Document of The World Bank FOR OFFICIAL USE ONLY Report No. 11542-RO STAFF APPRAISAL REPORT ROMANIA INDUSTRIAL DEVELOPMENT PROJECT APRIL 26, 1994 MICroGHAPHiICS Report No: 11b42 RC Type: SAR Country Operations Division Country Department I Europe and Central Asia Regional Office This document has a restricted distribution and may be used by reipiens only In the perfonnace of their official duties. Its contents may not othenwise be disclosed wihout World Bank authoradon. CURRENCY EQUIVALENTS Currency Unit Romania Leu (L) US$1.00 - lei 450.00 on January 1, 1993 US$1.00 = lei 735.00 on July 1, 1993 US$1.00 = lei 1276 on December 31, 1993 US$1.00 - lei 1680 on April 15, 1994 ABBREVIATIONS AND ACRONYMS BA Bank for Agriculture CBF Chemical Bank CC Commercial Companies CCB Cooperative Credit Bank CEC Savings Bank CO Certificates of Ownership DFB Dacia-Felix Bank EFF Export Finance Fund EIB European Investment Bank EXIM Export Import Bank of Romania FX Foreign Exchange GDP Gross Domestic Product IDP Industrial Development Project IRR Internal Rate of Return LC Letter of Credit LIBOR London Inter-Bank Offered Rate MIND Bank for Small Industry and Private Initiative MOE Ministry of Environment MOI Ministry of Industry MOF Ministry of Finance NAP National Agency for Privatization NBR National Bank of Romania PFI Participating Financial Institution PHARE EC-Phare TA Program for Eastern Europe PO Purchase Order POF Private Ownership Fund PSD Private Sector Development RA Regie Autonomes RBFT Romanian Bank for Foreign Trade RC Restructuring Committee RCB Romanian Commercial Bank RDB Romanian Bank for Development SAL Structural Adjustment Loan SCL Single Currency Loan SGF Societe General SME Small and Medium Scale Enterprises SOE Statement of Expenditures SOF State Ownership Fund TA Technical Assistance TCB Ion Tiriac Commercial Bank TD/MOF Treasury Department of the Ministry of Finance UCECOM Central Union of Cooperatives ROMANIA - FISCAL YEAR January 1 - December 31 FOR OFFICIAL USE ONLY ROMANIA INDUSTRIAL DEVELOPMENT PROJECT STAFF APPRAISAL REPORT Table of Contents Page No. LOAN AND PROJECT SUMMARY . . . . . . . . . . . . . . . . . . . . . . . . . I. INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . ... . . A. Background .1... . . . . . . . . . . . . . . . . . . . . . . . . II. INDUSTRIAL RESTRUCTURING AND PRIVATIZATION PROGRAM . . . . . . . . . . . . 2 A. The Industrial Sector.. 2 (a) Industrial Structure. 2 (b) Economic Environment and Impact of Recent Policy Reforms . . 3 B. Enterprise Reform . . . . . . . . . . . . . . . . . . . . . . . . . 4 C. Privatization.. 5 (a) Privatization Program. 6 (b) Institutional Framework. 6 (c) Privatization to Date. 7 (d) Measures to Speed-up Privatization . . . . . . . . . . . . . 8 D. Restructuring . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 (a) Government's Industrial Strategy . . . . . . . . . . . . . . 9 (b) Institutional Framework and Recent Developments . . . . . . . 11 E. Private Sector Development ...... . ............ . 12 (a) Small Scale Private Sector (SME) . . . . . . . . . . . . . . 12 III. FINANCIAL SECTOR . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 A. Current Structure of the Financial Sector . . . . . . . . . . . . . 14 B. Financial Sector Reform ...... . . .. . . .. . . .. . . . . 15 C. Financial Markets ....... .. .. .. .. .. .. .. .. . . 16 IV. PROJECT RATIONALE ......... .. ............. ... . 19 A. The Bank Group Strategy for Assistance . . . . . . . . . . . . . . 19 B. Rationale for Bank Involvement ..... . . . . . . . . . . . . . 20 V. THE PROJECT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 A. Objectives and Scope of the Proposed Project . . . . . . . . . . . 22 B. Financing Component ........... .... .... .... . 23 C. Technical Assistance Component ...... . .. . .. . .. . . . 25 D. Project Cost and Financing Plan . . . . . . . . . . . . . . . . . . 26 E. Environmental Impact . . . . . . . . . . . . . . . . . . . . . . . 27 This document has a resticted distnbution and may be- usd by redpiens ondy Inthe pebmnsY of tber offidcaldutes.Itscontentsmaynototherwisebedisclosedwitd WoddBankaMtoraiat VI. PROJECT IMPLEMENTATION AND ONLENDING ARRANGEMENTS . . . . . . . . . . . . 27 A. Loan Terms and Conditions ... . . . . . . . . . . . . . . . . . . 27 B. Lending Arrangements .... . . . . . . . . . . . . . . . . . . . 29 C. Loan Administration . . . . . . . . . . . . . . . . . . . . . . . . 33 VII. BENEFITS AND RISKS . . . . . . . . . . . . . . . . . . . . . . . . . . . 35 A. Benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35 B. Risks .36 VIII. AGREEMENTS REACHED AND RECOMMENDATIONS .37 List of Tables Table 3.1 Non-Government Credit Volume in Real Terms . . . . . . . . . . . 17 Table 4.1 Policy-Related Measures and Objectives Accomplished During Project Preparation . . . . . . . . . . . . . . . . . . . . . . . 21 Table 5.1 Technical Assistance for Privatization and Restructuring . . . . . 25 Table 5.2 Estimated Total Project Cost .... . . . . . . . . . . . . . . . 26 Table 5.3 Proposed Financing Plan . . . . . . . . . . . . . . . . . . . . . . 26 Table 6.1 Participating Financial Institutiorns with Romanian Capital . . . . 31 Table 6.2 Conditions of Effectiveness . . . . . . . . . . . . . . . . . . . . 32 List of Annexes Annex 1 Technical Assistance Component Specification . . . . . . . . . . . 38 Annex 2 The Banking Sector . . . . . . . . . . . . . . . . . . . . . . . . 42 Annex 3 Participating Banks ..51 Annex 4 Foreign Trade and Export Credit Demand . . . . . . . . . . . . . . 66 Annex 5 Criteria and Procedure for PFI Qualification and Accreditation ..71 Annex 6 Foreign Exchange Market and Foreign Exchange Credit Market . . . . 77 Annex 7 Estimated Disbursement Schedule of the Proposed Loan . . . . . . . 83 Annex 8 Supervision Plan ..84 Annex 9 List of Documents in Project File . . . . . . . . . . . . . . . . . 87 This report was prepared by Ms. S. Brajovic-Bratanovic (EClCO), Mr. P. Van der Veen (IENIM), and Mr. A Goldschmidt (Consultant). Peer review was conducted by Messrs. M. Hinds (EMTDR), J. Nellis (PSD) and Ms. I. Zurayk (EC2CO). The following individuals have also contributed to project preparation: R. Heath, R. Chalk, H. Bhattacharya, E. Mangan (IENIM); S. Sattar (MNEPH), R. Roberts, L. Ponzio, C. Calcopietro (Consultants). ROMAN-IA INDUSTRIAL DEVELOPMENT PROJECT LOAN AND PROJECT SUMMARY Borrower: Romania Loan Amount: US$175 million Beneficiaries: Private enterprises and exporters, Ministry of Industry (MOI), National Bank of Romania (NBR), participating financial intermediaries. Loan Terms: Single currency loan (SCL) in US dollars for twenty years, including five years grace period, at Bank's standard variable rate for SCLs denominated in US dollars. Onlending Terms: The Government will onlend funds to the participating financial intermediaries (PFI) in US dollars at the prevailing six-months LIBOR plus a margin of 30 basis points to be charged by the Ministry of Finance (MOF). The PFI subsidiary loans will be extended on a first-come first-served basis, back-to-back to PFI subloans to final beneficiaries and vith the same maturities. The PFIs subloans to the beneficiaries will be denominated in US dollars at LIBOR plus the MOF margin and a market-based PFI spread. The subloans for investment finance will be provided at variable market-based interest rates with 3-17 year maturities and 1-5 years grace; the subloans for export finance will be provided at fixed market- based interest rates and up to one year maturities. For both credit components, the final sub-borrowers will bear the exchange risk. The PFIs will bear the full credit risk of their subloans. Proiect Descrigtion: The Project will finance (a) investment of private enterprises to improve international competitive- ness and/or expand exports; (b) exDorts by providing partial to full coverage of exporters' pre-shipment finance needs for imported inputs; and (c) technical assistance to help in designing and implementing policies and strategies for privatization and restructuring, and for strengthening institutional capacity of the individual PFIs. - ii - Benefits and Risks: The expected benefits include: (a) improved conditions for effective supply response; (b) increased export potential, efficiency and profitability of private industrial enterprises; (c) improved capacity of the financial sector to provide export and restructuring related finance; (d) increased competition and integration of Romanian financial markets; and (e) further advance in building policy and institutional framework to speed up ownership transformation and restructuring and to stimulate the private sector growth. The mechanisms developed and the technical assistance put in place should yield significant demonstration effects. Institutional weaknesses and skill deficiencies of banks, enterprise managements and government agencies is the main risk. It is addressed through TA covering all aspects where skill deficiencies may jeopardize successful implementation, and through increased Project supervision. There is also a risk concerning PFI intermediation capacity -- macroeconomic volatility and uncertain prospects may adversely affect the PFIs' willingness to engage in invc-tment lending or decrease their risk exposure capacity. This is addressed through the proposed Project conditionalities, by increasing the capacity of banks to take and sustain risk through mandatory loan classification and provisioning and by increasing the level of general loan loss reserves; through TA to improve the PFI's capacity to assess and manage risk; by keeping open access to eligible PFIs; and by maintaining flexibility in the allocation of funds to the export and investment finance components. The PFI credit risk and the foreign exchange risk of final beneficiaries have also been decreased by extending a single currency loan. The macroeconomic instability is a major risk, which is addressed by the SAL and through ongoing policy dialogue with the IMF and the Bank. In addition, the Bank will review project implementation one year after loan effectiveness with an option not to extend further commitments in case of adverse developments. Estimated Cost: (US$ Million) Local Foreign Total Investment Credit 55.0 102.0 157.0 Export Credit 104.0 70.0 174.0 Technical Assistance 0.0 3.0 3.0 TOTAL 159.0 175.0 334.0 - iii - Financinf Plan: (US$ Million) local Foreien Total IBRD 0.0 175.0 175.0 Sub-borrowers 40.0 0.0 40.0 Financial Intermediaries 119.0 0.O 119.0 TOTAL 159.0 175.0 334.0 Estimated Disbursement: (US$ Million) 95 FY97 FY98 Annual 53.0 61.0 35.0 21.0 5.0 Cumulative 53.0 114.0 149.0 170.0 175.0 ROMANIA INDUSTRIAL DEVELOPMENT PROJECT I. INTRODUCTION A. Background 1.01 In the period since the 1989 revolution, the Government of Romania has formulated and started implementation of far-reaching reform programs to stabilize the macroeconomic situation and to move towards an efficient market economy. A new legal and institutional framework has been established, and the policy framework has been substantially liberalized. Commercialization and corporatization of the state enterprise sector has been completed, and enterprise management has been freed from direct government intervention in production and investment decisions. Recognizing the difficulty of achieving an adequate supply response and efficiency gains in enterprises owned and operated by the public sector, the Government plans to divest 6,300 state-owned enterprises. Thirty percent of the state's equity in commercial enterprises has already been divested through allocation to five Private Ownership Fund^ and mass distribution of their shares. By end-1993, about 490 small and medium-size companies have been privatized and another 500 are in active preparation. A program is being developed to provide a variety of options for the full privatization of a large number of enterprises, while at the same time motivating and assisting the remaining viable enterprises to adjust effectively to the new market-oriented environment during the transition to eventual privatization. 1.02 The ownership reform of the state sector is supplemented by a broad program to support growth of indigenous private sector enterprises. About 546,000 new private firms were registered by end-1993, of which about 30 percent were in manufacturing and trade, and about 78 percent have already opened for business. About 29,000 joint ventures have been formed by end-1993, of which about 100 involve large state enterprises. In the 1991-1993 period, the private sector has productively absorbed over one million employees and its participation in GDP has grown from less than one percent in 1989 to about ten percent in 1991 and an estimated 30 percent in 1993. 1.03 There are, however, some areas where progress has been rather slow. The enterprises' response to systemic and policy changes has been largely reactive, such as stopping production and laying off labor; actual restructuring has barely started. The volume of foreign investments has been low, often because of expected difficulties to obtain finance for post-privatization restructuring. The growth of private firms has also been inhibited by crowding out from access to capital, raw materials, and infrastructure. Both the Covernment and most enterprise managers, however, have come to realize the need for an energetic proactive approach to restructuring and/or privatizing their enterprises and to attracting foreign partners. 1.04 The proposed Industrial Development Project will assist the Government to speed up the process of transition by creating conditions for faster and more efficient supply response and by supporting the establishment of enabling policies and institutions. While the restructuring needs of Romanian enterprises, especially in industry, are considerably greater than what can be - 2 - addressed through a single operation, it is anticipated that the proposed Project will have a broad impact on the overall transition process through: (a) promoting development of the private sector enterprises by providing financial support to private enterprise restructuring and investment programs and to exploiting the export potential of Romanian industry; (b) assistance in the desigr. of the institutional and policy framework for privatization and restructuring, and in creating an enabling environment to increase private sector share of the economy; and (c) supporting the banking sector reform by improving prudential regulations and bank supervision, strengthening individual banks and encouraging restructuring and privatization of state-owned banks. By generating growth and employment in the private sector, the proposed Project would facilitate reforms in the state sector by mitigating the cost of those reforms. 1.05 To support the proposed Project, the Government is requesting a Bank loan of US$175 million. The proposed Loan would include: (a) a financing component of US$172.0 million, including US$102 million for restructuring investments in private industrial enterprises and US$70.0 million for export financing to help realize Romania's export potential; and (b) a technical assistance comRonent of US$3.0 million to support institution building and training of staff in key government agencies and in the banking sector. II. INDUSTRIAL RESTRUCTURING AND PRIVATIZATION PROGRAM A. The Industrial Sector (a) Industrial Structure 2.01 By standards of most market economies, Romania has a la.ge industrial sector, which in 1989 accounted for 58 percent of net material product and 38 percent cf total employment. In the traditional pattern of socialist industrialization, Romania has promoted producer goods industries. In 1989, these accounted for 56 percent of the total industrial output, while the share of consumer goods subsectors (i.e., textiles, garments, food processing, electronics and consumer durables) declined during the 1980s to only 24.5 percent of the output. 2.02 Among the producer goods industries, machine building had a dominant position, accounting for about 28 percent of gross output in 1989 and about 36 percent of the net material product by industry. This specialization was strongly influenced by Romania's position in the CMEA markets. The second largest subsector was chemicals, including oil refining and petrochemicals. It accounted for about 21 percent of the total industrial output in 1989. This subsector oiiginally derived its importance from the domestic endowment in oil and natural gas resources. These resources have been badly depleted by the 1980s, however, and must now be supplemented by oil and natural gas imports. Metallurgy, the third largest subsector, kept its share at about 9.8 percent of industrial output throughout the 1980s. 2.03 High energy intensity and obsolete and worn-out capital stock are common characteristics of Romanian manufacturing technology. Priority given to new investments rather than modernization of the existing capital stock during the 1980s, combined witk the decline in equipment imports from OECD countries and the stagnation of imports from the CMEA, resulted in the growing obsolescence of Romanian industry. Whi? obscure depreciation rules make realistic estimates rather difficult, it appears that by 1990 about half of the fixed capital of Romanian industry had already been fully depreciated. The particular situation varies by sector. (b) Economic Environment and Impact of Recent Policy Reforms 2.04 At the start of the reform in 1990, large sections of Romanian industry were inefficient at international market prices. Historically, the inefficiencies persisted due to the price distortions in e. ptive domestic markets, an indiscriminate flow of funds from the Government, a certain degree of cross-subsidization between domestic and international markets and an orientation toward CMEA markets. The industrial performance in the past has been also constrained by the lack of micro level incentives fcr improving enterprise performance and the constrained mobility of resources. 2.05 The regulatory, institutional and business environment of the enterprise sector has significantly changed since the reform started. The policy reform started in 1991. Measures aiming toward correcting relative prices, imposing hard-budget constraints, limiting access to credit and increasing competition, have put the enterprise sector under enormous stress. With higher prices of inputs and limited scope for increasing output, due to the drastically falling demand in domestic and in the CMEA markets and increasing international competition, many enterprises have faced sharp declines in their sales. Industrial output fell by about 18 percent in 1990 and 20 percent in 1991 (a two- year drop of about 36 percent); in 1992, industrial production was about 22 percent lower than in 1991 (or about 52 percent of its 1989 level). The output decline leveled off in 1993; the total industrial production volume registered an increase of about one percent. There were, however, marked adjustments in the output of specific subsectors. For example, food and beverages, wood, pulp and paper, and textiles sector produced 10-15 percent less than in the same period in 1992; various branches of chemical industry (e.g., artificial fibers, plastic, rubber) increased output 2-5 percent, as have varioui branches of machine building; electrical machines and metallurgy increased output by 8 percent; most successful were the furniture, consumer electronics, and road transport vehicles branch, with 20-29 percent output increases. 2.06 The foreign trade performance was negatively affected by the decline of CMEA markets and by the confusion accompanying systemic collapse. In addition, in 1991 and 1992, Romania lost two prominent trading partners (Iraq and Yugoslavia) due to the UN embargo. In 1990, the convertible currency exports fell to about 56 percent of their 1989 level, and declined by another 4 percent in 1991. In 1992, the export decline was successfully arrested mostly due to the significantly improved policy environment, including trade liberalization, open entry policies, rationalization and lowering of tariffs, improved management of the foreign exchange regime and leave the full retention policy. The convertible - 4 - currency exports grew by about 22 percent compared to their 1991 volume and remained at about the same level in 1993. The industrial sector still accounts for the bulk of exports, with a share of about 85 percent in 1993, a decrease from about 95 percent in 1989. More detailed analysis of export performance is provided in Annex 4. The participation of the private sector in export activities has substantially increased; in 1993, the private sector accounted for about 27 percent of total exports. 2.07 The restructuring programs in Romania have been left almost entirely to the initiative of enterprise management. The most prominent element of the enterprise adjustment so far has been labor retrenchment. This has been more pronounced in labor-intensive sectors, where the cost of labor represents a higher percentage of the variable cost of production and the skill level is lower. In capital-intensive industries, the labor retrenchment is smaller, since the loss of skilled labor could become an unsurmountable problem if the enterprises' prospects improved. In the aggregate, in 1991, the retrenchment of labor led to an 11 percent decline in the total industrial employment as compared to 1989. The trend continued in 1992, with the total industrial employment falling to about 76 percent of its 1989 level. The manufacturing sector witnessed the most significant employment decline; in 1992, the employment stood at about 85 percent of its 1991 level and 77 percent of its 1990 level. Nonetheless, the slow pace of retrenchment relative to output contraction in industry gcnerated an 11 percent reduction in the average labor productivity in 1991, and further 17 percent decline in 1992. In 1993, however, this trend reversed, showing an increase in labor productivity of about 7 percent. B. EnterRrise Reform 2.08 About 6,300 enterprises in public ownership dominate the Romanian corporate sector. In 1989, they accounted for about 92 percent of the total economic establishments; the industrial sector comprised 2,102 public enterprises. By the end of 1990, essential elements of the new regulatory framework were in place to start the enterprise reform: Law No. 54, on Free Initiative and Small Business Establishment, legalized small-scale private initiative; Law No. 96 on Foreign Capital Investments opened Romania to foreign investors; and Law No. 31 on Corporations provided a regulatory framework for the establishment and management of commercial companies. Law 31 established a two- tier governance structure comprised of an Administration Council, elected by the general shareholders meeting to exercise ownership interest in a commercial company, and a Management Board, appointed by the Administration Council for operational management of a company. For companies in state ownership, the role of a general shareholders meeting is played by the Council of State Representatives. 2.09 Law No.15 on Restructuring of State Economic Unit has initiated a full-scale commercialization and corporatization of the Romanian state-owned enterprises, except for a number of designated strategic sectors (e.g., military, power, mining, oil and gas exploration and exploitation, telecommunications). Enterprises have been converted into state-owned autonomous companies (RA, regie autonomes) and commercial companies (CC, joint-stock limited liability). Allowing for full managerial autonomy, the Government's objectives were to impose . 5 - hard budget constraints and managerial accountability on both categories and to privatize the commercial companies. The National Agency for Privatization has been established to lead the conversion and the subsequent privatization process. 2.10 By mid-1991, the commercialization of the corporate sector was completed. Of the total number of about 6,700 companies, about 600 regie autonomes1 and about 6,300 commercial companies were established. Of about 2,140 enterprises under the manufacturing arm of the MOI, about 20 were classified as RAs and the rest are now operating as commercial companies. Through the conversion of enterprises into CCs, property rights were intended to be concentrated in a corporate board (i.e., the Administration Council) appointed by the owners: initially the parent ministries, then the State and tne Private Ownership Funds and eventually the new private shareholders. The introduction of the corporate governance framework, under Law No. 31, was accomplished rather quickly, but decision-making continued to be hampered by unclear ownership rights and responsibilities. 2.11 A numbsr of ownership and management issues critical for implementation were addressed during Project preparation, as otherwise they could have slowed privatization, negatively affected access to Bank credit lines, and complicated decisions related to enterprise borrowing and subproject implementation. Specifically, the Government has: (a) streamlined the structure and clarified the responsibilities of the Council of State Representatives, which acts as a general shareholders meeting for CCs in state ownership, and of the Administration Council, with an objective to enhance the decision-making process concerning enterprise privatization and restructuring;2 and (b) introduced management contracts for enterprises in (majority) state ownership aiming to clearly establish managerial accountability and performance-based management incentives.3 C. Privatizationl 2.12 The Government considers privatization to be the most effective way to improve enterprise efficiency by providing better incentives to capital, management and labor. The privatization policy has been gradually developed through extensive discussions with the Bank and through consulting assistance provided by the EC-PHARE. The Privatization Law was promulgated in mid-1991 with the principal objective of transferring all Romanian CCs to private hands within seven years. Besides speed, the other major concerns of the Government have been the transparency and fairness of the process, and the amelioration of its social costs. I/ Subsequent review mandated by the SAL reduced this number to about 430 at end-1993. 2/ Respective amendments to Law 31 were a condition for negotiations. 0/ Submission of Law on Management contracts to the Parliament was a condition for Board presentation. *6- (a) Privatization Program 2.13 The privatization program concerns about 6,300 enterprises with about 4 million employees. It stipulates the distribution of 30 percent of state patrimony to Romanian citizens in the form of Certificates of Ownership (CO) in five Private Ownership Funds (POF). Each citizen holds COs of all five funds, and the COs may be exchanged for shares of commercial companies in the process of privatization. The POFs, with portfolios of about equal values, hold 30 percent of the shares of virtually all Romanian CCs and are expected to manage their portfolios so as to advance the privatization process, and to raise the value of the outstanding COs. The 70 percent balance of the CCs shares have been allocated to the State Ownership Fund (SOF). The SOF mandate is to sell its portfolio of shares or liquidate enterprises or their components in annual programs, each comprising at least 10 percent of the initial SOF portfolio, until the CCs are completely privatized (in maximum seven years). 2.14 In addition, the Privatizarion Law has initiated early privatization of about 30 medium to large enterprises and a process of small asset sales. For the early enterprise privatization, the objective of the program has been to gain hands-on experience in various modes of privatization, including private placements, public floating of shares and employee or management buy-outs. For the sale of assets, where the enterprises themselves decide to offer an asset for sale and enjoy the sale proceeds, the objectives have been to: provide an immediate means to start restructuring enterprise balance sheets; allow more efficient use of assets by the private sector; and gain experience in competitive bidding processes. (b) Institutional Framework 2.15 The institutional framework for large-scale privatization in Romania assigns the major roles to the SOF and the five POFs. These institutions are placed under the auspices of the Perliament. The SOF by-laws were enacted in June 1992.4 They define the SOF as the public agency responsible for privatization, for restructuring including liquidations, and for providing corporate guidance to all Romanian companies. The SOF is expected to divest its ownership share of enterprises within a period of seven years; its first privatization program was presented to the Parliament in January 1993.5 Since its establishment in October 1992, the SOF has focused on attaining institutional capacity to privatize small and medium-size companies; its capacity to address restructuring and liquidation will be addressed only in 1994. Given the multitude of responsibilities and the size of its portfolio, the SOF must continue to devote a massive effort to building its capacity, and its institutional culture and skills. Success of this effort will be one of the critical factors in the transition. 4/ Finalization of the SOF by-laws, establishment of its Board and initial sw.affing were conditions for appraisal of the proposed Project. If Formulation of 1993 Privatization Program, its submission to the Parliament and subsequent approval was a condition of project effectiveness. - 7 - 2.16 The POF by-laws were adopted by the Parliament in July 1992. The POFs are defined as comr.mercial companies, which are a hybrid between a holding company and a mutual fund. They have a number of objectives: to improve the value of their portfolios and of underlying COs; to provide for orderly exchange of COs for CCs shares; and to speed up the privatization process by sharing with the SOF the responsibility for privatization. The POFs' headquarters are placed in five different towns to bring direct exposure to experiences of market economy to local environments. Since the POFs are smaller and more dynamic agents than the SOF, the portfolio allocation and the resulting portfolio management policies will substantially influence the speed and success of privatization and the course of restructuring in Romania. The proposed Project assisted in finalizing the design of the POFs.6 2.17 The next step in the privatization program is the development of methodologies, procedures and programs for large-scale privatization, including detailed quantitative targets and implementation plans for the various privatization schemes. The manner by which the state exercises its ownership rights is of utmost importance for privatization, as well as in critical cases of enterprises being restructured. Therefore, the formulation of a comprehensive package of instruments to exercise ownership rights and provide corporate guidance to CCs is also on the agenda. Constraints which may inhibit the pace of implementation would also have to be addressed, such as the occasional conflicting roles of the various agencies involved in the process; the inadequacy of the financial sector; and the lack of managerial and/or institutional capacity in many CCs to turn them around and make them profitable and attractive to private investors. (c) Privatization to Date 2.18 Considerable privatization has already taken place in Romania. The principal path to private ownership, in terms of private capital commitment, has been through joint ventures with a foreign partner. Since the enactment of the Law on Foreign Investments in 1990, over 29,000 joint ventures, with committed capital of about US$760 million, have been formed. Similar to experiences elsewhere in Eastern Europe, foreign investments have initially involved a large number of ventures with small capital commitments; in 1992, the investors' philosophy changed, and new joint ventures involved larger companies (about 103 joint ventures so far) and higher capital commitments. Another major path to privatization has been through leasing assets to a private company or through management contracts (an estimated 50,000 contracts). Both mentioned routes to privatization have largely been initiated and managed by the enterprises themselves. Finally, there has been a spectacular growth of indigenous private sector enterprises (further elaborated in Section E). 2.19 The early grivatization program was completed in early 1993. About 2,900 assets, mostly shops, warehouses, smaller production facilities and, to a lesser extent, underutilized production equipment, have been sold from the li Finalization of POF by-laws, POP portfolio allocations and registration of POTs, and establishment of their Boards were a condition for appraisal of the proposed Project. - 8 - initial list of about 7,800 assets. About 22 small and medium companies have been privatized. Shares of two of these companies were successfully floated on the market by the domestic banks; employee and management buyouts have been used in about 18 cases; and about five cases involved private placements with foreign investors. 2.20 The enactment of the small enterprises privatization methodology (para. 2.22), a fast-track standard procedure, has substantially advanced privatization of small companies. By March 1994, about 400 had been sold mostly through management and employee buyouts. The SOF, with the responsibility to prepare enterprise evaluation and lead negotiations, estimates that it would take another two years to privatize all enterprises in the "small" category, the major obstacle being the lack of institutional capacity to prepare evaluations and negotiate deals. The SOF is currently able to privatize about 60-80 enterprises per month. Of the medium size companies, about 100 have been targeted for privatization, and 39 have been privatized; of the large companies, three have been privatized. (d) Measures to Speed-up Privatization 2.21 In order to meet the ambitious privatization targets, specific measures are needed to speed up the process by proceeding on parallel tracks and by employing new innovative approaches, including mass privatization. The recently elaborated privatization program for 1994 recognizes this need and, as detailed below, the Government is committed to taking steps to introduce other measures to speed up the privatization process. 2.22 The aggregate CC portfolio has been classified in three categories, according to the size of the CCs. Privatization is now proceeding on parallel tracks; for each category, specific measures have been or will be introduced to speed up privatization. Small companies are to be privatized through a simple competitive bidding procedure, similar to the one used for the sale of assets. It is managed by a committee, including SOF/POF and NAP representatives.7 Of the total of about 6,300 CCs to be privatized by the SOF, about 3,100 have been classified in the "small" category. Likely investors targeted for this group of CCs include enterprise managers and employees; private entrepreneurs whose companies have successfully grown or who are integrating backwards from the trade business; and small foreign investors. 2.23 For the medium-size companies, a group of about 2,500 CCs, the responsibility to manage privatization is assigned to the POFs. The POF portfolio distribution allows POPs to specialize by industrial sectors or by geographical regions. In mid-1993, to encourage the privatization of the medium- size CCs, the SOF issued instructions empowering management of CCs in a financially viable condition and operating in competitive markets (i.e., there are more than three domestic producers) to seek private investors (targeting foreign companies). The SOF also issued methodological norms for the preparation 7/ The procedure was enacted in January 1993, originally being a condition for effectiveness of the proposed Project, and is in implementation since May 1993. of the privatization prospectus. Once an investor has been found, the management is asked to contact the SOF and to formally initiate the privatization process. To accelerate the privatization of medium-size CCs, a number of new innovative mass privatization schemes are being designed and will be introduced through selected pilot exercises, evaluated and then fully implemented on a large scale. 2.24 These include: a) Rrivatization funds, in the form of privately- managed investment companies which would bid for a majority of shares of CCs of their choice. A number of investment companies is currently under preparation and one (Capital SA) has already been established. The founders of investment companies are typically Romanian banks (e.g., Tiriac and RBFT in the case of Capital SA) or other non-bank financial institutions, and one or more foreign financial institutions (e.g., EBRD and Wasserstein Perella in the case of Capital SA); b) privatization through the use of success-fee-based privatization management contracts. The SOF plans to retain reputable foreign consultants to find foreign investors for a batch of companies in a sector and would reimburse consultants with a percentage of the sales price once the privatization deal is completed. The sector-based privatization will be initiated for textiles, garments, detergents, wood-based industries, and a number of other sectors; c) real estate investment funds are being discussed; and d) an additional mass privatization scheme or an improvement of the existing scheme allowing COs to be used to purchase the SOF shares is being actively considered. 2.25 The large companies, including about 700 CCs, are to be privatized on a case-by-case basis. The SOF will take the responsibility of preparing the company, in terms of downsizing and shaping up the operations, and actively seeking foreign investors. For certain very large companies, typically in capital-intensive sectors, foreign investors are few and can easily be identified from a small number of international conglomerates. The privatization of such sectors (e.g., steel, non-ferrous metallurgy, fertilizers, refineries, cement) would be approached on a sectoral basis and through specific sector restructuring and privatization strategies. D. Restructuring (a) Government's Industrial Strategy 2.26 The Government's approach to industrial restructuring distinguishes between two types of enterprises and subsectors: a) enterprises in capital- intensive sectors, where the restructuring should be introduced in the context of sector rationalization strategy and where the size of enterprises and their importance in local and national economy justify a more direct government involvement; b) enterprises in sectors which already operate in commercial market conditions and where the restructuring could be left to market forces and to enterprise management initiative. The first type of government-engineered restructuring notably includes sectors with the largest number of lossmakers (i.e., metallurgy, chemicals and machine building) and subsectors characterized by gross overcapacity comprising a number of production units with virtually identical technology and undifferentiated products (such as fertilizers and refineries). - 10 - 2.27 The short-term program specifically targets large lossmakers that need urgent intervention and support to cut the operating losses that will eventually be either liquidated, merged with others, or downsized to the point where resulting units may become viable. In almost all cases, it involves enterprises where liquidation or restructuring will have significant socio- political implications. About 100 large enterprises, mostly from metallurgy, chemicals and machine building sectors, have already been identified, including some of the 30 enterprises with the largest interenterprise arrears followed by the SAL, enterprises with the largest arrears with the banking system and with the largest overdue tax liabilities. In June 1993, the Government started implementation of an emergency program by selecting 30 enterprises in critical financial condition, isolating them from other economic agents and placing them under surveillance of a restructuring committee. 2.28 The medium-term adjustment program, beyond 1996, has a "constructive restructuring" dimension. It is intended for industrial branches and individual enterprises that are considered viable and with growth potential, even if they are not presently profitable. The targeted industrial subsectors include: light machine building, food industry, small-tonnage chemical industry, and traditional export-oriented light industries. In order to support the restructuring process, the Government plans to finance investment projects, guarantee commercial credits, reschedule debts, bring in private financing together with state funding, and provide moderate protection for the subsectors deemed to be in the national interest. 2.29 Both the short- and the medium-term industrial adjustment program give high priority to the closure of economically non-viable enterprises. However, the method of selecting such enterprises is still unclear and their access to finance seems to leave too much room for discretion. It is crucial that large state-financed restructuring be confined to a few vital RAs and to a limited number of CCs that are expected to remain in state ownership in the near future and that cannot be closed down, and to demonopolization that needs to be implemented prior to privatization. 2.30 The Government's exact role and the rationale for its involvement in the industrial restructuring process has still not been well defined. According to the Privatization Law, the SOF, being the majority shareholder of CCs, is responsible for their restructuring, while the responsibility for restructuring of RAs remains with branch ministries. The branch ministries are also responsible for industrial sector strategies. The MOI has launched extensive sector studies covering 85 subsectors, of which 52 have been completed. On the basis of these studies, the MOI plans to devise a comprehensive industrial policy, including restructuring and privatization, that will be forwarded to the SOF to serve as a guideline for enterprise restructuring strategies. The Government is currently refocusing the responsibilities of the MOI, including support to establishment of an enabling environment for the private sector. The proposed Project would support this effort in a number of ways: (a) by helping the MOI to define its new role and how it would be exercised; (b) by assisting the MOI to develop sector restructuring strategies; and (c) by providing technical assistance to the MOI to develop the necessary institutional capacity (Annex 1). - 11 - 2.31 In view, however, of the heavy competing demands on fiscal and external resources, the Government's direct role in enterprise restructuring can only be modest. It should be restricted to helping with labor retrenchment, and disposal of all peripheral activities and assets. Most restructuring is best left to new private owners. The provision of money for new investment can only be highly exceptional, and even then can most prudently be organized between the banks and their clients in enterprise workouts. To facilitate this restructuring, the Government should clearly signal to the enterprises that they must focus on reducing costs and that they should plan the rationalization of their activities without expecting state financial assistance. 2.32 Parallel to the Government-managed programs, there will be a restructuring process initiated and managed by enterprises themselves, which will be financed by enterprises' own funds and by the banking sector. This will include viable enterprises, which already operate in competitive markets, and enterprises subject to post-privatization restructuring. Restructuring of the latter will be supported by the investment component of the proposed Project. (b) Institutional Framework and Recent Developments 2.33 According to Law 58, the SOF bears the responsibility for corporate governance and restructuring of CCs. Since its establishment, the SOF has been primarily concerned with building institutional capacity for privatization and with privatizing small companies. To get ahead with the restructuring of the 30 isolated enterprises, the Government has created a provisional Rescructuring Committee (RC). International experts were retained, with Bank's help, to assess financial recovery programs prepared by managements of isolated companies and to recommend a course of action. In December 1993, the Restructuring Committee proposed and the Government endorsed an action plan to downsize 21, to liquidate six, and to privatize three enterprises. 2.34 The first isolation exercise having proved to be a promising approach in addressing the issue of enterprise restructuring and of enforcing financial discipline, the Government is planning to extend it to a second and larger group of troubled enterprises, including some RAs. In January 1994, the Government established another list of 30 enterprises (5 RAs and 25 CCs) which, on aggregate, represent 50 percent of the losses and 45 percent of the inter- enterprise arrears of the state-enterprise sector. In order to eventually return to profitability and to settle their arrears, these enterprises must undergo a drastic exercise in loss-reduction and downsizing. Some debt-relief measures and recapitalization may be inescapable. Eventually, some of them will be either liquidated, merged with others, spun off as separate units, or privatized. In almost all these cases, the restructuring will have significant socio-political implications. 2.35 A more permanent institutional arrangement has also been implemented in 1994. An independent SOF subsidiary, called the Directorate for Selective Restructuring, with a separate balance sheet, has been created to manage restructuring, including liquidation of large loss-making enterprises. It took over the implementation of the RC decisions and would eventually consider all 80 to 120 firms deemed critical to the stabilization process. The RC has been - 12 - dismantled, but the Government has institutionalized its functions in the form of a department called the Restructuring Agency, under the Council for Coordination, Strategy and Economic Reform. The most important immediate challenges are: a) to efficiently implement restructuring decisions regarding the first 30 problem enterprises; b) to clearly define rules that would help select the next group of enterprises that should be put in isolation; and c) to ensure that the new SOF subsidiary does not create an open-ended subsidy system with little or no incentive. to effectively force either exit or privatization. A strong signal must continuously be sent to loss-making and other enterprises that they must adjust or face liquidation. 2.36 Industrial Technology Infrastructure. Over the long run, the Government intends to develop a comprehensive industrial technology infrastructure to help enterprise managements to improve their business and technical practices. A study, financed by the proposed Project (Annex 1), would review the existing 140 institutes, which were a basis of the industrial technology infrastructure ir the old regime, aiming to conceptualize and develop a practical implementation program for a new market and service-oriented framework. Consideration would be given to streamlining and strengthening part of the existing structures, including changing the ownership of the institutes to transform them into private, specialized, services-oriented facilities. E. Private Sector Development (a) Small Scale Private Sector (SME) 2.37 A large number of private sector enterprises have been established since the revolution. By end-1993, about 546,000 firms were registered, of which 29 percent as family establishments under Law No. 54, and the rest as partnerships and joint-stock companies under Law No. 31. About 78 percent of these companies have opened for business. A breakdown of registered SMEs by area of economic activity indicates that about 30 percent are active in manufacturing and trade and the rest in the agriculture and services sector. There is relatively equal participation by family associations and commercial companies in manufacturing and trade; in the services sector, commercial companies dominate strongly, accounting for over 76 percent of SMEs. 2.38 Romania looks to the emerging private sector to provide a major impetus for economic expansion, employment, innovation and growth during the transition. Indigenous small and medium enterprises would likely be the only agents capable of absorbing the excess labor certain to be cast off from restructured or liquidated state enterprises. Despite the lack of proper institutional framework, difficulties with access to finance and "red-tape" in many other areas, the SME growth has been remarkable. In the 1991-1993 period, the SME sector (excluding agriculture) productively absorbed over one million people. By 1993, over 5,000 of these new private companies employed between 21 and 50 employees, and about 800 had more than 50 employees. Their output grew from less than one percent of GDP in 1989 to about ten percent in 1991, and an estimated 30 percent in 1993. The markets for larger production-oriented SMEs are mostly domestic; only about nine percent of their output is exported. They mostly operate in the final goods markets. - 13 - 2.39 As part of an effort to develop a viable and coherent PSD strategy, the Department for Private Small and Medium Enterprises of the National Agency for Privatization (DPSME/NAP) conducted a national survey on the impact of the social and economic environment on private sector development in Romania. The sample was composed of 1,500 small and medium enterprises. In a separate effort funded by the EC-PHARE, a consultant surveyed 200 newly-established SMEs. The survey findings raise concerns, as they indicate that the current environment does not allow the SME sector to utilize its full potential. The Government is aware of these problems and intends to create a more favorable environment and a supportive institutional framework for SME development, including actions to: (a) create a supportive institutional framework, including government agencies and non-governmental entities run by entrepreneurs, operating at the national and the regional levels; (b) improve coordination, eliminate overlaps, improve targeting and reLevance of programs and activities for SME support and increase the quality of SME-related services; (c) provide SME-related services, including direct advice and training of entrepreneurs on legal provisions, accounting and bookkeeping, financial management, loan applications and other banking matters, marketing, business planning, production management, financial planning, etc; (d) improve SME access to financing; and (e) address the most urgent problems related to SME operations and to remove red tape. 2.40 Progress has alread, been made on some of the programs agreed on in the course of the proposed Project preparation. At the regional level, the Government is playing a catalytic role to encourage formation of various associations of entrepreneurs. A study concerning options to provide the SME credit guarantees has been completed, and an SME Credit Guarantee Fund has been established.8 The SME Credit Guarantee Fund is owned by the Government, by the banks which intend to use its services and by a number of private investors, and will be operated on a commercial basis. From the twelve-point action program, the barriers to private sector access to the social safety net and other social services have been removed; a program for promotion of entrepreneurship through mass media has been finalized and its implementation started; two pilot incubation centers have been established; and agreements with a number of universities were signed allowing entrepreneurs access to their facilities and training. 8/ This was a condition for negotiations of the proposed Project. - 14 - III. FINANCIAL SECTOR A. Curgent Structure of the Financial Sector 3.01 Until December 1989, the Romanian financial system operated under the central planning mechanism. Financial flows were controlled administratively, leaving little role for central or commercial banking functions. The National Bank of Romania (NBR) issued notes but had little responsibility for the money, credit, or interest rate policy. Savings were mobilized through the Savings Bank (CEC), which lent out a small portion of its resources in the form of housing loans and passed the remainder to the NBR. The Romanian Bank for Foreign Trade (RBFT), the Investment Bank (now the Romanian Bank for Development, RDB) and the Bank for Agriculture and Food Industry (now Bank Agricola, BA), respectively, were responsible for lending to the trade sector, the state enterprise sector and agriculture. All risks were absorbed by the Government. Consequently, the banks' capitalization was extremely low. Funds were mostly borrowed from the NBR and supplemented by deposits from clients in their respective sectors. The NBR also had quasi-commercial banking functions, taking deposits of state enterprises and making short-term loans, mostly for working capital. 3.02 Reform of the banking system has been initiated early in the process of transition to a market economy. Entry to the banking sector was liberalized as soon as the new Government took office. A two-tier banking system was established by late 1990, and formally legislated in April 1991 with the passage of the Law on Banking Activity and the Law Concerning the Status of the National Bank of Romania. The Banking Law endows commercial banks with universal banking powers, and the NBR is given a high degree of formal independence. 3.03 By the end of 1990 a number of private banks was established, including the Bank for Small Industry and Private Initiative (MIND), the Cooperative Credit Bank (CCB) and the Ion Tiriac Bank for Commerce (TCB). Limits of the types of customers and financial services that could be provided by foreign banks were lifted, and entry for new foreign or mixed ownership banks was liberalized. This group currently includes the Chemical Bank (CBF), the Societe Generale (SGF), the Frankfurt-Bucharest and the MISR Bank. There were also new entries by banks in state ownership, including the Romanian Commercial Bank (RCB), which was formed in late 1990 by carving out the commercial portfolio from the balance sheet of the NBR; and the Export-Import Bank of Romania (EXIM), which was established in 1991 to strengthen financial services to the foreign trade- oriented industrial and services sectors. By late 1991, the private bank, Dacia Felix (DFB, based in Cluj), the Banca Creditului Romanesc S.A. (Credit Bank) and the Bank Post, S.A. were created. The Romanian commercial banking sector now comprises six state-owned banks, six private banks (with Romanian capital and joint ventures) and the Bucharest branches of four foreign banks. Another seven private banks have passed registration and are preparing to open for business. More detailed analysis of the Romanian banking sector is provided in Annex 2. - 15 - B. Financial Sector Reform 3.04 Substantial strengthening of the financial sector is required for it to be able to support the process of transition, especially privatization and industrial restructuring. The banking system is characterized by high market concentration, weak funding base, rigid and unsophisticated structure of funding and lending instruments, and high nominal growth (Annex 2). Open access and the universal banking principle have yielded a multitude of new private banks and the emergence of competition. Bank capitalization has been substantially improved. At end-1991, the capitalization of the commercial banking sector was about 2 percent. By end-1992, the capitalization improved to about 8 percent and in 1993 only two banks were below the international capital adequacy standard. 3.05 The NBR is increasingly using indirect instruments to manage monetary and credit policies, and interest rates have been fully liberalized.9 It has enacted prudential regulations concerning new bank licensing; ownership of banks and qualification of its management; branching; credit risk exposure to a single client and affiliated groups; and currency risk exposure rules. The Supervision Department has been reorganized and strengthened and has already started on-site supervision. Donor TA and direct assistance by the NB of Holland has been and will continue to be readily available to the NBR. 3.06 The current business environment is still not fully conducive to the development of healthy financial intermediaries. The macroeconomic environment is volatile, and a level playing field for all economic agents has not been fully implemented. This creates problems in appraising and pricing credit, interest rate and currency risks. The current level of (tax deductible) general loan loss reserves mandated at 0.5 percent of banks' asset portfolio, taxes banks' capacity to sustain risk. Income is reported on accrual basis which inflates banks' profitability and profits are taxed on nominal rather than inflation-adjusted bases. Specific measures are urgently needed to increase banks' capacity to take and sustain risk, and to make sure that reported financial position reflects banks' business reality. This includes: (a) introduction of rules for risk- based capital adequacy; (b) rules on asset classification and provisioning; and (c) increase in (tax deductible) general loan loss reserves to a level commensurate to financial risk inherent in the current business environment.10 3.07 The proposed Project would also contribute to strengthening of the banking system by improving business practices for appraisal of projects and clients and by providing technical assistance to strengthen individual banks' appraisal capacities; by introducing new instruments and financial services related to export finance; and by stimulating competition and assisting the small private banks to penetrate corporate credit markets. Assistance would also be provided to the NBR to facilitate the implementation of prudential regulations, 9/ The interest rates liberalization is not fully effective in Romanian financial markets, especially in the deposit market. This is due to the inherited structural rigidities (see Annex 2). 10/ Conditions for loan effectiveness of the proposed Project. - 16 - to improve banks' capacities to manage their risks and asset/liability portfolios; and to improve banks' internal controls and audits (Annex 1). C. Financial Markets 3.08 Financial intermediation in Romania is performed almost exclusively by the banking system. Credit markets have traditionally been characterized by strong segmentation. This segmentation was both logical (e.g., different credit conditions and access rules) and institutional (i.e., access was provided only through assigned banks). Due to the market segmentation, economic agents have faced different conditions of access and different marginal pricing, depending on their identity, economic activity, ownership, size, etc. The new Banking Law (i.e., free entry and branching, universal banking) and the change of rules allowing economic agents to select their bank addressed some of the main issues of the credit markets in Romania. The investment credit markets are, however, still dominated by the two state-owned banks (RDB and BA), which hold about 80 percent shares in the respective markets for industry and agriculture lending, and by the RCB, which dominates the short-term end of the corporate credit markets. The RBFT and the new private banks are successfully challenging their dominance. Moreover, these new banks are also playing an extremely positive role in contributing to the integration of the traditionally segmented credit markets in Romania. 3.09 While interest rate deregulation measures and the abolishment of direct credit controls have provided more scope for the working of market forces in banking and finance, other measures are also needed aimed at: (a) unifying the market; (b) strengthening the competitive structure of the banking system; (c) improving the competitiveness of financial institutions; and (d) improving the capacity of the banks to analyze risk and to price loans accordingly. The proposed Project, by opening access to all qualified banks and providing technical assistance to strengthen their capacities, aims to address operational aspects of the noted issues. 3.10 Since the revolution, the total credit has substantially contracted in real terms (Table 3.1). At end-1993, the volume of credit in real terms was only about 34 percent of that in 1989. The maturity structure has also changed. While the long-term end of the credit market accounted for 28 percent of the total market in 1989, its share declined to about 8 percent in 1993 and the volume to about 10 percent of that in 1989. Another important structural change is a much larger number of market participants. On the supply side, the number of banks has roughly doubled, although the newcomers still accounted for about 12 percent of the total domestic credit market at end-1993. There was also a substantial increase on the demand side. Due to the enterprise commercialization and the new private sector entrants, the number of credit transactions has increased by more than ten times. 3.11 Investment Credit Market. Bank credit has traditionally had only a limited role in the industrial investment finance. In the state enterprise sector, about 55 to 60 percent of investment has been financed directly by the budget, another 25 to 30 percent by the retained earnings and depreciation funds, and only 9 to 12 percent by the banks. For investments in modernization, - 17 - rehabilitation or expansion, up to 80 percent has been financed from depreciation and retained earnings. Credit control has traditionally been maintained through credit ceilings determined by the type of credit and industrial activity. The financial sector reform has formally replaced this mechanism with discretionary contractual relations based on bank assessments of projects' viability and clients' creditworthiness. The industrial credit market currently accounts for about 20-25 percent of total credit in Romania, a significant fall from the over 45-50 share traditionally held in the last two decades. The market is dominated by public enterprises. Table 3.1: Non-Government Credit Volume in Real Terms Domestic Credit | Foreign Exchange l Total Credit Credit 1/ Notn-goverrnment bil. Lei ;/ Short-Term Long-Term l___________LX' a/ A/ A/ v/ a/ 1989 810 100 100 70 100 28 100 2 1990 683 80 74 64 94 33 42 3 1991 1,375 58 28 77 34 19 24 4 1992 1,915 40 43 75 20 _ 14 56 11 1993 4,555 34 38 77 10 8 67 15 Source: NBR Annual Inflation: 1990 - 105; 1991 - 279; 1992 - 200; 1993 - 280 Deflator Coefficients in Relation to 1989: 1990 W 1.05; 1991 - 2.93; 1992 - 5.86; 1993 16.41 1/ Volume in real terms in percentages of 1989 volume a' Term structure in percentages of total credit 3/ Converted at official NBR reference rates: 1989 - 12; 1990 - 35; 1991 - 186; 1992 - 430; 1993 - 1250 3.12 Term-credit has severely contracted since the revolution. In 1991, its volume in real terms was a mere 34 percent of that in 1989; by end-1992, the market further contracted in real terms to about 20 percent and by end-1993 to about 10 percent of its 1989 volume. The foreign exchange non-government credit market in Romania initially took an even larger dip. In 1990, it contracted to 68 percent and, in 1991, to a mere 8 percent of its 1989 volume. In 1992, however, this market started to recover, due to the funds provided by international development banks and to suppliers credit. By end-1993, the volume increased to about 67 percent of that in 1989, and its share in the total credit market in Romania increased to 15 percent. In terms of demand/supply characteristics and instruments, this market is very different from the one that existed before and immediately after the revolution. 3.13 The transformation of banks into joint-stock companies brought more conservative lending practices. Due to high inflation, the maturities of available credits have shortened to well below two years, access to foreign exchange is difficult and credit for capital investments involving imports is - 18 - practically not available (Annex 6). The small and medium-size enterprises, including export-oriented enterprises and the new private enterprises which have grown to employ over 20 people, are most negatively affected by the lack of term- finance. This is particularly problematic because the supply response from these types of enterprises holds a potential for reversing Romania's current economic decline. 3.14 Based on the MOI surveys, the investment demand of viable export- oriented enterprises which operate in a competitive market environment totals about US$0.5 billion annually. It originates in export sectors such as textiles, garments and leather, wood, pulp and paper, building materials, light engineering and chemicals industries. Companies seek credit to improve international competitiveness and profitability, to consolidate theit export positions, or to facilitate privatization or joint ventures with foreign private investors. The NAP estimates that the SME investment demand currently amounts to about US$150 million annually. Neither estimate includes incremental permanent working capital demand, which would increase the estimates by US$200 million and US$50 million, respectively. 3.15 The volume of the proposed Project's investment credit component was determined based on intermediation capacity of t financially viable part of the Romanian banking sector, excluding the state-owned banks that were not financially viable and the branches of foreign banks. The assumption that the real growth of aggregate balance sheet size for such banks will be kept at about 20 percent annually, gives an estimated US$200 million incremental intermediation capacity."1 The existence of a pipeline of viable projects was confirmed by screening a number of investment proposals from various sectors, including textiles/leather, machine building, metallurgy, electronics and machine tools. The reviewed investment proposals amount to approximately US$55 million, of which about half are with IRRs of over 20 percent; these were presented by viable enterprises with a proven record as successful exporters. 3.16 Working Capital Finance. Access to working capital finance is of key importance for a successful supply response in Romania. As part of the tight control mechanism, enterprises in the central planning system were typically severely undercapitalized as compared to similar enterprises in a market economy. The conversion process to commercial companies in Romania did not take care of this problem, as the enterprises were not properly capitalized before they were converted. Furthermore, a large number of enterprises were participating in barter arrangements with the CMEA, which lowered their working capital needs. Once the CMEA disintegrated, working capital needed to be increased. Another reason has been a significant devaluation of national currency, which required a corresponding increase in working capital for enterprises which use imported inputs and spare parts. Increases in wages and prices of domestic inputs, combined with the general lengthening of collection periods, have also required an increase in working capital. 11/ However, this operation will remain within limits set by the Government's credit policy and is not incremental in this respect. - 19 - 3.17 Exacerbating increased working capital needs of the corporate sector is the lack of capacity of the financial sector to deliver, in terms of volume, timing and instruments. This has been reinforced by the NBR policy of credit restraint introduced as a part of the stabilization program. For initially viable enterprises, the limited access to working capital often has been a reason for the decline in capacity utilization and/or the loss of markets. For example, a few enterprises in the textiles and garments sector, which are successful exporters, operate at about 50 percent of capacity. Their effective capacity utilization has been determined not by their opportunity to sell, but by their access to working capital. The access to finance somewhat improved by 1993, and the volume of short-term finance recovered, in real terms, to about 38 percent of that in 1989. This was mostly due to the large spreads in the range of 20 to 30 percentage points which the banks considered adequate to accommcdate their credit risk concerns. 3.18 The lack of working capital finance combined with uncertainties in the terms of access to foreign exchange market and the ability to timely buy the foreign exchange has been especially detrimental to exporters. Unless an exporter has his own source of foreign exchange, he would normally obtain a foreign suppliers' credit, or a credit in domestic currency and then exchange lei for convertible currency in the foreign exchange (FX) market. (Foreign exchange credit markets and foreign exchange markets are analyzed in Annex 6). The FX market supply was typically 8-15 percent of the demand in the 1991-1992 period and about 2-5 percent of the demand in 1993, making access to foreign exchange by particular exporters haphazard and dependent on the FX position of the exporter's bank on any particular day. Potential exporters who need foreign exchange typically wait one to three months to satisfy their demand, hence they are not able to transact if an export order entails strict delivery schedules. 3.19 The proposed Project's demand estimates for export finance were derived based on the assumption that the export credit line under the Project should be able to finance major categories of positive value-added Romanian exports, taking 1993 as a base year. This yields a demand estimate of about US$630 million for export finance (Details are provided in Annex 4). This estimate was cross-checked by a detailed survey, by sectors and enterprises, of export potential unrealized due to the lack of adequate foreign exchange financing. The survey was conducted by the MOI in October 1992. Within sectors, enterprises were screened based on profitability and export experience. For the electronics, chemical/petrochemical, machine building and textile sectors, a potential incremental export volume in 1993 was estimated at US$1.36 billion, requiring an estimated US$443 million in foreign exchange financing. IV. PROJECT RATIONALE A. The Bank Group Strategy for Assistance 4.01 The reform strategy in Romania has been rather steady. The Government remains committed to moving decisively and coherently across a broad front to sustain the reform effort. The reform priorities include: (a) macroeconomic stabilization as a prerequisite for the success of the reform program; (b) accelerating the transformation of ownership; (c) rationalization - 20 - of productive sectors to make them efficient and ilternationally competitive; and (d) providing social protection to the affected segments of the population. 4.02 In intensive dialogues over the past three years, the Government and the Bank have found considerable agreement on the priorities for adjustment and development. The Bank's medium-term country strategy comprises several strategic themes as reference points for guiding the overall program in support of Romania's reform effort. The Bank aims to: (a) facilitate and support Romania's structural reform and its transformation to a market economy; (b) contribute to financing its balance-of-payments requirements, and help establish its creditworthiness; (c) support sectoral adjustment and development efforts; and (d) help mobilize resources from both official and private sources. - 4.03 The centerpiece of the Bank's current operations in Romania has been the SAL, which was approved in July 1992. The SAL program, along with the Fund stand-by arrangement, provided a macroeconomic framework for the transition. It supports stabilization efforts, including fiscal reform, price and trade liberalization; introduces measures to further policy reforms of the enterprise sector and to strengthen financial discipline; and aims to improve the affordability and effectiveness of the social safety net. Continued support to enterprise reform is critical for the success of the transition. The Bank intends to deliver this support through the proposed Project and the future adjustment operations. 4.04 The proposed Project is fully consistent with the Bank's assistance strategy for Romania and supports all its major elements. In the November 1991 to September 1992 period, the proposed Project was the main vehicle to assist the Government to conceptualize and develop a regulatory, institutional and procedural framework for privatization. Table 4.1 summarizes policy-related measures and the associated objectives which have been accomplished during Project preparation. The intention was to ensure that the overall environment is conducive to privatization and to the successful growth of the private sector. 4.05 Other related Bank projects include the Private Farmer and Enterprise Support Project and the Employment and Social Services Project. The former aims to stimulate transformation and development of the private agricultural sector in Romania, including its distribution and food processing aspects, while the latter aims to improve services associated with the social safety net, helping to ease the exit of non-viable firms and accommodate workers' retrenchment. B. Rationale for Bank Involvement 4.06 In the period since the revolution, the Government has successfully established the legal and institutional framework necessary for a market economy. The role of the state in both macro and microeconomic management has changed. On the macro-level, the new policies have emphasized liberalization (e.g., price, foreign trade, interest rates, entry and exit policies), decentralization and competition (e.g., in banking, industry, agriculture), and market and private sector orientation. At the micro level, the Government has already disengaged from involvement in operational management of enterprises; it has commercialized virtually all enterprises in trade and manufacturing sector and started to - 21 - enforce their financial discipline; and plans to fully divest its holdings in the next seven years. Financial policies and entry to the banking sector and markets have been liberalized, resulting in emergence of the new private institutions and in changes of financial market structure and availability and quality of financial services. Table 4.1: Policy-Related Measures and Objectives Accomplished During Project Preparation Macro Objective Measure sProjet Objective Completed Privatization • Complete development of legal * Finalize SOF by-laws and initiate * Allocate decision making * Aug. 92 1/ and institutional framework staffing of the SOF responsibilities * Finalize POF by-laws and complete * Sep. 92 1/ allocation of POF portfolios I Submit POF documents for * Oct. 92 1/ registration * Speed up privatization * Start distribution of Certificates of * Increase number of * Sep. 92 2/ Ownership potential clients * Finalize draft procedure for * Dec. 92 / privatization of small companies * Decree on privatization of small * Jan. 93 4/ companies * Adoption of 1993 privatization * Mar. 93 4/ program Enterprise Reform * Improve corporate guidance * Amendment to Law 31, para 212 * Improve corporate guidance * Nov. 92 2/ on Corporate Boards and decision-making * Submission to Parliament of Draft * Improve bank appraisal * Nov. 92 3/ law on Operations of Public capacity Accountants * Submission to Parliament of * Improve management * Feb. 93 _/ Performance Based Management Contracts Law * Create enabling environment for * Agreed SME loan guarantee private sector development program o Improve access to finance * Nov. 92 g/ for SMEs L, Onginally condition of Appramsal. ?/ Onginally condition of Negotdions. 2/ Onginally condfiton of Board Presention. 1/ Onginally conditon of Effcteness. - 22 - 4.07 The Government has also recognized that export development and integration of the Romanian economy into the international financial and goods markets is a key to successful transition and to achieving a sustainable growth path. To this end, the Government has opened access to the trade sector; liberalized foreign trade; unified and simplified the tariff regime; practically removed exchange controls on current account transactions; and started to manage the exchange rate through market-based mechanisms. However, a supply response to the new incentives and opportunities has been slower than expected, mostly due to the lack of managerial and technical skills in ministries, enterprises and banks and to difficulties in access to finance. 4.08 At the macro level, the Bank has been involved in the transition process in Romania from the very beginning. At the micro level, it has two p.:sible choices. One is to wait until the restructuring and privatization of the real sectors is completed and then provide investment resources. The transition, however, may take years to accomplish and the process may fail or be significantly slowed because of the lack of skills and financial resources. Another is to actively promote growth of the private sector and to support the process of transition through policies and institution-building work and by providing well calibrated financial assistance, through banks already operating on sound financial and commercial principles, to competitive private enterprises. The proposed Project elects the latter approach. It aims to address critical needs which impair the supply response of the export sector and which can be satisfied within the present system at minimum risks. V. THE PROJECT A. Obiectives and ScoDe of the Proposed Project 5.01 In line with the country assistance strategy, the principal objectives of the proposed Project are to: (a) promote growth of the private sector and create conditions for an effective supply response from viable private industrial enterprises; (b) advance structural transformation of the enterprise sector in Romania, and specifically privatization and restructuring; and (c) facilitate transformation of Romanian credit markets and introduction of safe and sound banking practices. These objectives would be achieved by: (a) improving access to foreign exchange credit for investment and export finance to viable private enterprises; (b) assisting in the design of the necessary policies and by strengthening the institutional framework for privatization and restructuring; and (c) strengthening the capacity of participating banks to efficiently allocate resources and to improve financial services tc the corporate sector. 5.02 The proposed Project would be supported by a US$175 million Bank loan. The Loan would be used to provide: (a) Finance for creditworthy enterprises capable of assuming foreign exchange risk, in two components: (i) Investment Finance for private enterprises to improve international competitiveness and/or to expand exports; and - 23 - (ii) Exnort Finance to provide partial to full coverage of exporters' preshipment finance needs for imported inputs; and (b) Technical Assistance to help in policy formulation and to strengthen institutional capacity in the areas of privatization and restructuring, and for capacity-building in the banking sector. 5.03 The finance component, in the total amount of US$172.0 million of Bank funds, will be divided into US$102 million for investment lending and US$70.0 million for export finance. The investment component will receive additional cofinancing by the European Investment Bank, amounting to ECU30 million. Proposed technical assistance of US$3.0 million would be provided in the context of an integrated overall program, financed by the Government budget and other multilateral (e.g., EC-PHARE, EBRD) and bilateral (e.g., USAID, UK-Know-How-Fund) institutions. B. Financing Component 5.04 The Investment Finance Comnonent would provide investment loans to private enterprises, in the context of broader restructuring programs. Due to the severe lack of foreign exchange financing in Romania, the investment finance is targeted to most viable enterprises in the industrial sector aiming to improve their international competitiveness, export capacity and profitability of exports. The availability of investment finance is also expected to address concerns of foreign investors. It has been noted that many of them might be willing to commit equity capital, but are discouraged by the lack of finance for post-privatization restructuring. 5.05 The access to investment finance would be open to viable private enterprises,12 which are capable of bearing the foreign exchange risk. A subloan application would have to be presented in the context of the enterprise restructuring program and business strategy. More specifically, eligibility of enterprises and projects would be determined based upon: (a) economic and financial viability of a project, with financial and economic rates of return of minimum 15 percent; (b) satisfactory financial condition of a prospective borrower and capacity to bear the foreign exchange risk. The latter will be assessed by reviewing: (i) recent history of export performance; (ii) future prospects including analysis of targeted markets and estimated growth of exports and foreign exchange income; and (iii) analysis of enterprise's international competitiveness; 12/ The term private refers to enterprises incorporated under Law 31, including wholly privately-owned enterprises established by private entrepreneurs and enterprises originally in public ownership which have been privatized under Law 58. If not majority privately-owned, enterprises will be required to present a program for full privatization and the State Ownership Fund (SOP) should initiate actions expected to lead to private ownership within one year after the subloan has been extended. The actions should commit the SOP to divest its ownership if an investor can be found, such as placing the enterprise on a list of enterprises offered for sale by the SOF. - 24 - (c) presentation of a satisfactory business plan and restructuring program clearly indicating: (i) measures which have been already taken; (ii) intended areas of further improvements of enterprise performance and efficiency; (iii) financing plan for elements not covered under the subloan with adequate assurances from other financing agencies; and (iv) if an enterprise is not wholly privately owned, intentions for completing privatization; and (d) clearance by the Ministry of Environment concerning environmental aspects. 5.06 The subloans will be denominated in US dollars to match the prospective export revenues of subborrowers. The interest rates would be variable, based on US dollar prevailing six-months LIBOR plus a market-based spread. The proceeds of the sub-loans would be used to cover the foreign currency cost associated with capital investments, including permanent working capital needs, to improve quality, packaging or to address other product deficiencies; to improve production cost structure; to address production bottlenecks; or, when having a reasonable prospect to increase exports, to increase capacity to produce exportable products. 5.07 The Export Finance ComRonent would address current problems of inadequate access to export-related working capital finance, which especially hurts private enterprises and less experienced exporters. These are due to balance-of-payment difficulties and imperfections in the foreign exchaxtge and the foreign exchange credit markets (Both markets discussed in Annex 6). It will be provided through a revolving fund to cover pre-shipment financing needs for the imported inputs of Romanian exporters. With an expected average maturity of 120 days, the US$70.0 million financed by the Bank would revolve about three times per year, yielding a US$210.0 million financing capacity. 5.08 The access to export finance will be open only to direct exporters. Eligibility will be determined based on: (a) possession of an irrevocable letter of credit (LC) in convertible currency issued by a creditworthy financial institution or a confirmed purchase order issued in his favor by a respectable foreign buyer; (b) exRort experience in products similar to the transaction for which export finance is being sought; and (c) positive value-added for the export product based on international reference prices. 5.09 The credit to participating financial institutions (PFIs) to refinance the subloans will be extended on a first-come first-served basis and back-to-back with the PFI subloans to exporters. The PFI subloans will be denominated in US dollars with an average maturity of up to one year and at fixed interest rates, with reference to US dollar LIBOR plus a market-based spread. To further alleviate the banks' risk concerns, especially regarding new - 25 - inexperienced exporters from the private sector, a special export guarantees program has been introduced by the EXIM Bank and is available to the sub- borrowers. 5.10 In the longer term, the export finance may become unnecessary due to the easing of foreign exchange constraints. The Bank and the Government will jointly monitor the use of funds allocated to this component against developments in the financial sector and assess the continuing need for export finance on an annual basis. C. Technical Assistance Component 5.11 The main objective of the TA component is to provide consulting assistance and training for the design and implementation of an effective policy and institutional framework for privatization and industrial restructuring, and to strengthen the capacity of PFIs. The cost estimates of the proposed technical assistance program are summarized in Table 5.1. Table 5.1 Technical Assistance for Privatiation and Restructuring l ________________________ (US Thousand) l l________________________ Project Funds Other Related Funds1' Total Ministry of Industry 1,700 10,700 12,400 National Bank of Romania 1,300 5,000 6,300 TOTAL 3,000 15,700 I 18,700 1/ Includes TA tunds for progfams and activres direcly retated to this Project by intemationai donors (EC-PHARE) and through biiatea assistance (US-AD, UK-Know-How, e GoenmenXt of Holland. Sweden. Switzenand. etc.). 5.12 The details of the technical assistance program are contained in Annex 10. The Bank funds would be used as follows: (a) Ministry of Industry (MOI), for: (i) sector studies and consulting assistance for the development of sector restructuring and privatization strategies; (ii) environmental consulting services for MOI; and (iii) a study on industrial technology infrastructure; (b) National Bank of Romania, consulting help to assist in: (i) implementation of a new Chart of Accounts for banks; (ii) formulation of guidelines and training in risk management and asset/liability management policies for commercial banks; and (iii) establishment and strengthening of internal controls and auditing in commercial banks; and (c) Participating Financial Institutions (through the NBR) for: (i) strengthening PFI credit and risk management policies; (ii) strengthening PFI appraisal capacity; and (iii) improving PFI loan administration. - 26 - D. Project Cost and Financing Plan 5.13 An estimate of the total cost associated of proposed Project is shown on Table 5.2. Table 5.2 Estimated Total Project Cost (US$ Milron) 7 ~Arnount| Local Foreign Total Investment Component 55.0'' 102.2 157.0l Export Component 104.OyE 70.0 174.0 TAComponentt ~~~0.0 3.0 3.0l Total 159.0 175.0 334.0 1/ Enterprises Funds and PFI Funds _/ From Table 5.1 5.14 The Bank financing would cover US$175 million equivalent, or about half of the total cost of the proposed Project. For the investment finance, local financing would come from enterprises and the PFIs, or, to a lesser extent, financing may be available from the State or Private Ownership Funds. For the export finance, local financing may be raised from the banking sector or funded by enterprises themselves. The financing plan developed with these assumptions is presented in Table 5.3. Table 5.3 Proposed Financing Plan (US$ Million) Amount Local Foreign Total IBRD 175.0 175.0 Enterprises 40.0 - 40.0 PFIs 119.0 . 119.0 Total 159.0 | 175.0 334.0 - 27 - E. Environmental Impact 5.15 The proposed Project has been classified in Category B. Environmental aspects would be addressed in the MOI and at the enterprise level. A capacity to address environmental issues would be established in the MOI, in order to be able to provide full cooperation on initiatives and programs of the Ministry of Environment (MOE). The MOI has already established a Department of the Environment; a consultant financed by the proposed Project would be assigned to the Department to help in building institutional capacity for environmental impact assessment, and to introduce specific measures to address identified environmental issues. 5.16 With the Bank's help, the Government has already developed a comprehensive strategy for environmental protection and conservation. The Environmental Law, setting up standards comparable to those in EEC, has been enacted. As required by that Law, an environmental impact analysis would have to be prepared for each investment project; the analysis would be reviewed by the MOI and cleared by the competent office of the Ministry of Environment. Investment projects, which seek term finance from the Bank credit line, would be required to present to PFIs the clearance of the Ministry of Environment concerning the environmental impact of the proposed investment. The PFIs will monitor compliance with environmental regulations in the course of normal subproject supervision. VI. PROJECT IMPLEMENTATION AND ONLENDING ARRANGEMENTS A. Loan Terms and Conditions 6.01 The proposed Loan of US$175 million will be made to the Government through the Ministry of Finance (MOF) for a period of 20 years, including five years of grace. It will be a single currency loan (SCL) denominated in US dollars at the Bank's standard variable interest rate for the US dollar SCLs. 13 The Government will administer directly the technical assistance component, but will onlend funds for export and investment finance to PFIs, which will channel these resources to eligible borrowers. Lending arrangements include: (i) Loan Agreement between the Bank and the Government; (ii) Subsidiary Financing Agreements between the MOF and the PFIs; and (iii) Subloan Agreements between the MOF and the PFIs, back-to-back to Subloan Agreements between the PFIs and final borrowers. The PFIs would be requested to sign a Subsidiary Financing Agreement as a condition of participation in the proposed Project.14 The 13/ The participating banks are eligi0le for SCLs since they have a need for a US dollar loan to match revenues from lending to their clients, who are expected to earn export revenues in US dollars. The SCL terms will reduce the currency and interest rate risk that the HOF or the PFIs would have faced with currency pool loan terms. The LIBOR basis of the SCL interest rate is appropriate for the export finance component, but may introduce interest rate risk in the investment finance component for sub-borrowers, whose revenues are not correlated to LIBOR movements. 14/ Signature by at least two PFIs is a condition of effectiveness of the proposed Project. - 28 - Subsidiary Financing Agreement will include: (a) an acceptance of financing conditions by a PFI; (b) a commitment to follow agreed appraisal procedures and eligibility criteria; (c) an agreement to establish or strengthen a technical appraisal unit; (d) an agreement to establish a Credit Committee; (e) an agreement to undertake external audits and to implement the auditor's recommendations; and (f) an agreement to provide periodic reports on the portfolio financed from Bank funds. The Subloan Agreements will refer to particular subprojects and must be in a form and content satisfactory to the Bank. 6.02 The MOF subloans to PFIs ("subsidiary loans") will be extended on a first-come first-served basis and back-to-back to the PFI subloans .to final beneficiaries, with identical amounts, maturities and repayment schedules. The subsidiary loans to PFIs will be made in US dollars at the prevailing LIBOR based IBRD rate, plus MOF spread of 30 basis points. The MOF spread will cover the real MOF cost, including administration cost, commitment fees, applicable interest charges and other incidental expenses. The PFIs would onlend the funds to eligible enterprises for eligible export transactions and investment projects. The PFIs will assume the related credit risk. The subloans will be made in US dollars, at interest rates priced on the basis of six-month LIBOR plus the MOF margin and a market-based PFF spread. The subloans for export finance will be extended at fixed rates; the term subloan will be extended at variable interest rates. The beneficiaries will assume the foreign exchange risk and the interest rate risk for the term lending. Subsidiary and subloans terms and spreads will be reviewed by the Bank from time to time. 6.03 Investment Finance. Maturities of subloans for investment finance will range from three to 17 years, with grace periods from one to five years. Grace periods and repayment schedules will be flexible to suit requirements of individual projects and enterprises. The maximum subloan size will be US$8 million. Exceptions may be authorized on a case-by-case basis based on significantly increased foreign exchange earning potential of particular project and/or borrower. This maximum will be reviewed and may be adjusted from time to time. 6.04 Repayments by the PFIs to the MOF will match the repayment schedules of the borrowing enterprises. Should the final sub-borrower prepay all or part of the subloan prior to maturity, the PFI should immediately prepay its subsidiary loan to the MOF. In case of arrears in principal or interest repayment on any due date from a borrower, the PFI will nevertheless be liable for payment to the MOF. The MOF will establish a rollover fund with resources generated by repayments of all subloans under the proposed Project. Resources from the rollover fund will be available to finance additional subprojects or to service the Bank Loan. 6.05 Export Finance. Subloans will be extended for up to US$5 million with maturities of up to one year. Specific subloan amounts and maturities will be determined based on particular export transactions and specific information about the average time frame of a production cycle from receiving the confirmed export order until payment. Exceptions on a case-by-case basis may be authorized by the Bank. The maximum subloan amount will be reviewed and may be adjusted - 29 - from time to time. An exporter will be obliged to assign the export proceeds to a PFI, and will receive only net proceeds. The PFI will be expected to repay, i.e., replenish the export finance revolving fund, even if the export payment does not materialize. 6.06 The following forms of financing will be available: (a) export credit to finance purchase of imported inputs; and additionally, from the revolving export finance fund; (b) discounting of an irrevocable LC of an exporter who has already financed an export transaction from his own sources, providing that the reimbursement request is made within 180 days and that the procurement procedures applicable under this proposed Project have been followed. The financing may be used to cover expenses for imported inputs. The !IOF will establish a revolving fund to hold the repayments under the export finance components. The revolving fund will continue to provide, during the loan grace period, transactions based on export finance under the same terms and conditions. 6.07 Free Limit. Initially, a free limit for both types of finance will not be established. The Bank will continue to review the subloans proposed by each PFI until a PFI's appraisal capacity is deemed satisfactory. At this time, a free limit for the particular PFI will be established. This free limit will be PFI specific and may be adjusted from time to time. 6.08 Technical Assistance. The Government plans to onlend funds for technical assistance to executing government agencies. This will be accomplished through interagency arrangements satisfactory to the Bank. B. Lending Arrangements 6.09 The Apex Arrangements. The financing for both components would be provided through an apex arrangement to allow open access of new PFIs. The apex functions would include: (i) qualification and accreditation of the PFIs; (ii) administration of the disbursements and collection (repayments) of funds advanced to PFIs; and (iii) monitoring of PFIs to ensure their continued qualifications. Initially, the Bank would retain the responsibility for qualification and accreditation of the PFIs and for periodic evaluation of their eligibility. This function would be discharged in close cooperation with the NBR. In particular, in accordance with agreed criteria (Annex 5), the NBR would screen financial institutions which have applied to participate in intermediation of the Bank funds and to propose to the Bank financial institutions which are deemed capable to qualify. As a part of the normal supervision process, the NBR will continue to monitor the soundness of PFIs, including their capacity to appraise subprojects, and inform the Bank of any deterioration of their financial and operating conditions; and to ensure that the PFI subject their financial statements to external auditing on a regular basis. 6.10 The Treasury Department in the MOF (TD/MOF) would have the primary responsibility for operational functions, including: (i) providing subsidiary loans to PFIs; (ii) for the investment finance, collection of funds from PFIs, for the export finance, maintenance of the revolving fund facility; (iii) repayment to the Bank; and (iv) reporting and monitoring the use of project - 30 - funds.'5 A unit having specific responsibility to administer the Bank Loan funds will be established in the TD/MOF.16 The unit will be staffed with experienced, adequately trained individuals. The monitoring and reporting would also require a good accounting and management information system in order to track disbursements and collections of funds and to provide the necessary reports in accordance with Bank procedures (e.g., procurement, reporting). 6.11 Participating Banks. The institutional objectives of the financing component are to: (a) encourage competition and provide enterprises with alternatives regarding access to finance; (b) strengthen financial infrastructure and the delivery system for export and investment finance; (c) reinforce the development of new financing methods and instruments employed by the banking sector; and (d) promote introductinn cf ..aFe and sound banking practices. It is, therefore, desirable that several banks participate in intermediating both the export and the investment finance subcomponents. The private banks have been encouraged to participate as PFIs, in order to strengthen their competitiveness and to spread the risk which would otherwise be confined to the public sector. 6.12 All banks operating in Romania are eligible to participate provided that they meet the qualification criteria (Annex 5). The qualification criteria include: (a) satisfactory financial position and capital adequacy meeting international standards; (b) good standing with the NBR and satisfactory financial policies and operating procedures, especially concerning loan classification and provisioning and project appraisal; (c) satisfactory operational performance, especially concerning past- due and non-performing loans and collection ratios regarding total loan portfolio and Bank's loan portfolio; and (d) satisfactory technical capacity to identify, appraise and supervise utilization of the Bank funds and, for the export finance, to handle international trade transactions and the related documentation. 6.13 The PFIs' responsibilities include: (a) promotion and building of the project piDeline; (b) subproject and borrower appraisal; (c) subloan administration; (d) subproject performance supervision; and (e) periodic reporting to the TD/MOF and the Bank. The PFIs would be required to establish a technical unit, specialized in long-term project lending, properly staffed with at least one industrial engineer, one financial analyst, and one economist, and capable of meeting Bank standards on project appraisal and supervisionl". The 15/ Note that the apex will not be involved in credit decisions and/or in rationing credit among the PFIs. 16/ Establishment of this unit was a condition for Board presentation of the proposed Project. 17/ For export lending, the unit staff should include a financial analyst and an export finance specialist. - 31 - unit will perform the appraisal and supervise all subprojects financed by a PFI. Appraisals should be cleared by the respective PFI Credit Committee. The PFIs are also expected to introduce appropriate internal audits and controls. 6.14 Ten banks have applied for participation so far, of which eight were prequalified by the NBR (Annex 3, Table A3.1). At the outset, a minimum of two eligible PFIs would be sufficient to start project implementation. The Bank appraisal was based on two types of criteria: (i) level of capitalization and capital adequacy, using international standards as qualification criteria; and (ii) qualitative criteria showing that a bank has a satisfactory capacity to intermediate Bank funds. The qualitative criteria included managerial structure and quality of management, management information systems, appraisal prqcedures and risk management (e.g., loan loss provisioning), internal control and auditing systems, accumulated experience in banking operation, plans for external auditing by qualified (foreign) auditors, corporate strategies and staff development and training programs. For qualitative criteria, the minimum acceptable standards, rather than standards for banks operating in developed market economies, were used. Annex 3 provides full details on the banks' financial position and appraisal, and Table A3.2 summarizes the appraisal results of the proposed eight banks. Table 6.1: Participating Financial Institutions with Romanian Capital (in billion lei, as of February 1994) Qualfied Pending Qualification l TRSF" ROB TCB OF8 EXIM RC8 Ownership Mixed in pvatz. Private Pite State State Capital 108 59 17 45 36 129 Total Assets 2Z445 812 278 447 74 2,681 Loan 844 411 123 247 22 1,395 cust.Deposlts 162 256 43 92 0 450 %LoanCoverage 32 77 49 55 100 42 % CredtMaikePeretatton 16 8a 2 5 26 Soure: N8R 6.15 Five banks have successfully passed the Bank's appraisal (Table 6.1. Detailed assessments are provided in Annex 3). The Foreign Trade Bank (RBFT), the Societe Generale (SGF), the Chemical Bank (CBF), the Romanian Development Bank (RDB) and the Tiriac Commercial Bank (TCB), were found fully eligible for participation. These banks cover about 22 percent of the Romanian total credit market, and about 85 percent of the foreign exchange credit market. Another three banks have substantially met the qualification criteria, but need to take specific actions before they are accredited. - 32 - 6.16 All banks are expected to further strengthen their appraisal and project follow-up capacity and their internal controls and auditing procedures. Technical assistance for this purpose will be provided even before the proposed Loan becomes effective. For the export finance, technical assistance will be financed by the Swiss Government and for the term-finance and loan administration by the EC-PHARE. 6.17 Specific measures will also be taken to increase banks' capacity to take and sustain financial risk, and to make sure that the reported financial position reflect the banks' business reality. These measures, which are conditions of loan effectiveness, are summarized in Table 6.2. Table 6.2: Conditions of Effectiveness Macro Objective Condition Project Objective Banking Sector Reform . Complete prudential regulations . Issue NBR regulations on rsk- . Facilitate supervision based captal adequacy . Increase banks capacity to . Issue NBR regulations on asset sustain risk classification and provisioning . Improve capital adequacy . Increase level of general loan loss . Improve risk-taking reserves capacity and capital I adequacy 6.18 Technical Assistance. The technical assistance component will be managed by the beneficiaries. Most beneficiaries of the proposed Project have already established Technical Assistance Coordination Units within their respective External Relations Departments.18 These units have been operational typically for about two years and have managed technical assistance by the Bank's TA/Critical Imports Loan, by the EC-PHARE and the other donors. Before Board presentation, the Bank would: (i) perform a final review of the organization and staffing of the units; and (ii) organize procurement seminars for staff responsible to manage technical assistance under the proposed Project. 6.19 The technical assistance to PFIs will help to improve their technical capacity. The TA would be managed by the NBR and will be available to all Romanian banks with priority given to the PFIs. For the TA to improve appraisal and loan administration capacity, consultants would be placed with the Romanian Banking Association, including specialists for financial analysis and loan administration, economic analysis, industrial process engineering, export finance and procurement specialist. In addition, the PFI lending operations would be 18/ Satisfactory orsanization and staffing of the units is a condition for Board presentation of the proposed Project. - 33 - closely supervised during the early stages. For the TA to improve portfolio risk assessment and asset liability management and internal controls, the TA will be placed with the Supervision Department of the NBR. 6.20 In addition, the market assessment and the quality of appraisals would be enhanced by a set of detailed sector studies financed by or through the Bank, and covering practically all sectors from which a viable demand is expected. Two of these studies have been completed (textiles, garments and leather, financed by the Swiss Trust Fund; wood based industries, pulp and paper, financed by the Swedish Trust Fund); another three will be completed by loan effectiveness (fertilizer, cement and artificial fiber sectors, financed by the Bank's TA/Critical Imports Loan); and two will be financed by the proposed Project. Fifty nine other studies financed by EC-PHARE have also been completed. C. Loan Administration 6.21 Procurement. Procurement will be performed by final beneficiaries. For items which cost less than US$100,000 equivalent, procurement will follow normal commercial practices satisfactory to the Bank. Procurement of items which cost US$100,000 equivalent or more will follow the Bank Procurement Guidelines established for financial intermediary operations. For the investment finance, items which cost US$100,000 to US$1 million equivalent would be procured through international shopping on the basis of at least three competitive quotations obtained from suppliers in two eligible countries; for items which cost more than US$1 million equivalent, the limited international bidding procedure would be followed. For the exDort finance, items which cost US$100,000 to US$3 million equivalent would be procured through international shopping on the basis of at least three competitive quotations obtained from suppliers in two eligible countries; for items which cost more than US$3 million equivalent, the limited international bidding procedure would be followed. 6.22 The PFIs will be required to maintain records of the procurement made under the proposed Project, with summaries of offers received and awards made under each subloan. These records would be used by external auditors in auditing the PFIs' statement of expenditures. The first contract cleared by a PFI and all contracts above US$1 million equivalent for the term finance and US$3 million for export finance will be subject to prior review by the Bank; review of other contracts will be on a sampling basis. The Bank will organize a procurement seminar for the PFIs. In addition, foreign consulting assistance in procurement matters would be made available to the PFIs. From time to time, procurement seminars will also be organized for the borrowing enterprises. 6.23 For consultants to be retained under the proposed Project, the implementing agencies would follow the Bank Guidelines for the Use of Consultants. A nature of consulting services and costs of individual TA items are specified in Annex 1. - 34 - 6.24 Disbursement. For the investment component, disbursements will cover up to 100% of: (i) foreign exchange expenditures (CIF) for directly imported goods or ex-factory costs of locally produced goods, as well as up to 80 percent for other items procured locally; (ii) foreign exchange expenditures for engineering, consultant services for the preparation of enterprise business plans and restructuring or privatization programs, and computerization; and (iii) foreign expenditures for technology transfer, licenses and other payments for specialized technology and associated equipment of proprietary nature. For the export finance component, disbursements will cover up to 100 percent of the CIF cost of imported production inputs. For the technical assistance component, disbursements will cover up to 100% of: (i) foreign exchange expenditures (CIF) for directly imported goods; (ii) foreign and local expenditures for consultant services; and (iii) foreign exchange expenditures for training. Proceeds of the proposed Loan may not be disbursed for payments of taxes and duties levied by the Government. 6.25 Due a the great number of small disbursements expected under the proposed Project, disbursements under US$1 million per item would be made against a certified statement of expenditures (SOE), for which appropriate documentation would be retained by the PFIs and the implementing agencies. Disbursements above US$1 million per item would be made on the basis of full documentation. The Bank's reimbursement would be limited to expenditures made by final borrowers not more than 180 days prior to the Bank's receipt of the request for reimbursement. A disbursement seminar will be organized by the Bank to familiarize the PFIs and the implementing agencies with the disbursement procedures. 6.26 Special Account. Since the proposed Project would involve the financing of many small items, a special account would be created in a mutually agreed bank to facilitate disbursement. Most expenditures under the proposed Project (which are approved by the PFIs and the TA implementing agencies, respectively, and subsequently authorized by the Bank) would be met out of the funds in the special account. When appropriate, special commitments or direct payment to foreign suppliers may also be used. The Bank would disburse an initial amount of US$17.5 million (representing about four months of disbursements) into the special account upon effectiveness of the Loan and would periodically replenish the account on the basis of reimbursement requests. 6.27 Revolving Export Finance Fund. For the export credit component, the MOF would create an account in a bank, on terms and conditions acceptable to the Bank, to hold the repayments of subsidiary loans by PFIs. Funds in the revolving fund would be used to finance other export credit applications for the same purposes and under the same terms and conditions as the original funds under the export credit subcomponent. 6.28 Disbursement Schedule. The estimated disbursement schedule for the proposed Project is contained in Annex 7. The expected disbursement of the proposed Loan is based on ECA/MENA experience with similar operations, adjusted for the expecteL impact of the export finance subcomponent. The technical assistance component is estimated to be fully committed in 12 months, and disbursed in 24 months. The export finance component is expected to be fully committed and disbursed in 18 months, beyond which the financing would continue - 35 - through the revolving fund mechanism. The investment component is expected to be fully committed in 39 months and disbursed in 51 months. 6.29 The initial commitment cut-off date is on January 1, 1996. At that time, the Bank will review exchange and interest rate policies, foreign trade policies and Project's implementation record. The performance criteria for a satisfactory implementation record are: (a) at least US$26 million of project funds committed; (b) at least US$20 million of project funds disbursed; (c) projects and export transactions amounting to at least US$20 million in the lending pipeline; and (d) at least two financial institutions still qualified and participating in the project. If, on the basis of this review, the Bank determines that the Project implementation record is satisfactory and that the macroeconomic environment remains conducive to the attainment of the Project's objectives, the final subloan commitment date will be extended to December 31, 1997. Otherwise, the Bank may choose, in cooperation with the Government, to redesign or close the proposed Project. The closing date for the loan is December 31, 1998. 6.30 Reports and Audits. The PFIs would submit semi-annual reports on commitments, disbursements, collections and arrears under the proposed Project to the Bank. In addition, the PFIs would maintain proper accounts for subloans, including supporting procurement and disbursement documents, which would be audited annually by external auditors acceptable to the Bank. Since most subloans would be disbursed on the basis of SOEs, the regular annual audit of the PFI would have to include a special opinion on the adequacy of SOE procedures. Audit reports have to be submitted to the Bank no later than six months after the close of a PFI financial year. These audits should include a certification that the PFI is in compliance with the financial covenants agreed under the proposed Project. 6.31 Under the technical assistance components, the implementing agencies would prepare and submit semi-annual progress reports to the Bank. Accounts specific to the project would be maintained separately and would be audited annually by external auditors acceptable to the Bank. Audit reports should be submitted to the Bank no later than six months after the close of the agency's financial year. In addition, the Government and TD/14OF will prepare a Project Completion Report for the entire project six months after the completion of disbursements, covering all related activities during project implementation and describing the project's costs and benefits. VII. BENEFITS AND RISKS A. Benefits 7.01 The proposed Project is an investment operation that would support implementation of reforms for private sector development, restructuring and privatization of state enterprises, and in the banking sector. The proposed Project will yield major benefits to Romania by: (a) promoting growth of viable private enterprises; (b) creating conditions for effective supply response; (c) increasing exports and improving competitiveness of Romanian exporters; - 36 - (d) improving the capacity of the financial sector to provide export finance services and to appraise, finance and supervise investment projects; and (e) assisting the Government to formulate and implement policies for furthering privatization and restructuring. 7.02 The proposed Project would support competitive private enterprises. It would directly assist in building healthy and efficient private financial institutions, which would increase competition and contribute to financial market integration. By helping PFIs to develop expertise in project lending, it would promote more efficient investments. The mechanisms developed and the technical assistance put in place would facilitate continuing transformation of the corporate sector. In addition, it should lead to improvements in enterprise management. 7.03 The proposed Project will have a positive environmental impacte through the rehabilitation and restructuring of enterprises, including more environmentally sound technologies and operations. The subloan covenants will require that any facilities to be provided under the Project meet new environmental standards. The proposed Project is thus introducing a concept which may lead to similar concerns by the PFIs in their future lending operations. In addition, the proposed Project aims to build institutional capacity of the Ministry of Industry to deal with environmental issues. B. Risks 7.04 The main risk of the proposed Project is a shortfall resulting from general institutional weakness, including skill deficiencies of banks and enterprise managements. This risk has been addressed by including technical assistance for all participants in the Project covering the most important aspects where skill deficiencies might jeopardize the Project's success. Close supervision, beyond a level normally allocated for Bank projects, will also be performed to contain this risk (Annex 8). 7.05 Volatility and uncertain prospects can adversely affect PFIs willingness to diversify and/or to engage in long-term lending; a general increase in non-performing assets would decrease the PFIs' capacity to take the credit risk associated with the proposed Project. This risk is addressed through increasing the capacity of PFIs to take and sustain financial risk, by introducing mandatory asset classification and provisioning and by increasing mandatory general loan loss reserves; through the technical assistance to PFIs to better manage risks, off- and on-balance sheet, and by improving their capacities to assess the credit risk associated with particular borrowers and projects; through the TA to banks and through preparation of sector studies which could be utilized in the project appraisal; by keeping the access open to eligible PFIs; and by maintaining flexibility in terms of reallocation of investment component funds to export finance, and vice-versa. The credit risk of the PFIs and the foreign exchange risk of the final beneficiaries has been decreased by extending a single currency loan rather than the Bank's standard pooled loan. 7.06 Macroeconomic instability and deterioration of enterprise business environment is a major risk. It may adversely affect investments and exports and - 37 - contribute to rapid deterioration of enterprise viability and the PFIs' financial conditions and profitability. This risk is addressed by the Bank's SAL, and through on-going macroeconomic policy dialogue with the IMF and the Bank. In addition, the macroeconomic environment and the progress-in-transition programs and in project implementation will be thoroughly reviewed one year after loan effectiveness, with an option to cut off further commitments in case of seriously adverse developments or to redesign the proposed Project. VIII. AGREEMENTS REACHED AND RECOMMENDATIONS 8.01 During the negotiations, final agreements with the Ministry of Finance have been reached on the following: (a) interest rate and on-lending terms to PFIs (para. 6,02); (b) content and form of Subsidiary Credit Agreements with PFIs (para. 6.01); (c) apex arrangements to be implemented by the MOF and the NBR (para. 6.09); (d) content of the TA program and agreements for channeling the TA funds (paras. 5.12 and 6.18); (e) establishment of special accounts on terms and conditions satisfactory to the Bank (para. 6.26); (f) a revolving fund for export finance (para. 6.27); and (g) content of audit reports and that they are prepared and furnished to the Bank in a timely manner (para. 6.30). 8.02 Regarding conditionalities, the following agreements have been reached: (a) Conditions of Effectiveness. (a) Subsidiary Credit Agreements signed by at least two PFIs; (b) NBR regulations to increase general loan loss reserves issued; (c) NBR regulations on asset classification and provisioning issued; and (d) NBR regulations on risk-based capital adequacy issued; (b) Condition of Disbursement. For the export finance component, the MOF would establish a revolving fund for export finance, satisfactory to the Bank, to revolve export credits during the loan grace period; and (c) Condition Concerning Loan Commitment Period. The initial commitment cut-off date will be on January 1, 1996. At that time, the Bank will perform a review (para. 6.29) and, if satisfied, extend the loan commitment date to December 31, 1997. 8.03 The proposed Project constitutes a suitable basis for a single currency loan to the Government of Romania in the amount of US$175 million at a Bank's standard variable interest rate for single currency loans for a period of 20 years, including five-year grace period, under terms and conditions outlined in Chapter VI. - 38 - Page 1 of 4 R0O4ANIA INDUSTRIAL DEVELOPMENT PROJECT Technical Assistance Component Specifi.ation 1. Skill deficiencies and the lack of institutional capacity are among the main reasons for the slow start of Romania's transition, for the sluggish progress of major transition programs, and for the persisting inefficiencies in resource mobilization and allocation. The main objectives of the TA component are: (i) to provide assistance for the design and implementation of an effective policy and institutional framework for privatization and industrial restructuring; (ii) to develop capacity in the banking sector to effectively manage its assets and liabilities and to appraise, price and manage financial risks; and (iii) to improve export and investment lending and loan portfolio management practices of participating banks. Table A1.1 summarizes TA to be provided under the proposed Project. Following is a brief description of specific TA components. Detailed Terms of Reference are kept in the project files. Table A1l1: Technical Assistance Siumary caCtPOy RECIPIENT COST (US$ SERVICE IXPECTED ___________ TOUSAND) PROVIDERI/ START/END (i) flestructurinR * Sectorel Studies MDI/CC 700 Electrical Machinery MDI/CC 300 FirD 9/94-4/95 Electronics + Consumer goods MOI/CC 400 Firm 9/94-4/95 Environmental Assistance "Di 150 Indiv. 1/95-1/96 Industrial Technology Infrastructure Study M01 250 Firm 9/94-4/95 Industrial Policies and Sector Strategies M01 6So Indiv. /Firm 9/94-9/95 (ii) TA for the Banking Sector Banus 500 Implementation of Unified Chart of Accounts 150 Indiv. Firm 7/94-3/95 Assistence for Asset/Liability and risk Mgmt. 200 Indiv. 9/94-9/95 Assistance for Internal Control Systems 150 Indiv. /Firm 1/95-S/95 (iii) TA to PartiCiDating Financinc Institutions FrI 800 Firm 5/94-9/95 Export Finance 150 Project Appraisal 350 Loan Administration 150 Procurement/Disbursement 150 CC - Commercial Companies MOt - Ministry of Industry 1/ FirA - Consulting company by shortlisting. Indiv, - Individual consultants; for amounts higher than 50,000. more than one individual in to be retained. Consultants will be selected based on CVs of three qualified consultants. PFI - Participating Financial Institutions - 39 - mm JL Page 2 of 4 2. TA for ProJect Preparation. The TA during project preparation included restructuring studies for sectors from which major financing demands are expected. The studies have multiple purposes: (i) to help the MOI design enterprise assistance programs to address issues common to most enterprises in particular sectors; (ii) to help the KOI develop restructuring strategies; (iii) to help SOF/POFs identify enterprises which could be privatized immediately; and (iv) to provide the PFIs with sectoral context upon which to base project appraisals. Two such studies have been completed during preparation of the proposed Project: the Wood Based Industries Study (including pulp and paper, wood processing and furniture manufacturing) has been financed by the Swedish Trust Fund and the Textiles, Garments and Leather Sector Study has been financed by the Swiss Trust Fund. A. Restructuring 3. The TA program for restructuring, to be administered by the NOI, amounts to US$1.7 million. Following is a brief description of the specific TA components. 4. Sector Studies. In order to be able to design targeted programs. for effective restructuring and rapid privatization, the Government plans to initiate reviews of all major industrial branches. The studies program was developed jointly with the MOI in December 1991 including about 80 industrial subsectors. In addition to the two studies mentioned above, about 51 subsector or branch studies financed by the EC-PHARE have been completed. Remaining studies to be financed under the IDP are for sectors for which donor funding could not be found including electrical machinery, electronics and consumer goods. 5. The overall objective of the sector studies is to provide detailed and up-to-date information on the institutional structure, competitive advantage, weaknesses, and prospects of particular sectors within the context of a market economy and world competition. With four major audiences, a sector study should: (1) assist the Ministry of Industrv to develop a sector restructuring strategy and identify assistance programs to support this strategy; (ii) assist government agencieg to develop strategies for accelerated privatization in the sector, and identify policy actions that may be required to help enterprises to prepare for privatization; (iii) assist individual firms to better assess their current operations, and identify viable development opportunities; and (iv) provide information to domestic and foreign private investors and banks to determine potential investment opportunities. 6. More specifically, the studies will cover three broad areas: (i) the existing structure of the industry, including products, capacities, number of companies, organization, historical profitability, investments, imports and exports, value added, etc., including international comparisons where appropriate; (ii) markets and marketing, and a review of local market potential and of export market potential, including an assessment of global trends; (iii) strategic direction, including identification of the industrial segments/products that are currently competitive and strategies that will be required to maintain and strengthen competitiveness; identification of the constraints that prevent - 40 - ANNEX 1 Page 3 of 4 certain segments from attaining international competitiveness and appropriate actions to deal with these constraints; and recommended strategies for sector restructuring including, as necessary, downsizing of production capacities. 7. Consulting assistance to the MOI to develop environmental assessment aud recovery management capabilities. The Ministry of Environment is currently responsible for the development of environment policies, standards and monitoring procedures and assessment guidelines. The role of the Ministry of Industry is to assist the enterprises in preparing environmental assessments and to achieve compliance with national standards and environmental policies. The consultant is expected to help the MOI develop the capacity to provide assistance to enterprises in preparing environmental assessments, including a set of manuals to be used by enterprises for environmental assessments, and to prepare specific pilots which will demonstrate efficient methods to address environmental problems in enterprises in specific sectors. 8. The Industrial Technologv Infrastructure Study will assess the existing situation and needs and propose the conceptual framework to develop industrial technology infrastructure in Romania, including its regulatory and institutional framework and development plan. This will specifically address regulations concerning standards, patents, technology purchase and licensing and other eleuents of regulatory and institutional framework concerning intellectual property rights, quality control framework, and the related institutions; address the future role of the 140 existing institutes in supporting the industrial sector; propose the framework for strengthening the capacity for applied research and industrial technology consulting; address financing aspects; and propose measures to strengthen, refocus or downsize a number of institutes. 9. Technical Assistance to the Ministry of Industry would include the following TA items: (i) advisors to the MOI to assist in the development of industrial policies and specific sector restructuring strategies; and (ii) computers and office automation equipment and training. B. TA to Banks 10. TA under the proposed Project would be needed to help the NBR and the banks in Romania to operationalize and implement the new systemic framework, especially prudential regulations, with the objective to improve safety and soundness of Romanian banks. More specifically, assistance will be provided to: (a) assist in implementation of the unified Chart of Accounts for banks, including development of the requisite accounting and conversion manuals, staff training and assisting the banks in converting their current system to the new chart of accounts; (b) assist in the development of guidelines and operational policies and the requisite implementation manuals concerning methods for assessment of and limits on the exposure to various types of financial risks on- and off-balance sheet, - 41 - ANNEX 1 Page 4 of 4 pricing of various risk elements and management of risk (including methods for loan classification and levels of provisioning) and staff training; asset/liability management for commercial banks including specific techniques to manage mismatches of asset/liabilities portfolio, advises on portfolio structure and instruments with various risk features that could/should be introduced in Romania, etc.; and (c) assistance in the conceptualization, development of respective manuals and technilues and implementation of a system of internal audits and controls in commercial banks and the requisite staff training. 11. This assistance will be provided for a period of nine months. Consultants will be situated in the NBR and will provide assistance to all banks licensed and operating in Romania. C. TA to Participating Financial Institutions 12. Technical assistance to PFIs for the duration of about 12 months is also deemed necessary to strengthen their capacity to appraise credits for export and investment finance, to administer the credit lines and to develop loan supervision capacity. Specifically, TA will be available to assist a PFI to start operations, to help internali--e operating procedures and to develop monitoring and reporting systems, to prvvide on-the-job training for staff, and to assist in initial appraisal and lo- supervision for subloans extended under the proposed Project. 13. This assistance would be managed by a steering committee including a representative of the NBR and of all PFIs. It would be provided under the auspices of the Banking Association and will be physically located in the NBR. Priority will be given to participating banks, but access to TA will be open to other banks. Experienced foreign consultants with the following profiles would be financed: (i) financial analysis and loan administration; (ii) economic analysis; (iii) industrial process engineering; (iv) export finance; and (v) procurement specialization. - 42- ANNEX2 Page 1 of 9 RQMANIA INDUSTRIAL DEVELOPMENT PROJECT The Banking Sector 1. Reform of the banking system was initiated early in the process of transformation to a market economy. Entry to the banking sector was liberalized in mid-1990. The two-tier banking system was established by late 1990, and formally legislated in April 1991 with a passage of the Law on Banking Activity and the Law Concerning the Status of the National Bank of Romania (NBR). The Banking Law endows commercial banks with universal banking powers, and the NBR is given a high degree of formal independence. 2. The dominant institutions in the sector are banks inherited from the central planning system: the Bank for Agriculture (BA), the Romanian Development Bank (RDB), the Savings Bank (CEC), and the Romanian Bank for Foreign Trade (RBFT). While still in state ownership, these banks are incorporated as joint- stock commercial companies and enjoy a universal banking license. By the end of 1990, a number of private banks was established, including the Bank for Small Industry and Private Initiative (MIND), the Cooperative Credit Bank (CCB) and the Ion Tiriac Bank for Commerce (TCB). The new regulatory framework provided for liberalized entry of new foreign or mixed-ownership banks, and removed limits on the types of customers and financial services that could be offered by foreign banks. This group currently includes the Chemical Bank (CBF), the Societe Generale (SGF), the Frankfurt-Bucharest and the MISR Bank. There were also new entries by banks in state ownership, including the Romanian Commercial Bank (RCB), which was formed in late 1990 by carving out the commercial portfolio from the balance sheet of the NBR; the Export-Import Bank of Romania (EXIM), which was established in 1991 to strengthen financial services to the foreign trade- oriented industrial and services sectors; and the Bank Post, S.A. By late 1991 the private bank Dacia Felix (DFB, based in Cluj) and the Banca Creditului Romanesc S.A. (Credit Bank) were created. The Romanian commercial banking sector now comprises six state-owned banks, six private banks (with Romanian capital and joint ventures) and the, Bucharest branches of four foreign banks. Another seven private banks are in the first phase of the registration process,1 and one has applied for registration. I/ Since mid-1992. banking licenses are issued in two steps. The first step allows the banJk to reSister std start preparing itself to open for busineses. After an NBR review and satisfactory findings conicorning readiness of the prospective bank, an operating license allowing the bank to open for business is issued. Sevn banks reoeived the first-stage licence in the October 1992 to October 1993 period including: Bancs Rt aneasca, Banca Cteditul Comnercial Roman (CREDCOI), Banc& de Credit Consurcial si Industrial., Banca de Credit si Detvaltare (RQ4EXTSRA), Banca IntercoufesionaLa Raena, Santa Roman a Patronotulut Privet (PATRWBARK) and Buchaxest Bank. - 43 - ANNEX 2 Page 2 of 9 3. The structure of the commercial banks' balance sheets is shown in Table A2.1. The main characteristics of the Romanian banking sector are: Table A2.1: Structure of the Commercial Banks Balance Sheets PercentaMe of Total Assets Percentage Chargesl/ Dec 1993/ Dec 1992/ Assets Dec 91 Dcc Pec93 DSc1992 Dec 1991 Foreign Assets 4.6 7.7 12.9 +343.9 2/ +184 / Cash 0.8 12 0.7 +154.7 +183 Non-Govt. Credit 60.1 492 47.8 +255.7 +39 Govt. Credit 5.4 5.1 3.9 +201.0 +60 Interbank Asets 21A 252 22.5 +2223 +106 Other Assetl/ 7.7 11.0 12.1 +298.3 + 151 Liabilities Foreign Liabilities 6.0 5.5 7.0 +296.6 +55 Clients Deposits 39.7 36.0 33.8 +240.1 +63 Loans from NBR 17.0 9.0 153 +435.6 - 10 Interbank Loans 12.6 24.6 11.8 +191.9 +42 Equity 3.0 7.8 4.8 +190.3 +337 ii Other asseu include non-peformg assets covetd by Dedsion 447/1991 and LAw 7/1992. 2/ Inaease also reflects depredation of leL In 1991, the vohime actually declned by 2% in US dollars tams; in 1992, it increased by 17 % in US dollar terms; in 1993, thfe volume increased by about 6% in US dollar tenns. l/ Changes in nominal values Annual inflation in 1991 was 279%, in 1992 - 200%, and in 1993 - 280%. VerX higb market concentration. At end-1990, over 93 percent of the banking sector non-government credit was concentrated in four government-owned banks (BA, RDB, RCB and RPFT), and about 40 percent of the total deposits in the Savings Bank. By end-1993, the share of the largest four banks in the credit market stood at 87 percent; on the deposit side, their total share (including the Savings Bank) stood at 50 percent. Weak funding base and dependence on NBR refinancing and interbank liabilities. In 1990, the NBR and interbank financing accounted for about 45 percent of the total domestic liabilities (of which about 80 percent is NBR refinancing); own deposits (excluding the CEC) accounted for 18 percent of the total domestic liabilities; and the ratio of own funding to the total non-government lending was about 27 percent. The situation has substantially improved in the 1991- 1992 period. By end-1992, the interbank financing accounted for only 26 percent of the total domestic liabilities (of which about 48 percent is NBR refinancing); own deposits accounted for 28 percent of the total domestic liabilities and the ratio of own funding to - 44 - Page 3 of 9 the non-government lending improved to about 55 percent. There was also a modest improvement in 1993; by end-1993, own deposits accounted for about 30 percent of domestic liabilities, and loan coverage increased to about 58 percent. Unsophisticated structure of instruments and poor quality of the loan portfolio of state-owned banks, including heavy concentration by sectors and enterprises. Some of the commercial banks started their operations with exposures to a single borrower higher than their equity capital. The heavy portfolio concentration in specific sectors (e.g., BA in agriculture, RDB in manufacturing) coupled with the dominant position of these banks in their respective credit markets, has also created an effective sector-bound segmentation of credit markets in Romania. High_ jnstitutional growth. About 25 new licenses have been issued since the entry was liberalized and 17 new banks have opened for business. However, the highest growth in absolute terms was witnessed with the largest state-owned banks. In the 1990-1992 period the RCB staff increased from 3,000 to 9,200 employees and the number of branches from 110 to 221; the RDB increased employment from 2,000 to 3,600 and the number of branches from 49 to 170. Strong contraction in real terms. The growth of the commercial banks' balance sheet was high in nominal terms; in real terms, however, the size of the balance sheet substantially contracted in the 1990-1993 period. Total assets of commercial banks rose by 114 percent in 1991, by another 75 percent in 1992, and by 256 percent in 1993; in real terms, however, the total assets at end-1992 were about 85 percent, and at end-1993 about 72 percent of that at end- 1990. Non-government credit volume in nominal terms doubled in 1991, grew another 40 percent in 1992, and 256 percent in 1993; in real terms, the end-1992 volume was 64 percent and at the end-1993 volume about 54 percent of its end-1990 level. Medium- and long- term credit volume increased by 71 percent in nominal terms in the 1990-1993 period; in real terms, at end-1993, it was about 13 percent of that at end-1990. Financial Position and Profitability. In the course of 1992, the profitability of Romanian banks has substantially increased, mostly due to the very large spreads (e.g., at end-1992, deposit rates stood in the 13.5-65 percent range, and lending rates in the 33-96 percent range), lower tax levels, and growth of the off-balance sheet services and the related commissions. The portfolio risk of all private banks and a number of smaller state-owned banks has generally decreased, including maturity mismatches of assets and liabilities and interest rate risk exposure, foreign exchange risk exposure, and credit risk exposure. The latter is due to a combination of factors including conservative credit policies, more - 45 - ANNEX_g Page 4 of 9 careful clients and project appraisals and sign ,icantly shorter average maturities. General improvement of the financial positions of a certain class of corporate clients has also played a role. The financial condition of the largest state-owned banks, however, has remained precarious. With a weak funding base, they almost completely rely on the CEC and the NBR refinancing, and continue to engage in adverse selection. Increasing Private Sector ParticiRation and Improved Capitalization. As of end-1991, private capital in the banking sector accounted for about 6.4 percent of the total capital. The newly created EXIM Bank brought to the system about three time more than the total private capital committed in the 1990-1991 period. In 1992, the private capital increased to about 22 percent and, in 1993, to 28 percent of the total capital. At end-1990, equity capital in the Romanian banking sector was about two percent of the total liabilities. Low capitalization was mostly confined to state-owned commercial banks. In 1991, the capitalization of the banking system increased to about three percent, due to the occasional recapitalization of the state-owned banks and to the new capital brought by the new entrants. By end- 1992, the capitalization of the banking system increase- to about eight percent due to the strong contraction of the banks' aggregate balance sheet in real terms. At end-1993, capitalization has declined to about six percent; while the new capital committed in 1993 greatly surpassed the volume committed in 1992, an aggressive growth of the banking sector asset portfolio has brought the overall deterioration of capital adequacy. However, the private and the smaller state-owned banks have kept their risk based capital adequacy ratios at eight percent or more, and the deterioration has been mostly the result of the significant worsening of the financial position of the two largest state-owned banks which account for about 40 percent of the total capital in the banking system. Policy Environment 4. A monetary control framework based on the two-tier banking system was established quite early in the 1990 banking reform. The NBR has gradually introduced reserve requirements, limits on re-financing credit and re-financing rates as instruments for monetary control. Given that the financial markets were underdeveloped and that neither banks nor enterprises were fully responding to market signals, there were limits to the effectiveness of these indirect instruments. Minimum reserve requirements were introduced in January 1992, but the instrument has not been used as a tool for controlling liquidity on an on- going basis. The NBR capacity for monetary programming has been and is still limited, partly due to the lack of capacity in the NBR and partly due to the lack - 46 - ANNE 2 Page 5 of 9 of precision and the difficulties with consolidation of branch accounts of large banks. S. In the course of 1991, the NBR continued use of global credit ceilings. The global ceilings were translated into guidelines for individual banks, thus inhibiting emerging competition in the credit markets. Moreover, direct credit controls could have been a major stimulant to the increase in inter-enterprise lending, both voluntary and involuntary. During 1992, the NBR started to rely more on its refinancing operations to control the evolution of the monetary base by using three types of refinancing facilities: lines of credit, including regular credits (two week maturity at NBR reference rate), special credits (medium to long term with interest rates below the reference rate), and auction credits (short term with a rate determined by bidding and each bank having a pre-assigned bidding amount). By end-1992, the share of special credit lines in the total NBR refinancing operations rose to 79 percent and by end-April 1993 to 96 percent, thereby rendering the auction mechanism inoperative and the NBR getting close to loosing its capacity to effectively influence the monetary aggregates. In October 1993, the NBR initiated a major restructuring and repricing of its refinancing facilities aiming to regain monetary control and to influence adjustment of interest rate levels to posicive real terms. By end- 1993, against the background of increasing refinancing rates which became comparable to the level of inflation, the NBR refinancing facilities included about 35 percent in regular credit lines, 20 percent as preferential credits, 34 percent as auctioned credit, and 11 percent as overdraft facilities. 6. The interest rate liberalization was ir.troduced in 1991, but with mixed effects. Interest rates on deposits remained depressed, partly due to the Savings Bank business policies and its extremely high concentration in the deposit markets. Another significant factor was low-interest government deposits with commercial banks, which were due to the large operating surpluses of extra budgetary funds; at end-1992, these amounted to about L240 billion or about 17 percent of commercial banks' total liabilities. At end-1991, the average deposit rates stood in the 6-14 percent range; at end-1992, the cost of deposits increased to the 13.5-65 percent range with government deposits covering the low end of the spectrum. 7. The increase in refinancing rates of the NBR, from an average nominal interest rate of about 49 percent in July to about 120 percent in December 1993, has been followed by the substantial increase of deposit ratds in the banking system. By January 1994, the level of deposit interest rates was in the 60-110 percent range. The lending rates have followed a similar path, from the 50-85 percent range in July to the 75-130 percent range at end-1993. In 1994, the interest rates on loans have, for the first time in recent Romanian economic history, reached positive real levels. Recent Banking Sector DeveloRments 8. The mid-1993 to end-March 1994 period was characterized by deterioration of the banks' financial positions triggered by the withdrawal of - 47- ANEL. Page 6 of 9 government deposits in July 1993, followed by a substantial increase in the cost of NBR refinancing and the cost of funding in general. The withdrawal of government deposits (at 10 percent annual interest rate) was initially fully compensated by tha increased volume of NBR refinancing (from about Lei 235 billion average in June to Lei 767 million by August 1993) delivered through regular ("current") credit lines at the NBR reference rate of 70 percent (compounded rate of about 97 percent); the NBR auction and overdraft facilities have practically rtot been used until September 1993. In October, however, the NBR moved Lo restructure the composition and to reprice its refinancing facilities. Regular credit lines were partly replaced by auctions (from practically zero volume in August to Let 396 billion in October and Lei 642 billion in December 1993) with the respective nominal rates increase from about 84 percent to over 150 percent in the October-December 1993 period, and overdraft facilities (from practically zero to Lei 352 billion in October and Lei 187 million in December 1993) with respective nominal rates increase from about 106 percent to 250 percent. In real terms (i.e., compounded rate), the rates in January 1994 were as high as 540 percent for auction refinancing and 870 percent for overdrafts. The average cost of the NBR refinance (including very low cost preferential credit lines) increased from about nominal 49 percent (APR 56 percent) in June 1993 to 137 percent (APR 362 percent) in January 1994. 9. Consequently, competition has promptly developed in the deposit markets. The nominal rates on sight deposits increased from about 30 percent in June 1993 to 45 percent in January 1994 (and as high as 85 percent for certain banks with generally low deposit base) and from the 30-50 percent to 60-110 percent range, respectively, for term deposits. Most affected were, of course, banks who did not manage to develop their own funding base in the 1990-1993 period (notably BA and RCB) and private banks whose asset portfolio size grew well ahead of their own funding (notably Dacia Felix). The positive effects of these developments were the declining dominance of CEC in the deposit markets and an increase of domestic deposits (by about 72 percent in the July 1993 to February 1994 period), but the increase in the stock of deposits still remained below the level of inflation. In response to the higher funding cost, lending rates have also increased to 110-130 percent nominal rates (i.e., compound rates in the 180-240 percent range). This has brought an increased systemic risk, reflected in an increased level of losses; in the July 1993-February 1994 period, overdue credits increased by 2.3 times for domestic currency borrowing and about 4 times for foreign currency credits. 10. The dynamics of portfolio adjustments of Romanian banks was determined by inh.ent rigidities in the asset portfolio's structure by the level of viable domestic demand and by the size and ownership structure of particular banks. The three largest state-owned banks (RCB, RBFT and BA) continued their operations with little or no adjustment; this was essentially supported by allowing privileged access to the NBR regular credit lines (the three accounted for 99 percent of the total volume) priced at nominal 70 percent rates; exclusive access to preferential credit at 10-70 percent nominal rate (100 percent of the total volume); and access to NBR auctions (typically 100 percent of the total volume, with an exception of the Dacia Felix, who occasionally participated, - 48 - ANNEX-2 Page 7 of 9 accounting for 5-8 percent of total auctioned an.ount). In effect, by end-1993 the reliance of the banking system on the NBR refinancing facilities again increased to over 50 percent of the total liabilities; by February 1994, the volume of the NBR refinancing was roughly twice as big as the total household and commercial sector deposits. II. Against the background of increasing funding cost and uncertain funding perspectives, the adjustment of the private banking sector and the RDB was much more dynamic. Banks have kept the nominal volume of lending at about the July 1993 level (i.e., contraction for more than 50 percent in real terms) mostly due to the lack of viable demand at the level of nominal lending rates beyond 130 percent. Profit margins were also squeezed compared to their 1992 to mid-1993 levels, and banks were attempting to increase profits by increasing the frequency of loan service payments. Uncertainty has also been reflected in the significant shortening of maturities, from about three months average in mid- 1993, to less than two month average in March 1994. In the 1992 to mid-1993 period, the average maturity of domestic credits was about 3 months which corresponded to an average business cycle. Now, maturities of two months or less do not cover an average business cycle, and working capital finance is practically not available in Romania. Banks have, however, quickly realized the gravity of this situation and are in the process of addressing it through capital increase (50-200 percent increase has been announced by the DFB, Tiriac, RDB, Bank Post, Bank Coop and RDB). The new capital will typically be paid in foreign exchange and involves foreign investors. By significantly increasing equity, a bank promptly decreases its funding needs; the higher capital base will also allow somewhat longer maturities, and the bank would be better able to keep interest rates at levels attractive to its clients. Banking Environment 12. State-owned enterprises (often monopolies) are not accustomed and/or compelled to respond to market signals, and they either pass on the cost of financing or do not pay. Repeated debt forgiveness may have created a moral hazard problem, in that the beneficiaries of these schemes (i.e., the delinquent enterprises and the three largest state-owned commercial banks) may now expect the Government to continue this practice in the future. On the other hand, banks have not been in a position to increase their capacity to take and sustain risk other than through capital increase. The case in point is profit taxation, where the profit taxes are levied on nominal profits, rather than on profits adjusted for inflation, which leads to continuous erosion of capital. At the same time, mandatory loan loss reserves are low, and banks are not encouraged to provision, in that provisions and loss reserves are not considered to be a part of the banks' operating costs beyond the tax-deductible general provisions of 0.5 percdnt of the total loan portfolio. The proposed Project will address this issue through conditionalities for loan effectiveness: the NBR will introduce mandatory asset classification and provisioning according to internationally accepted standards, and general loan loss reserves will be increased to two percent. - 49 - ANNIEX 2 Page 8 of 9 13. The credit appraisal, however, is likely to remain difficult. In addition to the still limited capacity of financial institutions to identify and correctly price the credit risk, there are also systemic problems. Romania lacks stable institutions and the track record of political cohesion necessary to design and consistently implement the macroeconomic policy and institutional reforms. The rules of the game have not yet been fully established, and a level playing field for all economic agents has not been fully implemented. This creates problems in appraising and pricing credit risk, especially concerning non-negotiable financial instruments with longer maturities. Prudential Regulations and Supervision 14. The NBR is aware of the serious implications of the currently difficult business environment for the safety and soundness of the banking sector. The Supervision Department of the NBR has been established immediately after the new regulatory framework was enacted. The Department comprises three divisions and now employs about 25 staff. Since mid-1992, a comprehensive set of prudential regulations has been enacted, including: - new two-step licensing regulations with increased minimum required capital; - loan exposure limits and portfolio exposure limits including exposure to a single borrower and affiliated groups, regional and sector concentration limits, foreign currency exposure limits, and contingent liabilities exposure rules; - ownership and management/board qualifications; prohibited business and regulations concerning diversification; and - insider lending and connected lending. The issuance of prudential regulations concerning the definition of capital, capital adequacy and loan classification and provisioning, which are comparable to international standards, are conditions of effectiveness of the proposed Loan. 15. Most importantly, the NBR has started to exercise its supervisory authority, including off- and on-site supervision. In 1993, the NBR revoked the foreign exchange operations license of one bank; fined another bank for breach of regulations; and suspended a general manager of a third bank because of mismanagement of the bank's risks. The banking system appears to be reacting in a positive way. The NBR reports notable improvements in attentiveness of banks to supervisory initiatives from the NBR. 16. However, there are other areas that still need to be addressed. First, there is currently no mechanism to protect deoositors of the private or mixed banks. For the state-owned banks, the protection is provided only implicitly, except in the case of the state-owned Savings Bank (CEC). In the - 50 - ANNEX 2 Page 9 of 9 event of liquidation, individual depositors are to be reimbursed to the extent possible, given the state of the bank's assets. Second is grovth management. The Romanian banking sector is growing very rapidly, in terms of number of transactions, number of clients and branching. The negative aspect of the high growth environment is the danger of over-extension. At least three institutions are known to have seriously jeopardized their financial positions due to their failure to diligently manage growth. Third, according to the current regulations, there are few limits to business diversification, and banks can engage in certain types of capital market activities.2 So far, banks' activities have included the intermediation in the placement of securities in the process of privatization and the equity investments. Banks' engagement in the securities and equities business implies potentially large contingent exposures whicb must be subject to regulation and prudential supervision. However, this has so far received little attention by the NBR. I/ This is an approach followed by san EEC cout.rie (e.g. zaa='). but with corrs.poadis prudanti*L regulations and supervision. - 51 - ANNE 3 Page 1 of 15 INDUSTRIAL DEVELOPMENT PROJECT Participating Banks 1. The proposed Project has generated a very strong interest for participation by Romanian banks. The qualification summary is provided in Table A3.1. Ten banks have applied for participation, of which siX were able to meet qualification criteria, two were asked to take additional measures to be able to qualify and two were rejected. New applicants will be invited before the proposed Loan becomes effective and the application process will remain open until the funds are coomitted. Table A3.1: Qualification Sumary Fing Bank Ownesip Apisa 1/ ApaisaL 2f Commenets RBFr State 3J Yes Yes RCB State Yes No To be reppried llnac Bank Private Yes Yes Qualified in August 1993 RBD State Yes Yes Qualified in July 1993 Dacia Felix Mied Yes Yes To be reappraised Credit Bank Mixed No Bank Post State No EXIM State / Yes No To be re-sed Chemical Bank Forign Yes Yes Societe Generale Forein Yes Yes /Results of the NB apprasa / Participadon in the proposed Project 3/ Intheprocessofprvatizaonorsootoobepuivatled 2. The appraisal was based on the level of capitalization and capital adequacy, using international standards as qualification criteria, and on qualitative criteria. The following qualitative aspects were studied: - quality of management, managerial structure and human resources; - risk management - identification of risks, credit appraisal and monitoring procedures, loan loss provisions, funding structure; - information systems - data bases, computerization level and quality of management information systems; - internal control and auditing systems; - 52 - ANX 3 Page 2 of 15 business strategy and future growth/diversification plans; plans for external auditing (by international auditing firms) in the near future); and - in the case of the two private banks, their accumulated experience in banking business and operations. Annex 5 provides a detailed description of the qualification process and criteria. Table A3.2: Summary of Banks Appraisals ROMANIAN BANK FOR ROMUNIAN RCHARIAN ION TrRIAC DACIA FOREIGN COFMERCIAL BANK COtMMERCIAL FELIX CHEMICAL SOCIETE CRILERIA TRADE _a FCR DEYL EX IBANX _ ANK LUN , BADM GElnMIU Capital adequacy Yes No (4) Yes Yes Yes yes Yes (2) Yes (2) sufficient? Fin. performance Yes No Yes Yes (1) Yes Yes Yes Yes satxsfactory during last two years? -Financial policies Yes Yes Yes Yes Yes Yes Yes Yes meet min. standards?j/ -Satisfactory loan Yes Yes (7) Yes No Yes developing (3) (3) classification and provisioning?6/ -Standard credit Yes Yes Yes developing Yes Yes Yes Yes appraisal policies? -Skills sufficient Yes Yes Yes Yes Yes Yes Yes Yes for export finance? -Good standing with Yes Yes Yes Yes Yes (9) Yes (9) Yes Yes -External audits Yes Yes Yes Yes (8) Yes Yes (6) N/A N/A Note: (1) Less than two years of activity. (2) Branch of a foreign bank, with risk fully assumed by the headquarters. (3) Loan classification and provisioning as required by the headquarter supervisory authorities. (4) Final decision pending full review and classification of asset portfolio. (5) Standards reflecting commercial practices of the Romanian environment. (6) To be introduced by the NBR by end-1993. Currently not mandated by prudential regulations. (7) No systematic loan classification. (8) First external audit to be done at end 1993. (9) Except lending to connected parties which is being addressed. 3. For the financial performance, the appraisal has also included assessment of volatility of the financial condition of a bank, its risk profile and flexibility inherent in the structure of its balance sheet. For the qualitative criteria, minimum acceptable standards, rather than standards for banks operating in developed market economies, have been used. The quality of - 53 - ANNEX 3 Page 3 of 15 management has been given major importance at appraisal. Specific concerns included management appreciation of risks in the current business environment and of financial market conditions, existence of a coherent growth and diversification program, and management understanding of bank's major deficiencies and existence of plans to address them. Staff skills and relevant experience were also appraised. However, because of the developmental role of the proposed Project, willingness to develop such skills, if currently less than satisfactory, was also acceptable for participation. Staff training and massive technical assistance would be provided under the proposed Project to build the skill capacity to the fully satisfactory level. A summary of bank appraisals is provided in Table A3.2. Romanian Bank for Foreign Trade (RBFT) 4. The RBFT was established during central planning as a specialized bank with a monopoly over the conduct of all foreign exchange transactions and a responsibility for managing Romania's balance of payments. It was incorporated under the new Banking Law in December 1990 as a joint-stock company wholly owned by the state. By end-1993 about 1.3 percent of equity was sold to employees, and Private Ownership Funds owned 29.6 percent of equity. Senior management has proposed that the RBFT be privatized in 1994, through the floating of shares for Romanian investors and by direct placement of up to 50 percent of shares with foreign institutions. The EBRD has subsequently announced its intention to buy up to 20 percent of the total RBFT shares by dilution of ownership. 5. At end-1993, the RBFT capital amounted to LIOO billion, up from about L35 billion at end-1992 and L20 billion at end-1991. In the course of 1992, to prevent erosion, the RBFT capital was converted and is now recorded in foreign exchange; it is invested abroad yielding about 8-9 percent return. The capital increase was to improve its capital adequacy and to prepare the bank to implement its diversification and growth-oriented strategy. The strategy includes plans for aggressive marketing in order to diversify its customers base, which is now dominated by enterprises from the trade and services sectors; a program to diversify from financing import and export transactions into lending and provision of other business-related customer services (e.g., overdraft accounts, equity finance); and plans to improve regional coverage and access to its services. Application for participation in the proposed Project is seen as one of the steps in line with the RBFT business strategy. 6. The RBFT has been regularly audited by external auditors. Financial statements as of end-1991 and end-1992 received clean audit opinions. At end- 1992, the RBFT assets totalled L862 billion; by end-1993 the total assets were about L2 trillion (an increase by 2.3 times). The main assets were loans to public enterprises (L617 billion of which, 75 percent foreign exchange loans) and deposits with the NBR (L757 billion) and with other banks (L38 billion). The short-term credit constituted about 70 percent of the loan portfolio. The own- funding base, comprising sight and term deposits, provided full coverage of the loan portfolio, both for domestic and for foreign exchange credits. Aggressive growth of the loan portfolio, which increased by 88 percent in 1992, and by 2.3 times in 1993 has also brought some problems. The past-due loans amounted to - 54 - ANNEX 3 Page 4 of 15 about 4 percent of the RBFT assets in 1991 and the ratio increased to 8 percent in 1992 and 10 percent in 1993. The RBFT capital amounted to L100 billion at end-1993, and the capital adequacy ratio (based on the Basel formula) was close to 8 percent, down from about 18 percent at end-1992. The ratio was calculated with an assumption that 90 percent of the nominal value of loss and doubtful loans portfolio at end-1992, amounting to L40 billion, has been underwritten by the government.1 In addition, a reduced risk weight was attached to RBFT contingent liabilities, of which a significant part has been covered by cash collateral.2 With regard to the loan loss provisions, the RBFT external audits clarify that the provisions are based on the NBR regulatory requirements and management evaluation of portfolio risks. The RBFT profitability 'has been reasonably good. The net profit amounted to L7.7 billion providing for about 9 percent return on capital in 1992, and L14 billion and about 14 percent, respectively, in 1993. 7. The RBFT risk management has been substantially strengthened in recent years. As of now, and according to its declared policy, the RBFT does not take the maturity and interest rate risk; it does, however, take limited guarantee-related foreign currency risk. Thus, the main risk which exists in the bank's asset portfolio is the credit risk. However, the bank has recently diversified into equity investments. This was intended to help restructuring of some of the bank's larger borrowers, thus improving their financial position and decreasing their probability of default.3 8. The RBFT has introduced procedures for credit appraisal. These are specified in a detailed manual, which also defines the various credit approval and risk exposure limits. The adequacy of these procedures and their relevance to the changing structure of the Romanian economy needs to be periodically reviewed by the NBR, as well as by the RBFT's external auditors. The bank has recently established a loan review function, as the on-going monitoring of the quality of loan portfolio reduces the probability of loan losses.4 All customers with loans above L50 million are reviewed each month and problems are reported to management. I/ The bad loan portfolio includes a L23 billion credit to the OLTCIT plant which produced Citreon cars under license. and export credit in the form of deferred payments to several Middle Eastern and African countries. The OLCIT Loan was advanced before 1989. The ten percent weight factor is based on Decision 447 of 1991 and Law 7 of 1992. 2/ Contingent liabilities covered by government guarantees were assigned the risk factor zero. However. in the course of 1993 RBFT calLed about L84 million of unconditional government guarantees which the Government has not honored so far. I/ The RBFT Board of Directors recently imposed ceilings on such activities. Risks attached to such activities will be explicitly taken into account when determining the required level of capitalization of RBFT. j/ The establishment of a Loan Review function was a condition for qualification. - 55 - ANr, X 3 Page 5 of 15 9. The bank employs 1300 employees, of which 40 percent have academic degrees, and about 30 percent are under the age of 30. The bank conducts regular and comprehensive training programs for its employees (about 200 hours of training per employee per year) with the help of specialists and foreign financial institutions. All banks' commercial activities are computerized. Major actions are underway to further improve internal controls and management information systems. 10. The RBFT was found eligible for participation in the proposed Project. However, there are certain reservations with regard to the readiness of bank's staff to cope with the challenges of rapid growth of its loan portfolio and its branch network. These reservations relate to the unstable macro- conditions, the lack of relevant experience and less-than-satisfactory internal control and management information systems. However, the RBFT management is providing strong leadership and is fully conscious of the potential pitfalls of fast diversification and growth, and of the current skill deficiencies. Societe Generale (SGF) 11. The SCF has maintained a representative office in Bucharest from the mid-50s and opened a branch in 1980. It was initially restricted to operating in foreign currency and started to transact with Romanian entities only after the 1989 revolution. In 1992, the SGF has diversified into local currency operations. Its interest in participation stems from the changed business strategy of the headquarters, with a strong interest to expand operations and to become a major player in Eastern Europe. Senior management of the Bucharest branch see participation in the proposed Project as an opportunity for the branch to further penetrate local financial markets and to expand its customer base. 12. As of end-1993, the branch's total assets amounted to L59 billion, up from about 15.6 billion in 1992. The main activity of the branch is to take deposits, which are kept with its Head Office in Paris or with other branches within the banking group. These activities account for 86 percent of both bank's total liabilities and total assets. Since end-1992, the SGF started to engage in domestic credit activities. By end-1993, the total loan portfolio amounted to L644 million or about 1 percent of the total assets. About 98 percent of these credits were sbort-term trade finance. The SGF has a "nominal" capital of LU.3 billion. Its net profit for 1992 amounted to FF2.1 million. 13. The branch is controlled by the Head Office in Paris, which reviews its accounts on a monthly basis. The SCF authority to approve credit is limited to FF3.5 million, and it is obliged to follow Societe Generale's appraisal procedures. Larger loans have to be approved by the Head Office, which assumes full responsibility for the operations of the branch. The branch does not take foreign exchange or interest rate risk. The country risk limits set by the Head Office for Romania are high enough as not to impose an effective ceiling on the branch's local currency credits. However, the SGF is conservative with its domestic credit operations. This is due to the lack of financial information and of solid business records of potential borrowers. - 56 - ANNEX 3 Page 6 of 15 14. All risks undertaken by the branch are born by the Head Office. The appraisal of eligibility of the local branch to take part in the proposed Project was thus based on the financial strength and soundness of the Societe Generale. Since it is known to be a major international financial institution, the local branch was found to be eligible. Chemical Bank (CBF) 15. The CBF is a branch of a major US bank, with operations in Bucharest since 1974. The office has been previously operated under the name Manufacturers Hanover Trust. Its business has traditionally been confined to foreign individuals and companies operating in Romania and was restricted to foreign exchange operations. After the 1989 revolution, the CBF started to transact with Romanian individuals and enterprises and has developed a clientele of about 100 companies, mostly in private ownership. The CBF has recently applied to the NBR to start operations in domestic currency. 16. As of end-1993, the CBF's total assets amounted to L106 billion. The main activity is to attract foreign currency deposits (L71 billion) and place them with its headquarters or other branches around the world (L105 billion). A substantial amount of its activity is off-balance sheet in the form of stand-by L/C (US$0.5 million), confirmed L/C (US$33 million), and financial guarantees to exporters (US$11.5 million). In 1992, the bank accrued net profit of US$4.6 million. 17. The CBF currently does not have authorization to diversify into credit operations. It is tightly controlled by the Head Office, which receives all records on a daily basis, approves all transactions involving any kind of risk, and is fully responsible for operations of the branch. The CBF interest in participation stems from its management's concerns that the bank would not be able to compete, and could even loose its Romanian customers, unless it is able to provide a more comprehensive set of financial services. To that end, the branch has applied to headquarters to reconsider its business strategy in Romania and to assign the branch broader authorization to expand its business activities. The management hopes to get such authorization before the proposed loan becomes effective. 18. Given the existing risk exposure arrangements - i.e., all risks of Romanian operations are to be attributed to the parent's capital - the decision on eligibility of the local branch was based on the financial strength and soundness of the parent bank, and the CBF was found eligible for participation. ExRort-Import Bank of Romania (EXIM) 19. The EXIM was founded in March 1991 as a joint-stock company wholly owned by the state with an initial capital of L30 billion. The Government plans to privatize the bank in the near future, but a minimum 51 percent share would be kept in state ownership. The EXIM is a complex institution, expected to operate both on behalf of the state and on its own account. It is engaged in both lending and insurance business. - 5 7 - ANNEX 3 Page 7 of 15 20. On behalf of the state, the EXIM plans to provide financing of exports and imports of goods in domestic and foreign currency, and to guarantee import credits, medium and long-term export credits against political and commercial risks, and short term export credits against political risks. These operations are carried out within the limits established by the Romanian Inter- Ministerial Committee for Guarantees and Credits for Foreign Trade, and on terms established by the Government. On its own behalf, the EXIM activities include lending for exports and im.ports; insurance and reinsurance of export credits against commercial risks; equity participation in banks and insurance companies in Romania and abroad; banking and financial consultancy; assessments of commercial and political risks; and correspondent banking. Participation under the proposed Project belongs to the EXIM's own activities. 21. After about a year of very intensive training, commercial activities on the Government's behalf started in April and on its own behalf in August 1992. The opening balance sheet consisted of L19 billion paid-in capital, which was increased to L25 billion by end-1992 and to L35 billion by end-1993. The capital adequacy ratio is currently well above 50. The EXIM is engaged in two types of operations on its own behalf, including export financing and export insurance. It has originally maintained a consolidated balance sheet of its operations. At appraisal, the EXIM was advised to separate its banking and insurance business as a condition for participation. Since end-1992, the EXIM maintains separate financial statements for insurance and banking activities. For example, out of the bank's total capital, L5 billion are 'designated" to cover potential losses from its insurance activity. However, since this allocation is not legally binding, it still not certain that a loss in the insurance business will not impose a further strain on the part of the capital that is supposed to back credit and other banking risks. 22. Most of the EXIM's operations so far have been performed on behalf of the Government. The EXIM management is rather conservative concerning operations on EXIM's own behalf, in recognition of the lack of experience and limited capital. A long gestation period enabled EXIM to be rather systematic about organizing its business. Staff has received massive training through bilateral assistance from the EEC and technical assistance to develop policies and business procedures. All major areas of activity are covered by procedures and manuals adopted from major OECD financial institutions; for example, credit appraisal and monitoring process, country risk analysis, internal controls. Treasury procedures and internal auditing and controls that are being developed are expected to provide for better asset/liability and risk management. The management information system is rudimentary, but a more comprehensive computerized system is being developed. This and the accumulated experience from operating as a government agent will allow the EXIM to get into full-scale operations on its own behalf. 23. The EXIM currently employs 200 staff, organized in credit, insurance and risk management operations. They are a mix of experienced staff, who joined the EXIM from middle-level management positions in older Romanian banks, and young staff recruited from the university. The EXIM management has engineered an aggressive business development program. It is planning to open 6 to 8 new - 58 - ANNEX 3 Page 8 of 15 branches (with an investment of L6-8 billion), and to eventually be able to finance an export volume of about US$5 billion. 24. Since the first EXIM operations started only recently, there is no accumulated experience. By end-1992 period, the total volume of EXIM's credit activity amounted to L4.3 billion. By end-1993, the EXIM's credit portfolio increased to L27 billion, all funded from its capital, and mostly extended at preferential rates to selected importers and exporters. The quality of appraisals and EXIM's performance is therefore hard to evaluate. The final decision on EXIM participation (i.e., its accreditation) will be made after the current activities in developing systems, procedures, and management information are finalized. A foreign external auditing firm is currently auditing the bank books and advising on the organization of an internal audit division. In order to be able to qualify, the management has also been asked to formally delineate the EXIM's banking and insurance business. Preferably, the EXIM should be organized as a holding company with two subsidiaries engaged in banking and insurance business. The bank must also gain sufficient experience in export and project-related lending. Ion Tiriac Commercial Bank (TCB) 25. The TCB was set up in 1990 with an initial subscribed capital of L500 million, of which 50 percent in US dollars and the rest in domestic currency. By Romanian standards, the TCB has a broad shareholding base. Ion Tiriac and his group of foreign investors have subscribed 51 percent of equity; the rest was subscribed by individual Romanian and foreign investors and by some foreign banks. In the 1990-1992 period, the TCB capital continued to grow (partly due to revaluation of the foreign exchange portion). In December 1991, the share capital (equity) was L4.3 billion; by December 1992, the equity increased to about L7 billion and the total capital to about L17.5 billion. In 1993, the equity was further increased to L36 billion (five times). While remaining a private bank, the TCB ownership has changed in the process. The major shareholders are Ion Tiriac and his group (35 percent), and the European Bank for Reconstruction and Development (EBRD-20 percent). The third largest shareholder is a joint venture headed by the local SIVA company (18 percent). The rest is held by various companies (12 percent) and the Romanian public at large. For 1994, further capital increase has been announced. For the time being, the TCB capitalization level meets international capital adequacy criteria. Based on unaudited financial statements submitted to the NBR, the risk based capital ratio was 17.2 percent at end-1991, 50 percent at end-1992, and at end-1993 about 20 percent. The planned capital increase is to prepare the TCB for further growth and diversification of its activities. 26. At end 1993, the total value of the TCB's assets was L283 billion, up from about L15 billion at end-1991, and about L54 billion at end-1992. Of the total assets, L97 billion were the foreign liquid assets (i.e., casb, deposits and marketable securities). The total lending portfolio amounted to about L102 billion (36 percent of the total assets), of which 75 percent has been extended in foreign exchange. The TCB customers are almost exclusively private. A part of its asset portfolio is kept in the interbank market (10 percent), mostly in - 59 - Page 9 of 15 the form of short-term loans; the share is, however, significantly smaller than in 1991 and 1992, when the funds in the interbank market typically accounted for 50-70 percent of the TCB's asset portfolio. Management explained that the changed asset portfolio structure characterized by a rapid increase of the loan portfolio (about four times in 1992 and five times in 1993) results from liberalization of interest rates, allowing the TCB to charge spreads commensurate to what the bank perceives as appropriate in relation to the credit risk; and the build up of relationships with a number of reasonably creditworthy clients in the 1990-1993 period, allowing the TCB to extend on-balance sheet financing after initial positive experiences with first-time clients. The TCBE's loan portfolio is entirely funded from its own deposit base. In 1993, the TCB started to invest, rather aggressively, in stocks of private companies; equity investments increased from about L2 billion at end-1992 to L56 billion at end-1993. 27. The TCB's business experience has been positive so far. As a new bank, it had a limited scope of operation and risk exposure. It has originally focused on off-balance sheet operations related to the foreign trade business, and has avoided taking the interest rate and the foreign exchange risk. The credit risk was also limited: the major part of the asset portfolio has typically been in foreign liquid assets and in the interbank market. However, the TCB has started to change its business policy by increasing the size of its loan portfolio and, recently, by getting into investment banking operations. Concurrently, the bank has started to develop risk management policies, internal controls and management information systems. It has adopted standard credit appraisal procedures and the institutionalized credit review structure includes the Loan Committee and the Risk Committee. Since it began its operations, the TCB has had only a handful of loans in default. 28. The TCB board has 9 members, 3 of which are also bank executives. It employs 350 staff, of which 22 are credit officers. Managerial and senior staff positions have been typically filled with experienced managerial and technical staff from older Romanian banks (e.g., RDB, RBFT) and by Romanians with banking experience returning from abroad. Less experienced staff have received on-the-job training. There are no systematic plans for comprehensive upgrading of skills to be able to support business growth and diversification. One of the reasons cited for TCB interest in the proposed Project was the availability of TA and of other types of help expected to be made available to participating banks. 29. The TCB has a very high growth potential. The management foresees extensive growth in terms of volume and size of its operations and their regional coverage, as well as business diversification. The real problem is that the capacity of the TCB to prudently manage its growth is not fully in place, both in terms of skills and in terms of infrastructure needed to support staff and management decisions (e.g., risk management, management information systems). The TCB capacity to absorb fast growth successfully is especially problematic in terms of the planned increase in the number of branches and in terms of business diversification (for example, merchant banking and credit card business). - 60 - Page 10 of 15 30. At appraisal, the decision concerning the TCB accreditation has been postponed until the externally audited financial statement for 1992 become available. As a condition for qualification, the TCB has also been asked to: (a) adopt a policy that the amount of total credit granted to affiliated parties (shareholders and companies associated with them) would not exceed 20 percent of bank's capital, and reach settlement concerning exposure to affiliated parties (e.g., through capital increase); (b) introduce internal audits and controls, including formulation of an intensive annual audit program; and (c) improve coordination of growth and diversification plans with build-up of skills and institutional capacity. 31. In May 1993, the Bank was informed that the TCB succeeded in getting a clean audit opinion on its externally audited financial statements. It was re- appraised in early July 1993. The re-appraisal confirmed the TCB's solid financial condition with a capital adequacy ratio of over 50 percent. In the meantime, the management has satisfactorily addressed all issues raised at appraisal, except for the somewhat higher volume of connected lending. The TCB was qualified for participation by Bank's management decision in September 1993. Dacia Felix Bank (DFB) 32. The DFB is one of the newer bazks in Romania. It opened for business in March 1991. It is the only bank in Romania with headquarters out of Bucharest (the DFB headquarters are in Cluj). In December 1991, the DFB equity capital amounted to about L600 million; by end-1992 the capital reached L4.6 billion and by end-1993 about L15 billion. There are also plans to increase the equity capital by about 3-5 times by end-1994. The ownership of the DCB is well diversified. Among the bank's owners are 2800 private individuals, 2200 private companies and 318 government-owned companies. Private individuals and private companies account for well over 51 percent of capital. The largest DCB shareholder holds about 12 percent of its equity; there are two companies (one private and the other state- owned) which hold about 8 percent (each) of the DFB capital. However, the announced capital increase in 1994 will involve a reputable Swiss bank, which will become a majority shareholder. 33. As of end-1993, the DFB's assets amounted to L288 billion, up from about L27 billion at end-1992. The loan portfolio accounted for about 72 percent of the total assets (L208 billion of which L34 billion in foreign currency); it increased by about 10 times in 1993, and the foreign currency loan portfolio increased by 35 times. The portfolio is well diversified, although with high regional concentration, and mostly extended to private enterprises. Between end- 1991 and end-1993, the DFB's capital adequacy ratio fell from 27 percent to 6.3 percent, and the capital increase become necessary to bring the capital adequacy to a level required by international standards. The deterioration of capital adequacy was due to the rapid expansion of its credit operations. The management claims that the DCB arrears on principal or interest were never higher than 1 percent of the total loan portfolio. The DFB funding base is weak. About L67 billion (32 percent coverage of the loan portfolio) stems from own deposits, and the remainder is borrowed in the interbank market. - 61 - ANNEX 3 rage 11 of 15 34. The DFB has experienced very fast growth since its establishment. The bank employed 45 people in March 1991, 310 in October 1992 and close to 2000 by end-1993. From about 24 branches at end-1992, the DFB doubled the number by end-1993, and intends to open 16 new branches in the near future. Most employees have been recruited from the older government-owned banks. The largest department of DFB is a credit department. The DFB Board of Directors consists of 19 members. Most of the board members are private shareholders. There are also representatives of government companies which own shares of the bank, and four board members are bank officials. 35. Compared to other Romanian banks, the DFB's growth has been reasonably well managed. Early on, it established a relatively advanced computer system. All branches have PCs. The Head Office computer provides a daily balance sheet to the management, including branch balances. The bank is currently engaged in developing an even more comprehensive management information system. 36. The DFB has introduced appraisal procedures and risk management policies. It does not take the interest rate and the foreign exchange risk. A branch can grant a credit of up to L10 million. A credit committee at the headquarters may grant a loan for up to 10 percent of the DFB capital, and the board can increase the maximum loan amount up to 20 percent of capital. The board must explicitly approve all foreign exchange loans exceeding US$0.5 million. Each credit application includes balance sheets and income statements of the borrower for the last 3 years. For the medium-term credit, feasibility study is conducted by the DFB itself. As of now, the DFB has not made any specific loan loss provision above the general provisions required by the NBR. Every month, the whole credit portfolio is reviewed by credit officers and the overdues and borrowers in deteriorating financial conditions are brought to the board's attention. The bank, however, does not practice systematic borrower and loan classification. Given a very aggressive growth rate, the loan review function and the internal control systems need to be improved. 37. At appraisal in 1992, the DFB was found eligible to take part in the proposed Project, once its capital reaches US$10 million, and providing that its capital adequacy ratio continues to meet the international standard of 8 percent. This has been subsequently accomplished in April 1993. However, review of the DFB loan portfolio in July 1993 revealed an incidence of lending to connected parties amounting to about 80 percent of its capital. In addition, there were serious concerns regarding too fast growth of the DFB loan portfolio and especially regarding the extremely weak funding base, which could easily backfire if financial environment in Romania deteriorates in any respect. The management was informed that the bank will be qualified only after the connected lending has been brought in line with NBR prudential regulations, the DFB external audit report for 1993 is presented to the Bank, and the portfolio risk profile is adequately addressed. - 62 - ANNEX 3 Page 12 of 15 Romanian Development Bank (RDB. 38. The Romanian Development Bank (RDB) originated in the central planning system and has been known as the Investment Bank of Romania. Its responsibility was to advance investment loans -o the industrial and construction sector and to provide working capital finance to construction enterprises. Reform of the financial sector and introduction of the two-tier banking system in late 1990 led to the establishment of RDB on December 1, 1990, as a commercial company with universal banking license and wholly owned by the Government. The bank took over 41 former branches of the Investment Bank and its asset and liabilities portfolio. The RDB is a state-owned bank (30 percent owned by the five POMs); however, the Government has recently announced that it will be privatized in the course of 1994 and has started to prepare the bank for privatization. 39. In the end-1990 to end-1993 period, the RDB experienced high growth in nominal terms: its total capital increased from L9.5 billion at end-1991, to L30.7 billion at end-1992, and to L50 billion at end-1993; its total assets grew from L106.6 billion at end-1990, to L202.3 billion at end-1991, to L 282.8 billion at end-1992, and to L680.6 billion at end-1993. This was accompanied by an equally aggressive growth of the RDB's branch network, from 41 branches inherited from the Investment Bank to 140 branches at end-1992. However, in real terms, the RDB's balance sheet contracted by about 6 percent in 1991, by approximately 30 percent in 1992 and by another 30 percent in 1993. 40. From about L106 billion at end-1990, the RDB's loan portfolio grew to L221 billion at end-1991, of which L144 billion (.119 billion after loss adjustments) in customer loans and L77 billion in compensation credits; the bank wrote-off about L25 billion to cover loan losses (equivalent to about 17 percent of its loan portfolio). As a result, the customer loan portfolio contracted in 1991 by a total of 42 percent in real terms. At end-1992, the loan portfolio amounted to L193 billion, of which about L180 billion were customer loans and the remainder were compensation credits. With losses equivalent to about 15 percent of the loan portfolio (L27.8 billion), the real volume of the RDB loan portfolio was L152 billion. This was a contraction of further .6 percent in real terms compared to its size at end-1991, and of 64 percent in real terms compared to its size at end-1990. At end-1993, RDB's loan portfolio amounted to L374 billion, a further contraction of over 20 percent in real terms. This contraction of the RDB balance sheet and loan portfolio enabled the bank to consolidate its financial position and to change the risk profile of its balance sheet. The consolidation has been accompanied by a radical change of RDB clients, who now include a significant number of private enterprises. Against the background of similar contraction of Romanian enterprise credit market, the RDB managod to maintain its credit market share at about 8 percent level throughout 1992 and 1993. 41. The significant contraction of the RDB's asset portfolio coupled with increase in the RDB's share capital have brought a significant improvement of capital adequacy. The accumulated losses in the capital account were reduced from L20.8 billion in 1991 to L9.6 billion in 1992, and the bank received a - 63 - ANNEX 3 Page 13 of 15 capital injection of L 14 billion in the course of 1992. Consequently, the RDB moved to a positive net worth position of about L13 billion at end-1992. The ratio of capital to risk-weighted assets improved from negative 7 percent at end- 1991, to 7.9 percent at end-1992, and to over 10 percent at end-1993, thus meeting the international capital adequacy standards. Favorable conditions in credit markets, with spreads as high as 30 percentage points, have also boosted RDB's profitability. Net interest income increased from L3.9 billion at end- 1991 to L24.5 billion at end-1992. The total after tax income improved from a loss of L22 billion in to a profit of L14.9 billion. 42. Another positive development has been a much improved' funding structure. The RDB's customer deposits doubled from L88.3 billion in 1991 (43 percent coverage of the loan portfolio) to L 153 billion in 1992 (93 percent coverage), and L274 billion (73 percent coverage) in 1993. The RDB became a net lender in the interbank market. Consequently, the RDB has gained better control over its cost of funds. Coupled with successful resolution of the portfolio maturity mismatches, this has brought a significant degree of flexibility to adjust its balance sheet size and structure to changing conditions in the Romanian economic environment. 43. The RDB has also made an excellent progress in building its institutional capacity. Most important auditor's recommendations were successfully implemented in the course of 1992 including restructuring of the branch network, closer preoccupation with risk control and portfolio management and improvements in credit appraisal and supervision capacity. The bank has pursued an ambitious institution-building program in 1993, including computerization and introduction of a computerized management information system, further strengthening of risk management policies and procedures, and a massive training program for management and staff. 44. The RDB was originally appraised in October 1992,.and was rejected because it did not meet capital adequacy and other qualification criteria. Management was informed about major issues which need to be addressed for the bank to qualify for participation. It was re-appraised in July .993. The capital adequacy and the financial position were found satisfactory and all recommendation to management were successfully implemented. Consequently, the RDB has been qualified for participation in the proposed Project. Commercial Bank of Romania (RCB) 45. In the 1945-1989 period, the National Bank of Romania (NBR), under central planning system, provided working capital and other non-investment financial services to Romanian enterprises. The financial sector reform, which was initiated in early 1990, included establishment of a two-tier banking system. The RCB was formed in December 1990 by carving out commercial operations from the original NBR portfolio. It immediately became the largest Romanian bank. 46. At end-1990, the RDB accounted for about half of the total assets and about 60 percent of the total credit portfolio of the Romanian banking sector. Its dominance, with over 80 percent share, was especially strong in the short- - 64 - ANNEX 3 Page 14 of 15 term end of the credit market. In the 1991 to mid-1993 period, the RCB remained the largest Romanian bank. However, its degree of market dominance has been successfully challenged; its share declined to 35 percent in 1991 and to 24 percent of the total banking sector assets in 1992 and 1993; the total share in non-government credit market contracted to 47 percent and 30 percent, respectively. Table A3.3: Summary of RCB Balance Sheet (in L billion) 1990 1991 1992 1993 Dec. Dec Dee. June Assets 285 775 935 2.549 Loans 269 648 (2) 583 (3) 1,249 (4) (of which bad) (40) (70) (105) (5) customer Deposit 191 234 450 Sbare Capital 7 (1) 12 30 42 Total Capital 7.4 21 88 109 no. of Branches/Offices 110 180 200 221 No. of Employess 3000 6500 9200 10500 Notes: (1) Authorized capital of L 12 blUion of which L 7 billion paid-in capital (2) Includes L 334 billion in compensation credits under Law 80 (3) Of which L 29 billion are compensation credits under Law 80 (4) Of which L 19 billion are compensation credits under Law 80 (5) Of which L 36 billion to be absorbed by the Government under Law 7 47. Against the background of persistent decline of the RCB's share in the domestic credit market, the RCB's balance sheet grew in nominal and contracted in real terms. Key parameters are summarized in Table A3.3. An important reason for the significant contraction was that 96 percent of the RCB's loan portfolio consists of loans to state owned enterprises, with a heavy concentration in machine-building, chemicals and metallurgy. These were the sectors most severely affected by the loss of markets and systemic changes in the 1991-1993 period, with obvious consequences concerning the quality of RCB's assets. 48. At end-1991, the RCB took a major hit by putting aside L70 billion in provisions for bad and doubtful loans, and ended a year with a loss of L78 billion. However, 1992 was a good year thanks to the large interest margins: the RCB's net interest income increased from L16 billion in 1991 to L136 billion in 1992 (i.e. 8.5 times); fees and commission income increased from L1.7 billion to L9 billion, respectively. This has enabled the RCB to put aside additional L48 billion in loss provisions and hyperinflation reserves and to make a net after tax profit of L88 billion. With the L18 billion state capital infusion, the RCBs capital position consequently improved from L48 billion negative net worth at end-1991, to L42 billion positive net at end-1992. At the same time, - 65 - Page 15 of 15 the RCB's ratio of capital to risk weighted assets improved from negative 36 percent at end-1992 to 7.7 percent at end-1992, or close to international standard for risk based capital adequacy. 49. Funding strategy is the RCB's weak point. It's own funding base relative to the size of the portfolio continued to deteriorate from about 27 percent of total liabilities at end-1991 to 25 percent at end-1992 and 18 percent at end-1993. The proposed Loan coverage has worsened from 81 percent in 1991 to 71 percent in 1992 and to 36 percent in 1993. This has made the RCB especially vulnerable to changes of the cost of funds and conditions of access to the interbank market and the NBR refinancing facilities. 50. On the more positive side, the RCB has made significant progress in institution building. This includes automation of the RCB's branch nettiork; significant improvement in quality of management reporting; improvement in credit appraisal and loan administration procedures; establishment of strategic planning and of loan supervision function including a work-out unit; strengthening of bank's international activities; major staff training programs; etc. 51. The RCB was first appraised in November 1992. Based on financial statements at end-1991 and mid-1992, it was rejected due to the inadequate financial condition and the failure to meet capital adequacy criteria. It was re- appraised in June 1993. At this time, the RCB was able to meet the capital adequacy criteria established for participation in the proposed Project. However, the qualification was postponed until such time when the following actions have been taken: (a) full loan portfolio review and loan classification (allowing for meaningful portfolio with assessment) has been completed; (b) specific risk management policies and an action plan to address high portfolio concentration in machine-building, metallurgy and chemical sector have been developed; and (c) a program to expand its funding base and gain better control over the cost of funds has been designed. -66 - ANNEX 4 Page 1 of 5 INDUS¶RIAL DE2EL0PMENT PROJECT Foreigh Trade and Expnort Credit Demand Trade Balance 1. As in the other reforming socialist economies, Romania's trade and payments system operated in a barter-trade regime with the CMEA countries and through normal commercial contracts with the rest of the world. The trade volumes between the two zones were roughly equal in the 1980s. The trade account balance with the convertible currencies markets was positive throughout the 1980s; in 1988 it reached a peak of US$3.6 billion. 2. Compared to the other CMEA and to most developing countries, Romania has been a major exporter; exports accounted for 31 percent of GDP in the 1980. 1981 period. The policy of self-reliance and increasingly compressed imports eventually brought deterioration of export performance to about 19 percent of GDP in the 1988-1989 period. Systemic changes after the revolution and the CMEA collapse brought a further reduction of foreign trade in recent years. In 1990- 1991, the total exports fell to less than 10 percent of GDP. The trade account balance has been consistently negative since the revolution, with the worst deficit of US$3.4 billion experienced in 1990, the first year after the revolution. 3. In both absolute and relative terms, the decline of Romania's export performance after the revolution has been even worse than the decline of its GDP and industrial output. The total exports declined from US$11.4 billion in 1988 (of which US$6.5 billion to convertible currency markets), to US$5.8 billion in 1990 (of which US$3.4 billion to convertible currency markets), to US$4.28 billion in 1992, and US$4.5 billion in 1993 (Table A4.1). With an encouraging annual growth of about 29 percent in 1992 and 8 percent in 1993, the convertible currency exports have not yet reached their 1989 level and the total exports are about one-third of the export volume in the last full year of central planning. 4. The decline of exports in the face of systemic collapse and the CMEA disintegration has occurred in all former CHEA countries. However, Romania's peers in Eastern Europe (e.g., Hungary, Poland, Bulgaria) have experienced reasonably fast recovery of the convertible currency exports, which had not materialized in the Romanian case. This was mostly due to the unsustainable composition of Romanian traditional exports and to a number of other structural or systemic reasons. - 67- ANNEX 4 Page 2 of 5 Table A4.1: Romanian Trade Balance (in US$ million) -Tota- -ehnvtble Curendcs- -Tranferatle Ruble&- tno-rps lUoWs BEaince Imoons faalance Imnors Ex DJnBasa 1987 8,313 10,491 2,178 3,428 $864 2,436 4,349 4,206 .143 1988 7,642 11,392 3,750 2,903 6,511 3,608 4,271 4,450 179 1989 8,437 10,487 2,0z0 3,406 S,9S6 2,5S9 4,602 4,144 .458 1990 9,114 5,770 -3X364 S,107 3,364 -1,743 3,678 2,170 .1-,08 1991 5,345 4,125 -1220 45e2 3,236 .1,266 455 592 137 1992 5,433 4,286 -1,147 5,290 4,197 -1,093 143 89 -54 1993 S,675 4,527 -1,148 5,675 4.527 .1,148 - - Sourc: National Bank of Romania. Issues in Exi:ort Reco2very 5. Fuels and oil-based chemical exports have traditionally accounted for about 60 percent of Romania's convertible currency exports; these exports were mostly based on arbitrage between the oil prices within the CMEA block and the prices of oil-related products in international markets. Such arbitrage opportunities have disappeared since the CMEA disintegration. On the CHLk side, about 60 percent of exports during the 1980s were registered in the machinery and equipment category. The markets for capital goods were especially hard hit since the transition to a market economy started in the former CMEA countries. 6. Another systemic reason for declining export performance is the dilapidated capital stock of Romanian enterprises. The policy decision in the early 80s to repay Romania's external debt and the consequent halt in capital equipment imports, resulted in a situation where 75-100 percent of the Romanian capital stock is older than ten years even in the most prominent export sectors. Maintenance or restoration of their competitive positions requires significant investments in rehabilitation and modernization of enterprises' capital stock, in concert with other types of restructuring. 7. Other systemic reasons for the continuing decline of exports are to be found in the past industrial policies resulting in specific structural features of the Romanian manufacturing sector. As a legacy of the self-reliance policy, the producers in Romania maintain a highly diversified production spectrus and are all virtual monopolists at the single product level. In other words, a producer typically has monopolistic suppliers of his production inputs, and he is himself a monopolistic supplier to his customers. Problems affecting enterprises in a system with such structural characteristics are contagious, in that they very quickly spread down supply chains. Enterprises are not able to escape, unless they are well capitalized, have adequate access to finance and - 68 - ANNEX 4 Page 3 of 5 imported inputs, and have reasonably developed marketing and procurement capacity, none of which has been the case in Romania. 8. A highly volatile economic environment, with frequently changing rules of the game (e.g., price and foreign exchange management policies switching from fairly liberal to increasingly government c.r.trclld) Ies elso contributed to export decline. The case in point is the decline in exports following the November 1991 "full surrender of export proceeds" policy, and the fast recovery leading to a first monthly foreign trade surplus in August 1992, after the full retention policy was re-introduced. This generally difficult situation has been further aggravated by the lack of capacity of the banking sector to deliver appropriate financing in terms of volume, timing and instruments. Finally, the arrears problems have hurt Romanian exporters almost as badly as other enterprises. 9. On the positive side, there are sectors and enterprises which, despite all odds, have managed to do reasonably well. This has been the case in garments and knitwear, furniture and small engineering products industries. A common factor for these sectors is that the prices were liberalized early, and the enterprises have had long-term commercial arrangements with a company in some OECD country. Short-Term Remedies 10. The Government is aware that the rapid recovery of exports holds a key to economic recovery and to successful transition. On the policy front, a number of measures have been implemented aiming to improve the policy environment for exporters. Access to foreign exchange has been liberalized, and mechanisms allowing market based management of exchange rates were introduced. (Full details are provided in Annex 6). The tariff regime was unified and simplified. Import quotas and licensing for protection purposes are practically non-existent. Exports and imports can, with few exceptions, be undertaken without explicit government approval. This has provided for a relatively unbiased trade- incentives regime which promotes export and import activities based on efficiency and competitiveness. 11. Besides the mentioned policy and structural factors, which will take a longer time to address, exports are constrained by the difficulties in obtaining adequate pre-shipment finance. Since the import content of Romanian exports can be as high as 50 percent, the ability of exporters to obtain pre- shipment finance on time and at competitive rates is critical to the rapid improvement of export performance. 12. Government agencies (i.e., MOI, HOF, Ministry of Trade, National Statistical Office) do not presently collect detailed information concerning import dependency ratios of Romanian exports. Indicators of import dependencies were developed through a detailed survey of foreign trade enterprises, most of which are virtual monopolies concerning foreign trade in their respective sectors (Table A4.2) - 69 - ANEX 4 Page 4 of 5 Table A4.2: Import Dependency of Romanian Exports Name of Foreigp Trade Organization Sectoral Direct Average Import Content Products as a % of Export Value ARPIMEX Shoes, Leatherwear up to 50l CONFEX Garments 30 to 40% CONST RANSIMEX Construction Services and Equipment up to 509'l | LECTRONUM Electronic Equipment, Cable, Telecomm. up to 15% Equipment |FlUCT EXPORT Agricultural Products 30% IELXIM Furniture, Cast Products, Carpets. Toys up to 30% MASINO EXPORT IMPORT Machine Tools, Woodworking, and Textile up to 15% Machinery MEHANO EXPORT IMPORT Construction Equipment, Railway Roling up to 20% Stock, Diesel Engines, Air Compressoss ROMANO EXPORT Teiles, Fabtic, Knitwear, etc. up to 20% ROMELECRO JElectrical Equipment and Appliances 15% ROMSlT Glassware, and Ceramies up to 20o TEHNO FOREST EXPORT Furniture, Wood Products, Prefab. Houses IS% TEHNO IMPORT EXPORT Ball Beatrings, Technical Goods up to 40% UNWMERSALTRADING Tractors, Farm Macbinezy, Trucks, Buses 10-20% vrrRoaiM Building Materials, Woodworking and up to SO% *,1 _________________________ Building Machinery Soumce: Foreign Trade Companies. 13. The availability of pre-shipment export finance in foreign currency is currently limited to the foreign supplier credit lines. Access to finance is complex azd expensive relative to financing terms of Romania's international competitors. (Elaborated in detail in Annex 6). Due to the inability to convert domestic currency into foreign exchange in a timely manner, the domestic credit markets are also inconvenient. The exporters are practically forced to finance the export production almost entirely from their own funds. This limits the realization of their full export potential. The proposed line of credit in foreign currency under the proposed Project, appropriately priced at competitive rates, can help remove the credit constraint to exports and enhance the price competitiveness of Romanian exporters. - 70 - A~~~~NNEX 4 Page 5 of 5 Export Credit Demand 14. Export credit demand estimates were derived in two ways. First, an assumption was made that a credit line under the proposed Project should be able to finance all major categories of positive value-added Romanian exports. Estimates are summarized in Table A4.3. Given an average of about 100-120 days per export cycle, the annual foreign exchange financing demand would total about US$631 million, which translates to about US$180 to 210 million for a revolving export credit line. Table A4.3: Convertible Currency Exports of Selected Industrial Sectors and Their Financing Estimates (in US$ million) Average Estimated 1991 1992 1993 % Import Financing Content Demand Plastic, Rubber Articles 52.0 85.4 76.4 10 7.6 Leather Products 16.9 24.8 27.9 15 4.2 Wood-Based Industries 112.2 154.6 159.5 15 24.0 Tetiles, Garments 3253 4543 7003 20 140.0 Footware 66.8 72.7 145.2 50 72.5 Base Metals and Artidces 608.8 733.9 926.4 15 3.9 Machinery and Electronics 3859 464.7 386.4 20 77.2 Transport Equipment 300.5 444.0 372.4 25 93.0 Industrial Goods 363.8 365.7 368.0 20 73.6 631.0 Source: Ministryof Industry. 15. Alternative estimate of pre-shipment export credit demand was made through a detailed survey of exporters with a proven track record, conducted by the Ministry of Industry in late 1992. The exporters were asked to identify very specific export opportunities which they would not be ab.e to fulfill due to the lack of pre-shipment finance. The opportunities referred to potential 1993 export contracts for which the companies have received invitation to bid, or to specific detailed information received from their old clients or their trading compar4ies. This survey yielded a total of US$1.36 billion in potential incremental export volume, requiring an estimated US$443 million in foreign exchange financing. - 71 - 6AE 5 Page I of 6 INDUSTRIAL DEVLOPUi4NT -PROJECT Criteria and Procedure for PFI Cualification and AccXtditation 1. ApplicatioL for ParticiRatio. An application for participation of a financial institution in the intermediation of IDP-financed credit lines shall be filed with the Department of Bank Supervision, National Bank of Romania. 2. Papers Reguired. The applicatior. for participation sboild be accompanied by: (a) a full set of documents and tables as listed in Attachment 2 of this document; (b) an outline of operational policies and guidelines as specified in Attachment 3; (c) a brief corporate strategy outline as explained in Attachment 4; and (d) a statement, signed by the Chief Executive Officer, that the financial institution agrees to be subject to the Bank's appraisal process. 3. Screening. Upon submission of the application supported by the above listed documentation, the National Bank of Romania (NBR) will review the application. According to the qualification criteria listed in Attachment 1, the NBR would decide whether a bank qualifies for full appraisal or not. If the opinion is positive, both the World Bank and the applicant bank should be notified. A bank, which, according to the opinion of the NBR, does not meet the qualification criteria will be informed in writing, including specific reasons for refusal of their application and advice regarding necessary improvements before it could re-apply. A copy of this letter would be forwarded to the World Bank. 4. AoRraisal. At an opportune time, the World Bank would appraise a bank for which a positive opinion by the NBR has been received. If the appraisal were satisfactory, the bank would be advised to submit papers necessary for accreditation. Otherwise, the bank would be informed in writing as to why it is not able to qualify. 5. Accreditation. The accreditation would be effected upon presentation of the following documentation: (a) Board Resolution - A copy of the resolution of the Board of Directors of a PFI authorizing the PFI to sign with the Ministry of Finance a Subsidiary Credit Agreement concerning loans financed by IDP against subloans that it intends to extend to eligible borrowers and subprojects, and designating twc authorized signatories (at least one signatory shall have the rank of vice president or officer of equivalent rank to sign on behalf of the PFI all papers pertaining to the loans; (b) Letter of Understanding, accepting for IDP-financed projects and transactions to: (i) adhere to the Operating Policy guidelines for - 72 - ANNEX S Page 2 of 6 IDP-financed credit lines; (ii) establish a unit or an identifiable group to be responsible for approval and supervision of IDP-financed subprojects and a Loan Review Committee; and (iii) provide training for the unit or group staff as advised by the World Bank; and (c) Agreement for IDP-financed projects and transactions to: (i) adhere to procurement and disbursement procedures of the World Bank; (ii) maintain loan accounts and documentation; and (iii) submit annually externally audited financial statements concerning the IDP related portfolio for as long as the bank continues to participate in IDP- financed credit lines. 6. Susnension/Termination of 4ccreditation. In case a subsequent evaluation of the eligibility of a PFI shows that it has not maintained compliance with the qualification and accreditation criteria and/or with the Operating Policies Guidelines, it will be suspended from further participation. Once the reasons for suspension have been satisfactorily resolved, the bank would be able to re-apply for participation. - 73 - AM S Page 3 of 6 ATTAQCME 1 TO ANNX .2 QUalifleation Criteria 1. A financial institution that seeks to participate in IDP-financed credit lines should be in a sound financial condition and have a satisfactory performance reflective of the healthy loan and investment portfolio, and should adhere to sound operating policies and procedures. Specifically, a financial institution must comply with the following qualification criteria: (a) The ratio of total capital to risk assets should not be lower than 8 percent, of which 4 percent primary capital. (b) It must have demonstrated satisfactory performance, including profitable operations, for at least a year immediately preceding the date of application for accreditation. (c) It must have satisfactory financial policies and operating procedures, including loan classification and provisioning on the asset-by-asset basis. (d) The PFI shall comply with the ceilings and limitations on loans to directors, officers, stockholders, and related interests, including the 20 percent single borrower limit in accordance with existing regulations. A bank would be obliged to report to the National Bank of Romania all assets where the exposure to a single borrower exceeds 10 percent of bank capital. (e) The total past due loans must not exceed 10 percent of the total loan portfolio of assets acquired after January 1, 1991. A financial institution whose level of arrears exceeds the 10 percent ceiling may still apply for participation, providing that the unimpaired capital and reserves are sufficient to meet the minimum capital requirements. Appraisal of such a financial institution should finally determine whether or not it will be allowed to participate. (f) It must ha-ve satisfactory credit appraisal policies and an organization, management and staff with the requisite expertise to identify, appraise and supervise the utilization of the loans; and, for export finance, to handle international trade transactions and the related documentation. (g) It must be in good standing with the National Bank of Romania, and be in satisfactory compliance with all pertinent laws, rules and regulations to the satisfaction of all regulatory authorities. (h) It must have a business strategy acceptable to the World Bank. - 74 - ANN Page 4 of 6 ATTACHMENT 2 TO ANNEX 5 Documents and Data to be Provided with Annlication for Participation I. Documents 1. Financial statements for three years immediately preceding the date of application, including Balance Sheet, Income Statement and Sources and Uses of Funds Statement; 2. Articles of Establishment and By-Laws; 3. Number of branches/subsidiaries, their relationship with head office, their authorizations; 4. List (including very short biography) of Board members and Senior Management; 5. Manuals on different policies and procedures specifically including: income accrual, loan classification, provisioning, project appraisal, project supervision and risk exposure; 6. Three samples of project/credit analysis; 7. Business plan including assumptions of financial market demand; 8. List and exposure to 20 largest clients; 9. Technical assistance or staff capacity building program currently in progress or planned; II. List of Tables 1. Table 1: Organizational Chart including number of professional staff 2. Table 2: Highlights of Past Operations (Product Lines) 3. Table 4: Portfolio Risk (exposure and arrears) 4. Table 5: Funding Position 5. Table 6: Actual and Projected Income Statements 6. Table 7: Actual and Projected Balance Sheets 7. Table 8: Actual and Projected Cash Flow Statements - 75 - AME 5 Page 5 of 6 Outline of Policy Statements 1. mission Statement 2. Policies to Maintain Institutional Strength and Soundness 2.1 Portfolio quality 2.2 Appraisal standards 2.3 Exposure limits: single enterprise, industry/subsector, business groups, affiliates 2.4 Relationship vis-a-vis directors, officers, shareholders and related interests 3. Asset-Liability Management Guidelines 3.1 Liquidity management 3.2 Currency matching 3.3 Maturity matching 3.4 Matching of variable vs. fixed rate assets and liabilities 4. Rate of Return Criterion 5. Borrower Restrictions 5.1 Minimum current ratio 5.2 Maximum debt/equity ratio 5.3 Minimum debt service coverage ratio 6. Financial Prudence Ratios/Guidelines 6.1 Capital adequacy 6.2 Adequacy of provisions 6.3 Minimum debt service coverage ratio 6.4 Minimum collection ratio 7. Procurement Policy 8. Environmental Considerations -76- A_ E Page 6 of 6 ATTACHMENT 4 TO ANNEX 5 Outline of Corporate Strategy 1. Relations with Corporate Sector, Financial Sector and Government 2. Strategies to Strengthen the Balance Sheet 2.1 Portfolio quality 2.2 Capital adequacy 2.3 Balance sheet vs. off-balance-sheet growth 2.4 Diversification of asset mix and liability base 3. Business Strategies 3.1 Product line development/diversification, including time-bound targets 3.2 Relative importance of various asset/liability product lines 3.3 Marketing strategies 3.4 Target market shares 4. Funding Strategies 4.1 Products offered or planned to increase the own funding base 4.2 Measures to manage the funding risk 5. Operational Strategies 5.1 Improvements in internal control 5.2 MIS development 5.3 Automation 5.4 Planning and budgeting 5.5 Financial management systems 5.6 Project finance: appraisal and supervision standards and procedures 6. Operations, Profitability and Balance Sheet Projections 6.1 Profitability of product lines, relative growth and importance over time 6.2 Relative contribution to profit by product lines 6.3 Relative magnitude and composition of assets and liabllities on the balance sheet a:\annez5 (April 25. 1994) -77 - ANNEX 6 Page 1 of 6 ROMANIA INDUSTRIAL DEVELOPMENT PROJECT Foreign Exchange Market and Foreign Exchange Credit Market A. The Foreign Exchange Markets (a) Exchange Rate Management Policies 1. The liberalization of the foreign exchange markets and operations in Romania was initiated in November 1990, as a part of the first package of policies initiating the transition to a market economy. The liberalization measures included 50 percent foreign exchange retention of export proceeds; liberalization of current account payments and trans-border capital transfers, including cash payments, bank transfers and foreign debt service; and introduction of foreign exchange asf,ounts for physical and legal persons in financial institutions authorized to oterate in Romania. In February 1991, the Government established a foreign exchauge market allowing access to banks legally operating in Romania and to government agencies and the NBR. The original rules were somewhat modified in June 1991, by placing limits on the amounts and purposes of current account payments and trans-border capital transfers. The foreign exchange market was further liberalized in July 1991, allowing the establishment of foreign exchange bureaus and, in effect, opening direct access to the foreign exchange market to physical persons. 2. In practice, the active exchange rate management policy was implemented only half-way. The government state-owned enterprises (i.e., RAs) and certain other enterprises operating in sectors deemed of strategic importance, continued to operate in a fixed exchange rate regime. Since November of 1990, for about a year, the exchange rate was kept at US$1 - 60 leu. The rest of the economy was operating in a "free floating' exchange rate regime. If an enterprise was not an exporter, foreign exchange needs were to be satisfied in the foreign exchange market. In the period November 1990 to November 1991, the exchange rate on the free market segment increased from US$1 - 60 lei to US$1 - 250 lei. Thus, there was an exchange rate difference of over 4 times between those who had access to the fixed rate segment of the market and those who did not, with accompanying relative price distortions. 3. The policy shifted again in November 1991 due to the need to unify the exchange rate and to get hold of sufficient foreign exchange to bring the country through the winter period, since the anticipated disbursements from the C-24 did not materialize. The four sets of regulations enacted in November/December of 1991 included: exchange rate unification and a new mechanism for government management of the exchange rate; rules for and priorities in foreign exchange allocation; limitations on current payments and trans-border capital transactions; and strict control of foreign exchange accounts of physical and legal persons. The new rules resulted in a significant decline of Romanian exports. - 78 - ANNEX-6 Page 2 of 6 4. In May 1992, as a part of a policy package associated with the second IMF stand-by, the foreign exchange related policies and markets were again liberalized, including introduction of 100 percent retention of export proceeds. The main elements of the foreign exchange related regime include: (i) re- establishment of the foreign exchange market in the form of interbank market for buying/selling operations effected by legal persons, and a market consisting of a network of foreign exchange bureaus for buying/selling of foreign currency effected by physical persons. The interbank market operates in two forms, as a daily auction market and through direct interbank settlements (originally allowed for amounts of less than US$50,000 per transaction). Legal persons participate in the interbank market through their "principal" bank. Buyers in that market are requested to present documents attesting to the current account nature nf their operations and are allowed to buy an amount of up to the payment due value; if they already owe some foreign exchange funds, they may only buy the difference; (ii) capital transfers are allowed only for specifi'- purposes and need to be authorized by the NBR and, in some cases, by the MOF. The applicants must prove the source of financing and that they do not have other outstanding liabilities; (iii) legal and physical persons are allowed to keep foreign exchange accounts. The regulations stipulate the legal sources of foreign exchange for deposits; and (iv) the exchange rate for leu is based on the average price determined in daily auctions in the interbank market. The NBR has been allowed to participate and conduct operations in the market to protect the national currency and to manage international reserves. (b) Recent Developments 5. 'While establishing the foreign exchange market, the course of the exchange rate policies was dictated primarily by a wish to avoid a vicious spiral of inflation-depreciation, that could be established if the exchange rate was freed in the absence of complementary supporting macroeconomic policies. The Government also wanted to ensure secure access to foreign exchange for imports of energy and raw materials. Large fiscal deficits (especially in 1992), highly negative interest rates through most of the period, and episodic price liberalizations contributed to pressures on the exchange rate. In concert with the policies of gradualism in other areas, the authorities opted for a policy of gradual liberalization of the exchange regime intended to lead to eventual convertibility, by manipulating the rules of market access and limiting the daily changes cf the exchange rate. In the event, the leu has undergone substantial nominal devaluation with episodic phases of real appreciation and depreciation. By end-l991, the leu was trading at 1276 lei to one US dollar, from the rate of 20 lei to tne US dollar in October 1990, a depreciation, in real terms of about 35 percent; compared to the fourth quarter of 1992, however, the rate experienced a real appreciation of about 40 percent. 6. In summary, substantial distortions have emanated from management of the exchange rate. Recognition that these policies were harming Romania's prospects for sustained income growth become more apparent in late 1993. In early 1994, the Government finally decided, under the umbrella of the IMF Stand- by agreement, to fully liberalize access to foreign exchange market and allow free float of the exchange rate. - 79 - ANNEX 6 Page 3 of 6 (c) Foreign Exchange (FX) Market Operations 7. The exchange rate has been managed through the FX market, and it has not been allowed to move more than 5 percent from the reference exchange rate of the praceding day. Since August 1992, the banks have been obliged to bring to the FX market auctions all orders above US$2,000 equivalent. This has Increased the volume of market transactions but the level of executions, however, has remained rather low. The market mechanism in the mid-1992 to end-1993 period has been the following. The auction participants submit to the NBR their sale or purchase orders in closed envelopes, quoting the amount and the respective exchange rate. The sale offers are then organized in the ascending order, starting from the lowest exchange rate; and the purchase offers are organized in the descending order, starting with the highest bid. Both are executed in the range in which the sale/purchase orders match, the rest remains unfulfilled. The daily average of executed orders determines the equilibrium foreign exchange. 8. In September 1992, the rules of the auction market were further changed in that the sale/purchase orders were to be first organized and executed only among clients of the same bank. After the operations within a bank have been settled, the remaining selling orders were to be executed. The rationale for the new rules was to motivate the banks to be more aggressive in convincing their exporter-clients to sell their foreign exchange. In the September-November 1992 period, the typical daily volume of the FX auction market stood at about US$3-5 million equivalent on the supply side, and US$15-20 million equivalent on the demand side. The percentage of fulfilled orders for the market as a whole was in the 7-25 percent range. The situation has substantially worsened during the winter months when the level of executions typically stood at 5 percent or less of the foreign exchange demand. Against the background of the Government's firm resolution not to allow fast depreciation of the exchange rate, this was mostly because the purchase orders associated with imports of energy products, food, medications and similar necessities preempted orders of other market participants. 9. The spring 1993 brought little improvement. The GovernmentIs exchange rate policy with managed movements within the 5 percentage range has brought an increasing disparity of supply and demand in the foreign exchange market. Rather than allowing a free float until an equilibrium is established, the disequilibrium has been addressed by de-facto tightening the rules of access to the foreign exchange market. However, there has been no real improvement. In summer 1993, the average level of purchase orders execution was still in the 2-5 percent range. The total amount of foreign exchange offered in the market in June 1993 was US$61 million, of which US$48 million (79 percent) was sold at prices within the administered range; on the other hand, the registered foreign exchange demand amounted to US$ 1.7 billion, of which US$48 million (2.8 percent) was successfully transacted. 10. Government interventions in determining the exchange rate were not able, however, to prevent continuing depreciations. Moreover, parallel markets flourished, at premiums often much above the official rates. At the end of 1993, it was estimated that only about 15 percent of exchange transactions was passing - 80 - ANNEX 6 Page 4 of 6 through the official auction market. About two-thirds of the flow that was successfully transacted was using an unofficial "grey" market, consisting largely of interenterprise transactions, at a premium generally between 25-35 percent of the auction rate. The persistent wide divergence between the official and parallel rates entailed substantial implicit subsidies to those importers who were able to obtain foreign exchange in the auction. In addition, pricing of energy and agricultural products referenced the official rate as the benchmark for domestic price setting, entailing considerable implicit subsidies to energy users. Meanwhile, the many changes in the foreign exchange regime undercut Romania's drive for sustained export growth and reduced confidence in the leu. 11. Radical changes, including liberalization of market access and taking steps towards allowing for free float of the exchange rate introduced in January 1994, have had a positive effect on the market. Against the background of substantial depreciation of leu (from 1250 lei to one US dollar at end-1993 to 1600 lei to one US dollar at end-March 1994), the "grey" market rate fell within the range of 5-10 percent of the nominal (i.e., official) exchange rate, and the percentage of the foreign exchange purchase order execution increased to the 70- 80 percent range. B. Foreign Exchange Credit Market (a) Sources of Foreign Exchange Credit 12. Excluding the international financial institutions, the typical sources of foreign exchange credit in Romania include: 13. (i) Credit extended by foreign supgliers directly to Romanian importers. The total volume of such credits is not precisely known, as the credit is not reported in banking statistics. However, it is reported in the balance-of-payment statistics. Foreign suppliers provide credit to Romanian importers from their own sources, i.e., in the form of inter-enterprise credit. These are short-term credits; maturities rarely exceed five years and are typically 18-30 months. To cover their credit risk, suppliers may purchase credit insurance in their home countries. 14. (ii) Credit by foreign sumnlier's bank to Romanian importers. This arrangement typically includes the RBFT as a provider of an irrevocable payment guarantee for Romanian importers. The RBFT typically asks for irrevocable counter-guarantee by the Romanian importer's local bank. A Romanian importer is typically asked to deposit cash collateral of 120 percent of the guarantee amount, expressed in lei, at the prevailing exchange rate. Rather than seeking guarantees from Romanian banks, a foreign supplier's bank may seek a guarantee from government-owned foreign credit insurance agency in the supplier's domicile (e.g., EXIMBANK in US, COFACE in France, HERMES in Germany, SACE in Italy, ERG in Switzerland, etc.). The availability and cost of such guarantees vary and the fees may or may not be market-based.. If the cost of a guarantee is at below- market rates, then the total amount is typically authorized by governments (or sometimes Parliaments) of respective countries. In some cases, guaranteec are available only for specific sectors or purchases. - 81 - ANNEX Page 5 of 6 15. (iii) Credit lines opened by various Foreign ExDort Credit Agencies to stimulate exports from their countries to Romania. The credit lines are normally intermediated by the RBFT, due to its long-standing business relationships and a good reputation abroad. Utilization of these credit lines may require an RBFT guarantee, and the RBFT may ask for a counter guarantee from the Romanian importer's local bank. 16. These credits are typically extended with maturities of up to five years, with six months to one year grace periods. Credits are delivered to Roman.an banks at fixed interest rates; the RBFT reports that the rates negotiated in early 1994 were 5.63 percent for US dollar credit lines; 6.21 percent for DM credit lines; 5.37 to 6.125 percent for SF credit lines; and 7.97 percent for FF credit lines. Interest rates on credits to final borrowers are established by taking this basis and adding a margin which covers the intermediation cost and risk of a Romanian bank, plus a profit margin. (b) Foreign Exchange Credit Market Volume 17. The total size of the foreign exchange credit market in Romania is small, relative to the domestic credit market size and also relative to the size of Romanian economy (Table A6.3). In the 1989-1991 period, the market has substantially contracted in absolute terms. The contraction was parallel to that of the domestic credit market. In 1992, against the continued contraction of the domestic credit market, the foreign exchange credit market started to recover. Its size increased by 44 percent in dollar terms, and its share in the total credit volume increased from 3.3 to 11 percent. The growth of the foreign exchange credit market continued in 1993; its share in the total credit increased to 20 percent and the market volume increased by about 45 percent in dollar terms and by almost four times in the domestic currency terms. Table A6.3: Non-Government Foreign Exchange Credit Market Volume FX Credit as X (milile1) (Il1U.SS Total NG Credit 1989 20,309 846 4.0 1990 23,100 385 3.8 1991 57,915 322 4.4 1992 213,554 464 11.0 1993 841.764 673.41 20.0 Source: NBR. Note: Note that the foreign guarantee progr do not appear in the statistics. 18. The foreign exchange credit market growth did not realize its full potential. In 1993, of about US$900 million foreign export credit lines and guarantee programs available, only about 70 percent has been committed. Less - 82 - ANNX 6 Page 6 of 6 than half of this amount has actually been utilized. There Is a number of possible reasons for the low utilization: - The total cost of financing, including credit and associated guarantees and counter guarantees, is very high; - The cost of goods, which could be financed througb these programs, is not price competitive when compared to prices in international markets; - Romanian importer may not be willing to switch from his normal supply channels if he cannot be assured of long-term relationships (including availability of financing) with a foreign supplier implied by the use of particular foreign credit/guarantee facilities; - Procurement management problem concerning higher value-added Romanian exporters, who may need to import a number of items requiring establishment of specific credit arrangements and the use of a number of credit lines/guarantees for a number of suppliers from different countries; - Various limitations introduced by foreign creditors and/or guarantee providers (e.g., limited to specific sectors or suppliers) or by Romanian government policies (e.g., import license requirements on certain products, or prohibitions to pay prices higher than international prices). - The RBFT acts as a hub of foreign governments' guarantee and export credit programs in Romania. The RBFT intermediation capacity and/or business decisions concerning the off-balance sheet foreign exchange rlsk exposure act as an effective limit to utilization of these credit lines or guarantee programs. - 83 - A7 Page 1 of 1 ROMAIAZI lNDUSTRIAL DEVELOPMENT PROJECT Estimted Disbursement Schedule of the Pronosed Loan Egtimated Schedule Cumulative Calendar Year Fiscal Year Amount Amount Z of Total and Semester and Semester -(US$ Million)-- 1994 II FY95 I 15.0 15.0 8.6 1995 I II 38.0 53.0 30.3 1995 II FY96 I 42.0 95.0 54.3 1996 I II 19.0 114.0 65.1 1996 1 FY97 I 20.0 134.0 76.6 1997 I II 15.0 149.0 85.0 1997 rI FY98 I 12.0 161.0 92.0 1998 1 II 9.0 170.0 97.0 1998 II FY99 I 5.0 175.0 100.0 Note Amouts rfe to en of period. D hih l_e of diburement durng the fit 18 monts Is due to: (i) the wpom finu componetm (US70 Mion equM lent), whudi is aexcted to dbure USSIS, USS30 and USS2 milion. tecv* i the dtr se amneters after the loan becomtes eective; and (I the tedmica sulsmncotnent, whd &s a twoyr pplm and minmed to disbumewith a seedule USS1-14 mnion die Om four aesete req"a*We. For the n of cradit (USS102 miion) the andard disuremnt >prfil hor Romanis has ben used as bausL To refet the xpeaed dynenc of the Project quaner 1820 in the sandrd dibunement table for Romama whid aornt for 6 pero" of the total credi wwo added to quaner1s516. -84 - ANNEXa8 Page 1 of 3 ROMANIA INDUSTRIAL DEVELOPMENT PROJECT Supnrvision Plan Approximate Dates Activity Expected Skill Staff Input (Month/Year) Requirements (Staff Weeks) …-. -.- -- --- . - - . - --- . . . . . -_ -.. -- . . -- . . . - . . ...-- -- - . . . . -_ _ 1/95 Supervision Mission 10 - Review accreditation of Banking Specialist PFIs Financial Specialist - Review EFF arrangements Disbursement Specialist in TD/MOF Procurement Specialist - Review PFI export and Engineer investment appraisal arrangements - Review TA for MOI 6/95 Supervision Mission 12 = Review credit pipelines 2 engineers = Review appraisal Financial Specialist procedures Economist * Review TA to PFIs Procurement/ - Review progress of Disbursement SpecialLst - consultancy studies - Verify phase-out of subsidized credits - Conduct procurement/ disbursement seminar - Review TA/TORs and short 1Lst for Banks - 85 - ANNEX 8 Page 2 of 3 Approximate Dates Activity Expected Skill Staff Input (Month/Year) Requirements (Staff Weeks) 12/95 Supervision Mission 10 - Review export finance Banking Specialist appraisal, procurement, Financial Specialist disbursement Engineer - Confirm PFI eligibility Economist - Review TA for MOI/MOF/NBR/ SOF - Review investment lending pipeline, appraisal quality, procurements/disbursements 6/96 Sugervision Mission 10 = Review macroeconomic Banking Specialist Developments Economist - Review business Engineer environment - Assess Project Implementation Results - Review continuous PFI eligibility - Review benefits/risks related to a choice of single currency loan Supervision Mission 12/96 - Review TA for MOI/NBR Financial Specialist 6 6/97 - Review investment Engineer 6 6/98 component Economist 6 - Review export component - Review EFF procedures - Review procurements/ disbursements - 86 - ANNEX 8 Page 3 of 3 Approximate Dates Activity Expected Skill Staff Input (Month/Year) Requirements (Staff Weeks) Supervision Kission 12/97 - Rev4.ew investment Financial Specialist 6 component Engineer - Review export component Banking Specialist - Review Procurements/ Disbursements - Review continuous PFI eligibility (Assess continuous need for EFF) 12/98 Supervision Mission 6 - Review Special Accounts Financial Specialist - Review Procurements/ Economist Disbursements - Review outstanding issues - Agree on Project closing date 6/99 Project Completion Report 8 Preparation of project Engineer completion report at Financial Specialist Headquarters Economist Total Missions Total Staff Weeks FY94 2 22 FY95 2 20 FY96 2 12 FY97 2 12 FY98 1 6 PCR 80 - 87 - ANNEX 9 Page 1 of 1 ROQkWIA INDUSTRIAL DEVELOPMENT PROJECT List of Documents in Project e 1. Mission Aide-Memoires and Back to Office Reports dated December 1991; February, May, July and November 1992; August 1993; April 1994. 2. Wood-Based Industry Study, Jaako Poyry, Sweden, September 1993. 3. Romania Textile and Leather Industry Study, Rovetex, Switzlerland, April 1994. 4. Romania - Machine Building and Steel Sector Assessment, Back to Office Report, April 8, 1992. 5. Romania - Non-Ferrous Metal/Mining Sector Assessment, June ?O, 1992. 6. Romania - Fertilizer Sector Assessment, June 1992. 7. Romania - Petrochemical Sector Assessment, October 1992. 8. Romania - Review of the Industrial Sector and Enterprise Reform: Main Report; 6 Annexes; Attachments. 9. Statistics Concerning Export Financing Demand, October 1992. 10. Intermediate Report on SMEs, June 1992 and February 1994. 11. Blueprint of Government Strategy to Promote PSD and SME Sector, CNS Veneto, December 1991. 12. Lazard trere - Strategy for Implementation of the Privatization Law (in French), April 1992. 13. Consultants Report - Summary of Bank Appraisal Results, December 1992 and July 1993. 14. Survey of the Impact of Social and Economic Environment on Private Sector Development in Romania, NAP, May 1992. 15. Technical Assistance for organization and implementation of the SOF and five POFs, Roland Berger, February 1993. 16. Terms of Reference for Technical Assistance under the Industrial Development Project. MAP SECTION IBRD 24742 UKRAINE j ROMAN IA INDUSTRIAL I N<> Ir , j-1RDEVELOPMENT PROJECT Ri.o, G.,n 04 EI,t g DW.I 0 bnlin~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~Wg Dik.- ~d Ri~., CoUW Wo,b A~~~~~~~~~~~~~~~~~~~~~~~~I~ ALAJ F-,~~~~~~~~~~~~~~~~~~~~~~~~~ Lr [.. High.Wo ~~~~~ ~~~Mnj.,Hig6oyA * Nf1iOd C0pim1 - hd-r-l B .. Endnd.. GALAT ( UKR~AINE CAAA R I AAC onto ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ LE B 1/1~~~~~~~~~~~~~~~~~~~~~~~~~~~~AC 9.