Document of The World Bank FOR OFFICIAL USE ONLY Report No. 11682-MAG STAFF APPRAISAL REPORT REPUBLIC OF MADAGASCAR FINANCIAI. INSTITUTIONS DEVELOPMENT TECHNICAL ASSISTANCE PROJECT APRIL 28, 1993 Industry and Energy Operations Division South-Central and Indian Ocean Department Africa Regional Office 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 EOUIVALENTS Currency Unit = Malagasy Franc (FMG) USS 1 1,899 FMG (March 1993) = 1,833 FMG (average for 1992) WEIGHTS AND MEASURES Metric BritishtUS Eauivalent 1 meter (m) = 3.28 foet 1 square meter (sq. m) = 10.76 square feet 1 kilometer (km) = 0.62 mile 1 square kilometer (sq. km) = 0.39 square mile ABBREVIATIONS AND ACRONYMS AON = Appels d'Offres Negatives (Liquidity Withdrawal) AOP = Appels d'Offres Positives (Liquidity Injection) BCRM = Banque Centrale de la Republique Malgache (Central Bank) BFV = Banky Fampandrosoana ny Varotra (State-Owned Commercial Bank) BITS = Swedish Agency for International Technical and Economic Cooperation BMOI = Banque Malgache de l'Ocean Indien (Private Commercial Bank) BNI = Bankin'ny Indostria (Private Commercial Bank) BTA = Bon du TrEsor par Adjudication (Short-Term Treasury Bill) BTC = Bon du TrEsor Classique (Medium-Term Treasury Bond) BTM = Bankin'ny Tantsana Mpamokatra (Stae-Owned Commercial Bank) CCBEF = Commission de Contr6le des Banques et Etablissements Financiers (Financial Supervisory Commission) CCP = Compte de Chequer Postaux (Postal Checking Institution) CD = Certificates of deposit CEM = Caisse d'Epargne de Madagascar (Postal Savings Institution) CNAPS = Caisse Nationale de Prevoyance Sociak (Social Security Fund) CNFPB = Centre National de Formation de la Profession Bancaire (School of Banking Training) CPI = Consumer Price Index IASC = Intenational Accounting Standards Committee IFAC = Intenational Federation of Accountants INSCAE = Institut National des Sciences Comptabia et de l'Administration des Entreprises (School of Business Management and Accounting) NGO = Non-govemmental Organization NPCB = Nouveau Plan Comptable Bancaire (New Banking Chart of Accounts) PCM = Plan Comptable Malgache (1987 General Chart of Accounts) PIT = Postal and Teleommunications Services SA = Societe Anonyme (Private Limited Company) SDP = Plan StratEgique de DEveloppement (Strategic Development Plan of BCRM and CCBEF) SILI = Syst&me d'Importations Liberalis&a (Open General License) SME = Small and Medium Enterprises FISCAL YEAR January 1 - Deenmber 31 FOR OFFICIAL USE ONLY STAFF APPRAISAL REPR MADAGASCAR FINANCIAL INSTITUTIONS DEVELOPMENT TECHNICAL ASSISTANCE PROJECT TABLE OF CONTENTS Page No. CREDIT AND PROJECT SUMMARY ...................... (i) I. INTRODUCTION .......................................... 1 II. THE FINANCIAL SYSTEM ....................................... 2 A. Macroeconomic Context ......................................... 2 - Background .......................................... 2 - Recent Developments ......................................... 3 B. The Financial Sector ......................................... 4 - Recent Developments ......................................... 4 - Required Institutional and Policy Reforms ........ .................... 6 - Financial Sector Strategy ....................................... 7 C. The BCRM (Central Bank) ........................................ 9 D. The CCBEF (Financial Supervisory Commission) ......................... 13 E. The Commercial Banks ......................................... 14 F. The Insurance Sector ......................................... 14 G. The Social Security Fund. 15 H. Postal Financial Services ............................. 15 I. The Payments System ............................. 16 J. Financial Markets ............................. 16 K. Accounting and Audit Framework .............................. 16 III. THE PROJECT ............................. 18 A. Project Objectives and Scope ............................. 18 B. Rationale for IDA Involvement . ............................. 19 This report is based on the findings of a Bank appraisal mission which visited Madagascar from Pebruary 20, 1993, to March 5, 1993, comprising of Messrs/MMme Govindan Nair, financial economist, (AF31E - mission leader and task manager); Simon Gray, economist, (AF31E); Maud Borg (consultant, central bank mauagement); and Ake Andolf (consultant, information systems). Mr. Khalid Siraj (ASTlF) was Iead reviewer and Mr. P"cal Bouvier (IMF) was peer reviewer. Contributions are acknowledged from Mrs. Claudine Morin, lawyer (LEGAF), and Mr. Colin Lyle, auditing and accounting specialist (AFTCP). Messrs. Stokes and Thomet, respectively consultants for USAID and the Swiss Government, also participated in various aspects of the appraisal mission. Bilingual seretarial support was provided by Mrs. Franqoise Schatten, staff assistant, (AF31E). Messrs. Francisco Aguirre-Sacasa (AF3DR) and Michael N. Sarris (AP31E) are respectively the Department Director and the managing Division Chief for the operation. 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. C. Project Description ....................... .... .... ..... .... .. . 19 1. Restructuring BCRM ........... ............................. 19 2. Strengthening CCBEF .......... ............................. 23 3. Improving the Accounting and Audit Framework ....................... 24 4. Support to State Bank Privatization ............................... 25 D. Project Costs. 25 E. Project Financing .26 F. Project Implementation, Monitoring and Mid-Term Review .26 G. Procurement .27 H. Disbursements .29 I. Accounting, Auditing and Reporting .30 J. Project Supervision .30 IV. PROJECT BENEFITS AND RISKS ................................. 31 A. Project Benefits . ......................................... 31 B. Project Risks . .......................................... 31 V. AGREEMENTS TO BE REACHED AND RECOMMENDATIONS .. 32 ANNEXES 1. Statement of Financial Sector Reform and Development Policy 2. Madagascar: Monetary Survey, 1986-1992 3. Main Technical Assistance and Training Activities: Summary Description of First Year Tasks. 4. BCRM Informatics Program 5. Project Costs 6. Estimated Disbursement Profile 7. Implementation Schedule for Key Project Components 8. Monitorable Actions under the Project 9. Project Supervision Plan 10. Terms of Reference for BCRM Coordinator of Strategic Planning and Development MADAGASCAR FINANCIAL INSTITUTIONS DEVELOPMENT TECHNICAL ASSISTANCE PROJECT CREDIT AND PROJECT SUMMARY Boffower: Republic of Madagascar. Beneficiaries: Central Bank of the Republic of Madagascar (BCRM), Financial Supervisory Commission (CCBEF), Ministry of Finance. Amount: SDR 4.6 million (US$6.3 million equivalent). Terms: Standard IDA terms with 40-year maturity. PRelending Government passes SDR 3.5 million of the Credit to ITrms: BCRM on a grant basis. Objectives: The project objective is to facilitate investment and growth in the productive sectors by improving the functioning of the financial system. This is in line with the Bank's country assistance strategy which emphasizes increased private sector savings and investment as engines for future growth. The project aims at strengthening key financial institutions and markets in Madagascar (including privatization of the two remaining state banks), thereby enhancing public trust in them and enabling them to mobilize savings to meet the investment financing needs of the private sector. The project will be implemented in the context of the Government's Statement of Financial Sector Reform and Development Policy adopted in March 1993. Specifically, the project would aim at: (i) enhancing the Central Bank's (BCRM) ability to formulate and conduct monetary policy based on indirect instruments; (ii) improving the prudential supervision environment through the strengthening of the Financial Supervisory Commission (CCBEF); (iii) formulating and enforcing accounting audit and financial disclosure standards based on international norms; and (iv) supporting the privatization of state banks. Project Description: The project consists of: (a) restructuring BCRM, the Central Bank, principally through improvements in its research, open market, treasury, internal audit and accounting operations, and through the implementation of information technology and human resource development plans; (b) strengthening CCBEF, the Financial Supervisory Commission, with technical assistance to create an effective supervision structure, training for inspectors and equipment for on- and off- site surveillance; (c) improving the accounting and audit enviroment, through two sets of activities: (i) training and technical assistance activities to accelerate the development of the - ii - accounting profession and to ensure the availability of reliable financial information on enterprises based on international standards; and (ii) specific technical assistance and training to bankers, auditors and other professionals to establish, disseminate and implement transparent international accounting and audit procedures for commercial banks and financial institutions; and (d) supporting the privatization of banks in the context of an ongoing process of privatizing one of the two state banks, BTM, and a Government commitment to a similar process for the other state bank, BFV, by supporting specialized consultant services such as for valuation and placement of these banks with private investors. The Credit would finance technical assistance, training, equipment and vehicles. Benefits: The major benefits of the project will derive from its contribution to the establishment of an efficient financial system, with an effective banking system at its core, which is essential for the development of a market-oriented economy. The project will help implement an overall strategy for market oriented financial reforms, particularly in strengthening the framework for prudential supervision, accounting and audit. In turn a sound financial system will facilitate productive investments and contribute to accelerated economic growth and the creation of employment opportunities which are key factors in poverty alleviation. Specifically, the project is expected to: (i) enhance the effectiveness of BCRM to conduct monetary policy; (ii) strengthen the prudential supervision role of CCBEF and over time engender greater confidence in the use of indirect controls rather than direct controls to allocate resources; (iii) enhance the security and efficiency of financial transitions and the quality of financial intermediation through a greater stimulus for financial savings and more efficient allocation of capital; and (iv) help avert future financial crises rather than simply react to them. Risks: The major risks of the project stem from the possible impact of the present transitional political decision-making structure on effective implementation. Successful implementation is predicated on political will being maintained to preserve the authority of BCRM and CCBEF, respectively, to formulate and execute monetary policy and to exercise prudential oversight of banks. At the same time, the institutional development goals for BCRM and CCBEF are complex and ambitious, including significantly redefined business objectives and extensive use of information technology, and could be subject to implementation slippages. These risks are mitigated by: (i) the high level of commitment to project objectives and to the project's urgency expressed by a broad spectrum of political figures and technicians; (ii) limiting the project core to BCRM which has demonstrated continuity in its institutional capacity; (iii) the progress already made, by BCRM and CCBEF themselves, towards preparing this project, indicating early ownership and internalization of project design and objectives; and (iv) up-front agreement and implementation of key organizational and institutional changes necessary to execute the project. Rate of return: Not Applicable - iii - SUMMARY PROJECT COSTS ESTIMATES f (USS thousand) ESTIMATED PROJECT COSTS: L l gl l ~~~~~~~~~~~~~~~~LoOcal Foreign Total 1. Strengthening BCRM T T Advisory Services for Central Bank Organization - 60.0 60.0 Research Department - 832.0 832.0 Credit Departmnt - 295.0 295.0 Foreign Exchange - 315.0 315.0 External Debt Management - 218.0 218.0 Planning & Management of Circulation of Notes & Coins 53.0 854.0 907.0 Accounting 82.0 499.0 581.0 Internal Audit 26.0 307.0 333.0 Information Systems 345.0 4,014.0 4,359.0 Human Resources 144.0 380.0 524.0 Project Management Assistance - 502.0 502.0 Sub-Total 650.0 827 892.0 2. Strengthening CCBEF 21.0 556.0 577.0 3. Improving the Audit & Accounting Framework 204.0 456.0 660.0 4. Supporting the Privatization of State Banks - 200.0 200.0 TOTAL _.488.5 D0.360 a The incremental staff and operating costs under the project will be borne by the implementing agencies concerned, mainly BCRM. k/ Includes annual physical contingencies of 5%, and annual price contingencies of 4% in US$. - iv - Financin2 Plan: (USS milion) SOURCE ~LOCAL PfEO OA IDA 0.6 S.7 6.3 USAID 0.3 2.7 3.0 Switzerland 0.6 0.6 BITS 0.S 0.5 TOTAL 0.9 9.S 10.4 ESTMATED IDA DISBURSEMENTS (US$ million) FY 1994 199S 1996 1997 1998 19991 Annual 0.7 1.8 1.6 1.1 0.7 04] Cumulative 1 0.7 2.5 4.1 5.2 T 5.9 1 6.3 MADAGASCAR FINANCIAL INSTITUTONS DEVELOPMENT TCNCAL ASSISTANCE PROJECT STAF APPRAISALRE R L.INTRODUCTO 1.1 In 1991, a number of economic reforms were abandoned as Madagascar entered into a period of political turbulence. Fundamental weaknesses in the financial sector had severely undermined the capacity of the authorities to execute structural adjustment programs and as a consequence their sustainability was thwarted. Madagascar is still in a period of political transition with limited authority to undertake a comprehensive structural adjustment program. This period of transition does, however, present the opportunity to strengthen key financial institutions in preparation for the resumption of broad economic reforms and economic recovery and growth. 1.2 Significant strengthening of the Central Bank (BCRM) and the Financial Supervisory Commission (CCBEF) is indispensable for mobilizing savings to meet the investment financing needs of the private sector and to laying the foundations for sustainable economic growth. The proposed project will be implemented in the context of a Government Statement of Financial Sector Reform and Development. The core of the project is centered on BCRM which has demonstrated continuity in its institutional capacity over the transition period. 1.3 The project will specifically: (i) reinforce the institutional capacity of BCRM so that it can initiate and sustain financial sector reform through more effective formulation and execution of monetary policy; (ii) develop CCBEF so that it can effectively execute its prudential supervision functions and consequently engender greater confidence in the use of indirect controls in allocating financial resources; (iii) improve financial accounting and audit in enterprises and in the financial sector, specifically the banking system, by basing them on internationally accepted standards; and (iv) help complete the process of privatizing the remaining two state banks. 1.4 The proposed project was appraised in February 1993 by a World Bank mission consisting of: Messrs./Mme Govindan Nair, financial economist, (AF3IE - mission leader and task manager); Simon Gray, economist (AF3IE); Claudine Morin, lawyer (LEGAF); Maud Borg, (consultant, central bank management); and Ake Andolf (consultant, information systems). Contributions are acknowledged from Mr. Colin Lyle, accountant (AFTCP), and Messrs. Stokes and Thomet, respectively consultants for USAID and the Swiss Government, who also participated in various aspects of the appraisal mission. - 2 - II. HE FINANCIAL YSTEM A. Macroeconomic Context Background 2.1 Madagascar, with a population of 12 million growing at 3 percent per year, and per capita income of about US$220, is one of the world's poorest countries. It is the fourth largest island on the planet with wide variations in soils, topography and climate, and it features unique flora and fauna. The country's staple is rice, and the major exports are coffee, vanilla, cloves and shellfish. In the early years of independence in the 1960s, Madagascar witnessed modest growth, followed by stagnation from 1970 to 1980, and a severe downturn to 1982. Financial stabilization followed with limited economic growth from 1983 to 1987. Since 1988, the economic results were encouraging until 1990, shortly after which the country entered into a period of political turbulence in 1991. 2.2 In the period from 1983 to 1988, Madagascar implemented a comprehensive program of stabilization and economic reform. The Government's deficit was slashed from 18 percent of GDP in 1981 to just over 4 percent in 1989. Monetary creation slowed and so did inflation from a high of 31 percent in 1981 to 9 percent in 1989. At the same time the external current account deficit (including transfers) dropped from 10 percent to 5 percent of GDP. In achieving these stabilization measures Madagascar was supported by four IMF standby arrangements since 1985, which were subsequently replaced by arrangements under the Enhanced Structural Adjustment Facility in 1989. 2.3 Actions, albeit slower than required, were also taken to reform the trade and exchange rate regimes. The exchange rate moved away from being fixed administratively to more flexibly managed with significant depreciation of the real effective exchange rate. Complementary actions on tariff reform were also implemented. All quantitative restrictions were lifted by 1988, followed by a four-year program instituting ad valorem tariffs, rationalizing product import categories from 69 to 16, and introducing minimum and maximum tariffs of 5 percent and 80 percent, respectively. 2.4 In tandem with these trade reforms, structural adjustment was tackled on a number of different fronts. Price controls were virtually eliminated over the decade with prices on agricultural commodities and the consumer price of rice being completely freed in 1985 and retail prices on 90 percent of value added in industry being decontrolled by the end of the decade. Over the same period, the Government rolled back the monopoly of public marketing authorities, most notably in coffee, clove and pepper exports and through the legalization of private trade in rice, pulses and groundnuts. Currently, only the vanilla trade remains controlled. The effect on the rice industry was immediate, with significant increases in production in the 1987 season and a significant decline in import rice dependency to 1990. 2.5 Public expenditures underwent a fundamental reorientation in the 1986-90 Development Plan that emphasized: maintenance and rehabilitation, improved utilization of capacity, a much reduced role of the State in manufacturing, and a major rationalization for agriculture. The first rolling triennial investment program was formulated for 1989-1991 and was followed by further improvements in a subsequent program for 1990-1992, which included increased aggregate provision for counterpart funding for externally assisted projects, and the beginning of a significant reorientation of current expenditures toward priority needs in primary health, basic education and public safety. 2.6 The Government took initial steps to reform the completely state-owned banking sector. By the end of 1989, the loan portfolios of these banks had been cleaned of most non-performing and doubtful assets. In 1990, a new full private bank with majority foreign capital started operations, and in 1991 one of the state banks was privatized and another obtained minority private participation. Moreover, in 1990, Central Bank (BCRM) embarked upon a process of replacing direct credit allocation with a more flexible system based on indirect market instruments. 2.7 BCRM losses, however, mounted over the 1980s which indicated a fundamental flaw in the financing of public expenditure. In taking direct liability for the exchange rate risk on government external debt, in addition to providing advances to the Government at well above the statutory limit and at near zero percent interest rates, BCRM registered operating losses which averaged 3 percent of GDP from 1985 to 1990 and resulted in accumulated losses equivalent to 9.6 percent of GDP in 1990. Limited action was taken to redress this situation in 1991 when it was decided to remunerate Treasury deposits and charge Treasury borrowing with the BCRM at money market rates. 2.8 Overall, the stabilization and subsequent structural reforms contributed to the resumption of per capita growth in early 1988. This supply response was, however, slower than desired partly because of inadequate progress in institutional reforms in the financial sector. It was undermined by political events in 1991. Recent Developments 2.9 In 1988-90, strong growth in agricultural production and new export-oriented manufacturing activities (e.g., garments, leather, wood processing) led to modest per-capita GDP growth. The developments in 1990, however, demonstrated the fragility of the reform and recovery. Even prior to the political turmoil, growth in agricultural production slowed to about 2 percent due to poor weather, while the secondary sector stagnated due to weak performance in the public sector textile and food industries, despite continued strong performance by the new manufacturing enterprises. The setback centered on the failure of the authorities to effectively link and manage exchange rate policies and credit policies. Merchandise imports rose by 58 percent in nominal U.S. dollar terms as a result of an uncontrolled expansion of credit (provided largely through BTM, the only remaining fully state-owned commercial bank), an appreciating real effective exchange rate, and an increased oil bill. This, together with stagnating merchandise exports in current dollar terms, due largely to the continued sharp decreases in the prices of the country's major exports (in particular that of coffee), led to a trade deficit of 6 percent of GDP, compared to a small surplus in 1989. As a result, the external current account deficit widened from 8.6 percent of GDP in 1989 to 11.7 percent in 1990. These developments, combined with lower-than expected aid inflows, caused foreign exchange reserves to decline from five months of imports at end-1989 to less than two months by end-1990. 2.10 The Government acted, albeit slowly, to restore financial equilibria by devaluing the FMG by 16 percent in January 1991 and by severely tightening credit expansion between November 1990 and June 1991. These measures and increased external support helped improve the country's external position during the first half of 1991, and the economy was on the way to another year of positive growth, when political turmoil broke out in the second half of 1991. As widespread demonstrations and strikes paralyzed public administration, economic activity was severely disrupted, and the adjustment process went off-track. - 4 - 2.11 Real GDP contracted by 6 percent in 1991; inflationary pressures built up; financial imbalances widened significantly; and large domestic and external payments arrears were accumulated. Political disturbances in 1991 resulted in a shortfall in tax collection and the rise in the budget deficit to about 10 percent of GDP; in 1992, tax collection did not improve and budgetary discipline worsened. The true size of the fiscal deficit was masked by the quasi-fiscal operations of the Central Bank which since 1983 has been assuming debt-servicing obligations once borne by the Treasury. The internal imbalances were reflected in a worsened external position of Madagascar, with the overall current account deficit reaching 10 percent of GDP in 1992. The growing shortage of foreign exchange had led to the suspension of the Open General License system in October 1991. 2.12 A transitional power-sharing arrangement, agreed in late October 1991 by all major political forces, became effective in January 1992. Under this arrangement, the President remained in office with greatly curtailed executive powers; the National Assembly was dissolved and replaced by a High State Authority headed by a key opposition leader; and a government of national consensus was formed. The new Constitution was approved by referendum in August 1992, followed by presidential elections in late November 1992 and February 1993. Legislative elections are scheduled for June 1993. Political and economic turmoil have exacerbated issues which were already adversely affecting Madagascar's project implementation performance. Notable among these is weak management, ill prepared to meet the challenges of a market economy. While the political transition runs its course, institution building will be critical to permit the timely and efficient return to private sector led growth. B. The Financial Sector Recent Developments 2.13 In the second half of the 1980s, reforms in the financial sector centered on steps to strengthen the banking sector, which was completely state-owned and experiencing severe financial problems. By the end of 1989, the loan portfolios of these banks had been cleaned of most non-performing and doubtful assets. In 1990, a new, fully private bank with majority foreign capital started operations; in 1991, one of the state banks was privatized and another obtained minority private participation while two private foreign banks opened representative offices in Madagascar. In parallel with these actions, the Central Bank embarked upon a process of replacing direct credit allocation with a more flexible system based on indirect market instruments. These financial sector reforms have had mixed results. The new private banks and the majority privatization of one of the state banks has proved successful. Progress was less sustainable, however, in maintaining the overall health of the banking system following the portfolio clean-up of 1989, because the two majority state banks have shown increasing weaknesses since 1991. These difficulties led to a virtual standstill in the interbank money market, jeopardizing the success of a market-based system of interest rates introduced in November 1990. As discussed below, the establishment of market-based interest rates was also undermined by the suspension of the Treasury Bill market in mid-1991. 2.14 Problemns in establishing market-based interest rates. Direct refinancing operations by BCRM were replaced in November 1990 by money market auction operations, to both inject and remove liquidity from the financial system. They were interrupted in June 1991 in the wake of political strife, but were reinstated again in November 1991. The root of this perturbation in the money market was the re-emergence of macroeconomic instability in 1991, as outlined in paragraph 2.11. At the same time, institutional weaknesses in the two state banks have undermined the development of a money market. Specifically, in 1990/1991 a rapid expansion in credit by the largest state bank undermined monetary stability, which was later compounded by a similar increase in credit in the other remaining state bank in 1992. It is noteworthy that while the two state banks have at various times exceeded their credit ceilings for extended periods, the two private banks have generally kept within their credit ceilings. 2.15 Another reason the money market has not worked well has been the lack of clear objectives in monetary policy which is partly reflected in an inability to coordinate money market operations with public financing operations of the Treasury. Currently the only treasury bills being issued are BTCs (Bons du Tresor Classiques), representing medium to long-term investments. Returns on this paper, because of up front interest payments and tax exemption, provide effective rates which have remained static over a two-year period and bear little relation to the prevailing market conditions. Since the money market was reinstated in November 1991, the market has been highly liquid, due to the suspension of the OGL import system combined with lower tax recovery and increased government spending. BCRM has, therefore, been systematically removing liquidity from the system through the money market auction instrument "appel d'offres n6gatives' (AONs). To avoid wide fluctuations in rates that could result from fiscal problems and weaknesses of state banks, BCRM openly or covertly attempts to regulate the market which results in rigid interest rates, while basic policies of either removing or injecting li-uidity are mechanistically followed. Under these conditions, the Treasury has no incentive to issue short-, erm paper (BTAs) in lieu of borrowing from BCRM at money market rates. 2.16 The problems of state banks and lack of adequate coordination of monetary and fiscal management have resulted in three indications of a lack of market-based interest rates. First, interest rates on both BCRM deposit and refinancing instruments have remained exceptionally static over the last two years despite a complete reversal in the money market situation from a highly illiquid market from November 1990 to June 1991, to a highly liquid situation following the resumption of the market in 1991. Second, operations in the interbank market have been extremely modest, with most of the operations occurring between the two state banks, while the private banks, for reasons of confidence, prefer to refinance or place resources directly with BCRM. Third, the wide divergence in returns on savings is indicative of the of lack of market forces at play: sight deposits averaging 2.6 percent, term deposits averaging 14 percent, AONs 8.75 percent, special deposits with BCRM 5 percent, and six-month treasury bills (Bons du Tresor par Adjudication, BTAs) 18 percent and with an effective return of 25 percent. 2.17 Problems of state banks. With regard to the banking system, despite the 1986 to 1988 portfolio clean up and the privatization moves referred to in paragraph 2.6, the authorities were unable to satisfactorily control the growth of credit in 1990 and 1991. This inability to control credit centered on institutional weaknesses in one bank, the wholly state-controlled BTM, which witnessed a severe degradation of its loan portfolio over the 1990/1991 period. This was a major factor in the discontinuation of the OGL import system in September 1991. Remedial action was taken in February 1992 with the replacement of BTM top management, which has led since April 1992 to the reduction of BTM loan portfolio to within the specified BCRM credit ceiling, and to a position where BTM reversed its normal refinancing requirement with BCRM to a situation where it placed excess liquidity with BCRM as of August 1992. While BTM's adverse impact on overall credit management appears to have now been contained, the state of the bank's loan portfolio has worsened. Consequently, the profitability of the bank is declining while provisioning requirements for doubtful assets increase, making the prospects for immediate privatization more remote. 2.18 Problems at BTM recently spilled over to the other remaining state bank, BFV. The 1991 accounts for this bank could not be satisfactorily audited and the loan portfolio has significantly deteriorated and, consequently, a large increase in provisions is required. Furthermore, since late 1991, - 6 - BFV has consistently failed to respect credit ceilings. While the two private banks have been in positions of excess liquidity and BTM reduced its refinancing requirement, showing excess liquidity in August 1992, BFV still had a net refinancing requirement with BCRM. 2.19 The problems of establishing market-based interest rates and of the state banks reflect two sets of weaknesses in the financial system. First, the lack of independence of the Central Bank (BCRM) and Financial Supervisory Commission (CCBEF) has resulted in the conduct of monetary policy and prudential oversight being influenced by political factors. Second, the lack of independence of these key institutions is compounded by inadequate capacity to formulate and execute monetary policy based on indirect instruments and the lack of concise and comparable information on the health of banking institutions as well as inadequacies in the prudential supervision system, the accounting framework, and the financial disclosure and audit standards for banks. All these factors have made early detection and correction of financial distress difficult. Required Institutional and Policy Reforms 2.20 The Government and BCRM are conscious that a wide variety of monetary and financial reforms are required to develop a market oriented economy. Accordingly, the Government adopted a Statement of Financial Sector Reform and Development Policy in March 1993 containing a two-stage strategy for strengthening the financial system (see Annex 1). The first phase of reform aims at the following priority institutional reforms: (i) strengthening the independence and accountability of the Central Bank; (ii) enhancing the capacity of CCBEF in prudential supervision; (iii) improving the framework for audit and accounting; and (iv) supporting the privatization of state banks. Some of the remaining reforms are predicated on macroeconomic stability through fiscal prudence and clear policy decision with political stability. In many cases, however, the ground can be laid to facilitate the implementation of future reforms while the necessary fiscal and political preconditions are in the process of being fulfilled. Indeed, the unsatisfactory results of earlier financial sector reforms underscore the urgency of institutional strengthening in order to allow macroeconomic reform to succeed. 2.21 On the monetary front, a number of improvements are required to the workings of the market. Chief among these is the implementation of a pure Dutch auction system for BCRM refinancing with the removal of any BCRM limits on interest rates for auctions. In addition to this, the standardization of maturities and a well defined and publicized auctioning schedule for both refinancing and placing needs to be accomplished. Furthermore, alternative BCRM instruments to borrow and deposit funds which undermine the auction system should be removed. This must be complemented with a well designed research capacity combined with improvements in the monetary programming in BCRM. Eventually, bank credit ceilings and limits should be abolished once there is adequate progress towards: (i) the development of an active money market; (ii) a sound privatized banking system; and (iii) improvements in planning and financing public debt. This series of measures should begin to place the functioning of financial markets and conduct of monetary policy using market instruments on a more firm footing. 2.22 While progress has been made in developing reserve requirements into a fully fledged tool of monetary control, a number of measures are required to improve this instrument. These include improving the computing lag time, being more flexible on what constitutes reserves and not being unduly severe on the penalty when reserve requirements cannot be met. Again, capacity building measures in BCRM could overcome many of these shortcomings. - 7 - 2.23 In the area of public finance and monetary policy, greater coordination between BCRM and the Treasury needs to be developed to ensure a more planned and systematic approach that avoids ad hoe financing and increases the efficiency of public finance operations. BTAs issued for six months and twelve months should be reintroduced. This will require concurrent flexibility in auction operations to guarantee that rigid auction rates do not undermine the attractiveness of BTAs. Increased research and management capacities at BCRM are required to ensure that short-term liquidity management is integrated within a well formulated overall policy of monetary management and that returns on BTCs are more in line with the market, and to allow for the development of a secondary market for both types of treasury bills. 2.24 While prior credit approval has been abolished by BCRM, there remains a prior authorization by BCRM of any individual loan that a bank uses to collateralize refinancing with BCRM. As capacities to enhance supervision of financial institutions in CCBEF improve, this requirement should be abolished. BCRM refinancing will become more a function of the commercial bank risk rather than the individual borrower risk, though provision could still be made to exclude loans to specific individual borrowers with insufficient creditworthiness from being used as collateral for BCRM refinancing. 2.25 In the light of the present banking crisis and given the policy objective to shift to indirect monetary controls, increased support for banking supervision and the upgrading of financial accounting and auditing standards is crucial. This will require strengthening the technical and legal capacity of the Financial Supervisory Commission (CCBEF) in tandem with the dissemination and implementation of an improved and uniformly applicable chart of accounts for commercial banks, as well as the introduction of appropriate auditing procedures, both of which should reflect international norms. 2.26 Besides improved supervision, the key to solving present problems in the banking system is the privatization or liquidation of the two state banks. The privatization route may necessitate the introduction of interim management to turn these banks around and render them privatizable. In the event that it is concluded that the alternative of liquidation is the only feasible outcome, financial policy will dictate that all efforts are made to explore the possibility of selling the assets to another bank with a view to maintaining the depth and range of financial services as is economically feasible. 2.27 In the process of restructuring the financial sector, policies which engender financial and economic autonomy and transparency of financial institutions, should be pursued to ensure that they operate in an efficient and self sustaining manner. This is a particularly important objective for BCRM, whose institutional and financial independence will also form an important policy objective. Furthermore, wherever feasible, policy to broaden and deepen the financial markets through the creation and strengthening of existing institutions and instruments will be pursued. Financial Sector Strategy 2.28 The strengthening of the financial sector is critical to sustaining the reforms embarked on in the late 1980s, whose principal objective was to ensure the successful transition from a state to a private sector-based market economy. The centerpiece of the financial strategy is to efficiently mobilize savings to meet the investment fmancing needs of the private sector. The major constraint to increasing the level of investment in Madagascar, particularly private sector investment, is the low level of domestic savings. Despite increases in domestic savings to 10 percent of GDP in 1989, Madagascar's gross domestic savings rate is below the average for sub-Saharan Africa (12 percent). Equally, Madagascar's investment rate has been below the sub-Saharan average at 10 percent of GDP between 1985 and 1989, against a sub- Saharan average of 14 percent. While the primary obstacle to mobilizing savings and increasing investment remains a fiscal problem crowding out private investment and dampening incentive to save, a number of secondary problems are related to institutional capacities and the quality of financial intermediation. 2.29 To enable the financial sector to play its role in recovery and growth, a seven-part sector strategy has been developed jointly with the Government. This strategy is the outcome of a dialogue which began in January 1992 with discussions of the World Bank's Financial Sector Study (Report No. 9817-MAG). The various elements of this strategy are included in a Government Statement of Financial Sector Reform and Development Policy (See Annex 1). EiM, the Government will pursue a public expenditure program consistent with a significant lowering of the budget deficit in the short to medium term, and will relieve BCRM of all its quasi fiscal obligations. Second, a full range of institutions, markets and instruments will be developed over time to ensure that all segments of the population have access to financial services, which effectively mobilize financial savings and efficiently transfer them into the real economy. Financial depth, M2/GDP, has hardly changed and remained below 25 percent of GDP in Madagascar since the 1970s (1985-88 average: 22.5 percent), which is low when compared with other developing countries. Furthermore there is highly disparate availability of financial intermediation in Madagascar, depending on geographical location and income group. The majority of the rural population has limited access to financial services, and these services have limited usefulness to a large part of the active population because of the low level of incomes and the restricted and inflexible nature of the services offered. ThiW, over time the financial system will promote a market determined set of key prices, notably interest rates that would remain positive in real termns and, eventually, an exchange rate that is market determined. At present, despite monetary reforms, interest rates are extremely rigid and thus fluctuate in real terms from negative to positive without any reference to demand for and supply of resources. Removal of the rigidities in interest rates is, therefore, key to the efficient allocation of resources. It is recognized, however, that this can only be achieved if macroeconomic stability is restored and fundamental institutional weaknesses in the banking sector are resolved. 2.30 A fQ.gh element of the financial sector strategy is the development of a rigorous and effective prudential supervision which also implies an appropriate framework of accounting, auditing and financial disclosure for financial institutions. At the core of many of the financial sector problems experienced in Madagascar over recent years has been the lack of reliable financial information, combined with a deficiency in the prudential supervision of financial institutions. A strategy to raise standards in financial information and strengthen supervision is, therefore, essential to the financial sector reform. Fifth, there will be an eventual shift to indirect instruments of monetary control. sixth, state ownership and control in all bank and non-bank financial institutions will be removed and a sound institutional framework with strong and competitive financial institutions will be promoted. Finally, the appropriate financial infrastructure (legal system, payments system) will ensure the efficiency and security of all financial transactions (payments, deposits, loans, etc.). 2.31 The proposed project will help in the implementation of the overall sector strategy. It will focus on immediate priorities of reforms in BCRM and the CCBEF and improvements to accounting and audit. It will provide technical assistance, training, equipment and supplies to strengthen both BCRM and CCBEF. Furthermore, the project will strengthen the accounting and auditing environment by providing technical assistance and training for upgrading and disseminating improved accounting and auditing standards in line with international norms. Experience with prior adjustment programs has demonstrated that there are advantages to initiating institutional reforms as early as possible, because of the time it takes to bring them about. Having stronger institutions is a precondition for the application of effective financial policies and structural reforms in the sector. -9 - 2.32 IDA involvement in financial sector reforms: World Bank involvement in the financial sector dates back to the mid-1980s when the Government began to place limits on banking sector credits to public enterprises. In 1987, state owned banks started restructuring their portfolios by provisioning more aggressively against non-performing assets. In 1988, a new banking law allowed private sector participation in the financial sector, which resulted in a new private commercial bank opening its doors in 1989 and one of the three state banks being fully privatized and another partially. The World Bank's role in these initiatives was complemented by the IMF which, inter alia, provided assistance in the design and launching of a new money market in Madagascar in 1989-1990. Bank/IMF collaboration included IMF participation in the Bank's Financial Sector Study (Report No. 9817-MAG, March 1993). 2.33 The Government, conscious of the need to establish solid financial institutions as a vehicle for private sector development and the resumption of growth, requested in January 1991 assistance from the Bank in preparing a series of operations designed to meet this objective. With regard to the proposed project, the World Bank has been involved in a series of discussions with both the Government and BCRM, including seminars in three subsequent missions before appraisal in February/March 1993. These discussions have been aimed at early ownership of the project by BCRM which created a project group in August 1992 to draft a strategic development plan. In parallel with these discussions, the IMF reviewed BCRM and banking issues and reforms in May 1992, and provided advice on how the balance sheet of BCRM could be restructured to eliminate all quasi fiscal obligations more properly attributed to the State. At the same time, the IMF has taken the lead in reviewing the statutes of BCRM and in helping define appropriate steps for strengthening the supervisory role of CCBEF, including an IMF initiative to recruit a foreign bank supervisor as technical adviser. These initiatives intimately complement those of the project, and reflect the critical role the IMF has played in reviewing and defining the framework for this technical assistance operation. C. BCRM (Central Bank) 2.34 The core functions of the Central Bank of the Republic of Madagascar (BCRM) are consistent with those of a modern central bank, namely: issuing legal tender and assuring economic growth with price stability through appropriate monetary policy. However, as is the case with many countries in the developing world, BCRM has taken on a number of other functions, notably quasi fiscal activities, which are inconsistent with its development into an independent institution ensuring stability in money and financial markets. To better identify institutional development needs of BCRM, the scope and results of its primary functions (domestic and foreign operations, credit, research), as well as support (accounting and audit, information systems, human resources) are reviewed below: (a) Formulating and Executing Monetary Policy 2.35 As previously indicated, there are major weaknesses in the monetary operations of BCRM which have resulted in a rigid money market and the maintenance of a number of direct controls on the market. The first weakness is a lack of research capacity to formulate monetary policy based on an analysis of developments in the real and financial sectors (see paragraph 2.39 below). The second weakness is the lack of coordination with the Treasury on government financing and open market operations. Institutional strengthening through the development of (i) research capacities, (ii) open market operations and (iii) improved coordination with the government financial operations, would give BCRM more confidence in allowing the market to function. BCRM would, therefore, be better prepared to remove credit ceilings - 10 - and other direct controls, once macroeconomic stability has been established and fundamental institutional weaknesses in the commercial banks resolved. (b) Government Banker 2.36 Apart from acting as the Government's banker, BCRM has also been implicitly obliged to finance the public sector deficit, which is illustrated by the mounting operating losses of BCRM in the 1980s. This financing took three forms: (i) taking direct liability for the exchange rate risk on Government and private sector external debt during the London and Paris Club rescheduling negotiations in the 1980s which, in the case of the Government, effectively meant recording losses on the balance sheet of BCRM that should have been ascribed to the national budget; (ii) providing advances to the Government well above the statutory limit; and (iii) providing the advances at virtually zero percent interest until 1991. Since the Government does not systematically respect its obligations to compensate foreign exchange and operating losses, three fifths of BCRM operating assets represented unremunerated claims on the Government by the end of the 1980s. 2.37 The resolution of this problem centers on legally enshrining the independence of BCRM and restructuring its balance sheet. Initiatives involving the IMF in both these areas are already underway. With regard to the independence of BCRM, revisions to the 1973 Ordinance setting forth BCRM's Statutes have been prepared to: (i) clearly limit the objective of BCRM to the stability of the currency; (ii) increase its authority in formulating monetary policy; (iii) increase the independence of the Governor and Board through lengthened tenure, fixed-term appointments and clear dismissal criteria; and (iv) ensure the regular publication of BCRM audited accounts. A first step towards the restructuring of the balance sheet was undertaken in 1992, when the non-interest earning assets of BCRM representing claims on Government and associated liabilities were recorded in specific new accounts outside of the balance sheet of BCRM, which now render these quasi fiscal operations more transparent. 2.38 Increased legal and financial independence of BCRM are key to general financial sector reform and critical to the successful application of any technical assistance provided to BCRM or CCBEF. Consequently the independence of BCRM and the elimination of its fiscal obligations constitute explicit objectives of government policy for the financial sector which need to be forcefully pursued. (See the Government's Statement of Financial Sector Reform and Development Policy, Annex 1). (c) Primary Functions 2.39 Research. A fully fledged research and statistics function does not exist in any significant sense at BCRM. Currently, a unit consisting of four staff is engaged in collecting macroeconomic data, mainly in preparation for BankI/IMF missions. There is a multitude of research and policy-related data gathering and processing efforts through BCRM which are uncoordinated and which result in numerous redundant data requests from various departments of BCRM to the outside (commercial banks and financial institutions, ministries, etc.). The research function until very recently lacked a director and, as a result, the authority to coordinate and streamline data requests from the outside and data flows within BCRM. Consequently, no monetary programming is carried out. Furthermore, there is no strategic or policy research, for example for helping formulate monetary policy or better understanding links between the financial system and the real economy. 2.40 Credit. The credit department in BCRM has primary responsibility for the implementation of direct monetary controls, and in the last few years has been responsible for reforming a number of these - 11 - instruments and for implementing new money market instruments to manage the level of liquidity in the market. While some progress has been made in dismantling some of the direct controls, notably in abolishing all prior credit approval and in developing reserve requirements as a tool of monetary control, the operation of the money market remains rigid (See para. 2.15) and credit is still micro-managed by BCRM. Notwithstanding that credit ceilings will need to be maintained until fiscal problems and institutional weaknesses in the commercial banks are resolved, a great deal of institutional strengthening is required over the transition to improve the flexibility, responsiveness and effectiveness of the nascent money market and the new monetary instruments. 2.41 Foreign Exchange Operations. BCRM monitors all foreign currency operations and manages all foreign currency transactions on behalf of the Government. Until September 1991, when the Open General License System (OGL) was abolished, all foreign currency receipts had to be surrendered to BCRM. Currently the commercial banks are permitted to keep 60 percent of the foreign currency receipts while ceding 40 percent to BCRM, which maintains its role of monitoring all foreign currency transactions. Given the existing foreign exchange shortage and the need for commercial banks to conduct foreign exchange transactions at an overvalued official rate, this system effectively puts the burden of rationing on commercial banks. A strategy, cognizant of present fiscal and monetary problems, needs to be developed with the long term objective of BCRM playing a supervisory role in a market where foreign currency is freely traded. Furthermore institutional weaknesses in managing and monitoring foreign currency operations have to be addressed to prepare BCRM for the implementation of this strategy and to increase the efficiency of existing operations. 2.42 External Debt Management. BCRM manages all external public debt on behalf of the Government, and has been obliged to bear losses on external debt that should have been borne by the Treasury, notably exchange rate losses. A strategy to ensure that all obligations on foreign debt contracted by the Government are correctly attributed to the Treasury was developed in 1992 as part of the overall policy to eliminate quasi fiscal activities from BCRM balance sheet, referred to in paragraph 2.37. This resulted in the creation in early 1993 of a distinct department within BCRM to implement this strategy and to manage all external debt. Technical assistance is required to develop the capacities of this department to manage these external debt operations. 2.43 Circulation of Bank Notes. Activities associated with the circulation of bank notes at BCRM center on national currency management. BCRM is poorly equipped to monitor and manage the level of national currency in circulation due to: (i) limited operational capabilities within BCRM to forecast and control demand for national currency; and (ii) poor communications with both BCRM domestic correspondents and the commercial banks. These problems need to be tackled in tandem with a review of the domestic payments system. (d) Support Functions 2.44 Accounting. Whereas BCRM appears to have managed to maintain and prepare accounts on a regular basis, the internal organization of the accounting function suffers certain weaknesses. These result, principally from an unsatisfactory segregation of responsibilities, and the fact that there is no separate unit which is primarily responsible for accounting and for reporting on financial matters directly to management. Currently, departments or units are not only initiating transactions but are also responsible for recording them, thus bypassing a fundamental principle of adequate internal control within the institution. Furthermore this situation inhibits the preparation and diffusion to general management on a timely basis, of the financial information necessary to effectively execute their managerial - 12 - responsibilities. The absence of regular external audits of BCRM accounts is an additional shortcoming in the overall control exercised over the bank's operations. 2.45 Internal Audit. Within BCRM the activities normally attributed to an internal audit office or unit are currently carried out by the Inspection Department. This includes routine verification and internal control functions which are more properly handled by a separate accounts unit. The Inspection Department also carries out a variety of other activities (review of applications for the banking licenses, on-site and off-site inspection of financial institutions) which should now be the responsibility of CCBEF. Moreover, the Inspection Department is not directly responsible to the Board of Directors of BCRM and does not, therefore, enjoy the independence usually associated with the function of internal audit. 2.46 Information Technology. Information processing plays an important role in the day to day operations of BCRM, though a number of activities lack required computer support due to the scarcity of data processing resources. Likewise there is a need for more active general management participation in data processing planning and implementation. Furthermore, in a changing environment with a progressive shift to using indirect instruments of monetary policy, the role of information technology will become increasingly important in attaining BCRM objectives. Strengthening strategic capacities in the area of information technology is, therefore, a central part of BCRM development. 2.47 Information processing at BCRM today relies on an outdated mainframe computer system for which the supplier has discontinued maintenance. Although spare parts can still be procured from places as far away as Europe, it often entails a wait of up to ten days. This constitutes a considerable operational risk for some of the basic data processing functions. High priority is, therefore, being accorded to moving the most important systems, accounting and payroll, to other hardware. Despite the relatively high quality of BCRM computer staff, compared to that of other countries at a similar stage of development, the number of qualified systems analysts and programmers is limited. Significant emphasis on training programs is required to meet the information technology skills requirements of BCRM. 2.48 Human Resources. While the quality of staff in BCRM is quite high on average, there appears to be a lack of broad-based understanding of the functions of central banking. Most staff have only limited knowledge of the operations of departments other than the one in which they are working. There is virtually no systematic planning for staff rotation or long-term training. BCRM senior management have also expressed the need to review the present system of classifying personnel to improve incentives and prospects for horizontal and vertical mobility. BCRM is examining the possibility of introducing of occupational streams (economists, financial analysts, etc.) to guide future recruitment, training, and promotion. (e) Recent BCRM Reforms 2.49 BCRM senior management and staff have generally been conscious of the problems and the need for improvements within the institution. A number of steps have been recently initiated to strengthen BCRM capabilities to more effectively meet its responsibilities in an increasingly market-based economy. A major initiative is the revision of the 1973 Statutes of BCRM, which will give BCRM a clearer and more independent role in both the formulation and execution of monetary policy. The Government has adopted the ordinance setting forth the revised Statutes, which were agreed at negotiations, and the promulgation of this ordinance is a condition of Credit effectiveness. - 13 - 2.50 Furthermore, BCRM began preparing in August 1992 a strategic development plan (SDP) which will constitute a business plan for its organizational development over a 3 to 5 year period. The plan has four elements described below: (i) a statement of key policy and business objectives; (ii) action plans for department strengthening and restructuring BCRM; (iii) more effective application of information technology systems; and (iv) human resource development. The SDP represents the beginnings of a strategic planning and development function in BCRM. Although the SDP will remain a working document to be continually reviewed, a first completed version of the text was adopted by the Board of BCRM in April 1993 to commit the institution to a more strategic approach to its organizational development. In addition, to help institutionalize this new function, a new position of Coordinator for Strategic Planning and Development has been created in BCRM. The coordinator is expected to help the senior management of BCRM to more effectively plan and co-ordinate organizational changes and the use of information technology. BCRM will also form a steering committee comprised of senior BCRM management and department managers to continually review the implementation of the SDP and approve organizational and information technology plans. The steering committee will continually consult with outside advisors on worldwide organizational practices in central banking. 2.51 Under its SDP, BCRM statement of objectives are categorized into 'business objectives" and 'institutional objectives". The business objectives comprise: (a) price stability through the pursuit of monetary policy, eventually based on indirect instruments, and (b) legal, administrative and financial independence of the Central Bank through the revision of its statutes and the removal of all quasi fiscal obligations. Institutional objectives include: (i) strengthening the budget and internal control functions within BCRM through improved accounting systems and procedures and their harmonization with a new chart of accounts for banks; (ii) development of an internal audit function; (iii) development of a fully- fledged research and statistics department; (iv) strengthening of capacities in foreign exchange management, with the Central Bank ultimately playing a supervisory rather than a clearing role in the foreign exchange market; (v) strengthening capacity to implement monetary policy through indirect instruments and, ultimately, open market operations; (vi) increasing capacities to monitor credit- worthiness of banks going hand in hand with the elimination of the review of individual bank loans for BCRM refinancing; (vii) enhancing domestic currency management by improving planning and communication capacities; (viii) development of modern information systems for the generation, processing, storage, transmission, and retrieval of operational and management information in all departments; and (ix) improvement of human resource functions especially in the areas of recruitment, training, and promotion. D. CCBEF (Financial Supervisory Commission} 2.52 The Financial Supervisory Commission (CCBEF) was established under the April 1988 Banking Act governing the banking sector. CCBEF which is not a legal entity is chaired by the Governor of the Central Bank. The primary roles of CCBEF are to monitor and safeguard the financial health of all financial sector institutions and to ensure that these institutions respect all laws and regulations governing their operations. CCBEF also has the power to issue regulations regarding the management, accounting and other technical practices of these institutions. 2.53 The development of CCBEF since its inception has, however, been stunted. Consequently, its present available capacity is inconsistent with the demands of full regulatory and supervision functions of financial institutions in an environment of greater reliance on indirect controls in the conduct of monetary policy and increased competition among banks on both sides of their balance sheets. CCBEF - 14 - has lacked full-time trained staff and, until recently, had only one full-time professional, its Secretary General. Instead, it has relied on the staff of the Inspection Department of BCRM on an ad hoc basis, which has impeded effective financial sector supervision. The principal reasons for this are: (i) the continued reliance by BCRM on direct controls, entailing review of individual bank loans for refinancing, rather than ensuring financial institution health through supervision activities. The Credit Department of BCRM has thus also assumed responsibilities for off-site surveillance, and remains a major force within BCRM for directing credit, while the function of monitoring commercial bank risk has secondary importance; (ii) the lack of distinction between the roles of the Inspection Department in BCRM and CCBEF; and (iii) the absence of accounting and auditing standards, particularly for banks, which reflect international norms. Rationalization of BCRM and CCBEF roles in on- and off-site supervision is required, with primary responsibility for supervision belonging to CCBEF. A systematic program of training under a seasoned bank supervisor is envisaged to strengthen CCBEF supervision capacities. E. The Commercial Banks 2.54 In 1975, Madagascar's banking system was nationalized and in 1977 the five nationalized banks were restructured into three commercial banks with the intention of each specializing in a sector of the economy, i.e., agriculture (BTM), industry (BNI) and commerce (BFV). Credit increased rapidly from 1975 to 1980 and witnessed more modest growth thereafter. In 1985, following the first steps of structural adjustment, there was a rapid deterioration of the commercial banks' overall loan portfolio, with 40 percent considered doubtful. In the 1986 - 1989 period, through a process of revaluation of fixed assets, commercial banks loan portfolios were significantly cleaned up, reducing doubtful loans to 15 percent of gross loans by the end of 1989. In May 1988, a new Banking Act paved the way for the privatization of the banking sector. In August 1989, a new commercial bank, BMOI, opened its doors with two major foreign investors, BNPI and SFOM. In February 1991, Credit Lyonnais acquired the majority shareholding and took over the management of BNI (now known as BNI-Credit Lyonnais), and Instituto Bancario San Paolo di Torino (IBSP) acquired a 22 percent stake in BFV in March 1991. 2.55 As previously indicated in paragraph 2.17, despite the 1986 to 1989 portfolio clean up and the privatization achievements, the banking sector again finds itself in crisis, because of renewed deterioration in the portfolios of the two remaining state controlled banks, BTM and BFV. BTM profitability is declining while provisioning requirements for doubtful assets increase, making the prospects for immediate privatization more remote. However, as of mid-1992 BTM began keeping within its credit ceilings and has reduced its refinancing requirement, which is not the case of the BFV. The BFV has consistently failed to respect credit ceilings since the strike of 1991, and while the other three commercial banks had excess liquidity in August 1992, BFV still had a net refinancing requirement with BCRM. Moreover, the 1991 accounts for this bank could not be certified and the loan portfolio has deteriorated significantly. The two private commercial banks by contrast appear to be in a sound financial situation despite the numerous political and economic problems witnessed in the years 1991/92. More encouraging, a fifth commercial bank with Mauritian and South African investors has recently opened its doors in Madagascar, and a sixth bank is currently in the process of being granted its banking license. F. The Insurance Sector 2.56 Madagascar's insurance industry, both non-life and life insurance, is in the early stages of development. The ratio of gross insurance premiums to GDP (1987) was 0.05 percent, compared to that - 15 - in developed countries of 4.5 percent. There are two major insurance companies in Madagascar, ARO and NY Havanana; these are joint-stock companies with majority interest held by the Government. A further two insurance companies are in quasi liquidation, and have no impact on the market. The nature of the industry is consequently highly oligopolistic, which includes provision for the sharing of information and a non-competitive agreement between the two companies ensuring that one company will not take a client from another. These barriers to competition have allowed these companies to do relatively well even in harsh economic times, and as is the nature of the business they have accumulated substantial reserves and thus are important investors. While strong arguments have been made to maintain the duopolistic nature of the industry because of the small size of the market and the need to protect individual savings, there is little rationale to defend continued government participation in these industries. The insurance sector could therefore have an important role to play in terms of both the privatization process and the development of a securities market discussed in section J below. G. The Social Security Fund 2.57 In Madagascar wage earners are covered by two systems of social security - a small government scheme for public sector employees through the Ministry of Finance and the social security fund, the Caisse Nationale de Prevoyance Sociale (CNAPS). CNAPS undertakes three social security functions, i.e., family benefits, workers' compensation, and retirement benefits. The fund, together with the insurance companies, is one of the major mobilizers of term funds and an important institutional investor in Madagascar. However, its soundness as a financial institution has been under question. The World Bank is financing under the APEX project a series of studies on CNAPS - a financial audit, an organizational diagnosis, an actuarial study, and a study of investment policies - which are being executed since October 1992 by the Social Security Department of the International Labor Organization (ILO). H. Postal Financial Services 2.58 The Postal and Telecommunication Services (PTT) is made up of three entities, the Post Office, the postal checking institution (Comptes Cheques Postaux - CCP) and the postal savings institution, CEM. Although CEM was transformed into a savings bank in 1985 it continues to operate as a traditional postal savings institution. It has a number of advantages in that, through the post office, it operates 220 windows in 208 towns throughout Madagascar, with a high number of individual accounts. (e.g. every fourth resident of Antananarivo has an account). Its major weaknesses are: (a) its total dependence on the Treasury for financial management, which requires it to place all funds with the Treasury at below market rates; and (b) the lack of financial transparency in the costing of services between the three PTT entities. In July 1992, the Government adopted a new policy for restructuring the post and telecommunications sector. Besides proposing to commercialize the telecommunications entity, the new policy proposes to reorganize the Post Office and the two postal financial services as independent entities. A number of proposals are currently being considered by the Minister of Post and Telecommunications to strengthen the autonomy of postal financial services. One proposal is that the Post Office and the two postal financial services each be established as individual enterprises with independent boards which could in an initial phase be placed under a holding company. Subsequently, private capital should be allowed into any one or all three of these entities. The Post Office should become a service provider on a fee basis to the new postal checking and postal savings entities and should structure contractual relationships for providing services through its post office network to these entities. - 16 - I. The Payments System 2.59 The present system of effecting payments through financial instruments (checks, wire transfers, money orders, etc) is riddled with delays, risks and inefficiencies, particularly for out-of-town transactions. Clearance and settlement of checks and transfers can in some instances take up to 90 days. Most of the delays are due to basic problems with road transport and inadequacies in the quality of public network telecommunications. The present institutional set-up includes 15 clearinghouses throughout Madagascar for clearance of checks, in which all four banks, BCRM and the post office participate, and the use of windows at about 220 post offices for payments through the postal checking system (CCP). Some improvements that have already been suggested to the Government are as follows: (i) introduction of a single clearing center in the capital for all out-of-town checks, to avoid the delays currently incurred through bilateral exchanges of checks among all 15 clearinghouses; (ii) development of either an express mail system or a low-cost high-frequency radio network for data transmission, to expedite information exchange; and (iii) introduction of new safety standards and procedures to allow clearing based on exchange of information rather than documents. J. Financial Markets 2.60 In addition to the money markets described in para. 2.15, there is further potential for financial market deepening through the trade of equities and private debt instruments. One of the economic changes that Madagascar is currently undergoing involves the privatization of state enterprises and the strengthening and creation of private shareholding in a number of existing and new enterprises. A mechanism to facilitate the trading and transfer of equity would enhance this process of expanding private ownership. Analysis of the potential for a small securities exchange was undertaken in 1992 and it is envisaged to be further developed in the near future, which will include the fiscal and legal changes that would be required to allow for an efficient system of share transfer. Furthermore public securities could also be traded in a secondary market, which could facilitate the reintroduction of BTAs (referred to in paragraph 2.23). Finally in the light of the weaknesses in the interbank market there is potential to allow financial institutions (principally the banks and insurance institutions) to issue negotiable certificates of deposit (NCDs). In broadening the market this would allow banks with excess liquidity another form of investment apart from BCRM in which to place their surpluses, and provide alternative sources of refinancing (again apart from BCRM) for other financial institutions. All these aspects of the financial market require further analysis in preparation for regulatory and institutional reforms. K. Accounting and Audit Framework 2.61 Accounting. Financial information in a concise and comparable form is not easily available in Madagascar. Outdated accounting principles continue to be applied by commercial banks, as Madagascar has failed to revise its 1983 Bank Chart of Accounts or even ensure its universal application. This causes major problems in gaining an accurate interpretation of the financial position of banks and other financial institutions; specifically with regard to the provisioning of doubtful debts, income recognition, and the use of suspense accounts. Therefore, difficulties are experienced in comparing the financial performance of like organizations in Madagascar such as commercial banks. Consequently BCRM, concerned with institutional weaknesses and the veracity of financial information, has been reluctant to give up direct monetary controls. On the other hand, the implementation of indirect controls, such as reserve requirements, over the last two years has been accompanied by confusion on the part of the commercial - 17 - banks as to the exact nature of financial accounting required and the rationale behind BCRM demands. The lack of understanding on both sides has generally led to the implementation of an overly rigid system with penalties for reserves deficiencies that are unduly severe. This has neither inspired confidence in indirect controls nor in either BCRM or CCBEF capacity to effectively regulate the financial markets. 2.62 Although there have been some developments in accounting over recent years (the development of the 1987 General Chart of Accounts, PCGM-87, introduced with effect from January 1, 1989, and a new uniform chart of accounts for commercial banks, NPCB, for introduction with effect from January 1st, 1994), two fundamental weaknesses in the accounting profession need to be addressed. These are (i) the limited number of professionally qualified accountants; and (ii) the lack of a regulatory framework to stimulate the development of a national accounting profession with standards and ethics at par with levels accepted internationally. The absence of a suitable regulatory framework has been at the core of the problem although a professional body has been in existence since 1962. The IDA financed Accounting and Audit Organization and Management Training Project (Cr. 1 155-MAG), sought to establish legislative and training requirements for the accounting profession and financed the National Institute for Accounting Science and Enterprise Administration (Institut National des Sciences Comptables et de l'Administration des Entreprises (INSCAE). INSCAE ongoing activities and development are currently being supported under the ongoing Accounting and Management Training Project (Cr. 1661-MAG). However, INSCAE is currently able to train to the level of accounting technician only. 2.63 Under new legislation governing the accounting and audit profession, a student who has successfully completed the INSCAE program or who has obtained an equivalent diploma, can take exams for admission as a trainee for the qualification of ExDert Comptable et Financier, as defined by this new legislation, and thus become a fully fledged member of this professional body. Furthermore, there are a number of transitory measures which will expand the admission to the profession of other practitioners, provided they can demonstrate an acceptable level of expertise. This new regulatory framework is a key tool in the development of the profession and in the introduction of accounting and auditing standards acceptable internationally. The new legislation does, however, have fundamental flaws in that foreign accounting and audit firms are discriminated against, and certain anomalies need to be resolved to facilitate the development of international accounting standards. Allowing foreign nationals with the appropriate qualifications to compete freely with national firms in the local market is important in stimulating future development in the profession. 2.64 This process will not only improve the quality of local services but together with the new regulatory framework, will also expand employment opportunities for graduates of INSCAE. Many of these graduates have been unable to find worthwhile jobs in the professional sector and these initiatives will help create incentives for their professional development. These regulatory changes in addition to technical assistance to facilitate the introduction of the NPCB, will help in overcoming the problems of unsatisfactory audits particularly in the commercial banks experienced in the past, and create a local profession capable of providing accounting and audit services acceptable internationally. 2.65 Audit. There are four professionally qualified accountants in the country with either French or Canadian qualifications, each of whom has his/her own auditing firm. The four firms together employ a total of some 300 people, about 40 of whom are audit staff with experience ranging from one to ten years or more. Although a body of qualified accountants with legal status was set up in Madagascar on 1st October 1962, it has never become a dynamic force in developing the profession and has but the four professionals referred to above as members. As a result, auditing standards have not evolved in an orderly manner in line with those applied internationally. The legal framework for statutory auditing - 18 - continues to be the French 'Companies Act' of 1867 which provides for the appointment of a Commissaire aux Comptes but fails to clearly define the scope of his audit interventions. Most financial institutions, therefore, have undertaken the report of the Commissaire in tandem with an audit report on more conventional lines but not governed by local or international standards. In implementing the NPCB, complementary projects need to be carried out to ensure that International Standards of Auditing, as established by the International Federation of Accountants (IFAC), are being applied. m. HE PROJECT A. Project Objectives and Scope 3.1 The project objective is to facilitate investment and growth in the productive sectors by improving the functioning of the financial system. This is in line with the Bank's country assistance strategy which emphasizes increased private sector savings and investment as engines of future growth. The project aims at strengthening key financial institutions and markets in Madagascar (including privatization of the two remaining state banks), thereby enhancing public trust in them and enabling them to mobilize savings to meet the investment financing needs of the private sector. The project will be implemented in the context of the Government's Statement of Financial Sector Reform and Development Policy adopted in March 1993. Specifically, the project would aim at: (i) enhancing the Central Bank's (BCRM) ability to formulate and conduct monetary policy based on indirect instruments; (ii) improving the prudential supervision environment through the strengthening of the Financial Supervisory Commission (CCBEF); (iii) formulating and enforcing accounting audit and financial disclosure standards based on international norms; and (iv) supporting the privatization of state banks. 3.2 The scope of the project, which would be supported by the proposed SDR 4.6 million Credit, is described in detail below. The project consists of: (a) restructuring BCRM, the Central Bank, principally through improvements in its research, open market, treasury, internal audit and accounting operations, and through the implementation of information technology and human resource development plans; (b) strengthening CCBEF, the Financial Supervisory Commission, with technical assistance to create an effective supervision structure, training for inspectors and equipment for on - and off - site surveillance; (c) improving the accounting and audit environment, through two sets of activities: (i) technical assistance and training activities to accelerate the development of the accounting profession and to ensure the availability of reliable financial information on enterprises based on international standards; and (ii) specific technical assistance and training to bankers, auditors and other professionals to establish, disseminate and implement transparent international accounting and audit procedures for commercial banks and financial institutions; and (d) supporting the privatization of banks in the context of an ongoing process of privatizing one of the two state banks, BTM, and a government commitment to a similar process for the other state bank, BFV, by providing specialized consultant services such as for valuation and placement of these banks among private investors. - 19 - The project components are described in detail in paras. 3.4 to 3.27 below. The Credit would finance technical assistance, training, equipment, and vehicles. Several working groups were created within the Government and the private sector for preparing and eventually implementing these financial sector reforms. Collaboration with IMF has been especially important in: (i) the design of CCBEF component of the project in follow-up to IMF initiative in recruiting and placing a seasoned bank inspector to lead the institutional development of CCBEF; and (ii) the review of BCRM statutes. The revision of BCRM Statutes, recently adopted by Govermnent, will ensure greater independence and accountability of BCRM. During negotiations, when the revisions were finalized, assurances were obtained that promulgation of the ordinance on the revised statutes would take place prior to credit effectiveness. The project is a critical first step in a wider program of financial reforms which is needed to help revive private savings and investment after an extended period of political turbulence. It will lay the foundations for broader policy reforms in the financial sector, which will facilitate and reinforce an adequate macro-economic framework once it is developed. B. Rationale for IDA Involvement 3.3 The project conforms to the Bank's country assistance strategy as presented to the Board on June 9, 1992, in that it supports the country's key objectives to: (i) improve macroeconomic management by strengthening formulation and execution of monetary policy, which would entail increased Central Bank independence, with a view to promoting the productive use of credit and containing inflation; (ii) reduce the role and scope of the public sector, notably in the financial system; and (iii) promote private sector development by enhancing the quality of financial intermediation. The project forms part of the Bank's "core" lending program to Madagascar aimed at institutional capacity building. The project follows IDA's Madagascar financial sector study (Report No. 9817-MAG, March 1992) and extensive dialogue and preparation in close collaboration with the IMF, notably in the areas of reviewing the BCRM Statutes and the design of the CCBEF component. C. Project Description 1. Restructuring BCRM 3.4 BCRM has demonstrated continuity in its institutional capacity over a number of difficult periods of economic and political transition. Its structure, however, is still largely geared to the allocation of credit through direct controls. BCRM is ill prepared to play its role of formulation and execution of monetary policy through indirect market based instruments. Two distinct deficiencies are at the base of the institutional weaknesses of BCRM. Firstly, BCRM has an inappropriate structure in both primary (e.g., research) and support functions (e.g., accounting) to conduct monetary policy through indirect controls. Secondly, the Bank's human and information technology resources need to be improved and adapted so that they are better equipped to meet the demands of a market oriented financial sector. 3.5 The project is designed to strengthen BCRM to ensure that both an appropriate structure and resource base develop so that BCRM has the institutional aptitude to perform its transformed central banking role, as discussed in paragraphs 3.6 - 3.22 below. Much of the preparation work for the project was done by BCRM itself through the development of its Strategic Development Plan (SDP) which has been the basis for the preparation of the project. Over seventy BCRM staff members, including all - 20 - department managers and professionals, have been involved in the preparation of the SDP since August 1992. The BCRM SDP was adopted by its Board as working document in April 1993. (a) Streng2tening and Restructuring BCRM DeDartnents and Functions 3.6 The SDP that BCRM has prepared contains a statement of objectives on which will be based action plans to restructure and strengthen all departments of BCRM. In their current form, these action plans diagnose existing problems in the functioning of these departments and propose a three-year strategy for revamping each department's operating methods, logistics and manpower. The project will provide assistance in further specification of these action plans and financing for key features thereof as discussed below. 3.7 Advisory services in Central Bank Organization: The project will finance the services of a small team of Central Bank advisers who will advise the management of BCRM in worldwide organizational practices in central banking and particularly assist in redefining the functional responsibilities of various departments of BCRM. This will enable the management of BCRM to identify the best or most appropriate practices developed in other central banks to apply in reorganizing the BCRM over the three-year span of the project. 3.8 Research Functions. With the requirement for BCRM to have access to macroeconomic, and policy related data on a systematic basis so that it can fulfill its role in formulating and executing monetary policy, the SDP provides for the development of the Research Department exercising specific data analysis and policy functions. The project will support: (i) the work of an expatriate technical advisor to help implement a three-year action plan for this department, during which time a local director and core staff will be trained to take over this function and ensure the flow of critical information in the formulation of monetary decision (see terms of reference in Annex 3); (ii) strengthening, through specific training and technical assistance, BCRM capacity to formulate monetary policy as well as act as advisor to the Government ; and (iii) improvement of BCRM ability to keep the public informed through the regular publication of statistical, policy and research information. This element of BCRM component will be financed in large part by the United States Agency for International Development. Actions will then result in: (a) the preparation of an annual review of the economic and monetary environment; (b) enhancement of the quarterly statistics bulletin; and (c) the publication of occasional research papers. 3.9 Open Market Operations. In preparation for a progressive shift away from direct to indirect monetary controls, as and when fiscal and commercial bank reforms permit, the project will provide training and technical assistance to the Credit Department to: (i) improve money market auction operations so that they are responsive to the supply and demand for resources; (ii) develop reserve requirements into a fully fledged tool of monetary control; (iii) improve planning and coordination with the Treasury in the financing of public debt; and (iv) generally improve the utilization of information in order to permit better liquidity management. 3.10 Foreign Exchange Operations. In preparation for a gradual shift to a market determined system of allocating foreign resources, which will be closely coordinated with fiscal and institutional reforms, the project will provide training and technical assistance to the Foreign Services Department in BCRM to: (i) improve information systems so that BCRM is in a position to play a supervisory rather than an allocative role in the foreign exchange market; and (ii) improve procedures in forecasting and analysis of treasury management in foreign currencies. The Government of Switzerland (GOS) has confirmed its interest to finance this component, administered directly by the Swiss Development Cooperation. -21 - 3.11 External Debt Management. To support the efficient management of external debt, the project will provide technical assistance and training to the newly created department (Department for the Management of External Debt) in BCRM to: (i) improve procedures in forecasting and analysis of external public and private debt servicing burdens and appropriate asset-liability management techniques, and; and (ii) improve planning and coordination with the Treasury in the management of public external debt. 3.12 Clearing Operations and Circulation of Bank Notes. To increase the efficiency of management in clearing operations and in the distribution of notes and coins, the project will provide technical assistance, training, and equipment to the Financial Operations Department to: (i) strengthen capacities in forecasting currency requirements for payments needs of the banking system; (ii) improve logistics in note and coin management to minimize insurance and transportation costs; (iii) improve domestic communications with the bank's branch in Tamatave and its agencies throughout the country; (iv) review the need and possibilities to introduce clearing based on exchange of information rather than documents; and (v) strengthen security in the handling and distribution of coins and bank notes for payments needs. 3.13 Accounting Systemns. In order to provide the appropriate financial information to management and, at the same time, improve the capacity within BCRM to monitor and control its accounting functions, the project will provide technical assistance to: (i) evaluate the accounting system and make recommendations for its improvement; (ii) introduce an improved accounting system permitting a proper separation of responsibilities between the different departments and operating units involved, as well as more effective record keeping and internal control; (iii) assist in the introduction of the NPCB within BCRM, taking into account the specific requirements of a central bank and the need to adhere to the International Accounting Standards applicable to banking institutions. This work will include the elaboration of an accounting manual; (iv) provide associated training; and (v) assist in establishing a modern archiving system which will be coordinated with the overall filing initiative at BCRM. An external audit of BCRM will be undertaken in mid-1993. Apart from the traditional audit, this will also include an assessment of the accounting and internal audit capacities of BCRM. The process of undertaking the external audit is already underway and its completion is a condition of Credit effectiveness. This first external audit also lays the ground for regular annual audits beginning in 1994, and the annual publication of audited accounts. Recommendations resulting from this audit will be taken into consideration when redefining and reorganizing the accounting system of BCRM. The redefinition and reorganization of the accounting system will be undertaken in a broader study, the terms of reference of which are presented in Annex 3 and which will initiate the technical assistance described above. 3.14 Internal Audit. The SDP envisages the creation of an internal audit unit within BCRM with a clear distinction between its activities and those associated with prudential supervision of financial institutions, thereby eliminating the problems being experienced by the present Inspection Department. The project will provide technical assistance to: (i) define the structure and responsibility of the internal audit unit with a view to ensuring its independence. This unit will be directly responsible to the Board but will report to the Governor on a day to day basis; (ii) assist in developing and implementing methods needed for meeting the requirements of an efficient internal audit unit; (iii) assist in developing an internal audit work plan for 1994, as well as appropriate detailed audit programs, procedures and reporting formats. The annual internal audit work plan and a report on its implementation, will be presented to the Board of BCRM; and (iv) evaluate the capabilities of existing and newly recruited staff and develop and implement a training program to ensure that the unit has the human resources and skills necessary to implement its work plan effectively and thereby assume its role as a key element of control within BCRM. The project will also provide the necessary equipment needed to by the internal audit unit - 22 - including the provision of calculators. The Government of Switzerland (GOS) has confirmed its interest to finance this component. (b) Information Systems 3.15 Restructuring of the information systems in BCRM will be guided by an information technology strategy whose objective will be to ensure that the information needs of the restructured and strengthened BCRM departments (outlined in paras. 3.8 to 3.14 above) and more generally the evolving information requirements of the bank are met. The overall objective is to develop new institutional capabilities at BCRM through improvements in administration and information systems. While computer technology will be used for this, the emphasis of the program is placed not on the technology itself, but on the institutional improvements that can be achieved through its judicious use. Following the definition of an information strategy, a three-year information plan will be drawn up as part of the project (see Annex 3 for terms of reference of first year activities and Annex 4 for detailed description of informatics program). 3.16 The project will provide technical assistance, training and equipment which will: (a) Support the finalization and implementation of the Information Technology Strategy (IT) including: - procedures for annual planning and follow up on the information technology plan; - introduction of modern information technology methods and techniques, as well as improvement of management and staff skills to plan, develop, maintain and use information systems; - development and implementation of an IT security strategy. (b) Assist in the development and the implementation of an information technology plan. Based on the information strategy this plan will detail the work to be done during 1993- 1995. This includes both procurement of application packages and systems development; (c) Assist in the procurement of hardware, which will include a strategy for the replacement of the outdated mainframe system; (d) Assist in the design and implementation of a pilot information system in the bank. 3.17 The introduction of the information technology plan will be phased, taking into account the institutional readiness to absorb new technology and implement administrative and managerial changes. The plan will be sensitive to the fact that modern information technology - while flexible, ubiquitous, and relatively inexpensive - requires orderly implementation to yield expected benefits. It also recognizes that investments in information technology will only be successful if BCRM first has an information technology strategy and concurrently takes measures to improve its operational, administrative and accounting practices. 3.18 Implementation of Information Technology. The planned steps for implementing the information systems aspects of the project are as follows: (i) first, the Information Technology strategy - 23 - will be finalized; (ii) in parallel, with the implementation of the IT strategy, a pilot subproject will run with a view to test the IT strategy and at the same time replaced the outdated mainframe; (iii) an Information Technology Plan for 1994-96 will be developed and adopted during the last quarter of 1993 as part of the budget process of BCRM; (iv) based on the IT plan, the information systems agreed upon will be developed and implemented in different areas of BCRM; and (v) the hardware required will be procured in accordance with the IT strategy and installed in pace with the implementation of the applications. Annex 4 provides further details on the information technology aspects of the project. Human Resource Development 3.19 A human resource development plan will ensure that the skills requirements of the restructured and strengthened BCRM departments (outlined in paras 3.8 - 3.18 above), and more generally the evolving personnel needs of BCRM, are met. Initial work has already been carried out to determine the qualifications and the quality of skills in 35 of the higher professional staff at BCRM. 3.20 The project will provide assistance to: (i) develop and implement an improved personnel policy including systems for staff classification, career planning and promotion and job-rotation; (ii) review personnel needs in different departments and to define the complementary training needed for redeployment; (iii) define training modules for various occupational streams such as economist and financial analysts; (iv) support training programs to meet the skills requirements of the restructured bank over a three-year period; and (v) assist in the development of the personnel management function to improve staff classification, rotation, promotion and training. This element of the component of BCRM will be financed in large part by the United States Agency for International Development. 3.21 It should be noted that the training areas outlined in the human resource development plan will identify the needs and plans in the restructured departments outlined in paragraphs 3.8-3.14 and supplement them in functions which cut across more than one department (eg. accounting). 3.22 Project Management Assistance. To ensure the sustainabiity of the new strategic planning and development function it has created, BCRM will seek assistance over a two-year period in project planning and execution. The initial objective will be to train and support the Coordinator for Strategic Planning and Development, a new director-level position that has been created in BCRM, in latest methods of business planning and execution of information technology projects. At the end of two years, it is expected that BCRM will acquire a basic capacity to design and execute institutional development projects of this kind on its own. Consulting services for this component is expected to be financed by the Swedish Agency for International Technical and Economic Cooperation (BITS). The project will provide additional support for overseas training and study visits. 2. Strenethenine CCBEF 3.23 In anticipation of a shift to greater reliance on indirect controls in the conduct of monetary policy, the supervision capacity of CCBEF will be strengthened under the project so that it can undertake complete prudential supervision of financial institutions, consistent with the management of an open market system. The project complements the initiative of the Monetary and Exchange Affairs Department in IMF to recruit a seasoned bank inspector before July 1993, as external advisor to the Chairman of CCBEF. The advisor will, in close cooperation with the Secretary General of CCBEF, define the objectives and action plan for CCBEF to be financed by the project based on CCBEF Strategic Development Plan to be adopted by its Board. This action plan will ensure that CCBEF, in assuming the - 24 - primary role of supervision of financial institutions, develops adequate capacity for this purpose. A key feature of the action plan will be the systematic on site inspection of all the commercial banks. The first round of these annual on-site inspections will be completed by June 1994. Another key element in the program of the advisor will be to lead a training program to upgrade skills in existing and newly enlisted staff to ensure the sustainable implementation of rigorous prudential supervision. The project will finance additional necessary training and equipment and standard packages for developing and implementing information systems, hardware in the form of stationary and portable micro computers, and vehicles to facilitate on-site inspections. CCBEF will also monitor the interventions of external auditors (including the Commissaire aux Comptes) and will promote the application of international standards of auditing in the examination of the accounts of banks. 3. Improving the Accounting and Audit Framework 3.24 Two issues are addressed in this part of the project to improve the transparency and effective supervision of the banking system, corresponding to two sets of activities. First, improvements in accounting and audit practices are supported to accelerate the development of the accounting profession and to ensure the availability of reliable financial information on enterprises based on international standards. Training and technical assistance activities in this area will be complemented by the Ministry of Budget in collaboration with the Ordre des Experts Comptables et des Comptables Agres (Institute of Chartered Accountants). Modifications to the existing ordinance governing the profession, which ensure that international standards are subscribed to and foreign accounting firms are not discriminated against, were detailed during negotiations and the promulgation of a revised ordinance is a condition of disbursement of this subcomponent of the credit. The development of the profession should allow for the admission of appropriately qualified accountants of other nationalities, and the general application of International Accounting Standards and International Standards of Auditing throughout the country, thus facilitating the eventual entry to membership of IFAC of the Malagasy accounting profession; and the provision of the training necessary for the implementation of such Standards. Terms of reference for these activities are found in Annex 3. 3.25 Second, improvements in accounting and audit practices are supported to ensure the availability of reliable financial information in the banking sector to facilitate financial supervision by CCBEF, so that it can adequately perform its regulatory functions.The new chart of accounts for banks and financial institutions (NPCB) has been discussed between CCBEF and the commercial banks and its introduction has been agreed. It now needs to be finalized, approved by CCBEF, and disseminated with a view to being correctly implemented in all financial institutions, with special reference to BCRM and the commercial banks, from January 1, 1994. This will ensure that, in the future, financial information in a concise and comparable form is readily available. Furthermore the presentation of this information should conform to International Accounting Standards as laid down by the International Accounting Standards Committee (IASC). The project will support: (i) an ongoing review of the NPCB to ensure that it adheres to existing and future international accounting standards applicable to financial institutions, including IAS30 (Disclosure in the Financial Statements of Banks and Similar Financial Institutions); and (ii) the implementation of the NPCB through training and seminars in the financial sector with special reference to the commercial banks. CCBEF will assume a key role for undertaking these activities. The resulting training activities are expected to be placed in INSCAE (School of Business Management And Accounting) in association with CNFPB (Banking Training School). Detailed terms of reference are found in Annex 3. - 25 - 3.26 Training and technical assistance activities in both the above activities will be implemented by the Ministry of Budget in collaboration with the Ordre des Experts Comptables et des Comptables Agres (nstitute of Chartered Accountants) and CCBEF respectively. 4. Support to State Bank Privatization 3.27 The privatization of the two state banks is featured as a goal in the Government's Statement of Financial Sector Reform and Development Policy (see Annex 1). The process of privatizing one of the two state banks, BTM, has already begun and the Government has committed itself to a similar process for the other state bank, BFV. Preliminary valuation work for BTM was financed under the on-going IDA Financial And Private Sector Development (APEX) Project (Cr. 2104-MAG). A strategy detailing further steps to be taken in the privatization of both banks was agreed at negotiations. The project will support the privatization process to the point of sale, by financing specialized consulting services such as for the valuation and placement of these banks with private investors. In the course of privatization, it is expected that all regular activities such as annual financial audits will continue to be self-financed by the banks themselves. D. ProJect Cost 3.28 Total project costs are estimated at US$10.4 million, with a foreign exchange component of US$9.5 million. These are summarized in the Project Summary Table on page (iii) and detailed in Annex 5. Costs have been calculated excluding taxes and duties. Costs include expenses related to consulting services for technical assistance and studies; training both locally and abroad; the purchase of equipment, including computer hardware/software, vehicles and teaching materials. 3.29 Technical assistance and training costs are based on recent costs for comparable technical assistance and training being provided by the Bank under other projects and by other institutions, including UNDP. The costs include transportation and housing allowance where needed, such as in the case of the short term consultants and of travel abroad. The costs have been estimated as follows: (i) specialist services, USS130,00 per annum; (ii) short-term consultants, US$20,000 per month; (iii) short-term seminars abroad for high level staff, US$10,000 per week. 3.30 Equipment costs are based on (i) international procurement prices recently awarded for similar projects following ICB procedures and (ii) estimates of freighting costs to Madagascar. 3.31 The base costs for the project are expressed in end-1992 prices. Project costs include physical contingencies for equipment averaging about 5 percent of base costs per annum. Price contingencies (expressed in dollars) have also been added, with annual rates of 4 percent during project implementation. 3.32 Estimates for the foreign exchange component were arrived at as follows: (a) equipment and vehicles, 100 percent; (b) training abroad, 100 percent; and (c) specialist services and short-term consultants, 88 percent. The resulting foreign exchange component, including contingencies, is estimated at about US$9.5 million. - 26 - E. Project Financing 3.33 The proposed IDA credit of US$6.3 million equivalent would finance 60 percent of total costs. USAID financing, estimated at US$3.0 million, would provide technical assistance and training support for the areas of research and human resource functions element under the BCRM component of the project. Switzerland will contribute an estimated US$0.6 million of the project which will cover technical assistance, training and equipment for foreign exchange and internal audit operations. BITS, the Swedish technical assistance agency, will provide US$0.5 million equivalent for project management assistance for project coordination. Effectiveness of all co-financier agreements will be a condition of IDA Credit effectiveness. A summary of the financing plan is outlined in the Project Summary Table on page (iii), with Annex 5 giving details of the project financing by nature of the activity to be funded. All incremental staff costs of formulating and implementing Strategic Development Plans (SDPs) will be directly and fully assumed by BCRM and CCBEF, including the costs of the newly-created Department of Strategic Planning and Development. Furthermore, the project coordinating cost in the Ministries of Finance, Budget, BCRM and CCBEF will be borne by these implementing agencies. F. Project Implementation, Monitorinf and Mid-Term Revi 3.34 Institutional arrangements: BCRM is the executing agency for the BCRM component of the project. Since CCBEF is an independent commission but not a legal entity, and is chaired by the Governor of BCRM, the Government has also designated BCRM as the executing agency for the CCBEF component. The Ministry of Budget has been designated the implementing agency for the third component - improving the accounting and audit framework - in which it will collaborate with the Ordre des Experts Comptables et Comptables Agrees and with CCBEF. The Ministry of Finance will implement the fourth component - supporting the privatization of banks - in collaboration with BCRM. Project funds for the first and second components will be made available by the Government to BCRM on a grant basis as provided for in a subsidiary credit agreement, to be signed prior to Credit effectiveness. 3.35 To implement its strategic development plan, BCRM has created and filled a new position of Coordinator for Strategic Planning and Development. (See Annex 10 for the Terms of reference of the coordinator). The coordinator will also be responsible for the overall coordination and monitoring of this project. During negotiations, assurances were given that this position will be filled at all times with qualified personnel acceptable to IDA. The project coordinator will act as secretary to BCRM steering committee which will review and approve all organizational and information technology plans for BCRM. The BCRM component of the project will be guided by the BCRM Strategic Development Plan and its composite Human Resource and Information Technology plans. 3.36 In addition, an expatriate adviser to the Research Department will be responsible for helping implementation of this key area under the BCRM component of the project. Project coordinators in the CCBEF and Ministries of Budget and Finance, whose terms of reference were finalized at negotiations, in addition to the BCRM Coordinator for Strategic Planning and Development will supervise the selection of consultants and procurement of equipment, materials and supplies for the components which concern them directly. 3.37 In the case of the accounting and audit component, the Ministry of Budget will take the lead in implementing this component in collaboration with the Ordre des Experts Comptables et Comptables Agrees and CCBEF. Technical assistance to review and implement changes in the regulatory framework - 27 - of the accounting profession will primarily be under the responsibility of the Ordre des Experts Comptables et des Comptables Agrdes. Technical assistance specifically related to reviewing the NPCB and providing training for its implementation within the financial sector will primarily be coordinated by CCBEF. 3.38 The Ministries of Finance and Budget, BCRM, CCBEF and IDA will jointly organize a project launch workshop immediately after credit effectiveness to familiarize key officials of all agencies with important aspects of the project, including procurement and disbursement procedures. The scope of the project launch workshop has been discussed with the beneficiary agencies. 3.39 An annual project implementation review will be conducted by the World Bank, BCRM Strategic Planning and Development Coordinator, the coordinators of the Ministries of Finance and Budget and of the CCBEF, and relevant staff from each of the beneficiaries. These reviews will, in addition, monitor overall project execution with specific reference to the monitorable indicators mentioned in Annex 8 and agreed at negotiations, update the project timetable, identify implementation issues and develop appropriate solutions to arising problems. The BCRM, CCBEF and Ministries of Finance and Budget coordinators will make the necessary arrangements to provide the required information for the annual review and to furnish any other information that maybe required by IDA on an ad hoc basis of the project. 3.40 Mid-Term Review. It was agreed that BCRM and the Ministries of Finance and Budget shall no later than September 30, 1994, carry out, jointly with IDA and with the participation of CCBEF, a mid-term review of the project with a view to implementing soon thereafter the recommendations of the review. This review will cover inter alia: (a) overall project performance against established and agreed key performance indicators (see Annex 8); (b) an assessment of project sustainability; (c) evaluation of consultant's performance; (d) review of the organizational changes in BCRM and CCBEF during the first year of the project to gauge how far departmental functions have been appropriately streamlined; (e) evaluation of the progress of the accounting and audit component; and (f) evaluation of the completion of privatization of banks. In order to facilitate this review, BCRM and the Ministries of Finance and Budget have agreed to prepare, no later than four weeks before the review date, a preliminary mid-term review report, the format of which will be agreed upon beforehand with IDA. 3.41 Finalization of the action plans of individual BCRM departments and the related allocation of project funds among different departments is expected to be agreed upon during the mid-term review. This would enable the major parts of the informatics program and human resources development plan to take place during 1995 and 1996. The mid-term review will also be the occasion to finalize the new organization charts for BCRM and CCBEF, detailing the new functional responsibilities and staffing of various departments, based on the implementation of their strategic development plans (SDPs) during the first year of the project. G. Procurement 3.42 Madagascar's cumbersome procurement regulations were a major constraint to the implementation of Bank-financed projects. This was due to the fact that many ministries performed numerous reviews. In January 1991, the Government issued new regulations on public procurement following a comprehensive review of the country's procurement regulations (Country Implementation Review (CIR), December 1990). A follow-up CIR occurred in March 1992, resulting in the - 28 - Government's decision to use Bank Sample Bidding Documents (Prime Minister's decree No. 892/92, March 6, 1992). This is expected to speed up procurement and project implementation considerably. 3.43 Procurement for equipment amounting to more than US$125,000 would be based on contracts awarded following international competitive bidding procedures, in accordance with 'Guidelines for Procurement Under IBRD Loans and IDA Credits," dated May 1992. Bid packages for goods with an estimated value below $125,000 up to an aggregate amount equivalent to US$600,000 would be awarded through local competitive bidding procedures advertised locally in accordance with procedures satisfactory to IDA. Small contracts for equipment, furniture and office supplies amounting to US$50,000 or less per contract, and up to an aggregate amount equivalent to US$200,000, would be procured through local shopping with price quotations from at least three local suppliers, in accordance with procedures acceptable to IDA. Consultancies include technical assistance, training and studies (US$3.2 million). Consulting services would be selected in accordance with "Guidelines: Use of Consultants by World Bank Borrowers and by the World Bank as Executing Agency," dated August 1981. This would allow the Project coordinators to engage consultancy services up to a limit of US$50,000 based on standard documents agreed during negotiations. All major consultancy works above this ceiling would require IDA approval on a non-objection basis. A summary of procurement arrangements is given in Table 1 below. Procurement will be the responsibility of the project coordinator who will organize selection committees consisting of the relevant departments of their respective organizations and government agencies to review each tender offer. Table 1: Summary of Proposed Procurement Arrangements (US$ million) PROCUREMENT METHOD Project Element Total I.C.B. L.C.B. Other N.B.F. Cost 1. Good 1.1 Equipment, Vehicles and 0.3 0.3 0.1 - 0.7 Supplies (0.3) (0.3) (0.1) - (0.7) 1.2 Informatics 2.0 0.3 0.1 - 2.4 (2.0) (0.3) (0.1) - (2.4) 2. Techmical Assistance, Audifing Services & Training -- 2.8 4.1 6.9 - ~ ~~- (2.8) (2.8) 3. MisCedianeois 3.1 Refinancing PPF (- 0.4 - 0.4 - - (0.4) - (0.4) TOTAL 2.3 0.6 3.4 4.1 10.4 (2.3) (0.6) (3.4) - (6.3) Note: Figures in parentheses are the amounts financed by the IDA credit. N.B.F: Not Bank-financed. - 29 - 3.44 IDA-financed contracts above a threshold of US$50,000 would be subject to IDA's prior review for the first year of the project, or until it is determined that there is sufficient experience; at that point, a higher ceiling may be set. Under these procedures, IDA's prior review would cover about 80 percent of total contracts. Selective review of awarded contracts below the threshold levels should be carried out on about one in six goods contracts. To simplify the task of contract review, standard bidding documents and letters of invitation for consultants will be prepared prior to effectiveness. H. Disbursements 3.45 Disbursement under the IDA Credit would be made on the basis of categories and percentages shown in Table 2 below. The Credit would be disbursed on the basis of fully documented withdrawal applications, except for expenses disbursed against SOEs, as described in para.3.46. The estimated disbursement profile is outlined in Annex 6. 3.46 Special Accounts: In order to facilitate the disbursement of funds, two Special Accounts will be opened, one by BCRM in one of its foreign correspondents and the other by the Ministry of Finance in a commercial bank, acceptable to IDA. The initial deposits amount to US$ 200,000 and US$ 100,000 respectively and cover four months of eligible expenditures. Replenishments of the Special Accounts would be made on a monthly basis and would be fully documented except for contracts valued at less than $ 20,000 equivalent which will be on the basis of Statements of Expenditures (SOEs), for which documentation shall be reviewed as part of annual audits of the project. Replenishments will be supported by bank statements and reconciliation of statements. Table 2: Summary of Disbursements Percentage US$ Financed Million Category 1. Equipment, Vehicles & Supplies " 1.1 BCRM 100% I/ 2.63 1.2 CCBEF 100% Z/ 0.20 1.3 Accounting & Audit Framework 1.3.1 Regulatory Framework Reform 100% I/ 0.06 2. Technical Assistance, Auditing Services & Training 2.1 BCRM 100% 1.53 2.2 CCBEF 100% 0.36 2.3 Accounting & Auditing Framework 2.3.1 Regulatory Framework Reform 100% 0.45 2.3.2 Review & Implementation of NPCB 100% 0.12 2.4 Supporting Privatization of Banks 100% 0.20 3. Refunding of Project Preparation Advance Amounts due 0.35 4. Unallocated 100% 0.40 TOTAL - 6.30 All foreign costs exclude taxes and duties. Z/ Except local expenditures for which the credit will finance 85 of local costs. - 30 - I. Accounting. Auditing and Reporting 3.47 BCRM, CCBEF and the Ministries of Finance and Budget will establish and maintain project related accounts for their respective interventions. Project accounts, to reflect all project resources, expenditures, assets and liabilities, will be maintained in accordance with generally accepted accounting principles. Annual General Statements will be prepared in accordance with International Accounting Standards and audited in accordance with International Standards on Auditing by independent auditors acceptable to IDA. A review of the Special Account and an auditor's opinion with special emphasis on the audit of SOEs will be provided. The auditor's report will include a statement on the inadequacy or otherwise of the accounting systems and internal controls, the reliability of the statement of expenditures as a basis for credit disbursements, and compliance with financial covenants. BCRM annual financial statements will be prepared and audited in accordance with International Accounting Standards and International Standards on Auditing. The audited financial statements and auditors' reports thereof will be submitted to IDA within six months of the end of the period to which they relate. 3.48 The Ministries of Finance and Budget, BCRM, and CCBEF no later than September 30 of each year, will provide IDA for its review and approval detailed work programs of their respective components of the Project for the forthcoming year. Furthermore, the Ministries of Finance and Budget and BCRM will provide IDA with an evaluation report of the Project activities undertaken in the previous twelve month period between September 1 and August 31. These programs, budgets and reports will be prepared by BCRM, with the assistance of CCBEF for the first and second components of the project referred to in paragraph 3.2., and by the Ministry of Budget, with the assistance of the Ordre des Experts Comptables and CCBEF, for the third component, and by the Ministry of Finance, with the assistance of BCRM, for the fourth component. During negotiations, assurances were obtained in that respect. 3.49 The project coordinator of BCRM, in collaboration with the coordinators in the Ministries of Finance and Budget, and CCBEF, will submit to IDA semi-annual reports on project implementation, including procurement information and expenditures by March 30 and September 30 of each year, beginning in March 1994, using a standardized reporting format, and indicating: (a) updated cost estimates for individual contracts and the total project; and (b) the revised timing of procurement actions, including advertising, bidding, contract awards, and completion time for individual contracts. 3.50 The Project completion date is expected to be September 30, 1996. A Project Completion Report will be submitted to IDA within six months of the Closing Date of the IDA Credit. J. Project Supervision 3.51 Given the multi-faceted nature of project components requiring specialized follow-up and involving important institution building efforts, project supervision input by Bank staff is expected to be above average in the early stages of the project (during the first fifteen months, beginning with Credit effectiveness). The organizational structure of the project, which includes an experienced Project Coordinator at the BCRM to oversee BCRM component, and the common reporting and review arrangements, which the co-financiers have agreed to adopt, will facilitate project implementation and supervision. To ensure clear understanding of project implementation requirements, an implementation _ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ - - - - - - - - 31 - manual has been drafted and will be finalized with Malagasy counterparts during the project launch workshop in September 1993. The workshop will include sessions on procurement and disbursement under IDA-financed projects, standard formats and procedures to be used for project reporting, and detailed review of the implementation timetable with all concerned departments of BCRM and CCBEF. A proposed supervision plan for the project is found in Annex 9. IV. PROJECT BENEFITS AND RISKS A. Project Benefits 4.1 The strengthening of the financial sector is critical to the development of market oriented financial institutions. In turn, a sound financial system, with an effective banking system at its core, will facilitate productive investments and contribute to accelerated economic growth and the creation of employment opportunities which are key factors in poverty alleviation. Fundamental institutional weaknesses in Madagascar's financial sector have undermined previous structural adjustment programs, underscoring the importance that needs to be attached to institution capacity building to ensure the effective resumption of economic reform and its sustainability. This project takes advantage of a period of political transition to improve the effectiveness of the financial sector in preparation for further strides towards a market determined economy. The project will help implement an overall strategy for market oriented financial reforms, particularly in strengthening the framework for prudential supervision, accounting and audit. 4.2 The project is expected to contribute significantly to enhancing the capacity, transparency and accountability of key financial institutions, notably the central bank (BCRM) and the Financial Supervisory Commission (CCBEF). Through a process of restructuring and improvements to human and information technology resources, BCRM and CCBEF will be better prepared to play their fundamental respective roles of regulation and supervision of the monetary and financial markets through indirect market based instruments. Furthermore the project will play an important role in strengthening the bank environment by providing technical assistance for the implementation transparent accounting and audit procedures with specific emphasis on the commercial banks and support for the privatization of the two remaining state banks. 4.3 Through these initiatives the project is expected to increase the capacity and consequently the quality of financial intermediation, better preparing the financial sector to play its role in stimulating financial savings and efficiently channeling them into the real sector, to promote private sector investment. The project will, therefore, enhance the financial sector's ability to respond to future economic reforms in a manner that ensures their successful implementation, and helps avert crises rather than simply react to them. B. Project Risks 4.4 The major risks of the project stem from the possible impact of the present transitional political decision-making structure on effective implementation. Successful implementation is predicated on political will being maintained to preserve the authority of BCRM and CCBEF, respectively to formulate and execute monetary policy and to exercise prudential oversight of banks. At the same time, the - 32 - institutional development goals for BCRM and CCBEF are complex and ambitious, including significantly redefined business objectives and extensive use of information technology, and could be subject to implementation slippages. Another set of risks relates to the timing of resumption of macroeconomic reforms. This project is designed to strengthen institutional capacities in anticipation of a return to further economic liberalization in the medium term. If the political transition is longer than expected, institutional capacity building now will have limited application in the immediate future and consequently limited sustainability. 4.5 These risks are mitigated by: (i) the high level of commitment to project objectives and to the project's urgency expressed by a broad spectrum of political figures and technicians; (ii) limiting the project core to BCRM which has demonstrated continuity in its institutional capacity; (iii) the progress already made, by BCRM and CCBEF themselves, towards preparing this project, indicating early ownership and internalization of project design and objectives. Over seventy staff members of BCRM and CCBEF, including all senior and department managers and professional staff, have participated in the preparation of the strategic development plans (SDPs) of both institutions since August 1992; (iv) the inclusion in the project of project management assistance for a two-year period which will help BCRM strengthen its capacity to plan and implemmnt projects of this kind involving strategic business analysis and use of information technology; and (v) up-front agreement and implementation of key organizational and institutional changes necessary to execute the project. V. AGREEMENS SURANCES AND RECOMMENDATIO 5.1 Prior to Board Dresentation: (a) the Government adopted in early May 1993 the revised Statutes of BCRM (para. 3.2); (b) the Government furnished to IDA a Statement of Financial Sector Reform and Development Policy dated March 3, 1993 (para. 3.1 and Annex 1); (c) the BCRM and CCBEF Boards adopted their respective Strategic Development Plans (SDPs) in April 1993 (para. 3.5 and 3.23). 5.2 During negotiations. agreement was reached on: (a) the terms of reference for BCRM external audit and the process for selecting the external auditors was started (para. 3.13); (b) the position of Project Coordinators in BCRM, in the Ministries of Finance and Budget and in CCBEF to be filled at all times with personnel with responsibilities, qualifications and experience satisfactory to the Association (para. 3.39); (c) a privatization strategy for the remaining two state banks (para. 3.27); (d) the modifications required for the ordinance governing the accounting profession (para. 3.24); - 33 - (e) monitorable actions for the project (para. 3.39, Annex 8); (f) the timing and scope of the mid-term review (para. 3.40). (g) annual detailed work programs and budgets to be furnished to IDA for review and approval together with an evaluation report of project activities undertaken during the previous year (para. 3.48). 5.3 Conditions of effectiveness: The following will be conditions of effectiveness for the proposed Credit: (a) promulgation of the ordinance setting forth revised BCRM statutes (para. 3.2); (b) receipt by IDA of the external audit report of BCRM for fiscal year 1992 (para 3.13); (c) signing of the subsidiary credit agreement between the Government and BCRM (para. 3.34). (d) effectiveness of all co-financier agreements (para 3.33). 5.4 Conditions of Disbursement: The promulgation of a new ordinance, with contents satisfactory to IDA, for the "Ordre des Experts Comptables et Financiers et Comptables AgrWes (Institute of Chartered Accountants) will be a condition of disbursement for technical assistance, training and equipment to the Ordre des Experts Comptables et Comptables Agr6ds under the third component of the project (para. 2.63 and 3.24). 5.5 Recommendation: Subject to the above terms and conditions, the proposed project would be suitable for an IDA Credit of SDR 4.6 million (US$ 6.3 million equivalent) to the Republic of Madagascar on standard IDA terms with 40 years maturity. Annex 1 Page 1 of 6 UNOFFICIAL TRANSLATION MADAGASCAR FINANCIAL INSTITUTIONS DEVELOPMENT TECHNICAL ASSISTANCE PROJECT Statement of Financial Sector Reform and Development Policy 1. Recognizing the vital importance of ensuring the effective allocation and mobilization of capital through the use of efficient financial systems, the Government wishes to pursue a two-phase comprehensive program for the reform and development of the financial system in Madagascar. This program is related to the pursuit of macroeconomic stability and economic growth based on a reduction and non-inflationary financing of the budget deficit, including the elimination of the quasi-fiscal deficit of the Central Bank of Madagascar (BCRM), the program related to the Government's divestiture from the productive sectors of the economy, and a higher degree of factor mobility. The importance which the Government attaches to this program is primarily a reflection of the concern for sound development in the private sector, so that restored private investment and savings can serve as a driving force for economic growth in the coming years. 2. The comprehensive program for the reform and development of the financial sector is designed to reach the following objectives: (i) To improve the regulatory, legal, and accounting environment with a view to ensuring the security of contracts and financial instruments, and the sound management of financial institutions in accordance with the internationally-accepted rules of prudence and transparency; (ii) To shift to a monetary policy based on indirect instruments, to enable BCRM in the long term to eliminate the credit ceilings allocated to individual banks; (iii) To reinforce the market mechanisms with increased competition resulting from the entry of new private institutions operating within an appropriate regulatory framework; (iv) To encourage the creation of money and capital markets, aiming initially, inter alia, at implementing a more effective structure for the issuance and trading of treasury securities (concurrently with a strict ceiling on claims on Government and Government paper held by BCRM), and the gradual issue of financial securities by financial institutions and/or private nonfinancial enterprises; and (v) To promote interest rates determined by the market as competition intensifies and as a more market-oriented regulatory framework develops; 3. In the context of this comprehensive program, reinforcement of the institutional capacities of the financial system, primarily those of BCRM, the Financial Supervisory Commission (CCBEF), and the strengthening of the accounting and audit framework, constitute an absolute priority for phase one of the Anex 1 Page 2 of 6 financial system reforms, aiming to lay the foundations for other fundamental reforms which include, among others, the shift to the use of indirect monetary policy instruments. The reform and development of the financial system in Madagascar will begin with an initial phase of reforms. This first phase primarily involves the institutional reinforcement of the financial system as stated below: (i) to strengthen the independence of BCRM and its institutional capacity to formulate and execute monetary policy, eventually through indirect instruments (see paragraphs 6 to 10); (ii) to restructure financial institutions and remove the Government from the ownership and management of financial institutions, and specifically commercial banks (see paragraphs 11 and 12); and (iii) to reinforce the supervision of banks and financial institutions and to adapt the regulatory framework (see paragraphs 16 to 18). 4. Phase one pertains to specific priority measures already identified and under way, and measures to be defined by June 1993. The Government believes that the specific strategy for phase two of the program will be developed before end-1993. 5. All activities and measures stipulated in the comprehensive program for reform and development of the financial sector cover all financial institutions, infrastructure, and financial markets. The strategic orientation of this program and the activities under way and to be undertaken are indicated below. I. Financial Institutions Central Bank of Madagascar 6. In light of the critical role which an efficient, independent, and responsible central bank plays in any program to develop the financial system, the restructuring and strengthening of the capacities of BCRM constitute one of the priorities of the program which is being pursued by the Malagasy authorities. This objective involves three areas of focus: (i) strengthening BCRM institutional and financial independence; (ii) making BCRM more accountable and its operations more transparent; (iii) strengthening the human and logistic resources of BCRM to prepare it more effectively to formulate and execute monetary policy, primarily with a view to the shift to indirect control of monetary aggregates. 7. The independence of BCRM involves both institutional and financial factors. As regards the institutional aspect, revised statutes for BCRM will be developed by the end of April 1993. This revision aims primarily at limiting its excessive dependence vis-a-vis the Government in matters concerning the development and execution of monetary and credit policy. These new statutes will be adopted by the Government before the middle of May 1993. The financial aspect of BCRM independence consists primarily of ensuring that its activities do not include those responsibilities which must clearly be incumbent on the Treasury. To that end, there are two types of actions. The first, which was completed at the end of 1992, consists of isolating credit to the Government resulting from previous losses and placing it in a separate account, while stipulating the conditions and modalities for settling these claims. This makes the quasi-fiscal activities of BCRM which to date have encumbered its balance sheet with non- interest earning assets and liabilities more transparent. Stage two consists of taking steps before the end Annex 1 Page 3 of 6 of 1993 to prevent the recurrence of past problems and the accrual of new losses. These steps would be accompanied by a reduction in the budget deficit. 8. The accountability of BCRM and its more transparent operations will be accompanied by strengthening of ifs independence, as described above. Accordingly, an external audit of BCRM and an analysis of its internal audit function will be assigned to an independent firm, to be undertaken during the first half of 1993. In addition to a conventional financial audit, this audit will include a study of the present internal audit function in BCRM and will make recommendations to strengthen this function. The Government has specified that FINDEP should provide assistance for the structuring and development of a new internal audit function for BCRM, which would be separate from other functions of BCRM and would report directly to the Governor and the Board of BCRM. 9. This initial external audit will then lead to systematic external audits of BCRM for each fiscal year, to be conducted by an independent and qualified firm, and which would lead to an annual report published by BCRM accompanied by audited financial statements. The first report is scheduled to be published in 1994. 10. The independence of BCRM and its increased accountability will be facilitated by strengthening of its human and logistic resources, with a view to pursuing its main objective, i.e., to ensure price stability through monetary policy. To that end, BCRM has prepared a strategic development plan which it will adopt in March 1993 and which provides for a strengthening of the departments which are directly responsible for the core functions of central banking (Credit, Foreign Services, and Research) and all support functions (primarily accounting, data processing, and administration). The assistance of FINDEP should contribute to the implementation of this plan over a three-year period. Commercial Banks 11. In keeping with its concern to ensure that the above mentioned objective is attained, i.e., the creation of a real financial market with freely determined interest rates, the Government recognizes the importance of a competitive banking system which meets the needs of economic agents. This goal is consistent with the orientation which the government adopted in 1988, which consists of replacing the former roles of the Government as the owner of the financial institutions, and the decision maker for selective policies for credit and direct control, with a strategy which limits the role of the Government essentially to providing the appropriate regulation and the supervision necessary for market mechanism to function properly. 12. With the final objective of Government divestitureof remaining ownership and bank management, the Government intends to pursue and accelerate the policy which it began in 1988. Accordingly, the process of privatizing the BTM was undertaken in 1992, and the Government has followed up on the recommendations of the consulting firms recruited to that end. Similarly, the Government will pursue the privatization of the BFV by increasing the share of private stockholders to at least a majority level, if not to one hundred percent of the capital, by end-1993. Ins-rance 13. In the insurance sector, the Government will pursue the objective of introducing private capital into the two existing state-owned corporations and to open this sector up to competition. Concurrently the regulatory system governing this sector will be reviewed. These activities will be carried out during phase two of the program for reform and development of the financial system. Page 4 of 6 CNaPS and Social Security 14. Considering the weight which it carries in mobilizing financial resources, the Caimn Nationale de Prevoyance Sociale (CNaPS) is, in addition to its fundamental role as a social institution, a considerable institutional investor and, therefore, is one element which must be taken into account in the reform and development of financial markets and institutions in Madagascar. The Government's goal is to make the management of CNaPS more efficient by providing it with the required transparency and increasing its level of accountability. In this connection the Government during the last quarter of 1992 initiated a series of three studies on CNaPS with the assistance of the World Bank and the Intenatonal Labor Office, i.e., an organizational and financial analysis of CNaPS, an actarial study, and a tudy on the investment of funds. After these studies are completed, prior to June 1993, nd in the context of phase two of the program for reform and development of the financial system, a plan of action will be developed to reorganize CNaPS, which will primarily involve the following elements: (i) more transparent operations, achieved, inter alia, by preparing financial statements according to international accounting procedures and auditing them in accordance with the relevant international standards; (ii) strengthened management of this institution, which includes establishing actuarial forecasting and analysis capabilities; and (iii) regulations concerning investments of funds more suitable to ensure the security of funds while participating in the development of financial markets. Postal financial services 15. The postal financial services, i.e., the Caisse d'Epargne de Madagascar (CEM), a postal savings institution, and the Centre de Cheques Postaux (CCP), a postal checkling institution, wIll be restructured with a view to making them better suited to meet the needs of small- and medium-scale savers and the payments system, respectively. In the context of its sectoral policy on post and telecommunications adopted on June 30, 1992, the Government already provided for these services to be more autonomous and to be managed according to commercial principles. This policy is intended to result in a separation of the activities of the postal financial services from the Treasury's overall operations, and their privatization, to the greatest extent possible. The practical ways and means for the implementation of this strategy are being studied, including the development of the relationships between these services and private businesses and financial institutions. Phase two of the reforms will include the implementation of this strategy to be adopted before end-1993. II. The Financial Infrastructure 16. The Government attaches particular importance to the financial infrastructure, primarily the regulatory framework governing banking operations, including prudential supervision, the accounting and audit framework, and the legal environment for financial transactions. The reinforcement of the process of the supervision of banks and financial institutions and the improvement of accounting and audit standards will, inter alia, facilitate the elimination of direct controls applicable to banks and the shift to indirect monetary policy instruments. The first phase of the reforms stipulated in this connection will accordingly give priority to the strengthening of the Financial Supervisory Commission (CCBEF), the implementation of a regulatory framework governing the accounting profession, and the adoption of texts governing financial institutions before end-1993. 17. As regards the operation of CCBEF, the present situation which is characterized by shared responsibilities between BCRM and CCBEF for the functions and staff involved in supervising the banking system, will be modified in the context of the implementation of the strategic development plan for BCRM. The main responsibility for the supervision of banks and financial institutions, as regards Annex I Page 5 of 6 on- and off-site supervision, will fall to CCBEF. The transfer of the banking supervision functions of BCRM to CCBEF, the strengthening of the human resources of CCBEF by the assigmnent of a minimum number of permanent staff, and the development of a plan of action for CCBEF, under the supervision of a technical assistant-a seasoned inspector recruited from the outside before June 1993 for a three-year period-will be completed by the end of 1993. The technical assistant will serve as an advisor to the Governor of BCRM, as Chairman of CCBEF, and will be responsible for implementing a systematic training program for CCBEF staff, including on-the-job training, and for reinforcing all aspects of on- and off-site supervision. CCBEF will conduct a general on-site inspection of each commercial bank at least annually. The first series of these on-site inspections will be completed by June 1994. 18. Financial management will be reinforced by the establishment of audit and accounting standards compatible with international standards. To ensure that these standards are applied and observed, the accounting profession will be subjected to a regulatory framework developed by the profession itself and submitted for the approval of the authorities before end-1993. This regulatory framework will ensure that accounting experts uphold high professional ethics and standards in their endeavors, so that the requirements of sound financial management can be met more effectively, primarily thorough the use of the following measures: - Authorization of the title of accountant and the right to practice this profession; - Professional ethics to be observed, and disciplinary measures for failure to observe them; - Organization and operation of the Association of Accounts, including its goals, initiation fees, financial conditions, etc.; and - The statutory component, including the production and auditing of annual financial statements and the filing of such statements with the competent authorities, and the deadlines to be met. 19. In the general context of improving the legal framework governing business, more particular attention will be focused on filling the gaps both in the basic legal texts and in the application texts related to financial transactions. These gaps involve the following fields of business law: law applicable to stocks and bonds; general law and procedures pertaining to guarantees, mortgages, and collection of claims, as well as bankruptcy and liquidation. The actions to be taken to that end will be coordinated with the other components of the legal framework to be improved (commercial code, law on competition, and mining code), as discussed earlier with IDA. A program of specific activities will be developed before end-1993, to be incorporated into phase two of the reforms stipulated in this program. 20. The Government, BCRM, and the banking industry will examine the different options for making the existing payments system more effective. The Government and IDA will examine the recommendations of a consultants' study on this subject, with a view to identifying a strategy before the end of 1993. III. Financial Markets 21. The Government's goal is to promote the development of financial markets which can determine interest rates through the interplay of supply and demand for financial resources. The immediate priority for the Government in the development of such financial markets is to restore the proper operation of the interbank market, which has for all intents and purposes been dormant since the two Government banks Annx I Page 6 of 6 began to experience problems. The privatization of these banks and the opening of the sector should improve the operation of the interbank market. 22. The Government intends to restore the regular issue of Treasury bills and concurrently reduce its direct recourse to BCRM. This action to reinforce the operation of the money market will be accompanied by a considerable effort to manage Government cash flow and to implement stricter coordination between the Treasury and BCRM. This will result in improved liquidity forecasts made by BCRM in the context of monetary policy management. 23. The Government also believes that initiating the development of a nascent capital market in Madagascar would be a decisive step in fostering the economy's market orientation. The private sector should play a vital role in the design and organization of such a market. With a view to helping stimulate the start-up of such a market with high grade marketable securities, the Government will accelerate as much as possible its program to privatize financially viable public enterprises (for example, in the insurance sector, banks, telecommunications, and transportation) and for which a portion of the designated capital could be privatized through a public offering for sale, aimed, inter alia, at small-scale owners and institutional investors. The Government will examine the ways and means to reach this goal as quickly as possible in the context of phase two of the reforms under the comprehensive development program for the financial sector. Adopted by the Government Antananarivo, March 3, 1993. Annex 2 Pego 1 of i MADAGASCAR FINANCIAL INSTI1UTIONS DEVELOPMENT TECHNICAL ASSISTANCE PROJECT Morlery Survey. 1966-92 yAaIamy Franc billon: End of Pwiod) 1900 1967 !90 193 2K 1991 __ Est Total Domestic Credit WI-2 .9 91
Группа Всемирного банка · Staff Appraisal Report
Madagascar - Financial Institutions Development Technical Assistance Project
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