Mozambique - Second Economic Recovery Credit Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 18078 IMPLEMENTATION COMPLETION REPORT MOZAMBIQUE SECOND ECONOMIC RECOVERY CREDIT (Credit 2628-MZ) June 25, 1998 Mozambique Resident Mission Africa 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 Currency Unit is metical (MT); plural - meticais; rate per US$ 1993 5,800 1994 7,190 1995 11,300 1996 11,900 1997 (August) 11,700 1997 11,700 1998 (April) 11,850 ABBREVIATIONS AND ACRONYMS ADB African Development Bank AGRICOM State Enterprise for Agricultural Marketing BM Banco de Mogambique/Bank of Mozambique (central bank) BCI Banco Comercial e de Investimentos BCM Banco Comercial de Mo,ambique/Commercial Bank of Mozambique BFE Banco de Fomento e Exterior BIM Banco Intemacional de Mo9ambique BPD Banco Popular de Desenvolvimento/Popular Development Bank BSTM Banco Standard Totta de Mo,ambique/Standard Totta Bank CG Consultative Group ERC Economic Recovery Credit ERP Economic Rehabilitation Program ESAF Enhanced Structural Adjustment Facility FSCB Financial Sector Capacity Building Credit GDP Gross Domestic Product IDA International Development Association IERP Industrial Enterprises Restructuring Program IMF International Monetary Fund INE Instituto Nacional de Estatistica MICTUR Ministry of Industry, Commerce and Tourism NGO Non-Governmental Organization PFP Policy Framework Paper SERC Second Economic Recovery Credit TERC Third Economic Recovery Credit ULC United Leasing Company UTRE Enterprise Restructuring Unit FISCAL YEAR January 1 - December 31 Vice President Callisto Madavo Director Phyllis Pomerantz Sector Manager Thomas Allen Technical Manager Ataman Aksoy Task Team Leader Simon Bell  FOR OFFICIAL USE ONLY MOZAMBIQUE SECOND ECONOIMIC RECOVERY CREDIT (CREDEIT 2628-MOZ) IMPLEMENTATION COMPLETION REPORT TABLE OF CONTENTS Page PREFACE EVALUATION SUMMARY .................... i-iv Part I: PROGRAM IMPLEMENTATION ASSESSMENT .1 A. Background.. ................ I B. Achievement of Program Objectives .1 C. Achievement of Program Objectives .5 D. Major Factors Affecting the Program .11 E. Project Sustainability .II F. Borrower Performance.12 G. Bank Performance .13 H. Assessment of Outcome .13 I. Future Operations .............. , 14 J. Key Lessons Learned .15 Part II: STATISTICAL TABLES ................................................ 17 Table 1: Summary of Assessments ................................................ 18 Table 2: Related Bank Operations ................................................ 19 Table 3: Project Timetable ................................................ 20 Table 4: Disbursements ................................................ 20 Table 5: Key Indicators: Actuals and Projected, 1994-96 ......................................... 21 Table 6: Economic Performance, 1987 - 1997 .................................. .............. 22 Table 7: Social Indicators, 1993, 1994 and 1995 .............................................. 23 Table 8: Status of Legal Covenants ................................................ 24 Table 9: Bank Resources: Actual Staff Inputs ................................................ 25 Table 10: Bank Resources: Missions ..................... ........................... 26 Part III BORROWER ASSESSMENT OF OUTCOME ................................................ 27 This document has a restricted distribuition 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.  MOZAMBIQUE SECOND ECONOMIC RECOVERY CREDIT (SERC) (CREDIT 2628-MOZ) IlPLEMENTATION COMPLETION REPORT Preface This is the Implementation Completion Report (ICR) for the Second Economic Recovery Credit (SERC) in Mozambique -- for which Credit 2628-MOZ, in an amount of SDR 141.7 million (US$200.0 million equivalent), was approvedl on June 16, 1994 and made effective on July 19, 1994. The Credit closed on August 30, 1997, as envisaged in the original Board documentation. The first tranche, released upon effectiveness, was fully disbursed by June 1995. The second tranche was released on July 24, 1995 and was fully disbursed by August 1996. The third tranche was released on October 28, 1996 and was fully disbursed by November, 1996 -- nine months in advance of the closing date of the credit - due to changes in the disbursement criteria for adjustment lending. Cofinancing for the credit was provided by Great Britain (L1 0.0 million pounds sterling, US$15.5 million equivalent), Switzerland (10.0 million Swiss francs, US$7.5 million equivalent), and Denmark (40.0 million Danish kroner, US$6.5 million equivalent). This ICR was prepared by Simon Bell, Senior Financial Economist and Task Manager, AFMMQ/AFTPI and Carolina Machado, AFTMI. This report was reviewed by Phyllis Pomerantz (Country Director for Mozambique), Atam;an Aksoy (Technical Manager, Macroeconomics I, Southern Africa), Paul Murgatroyd (Technical Anchor, Financial Sector, PSF, Africa Region), and lain Christie and Brian Levy (Technical Anchors, Private Sector, PSF, Africa Region). Very useful comments were also provided by Arnold Sowa and Gabrielle Rooz (AFTP 1), Manuela Ferro (AFTM1), and Jim Coates (Resident Mission, Mozamnbique). The Borrower contributed to the preparation of the ICR with its own evaluation of the program. Preparation of this ICR began in November 1997. It is based on discussions with Bank staff, Government officials, and on the President's Report, the Loan Agreement, and other materials in the project files.  MOZAMdBIQUE SECOND ECONOMIC RECOVERY CREDIT (Credit 21628-MOZ) Evaluation Summary i. The period 1992 to 1994 marked a turning point in the development history of Mozambique. Beginning in October 1992, the Government and the rebel movement signed a peace agreement which led to the cessation of hostilities which had plagued Mozambique over much of the post- Independence period. This permitted an almost instant return to more normal economic life -- as demonstrated by the very high growth rate experienced in 1993 as refugees and displaced persons returned to their villages and re-commenced agricultural production. A United Nations peace keeping force monitored the peace process, the demobilization of soldiers and the transition to the country's first multi-party democratic elections. This process was successfully finalized in October 1994 resulting in the establishment of a young but thriving democracy. The pre- conditions for lasting peace had been established and hence the capacity of the nation to be developed as a coherent whole. The political transition had been achieved -- now it was time to secure the macro-economic transition. ii. These broad changes largely shaped the objectives of the Second Economic Recovery Credit (SERC), which was approved in June 1994. If peace could be sustained, economic growth was expected to increase sharply over the short to medium term mainly because of the continued resumption of agricultural activities. However, it was necessary to ensure that growth could be sustained over the longer term if there was to be, an impact on reducing poverty. iii. The interesting anomaly of Mozambique was that it had managed to sustain relatively high, albeit uneven, growth despite the fact that it had not achieved macro-economic stability. However, such a situation was not sustainable over the longer term and Mozambique really needed to achieve macro stability if it was to sustain high rates of growth. A major source of macro-economic instability emanated from two interlinked sources -- a state owned financial system which operated on a non-commercial basis, and an inefficient and publicly owned industrial sector. This resulted in monetary leakages through the state owned banks to the state owned enterprises. As these loans were frequently not repaid, this led to a vicious cycle of illiquidity and further money creation. iv. Dealing with the problems of the banking sector was critical to achieving macro stability. However, as a financial sector does not operate in a vacuum, it was equally important to deal with the "real sector" problems plaguing the borrowing clientele of the banks. These two issues helped set the agenda for the SERC in terms of bank restructuring/privatization and the rapid privatization of the state owned industrial parastatals -- so as to yield the twin benefits of macroeconomic stability (arising from tighter macro-monetary control) and more efficient, private sector driven, industrial growth. These reforms would be supplemented by central bank strengthening and monetary policy development -- as well as on-going fiscal reforms based on initiatives commenced under earlier adjustment operations. v. Program Design and Objectives. The SERC supported policy reforms aimed at: (i) continuing sound macroeconomic managernent -- specifically measures to improve the management of public expenditures and external aid; (ii) taking further steps to strengthen the central bank to enable it to play a leadership role in areas of monetary policy, monetary management, and supporting the development of a sound and efficiently operated banking system; 1  (iii) restructuring the financial sector and, in particular, dealing with the problems of the state owned banks; and (iv) taking the next steps in the enterprise reform agenda including the removal of subsidies, privatization, and restoring the financial soundness of some of the large public sector monopolies. The implementation of these reforms required technical assistance support, which was provided through a companion IDA project -- the Financial Sector Capacity Building (FSCB) credit. vi. The SERC was the fourth adjustment credit to Mozambique approved by the Bank. Like the Economic Recovery Credit (ERC) before it and the Third Economic Recovery Credit (TERC) after it, the operation was conceived as part of a sequentially designed program of support -- with important elements being built upon and developed over the course of the three operations. vii. In addition, the SERC was one component of a broad international program of support. In conjunction with the IMF's programs the SERC played an important role in mobilizing other external aid, particularly import support funds. Review of the Government's reform program also took place within the context of the annual Consultative Group meetings. Continuing high levels of project and balance of payment support, in the face of declining levels of aid world wide, bear testimony to this coordination effort and the strong commitment of the Mozambican Government to real economic reform. viii. Results of the SERC Program. Overall the SERC was very successful in achieving its twin aims of monetary policy stability/financial sector reform and greater private sector involvement within the economy. This has, in turn, engendered and supported the macro-economic stability which had eluded the Government under previous structural adjustment operations. After initial failures to successfully restructure the state owned commercial banks, the Government decision to fast track their privatization in 1995, marked an important turning point in the overall reform program. The privatization of Banco Comercial de Mocambique in July 1996 resulted in significantly slower money supply growth and a sharply reduced rate of inflation. These developments fed through into a stable currency. Only interest rates have taken time to fall into line with other macroeconomic variables. This accentuates the need for further financial sector deepening and broadening. ix. The subsequent privatization of the smaller state owned bank, Banco Popular de Desenvolvimento (BPD), in September 1997 completed the bank privatization process, consolidating the stabilization achieved thus far, and resulting in a completely privately owned banking system -- in marked contrast to the state dominated banking system which had existed several years before. In addition, increased entry has resulted in six additional financial institutions (and a further three banks are expected to commence operations in 1998) which are competing for banking business and providing better quality products and services. The transformation of the financial sector has been considerable. x. Given severe limitations, in terms of both financial and human resources, the Government has pledged its commitment to strong private sector led growth. Commitment to privatization resulted in 48 large scale enterprises and almost 900 small and medium scale enterprises being privatized over the period 1992 to 1997. The enterprise privatization program and enhanced macroeconomic stability will now make strong private sector led growth a more attainable goal. Indeed, increased private sector involvement in the economy has already resulted in faster economic growth. Whereas GDP growth averaged 6 percent per annum in real terms from 1991 to 1995; this increased to 6.4 percent in 1996; a projected 12.5 percent in 1997; and expectations of around 10 ii  percent in 1998. Summary macro-economic d[ata is provided in Tables 5 and 6 of the Statistical Annex. xi. The central bank has also emerged as a stronger, more independent, institution over the past three years. Considerable legal reform has been undertaken within the sector -- the most important of which have been the Banking Act and the Foreign Exchange Act. Steps have been taken to strengthen the bank supervision department and to increase its capacity to supervise and regulate a private owned banking system. The central bank is now producing timely, annual central bank reports, which include audited accounts for thie bank. Lastly, the Economic Studies Department and the Credit Department are involved in producing quarterly statistical bulletins for distribution; have boosted their research and policy capacities; and are now more actively issuing Treasury Bills as an alternative financial instrument for sale to the banks. xii. Support to the social sectors has also been better than originally envisaged under the program. Benefiting from a Peace Dividend, resulting from lower levels of military expenditure, the Government was able to increase expenditures to the social sectors by 44 percent in real terms in 1995. Further support has come in the form of the debt relief fund under which the Government has pledged to reallocate any freed up resources (contributed to by donors), to the social sectors. Although simple social safety nets were maintained, they were not without their drawbacks and were limited in their coverage. A greater benefit to poverty reduction resulted from the cessation of war, the restoration of agricultural activity., increased marketing and trading activity, and more liberalized pricing policies for agricultural products. Employment generation in urban areas resulting from increased investment in micro-enterprises as well as mega projects will also be important in helping to address urban poverty. xiii. Mozambique's accomplishment, however, must be viewed in the context of the enormity of the problems facing Mozambique; (1) Mozambique remains one of the poorest countries in the world, with a very small domestic market vwith a restricted purchasing capacity; (2) the human resource base of the country is extremely fragile -- with literacy rates of only 30 percent; (3) there has been a serious decline in the capacities of the Government as many of the best and brightest within the civil service have left to join the rapidly expanding and significantly more remunerative private sector; (4) Mozambique remains a difficult and bureaucratic place in which to undertake business -- as recently catalogued in the Foreign Investment Advisory Services Red Tape analysis; (5) linked to excessive bureaucracy and a poorly paid civil service, there is a growing concern over corruption; (6) Mozambique has a weak legal system and a poorly performing court system which requires substantial strengthening and modernization; (7) one of the highest levels of aid dependency in the world makes Mozambique particularly vulnerable to shifts in donor policies and at times reduces the scope for independent decision-making by the Government. Last, although not a weakness, the sustainability of the reform process is an area of concern. The recent positive economic developments do not have a long history. It is critical that Mozambique sustain and consolidate the macroeconomic stability achieved to date. xiv. A key feature accounting for the overall positive outcome of the SERC was the Government's continued strong commitment to the implementation of the reform program. The Borrower was actively involved in the design and implementation of the Credit, and clearly demonstrated ownership of the program. Of particular importance, the Government's commitment to reform was sustained and the implementation of the reform program since the Credit closed continues to be further consolidated. Despite this strong Government commitment, progress was, at times slow, as . .  reflected by the fact that both the second and third tranches of funding were delayed beyond their originally scheduled dates (by 4 months, and 11 months respectively). The summary ratings (Table 1) are: * Achievement of objectives: substantial * Program sustainability: likely * Bank performance: satisfactory * Borrower performance: satisfactory * Assessment of outcome: satisfactory xv. The main conclusions and lessons are: * Borrower ownership of the adjustment program is criticalfor success. The Government's strong commitment and ownership of the reforms supported by the SERC, ensured that even politically difficult decisions could be carried out. * Financial Sector Reform and macroeconomic stability are frequently strongly inter- related. The macro-economic stability which resulted from the privatization of the state banks indicated just how strong the macroeconomic linkages were with the banking system. The monetary leakages through the state banking system appear to have been the main source of instability. * Some flexibility within adjustment programs (by both the Government and the Bank) is important Initial resistance to privatize the state banks was overcome during the period of the SERC and wrs replaced by a program of full bank privatization. This required changes to the way in which elements of the adjustment program were implemented. Subsequent problems within the banks, in the lead up to their privatization, also required consultation and cooperation to limit the damage that could have resulted from an even greater loss of macro monetary control. Field based supervision from the Mozambique resident mission greatly assisted this process. * Reforms must be undertaken in a fully integrated manner. The interlinkages between monetary and fiscal policy are critical and must be built into adjustment operations. However, the interlinkages between the financial sector, private sector, and the macro- economy are sometimes less obvious. A well rounded and integrated program which takes these interlinkages fully into account will stand the greatest chance of success. * Administrative issues were just as important as economic policy issues in the adjustment program. The changes in disbursement arrangemeiLts introduced under the SERC were important -- not just in an administrative sense -- but also in terms of supporting the development of a deeper market in foreign exchange. iv  PART I: PROGRAM IMPLEMENTATION ASSESSMENT A. BACKGROUND 1. A difficult transition to independence from Portugal in 1975 was closely followed by the introduction of a system of central planning and civil war. Central planning, and the sudden departure of many Portuguese settlers, resulted in a large share of the economy falling into the hands of the state -- where inefficient, and frequently inappropriate, rnanagement resulted in sharply declining productivity and commercial orientation. The civil war made much of the countryside ungovernable. Agricultural production plummeted while much of the productive, social, and physical infrastructure was either destroyed or deteriorated at an alarming rate. Bly the mid-1980s, with the infrastructure base largely destroyed, GDP sharply reduced and declining, exports one-third their 1980 post-independence peak, debt at unsustainable levels, and poverty affecting most of the population, the Government recognized the need for radical changes in policy. 2. Consequently, the Government embarked upon a reform program in 1986 which aimed at reversing the decline in output and restoring orderly financial relationships with trading partners and creditors. A series of Bank adjustment operations supported the progressive reduction in the massive distortions which existed (particularly in prices and the exchange rate), decreasing administrative controls, rehabilitating state enterprises, mobilizing domestic resources, improving the sectoral allocation of expenditures, tightening credit policy and iniitiating a public enterprise restructuring program, while also focusing on trade reform issues. The Ec,snomic Recovery Credit (ERC) (FY92), immediately proceeding the SERC, supported the early phase of financial sector reform (particularly the separation of BM and BCM), as well as the further integration and liberalization of the exchange rate. 3. Mozambique's successful political transition over the period 1992 to 1994 -- from the signing of the Peace Accord to the holding of the first multi-party democratic elections -- was an important prerequisite for a successful economic transition. The cessation of hostilities permitted: the re- commencement of agricultural activities; the relhabilitation of economic and social infrastructure; and a growing investor interest in Mozambique by regional and international investors. These developments meant that Mozambique could at last achieve the economic transition which was now required. B. STATEMENT AND EVALUATION OF OB.JECTIVES 4. Nonetheless, the necessary pre-condition of peace was not, by itself, sufficient to achieve the macro-economic stabilization which could sustain high levels of growth over the medium to long term. And high levels of sustained growth were imperative if this poorest country in the world was ever going to deal meaningfully with poverty alleviation, huge fiscal imbalances, and low export levels which made the Government highly donor dependent on botJh balance of payments support and investment programs to support the overall budget. It was also important to focus on some of the important leakages within the economy which were causing the macro-economic instability -- resulting in high levels of inflation, exchange rate instability, and ultimately resulting in lower economic growth. As a reasonable degree of fiscal discipline had already been achieved, monetary policy increasingly became the focus of attention, and the leakages through the state owned banking system to the state owned parastatals was identified as the main culprit for this continuing instability. Supporting a program of inter-linked financial sector and private sector reformn, while also continuing some of the fiscal policy reforms commenced under previous adjustment operations, was seen has having the best chance of achieving macroeconomic stability -- and thereby setting the stage for long term sustained growth within a more stable environment.  2 5. The following policy reform areas were therefore supported by the SERC: (i) Management of Public Expenditures (a) Budgetary Policies. The Goverment was to: (i) remove remaining price controls (conditioned prices) on eight goods; (ii) allocate no more than 1 percent of gross domestic product for subsidies to publicly owned enterprises. (b) Poverty Focused Expenditures. To help address pressing poverty issues, the Government was to: (i) continue the social safety net programs which targeted the poorest urban households; and (ii) at least maintain budgetary allocations for education and health in real terms. (ii) Monetary Policy and Strengthening the Central Bank (a) Monetary Policy. The Central Bank was to: (i) introduce a broad central bank rediscount rate policy which would replace overdraft and other types of borrowing from the central bank; (ii) produce audited financial statements for the first time in 1993, and annually thereafter; (iii) design and launch a pilot Treasury Bill auction. (b) Foreign Exchange Laws and Regulations. The central bank also agreed to: (i) draft a new Foreign Exchange Act which provided the legal basis for a modem system of foreign exchange control; (ii) develop a supportive system of foreign exchange regulations which provided details on the implementation of the law; and (iii) maintain the official exchange rate at a market-related level. (c) Strengthen Banking Supervision. In an effort to strengthen bank supervision, Banco de Mocambique was required to (i) undertake an initial on-site examination of all the banks operating in Mozambique -- with technical support provided under the Financial Sector Capacity Building Credit (a companion credit to the SERC). (iii) The Financial Sector (a) Restructuring the State Owned Banks. In the absence of a Government commitment to privatization, the SERC sought to develop a better system of internal and external governance, and a stronger commercial orientation, within the state owned banks. To achieve this, it was agreed that the two state banks (BCM and BPD) would: (i) develop mutually agreed, and commercially oriented Strategic Plans; (ii) transfer bad loans to a"collection only" unit with no further lending being provided to any non-performing customers; (iii) bring in new interim management to run the largest of the state owned banks. (b) Increasing Banking Competition. The central bank undertook to: (i) permit new banking entry; and (ii) revise the system of allocating credit ceilings to take away existing historical biases and provide greater incentives to deposit mobilization. (iv) Enterprise Reform (a) State enterprises. The Government agreed to address the problems of the large service parastatals which were also non-perforrning borrowers within the banking system. Specifically it agreed to: (i) establish and monitor an Action Plan for reforming the national airlines (LAM); (ii) settle the debts of the Agricultural Marketing Board (AGRICOM) with the banking system; and  (iii) report on progress made in restructuring the national railways (CFM) as well as dealing with its banking system debt. (b) Privatization. The Government also undertook to: (i) privatize at least seven state owned enterprises from a list of twelve big enterprises with large non-performing loans. Evaluation of Credit Objectives 6. As a result of focusing on fiscal reform in previous adjustment operations most of the more egregious fiscal imbalances had been, at least partially, addressed by the time that the SERC was designed. What was becoming clearer was that monetary policy issdes were more important determinants of macroeconomic instability and that the transmission mechanism of credit creation from the central bank through the state owned banks to the state owned parastatals was a major source of monetary leakage and an important driving force of inflation. Dealing in a decisive manner with the state owned banks, while simultaneously strengthening the central bank, were therefore two interlinked and important priorities. However, the financial sector reflected the very poor underlying health of the state owned enterprises to which it lent. Therefore, reforming the banking sector could not be undertaken in isolation from enterprise reform. Previous attempts at banking reform and restructuring had not succeeded because of this. 7. An on-going Bank operation (the Industrial Enterprise Restructuring Program -- Cr. No. 20810) supported the main elements of the private sector reform program, including privatization and the creation of a more business friendly environment within which the private sector could operate. There was, however, a need to develop a companion project which could support the financial reform elements of the SERC program. To this end, the Financial Sector Capacity Building Credit was designed to support central bank strengthening, restructuring within the commercial banks, the development of better accounts, and so on. This project was approved several months after the SERC. 8. Management of Public Expenditures. 'These elements of the program, while important, do not appear to be as integrated into the SERC program as the other three main elements of the credit. They did, nonetheless, continue a program of budgetary reform which had focused on removing price controls and reducing subsidies to the state owned enterprises. By the time of the SERC most controlled prices had been removed. However, a system of "price conditioning" remained which involved post-review of prices set in the market. The removal of the system of conditioned prices on these last eight products largely removed the last remaining elements of price control on goods. Price controls on services, however, did remain. Reducing the level of subsidies to publicly owned enterprises was a measure of fiscal control. Although important, this condition was likely to work counter to the other elements of the program which sought to achieve greater efficiency and commercial orientation within the banking system as, with a system dominated by state banlks, the removal of subsidies was likely to force publicly owned enterprises into the banking system to obtain loans which were unlikely to be repaid. Lastly, in an effort to ensure adequate expenditures on the social sectors and the provision of some basic social safety nets, the program supported the maintenance of budgetary allocations for health and education and the continuation of the social safety net program to the 60,000 (frequently female headed) poorest households in urban areas. Simply maintaining expenditures within these important sectors was clearly a compromise -- but one that was considered warranted as Mozambique entered a period of high, and frequently unforeseen, expenditures on elections, resettlement, de-mobilization, mine clearing, and other "special activities" during 1994 and 1995. A commitment to maintain social sector expenditures and the then existing level of the social safety net ensured the maintenance of the status quo during a difficult and uncertain fiscal period with heavy demands upoII the public purse. This was made doubly important by  4 the fact that there was increasing evidence that expenditures in these areas were shrinking in real terms in the face of increasing expenditure demands from other sectors. 9. Monetary Policy and Strengthening the Central Bank. With the separation of Banco de Mogambique into its central and commercial banking components, there was a clear and pressing need to strengthen its core central banking functions. The credit focused on three main central banking areas: (a) monetary policy; (b) foreign exchange; and (c) bank supervision. The monetary policy elements of introducing a proper discount rate policy and producing externally audited central bank accounts were both important and necessary objectives in developing better monetary policy in Mozambique. The introduction of a Treasury Bill auction, however, may have been somewhat over ambitious from the perspective of 1994. An unhealthy and monopolistic banking sector, dominated by the state, would hardly have created the sort of competitive market for Treasury Bills, with market driven interest rates, that this component was clearly seeking to achieve. 10. Financial Sector Reform. Despite an earlier recommendation in a 1992 World Bank Financial Sector Study to either liquidate or privatize the two state owned banks, the Government was clearly not prepared for either eventuality at the time of the SERC preparation. It was argued that liquidation was impractical as these two banks virtually represented the entire banking sector, and privatization was simply not an acceptable alternative to the Government at the time. Consequently, the credit settled for a recognized "second best" alternative of trying to financially and managerially restructure the two state owned banks, and put in place measures which would limit their ability to lose further public funds or contribute further to monetary instability. Hence, the development of strategic plans, the transfer of bad loans, and the injection of interim management were all elements which were employed under the SERC. Meanwhile, the banking sector was opened up to foreign competition and new banking entrants. In retrospect, restructuring and recapitalization of state owned banks did not represent a useful utilization of public funds. Increasingly, the evidence from Africa shows that restructuring state owned banks has only a very small chance of being successful. Even bringing in outside management to operate state owned banks has only had very limited success. On the other hand, opening up the financial sector to competition would clearly help to increase sector efficiency and competitiveness while eroding the monopoly position of the largest state owned bank. Mozambique's experience with two re- capitalizations/restructurings in the early 1990s and in 1994 resulted in a lot of public money being put into institutions which subsequently lost these new resources -- and generally ended up even worse off than they had been prior to the recapitalization. 11. Enterprise Sector Reform. Although enterprise reform had commenced under the auspices of other projects, its progress had been very slow. This was partly occasioned by the need to clarify the legal situation of "intervened" enterprises (abandoned enterprises taken over by Government at independence but which legally still belonged to their initial owners). A 1991 Privatization Law helped establish the legal framework for privatization, and the establishment of a Unit within the Ministry of Finance to privatize state owned enterprises (UTRE) provided the administrative framework for the task ahead. By 1994, when the SERC was being prepared, UTRE had completed much of the preparatory work involved in its own establishment and was ready to start preparing dossiers for the enterprises which were to be privatized. In addition, in 1994, the IERP project was restructured to allow UTRE to focus only on privatization, which helped move the program forward faster. The requirement that seven large scale enterprises be privatized prior to second tranche release seems to have been a reasonable target. Meanwhile, dealing with the larger state owned service parastatals (the airlines, the railways, and the agricultural marketing board) added an important new dimension to the enterprise reform program. Identified as large, poorly performing borrowers within the banking system, these large service parastatals were themselves targeted for reform and restructuring.  5 C. ACHIEVEMENT OF PROGRAM OBJECTIVES 12. The macro-economic and structural objectives of the Credit were "more than" achieved. For the first time in over a decade of adjustment, the entire macroeconomy stabilized. Inflation fell from a high of over 70 percent to single digits in the first half of 1997 (Chart 3, page 21); the national currency stabilized against major international currencies (Chart 4), while appreciating against most regional currencies; growth accelerated from 4.5 percent to 12.5 percent per annum (Chart 1); exports increased by over 40 percent; and foreign investors began to take a more serious look at the Mozambican economy (with real FDI levels more than doubling over this period). This transformation has also included: a foreign exchange system which is market determined; a commercial banking sector which is now totally owned by the private sector; a state enterprise sector which has been largely privatized; and improved social conditions for the poor as budgeted social sector expenditures increased well beyond levels envisaged under the SERC program. These achievements resulted from a sequence of important events leading from the Peace Agreement, the demobilization, the first multi-party elections, and the appointment of reform minded individuals to critical ministerial posts within Government. The following sections highlight the main accomplishments and concerns of the program. 13. Economic growth. Real GDP CHART 1: GDP Growth in Mozambi, growth accelerated over the period 1994 to 1998, in percent 1991 to 1995 to reach 6 percent per annum on average compared to 5.1 14 percent per annum over the period 12 - --------------------- ---------- 1987-91. However, this masks some 0 - - , very important annual and sectoral - ---------------------------- -------------- --------variations. For exam ple, in 1993, the 8_ 6 - first full year of the peace, GDP growth 6 --is estimated to have been 19 percent as 3