Madagascar - Financial Sector and Private Enterprise Development (APEX) Credit Project

DEocument of The World Bank FOR OFFICIAL USE ONLY Rqot No. 7712-lAG STAFF APPRAISAL REPORT MADAGASCAR FINANCIAL SECTOR AND PRIVATE ENTERPRISE DEVELOPMENT (APEX) CREDIT FEBRUARY 16, 1990 Africa Regioi South Central and Indian Ocean Department Industry and Energy Operations Divisior. Tbis document has a restricted distribution and may be used by recipients only In the performance of their offcial duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS Currency Unit - Malagasy Francs (PMG) US$1.00 P MG 1,580 (March 1989) WEIGHT AND MEASURES Metric System FISCAL YEAR January 1 - December 31 ABBREVIATIONS AO - Money Market Bidding APB - Professional Bankers' Association APEM - Malagasy Enterprise Promotion Association AU - SME Assistance Unit BFV - Bank for Commerce BMOI - Malagasy Bank of the Indian Ocean BNI - Bank for Industry BP - Project Bureau BTM - Bank for Agriculture CB - Central Bank of Madagascar CBD - Central Banking Department of the IMF CCCE - Caisse Centrale de Cooperation Economique CCI - Chamber of Commerce & Industry CFC - Training Center for Managers CIDA - Canadian Intetnational Development Agency CNAPS - Social Security Fund CNFPB - National Banking Training Center FED - European Development Fund FIVMPAMA - Association of Malagasy Entrepreneurs FNI - National Investment Fund FNUP - Commodity Price Stabilization Fund GEM - Malagasy Entrepreneur Grouping GDP - Gross Domestic Product ILO - International Labour Organization ,.OCAE - National Institute for Commercial Science and Accounting IRF - Investment Rediscount Fund ISAc - Industrial Sector Adjustment Credit ITPAC - Industry and Trade Policy Adjustment Credit JCEM - Association of Young Entrepreneurs MEP - Ministry of Economy and Plan MFB - Ministry of Finance and Budget OGL - Open General License System PAS - French Structural Adjustment Credit PB - Project Bureau at the Central Bank PE - Public Enterprise PFI - Participating Financial Intermediaries PSAC - Public Sector Adjustment Credit SERDI - Industrial Development Studies Agency SDR - Special Drawing Rights SME - Small and Medium Enterprise UNDP - United Nations Development Program UNIDO - United Nations Industrial Development Organization  FOR OFICIL USE OM.Y MADAGASCAR STAFF APPRAISAL REPORT FNANCIAL SECTOR AND PRIVATE ENTERPRISE DEVELOPMENT (APEX) CREDIT Table of Contents Page No. Credit and Project Summary . . . . . . . . . . . . . . . . . . i-ii Introduction . . . . .... ...... ... ...... .... ....... .... ....... 1 PART I. THE SECTORAL ENVIRONMENT . . . . . . . . . . . . . . 1 A. Economic Setting .. . . . . . . . . . . . . . 1 Background ..1 Structural Adjustment Policies . . . . . . . . . . . . . 2 Recent Developments . . . . . . . . . . . . . . . . . . 4 B4 The Fnrri4al: Retor - e . ..... ......... . 4 Structure. 4 Performance of the Banking Sector . . . . . . . . . . . 7 Liquidity and Profitability . . . . . . . . . . . . . 7 Portfolio Restructuring . . . . . . . . . . . . . . . 8 Lack of Competition . . . . . . . . . . . . . . . . 9 Monetary Policy .10 Interest Rates, Resource Mobilization, and Efficiency in the Banking System . . . . . . . . . . 14 C. Private Enterprise Sector . . . . . . . . . 15 Past Performance and Policy . . . . . . . . . . . . . 15 Industry ... . . . . ..... 15 Agriculture . . . . . . . . . . . . . . . . . . . . . . 16 Services ... ... 17 Constraints and Development Potential . . . . . . . . 17 Small and Medium Enterprises . . . . . . . . 18 Government SME Policies . . . . . . . . . . . . . . . 19 Technical Assistance to SMEs . . . . . . . . . . . . . . 19 This report is based on the findings of an appraisal mission to Madagascar in January 1989. The mission was composed of Messrs. Christian Schmidt and Andres Jaime of AF3IE, of Philippe Callier of EDIFI and of Messrs. Heinz Bertsch and Roland Tenconi, Consultants. This document has a rtricted 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.  PARTU . W _GROUP LE ING STRATEGY . . . . . . . . . . . . 21 PART III. THE PROJECT . . . . . . . . . . . . . . . . . . . . 22 Project Objectives and Justification . . . . . . . . . . . 22 Lessons Learned from Previous Projects . . . . . . . . . . 22 Project Description . ................. . 23 Sector Policy Measures and Conditions . . . . . . . . . 23 APEX Credit Component . . . . . . . . . . . . . . . . . . 25 Size of the Component . . . .. . . . . . ... . .. . 25 Institutional Arrangements . . . . . . . . . . . . . . . 25 Eligible Intermediaries . . . ............ ... 26 Eligible Beneficiaries and Subprojects . . . . . . . . . 26 Terms and Conditions of Financing . . . . . . . . . . . 27 Subloan Processing and Administration . . . . . . . . . 29 Assistance and Training Component . . . . . . . .*. . . . 30 Design and Special Features . . . .... * . . . . . 30 Financial Sector TA Program . .... ..... ... . 30 Technical Assistance to the Mining Sector . . . . . . . 31 Private Sector Framework ... . . . . .............. . 31 Development of Small and Medium Enterprises . . . . . . 32 Summary of Estimated Cost ... ................. 35 Terms and Conditions .... . . I . ... 35 Project Bureau . . . . . . . . . . . . . . . . . 35 SME Assistance Unit . . . . . . . . . . . . . . . . . . . 36 Project Cost and Financing . . . . . . . . . . . . 37 Project Implementation .... . . . . ................ . 38 ProjectManagement ................. 38 Procurement and Disbursement ... . . . ............. . 38 Special Account .... . . . . . . . . . . . . . . 39 Auditing and Reporting ........ .... 39 Project Benefits and Risks ................ 40 Benefits . . . . . . . . . . . . . . . . . . . . . 40 Risks . . . . . . . . . . . . . . . . . . . . . . . . 40 PART IV - AGREEMENTS AND UNDERSTANDINGS REACHED . . . . . . . 40 ANNEXES I. Distribution of Credit by Sector . . . . . . . . . 43 II. Distribution of Credit by Term and Type of Borrower . 44 III. Summary Balance Sheet of BFV . . . . . . . . . . . . . 45 IV. Summary Balance Sheet of BNI . . . . . . . . . . . . . 46 V. Sumnary Balance Sheet of BTM . . K ......... 47 VI. Central Bank Organization Chart ... . . . . . . . . . 48 VII. Schedule of Disbursements . . . . . . . . . . . . . . . 49 VIII. Selected Documents Available in the Project File . . 50  MADAGASCAR FINANCIAL SECTOR AND PRIVATE ENTERPRISE DEVELOPMENT (APEX) CREDIT CREDIT AND PROJECT SUMMARY Borrower: Democratic Republic of Madagascar. Beneficiaries: Central Bank of Madagascar (CB), participating financial intermediaries, the Small and Medi'm Enterprise (SHE) Assistance Unit at the Ministry o' Economy and Plan, Chamber of Conmerce and Industry, Association of Young Entrepreneurs, local training institutions and consulting firms. Amount: SDR 36.4 million (US$48.0 million). Termst Standard IDA, 40 years. Relending Terms: Mi) The borrower would onlend US$45.0 million equivalent in local currency to CB at CB's regular reference rate (currently 12.0 percent p.a.) minus an administrative fee of 0.5 percent (to cover the operating cost of the Project Bureau within CB) for 30 years, including a grace period of 10 years. CB would onlend the funds to qualified participating financial intermediaries at its regular reference rate with a flexible amortization schedule reflecting the aggregate maturity of subloans extended by intermediaries. The onlending and final lending rates would be flexible and adjusted periodically. The spread which participating intermediaries could charge to beneficiary enterprises would initially be limited to a maximum of 7 percentage points. Prior to release of the Credit's second portion, this cap would be removed. The Government will assume the foreign exchange risk. With real interest rates in local currency roughly equivalent to real interest rates in internatlonal markets, and as the exchange rate and interest rate policies are broadly based on a market-clearance approach, domestic interest rates would adequately reflect the expectations of devaluation. The project would include provisions to ensure the continued adequacy over time of the onlending arrangements, i.e., that they continue to reflect the economic cost of capital, including the implicit foreign exchange risk. (ii) The Us$3.0 million equivalent in local currency allocated for Technical Assistance would be made available to implementing agencies by Government on a grant basis.  - ii - Benefits: Expected benefits are to help maintain the momentum of the reform process in the financial sector, especiallv now that the first new private comercial bank has just started operations. The Credit would furthermore act as a cacalyst, paving the way for more active private sector initiatives not only in the financial sector, but likewise in the industrial and other productive sectors, through helping support proposed reforms in the Chamber of Commerce and Industry and involving the private sector in the technical assistance component. Broader access to credit by the private sector is expected through the APEX line of credit component, which would encourage real sector supply response in the form of investment and reconstitution of permanent working capital. Risks: idagascar is undergoing substantial changes in its banking sector not only through portfolio restructuring of existing banks but also through allowing private capital to re-enter the sector for the first time since 1972. While the project aims at reinforcing and carrying forward these reforms, there remains a risk that the political will to continue with this process might falter, especially in implementing expected privatization efforts of financial institutions and within the enterprise sector in general. The Government's commitment to reform and achievements during the last five years suggest that the risk is not excessive. Estimated Project Costs: Local Foreign Total 2 ------------USS million----------- Investments 18.5 44.0 62.5 94.3 Technical Assistance and Tra'ning 1.6 1.9 3.5 5.3 SME Assistance Unit 0.2 0.1 0.3 0.5 TOTAL 20.3 46.0 66.3 100.0 Financing Plan: Subborrowers 18.1 - 18.1 27.3 SME Assistance Unit 0.2 - 0.2 0.3 Proposed IDA Credit 2.0 46.0 48.0 72.4 TOTAL 20.3 46.0 66.3 100.0 Estimated IDA Disbursements: IDA Fiscal Year 1990 1991 1992 1993 1994 1995 1996 1997 -------------------------(USS million)--------------------- Annual 0.5 3.5 7.5 8.5 8.3 9.4 6.0 4.3 Cumulative 0.5 4.0 11.5 20.0 28.3 37.7 43.7 48.0 Rate of Return: n/a Map: n/a  MADAGASCAR STAFF APPRAISAL REPORT FINANCIAL SECTOR AND PRIVATE ENTERPRISE DEVELOPMENT (APEX) PROJECT Introduction 1.01 Since the early 1980s the Government of Madagascar has demonstrated its commitment to the adjustment process through the implementation of important and difficult measures which were supported by several IDA adjustment operations and by successive IMF stand-by arrangements. The most recent adjustment operation, the Public Sector Adjustment Credit (PSAC), approved in June 1988, made substantial progress on banking sector issues and initiated a process of policy reforns, both to be supported and carried further by the proposed Credit. 1.02 Overall, the operation would blend into the ongoing Government policy reform program launched in 1983. It is intended to consolidate the financial sector policies supported by earlier credits, and to capitalize on the major restructuring efforts already made in the financial sector through additional supply-oriented measures in a number of important policy areas. Its main components would be: a US$45.0 million APEX credit line for financing viable majority private investment projects in all productive sectors, the provision of a US$3.0 million technical assistance and training component and, finally, a set of accompanying policy reforms concernxing the financial and private enterprise sectors. PART I - THE SECTORAL ENVIRONMENT A. Economic Setting 1.03 Background. With a population of 11.6 million growing at 32 per year and a per capita income of US$200 in 1987, Madagascar remains one of the poorest countries in the world. Its economic record is mixed, characterized by stagnation from 1972 to 1980, sharp deterioration between 1980 and 1982, and financial stabilization with limited economic growth since 1983. Preliminary estimates for 1989 suggest that economic growth has picked up, reaching over 4X. Agriculture continues to be the mainstay of the economy, employing four-fifths of the population, creating about 42Z of GDP and generating over 802 of export earnings.  1 '4 The poor economic performance of the 1970s stemmed largely from in&ppropriate economic policies, which emphasized a much increased role for the public sector, with industrialization as the central objective, agri- culture in a supporting role, nationalization of foreign-owned enterprises, extensive consumer subsidies, and controls over private economic activity. Nevertheless, until 1978, the Government also pursued cautious financial policies that kept the fiscal deficit low, held the balance of payments in approximate equilibrium and resulted in a debt service ratio of only 4Z. 1.05 Between 1978 and 1980, the Government embarked on a policy of massive public investment. It was poorly coordinated, concentrated on economically unviable prujacts, and was financed mainly with external borrowing on commercial terms. This policy, combined with declining terms of trade and stagnant domestic revenues produced a fiscal deficit of 142 of gross domestic product (GDP) in 1980, an annual inflation rate of 302, and a large increase in the external debt burden that has severely constrained economic growth. 1.06 In mid-1980, the Government ini.Ated measures aimed at financial stabilization, and from 1982 ons-,rds it reinforced them, with IMF assistance. From 1981 to 1986, policy adjustment centered largely on demand management. During this period, the fiscal deficit was reduced substantially (from 14Z to 4.5Z of GDP in 1988), mainly by lessening expenditures. 1.07 Largely as a result of these developments, the annual expansion of domestic credit fell sharply, and annual inflation dropped from about 30Z in 1981-82 to about 132 in 1983-86. On the external side, the current account deficit was cut almost in half from its level of about US$425 million in 1981. With exports stagnating and scheduled external interest payments almost doubling, the brunt of the adjustment feil on imports, which dropped by more than half in real terms since 1982. Real GDP, which had contracted by 10? between 1980 and 1982, started growing again in 1983, and reached an estimated growth rate of 32 in 1938 and over 42 in 1989. Structural Adjustment Policies 1.08 After several years of progress in stabilizing the economy, the Government turned its attention to restructuring the economy through supply-oriented measures after 1985. Initially, it pursued a cautious reform strategy addressing structural distortions sector by sector, based on their importance, beginning with industry, moving on to agriculture and the trade and exchange rate regimes and then, with support from the Bank's PSAC, approved by the Executive Directors in June 1988, on to a broader agenda that includes public sector and partial banking sector reform. 1.09 Concerning industry, the Government, in 1985, eliminated most ex-factory price controls and reduced the controls on profit margins. It also improved the quality of public investment in manufacturing, eliminated the export taxes on manufactured products, and ovex-hauled the investment code. IDA supported this effort with an Industrial Sector  -3 Adjustment Credit (ISAC) in FY86. In 1987, the Government-owned banking sector tightened credit to loss-making public enterprises, a step that led some unviable units to close. In parallel, the Government undertook a series of studies to determine the viability of public enterprises and of the financial sector. 1.10 The sectoral policy improvements in industry could not result in a lasting supply response as long as the external trade and exchange regime continued to be dominated by quantitative restrictions and an overvalued exchange rate. Thus, in 1987, the Government moved to establish a trade and foreign exchange allocation regime broadly based on market forces. The measures included: (i) a large devaluation totaling 462 in foreign currency terms (Hay-June 1!87); (ii) replacement of the quantitative import restrictions, which were being used for protective purposes, with a simplified tariff structure (January 1988); and (iii) implementation of a market-determined allocation system for foreign exchange for imports, through the open general license (OGL) system (July 1988). IDA supported these reforms with the Industry and Trade Policy Adjustment Credit (ITPAC) in FY87. More recently, and in carrying the above sector specific changes further, IDA approved the PSAC in FY88, which centered on: (i) reforming the budgetary process to raise the efficiency of allocation and utilization of Government resources; (ii) streamlining the parastatal sector to concentrate public resources on activities that are economically viable and that belong in the public domain; (iii) reforming the commercial banking system, including its opening to private capital to improve competitiveness and efficiencyt and (iv) removing of administrative obstaclas to the expansion and diversification of exports, including elimination of the state monopolies over traditional export crops. 1.11 These st:uctural reforms are complex and it will take two to three years to implement them effectively. During this period, GDP growth is expected to continue improving gradually and surpassing pzpr2t