Mozambique - Small and Medium Enterprise Development Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No. P-5106-MOZ MEMORANDUM AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PR'POSED CREDIT OF SDR 25.1 MILLION TO THE PEOPLE'S REPUBLIC OF MOZAMBIQUE FOR A SMALL AND MEDIUM ENTERPRISE DEVELOPMENT PROJECT NOVEMBER 21, 1989 Thbis document has a restricted distributon and may be used by reciplets only iD the pr fornnawe of their offical duties. Its contents may not otherwise be disclosed without World Bank autborization.  CURRNC EQUIVAETS (OCTOBER 1989) US$ 1 8 1l3 Meticais (MT) - October 1989 US$1 - 682 l4eticais (NT) - at time of appraisal MT 1000- US$1.47 p ABBREVIATIONS AND ACRONYIS BM Bank of Mozambique ZIB European Investment Bank ERP Economic Rehabilitation Program IDIL Instituto Nacional da Desenvolvimento de Industria Local (National Institute for Local Industry Development) PFI Part.4.cipating Financial Institution PPF Project Preparation Facility SME Small and Medium Enterprise FISCAL MR Government and Public Enterprises: Calendar Year  FOR OMCLuL USE ONLY MOZAMBIQUE SMALL AND MEDrIJ ENTERPRISE DEVELOPMENT PROJECT. CREDIT AND PROJECT SUINKARY Borrower People's Republic of Mozambique Beneficiaries Bank of Mozambique, Ministry of Industry and Energy (Instituto Nacional da Desenvolvimento de Industria Local), participating banks, and eligible small and medium business enterprises. Amount SDR 25.1 million (US$32.0 million equivalent) Terms Standard IDA terms, with 40 years maturity Onlending terms From the IDA funds of US$32.0 million equivalent, the Bank of Mozambique (BM), acting as executing agent, would make available approximately US$28.5 million to the participating financial institutions (PFIs), for onlending on the basis of actual loan approvals and agreed eligibility criteria. The remaining total of about US$3.5 million would be retained by BM(Central) for technical assistance to the banks and the industrial promotion organization (IDIL), and for training. The PFIs would onlend the credit proceeds in local currency to beneficiary enterprises at adjustable interest rates based on the structure of rates prevailing in Mozambique. The onlending credit risk would be borne by the PFIs who would receive a spread as determined within the banking system. The foreign exchange risk would be borne by the BM(Central) on behalf of the Government, and would be covered by the interest yield on funds onlent, net of the service charge on the IDA credit, the administration costs, and the spreads of the PFIs on onlending. Subloans under the Credit would have a maturity of 3 to 12 years with 1 to 4 years grace period. The onlending terms and conditions are to be reviewed annually. Financing Plan (US$ million) IDA 32.00 Banks 3.00 Beneficiary enterprises 5.50 Multilateral cofinancing 7.50 Government 2.20 50.20 Completion Date June 30, 1996, and closing date of December 31, 1996 Rate of Subprojects under the Credit must earn financial Return and economic rates of return of not less than 12Z. Staff Appraisal Report Report No. 7987-MOZ 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.  MEMORANDUM AND RECOHMENDATIONS OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED CWEDIT TO THE PEOPLE'S REPUBLIC OF MOXAMBIQUE FOR A SMALL AND MEDIUM ENTERPRISE DEVELOPMENT PROJECT 1. The following memorandum and recommendation on a proposed development credit to Mozambique for SDP. 25.1 million (US$32 million. equivalent) is submitted for approval. The proposed credit would be on standard IDA terms with 40 years maturity and would help to finance a Small and Medium Enterprise Development Project. Parallel cofinancing for the project has been provided by UNDP and provisionally confirmed by the European Investment Bank. Discussions with other agencies are also ongoing. The principal implementing agencies would be the Bank of Mozambique and the Ministry of Industry and Energy, and beneficiary enterprises. 2. Backaround. After independence in 1975 Mozambique's industry encountered serious problems through: (a) the departure of many enterprise owners and almost all skilled manpower which obliged the new Govermnent to take control of over 300 enterprises, many neglected and with debt arrears; (b) the adverse security situation after 1980, which led to a severe drop in export earnings and an acute scarcity of foreign exchange for imports of industrial inputs; and (c) control of exchange rates, interest rates, product prices, production and distribution under the central plan. These factors resulted in currency overvaluation and major domestic market distortions and the build up of the fiscal deficit and external debt. As a result, 1986 industrial output fell to about 45? of that of 1980, with widespread disinvestment and excess capacity. The banks faced parallel problems: (a) interest rates were fixed at negative real levels; (b) term lending ceased, with a loss in appraisal capability; (c) the sole private bank's share of lending fell to 3? by 1986, while the state-controlled Bank of Mozambique (BM) built up an 80? lending share, in addition to attempting to fulfill its responsibilities as Central Bank; and (d) financing of enterprise losses led to serious loan arrears, and solvency problems. Short- term stability was possible due to high liquidity and high spreads over cost of funds. Enterprises of below 10 workers were particularly successful in adapting to adverse economic conditions, and the overall recorded share of the small and medium enterprises (SMEs), including micro-enterprises, rose from 25Z to over 30? of industrial output between 1973 and 1587. 3. Government's obiectives and strategy. Since 1987 the Government has been addressing the economic distortions ard structural constraints through a comprehensive Economic Rehabilitation Program (ERP). Government objectives for industry under the ERP are: (a) to rehabilitate directly a selected group of larger scale enterprises; ard (b) to create a supportive environment for development and rehabilitation of SMEs, requiring restoration of the banks' capacity to mobilize deposits and conduct appraisal based lending. The SME project focusses on objective (b), while a parallel project, the Industrial Enterprise Restructuring Project, addresses (a). The enhanced role proposed for the SME sector is justified because of its resilience, dynamism, and potential for development of e trepreneurship. Under the ERP, Government strategy for industry has incl. led: (a) currency devaluation (which has reduced real wages), and opening up of foreign exchange allocation; (b) price and distribution decontrol; (c) investment promotion through foreign and domestic investment codes, an exchange retention scheme,  - 2 - and corporate tax and tariff reforms; and (d) increased private sector participation, management autonomy and accountability. Out of approximately 300 enterprises initially intervened by the Government during 1975-77, about 140 have been returned to private interests, especially at the small-scale level. A UNDP-financed, Bank-executed, Business Environment Study made a series of recommendations for the design of fiscal and monetary incentives for industry with special emphasis on SHEs, industrial efficiency, and the development of industrial finance. The report endorsed the general direction of policy reform in the sector as it is currently being implemented. 4. In the banking sector a parallel reform process is under way to rehabilitate the banks as vehicles for efficient mobilization of savings and investment. Government strategy has includedt (a) increasing nominal interest rates to positive real levels in 1990, with rationalization of the rate structure; (b) curtailment of lending for enterprise deficits; (c) expanding the role of the private sector bank and smaller state bank, with increase in their lending share (from 25Z to 502 during 1988). The role of BM, as Central Bank, will be clarified by the separation of the accounts and staffing of its commercial and central banking functions. Portfolios are being strengthened with the curtailment of enterprise deficit funding and Government assumption of responsibility for certain noncollectible loans. A credit survey carried out for IDA shows significant unrealized demand for term lending for fixed investment by SMEs. Future banking reform will need to focus on: (a) further clearance of lending arrears and recapitalization of the banking system; and, (b) use of appraisal based lending to strengthen loan portfolios. Despite the obvious weakness of both the industry and the financial sector the recent indications are that a genuine policy turnaround has been achieved. The strengthening of this process is now essential. 5. Rationale for IDA involvement. The ERP has been supported by three IDA Rehabilitation Credits which have supplied significant assistance to industry, as well as by considerable bilateral and multilateral assistance. Industrial sector support mainly through short-term commodity aid has been provided by Sweden, UK, Italy and other bilateral agencies, and by the African Development Bank. The rationale for the SME Development Project is to build on these and IDA's sector advisory work, and to support the policy developments already under way in industry and banking at a strategic stage in the reform process. A multi-bank credit line will assist the banking system as a whole to recover from its weak position, and will provide a lead in addressing the longer term issue of increasing investment through bank lending to viable enterprises. IDA support for SHE will also provide a framework through which bilateral donor support could be coordinated. 6. Project objectives . The objectives of the proposed project are: (a) to promote the rehabilitation and development of the SME sector by financing small and medium enterprises capable of efficient operation within the reformed business environment; (b) to promote institution rebuilding by restoring the capacity of the public and private sector banks to deliver and manage term credit to SMEs; and (c) to assist in the formulation of Government policy for SME development.  - 3 - 7. Pro3ect description. The project has an SME financing and an institutional strengthening component. Under the financing component a line of credit would be made available through a subsidiary administration agreement between the Government and BM (Central), for onlending to BM (Commercial), the state controlled Banco Popular de Desenvolvimento, and the private Banco Standard Totta. The foreign exchange risk will be borne by BM (Central) on behalf of Government, with credit risk absorbed through appropriate spreads by the commercial banks. The line of credit will be supervised by an apex unit in BM (Central) overseen by a Government interdepartmental committee. Subject to meeting eligibility and efficienc- (including environmental) criteria, subproject loans will be available for fixed investment and incremental permanent working capital. In order to ensure satisfactory project implementation, an annual review of project issues, including onlending interest roete and terms, would take place. 8. Under the institutional strengthening component a training program funded by UNDP is already under way and will be completed prior to the implementation of the project. This will train about 50 banking and promotional staff in loan appraisal and loan processing, with IDA funding for follow up training. Technical assistance will also be provided through BM for the start-up and operation of the apex unit and the credit mechanism, for strengthening of accounting capabilities in the participating banks, and for studies to assist the restructuring of the banking and industrial sectors. The project would also support the Instituto Nacional da Desenvolvimento de Industria Local to set up a small business advisory service, part of whose role would be to help prepare loan applications under the line of credit. 9. Total project costs are estimated at US$50.2 million equivalent, of which US$39.5 million (792) is in foreign currency. The project cost and financing plan is at Schedule A. Procurement and disbursement details are at Schedule B. The timetable of key project processing events and status of Bank Group operations in Mozambique are at Schedules C and D. The Staff Appraisal Report, No. 7987-MOZ is attached. 10. Status of cofinancing. Parallel cofinancing of ECU6.0 million (about US$7.0 million equivalent) has been proposed by the European Investment Bank, who attended negotiations as observers and will negotiate separately with the Government. UNDP has provided training and consultant funding of US$0.5 million. There is no financing gap; however, in view of the level of unrealized demand for industrial credit, further financing may be justified, and indications are that additional cofinancing may be available, both for enterprise investment and technical assistance. 11. Actions agreed. The Government will be expected to carry out the following actions: (a) before the Credit is declared effective, enter into a Subsidiary Administration Agreement with BM; finalize the staffing of the apex unit and make it fully operational; finalize and provide to IDA the participation agreements between at least two commercial banks and BM (Central); and (b) before first disbursement by each PFI, provide to IDA for review the model subloan agreement between each PFI and beneficiary enterprises.  - 4 - 12. During the Implementation of the project the Government would, through BM, prepare, not later than March 31, 1991, an action program to strengthen the accounting capabilities of the PF1s, and a phased program for the separation of the central and commercial banking functions of BM, by June 30, 1991, to be implemented promptly thereafter. With regard to the rehabilitation of the banks, the Government would formulate action prograr- as follows: (a) by December 3', 1991, to settle lending arrears of t. commercial banks, including BK CCommercial); and, (b) by June 30, 1992, for the financial restructuring of the banking system, and for extension of competition in the banking sector. The Government has agreed to facilitate provision of foreign exchange for replenishment of imported inputs and provision of licences for imports by subprojects. The Government would also hold annual project implementation reviews with IDA, inter alia. tot (a) monitor progress made in achieving project objectives: (b) review progress in the implementation of the above action programst (c) review onlendir.g terms and conditions and progress on achieving positive real lending interest rates (in accordance with Government's program to achieve positive rates by 1990); and, (d) review the audited financial statements of the PFIs. The first implementation review would consider proposals for continuing industrial policy reform, based on the Business Environment Study, and on the action program for upgrading the accounting capabilities of the PFls. 13. Benefits and risks. Significant economic benefits are expected to arise from the start-up and rehabilitation of SMEs that are efficient earners or savers of foreign exchange, and capable of providing increased employment and income. The small enterprise sector is expected to provide relatively good prospects for the development of indigenous resources and entrepreneurship. In addition benefits will flow from strengthening of the banking system. All enterprises financed will be appraised; all subprojects will require a minimum 12Z financial rate of return, and larger subprojects will also require a 12Z economic rate of return. The main areas of risk includes (a) implementation delays due to problems in bank reorganization, the lack of credit experience of the banks themselves, and the need to resolve enterprise financing problems, (to be mitigated through technical assistance, and training in loan appraisal); (b) slowdown of price reforms under the ERP due to social or political pressures; however the commitment shown by Government suggests that these risks are not high; (c) possible deterioration of the security situation; however because of their small capacity and urban location, most SMEs are less vulnerable to security related disruption of rural infrastructure, supplies and markets. 14. Recommendation. I am satisfied that the proposed credit would comply with the Articles of Agreement of the Association and recommend that the Executive Directors approve the proposed credit. Barber Conable President. Attachments Washington DC. November 21, 1989  -5- Schedule A Page 1 of 2 SMALL AND =EDIUN ENTERPRISE DEVELOUPEN? PROJECT PROJECT COST ESTIMATES (US$ Million) Local Foreign Total Z of C0ot Cost Cost Total (1) Bnterprise Financin ComPonent Civil works, machinery, equipment, spares, materials 10.00 34.07 44.07 Consultants services 0.50 1.50 2.00 Sub-Total . 10.50 35.57 46.07 91.80 (2) Institutional Strengtheninu Component IDTh Advisers - 0.36 0.36 Equipment, facilities 0.05 0.07 0.12 Apex Unit/BM Adviscr - 0.36 0.36 Equipment, facilities 0.05 0.20 0.25 Materials, office supplies 0.05 0.10 0.15 Consultants Services Studies (financelindustry) 0.24 0.24 Training 0.05 0.48 0.53 PFI accounts upgrading - 2.00 2.00 Policy Study (Business environment) - 0.12 0.12 Sub-Total 0.20 3.93 4.13 3.20 (3) GRAND TOTAL 10.70 39.50 50.20 100.00  _6- Schedule A Pla. 2 of 2 SMALL AND HIDIU ENTIRPUsZ DEW gamTP3OC PROPOSED FIMNACING PLAN (US$ million) Local Foreign Total S of Cost Cost Cost Total (1) Enterprise Pinancing Camponent IDA - 28.57 28.57 European Iivestmert. Bank - 7.00 7.00 Enterprises 5.50 - 5.50 Particiipatizg Banks 3.00 - 3.00 Government 2.00 - 2.00 Sub Total 10.50 35.37 46.07 91.80 (2) Institutional Strengthening Component IDA - 3.43 3.43 UNDP - 0.50 0.50 Government 0.20 - 0.20 Sub Total 0.20 3.93 4.13 8.20 (3) Totals 10.70 39.50 50.20 100.00 of which: Total IDA - 32.00 32.00 63.70 Total Cofinancing (EIB, UNDP) - 7.50 7.50 15.00 Total Banks and Enterprises 8.50 - 8.50 16.90 Total Government 2.20 - 2.20 4.40 Total 10.70 39.50 50.20 100.00  -7 Schedule B Page 1 of 2 SMALL AND MEDIUM ENTERPRISE DEVELOPHENT PROJECT Procurement Arrangements (USS million) ICB a/ Direct Co- Other Total Contracting financing Procedures ILSILCB b/ Enterprise Finance Component Civil Works, Equipment Materials 8.00 29.07 7.00 44.07 (8.00) (19.07) (0.00) (27.07) Consultancy 2.00 2.00 (1.50) (1.50) Institutional Strengthening Component Equipment, facilities 0.37 0.37 (0.27) (0.27) Consultants, advisers 0.12 2.96g.' 3.08 (0.00) (2.96) (2.96) Training 0.05 0.38 0.10S 0.53 (0.00) (0.00) (0.10) (0.10) Operating supplies 0.15 0.15 (0.10) (0.10) Total 8.00 31.64 7.50 3.06 50.20 (8.00) (20.94) (0.00) (3.06) (32.00) Note: since the type of subprojects are not known in advance, these cost breakdowns are indicative only. Figures in parentheses are the respective amounts financed by IDA. a/ ICB = International Competitive Bidding. This would apply to contracts of above $500,000. b/ ILS (International and Local Shopping), and LCB (Local Competitive Bidding) are applicable to contracts below US$500,000, with public bid offering for civil works contracts. Direct contracting vill apply to goods and works contracts of less than US$100,000. c/ Contracts would be awarded in accordance with IDA Guidelines for Use of Consultants.  Schedule 8 SMMLL AND I!pZUM UI!RPUSU DILOP)U? PROJECT DisbursemAmt ArraYnmate nad Schetule Amount of the Percentage of Credit Allocated Expenditures Cateaorn to be FinLaced Part A of the Project, Subloans for. (a) Goods 15,000,000 100* of foreign expenditures and 702 of local expenditures (b) Civil and 10,300,000 100* of total engSineering works expenditure (c) Consultants' services 1,500,000 100* of total (part 34) expenditure Part B31 of the Project lUOP)s (a) Goods and services 310,000 100 of total expenditure (b) Operating costs (office supplies) 100,000 100* of foreign expenditures and 702 of local expenditures Part 32 (a) and (b) of the Projects Consultants' services and training 340,000 100* of total expenditure Part B2(c) of the Project (PFI accounts)t Goods and services 2,000,000 100* of total expenditure Part B3 of the Project (IDIL)s Goods and Services 425,000 1002 of total expenditure Refunding of PPF 250,000 1002 of amount advanced Unallocated 1,775.000 TOTAL 32,000,000 A_roximte'pojected IDA disbursements (US$ million or equivalent) Fiscal Year 1990 1991 1992 1993 1994 1995 1996 Total Enterprise financing 2.00 4.00 6.00 6.00 7.00 3.57 28.57 Equipment - 2.58 0.50 - - - - 3.08 Training 0.10 - - - - - 0.10 Refund of PPF 0.25 - - - - - - 1.00 TOTAL 0.25 4.U 4.50 6.00 6.00 7.00 3.57 32.00  -9- Schedule C SMALL AND MEDIUM ENTERPRISE DEYVFOPHENT PROJBCT Timetable of ley Processing Events (i) Time taken to prepare: 14 months (ii) Prepared by: Government with IDA assistance (iii) First IDA mission: February 1988 (iv) Appraisal mission departure: March 1989 (v) Negotiations: October 1989 (vi) Planned date of effectiveness: June 1990 (vii) List of relevant PCRs and PPARs: None  - 10 - Schedule D Page 1 of 2 MOZAMBIQUE SMALL AND MEDIUM ENTERPRISE DEVELOPMEN4T PROJECT jTAT111 O A.rOUPflPfAIlgIDHwIozAn,:gu IPNLOA - UmuuAnsig GAiI A IIAI CAIT .._..._.................... Aeut in UP .iIIi: (lee :ancell iol|p CNt Y0. Y Barrawe PUrg, ;WA *t; .edl ;| Credits 0 Cr"hdts() clsoed C140-O 196 OAI URN REMA 60.d0 TOTAL nuabr Credits * 11 U9.50 246.12 el w9hich read TOTALU hed y aa &ID AwAt sold Of thich rapid TOTAL undisbarud 246 J2 NOTES: * Not yet effectve is Not et tiged IS$ Total Appro#f,ved eauts, pibWmtr*tpilne aavea tuoLo 8 Ca (RI indicat om ri u t;it The Nlt Apro d I d au bts ae hstria val, all thnr an wl vale. The iSiinaQ EffeKtiv ad Cluingt uo k pwV tbe Low h rbtmt otical ad en Mt tae fr~tTik-dV ie  i4 oI- 0