Morocco - Financial Markets Development Loan

 ICRR 10337 Report Number : ICRR10337 ICR Review Operations Evaluation Department 1. Project Data : OEDID : OEDID: L3928 Project ID : P005522 Project Name : Financial Markets Development Loan Country : Morocco Sector : Financial Adjustment L/C Number : L3928 Partners involved : Prepared by : Laurie Effron, OEDCR Reviewed by : Alice Galenson Group Manager : Ruben Lamdany Date Posted : 06/23/1999 2. Project Objectives, Financing, Costs and Components : The two main objectives of the loan were to establish a market -based financial system and develop the domestic capital market as a main supplier of long -term capital for private investment . The financing consisted of an adjustment loan of $ 250 million equivalent (of two single-currency loans, in US dollars and French francs, each for US$ 125 million equivalent) to be released in two tranches of $ 150 million (upon effectiveness) and $100 million (about 15 months later). It was intended to offset most of the fiscal costs of one of the major reforms envisaged under the loan : the elimination of mandatory placements in banks of Treasury bonds at below market cost. The President's Report contained a calculation of the incremental cost to Government over the following three years of financing the gradual increase in Treasury bonds financed at market rates, and this came to $272 million equivalent. The loan was approved in July 1995. It consisted of reforms in four major areas : (i) Treasury financing, which included (inter alia) elimination of mandatory placement of Treasury bonds in banks at below market rates, changing features of Treasury bonds to improve marketability, and elimination of fiscal incentives on Treasury bonds; (ii) Indirect monetary control, which included interest rate liberalization and a change in the reserve requirement; (iii) capital market development, through improving the regulatory framework of the stock exchange and mutual funds and the legal framework for corporations; and improving the accounting framework for insurance companies; and (iv) the banking system, which included privatization through offer of Government owned shares in 3 specialized banks and establishment of a foreign exchange market . 3. Achievement of Relevant Objectives : All of the reforms were carried out within the expected time frame, except the sale of Government -owned shares in two of the three specialized banks and the total elimination of mandatory ratios of bank holding of Treasury securities. The second tranche was released as expected, in late 1996. The Treasury financing is now based more on market mechanisms than in the past, the Treasury has moved to indirect monetary control, the regulatory and institutional framework of the capital market has been put in place, and Government had an attempted sale of one of the specialized banks (that did not succeed for lack of acceptable bids in the first round and absence of bidders in the second), but apparently remains committed to privatization of all three specialized banks . 4. Significant Achievements : Most of the key indicators for project implementation have been achieved or exceeded : the macro-financial indicators and indirect monetary control have been pretty close to targets and several of the capital markets indicators have done better : treasury bond auctions as a proportion of treasury domestic debt and market capitalization as a proportion of GDP substantially exceeded the targets in 1996 and 1997. Although behind schedule, Government did, after tranche release and as it committed to do, eliminate the mandatory placement of Treasury bonds in banks . 5. Significant Shortcomings : The second tranche was released with a waiver of two conditions, which are arguably the two most important ones of the operation. One of them, the reduction of mandatory Treasury bond placements, the Government did eventually fulfill (see next para.), but the other on bank privatization, Government has yet to carry out, even now, two and a half years later. The Bank either overestimated Government's commitment to privatization or the time required to carry it out. The fiscal justification for the adjustment loan was to finance the incremental cost to the Government of eliminating mandatory placements of Treasury bonds in banks at below market interest rates and having to fund the bonds at market rates. The ratio was to decrease from 20% of the banks' liabilties before Board presentation to 0% about 15 months later, prior to second tranche release . In the event, mandatory placements were eliminated only in December 1997, some 15 months later than expected. A recalculation of the fiscal costs of the actual reduction shows that at the time of the second tranche release the incremental cost already incurred and expected over the following 18 months was already covered by the first tranche release of US$ 150 million. Thus the fiscal justification for releasing the second tranche no longer existed . A third shortcoming is the limited liquidity of Treasury bonds; the secondary market for government securities remains thin and the interest rates are still partly administered . Finally, one of the two major objectives of this operation was to develop the capital markets as a main supplier of capital for private investment. Banks continue to hold 25% of their assets in government securities and long term financing for private investors remains, according to the ICR, relatively scarce . In addition, although the stock market has grown more than expected, no private non -financial firms have issued initial public offerings, either in the form of debt or equity. Thus, although many of the indicators have been exceeded, one of the main objectives of the reform has not yet been achieved . 6. Ratings : ICR OED Review Reason for Disagreement /Comments Outcome : Satisfactory Marginally Because of significant shortcomings listed Unsatisfactory in section 5 above. Institutional Dev .: Substantial Modest No bank privatization occurred; no secondary market for Treasury securities developed; and capital market not yet playing expected role of providing financing to private firms. Sustainability : Likely Likely Bank Performance : Satisfactory Unsatisfactory Downgraded mainly because the justification for releasing the second tranche was absent. Also, a more minor reason is the Bank's overoptimism on the speed of privatization of the specialized banks. Borrower Perf .: Satisfactory Satisfactory Quality of ICR : Satisfactory 7. Lessons of Broad Applicability : OED agrees with both of the lessons cited in the ICR : a long-term relationship is essential for seeing through various stages of sectoral reform, particularly in the financial sector, which can take a long time; and the Bank needs to be realistic in setting timetables for certain reforms, particularly privatization of state banks which may not be in great health. 8. Audit Recommended? Yes No 9. Comments on Quality of ICR : The ICR is satisfactory; it gives a balanced account of what was achieved, some of the shortcomings of the achievements, and what remains to be done . It would have helped the reader, however, if it had included the policy matrix from the President's Report with the list of conditions and noted which ones had been fulfilled and when, so that the reader could see in one place, for example, whether the law on consolidated financial statements had been adopted, and the government guarantee eliminated on domestic bond issues by public enterprises . In addition, the report is a little confusing on a couple of points . For example, the expectation at the time of appraisal was that banks' profitability would increase because the interest paid on government securities in their portfolios would double. The report notes that government securities are 25% of banks' assets, implying that they have either remained constant or increased in the balance sheets of the banks, and that investment credit to private firms is therefore relatively scarce (although no evidence is presented to support the statement about scarce credit ). Yet later the report notes (para. 17) that banks' profitability has increased because of the elimination of the mandatory holdings and thus (sic) an increase in the relative weight of loans on the banks' balance sheets . It would have been useful to have a clear analysis of whether government securities have decreased as a proportion of banks' assets and when this happened, in relation to the reduction in mandatory holdings; and whether the increased profitability is coming from the higher interest rates on the government securities or the shift to more lending . The report also asserts that the banking system operates according to internationally recognized norms and standards, yet these norms were only recently applied (mid-1996) to the specialized banks, which may be a relatively significant part of the banking system's term -lending, so it may only be a part of the banking system that is operating according to these norms .