Tajikistan - Structural Adjustment Credit Project

Document of The World Bank FOR OF:FICIAL USE ONLY Report No. P- 7253 -TJ REPORT AN;D RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUrIVE DIRECTORS ON A PROPOSED STRUCIURAL ADJUSTMENT CREDIT IN AN AMOUNT SDR 37.1 MILLION TO THE REPUBLI]C OF TAJIKISTAN June 25, 1998 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 (as of June 25, 1998) Currency Unit Tajik Rubles TR I US$0.0013 US$ TR 754 PERIOD AVERAGE EXCHANGE RATES The Tajik Ruble replaced the Russian Ruble on May 10, 1995, at an initial conversion rate of TR = Rus RI O Russian Rubles per US $ 1 Tajik Rubles per US $1 1993 932 1995 95 1994 2,192 1996 300 1997 748 (end of period) WEIGHTS AND MEASURES Metric System ABBREVIATIONS AND ACRONYMS ARSP - Agriculture Recovery and Social Protection CAS - Country Assistance Strategy CIS - Commonwealth of Independent States CNR - Commission for National Reconciliation ESAF - Enhanced Structural Adjustment Facility FSU - Former Soviet Union GNP - Gross National Product IBTA - Institution Building Technical Assistance IAS - International Accounting Standards IDA - International Development Association IDF - International Development Fund IFC - International Finance Corporation MoF - Ministry of Finance IMF - International Monetary Fund NBT - National Bank of Tajikistan PCRC - Post-Conflict Rehabilitation Credit PCERC - Post-Conflict Emergency Reconstruction Credit PFP - Policy Framework Paper PPAP - Pilot Poverty Alleviation Project RCPT - Republican Corporation of Pakhteh Tajik SPC - State Property Committee TADAZ - Tajik Aluminum Plant TBB - Tajikbankbusiness UNDP - United Nations Development Project UTO - United Tajik Opposition VEB - Vnesheconombank TAJIKISTAN - FISCAL YEAR January 1 - December 31 Vice President: Johannes Linn. ECAVP Country Director: Ishrat Husain, ECCOl Sector Director: Pradeep Mitra, ECSPE Sector Leader: Robert J. Anderson, ECSPE Task Team Leader: M. R. Ghasimi. ECSPE  FOR OFFICIAL USE ONLY REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNAI'IONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED STRUCTURAL ADJUSTMENT CREDIT IN AN AMOUNT ]EQUIVALENT TO SDR 37.1 MILLION TO THE REPUBLIC OF TAJIKISTAN CONTENTS Credit Summary ............1 I. RECENT ECONOMIC DEVELOPMENTS AND PROSPECTS . 3 A. Recent Security and Political Situations .4 B. Recent Economic Developments .5 C. Medium Term Economic Prospects .6 II. THE GOVERNMENT'S ECONOMIC REFORM PROGRAM . 7 A. Macroeconomic Stabilization .7 B. Structural Reforms .8 III. FEATURES OF THE PROPOSED CREDIT .15 A. Objectives and Features of the Credit .15 B. Country Assistance Strategy and Rationale for Bank Involvement .18 C. Implementation Arrangements .18 D. Monitorable Actions and Tranche Release Conditions .19 E. Benefits and Risks .21 IV. RECOMMENDATION .22 ANNEXES: Annex 1: Letter of Development Policy Annex 2: Key Economic Indicators Annex 3: Timetable of Key Processing Events Annex 4: Status of Bank Group Operations Annex 5: Tajikistan at a Glance MAP IBRDNo. 25721 This documentation 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.  REPU:BLIC OF TAJIKISTAN Proposed Structural Adjustment Credit Credit Summary Borrower: Republic of Tajikistan Amount: SDR 37.1 million (US$50 million equivalent) Terms: IDA terms, with 40 years maturity, including a 10 year grace period. Commitment Fee: Variable rate, between 0.0-0.5 percent of the undisbursed credit balance, set annually by the Executive Directors of IDA and beginning 60 days after signing. Executing Agency: Office of the Prime Minister Objectives: The proposed credit's main objectives are to support the Government's efforts to: (i) restore macroeconomic stability by providing foreign exchange that will help maintain essential imports and non-inflationary financing for budget; (ii) develop the private sector through privatization of state-owned enterprises; (iii) promote an efficient banking system; and (iv) enhance budgetary provisions for health, education and social safety net. Benefits: Major benefits of the proposed credit include: (i) further progress toward sustained stabilization and growth; (ii) financing imports critical to economic activity through balance of payments and budgetary support; (iii) fostering private sector development and more competitive banking, transport, construction and cotton sectors; and (iv) increased budgetary provisions for health, education and social safety net. Risks: The proposed credit's main risks center on: (i) deterioration of the political and security environment; (ii) the Government's limited implementation capacity; (iii) policy slippage due to opposition to reforms by vested interests; and (iv) a high level of external debt, combined vvith weak external debt management. Signing of the peace agreement has led to improvement of the country's political situation. Additionally, Government's efforts to foster economic recovery will facilitate national reconciliation and help lessen the political risk associated with the reform process. Support provided by the Institution Building Technical Assistance Credit will help the Government to overcome its limited implementation capacity. Various stakeholders will be fully informed of the nature of the reform process and opportunities available under the proposed credit and will be brought into the reform program's design and implementation to the extent possible. Risks will also be reduced  by intensification of the authorities' efforts to reschedule agreements with Tajikistan's external creditors; external assistance in the form of generous debt relief and sustained balance of payments support on concessional terms; and creation of the external debt management unit in the Ministry of Finance. Rate of Return: Not applicable. Poverty Category: Budgetary allocations for health, education and social safety net are expected to increase under the proposed credit. Appraisal Report: Not applicable. Disbursement: The proposed credit would be provided in two tranches. The first would become available upon credit effectiveness and the second upon fulfillment of the second tranche conditions. Disbursements will be deposited in a Government account without need for evidence of imports of eligible goods. The borrower will undertake not to use the proceeds for items covered in the negative list and to have the account audited upon IDA's request. Map: IBRD No. 25721 Project ID Number: TJ-PA-47438  REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A STRUCTURAL ADJUSTMENT CREDIT TO THE REPUBLIC OF TAJIKISTAN I. I submit for your approval the following report and recommendation on a proposed Structural Adjustment Credit (SAC) to the Republic of Tajikistan in the amount of SDR 37.1 million (US$50 million equivalent) to support the Government's reform program. The credit would be on standard IDA terms, with a 40 year maturity, including a 10 year grace period. The SAC is proposed in the context of a three-year Policy Framework Paper 1998-2001, and a multi-year economic program to be supported by an IMF Enhanced Structural Adjustment Facility (ESAF). The proposed SAC is consistent with the Country Assistance Strategy (CAS) discussed by the Board of Directors on May 12, 1996, and a new CAS, to be discussed by the Board in conjunction with this operation. 2. Tajikistan became a member of IBFD and IDA in June 1993, and of IFC in 1994. To date, World Bank Group assistance has consisted of policy advice, an IFC investment in Zarafshan Gold Company, and five IDA operations. These operations were: (i) Institutional Building Technical Assistance (IBTA), approved May 1996; (ii) the Agricultural Recovery and Social Protection (ARSP) Credit, approved September 1996; (iii) the Pilot Poverty Alleviation Project (PPAP), approved April 1997; and (iv) two post-conflict credits, approved on December 16, 1997 and January 29, 1998. In August 1997, the Bank provided an Institutional Development Fund (IDF) grant to Tajikistan to finance an external debt advisor to strengthen the Ministry of Finance's capacity for external debt management. A Country Economic Memorandum was issuedi in August 1994. At the Government's request, the World Bank organized the first Consultative Group (CG) meeting for Tajikistan in Tokyo on October 31, 1996, followed by a second CG meeting in Paris on May 20, 1998. 3. In addition to its immediate role in providing assistance to the budget and the balance of payments, the proposed SAC supports the following principal objectives of Tajikistan's reform program: (i) developing the private sector and reducing the state's role in economic and commercial activities through privatizing state-owned enterprises; (ii) promoting an efficient banking system through restructuring major banks; and (iii) mitigating adjustment's adverse impact on the poor by increasing budgetary provisions for health, education and social safety net. I. Recent Economic Developments and Prospects 4. As one of the poorest country in thle Former Soviet Union (FSU), Tajikistan had an estimated 1997 per capita income of US$330. Severity percent of the country's 6 million people reside in rural areas. The population is large relative to the available arable land. The country is mostly mountainous and only 7 percent of its 143,000 square kilometers is arable. The economy is rural; agriculture contributed about 34 percent of GDP and 50 percent of employment in 1997. Tajikistan's main agricultural products are cotton, which accounts for about half of total agricultural production; vegetables; grains; and livestock. These products, especially cotton, are heavily dependent on exports - 3 -  and external markets. The industrial sector accounted for about 24 percent of GDP and 15 percent of employment in 1997 and is dominated by over 7000 state-owned enterprises. The availability of hydro- electric power has influenced the pattern and structure of this sector, with aluminum, chemicals and other energy-intensive industries the sector's mainstays. Plagued by shortages of spare parts and raw materials, many industries operate only a few months a year and the country's main exporting industry, the Tajik Aluminum Plant (TADAZ), has been running at about half capacity. 5. Tajikistan's economy was shattered by a civil war that inflicted extensive human and physical devastation. This conflict combined with the breakup of the FSU and severe floods, resulted in a roughly 50 percent decline of Tajikistan's GDP during the first half of the 1990s. Additionally, imprudent borrowing immediately after the FSU's collapse created a crushing debt burden. By the end of 1997, the country had accumulated (mostly assumed on commercial terms between 1992 and 1994) US$1,039 million of external debt (about 96 percent of GDP). About 70 percent of the total debt is owed to CIS creditors (including $289 million to Russia). Debt to other official bilateral creditors accounts for 25 percent of Tajikistan's total external debt. Since 1996, the Government, in consultation with the IMF, has adopted an external debt management strategy aimed at regularizing relations with its external creditors and reducing the external debt burden over the medium term, compatible with the country's ability to pay. The Government has entered into debt rescheduling agreements with Russia, Kazakhstan, Uzbekistan, Kyrgyz Republic and Turkey. By the end of first quarter 1998, the outstanding external arrears to India, Russia and the United States were US$2.7 million. Arrears to Russia and the United Sates were settled in April 1998; those related to India are expected to be settled shortly. A. Recent Security and Political Situations 6. Since its independence from the FSU in 1991, political instability and civil conflict have wracked Tajikistan's economy. Armed conflict erupted in May 1992, as different regional and political interests struggled for power after the previous system's collapse, and continued for five years, with major hostilities concentrated in 1992 and 1993. On June 27, 1997, the Government of Tajikistan and the United Tajik Opposition (UTO) signed a peace agreement laying the foundation for peace and security and establishing a 12-18 month transition period, during which the peace agreement's provisions are expected to be fully implemented. 7. One year after signing the peace agreement, implementation is broadly on track but progress on some specific aspects has been slow. While refugees from Afghanistan have been repatriated sooner than originally expected, delays have occurred in implementing the agreement's provisions on military issues and integrating UTO members into the Government structure. Additionally, adoption by the Parliament (Majles Oli) on May 23, 1998, of a law that imposed restriction on political parties with religious connection created tensions between the Government and the UTO. The security situation continues to be fragile with frequent incidents of violence attributed to political groups that remain outside the political framework created by the peace agreement. Parliamentary elections that were scheduled for September 1998, have been delayed. Although the peace process has been uneven and the rivalry between the Government and the UTO continues in various forms, the two are fully committed to making the peace agreement work. In February 1998, the President and the UTO leader agreed to appoint UTO representatives as the ministers of economics, labor and employment, water resources and land improvement and head of the customs committee. The Government and the UTO leader have agreed to create an ad hoc crisis management group to deal with incidents of violence. Agreement has also been reached to amend the law on political parties to allow parties of religious character to operate freely in Tajikistan. Hence, while Tajikistan remains in a post-conflict situation and is characterized by high risk, -4-  there has been an improvement in political condition and there is cause for some optimism to allow the Government to begin focusing again on implementing its medium term economic reform program. B. Recent Economic Developments 8. Output Trends. 1997 GDP growth is estimated at 2 percent, the first positive rate since 1991. The end of the civil war has helped GDP rebound from its low level of 1996. The growth was driven by increased agricultural production, especially a 15 percent increase in the cotton harvest due to the availability of private external financing to help plant and harvest the cotton crop, and trade and price liberalization. Fruit and vegetable production also increased, due to liberalization of domestic marketing and prices and land distribution to private farners. It is estimated that while 17 percent of non-irrigated agricultural land was in private hands, personal plots accounted for an estimated 45 percent of agricultural production. On the other hand, industrial output declined by 2.5 percent in 1997, despite expanded activities in textiles and gold mining. Aluminum production remained unchanged at around 200,000 tons and prospects for the aluminum plant remained uncertain, due to a shortage of skilled manpower, the plant's heavy indebtedness and the need for considerable investment. GDP growth is estimated to have continued in first quarter 1998 at 1.3 percent over the corresponding period of 1997. 9. Financial Stabilization. Progress in financial stabilization was mixed in 1997. While major slippages characterized the first half of the year, the improved political environment contributed to marked economic progress in the second half of 1997. Faced with large, unanticipated fiscal pressures, the budget deficit exceeded the 1996 level of 5.8 percent of GDP, rising to around 10 percent of GDP in the first half of 1997. By the end of June 1997, social safety net arrears had increased to TR 5.1 billion-- about one-third of total state expenditure arrears, 1.0 percent of GDP, and equivalent to 8 months of entitlements. Reserve money increased by 115 percent and broad money by 50 percent during the first half of 1997. The Tajik ruble depreciated sharply in nominal terms in the official markets, from an average rate of TR 300 per US dollar in 1996 to TR 541 by the end of June 1997. Inflation was 52 percent during the first half of 1997, compared to 40 percent during all of 1996. 10. With the restoration of political stability in the second half of 1997, the Government attempted to re-establish financial discipline by removing some of the controls imposed on the economy. It reactivated the foreign exchange auction, eliminated foreign exchange credits by the Ministry of Finance (MoF), introduced a uniform low tariff rate of 5 percent, eliminated export taxes, established a credit auction and made satisfactory progress in macroeconomic stabilization by considerably tightening fiscal and monetary policies. As a result, the inflation rate declined from 20 percent in July to 2.3 percent in December 1997 and to 1.3 percent in the first four months of 1998. The budget deficit for 1997 as a whole declined to less than 3.5 percent of GI)P and reached 1.6 percent of GDP during the first quarter of 1998. The official nominal exchange rate remained broadly stable since September 1997, and the real exchange rate appreciated by 12 percent during the same period. This noticeable progress led to approval of two purchases of SDR 7.5 million each under the IMF Post-Conflict Emergency Assistance, on December 18, 1997 and April 1, 1998, reslpectively. Tajikistan's economic reform program was also supported by the World Bank Post-Conflict Rehabilitation Credit (PCRC) and the Post-Conflict Emergency Reconstruction Credit (PCERC) of US$10 million each, approved on December 16, 1997 and January 29, 1998. -5-  C. Medium Term Economic Prospects 11. Tajikistan's medium term economic prospects have been improved by increased political participation resulting from the peace agreement, the re-establishment of the Government's role throughout the country, and Government and UTO consensus on the need to pursue macroeconomic stabilization and structural reforms. If this constellation of factors continues for the next 2-3 years, economic growth should take firm root and reduce the economy's present fragility and vulnerability. The development of trust and reconciliation among different ethnic groups and the build up of social capital are absolutely essential for sustainable and equitable development, but this poses a dilemma. Widespread poverty, large reconstruction and rehabilitation needs in the aftermath of the civil conflict, and reconciliation itself demand large budgetary outlays, but the limited tax base and weak administrative capacity have reduced revenue collection. Foreign development assistance, which has bridged the financing gap in other countries, has been negligible in the case of Tajikistan. To a large extent, Tajikistan's medium term prospects will depend on both successful implementation of macroeconomic and structural reforms, and the availability of external economic assistance to provide a catalyst for reconciliation, peace and sustained growth. 12. Several factors bear upon Tajikistan's medium term prospects for growth in output and employment. First, improved economic efficiency resulting from successful implementation of structural reform, increased capacity utilization, and higher levels of investment, including direct foreign investment in privatized enterprises, should help revive economic growth. Agricultural activities will remain the main source of growth in the medium term. Price and marketing liberalization in this sector and adequate input supplies, such as fertilizer, should help agricultural output recovery. Privatization of state-owned enterprises and transfer of ownership of assets from the public to private sector will create the necessary environment for industrial output recovery. Deepening reform in the legal and regulatory framework is expected to facilitate growth of the services and trade sectors. Second, successful implementation of the peace agreement and reconstruction of war-damaged infrastructure will open the center-east of the country (Karatigin and Tavildara valleys) to the rest of Tajikistan and create an opportunity to expand domestic trade. Third, the country's improved relationship with Uzbekistan will help expand regional international trade and improve the security situation. Taking all these factors into consideration, GDP growth is expected to be about 3.5 percent in 1998 and remain at around 4.0 percent during 1999-2000. 13. Tajikistan's medium term balance of payments outlook remains difficult, as reflected in Table 1. Financing requirements are expected to rise to facilitate some recovery in reserves, which have been under considerable pressure over the past few years, and to meet the high import bill for war recovery and rebuilding the economy. With a planned reserve increase of US$66 million and regularization of US$111 million of external debt, the financing items for 1998 are expected to be about US$177 million. With an overall balance of payments deficit of US$17 million, the financing gap for 1998 will be US$194 million. The financing gap will be filled by IMF support under an ESAF arrangement (US$49 million); the disbursements of the first tranche under the proposed SAC (US$20 million equivalent); US$10 million expected from the Asian Development Bank, and the anticipated rescheduling of external arrears of US$115 million assumed to be rescheduled at a 2.8 percent rate of interest and repaid over the 2000- 2009 period. At the Consultative Group meeting in Paris on May 20, 1998, donors pledged some $280 million for Tajikistan's development program over the next 18 months and some $60 million for humanitarian assistance, food aid and other official flows. In order for Tajikistan to attain a viable balance of payments position and avoid further output decline in the economy, the international donor community will need to sustain its financial support over the medium term. - 6 -  Table 1: TAJIKISTAN: BALANCE OF PAYMENTS, 1997-2000 (In millions of US dollars) 1997 1998 1999 2000 Current Account -60 -56 -62 -70 Exports 746 762 849 939 Imports 759 768 854 944 Services (net) -47 -50 -57 -65 Capital Account 27 40 19 38 Overall Balance -33 -17 -42 -32 Financing items 33 -177 -55 -58 Financing gap 0 194 97 90 Current Account (% of GDP) -5.5 -4.5 -4.1 -4.1 Overall Balance (% of GDP) -3.0 -1.3 -2.8 -1.9 External debt (% exports) 202 215 197 189 External debt service (% exports) 13.9 9.8 8.5 11.7 Gross reserves ( in months of imports) 0.6 1.7 2.5 3.0 Real GDP (% change) 1.7 3.5 4.0 4.0 Source: IMF HI. The Government's Economic Reform Program 14. Tajikistan began economic refoim later than other FSU republics, adopting its first comprehensive economic reforn program in November 1995. The country's reform program concentrates on: stabilizing the macroeconomic situation and implementing structural reforms with particular emphasis on privatization and agricultural restructuring. A. Macroeconomic Stabilization 15. Tajikistan's first comprehensive alttempt to restore macroeconomic stability began in 1996. Supported by an IMF stand-by arrangement and the World Bank's ARSP credit, the Government implemented tight monetary and fiscal policies to control inflation. Exchange and trade policies were liberalized and price controls were substantially removed. The results were promising; inflation declined to 40 percent during 1996, compared withi 2000 percent during 1995. Program implementation was satisfactory until late 1996, when defense expenditures increased significantly in response to renewed fighting. The increased defense expenditures were financed by a combination of monetary expansion and budget arrears, including significant amounts owed to the social safety net. 16. Since the peace agreement was signed on June 27, 1997, the Government has made good progress in stabilizing the macroeconomic environment. Fiscal and monetary policies have been tightened, and foreign exchange auctions were restarted in late July 1997. These efforts have borne fruit, with most economic indicators showing drarnatic improvement during the second half of 1997 (para.10). -7-  17. Available information confirms that the financial performance for end-December closely adhered to IMF program targets. Consumer prices increased by 2.3 percent in'December 1997, compared with a program target of 4.6 percent. Satisfactory control of inflation continued in early 1998. The average monthly increase in consumer prices during the first four months of 1998 was only 1.3 percent. Fiscal performance was also better than anticipated, with all fiscal targets for end December 1997 having been met. Overall, satisfactory fiscal performance was the key to improved macroeconomic stability. In the first quarter of 1998, the budget deficit was 1.6 percent of GDP, compared with a program target of 4.6 percent. All of these factors have contributed to a stable official nominal exchange rate since September 1997. 18. The Government's main macroeconomic objectives during the remaining months of 1998 are: stronger balance of payments; continued economic growth; and control of inflation. Higher gross international reserves, from two weeks of imports at the end of 1997 to six weeks by end 1998, are targeted. The planned budget calls for the deficit to decline from 3.3 percent of GDP in 1997 to 2.8 percent of GDP in 1998. Measures to increase revenues include further elimination of exemptions and improved tax collection. Despite implementation of these measures, urgent need to repair the recent flood damage has confronted the Government with a difficult challenge to attain the planned fiscal deficit reduction. Successful implementation of the program is expected to result in real GDP growth of about 3.5 percent and a 17 percent inflation rate by the end of the year. B. Structural Reforms 19. Current structural reforms in Tajikistan focus on (i) liberalizing prices and restructuring the agricultural sector; (ii) privatizing state-owned enterprises; (iii) promoting an efficient financial sector; and (iv) protecting the social safety net and social sectors. Liberalizing Prices and Restructuring the Agricultural Sector 20. The Govemment has tried to slow the economic decline and increase employment opportunities, household income and foreign exchange earnings by focusing on structural changes in agriculture, the backbone of the Tajik economy. Agricultural reform has emphasized liberalization of agricultural prices and marketing and the restructuring of state collective farms. In 1996, the Government removed price controls and abolished the state order system for all agricultural commodities. Rents, communal services, transportation and water usage charges are still subject to price control. 21. Cotton is the most important agricultural commodity in Tajikistan. Efforts to liberalize its production and marketing system have been mixed. Beginning in 1996, while agricultural producers have benefited from higher cotton prices as a result of the 1996 liberalization, in late 1996, the Government re-imposed some restrictions on cotton exports, which hindered the development of private trade in cotton. In September 1997, the Government again eliminated these restrictions and simplified cotton export mechanisms. The cotton marketing agency (Glavklopkoprom) was transformed into the Republican Corporation of Pakhteh Tajik (RCPT), and other trading companies were allowed to compete with RCPT. The creation of the Land Reform Committee has removed the land reform process from the exclusive domain of the Ministry of Agriculture and given it greater visibility and political support. In late 1996, a land code, creating the legal framework for farm restructuring, was approved by the Majles Oli. The Land Code's four major principles are: (i) transparent and equitable criteria for selecting farmers to acquire land use rights; (ii) unrestricted transfer of land access rights; (iii) conversion of all land controlled by state and collective farms to private farms operated under life-long inheritable lease; - 8 -  and (iv) reliance on Local Land Committees; to allocate state and collective farm assets. Progress on farm restructuring has been slow due to the civil conflict and uneven political commitment to land reform. The Government plans to accelerate its farm restructuring program, liquidate the RCPT, sell all its assets and transfer supervision of seed production and cotton grading to the Ministry of Agriculture, privatize all cotton ginneries and undertake a number of other measures to strengthen agricultural sector reform. Privatization of State-owned Enterprises 22. After a promising start in late 1991, the civil conflict largely halted the privatization process. From 1993 through 1997, program implementation was restrained by continued political instability, lack of a national currency, weak commitment to the program and lack of institutional capacity. By the end of 1997, 2,414 (or 44%) of 5,440 enterprises proposed for privatization, were privatized of which 85% were in the service and trade sectors and all but one were small-scale enterprises. The Government considers private sector development an essential aspect of the reform program and seeks to achieve this by developing the legal framework and accelerating privatization of small-scale enterprises and the cotton processing sector. Over the medium term, the Government intends to extend privatization to medium and large enterprises, strengthen the business environment and promote capital market development. 23. Legal Framework for Accelerated Privatization and Private Sector Development. The legal framework for privatization has undergone a number of changes since 1991. The first Privatization Law (1991) was very restrictive regarding the enterprises and sectors targeted for privatization. It established a bottom-up approach and required the labor collectives to initiate the privatization process. Approval was required from those who had shown the least willingness to relinquish control over the enterprises they supervised, namely, enterprise directors, line ministries and local officials. When sales did occur, non-competitive transfer to the collective was the main method of privatization. 24. To overcome problems experienced during the first phase of privatization, the Privatization Law was amended in November 1995 to expand significantly the scope of enterprises and sectors proposed for privatization, give the Government control over selection of enterprises to be privatized, and simplify valuation procedures. On May 16, 1997, the Majles Oli approved a new Law on Privatization that provided for a much simplified and accelerated privatization program. The new law eliminated the privileges granted to collectives, introduced competitive and transparent methods of privatization, further simplified the valuation process and introduced market-based pricing. With technical assistance provided under the IBTA credit, the State Property Committee (SPC), prepared regulations to implement the new law, including regulations on auctions and tenders, valuation, segmentation, incorporation procedures, sale of unfinished construction and share registries. 25. During the early years of independence, the Government made progress in establishing the legal foundation for a private and market-oriented economy. The Majles Oli passed laws on Property Rights, Joint Stock Companies, Bankruptcy, Foreign Investment, Securities and Stock Exchange and a new Civil Code. While this set of commercial laws represents a sound start to establishing the legal framework required for transition to a market economy, gaps and inconsistencies exist in several of these laws. 26. The Universe of Enterprises. The Law on Privatization divides enterprises into three groups: those proposed for privatization; those proposed for privatization by special decision of the Government (primarily infrastructure, hospitals, clinics, pharmacies, schools, road repair, and other public services); and those not proposed for privatization (primarily defense establishments, flora, fauna, radioactive materials, minerals and cultural entities). Enterprises are further classified into three size categories, with -9-  privatization methods differing depending upon size classification. Enterprises with 1-99 working spaces are considered small-scale and are sold only through auctions, which are organized at the local level. Enterprises with 100-199 working spaces can be classified as either small-scale or large-scale for privatization purposes. Enterprises with more than 200 working spaces are considered large-scale and must be sold through auction, tender or case-by-case methods. The program to which the Government agreed under the SAC addresses only enterprises proposed for privatization. Table 2 delineates the enterprise classifications. Table 2: Enterprise Classification Working Total Proposed Proposed for Not Privatized To be Spaces for Privatization Proposed Privatized Privatization by Decision for Privatization 0-99 6024 4641 912 471 2413 2228 100-199 658 492 97 69 26 466 >200 627 281 263 83 1 280 Total 7309 5414 1272 623 2440 2974 27. As of January 1998, 2413 of 4641 small-scale enterprises proposed for privatization were privatized. By May 15, 1998, the Government had sold another 540 small-scale enterprises and plans to complete privatization of all small-scale enterprises before the end of the first quarter of 1999. There are 492 enterprises with 100-199 working spaces proposed for privatization, of which 26 are privatized, leaving a total of 466 to be privatized. In general SPC will treat enterprises in this group as large-scale enterprises for purposes of selecting the privatization method. As of January 1998, there were 281 enterprises with more than 200 working spaces proposed for privatization, of which only one had been privatized. Since SPC intends to treat all enterprises with more than 100 working spaces as large, in effect, as of January 1998, 746 large enterprises remained to be privatized (466+280). The Government plans to privatize at least 120 of these large enterprises before the end of the first quarter of 1999 and complete privatization of large enterprises by the end of 2001. 28. Under the new Instruction on Valuation, adjusted book value serves as the reference price for auctions. Because accounts are not always up to date, book values are adjusted for inflation with standardized coefficients provided by the Statistics Agency. Under the Regulation on Auctions and Tenders, SPC must first offer enterprises through English-style auctions, where adjusted book value serves as the starting price and bids rise until no further bids are made, with the enterprise sold to the highest bidder. If an enterprise remains unsold after two English auctions, the Regulation allows SPC to switch to Dutch-style auctions, where the starting price is at least five times adjusted book value and offer prices fall until the first bid is made; the enterprise is sold to the first bidder. The minimum price allowed by regulation for any auction is 50 times the minimum wage (about $50). The new valuation method greatly simplifies the process and will enable SPC to carry out valuations much faster. The new auction regulation's pricing arrangements will put final prices within reach of many Tajiks and enable SPC to privatize larger numbers of enterprises over shorter periods of time. 29. All large enterprises must be converted into open joint stock companies as a first step in privatization. The Government has made many important changes to the incorporation procedure, which is now much faster because it is a top-down process and because the state becomes a 100 percent - 10-  shareholder from the moment of incorporation. Since collectives no longer have any special purchase rights, their decision is no longer required. The founders' agreement and need for a shareholders meeting have also been eliminated, since there is only one founder and one shareholder, the state. A sales agreement is not needed because no sale takes place upon incorporation. Within three days of being informed that their enterprise is to be transformed into a corporation, directors must establish a commission that must submit all necessary documents to SPC or the local authority (depending upon whether the enterprise is Republican or Communal property) within 30 days. These new procedures have enabled SPC to incorporate enterprises in much less time. As of May 1998, 123 of the 746 large enterprises remaining to be privatized have been corporatized. The Government plans to corporatize all remaining large enterprise by the end of the first quarter of 1999 as part of its program for completing privatization by end-2001. 30. Privatization of Unfinished Construction. SPC currently estimates that there are approximately 800 unfinished construction sites throughout Tajikistan. Construction work on these sites stopped when the civil conflict began and could not be completed due to fiscal constraints. The Government is anxious to transfer 350 of these sites which are at various stages of completion, to private owners as quickly as possible to prevent further deterioration of these assets, create employment opportunities in the construction sector, and expand the stock of business premises available to the private sector. 31. The Government recently issued a decree to allow the 350 unfinished construction sites subject to privatization to be sold through auction rather than tender, which was the previous method applied to unfinished construction. Fifty of these sites were intended to provide social services to local communities, such as schools or clinics. The Government will require buyers of these sites to implement specific contractual conditions to provide these services. 32. Trucking Privatization. Privatization of the state-owned trucking fleet is a Government priority in order to increase competition in the transport sector and promote efficient operation of transport services. Best available estimates indicate that there are about 50,000 transport vehicles under state ownership, of which only 50 percent are functioning. These vehicles are currently under the control of line ministries (particularly the Ministry of Transport), republican and communal enterprises and farm collectives. The Government strategy is to privatize the state-owned trucks in a manner that maximizes competition, thereby promoting greater efficiency and lower costs in this sector, which has such a profound impact throughout the economy. The Government therefore plans to break up monopolies and promote competition in the large trucking operations prior to privatization. 33. Privatization of Cotton Ginneries. The cotton sector is one of Tajikistan's most important sectors and has been undergoing liberalization over the last few years. Cotton production is an essential source of foreign exchange and significant numbers of farmers depend upon it as their primary source of income. Privatization of the ginneries will htelp promote efficiency and make the gins more responsive to farmers' needs. Gins will be able to compete with each other for raw cotton, leading to lower ginning tariffs and higher producer prices. Since privatized ginneries will be responsible for their own repairs and maintenance and not be dependent on a centrally run bureaucracy, they will be able to maintain their equipment more efficiently. Although Government Decree No. 203 of May 1996, called for all cotton ginneries to be privatized by the end of 1997, only one ginnery belonging to the Republican Corporation of Pakhteh Tajik (RCPT) and one under the control of a state farm have been privatized; three others are owned by farm collectives. Thus, 23 ginneries remain to be privatized by the first quarter of 1999. Minority shares in eight of these have been sold to the collectives. - 11 -  34. Restructuring Glavkhlopkoprom. Glavkhlopkoprom was the state-owned organization involved in processing, storing and marketing Tajikistan's cotton. It reported directly to the Cabinet of Ministers, and until 1996, had a monopoly over cotton marketing. Since 1996, it has competed with foreign and local buyers in purchasing cotton fiber and carried out its services of acceptance, ginning and storage on a contract basis. On September 18, 1997, the Government transformed Glavkhopkaprom into RCPT, which is responsible for: (i) providing technical management to and rehabilitating the ginneries, and controlling the quality of cotton fiber, (ii) supplying spare parts and fuel to the ginneries, and (iii) contracting with farms for supply of cotton. The Government plans to liquidate the RCPT, sell its assets and transfer some of its functions to the Ministry of Agriculture. 35. Privatization of the Tajik Aluminum Plant (Tadaz). Tadaz, a state enterprise, is responsible for some 30 percent of all exports. The plant was built in the mid-seventies. It has an installed capacity of 512,000 tons and consumes nearly 40 percent of the nation's production of electrical power, mainly from Nurek hydro-electric power. Operating at only a third of its capacity, it employs about 10,000 people and is the major means of support to a community of about 75,000 in Tursunzade, about 50 kilometers to the west of Dushanbe. Plant performance has deteriorated in recent years. The plant is heavily indebted and suffers from a shortage of working capital, skilled manpower and poor quality control. Frequent disruptions in the supply of raw materials and spare parts threaten to render the facility totally inoperable. The Government plans to complete a privatization study of Tadaz and agree with IDA on an action plan for its privatizing. Promoting an efficient Financial Sector 36. Tajikistan has a two-tier banking system, with the National Bank of Tajikistan (NBT) performing the functions of a central bank, including conducting monetary policy, managing foreign exchange reserves, supervising commercial banks and overseeing the payments and clearing systems. According to the National Bank Law passed by Parliament in December 1996, NBT is accountable to Majles Oli, which must approve the appointment and dismissal of the NBT Chairman, based on the recommendation of the President. The law grants NBT legal authority to independently determine and implement monetary and foreign exchange policies and prohibits any interference by Government bodies. Nevertheless, until Presidential Decree No. 673 was issued in July 1997 and reiterated NBT's independence, NBT continued to receive and often followed Government instructions to extend credit to the Government and state enterprises. 37. Structure of Five Largest Banks. As of January 31, 1998, there were 25 licensed commercial banks in Tajikistan. The five largest (Agroinvestbank, Tajikbankbusiness, Orienbank, Vnesheconombank and Sberbank) account for 76 percent of loans and 97 percent of deposits. These five banks have historical roots in the FSU banking structure, with its large specialized sectoral banks. Four of the five banks have become joint stock companies and were privatized through a combination of infusion of new private capital and privatization of some of the shareholders. Only the Sberbank (Savings Bank) has remained a state-owned bank chartered under a specific law but covered by the Law on Banks and Banking Activities. Of the remaining 20 banks, the State Bank on Reconstruction and Development of Khatlon Region, was created as a fully state owned bank to provide finance in Khatlon region. Another is 50 percent owned by state-owned enterprises that are expected to be privatized, and the rest are banks with at least 70 percent private ownership. Private banks control 45 percent of the banking system's deposits and 95 percent of its loans. 38. Four of the five largest banks are in poor financial condition and would be insolvent if adequate provision for loan losses were made. Agroinvestbank had problems with 80 percent of its loan portfolio, - 12 -  which consisted mostly of directed credits to state farms. Draft diagnostic studies in 1997 of Orienbank and Tajikbankbusiness estimated that they needed' loan loss provisions of 30-35 percent of the loan portfolios. While Orienbank's net worth can absorb the loan loss provisions, the net worth of Tajikbankbusiness becomes negative after pirovisioning. Diagnostic studies and International Accounting Standards (IAS) audits for Vnesheconombank, Agroinvestbank and Sberbank similarly indicate negative net worth after provisioning. 39. Factors Affecting Sector Performiance. Macroeconomic instability and political uncertainty have been major factors in the deterioration of loan portfolios. The use of directed credits to priority state enterprises also contributed to poor performance. Lack of progress in privatization of state-owned enterprises has hindered the banks' ability to diversify portfolio risk. The inadequate legal framework for banking and commercial activities (e.g., law on collateral) is exacerbated by high transaction costs and lack of enforcement. Information infrastructure consistent with a market economy is undeveloped and prudential regulations and banking supervision capacity do not allow prudent banking practices. 40. Prudential Regulations and BankLs Restructuring. Creating a sustainable competitive and prudent banking system in Tajikistan requires action on two fronts. First, a framework that fosters competition, encourages prudent risk-taking, minimizes transaction costs and clearly defines the Government's role must be put in place. It is clear that the Government should stop influencing bank credit decisions and avoid using banks as instruments for monitoring the population. Furthermore, prudential regulations need to be restructured and accompanied by capable supervision to ensure that banks follow prudent banking practices. Second, banks should pursue financial and operational restructuring to deal with portfolio problemis and strengthen their capital position, as well as improve governance and risk management. NBT should encourage bank restructuring by setting standards that banks should meet and imposing penalties, including withdrawal of licenses, for banks that do not meet the standards within an agreed time period. NBT should also more intensively review certain risk management practices, especially in the areats of connected lending and currency exposure, and continue using compliance with prudential standards as a basis for bank participation in credit and foreign exchange auctions. 41. Sberbank. To create a competitive environment for banking activities and at the same time provide a safe haven for household deposits, Sberbank's activities need to be restricted. Sberbank currently operates as a state financial institution with an explicit Government guarantee on funds deposited in the bank. Governance and moral hazard problems linked to its being a state owned institution, together with its dominance in the household deposit market, indicate that Sberbank should in the short and medium term focus on deposit mobilization and limit its risk taking activities by investing or placing most of its deposits in government securities or accounts with NBT. Sberbank should limit its lending activities to collateralized lending to the public. Other banks can compete for deposits by offering higher interest rates and depositors can decide whether the premium is worth the risk of placing their funds in uninsured banks. A review of longer term options for Sberbank, such as privatization to a strategic investor and conversion to a full fledged commercial bank, could be done in two to three years. 42. Agroinvestbank. Agroinvestbank began financial restructuring in 1997 by transferring half its problem portfolio to the Ministry of Finance (correspondingly reducing its liability to NBT) and extending the maturities of the remaining half to 2002. The bank has also begun to search for strategic investors to boost its capital and improve governance. Diagnostic studies and audit have determined additional actions the bank must undertake to meet prudential standards. -13 -  43. Reform Outcomes. Reform of the banking system and enforcement of prudential standards (including the increase of minimum capitalization to $1 million by end-1998) will consolidate the banking system into fewer but stronger banks. In time, additional competition will come from entry of foreign banks. The banking sector's further development will depend on parallel development of the private sector, establishment of macroeconomic stability, sustainability of the peace agreement, and lessened state intervention in the allocation of resources. Protecting the Social Safety Net and Social Sectors 44. The Government has recognized that it can not afford to maintain the level of social services and welfare subsidies enjoyed under the Soviet system and that during the transition period, the economy will not generate sufficient resources to fully alleviate poverty, which has been aggravated since Tajikistan's independence. In light of this limitation, the Government has adopted a three-part strategy to reduce poverty through: (i) macroeconomic stabilization, control of inflation and resumption of growth; (ii) targeting assistance to the poor; and (iii) protecting budgetary expenditures on education and health. The IMF financial program and four IDA credits (ARSP, PPAP, PCRC and PCERC) have supported this strategy. Progress in stabilizing the macroeconomic situation, controlling inflation and reviving economic growth has been mixed in the past few years (see paragraphs 9-10). Some progress has been made on targeting assistance to the poor and protecting budgetary expenditures on health and education since Fall 1997. 45. Salary and Social Safety Net Arrears. Increased budgetary allocations for defense and security expenditures and revenue shortfalls since independence have curtailed the availability of resources for other public services and built up arrears in social safety net payments, salary and pensions. Arrears in social safety net payments increased from TR 1.5 bn in 1996 to TR 5.9 bn (1.0% of GDP in 1997) in September 1997. Arrears on salary and pension payments increased from TR 0.8 bn in 1996 to TR 2.2 bn (0.4% of GDP in 1997) in June 1997. The situation improved after the peace agreement was signed in June 1997. By the end of 1997, the state budget's salary and pension arrears fell by TR 0.4 bn (0.1% of GDP in 1997), to TR 1.8 bn. The Government has been trying to address the problem of arrears in the social safety net with support under the PCRC. It has used US$7.0 million of credit's disbursement proceeds to improve performance of the social safety net for the country's most vulnerable groups, particularly, children under the age of eight and pensioners. Social safety net arrears were reduced to no more than 3 months (about TR 2.1 billion) by March 1998, and all arrears with respect to pension payments have been eliminated. 46. Although the move from universal bread to targeted-bread compensation in 1996 and further tightening of eligibility conditions, together with the administrative reforms introduced in April 1997, have improved the effectiveness of the social safety net, additional reforms are needed to further refine the target group, and make sure that the social safety net's limited resources reach the society's most vulnerable groups. 47. Protecting Education and Health Services. As the Government scrambled to supplement its limited resources and meet defense expenditures, long term priorities gave way to day-to-day crisis management and fewer resources were devoted to the social sectors. The share of GDP allocated to the health and education sectors dropped from 17 percent in 1992 to only 7 percent in 1995. Actual expenditures for both sectors amounted to 15 percent of total expenditures and 3 percent of GDP in 1996, compared to targets of 20 and 6 percent, respectively. Arrears continued to increase substantially in nominal and relative terms in 1997, with those in education largely associated with salaries and pension - 14-  and those in health with operations and maintenance. Despite disappointing results during the first half of the year, spending on health and education in 1997, exceeded the 1996 allocations to these sectors, both as a percentage of total expenditures of the state budget and as a percentage of GDP (21% in total expenditures and 3.4% of GDP in 1997 compared to 15% and 3%, respectively, in 1996). The 1998 state budget builds on this achievement by maintaining the total expenditure share for. the education and health sectors at around 22%. 48. Health and education services have badly deteriorated in the past few years. The health sector suffers from inadequate funds to pay pers,onnel, very limited stocks of medicine and medical supplies, aging facilities and equipment, with many buildings and other infrastructure damaged during the war, and a growing tendency for people to defer medical care. Health indicators have also deteriorated, especially in rural areas. For instance, infant and maternal mortality rates have increased and immunization coverage is falling. In the education sector, school attendance has fallen and about one-fifth of school children (7-18 years old) are not receiving any formal education. For girls, the absentee rate is 25 percent. 49. Faced with this situation, the Government has implemented a number of structural measures, including some cost recovery. Parents' contribution to teacher salaries (in kind and cash) is increasing and students' education is increasingly financed by employers. In health, patients have to buy their own drugs and bring their own food to the hospitals in most cases. Marketing of pharmaceutical products has been de-facto privatized, though with liltle regulation (quality control and consumer protection) or appropriate storage facilities. Despite reform, the health and education sectors suffer from inadequate budgetary allocations, an issue the Govermnent plans to address in its 1999 budget. III. Featiures of the Proposed Credit A. Objectives and Features of the Crediit 50. The proposed SAC aims to contribute to the achievement of the following objectives: (i) restore macroeconomic stability; (ii) implement a transparent privatization program; (iii) reform the financial sector to establish a conducive environment for private sector development and restructure the banking system; and (iv) lessen the adverse impact of adjustment on the poor by enhancing budgetary provisions for health, education and social safety net. The proposed SAC builds on policy achievements under the World Bank's ARSP credit and is supported by the IBTA credit. The proposed credit will benefit from the impact of the PPAP and the two post-conflict credits, PCRC and the PCERC, which aim to minimize the transitional social cost of reform and facilitate moving away from a wartime economy. Details of the Government's reform program, including timetables for implementing specific measures, are presented in the attached Letter of Development Policy. 51. Although not part of the proposed credit, policy changes at the macro level (fiscal, monetary and exchange rate) are required to provide an environment conducive to private sector development. Government efforts to formulate a comprehensive stabilization program and achieve macroeconomic stability are supported by the IMF under the ESAF arrangement discussed and approved by the IMF's Executive Board on June 24, 1998. The proposed SAC complements the program supported by the ESAF. 52. Privatization of Enterprises. Under the proposed SAC and prior to Board presentation, the Government amended the Laws on Joint Stock Companies, Securities and Stock Exchange and - 15 -  Bankruptcy and approved a comprehensive Privatization Action Plan for 1998. The Action Plan envisions privatization of all small-scale enterprises and at least 15 percent of large enterprises (more than 100 working spaces) before the end of first quarter of 1999. The Action Plan sets bi-monthly privatization targets for all 72 raions of the Republic and identifies preparatory actions needed to meet the targets and the entities responsible for carrying out the planned actions. Before the proposed SAC's second tranche release, all large enterprises will be converted into joint stock companies and their shares registered in a centralized share registry in the MoF. Prior to Board presentation, the Government issued a decree to allow sale of all 350 unfinished construction sites subject to privatization through auctions. Under the SAC, the Government also plans to sell or scrap at least 30,000 state-owned trucks before second tranche release. 53. Also before second tranche release, the Government intends to privatize all 23 state-owned cotton ginneries, strengthen the legal basis and enforcement capacity to facilitate competition among ginneries and ensure that dominant or monopolistic privatized gins are prevented from mergers that hinder competition. Newly privatized gins will be monitored to ensure fair market behavior and competition will be promoted by encouraging entry of new gins. The Government plans to dissolve the RCPT, sell its assets and transfer supervision of seed production and cotton grading functions to the Ministry of Agriculture before second tranche release. The Government will also prepare and initiate implementation of a privatization plan for the Tajik Aluminum Plant. The plan will consider options for breaking up the plant, privatizing its constituents units and address the social and environmental implications of the process. The Government has agreed with the World Bank on the terms of reference for the privatization plan during negotiations of the proposed SAC. 54. Financial Sector Reform. The proposed credit's financial sector component aims to: (i) improve the legal framework for banking activities; (ii) upgrade the regulatory framework and supervision capacity; and (iii) restructure individual banks, focusing on the five largest. 55. Under the proposed credit and prior to Board presentation, the Law on Banks and Banking Activities and the revised Law on Collateral were submitted to the Majles Oli. These laws more clearly define the boundaries of banking activities, improve creditors' enforcement capacity to realize collateralized assets in case of debtors' nonpayment, and reduce registration fees and transaction costs. 56. Under the proposed credit and prior to Board presentation, NBT issued a revised set of prudential regulations setting norms for the conduct of banks. To remove the banks' disincentive to adequately provision for loan losses, the MoF agreed to make loan loss provisions a tax deductible expense. Additionally, NBT instructed banks to convert the current accounting system to International Accounting Standards (IAS) starting in 1998. The five major banks have agreed to IAS audits by reputable firms beginning with their 1998 accounts, while the rest of the banks will face the same requirement beginning with their 1999 accounts. Under the proposed SAC, NBT's Banking Supervision Department will be upgraded and reorganized and the number of qualified staff will be increased. NBT has also agreed to adopt a plan to improve the payments system to reduce the time it takes to effect payments and minimize the idle funds banks must keep with the NBT. 57. Sberbank. Under the proposed SAC, Sberbank will be required to safeguard household deposits by depositing 80 percent of client deposits either with NBT or investing in government securities. Furthermore, Sberbank's lending activities have been limited to collateralized lending to households or individuals and will not exceed 20 percent of deposits plus net worth. - 16-  58. Agroinvestbank. As part of its restructuring under the proposed SAC, to ensure that its financial condition does not deteriorate further, Agroinvestbank has taken the following steps: First, it eliminated Government influence in Agroinvestbank credit decision that forced it to lend under Government credit programs, at the risk of the bank's resources. Second, it cleaned up its portfolio by dealing with the remaining loans for which the Government hEas responsibility. When Agroinvestbank has restructured its operations to comply with the proposed SAC, the MoF and the NBT will consider restructuring the Agroinvetsbank loans granted under the central agricultural credit programs funded by the NBT, which will involve restructuring Agroinvestbank's corresponding liabilities at NBT. Third, it recapitalized the bank from private investors, bringing the capital adequacy ratio to prudential standards. (Prior to Board presentation, foreign investors injected US$1.6 million of capital into the bank, to be followed shortly by an additional US$0.8 million.) Fourth, it improved its risk management and internal operations, including cutting back on personnel and branches. Agroinvestbank is expected to implement the diagnostic study recommendations proposed by consultants under the IBTA credit and to meet all prudential regulations by November 30, 1998. Finally, it has improved management and human resources; managers have been hired and a staff training program is underway. 59. Tajikbankbusiness (TBB). TBB suffers from liquidity problems and is in fact insolvent. Under the proposed SAC, NBT has placed restrictions on TBB's lending operations and if necessary, will appoint a controller to approve all loans and capital expenditures until the bank has paid its obligations to NBT. If TBB does not meet the prudential regulations by end 1998, NBT will revoke its license immediately. 60. Vnesheconombank (VEB) and Orienbank. Under the proposed SAC, VEB and Orienbank have agreed to implement diagnostic studies recommendations that cover credit management; asset liability management; information technology; and upgrading human resources. NBT has restricted VEB's lending operations due to its poor financial condition, and restructuring has begun to enable VEB to meet all prudential norms by November 30, 1998. Otherwise, VEB will be subject to penalties, including withdrawal of its license and fiirther restrictions on its banking activities. Orienbank is currently in compliance with all prudential regulations. 61. Other Banks. Restructuring other banks is based on two principles: (i) elimination of weak banks by enforcing minimum capital requirements that will substantially reduce the number of banks through liquidation and mergers; and (ii) requiring banks to meet all prudential regulations by November 30, 1998 and imposing penalties, including withdrawal of license, on banks that fail to meet prudential standards. 62. Enhancing Budgetary Provisions for Social Safety Net and Health and Education. Under the proposed SAC, the Government is expected to: (i) ensure the timely payment of salaries, pensions, and social safety net payments and have no outstanding arrears in the state budget to these sectors during the second half of 1998; (ii) review the expenditure composition for 1999 in the social sectors, including health and education and social safety net, in consultation with the World Bank and agree on the 1999 state budget allocation to education and health; and (iii) agree with the World Bank on a plan to restructure the social protection system, based on the living standard survey, and submit the necessary legislation to the Majles Oli in order to implement the new system. -17-  Country Assistance Strategy and Rationale for Bank Involvement 63. Since Tajikistan is the FSU's poorest country, with a 1997 per capita income of US$330 and approximately 90 percent of its population living below the poverty line, the Bank Group's strategic focus is poverty reduction. The challenge is to achieve results, which will be quite difficult. 64. The poverty reduction strategy in Tajikistan has five main elements, each of which addresses a particular aspect of the poverty problem. First, the existing pattern of resource utilization is inefficient; transferring publicly owned commercial, industrial, agro-processing and mining enterprises to the private sector through a transparent and competitive mechanism will improve the efficiency of labor and capital in these sectors, help reallocate resources, and contribute to a higher growth rate. Second, most of the poor live in rural areas and derive their livelihood from agricultural production and services; privatizing land and establishing secure property rights, restructuring agricultural enterprises, liberalizing producer prices and marketing, and investing in rural infrastructure will improve agricultural productivity and increase the rural population's income. Third, the social sectors, particularly education and health, have suffered badly since independence, due to declining public expenditures, deteriorating quality of services and actual shutdown of facilities in the war-affected areas. The poor will benefit directly from greater social expenditures and improved coverage, access and quality of social services. Fourth, a significant proportion of the population was displaced from their homes and either became refugees in other countries or moved to other parts of the country. Peace and post-conflict reconstruction will help these families to return to their homes and restart economic activities. The resulting income gains will help improve the living standards of this vulnerable group. Finally, the Bank will target the extreme poor through a series of community-based, demand-driven interventions, such as public works, water supply, schools, and clinics under the PPAP. 65. The proposed SAC is aimed at supporting the implementation of two parts of this strategy: transferring publicly owned enterprises to the private sector and greater social expenditures with improved social services. Privatizing small, medium and large scale enterprises will halt major inefficiencies in resource use. A stable macroeconomic framework that removes price distortions, which is the goal of the complementary IMF program, will create a favorable environment for competition and nurture modem business practices. Private owners will also help bring in new technology, train employees and, if foreign investors are involved, provide access to new sources of capital. The second component of this credit, the banking sector reform under the SAC, will strengthen the mobilization and allocation of domestic savings and provide these savings to investors interested in expanding, modernizing and restructuring newly acquired enterprises or entering new areas of production and services. The third component, i.e. reallocation of social expenditures, will have a direct impact on the goal of poverty reduction. By increasing the level of public expenditures on primary and secondary education and basic health services, the Government will be able to overcome existing budgetary constraints on providing these services and lessen the burden of adjustment on the poor. Implementation Arrangements 66. The SPC, NBT and MoF have been given primary responsibility for implementing the proposed SAC, with overall guidance and coordination to be provided by the Office of the Prime Minister. The State Advisor on Economic Matters is the Bank's counterpart on the proposed credit and will oversee, coordinate and monitor implementation of the policy reform program. The IBTA Implementation Unit will provide day-to-day project implementation assistance based on information from the various agencies involved in the credit implementation. Within six months of the closing date, the office of the Prime Minister will prepare the Borrower's contribution to the Project Completion Report. - 18-  67. The borrower will be the Republic of Tajikistan, represented by the MoF. The proposed credit, in the amount of SDR 37.1 million (US$50 million equivalent), will be disbursed in a MoF account at NBT, to be converted into Tajik rubles at the exchange rate prevailing on the day of deposit. Credit disbursement provisions will be designed by NBT, in consultation with IDA and the IMF, to support a market-based auction and ensure the smtooth flow of funds into the market. IDA disbursement procedures allow credit disbursement without evidence of imports of eligible goods. The authorities undertake not to use the proceeds for itemis covered in the negative list and agree to audits upon IDA request by independent auditors acceptable to IDA. The credit would be on standard IDA terms, with 40 years maturity, including a 10 year grace period. 68. The proposed credit would be disbursed in two tranches, the first tranche to be released on effectiveness and the second on fulfillment of the specific tranche release conditions, after IDA review of program implementation a whole. The first tranche will be for SDR 14.840 million (US$20 million equivalent) and the second for the remaining amount SDR 22.26 million (US$30 million equivalent). D. Monitorable Actions and Tranche Release Conditions 69. Measures Taken Prior to Board Presentation. All conditions for presentation to the IDA Board of the proposed SAC were met before May 15, 1998, as follows: * On April 22, 1998, the Government prepared amendments to the laws on Bankruptcy, Joint Stock Companies, and Securities and Stock Exchange and submitted them to the Majles Oli. * As of May 15, 1998, the Government privatized through auctions 540 additional small- scale enterprises. - The Government corporatized 100 additional large-scale enterprises as of May 15, 1998. - On March 6, 1998, the Government approved and agreed to implement the Privatization Action Plan for 1998. * On April 27, 1998, the Government established a centralized share registry in the MoF to be the sole legal list of shareholders in open joint stock companies. * On May 14, 1998, the Government issued a decree to allow privatization of 350 unfinished construction sites through auctions. * The Government submitted the Law on Banks and Banking Activities to the Majles Oli on March 2, 1998. * The Government submitted amendments to the Collateral Law to the Majles Oli on April 20, 1998. * NBT issued a revised set of prudential regulations on April 21, 1998. - 19 -  * The Government issued Decree No. 120 on April 17, 1998, to make loan loss provision as a tax deductible expense * On May 15, 1998, NBT agreed on a set of measures to upgrade its Banking Supervision Department. * On April 4, 1998, NBT issued instructions requiring: (i) all banks to adopt IAS accounting systems beginning in the 1998 financial year; (ii) the five largest banks to subject their 1998 accounts to IAS audits; and (iii) all banks to submit IAS audited financial statements starting in 1999. * On May 15, 1998, NBT agreed on a time bound set of actions to upgrade the payments system. * NBT and five largest banks reached individual bank restructuring agreements on May 15, 1998. * Based on a February 26, 1998 interim agreement between Sberbank and NBT, Sberbank has stopped all new lending and collected all loans to commercial banks with maturities up to May 15, 1998. D Agroinvestbank has fulfilled the conditions of its February 26, 1998 interim agreement with NBT, including no increase in loan levels as of that date and a capital increase from strategic investors. 70. Effectiveness Condition. As an additional condition to the effectiveness of the Development Credit Agreement, all arrears towards the social safety net and salaries in the state budget will be cleared by the Government. 71. Second Tranche Conditions. The second tranche of the proposed SAC will be released upon completion of the following conditions: Privatization * The Government will complete privatization of not less than 1500 state-owned small- scale enterprises in addition to 500 such enterprises privatized prior to May 15, 1998. * The Government will complete the process of corporatization of not less than 600 state- owned large-scale enterprises into joint-stock companies in addition to 100 such enterprises corporatized into joint-stock companies prior to May 15, 1998. * The Government will complete privatization of not less than 120 state-owned large-scale enterprises. * The Government will sell 350 unfinished state-owned construction sites. * The Government will sell or scrap 30,000 state-owned trucks. - 20 -  The Government will privatize all 23 state-owned cotton ginneries. The Government will liquidate the Republican Corporation of Pakhteh Tajik (RCPT), sell all its assets and transfer supervision of seed production and cotton grading to the Ministry of Agriculture. The Government will prepare a plan to privatize the Tajik Aluminum Plant (Tadaz) and will take measures, satisfactory to the Associations, to implement it. Financial Sector Development and Bank Restructuring * NBT will implement a plan to upgrade NBT's Banking Supervision Department. * NBT will implement a plan to upgrade the payments system. * NBT will implement a revised set of prudential regulations, satisfactory to the Association. * The five largest banks will meet the provisions of the restructuring plans agreed with the NBT. Protecting Social Expenditures * ''The Government will ensure timely payment for salaries, pensions and social safety net. * The Government will ensure that there are no outstanding arrears in the 1998 state budget for these payments. * The Government will finalize social sector expenditures, including allocations to health and education in the 1999 state budget, in a manner satisfactory to the Association. * - The Government will complete a plan to restructure the social protection system and submit draft legislation to the Majles Oli. E. Benefits and Risks 72. Benefits. The main benefits of the proposed credit would be: (i) further progress toward sustained stabilization and growth; (ii) financing imports critical to economic activity through balance of payments and budgetary support under the proposed SAC; (iii) fostering private sector development and more competitive banking, transport, construction and cotton sectors; and (iv) increasing budgetary provisions for health, education and social safety net. 73. Risks. The proposed credit has four potential risks: (i) deterioration in the political and security environment could undermine the Government's commitment to policy reforms, delay project implementation and possibly result in long term set-backs; (ii) implementing policy reforms under the - 21 -  proposed credit may place heavy demands on the Government's weak institutional capacity; (iii) opposition to reforms by some vested interests may result in policy slippage; and (iv) high external debt and weak external debt management may add to the budgetary pressures and damage the country's creditworthiness. 74. The following factors help lessen the risks: The country's political situation has gradually improved with the signing of the peace agreement on June 27, 1997, specifically the operation of the CNR, the Government's and UTO's renewed commitment to a sustainable peace process, and Government's efforts to foster economic recovery have reduced the political risk to the reform process. The Government's institutional capacity to implement policy reforms under the proposed credit is being supported by the highly focused IBTA credit. The problem of vested interest will be addressed by fully informing various stakeholders, including the managers of enterprises to be privatized, about the privatization program's objectives, the nature of the process and available opportunities and including them in the design and implementation of the reform program to the extent possible. As to the high level of external debt, the authorities have intensified their efforts to reschedule debts with Tajikistan's external creditors. Generous debt relief and sustained balance of payments support on concessional terms, together with the creation of the external debt management unit in the MoF, will help reduce this risk. IV. RECOMMENDATION 75. I am satisfied that the proposed credit complies with the Association's Articles of Agreement and recommend that the Executive Directors approve the proposed credit. James D. Wolfensohn President by Caio Koch-Weser Washington, D.C. June 25, 1998 - 22 -  TAJIKISTAN: STRUCTURAL ADJUSTMENT CREDIT POLICY MATRIX Objectives Current Status Measures taken Prior to Board Measures to be taken Presentation before Second Tranche Release PRIVATIZATION OF STATE-OWNED ENTERPRISES Prepare the necessary legal The privatization program was initiated in 1991. The privatization On April 22, 1998, the Government prepared framework for accelerated law was amended by Majles Oli on November 2, 1995. On amendments to the laws on Joint Stock privatization and May 16, 1997, Majles Oli approved a new law. Regulations and Companies, Bankruptcy, Securities and development of the private directives necessary to implement the new law were also Stock Exchange and submitted them to the sector. approved, including: Instruction on Valuation (May 4, 1997); Majles Oli. Regulation on Segmentation (May 4, 1997); Procedure for Incorporation (June 18, 1997); List of Enterprises Proposed for Incorporation (June 18, 1997); Regulation of Investment Funds (May 4, 1997); Regulation on Sale of Unfinished Construction (August 12, 1997); and Regulation on Auctions and Tenders (December 16, 1997). Majles Oli also approved laws on Joint Stock Companies, Bankruptcy and Securities and Stock Exchange. Nevertheless, gaps remain in some of these laws, while others are inconsistent with current requirements. Develop a comprehensive To implement the Privatization Law and create effective program The Government approved the Privatization Privatization Action Plan monitoring, the Government has recognized the need for a Action Plan for 1998, on March 6, 1998. for 1998. privatization action plan for 1998. Accelerate privatization of As of January 1998, 4641 enterprises with fewer than 99 working As of May 15, 1998, the Government The Government will small-scale enterprises. spaces had been proposed for privatization. 2413 of these have privatized through auction 540 additional complete privatization of been privatized since 1991, 2,228 remain to be privatized. small- scale enterprises. state-owned small scale enterprises by privatizing not less than 1500 in addition to 500 such enterprises privatized prior to May 15, 1998. - 23 -  Objectives Current Status Measures taken Prior to Board Measures to be taken Presentation before Second Tranche Release Accelerate conversion of As of January 1998, only 23 enterprises had share registered, As of May 15, 1998, the Government The Government will large-scale enterprises to leaving 723 to be corporatized. The new incorporation procedure corporatized and registered more than 100 complete the process of open joint stock companies. is much faster because it is a top-down process. additional large enterprises. corporatization of not less than 600 state-owned large- scale enterprises into joint- stock companies in addition to 100 such enterprises corporatized into joint-stock companies prior to May 15, 1998. Protect shareholder rights Enterprises are currently responsible for maintaining share The Government established a centralized by establishing a centralized registries. share registry in the Ministry of Finance on share registry. April 27, 1998. Accelerate privatization of As of January 1998, 281 large enterprises (with more than 200 The Govemment will large-scale enterprises. working spaces) had been proposed for privatization, of which complete privatization of not only one was privatized, leaving a total of 280. As of January less than 120 state-owned 1998, there were 492 medium-scale enterprises (100-199 working large-scale enterprises. spaces ) proposed for privatization, of which 26 were privatized, leaving a total of 466. SPC has decided to treat 466 medium-scale enterprises as large-scale enterprises, so that 746 "large" enterprises remain to be privatized (466+280). Under the new Privatization Law, large-scale enterprises can be privatized through share auctions, tenders and case-by-case methods. Sell state-owned unfinished According to SPC, approximately 800 unfinished construction Presidential Decree No.184 was issued on The Government will sell construction. sites exist in the country, of which 350 are subject to privatization. May 14, 1998, to allow sale of 350 Fifty of these were intended to provide social services to local unfinished construction sites through construction sites. communities, such as schools or clinics; for them, the Government auctions. plans to require buyers to implement specific contractual conditions to provide these services. Accelerate privatization of As of January 1998, there were about 50,400 state-owned trucks, The Government will sell or the state-owned trucking and about 50 percent of the fleet is not in working condition. scrap 30,000 state-owned fleet. trucks. - 24 -  Objectives Current Status Measures taken Prior to Board Measures to be taken Presentation before Second Tranche Release Restructure the cotton Under a decree dated September 18, 1997, the Government created The Government will marketing agency, the Republican Corporation of Pakhteh Tajik (RCPT) as the first liquidate the RCPT, sell all Glavkhlopkoprom. step to restructuring the cotton marketing. its assets and transfer the supervision of seed production and cotton grading functions to the Ministry of Agriculture. Restructure the Tajik The Tajik Aluminum Plant is loss-making at current production The Government agreed upon Terms of The Government will prepare Aluminum Plant. level, and is burdened by unfavorable long-term contracts for the Reference for the privatization plan of the a plan to privatize Taj ik purchase of raw materials and finished products. Tajik Aluminum plant. Aluminum Plant and take measures, satisfactory to IDA, to implement it. PROMOTION OF AN EFFICIENT FINANCIAL SECTOR Strengthen the banking IBTA credit financed the drafting of a new Law on Banks and The Government submitted the Law on sector's legal framework by Banking Activities that better defines what a bank is and what Banks and Banking Activities to the preparing and submitting a activities it can engage in. Majles Oli on May 2, 1998. new law on banks and banking to the Majles Oli. Provide banks with Bankers have complained about the ineffectiveness and high The Government submitted the additional mechanisms to transaction costs of the current collateral law. amendment on collateral Law to the protect themselves against Majles Oli on April 20, 1998. borrower defaults by improving the current Law on Collateral. Ensure that banks manage The World Bank, the IMF and the USAID have been working on NBT issued a revised set of prudential NBT will implement a risk in a prudent manner by reforming the prudential standards and upgrading the Banking regulations on April 21, 1998. NBT revised set of prudential restructuring the current set Supervision Department at NBT. agreed on a set of measures to upgrade regulations and a plan to of prudential regulations NBT's Banking Supervision Department upgrade NBT's Banking and improving supervision on May 15, 1998. Supervision Department. capacity and enforcement. - 25 -  Objectives Current Status Measures taken Prior to Board Measures to be taken Presentation before Second Tranche Release Improve information on The existing accounting system is geared toward budgetary NBT instructed all banks to adopt IAS banks for shareholders, control under a centralized fund allocation system. To meet the accounting systems, beginning in 1998 management, creditors, needs of a market economy and new system of govemance, a new financial year. The 1998 accounts of the regulators, and the public accounting system and an effective audit system is needed. five large banks will be subject to IAS by requiring banks to audits and all banks will be required to introduce IAS accounting submit IAS audited financial statements, systems and be audited starting in 1999. under international standards by independent and reputable firms. Improve the payments A study conducted under the IBTA credit concludes that the NBT agreed on time-bound measures to NBT will implement a plan system to reduce risk and current payments system is highly inefficient. upgrade the payments system. to upgrade the payments transaction costs. system. Restructure the banking Four of the five largest banks are in poor financial condition and NBT has reviewed the financial condition The five largest banks will sector and promote savings would be insolvent if adequate provisions for loan losses were of the five largest banks to determnine their meet the provisions of the mobilization and efficient made. Agroinvestbank had problems with 80% of its loan compliance with a revised set of prudential restructuring plans agreed intermediation. portfolio, most of which were directed credits to state farms. ratios and has entered into individual with NBT. Draft diagnostic studies in 1997 of Orienbank and agreements with the five banks on a plan to Tajikbankbusiness estimated that loan loss provisions of 30-35% enable them to meet the prudential of loan portfolios would be required, and while the net worth of standards by November 30, 1998. Orienbank can absorb the loan loss provisions, the net worth of Tajikbankbusiness becomes negative after provisioning. Diagnostic studies and IAS audits for Vnesheconombank, Agroinvestbank and Sberbank indicate negative net worth. The Government has agreed that banks should pursue financial and operational restructuring to deal with portfolio problems, strengthen their capital position, and improve govemance and risk management. - 26 -  Objectives Current Status Measures taken Prior to Board Measures to be taken Presentation before Second Tranche Release PROTECTING THE SOCIUAL SAFETY NET AND SOCIAL SECTOR Protect social expenditures The Government has adopted a three part strategy to reduce As an additional condition to by ensuring that education, poverty: (i) macroeconomic stabilization, inflation control and the effectiveness of the health and social safety net resumption of growth; (ii) targeting assistance to the poor; and (iii) Development Credit receive a reasonable share protecting expenditures on education and health. Agreement, all arrears of the budget. towards the social safety net Increased budgetary allocations for defense and security and salaries in the state expenditures, combined with revenue shortfalls, resulted in a budget will be cleared by the build-up of arrears in social safety net payments, salary and Government. pensions. The Government has been trying to address the arrears problems on the social safety net with support under the PCRC. The Government will: (i) Under the PCRC, arrears on the social safety net were reduced to ensure timely payment for no more than 3 months (about TR 2.1 billion) by March 1998, and salaries, pensions and social all arrears with respect to pension payments have been eliminated. safety net; (ii) ensure that there are no outstanding Since independence, revenue shortfalls and increased defense and arrears in the 1998 state security allocations have resulted in fewer resources being devoted budget for these payments; to the social sectors, to the detriment of the health and education (iii) finalize the composition sectors. of social sector expenditures and the allocations to health and education in the 1999 state budget in a manner satisfactory to the IDA; and (iv) complete a plan to restructure the social protection system, including submitting draft legislation revising social protection system to the Majles Oli. - 27 -  CAPBA3RPM -PEMbEP-MHHCTP 4jYMXYPHK TOLIKI(CTOH PECHYBJII4KH TAJ)KIKHCTAlf N2 /0?/ ct -3 __ 1__99_ _. LETTER OF DEVELOPMENT POLICY Tajikistan: Structural Adjustment Credit Mr. James D. Wolfensohn President The World Bank 1818 H Street, N.W. Washington, D.C. 20433 USA Dear Mr. Wolfensohn, 1. Political instability and civil war have adversely affected our country since we gained independence from the Former Soviet Union (FSU) in 1991. The civil war, which erupted in May 1992, shattered our economy and inflicted extensive human and physical devastation. The armed conflict continued for five years with varying degrees of intensity, with major hostilities concentrated in 1992-1993. The combined effect of the civil war, the breakup of the FSU (which broke trade links and ended generous budget transfers from Moscow, amounting to about 40 percent of GDP) and severe floods, (which damaged much of the remairning infrastructure) resulted in a roughly 50 percent decline in Tajikistan's GDP during the first half of the 1990s. Following our efforts to restore peace and security, the Government of the Republic of Tajikistan and the United Tajik Opposition (UTO) signed a peace agreement on June 27, 1997, which laid the foundation for peace and security in our country. Macroeconomic Framework 2. We launched, in late 1995, a comprehensive economic reform program to move from a planned to a market economy. Our objective was to restore macroeconomic stability and implement the required structural reforms. Supported by the IMF and the World Bank, we followed tight monetary and fiscal policies and managed to control inflation. We also liberalized exchange and trade policies and removed price controls. The results were promising, with inflation declining to 40 percent during 1996, compared with 2000 percent during 1995. Program implementation was satisfactory until late 1996, when we were forced to increase defense expenditures in response to renewed fighting. The increased defense expenditures were financed by a combination of monetary expansion and budget arrears, including significant amounts owed to the social safety net. Additionally, imprudent borrowing immediately following the collapse of the FSU imposed a crushing debt burden on us. By the end of 1997, we had accumulated nearly US$1,039 million of external debt (about 96 percent of GDP), mostly assumed on commercial terms between 1992 and 1994. 3. Since the signing of the peace agreement, we have again made satisfactory progress in stabilizing the macroeconomic environment. We tightened fiscal and monetary policies considerably and in late July 1997, restarted foreign exchange auctions. Inflation decreased due  -2- to slower credit expansion and a lower budget deficit. Our renewed efforts since the second half of 1997 to stabilize the economy have borne fruit and most macroeconomic indicators have recorded improvements. The monthly inflation rate declined from 20 percent in July to 2.3 percent in December 1997. The budget deficit for the year as a whole declined to less than 3.5 percent of GDP, with the exchanlge rate premium declining from 19 percent to less than 3 percent during the same period. For the first time since 1990, we have witnessed a positive real growth of GDP in 1997. Furthermore, we adopted an external debt management strategy compatible with our ability to pay, and aimed at reducing our external debt burden over the medium term. We entered into debt rescheduling agreements with Russia, Kazakhstan, Uzbekistan and Turkey. The above mentioned noticeable progress led to approval of the IMF Emergency Post-Conflict Assistance and the World Bank Post-Conflict Rehabilitation Credit in December 1997. 4. Our macroeconomic objectives during the remaining months of 1998 are: continued economic growth, stronger balance of payments and further reduction in inflation. We plan to strengthen balance of payments and increase the level of gross international reserves to 1.4 months of imports by the end of 1998. To this end, we are also committed to confine the budget deficit (on a cash basis) to about 2.8 lpercent of GDP in 1998. Measures to increase revenues include further elimination of exemptions, improved tax collection and introduction of a low uniform tariff rate. We expect the annual inflation rate not to exceed 17 percent in 1998. Over the next 2-3 years, the consolidation and resurgence of economic growth will take root and reduce the fragility and vulnerability of our economy. In the medium term, we are committed to maintaining financial discipline in our economy and to stabilizing the macroeconomic environment through tight fiscal and monetary policies and controlling inflation. We are firmly committed to structural reforms and are currently focusing on: (i) development of the private sector; (ii) promotion of an efficient financial sector; and (iii) protection of the social safety net and the social sectors. Development of the Private Sector 5. The Government considers development of the private sector one of the highest priorities of its reform agenda. This agenda reflects our firm conviction that recovery of output and sustained economic growth can only be achieved through policy actions which promote private ownership and private investment. In the short-term we seek to achieve these goals through acceleration of the privatization program for small-scale enterprises and the cotton processing sector and development of a legal framework which protects private property rights, promotes free entry and exit, and mobilization of private capital. Our priority for privatization is to focus on those sectors which offer the greatest potential for maximizing employment and income generation. Over the medium term, as institutional and policy development capacity is strengthened, the Government will strive to extend privatization to large enterprises and infrastructure sectors, strengthen the business environment by reducing and simplifying regulation, and promote development of capital markets. 6. The Legal Framework for Privatization. The legal basis for privatization has undergone a number of important changes over the last three years. First, the Privatization Law of 1991 was amended in 1995 to expand the scope of enterprises subject to privatization, give us control over selection of enterprises to be privatized, and simplify valuation procedures. Then in May 1997, the Majles Oli approved a new law which laid the basis for a simplified and accelerated privatization program. This law eliminated privileges for collectives, introduced competitive and  -3 - transparent privatization methods as well as market-determined prices, and substantially simplified procedures. To implement the new law, we have approved regulations on auctions and tenders, valuation, segmentation and incorporation procedures. 7. In March of this year we approved a comprehensive Privatization Action Plan for 1998. This document establishes raion-level privatization targets for all categories of state-owned entities, requires bi-weekly progress reports to my office, establishes fixed dates for the completion of preparatory measures required to meet the privatization targets and identifies the authorities responsible for implementing these measures. We are also taking all necessary actions to support municipal officials, who are responsible for privatization of locally-owned enterprises, in achieving our common goals. In this regard, SPC is providing training in auction procedures to municipal privatization staff and assisting local officials to prepare privatization schedules. 8. Privatization of Small-Scale Enterprises. We intend to privatize all small-scale enterprises (the majority of which are in the trade and service sectors), unfinished construction sites and the state-owned trucking fleet before the end of the first quarter of 1999. According to the Privatization Law, enterprises with less than 100 working spaces are classified as small-scale. We began the transition to a market economy with a total of 6,024 small enterprises. Of these, 4,641 are subject to privatization (of which 2,413, or 52 percent, are privatized), 912 are subject to privatization by special decision of the Government, and 471 are excluded from privatization, because they fall into the negative list categories stipulated in the 1997 Privatization Law and include assets of historic or cultural significance and defense enterprises. Small enterprises are sold exclusively through auctions. The Regulation on Auctions and Tenders stipulates that enterprises are offered for sale first through English auctions. Book value serves as the starting price, and bidding goes up until the enterprise is sold. If an enterprise is not sold after two attempts it is offered through a Dutch auction where offer prices decline until the first bid is made; the enterprise is sold at this price. After this, unsold enterprises will be liquidated and their assets will be sold through Dutch auction. 9. Our program, as specified in the Privatization Action Plan, calls for the sale of at least 500 small enterprises by May 15, 1998 -- which we accomplished -- and the completion of all small-scale enterprise privatization (at least 1,500 more enterprises sold) before the end of the first quarter of 1999. 10. Corporatization and Privatization of Large Enterprises. Enterprises with 100 or more working spaces are classified as large-scale. Of the 1,285 enterprises in this group, 773 are approved for privatization, 360 are proposed for privatization by special decision of the Government, including rail and air transport, electric power generations, educational and cultural institutions and 152 are excluded from privatization. The enterprises excluded from privatization include assets of historic or cultural significance and defense enterprises. Of the 773 to be privatized, 27 have already been sold, leaving 746 still to be privatized. 11. Prior to privatization, all large enterprises must be converted to joint stock companies. We have made a number of important changes to the procedures governing the incorporation process. Since the collectives no longer have any special purchase rights, a decision of the collective is no longer required. The founders' agreement and need for a shareholders meeting have been eliminated since there is now only one founder (instead of the state and collective) and only one shareholder (the state). Further, a sale agreement is not needed since no sale is taking place to the collectives upon incorporation. Enterprise directors must submit all documents to SPC or the  - 4 - local authority within 30 days of being notified of the requirement to incorporate. These changes have substantially simplified the process and now enable SPC to accelerate the pace of incorporation. Of the 746 large enterprises remaining to be privatized, 23 were incorporated as of February 1998. We have corporatized an additional 100 enterprises (resulting in a total of 123) and are committed to corporatizing the remaining 600 enterprises before the end of the first quarter of 1999. This will lay the foundation for acceleration of large-scale privatization during 1999. 12. Privatization of large enterprises is a time-consuming process and we intend to complete this component of the program between now and the end of 2001. In the short-term, we are committed to privatizing at least 120 large enterprises before the end of the first quarter of 1999.1 In this process, the Privatization Law allows the use of auctions or tenders. It is our policy to apply tenders only where there are compelling reasons to do so (for example, for very large enterprises in need of strategic investors). Otherwise, share auctions will be utilized applying the same procedures as those applied to the sale of small-scale enterprises. To ensure effective corporate governance, our policy is to sell at least 51 percent of each large enterprise as a single package. The remaining shares may be sold in smaller packets or distributed to bidderspro rata. Unsold enterprises will be liquidated and their assets will be sold through Dutch auctions. 13. To facilitate privatization of joint stock companies and to ensure protection of shareholder rights, we have established a centralized share registry in the Ministry of Finance. The registry will serve as the sole legal list of shareholders in open joint stock companies. 14. Privatization of Unfinished Construction. SPC currently estimates that there is a total of 800 unfinished construction sites throughout the country. Work on these sites, at various stages of completion, ceased when the civil war began and could not be completed due to fiscal constraints. We place priority on rapid transfer of these sites to private ownership in order to prevent further deterioration of the assets, create employment opportunities in the labor-intensive construction sector and expand the stock of business premises available to the emerging private sector. 15. A total of 350 of these sites are privatizable and we will privatize all of these assets before the end of the first quarter of 1999. We have issued a decree to allow privatization of all 350 unfinished construction sites through auctions. Portions of fifty of these sites were intended to provide social services, such as clinics or schools. For these 50 sites, we will require buyers to follow specific contractual conditions in order to facilitate provision of these services. 16. Privatization of Trucking. SF'C estimates that there is a total of about 50,000 trucks under state ownership. These are primarily under the control of the line ministries, state enterprises and farm collectives. Our priority in this sector is privatize in a manner which maximizes competition, thereby promoting greater efficiency and lower costs in this sector which has such a profound impact throughout the economy. We will rigorously apply the Regulation on Segmentation to this process, breaking up monopolies and promoting competition in the large trucking operations prior to privatization. The sales process will be simple, competitive and ' Privatization is defined as sale of at least 75 percent of an enterprise's shares or sale of assets through liquidation of the enterprises; only shares for which payment has been received will be included in the calculation.  - 5 - transparent. Because our goal is to make these assets available to private sector operators as rapidly as possible, all units will be sold exclusively through Dutch auctions with no minimum price imposed. However, a proportion of the fleet must remain under state ownership to support the functions of the military and to carry out the necessary and legitimate functions of government. A total of 30,000 trucks are subject to privatization/liquidation before the end of the first quarter of 1999. We will attempt to dispose of unsold trucks by selling them in volume as scrap. 17. Agricultural Reform and Privatization of Cotton Ginneries. In the past few years, we have been concentrating on structural changes in agriculture, which is the core of our economy, in order to promote increased productivity and production and increase employment opportunities, household income and foreign exchange earnings. In 1996 we removed price controls on all agricultural commodities and abolished the state order system. Rents, communal services and transportation and water usage charges are the only areas that are still subject to price control. Beginning in mid-1996, we required the industrial and agricultural water users to pay for water. In September 1997, we eliminated restrictions on cotton exports and considerably simplified cotton export mechanisms. We transformed the cotton marketing agency (Glavklopkoprom) into the Republican Corporation of Pakhteh Tajik (RCPT) and facilitated competition from other trading companies. As part of restructuring state and collective farrns, we revised the Land Code and established transparent and equitable criteria for selecting farmers to receive land and to enjoy unrestricted transfer and inheritability of land access rights. 18. We have given greater visibility and political support to the land reform process, created the Land Reform Committee and removed the land reform process from the exclusive domain of the Ministry of Agriculture. Our policy reform for the agricultural sector will be developed in a Letter of Sectoral Policy which will be underpinning our request for a Farm Privatization Project to be funded by IDA. 19. Cotton is one of the most important sectors of our economy. It is an essential source of foreign exchange and significant numbers of farmers depend upon cotton production as their primary source of income. The ginneries are currently operating at a fraction of their capacity and their financial condition continues to worsen. We expect privatization - and competition amongst ginneries - to lead to more efficient operations and greater responsiveness to farmers' needs. According to Government Resolution No 203 of May 1996, all 25 state-owned cotton ginneries were to be privatized by the end of 1997. One RCPT ginnery and one under the control of a state farm were privatized. Thus, 23 ginneries remain to be privatized. In eight of these, minority portions of shares have been sold to the collectives. 20. We are fully committed to privatizing all 23 state-owned ginneries before the end of the first quarter of 1999. To facilitate this, we will announce the auctions locally and in at least one international news paper. The auctions will be conducted with sealed bids, price will be the sole criterion for determination of winning bidders and no minimum price will be imposed. Bids will be opened in public and winners will be announced immediately. Foreign investors are welcome and are free to participate in the auctions on equal terms to domestic investors. We will structure the transactions in a manner which balances the need for effective corporate governance with measures to mitigate potential monopoly abuses. Transactions will be structured as follows: (i) potential buyers will be allowed to bid between 76 to 100 percent of shares of each ginnery; and (ii) the number of ginneries purchased by a single bidder will be limited, in consultation with the World Bank, in order to prevent emergence of private monopolies. The newly privatized gins  -6 - will be carefully monitored to ensure fair market behavior and further exposed to competition by encouraging new entrants into the market. Under the Anti Monopoly Law, we will restrict mergers by the privatized ginneries wh:ich may result in anti-competitive behavior. Our free trade regime will ensure free entry through imports of small gins which we expect to contribute to a more competitive environment. 21. Restructuring the Republican Corporation of Pakhteh Tajik (RCPT). RCPT is the descendant of Glavkhlopkoprom, a multi-function state organization engaged in management of cotton processing, grading and certification of cotton fiber, concluding futures contracts with cotton producers, supply of fuel and spare parts to cotton ginneries and overseeing the production of cotton seed. Insofar as RCPT now competes with private groups in cotton marketing and will soon lose responsibility for technical mnanagement of ginneries, we plan to dissolve RCPT, sell off all its assets and transfer the taslc of supervision of seed production and cotton grading functions to the Ministry of Agriculture before the end of the first quarter of 1999. 22. Privatization of Tadaz. Tadaz, a state enterprise which is engaged in the production of aluminum, is responsible for about 30 percent of all exports. Built in the mid-70s, the plant has an installed capacity of 512,000 tons and consumes nearly 40 percent of the nation's production of electrical power. All bauxite for the plant is obtained from foreign sources. It operates at a third of its capacity, employs about 10,000 people and is the major means of support for a community of about 75,000 people in Tursunzade. Plant performance has deteriorated in recent years. The smelter is heavily indebted and suffers from a shortage of working capital, skilled manpower and low product quality. Frequent disruptions in the supply of raw materials and spare parts threaten to render the plant totally inoperable. 23. We plan to privatize Tadaz. To undertake this important task, we will prepare a privatization plan for Tadaz, to be agreed with the World Bank, and initiate implementation of the plan before the end of the first quarter of 1999. The plan will consider options for breaking up Tadaz and privatizing its constituents units and address the social implications of the process. The terms of reference for the Tadaz privatization plan have been agreed with the World Bank. 24. Strengthening Commercial Legislation. During the early years of independence, we made good progress in establishing the basic legal framework for a private, market-oriented economy. In a recent review of commercial laws, we concluded that a number of improvements could be made to the legislation. Consequently, we have prepared and submitted to the Majles Oli amendments to the laws on Joint Stock Companies, Bankruptcy and Securities and Stock Exchange. With regard to the law oni Joint Stock Companies, we introduced amendments to strengthen protection of minority shareholder rights, set of maximum number of shareholders allowed for closed joint stock companies, shift responsibility for maintenance, of shareholder registries from open joint stock companies to a centralized share registry in the Ministry of Finance and eliminated unwarranted regulation of share transfers. On the Bankruptcy law, we introduced amendments to strengthen creditor rights, imposed time limits on court-appointed trustees to either conclude a settlement: between creditors and debtors or initiate liquidation, and to allow creditors to file a bankruptcy application immediately after a payment from a debtor is overdue. With regard to the Securities law, we introduced amendments to make the law consistent with changes to the law on Joint Stock Companies, clarified the types of securities which can legally circulate in Tajikistan and the property rights attached to those securities and eliminated unnecessary regulations on trading of securities.  -7 - Promotion of an Efficient Financial Sector 25. We have begun the process of reforming the financial sector to be able to provide competitive financial services in a market economy. Our reform program has focused on restructuring of the banking system. The first stage of banking reform has three main goals: (a) improving the legal framework for banking activities; (b) upgrading the regulatory framework and supervision capacity; and (c) restructuring individual banks, focusing on the five largest banks. 26. Structure of the Banking System. As of January 30, 1998, there were 25 licensed commercial banks of which the five largest (Sberbank, Agroinvestbank, Orienbank, Tajikbankbusiness, and Vnesheconomobank) accounted for 85% of assets, 76% of loans, and 97% of deposits. These five banks have their roots in the FSU banking structure, and four of them were privatized mainly by infusion of new capital. We recognize that the privatization of state owned banks did not solve all of the governance and management issues, as would have been the case had strategic investors -- mainly reputable commercial banks -- bought into these banks. For this reason, bank restructuring will emphasize governance and managerial issues, in addition to financial restructuring and risk management. 27. Of the major banks, only Sberbank as a state financial institution remains under the control of the state. The rest of the banks, with the exception of one small bank that is 50% owned by SOEs slated for privatization, have at least 70% private ownership. Private banks account for 70% of the assets, 45% of the deposits, and 95% of the loans in the banking system. 28. Financial Condition of Banks. We recognize that many of the banks, including the five largest banks, are in poor financial condition. To get a better picture of the financial state of the banking system, we commissioned diagnostic studies of the five major banks. The studies concluded that a significant proportion of bank portfolios were nonperforming, and that the amount of loan loss provisions that would be required could not be absorbed by the capital of all but one bank. Increasing the capital of banks is therefore an important component of banking reform, and for this reason the minimum capital requirement for all banks has been increased from $300,000 to $1.0 million effective June 30, 1999. This minimum capital requirement will also prevent many of the weaker banks, which came into existence at a time when the licensing process was lax. We expect to have a smaller number of banks, but these would have stronger financial structures. 29. While increasing capital would improve the financial condition of banks in the short term, there is a need to establish an environment that would promote prudent banking and minimize the occurrence of banks engaging in activities that go beyond the norms for risk taking. This environment would consist of a supportive legal framework and clear rules of conduct and performance, and would be an important basis for individual bank restructuring. 30. Legal Framework for Banking Activities. There are two areas in the legal framework where we have undertaken actions to improve the environment for banking activities. First, we have submitted to Parliament the draft Law on Banking and Banking Activities. This law will provide a clearer definition of the boundaries of banking activities. Second, we have submitted amendments to the Collateral Law. These amendments would improve the ability of creditors to realize collateralized assets in case of nonpayment by debtors. In addition, we have made revisions in the registration fee structure to reduce transaction costs.  - 8 - 31. Prudential Regulations. To provide the banks with clear and appropriate prudential regulations, we have issued a revised set of prudential regulations which were designed with the help of the IMF and the World Bank. These regulations set the norms of conduct for banks. We have prepared the regulations taking into account the conditions in Tajikistan, where the current economic climate is fraught with risk and where banks have yet to acquire the proper means of dealing with those risks. These regulations cover capital adequacy, liquidity, connected lending, large exposures, foreign exchange positions, and investments in nonbanking activities. We have also issued guidelines on loan loss provisioning. To remove the disincentives to banks in making adequate provisions for loan losses, the MoF has approved the inclusion of loan loss provisions as a tax deductible expense. As mentioned earlier, we will increase the minimum capital of banks to $1.0 million effective June 30, 1999. We will continue to review the appropriateness of the regulations with the help of the IMF and the World Bank. 32. The norms of conduct will have to be measured in a manner that provides adequate information to stockholders, management, regulators, depositors, and creditors. The current accounting system used by banks is a carryover from an era of directed credits and centralized control. We have therefore issued instructions that banks will convert to International Accounting Standards (IAS) starting 1998. To this end, we commissioned accounting advisors to provide a set of accounts and accounting procedures consistent with (IAS). The advisors are also assisting the banks in the implementation of the new accounting system, which will run in parallel with the banks' existing systems during 1998. Starting 1999, the banks will completely switch over to IAS. The five major banks will be required to have IAS audits by reputable firms beginning with their 1998 accounts, while the rest of the banks will face the same requirement beginning with their 1999 accounts. 33. Upgrading Supervision Capacity. We recognize the importance of an effective banking supervision capacity in enforcing the prudential regulations and in analyzing and dealing with risks faced by the banking system. We are implementing the recommendations of the IMF, the World Bank and the US AID on upgrading the Banking Supervision Department (BSD) in the NBT. We have reorganized the BSD and started to increase the number of qualified staff in line with the organization and staffing plan recommended by the IMF and the World Bank. We have also begun training of staff in analyzing banks in the context of the new prudential regulations and new accounting system. To this end, we have sent our staff to training with accounting advisors in the implementation of the IAS in commercial banks. We have also begun to make changes in our systems and information data base in line with new system of accounts and revised definitions in the prudential regulations. We will strengthen our off-site supervision and increase our on-site inspections of banlcs. While institutional strengthening is our ongoing effort, we expect the BSD to be fully upgraded by mid-1999. 34. Sberbank. We believe that privatizing Sberbank is not feasible at this time, since there are no reputable domestic strategic investors who can manage the bank and we cannot attract reputable foreign banks due to current economic and security conditions. In the medium term, we expect to privatize Sberbank by selling the bank to a reputable financial institution. In the short to medium term, our objective is to safeguard the 90% of household deposits by requiring that 80% of client deposits be either deposited with NBT or invested in government securities. In addition, Sberbank's lending activities will be limited to collateralized lending to the population with total loan portfolio not exceeding 20% of deposits plus capital as defined by the NBT. When the banking system becomes more stable and supervision capacity is improved, we will  9- decide to either remove deposit insurance altogether or extend it to the qualified banks. As far as the maturing loans are concerned, in case Sberbank is not able to collect them, it will follow the regulations on loan loss provisioning. 35. Agroinvestbank. Even though the Agroinvestbank is a private bank, the Government has exerted a heavy influence in the credit decisions of the bank, mainly due to the bank's role in the Government's agricultural credit programs. Thus, when a major portion of the bank's loan portfolio became nonperforming, the MoF took over half of the nonperforming loans and the other half were given extended maturities. The following steps have been undertaken to restructure the Agroinvestbank. The first step in the restructuring of the Agroinvestbank is the elimination of Government influence in credit decisions of the bank. To this end, Agroinvestbank will not be forced to lend under Government credit programs at the risk of the bank's resources. The second step is dealing with the remaining loans for which the Government has responsibility, thus cleaning up the bank's portfolio. Upon compliance of Agroinvestbank of the operational restructuring, the Ministry of Finance and the NBT will consider restructuring the Agroinvetsbank loans ( which involves the restructuring of the corresponding liabilities of the Agroinvestbank to NBT) which were granted under the central agricultural credit programs funded by the NBT. The third step is recapitalizing the bank from private investors. In May 1998, foreign investors injected $1.6 million of capital to the bank, to be followed by additional amount of $0.8 million in July 1998, bringing the capital adequacy ratio to prudential standards. The fourth step is the improvement of the bank's risk management and internal operations, including cutting back on personnel and branches. Agroinvestbank is currently implementing the recommendations of the diagnostic study of the accounting consultants and is expected to meet all prudential regulations by November 30, 1998. The fifth step is improving management and human resources. New managers will be hired and a staff training program in underway. 36. Tajikbankbusiness. During the first quarter of this year, Tajikbankbusiness (TBB) suffered liquidity problems. An analysis of the bank also showed that it was insolvent. After examining several options, NBT decided to restrict its lending operations and other activities while TBB is undergoing restructuring as defined in the Restructuring Agreement between NBT and TBB dated April 29, 1998. One of the restructuring conditions is for the completion of the negotiation between the MoF and TBB on the disposition of the $874,000 in "blocked accounts". If the MoF rules against TBB, the bank will have to incorporate the impact on its financial statements and do what is necessary, including capital increase to meet the NBT's prudential standards by November 30, 1998. If TBB does not meet the prudential regulations by November 30, 1998, NBT will revoke the license of TBB immediately. 37. Vnesheconombank (VEB) and Orienbank. VEB and Orienbank have agreed to implement the recommendations of the diagnostic studies. These diagnostic studies cover credit management, reporting, asset liability management, information technology, and human resource upgrading. These two banks are expected to meet all prudential norms by November 30, 1998. If they do not meet all the prudential norms, there will be penalties and restrictions on their banking activities. 38. Other Banks. Our strategy with the other banks has two components. First, we want to eliminate the weak banks through the enforcement of the minimum capital requirements. This will substantially reduce the number of banks through liquidation and mergers. Second, NBT will require of banks to meet by November 30, 1998, all of the prudential regulations. The NBT will impose penalties -- the most severe of which is a withdrawal of license -- on those banks that  -10- fail to meet prudential standards. 39. Payments System. Based on the recommendations of accounting consultants, we have adopted a plan that would improve the working of the payments system. These improvements involve minimal investments, but have significant impact in reducing the time it takes to effect payments, improving the control systems, and minimizing the amount of idle funds that banks have to keep with the NBT. These improvements take into account the inability of banks and the NBT to invest heavily in sophisticated hardware and software, as well as the undeveloped state of the communications system in the country. 40. Sustainability of Reforms. We recognize that the reforms that we have begun to implement will have to be sustained in order to have a lasting impact on the banking system. We also know that further reforms will be necessary as the banking system and the economy begin to develop, and different types of risk may arise that may need a policy and regulatory response. In order to sustain and build on the reforms, we will continue the process of strengthening the BSD of the NBT, especially the upgrading of skills to keep up with the growing sophistication of the delivery of financial services. We hope to be able to secure continuing support from the IMF on technical assistance to our banking supervision. Through an effective BSD, we will be able to keep the pressure on banks to maintain the implementation of recommendations of the diagnostic studies. We will be especially mindful of governance issues, which we will address through better information flows to all those involved with the governance of banks. We will encourage the banks to deal with managerial and human resource upgrading, and work with the Bankers' Association in providing better progranns for training. Finally, as the economy improves and the political and, security situation stabilizes, we hope to be able to attract reputable foreign banks through which competition and partnerships can be a major source of continual upgrading of our banks and banking system. Protection of the Social Safety Net and Social Sectors 41. The Government considers the alleviation of poverty as one of its key priorities. We confirm our commitment to a three part strategy to reduce poverty: macroeconomic stabilisation and economic growth, protecting expenditures on education and health, and targeting assistance to the poor. This strategy was supported by three IDA credits (Agricultural Recovery and Social Protection Credit, Pilot Poverty Alleviation Project, and Post-Conflict Rehabilitation Credit), and by an IMF financial program. After the initial implementation of the strategy, weran into major difficulties by the end of 1996. Progress, however, has been made in a number of areas since Fall 1997.  - 11 - 42. Eliminating Salary and Social Safety Net Arrears. One important element in the alleviation of poverty is the timely payment of salaries, pensions, and social safety net transfers by the Government. A combination of revenue shortfalls and increased allocation to defense and security resulted in a built up of arrears of salary and pension payments from TR 0.8 bn at the end of 1996 to TR 2.2 bn (0.4% of GDP in 1997) at the end of June 1997. Arrears in social safety net payments rose from TR 1.5 bn at the end of 1996 to TR 5.9 bn (1.0% of GDP in 1997) at the end of September 1997. The situation has improved over the last six months. Partly with the help of funds from the first disbursements of the Post-Conflict Rehabilitation Credit, arrears on social safety net were reduced, and pension arrears eliminated. By the end of 1997, salary and pension arrears of the state budget fell by TR 0.4 bn (0.1% of GDP in 1997) to reach a level of TR 1.8 bn. Over 85% of these arrears accrued to local budgets. 43. We will meet our commitment to reducing payment arrears by eliminating the remaining arrears in salary and social safety net by June 1998. Furthermore, we will provide the World Bank the quarterly budget data and monitor quarterly spending execution compared to the 1998 budget plan to ensure the full realization of the planned budget allocation on social sectors in the 1998 budge and will monitor quarterly spending execution compared to the 1998 budget plan. To prevent arrears from recurring again in the next year, we will adopt a realistic budget in consultation with the World Bank and IMF and ensure the timely payment of salaries, pensions, and social safety net payments and no outstanding arrears in the state budget in these sectors during the second half of 1998. 44. Protecting Education and Health Services. The Government is concerned about the ongoing worsening indicators in health and education, in particular the decline in basic health care and primary education services. Spending on health and education in 1997 exceeded the 1996 allocations to these sectors both as a percentage of total expenditures of the state budget and as a percentage of GDP (21% of total expenditures and 3.4% of GDP in 1997 compared to 15% and 3%, respectively, in 1996), despite disappointing results during the first half of the year. The 1998 state budget builds on this achievement by maintaining the total expenditure share of the education and health sectors at around 22%. A reversal of the deterioration of health and education services will not only necessitate further increases in budgetary spending on these sectors, but also the implementation of fundamental reforms to improve cost-recovery and spending allocation within the sectors. 45. We will ensure the full realization of the planned quarterly budget allocations for the education and health sector during 1998. The expenditure composition for 1999 in the social sectors, including health and education sectors and social safety net, will be reviewed in consultation with the World Bank and the Government will agree on the allocation and composition of the 1999 state budget to education and health. 46. Improving the Targeting of the Social Safety Net. In view of the difficult fiscal situation and the substantial differences in living standards within the population, we have to ensure that the limited resources spent on the social safety net reach the most vulnerable groups of the society. The move from universal bread to targeted-bread compensation in 1996, and the further tightening of the eligibility conditions together with the administrative reforms introduced in April 1997, improved the effectiveness of the social safety net. Yet, additional reforms are needed in order to further refine the target group. The reforms will take into account new information on the extent and characteristics of poverty from two sources. The Pilot Project on Poverty Alleviation by TASIF (Tajik Social Investment Fund) analyzed the distribution of  -12- poverty across communities. The Taji'kistan Living Standard Survey, which is to be conducted during the summer, will enable us to obtain nationally representative data on living standards. Based on the living standard survey, the Government will develop a poverty alleviation plan and agree with the World Bank on restructuring the social protection system and submit the necessary legislation to the parliament for implementation of the new system. Implementation of the Economic Reform Program - the Need for External Support 47. Effective implementation of the economic reform program supported by the proposed SAC requires external financing and will certainly put pressures on medium term balance of payments. The disbursements of the first and second tranches under the proposed SAC and the IMF balance of payments support under the ESAF arrangement will provide considerable assistance in closing the gap. Additional balance of payments support from the international donor community will be needed to attain a viable balance of payments position and further avoid severely compressing the economy. We aim at the full funding of the 1998 financing gap and will actively explore other donors' support during the forthcoming CG meeting of May 20, 1998, in Paris. 48. At our request, the World Bankc organized the first Consultative Group meeting in Tokyo on October 31, 1996. This forum gave us a unique opportunity to brief the donor community about our efforts in reforming the economy. It also enabled us to get commitment of US$185 million for balance-of-payments support, investment and technical assistance. However, to date, only a limited amount has been disbursed due to a number of factors, namely the deterioration in the security situation during the first quarter of 1997. We have requested the World Bank to organize a second Consultative Group meeting for us in Paris to discuss progress on economic stability, peace agreement implementation and our Public Investment Program along with technical and financial assistance requirements. 49. We are fully convinced that a frontal attack on the factors that breed corruption is required if the country has to make progress in achieving broad-based economic and social development and alleviating poverty. The costs of not doing anything at this point are likely to be substantial in terms of elevated risks of economic and social unrest, and increased income and regional inequalities. Having gone through a lengthy civil war which has damaged our country physically, economically and emotionally, we cannot afford to plunge into another era of darkness once again. For us, the anti-corruption agenda is not only good governance, but a critical policy for national survival. The underlying objectives in our reform program are improvement of economic policy framework, enhancing accountability, transparency and efficiency in the economy which will address anti-corruption indirectly. We need, however, to address corruption more directly. We have developed a direct approach in combating corruption and have presented an agenda to the CG meeting in Paris in order to obtain the necessary financial and technical assistance support for its implementation. 50. We are committed to implement quickly, effectively and consistently our economic reform program. The proposed SAC, augers well for this endeavor. It will create greater efficiency in our economy, facilitate development of the private sector and strengthen the banking system. By supporting the budget, it will facilitate enhancement of the budgetary provisions for health, education and social safety net. We expect to stabilize the macro economy, achieve economic recovery and pursue vigorously the necessary structural reforms. Sincerely yours, Yakhyo Azimov Prime Minister Republic of Tajikistan  Annex II TAJIKISTAN: Key Economic Indicators Projected 1997 1998 1999 2000 National Accounts 1/ (% of GDP at current prices) Gross Domestic Product 100.0 100.0 100.0 100.0 Agriculture 34.0 35.0 36.0 36.0 Industry 24.0 23.0 22.0 Services 42.0 42.0 41.0 42.0 Total Consumption 97.0 94.0 93.0 91.0 Gross Domestic Investment 7.1 9.1 10.6 11.7 Public 0.6 2.1 3.1 3.7 Private (incl. change in stock) 6.5 7.0 7.5 8.0 Exports (GNFS) 74.0 67.0 61.0 59.0 Imports (GNFS) 80.0 71.0 65.0 63.0 Gross Domestic Savings 1.6 4.6 6.5 7.6 Gross Domestic Product (US$ mil) 1087 1242 1499 1714 GNP Per Capita (US$, Atlas method) 330 Real Annual Growth Rates (%): Gross Domestic Product at mkt prices 1.7 3.4 4.0 4.0 Balance of Payments (US$ mil) Exports 746 762 849 939 Imports 759 768 854 944 Resource Balance -13 -6 -5 -5 Current Account Balance -60 -56 -62 -70 Residual Financing Gap 0 194 97 90 Memorandum Items: Current Account Balance/GDP (%) -5.5 -4.5 -4.1 -4.1 Mechandise Export Growth (%/6) 2.9 5.1 5.0 5.4 Mechandise Import Growth (%) 1.3 2.6 5.6 5.9 1/ The ratios at current prices are based on IMF projections.  TAJIKISTAN: Key Economic Indicators Projected 1997 1998 1999 2000 Public Finance (% of GDP) Total Revenues 13.7 14.8 15.9 16.2 Total Expenditures 17.0 18.1 19.7 19.3 Overall Budget Deficit -3.3 -3.3 -3.8 -3.1 Price Indices (1994=100) Merchandise Exports 105.2 107.5 111.1 114.7 Merchandise Imports 110.5 100.6 101.3 103.0 Merchandise Terms of trade 95.2 106.9 109.7 111.3 Nominal Exchange Rate (LC/US$) 581.0 751.0 750.0 750.0 Real Exchange Rate (LC/US$) 635.8 810.7 844.2 801.2 Domestic Inflation (%) 101.4 42.8 15.9 10.0 Total Debt Outstanding & Disb (DOD) 1039 1114 1208 1297 Net Disbursement -18 -5 3 2 Total Debt Services 72 54 53 80 Debt & Debt Service Ratios (%) DOD/Exports of Goods & Services 202.0 202.0 189.0 187.0 DOD/GDP 96.0 90.0 81.0 76.0 Debt Services/Exports of GS 13.9 9.8 8.2 11.5 Concessional Debt/Total Debt 15.8 23.3 29.0 32.9 World Bank Exposure Indicators IDA Outstanding & Disb (US$ mil) 41 69 105 133 IDA DOD/ Total Debt (%/6) 3.9 6.2 8.7 10.3 Sources: Data provided by the Tajik authoities and IMF staff estimates.  Annex III Page 1 of 1 TAJIKISTAN PROPOSED STRUCTURAL ADJUSTMENT Credit Timetable of Key Project Processing Events 1. Time taken to prepare: Eight months 2. Project prepared by: Government with IDA assistance(*) 3. Identification/preappraisal mission: January 1998 4. Negotiations: May 15, 1998 5. Planned Board Presentation: July 21, 1999 6. Planned effectiveness: July 31, 1999 7. Expected project completion: December31, 1999 * This Credit was prepared by a Bank staff team composed of: Messrs./Mme. M. R. Ghasimi, Task Team Leader; Robert J. Anderson, Sector Team Leader; Ishrat Husain, Director; Razi Batley; Stuart Bell; Subash Chandra; Robert E. Christiansen; Omar Hadi; Pirouz Hamidian-Rad; Tariq Hassan; Ahmed Jehani; Christine Jones; Albert Martinez; Michael Mills; Ian Newport; Kaspar Richter; and Mustapha Rouis.  Annex IV Page 1 of 2 Status of Bank Group Operations in Tajikistan IBRD Loans and IDA Credits in the Operations Portfolio Original Amount in US$ Millions Project ID Loan or Fiscal Borrower Purpose Credit No. Year IBRD IDA Cancellations Undisbursed Number of Closed Loans/Credits: I TJ-PE-53386 IDA 30370 1998 GOVT. OF TAJIKISTAN P-C RECONSTRUCTION 0.00 10.00 0.00 9.73 TJ-PE-55133 IDA 30220 1997 GOVT. OF TAJIKISTAN P-C REHABILTATION 0.00 10.00 0.00 0.00 TJ-PE-44202 IDA29460 1997 GOVT. OF TAJIKISTAN PILOT POVERTY ALLEV. 0.00 12.00 0.00 9.47 TJ-PE-43231 IDA28610 1996 GOVT. OFTAJIKISTAN INST. BLDG./TA 0.00 5.00 0.00 1.91 Total 0.00 37.00 0.00 21.11 Active Loans Closed Loans Total Total Disbursed (IBRD and IDA): 14.90 49.40 64.30 of which has been repaid: 0.00 0.00 0.00 Total now held by IBRD and IDA: 37.00 50.00 87.00 Amount sold 0.00 0.00 0.00 Of which repaid 0.00 0.00 0.00 Total Undisbursed 21.11 0.00 21.11 Generated by the Operations Information System (OIS)  Annex IV Page 2 of 2 Tajikistan STATEMENT OF IFC's Committed and Disbursed Portfolio As of March 31, 1998 (In US Dollar Millions) Committed Disbursed IFC IFC FY Approval Company Loan Equity Quasi Partic Loan Equity Quasi Partic 1997/98 Zeravshan Gold 3.00 4.20 6.74 0.00 3.00 1.20 6.74 0.00 Total Portolio: 3.00 4.20 6.74 0.00 3.00 1.20 6.74 0.00 Approvals Pending Commitment Loan Equity Quasi Partic 1997 NELSON GOLD 0.00 2.05 0.00 0.00 1998 ZERAVSHAN-NGC 0.00 3.00 0.00 0.00 Total Pending Commitment: 0.00 5.05 0.00 0.00  Annex V Page 1 of 2 Tajikistan at a glance 6/19/98 Europe & POVERTY and SOCIAL Central Low- Tajikistan Asia Incone Developmentdlamond- Population mid-1997 (millions) 6.0 478 3,236 GNP per capita 1997 (Atlas method, US$) 1/ 330 2,200 490 Life expectancy Average annual growth, 1901-97 Population NO) 1.6 0.3 1.8 Labor force (%) 2.2 0.5 1.7 GNP Gross per primary Most recent estinmat (latest year available since 1990) capita 7 enrollment Urban population (% of total population) 32 66 29 Life expectancy at birth (years) 69 68 63 Infant mortality (per 1,000 live births) 30 24 68 Access to safe water Child malnutrition (% of chikdrn under 5) .. .. 43 Access to safe water (% of population) . .. 76 Illiteracy (% of population age 15+) .. .. 34 ... Gross pnmary enrollment (% of schoo'lage population) 89 100 107 - Liaicmrstan Male 91 101 112 Female 88 100 102 KEY ECONOMIC RATIOS and LONG-TERM TRENDS 1976 1986 1996 1997 Economic rauos' GDP (US$ billions) .. .. 1.0 1.1 Gross domestic investment/GDP .. .. 7.2 7.1 Openness of economy Exports of goods and servicestGDP .. .. 77.0 74.0 Gross domestic savings/GDP .. 1.6 Current account balance/GDP -7.2 -5.5 Savings Investment Interest payments/GDP 0.0 2.9 Total debt/GDP 84.0 96.0 Total debt service/exports . .. 34.0 13.9 Indebtedness 197646 1987-97 1996 1997 199842 (average annual growth) Tajistan GDP . . 4.4 1.7 4.4 GOP per capita .. .. -5.8 -0.3 2.2 Low-income group Exports of goods .. .. -02 2.9 5.4 STRUCTURE of the ECONOMY 1976 1986 1996 1997 (% of GDP) Growth rates of output & Investment (%) Agricuture .. 28.1 32.0 34.0 *o Industry 372 25.0 24.0 0 I Services 34.7 43.0 42.0 -10 2 Private consumption 64.5 . .. General govemment consumption . 21.7 . - GDI GDP Imports of goods and services .. .. 81.0 80.0 197646 1987-97 1996 1997 Growth rates of exports & Imports(# (average annual growth) Agriculture -17.8 .. 20 Industry -23.8 0 o Services -35.0 .. .201 2 3 7 Gross domestic investment .4.9 -5.9 Imports of goods -12.9 1.3 Note: 1997 data are preliminary estimates. Aggregate data is to 1996. Figures in italics are for years other than those specified. The diamonds show four key indicators in the country compared with its income group average. If dat are missing, the diamond will be incomplete.  Annex V Page 2 of 2 Tajikistan PRICES and GOVERtUENT MiNANCE ________199___99 1976l 1StS 1S98 1997 nXn% Inflation I%) Oom"dec ptce (% change) ,. . Consumer prices 41.8 88.0 o Implicit GDP deflator 101.3 co Goverment flnhc. 200 (% of GOP) 0 0 Current revenue 12.1 13.7 01 92 02 54 s 07 Current budget balance -4.8 -2.0 Overall surplus/deficit .5 .8 -33 .3P de O CPI TRAOE TRADE ~ ~~~~~1976 1936 1996 1997 (ISS millions) 1 19tS 1SSS 1997 Export and import levels (US$ mill.) Total exports (fob) 770 746 eooo Agriculture 304 319 No Others 466 427 so_ Total imports (cif) 808 759 4M Food 122 107 20 Fuel and energJy 261 356 o , E |_ , Export price index (1994=1`00) 108.8 105.2 91 02 53 94 U 97 Import pice index (1994=100) 114.6 110.5 aEport *Imports Terms of trade (1994=100) 94.8 95.2 BALANCE o PAYMENT9 1976S 19t36 1S9S6 1997 (USS millions) Current account balance to GDP rao (%) Exports of goods and services 800 804 Imports of goods and services 838 8t8 o Resource balance -36 -84 t 2 Net income -48 -36 4 Net current transfers 30 40 .1 Current account balance, . 1 before official capital transfems -74 -80 -e Financing items (net) 84 43 20 Changes in net reserves -10 17 22 bemo: Reserves inciuding gold (USS millions) 14 30 Conversion rate (locaUVSS) 298.4 581 0 EXTERNAL DEST and RESOURCB FLOWS 19____9___199__199_ 1976 19t36 1996S 19S7 (US$ millions) ComposMton of total debt 1997 Total debt outstanding and disbursed 868 1039 (US* mill.) IBRO 0 0 IDA 30 41 a c Total debt service 180 72 F 41 32 0 IBRD 30 _. 0 022 IDA 0 0 0 0 Composition of net resource flows Official grants 30 19 3 Official creditors - Prvate creditors E Foreign direct investment 11 576 Portfolio equity 0 0 World Bank program Commitments 0 55 A- loRC E ateral Disbursements 30 22 8 - IDA D-Other murlsterml F - Prvate Pnncipal repayments 0 0 c-IMF G - Short-tern Net flows 30 22 Interest payments 0 0 Net transfers 30 22 ECSPE 8/19/98 1/ Estimated.  \STANAte7 l TAJIKISTAN MAIN ROADS ' To Tashkent T T Toashkent - +-- ; RAILROADS ._'--~- ,_ t *0 SELECTED CITIES . ( r A9t U Z B E K0. O AUTONOMOUS OBLAST (AO) CENTER To Guliston ~~~~~~,,, ~To Ouqon