1 I 1 FROM:The President PROPOSEDGRANT OFUS$900,000 FROMTHE DEBT REDUCTION FACILITY FOR IDA-ONLY COUNTRIESTO THE DEMOCRATICREPUBLIC OF CONGO FORTHE PREPARATIONOF A DEBTREDUCTION OPERATION. I. OVERVIEW 1. IsubmitthefollowingMemorandumandRecommendationforaproposedgrant o f up to US$ 900,000 from the Debt Reduction Facility for IDA-Only Countries (hereafter the "Facility") to the Democratic Republic o f Congo (hereafter the "DRC") to cover the cost o f hiring financial and legal advisors to assist the Government o f the DRC (hereafter "the Government") in the preparation o f a proposed debt reduction operation. 2. This proposed operation constitutes the first operation supported by the Facility for the DRC. This debt reduction operation will address the commercial debt o f the DRC and will facilitate the provision o f debt relief by the remaining commercial creditors as envisioned under the HIPC debt initiative. As reported previously to the Executive Directors, the Government has formalized its request to access the Facility. 3. The DRC continues to meet the eligibility criteria set out in the operational guidelines for the Facility]. The DRC i s an IDA-only country; i t i s implementing a medium-term adjustment program that i s acceptable to the Association; and i t has a debt management strategy that includes programs for resolving commercial private internal debt and for obtaining substantial debt relief from official bilateral creditors. At the same time, the DRC has reached inJuly 2003 its decision point under the HIPC Initiative. The proposed commercial debt reduction operation i s part o f the DRC's external debt management strategy. 4. The DRC estimated eligible commercial debt i s approximately US$900 million (principal and interest). The cost to finance the operation will depend on the amount o f debt tendered and the buyback price offered. It is expected that a request will be made within the next twelve months to the Executive Directors for a further grant from the Facility to finance the operation after the advisors have completed the preparatory work. 5. The DRC continues its recovery from decades o f mismanagement and collapse o f State under the regime o f Mobutu Sese Seko (1965-1997) culminating in a dreadful ' "Operational Guidelines and procedures for the Use of Resources o fthe Debt ReductionFacility for IDA- only Countries" (R89-156, IDAiR89-103, July 13, 1989); "Review of Progressunder the Debt Reduction Facility for IDA-Only Countries)(R-92-33, IDA/R92-26, March9, 1992 andR93-114, June 30, 1993). "Debt ReductionFacility for IDA-Only Countries: ProgressReview, Support to the HIPC Initiativeand ProposedEnhancements" (IDNR2004-184, June 28,2004) 2 decade o f political instability and conflict involving groups from the entire Great Lakes region. The destruction and decay o f physical and social infrastructure caused by the conflict has contributed to a death toll o f over 3 million. Since January 2001, the Congolese authorities have taken a number o f important steps to implement the 1999 Lusaka Peace Accord and agreements reached through the inter-Congolese dialogue, to liberalize political life and to address key economic issues. A transition government o f national unity i s functioning and the country i s on track for elections, planned for end June 2006. A United Nations peacekeeping force has been deployed throughout the country, however, localized ethnic violence continues. Instability and conflict inthe DRC had regional implications. Therefore, the stabilization of the DRC is a key to sustainable peace in the region. 6. Management i s proposing at this time that the Executive Directors approve a grant of up to US$900,000 from the Facility to DRC to cover the cost o f financial and legal advisory services and related expenses needed to prepare the proposed operation. Management believes this amount to be appropriate, based on experience in other such operations. The advisors will be retained by the D R C in accordance with IDA procedures for the recruitment o f consultants. 11. THE ECONOMY A. Economicbackground 7. About eight decades o f colonial rule, several conflicts in the immediate post- independence period, a long period o f corruption and mismanagement coupled with steady political unrests from the early 1990's have weakened economically and socially the DRC, the second largest country in sub-Saharan Africa. The country's principal exports, copper, cobalt, diamonds, gold, zinc, other base metals and petroleum extraction used to account for 75 percent o f total export revenues, and about 25 percent per capita Gross Domestic Product (GDP) and declined drastically to about 5 percent o f GDP. Country financial reserves decreased from US$ 196 million to US$22 million. Finally, the GDP per capita collapsed from US$380 in 1960 to US$96 in 2002, giving a clear evidence o f the country's impoverishment. B. Macroeconomicperformancein2001-2003 8. The DRC was cut off from international financial assistance from 1993 until 2001, primarily due to economic and financial mismanagement, conflict and war. From 1997-2001, the conflict and its socioeconomic impact led to over three million deaths, most o f which were due to widespread disease and hunger, as well as extensive destruction o f infrastructure and the collapse o f institutions. When President Joseph Kabila took office following his father's death in January 2001, he sought to reestablish relations with international financial institutions. The IMF responded with a staff- Monitored Program (SMP), covering the period June 1, 2001 - March 31, 2002 and in 3 July 2001 IDA approved a Transitional Support Strategy (TSS), initially underpinned by US$ 50 million grant for an Emergency Early Recovery Project (EERP). 9. Progress towards peace and good performance under the SMP and the EERP has led to substantial financial reengagement by multilateral and bilateral institutions. As consequences, the Interim PRSP (I-PRSP) was discussed by the IDA Board on June 11, 2002. Following clearance o f arrears to IMF, a three-year PRGF and the I-PRSP were discussed by IMF Executive Directors on June 2002. have been discussed. IDA'S Economic Recovery Credit (ERC), approved by the IDA Board on June 13,2002 became effective following arrears clearance on July 3, 2002. The Paris Club granted significant relief on bilateral debt at its September 2002 meeting. The first review o f the PRGF was completed on March 24, 2003 at the same time as the IMF's 2002 Article IV consultation. The decision point under the Enhanced HIPC Initiative was approved by IMF Executive Directors on July 23, 2003 (at the same time as the conclusion o f the second review under the PRGF), and by IDA Executive Directors on July 24, 2003. In December 2003 at the Consultative Group meeting in Paris, donors pledged US$ 3.9 billion in financial assistance to the D R C over the next few years. The fifth PRGF review i s underway, the results are expected in July 2005. 10. The PRGF aims both to spur economic growth and to tackle some of the deep- rooted structural issues which have hampered the DRC's economic development in the past, Indeed, the challenge o f recovery i s also a challenge o f transition: even prior to the conflict, the DRC's successive Governments had not been able to translate the country's immense potential into actual improvements o f living conditions for the population. The formal economy has been largely disrupted, and hence transformed, by years o f conflict- and the challenge i s not to reconstruct the earlier system, but to take advantage o f the ` war-time changes to re-build the economy on a more solid and sustainable basis. 11. Measures to continue stabilize the economy and implemented since February 2005, include a sharp increase in the interest rate from 20% to 65%, an aggressive reduction in Government's expenditures except for pro-poor spending (by 0.7% o f GDP), a significant curtailing o f the emergency extra-budgetary expenditures. These measures seemed to have started to take hold: exchange rate stabilized at around 500 CGF/US$, and prices stopped rising. However, the depreciation resumed end MarcWearly April (the exchange rate stands at around 515 CGF/US$ as o f April 20, 2005) and inflation i s starting to creep up again, apparently for market's loss/lack o f confidence in the Government. 12. Parallel efforts have been made on the structural side, with significant achievements in a broad range o f areas. Reforms have been aimed at correcting major deficiencies - to spur growth through private sector activity, and to start tackling key transparency and efficiency issues in the management o f natural and public resources. Public enterprise reform has started and business environment measures have been taken. 13. These actions have elicited a strong private sector response. About US$ 2.4 billion in new investments under consideration have been registered by the Government 4 since early 2003, in a broad range o f sectors (e.g., services, agro-business, constructions, natural resource exploitation). Flagship operations include a US$ 94 million cellular phone project, a phasedUS$600 million investment project to install a telecom backbone inthe country, andthe launcho fa three-year program to increase offshore oil production. 14. As a result, economic growth retumedin 2002 after ten years o f contraction, and i s accelerating at about 7% on annual basis. Growth has been mainly pulled by the resumption o f economic activity which followed the re-establishment o f security and the reunification o f the country, an increase in agricultural production, the booming o f selected services, and the comeback o f the construction industry - reflecting the beginning o f the transformation o f the economy away from the traditional mining and export sectors. C. Key economic outlook 15. The key challenge for the DRC i s to ensure that economic growth i s both sustainable and broadly shared. In a country as richly endowed as DRC, it is no surprise that the retum o f peace and progress towards macro-economic stability rapidly results in renewed economic growth. But the economic history o f the country over the past decades suggests that growth does not necessarily translate into enhanced living conditions for the majority o f people. It also suggests that the past focus on natural resources and extractive industries might have contributed to mismanagement o f the economy. The objective is therefore to go beyond growth - towards shared growth. 16. This will require action in a number o f areas - and there i s a broad consensus among all stakeholders around a five-fold agenda: - Consolidate macro-economic stability, fiscal mobilization, and public expenditure management - within the context of the economic program supported by the Bretton Woods Institutions. This expected to be multi-year effort, requiring both difficult political decisions and external support (budget support, institutional strengthening, and targeted analytical work). - Reconstruct key large infrastructure which underpin economic activity (in particular in the transport and power sectors)'- and improve their operation and maintenance systems. This will require sizable external financial support as well as some institutional strengthening - with a particular view to the regional dimension o f this endeavor. - Continue to improve the business environment. Building on recent achievements, a series o f new reforms need to be undertaken, while the recently-adopted ones need to be implemented throughout the country. Extemal support will be needed through a mix o f budget support, institutional strengthening, and targeted analytical work, as well as direct support to private sector (e.g., by IFC or MIGA). 5 - Continue to improve natural resources management. Efforts will aim to ensure a proper and country-wide implementation o f the new mining and forestry codes, with a view to improving both transparency in allocating mining and forestry rights and management o f the revenues generated in these sectors. This is expected to require external assistance inthe form o f policy advice and analytical work, as well as targeted capacity strengthening. Revitalize agriculture, to remedy decades o f neglect and conflict-induced destruction. To ensure high and sustainable growth in this sector, the deep- rooted constraints to growth (e.g., regulatory issues, rural credit, agricultural productivity) need to be removed. But this is a complex and lengthy process- and, in view o f the ongoing social crisis, visible results are needed early on to stabilize the situation and create an environment for eventual reforms. In the short-term, efforts will hence focus on opportunities for quick-wins (while also laying the ground for medium-term reforms) - which require both financial assistance and analytical work. 111. DEBT SITUATION AND PROSPECTS Debt situation 17. At end 2002, DRC total stock o f extemal debt outstanding after traditional debt relief amounted to US$ 10.1 billion in nominal terms or US$7.9 billion in NPV terms. D R C reached the HIPC Decision Point in July 2003. Total HIPC debt relief is estimated to amount to US$6.3 billion inNet Present Value (NPV) terms. 18. Despite access to interim debt relief under the HIPC initiative, however, the debt issue remains a major threat to the DRC's recovery. In the short-term, debt relief is critical to free up resources for peace and development. However, although reaching the Decision Point made it possible to implement an arrears clearance strategy and to normalize the relations with the intemational financial community, the resumption o f debt service, even at a reduced level, i s imposing a heavy toll on fiscal resources: extemal debt service i s expected to represent between 32 and 40 percent o f Government revenues between 2003 and 2007, before starting to sharply decline to less than 5 percent after 2010. The internal debt i s estimated over US$600 million, which is a major obstacle to the resumption o f activity by the private sector. Audits and negotiations are ongoing but the amounts are such that substantial external assistance will be needed. The external private debt amounts to about US$ 900 million, and poses a threat to the DRC's creditworthiness and access to private capital. Contacts with the London Club are ongoing, but even with a very significant discount rate it will be difficult for the D R C to face its obligations. Considering the extemal public debt, access to H P C has provided only partial relief- and significant amounts o f further assistance may be needed 6 Prospects 19 Overall, the situation remains fragile: assuming a 5.3 percent economic growth on average, it will take until 2060 for the country to reach the level o f GDP per capita it had in 1960. While substantial progress has been made over the past period, the challenges remain daunting and have to be faced in a context o f limited fiscal resources and compromised administrative capacity. The new Government has re-affirmed its commitment to implement the economic program but attention needs to be paid to maintaining the pace o f reforms, inparticular during the period o f political transition, and to tackling some o f the key issues associated with the country's reunification. IV.THE PROPOSEDOPERATION 20. The Government estimates that the commercial debt eligible for the commercial debt reduction operation under the IDA Debt Reduction Facility amounts to US$ 900 million, as o f December 2004. Bank closings, debt acquisitions and maybe other types o f transaction between creditors have reduced the number o f the D R C external commercial debt owners to two main institutions namely L a Belgolaise (88 % approximately) and Citibank (11 % approximately). 21. The commercial debt reduction operation envisaged under the Facility would be important to the DRC economy as it would help reduce the country's burden, thereby facilitating the achievement o f debt sustainability. This would in turn free up resources for the much needed social and infrastructure programs that underpin economic growth and development. With prospects o f debt sustainability and long-term growth enhanced by having reached the completion point under the HIPC Initiative, the DRC is now in a much better position to attract both domestic and foreign private investment. 22. Following the procedures o f recent operations, the contracts with the financial and legal advisors will be capped. The estimated advisory fees are based on (i) median rates o f advisors with relevant experience in debt buy back operations; (ii)workload assumptions taking into account the number o f creditors and claims, the nature o f the debt involved, and the expected complexity o f negotiations; and (iii) comparable previous and ongoing debt reduction operations. 23. The advisors would be selected according to IDA procedures for recruitment o f consultants. Barring unforeseen complications during the preparation phase, the proposed grant amount would be sufficient to pay fees o f the advisors and other related expenses for both the preparation and implementation o f the operation. Xn order to simplify contractual arrangements with the advisors, the services for both stages would be covered in the initial grant agreement for advisory services. Any unused portion of the grant would be returned to the facility for allocation to operations inother countries. 7 V. RECOMMENDATIONS 24. IrecommendthattheExecutiveDirectorsapproveagrantofuptoUS$900,000 from the Facility to the DRC to provide financing o f financial and legal advisors and related expenses to assist DRC in the preparation o f the proposed commercial debt reduction operation. The grant agreement provides that the qualifications, experience and terms and conditions o f employment o f such advisors be satisfactory to IDA. A request for a further grant from the Facility for the implementation o f the operation is expected to be submitted to the Executive Directors within the next twelve months for approval, contingent on: (i)continued adherence by the Government to its medium-term adjustment program; (ii) the terms o f the debt reduction operation being satisfactory to IDA; and (iii) agreement by the Government's commercial creditors to eliminate a substantial portion of their claims through the proposed debt reduction program. Paul Wolfowitz President