Document of The World Bank FOR OFFICIAL USE ONLY Report No: PAD771 INTERNATIONAL DEVELOPMENT ASSOCIATION PROJECT APPRAISAL DOCUMENT ON A PROPOSED CREDIT IN THE AMOUNT OF SDR 6.5 MILLION (US$10 MILLION EQUIVALENT) AND PROPOSED GRANT IN THE AMOUNT OF SDR 6.5 MILLION (US$10 MILLION EQUIVALENT) TO LAO PEOPLE'S DEMOCRATIC REPUBLIC FOR A SMALL AND MEDIUM ENTERPRISE ACCESS TO FINANCE PROJECT MAY 7, 2014 Financial and Private Sector Development Department Southeast Asia Country Unit East Asia and Pacific Region This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. CURRENCY EQUIVALENTS (Exchange Rate Effective March 31, 2014) Currency Unit = Lao Kip (LAK) LAK 8,018 = US$1 US$ 1.54563 = SDR 1 FISCAL YEAR January 1 – December 31 ABBREVIATIONS AND ACRONYMS ADB Asian Development Bank AEC ASEAN Economic Community ASEAN Association of South-East Asian Nations BDS Business Development Services BOL Bank of Lao PDR CAR Capital Adequacy Ratio CPS Country Partnership Strategy DA Designated Account DOSMEP Department for Small and Medium Enterprise Promotion (of MOIC) ESMF Environmental and Social Management Framework ESMS Environmental and Social Management System FIs Financial Institutions FM Financial Management GDP Gross Domestic Product GIZ German International Cooperation (Gesellschaft für Internationale Zusammenarbeit) GOL Government of Lao PDR IBRD International Bank for Reconstruction and Development IDA International Development Association IFC International Finance Corporation IFR Interim Financial Report IMF International Monetary Fund LOC Line of Credit LSX Lao Securities Exchange MDGs Millennium Development Goals MOF Ministry of Finance MOIC Ministry of Industry and Commerce MOU Memorandum of Understanding MTR Mid Term Review NGOs Non-Governmental Organizations NIU National Implementation Unit (of MOIC) NPL Non-Performing Loan NSEDP7 Seventh National Socio-Economic Development Plan ORAF Operational Risk Assessment Framework PAD Project Appraisal Document PEC Program Executive Committee PFIs Participating Financial Institutions PIM Project Implementation Manual ii PMU Project Management Unit PNG Papua-New Guinea ROSCA Rotating Savings and Credit Associations RSF Risk Sharing Facility RSFA Risk Sharing Framework Agreement SFA Subsidiary Financing Agreement SFB SME Fund Board SMEs Small and Medium Enterprises SOCB State-Owned Commercial Banks SOEs State-Owned enterprises TA Technical Assistance TDF Trade Development Facility Project WB World Bank WTO World Trade Organization Regional Vice President: Axel van Trotsenburg Country Director: Ulrich Zachau Sector Director: Tunc Tahsin Uyanik Sector Manager: Hormoz Aghdaey Task Team Leader: Jose De Luna Martinez iii LAO PEOPLE'S DEMOCRATIC REPUBLIC Small and Medium Enterprise Access to Finance Project (P131201) TABLE OF CONTENTS Page I. STRATEGIC CONTEXT .................................................................................................1 A. Country Context ............................................................................................................ 1 B. Situations of Urgent Need of Assistance or Capacity Constraints (if applicable) ........ 2 C. Sectoral and Institutional Context................................................................................. 2 D. Higher Level Objectives to which the Project Contributes .......................................... 7 II. PROJECT DEVELOPMENT OBJECTIVE(S)/GLOBAL ENVIRONMENT OBJECTIVE(S)..............................................................................................................................7 A. PDO............................................................................................................................... 7 B. GEO ............................................................................................................................... 8 Project Beneficiaries ........................................................................................................... 8 PDO Level Results Indicators ............................................................................................. 8 III. PROJECT DESCRIPTION ..............................................................................................8 A. Project Components ...................................................................................................... 8 B. Project Financing .......................................................................................................... 9 C. Series of Project Objective and Phases ....................................................................... 10 D. Lessons Learned and Reflected in the Project Design ................................................ 10 IV. IMPLEMENTATION .....................................................................................................11 A. Institutional and Implementation Arrangements ........................................................ 11 B. Results Monitoring and Evaluation ............................................................................ 11 C. Sustainability............................................................................................................... 11 V. KEY RISKS AND MITIGATION MEASURES ..........................................................12 A. Risk Ratings Summary Table 4 .................................................................................. 12 B. Overall Risk Rating Explanation ................................................................................ 12 VI. APPRAISAL SUMMARY ..............................................................................................13 A. Economic and Financial (if applicable) Analysis ....................................................... 13 B. Technical ..................................................................................................................... 13 iv C. Financial Management ................................................................................................ 13 D. Procurement ................................................................................................................ 14 E. Environment (including Social Safeguards) ............................................................... 14 F. Other Safeguards Policies Triggered (if required)...................................................... 15 Annex 1: Results Framework and Monitoring .........................................................................16 Annex 2: Detailed Project Description .......................................................................................21 Annex 3: Implementation Arrangements ..................................................................................28 Annex 4 Operational Risk Assessment Framework (ORAF) ..................................................37 Annex 5: Implementation Support Plan ....................................................................................42 v . PAD DATA SHEET Lao People's Democratic Republic Small and Medium Enterprise Access to Finance Project (P131201) PROJECT APPRAISAL DOCUMENT . EAST ASIA AND PACIFIC (EASFP) Report No.: PAD771 . Basic Information Project ID EA Category Team Leader P131201 F - Financial Intermediary Jose De Luna Martinez Assessment Lending Instrument Fragile and/or Capacity Constraints [ ] Investment Project Financing Financial Intermediaries [X ] Series of Projects [ ] Project Implementation Start Date Project Implementation End Date 01-Sep-2014 31-Dec-2018 Expected Effectiveness Date Expected Closing Date 01-Sep-2014 June 30, 2019 Joint IFC Joint Level Joint Project - involving co-financing with IFC Yes (loan, equity, budget, other) or staffing Sector Manager Sector Director Country Director Regional Vice President Hormoz Aghdaey Tunc Tahsin Uyanik Ulrich Zachau Axel van Trotsenburg . Borrower: Lao People’s Democratic Republic Responsible Agency: Ministry of Industry and Commerce Contact: KINGXAY Title: Director, SME Fund Management CHOUNLAMOUNTRY Division, DOSMEP. MOIC Telephone: +856- 21-414-064 Email: KINGXAY@Yahoo.com . Project Financing Data (in US$ Million) [ ] Loan [ ] Grant [ ] Guarantee [X] Credit [ X ] IDA Grant [ ] Other Total Project Cost: 20.00 Total IDA Financing: 20.00 vi Financing Gap: 0.00 . Financing Source Amount BORROWER/RECIPIENT 0.00 International Development Association (IDA) 20.00 Total 20.00 . Expected Disbursements (in US$ Million) Fiscal Year 2015 2016 2017 2018 2019 Annual 1.00 3.00 4.00 5.00 7.00 Cumulative 1.00 4.00 8.00 13.00 20.00 . Proposed Development Objective(s) The objective of the Project is to provide long-term funding sources for banks to provide long-term credit to small and medium enterprises. This PDO will be achieved by increasing the supply of long- term finance provided by commercial banks and by strengthening the capability of DOSMEP to formulate and implement public policies that promote access to finance for SMEs. . Components Component Name Financing (US$ million) 1. Line of Credit Facility 12.00 2. Risk Sharing Facility 3.00 3. Technical Assistance 5.00 . Institutional Data Sector Board Financial Inclusion . Sectors / Climate Change Sector (Maximum 5 and total % must equal 100) Major Sector Sector % Adaptation Mitigation Co-benefits % Co-benefits % Finance SME Finance 100 Total 100 I certify that there is no Adaptation and Mitigation Climate Change Co-benefits information applicable to this project. . Themes Theme (Maximum 5 and total % must equal 100) Major theme Theme % Financial and private sector development Micro, Small and Medium Enterprise 100 vii support Total 100 . Compliance Policy Does the project depart from the CAS in content or in other significant Yes [ ] No [ X ] respects? . Does the project require any waivers of Bank policies? Yes [ ] No [ X ] Have these been approved by Bank management? Yes [ ] No [ ] Is approval for any policy waiver sought from the Board? Yes [ ] No [ X ] Does the project meet the Regional criteria for readiness for implementation? Yes [X ] No [ ] . Safeguard Policies Triggered by the Project Yes No Environmental Assessment OP/BP 4.01 X World Bank Group Performance Standards OP/BP 4.03 X Natural Habitats OP/BP 4.04 X Forests OP/BP 4.36 X Pest Management OP 4.09 X Physical Cultural Resources OP/BP 4.11 X Indigenous Peoples OP/BP 4.10 X Involuntary Resettlement OP/BP 4.12 X Safety of Dams OP/BP 4.37 X Projects on International Waterways OP/BP 7.50 X Projects in Disputed Areas OP/BP 7.60 X . Legal Covenants Name: Recurrent Due Date Frequency Project Institutional Arrangements X Continuous Description of Covenant Obligation of the Recipient to maintain, at all times during the implementation of the Project, the SME Fund Board, the Project Management Unit (PMU) and the National Implementation Unit (NIU) all with functions, composition, staffing and resources satisfactory to IDA. Name Recurrent Due Date Frequency Project Implementation Manual X Continuous Description of Covenant Obligation of the Recipient to carry out the Project in accordance with the Project Implementation viii Manual. Legal Covenants Name Recurrent Due Date Frequency Mid Term Review October 31, 2016 Once Description of Covenant Obligation of the Recipient to carry out a Mid-Term Review (MTR) of the Project within two years after the Project Effectiveness (by October 30, 2016) to assess implementation progress and make any adjustments considered appropriate. Legal Covenants Name Recurrent Due Date Frequency Safeguards X Continuous Description of Covenant Obligation of the Recipient to ensure that the Project is carried out in accordance with the provisions of the Environmental and Social Management Framework (ESMF) and the Participating Financial Institutions’ Environmental and Social Management Systems (ESMS), including the preparation and implementation of environmental and social safeguard assessments and plans in accordance with the ESMF. Legal Covenants Name Recurrent Due Date Frequency Line of Credit Facility X Continuous Description of Covenant Obligation of the Recipient to appraise and select PFIs, and conclude Subsidiary Financing Agreement, acceptable to the Association, with each PFI, on the terms and conditions specified in the Financing Agreement and detailed in the PIM, including the obligations of the PFIs to enter into sub-loan agreements with beneficiary SMEs on the specified terms and conditions. Legal Covenants Name Recurrent Due Date Frequency Risk Sharing Facility X Continuous Description of Covenant Provisions under which the Recipient entrusts IFC to administer the Risk Sharing Facility on behalf of the Recipient, in accordance with the Risk Sharing Framework Agreement between the Recipient, IDA and IFC, and the Risk Sharing Agreements between IFC and each PFI, all on terms and conditions acceptable to IDA. . Conditions Name Type Withdrawal Conditions Conditions of disbursement Description of Condition Provisions specifying that no withdrawals can be made: (i) for payments made prior to the date of ix signing of the Financing Agreement, except for a maximum retroactive financing of US$2 million equivalent for eligible expenditures under Component 3 of the Project incurred after April 1, 2014; (ii) for payments to an individual PFI under the Line of Credit Facility until the Subsidiary Financing Agreement with such PFI is signed, and such PFI has adopted its Environmental and Social Management System satisfactory to IDA; and (iii) for payments to an individual PFI under the Risk Sharing Facility until the Risk Sharing Framework Agreement between the Recipient, IDA and IFC, and the Risk Sharing Agreement between IFC and such PFI have been signed, and such PFI has adopted its Environmental and Social Management System satisfactory to IDA. Team Composition Bank Staff Name Title Specialization Unit Jose De Luna Martinez Sr Financial Economist Team Lead FFSAB Wei Zhang Financial Sector Specialist Financial Sector EASFP Manida Unkulvasapaul Consultant Consultant CEAMV Vinod K. Goel Project Advisor Finance and Private Sector EASFP Chau-Ching Shen Sr Finance Officer Loan Disbursement CTRLN Manush Hristov Senior Counsel Legal LEGES James Seward Lead Financial Sector Financial Sector EASFP Specialist Christopher Robert Fabling Sr Financial Management Financial Management EASFM Specialist Sirirat Sirijaratwong Procurement Specialist Procurement EASR2 Ratchada Anantavrasilpa Sr Financial Sector Spec. Financial Sector EASFP Satoshi Ishihara Sr Social Development Social Issues EASTS Specialist Josefo Tuyor Sr Environment Specialist Safeguards EASDE Phaymany Philakone E T Consultant Financial Management EASFM Phongsavanh Phomkong Country Officer (IFC) Operations IFC Giang Phuong Thi Truong Investment Analyst Operations IFC Piathida Poonprasit Team Assistant Team Assistant EACTF Non-Bank Staff Name Title Office Phone City . x I. STRATEGIC CONTEXT A. Country Context 1. Although Lao PDR is one of the poorest countries in Southeast Asia, it is currently in the midst of an economic transformation. GDP growth rates have been high over a long period and are expected to continue with the target of 8 percent growth rate per year. The country is blessed with many natural endowments and is located in the center of a fast growing region. Lao PDR has embarked on a path of exploiting its abundant natural resources and is likely to maintain the momentum and become a middle- income country by 2020. 2. The country is on a path of increasing openness to trade flows and integration to the world economy. In February 2013, Lao PDR completed its accession to the World Trade Organization (WTO). As part of its efforts to secure WTO membership, recent legislative amendments have been designed to meet the WTO’s requirements in a number of areas, including tax, trade and intellectual property. The country has signed a series of free-trade agreements with China; Japan; Taiwan, China; the EU; and the USA; among other countries. Along with the other members of the Association of South-East Asian Nations (ASEAN), Lao PDR is preparing for the regional grouping's planned establishment of a single market, the ASEAN Economic Community (AEC), in 2015. 3. Economic growth has been impressive in the past years. Following the introduction of market- oriented reforms beginning in 1986, the economy expanded on average by 6.5 percent per year between 1990 and 2009. Despite the global financial crisis of 2008, Lao PDR’s GDP grew on average 8 percent per year in the period 2008 to 2011. Per capita income has more than doubled since 1990 reaching US$1,202 in 2011. The country’s real GDP growth remained robust in 2012 with growth of 8.3 percent, and is projected to be at 8.0 percent in 2013, significantly driven by investment projects in hydropower, infrastructure, and real estate construction as well as domestic consumption. 4. Rapid economic growth associated with the resource boom has led to poverty reduction. Impressive poverty reduction has been achieved in Lao PDR over the past decade. According to national measures, poverty fell from 39.1 percent of the population in 1998 to 33.5 percent in 2003 and to less than 20 percent in 2012 (IMF, 2013 Article IV Consultation). Nevertheless, the country still lags behind the rest of the region in terms of achieving the Millennium Development Goals (MDGs), and social indicators have not improved as expected, notably some population groups in remote areas lagging behind. 5. Despite the solid economic growth, in the short-term there are signs of vulnerabilities that need to be closely monitored. In the past two years, the economy has been overheating from expansionary macroeconomic policies. The fiscal deficit is estimated to have widened to 6.5 percent of GDP in 2013 from 4.8 percent in 2011, mainly from a doubling of public sector employee compensation and higher capital spending. Government liquidity is tight, and wage and other arrears of 2–3 percent of GDP have emerged. Monetary policy has been accommodative, and credit growth remains vigorous. Real GDP growth is projected at 8¼ percent this year, led by investment and private consumption, and consumer price inflation is projected to rise to 7.5 percent by year-end from 4.3 percent in 2012. The current account deficit is expected to remain close to 30 percent of GDP, and despite strong foreign direct investment inflows, international reserves—amounting to US$0.5 billion (0.8 month of prospective imports) in June 2013—are very low. Fiscal consolidation is central to restoring macroeconomic stability. 6. In the medium term, the economy will have to become much more competitive and the overall business environment much more conducive towards private sector activity. According to the World Bank Doing Business Report 2014, Lao PDR ranks 163 out of 185 countries for overall ease of doing 1 business. Lao PDR ranks particularly low in terms of the time and cost of resolving insolvency (position 185), protecting investors (184), getting credit (167), trading across borders (160), paying taxes (126), and enforcing contracts (114). Becoming a prosperous market-based economy will require structural reforms in Lao PDR to enable entrepreneurs to conduct their business activities on an efficient and competitive manner vis a vis other nations. B. Situations of Urgent Need of Assistance or Capacity Constraints (if applicable) 7. Not applicable C. Sectoral and Institutional Context 8. The development of a large, competitive and innovative small and medium enterprises (SMEs) sector is one of the key elements of Lao PDR’s long term development strategy. As in other countries in the world, SMEs create most of the private sector jobs in the economy and are a critical element for poverty alleviation and shared prosperity. 9. Despite impressive macroeconomic performance in the past years, most firms in Lao PDR still remain small. According to a report on SMEs prepared by the Department for Small and Medium Enterprise Promotion (DOSMEP) of Lao PDR, at the end of 2010 there were 126,913 registered firms out of which only 196 (0.15 percent) were large enterprises with more than 100 staff; 1,081 were medium firms (0.85 percent) with 20 to 99 staff; and 125,616 (98.98 percent) were small-size enterprises with 1 to 19 staff, as shown in the following Table 1. Table 1. Overview of SMEs in Lao PDR Enterprise Size Units Percent Small enterprises (1 to 19 staff) 125,616 98.98 Medium enterprises (20 to 99 staff) 1,081 0.85 Large enterprises (more than 100 staff) 196 0.15 No answer 20 0.01 Total 126,913 100.00 Source: DOSMEP (2010): Overview of Small and Medium Enterprises in Lao PDR. 10. The contribution of SMEs to employment is large, but to GDP is modest. According to DOSMEP (2010), SMEs in Lao PDR employ 81 percent of the total labor forced employed by registered firms. It is estimated that SMEs contribute to about 16 percent to GDP, which is a relatively low contribution compared to 38.9 percent in Thailand, 32 percent in Malaysia and 32 percent in Philippines. It also reflects the low productivity of SMEs versus larger firms. Due to the lack of detailed data and statistics on firms in Lao PDR it is not possible to quantify the contribution of SMEs per economic sector. Moreover, the lack of data makes it impossible at this time to estimate the number of firms and micro- entrepreneurs operating in the informal economy, such as street vendors, tuk-tuk drivers, maids, subsistence farmers, handymen, construction workers, etc. 11. Women are actively participating in the labor force and are increasingly running their own businesses, but face a number of constraints. At least 30 percent of the SMEs are owned by women in Lao PDR, which compares favorably to many countries and regions, but still lower than the average for 2 East Asia. Around 31 percent of formal enterprises with more than five employees are owned by female, and female-owned firms are more likely to operate in the retail sector and less in the manufacturing sector. Those firms owned by women are much smaller in terms of number of employees compared to firms owned by men. Analysis from the 2013 Joint ADB/World Bank Country Gender Assessment for Lao PDR also indicates that while the legal framework for doing business does not have gender discriminatory elements, in practice enterprises owned and operated by women face a number of barriers. Female entrepreneurs report that their household responsibilities and lack of mobility due to personal duties makes it more difficult to start a business. Female entrepreneurs in Lao PDR are also less likely to have a bank account or credit line, and are more likely than male entrepreneurs to cite financial obstacles as the most significant investment climate constraint. Major constraints for SME finance in Lao PDR 12. Access to finance is one of the three major constraints faced by SMEs in Lao PDR. As shown below (Figure 1), data collected from the World Bank’s Enterprise Survey in 2012 shows that small (and registered) firms in Lao PDR see unfair competition from informal sector, tax rates, and access to finance as their three major obstacles for business growth. Registered medium enterprises see the inadequately educated workforce as its main constraint, followed by unfair practices from the informal sector, and access to finance. For large firms in Laos, the main constraints are inadequately educated workforce, transportation, and unfair practices from the informal sector. Figure 1. Percent of Firms Identifying the Problems as the Main Obstacle Small Firms Medium Firms Large Firms (1-19 Employees) (20-99 Employees) (100+ Employees) 40 35 30 25 20 15 10 5 0 Source: Enterprise Surveys: Lao PDR 2012. 13. Access to finance is also a major challenge to firm start-up, maintenance and expansion with firms citing the extensive requirements by banks for loan documentation and collateral as key barriers. According to the World Bank’s Enterprise Survey database, only 24.7 percent of small and registered firms in Lao PDR had a loan or a line of credit from a bank in 2012. For medium firms, the ratio was 46.7 3 percent. Complex bank loan application procedures and high collateral requirements by the banks were identified as the primary reason why firms in need of funding did not apply for a loan. Firms are required to provide more collateral coverage for the loan than other countries in the region. The value of collateral is on an average 3 times the value of the loan, compared to two times the value in Cambodia and Vietnam. Moreover, as discussed below, loans from commercial banks are generally available to cover short-term working capital needs, and not to carry out long-term fixed investments. 14. SMEs rely on informal sources of finance. Although SMEs are not borrowing from the banks, they do have their own way to finance their business through informal financing. The traditional Rotating Savings and Credit Associations (ROSCA), or “Houay” in local language, are partly filling the gap. A ROSCA is a group of 12 people that contribute each 1 million Kip per month for 12 months. The 12 million collected each month is loaned to one member. After having received the lump sum amount, member then pays back the amount in regular monthly contributions. Depending on the cycle in which a member receives his/her lump sum, members alternate being lenders and borrowers. Due to its informal nature, usually the amount of financing is small and the term of the loan is short. Banks reluctance to lend to SMEs 15. Banks are reluctant to lend to SMEs due to serious information asymmetries and serious difficulties in executing collateral. A large number of SMEs that apply for bank loans are simply not registered. From a legal point of view, this means that they do not exist and banks can simply not lend to them. Moreover, most SMEs do not have or keep accounting records. A large number of business transactions conducted by SMEs are settled in cash without invoices. Moreover, many of the firms that have accounting records are not able to convince banks to lend to them, because their accounting records are not reliable in the eyes of banks. When SMEs default on their loans, the execution of collateral becomes a lengthy and costly process for commercial banks. In Lao PDR, the judicial system is not prepared to handle collateral execution in an expedite manner. It takes up to 5 years for banks to take possession of collateral through the judicial system. 16. Credit to private sector has been growing, but with limited products and outreach. The total bank credit as percentage of GDP has increased from 23 percent in 2009 to 42 percent in 2012. Credit to private sector to GDP was at 27.4 percent, compared to a median of 33.7 percent in the region in 2011. Credit growth in the last 3 years has been driven by credits to private sector and state-owned enterprises (SOEs). Private sector credit growth has been mainly driven by increased buoyant growth in the industry, construction and service sectors. However, the growth in credit to the economy is expected to slow down in the next few years given lower financing of local governments and with loan-to-deposit ratios of commercial banks reaching the regulatory thresholds; latest data on loan to deposit ratios of commercial banks is 116 percent at the end of 2012. Sector wide loans to deposits ratio has reached 74 percent over the last few years, approaching the regulatory threshold. Moreover, as part of the efforts to reduce vulnerabilities in the banking system, authorities expect the growth of credit to the economy to decelerate. 17. The credit to SMEs provided by banks is also mostly short-term. Because the main source of funding for commercial banks is short-term deposits, most banks find it difficult to provide long-term credit to their customers. Despite enormous efforts to attract long-term deposits through high interest rates, 80 percent of total deposits have less than one year maturity. Moreover, the local capital markets are still rudimentary and banks do not issue medium or long-term bonds. Loans granted by banks have also a short-term maturity. Around 90 percent of total bank lending has a maturity of less than 3 years. Most loans to the private sector are given to meet the working capital needs of clients, with very little loans granted for purchase of fixed assets or investments. 4 Under-developed Banking and Financial System 18. The unwillingness and lack of capacity of commercial banks to expand their lending to SMEs reflects an under-developed financial system. The Lao financial system is small, with a dominating banking sector and very small insurance and capital markets. The banking sector contributed 29 percent of the country’s GDP in 2011, increasing from 7.5 percent in 2006. The capital market and insurance market represents a fairly small proportion of all financial services, while the Lao Stock Exchange (LSX)’s market capitalization contributes around 0.1 percent of the country’s GDP. Alternative financing such as equity finance, supplier finance other non-bank financing vehicles are not yet available in the market. 19. The banking sector is highly concentrated with the 4 state-owned commercial banks (SOCB), which account for 55 percent of total assets, 64 percent of total loans and 64 percent of total deposits in the system. At the end of 2013, there were 31 commercial banks operating in Lao PDR, including 4 state-owned commercial banks (SOCBs), 2 joint venture banks (JV Banks), 9 private banks, and 16 foreign bank branches. For the fourth quarter of 2012, the joint venture banks had a 9 percent market share, private banks took over about 18 percent, and foreign bank branches accounted for 17 percent of total assets, as illustrated in Table 2. In terms of branches, the banking system is also dominated by the state-owned banks which operate 60 out of 82 bank branches in Lao PDR. Table 2. Composition of the Banking System of Lao PDR in 2013 State-owned Joint venture Private banks Foreign branches commercial banks banks • Banque pur le • Laot-Viet Bank • Joint Development • Bangkok Bank Commerce Exterior • Bank Franco Laos Bank • Kreung Thai Bank Lao • Phongsavahn • Ayudhya Bank • Lao Development • ST Bank • Thai Military bank Bank • Indochina Bank • Siam Commercial Bank • Agriculture • Booyong Lao Bank • Public Bank Promotion Bank • Lao Construction • Public Bank Sikhai • Nayoby Bank Bank • Public Bank Savanakhet • ANZ Lao Bank • Sacom bank • Acleda Bank Lao • Military Commercial • International • ICBC Bank Commercial Bank • Vietin Bank Lao Branch • Saigon-Honi Commercial Bank • Public Bank Pakse • Maybank Sub-total 4 2 10 16 Share in total assets 55.70 9.35 17.96 17.08 Share in total loans 64.64 3.80 19.57 12.00 Share in total deposits 64.25 7.19 21.66 6.89 Number of branches 60 6 16 0 Source: Bank of Lao PDR. 20. Capital adequacy of commercial banks has improved over the last several years after many steps have been taken by the government to restructure the SOCBs. Most of the NPL overhang in the SOCBs has been written off. As a result, the average NPLs ratio has been decreasing over the last 5 years and was at 2.2 percent in 2012. For the first and second quarter of 2012, the average NPLs ratios were at 3.7 percent. According to the Bank of Lao PDR, the capital adequacy ratio (CAR) of the commercial 5 banks in the country stood at 9.45 percent, 13.82 percent, 23.47 percent, and 14.44 percent in 2008, 2009, 2010 and the second quarter of 2012, respectively. Two SOCBs are still unable to comply with the minimum capital adequacy ratio. 21. However, information on the soundness and performance of individual banks is limited. Foreign-owned and privately-owned banks are able to prepare and disclose their financial information on time. However, most state-owned banks do not publish their annual reports and financial statements even though they are required to do so under existing laws and regulations. Only few banks disclose their capital adequacy ratios and the level of non-performing loans. Moreover, the Bank of Lao PDR does not disclose a detailed financial sector stability assessment as most other central banks do. Banks are not rated by international rating agencies. For years, none of the international financial institutions operating in Lao PDR – such as the IMF, ADB, and the WB -- has ever had access to detailed bank data. Lao PDR is one of the few countries in the world that has never participated in the IMF-WB Financial Sector Assessment Program (FSAP). Therefore, the amount of information on the banking system, and in particular state- owned commercial banks, available to international financial institutions is extremely limited. Government SME Development Policy and Program 22. The government’s first National SME Development Strategy 2006–2010 was completed in 2010, with support from GIZ and other donors. The focus of the 2006-2010 SME Development Plan was: (i) creating enabling regulatory environment for SMEs; (ii) enhancing competitiveness; (iii) expanding domestic and international markets; (iv) improving access to finance; (v) encouraging and creating favorable conditions for establishing business membership organization; and (vi) encouraging entrepreneurial culture within society. Some of the key results of the 2006-2010 program include: • formulation of the 2011-2015 SME Development Plan • promulgation of the SME Promotion Law in 2011 • enactment of the Investment Promotion Law in 2009 • launch of a web-based enterprise registry system, the launch of the online credit information system at the Credit Information Bureau in November 2011 • Secured Transaction Law was approved to be implemented in June 2011 to allow SMEs to use movable assets as collaterals • MOF established the secured transaction registry in 2013 • licensed 4 finance leasing companies • microfinance institutions are now under regulations of the Bank of Lao PDR 23. As part of recent government initiatives to support access to finance, DOSMEP established the SME Promotion and Development Fund in August 2012. The government provided US$2 million grant to DOSMEP for this SME Fund. The DOSMEP has signed a MoU with the Lao Development Bank (LDB) to provide loans to SMEs. DOSMEP allocated US$1.8 million to LDB for loans to SMEs, and US$600,000 has been disbursed as of August, 2013. Under this Fund, small business can apply for a loan up to US$30,000, while medium business can apply for a loan up to US$60,000. The LDB will provide loans at interest rate of 9 percent for less than 1 year loan and 10 percent for 1 to 3 years loan. DOSMEP uses the difference of US$0.2 million for its own management fee and technical assistance to SMEs through the Business Development Service (BDS) Network. 24. International donors have supported the government of Lao PDR’s SME Development Strategy in the last decade through technical assistance programs on private sector and SME policy, legal and regulatory framework development, SME Development Strategy, SME capacity building, promoting women entrepreneurship, and improving access to finance. International donors (such as KfW, GIZ, and 6 ADB) have also contributed significantly to financial infrastructure development, which will pave way for improving the SME finance in the future. 25. However, enormous challenges remain. Statistics and information on SMEs in Lao PDR remain extremely limited. A major problem is that statistics do not distinguish between micro-enterprises and small enterprises, as most other jurisdictions do. Moreover, statistics do not capture informal firms, or firms operating in rural areas. As a result, it is difficult to know the size of informal enterprises, their features and the factors that prevent them from becoming formal. DOSMEP, the government agency responsible for SME development, is still a young and weak institution. Its capability to formulate policies, implement new programs, monitor implementation, and evaluate the impact of its different programs to support SMEs is quite limited. D. Higher Level Objectives to which the Project Contributes 26. This project is aligned with the government’s strategic objectives and actions in the area of private sector development, as described in the Seventh National Socio-Economic Development Plan (NSEDP7) 2011–2015, which is the master plan guiding the overall government’s strategic objectives and actions in Lao PDR. The fundamental objective of the NSEDP7 is to gradually transform Lao PDR into a more open and private sector led economy. Under NSEDP7, the strengthening of SMEs is a critical element to achieve economic growth, improve competitiveness of the economy, and provide employment opportunities in the formal sector. A key pillar of NSEDP7 is the 2011-2015 SME Development Plan, formulated by DOSMEP. 27. The project is fully consistent with the Government’s SME Development Plan, and Trade and Private Sector Development Roadmap. As part of the Diagnostic Trade Integration Study Update carried out in 2012, GOL and Development partners validated a Trade and Private Sector Development Roadmap aims to promote economic diversification through establishing trade and investment environment, improving competitiveness of non-resource sectors, and strengthening aid effectiveness. Among others, the Roadmap proposes to improve access to finance for SMEs through promoting cash flow based SME lending through provision of technical assistance to selected commercial banks and establishment of risk-sharing facility. The project will support these efforts to improve access to finance of SMEs and the capacity building of DOSMEP, the agency responsible for SME promotion in Lao PDR. The project will also support the production of new statistics and data on SMEs to help DOSMEP improve policy formulation, implementation and evaluation. 28. Finally, the project is also aligned with the World Bank Country Partnership Strategy (FY2012-2016). It is one of the planned activities to support the strategic objective of “competitiveness and connectivity” in Lao PDR. The 2012 Country Partnership Strategy (CPS) for Lao PDR specifies that under Strategic Objective 1 on Competitiveness and Connectivity, the World Bank will focus on using investment and analytical services to support diversification of trade and private sector development and a competitive and efficient regulatory framework for private sector, to strengthen the linking mechanism between GDP growth and household income growth. II. PROJECT DEVELOPMENT OBJECTIVE(S)/GLOBAL ENVIRONMENT OBJECTIVE(S) A. PDO 29. The objective of the Project is to provide long-term funding sources for banks to provide long-term credit to small and medium enterprises. This PDO will be achieved by increasing the supply of long-term 7 finance provided by commercial banks and by strengthening the capability of DOSMEP to formulate and implement public policies that promote access to finance for SMEs. B. GEO 30. Not applicable Project Beneficiaries 31. There will be three types of beneficiaries in the project: • Commercial banks with sound financial condition and in compliance with fiduciary and regulatory standards, willing to participate in the project and provide long term credit to SMEs. • Privately-owned and registered SMEs willing to borrow from commercial banks to expand their business activities, carry out new investments, or enhance their productivity. • The Department of Small and Medium Enterprise Promotion. PDO Level Results Indicators 32. Key results will be measured by: (i) Increase in the portfolio of long term loans to SMEs provided by commercial banks participating in the line of credit (ii) Increase in the portfolio of SME loans provided by commercial banks participating in the risk-sharing facility. (iii) Increase in sales volume of beneficiary SMEs (iv) Formulation of a new multi-year master plan for the development of SMEs in Lao PDR. III. PROJECT DESCRIPTION A. Project Components 33. The project has three components: 1) A Line of Credit Facility 2) A Risk Sharing Facility 3) Technical Assistance Component 1: A Line of Credit Facility (IDA US$12 million) 34. This component aims to alleviate the lack of long term sources of funding that prevents commercial banks from providing long term credit (more than 2 years) to SMEs. IDA will provide US$12 million equivalent to the Ministry of Finance (MOF) which will pass on project funds to the Department of SME Promotion (DOSMEP). DOSMEP will provide long-term funding in local currency to participating financial institutions (PFIs) - financially-sound and well administered commercial banks. Because DOSMEP is not a financial institution, the funds to be provided by DOSMEP to PFIs will be in the form of long-term bank deposits (5-7 years) in local currency (maximum US$4 million to a PFI). The PFIs will pay interest to DOSMEP same as the 3 month deposit rate in local currency (or interbank rate), and pay back the entire deposit amount to DOSMEP at the end of the agreed period. The PFIs will on-lend these funds for long term loans (up to US$200,000 equivalent in local currency with 2-7 years maturity at 8 market rates) to privately-owned SMEs enabling them to carry out long term capital investments that increase their business operations and enhance their productivity, such as acquisition of machines and equipment, construction or expansion of facilities and warehouses, modernization of transportation and communications equipment, upgrading quality labs and systems, and so forth. Component 2. Risk Sharing Facility (IDA US$3 million) 35. Under this component, IDA will provide US$3 million to support the establishment of a Risk Sharing Facility (RSF) which will provide a partial credit guarantee to eligible private commercial banks (PFIs) that lend to SMEs. The RSF will cover 50 percent of the losses, on a pari passu basis, that the PFIs may incur in their SME lending operations (enabling them to lower their excessive collateral requirements for loans to SMEs). The IFC will serve as the Facility Agent, on behalf of DOSMEP, to manage the RSF, and will conduct due diligence of PFIs to ensure only sound institutions with proper risk-management capabilities are selected. A Risk Sharing Framework Agreement (RSFA) will be signed by DOSMEP, IFC and the IDA. The total lending amount to be covered by the RSF could reach up to US$30 million, where PFIs absorb potential losses of up to US$15 million and the RSF the remaining US$15 million). To cover claims from PFIs to the RSF, the resources from IDA will be used first (first loss). In the remote case that the IDA resources are exhausted, then IFC will use its own resources to cover the remaining losses (second loss) from the loan portfolio. Component 3: Technical Assistance (US$5 million) 36. This component will provide technical assistance (TA) to strengthen capacity of DOSMEP and other agencies in areas such as formulation and implementation of a SME development strategy, SMEs census, design of new SME lending and non-lending products, impact assessment, SME business advisory services, as well as project implementation and monitoring and evaluation, including outsourcing of procurement, financial management functions to the National Implementation Unit (NIU) of the Ministry of Industry and Commerce (MOIC). The project will also provide TA to PFIs (and other financial institutions) for improving their SME lending business such as the design of SME banking strategy and new SME banking products, and compliance with Bank’s social and environmental operational policies and IFC’s performance standards. The project will assist SMEs to access credit by supporting their efforts to improve their accounting records, draft business plans, and improve their productivity through the adoption of better management and marketing techniques. Further details on Project Description are provided in Annex 2. B. Project Financing 37. The IDA will provide US$20.0 million equivalent to the Ministry of Finance of the Lao PDR; 50 percent as Grant and 50 percent as Credit on standard terms. The total project cost amounts to US$20.0 million. Table 3. Project Cost and Financing Project Cost IDA Financing Project Components % IDA Financing (US$ million) (US$ million) 1. Line of Credit 12.00 12.00 100 2. Risk-sharing facility 3.00 3.00 100 3. Technical assistance 5.00 5.00 100 Total Costs 20.00 20.00 100 Total Project Costs 20.00 20.00 Total Financing Required 20.00 20.00 9 C. Series of Project Objective and Phases 38. Not applicable D. Lessons Learned and Reflected in the Project Design 39. In the design of this project, the team reviewed various reports documenting and evaluating the World Bank’s experience with SME finance operations and took into account relevant lessons. For the line of credit component, a lesson learned from previous credit lines is that implementation problems have stemmed mainly from weak borrower accountability and management capacity, lack of clearly defined and transparent indicators for monitoring of the financial performance of concerned financial intermediaries, as well as poor monitoring of the overall project impact, inadequate demand from ultimate beneficiaries and lack of bankable sub-projects, and inflexibilities in project design that make it difficult to adjust design to reflect changing ground realities. The team also reviewed experiences with several risk-sharing facilities supported by the World Bank. In particular, the team examined in detail the Cambodia and the Papua-New Guinea (PNG) cases, which offer completely different results, with Cambodia being considered a problem operation and PNG a success story so far. Among the key lessons for the success of the RSF are the following. Ensuring that Financial Institutions and Authorities Understand the Features of the Product 40. In the case of Cambodia, bankers at participating financial institutions did not understand in detail how the risk-sharing facility works. Confusion and misunderstandings prevailed during project implementation which made bankers reluctant to participate in the project. In particular, the inclusion of working capital loans in the facility and the rules for the calculation of fees were not clear for IFC and the participating banks. To avoid this, the joint World Bank and IFC team has engaged in extensive meetings with prospective PFIs and authorities to ensure there is a real appetite for this product and they understand well how the risk-sharing facility works, what the benefits and risks are, and ultimately what features of the RSF make it a profitable product for IFC. DOSMEP has requested assistance from IFC, and IFC has agreed, to be able to design and implement this type of financial products in the future. Close coordination between the World Bank and IFC, and the interaction with the government 41. Another important lesson is that the World Bank and IFC should work together from the beginning and closely coordinate in the structuring process to avoid repetition of efforts, delays, and the delivery of inconsistent messages to the government counterparts and prospective banks. To ensure this, a team of World Bank and IFC staff has been working together in the preparation of this operation. Regular meetings and exchange of information take place between both teams and an effort is being made to present this operation to counterparts as a World Bank Group product. Moreover, the World Bank team is taking the leading role on the line of credit, while IFC is leading the risk-sharing facility. Clear commitment of Participating Financial Institutions to serve SMEs 42. PFI’s commitment to the target market and a clear vision for market positioning are key components for the success of the facility. Starting with at least one bank is suggested to encourage others to follow. Technical Assistance to build lending capacity to SMEs can be provided to PFIs and local banks, if necessary. For this operation, a bank has already expressed a strong interest to participate in the RSF. Other potential banks have been identified. Moreover, the operation will provide technical assistance to other local banks to ensure they address the areas needed to become eligible to participate in the program. Moreover, the project also includes assistance to help local banks comply with the social and 10 environmental safeguards of the program. Establishing a realistic base-line estimate on demand and supply of financing to the target market is important to adequately track development impacts of project, and this will allow the government to learn how to run RSF by itself while developing appropriate systems for collecting and analyzing outputs and impacts. IV. IMPLEMENTATION A. Institutional and Implementation Arrangements 43. The Department of SME Promotion at the Ministry of Industry and Commerce will be the Executing Agency for the project; other agencies involved in project implementation include the IFC, PFIs and NIU. DOSMEP was established in 2005 under the Prime Minister Decree No. 42/2004, dated 20 April 2004, with the mandate to develop a national strategy and policy to promote SME development and to coordinate and supervise the implementation of national SME development strategy. DOSMEP has been supported by ADB, GIZ and other donors since its establishment in developing SME sector analysis, legal and regulatory framework and infrastructure for SME development, as well as in institutional capacity building during the 2006-2010 SME Development Plan implementation. DOSMEP works with the Departments of Industry and Commerce at local government level in municipalities and all provinces and has established focal points with various production groups, associations, cooperatives and others. DOSMEP is also managing a SME Fund (US$2 million funded from budgetary resources) which gives long term funding to the Lao Development Bank (LDB) for providing long term loans to SMEs. 44. This is the first time that DOSMEP will implement a World Bank project and its capacity to manage World Bank projects is limited. DOSMEP will administer Component 1 and 3, and will engage appropriate expertise for project implementation and monitoring including complying with fiduciary and safeguard policies. IFC will administer Component 2 (Risk Sharing Facility) on behalf of DOSMEP, and will conduct due diligence of PFIs. For smooth project implementation, DOSMEP has decided to delegate fiduciary aspects related tasks (procurement and financial management) to the National Implementation Unit (NIU), which has set up a competent unit to manage various World Bank projects, including the Trade Development Facility (TDF) Projects sponsored by the World Bank. B. Results Monitoring and Evaluation 45. A systematic monitoring and evaluation (M&E) plan will be a core part of project implementation. The objective of monitoring and evaluation will be to: (i) monitor the progress of project implementation and provide timely feedback to stakeholders (DOSMEP, IDA, IFC and PFIs); (ii) assess and summarize the achievements; and (iii) draw lessons in project design and implementation that can guide future replication efforts. PFIs will have prime responsibility for generating and providing core data. DOSMEP with the support of NIU will take responsibility for compiling, analyzing, and reporting this information to the World Bank, and other relevant stakeholders, and carry out impact evaluations. Additionally, World Bank staff will carry out supervision missions and its own impact evaluation. 46. The Results Framework and measurement proposals show where the required data will be sourced and by whom (Annex 1). DOSMEP and/or IDA will ensure that M&E consultant(s) are hired at the end of the project to measure the impact on SMEs that received financings from the participating banks, through polling samples of SMEs that compare clients vs. non-clients. C. Sustainability 47. The project has been designed in such a way that it will provide DOSMEP with the ability to continue supporting access to long term finance to SMEs once the project closes. During the project 11 implementation, DOSMEP will be learning from IFC how to design a risk-sharing facility, price credit guarantee, carry out the due diligence of banks, monitor performance of SME loans, analyze banks’ reports, and evaluate impact and outcomes of the RSF. The funds coming from the repayment of loans to SMEs are expected to be recycled by PFIs for lending to SMEs (until they are due to DOSMEP). 48. The project is financially sustainable. In the line of credit component, participating banks fully absorb the credit risks of lending to SMEs; repayment to DOSMEP will be further supported by the Bank of Lao PDR (BOL), who can compensate DOSMEP from PFI funds at BOL, in the event of default or delay by any PFI. The RSF is also designed in a sustainable manner, with conservative eligibility criteria set by IFC for PFIs. The two financial products offered under this operation (Line of Credit and RSF) are priced at market rates, thus minimizing distortions in the financial system. 49. Moreover, the operation will target registered SMEs that have been in business for at least two years and are able to submit viable business plans to commercial banks, which will ultimately make the lending decisions with no government interference. The operation follows a conservative approach. Start-up firms or firms operating in the informal sector will not be supported. No seed capital is being provided to test new business ventures. As a result, the beneficiary SMEs will have a low risk profile. In the future, as the financial system develops, it is expected that financial institutions will be able to develop new financial instruments to target riskier segments of the SME market where the finance gaps are even larger. V. KEY RISKS AND MITIGATION MEASURES A. Risk Ratings Summary Table 4 Risk Category Rating Stakeholder Risk Substantial Implementing Agency Risk - Capacity Moderate - Governance Substantial Project Risk - Design Substantial - Social and Environmental Moderate - Program and Donor Low - Delivery Monitoring and Sustainability Moderate - Other (Perception of conflict of interests) Low - Other (Optional) Overall Implementation Risk Substantial B. Overall Risk Rating Explanation 50. There are three major risks in this project. First, the Lao financial system is vulnerable to systemic risks due to a combination of factors including aggressive credit growth in the past years, weak banking supervision framework, limited enforcement of rules and regulations by Bank of Lao PDR, and narrow market discipline. If risks in the system are not properly handled, the banking system as a whole may experience a decline in profitability, higher NPLs and lower capitalization levels. In a separate project, the 12 World Bank will start to assist the Bank of Lao PDR in strengthening its capability to monitor the financial sector. 51. Secondly, in Lao PDR some state-owned banks do not disclose their annual reports and financial statements, which make it difficult to assess the performance of every commercial bank operating in Laos. To prevent supporting institutions that are not sound and well-administered, the project has set strict eligibility criteria. This will restrict the number of eligible financial institutions in the line of credit to no more than six out of 31 commercial banks currently licensed in Laos. For the risk-sharing facility, IFC is expected to select few institutions as participants. 52. Another important risk is related to the ability of the implementing agency, DOSMEP, to meet the World Bank standards in terms of financial management and procurement, as well as the Bank’s environmental and social safeguards. To mitigate this risk, DOSMEP will receive technical assistance to meet the World Bank standards. As explained earlier, Component 2 (RSF) will be directly administered by IFC. The NIU will support DOSMEP on safeguards, procurement and financial management tasks. All these arrangements will strengthen the capability of the Executing Agency to monitor and execute the project. Other risks in the project are considered moderate and appropriate measures are proposed in the project to minimize them. VI. APPRAISAL SUMMARY A. Economic and Financial (if applicable) Analysis 53. SME sub-projects to be funded are not pre-identified and project costs also are not defined, thus a traditional economic/financial analysis cannot be conducted. Annex 2 describes the eligibility criteria for PFIs, and terms and conditions of sub-loans to be financed by the project. B. Technical 54. The Project is designed to address a clear market failure in the Lao’s banking system, namely the lack of long term resources in local currency to enable commercial banks to lend to SMEs on a long-term basis. The structure of the line of credit and RSF ensures that the PFIs book good assets. Provisions are included in the project to ensure that lending rates and other charges reflect the cost of intermediating project funds and an appropriate credit risk and risk sharing margins. The final lending rates, commissions and fees will be in line with the prevailing market conditions. C. Financial Management 55. The Financial Management assessment indicates that the project will be implemented in an inherently Substantial risk environment. This conclusion comes from the current weak government financial management systems which are undergoing reform. Appropriate mitigation measures have been incorporated into the design of the financial management arrangements to reduce the residual FM risk of the project to “Moderate”. These mitigation measures include the delegation of the project’s consolidated accounting and financial reporting functions to NIU, hiring required staff (and technical assistance) to support NIU and DOSMEP, annual audit of the project. An action plan outlining mitigating measures has been agreed with DOSMEP to enhance arrangements for efficient project implementation (see Annex 3). 13 D. Procurement 56. Procurement of goods and works under the project and financed in whole or in part by IDA funds will be carried out in accordance with the IDA’s "Guidelines: Procurement under IBRD Loans and IDA Credits" dated January 2011, and the provisions stipulated in the legal agreement. The procurement of consultant services financed in whole or in part by IDA funds will be carried out in accordance with the IDA’s "Guidelines: Selection and Employment of Consultants by World Bank Borrowers" dated January 2011, and the provisions stipulated in the legal agreement. The DOSMEP/NIU has prepared a detailed Procurement Plan for the first 18 months, which provides the basis for the selected procurement procedures. This Plan was discussed at negotiations and agreed with the IDA. The Plan will be updated with the IDA’s prior concurrence, annually or as required, to reflect changes in implementation needs and improvements in institutional capacity. The procurement risks of the project will be managed and mitigated through an action plan that has been incorporated into the project design and the project implementation manual. The details about procurement are provided in Annex 3. E. Environment (including Social Safeguards) 57. The project has been categorized as Financial Intermediary (FI) in accordance with World Bank Operational Policy 4.01 (Environmental Assessment). As an FI, beneficiary SMEs of Line of Credit (Component 1) and Risk Sharing Facility (Component 2) are expected to engage in diverse types of activities some of which may entail negative impacts on local people and environment. The exact location, nature, scale and scope of environmental impacts can only be known during implementation when PFIs receive applications from eligible SMEs. Environmental Assessment policy (OP 4.01) is triggered for this project. As a precautionary approach, the following policies are also triggered: Natural Habitats (OP 4.04), Forests (OP 4.36) and Indigenous Peoples (OP 4.10). Given the nature and size of credit to be provided to each SME (mostly under US$50,000), the potential negative impacts are likely to be minor, localized, and reversible and can be addressed with proper environment and social safeguards screening, implementation of simple measures and environmental and social good practices. No large scale, significant and/or irreversible impacts are expected under the proposed project. 58. To ensure that the potential environmental and social risks are adequately screened and mitigated, an Environmental and Social Management Framework (ESMF) has been developed describing the procedures and the safeguard measures to be carried out by PFIs and the eligible SMEs for each transaction, including environment and social screening, assessment, mitigation of potential negative impact and the establishment of Environmental and Social Management System (ESMS) for PFIs involved in the risk sharing facility. The ESMF also includes a list of ineligible activities under the project primarily because the significant adverse impacts that these activities may bring outweigh their costs and benefits. It also includes an Ethnic Groups Planning Framework detailing the process and requirements to be undertaken in case a transaction triggers OP 4.10 in the course of project implementation. The ESMF will be operationalized through the Project Implementation Manual (PIM). The PIM needs to be completed by including the section on combined application of WB and IFC safeguards policies. The ESMF was disclosed locally and in the Bank’s Infoshop in line with the disclosure requirements of the World Bank. 59. The Department of Small and Medium Enterprises Promotion is responsible for the management of SME services and will be responsible for the implementation of the project. Given the weak institutional capacity of DOSMEP on policy and regulatory issues related to safeguards for SMEs, and limited knowledge and capacity of PFIs and SMEs, technical assistance will be provided as part of Component 3 to build knowledge and develop the capacity of DOSMEP, PFIs and SMEs to ensure effective implementation of the ESMF. 14 F. Other Safeguards Policies Triggered (if required) 60. See above Section E. 15 Annex 1: Results Framework and Monitoring . Lao People's Democratic Republic Small and Medium Enterprise Access to Finance Project (P131201) . A: Results Framework . Project Development Objectives . PDO Statement The objective of the Project is to provide long-term funding sources for banks to provide long-term credit to small and medium enterprises. This PDO will be achieved by increasing the supply of long-term finance provided by commercial banks and by strengthening the capability of DOSMEP to formulate and implement public policies that promote access to finance for SMEs. These results are at Project Level . Project Development Objective Indicators Data Responsibility Cumulative Target Values Source/ for Unit of End Methodolog Data Collection Indicator Name Core Baseline YR1 YR2 YR3 YR4 YR5 Frequency Measure Target y Volume of Bank Amount Support: Line of 0.0 0.5 2.0 6.0 8.0 12.0 12.0 Quarterly PFIs DOSMEP (US$ mln) Credit - SME Outstanding SME Loan Amount Quarterly IFC and 0.0 1.0 3.0 5.0 15.0 20.0 30.0 PFIs in RSF Portfolio (risk- (US$ mln) reports DOSMEP sharing facility) 16 Percentage % of project- Sub-Type 0.0 100.0 100.0 100.0 100.0 100.0 100.0 supported PFIs Supplemental Increase in Sales Six monthly by beneficiary Percentage 0.0 10.0 15.0 20.0 25.0 30.0 30.0 SMEs DOSMEP reports SMEs SME Six monthly Report 0 0 1 1 DOSMEP DOSMEP Masterplan reports . Intermediate Results Indicators Data Responsibility Cumulative Target Values Source/ for Unit of End Methodolog Data Collection Indicator Name Core Baseline YR1 YR2 YR3 YR4 YR5 Frequency Measure Target y Direct project Quarterly beneficiaries Number 0 20 50 80 120 150 150 PFIs DOSMEP reports (line of credit) Female % Sub-Type Quarterly beneficiaries 0 5 5 10 12 15 15 PFIs DOSMEP Supplemental reports (line of credit) Direct project beneficiaries Quarterly IFC and Number 0 25 50 100 150 300 300 PFIs (risk-sharing reports DOSMEP facility) Female beneficiaries % Sub-Type Quarterly 0 5 5 10 12 15 15 PFIs DOSMEP (risk-sharing Supplemental reports facility) Performance of Quarterly % 0.0 0.0 3.0 5.0 5.0 5.0 5.0 PFIs DOSMEP SME loans reports 17 (NPLs) Change in sales volume by Six monthly Percentage 0.0 10.0 15.0 20.0 25.0 30.0 30.0 SMEs DOSMEP beneficiary reports SMEs Formulation of new SME Quarterly Development Report 0 0 1 1 progress DOSMEP DOSMEP Master Plan reports (2016-2020) Number of Quarterly DOSMEP Staff Number 0 10 20 20 20 20 30 progress DOSMEP DOSMEP trained reports Number of Quarterly SMEs benefiting Number 0 10 20 50 60 70 70 DOSMEP DOSMEP reports from TA Formulation of SME Census Every six Report 1 1 DOSMEP DOSMEP Plan and months Methodology . 18 Annex 1: Results Framework and Monitoring . Lao People's Democratic Republic Small and Medium Enterprise Access to Finance Project (P131201) . B: Results Framework- Definitions . Project Development Objective Indicators Indicator Name Description (indicator definition, etc.) Volume of Bank Support: Lines of Credit – SME Amount of funding provided by PFIs to SMEs cumulative amounts disbursed as of most recent data available. Outstanding SME Loan Portfolio (risk-sharing facility) Outstanding amount of the SME loan portfolio for each PFI. This is the entire portfolio of the PFI, not just the Bank-financed portion. Increase in Sales by beneficiary SMEs Percentage increase in yearly sales volume by SMEs benefiting from line of credit or risk sharing facility SME Development Master Plan (2016-2020) Formulation and publication of a new SME Development Master Plan (2016-2020) that articulates the objectives, goals, and actions to be carried out by DOSMEP in the period 2016-2020 to strengthen SMEs in Lao PDR. . Intermediate Results Indicators Indicator Name Description (indicator definition, etc.) Direct project beneficiaries SMEs receiving project support through any of the three project components. Female beneficiaries (line of credit) Percentage of SMEs owned by female. Female beneficiaries (risk-sharing facility) Percentage of SMEs owned by female. Performance of SME loans (NPLs) Percentage of SME loans granted by PFIs under the project that are classified as non- performing. Change in Sales by beneficiary SMEs Percentage increase in yearly sales volume by SMEs benefiting from line of credit or risk sharing facility SME Development Master Plan (2016-2020) Formulation and publication of a new SME Development Master Plan (2016-2020) 19 that articulates the objectives, goals, and actions to be carried out by DOSMPEP in the period 2016-2020 to strengthen SMEs in Lao PDR. Number of DOSMEP Staff receiving training Number of DOSMEP staff receiving training (English language, finance and accounting courses, monitoring and evaluation workshops, etc.) Number of SMEs benefiting from Technical Assistance Number of SMEs that receive technical assistance from DOSMEP to improve their business plans, improve accounting, apply for loans, marketing, etc. Formulation of SME Census Plan and Methodology Detailed plan and methodology to carry out the SME Census, including scope, questions, timeframe, resources, definitions, etc. 20 Annex 2: Detailed Project Description LAO PDR: SME Access to Finance Project 61. The project will have three components: 1) A Line of Credit Facility for on-lending to SMEs 2) A Risk Sharing Facility for SME finance 3) Technical Assistance for DOSMEP and PFIs Component 1: A Line of Credit Facility (IDA US$12 million) 62. IDA will provide US$12 million to the MOF which will pass on these funds to DOSMEP (at terms and conditions to be agreed between MOF and DOSMEP). DOSMEP will provide long-term resources to PFIs for on-lending long term credit in local currency to SMEs. The project will support small (1-19 employees) and medium enterprises (20 to 99 employees) that are privately-owned, registered, have been in business for at least two years and wish to expand their business activities. SMEs will present a viable business proposal to the commercial banks, have a good credit history, and have all legal documents required by banks willing to finance them, including collateral. 63. A Mid-Term Review (MTR) of the project will be conducted by DOSMEP about two years after the Project Effectiveness (around by October 30, 2016), to assess implementation progress and make any adjustments considered appropriate. 64. Because DOSMEP is not a financial institution, the funds to be provided by DOSMEP to PFIs will take the form of a long-term bank deposit. To ensure that DOSMEP recovers its money, DOSMEP and the PFIs will sign a Subsidiary Financing Agreement (SFA) that will give DOSMEP the right to be compensated directly by the Bank of Lao PDR (BOL), using the PFI’s deposits at BOL, in the event of delay or default by the PFI. Eligible PFIs will have to be financially-sound and well administered. Out of a total of 31 banks operating in Laos, some 3-5 commercial banks are expected to participate in the line of credit. Several banks have expressed keen interest in participating in this operation. A large bank is planning to submit an application to borrow from the Line of Credit as soon as the operation is approved. 65. Details on the lending arrangements are given below. (a) Terms and conditions between the IDA and DOSMEP • DOSMEP will provide project funds as deposits in local currency to PFIs (5-7 years maturity), subject to a maximum US$4 million equivalent per PFI using Subsidiary Financing Agreements that will define the terms and conditions. Selection of PFIs and SFAs will be subject to prior review and acceptance by IDA. • PFIs are expected to recycle/on-lend to SMEs under similar terms and conditions, funds coming out of repayments from SMEs until funds are repaid to DOSMEP. • DOSMEP will maintain, during project implementation, a Project Management Unit (PMU) with procedures, responsibilities and staffed with qualified personnel capable of satisfactorily implementing all aspects of the project. It is agreed that the NIU (in MOIC) will handle procurement, disbursement, financial management, and safeguards until such time DOSMEP builds its own capacity. • DOSMEP must be in compliance with the requirements (including the fiduciary and safeguard requirements) listed in the Project Implementation Manual. 21 • For the duration of the project implementation period, beginning with the year 2014, DOSMEP/NIU will annually submit an audit report on the project prepared in accordance with International Auditing Standards and International Financial Reporting Standards. • DOSMEP will submit (with assistance from NIU) relevant reports including the semi-annual un-audited Interim Financial Reports (IFRs) and quarterly project progress reports. • DOSMEP (with help from NIU) will be subject to monitoring of the PDO and Intermediate Results Indicators in Annex 1 “Results Framework and Monitoring” and the Additional Indicators in the Project Implementation Manual and Annex 3 on a quarterly, semi-annual and yearly basis. (b) Subsidiary Financing Agreement terms and conditions for DOSMEP funding to PFIs 66. Before final selection of the PFIs, DOSMEP will submit to the World Bank the evaluation report including financials of the proposed PFIs together with a request to include the PFIs in the project. The World Bank will review and clear DOSMEP’s assessment by conveying “no objection” for each PFI’s participation for the requested amount. The no objection will be based on the criteria included in this section and elaborated in the Project Implementation Manual. DOSMEP will send the financials of the PFIs (including Audit Reports) to the World Bank every year to ensure that the selected PFIs continue to meet the required criteria throughout the life of the project. The no objection will not be required for the continued participation of the PFIs. (i) Eligibility criteria for the PFIs that will be under the Line of Credit 67. PFIs will be selected based on their expression of interest to participate in the project and on acceptance by DOSMEP of their credit risk, as well as the following minimum eligibility criteria: • Total assets during the last two years to exceed a minimum of US$50 million equivalent. • Profitable for the past two years. • Non-performing loan (NPL) ratio below 5 percent during the past 2 years. • Audited IFRS financial statements as per BOL requirements for the past two years. • Compliance with all BOL prudential norms. General compliance with legal and regulatory requirements applicable to the banking industry, including but not limited to such prudential regulations as minimum capital adequacy ratio, maximum foreign currency exposure limits, maximum large exposure to single and connected clients and maximum insider lending limits, etc., duly certified by the banks’ auditors every year and confirmed by the management as of June 30 every year. (ii) Terms and conditions of subsidiary financing between DOSMEP and PFIs • PFIs must start and remain in compliance with the above eligibility criteria for PFIs. • The funds available to PFIs will depend upon the availability of funds to DOSMEP from MOF/IDA. • The cost of subsidiary loans to PFIs will include, at a minimum, the cost of the IDA funds to MOF plus an on-lending margin reflecting: (a) DOSMEP’s administrative costs, and (b) a credit risk margin. Interest rates on deposits from DOSMEP to PFIs will be equivalent to rates on 3 months deposits rates, or interbank rate, prevailing in the market. • PFIs will be responsible for ensuring that SME sub-borrowers comply with the well-established Private Sector Procurement Methods or Commercial Practices which have been found acceptable to the Association for the procurement of goods, works, non-consulting services and consultant services under sub-loans, and applicable Lao environmental and social legislation and 22 regulations, and the environmental and social safeguard requirements of the Financing Agreement and applicable safeguard instruments. • PFIs will provide DOSMEP with a set of documentation for all sub-loans to enable it to maintain all project records and make them available for ex-post review by the World Bank or by external auditors as necessary. • PFIs and SMEs will be required to provide reasonable information for the purpose of monitoring and impact assessment during the life of the project (and for a certain period after the project), as may be requested by the World Bank and/or DOSMEP. (c) Sub-loan terms and conditions for PFIs’ sub-project lending to SMEs • For the purpose of this project, SMEs are defined as small firms with less than 20 employees and medium firms with 20-99 employees as per Lao PDR Decree No. 42/PM, dated 20 April 2004, or as may be modified by the GOL in future. Only employment criteria of the Decree will apply for this purpose. • All private SMEs (private ownership more than 50 percent) and properly registered, irrespective in any economic sector will be eligible. Sub-loans will be evaluated in accordance with PFI’s normal project and credit evaluation guidelines. DOSMEP will ascertain the eligibility of the sub-loans provided by PFIs to ensure that they meet the project requirements, but will not conduct its own evaluation of sub-loans or sub-projects. • The cost of sub-loans by PFIs to SMEs will include, at a minimum, the cost of the project funds to PFIs plus an on-lending margin reflecting PFIs’ administrative costs plus a credit risk margin. • Sub-loans may be made in local currency for working capital and/or investment purposes, subject a limit for working capital loans of not more than 30 percent by a PFI. • The amount of an individual sub-loan to a SME will not exceed US$200,000 equivalent. • PFIs may provide more than one sub-loan to a SME. But the aggregate amount of all outstanding sub-loans to any one SME from all PFIs under this project shall not exceed US$300,000 equivalent. • All sub-loans must have a maturity of not less than 2 years and not more than 7 years. • Procurement of all goods, works and services for all sub-projects financed by the sub-loans must be completed before the Project closing date, but SMEs will be able to repay their loans to PFI after the closing date, if required. • The first two sub-loans from each PFI, irrespective of size will be subject to prior review by the World Bank. In addition, the World Bank will carry out a prior review of sub-loans exceeding US$200,000 equivalent. • All sub-loans not subject to prior review may be subject to ex-post review by DOSMEP and/or by the World Bank to verify compliance with the subsidiary and sub-loan agreement terms. • PFIs (or the relevant authorities) will certify that the SMEs (sub-borrowers) and sub-projects meet environmental and social laws and standards in force in Lao. The requirements of the World Bank environmental and social safeguard policies as reflected in the Financing Agreement and ESMF and applicable safeguard instruments will also be complied with. • Sub-projects classified as World Bank’s Environmental Category A or involving dams and international waterways will not be financed. • Purchase of land, and goods, works, non-consulting services and consultant services on the ESMF’s negative list will not be eligible for financing. • Contracts with firms and individuals that are on the World Bank lists of debarred or suspended firms and individuals will not be eligible for financing. • Sub-borrowers must comply with the World Bank’s Procurement Guidelines for the procurement of goods, works, services and consulting services to be financed under the project. They will follow well established Commercial Practices as outlined in these Guidelines. 23 • Sub-borrowers will be required to obtain adequate insurance for the goods and works financed from the Project funds, if available in the market and at reasonable cost, in line with sound business practices. • SMEs will be required to keep copies of invoices for all expenses financed with working capital and investment loans received under the project. SMEs will be required to send to their respective PFIs copies of invoices for expenses financed with investment loans. The invoices for working capital loans will be kept by the SMEs and made available to the PFIs, DOSMEP, the World Bank and the auditors on request. • Sub-borrowers will be required to provide reasonable information for the purpose of monitoring and impact assessment during the life of the project (and for certain period after the project), as may be requested by the World Bank and/or DOSMEP. • Sub-borrowers are required to comply with the World Bank's "Guidelines on Preventing and Combating Fraud and Corruption in Projects Financed by IBRD Loans and IDA Credits and Grants," dated October 15, 2006, and revised January 2011 (Anti-Corruption Guidelines) as part of its general obligations relating to the receipt and use of such proceeds of the Loan. The local translation of the Anti-Corruption Guidelines is available on the World Bank website in Lao (http://www.worldbank.org/en/country/lao). The English language version will apply in case of any inconsistency between the Lao and the English versions of the Anti-Corruption Guidelines. 68. At the end of this Project, the proceeds of the line of credit will be used exclusively to finance additional development projects to further the development of the SME sector unless the Government of Lao PDR and IDA agree otherwise. Component 2. A Risk Sharing Facility (IDA US$3 million) 69. In Lao PDR, commercial banks require too much collateral from SMEs (usually up to 3 times the loan amount) thus discouraging SMEs from borrowing from banks. Moreover, only land and building are accepted as collateral. Recognizing this problem, a Risk Sharing Facility (RSF) will be set up that will provide a partial credit guarantee to eligible private banks that lend to SMEs. The RSF will cover 50 percent of the losses that the PFIs may incur in their SME lending operations. With the use of this RSF, the risk (and potential losses) faced by commercial banks will decline. As a result, commercial banks will be expected to lower their excessive collateral requirements and thus serve a growing number of SMEs, even those with limited collateral. 70. The RSF will cover an underlying loan portfolio consisting of eligible SME loans originated by the participating commercial banks. In the event of a SME default, the RSF will absorb 50 percent of the loan loss amount and the other 50 percent will be borne by the PFI on a pari passu basis. To cover claims from commercial banks, the resources from IDA (US$3 million) will be used first (first loss). The maximum amount of resources from IDA to be used as a first loss will be US$1 million per PFI. If, and in the remote case the IDA project resources (on behalf of GOL) are exhausted, then IFC will use its own resources to cover the losses (second loss) from the loan portfolio, as illustrated in Table 5. IFC is expected to enter into Risk Sharing Agreements (RSAs) with eligible PFIs within 24 months after the effectiveness of the project at which time IDA funds will be committed for a particular PFI (up to US$1 million per PFIs). In order to make maximum use of project’s IDA funding, any uncommitted funds after this period will be available for reallocation to other Components. In the case, if such committed funds are not utilized by IFC for paying out first loss, they may be utilized by DOSMEP for SME development purposes in agreement with IDA (to be reached before Project Closing date). 24 Table 5. Distribution of Risks under the RSF PFIs RSF Government of Lao PDR 1st loss (funded by IDA): First loss PFIs: 50% of the (US$ 3 million) risk (up to $15 million) IFC: Second loss 2nd loss (eventually up to US$12 million) 71. Commercial banks will originate the SME loans in accordance with the loan eligibility criteria as per Risk Sharing Framework Agreement (RSFA, to be signed by the Government, IFC and IDA), and will take credit decisions and administer/service the loans. As in the Line of Credit, the RSF will target loans to SMEs that are fully owned by the private sector and properly registered. Most of the loans are expected to be from SMEs in the manufacturing, trading and services sectors. The IFC will serve as the Facility Agent to manage the RSF (on behalf of the Lao Government) and will share relevant information with DOSMEP and the World Bank on the design and operation of the RSF, so that DOSMEP can learn how to establish and administer such a facility on a profitable basis. IDA, IFC and DOSMEP will jointly monitor and evaluate the performance of the RSF. 72. At the time of preparation of this lending operation, IFC has started discussions with one potential bank, which has shown strong interest to participate in the RSF. IFC is conducting due diligence of this bank. Detailed terms such as a tenor, RSF fee, and the first loss size will be determined upon a closer look at bank’s loan portfolio and its business plan specific to the SMEs sector after the appraisal. More private commercial banks are expected to participate in the facility, once it starts to operate. The Risk Sharing Framework Agreement between DOSMEP and IFC as well as participation of a bank in RSF will be subject to approval of IDA. 73. The Line of Credit and RSF will not compete against each other as each of them has different objectives. The Line of Credit will provide long term resources to commercial banks, so that they can provide long-term credit to SMEs. The RSF seeks to lower the excessive collateral requirements that commercial banks require from SMEs by sharing up to 50 percent of the losses of commercial banks in the event of SME default. To access any of these two instruments, banks will pay interest in the case of line of credit and an annual fee in the case of the RSF. An eligible PFI may participate in the Line of Credit (Component 1) or RSF (Component 2) or both, subject to meeting the eligibility criteria applicable to respective Components. Component 3: Technical Assistance (IDA US$5 million) 74. This component will support capacity building of DOSMEP, PFIs and SMEs as well as project implementation, safeguards and monitoring related activities. The design, scope and funding for tasks will be kept flexible so as to identify and support the needs as they arise. Steps will be taken to explore synergies and avoid overlap with other ongoing programs such as TDF-2. Sub-Component 3.1: Technical Assistance to DOSMEP- (around US$3.5 million) 25 75. This component will support strengthening DOSMEP capabilities to formulate and implement an updated SME development strategy and to implement and monitor the project including ensuring compliance with World Bank’s social and environmental operational policies and IFC’s performance standards. The design and scope of this component will be kept flexible so as to cover the needs as they arise. The activities to be supported are likely to include the following: • Preparation of a SME Development Master Plan • Generating a new set of data and statistics on SMEs in Lao PDR, including firms and micro- enterprises operating in the informal sector, with the support of the National Statistic Office or other relevant agencies. • Design and impact assessment of SME development policies and programs • Design of new SME lending and non-lending products including business advisory services • Feasibility of an information clearing house on SMEs • Studies to learn how well-functioning SME Promotion Agencies in other countries operate and what programs, activities, lessons and sound practices DOSMEP could adopt from them. • Provision of business advisory services to SMEs in areas such as financial literacy, business planning, preparation of loan application, accounting, marketing, tax, etc. • Training and study tours for DOSMEP staff and other relevant organizations • Project implementation and monitoring including additional staff and external consultants for: (i) the assessment and monitoring of PFIs; (ii) compliance with the World Bank’s social and environmental operational policies and IFC’s performance standards including building knowledge and developing capacity of DOSMEP, PFIs and SMEs to ensure effective implementation of the ESMF; (iii) cost of outsourcing the procurement, financial management including IFR reporting functions to the NIU; and (iv) M&E, reporting, and project audits. 76. Contributing towards increased women’s economic empowerment, special efforts will be made to see that DOSMEP services to SMEs are tailored to the differential needs and constraints faced by female entrepreneurs. The project will support efforts by DOSMEP to produce SME data and statistics that are sex-disaggregated. Moreover, it will help DOSMEP adopt SME development policies and programs that are gender informed, and that business advisory services (including on key financial literacy, business planning and loan application preparation) are also targeted and reflect the specific needs of female entrepreneurs. Activities will build on prior World Bank-financed activities including assistance to young entrepreneurs under the Adolescent Girls Initiative, the Mekong Women’s Entrepreneurship Challenge as well as the ongoing Business Assistance Facility matching grants scheme financed under TDF-2. Sub-Component 3.2: Participating Financial Institutions (PFIs) - (around US$1 million) 77. One of the factors contributing to limited SME access to financial services in Lao PDR is a lack of up-to-date knowledge and expertise within financial institutions, in particular local financial institutions, relating to international good-practices in SME banking. Internationally, over the past 10 years, significant advances have been made in areas such as product development and marketing, market segmentation, credit scoring, risk management, organizational structures and management information systems. The project will support TA and training to PFIs and other relevant financial institutions in improving their SME lending business capacity such as: • the development of SME banking strategy, SME banking products and marketing approaches. • compliance with World Bank’s social and environmental operational policies and IFC’s performance standards. 26 • adaptation, testing and roll-out of an automated credit origination and decision-making methodology and process (including a credit scoring methodology); and related work to improve the quality and efficiencies of loan origination, processing and portfolio management. 78. The assistance will not overlap or crowd out other support that is already being provided by other donor institutions to PFIs. Assistance under this component will be provided at no cost for PFIs. Sub-Component 3.3: SMEs - (around US$0.5 million) 79. SMEs in Lao PDR face significant constraints in terms of business and financial management capacities and this component will aim to develop capacity for participating SMEs by providing training on business administration and financial management, focusing on SME mentoring and coaching. The Project will support SMEs who receive loans under the LoC or RSF facilities or are referred by DOSMEP. The training will focus on some of the following topic areas for SMEs: (1) Basic bookkeeping and management information systems; (2) Staff management; (3) Financial products and how to develop business plans and apply for bank financing; (4) sales and marketing; and (5) Legal and tax issues. The assistance will not overlap or crowd out other support that is already being provided by other donor institutions to SMEs. Assistance under this component will be provided at no cost to SMEs. 27 Annex 3: Implementation Arrangements LAO PDR: SME Access to Finance Project Institutional and Implementation Arrangements 80. The Department of SME Promotion (DOSMEP) at the Ministry of Industry and Commerce (MOIC) will be the Executing Agency for the project; other agencies involved in project implementation include the IFC, PFIs and NIU. DOSMEP was established in 2005 under the Prime Minister Decree No. 42/2004, dated 20 April 2004 with the mandate to develop national strategy and policy to promote SME development and to coordinate and supervise their implementation. 81. DOSMEP already manages an existing Government line of credit program that is similar to the one proposed under the project. Further, DOSMEP has been supported by the ADB, GIZ and other donors in developing SME sector analysis, legal and regulatory framework and infrastructure for SME development, as well as in institutional capacity building during the 2006-2010 SME Development Plan implementation. DOSMEP works with the local Department of Industry and Commerce at local government level in municipalities and all provinces and has established focal points with various production groups, associations, cooperatives and others. Dealing with conflicts of interests in the project 82. IFC’s participation in the Project may give rise to actual, potential or perceived conflicts of interest in view of the possibility that some of the PFIs and/or SMEs that could potentially benefit from the risk sharing facility and other components of the Project might be existing or future IFC clients. Should such a situation arise, IFC will disclose its business interests in or relationship with these entities. Any actual, potential or perceived conflicts of interest will be managed in accordance with the World Bank Group’s guidelines for the management of inter-institutional conflicts of interest. 83. In particular, the following arrangements have been put in place and agreed to with GOL to ensure that any such conflicts of interest are properly managed. First, in order to ensure that no preferential treatment is given to any PFI or SME, their selection will be based on objective, clear and transparent eligibility criteria which have been agreed to by the Government, IDA and IFC. Selection of each PFI will involve the Government, IDA and IFC, and each PFI will select the beneficiary SMEs in accordance with the pre-agreed criteria. Second, the World Bank Group has maintained and will continue to have separate teams for the WBG advisory role and the IFC investment role, i.e. separate teams of staff will continue to handle the overall supervision of the Project, on the one hand, and the detailed appraisal and contracting of PFIs under the PCG, on the other. Third, confidential or privileged information belonging to the Government or any PFIs or SMEs will not be shared between the World Bank Group advisory and IFC investment teams without the prior consent of the affected parties. Project administration mechanisms 84. The SME Fund Board (SFB) will serve as the Steering Committee for the project. The SFB is chaired by the Vice Minister of MOIC who is supervising person for DOSMEP. This Board established pursuant to Decree No. 123/PM, dated March 3, 2010, for the purpose of making decisions related to SME development funding, comprises the Vice Minister of MOIC, the Director General of the Planning Department of the Ministry of Planning and Investment and members from the Lao National Chamber of Commerce and Industry, the Ministry of Finance, the Prime Minister’s Office, Bank of Lao PDR, the Ministry of Planning and Investment and DOSMEP. The Board is expected to meet twice a year during which relevant project information (i.e. annual work plans, progress reports, significant changes to project 28 design, etc.) will be presented for review and endorsement. Other key stakeholders may be invited to participate in meetings of the SFB as observers. The SFB will not be involved in day-to-day operation of the project, which would be handled by DOSMEP management. Additionally, as part of alignment with overall aid effective governance structure, the project will update its implementation progress the existing Program Executive Committee (PEC) established under the Trade and Private Sector Working Group as part of the Roundtable Process as deemed necessary. Such reports will be provided for information purposes and PEC will not be involved in any decision making or oversight aspects of the Project. 85. This is the first time that DOSMEP will implement a World Bank-financed project. Its capacity to manage World Bank projects is limited, as its staff is not familiar with World Bank policies and procedures. Therefore, DOSMEP will engage appropriate expertise to implement and monitor the project including international advisors on PFI assessment, and project implementation, as well as safeguards and M&E experts. It has set up a Project Management Unit (PMU) headed by the Director of SME Fund Management Division. The PMU will engage adequate staff, external consultants and other resources necessary for the successful implementation of the project. Further, it has decided to outsource the fiduciary related tasks (procurement and financial management including IFR reports) to the National Implementation Unit (NIU), within the Department of Planning and Cooperation at the MOIC, which has set up a competent unit to manage various World Bank-financed projects, including the Trade Development Facility (TDF) Projects financed by the World Bank. The NIU is competent to help manage this project and will hire additional staff as required. This arrangement will be reviewed by the Bank as and when DOSMEP has fully built its own capacity to handle fiduciary responsibilities. 86. IFC will administer Component 2 (Risk Sharing Facility) on behalf of DOSMEP, and will conduct due diligence of PFIs. For the purpose of this task, the GOL will enter into a Risk Sharing Framework Agreement (RSFA) with IFC (and IDA), which will include the obligation of IFC to: • Establish, and administer, on behalf of the GOL, a trust fund, under a trust fund administration agreement to be entered into between IFC and the DOSMEP, on terms and conditions satisfactory to IDA, for the purpose of holding funds to be used to satisfy the DOSMEP obligations concerning the first-loss coverage under the RSF. • Enter into a Risk Sharing Agreement, in form and substance satisfactory to DOSMEP and IDA, with each PFI, and exercise its rights under each such Risk Sharing Agreement in such a manner as to protect the interests of the GOL and IDA. • Ensure that each PFI carry out their respective parts of the project in accordance with the provisions of the IFC's anti-corruption approach for the private sector. • Ensure that RSF component of the project is implemented in accordance with the provisions of the Risk Sharing Framework Agreement and the relevant Risk Sharing Agreements. • Ensure that each PFI apply a specific Environmental and Social Management System (ESMS) that is consistent with the requirements and procedures set out in ESMF. • Carry out periodic supervision of each PFI and provide regular reports (quarterly and annual) to DOSMEP and the World Bank. Financial Management, Disbursements and Procurement Financial Management 87. The Financial Management (FM) assessment indicates that the project will be implemented in an inherently ‘Substantial’ risk environment. This conclusion comes from the current weak government financial management systems which are undergoing reform. Appropriate mitigation measures have been 29 incorporated into the design of the financial management arrangements in order to reduce the residual FM risk of the project to ‘Moderate’. These mitigation measures include: • delegation of the project’s consolidated accounting and financial management and IFR reporting functions to NIU. A qualified financial management staff will be recruited by NIU. • modification of existing NIU Financial Management Manual and computerized accounting software to accommodate any necessary changes to the accounting policies and procedures including the new IFR template. • the Risk Sharing Facility will be administered by IFC with periodic reporting to the DOSMEP/NIU and World Bank for project consolidated reporting purposes. • an independent auditor will be engaged to conduct an external audit of the Project’s consolidated financial statements for all three components. • The project is required to submit the IFR within 45 days after the end of each semester. 88. In conclusion, the proposed financial management arrangements will meet the World Bank’s minimum requirements for project financial management as per OP/BP 10.00. Based on the World Bank’s Access to Information Policy, the project’s audit report, together with audited financial statement, will be subject to public disclosure. Disbursements 89. An Account for Credit and Grant, respectively, will be opened for this project by IDA. The IDA funds will be transferred to a pooled Designated Account (DA) which will be opened in USD at the Bank of Lao and managed by the Treasury of the MOF as per the current practice in Lao for ODA projects. 90. Component 1: Line of Credit Facility, DOSMEP will sign Subsidiary Financing Agreements (SFAs) with PFIs with terms and conditions acceptable to IDA. These SFAs will include details about the amount to be deposited to PFIs, how the interest from deposits with PFIs will be transferred back to DOSMEP account, eligibility for SMEs financing, monitoring arrangements, the reporting requirements, etc. The signed SFAs will be used as a basis for disbursement to PFIs. Project funds will be transferred from the Designated Account at BOL to DOSMEP account, DOSMEP will transfer fund to eligible PFIs for on-lending to SMEs. Alternatively, funds may be transferred directly by IDA through Direct Payment to a PFI at the request of DOSMEP (thus eliminating the need for a separate account at DOSMEP). NIU will have access to information on DOSMEP account including all deposits and disbursements to and from IDA, DOSMEP and PFIs in order to fulfill its fiduciary responsibility. 91. Component 2: Risk Sharing Facility, the IDA funds will be transferred into an IFC managed RSF trust account. IFC, as part of the World Bank Group, has similar fiduciary requirements and processes as IDA, and has the institutional capacity to observe IDA's FM requirements. IFC will maintain an acceptable financial management system including books of accounts and will make available to DOSMEP/NIU and IDA the financial information relating to receipts, disbursements and fund balance with respect to the funds in the relevant Trust Fund via the World Bank’s Trust Funds Donor Center secure website. The financial information will be updated on a monthly basis. Within six (6) months after all commitments and liabilities under a Trust Fund have been satisfied and such Trust Fund has been closed, the final financial information relating to receipts, disbursements and fund balance with respect to the funds in the relevant Trust Fund will be made available to DOSMEP/NIU and IDA via the World Bank’s Trust Funds Donor Center secure website. 92. The disbursements into the RSF TF will be made based on an individual PFI risk sharing coverage as they enter under the RSF upon signing the Risk Sharing Agreement (RSA) with IFC after 30 project effectiveness. Expenditures will be recognized as expended when IDA proceeds are committed to providing partial credit guarantees to PFIs when RSAs are entered into by IFC with the PFIs. The disbursement amount will be equal to IDA first loss coverage (subject to a maximum limit of US$1 million per PFI). IDA would not make any disbursements beyond first PFI unless and until a second and subsequent eligible PFI has become a party to Risk Sharing Agreement, with IFC, satisfactory to IDA. If two years after effectiveness, not enough PFIs have entered into an agreement to participate in RSF, IDA portion of allocation may be reallocated to other parts of the project with mutual agreement between DOSMEP and IDA, unless DOSMEP, IDA and IFC agree otherwise. 93. Recognizing that PFIs may extend loans to SMEs with a maturity beyond the project closing date, IFC will continue to administer the risk-sharing facility beyond the project closing date until all SME loans covered by the risk-sharing facility are closed. In the case committed funds are not utilized by IFC for paying out first loss coverage, they may be utilized by DOSMEP for SME development purposes in agreement with IDA. If no agreement is reached between IDA and DOSMEP before Project Closing Date, such funds will be returned to IDA and allocated amount will be cancelled. 94. Component 3: Technical Assistance (i.e. consulting services, goods, study tours, trainings/ workshops and IOC), The NIU (on behalf of DOSMEP) will establish an Operating Account in a commercial bank to facilitate the project expenditure for DOSMEP, banks and SMEs. In budgeting for in and out country travel, MOF Decision 0008/MOF dated 5 January 2010, and any related notifications by IDA or by MOF on the use of ODA will be followed. Advances for training activities should be liquidated within 15 working days after the completion of an activity; further advances will not be made unless the previous advance is cleared. Allocation of IDA Proceeds 95. The project would be implemented over a four-year period with an IDA funding of US$20 million (Grant US$10 million and Credit US$10 million). The allocation of IDA proceeds against eligible expenditures is given in Table 5 below. IDA will provide 100 percent financing, inclusive of taxes, for category (1) and (3); for category (2), IDA will provide 100 percent financing of the first loss up to the allocated amount of US$3 million. For category (1) where both IDA Credit and Grant are allocated, IDA Grant will be utilized fully first. One Designated Account in USD and with a ceiling of US$2.5 million will be established for the project and used to receive funds from both IDA Grant and IDA Credit. Disbursement methods may include advance, reimbursement, direct payment or special commitment, with the bulk of the funds to be made through advance or direct payment. Supporting documentations required may include Summary Sheet for claims against contracts subject to prior review, and Statement of Expenditures for all other contracts or expenditures. Table 5. Allocation IDA Proceeds Categories IDA Credit IDA Grant Financing % (US$ million) (US$ million) (1) Sub-Loans under Part 1 of the 10.00 2.00 100 Project (2) First Loss Coverage for Partial -- 3.00 100 Credit Guarantees under Part 2 of the Project (3) Goods, Non-consulting Services, -- 5.00 100 Consultants’ Services, Training and Operating Costs under Part 3 of the Project 31 TOTAL 10.00 10.00 96. Disbursement conditions: The following need to be met before disbursements under category (1) can take place: Subsidiary Financing Agreement with each PFI is signed, and each PFI has also adopted its Environmental and Social Management System satisfactory to IDA. For disbursements under category (2), the following need to be met first: The Risk Sharing Framework Agreement between the Project, IDA and IFC, and the Risk Sharing Agreement between IFC and PFI has been signed, and such PFI has adopted its Environmental and Social Management System satisfactory to IDA 97. Under this project, up to US$2 million will be available in retroactive financing starting April 1, 2014. The expected activities to be supported with retroactive financing are preparation of the new SME Development Master Plan, assessment of interested commercial banks, building the monitoring and evaluation framework for the project, assessment of commercial bank’s needs in terms of environmental safeguards, preparatory work for the new SME census, staffing of PMU, technical assistance, study tours and training, etc. Procurement 98. Procurement for the project will be carried out in accordance with the World Bank’s Procurement and Consultant Guidelines (January 2011), and the provisions stipulated in the Financing Agreement. SMEs borrowing under the Line of Credit and Risk Sharing Facility will follow Private Sector Commercial Practices for the procurement of goods, works, non-consulting services and consulting services. 99. Assessment of the NIU’s capacity to implement procurement as MOIC’ Unit in-charge of day-to- day project management. An assessment of the NIU procurement capacity was carried out by IDA’s procurement staff in accordance with relevant instructions. The NIU within the Department of Planning and Cooperation at the Ministry of Industry and Commerce has been carrying out procurement under the recently closed TDF-1 Project and the ongoing TDF-2 Project. The assessment confirmed that NIU has satisfactorily carried out procurement under TDF projects; and there were no major procurement issues. 100. Keeping in mind the broader fiduciary risks present in Lao PDR, including a weak country procurement environment, the overall project procurement risk is currently Substantial. However, the risk will be managed and mitigated through the action plan that is being incorporated in the project design as listed below. In addition, procurement staff experience and the incorporation of the capacity strengthening measures lower the residual procurement risk to Moderate. 101. Action Plan to Improve Procurement Capacity. From the experience of the current phase of TDF- 2, it is expected that the following key issues and risks concerning procurement could arise when the project is implemented, and measures necessary for mitigation have been agreed with DOSMEP/NIU, as follows: • Delays in procurement process: Based on the past experience, procurement can be subject to delays at various stages, which may in turn cause delays in project implementation. This risk would be mitigated by careful procurement planning and scheduling, procurement advancing as much as possible, closer coordination between NIU, DOSMEP and IDA and more frequent supervisions and follow up by IDA. • Strengthening the NIU Procurement team: This includes procurement capacity building to both NIU government officers and local consultants. NIU should ensure to allocate enough staff time for the NIU officers to work with the Procurement Advisor to handle procurement 32 and for the purpose of on-the-job training. To further strengthen the capacity, a national procurement consultant may also be considered. • Detailed procedures on Component 1 (Line of Credit to PFIs to support SME loans– US$12 million): The detailed policies and procedures for management of the Component 1 related to Line of Credit to PFIs will be fully documented in the Project Implementation Manual. The Manual will provide the clear responsibility of each party and detailed procurement procedures and forms. 102. Procurement Plan. The DOSMEP has prepared a detailed Procurement Plan for the first 18 months, which has provided the basis for the selected procurement procedures. This Plan was discussed at negotiations and agreed with IDA. The Plan will be updated with IDA’s prior concurrence, annually or as required, to reflect changes in implementation needs and improvements in institutional capacity. Goods and works and non-consulting services Prior Review Threshold: Procurement Decisions will be subject to prior review by the Bank as stated in Appendix 1 to the Guidelines for Procurement: S/N Procurement Method Prior Review Threshold Comments US$ 1. ICB (Goods) All >US$600,000 2. NCB (Goods)* The first contract US$300,000 2. CQS, LCS US$ 100,000