Dmme of 37 Z- LIv TheWorldBank Z-A /7 37'i,S .2/ - FOR OFFICIAL USE ONLY Report No. P-6338 LV MEMORANDUM AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED CURRENCI POOL LOAN IN AN AGGREGATE LOAN AMOUNT OF US$20 MILLION EQUIVALENT, A PROPOSED SINGLE CURRENCY LOAN WITH A TRANCHE OF US DOLLARS IN AN AGGREGATE AMOUNT OF US$10 MILLION EQUIVALENT, AND A TRANCHE OF DEUTSCHE MARK IN AN AGGREGATE AMOUNT OF DM8.5 MILLION EQUIVALENT TO THE REPUBLIC OF LATVIA FOR AN ENTERPRISE AND FINANCIAL SECTOR RESTRUCTURING PROJECT August 16, 1994 Privatization and Enterprise Development Division MI CROGRAPH ICS County Deparment IV Europe and Central Asia Region Thi document has a restricted distrbutlion and ma3 Report No: P- 6338 LV their offidal duties. Its contents may not othewise I Type: MOP . Currency Equivalents (as of July 20, 1994) Currency Unit = Latvian lati (introduced May 1993) Ls I = US$1.79 US$1 = 0.56 Ls Average Exchange Rates per US$1 Rate 1993 May 1993 .67 1994 April 1994 .56 1994 June 1994 .56 Fiscal Year January I - December 31 Weights and Measures Metric System Abbreviations and Acronyms CAS - Country Assistance Strategy EBRD - European Bank for Reconstruction and Development EC PHARE - European Commission Assistance Program for Eastern Europe FSUB - Former Soviet Union and Baltics GDP - Gross Domestic Product ICB - International Competitive Bidding IMF - International Monetary Fund LCB - Local Competitive Bidding LPA - Latvian Privatization Agency Ls - Latvian currency unit (Latvian Lati) MOF - Ministry of Finance PCR - Project Completdin Report PFI - Participating Financial rnstitf;tion PMU - Project Management Unit PPAR - Project Performance Audit Report SCL - Single Currency Loan SCF - Swedish Capital Fund TA - Technical Assistance TU - Technical Unit FOR OFFICIA1L USE ONLY EntRfise and Finndal Sewor Restncturi Loan Lan and Proect S_vMM Borrower: Republic of Latvia Guarantor: Ministry of Finance Beneficiaries: The Govenmment of Lavia, Bank of Latvia, Latvian Privatization Agency, private enterprises, and participating commercial banks Amount: Two loans, in the following amount, aggregating about US$35 million equivalent: (a) US$20 million equivalent (b) US$10 million and DM8.5 million equivalent (about US$5.0 million) Terms: Two loans ach repayable over 17 years, including 5 years' grace: (a) a US$20 million equivalent currency pool loan at the Bank's standard variable rate; (b) a single currency loan of two tranches: a US dollar tranche in an amount of US$10 million equivalent at the Bank's standard US$ LIBOR-based rate; and a deutsche mark tranche in an amount of DM8.5 million equivalent at the Bank's standard DM LIBOR-based rate. Onlending Terms: From the Government to the financial intermediaries in Latvian lati, US dollars and deutsche mark; from the financial intermediaries to individual borrowers in the same curencies and maturities at freely-determined interest margins. Depending on the subproject requirements, the maturity for subloans granted to finance fixed capital formation would vary from I to 12 years, with a maximm grace period of 3 years. Associated permanent working capital subloans would be for a maximum of 2 years, with a 6-month grace period. Financing Plan: Local Foreign Total ~~ US$ million IBRD 0.00 35.00 35.00 Other Bilateral Donors 0.00 11.68 11.68 EC PHARE 0.00 3.63 3.63 Gov't of Sweden 0.00 10.60 10.60 Gov't of Latvia 46.50 0.00 46.50 Participating Banks 6.00 0.00 6.00 Beneficiaries 0.20 0.00 0.20 TOTAL 52.70 60.91 113.61 Poverty Category: Not applicable Staff Appraisal Report: Report No. 12977 LV Map: IBRD No. 24630R Tis document bas a reticed disbutio and ay be usd by rcients only ini the aofter ofa e Its_ ontnt may notow be dclosed without Word Bank w-iorz tion. MEMORANDUM AND RECOMMENATION OF TNE PRESIDENT OF THE lNTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO TE EXECUTIVE DIRECTORS ON PROPOSED LOANS FOR AN ENTERPRISE AND FINANCIAL SECTOR RESTIRUCTURING PROJECT 1. I submit for your approval the following memorandum and reconmendation on two proposed loans to the Republic of Latvia for the equivalent of US$35 million to help finance an Enterprise and Financial Sector Restructuring project. The first is a single currency loan with a US dollar tranche of US$!0 million equivalent and a deutsche mark tranche of DM8.5 million eqvivalent. This loan will be repayable in seventeen years including 5 years of grace at the Bank's standard LIBOR-based interest rate for US dollar and deutsche mark SCLs, respectively. The second is a US$20 million currency pool loan at the Bank's standard variable rate repayable over seventeen years including five years of grace. 2. Sector Background. In the enterprise sector structural reforms encompassing privatization of rural land and small businesses have been progressing well; but, privatization of medium and large scale enterprises has been at a virtual standstill since 1991. The current government, however, is comnmitted to quickening the pace of privatization. Progress has been made in preparing the legal and institutional infrastructure to begin the mass privatization of medium and large-scale enterprises. An amended Privatization Law was enacted, for instance, in March 1994 and a State Property Fund and Privatization Agency have been established. A first phase of privatization transactions is now being prepared with the assistance of the Bank and a number of bilateral and multilateral donors. 3. In the financial sector the reform process-particularly the restructuring of the banking sector-had been proceeding slowly until early 1993. However, considerable progress has now been made in addressing the future of the 49 branches of the Bank of Latvia that were formerly branches of the Soviet specialized banks. Some branches have been sold to existing banks, some have been privatized individually, and the remaining 19 have been amalgamated into a new state commercial bank-the Universal Bank of Latvia (Unibank)-which the Government intends to privatize. The Government has also decided to rehabilitate and privatize the Savings Bank, which has a large branch network and still commands the confidence of the public at large. World Bank preparatory nissions have been working with the Latvian authorities since February 1993 on a strategy for addressing the strucal issues in the banking system. 4. Lessons Learned from Previous Bank Operadons. Previous bank involvement in project implementation in Latvia has been limited to the Rehabilitation Project (Ln 35250 LV) and the Agricultural Development Project (Ln 3695 LV). In addition to this involvement, the experience of a number of bank missions to Latvia bas underlined the inadequacies in management and institutional capacity to support adjustment and restructuring. Experience in Eastem Europe also points to the necessity of supporting enabling institutio-s as the economy opens to entrepreneurial activity. Another pertinent lesson from this region is that bank and enterprise reform should proceed, to the extent possible, in tandem. The Latvian bankng system has begun to act as a channel for credit lines, most recently through facilities provided by the G-24 and IMF. Experience with the former facility suggests that, on the one hand, there is a significant demand for longer-term funding. On the other, the reported misuse of funds in some speciic cases suggests that it is important to design and implement a robust mechanism for the channeling of credit. -2- 5. Rationale for Bank Involvement. The Bank has a firm commitment to assisting Latvia undertake the difficult transition from a centrally planned to a narket economy. However, structural reforms in the enterprise and financial sectors have, until rel.'tively recently, proceeded slowly in Latvia. Given the central impormance of the two sectors to the economy, it is vital to reinvigorate the reform process in these areas if the overall reform program is not to stall. 6. The proposed project is designed to provide an impetus to the reforms in the enterprise and financial sectors and bring closer the point at which income and employment generated by new industrial activity begins to exceed income and employment falls in the declining industries. The project is consistent with current bank policy in that it helps to catalyze trans-sectoral support for private sector development, privatization and subsequent restructuring. As Latvia is a new member, an interim Country Assistance Strategy (CAS) was discussed when the first Bank-supported Rehabilitation Loan (Ln 35250 LV) was presented in October 1992. A comprehensive CAS, to be presented to the Board alongside this project, provides a full discussion of the Bank's assistance strategy for Latvia of which this project is an integral component. 7. Project Objectives. The project's main objective is to support-and help accelerate-the Government's reforms in the ttiterprise and financial sectors, focussing in particular on entetprise privatization and bank restructuring. An important aspect of this is the design and implementation of a coordinated stregy of reform for both sectors and the development of skills for addressing problems on the interface between the sectors (i.e., work-out capacities for dealing with bad debtors). These reforms will pave the way for improved intermediation through the banldng sector, specificaly to newly-privatized and other emergng private sector enterprises. To further support intermediation thogh the banking system, the project will assist in the development of the payments system. The credit component of the loan wi1l act as a catalyst to the development of intermediation at the medium- and long-term end of the maturity spectrum and will encourage new investment in the emerging private sector. A key objective in this context will be the establishment of a strong mechanism-a Technical Unit-for channeling credit lines to the private sector. 8. Project Description. The project comprises the following three components: (1) a Credit L;ne-in tandem with a Capital Fund for bank capitalization that is expected to be provided by the Government of Sweden-to finance investme and related permanent working capital needs in newly privatized and other private sector enterprises; (2) an Insitonal Development Component, in support of the Latvian Privatization Agency (LPA), the Project Management Unit (PMU) and the Technical Unit (TU); and (3) a Financial Irfrastrutre Invesonen Component, for the purchase of computer hardware and software for payments system development. (1) CreditLine Component (US$29.58mllion'): This component will be financed out of the single currency loan-US$10 million and DM8.5 million (about US$5.0 million equivalent)-and US$14.58 million equivalent from the currency pool loan. The purpose of the credit component is to provide resources for invesmunent finance (and associated permanent working capital) for newly-privatized enterprises and other private sector enterises. US$10 million of the credit line will be earmarked for newly privatized enterprises. If this element is not I This amount includes US$980,000 of unallocated funds under the currency pool loan that are expected to be deployed in the credit line. -3 - disbursed within eighteen months, it will be made available for other private sector borrowers. This component will be supported by the Swedish Government in the form of a Capital Fund (of US$10 million) that will be used for bank capitalization. A small number of private commercial banks will be eligible for injections of capital (US$2 million) from this Fund. These will also be recipients o funds- from the credit line. Unibank and the Savings Bank are also expected to be direct recipients of a capital injection from the Capital Fund (US$5 million and US$3 million, respectively). The Government has already replaced non- performing loans in Unibank's balance sheet with government bonds as part of an overall recapitalization program for the bank. Over time, as Unibank develops acceptable investment projects, subloans under the credit line will replace the bonds (which will then be extinguished). The Savings Bank-which has also been recapitalized by an injection of govenment bonds-will not, however, be a participating bank for the channeling of the credit line. (2) Institaional Development Component (US$3.42 million): This component is financed entirely from the currency pool loan. A subcomponent for the LPA (US$3 million) will help to fill critical gaps in the overall progr -- of TA being provided to support the enterprise privatizaton process by a ra.6; of bilateral and multilateral donors. Grant funding will be sought to finance this component also, where possible. Where additional grant funding is obtained there will be a reallocation of this loan component's proceeds to the credit line component. The technical assistance being included under this component (US$ 2.5 million) will support the auction track of the Mass Privatization Program. Channeled through the Latvian Privatization Agency, loan funds will be used to assist in the preparation of selected enterprises for privatization, specifically through the provis .n of basic pre-privatization financial and organizational restucturing. To this end, about 10 advisory teams will be formed, comprising local experts and foreign specialists with extensive privatization experience in Cental and Eastern Europe. Each team will analyze the economic and financial situation of the enterprise, recommend 'soft' restructuring measures to be taken prior to auction, develop a strategic business plan, and prepare a short prospectus for auction participants. The loan will also finance the equipment necessary for a bidding center to facilitate the auction process. US$0.5 million will also be used to finance computer hardware and software for strengthening the LPA and for establishing the auction mechanism. A subcomponent of US$0.42 million will also be provided to strengthen the PMU and the TU. With regard to bank restructunng, the Bank has taken the lead during the loan preparation phase in providing assistance, with the help of a PHRD grant, for rehabilitating Unibank. During the loan in phase, the Bank has secured resources from a range of donors in support of the further institutional development and privatization of Unibank and the Savings Bank. (3) Financial Infrasructure Investment Component (US$2.0 million): This component is financed entirely from the currency pool loan. The Government has decided to undertake a modernizaon of the domestic payments and clearing system. In the first phase of development, which will be supported under the loan, the existing payments and clearing mechanism will be upgraded to Western -4 - standards. This component will finance the acquisition of comrputer hardware and software equipment to assist the Bank of Latvia in the upgrading of the payments system. The component will be cofinanced by EC PHARE and bilateral donors. If, subsequently, grant sources are identified to finance equipment needs, the proceeds of this component will be reallocated to the credit line component. 9. Project Inplemeutaton. The proposedproject would be supported by the establishment of a strengthened Project Management Unit in the Ministry of Fiance and a new Technical Unit that will be an independent state entity. The project cost is estimated at US$114 million equivalent, with a foreiga exchange component of US$61 million equivalent (54%). The Bank's standard variable interest rate would be charged on the disbursed portion of the currency pool loan. For the single currency loan - in US dollars and deutsche mark - t*. Bank's standard LIBOR-based interest rate for the relevant currency will-be charged. Of the total financing requirement of US$114 million, the Bank will fmance US$35 million (31%). A breakdown of costs and the financing plan are shown in Schedule A. Amounts and methods of procurement and of disbursements, and the disbursement schedule are shown in Schedule B. A timetable of key project processing events and the status of Bank Group operations in the Republic of Latvia are given in Schedules C and D, respectively. A map is also attached. The Staff Appraisal Report, No. 12977 LV dated August 5, 1994, is being distributed separately. 10. Agrements reached at Negotiations. Agreements were reached at Negotiations on: (1) the overall structuring of the loan; (2) the organization, staffing, functions and financing of the PMU and TU; (3) the guidelines for the Credit Line Regulations Manual and the Operating Procedures for the TU; (4) the framework for the Special Performance and Monitoring Program for participating banks, and; (5) environmental review procedures and the content and scope of environmental technical assistance. In addition, agreements were reached on two "set asides." First, a set aside of US$10 million equivalent of loan finds for newly-privatzed enterprises that become eligible for subloans. This set aside would be in effect for the first eighteen months following loan effectiveness. Second, a set aside of US$2 million for the Swedish Capital Fund (SCF) for eligible participating financial institutions (PFIs). This would be in effect for the first nine months following loan effectiveness. The funds from the set aside will be disbursed to specific PFIs eligible for participation in the SCF established under an Agreement, acceptable to the Bank, between the Borrower and the Govermment of Sweden. The following conditions of effectiveness were established: (i) the V'-bsidiary Loan Agreements between at least two participating banks and the Bond Redemption Agreement for Unibank, satisfactory to the Bank, must have been executed by the relevant parties; (ii) a Financial Agency Agreement, satisfactory to the Bank, must have been signed and a Separate Project Account must be opened at thi Bank of Latvia on behalf of the Republic; (iii) the TU must have been staffed in a manner satisfactory to the Bank; (iv) an environmental screening procedure for subproject financing, satisfactory to the Bank, must be established (including an Environmental Assessment Manual); (v) a model of the Subloan Agreement, satisfactory to the Bank, must be submitted to the Bank; (vi) a privadzation program for Unibank, satisfactory to the Bank, must be prepared; and (vii) the Credit Line Regulations Manual and the Operating Procedures of the TU must have been agreed with the Bank. 11. Environmental Aspects. This project is classified as a category "B" project involving intermediary lending. An enviromnental review mechanism will be built into the subproject approval process. Technical assistance will be provided to strengthen the capacities of the Ministry of Environment to monitor subprojects. Technical assistance will also be provided to help the Govermnent develop legislation that will address the issue of liability for past pollution in regard to enterprises that are being privatized. -5- 12. Project Benefits. The project will assist tht marshalling and efficient allocation of resources in Latvia by enabling improved intermediation. The heavy emphasis in the project on the restructuring of the banking system, coupled with the strengthening of the flivancial irastructure (through the upgrading of the payments system) will place the fir_ncial system in a better position to support an enhanced level of activity in the real sector. The project will also encourage new investment in the emerging enterprise sector through the provision of medium- and long-term credit. By acting as a catalyst to the privatization process it will improve the supply response in tL. econonw- and quicken the transition to a market based economic system. Undergirding all of the loan components is a major effort to support the development of ir.ditutions-and the associated skill transfers-that will be vital to the success of transition. The choice of single currency loan terms for a portion of the credit line will enable the onlending of that currency which is best suited to the needs of the subborrowers without requiring the govermnent or the conunercial banks to take the foreign exL ange risk. 13. Risks. The project is being developed against the backdrop of a fragile coalihion governnent. This increases the risk that project objectives could be undermined by a sudden change in government. Another risk is the development of unacceptably high budgetary costs associated with enterprise and financial restructuring that might act as a drag on the reform process. With regards to the channeling of the credit component, any resurgence of inflation would curtail the trend towards lower nominal interest rates. This could undermine the credit line by reducing the demand for credit by the private sector. Similarly, there is some pcssibility that the highly profitable trade transactions (involving trading in Russian commodities and metals which is stimulated by Russian prices. below international levels), which have been financed at very high rates of interest, will not run down quicldy. This type of financing is dominating bank lending and distorting the interest rate structure at present. A specific risk to the bank restructuring effort is that a ftrther deterioration in the economy will lead to a significant future build-up of non-performing loans that would undermine the stability of the banking system. The LIBOR basis of the single currency loan component may create interest risk for those subborrowers whose revenues do not have the same interest rate sensitivity: credit appraisals should take into accoun the capability )f subborrowers to manage this risk. 14. Recoendation. I am satisfied that the proposed loan would oomply with the Articles of Agreement of Bank and recommend that the Executive Directors approve the proposed loan. Lewis T. Preston President Attachments: Schedules A - D Washington, D.C. August 16, 1994 -6- ScheduleA ENTERPRISE/FINANCIAL SECTOR RESTRUCTURING PROJECT (US$ million) Estimated Costs and Financing Plan (US$ 113.6 million) Local Foreign Total Estinated Project Cost Credit Line 6.20 29.58 35.78 Institutional Development 45.70 23.03 68.73 Financial Infrastructure Investment 0.80 8.30 9.10 Total Cost 52.70 60.91 113.61 Financing Plan IBRD 35.00 Other Bilateral Donors 11.68 EC PHARE 3.63 Gov't of Sweden 10.60 Gov't of Latvia 46.50 Participating Banks 6.00 Beneficiaries 0.20 Total 52.70 60.91 113.61 -7- Schedule B Page I of 2 ENTERPRlSEMFINANCIAL SECTOR TRUCEIWNG PROJEC= (US$ million) Summaaa of groposed Pcument Arran ents (US$113.6 million equivalent)W ICB LCB OTH N.B.F. TOTAL Credit Line 2.0 5.0 30.8 8.0 45.8 (1.0) (4.0) (24.6)' (29.6) lsitutional 3.4 17.2 20.6 Development (3.4)' (3.4) Finanial 2.0 0.2 2.2 Infrastructure (2.0)a' (2.0) investment Othera' 45.0 45.0 TOTAL 2.0 5.0 36.2 70.4 113.6 (1.0) (4.0) (30.0) (35.0) 1' Figures in paentes are the respective amounts fnanced by the Bak loan. ' This catgory represents the approximate budgetary cost for the Governmet of Latvia of paying interest (for three years) on the govemment bonds that have been placed on the balnce sheets of Unibank and the Savings Bank in replacement of nonperforming loans. 1 Other is expected to include goods, works and services procured under commerci practices (US$16.6 million) and through International Shopping (US$8 million). f Fortchmical asance, services will beprored acoringto the Bank'sGuidelines onthe UseofConsuan (1981). Proem ent of reu t costs required for the operation of the TU will follow a program previously agreed with the Bank. Office eipmet would be procuWed through local shopping. 1 This is epected to be procrd through Intenational Shopping. However, becaus of the amount and cost of the equipment, there might eventually be a need to procure some of it through ICB. Schedue B Page 2 of 2 LATVIA ENTERPRISE AND FINANCIAL SECTOR RE=SRUCTURING IBRD Disbursements Category Amount (US$000) Percent of Expenditum to be financed Credit Line Goods and services under approved 28.6 100% of foreign expenditure subloans (C.I.F.), and local expenditures (ex- factory costs, and consultants' services); 80% of expenditures for other items procured locally. Unallocated Funds 1.0 '-Institutional Development Consuling Services 2.5 100% of expenditures hcemental Rewrrming Costs of 0.4 100% of expenditmes Opeating the TU Equipment and Materials 0.5 100% of foreign expaditu (C.I.F.), and local expenditues (ex- factory costs); 80% of expenditures for other items procured locally. Financial Infrastructure Investment Computer Hardware & Software 2.0 100% of foreign expenditures (C.I.F.), and local expenditures (ex- factory costs); 80% of expenditures for other items procured locally. TOTAL 35.0 Estimated IBRD Disbursements (US$ Millions) CumulavY95 FY96 FY97 eY98 Annual ~~~~8 12 10 S bve L 8~~~~~~~~~~2 30 35: -9- Schedule, C ENTERPRISE/FIANCIAL SECTOR REST.RUCTURING PROJECT Timetable of Key Project Processin Events (a) Time taken to prep the project: 12 months, Beg-March 1993 - End- March 1994 (b) Prpared by: Foreign consultants md Governmet with Bank Assistance (c) First Bank mission: March 1993 (d) Appraisal mission deparu: February 1994 (e) Negotiations: June 1994 (f) Board Presentation: September 1994 (g) Plamned date of effectiveness: October 1994 (h) List of relevant PCRs and PPARs: N.A. TheprojectwaspreparedbyAlecanderE. Fleming, Prindpal Financial Economist, PrivatizationandEnterpriseDevelopment Division, Country Department IV, Europe and Central Asia Region. 10- LATI ENTERPRISE/FINANCIAL SECTOR RESTRUCTURING A. Staement of Bank Loans (As of July 20, 1994) Us$ Million (less cancellations) Loan No. Y Borrower Project L-n Undisbwsed 35250 LV 1993 Rep. of Latvia Rehabilitation 45.0 12.0 3695 LV 1994 Rep. of Latvia Agriclture 25.0 23.0 Total Of Which: Repaid 00.0 Total held by Bank 70.0 Total amount sold 00.0 of Which: Repaid 00.0 Total undisbursed 35.0 B. Statement of IFC Investments (As of July 20, 1994) Epected Fiscal Baard Dabe Year Borrower Project Amount (US$ millionl Septeer 1994 1995 elekom Infrasucture 16.4 IBRD 24630R rb Vi! jandi TO ~ ~ ~ ~ ESOI | V 5 t/> ~~~~~~~~~~~~~~~~~~~~~~~E S T O N I A <==< %\ \ ~~~~~~~~~~~~~~~~~~~RUSSIAN| EMp,IJf-S\ Gulf ( Volniet { FEDERATION R ~~~ V/add of~~o c -- 0 X RERS - INTER OL BOUNDAES Big POLAND Kbliniags T , -0 F- --7- --- -- - - 150 URBANAREAS MAIN ROADS . , iAO bOUAdOf105,{APL9 >~~~~ .0 20 - 0 t EETDmE ALOD ofnius n 3E *4 POLAND INLAND ro Fnndri L~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~PI A1994 o t"