by the end of March, 1997. The energy sector's debts to Ukraine (for electricity and coal) totals over US$ 50 million. The continued growth in these arrears, if unchecked, will compromise Moldova's creditworthiness. D. Extending the Privatization Program is Necessary for Growth 14. While payments discipline is needed to consolidate stabilization, maintain creditworthiness and restructure the economy, growth will necessitate ownership change. Accelerating the pace of privatization in agriculture (which, together with agro- processing, represents 60 percent of GDP) is particularly important. Less than a fifth of Moldovan agricultural land is privately managed. The former collective and State farms (now registered as joint-stock companies) continue to manage some 80 percent of agricultural land. They are performing very poorly, with agriculture output dropping by 11 percent in 1996. The majority of former collective and State-owned farms are in arrears to their workers and to the Social Fund. As a result, there is pressure for change from within the agricultural sector. The Government has begun the process by launching two pilot farm restructuring projects in the Orhei and Nisporeni regions, with financial and technical assistance from USAID and TACIS. The Nisporeni program has now been expanded to 70 farms nationwide. 15. In the urban sectors, mass privatization has been successful, but small-scale privatization is being hampered by municipalities which prefer to lease premises rather than sell. Privatization of urban land is proceeding very slowly, and the land under privatized enterprises is only beginning to be sold to the new owners. These problems jeopardize the development of small businesses, with particularly negative consequences for the services sector, which represents only 27 percent of GDP. The experience of Central European countries indicates that expanding services is key to economic growth in transition economies-for example, the services sector is about 54 percent of GDP in Poland and 60 percent in Hungary. The Government is determined to move ahead with the privatization of urban land and small-scale enterprises. E. Towards Achieving Moldova's Economic Goals 16. Moldova's medium-term economic prospects will depend greatly upon the implementation of structural reforms, and, to some extent, on the presence or absence of external shocks (related to the weather and its impact on the harvest). Growth will come  5 from increased private sector activity in agriculture, agro-processing and the services sector. This requires domestic and foreign investment. To promote investment, Moldova needs macroeconomic stability, a liberalized economy, and further privatization. The implementation of policies in these areas, supported by the proposed SAL II, should produce sustainable growth with a projected median of about 5 percent per year (see Annex 1). 17. Continued stabilization requires efforts to increase revenue and reduce expenditure commitments. The Government's objective is to reduce the fiscal deficit on a commitments basis from 9.7 percent of GDP in 1996 to below 4 percent by 1998. This is a major adjustment that would allow for a reduction in arrears of around one percent of GDP. It would also be consistent with a rigorous monetary stance and declining inflation. Inflation is projected to drop under the program to about 12 percent in 1997 and seven percent in 1998. 18. Macro-economic stability, together with increased liberalization and accelerated privatization would encourage private entrepreneurs to invest. The rate of fixed investment, which is currently under 9 percent of GDP, is targeted to rise to 14 percent over the next decade-which is comparable with countries in Central Europe.' Initially, growth is expected to be concentrated in services, such as retail trade and transportation, where the legacy of central planning has left a great deal of unfulfilled demand and where the required investment is typically small. The service sector could grow by as much as 10 percent a year, so that its share in GDP would gradually rise. This expansion in services will require that the private sector be able to purchase real assets (land and office space). Land reform and farm restructuring-together with free markets for inputs and outputs, and adequate support services for private farmers-will be critical for the expansion of agriculture. After a short adjustment period, agriculture growth could reach a median rate of about five percent over the medium-term, with annual fluctuations related to weather conditions. Industry, especially export-oriented agro-processing, should pick up in tandem and grow at roughly the same rate as agriculture. This would be fueled in the medium term by increased inflows of direct foreign investment, which is projected to rise from US$ 59 million in 1996 to the range of US$ 100 million by 2002. 19. Full implementation of structural reforms would also bring about a large improvement in the social situation. A key objective of the program is to ensure that government workers receive their wages on time, and pensioners, many of whom are among the most vulnerable groups, can count on steady monthly payments. The unemployed will benefit from expanding job opportunities, mainly in the service sector. Much of Moldova's official investment and saving is due to inventories (stocks), which were recorded to have increased by 20 percent of GDP in 1995. It is likely that this inventory is overvalued (and some of them are "waste" stocks that may not eventually be sold. Much of the remainder will be drawn down as demand recovers (see Annex 1, Table 1). It is useful, therefore, to look at savings and investment figures corrected for rough estimates about the size of waste stocks.  6 As the labor market tightens, real wages will begin rising, and are projected to reach their 1991 level in five to seven years. 20. External stability will depend crucially upon reforms of the energy sector. The program aims to stop the uncontrolled build-up of energy debt as much-needed structural reforms are introduced. Energy imports, US$ 316 million in 1996, are projected to decline steadily to about US$ 302 million in 2000, slowing the growth in imports. Macro-economic projections indicate the need for significant externalfinancing over the medium term. The current account deficit is projected to come down steadily, but is estimated to remain as high as 6.8 percent of GDP by the year 2000, partly due to the projected rise in investment. The stock of external debt is projected to reach a peak of over 52 percent of GDP in 1999, before declining to around 40 percent by 2006, and the debt service ratio is projected to exceed 22 percent of exports by the turn of the century, before declining to below 18 percent thereafter. These creditworthiness indicators are acceptable, but do indicate serious risks, especially if growth of GDP and exports does not recover in the short term. PART II. MOLDOVA'S ADJUSTMENT PROGRAM A. Program Objectives 21. The Government's program aims at laying the foundations for a resumption of growth through reforms at the macro and micro-economic levels. Past macro-economic frameworks focused on monetary stabilization, and succeeded in bringing inflation down. However, by combining loose fiscal policies (commitments deficits of nearly 10 percent of GDP) and tight money (cash deficits of some 3 percent of GDP) the Government was taking scarce resources away from the private sector through the build-up of budgetary expenditure arrears. The present program marks a tightening of fiscal policy and a reduction of budgetary arrears, with the goal of releasing resources for the private sector. At the same time, the program deals with key supply bottlenecks. Land reform and farm restructuring should reverse the decline in agriculture, Moldova's largest economic sector. Small-scale privatization and the creation of an urban real estate market should help bring about an expansion of the service sector and increase employment. Restructuring and privatizing the energy sector should enhance the quality of energy supply and reduce costs, making Moldovan enterprises more competitive. 22. Policy reforms are complemented by other actions under the program aimed at helping bring about a supply response. In agriculture, the Government is putting in place-with Bank and other donors' support-a project to build a system of rural financing, and to provide technical and marketing support to the newly-privatized farms. A Private Sector Development Project-also supported by the Bank and other donors- supports enterprise restructuring and provides management training and a line of credit.  7 The Government's public investment program, and donors' project financing, support the objectives of the reform program. 23. The reform program has two key components: (i) resolving the arrears problem and enforcing financial discipline; and (ii) laying the foundation for stable growth by expanding the privatization program. The Government's strategy to deal with arrears is based upon action in three areas. First, fiscal policy aims to ensure that obligations to wage earners, the Social Fund and the energy sector are adequately funded within a realistic revenue envelope. Second, the energy sector is being restructured to ensure that no more arrears will be accumulated. This restructuring is based on de-monopolization and privatization, to enforce financial discipline, lower production costs and improve service quality. Third, the system of social protection and pensions is being overhauled to ensure adequate, but affordable, protection for the elderly and the vulnerable. 24. The Government's strategy to lay the basis for sustained growth focuses on farm restructuring, privatization of agricultural and urban land, small-scale privatization, and ensuring good quality energy services. The objective is to privatize at least 25 percent of Moldovan farms and to complete small-scale privatization over the next two years. The program aims to complete enterprise privatization, focusing on privatization to strategic investors, cash privatization, and privatizing key infrastructure sectors-energy and telecommunications. Industry and agriculture are suffering from poor energy services and unpredictable supply. Therefore, the program encompasses reforms in the energy sector to improve service quality-which will have a positive effect on growth, in addition to improving financial discipline and creditworthiness. B. Promoting Macroeconomic Stability 25. Macroeconomic stability has been jeopardized by the mounting arrears from the budget, which has led to increasing economic and social problems. The budget's debt to the energy enterprises has contributed to the enterprises' inability to repay foreign creditors for energy imports, and the debt to wage earners and to pensioners has threatened their income security and engendered protests and social unrest. Reducing budgetary arrears has emerged as one of the top priorities of the Government. The Government has decided to focus its efforts on controlling the commitments deficit, not just the cash deficit as in the past. 26. Parliament has passed a 1997 budget which implies a dramatic decline in the commitments deficit-from 9.7 percent of GDP in 1996 to less than 4 percent in 1997. The cash deficit is likely to be higher, at about 5 percent, to allow for a reduction in arrears. At the same time, expenditure estimates are now more realistic than in the past, and ensure adequate financing for wages, pensions and energy consumption by budgetary institutions. Fiscal adjustment is being achieved through a combination of revenue increases and expenditure reductions. Revenue measures include a doubling of gasoline and diesel excises, increased excises on wine and cigarettes, and a strengthening of tax  8 enforcement through a strengthening and reorganization of the customs department and the tax police. The Parliament also adopted the general framework of a reformed Tax Code, and rationalized the income tax system. Expenditure measures concentrate on freezes in public sector wages and nominal pensions, and reduced subsidies to enterprises and consumers. The budget also includes a mechanism to withhold revenues from local authorities that fail to be current on Social Fund, energy, wage and other priority payments. To eliminate unplanned shocks to the budget, it also sets a ceiling on new Government guarantees. 27. Those policies are starting to yield results. During the first half of 1997, the commitments deficit dropped to an estimated 4.5 percent of GDP. Revenue collections improved. Excluding Social Fund contributions, tax revenues were up by about 8'/2 percent over the first quarter of 1996. Current wages and pensions are being paid in a timely manner (Box 1). I,I i J L2]bL L ^ end-December 1996 end-May 1997 Million lei % GDP Million lei % est. GDP GOVERNMENT EXPENDITURE ARREARS (excluding intra-govt. arrears) 964 11.8 908 9.1 Budgetary Arrears (gross) 690 8.4 862a 8.6 o/w To budgetary employees 112 1.4 II1 1.1 To energy sector 213 2.6 180 1.8 For capital investment 98 1.2 93 0.9 Social Fund Arrears (gross) 395 4.8 181 1.8 o/w Topensioners 315 3.8 111 1.1 a/ includes Lei 82 million of external arrears that were paid on June 6, 1997. 28. The Government expects that, at a minimum, its reform measures will prevent an increase in arrears-a second and third tranche condition of SAL II. The data in Box 1, and subsequent indications, show that it has so far been successful in reducing pension arrears, and in stabilizing wage and energy arrears. However, arrears to other suppliers continue to grow. The process of controlling arrears will be facilitated by the deepening of fiscal reforms under the 1998 budget, implementing the new Tax Code and making progress in rationalizing expenditures, especially in the health and education sectors. The Government will be assisted in this process by the newly established Strategic Studies Center, an autonomous organization responsible for macroeconomic analysis, policy formulation, and monitoring implementation of the reform program  9 C. Creating a Fair and Affordable Pensions System 29. Fiscal adjustment will allow the Government to meet important social obligations. In 1996, some pensioners-as well as other social benefit recipients-did not receive any payments from the Social Fund for nine consecutive months. The Governnent is determined that this situation will not recur in the future. In the short run, this will be accomplished by more realistic Social Fund budgets that rationalize expenditures and ensure that revenue shortfalls are covered through transfers from the State Budget. The Government is also committed to implementing more far-reaching structural reforms to ensure that the system is viable and equitable over the medium-term. 30. The 1997 Social Fund budget approved by Parliament in March will help ensure that the Fund's current obligations will be met. This budget has four important features: (i) it refrains from any increases in nominal pensions-the Government is now operating on the principle of no pension increases until all arrears are repaid; (ii) it reduces contributions from 35 percent of the wage bill to 30 percent, so as to lower their negative impact on the labor market and improve compliance; (iii) it cuts administrative expenditures; and (iv) it provides for substantial transfers from the State Budget (about 2.5 percent of GDP) to cover the deficit. The Government is aware that transferring large amounts of resources from the Budget to the Social Fund is not sustainable over the medium term. It has identified measures to save 25 million lei in Social Fund expenditures in 1998 and proposed to Parliament an increase in the pension age of six months per year over 10 years. In June, the Government adopted a strategy to improve the public pension system, which is outlined in a strategy paper on reforms of the public pension system prepared by the Ministry of Labor and Social Protection. 31. The proposed reforms in the strategy paper have three goals. First, adequate income support in old age for the whole population, from both State and supplemental pensions. Second, affordability for all generations, by relying on realistic levels of contribution from all age groups. Third, fairness-through equal treatment for all, pensions mostly related to contributions, and transparency. Pensions granted after 1998 will thus be based on a new formula. People will have to work longer before retiring, but in return they will get a better pension. For most people the main pension will be the contribution- determined service pension, with all contributions counting the same regardless of sector. A "social pension" will be used as the Government's security valve. It will be either: (i) in addition to the service pension, but very low so that the main pension is the service pension; or (ii) a minimum guaranteed pension, if the service pension is too small. Enactment by Parliament of a law based on these principles is a condition for the second tranche of SAL II, and the 1998 Social Fund budget will reflect these principles. 32. Individuals and employee groups will have the opportunity to complement their State pensions with fully funded, privately managed pensions. The Government will put in place the regulatory and institutional framework for the operation of private pension funds. It has established a working group, including representatives of Parliament, the Government, banking and insurance supervision units, insurance companies, banks and  10 large employers, to prepare a revised version of the draft Law on "Non-State Pension Funds". A key concern is to provide sufficient security for private pension schemes. Enactment by Parliament of legislation on private pensions is a second tranche condition. To regulate the non-State pension funds, a regulatory body will be established by the Government in 1998. D. De-Monopolizing and Privatizing the Energy Sector 33. Lack of reform in the energy sector has been a serious impediment to both stabilization and growth. Financial indiscipline has contributed to mounting external arrears, while the lack of assured and high-quality supplies of power has helped hold back industrial growth. The Government's program takes action in three areas: (i) restoring the energy sector's financial equilibrium, and stopping the build-up of energy-related external debt, through debt management and price adjustment, (ii) ensuring domestic financial discipline, hard budget constraints, and better quality of energy services for consumers through creating an appropriate regulatory system and demonopolizing and privatizing the electricity, gas and petroleum industries; and (iii) ensuring that these reforms do not deprive poor households of a minimum supply of energy through measures to mitigate the impact of energy price increases on vulnerable groups. 34. A Debt Management Plan (DMP) adopted by the Government outlines a set of actions to restore the financial viability of key enterprises operating in the sector: Moldenergo (electricity); Moldovagas (gas supply); Termocom and Termocomenergo (district heat). These actions include price adjustments, improvements in payment collections, write-off of uncollectable receivables, mutual payment cancellations, and the repayment of debt with interest over a period of five years. In order to implement the DMP, the Government increased energy prices twice-in March and June 1997. Household tariffs for gas were increased by 15 percent in March and then by 40 percent in June; for electricity by 33 and 44 percent; and for heating by 31 and 100 percent. Now, prices fully cover costs, including debt repayment. Moreover, the structure of prices has improved, with the difference between the prices charged to households and other consumers for electricity and gas eliminated. The price differential for district heat will be eliminated in 1998. The Government is determined to completely eliminate cross subsidies, which will involve raising the electricity and gas prices for households above those charged high- volume consumers in order to reflect the higher cost of service. Despite the price increases, the Government will ensure that, for electricity and gas, end-user collections will rise steadily into 1998. To further ease constraints on the energy companies' financial viability, the Government will, in 1998, reduce subsidies to privileged groups (now paid for by the energy companies), and fund any remaining subsidies from the State Budget. These measures will help resolve the financial difficulties faced by the energy sector. 35. In order to avoid the development of a gap between energy prices and costs in the future, the Government is putting in place a transparent and predictable regulatory system  11 that will be independent of short term political interests. It has already established a regulatory agency, and issued a resolution that spells out its main responsibilities, determines its structure, and provides financing until it becomes self-supporting through a system of license fees. The responsibilities of this agency, and its successor regulatory body, are restricted to the regulation of prices, the promotion of competition, and the control of the quality of service provided to consumers. It will fulfill these responsibilities by licensing each type of activity and enforcing compliance with the rules and conditions stipulated in the licenses. By the fall of 1997, the regulator will develop generic/model licenses and will issue specific licenses to all the entities in the natural gas and electricity subsectors that are eligible for licenses. For district heating, the Government will transfer the regulatory responsibility to the municipalities in 1998. 36. Privatization will begin once the regulatory framework is fully in place. In July 1997, the Government adopted a detailed plan for de-monopolization and principles of privatization of the electricity industry. The plan calls for restructuring the industry in order to develop competition among generators, to de-monopolize wholesale electricity trading (which are second tranche conditions) and, following a period of about three years, to de-monopolize retail trading and provide a choice among suppliers for large consumers. The Government expects that, by end- 1998, a majority of the shares of electricity generation and low-voltage distribution companies will be sold to private investors who have the ability to bring the capital and know-how needed for the modernization of the sector (offering the shares in these companies for sale is a third tranche condition!. 37. Privatization of the gas industry and the oil trading subsector is expected to proceed rapidly. The Government has already sold 50 percent of the shares of Gazsnabtransit (the company that owns the high-pressure transmission system). Low pressure pipelines are owned by 25 regional gas distribution and supply companies that are also engaged in the marketing of LPG. These companies have already been corporatized, and about 20 percent of their shares have been sold to their employees. It is expected that, by March 1997 (a second tranche condition), no less than 51 percent of the shares of these companies will be offered for sale to private investors. The Government has also adopted a plan to de-monopolize the distribution and marketing of oil products, by selling parts of the depots and transport assets of Tirex Petrol (an oil trading company) to private investors. Ft then plans to sell the majority of the shares of Tirex Petrol. 38. The Government has taken steps to offset the impact of the price increases on the poor and the more vulnerable groups in society. The 1997 budget includes 3 5 million lei to compensate vulnerable groups for energy tariff increases. The Social Fund will provide additional compensation to people who are unemployed or fall in one of the special categories (e.g. families with more than 3 children) for the energy price increase, for which its budget includes 49 million lei. In 1998, these compensations are expected to be targeted to the most vulnerable.  12 E. Creating a Competitive, Private Agricultural Sector 39. Efforts to enhance financial discipline are being complemented by policies to promote rapid economic growth. In primarily agrarian Moldova, the agricultural sector is a key engine for growth. The agrarian reforms implemented by the Government aim to revitalize private initiative in the sector. This is being done by: (i) accelerating the process of farm restructuring and land privatization in order to complete the transition from collective and State farms to arrangements where farmers are free to farm in any system they choose; (ii) creating an efficient market for land by removing regulatory impediments; (iii) liberalizing rural and agricultural markets; and (iv) enhancing efficiency by reducing tax and subsidy distortions. 40. Land reform in Moldova began with the Government increasing the number of household plots and giving out land shares (for land used by large-scale farms) to almost a quarter of the population. Until 1996, actual restructuring of large-scale farms was slow-out of about 950 large-scale farms, only 80 farms were fully restructured into entirely private operations, partly because a February 1995 amendment to the Land Code blocked individual exit from large-scale farms. However, the process accelerated in 1996 for two reasons. First, a Constitutional Court decision restored the possibility of individual exit. Second, pressure created by the increased economic difficulties of unrestructured large-scale farms resulted in a new push for restructuring. Local restructuring initiatives now receive increased support from the Government. Ongoing pilot projects for farm restructuring supported by international donors have succeeded in developing new private farm structures. 41. The Government is accelerating the process of large-scale farm restructuring, and plans to complete the restructuring of about 250 large-scale farms over the next 18 months (satisfactory progress in restructuring is a second and third tranche condition). The restructuring will be based on full privatization of land (physically identified land plots for each beneficiary with individual titles), and the new land owners will freely decide on the way they wish to continue farming (Box 2). Land will remain in individual private ownership in the various forms of newly emerging farming organizations, and these forms provide opportunities for further restructuring and modifications in land use. In order to facilitate this process the Government has already (i) revised and improved the exit and registration procedures for establishment of private farms (simplified procedures, set clear and reasonable time limits, ensured a reasonable appeal process etc.); (ii) reviewed ongoing farm restructuring pilot projects and prepared practical guidelines for the dissemination of these experiences, as well as a program to extend these projects to the national level; and (iii) commenced the functioning of the Agricultural Restructuring Agency, a non-governmental institution created to implement and support the nationwide program of farm restructuring.  13 Box 2: Farm Restructuring For a former kolkhoz (agricultural cooperative) or sovkhoz (State farming enterprise) to be "restructured" in Moldova, the following have to hold: * the assembly of the members of the farm decide to enter into a restructuring process; * identified plots of lands are transferred to individuals, in accordance with the individuals' rural land entitlements under Moldovan law; * movable and fixed assets of the farm are distributed to the individual farm members in accordance with their asset share entitlements; * successor farming units are created, and the members have freedom of choice to adopt or join any of the various forms of farm organization. 42. The Government is establishing legal and institutional conditions for a functioning land market, necessary for the success of land reform. The foundation was laid by a September 1996 decision of the Constitutional Court, which eliminated the moratorium on land sales. Since then, several key measures have been taken to promote land transactions. In July 1997, the initial legal framework for the land market was created by enacting a new Law on Normative Price of Land, which also restricted the use of normative prices and eliminated lease control for privately-owned land. The new Law contains provisions that may still act to hamper the full and free operation of the land market. These include a moratorium on resales of land and a broad range of pre-emptive purchasing rights. To ensure that the land privatization process proceeds as envisaged, the Government will closely monitor progress. As a second tranche condition, it will then take needed measures to remove any impediments to the functioning of the land market (including, if necessary, adoption by Parliament of necessary amendments to the new Law). The transfer tax on land sales was lowered by Parliament from five to two percent of the normative price. At the same time, the establishment of a national cadastre system including land registration and titling has begun, with the National Agency for Geodesy, Cartography, and Cadastre being established to coordinate this process. The Government expects to complete the titling and registration of about 15 percent of land parcels over the next 18 months. 43. Concomitantly, the Government is following up on the market liberalization measures that were started under the program supported by SAL I. To open up the grain market, it has introduced a system of auctions for the marketing of concessional food grain deliveries, applied the new public procurement system to State purchases (including grain), and ensured that grain exports do not require any prior permissions. It has also adopted a plan to complete the privatization of the two largest public enterprises in the sector-Fertilitate and Cereale-that would remove residual monopolistic features from agricultural markets. Most of the remaining Government-owned shares for Fertilitate and Cereale will be offered for sale by mid-1998 and end- 1998, respectively (second and third tranche conditions).  14 44. The Government will also carry out a study of the system of direct and indirect taxation and subsidization of agriculture. The study will include recommendations to render the agricultural tax and subsidy system more comprehensive, enforceable and market-friendly. It is also expected to recommend that a cap is put on annual subsidies and that support programs focus on efficiency enhancements. Completion of the study is a second tranche condition and implementation of its recommendations is a third tranche condition. F. Completing Enterprise Privatization 45. While land reform is key for agricultural development, broad-based economic growth necessitates growth in industry and in services. The creation of an enabling environment for such growth in Moldova requires accelerating privatization in urban areas. The process has already begun, with the successful mass privatization program. As a result of the mass privatization and the development of small private businesses, the private sector has increased its share in production of goods and services. Today, about 60 percent of industry, 70 percent of trade and services, and 44 percent of construction and transport is under private ownership. At the same time, 85 percent of public housing has been privatized. 46. The Government intends to privatize most productive assets which remain in State hands. The Government has a three-pronged strategy for enterprise privatization: (i) completing the mass privatization program to divest the State of any remaining shares in enterprises that were due to be privatized; (ii) privatizing urban real estate and creating a land market to encourage the growth of small and medium enterprises; and (iii) shifting from voucher privatization to cash privatization to help encourage domestic and foreign investment, promote rapid restructuring of privatized companies, and generate government revenues. 47. Moldova' s mass privatization program achieved its objectives, with the participation of around 3.1 million Moldovan citizens (90 percent of "patrimonial bond", or voucher, holders). Most citizens invested their "patrimonial bonds" in 1,142 medium and large joint stock companies (JSCs) and 1,093 small-scale enterprises (shops, coffee houses, etc.). The State, however, still holds shares in over 1,000 companies that were undersubscribed when their shares were offered. The Government is now selling these shares, and intends to complete the offer of at least 50 percent of the shares by mid- 1998. 48. The sale of leased premises and land under privatized enterprises is needed to encourage small private businesses, and to expand the real estate market. Privatization of land under privatized enterprises will support a faster restructuring of the enterprises, making them more attractive for local and foreign investors, and providing them with a collateral for bank lending. To date, about 2,000 leased premises have been identified as potential candidates for privatization. The sale of these leased premises has started-the Ministry of Privatization has received 74 applications for buying leased premises and has  15 approved and processed 48. A barrier to the acceleration of this process has been the unrealistically high normative prices for land. In May 1997, the normative prices for the privatization of land under privatized enterprises were reduced by Parliament. The Government proposes to allow buyers to pay for the land in installments for up to five years. 49. The results of cash privatization have been below expectations. Out of 190 small-sized enterprises approved to be privatized for cash, only 45 were sold in 1995, and 17 in 1996. To expand cash privatization, the Government has started implementing a more flexible pricing policy, and is reducing the starting price after the first auction if the small-sized enterprise is not sold. It is also holding a new type of auctions. On March 14, 1997, the first "Dutch auction" was held for the sale of small scale objects. In order to encourage the participation of Moldovan citizens in cash privatization, the Government has created a mechanism for selling a small number of shares to individuals, who may not be able to afford to buy large quantities. 50. The Government plans to privatize shares in hundreds of JSCs and other State Owned Enterprises (SOEs) that were left out of previous privatization programs. This is a difficult task even for a country with a developed capital market where the JSCs and SOEs have a business record. Each JSC or SOE will require a feasibility study in order to choose an appropriate privatization strategy, based on its size, profile and market condition. The privatization program supported by SAL II includes a large menu of privatization methods such as auctions, selling shares through the Stock Exchange, public offerings, trade sales, debt-equity swaps, and capitalization of the privatized enterprises. The Government is pursuing a program of institutional strengthening and technical assistance for the Ministry of Privatization. 51. The Privatization Program for 1997-1998 (97/98 PP) was approved by Parliament in July 1997. The 97/98 PP contains most of the productive assets still owned by the State, including: * Real estate: leased premises of small-sized enterprises, and the land under or adjacent to privatized enterprises; * Small-scale enterprises: both those approved earlier for cash privatization but remaining unsold, and those left out of previous privatization programs; a Medium and large enterprises: those left out of the previous privatization programs, and JSCs that have already been restructured; * Most State shares injoint stock companies; a Companies in the infrastructure sectors: including energy and telecommunications companies (the Government has retained an international investment bank, with EBRD support, to help privatize Moldtelecom through sale to strategic investors). 52. Implementation of the 1997-98 Privatization Program is a condition for the release of the second and third tranches.  16 PART III. THE PROPOSED LOAN A. The Proposed Loan is Central to the Country Assistance Strategy 53. The CAS of April 1996 presents a three-pronged assistance program aimed at supporting private sector development, strengthening public institutions and financial discipline, and improving social services and safety nets. In the CAS, agreement on a program for SAL 11 and its implementation are the triggers for the base case FY 96-98 lending program-1I projects totaling US $290 million. The justification is that the measures supported by SAL 11-payments discipline and completion of privatization and land reform-are necessary conditions for sustainable growth and creditworthiness. Without the SAL II reforms, the Bank's program would move to a low case. 54. SAL 11-supported policy reforms are also necessary for the success of Bank investment operations. Hardening the budget constraint facing enterprises and completing ownership change are needed for the success of Bank-supported Private Sector Development projects (PSD I and II). Land privatization and rationalizing the taxation/subsidization of agriculture would help achieve the objectives of the Agriculture I and II, Cadastre and Irrigation projects. Improving payments discipline and reducing government arrears-to energy enterprises as well as to teachers, doctors and pensioners-are critical for the success of the Energy and Education projects. 55. In turn, investment lending is designed to support the adjustment program Institution building and detailed conditions that are required for the success of the reforms under SAL II are supported by investment operations in the key sectors: PSD, agriculture, energy and the social sectors. The investment operations will accelerate the supply response to the policy changes, and expand political support for the reforms. 56. The proposed loan and credit amount is double the US $50 million proposed in the CAS, because it supports a broader and deeper program than initially expected. The need for a stronger program is driven by the unexpected worsening in the macro- economic situation in the second half of 1996-GDP fell by nearly 15 percent in the second semester and arrears doubled. The program has been strengthened in three key areas: reversing the build-up of budgetary and Social Fund arrears, privatizing the energy sector (which was not considered to be an option a year ago), and land reform and farm restructuring (where the Government wants to go deeper and faster than was expected at the time of CAS preparation). The depth of the reform program supported by SAL II implies an increase in its short term costs-eliminating budgetary and Social Fund arrears alone will cost the Government almost US$ 200 million. It also means that implementation of the reform program and disbursement of SAL II will require more time. Mainly because of the time needed to privatize the energy sector, carry out land reform, and develop the social consensus for pension reform, the proposed loan and credit are now expected to disburse over 18-24 months in three tranches. The CAS envisioned SAL II as a two tranche operation that would disburse over 9-12 months.  17 B. Benefits and Risks 57. Benefits: SAL II would provide the financial underpinning for the Moldovan Government's cross-sectoral reform program. It will have three fundamental benefits. First, the reform program supported by SAL II will address key bottlenecks, and enhance the prospects of long-term growth and improved living standards by setting in place a comprehensive program of reforms that will span the 1998 Parliamentary elections. Second, it will provide short-term budgetary support essential for maintaining the level of basic public services at a time of fiscal adjustment. The availability of low cost, non- inflationary budgetary financing will help consolidate Moldova's economic stabilization. Third, it will provide necessary foreign exchange to purchase imports critical for Moldova's economic activity while maintaining creditworthiness. Risks Mitigation Measures . Delays in policy implementation due to . Front-loading the core policy reforms as upcoming Parliamentary elections pre-Board conditions . A new Government with weaker . Extensive dialogue with broad elements ownership of the reform program could be of civil society, and a public education in place after the Parliamentary elections program, to build consensus for the reform program . Weak implementation capacity of * Essential elements of the TA program are Government already in place, and donor coordination meetings are regularly organized * Slow rebound in economic growth, due to . Front-loading the core policy reforms as delayed implementation of reforms or pre-Board conditions and focus on exogenous shocks implementation . Social mitigation programs in place as part of program 58. Risks: The operation has three important risks (Box 3). The greatest risk is political. With Parliamentary elections due in early 1998 (paragraph 10), it is possible that the reform process may be slowed or stalled. In case there is a new government, it might be less reform-minded than the present one, lack ownership of the SAL II program developed by its predecessor, and not implement it fully. There may also be delays in policy implementation during the months preceding the elections. The operation seeks to minimize the overall risk by ensuring that a major part of the reform agenda is front- loaded (Box 4). Most of the core reforms under the program have already been taken. The Government, with support from the Bank, has been carrying out an extensive dialogue with many elements of civil society. A public education campaign, including regular roundtable discussions led by the Resident Mission, has helped explain the reform program and build broad-based support for it.  18 59. The Government's reform program is very ambitious, and will require a great deal of institutional capacity for effective implementation. This is especially true for farm restructuring and energy sector privatization. The Government wants to move very quickly in these two areas and has set ambitious targets and deadlines. However, weak institutions and lack of experience could hamper implementation, and in turn delay release of the second and third tranches of SAL II. In order to minimize this risk, the Government has created a special Agricultural Restructuring Agency (ARA) and ensured the availability of sufficient technical assistance to carry out the program. In the area of energy sector privatization, technical assistance is being provided to the Agency for Enterprise Restructuring (ARIA) and a program for strengthening the Ministry of Privatization is being put in place. The Bank is helping the Ministry of Privatization with technical assistance proposals to support implementation of the 1997/98 PP. To help ensure arrears reduction, the Bank is cooperating closely with the IMF in monitoring the fiscal program of the Government. 60. The reform program supported by the proposed SAL II is designed to lay the foundations for a resumption of economic growth. But there is the risk that there will be a delay in the return to growth, pushing Moldova onto a less sustainable economic path. This could happen if reform implementation is slow, or if there is an exogenous shock affecting production (for example bad weather) or income (for example a deterioration in the terms of trade). If the resumption of growth is delayed by two to three years, even with structural reforms in place, the current account balance could worsen significantly, lifting debt indicators to unsustainable levels (for instance, debt-to-GDP ratios of over 70 percent, and debt service ratios of around 25 percent, by the year 2000). Continued economic decline could weaken the reformers in Government and erode support for the program. The program is designed to mitigate this risk by front-loading key reform conditions and concentrating on implementation. The program includes social mitigation efforts to cushion the worst-off in society, by ensuring that arrears to the population are paid promptly, pension reform ensures prompt payment of pensions, and the poor are shielded from the effects of increased energy prices.  19 Box 4: Moldova SAL 11: Actions Already Taken Under the Program Macroeconomic Stability . Adopted a realistic 1997 budget, and satisfactorily implemented it. * Improved revenue collections, ensured no increase in total arrears from 1997 general budget, and adhered to the guarantees ceiling. . Parliament adopted the general framework and the chapter on income taxes of the new Tax Code. * The Ministry of Finance mandated improved financial reporting by Govemment agencies, and the 1997 budget law included a mechanism for improving financial discipline of local govemments. * Started operations of the Strategic Studies Center Pension Reform: * Enacted a viable 1997 Social Fund budget. Covered the 1997 Social Fund deficit by a transfer from the State Budget, to ensure 1997 liabilities are timely. . Froze nominal pensions, reduced payroll taxes, and lowered administrative expenditures. * Continued timely payments to pensioners, and pension arrears reduced by about 60 percent. . Produced a draft strategy paper for reform of the public pension and social protection systems. Adopted Govemment resolution endorsing the condusions of the strategy paper and outining the directions of reforms of the public pension system * Established a permanent working group, for the preparation of a new law on non-state pension funds. Enerav Sector Reform: * Prepared a Debt-Management Plan (DMP) and restructured the stock of payables and receivables of electricity, gas and heating companies. * Increased, effective March and June 1997, the prices and tariffs of electdricity, heat and gas, to attain full cost recovery. . Started implementing the surcharge applicable to electricity consumption above the norms set by Govemment Resoluton 807 of December 1995. . Adopted a plan to de-monopolizethe distributionand marketing of oil productsby selling parts of the depots and transportassetsof Tirex Petrol to private investors. . Issued resolution to formally adopt Debt Management Plan (DMP) and adopted a schedule to fully eliminate cross subsidies in the energy sector. . Adopted detailed de-monopolization plan and the principles for privatizaton of the gas and electricity industries. . Established a national regulatory body for the energy sector as a non-govemmental organization. Agricultural Reforms: . Improved exit and registration procedures and performance standards for establishment of private farms. . Adopted process for providing fiscal and statistical identification numbers for farms registered at the local level, and simplified the farm registration process. * Reviewed farm restructuring pilot projects, disseminated the experiences and prepared a program to extend these projects to the national level. . Initiated functioning of the Agricultural Restructuring Agency for farm privatization and restructuring. . Moratorium on land sales removed by decision of Constitutional Court. . Established the National Agency for Geodesy, Cartography and Cadastre to implement national cadastre system. . Liberalized prices and marketing regimes. * Made progress in demonopolizing input supply and grain handling. . Completed first phase of privatization of agro-processing. . Amended the Law on the Normative Price of Land, for agricultural land, removed lease control for privately owned land and provided the legal framework for land sales. . Removed requirement that Rayon Executive Committees approve land allocatons for persons exiting ex-collective and state farms. . Initiated review of the systems of direct and indirect taxes/subsidies in agriculture. . Developed procedures to apply new public procurement system to grain purchases, and ensured grain exports do not require prior permissions. Privatization: * Prvatized 85 percent of public housing * A comprehensive privatization program for 1997/98 adopted by Govemment, and enacted by Parliament * Induded in the privatization program regulatons to allow Moldovans to participate in cash privatization by buying a small number of shares. . Held 'Dutch auctions', to ensure more flexible prices if firm is not sold at asking price. . Approved a resolution setting the mechanisms for the sale of shares still held by the State but approved to be privatized for patrimonial bonds. * Lowered the normative price of land under enterprises as agreed with the Bank. . Offered for sale 200 leased premises of small scale firms * Eliminated baniers to cash privatization of small-scale firms. * Prepared a technical assistance program, satisfactory to the Bank, to support the implementaton of the 1997/98 PP * Conducted a review of the functioning of the Share Registry and transferred privatized companies to that registry.  20 C. Bank Operations 61. The Bank's assistance program in Moldova has combined policy-based lending with investment operations, technical assistance and ESW. Policy lending has provided quick disbursing balance of payments funds in support of macroeconomic stabilization, price and trade liberalization, and the initial phase of structural reform, notably privatization, financial sector reform, and enterprise restructuring. Quick disbursing loans have included the US$ 26 million Drought Recovery project and the follow-up US$ 60 million Rehabilitation Loan, both approved in 1993, as well as the US$ 60 million Structural Adjustment Loan approved in late 1994. 62. Investment lending began in 1995 with the US$ 30 million Pre-export Guarantee Facility, which offers political risk insurance designed to attract working capital loans from abroad. The investment lending program accelerated in 1996 with the approval of a US$ 35 million loan for the Private Sector Development project, a US$ 10 million loan for the First Agriculture project, and a US$ 10 million loan for the Energy project. The first IFC investment in Moldova (US$ 10 million in INCON, a major agroprocessor) was approved in December 1996. Expansion of investment lending has continued in 1997, with a US$ 16.8 million loan for the General Education project, approved in April, a SDR 6.6 million IDA credit for the PSD II project, approved in June, and the US$ 23 million Cadastre project, scheduled for Board presentation in late 1997. Priority sectors for future investment lending include agriculture, PSD and the social sectors. Although US$ 81 million in investment lending has been committed to date, disbursements have been delayed by a number of factors, including the slowdown in structural reform in 1996, unfamiliarity with World Bank procedures, and a chronic shortage of counterpart funds. 63. The lending program has been complemented by a portfolio of grant funded technical assistance projects, ranging from the preparation of public procurement legislation to the development of modem enterprise accounting standards and the design of health care reforms. The country assistance program includes an active non-lending services program which mixes short policy notes on issues of immediate importance with in-depth macroeconomic and sector studies. A core component of the ESW program is the Poverty Assessment scheduled for completion in December, 1997. D. Financial Arrangements 64. Loan Amount and Borrower: The proposed Structural Adjustment Credit (SDR 32.6 million) and Structural Adjustment Loan (US$ 55 million) would be made to the Republic of Moldova, represented by the Ministry of Finance. Disbursements under the proposed Credit and Loan will be made to two accounts ("Deposit Accounts"), one each for the Credit and Loan, of the Ministry of Finance established at the National Bank of Moldova for this purpose.  21 65. The Credit will be on IDA terms, with a maturity of 35 years including a grace period of 10 years, and would be disbursed in two tranches: SDR 25.36 million (equivalent to US$ 35 million) immediately after effectiveness, and SDR 7.24 million (equivalent to US$ 10 million) to be disbursed upon satisfaction of second tranche release conditions (expected about June 1998). 66. The Loan would be made for 20 years, including a grace period of 5 years, at the standard interest rate for LIBOR-based US Dollar single currency, and would be disbursed in two tranches: US$ 25 million to be disbursed upon satisfaction of second tranche release conditions (expected about June 1998), and US$ 30 million to be disbursed upon satisfaction of third tranche release conditions (expected about March 1999). 67. Disbursements. The loan and credit will be released in three tranches, against satisfactory implementation of the adjustment program, include compliance with stipulated second and third tranche release conditions and maintenance of a satisfactory macroeconomic framework. Upon notification by the Bank of loan effectiveness and of second and third tranche release, the proceeds of the first, second and third tranches respectively of the Credit and Loan will be deposited by the Bank into the respective Deposit Accounts at the request of the Borrower. If after deposit into these account the proceeds of this Credit or Loan are used for ineligible purposes (i.e., to finance imports from non-member countries, or goods and services on the Bank's standard negative list), the Bank will require the Borrower to either; (a) return that amount to the account for use for eligible purposes; or (b) refund the amount directly to the Bank (in which case the Bank will cancel an equivalent undisbursed amount of the Credit or Loan). In accordance with the Operational Directive on the Simplification of Disbursement Rules under Structural Adjustment and Sectoral Adjustment Loans (February 8, 1996), disbursements will not be linked to specific purchases and, hence, there will be no procurement requirements. 68. Reporting, Accounting and Auditing. The National Bank of Moldova would maintain records of all transactions under the loan/credit in accordance with sound accounting practices. Although routine audits of the Deposit Accounts will not be required, the Bank reserves the right to require audits at any, time. 69. Closing Date. The closing dates of the proposed Credit and Loan will be December 31, 2000. E. Collaboration With IMF And Other Donors 70. Cooperation with the IMF on Moldova is very close. A SDR 135 million three year EFF was approved in May 1996. Although disbursements under the EFF were suspended in late 1996, a successful program review and implementation of agreed prior  22 actions put disbursements back on track in July 1997. The SAL II team collaborated with the Fund on the analysis of the 1997 State Budget and Social Fund. Members of the team participated in the February IMF review mission. Cooperation with other major donors is also excellent. The Governments of the Netherlands and Japan cofinanced previous Bank adjustment operations. The Netherlands Government, USAID, TACIS, and GTZ are cofinancing the PSD project. The Netherlands Government and USAID are providing technical assistance for the energy sector restructuring program. The Netherlands Government and TACIS are providing financial support to the Agriculture Restructuring Agency, and USAID is supporting the farm restructuring program. The TACIS program includes technical assistance for pension reform. The Bank and EBRD have worked closely together on PSD and the financing of the public investment program. The two institutions have also cooperated on the implementation of structural reform, notably privatization. The Bank is cooperating with UNDP on the development of a poverty alleviation strategy and the establishment of the Strategic Studies Center. PART IV. RECOMMENDATION OF THE PRESIDENT 71. 1 amn satisfied that the proposed credit and loan would comply with the Articles of Agreement of the Association and the Bank, respectively, and I recommend that the Executive Directors approve it. James D. Wolfensohn President by Caio K. Koch-Weser Washington, DC August 18, 1997 Attachments  Annex I Table 1: Moldova: Main Economic Indicators Table I of 4 1995 1996 1997 1998 199 2000 2001 2002 2003 2004 2005 2006 Real Growth Rate GDP 3.0%/o -10.0% 1.2% 3.0% 4.5% 5.0% 4.9% 4.8% 4.7% 4.6% 4.6% 4.5% Consumption 0.0%/o 4.8% 5.6% 6.1% 5.3% 4.9% 3.1% 2.4% 2.8% 3.1% 3.5% Inflation (average) 35.5% 20.8% 14.4% 9.0% 5.6% 5.1% 5.1% 5.0% 5.0% 5.0% 5.0% 5.0% Inflation (end of period) 29.5% 17.6% 11.7% 7.3% 5.4% 5.1% 5.0% 5.0% 5.0% 5.0% 5.0% 5.00/4 Exports (GNFS) 8.2% 7.7% 7.5% 8.3% S.3% 7.6% 6.7% 5.9% 5.3% 5.0% 5.0% Imports (GNFS) 18.1% 6.2% 5.3% 4.7% 4.7% 4.8% 4.8% 5.0% 5.0% 5.0% 5.0% o/w: Energy 7.8% 0.6% -1.1% -2.8% -1.0% 0.2% 1.6% 2.5% 2.5% 2.5% 2.5% 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 As % GDP Exports 50.9% 51.9% 49.2% 47.6% 47.2% 47.2% 48.3% 49.0% 49.5% 49.6% 49.7% 49.8% Imports 59.8% 66.1% 61.2% 57.4% 54.4% 52.1% 51.2% 50.6% 50.1% 49.6% 49.2% 48.9%6e Resource Balance -8.9% -14.2% -12.0% -9.% -7.3% 4.8% -2.9% -1.5% -0.6% 0.0% 0.5% 0.9% Current Account -8.6% -13.1% -11.1% -10.4% 8.6% -6.8% -5.6% -4.6% -4.0% -3.7% -3.3% -3.0% Gross Domestic Saving 20.90/o 14.1% 12.4% 10.6% 9.0