Moldova - Structural Adjustment Loan Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 16544 IMPLEMENTATION COMPLETION REPORT REPUBLIC OF MOLDOVA STRUCTURAL ADJUSTMENT LOAN (LN 3815 - MD) MAY 28, 1997 Country Operations Division II Country Department IV Europe and Central Asia Region This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS (as of April 30, 1997) Currency Unit = Leu US$1 4.60 Leu WEIGHTS AND MEASURES Metric System ABBREVIATIONS AND ACRONYMS ARA - Agricultural Restructuring Agency ARIA - Enterprise Restructuring Agency CAS - Country Assistance Strategy CG - Consultative Group EFF - Extended Fund Facility FSU - Former Soviet Union GDP - Gross Domestic Product G&NFS - Goods and Non-Financial Services IDF - Institutional Development Fund IFC - International Finance Corporation IMF - International Monetary Fund NBM - National Bank of Moldova PSD - Private Sector Development SAL - Structural Adjustment Loan SBA - Stand-By Arrangement SOE - State Owned Enterprises STF - Systemic Transformation Facility MOLDOVA'S FISCAL YEAR January 1 - December 31 Vice President: Johannes Linn, ECAVP Director: Basil Kavalsky, EC4DR Acting Div.Chief: Hafez Ghanem, EC4C2 Responsible Staff: Kristin Gilbertson, Country Officer, EC4C2  FOR OFFICIAL USE ONLY Table of Contents Preface ........................................................i Evaluation Summary ...................................................... ii Part I: Project Performance Judgment and Analysis .......................................................1 I A. Project Objectives .................................................1I B. Achievement of Project Objectives ..................................................3 C. Implementation Record and Major Factors Affecting the Project .................................3 D. Project Sustainablity ..................................................7 E. Bank Performance ..................................................8 F. Borrowers Performance ..................................................8 G. Assessment of Outcome ..................................................9 H. Future Operation ..................................................9 I. Key Lessons Learned ................................................. 10 Part II: Statistical Tables .............................................................11 Table 1: Sunmnary of Assessments ......................................................11 Table 2: Related Bank Loans/Credits ..................................................... 13 Table 3: Project Timetable ..................................................... 14 Table 4: Loan/Credit Disbursements: Cumulative Estimated and Actual ....................... 15 Table 5: Key Indicators for Project Implementation ..................................................... 16 Table 6: Key Indicators for Project Operation ..................................................... 21 Table 7: Studies Included in Project ..................................................... 22 Table 8A: Project Costs ..................................................... 23 Table 8B: Project Financing ..................................................... 24 Table 9: Economic Costs and Benefits ..................................................... 25 Table 10: Status of Legal Covenants ..................................................... 26 Table 11: Compliance with Operational Manual Statements ........................................... 27 Table 12: Bank Resources: Staff Inputs ..................................................... 28 Table 13: Bank Resources: Missions ..................................................... 29 Appendices Appendix A - Borrower's Contribution to ICR Appendix B - Aide Memoire Appendix C - Map 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.   Implementation Completion Report Republic of Moldova Structural Adjustment Loan (Loan 3815-MD) Preface This is the Implementation Completion Report (ICR) for the Structural Adjustment Loan to Moldova, for which a loan (3815-MD) in the amount of US$60 million was approved on December 8, 1994 and made effective on December 14, 1994. The loan was closed in June 1996, the original closing date. The loan was fully disbursed by September 1995. There was cofinancing for the project of ten million Dutch Guilders (equivalent to US$5.4 million) from the Government of the Netherlands. The Task Manager for the loan was Helen Sutch, Senior Country Economist for EC4C2. The ICR was prepared by Kristin Gilbertson (Country Officer) based on an earlier draft by Alma Kanani (Consultant). The ICR was reviewed by Hafez Ghanem (Acting Chief of EC4C2) and Judy O'Connor (Principal Operations Officer of EC4DR). Preparation of this ICR was undertaken during the first quarter of 1997. It is based on material in the project file, including Report No. P-6444-MD for the Structural Adjustment Loan to the Republic of Moldova. This report also incorporates the findings of a mission to Moldova in October 1996 for preparation of the proposed second Structural Adjustment Loan.   -11- Republic of Moldova Structural Adjustment Loan (3815-MD) Evaluation Summary Introduction 1. The Structural Adjustment Loan (SAL) was the third loan to Moldova following on the Emergency Drought Reco-very Loan (US$26 million) and the Rehabilitation Loan (US$60 million). The SAL was also preceded by a stand-by arrangement and a Systemic Transformation Facility (STF) from the International Monetary Fund (IMF). Since the approval of the SAL by the Board in December 1994, the Bank has also prepared a number of investment operations including the Energy (US$ 10 million), Agriculture (US$ 10 million), Private Sector Development (US$35 million) and Education (US$16.8 million) Projects and the Pre-Export Guarantee Facility (US$30 million). The Moldova Country Assistance Strategy was discussed by the Board in April 1996. The IMF has since approved an Extended Fund Facility (EFF). Project Objectives 2. The objectives of the Structural Adjustment Loan (SAL) were to induce a quick response in the real economy to macroeconomic tightening and sharp relative price movements and to produce the reallocation of resources needed to promote a recovery in sustainable export-led growth, while providing for the most vulnerable groups. Implementation Experience and Results 3. The project was marginally successful with limited achievement as measured against stated project objectives. Macroeconomic policies pursued during the SAL period continued to advance the process of stabilization that had begun in late 1993 following resolution of the Transnistria conflict in eastern Moldova. Inflation has subsided to an annual level of 15 percent for 1996. However, growth has yet to be achieved and output declined a further 3 percent in 1995 and 8 percent in 1996. Progress on enterprise privatization, restructuring and financial sector reforms was strong. Under the 1994/1995 privatization program, 70 percent of enterprises were privatized. A number of pilot liquidations and restructurings were launched, and a State Creditors' Committee was formed to supervise debt restructuring for bankrupt enterprises willing to meet current obligations. New capital adequacy standards were phased in and the central bank strengthened. The Enterprise Restructuring Agency (ARIA) was established by the Government and is being supported with support from the Government of the Netherlands in the form of co- financing for the SAL and with support from the Bank-financed Private Sector Development (PSD) operation. 4. Progress on agriculture, energy and the social sectors was minimal under the SAL with backsliding in market liberalization policies for agriculture, inadequate privatization of state- owned agricultural enterprises (SOEs), a serious reversal of sector policy with the changes in  -iii- land reform policies after negotiations, continued increase in energy sector debt and continued growth in pension arrears. Although no conditions were specifically breached, legislation to increase the pension age was not adopted by the Parliament, and the privatization of Cereale and Fertilitatea (the state grain and input marketing enterprises) remains incomplete. Elements of the Letter of Development Policy relating to agriculture and energy were at best only partially adhered to. Although the major reason for lack of progress was difficulty in obtaining the political consensus necessary to advance these reforms through Parliament, in retrospect, the SAL could have incorporated stronger conditionality in the energy sector and enforcement of existing agreements in agriculture could have been tougher. Summary of Findings, Future Operations, and Key Lessons Learned 5. Although the project did not achieve its stated objectives of restoringr growth and providing adequately for vulnerable groups and although the reform agenda could have been advanced more aggressively in agriculture, energy and the social sectors, the program supported by the loan led to significant reforms in the areas of macroeconomic stabilization, privatization, enterprise reform and financial sector development. 6. As noted above, investment operations in key sectors have since been approved by the Board and are under preparation. Additional projects under discussion include a second private sector development project, rural finance, a water resources and irrigation project, cadastre, transport and a social investment fund. As Moldova continues to require balance of payments support, a second Structural Adjustment Loan is now under preparation which will address the remaining reform agenda in agriculture, energy, the social sector, public expenditures and privatization. 7. The main lessons learned from the project are as follows: (i) The definition of project objectives was ambitious, and, in retrospect, the Bank should have been less optimistic as to how quickly growth could be restored. (ii) Compromises were made in the scope of project design and in elements of conditionality that limited the ability of the project to achieve its stated objectives. (iii) The Parliament has proved to be more conservative than the Government on the pace of reforms. To ensure implementation of further reforms, it is essential that Parliamentary leaders be brought into the process earlier. (iv) Commitment to reforms is somewhat reluctant in critical areas involving energy, agriculture and the social sectors. Future operations should require strong up-front conditionality and subsequent tranche conditions should be framed more strictly to allow for more transparent enforcement. At the same time, it is critical that the Bank adopt only such conditions as it is willing to enforce even when that means holding a multi-sectoral operation hostage to lack of action in one or more sectors.  -iv- (v) There can be considerable synergy between a SAL and sectoral operations, particularly when conditionality is able to remove key constraints to sector development and when sector operations support development of institutional capacity. However, this requires a critical mass of effort and resources. Judicious employment of technical assistance has proved critical in creating an institutional basis for reforms in the enterprise sector and would have been useful in other areas.   Implementation Completion Report Structural Adjustment Loan (Loan No. 3815) Republic of Moldova Part I: Project Performance Judgment and Analysis A. Project Objectives 1. Moldova is a small landlocked country situated between Romania and Ukraine with a population of 4.3 million and a land area of 33,700 square kilometers. Endowed with rich agricultural land and a temperate climate, Moldova is a producer of raw and processed foodstuffs (primarily grapes, grains, wines, fruit, vegetables and livestock). Agriculture and agro- processing represent about 60 percent of GDP. The country is almost entirely dependent upon imports for its primary energy requirements and for inputs to its manufacturing industries. 2. Following independence on August 27, 1991, the economy suffered from one of the greatest terms of trade shocks -- estimated as equivalent to a 30 percent decline in 1992 income -- in the former Soviet Union due to the move towards world prices for energy. The cumulative decline in GDP between 1990 and 1994 was over 60 percent. Living standards fell sharply with a fall in real average wages of 53 percent between December 1992 and January 1994. The balance of payments position deteriorated substantially reaching 5 percent of GDP. The budget deficit increased rapidly to 22 percent of GDP in 1992 and inflation accelerated, reaching 1,200 percent. Natural calamities -- floods, hurricanes and droughts -- further exacerbated the situation. In early 1992, an armed conflict arose between the regions on the right and left (Transnistria) banks of the Nistru river due to differences on economic policies and ethnic tensions. A cease-fire was instituted in July 1992 and political stability restored at the expense of a defacto partition of the country. 3. After resolution of the Transnistria conflict, the Government moved quickly in 1993 to implement a successful stabilization program. The budget deficit was reduced from 22 percent of GDP in 1992 to around 8 percent of GDP in 1994 on a cash basis, mainly by cutting government spending and transfers to public enterprises. The Government introduced new taxes, removed some exemptions and extended the scope of excise taxes. Monetary policy was tightened and a new currency (the leu) was introduced on November 29, 1993. These policies led to a reduction in inflation from a monthly rate of 37 percent in January 1993 to a monthly rate of less than 2 percent by the end of 1994. 4. However, adjustment in the real economy was slower than the pace of stabilization due to delays in implementation of key structural reforms. In 1994, state-owned enterprises (SOEs) continued to predominate with preferential access to credit. Reallocation of resources in  -2- response to macroeconomic adjustment and relative price movements was muted by widespread rollover of non-performing loans, capitalization of interest and an expansion of arrears. Privatization of small-scale businesses began in October 1993, but the program was delayed for both political and technical reasons. In the agriculture sector, adjustment had been minimal with little progress on land reform and farrn restructuring. The result was a continuation of the decline in output. 5. The Structural Adjustment Loan (SAL) was the third Bank lending operation to Moldova, following the Emergency Drought Recovery Loan (March 1993) and the Rehabilitation Loan (October 1993), both of which had financed critical imports in an effort to ease the path for the Government's reform program. The SAL was also preceded by a stand-by arrangement (SBA) and a Systemic Transformation Facility (STF) from the International Monetary Fund. The SAL was cofinanced with a grant of ten million Dutch Guilders from the Government of the Netherlands. 6. The objectives of the Structural Adjustment Loan (SAL I) were to induce a quick response in the real economy to macroeconomic tightening and sharp relative price movements and to produce the reallocation of resources needed to promote a recovery in sustainable export- led growth, while providing for the most vulnerable groups. The core elements of the program were: (i) privatization including introduction of cash auctions and negotiated direct sale to domestic and foreign core investors; (ii) hardening the budget constraint on enterprises including withdrawal of subsidies, improved tax collection, recovery of debts to the budget, application of bankruptcy and collateral laws to strengthen payment discipline, liquidation, restructuring and strengthening of banking regulations; (iii) creating a competitive environment through introduction of a competitive trade and price regime, privatization of Cereale (state grain marketing enterprise) and Fertilitatea (state agricultural input supplier), demonopolization of agricultural markets and restructuring of state and collective farms; and (iv) better targeting of social benefits within fiscal constraints through a gradual increase in pensionL age and de-linking benefits from the minimum wage. 7. The program supported by the SAL was consistent with the limited Country Assistance Strategy (CAS) presented to the Board in 1993 which involved support for macroeconomic stabilization, enterprise privatization and governance, private sector developmnent, financial sector reform, an effective social safety net, sectoral reforms in agriculture and energy, institution building and reinforcement of the Government's implementation capacity. The SAL program was also consistent with the subsequent full CAS presented to the Board in April 1996 which emphasized macroeconomic stabilization, acceleration of enterprise privatization, land privatization, establishment of the legal and regulatory framework for private sector development, trade and price liberalization, energy sector reform and rationalization of public expenditures with supporting reforms in the social sectors. 8. In retrospect, the SAL could have been stronger on energy and agricul]ture sector issues. Energy did not figure strongly in project conditionality, having been deferred to a sector investment project which did not ultimately have the leverage to induce change. Some elements were included in the Letter of Development Policy (reduction of energy sector arrears and  -3- disconnection) but were not subsequently enforced by the Bank. Similarly, the SAL did not include conditionality on farm restructuring because the then existing legislation was supportive of land reform and farm restructuring and only after approval of the loan did it become clear that the politics had changed. 9. The primary risks associated with the program were the potential division between the Government and the Parliament on the speed and depth of the reform process and the potential for disjunction between implementation of the reforms and predicted growth. These concerns were justified and did ultimately limit the achievements under the SAL. B. Achievement of Project Objectives 10. Although the SAL was critical in moving forward a number of needed reforms, particularly in enterprise privatization and restructuring, the SAL did not achieve its broadly stated objectives of stimulating growth or of reorienting the social sector to more efficiently protect vulnerable groups. The macroeconomic stabilization program put in place in 1993 held steady with inflation down to an estimated 1 5percent in 1996; however, the economy continues to decline. GDP fell by 3 percent in 1995. In 1996, GDP fell a further 8 percent, due in part to poor weather conditions lbut due mainly to continued lack of reform in the dominant agriculture sector (which accounts for roughly 60 percent of output), delayed wages and declining motivation of agricultural workers. The cash deficit for 1996 was at 6.5 percent of GDP and the commitment deficit was at 9.5 percent of GDP, both numbers being well above program levels agreed upon with the IMF. The debt service/exports ratio is now expected to reach 20 percent in 1999. 11. Progress on structural reform measures has been uneven. Although pensions were de- linked from minimum wage and the overall structure flattened to contain pension expenditures, the planned increase in the pension age did not take place. In the absence of any significant reforms, arrears to pensioners have reached an average of 4.5 months and represent roughly 4.5 percent of GDP. There was little or no progress on agriculture restructuring with a serious reversal of policies on land reform and only partial privatization and demonopolization of state owned enterprises engaged in grain and input marketing. Meanwhile, energy sector arrears and external indebtedness have continued to mount in view of continued delays in moving towards cost recovery prices and in view of continued impediments to collections of energy sector debt. C. Implementation Record and Major Factors Affecting the Project 12. Performance under the SAL program was uneven with good progress in macroeconomic stabilization, enterprise privatization and restructuring but with little success in the critical agriculture sector, energy, public expenditure management, pensions or social assistance. This can be explained in part, though not exclusively, by differences between the Govermment and Parliament in attitudes regarding the pace of reform. Progress against major elements of the agreed reform program are summarized in more detail below.  -4- 13. Privatization. The Parliament approved the Privatization Law in July 1991, but initial implementation was delayed by the outbreak of the Transnistria conflict and continuing debate on methods of privatization. Privatization had come to a virtual standstill in early 1994 as elections approached. The privatization process regained momentum when the newly elected Government under Prime Minister Sangheli set up a new Ministry of Privatization and State Property Administration to preside over the previously warring agencies, streamlined the regulatory framework, mobilized broader public support for the program and required enterprises to prepare their own privatization plans. 14. At the time of the SAL's presentation to the Board (December 1994), substantial progress had been made in completing the 1993/1994 privatization program, and the Government had submitted the 1995/1996 privatization program to Parliament for approval. The 1995/1996 program was adopted by the Parliament in March 1995 and the first part of the program (voucher privatization) was completed on schedule, transferring over 70 percent of industrial enterprises into private hands. 15. Implementation of the second part of the program (cash auctions and negotiated direct sales to domestic and foreign core investors) has been delayed. Out of 190 small-scale enterprises approved to be privatized for cash, only 45 were sold in 1995 and an additional 17 were sold in 1996. The Government plans to introduce new procedures allowing for the reduction in the starting price after the first auction if the enterprise is not sold and eliminating the income declaration requirement for citizens wishing to participate in the auctions. The first international tender, for privatization of the tobacco industry, was initiated in 1995 but has so far not been completed and the negotiations have now broken down due to atternpts by the winning bidder to change the terms of the privatization subsequent to award of the tender. 16. Despite some of the difficulties with implementation of the newer elements of the privatization program, Government commitment to privatization remains high. The draft 1997/1998 privatization program will contain all of small-scale objects, state shares in companies and virtually all state enterprises which were left out of the previous privatization programs including wine combinats and infrastructure enterprises engaged in energy, comm-unications and transport. The Government has also indicated its commitment to allocate part of the proceeds of the privatization program to build expertise in the Ministry of Privatization to handle cash privatization and, in particular, large-scale transactions involving international tendering. 17. Hardening the Budget Constraint. Macroeconomic tightening in Mo]dova was accompanied by various forms of soft finance to the public enterprise sector through the accumulation of arrears to the budget, energy utilities, wages and fragile commercial banks, as well as by an increased recourse to barter trade. The Government realized that it was essential to harden the budget constraint on enterprises if the incentives created by the liberalized prices and ownership change were to be effective in producing changes in economic behavior. 18. As a signal that financial discipline must be imposed, the Government initiated liquidation procedures for seven loss-making SOEs in December 1994. This process continued  -5- in 1995 with the start of 15 additional liquidations. Improvements needed in the institutional and regulatory framework for liquidation were identified and new regulations put in place. Experience has been gained in the use of auctions to release assets to the market. During 1995, restructuring plans were adopted for another twelve highly indebted SOE's. These plans included the privatization of production lines, the sale of assets and other measures to impose financial discipline. A number of smaller enterprises have emerged from this process. This process was also supported by the subsequent PSD project financed by the Bank and by technical assistance provided under Dutch cofinancing of the SAL. 19. A State Creditor's Committee has been in operation since May 1995, which has the power to conclude debt restructuring agreements for those enterprises that reorganize to meet current charges and service restructured debt in the future. The banks and the Ministry of Finance also established a monitoring system to track the financial situation of state enterprises and record arrears on a regular basis. In addition, as part of the preparations for a PSD project, a non-governmental Enterprise Restructuring Agency (ARIA) was set up in July 1995 to facilitate flows of technical assistance to restructuring enterprises and disseminate information about best practices. 20. The Government has supported the development of an autonomous central bank and modern commercial banking and insurance sector. At the time of the SAL's approval by the Board, the National Bank of Moldova (NBM) had introduced new regulations governing the classification and provisioning of the loan portfolio for commercial banks. Subsequently, NBM has introduced new capital adequacy standards and prudential regulations governing exposure limits and insider lending. External assistance has been obtained to coordinate the transition to Western accounting and audit standards which is now underway. The banking sector remains relatively stable, though credit markets are underdeveloped, with banks commanding large spreads and showing little interest in investment lending. 21. Despite these actions, enterprise arrears still remain a serious problem in Moldova. In particular, arrears to energy utilities and to the budget continue to mount. Although the Govermment has implemented measures calling for penalties on non-payment of taxes and allowing disconnection of non-paying customers, the Parliament has intervened to prevent implementation of these measures by suspending the collection of tax penalties and by mandating that Moldenergo ensure the supply of electricity to all consumers during the morning and evening peak hours irrespective of their payment performance. Tax administration remains particularly weak. 22. Although most explicit subsidy programs have been eliminated, the Government continues to guarantee enterprise loans and to on-lend to enterprises from the budget. These result in large unbudgeted subsidies, as most loans (78 percent) are outstanding and most guarantees are called and never repaid. At the same time, the Government continues to assume implicit responsibility for external energy sector debt, and has recently agreed to US$140 million of energy sector arrears into state debt.  -6- 23. Creating a Competitive Environment. The program supported by the Rehabilitation Loan made substantial progress in establishing an enabling environment for private sector development through removal of export taxes and almost all quantitative restrictions on exports, elimination of most export controls and loosening of margins controls. To complement these advances, the SAL aimed to tackle remaining constraints in the areas of trade, prices and foreign exchange, state procurement, and dernonopolization and privatization in the agricultural sector. 24. Import tariffs were reduced substantially in 1995 and 1996 to a maximum of 20 percent (with a limited number of exemptions) and Moldova has initiated the process of accession to the World Trade Organization. The surrender requirement for foreign exchange was removed. Liberalization of agricultural trade was to some extent undermined after release of the second tranche through informal practices and the issue of regulations reversing essential policy changes on grain exports. 25. A draft law on public procurement was prepared with the assistance of a World Bank IDF grant in 1995 and 1996. However, the law has not yet been adopted, though it is now being prepared for the second reading in Parliament and has passed all committees. 26. Previously, the supply, distribution and allocation of key inputs (seeds, agro-chemicals) were controlled by the public enterprise Fertilitatea. Grain procurement, storage and sales were controlled by another public enterprise, Cereale, which also ran a number oif milling and baking enterprises. In August 1994, the Government dissolved Cereale and transferred its regulatory functions to the Ministry of Agriculture. Parallel actions on Fertilitatea followed, and the individual constituent enterprises of both conglomerates were included in thLe 1995/96 Privatization Program and privatized. However, the changes in ownership and formal organization structures have not resulted in real competition in the grain and input markets. Although competitive procurement was introduced for the State grain reserves, Government control and influence remain strong in the grain market. There is slightly more competition in the fertilizer and chemical input market, and private firms other than Fertilitatea have gained a market share of about 15 percent. 27. Although the corporatization and privatization of former state and collective farms seemed to be proceeding when the SAL was approved, problems arose in early 1995 when a series of amendments restricting exit were adopted by the Parliament. While severely restrictive, these amendments did not altogether preclude exit, which continued to occur. During the second tranche review, the authorities argued that the restrictions were temporarily r equired to better organize the restructuring process. Bank management accepted this argument reluctantly, and only on condition that exit continue in practice. However, farm restructuring slowed tremendously, and today the bulk of the agricultural land is still used by large-scale former kolkhozes and sovkhozes. Only 18 percent of land is under fully private management (14 percent household plots, 4 percent independent private farms). Of 950 kolkhozes and sovkhozes, only 80 have been fully restructured into private ownership-based operations. However, the future outlook may be more positive. The Government has recently moved to set up the Agricultural Restructuring Agency (ARA) to oversee farm restructuring and has committed preliminarily to the restructuring of 200 farms in 1997 and 400 farms in 1998. The moratorium  -7- on land sales was recently overturned in a 1996 decision by the constitutional court, and preparation of enabling legislation for the land market is underway. 28. Social Protection. At the time the SAL was approved, the Government's capacity to pay pension and social benefits at pre-transition levels had plummeted as a result of the drastic fall in GDP and growing arrears in enterprise contributions to the Social Fund which administers most programs. In response, the Government decided in November 1994 to de-link pensions and other benefits from the minimum wage and to freeze the earnings related component of pensions and other benefits and replace them with flat nominal increases based upon price changes and available budget resources. This had the impact of flattening the pension structure and achieved some expenditure reduction. 29. The Government also submitted legislation to the Parliament calling for a phased increase in the pension age by six months per year for men and six months per year for women until the pension age reached 65 for men and 60 for women. Introduction of this legislation to the Parliament was delayed due to political opposition from the trade unions and this condition was waived on assurances from the Prime Minister that the legislation would be introduced after a public information campaign could be conducted. The legislation was subsequently introduced; however, it has never passed, and the pension age remains 60 for men and 55 for women. 30. In the absence of fundamental reform, the situation with respect to pension arrears has become extreme, with an average delay of 4.5 months almost exclusively at the expense of rural pensioners for whom the system hardly functions. The arrears are driven by continued shortfall in Social Fund collections combined with intense political pressure to increase pension benefits, which are still being paid regularly in urban areas. There is growing realization that the situation is not sustainable, and the Parliament has adopted a Social Fund budget for 1997 that excludes any pension increase. D. Project Sustainablity 31. The project supported the Government in maintaining macroeconomic stability and in achieving clear progress in the area of enterprise privatization, enterprise restructuring and banking supervision. However, stabilization remains fragile and growth prospects remain limited in the face of growing budgetary arrears, high debt service levels and the slow pace of structural reforms. Action is needed to: (i) stop the buildup of energy sector arrears through the introduction of cost recovery measures, improved collections performance and an appropriate legal and institutional framework to limit recourse of energy suppliers to the state budget; (ii) contain the cash and commitment deficits through rationalization of expenditures and improvement in revenues; (iii) reform the pension and social assistance systems to contain arrears and to ensure the timely payment of benefits to vulnerable groups; and (iv) move forward with agriculture restructuring in order to restore and increase output in the economy's most important sector.  -8- E. Bank Performance 32. After resolution of the Transnistria conflict in 1992, the Bank provided a steady flow of financing to the Government of Moldova. The SAL was the third Bank lending operation following the Emergency Drought Recovery Loan (US$26 million) and the Rehabilitation Loan (US$60 million). The loan was prepared relatively quickly, with 7 months 'between identification and Board approval. Two supervision missions were conducted between Board approval and second tranche release, and a consultative group (CG) meeting was held in March 1995 following Board approval. A Private Sector Development Loan was prepared during this period and substantially reinforced the Government in consolidating the achievements of the SAL in enterprise privatization, restructuring and financial sector management. Monitoring of energy and social sector actions by the Bank was more limited and may have contributed partially to poorer results in these two areas. 33. Resources provided under the SAL were critical to maintenance of stabilization policies and to continued positive development of the macroeconomic environment. The policy program supported under the SAL addressed critical reform needs in enterprise, finance, trade, macroeconomic management, agriculture marketing and the social sectors; however, the actual conditionality was relatively weak in the areas of energy and farm restructuring with minimal prior action and no second tranche conditions required in either area. 34. Deferral of such conditionality was motivated due to the difficulty in achieving political consensus needed to move forward in these areas. On the strength of Moldova's strong macroeconomic performance, action here was sacrificed to some extent to mLaintain the dialogue and to push forward the reforms in other areas where the Government had manifested strong commitment. This was particularly true in the energy sector where difficult institutional issues and entrenched interests made reform difficult and unlikely. However, the Bank was perhaps too flexible, and it is possible that the Government and Parliament might have been more motivated to push forward, and energy and agriculture reforms could have been better realized, had the Bank taken a tougher stance on these issues. F. Borrower's Performance 35. Moldova has pursued a course of macroeconomic stabilization with good success since resolution of the Transnistria conflict in 1992 and consolidated its achievements in this area throughout the period of the SAL. This represents a significant accomplishment, and it is recognized that Moldova has moved more quickly than some other former Soviet republics in this area. 36. Progress under the SAL in the areas of enterprise privatization, restructuring and financial sector management have been considerable, and again Moldova has performed well in comparison with other transition countries. Although these successes have not yet translated into growth for the economy, this is not unexpected given Moldova's predominantly agricultural economy.  -9- 37. Government commitment to other elements of the reform program included under the SAL was more reluctant and hampered by the disconnect with Parliament over the pace and scope of the reform effort. There was only nominal compliance with conditions on the privatization of Cereale and Fertilitatea. The manner in which privatization was conducted and the failure to first sell off excess capacity have resulted in the creation of defacto regional monopolies, and the Ministry of Agriculture retains substantial control over many of the most critical units of the former enterprises. Similarly, in the area of social protection, there was nominal (though delayed) compliance with the second tranche condition on introduction of legislation on increasing the pension age, but this was not adopted by the Parliament. In the area of farm restructuring and land reform, there was virtually no progress made during the SAL period. Actions agreed to in the Letter of Development Policy on energy sector arrears and collections were also only partially complied with. G. Assessment of Outcome 38. The project did achieve good results with regard to continued progress on macroeconomic stabilization and enterprise reforms. However, overall, the outcome of the project must be regarded as only marginally satisfactory if viewed in the context of subsequent economic developments and the limited progress achieved with regard to major elements of the structural reform program. The sustainability of macroeconomic stabilization is now highly dependent on resolution of energy sector issues, containment of arrears, public expenditure reform and acceleration of agriculture restructuring. Without action in these areas, the economy will continue to stagnate and external debt will continue to increase. Going forward, it is critical that the Bank and the Fund maintain a strong position on these and other structural reform issues. H. Future Operation 39. Moldova continues to require balance of payments support and the Bank is currently working with the Government to prepare a second Structural Adjustment Loan (SAL II). The preliminary conditionality for this operation includes actions in the energy, agriculture, and social sectors and further actions to consolidate gains already achieved in the area of enterprise reform and macroeconomic stabilization. Upfront action is being stressed on account of previous difficulties in obtaining passage of critical legislation. 40. The Bank has also moved forward with the first investment operations in Moldova including energy, agriculture, private sector development, education and a pre-export guarantee facility. Follow-on projects are being prepared in these sectors as well as projects in the areas of education, cadastre development, irrigation and water resources, transport and a social investment fund.  -10- I. Key Lessons Learned 41. The main lessons learned from the project are as follows: (i) The definition of project objectives was ambitious, and, in retrospect, the Bank should have been less optimistic as to how quickly growth could be restored. (ii) Compromises were made in the scope of project design and in elements of conditionality that limited the ability of the project to achieve its stated objectives. (iii) The Parliament has proved to be more conservative than the Government on the pace of reforms. To ensure implementation of further reforms, it is essential that Parliamentary leaders be brought into the process earlier. (iv) Commitment to reforms is somewhat reluctant in critical areas involving energy, agriculture and the social sectors. Future operations should require strong up-front conditionality and subsequent tranche conditions should be framed more strictly to allow for more transparent enforcement. At the same time, it is critical that the Bank adopt only such conditions as it is willing to enforce even when that means holding a multi-sectoral operation hostage to lack of action in one or more sectors. (v) There can be considerable synergy between a SAL and sectoral operations, particularly when conditionality is able to remove key constraints to sector development and when sector operations support development of institutional capacity. However, this requires a critical mass of effort and resources. Judicious employment of technical assistance has proved critical in creating an institutional basis for reforms in the enterprise sector and would have been useful in other areas.  -11- Part II: Statistical Tables Table 1: Summary of Assessments A. Achievement of Objectives Substantial Partial Negligible Not applicable (1') (V') (V') (V) Macro Policies [J a a a Sector Policies E El E Financial Objectives a E IK Institutional Development [ E El a Physical Objectives l E E l Poverty Reduction E L] l a Gender Issues []1 El[ Other Social Objectives E Ix] Environmental Objectives E Ix] Public Sector Management El I] 0 Private Sector E E El Development Other (specify) E E El E B. Project Sustainability Likely Unlikely Uncertain (V) (V) (/) ElCE] El Continued  -12- Highly C. Bank Performance satisfactory Satisfactora Deficient (/) (/) (V) Identification [D i Preparation Assistance iii Appraisal Cl ii0 Supervision IIII Highly D. Borrower Performance satisfactory Satisfactorv Deficient (1) (/1) (V) Preparation [0 Implementation [l Covenant Compliance rr Fl Operation (if applicable) a Highly Highly E. Assessment of Outcome satisfactory Satisfactory Unsatisfactory mnsatisfactory El] L~ ~ ~~~I LI  -13- Table 2: Related Bank Loans/Credits Loan/credit title Purpose Year of Status approval Preceding Operations 1. Emergency Drought Recovery Finance inputs essential for FY93 Closed Loan agriculture, the most important sector of the economy; narrow balance of payments gap. 2. Rehabilitation Loan Support economic reform; FY 94 Closed finance imports of essential production inputs and health care supplies. Following Operations 1. Pre-Export Guarantee Facility Attract foreign private finance FY95 Under Loan for pre-export transactions. implementation 2. Private Sector Development I Accelerate emergence and FY96 Under Loan growth of SMEs*; streamline implementation larger enterprises; increase efficiency of resource mobilization and credit allocation. 3. Agriculture I Loan Strengthen agriculture sector to FY96 Under promote agricultural exports; implementation increase agricultural incomes of the rural pop.; strengthen sector institutions. 4. Energy Loan Strengthen financial mgmt. and FY96 Under accounting systems needed to implementation place gas and electricity sales on a commercial basis; improve measurement of consumed energy to reduce losses and waste of costly imported fuels. 5. Education Loan Provide support for new FY97 Under curriculum development. implementation *SMEs: small- and medium-scale enterprises  -14- Table 3: Project Timetable Steps in Project Cycle Date Planned I)ate Actual/Latest Estimate Identification (Executive Project Summary) 03/94 03/94 Preparation 04/94 04/94 Pre-Appraisal 06/94 06/94 Appraisal 09/94 09/94 Negotiations 11/94 11/94 Letter of Development Policy N/A N/A (if applicable) Board Presentation 12/94 12/94 Signing 12/94 12/94 Effectiveness 12/94 12/94 First Tranche Release 12/94 12/94 (if applicable) Midterm Review N/A N/A (if applicable) Second (and third) Tranche Release 12/95 9/95 (if applicable) Project Completion 6/96 6/96 Loan Closing 6/96 6/96  -15- Table 4: Loan/Credit Disbursements: Cumulative Estimated and Actual (US$ millions) FY95 FY96 Appraisal estimate 45.0 15.0 Actual 30.0 30.0 Actual as % of estimate 67.0% 200.0% Date of final disbursement: October 5, 1995  -16- Table 5: Key Indicators for Project Implementation I. Macroeconomic Stabilization 1. Prior Actions * New currency introduces in November 1993. N/A . Stabilization program with defined ceilings on total N/A credit and credit to Government in place. 2. First tranche conditions * Maintain a satisfactory stabilization program. Since the introduction of the new national currency in November 1993 (Moldovan leu) the exchange rate has remained stable against the US dollar. Stand-by facilities approved in December 1993 and March 1995. EFF approved in May 1996. Perfornance against quantitative performance criteria has been satisfactory. Inflation declined from 116 percent annually during 1994 to 24 percent annually in 1995 and subsequently to 15 percent annually for 1996. II. Privatization 1. Prior Actions . Regulations established on mechanisms for N/A transforming enterprises for privatization purposes. * Regulated investment funds and other financial N/A intermediaries have been created. 2. First tranche conditions * Substantial completion of the 1993/94 Privatization The 1993/94 Privatization Program was fully completed Program. in July 1995 with the sale of the last 59 small objects and 150 medium to large enterprises. * Submission to the Parliament of a new 1995/96 The 1995/96 Privatization Program was submitted in the Privatization Program and strategy. Parliament on March 1995. 3. Second tranche conditions * Progress with the implementation of the 1995/1996 The main component of the 1995/96 Privatization program as evidenced by the establishment of the Program was mass privatization for patrimonial bonds regulatory framework and institutional capacity, and which was completed in November 1995. The by monthly auctions and advertisements for privatization for cash and privatization of individual auctions. projects delayed to 1997/98 Privatization Program.  -17- Table 5: Key Indicators for Project Implementation Policy Commitments Program Implementation III. Strengthening Financial Discipline 1. Prior Actions * Ministry of Privatization and State Property N/A established. New Law on SOE's passed. Regulations and mechanisms for corporatizing enterprises established. * Budgetary subsidies to enterprises reduced. N/A Commission for arrears identification established. SOE's permitted to sell assets in the market. . Amendments to banking laws adopted, including N/A strengthening of the autonomy of the NBM. Regulations introduced limiting bank loans to 20% of bank capital for any shareholder who owns/controls 10% or more of the bank and 30% for any single borrower. Audits for the four largest banks completed. 2. First tranche conditions * Start liquidations and bankruptcy procedures for 5 Improvements needed in regulations for liquidations loss-making SOE's. Adopt action plans to involve were identified and new regulations put in place. measures such as privatization, asset spin off, Institutional framework and liquidation procedures for 5 changes in cost-plus pricing and other practices. loss making SOE's initiated in December 1994. Additional liquidations and restructuring continued during 1995, including asset sales, creating a number of smaller enterprises. * Introduce mechanisms for dealing with arrears to As of July 1994, a Government decision allowing energy utilities. energy enterprises to cut off non-paying customers was reinstated. However, as of 1996 Parliament has intervened to prevent the Government from enforcing this decision. 3. Second tranche conditions . Achievement of satisfactory progress in the sales of The legislation was revised to permit de-registration of assets of seven enterprises under liquidation agreed SOEs to be liquidated and to permit asset sales. Asset with the Bank. sales took place and the proceeds were placed in Special Accounts for satisfaction of creditor claims. . Initiation of the managerial, organizational and Early efforts in imposing financial discipline on SOEs ownership restructuring of a least 10 highly were accompanied by the creation of a State Creditors indebted SOEs, including provisions for Committee in May 1995, which has the power to privatization of production lines, sale of assets and conclude a debt restructuring plan (including of debts to other measures require to impose financial the budget) for those enterprises that reorganize to meet discipline without injection of new capital from the current charges and service restructured debt in the budget. future. In addition, a non-governmental Enterprise Restructuring Agency (ARIA) was set up in July 1995 to facilitate flow of TA.  -18- Table 5: Key Indicators for Project Implementation Poicy Commitment s Prog Iam Implementatio . Introduction by the NBM of regulations on simple The NBM issued regulation on risk-weighted capital in risk-weighted capital standards for commercial May 1995. banks, as part of a timetable for moving into line with international practice. * Reinstatement of the regulation limiting loans to The regulation limiting loans to shareholders and other any shareholder of a bank who owns or controls 10 related parties was passed in July 1995. percent or more of the bank's total shares to an amount not exceeding 20% of the bank's capital. * Submission to the bank of satisfactory evidence that The Bank received satisfactory evidence that all commercial banks have made provisions for commercial banks were phasing in provisions against possible loan losses on loans extended after March loan losses according to NBM regulations during June 1, 1995 in accordance with the requirements of the and July 1995. NBM. IV. Creating a Competitive Environment 1. Prior Actions * Official exchange rate was unified and foreign First two reductions in import tariffs took place as exchange auctions were introduced. Quotas on hard planned in 1995. Reduction to a rate of 20% largely currency exports were eliminated and export taxes completed though some tariffs for agricultural products were abolished. New import tariffs were adopted. remain above this level. . Bread and milk prices fully liberalized. Price cap was subsequently imposed on flour and as of February 1997 the Government hats announced its intention to remove this. * Administered prices and state procurement removed N/A including for grain. * Restructuring and privatization of state and N/A collective farms underway. 2. First tranche conditions * Submission to the Parliament of legislation Legislation providing for the elimination of all margin eliminating margin controls except for a small controls, except for a small group of essential goods, group of staple commodities. was submitted to the Parliament in January 1, 1995 as part of the budget submission for 1995. Legislation for removing all such controls was submitted to Parliament on August 16, 1995. * Inclusion of Cereale and Fertilitatea in the 1995/96 Cereale and Fertilitatea were included in the 1995/96 Privatization Program together with the Privatization Program. privatization plan assuring separation of operating units and competitive domestic markets both regionally and nationally.  -19- Table 5: Key Indicators for Project Implementation Policy Commitments Program Implementation 3. Second tranche conditions . Progress with the privatization plans for Cereale and Cereale and Fertilitatea were formally privatized Fertilitatea, including early disposal of excess through the 1995/96 Privatization Program. However, storage. changes in the ownership structure have not resulted in a real competition in the grain and input markets. * Transfer of the regulatory functions of Cereale and The regulatory functions of Cereale and Fertilitatea were Fertilitatea to the Ministry of Agriculture and other transferred to the Ministry of Agriculture. Ministries, as appropriate. * De-monopolization of the traditional market of There has been no significant progress in de- Cereale and Fertilitatea through the introduction of monopolization of the traditional markets of Cereale and competitive procurement of the State grain reserves. Fertilitatea and the Government continues to intervene in the grain markets, V. Social Protection I. Prior actions . Equalization of Social Security Tax across all N/A sectors. * Review of pension and other benefits when Social N/A Fund went into deficit. . Unemployed whose benefit entitlement has expired N/A can be offered "social jobs". * Obligation removed to pay for worker retraining N/A before dismissal. 2. First tranche conditions * Announce decision by November 1994, de-linking The new system was announced in November 1994 and social benefits including pensions from the became effective on January 1, 1995. The earnings minimum wage and linking them to the price index related component of pension income was frozen. through flat nominal increases, thus freezing earnings related supplements; for implementation in January 1995. * Transfer responsibility for severance payments to Responsibilities for severance payments were Employment fund in cases where bankrupt or transferred to the Employment Fund. liquidated enterprises cannot cover severance obligations.  -20- Table 5: Key Indicators for Project Implementation i PoliyCmOmitm en ts Pr Imvplementationw 3. Second tranche conditions Adoption and implementation of a system of The new system was introduced under legislation and pensions and benefits increases which will be de- passed in February 1995. The first increase took place linked from the minimum wage and pursuant to on July 1, 1995. The Government also froze the which all qualifying beneficiaries will receive a flat minimum wage which remains frozen as of today. nominal increase based upon the price changes in the previous quarter and the overall fiscal context. * Submission to the Parliament of legislation on the Government introduced legislation subsequent to receipt phased increase in the pension age which shall of waiver. Parliament did not adopt the legislation, and provide, inter alia, that commencing in mid-1995, the pension age remains unchanged. the pension age for men and women will be extended in six month increments in each calendar year until the age of 60 is reached for women and 65 for men.  -21- Table 6: Key Indicators for Project Operation Estimated Actual 1994 1995 1996 1994 1995 1996 Summary Indicators (Real Growth Rates) Gross Domestic Product -6.0 0.5 2.0 -31.2% -3.0% -8.0% Annual Inflation 345.11 19.6 10.0 329.0' 23.8 15.1 Export of G&NFS 5.0 4.8 5.6 NA 16.7 5.4% Imports of G&NFS 4.0 1.0 1.5 NA 15.8 23.2% National and Fiscal Accounts (% of GDP) Investment 8.7 11.0 13.0 34.92 29.82 28.32 o/w Government Investment 4.0 4.1 4.0 3.6 1.8 1.8 Gross Domestic Savings -6.7 -3.1 0.3 28.8 20.9 14.1 Budget Revenues 15.0 16.0 16.5 23.8 25.1 27.1 Budget Expenditures 21.8 20.6 18.9 32.1 30.8 33.4 Fiscal Deficit -6.8 -4.6 -2.4 -8.3% -5.7% -6.3% Exports 28.7 30.5 32.0 45.7 50.9 49.5 Imports 44.1 44.6 44.7 49.6 59.8 63.6 Resource Balance -15.4 -14.1 -12.7 -3.9 -8.9 -14.1 Current Balance -15.4 -14.4 -13.8 -5.8 -8.6 -13.2 Average to average Data are overestimated due to inclusion of surplus inventory which had not been included in earlier estimates  -22- Table 7: Studies Included in Project Study Purpose as defined at Status lInpact of study appraisal/redefined - NOT APPLICABLE -  -23- Table 8A: Project Costs Appraisal estimate Appraisal/latest estimates (US$ million) (US$ million) Item Local Foreign Total Local Foreign Total costs costs costs costs 1. Import 0.0 65.4 65.4 0.0 65.4 65.4 Total 0.0 65.4 65.4 0.0 65.4 65.4  -24- Table 8B: Project Financing Appraisal estimate Appraisal/latest estimates (US$ million) (US$ million) Source Local Foreign Total Local Foreign Total costs costs costs costs 1. IBRD/IDA 0.0 60.0 60.0 0.0 60.0 60.0 2. Cofinancing institutions * 0.0 5.4 5.4 0.0 5.4 5.4 3. Other external sources 0.0 0.0 0.0 0.0 0.0 0.0 4. Domestic contribution 0.0 0.0 0.0 0.0 0.0 0.0 Total 0.0 65.4 65.4 0.0 65.4 65.4 * NLG 1OM - Dutch Grant (US$ equivalent 5.4 million)  -25- Table 9: Economic Costs and Benefits - NOT APPLICABLE -  -26- Table 10: Status of Legal Covenants Original Revised Agreement Section Covenant Status Fulfillment Fulfillment Descripition of Comments Type Date Date Covenant CA 3.01(a) 9 C --- Consultation and exchange of views CA 3.01(b) 9 C Progress reports CA 3.02 3 C --- --- Procurement CA 3.03(a) I C --- Maintain records and accounts CA 3.03(b) 1 C --- --- Audit and furnish records and accounts CA 3.03(c) 1 C --- Maintain, audlit and furnish records and accounts Covenant type: Present status: I = Accounts/audits 8 = Indigenous people C = covenant complied with 2 = Financial performance/revenue 9 = Monitoring, review, and reporting CD = complied with after delay generation from beneficiaries 10 = Project implementation not CP = complied with partially 3 = Flow and utilization of project funds covered by categories 1-9 NC = not comiplied with 4 = Counterpart funding 11 = Sectoral or cross-sectoral , = Management aspects of the budgetary or other resource allocation project or executing agency 12 = Sectoral or cross-sectoral policy/ 6 = Environmental covenants regulatory/institutional action 7 = Involuntary resettlement 13 = Other  -27- Table 11: Compliance with Operational Manual Statements Statement number and title Describe and comment on lack of compliance - NOT APPLICABLE -  -28- Table 12: Bank Resources: Staff Inputs ($ '000) Planned Revised Actual State of Project Cycle Weeks US$ Weeks US$ Weeks US$ Preparation to appraisal 0.0 0.0 77.7 231.3 77.7 236.9 Appraisal 40.1 117.1 21.9 72.9 21.9 64.5 Negotiations through 10.0 22.5 16.0 44.5 16.0 44.5 Board approval Supervision 50.0 220.3 39.9 166.2 47.2 189.5 Completion 10.0 30.8 3.2 7.4 3.2 7.4 Note: Actual data as of 04/30/97  -29- Table 13: Bank Resources: Missions Performance Rating 2 Stage of project Month/ No. of Days Specialized Implement. Development Type of year persons in field staff skills status objectives problems Preparation 04/94 6 15 CE, PSDS, PSDS, FSE, FSS, SPS Pre-Appraisal 06/94 8 19 CE, PSDS, ERS, PSDS, AS, FSE, CE, SPS Appraisal 09/94 2 CE, DC Negotiations 11/94 8 - DC, CO, CE, CRO, DO, LC, AS, ERS, ERS, ERS, FSE, EE Board approval 12/94 - Signing 12/94 - Effective 12/94 - - Supervision 1 05/95 2 12 CE, ERS 2 2 Supervision 2 07/95 5 14 SPS, CE, AS, 2 2 TE, PSRS Portfolio status update 06/96 - - 2 2 Completion 06/96 - - Specialized staff skills - Performance ratings - _-_Types of problems AS = Agricultural Specialist I = Highly Satisfactory F = Financial CE = Country Economist 2 = Satisfactory M = Managerial CO = Country Officer T = Technical CRO = Country Relations Officer DC = Division Chief DO = Disbursement Officer EE = Energy Economist ERS = Enterprise Reform Specialist FSE = Financial Sector Economist FSS = Financial Sector Specialist LC = Legal Counsel PSDS = Private Sector Dev. Specialist PSRS = Public Service Reform Specialist SPS = Social Protection Specialist TE = Trade Economist   Appendix A Page 1 of 2 Mr. B. G. Kavalsky Director Department IV Europe and Central Asia World Bank Subject: Implementation of the First Structural Adjustment Loan (SAL I) Dear Mr. Kavalsky: First of all, I would like to express my sincere gratitude for your constant cooperation during the development and implementation of the SAL I project. SAL I offered needed balance of payments support at a critical moment in the transition period. Financing provided under SAL I facilitated the continuation of macroeconomic and structural reforms aimed at restoration of economic growth including privatization, strengthening of enterprise budget constraints, establishment of a competitive environment and the efficient distribution of social benefits. Monetary and fiscal policy advanced substantially as a result of this project during implementation (1994-1995), and there has been continued progress since. In 1996, the inflation rate fell to 15%; there has been a marked and continued reduction of the budget deficit; the national currency remained stable; and the rate of decline in GDP has slowed down. Substantial progress in implementation of the 1995-1996 Privatization Program has been attained, with 70% of enterprises now privatized. The experience gained during implementation of the project assisted in the design of the 1997-1998 Privatization Program and in its approval by the Parliament in first reading. A pilot program for enterprises' liquidation and restructuring has been implemented. Privatization of the "Cereale" and "Fertilitatea" companies was also initiated under the Privatization Program. In order to complete these reforms, it is necessary to continue restructuring and demonopolization of large farms. Resolution of issues related to land privatization is also necessary. The banking sector remains relatively stable. It should be noted that there has been substantial strengthening of bank supervision and accounting during the previously mentioned period of project implementation. Essential progress has been achieved in creating a favorable environment for the development of the private sector through the elimination of export taxes and all quantitative restrictions on exports. Customs control has become transparent and has  Appendix A Page 2 of 2 been simplified. Import taxes have been substantially reduced to a level of 20%"o (vvith a limited number of exceptions). We would like to inform you that an extensive program on social refonms is now being prepared. With respect to the increase in retirement age, the drafts of the proposed amendments to the current legislation have not yet been adopted by the Parlianment of the Republic of Moldova. Although not all the reforms initially planned under the Project took place, permanent and substantial progress has been achieved, particularly, in the enterprise and financial sectors, and macroeconomic stabilization has been maintained. The Government of Moldova maintained relations of close cooperation with the World Bank and received constant support for its program of reform over the period of preparation and implementation of this Project. The increase in World Bank investment lending activity has also been a source of financial support for the Government over this period. Please be assured of my high consideration and sincere gratitude for your personal assistance and support. Respectfully, Is! Ion Gutu Deputy Prime Minister Minister of Economy and Reforms Translation  Appendix B Page 1 of 18 Moldova: SAL II Preparation Mission Aide Memoire 1. A World Bank mission--consisting of Arup Banerji, Csaba Csaki, Louise Fox, Hafez Ghanem (task manager), Kristin Gilbertson, Clive Grey (consultant), Laszlo Lovei, Marcus Nievergelt (consultant) and Theodor Stolojan--visited Moldova from October 15 to November 1, 1996 to work on the preparation of a second Structural Adjustment Loan (SAL II). The mission would like to thank the Moldovan Authorities for their excellent cooperation. This Aide-Memoire describes prelirninary results of the mnission's work. It is divided into two sections: SAL H's objectives and a possible structure of the loan. A. OBJECTIVES 2. The SAL program should aim at ensuring that Moldova's achievements in the areas of macroeconomic stabilization and structural adjustment are sustained over the medium term. Moldova has succeeded in stabilizing its economy and reducing inflation to an annual rate of less than 20 percent in 1996. It has also carried out a far-reaching privatization program in the enterprise sector and took important steps to liberalize and de-regulate its economy. These policies are starting to yield results: exports rose by 20 percent in 1995 and industrial production increased by 11 percent in the first half of 1996. Consolidating the Stabilization Program 3. The stabilization effort is still very fragile, however. Tight monetary policies were not accompanied by structural reform in government expenditures, in the system of social protection, nor in the energy sector. Financial discipline is not implemented and hard budget constraints have not been imposed. Arrears to government workers, pensioners and energy companies have continued to rise. The budget owes about lei 80 million in back wages and about lei 300 million in energy bills. The Social Fund owes pensioners about lei 200 million. 4. Clearly this situation is unsustainable and the first objective of SAL II should be to deal with the arrears problem. Building up arrears to pensioners and government workers cannot continue over the medium term. It could have serious social and economic implications. Arrears from the budget, enterprises and households to the energy companies, together with inadequate pricing policies, have translated into arrears from the energy sector to external suppliers, estimated now at more than US $170 million (excluding Transnistria). If Moldova's external debt continues growing at this rapid and uncontroled rate the country could face serious balance of payments and creditworthiness problems. 5. A strategy to deal with arrears could be based upon action in three areas. First, the budget should be examined carefully to ensure that obligations to wage earners, the Social Fund and the energy sector are adequately funded within a realistic revenue envelope. This is especially true for the budget for local authorities who are responsible for the majority of arrears. Second, the energy sector needs to be restructured in order to ensure  Appendix B Page 2 of 18 that no more arrears would be accumulated in the future. Restructuring should be based on the principles of de-monopolizing and privatizing the sector to enforce financial discipline. Third, an overhaul of the system of social protection and of pensions to ensure adequate, but affordable, protection for the elderly and the vulnerable. Laying the Basis for Sustained Growth 6. Structural reforms are also fragile, and the momentum for future growth may be lost. Agriculture, by far the largest sector in the economy, is yet to be fully privatized and restructured--only 5 percent of agricultural land is used by truly private farms and an additional 14 percent are family and household plots. Services, which has proven to be a very dynamic sector in most transition economies has not fully benefited from privatization because small scale privatization is lagging and privatization of urban land is not taking place. Under the circumstances it is not surprizing that growth in those two key sectors is not picking up. 7. This situation is also not sustainable because industrial growth cannot continue if the other sectors do not follow. Hence, the SAL's second objective should be to extend the privatization process to agriculture and services. The majority of Moldova's population would benefit from the economic growth process mainly through more employment and higher wages. Therefore, it is vital that agriculture which is responsible for about 45 percent of total employment, and services which accounts for 35 percent be fully covered by the privatization and liberalization efforts. 8. A strategy to lay the basis for sustained growth would focus on farm restructuring, privatization of agricultural and urban land, small-scale privatization, and ensuring good quality energy services. The objective should be to complete land reform and small-scale privatization over the next two years. It is also necessary to complete the enterprise privatization program, focussing on privatization to strategic investors, cash privatization to Moldovans and privatizing key infrastructure sectors. Industry and agriculture are suffering from poor energy services and unpredictable supply. Reforms in the energy sector to improve service quality should therefore be a key element of any structural reform program. B. A POSSIBLE STRUCTURE OF THE LOAN 9. In view of the above SAL II would support reforms in five areas: (I) public expenditure management; (2) pensions and social assistance; (3) energy; (4) land reform and agricultural restructuring; and (5) privatization. Work on public expenditures, pensions and energy would aim mainly at consolidating the stabilization gains and reducing arrears. Clearly, it will also have other effects. Pension and social sector reformis would have an important impact on poverty reduction and mitigating the social costs of the transition. A well functioning energy sector providing good quality and reliable services is important for the expansion of industry and agriculture. The primary goal of reforms in agriculture and of privatization is to lay the foundations for sustainable growth. They  Appendix B Page 3 of 18 would also have positive social effects, as expanding employment opportunities in agriculture and services is key for increasing income and improving standards of living. Public Expenditure Management 10. The Government intends to maintain tight fiscal policies with the 1996 cash deficit projected to decline to [3.6] percent of GDP. However, it is worried by the accelerating growth of budgetary arrears. By end-1995, budgetary arrears were 552 million lei (seven percent of GDP), and have grown by a further 337 million lei in the first three quarters of 1996. As of October 1, 1996, 298.7 million lei (plus penalties) were owed by the budget to Moldenergo and Termocomergo, the two energy enterprises (rising from 233.5 million lei in end-1995). By October, the Government owed 80 million lei in wages to budgetary employees, and 117 million lei to the Social Fund. 11. Government needs to stop overestimating the revenue stream. The growth in revenues needs to be estimated conservatively, to minimize the likelihood of unplanned shocks. Tax arrears are widespread, and the authorities are unable to tax all of economic activity. When revenues have unexpectedly fallen below planned expenditures, this has threatened "deficit blowouts", and forced ad hoc cuts in cash expenditures through arrears buildup. 12. Government is considering phasing down guarantees, and limiting them to a small number of sectors; the isk of default has to be assessed more realistically, and adequate provision made for the risk. Provisioning against called Government guarantees has been too low, at 25 million lei in the 1996 and 1997 budgets. This ensures an expenditure shock--since the Government paid out 131 million lei in called guarantees in both 1994 and 1995 (almost half the fiscal deficit in 1995). 13. Another proposal is to stop on-lending from the budget. Non- or partial payment of lending and on-lending from the budget is a problem. Through end-1995, 134 million lei (78 percent of loans made) were outstanding (including 90 percent of US$ 37 million lent to Moldenergo). As the unpaid part becomes an unbudgeted subsidy, it tends to create uncertainty in resource allocation and budget planning, and, perhaps more important, diverts expenditure from other critical needs. 14. "Planned arrears" in the budget should be avoided. The Government's overall expenditure targets in its budgets are sometimes unrealistic. Allocating insufficient resources for wages, Social Fund contributions and payments to the energy sector inevitably leads to the buildup of arrears. This could be a problem in 1997. The estimated energy bill for the consolidated government is of the order of 280 million lei at current tariff levels, and about 109 million lei are budgetted by the Central Government. It is important to ensure that local authorities have sufficient resources to meet their energy consumption. The approximately 175 million lei budgeted in 1996 by the Central and local governments to pay for Social Fund contributions had already led to an arrears buildup of 117 million lei by October. Yet, similar levels of funding are planned for 1997. Hence, it is probable that arrears will continue growing. This should be avoided.  Appendix B Page 4 of 18 15. Reforms need to be undertaken in the government's administrative structures, to enable the budget to rationalize and reduce its future liabilities, and to impose financial discipline on local authorities. The budget mechanism as it is set up does not easily permit monitoring of expenditures. Appropriations are made on a very aggregated basis, and are not clearly linked to specific agencies and specific items of expenses. The 1997 draft budget does set out separate line items for wages and Social Fund payments, but it does not separate out energy expenses. Further, there are no control mechanisms, and no disincentives, to prevent budget-covered organizations to use resources (especially energy) beyond allocated expenditures. Although local authorities are responsible for the majority of the arrears, there is no effort to monitor their expenditures at a disaggregated level. 16. Payments and arrears need to be regularly monitored. If allocations are exceeded, the manager of the unit or sub-unit has to be held accountable. These could irLclude sequestering Central budgetary transfers to local governments on a monthly basis unless arrears are cleared; or, for localities which do not receive direct transfers, not transferring a portion of the Centrally collected revenues owed to them until arrears are cleared. 17. In addition to maintaining overall satisfactory macro-economic policies, specific actions that could be supported by SAL II in this area may include: Actions in the immediate term ("y Januarv 1997?) o Agree on a mechanism to impose discipline on budgetary sector institutions for energy, Social Fund and wage payments, which needs to include: more detailed monitoring of use, payments and arrears. [in cooperation with IMF] a Agree on a 1997 budget which is based on realistic revenue projections and that includes sufficient funding for committments to wages, Social Fund contributions and energy consumption. A system of earmaking energy and Social Fund obligations could be considered. [in cooperation with IMF] * Commence functioning of the Strategic Studies Center. [in cooperation with UNDPI * Develop a plan for reducing the stockc of budgetary arrears to the Social Fund, the Energy Sector and Wage Earners. [in cooperation with IMF] Actions in the short ternm (b March 1997J1 * Wage and pension arrears and budgetary arrears to energy enterprises should be lowered to at most ----- ----- and ------ million lei. [in cooperation with E.IFI * Design a two-year timetable, for the elimination of on-lending from the budget to enterprises by September 1998. * Implement a new law on public procurement. * Design a system to improve expenditure management and monitoring capability. This would include a more detailed structure of appropriations linked to agencies and items of expenditure. * Budget agencies' arrears to the Social Fund should be eliminated and the SociaI Fund should have made at least two months of regular payments to pensioners.  Appendix B Page 5 of 18 Actions in the medium term (bv September 1997?) * Wage and pension arrears and budgetary arrears to energy enterprises should be lowered to at most ----, ----- and ------ million lei. [in cooperation with IMF] * Adhere to the timetable for elimination of on-lending and the reduction of guarantees. Actions in the long term (hy March 1998?) * Wage and pension arrears and budgetary arrears to energy enterprises should be eliminated. * The elimination of all on-lending and guarantees. Actions before the end of the SAL II program * No wage and pension arrears nor budgetary arrears to energy enterprises. * No on-lending nor guarantees. Pensions and Social Assistance 18. Some pensioners have not received pension payments for six to seven months. Arrears to other Social Fund beneficiaries are also building up and now amount to about 60 million lei. This reflects the fact that arrears from enterprises and the budget to the Social Fund have continued to increase and now total about 480 million lei. The agriculture sector is the biggest debtor to the Social Fund with arrears of some 240 million lei, and as described above central and local government budgetary institutions are also not paying their Pension Fund contributions. 19. Government has not started tackling this problem. There has been little action to either improve collections or to bring pension expenditures in line with more realistic estimates of Social Fund revenues. On the contrary, pensions were increased on paper by 20 percent in February 1996. 20. The current system of pension and social benefits has clearly shown itself to be unsustainable. In order to avoid a complete breakdown of the system with the attendant social consequences, it is essential to reform it and to: (i) implement measures immediately to enable the Social Fund to meet its current obligations and to stop the build- up of any further arrears to pensioners and other beneficiaries; and (ii) design a pension reform which meets the needs of current pensioners and future beneficiaries. 21. As a first step in the reform process, the Government has decided to produce a draft strategy paper for the reform of the pension and social protection systems by January 1, 1997, and has established a working group including representatives from the Ministry of Labor and Social Protection, the Ministry of Finance and the Ministry of Economy. It was agreed that this strategy paper will contain: (i) an overview of the existing system of social protection; (ii) analysis of the problems of the current system including short-tenn and long-term modelling of pension and social protection systems; (iii) principles for the new system; and (iv) proposals for change.  Appendix B Page 6 of 18 22. Based on the findings of this analysis, the Government would implement measures to ensure that payments to current pensioners and to persons due to retire in 1997 can be made in a timely manner. The exact measures remain to be determined but could include: de-linking pensions from the minimum wage; indexing pensions to actual collections during the previous quarter and limiting contemplated pension increases to people older than 65 years of age. The likely effectiveness of such measures will be reviewed during the appraisal mission and the need for additional action discussed. 23. By March 1996, the Social Fund should have made at least two months of regular payments to pensioners and measures should be taken to increase the retirement age, without which it will be impossible to balance the revenues and expendiitures of the Social Fund. In the medium term, the Government has agreed to introduce a new' law on pension and social protection which would be the vehicle for introducing longer-term reforms. 24. The Government has also decided to establish a working group to prepare a revised version of the draft Law on Non-State Pension Funds. The working group would include representation from the members of Parliament, the Government, banking and insurance supervision units, insurance companies, banks and large employers. The existing draft law does not, in the view of the mission, adequately provide for the security of private pension schemes. It was recognized that without additional security provisions, the draft law could open a wide field for abuse and could jeopardize the success of voluntary pension schemes into the future. Although it is necessary to slow the pace of preparation of this legislation, it would be anticipated that the Government would adopt a revised version of the Law on Non-State Pension Funds under the SAL II program. 25. Specific actions that could be supported by SAL I1 in this area may include: Actions in the immediate term (by Januar 1997?) * Draft a strategy paper for the reform of the public pension and social protection systems. * Implement measures to ensure that payments to current pensioners and to persons due to retire in 1997 can be made in a timely manner. These could include: de-linking pensions from the minimum wage; indexing pensions to actuall collectuions during the previous three months; setting a ceiling on pensions; increasing pensions only to people older than 65 years; etc. [This needs to be strengthened and made more credible. Agreement on specific measures to be reached following Clive Grey's mission in November] * Establish a permanent working group for the preparation of a new draft law on private pensions. The group should not be limited to members of Parliament. It should also include government officials and representatives of insurance companies, banks, labor unions and employers. [Marcus Nievergelt to return before end-December to provide technical support to this group]  Appendix B Page 7 of 18 Actions in the short term (by March 1997?) * Increase immediately the retirement age to 60 years for women and 65 years for men. [does Government agree with "immediately"?] * Produce draft of new law on private pensions. Actions in the medium term (by September 1997?) * Adopt a new law for the public pension and social protection systems. * Adopt a new law on private pensions. Actions in the long term (b!y March 19982) * Satisfactory implementation of the new public pension and social protection systems. * Satisfactory implementation of the law on private pensions. Actions before the end of the SAL II program * Satisfactory implementation of the public pension and social protection systems. Satisfactory implementation of the law on private pensions. Energy 26. Moldova's energy sector is in a deep crisis. The sector is building up intemal and extemal payment arrears at a rate that is not sustainable. Moldenergo's receivables (Lei 482.8 nillion on October 1, 1996), even if fUlly paid in the future, will cover less than half of its payables (Lei 1062.2 million). Its payables, among other things, include Lei 182.3 million (about US$ 40 million equivalent) to Ukraine's National Dispatch Center, and Lei 609.2 million to Moldovagaz. Moldovagaz' arrears to RAO Gazprom, without including payment arrears in Transnistria, reached Lei 810 million (US$ 175 million equivalent) plus about Lei 200 million in penalties in September. The government has recently agreed to convert part ofthese arrears to a state debt of US$ 140 million to be repaid over seven years. Tirex Petrol's customers owe the company Lei 270 million, however, most of its suppliers demand prompt payment. In order to remain in business, Tirex Petrol had to be provided repeatedly with credit from the budget and the banking sector (Lei 200 million of these credits is still outstanding - the full sum was guaranteed or provided by the government). Based on data for the first 9 months, the build-up of new payment arrears to foreign suppliers of gas, oil products, coal, and electricity is expected to reach about US$ 100 million during 1996. 27. The quality of energy supply is extremely poor. For example, there are large fluctuations of frequency and rotating black-outs in the electricity system, causing serious damage to sensitive equipment at the final consumers. Uneven temperatures in the buildings as a result of the obsolete district heating system are forcing many consumers to rely on supplementary electrical heating devices. The poor quality of supply reduces the ability of potentially profitable businesses to grow and pull the economy out of recession. 28. Energy production and consumption processes are very inefficient. Self consumption and losses in the electricity industry increased from 1.22 TWh in 1990 to 1.43 TWh in 1995, despite a 42% drop in final electricity consumption. About 5% of gas received at the border is  Appendix B Page 8 of 18 lost due to leakage and inefficient distribution stations. About one quarter of the gas pipeline network is at a high risk of being inTeperably damaged by corrosion unless there is a decisive intervention. A large share of district heating is produced in heat-only-boilers of small capacity and low efficiency. The efficiency of energy use in the industrial, agricultural and residential sectors is low due to the lack of energy saving measures and energy efficienrt technologies. These factors increase the cost of energy supply and reduce the competitiveness of Moldova's industrial and agriculture sectors on the world market. 29. This crisis is due to several causes. State owned energy suppliers (vIoldenergo, Moldovagaz, Termocom, Termocomenergo, Tirex Petrol) tolerate non-paymernt in response to political pressure. For example, Tirex Petrol was ordered every spring during the last four years to provide interest free credit to agriculture cooperatives despite the growing fuel arrears of these entities. The Parliament has recently demanded that Moldenergo ensure the supply of electricity to all consumers during the morning and evening peak hours irrespective of their payment performance. 30. Energy suppliers and consurners expect that the government will ultimately take over the responsibility for settling energy payment arrears, and show little interest: in improving the situation by exploring measures such as cutting off non-payers, rescheduling payment arrears, improving the billing of customers, introducing energy saving measures, etc. The practice of grossly underestimating the energy expenses of budgetary organizations leads to repeated mutual cancellations of payment arrears between the budget and the energy suppliers, makdng it impossible to enforce payment discipline. Mid-level managers in Moldenergo are of the opinion that the large stock of Moldenergo's payables is a problem that the govemrnent should solve, and they have not shown any interest in starting negotiations with their creditors (and debtors). Moldenergo has not even used the possibility of charging a 100% higher tariff to those residential customers who consume more electricity than the monthly norm (as established by Government Resolution 807 of Dec. 1995). The recent takeover of Moldovagaz's debt to RAO Gazprorn by the state, and the govemment's decision that various enterprises should provide Moldovagaz a credit of US$ 35 million (in the form of goods), has reconfirned the perception that the government will take care of energy payment arrears. 31. The separation of the regulation of energy prices from the regulation of the quality of supply has lead to the illusion that prices can be kept below costs without a penalty. Prices are regulated on an ad-hoc basis without relying on a stable and transparent set of rules. For example, the average retail price of gas (Lei 333 per 1000m3) was established at a time when the exchange rate of US$ was about 10% lower. As a result of the deprecialion of the exchange rate, Moldovagaz suffered a loss of about Lei 58 million. Similarly, the average price of electricity falls short of actual costs by about 10%. Taking into account the need to recover the difference between Moldenergo's payables and receivables over a period of (say) 5 years, the average tariff would need to be increased by more than 30%. These low prices would have led to the accumulation of payment arrears and unreliable service even if customers had paid fully for their energy purchases. 32. Low payment discipline and distorted prices lead to the waste of energy resources. Neither budgetary organizations nor residential consumers are interested in reducing their  Appendix B Page 9 of 18 energy consumption. Low household electricity, gas, and heat prices (in comparison to costs) and the lack of metering make energy saving measures uneconormic for the population. The system of cross subsidies results in high gas, electricity and district heat prices for industrial enterprises, reducing their competitiveness. The extremely high price of district heating forced many industrial enterprises to rely on their own sources of heat, even if their costs were higher than the true cost of supply from Termocom(energo). 33. The inability of energy supply enterprises to generate cash internally, their low creditworthiness, and the dire financial situation of their main (or only) owner, the state, has lead to a chronic shortage of capital. This shortage of capital delays the implementation of urgently needed investments in metering, loss reduction, rehabilitation, and modernization of energy production and delivery systems. 34. The government has recognized the severity of the crisis and has already started the development of measures in order to solve it. Government Resolution 478 of September 2, 1996, ordered, among other things: (i) the preparation of a proposal to restructure the energy sector in line with the requirements of a market economy; (ii) energy price increases starting from January 1, 1997; (iii) the development of a new methodology for the regulation of electricity, gas and heat prices; (iv) the improvement of the social safety net, including the development of a mechanism to provide targeted cash compensations for households for the higher energy bills; and (v) the preparation of a schedule to settle payment arrears. 35. The main thrust of restructuring should be towards demonopolization and privatization. In order to stop the accumulation of payment arrears (these arrears, defacto if not dejure, seem to be guaranteed by the state), the responsibility for the import and supply of oil products, gas and electricity should be tumed over to the private sector. This could be accomplished by either giving exporters from Russia, Ukraine and other countries the right to market their products in Moldova (directly or through agents selected by them), or by privatizing the oil, gas and electricity distribution companies. If the former option is selected, the distribution companies will simply provide a package of services (e.g., distribution, meter reading and customer billing) to the owners of the products for a regulated fee. If the latter option is selected, the management of the distribution companies should be turned over to strategic investors who have the necessary know how and capital to operate the companies, and will not be subject to political influence. This could be achieved by either selling a minority of the shares of these companies to strategic investors combined with a management contract, or selling the majority of shares right away. All these options will require that the gas and electricity transmission systems (i.e., the high voltage electricity network and the high pressure gas transport system) provide open access to their facilities for a regulated service fee. 36. In addition to the need to increase urgently average electricity and gas tariffs and to phase out gradually the cross-subsidization of households by other consumers, the regulation of the energy sector should aim at establishing a transparent, predictable regulatory regime that combines the regulation of prices and service quality. The experience of several countries have demonstrated that the best way to achieve this is to introduce a licencing regime administered by a professional body. The licences would spell out the rights and obligations of energy  Appendix B Page 10 of 18 suppliers and consumers. The activity of the regulatory body should be governed by a set of procedural rules and be subject to the scrutiny of the public. 37. The implementation of the above reform program will require substantial technical assistance. The World Bank is reacly to assist Moldova in securing this assistance from bi- and multilateral donors. 38. Specific actions that could be supported by SAUl in this area could include: Actions in the immediate term fby January 1997?) * Restructure the stock of payables and receivables of Moldovagaz, Moldenergo and Termocom(energo), and adopt a debt management plan. The restructuring should take into account the partial takeover of Moldovagaz' debt to RAO Gazprom by the government, the arrears of the budgetary organizations to the energy companies, the write- off of uncollectable receivables (from customers who went out of business), and the settling of payables and receivables over a period agreed between the various parties. The net payables of the companies (particularly for Moldenergo) would have to be recovered from the customers over a period of 3-5 years via a surcharge on electricity sales. [Has Government agreed that this work will be carried out by ARIA?] * Increase the average price of electricity, heat and gas to a level that fully covers costs (including the above calculated surcharge to settle net payables), while reducing (in absolute terms) the difference between the prices paid by households and other consumers. Part of the increase of household energy prices could take the forn of a reduction in the number of privileged consumers, and implementation of the applicable suLrcharge for excess consumption (see below); [specific figures to be agreed at wrap-up oii October, 31? link with IMF agreement?] * Start monthly electricity meter reading for households in order to imnplement the surcharge applicable to electricity consumption above the norms set by Government Resolution 807 of December 1995. * Adopt a plan to eliminate fiully the cross-subsidies to households from otfher electricity, gas and heat consumers and establish a tariff structure that reflects costs by not later than end- 1997 for gas and electricity, and end-1998 for district heat. Actions in the short term (by March 1997?) * Adopt a Government decision to establish a system of regulating the electricity, gas and district heating industries through licences. The licences will include fomiulas for the setting of prices, specify the quality of service, and ensure open access to the high voltage electricity network and the high pressure gas transmission system. * Remove the responsibility for the import and supply of natural gas from (majority) state owned enterprises by implementing one of the following: (a) tum over the task of selling gas on the territory of Moldova to RAO Gazprom (the distribution companies would provide distribution, meter reading, and customer billing services for a regulated fee); (b) sign a contract with 1-3 experienced foreign companies that are willing to take over the management of the gas distribution companies for a period of at least one year, or (c) sell enough shares of the gas distribution companies to ensure that the state is not their single  Appendix B Page 11 of 18 largest shareholder anymore. Options (b) and (c) would likely require the merger of the gas ditribution companies into not more than 4-6 entities. [which option does the Government prefer?] * Separate the Moldavskaya and Chisinov I-II power plants, the high voltage transmission system, and electricity dispatch from the low voltage distribution network. Establish a single company for dispatch and transmission. Actions in the medium term (bv September 1997?) Corporatize the two power generation companies and the electricity distnbution companies. Develop and sign contracts between the market participants, including the exporters in neighboring countries. * Increase the price of gas and electricity for households to the level of industrial prices. * Establish a system of assisting low income households to pay their energy bills (the subsidies should be paid from the budget). Replace the price discounts given to the households of privileged consumers with personal subsidies paid also from the budget. * Eliminate the control over oil product prices (including indirect control through limits on profitability). Demonopolize the oil products distribution subsector by selling part of the depots and transport assets of Tirex Petrol to private investors. Privatize more than 50% of the shares of Tirex Petrol. Actions in the long term ({y March 19982) I 7ssue licences to all regulated entities in the power, gas and district heating industries. * Adopt a tariff structure for gas and electricity that reflects the true cost of supply to various categories of consumers. Abolish electricity consumption norms and penalties for above- the-norm consumption. 3 Sign management contracts with experienced foreign firns or adopt a privatization plan for the electricity generation and distribution companies (as well as gas distribution companies unless already privatized). * Increase the price of heat for households to 2/3 of the level of industrial prices and elimninate cross-subsidies between cities. Actions before the end of the SAL II program * Privatize the electricity generation and distribution (and gas distribution) companies (or extend the management contracts). * Adopt a tariff structure for heat that reflects the true cost of supply to various categories of consumers. * Transfer responsibility for the regulation of the district heating industry to municipal governments. Land Reform and Agricultural Restructuring 39. Agriculture, 33 percent of GDP, has been hit hard by the collapse of the former Soviet Union and transition-related events. The total agricultural output declined by more than 50% in comparison to pretransition levels (47.1% of the 1986-1990 avergae in 1995).  Appendix B Page 12 of 18 According to Government statistics in 1995 output was 4% more than in thte previous year but a modest decline of output is forecasted for 1996. 40. Progress in creating market based privatized food and agricultural sector in Moldova has been slow. Achievements of the reform process include: (a) the creation of a liberal price and market regime for agriculture; (b) progress in the demonopolization of input supply and grain handling, and (c) the completion of the first phase of privatization of agro-processing and starting land reform. Some of the most important tasks of transition, especially the creation of a land market and land reform, the demonopolization and privatization of the grain sector, and the emergence of a competitive input supply sector, agro-processing and agricultural product marketing services remain unfinished. 41. The most critical policy issues that will affect rural recovery in Moldova are: (a) accelerating the process of land reform and farm restructuring; (b) maintaining a liberal course of macro-economic policies for agriculture; (c) ensuring international competitiveness of agro-processing industries and an efficient input supply for agriculture; and (d) creating an improved financial and institutional framework. Reforrns supported by SAL II will focus on points (a) and (b). Issues of competitiveness, input supply and building financial institutions will be addressed through other World Bank operations and non-lending services. 42. In the first phase of land reform, household plots were increased and land shares for land used by large-scale farms were given to about a million people. Actual restructuring of large-scale farms, however, did not take place. At that time the Government's intention was to maintain the core of large-scale farming under state control. This resulted in very complicated bureaucratic procedures for land privatization and private farm registration. The 1995 amendment of the land code thwarted the real restructuring of large-scale farms. Hence, land privatization is at an early stage--by October 1996 the number of independent private farms reached 90 thousand farming on 130,000 ha which is still only about 5% of total agricultural area. Household plots cover about 14% of total agricultural land. 43. Out of about 950 large-scale farms only 80 farms so far have been fuilly restructured into entirely private operations. However, the process has accelerated in 1996 for two reasons. First, a Constitutional Court decision restored the possibility of individual exit from large-scale farm. Second, pressure created by the increased economic difficulties of unrestructured large-scale farmns, combined with progress in overall reform, resulted in a new push for restructuring. Local restructuring initiatives ncw receive more support from the Government and they also receive international donor assistance. Ongoing pilot projects for farm restructuring have succeeded in developing new farming structures that are fully privatized. These pilot projects have distinctly positive features compared to earlier restructuring efforts in Moldova and compared to methods used in other FSU Republics. 44. SAL II will support the Government's efforts to accelerate the process of large- scale farm restructuring and complete the restructuring of 400 large-scale farms. The  Appendix B Page 13 of 18 restructuring will be based on full privatization of land (physically identified land plots for each beneficiary with individual titles). The new land owners freely decide on the way they wish to continue farming. Land will remain in individual private ownership in the various forms of newly emerging farming organizations, and these forms provide opportunities for further restructuring and modifications in land use. In order to facilitate this process the Government will (a) revise and improve the exit and registration procedures for establishment of private farms (simplified procedures, clear and reasonable time limits, reasonable appeal process etc.); (b) review ongoing farm restructuring pilot projects and prepare practical guidelines for the dissemination of these experiences as well as a program to extend these projects to the national level; (c) commence the functioning of Agricultural Restructuring Agency, a non-governmental institution created to implement and support the nationwide program of farm restructuring. 45. SAL II will support the establishment of a uniform cadastre system and other legal and institutional conditions for a functioning land market. Land reform is seriously constrained by the absence of a well-functioning land titling and registration system, as well as by the absence of a functioning land market. The current process of land titling is complicated and very bureaucratic, with inadequate capacity to deal with existing and projected demand. The Ministry of Agriculture and Food and the regional Land Arrangement Services (LAS) under the Ministry manage the process. About 91% of the beneficiaries of the land reform have received land shares certificates, but only 10,000 land owners have obtained final title out of 983,000 potential title holders. The establishment of a national cadastre system including land registration and titling has begun. The national Agency for Geodesy, Cartography, and Cadastre (NAGCC) was established recently to coordinate this process. A September 1996 decision of the Constitutional Court eliminated the moratorium on land sales. The legal framework for land registration and handling of land transactions as well as related institutional arrangements are, however, missing. The normative land pricing and regulations on land leasing are also constraining emerging land markets. 46. The incomplete implementation of the SAL I reform package has left the market environment for agriculture distorted. Government intervention still remains significant for bread, grain and milk products and some of the tariffs for agricultural products are high.. The Government is committed to proceed with further actions to liberalize the food and agricultural markets. 47. Specific actions that may be supported by SAL II in this area could include: Actions in the immediate term (y January 1997?) * Improve exit and registration procedures and performance standards (time limits, simplified procedures, clear and reasonable appeal process etc.) for establishment of private farms. * Review farm restructuring pilot projects, disseminate the experiences with practical guidelines and prepare a program to extend these projects to a program with national coverage. * Introduce a system of auctions for the marketing of concessional food grain deliveries.  Appendix B Page 14 of 18 * Liberalize foreign trade in grain. * Commence the functioning of Agricultural Restructuring Agency. Actions in the short term (by March 1997?) * Apply the new public procurement system (based on competitive tendering) to state grain purchases. * Adopt legislation to establish a single land registration system (i.e. for urban and rural land) and prepare action plan to implement the new land registration system together with clear institutional arrangements and procedural regulations needed for a functioning land market. * Ensure that the new Civil Code provides the necessary legal framework for the land market and refrain from introducing any laws or regulations that could hamper its operations. [will the Civil Code be adopted by March? when can thie Bank receive a copy of the draft law?] * Amend legislation on the normative pricing of land by eliminating or drastically reducing normative prices and eliminating lease control. [the mission's prefered option is to fully eliminate normative prices? what is Government's position?] - Remove margin control in the bread production and stop indirect subsidization of bread consumers [the Government wants to continue to subsidize two categories of bread, how important is the sale of these categories? how will the subsidy be administered? should the SAL support this action?] * Remove state intervention from milk pricing and eliminate budgetary subsidies to milk producers [Government wants to maintain indirect subsidies. W'hat does this mean? if Government is not ready for this reform, should we drop it from SAL I?] * Replace the use of reference prices for exports with the publication of non-biding price information in agricultural foreign trade. * Reduce import tariffs to a uniform maximum 20% level with the exception of luxury goods (the latter category doesn't include fresh fruits and wine). * Adopt a plan to complete the privatization of Cereale and Fertilitate. Actions in the medium term (by September 1997?) * Measurable progress in farm restructuring and farm debt restructuring (minimum 200 farms restructured and reorganized according to mutually agreed methods). * Measurable progress in land titling and registration (10% of parcels aLre titled). * All of applications to exit from large-scale farms individually, submitted up to March 1997 are processed. * Complete the privatization of Fertilitatea and Cereale according to a prograrm agreed with the Bank. Actions in the long term (wb, March 1998?) * Measurable progress in farm restructuring and farm debt restructuring (mninimum 300 farms restructured and reorganized according to mutually agreed methods). * Measurable progress in land titling and registration (20% of parcels are titled).  Appendix B Page 15 of 18 Actions before the end of the SAL IIroggram * Measurable progress in farm restructuring and farm debt restructuring (minimum 400 farms restructured and reorganized according to mutually agreed methods). * Measurable progress in land titling and registration (30% of parcels are titled). * All of applications to exit from large-scale farms individually, submitted up to March 1998 are processed. Privatization 48. Moldova's mass privatization programs achieved their objectives: they were fast, transparent, fair and most Moldovan citizens invested their patrimonial bonds (PB) in 1,142 medium-sized and large joint stock companies (JSC) and 1,093 small-scale enterprises (shops, coffee houses, etc.). As a result of mass privatization and development of small private businesses, the private sector increased its share in production of goods and services up to: 60 percent in industry; 70 percent in trade and "social services" (restaurants, coffee houses, hair cut, etc.); and, 44 percent in construction and transport. Around 3.1 million Moldovan citizens (90 percent of PB holders) participated in the mass privatization. At the same time, 85 percent of public housing was also privatized. 49. But the task of privatization is far from over. The state still owns a large amount of productive assets. Moreover, the time has come to shift from voucher privatization to privatization for cash. State owned productive assets include: (a) the leased premises of about 2,000 small sized enterprises; (b) the land under already privatized JSC and small scale enterprises; (c) the rest of State's shares in 585 companies which were approved by Parliament to be privatized entirely during mass privatization but remained in State hands because of low demand; (d) 121 small-sized enterprises, the State's controlling block of shares (60 percent) in 41 JSC, and 7 so called "unique enterprises" which could not be privatized for cash in 1995-1996; (e) the State's shares in about 311 JSC (between 30-60 percent) which were approved by Parliament to remain in the State ownership (the rest of shares between 70 and 40 percent was privatized); and (f) small-sized, medium and large enterprises which were not included in the previous two privatization programs, including some of the most successful "wine combinats" and enterprises in energy and other infrastructure sectors. 50. The Government has shifted the focus of privatization from mass privatization for vouchers to cash privatization. The Government believes that this new privatization strategy will help: encourage domestic and foreign investment; bring about a rapid restructuring of the privatized companies; and generate government revenues. A draft of the Privatization Program for 1997-1998 (97/98PP) has been prepared by the Ministry of Privatization and is expected to be approved by Parliament around the end of 1996. 51. The draft 97/98PP contains most of state-owned productive assets, including: (i) premises of all small sized enterprises which were leased by end of 1995 and the land under privatized enterprises; (ii) small-scale enterprises which were approved to be privatized for cash but remained unsold; (iii) most of State's shares in JSC; (iv) most of small sized and medium and large enterprises which were left out of the previous  Appendix B Page 16 of 18 privatization programs, including famous wine combinats and factories; and (v) infrastructure sectors, including energy companies. 52. The sale of leased premises and land under privatized enterprises is needed to encourage small private businesses, and to extend the real estate market. To date, about 2000 leased premises have been identified as potential candidates for privatization. While identification of other leased premises should continue, the Government plans to sell the first 250 leased premises by end of March, 1997, another 750 by September 1997, and another 1,000 by end of March 1998. Privatization of land under privatized enterprises will support a faster restructuring of the enterprises, making them more attractive for local and foreign investors, and providing them with a collateral for bank lending. 53. The results of cash privatization in Moldova are well behind expectations. Out of 190 small-sized enterprises approved to be privatized for cash, only 45 were sold in 1995, and 17 in 1996 (end of October). To expand cash privatization the Government plans to: reduce the starting price after first auction if the small-sized enterprise is not sold; and elirninate the income declaration requirement for citizens who want to participate in auctions. The Government also plans to hold new type of auctions (e.g. Dutch auction). The Government wants to encourage the participation of Moldovan citizens in cash privatization. Therefore, it plans to: (a) create a mechanism for selling a small number of shares to individuals, who may nolt be able to afford to buy large quantities, through public offering and other mechanisms which can be developed by the Stock Exchange; and (b) develop a system of payment facilities for Moldovan buyers (payment in installments, low down-payment, etc.). 54. The Government plans to privatize shares in hundreds of JSC and other State Owned Enterprises (SOEs) that were left out of previous privatization programs. This is a difficult task even for a country with a developed capital market where the JSCs and SOEs have a business record. Each JSC or SOE will require a feasibility study in order to choose an appropriate privatization strategy (based on its size, profile and rrarket condition). Therefore, the draft 97/98PP includes a large menu of privatization methods such as auctions; selling of shares through the Stock Exchange; public offering; trade sales; debt-equity swaps; and capitalization of the privatized enterprises. The Government also plans to extend privatization to infrastructure. It has drafted a project to open the telecommunications sector to competition and private sector participation. It wants to extend this experience to other infrastructure sectors, including transport; and energy. 55. Effective implementation of the 97/98PP will require some institutional strengthening. The shift of the Moldovan privatization program from mass privatization to cash privatization requires new expertize in the Ministry of Privatization, in other ministries which will participate in implementation of the infrastructure projects, and in local consulting firms. Technical assistance will be needed for this purpose. Moreover, the Government will allocate a parl: of the proceeds from privatization to implement the 97/98PP (a privatization find managed by the MOP).  Appendix B Page 17 of 18 56. Specific actions that may be supported by SAL II in this area could include: Actions in the immediate term (by January 1997?) * Propose a satisfactory p;rivatization program for 1997/1998 (97/98PP) which contains all of small scale objects, state shares in companies and state enterprises which were left out from the previous privatization programs, shares of companies that were only partially privatized under previous programs, wine combinats, and infrastructure companies (energy, comrnunications and transport). * Approve and implement the draft resolution which sets the mechanisms for the sale of shares still held by the State but which were approved to be privatized for patrimonial bonds. * Implement regulations to encourage Moldovans to participate in the cash privatization program. This could include: allowing payment in installments, and allowing sale of a small number of shares through public offerings. * Start implementing resolution No 562 of October 23, 1996 concerning the sale of land under privatized enterprises. Incentives for this sale should be created, including: allowing payments in installments and eliminating (or lowering) normative prices for land. Actions in the short term (byMarch 1997?) * Sale of 250 premises of s:mall scale objects that were leased by December 1995. 3 Eliminate barriers to the cash privatization of small scale objects already approved for privatization; the Government will reduce the starting price after the first auction if object is not sold; introduce a new type of auction (e.g Dutch auction); and eliminate the income declaration for citizens who want to participate in auctions. * Put in place a Technical Assistance program to support the implementation of the 97/98 privatization program, especially regarding cash privatization. * Ensure the proper functioning of the Share registry and transfer privatized companies to that registry. Actions in the medium term (by September 1997?) * Sale of an additional 750 premises of small scale objects which were leased by December 1995. * Sale of ---- percent of land under privatized enterprises. * Satisfactory progress in irnplemerfting the 1997/98 privatization program, including its cash component. * Satisfactory progress in small-scale privatization. Actions in the long term (by March 1998?) * Sale of an additional 1000 premises of small scale objects which were leased by December 1995. * Sale of---- percent of land under privatized enterprises. * Satisfactory progress in implementing the 1997/98 privatization program, including its cash component. * Satisfactory progress in small-scale privatization.  Appendix B Page 18 of 18 Actions before the end of the SAL IIro-gram * Completion of sale of land under privatized enterprises. * Completion of the 1997/98 privatization program. * Completion of small-scale privatization.  MAP SECTION   IBRD 24285R3 28