Document of The World Bank Report No: 29186 IMPLEMENTATION COMPLETION REPORT (IDA-34420 TF-24886 FSLT-70410 TF-52698) ON A LOAN IN THE AMOUNT OF US$ 30,310,000 AND CREDIT IN THE AMOUNT OF SDR 15,200,000 TO THE FORMER YUGOSLAV REPUBLIC OF MACEDONIA FOR A Second Financial and Enterprise Sector Adjustment Loan May 28, 2004 CURRENCY EQUIVALENTS (Exchange Rate Effective May 28, 2004) Currency Unit = Denar 1 Denar = US$ 0.019 US$ 1 = 51.54 FISCAL YEAR January 1 December 31 ABBREVIATIONS AND ACRONYMS AMA - Asset Management Agency BIS - Bank for International Settlements BRA- Bank Rehabilitation Agency BSD- Banking Supervision Department (of the National Bank of Macedonia) CA Corrective Action (Program) CAMEL Capital/Asset quality/Management/Earnings/Liquidity CAS- Country Assistance Strategy CRO- Central Register Organization CSD/CSR Central Securities Depository/Central Share Registry DEM- Deutsche Mark DVP- Delivery-versus-Payment EBO Employee Buyout EBRD- European Bank for Reconstruction and Development ECA- Europe and Central Asia EFF Extended Fund Facility ES Elektro Stopanstvo (state-owned energy utility) ESAF- Enhanced Structural Adjustment Facility EU- European Union FDI- Foreign Direct Investment FESAC- Financial and Enterprise Sector Adjustment Credit (First) FESAL Financial and Enterprise Sector Adjustment Loan (Second) FSAP- Financial Sector Assessment Program FIAS- Foreign Investment Advisory Service FR- Federal Republic (Yugoslavia) FSD- Financial Sector Development FSVC- Financial Services Volunteer Corps FYR- Former Yugoslav Republic (Macedonia) GDP- Gross Domestic Product IAS- International Accounting Standards IBRD- International Bank for Reconstruction and Development ICR- Implementation Completion Report IDA- International Development Association IFC- International Finance Corporation IMF- International Monetary Fund MBO Management Buyout MIGA- Multilateral Investment Guarantee Agency MKD- Macedonian Denar MOF- Ministry of Finance MSE- Macedonian Stock Exchange NBRM- National Bank of Republic of Macedonia (Central Bank) NBG- National Bank of Greece OCC Office of the Comptroller of the Currency OTC Over-the-Counter (market) PRGF- Poverty Reduction and Growth Facility PSD- Private Sector Development RTGS- Real-Time Gross Settlement ROSC Report on Observance of Standards and Codes SEC- Securities and Exchange Commission SME- Small and Medium-Size Enterprise SRO- Self Regulatory Organization SRP- Special Restructuring Program TA- Technical Assistance TORs- Terms of Reference ZPP - Bureau of Payment Operations Vice President: Shigeo Katsu Country Director Orsalia Kalantzopoulos Sector Manager Gerardo Corrochano Task Team Leader/Task Manager: Jasminka Varnalieva MACEDONIA, FORMER YUGOSLAV REPUBLIC OF Second Financial and Enterprise Sector Adjustment Loan CONTENTS Page No. 1. Project Data 2. Principal Performance Ratings 3. Assessment of Development Objective and Design, and of Quality at Entry 4. Achievement of Objective and Outputs 5. Major Factors Affecting Implementation and Outcome 6. Sustainability 7. Bank and Borrower Performance 8. Lessons Learned 9. Partner Comments 10. Additional Information Annex 1. Key Performance Indicators/Log Frame Matrix Annex 2. Project Costs and Financing Annex 3. Economic Costs and Benefits Annex 4. Bank Inputs Annex 5. Ratings for Achievement of Objectives/Outputs of Components Annex 6. Ratings of Bank and Borrower Performance Annex 7. List of Supporting Documents Project ID: P042400 Project Name: Second Financial and Enterprise Sector Adjustment Loan Team Leader: Jasminka Varnalieva TL Unit: ECSPF ICR Type: Core ICR Report Date: June 21, 2004 1. Project Data Name: Second Financial and Enterprise Sector L/C/TF Number: IDA-34420; TF-24886; Adjustment Loan FSLT-70410; TF-52698 Country/Department: FORMER YUGOSLAV REPUBLIC OF Region: Europe and Central Asia MACEDONIA Region Sector/subsector: Banking (47%); General industry and trade sector (20%); Payment systems, securities clearance and settlement (13%); Central government administration (13%); Law and justice (7%) Theme: State enterprise/bank restructuring and privatization (P); Regulation and competition policy (P); Standards and financial reporting (S); Administrative and civil service reform (S); Legal institutions for a market economy (S) KEY DATES Original Revised/Actual PCD: 01/14/1999 Effective: 12/20/2000 12/20/2000 Appraisal: 06/02/2000 MTR: Approval: 12/14/2000 Closing: 12/31/2002 12/31/2003 Borrower/Implementing Agency: Former Yugoslav Republic of Macedonia/MOF (Ministry of Finance) Other Partners: MOE(Ministry of Economy), NBRM (National Bank of Republic of Macedonia) STAFF Current At Appraisal Vice President: Shigeo Katsu Johannes F. Linn Country Director: Orsalia Kalantzopoulos Christiaan J. Poortman Sector Manager: Gerardo M. Corrochano Ilham Zurayk Team Leader at ICR: Jasminka Varnalieva Marie-Renee Bakker ICR Primary Author: Jasminka Varnalieva 2. Principal Performance Ratings (HS=Highly Satisfactory, S=Satisfactory, U=Unsatisfactory, HL=Highly Likely, L=Likely, UN=Unlikely, HUN=Highly Unlikely, HU=Highly Unsatisfactory, H=High, SU=Substantial, M=Modest, N=Negligible) Outcome: S Sustainability: HL Institutional Development Impact: H Bank Performance: S Borrower Performance: S QAG (if available) ICR Quality at Entry: HS S Project at Risk at Any Time: No 3. Assessment of Development Objective and Design, and of Quality at Entry 3.1 Original Objective: The main objective of the Loan/Credit was to support the Government's financial and enterprise sector reform program, which sought to significantly accelerate private sector growth through: (i) strengthening the health of the banking system and improving the quality of bank intermediation; (ii) improving the private sector business enabling environment; and (iii) resolving, through privatization/financial restructuring or closure, the universe of large loss making enterprises that crowd out private sector growth. 3.2 Revised Objective: The project objectives were not changed during implementation. 3.3 Original Components: FESAL II supported a comprehensive reform program in the following four areas: A. Financial Sector Regulatory and Supervisory Framework component supported the reforms aimed at upgrading the legal framework, including: (i) modernizing banking legislation, (ii) reforming bank-owned, weakly funded Deposit Insurance Scheme, (iii) strengthening NBRM regulations, (iv) strengthening NBRM enforcement actions, and (v) supporting proactive problem bank/bank failure resolution. B. Financial System Infrastructure Development component focused on creating a properly regulated and smoothly functioning banking system, including: (i) the reform of Payment Operations Bureau (ZPP); (ii) creation of effective pledge registration mechanisms; and (iii) creation of a Central Securities Depository/Central Share Registry (CSD/CSR) and a Delivery-versus Payment (DVP)-based securities clearing and settlement system. C. Business Environment Reform component supported reform efforts aimed at: (i) streamlining private enterprise entry and the FDI regime; (ii) strengthening the legal framework for enforcement of creditors' and shareholder' rights; and (iii) building institutions to support an effective accounting and auditing profession. D. Enterprise Sector Reform component supported (i) the resolution of approximately 30 large loss-making enterprises that were partially or fully socially or state-owned, or for which the Government was a large creditor on account of overdue claims, through either sale/financial restructuring or closure, using transparent and internationally-accepted procedures, and (ii) the rationalization of government support policy for the enterprise sector by creating a declining fiscal cap mechanism, and (iii) the resolution of the assets of the BRA. 3.4 Revised Components: N/A 3.5 Quality at Entry: FESAL II was rated as "highly satisfactory" for its quality of entry by the Bank's Quality Assurance Group. Its design was fully consistent with the Bank's lending program for FYR Macedonia as laid out in the Country Assistance Strategy (CAS) of the World Bank Group for FYR Macedonia (No. 18162-MK, dated July 14, 1998), updated by a CAS Progress Report dated May 17, 2000. The CAS key priorities were resumption of growth, reduction in unemployment, and a reversion of a rising poverty. Support for these objectives has been provided through a Structural Adjustment Loan/Credit, Social Sector Adjustment - 2 - Credit, several investment operations for private sector development, energy, agriculture, health and education. The FESAL II was one of the key operations in support of the CAS objectives and one of the triggers for continuation of a high case lending scenario. The risks to the implementation of the FESAL II were carefully evaluated. The main risk to the FESAL II was identified as lack of political commitment to resolve large loss making enterprises, many of which were politically/socially sensitive because of their importance to employment. This risk was partly addressed by the Bank's Social Support Project, approved by the Board in the summer of 1999, to mitigate the expected negative short term impact on the labor force of the large loss making enterprise resolution efforts under the FESAL II reform agenda, as well as the macroeconomic and trade disruption caused by the Kosovo conflict. This program financed severance pay for redundant workers and labor redeployment and retraining services. Weak institutional capacity was another risk that could have undermined implementation of the reform program. This risk was mitigated by several accompanying donor funded technical assistance projects (USAID, EU PHARE, Norwegian Government, Dutch Government, etc). Additional risks were associated with the lingering instability in the region. 4. Achievement of Objective and Outputs 4.1 Outcome/achievement of objective: The FESAL II largely achieved its main objectives and provided the framework for faster private sector growth and job creation, supported by a healthier and more developed financial system. Macedonia has made substantial progress in enhancing the overall soundness of the financial system, particularly, the banking sector. The supervisory and legal framework for the banking system has been substantially improved. Prudential banking regulations have been refined, supervisory practices have improved, and the legal framework for effective bank supervision has been strengthened, especially through the new Banking Law. The program contributed significantly to the recent decline in the stubbornly high levels of nominal and real interest rates and to a concomitant increase in domestic savings and financial sector intermediation, generating the working capital and investment finance essential for the private businesses to upgrade and expand their operations. It is expected that the recent entry of more sophisticated foreign banks will lead to provisioning more diversified financial products and services. The largest of the loss-making enterprises in the system that crowded out new private sector growth have been resolved, leaving the enterprise sector relatively clean and free of the big value subtracters. Changes in the business environment have removed major obstacles for private sector entry and have contributed to strengthening of the creditors' and shareholders' rights. Many new institutions have been established, creating the financial infrastructure for a functioning market economy. Although all specific conditions set forth in the FESAL II policy agenda have been successfully met, the impact of the reforms has not yet materialized to its full potential. A number of deficiencies and deep systemic problems in the judicial sector have undermined the success of the reforms in the financial and the enterprise sectors. In order to achieve long-term dynamic private sector-led growth, a number of comprehensive reforms in the judicial sector, as well as more sophisticated reforms related to the investment climate, rule of law, and governance will be essential. The FESAL II original closing date was December 31, 2002. However, as the reforms were interrupted during the military conflict in 2001, closing date was extended by one year to December 31, 2003. 4.2 Outputs by components: The principal outputs of the project are as following: - 3 - A. Financial Sector Regulatory and Supervisory Framework Overhaul of the Legal Framework for Banking Activity. With the help of the Bank, the Government prepared a new banking law that Parliament adopted in July 2000. The new law: (i) introduced definitions, allowable activities and prudential regulations for banks that are more in line with EU Banking Sector directives, IAS and Basle capital rules; (ii) strengthened bank corporate governance; and (iii) introduced efficient problem bank and bank failure resolution mechanisms. The Banking Law provides detailed rules relating to the structure and governance of banks, licensing, conflicts of interests and bank secrecy. The law also provides for the management of banks including the assembly, the managing board, the executive board, the risk management committee, the auditing committee and other bodies specified by law. The provisions in this regard are quite detailed. There are provisions for auditing supervision and surveillance. The law provides appropriate enforcement measures to improve the financial condition of banks including the provision of written warnings, orders, prohibitions on the payment of dividends, appointment of conservator or receiver and, ultimately, revocation of the license. It also provides for prompt corrective actions. Bankruptcy may be initiated when the Governor determines that rehabilitation is not viable. The Banking Law was assessed as satisfactory by the 2003 FSAP (Financial Sector Assessment Program) assessment. In addition, based on the FSAP recommendations and the practical experience gained during the first years of enforcement, the Macedonian authorities proposed and incorporated amendments into the law to further strengthen the legal foundation for regulation and supervision of banks. New Deposit Insurance Scheme. Parliament adopted a new deposit insurance law in July 2000, that replaced the previous bank-owned and operated deposit insurance system. The DIF (Deposit Insurance Fund) insures deposits of natural persons, including foreign currency denominated deposits held in commercial banks and savings houses. It covers 100 percent of deposits up to EUR 10,000 equivalent and 90 percent of the next EUR 10,000 equivalent, per depositor per institution. According to international practice, the combination of these provisions is considered very generous. The fund is being built up through an initial capital contribution of the Government, premium contributions from member banks, and investment returns. A flat premium of one percent is charged on all household deposits. As of March 2004, the reserve fund of the DIF amounted to 3.20 percent of the deposit base. The reserve fund aims to reach 4 percent of the deposit base. The DIF is allowed to borrow from the government and foreign sources, as well as receive payments from member banks up to a pre-specified limit. The DIF is considered to be transparent in its policies related to insurance coverage and operations. According to the FSAP 2003 assessment, many of the principles in the Transparency Code for Financial Policies are fully observed. Further upgrading of NBRM (National Bank of Republic of Macedonia) prudential regulations and strengthening of enforcement. Based on the findings of the joint IMF/ Bank Basle Core Principles of Bank Supervision Review of October 1999, the NBRM developed an action plan for implementation of necessary amendments to both the existing Banking Law (to the extent prudential rules are embedded in the law itself) and the existing NBRM prudential regulations for banks to bring all the regulations in line with international best practices. The process continued with the issuance of upgraded versions of the remaining prudential regulations for asset classification and provisioning, large/connected/insider lending, foreign exchange exposure, interest rate risk management, and capital adequacy. Much emphasis has been put on further improving in the practice of on-site inspections and off-site monitoring and the system and practice - 4 - of loan loss provisioning by the banks. The NBRM recognizes that even a regulatory regime based on international best practices will not change the behavior of the banks without proactive enforcement. While much progress has been made in modifying the legislation, the practice of prudential implementation still needs to be thoroughly established. Gradually the system of laws, decisions and instruction for the banks, as well as internal manuals for the Banking Supervision Department will become a coherent, stabilized system, and establish the required legal and procedural framework for banking supervision. Within this context, the NBRM started to prepare a banking system-wide Compliance Report, analyzing the extent of noncompliance by the banks in the system with its existing prudential regulations. Also taking into account the findings of the previously completed diagnostic studies of the four large banks, the NBRM has developed a time-bound enforcement action plan for all noncompliant banks. The NBRM started to monitor progress made by individual banks in this respect against established benchmarks on a quarterly basis, and regularly prepares updated banking system wide Compliance Reports that are expected to indicate a sizeable drop in noncompliance. The NBRM has provided its latest reports on prudential compliance for all twenty-one commercial banks in the country, and the reports demonstrate an improving pattern of prudential compliance and/or corrective action. The report features the respective banks' compliance with nine key prudential requirements and NBRM's corrective measures in place at eleven banks. It is expected that more experience will enable the NBRM to move toward a more risk-based supervisory system, from one that is now largely compliance focused. Problem Bank/Bank Failure Resolution. In order to address issues related to the problem banks in the system, the Government and the NBRM have implemented a number of reform actions. The recapitalization and sale of the Government's remaining ownership stake in the dominant Stopanska Banka has been completed. The NBRM has closed several insolvent but systemically unimportant banks, including Almako Bank, Export-Import Bank, and others. Furthermore, the NBRM has created and operationalized an enhanced monitoring (problem bank) unit to handle, through Corrective Action (CA) programs, problem banks that have been transferred to it by the Banking Supervision Department (BSD). A detailed manual of rules and criteria has been developed to trigger the transfer of the banks into the problem bank unit, including "prompt corrective action", as defined in the new banking law, as well as receivership for the insolvent banks. For the initial group of eight problem banks NBRM enforcement was aimed to bringing about corrective action to either upgrade the banks back into the mainstream BSD, or apply more stringent enforcement actions including the removal of managers. During the lifetime of the project, the central bank has demonstrated its commitment to improving prudential compliance through a more systematic approach to addressing institutions with recognized weaknesses. Thus, as of end-2003, four banks (which together account for less than 7 percent of total banking assets) have been subject to enhanced monitoring. Two of the banks are in fact high risk banks, while the NBRM expects to move the other two to regular supervision after the next full scope on-site supervision confirms progress in improved prudential compliance. With the help of the Bank and donor funding from the Netherlands, in June 2000 one of the big five accounting firms completed comprehensive diagnostic studies of four large banks. The banks concerned were Komercijalna Banka, Makedonska Banka, Stopanska Banka Bitola, and Tutunska Banka. The diagnostic studies have helped the NBRM to determine the actual financial condition and solvency of these - 5 - banks, as well as their compliance track record vis-à-vis its existing prudential regulations. Based on the conclusions of the studies, the NBRM developed tailor made CA (Corrective Action) programs for all four banks. As one of the four banks has been identified as a problem bank, the Letter Agreement for this bank has been designed within the parameters for resolving banks in the enhanced monitoring unit. Corrective action programs have been signed as parts of Protocols between NBRM and each of the banks. All agreements set forth in the programs have been implemented by the original deadline of June 2002, as confirmed through NBRM on-site examinations except for Makedonska Banka, which has had a long-standing pattern of supervisory concerns. Makedonska Banka managed to reach satisfactory compliance with the action plan by end-2003 through the bank's sale of 68 percent of existing shares, which clarified the bank's ownership structure, strengthened its governance and improved overall performance of the bank. Thus, the core aims of the Makedonska Banka's corrective action plan -- resolution of numerous governance and regulatory concerns -- have been met. B. Financial System Infrastructure Development Financial System Infrastructure Development. The Government's objective to create a properly regulated and smoothly functioning banking system, as well as to lay the foundations for further development of the capital market is conditioned on the presence of well-developed and modern financial system infrastructure. Therefore, the Government, jointly with the NBRM, ZPP (Zavod za Platen Promet, Payment Operations Bureau) and the MSE (Macedonian Stock Exchange), has developed and initiated implementation of a financial system infrastructure development program with the following objectives: (i) reform of ZPP; (ii) development of effective movable and immovable collateral registration systems; and (iii) creation of a Central Securities Depository/Central Share Registry (CSD) and a Delivery versus Payment (DVP)-based securities clearing and settlement system. Reform of Payment Operations Bureau (ZPP). As of January 1, 2002 a new two-tier payment system became fully operational, and all unblocked corporate accounts -- with the exception of accounts where there are internal disputes within the companies -- have been transferred to private banks. Thus, ZPP ceased to exist after that date. The major components of the new payment systems are the Macedonian Interbank Payments System (MIPS) and the Clearing Interbank System (KIBS) the clearinghouse for low-value payments. The MIPS is an RTGS system owned and operated by the NBRM that is used for all large-value (more than 3 million denar) payments and for any urgent or priority payments. There are 27 participants in the MIPS including all banks, the clearinghouses, the MOF and the NBRM. In addition to payments arising directly from financial market transactions, the MIPS has a connection to Macedonia's Central Securities Registry (CSD) and provides the platform for securities settlement on a DVP basis. The recent assessment of the payment system undertaken by the joint WB/IMF team against the Core Principles for Systemically Important Payment Systems (CPSIPS) revealed that the system is in close observance of most principles. Two areas identified for future attention are the need for clarification and strengthening of the NBRM's oversight role and the need to establish a remote back-up facility. Creation of effective pledge registration mechanism. With the help of Norwegian Government financed consultants, a new modern, electronic, movable pledge register has been developed and fully operationalized. Central register for imovable pledges is also being developed. These mechanisms, along with the changes in the legislation --new, integrated law on contractual pledge-- provide institutional framework for better protection of creditor's rights. - 6 - Creation of Central Securities Depository (CSD) and DVP-based Security Clearance and Settlement System. The Norwegian Government has also financed a feasibility study and assisted with the establishment of a new CSD, linked into a DVP-based securities clearing and settlement system that is in compliance with applicable G30 recommendations and is using dematerialized share ownership records. In view of this development, Parliament has adopted amendments to the securities law that mandate the transfer of share registers from companies to the new CSD and create the legal basis for the development of the new DVP-based securities clearing and settlement system. All joint stock companies have transferred their share registers into the new CSD. C. Business Environment Reform Private Enterprise Entry and the FDI Regime. To facilitate new enterprise formation, the Government has taken several important steps towards its goal of streamlining registration for all business enterprises. Parliament has adopted the necessary changes to legislation aimed at simplified company formation and registration. This includes reduction and simplification of the attachments to the registration form for establishing a company with limited liability. The amendments reduced requirements to only one organizational document (i.e. charter) for incorporation and registration of businesses instead of various articles of incorporation, charter, assembly of subscribers, company registration, and entrance requirements. The amendments require a maximum of eight days for approval or rejection of applications for entry into the company registry and eliminate investigations and subjective decision making by judges as to the merit of the registered enterprise. Nevertheless, the Government realized that substantial reforms in this area are still not fully completed, leaving additional actions to be undertaken in order to create an integrated registration system that will be moved out of courts allowing for very easy and quick entry of new businesses. Therefore, using the assistance of foreign consultants, it drafted a new company law, approved by the Parliament in April 2004, incorporating a number of much needed corporate governance improvements. Creditors' and Shareholders' Rights. To strengthen the legal rights of creditors to take action against defaulting debtors, in July 2000 Parliament adopted amendments to the Bankruptcy Law and the existing Law on Pledges (security interests in movable property). These laws have: (i) simplified and accelerated bankruptcy and collateral foreclosure proceedings; and (ii) closed loopholes currently open to debtors to delay creditor actions. Additionally, a new mortgage law (for security interests in immovable property) was also enacted by Parliament. As outlined above, the new movable pledge register operated and maintained by the CRO is already operational, and a new immovable pledge register is being established. To complete the reform agenda in this area, in January 2003 the Parliament adopted a new integrated law for both movable and immovable collateral that replaced the two separate laws for movable and immovable security interests. The new law provides workable and sufficiently clear rules for the creation and termination of pledges and pledge priority over movable and immovable assets. Furthermore, it provides a mechanism whereby notaries are able to initiate debt recovery cases without referral to the courts. The experience to date indicates that procedures are sound and that debt recoveries can be initiated relatively quickly and inexpensively. However, in cases where debtors prefer to delay the foreclosures, they could still go to the courts and drag the process out by abusing the opportunities for appeals. Supporting an effective Auditing and Accounting Profession. To support the above mentioned legal changes and strengthen creditor and shareholder rights, the Government also committed itself to carry-out reforms aimed at improving the quality of debtor and issuer financial statements and information, including establishment of a Self Regulatory Organisation (SRO) for chartered accountants and auditors, that would - 7 - have the responibility for: (i) determining minimum professional education standards; (ii) organizing and administering professional training; (iii) determining minimum ethical standards; (iv) disciplinary proceedings including revocation of SRO membership. As part of the Bank's assessment of the accounting and auditing module within the Reports on the Observance of Standards and Codes (ROSC) in Macedonia, progress in this reform area has been reviewed. Although the Government had in principle met the program requirement, it has been faced with implementation problems which could have undermined the functioning of the SRO in the long run. To remedy the future implementation problems, the Ministry of Finance (MoF) has prepared a new draft audit law. Moreover, the Bank provided technical assistance in reviewing and modifying the draft law to incorporate the findings of the ROSC and comply with the European Union Eighth Directive and subsequent European Commission recommendations. It is expected that after the law is adopted, additional technical assistance will be required to implement the new legislation, upgrade the accounting and auditing profession, and enhance the reliability of financial reporting. D. Enterprise Sector Reform Large Loss Making Enterprise Resolution. To substantially reduce losses, the Government committed itself to resolve, through either sale/financial restructuring or closure, 30 out of approximately 40 large loss making enterprises that were partially or fully socially or state-owned, or for which the Government was a large creditor on account of overdue claims. In order to guarantee transparency in the decision process to sell, financially restructure, or close individual large loss making enterprises, all related Government decisions have been taken based on additional binding guidelines, formalized through two Government decrees that were issued in August 2000. (These were the `Action Plan for Resolution of Loss Makers' and `Method of Sale of State/Social Shares'). The Government has formally resolved all 24 enterprises that were identified in the Minutes of Negotiations, as well as eight additional enterprises of its own choice. The 1999 total losses of these 32 enterprises were equivalent to 2.04 percent of 1999 GDP. The Government has gone beyond the formal conditions required by the Loan/Credit, which requires only that the creditors of bankrupt state-owned enterprises take the decision to liquidate the assets and to terminate the employees. Using funding from the Dutch Government to engage international sales consultants, it has embarked on an extensive program to sell the assets of the FESAL II designated enterprises through a transparent process. In total, four enterprises have been sold, 26 have been liquidated through bankruptcy, and two have been resolved through foreclosure actions by secured creditors. Of the bankrupt enterprises, the sales consultants have successfully sold 16, and are in the process of selling an additional five enterprises. The sale of the assets of liquidated enterprises produced revenue for the state budget in the amount of EUR 10.5 million. Total revenues from the FESAL loss making enterprises by December 2003, including the privatization proceeds, reached EUR 14 m. Within the process of resolving the loss-making enterprises 15,000 workers have been laid off, nevertheless, after the successful sale of assets of the liquidated enterprises, 5,200 workers have been re-hired by the new owners. Additional 2,200 workers are expected to be re-hired when the ongoing sale of assets will be completed. To mitigate the negative impact on the labor force of the large loss making enterprise resolution efforts under the FESAL II reform agenda, the Bank approved Social Support Project in the summer of 1999. This program financed severance pay for 4,483 redundant workers of five FESAL enterprises in the amount of US$ 4.7 million. It also financed 593 active labour projects including labor redeployment, and retraining services. - 8 - After official closing of the FESAL II, the Government continued its efforts in the same direction and resolved the remaining 11 loss-making enterprises of the original list, using the same decision making methodology for either sale or closure of the loss-makers, as well as the same procedures for transparent sale of assets of the bankrupt enterprises. Rationalization of government support policy for the enterprise sector. Additionally, the Government has adopted a declining cap on public support for enterprises. The declining fiscal cap (or ceiling on expenditures) has been established as a top-down policy approach intended to rationalize and make transparent government support for the enterprise sector. The objectives of this instrument were to limit and rationalize the provision of support to politically or socially sensitive enterprises. The cap encompassed a broad spectrum of parameters representing direct and indirect forms of Government support, including energy subsidies, forgiveness of overdue energy, tax and social security arrears, and forgiveness of overdue government guaranteed corporate debt, tax holidays and pay-outs on contingent liabilities assumed by the government as part of enterprise sales. A review of the accounting for spending of the fiscal cap allowance in the period ending June 2003 indicates that the Government has met the targets for the reduction in the fiscal cap (FESAL II targeted a reduction of 50 percent of 1999 levels of defined direct and indirect subsidies, expressed as a percentage of GDP.) Starting from a base of 1999, the reduction in spending was 67 percent by end-June of the discretionary component of the agreed fiscal cap expenditure categories. The main factors in the successful performance of the fiscal cap include: (i) the decision to liquidate, rather than sell, most of the FESAL II enterprises; (ii) the abolition of the discretionary right of the Minister of Economy to selectively grant exemptions from the customs duties and excise tax obligations; and (iii) a renewed focus on the collection of various tax, pension and health arrears, coupled with improved collection of electricity arrears; and (iv) the Government's new diligence in pursuing recovery from defaulters on Government-guaranteed loans and not allowing this deficit to increase. The experience to date indicates that fiscal cap proved to be a very efficient instrument not only in monitoring, but also in substantially reducing the support for the enterprise sector. As a result, the Government continues to use this mechanism after the closing date of the FESAL II. Resolution of the Assets of BRA. The Parliament also adopted amendments in order to speed up asset recovery and to ensure the BRA acts as a positive and supportive force for meaningful loss making enterprise resolution. Specifically, the Parliament: (i) renamed the BRA as the Asset Management Agency (AMA) to indicate clearly that the BRA is in fact an asset management agency and has no role in problem bank or bank failure resolution; and (ii) created a three-year sunset provision for AMA implying that the AMA should either have resolved its total existing asset portfolio by end-March 2004. After that time AMA will cease to exist and its employees, assets, and outstanding portfolio will be transferred to the MoF. Additionally, the Government has adopted a time bound plan to substantially reduce the BRA portfolio. According to this plan the BRA portfolio has been segregated to three parts consisting of: (i) amounts due from Government agencies and state-owned utilities, such as the Public Highways Fund and ESM, which will be transferred to the MOF; (ii) amounts due from the large loss making enterprises whose resolution is sought under the proposed FESAL II; and (iii) the residual portfolio, for which the BRA will continue to pursue collection using existing collection and sales techniques (e.g. sales of claims at discounts of 65-85 percent to originating debtors failure resolution). The amounts due from government agencies and state-owned enterprises have been transferred to the Ministry of Finance. The AMA has achieved a reduction in the value and number of borrowers of its portfolio as required in the project documents, which - 9 - was verified and confirmed by an independent auditor. As of March 31, 2004, AMA ceased to exist. 4.3 Net Present Value/Economic rate of return: N/A 4.4 Financial rate of return: N/A 4.5 Institutional development impact: The Project's institutional impact is assessed as high. The project assisted in capacity building in all institutions involved in the preparation and implementation of the program, thus creating a modern regulatory and institutional framework for sustainable economic growth. One of the main counterparts in creating the legal and regulatory framework for the banking sector, the NBRM, has embarked on all the suggested reforms, particularly with respect to the supervision functions with energy and enthusiasm. At the end of the FESAL II program, NBRM came out stronger, more capable and more independent. The continuous improvement of this institution has not ended with the FESAL II, as it is an ongoing process. Under the auspices of the FESAL II program, the deposit insurance fund also has been restructured and further developed. Many other institutions have been created building up the infrastructure of the financial system, such as a modern, two tier payment system, electronic central pledge registry, electronic central securities depository and registry, allowing the Macedonian Stock Exchange to completely dematerialize. Moreover, in addition to the new or strengthened institutions, a new legal and regulatory framework for sustainable economic growth has been put in place. This includes new banking and supervisory legislation, a new company law, a new integrated collateral and mortgage law, an amended securities law, and an amended bankruptcy framework. 5. Major Factors Affecting Implementation and Outcome 5.1 Factors outside the control of government or implementing agency: The project was designed and implemented in an environment of political turmoil and economic disruption caused by Kosovo crisis. Furthermore, the implementation has been adversely affected by the internal military conflict in 2001. Both Kosovo crisis and internal conflict have had a destabilizing effect on the political and economic situation in the country, further aggravating social problems, and making the pursuit of an ambitious reform agenda extremely difficult, if not impossible. The 2001 military conflict brought to an abrupt end the positive economic developments that began in the mid-1990s. Output contracted by 4.5 percent and the fiscal deficit and balance of payments severely deteriorated. The extended effects of the 2001 crisis as well as unsound economic policies and deterioration in the business climate leading to the 2002 Parliamentary elections resulted in a modest 0.7 percent growth in GDP and widening deficits which, if continued, might have threatened macroeconomic stability. After the disturbances subsided, the Government renewed its efforts to achieve the program objectives, and at its request, the closing date was extended to end-2003. The new Government, which took office in November 2002, has reconfirmed its commitment to the program and has pushed ahead with the remaining agenda. 5.2 Factors generally subject to government control: - 10 - During the preparation and the initial phase of implementation of the program, government commitment to the reforms was very strong. Being engaged in the second wave of reforms in the private and financial sectors, Macedonian authorities expected to achieve substantial improvements in both sectors and boost investment and growth. During the military conflict and security crisis however, the commitment to the reforms weakened. This was coupled with an extremely high level of corruption leading up to the 2002 Parliamentary elections, and caused huge damage to the overall political, macroeconomic and economic situation. It also resulted in the break off of the program with the IMF. Nonetheless, 2002 Parliamentary elections brought a change in government and a strong shift in government policies. The main goals of the new government, in addition to securing political stability, were to restart growth, reduce unemployment, and overcome corruption. In early 2003, policy discussions were held within the IMF's Article IV framework, focusing on creating a sustainable fiscal and external position and generating conditions for growth. Drawing on the discussions, the Government agreed upon an IMF Stand-by Arrangement covering the period from April 2003 to June 2004. One year after taking the office, the Government has demonstrated success in stabilizing the economic flows. In the first part of 2003, output increased by 2.6 percent driven by strong performance in a few manufacturing sectors (primarily in metal industries) and a solid performance in services, which has further spread to a broader base including food processing, construction, and textiles. Thus, output increased by 7 percent compared to its level a year earlier, and GDP growth for the year was 3.1 percent. 5.3 Factors generally subject to implementing agency control: The Government was responsible for monitoring overall commitment to the reform program. They did so throughout the implementation process. NBRM had the primary responsibility for the reforms related to the financial sector development, while main counterparts for the enterprise sector reforms were the Ministry of Economy and Ministry of Finance. At one point, the Government created a special "Body for Structural Reforms" that included half of the cabinet ministers. Its goal was to keep the momentum going for the reforms and alleviate the negative consequences of the resolution of the largest loss-making enterprises by having a broad consensus on the politically sensitive and socially costly reforms. 5.4 Costs and financing: The credit was for SDR 15,200,000 and the Loan was for US$ 30,310,000. There were no changes in financing during project implementation, and disbursements were handled as soon as the tranche release conditions were met. In addition to these amounts, the Government of Netherlands supported the FESAL II reforms with two trust funds co-financing in the amounts of US$ 15 million and EUR 17 million. The funds were provided as direct budget support financing. 6. Sustainability 6.1 Rationale for sustainability rating: The reforms supported by the FESAL II program have been far reaching and very comprehensive. Changes brought about with the successful completion of the reforms have had significant impact on the overall financial and enterprise sectors. The legal framework for the financial sector not only provides the sound foundation for viable and healthy financial system, but it is also expected to contribute to a large extent to private sector development. The renewed regulatory framework and strengthened supervision enforcement provides the most important building block for creating the appropriate financial infrastructure. Moreover, the new payment system -- established and operationalized in a record period of time -- and other elements of a modern financial infrastructure including the restructured deposit insurance fund, central pledge registry, central securities depository, and central registry of legal entities, provide an effective system that will allow the government to build upon in the future. In the same context, policy measures aimed at facilitating enterprise entry and exit, strengthening creditors and shareholders rights, and restructuring the - 11 - enterprises sector to reduce the large loss makers will allow the Government to build upon these achievements and take further actions to bring long awaited increased investments, employment, and growth. In summary, the reforms supported by the FESAL II program have had a significant overall impact on the private and financial sectors and are highly likely (HL) to be sustainable. 6.2 Transition arrangement to regular operations: The reforms outlined in the FESAL II program have already been completed. Nevertheless, to build upon these achievements, the Government is considering development of next generation reforms aimed at further improving the business enabling environment, enhancing competitiveness of Macedonian enterprises, enabling healthy competition, and improving access to accurate financial information. In order for these reforms to achieve substantial impact, comprehensive and in-depth reforms of the judiciary will be crucial. 7. Bank and Borrower Performance Bank 7.1 Lending: The FESAL II program was fully consistent with and a core component of the Bank Country Assistance Strategy. The reform agenda supported by this program has been the central element of the Government's enterprise and financial sector development program. Key areas of policy development including strengthening the legal framework, institutional capacity building, and modernizing infrastructure have been properly identified. The Bank staff involved in the project preparation incorporated the lessons learned from the previous adjustment operations in the same sectors, and appropriately assessed the potential risks. During a very difficult period for Macedonian authorities, project objectives were consistent with the Government's overall economic policies. Government ownership and commitment was critical for the success of the reforms, and the authorities used the preparation of the FESAL II program to focus on its own sectoral reform agenda. 7.2 Supervision: FESAL II was designed as a three tranche operation, with a very detailed, specific and measurable conditions required to be met prior to each tranche release. Multiple Bank missions have conducted regular reviews of progress in achieving benchmarks defined as triggers for second and third tranche release. Nevertheless, a continuous and open dialogue conducted with the authorities on almost daily basis has been a critical factor of success in meeting the objectives of each of the components set forth in the program. 7.3 Overall Bank performance: In view of highly satisfactory rating of the quality at entry, lending, and supervision, the Bank's overall performance is rated as satisfactory. Borrower 7.4 Preparation: Borrower performance in the project preparation was satisfactory. The Government discussed priorities in the context of CAS leading up to the FESAL II program, and the core of the Government's reform agenda in the enterprise and financial sectors became key components of FESAL II program. The main counterparts from the MoF, NBRM, MoE, BRA, and the PA were closely involved in the discussions and identification of the components of the reform program. 7.5 Government implementation performance: - 12 - In spite of the difficult environment particularly in 2001 when it became practically impossible to pursue the ambitious reforms in the enterprise and financial sectors, the Government remained committed to implementing all components and accomplishing project objectives. With the change in the Government following the 2002 general elections, the commitment to the FESAL II program objectives was reaffirmed. In general, government performance justifies a rating of satisfactory. 7.6 Implementing Agency: All agencies and institutions involved in the FESAL II implementation including the NBRM, MoF, MoE, BRA, PA and others had a critical role in successful implementation of the reforms supported by the FESAL II. As mentioned earlier, the Government created a special "Structural Reforms Body" involving various ministers to take active role in and provide support to the ongoing reform efforts. 7.7 Overall Borrower performance: In view of the Borrower's satisfactory performance during preparation and implementation, the overall Borrower performance merits a rating of satisfactory. 8. Lessons Learned Following are the major lessons to emerge from the project that are relevant to other adjustment operatons: Importance of clear project design and quality at entry. The quality of the project at entry, including project design, policy objectives, and specific performance targets to meet these objectives, has critical role in the project outcomes in the medium to long run. In the case of a multi-tranche adjustment operation, well determined, specific and measurable triggers for tranche release that leave little room for various interpretations and misunderstandings are crucial to allow close monitoring and effective implementation of the program. In addition, appropriate sequencing of reform measures within a defined timeframe is highly relevant to the success of the program. Significance of incorporating lessons from previous reform efforts. Drawing on the lessons from the past, assessment of potential risks, and suggesting appropriate ways to address them is very important. In the case of Macedonia, first wave of reforms in the financial and enterprise sectors did not fully create expected results, and left the country in the midway of transition to the market economy. Therefore, the residual issues had to be picked up and dealt with in the second wave of reforms (covered by the FESAL II program). FESAL II took into account previous reform efforts and lessons from the FESAC implementation. As a result, the FESAL II was better targeted and more clearly defined. Government commitment is a key success factor. Obtaining real commitment and ownership for the substance of the reforms is key to the success of the reform program. In the view of this, even in a hostile environment of permanent political and security turmoil, coupled with record high levels of unemployment, implementation of the ambitious and thorny reforms is possible, and is heavily dependent on effective champions. Moreover, open and frank dialogue on the daily basis allows the counterparts to better understand the reform objectives and the specific requirements of each of the components. Appropriate TA can greatly enhance the reform process. Providing appropriate technical assistance in a timely fashion, coupled with adequate level of economic and sector work is important for reaching the objectives of the reforms. In the light of this, providing guidance and coordinating effectively with donors active in the financial and enterprise sectors reinforced the significance of the reforms and made it easier for the authorities to implement the specified policy measures. In the case of Macedonia, almost all donors - 13 - provided technical assistance in support of the financial and enterprise sector reforms, and the Government of Netherlands provided additional direct budget support for the reforms. Certain reforms require appropriate social mitigation measures. When dealing with enterprise restructuring, associated with liquidations and shedding of labor, it is very important to provide appropriate social support programs. Thus, alongside with the FESAL II reforms, Bank helped the Government to design and implement the Social Support Project, aimed at facilitating the labor restructuring, providing severance payment for redundant workers, carrying out active labor programs for 35,000 unemployed and creating 14,000 new jobs. Success of the reforms in financial and enterprise sectors is closely related to functioning of the judiciary . Although all specific conditions set forth in the policy agenda have been successfully met, the outcome of the FESAL II reforms has still not materialized to its full potential. During the lifetime of the project, the urgent need for reforms in the judiciary became apparent, as the deficiencies and deep systemic problems in the judicial sector undermined the success of the reforms in the financial and enterprise sectors. In addition, after the completion of the FESAL II reforms, the need for further, third wave reforms aimed at improving the overall investment climate, rule of law and governance, became obvious. 9. Partner Comments (a) Borrower/implementing agency: On December 14, 2000 the Board of World Bank Executive Directors approved the FESAL II program for the Republic of Macedonia in the amount of US$ 50.3 million. The objective of this program was to support the Government efforts in the process of accelerating the private sector growth via the following: a) strengthening the soundness of the banking system and improving the quality of bank intermediation; b) improving the private sector business-friendly environment and c) resolving, through privatization/financial restructuring or closure, the universe of large loss-making enterprises crowding out private sector growth. During the three-year period of implementation of this reform program, the Government of the Republic of Macedonia successfully implemented the objectives envisaged with the FESAL II program, thus creating framework for faster private sector growth and job creation, supported by strengthened and more developed financial system. With FESAL II reforms and performance, substantial progress was made in the supervisory and legal framework for the financial system, particularly the banking sector. In accordance with the commitments made by the Government of the Republic of Macedonia to the World Bank and the International Monetary Fund regarding the conclusion and implementation of the FESAL 2 Arrangement and the PRGF/EFF Arrangement, the National Bank of the Republic of Macedonia was required to carry out certain activities and tasks, within deadlines set in advance. These activities were primarily directed towards strengthening the NBRM supervisory function through the following: 1. Strengthening of the prudent legal framework and its revision in line with the Basle standards and the European directives in the banking area. 2. Improvement of the compliance of the banks' operations with the regulations; 3. Implementation of the Corrective Actions Program by signing Protocols with the four largest banks (except for Stopanska Banka a.d. Skopje); and - 14 - 4. Undertaking corrective actions against the banks under enhanced monitoring for improvement of their operations and their transfer to the division that conduct regular supervision, as well as undertaking more stringent measures in the case the bank is irresponsive and shows no improvement in its operations. * * * 1. The basic regulation framework which defines the scope of the banking operations and the banking supervision in the Republic of Macedonia was established by the adoption of the Banking Law in July 2000. The Law was adopted following long and intensive preparatory activities, in consultation with the World Bank and includes solutions directed towards closer approximation to the European legislation and the European directives in the banking area, as well as larger compliance with the so-called Core Basle Principles for Effective Banking Supervision. The Banking Law creates solid ground for improving the situation in the banking and the overall financial system of the Republic of Macedonia and increasing the confidence of the citizens in the domestic savings. Also, one should take into account that the Banking Law was revised several times in order to be further improved. The amendments to this Law arose from the need for further compliance with the Core Basle Principles for Effective Banking Supervision and the European directives in the banking area, acceptance of the recommendations of the FSAP Mission, as well as from the practical experience in the application of the Law. Thus the Law was amended in 2002 and 2003. Furthermore, at the beginning of 2002, a new Law on the National Bank of the Republic of Macedonia was adopted. Its adoption created a ground for setting the functions and the organization of the central bank, in line with the legal solutions of the European Union member states. One of the most relevant innovations in this Law is the strengthening of the supervisory role of the National Bank of the Republic of Macedonia, through the expansion of the variety of corrective measures which may be undertaken against the banks or the savings houses in the Republic of Macedonia. Taking into consideration the recommendations of the FSAP Mission, amendments to this Law were made in 2003. The most significant amendment, regarding the implementation of the supervisory function of the National Bank of the Republic of Macedonia, is the creation of a legal ground for cooperation of the National Bank with other domestic supervisory bodies. The existing Law on the National Bank of the Republic of Macedonia allowed cooperation of the National Bank with the supervisory bodies of other counties for supervision of the internationally active banks, but not with the domestic supervisory bodies. In the 2000 ­ 2003 period, intensive activities for revision of the supervisory by-laws were performed on the basis of the Banking Law and the Law on the National Bank of the Republic of Macedonia, aimed at their compliance with the provisions included in these laws and acceptance of the Basle supervisory standards. Thus a set of new supervisory standards was finalized in this period, which replaced the existing decisions adopted in 1995 and 1996. The new supervisory decisions incorporate the modern Basle principles and practices for prudent operations of the banks and regulate the basic supervisory standards, such as the calculation of the banks' capital adequacy, credit risk assessment by establishing a methodology for classification of the banks' assets risk, identification, measurement and monitoring of the country risk; identification, measurement and monitoring of the credit concentration limits, etc. A list of all by-laws adopted or revised in the 2000 ­ 2003 period, follows: 1) Decision on the methodology for determining the banks' guarantee capital ("Official Gazette of the - 15 - Republic of Macedonia" no77/2000); 2) Decision on the manner of conducting supervision of banks and the procedure for undertaking measures for eliminating the identified irregularities ("Official Gazette of the Republic of Macedonia" 111/2000) 3) Decision on defining and the method of identifying affiliated entities in accordance with the Banking Law ("Official Gazette of the Republic of Macedonia" no. 28/2001); 4) Decision on the methodology for determining the banks' net debtors ("Official Gazette of the Republic of Macedonia" no. 28/2001); 5) Decision on the methodology for determining the banks' risk weighted assets ("Official Gazette of the Republic of Macedonia" no. 50/2001); 6) Decision on the amount and the manner of establishing a special reserve for loan loss provisions of the banks ("Official Gazette of the Republic of Macedonia" no. 50/2001); 7) Decision on determining and calculating open foreign exchange positions of the banks ("Official Gazette of the Republic of Macedonia" no. 103/2001 ­ revised text); 8) Decision on determining the methodology for classification of on-balance sheet and off-balance sheet asset items of the banks according to their risk degree ("Official Gazette of the Republic of Macedonia" no. 21/2002 ­ revised text); 9) Decision on determining the volume and the manner of operating the savings houses ("Official Gazette of the Republic of Macedonia" no. 111/2000 and 80/2002); 10) Decision on the necessary documentation for issuing licenses according to the provisions of the Banking Law, the Law on Securities and the Law on Banks for Microfinancing ("Official Gazette of the Republic of Macedonia" no. 81/2002 - revised text); 11) Decision on the necessary documentation for issuing approvals, the documentation enclosed for each payment of capital and each change in the ownership structure of the bank's shares and criteria for assessing the source of funds ("Official Gazette of the Republic of Macedonia" no. 81/2002 - revised text); 12) Decision on the supervisory standards for regulating the past due claims of the banks and the savings houses ("Official Gazette of the Republic of Macedonia" no. 19/2003); 13) Decision on the methodology for determining the banks' capital ("Official Gazette of the Republic of Macedonia" no. 66/2003); 14) Decision on the terms and conditions and the manner of concluding foreign exchange credit operations between residents ("Official Gazette of the Republic of Macedonia" no. 66/2003); 15) Decision on defining the standards for ensuring the banks' IT system security ("Official Gazette of the Republic of Macedonia" no. 77/2003); 16) Decision on consolidated supervision of banks ("Official Gazette of the Republic of Macedonia" - 16 - no. 84/2003); 17) Decision on determining, assessing and managing the banks' liquidity risk ("Official Gazette of the Republic of Macedonia" no. 84/2003); 18) Decision on the banks' credit exposure limits ("Official Gazette of the Republic of Macedonia" no. 1/2004 ­ revised text). For the purposes of completing the legal framework, the National Bank of the Republic of Macedonia also prepared manuals for uniformed implementation of the provisions contained in the laws and the by-laws. The National Bank of the Republic of Macedonia continued its practice of preparing supervisory circulars which represent an adequate mean for giving directions and instructions for more efficient implementation of certain legal obligations and banking activities and monitoring of the international supervisory standards and practices. Thus the following supervisory circulars were adopted during this period: - Supervisory Circular no. 3 - Purchase of Own Shares; - Supervisory Circular no. 4 - Systems of Corporate Operations with Banks; - Supervisory Circular no. 5 - Identification, Measurement, Monitoring and Control on the Country Risk; - Supervisory Circular no. 6 - Liquidity Risk Management. In this manner, the implementation of the Banking Law and the appropriate by-laws enabled strengthening of the criteria for licensing, strengthening of the prudent standards and practices in the banks' operations, strengthening of the corporate management in the banks, increased efficiency in the banking operations and strengthening of the banking supervision, especially in the area of corrective activities undertaken against banks with stated problems in their operations, which jeopardize their stability and safety. 2. For the needs of FESAL 2 Arrangement, as of June 30, 2000 the preparation of the Compliance Report of the Banks' Operations with the Legal Framework started for the first time. Since then, during the Arrangement, this Compliance Report was regularly prepared on a quarterly basis and it was submitted to the World Bank. This Compliance report enabled monitoring of the improvement or worsening of the banks' operations, i.e. condition for fulfilling the third tranche was to have improved operations of the banks from the aspect of the compliance with the legal framework. That is why a comparative analysis of the compliance of the operations of the banks with the legal framework as of June 30, 2000 and June 30, 2003 was made, in order to evaluate whether there is any improvement, i.e. whether the term for receiving the third tranche of the FESAL 2 Arrangement is fulfilled. The harmonization of the banks' operations with the legal framework was monitored through 10 limits and indicators such as: Minimum capital requirement (EUR 3.5 million / EUR 9 million), Capital adequacy (8%), Open foreign exchange position (20%, 30% - EUR, 50%), Large credit exposure to one debtor (25%, 10%, 3%), Aggregated large credit exposures / guarantee capital (800%), Aggregated exposure to insiders / guarantee capital (100%), Fixed assets+capital investments / guarantee capital (60%), Capital investments in legal entities / guarantee capital 930%) and Non-allocated loan loss provision. Generally, it can be concluded that there is an improvement in the banks' operations from the aspect of the compliance with the legal framework. The largest improvement was registered in the compliance with the limits pertaining to the Open foreign exchange position, as well as relative to the reduced exposure to the shareholders in the banks the participation of which in the shareholders structure exceeds 5%. Relative to - 17 - other indicators and limits, the banks are almost completely harmonized, except one or two banks. The largest indicator for the improved operations of the banks is also the fact of reduced number of banks under enhanced surveillance, i.e. only two banks face with more serious problems in their operations. 3. According to the responsibilities undertaken to the World Bank for realization of the FESAL 2 Arrangement, on April 26, 2001, the National Bank of the Republic of Macedonia concluded Protocols for the Implementation of the Recommendations given by the audit house Arthur Andersen pursuant to the diagnostic studies and agreed procedures, with Komercijalna Banka a.d. Skopje, Tutunska Banka a.d. Skopje and Stopanska Banka a.d. Bitola. The Protocol with Makedonska Banka a.d. Skopje was concluded later, in order to resolve the non-transparent shareholders structure and weaknesses identified in the corporate management structure, taking into consideration the changes in the legal framework pertaining to the ban on the political parties to possess capital parts and shares with business legal entities. After the conclusion of the Protocols, the National Bank of the Republic of Macedonia monitored the implementation of the recommendations in accordance with the stated dynamics, through its instruments of the off-site and on-site supervision. As of June 30, 2002, Komercijalna Banka a.d. Skopje, Tutunska Banka a.d. Skopje and Stopanska Banka a.d. Bitola implemented all the recommendations compliant to the stated dynamics in the Protocol signed with the National Bank of the Republic of Macedonia, while Makedonska Banka a.d. Skopje attained its objective at the end of 2003, through sale of 68% of the shares, thus enabling clearance of the shareholders structure, strengthening of management and handling process, having the performances of the Bank as a whole also improved. 4. On the basis of the recommendations of the missions responsible for monitoring the FESAL 2 Arrangement, a new organizational unit - Banks under Enhanced Surveillance Section within the Supervision Department was established. In time, the operations in this Section was improving through revision and upgrading of internal manual for the operation of the Section through setting a variety of suitable criteria for transferring a bank from regular supervision to enhanced surveillance, and vice versa. Meanwhile, the CAMEL rating system was upgraded with preparation of quantitative criteria for estimation of the individual composite parts pertaining to the equity, the assets quality and the profitability. Within this Section, the banks facing with larger problems in operations were subjected to a permanent monitoring through the application of enhanced reporting regime and tighten corrective actions. Such a treatment gave positive results. Namely, since the beginning of the analyzed period, this Section covered eight banks under enhanced surveillance, but in time their number reduced to four banks (without Export Import Banka a.d. Skopje). Two out of these four banks are expected to be transferred to regular supervision very soon, due to the improvement in their financial situation and performance indicators, which should be verified also through execution of full-scope on-site controls (in accordance with the plan on on-site examination). Hence, it can be stated that only two banks on the level of the banking system face with more serious problems in their operations, although there are real chances for overcoming the bad financial situation, but on a longer-term basis. As an conclusion, it can be stated that the implementation of the recommendations given in the FESAL 2 Arrangement produced positive effects, i.e. the projected objectives for strengthening of the supervisory function of the NBRM were met, as well as the stabilization of the banking system through improving the banks' operations in accordance with the prudent legal framework and through timely application of appropriate corrective activities. - 18 - After the adoption of the new Deposit Insurance Law (July 2000) by the Macedonian Parliament, new deposit insurance scheme was created. The newly established Deposit Insurance Fund (DIF) insures deposits of physical persons, including foreign currency denominated deposits held in commercials banks and saving houses. It covers 100% of deposits up to EUR 10,000 equivalent and 90% up to EUR 20,000 equivalent per depositor and per institution. DIF has been established with initial Government contribution, premium contribution from member banks and investment returns. Financial system infrastructure development was one of the Government top priorities as a condition for further development of the capital market. This reform covered: - Reform of Payment Operation Bureau (ZPP); - Creation of effective pledge registration mechanism; - Creation of Central Securities Depositary (CSD) and DVP-based Security Clearance system. As of January 1, 2002, the new two-tier payment system became fully operational and all blocked corporate accounts - except accounts subject to internal company disputes were transferred to the private commercial banks. As a result of this reform, ZPP (former Payment Operations Bureau) ceased to exist as of this date. The major components of the new payment system are the Macedonian Interbank Payment System (MIPS) and the Clearing Interbank System (KIBS)- the Clearing House for low-value payments. The MIPS is an RTGS System owned and fully operated by the NBRM, used for all large-value payments (over Denar 3 million) and for any urgent or priority payments. A new modern, electronic, movable pledge register has been developed and is fully operational and Central Registry for immovable pledge is also being developed. We have also created Central Securities Depositary (CSD) and DVP-based Security Clearance and Settlement System. The Macedonian Parliament adopted amendments to the Securities Law mandating the transfer of share registries from the companies to the new CSD/CSR and creating legal basis for development of new DVP-based securities clearing and settlement system. As a result of this reform, all Macedonian joint-stock companies transferred their share registries into the new CSD/CSR. In order to create positive business environment, in the past period, the Government undertook several reforms in the field of streamlining the registration for all business enterprises. The Parliament adopted the necessary changes in the legislation aimed at simplifying company establishment and registration. In addition to this, we would like to mention that in April 2004, new Company Law was enacted. To strengthen the legal rights of creditors, in July 2000, the Parliament adopted amendments to the Bankruptcy Law and the Law on Pledge. Additionally, a new Mortgage Law (for security interests on immovable property) was also enacted by the Parliament. In order to complete the reform agenda, in January 2003 new integrated law on both movable and immovable collateral, replacing the two separate laws on movables and immovables was enacted. In order to create effective auditing and accounting profession, we have prepared, with World Bank assistance, new draft Audit Law in compliance with the EU Eighth Directive and EC recommendations. We are expecting this Law to pass the Government and Parliamentary procedure in the coming months. - 19 - One of the conditions for successful realization of the FESAL 2 arrangement was also achieving harmonization with the declining cap of government support for the enterprise sector. The review of the accounting for spending the allowed fiscal cap/limit for the period until June 2003 inclusive showed that the Government has fulfilled the targets for reduction of the fiscal cap, meaning 50% target reduction in relation to 1999 levels of defined direct and indirect subsidies, expressed as a percentage of GDP. Starting from the base in 1999, reductions in spending the discretionary component of expenditure categories of the agreed fiscal cap was 67% by the end of June 2003. This means that the Government of the Republic of Macedonia has not only achieved the agreed target, but has also significantly exceeded it. The main factors for fulfillment of this condition were the following: (i) the decision to liquidate, rather than sell most of the enterprises under FESAL 2; (ii) abolishment of the discretion right of the Minister of Economy to selectively grant customs and excise exemptions; (iii) renewed concentration on collection of tax, pension and health insurance arrears, together with the improved collection of outstanding liabilities for electricity; and (iv) Government wariness in monitoring the collection from those who failed to repay the loans under sovereign guarantee and its decision not to allow for this deficit to increase. With regard to the condition set during the negotiations for FESAL 2 arrangement, referring to the commitment of the Government of the Republic of Macedonia to privatize, or if feasible, to financially restructure or close the loss-making enterprises covered with FESAL 2 program, the 1999 losses of which, coupled with the losses of Feni and the ones of the enterprises identified for the fiscal year 1999, constitute at least 2% of the 1999 GDP of the Republic of Macedonia, we should point out that the Government overcame the formal conditions required by and agreed with the World Bank, and accordingly, it was required only by creditors of the state enterprises under bankruptcy to reach a decision on property liquidation and employee lay-off. The Government formally resolved the 24 enterprises, the resolution of which was specifically required in the Minutes of the Negotiations, as well as eight (8) additional enterprises by its choice. The 1999 losses of these 22 enterprises equal to 2.04% of 1999 GDP. The Government managed to provide funds in the amount of EUR 800,000, a donation from the Dutch Government, thus covering the expenditures of the operations of an international consultant house which was entrusted with the task of assisting the Government and the trustees in the privatization process and/or sale of assets from the bankruptcy estate of the loss-making enterprises covered with the FESAL 2 program. The process of selling the property of these enterprises was carried out transparently, via an international tender. As of May 2004 the total inflow from the sale of the liquidated enterprises was EUR 10.5 million, and in the following period, after the completion of the tenders currently underway, possible inflow in the amount of EUR 16.5 million is expected According the final report prepared by the independent consultant house Lion's Bridge engaged in the process of privatization/sale of assets of the loss-making enterprises from the FESAL 2 list. In the context of the reforms envisaged with the FESAL 2 arrangement, we managed to resolve significant part of the portfolio of the Asset Management Agency (AMA) and to transfer the remaining in the Ministry of Finance, after March 31, 2004, when the AMA ceased operating. However, the reforms do not end here. The Government of the Republic of Macedonia is committed to change the present condition of low economic development, as well as to undertake measures and activities in the fight against corruption and organized crime, as well as approximation to the Euro-Atlantic - 20 - integrations. Thereby, in the future, the main focus of the Government of the Republic of Macedonia will be placed on reviving the economic growth and unemployment and poverty reduction. To that end, in 2003 we managed to stabilize the fiscal position and to reduce the deficit to a low, sustainable level (central budget deficit of 1.6% of GDP in 2003, in relation to the level of 5.6% of GDP in 2002), which is rare example of successful fiscal adjustment, as well as maintenance of low inflation and price stability. The Republic of Macedonia is the most successful among the countries in transition according to the price stability. The consolidation of the fiscal position created conditions for more moderate course of the monetary policy and for interest rates reduction. Sound fiscal and monetary policy will continue to be an objective of the Government of the Republic of Macedonia. We expect the macroeconomic stability and the structural reforms to enable more dynamic economic growth and unemployment reduction. The Republic of Macedonia has successfully implemented the agreed activities in accordance with the concluded Stand-By arrangement with the IMF in April 2003, thus continuously sending signals to the broader international and donor community about the commitment of the Government of the Republic of Macedonia to its reform course of conducting economic policy and fulfilling the projected activities on the basis of stable macroeconomic program. The reforms which would be further implemented in the Republic of Macedonia under the next arrangement with the IMF should be directed towards strengthening the institutions and continuation of the already initiated reforms. This could be done by implementing an ambitious structural program within an arrangement with the Fund, the implementation of which would require great efforts. Whatever is decided to be undertaken as a reform activity regarding the arrangement, will be part of the policies to which the Government is strongly committed and intended to implement. Those activities are to the end of continuing the reforms with accelerated dynamics, thus enabling more dynamic growth of the economy and job creation. Maintenance of economic and political stability and valuation of the effects from the painful reform moves requires strong support in the area of economic growth and employment by the World Bank and the IMF. The success of the reforms and the programs is not only to the end of maintaining low inflation rate, stable Denar exchange rate and closure of the unprofitable economic entities, but rather attracting new investments, creating jobs and improving the standard of living. This means designing adequate social support for the most vulnerable groups of the population and the persons who lost their jobs in the reform implementation process. Not only strong commitment, but also general consensus is required for successful implementation of the reforms, and that requires social protection measures for those affected by the short-term adverse effects from the reform implementation. Given the scope of the Government medium-term institutional reform strategy, the reform strategy objectives have been achieved with additional support and well-coordinated technical assistance programs. We would also like to express our gratitude towards the Government of the Netherlands for the extensive support received during the FESAL 2 arrangement for the two trust-fund co-financing in the amounts of US$ 15 million and EUR 17 million released with the disbursement of the first and second tranche of the FESAL 2 arrangement respectively. Those funds were provided as a direct budget support. In brief, we are pleased to note that the reforms supported by the FESAL II program have had significant overall impact on the private and financial sectors for their further development. It is our pleasure to say that we appreciate the strong support and efforts the World Bank extends to the - 21 - Government of the Republic of Macedonia. We are convinced the World Bank will continue to be a reliable partner on a long-term base and will support the forthcoming reforms in the private and financial sector. (b) Cofinanciers: (c) Other partners (NGOs/private sector): 10. Additional Information Tables 1-4 provide more detailed information on the banking system in Macedonia. In order to better demonstrate the impact of the FESAL II on the financial sector, it is worth noting the gradual improvements of the viability and stability of the system. These developments resulted in increased public confidence in the financial sector, translated into growing deposit base, and declining trend of the very high interest rates. At the same time, there is a positive trend of improving intermediation, through increased lending to enterprises and particularly households, although the lending is still not growing at the same rate as assets increase. Table 1. Aggregate balance sheet of the banking system (in million denars) 1998 1999 2000 2001 2002 2003 Assets Cash and balance with the NBRM 4,698 5,730 6,712 26,471 6,079 5,625 Securities rediscounted by the NBRM 410 1,718 1,711 1,932 1,968 3,975 Debt securities 1,491 8,292 10,337 7,647 865 995 Placements to other banks, out of which 15,760 22,364 27,285 29,576 33,803 37,301 Accounts with foreign banks 14,293 19,284 24,154 20,424 29,338 30,994 Placements to clients 26,141 25,426 27,725 30,642 32,070 37,111 Accrued interest and other assets 5,894 4,271 2,779 2,554 4504 6,061 Securities investments, out of which 765 1,400 1,093 1,248 7,734 7,355 Securities in foreign currency held until maturity - - - - 6,290 5,889 Fixed assets 3,891 4,147 4,669 5,661 6,211 6,453 TOTAL ASSETS 59,051 72,250 81,998 105,633 93,213 104,875 Liabilities Deposits of banks 2,669 3,061 4,954 2,379 2,924 2,195 Sight deposits, out of which 19,421 27,722 32,686 45,879 36,347 42,947 Foreign exchange deposits of enterprises 6,024 10,001 8,904 7,059 4,580 7,019 Foreign exchange deposits of natural persons 2,742 3,125 4,971 21,982 14,213 16,119 Short term deposits up to 1 year 6,444 8,279 10,892 19,734 18,076 23,836 Short term borrowing up to 1 year and issued debt 4,680 4,973 2,347 4,717 2,917 1,872 securities Other liabilities 1,689 2,698 2,544 2,975 2,296 3,083 Long term deposits over 1 year 2,858 3,713 3,066 4,383 3,482 3,405 Long term borrowing over 1 year 5,464 5,758 5,474 5,561 7,402 6,920 Provisions for off-balance sheet liabilities 1,019 1,110 934 847 490 542 Owned funds 14,808 14,936 19,102 19,158 19,279 20,075 TOTAL LIABILITIES 59,051 72,250 81,998 105,633 93,213 104,875 Source: NBRM data - 22 - Table 2. Data on the Macedonia banking system (in percent) 1998 1999 2000 2001 2002 2003 Depth of the banking system Total banking assets/GDP 30 35 35 45 39 41 Lending/GDP 13 12 12 13 13 15 Deposits/GDP 15 19 20 30 24 28 Concentration Assets of the three largest banks/banking system 58.9 61.9 64 63.3 64 66.9 Equity capital of the three largest banks/banking 27.3 30.9 39.7 35.4 34.5 44.3 Lending of the three largest banks/banking system 68.9 58.2 61.5 58.4 46.9 66.2 Deposits in the three largest banks/banking system 69.8 72.8 77.3 73.6 64.8 75.5 Ownership as a ratio of assets State ownership (excl. ownership of a foreign state) 22.8 23.2 16.5 15.7 14.1 1.8 Private ownership 77.2 76.8 83.5 84.3 85.91 51.3 Majority foreign owned, out of which 11.5 53.4 51.1 44 46.9 Owned by a foreign stat-owned bank 26.5 40.3 Capital adequacy ratio 25.9 28.8 36.7 34.3 28.1 25.8 Source: NBRM data Table 3. Interest rate margins, returns on assets and returns on equity (in percent, unless otherwise indicated, 1998-2003) 1998 1999 2000 2001 2002 2003 Interest rate margins 8.5 9 7.7 9.5 8.8 8 Average weighted nominal lending rates 21 20.5 18.9 19.4 18.4 16 Average weighted nominal deposit rates 12.5 11.5 11.2 9.9 9.6 8 Return on assets (ROAA) 2 0.8 0.8 -0.7 0.4 0.5 Return on equity (ROEA) 8.2 3.5 3.8 -3.2 2.1 2.3 Cost-to-income ratio1/ 0.7 0.8 0.8 1.1 0.9 0.9 Total number of employees 3,918 4,332 4,676 4,595 Total net assets/total number of employees (in million 21.5 24.9 23.4 22.8 denars) Source: NBRM data Table 4. Lending to households and corporate sector 1995-2003, in million Denars Year Lending to households Lending to corporate sector 1995 1,838 16,260 1996 1,765 22,626 1997 2,513 23,499 1998 2,320 28,894 1999 2,638 29,075 2000 3,826 33,640 2001 4,001 33,414 2002 5,898 33,461 2003 9,405 36,173 Source: NBRM data - 23 - Annex 1. Key Performance Indicators/Log Frame Matrix Outcome / Impact Indicators: 1 Indicator/Matrix Projected in last PSR Actual/Latest Estimate Output Indicators: 1 Indicator/Matrix Projected in last PSR Actual/Latest Estimate 1End of project - 24 - Annex 2. Project Costs and Financing Project Cost by Component (in US$ million equivalent) Appraisal Actual/Latest Percentage of Estimate Estimate Appraisal Component US$ million US$ million Total Baseline Cost 0.00 0.00 Total Project Costs 0.00 Total Financing Required 0.00 0.00 Project Costs by Procurement Arrangements (Appraisal Estimate) (US$ million equivalent) 1 Procurement Method Expenditure Category ICB NCB 2 N.B.F. Total Cost Other 1. Works 0.00 0.00 0.00 0.00 0.00 (0.00) (0.00) (0.00) (0.00) (0.00) 2. Goods 0.00 0.00 0.00 0.00 0.00 (0.00) (0.00) (0.00) (0.00) (0.00) 3. Services 0.00 0.00 0.00 0.00 0.00 (0.00) (0.00) (0.00) (0.00) (0.00) 4. Miscellaneous 0.00 0.00 0.00 0.00 0.00 (0.00) (0.00) (0.00) (0.00) (0.00) 5. Miscellaneous 0.00 0.00 0.00 0.00 0.00 (0.00) (0.00) (0.00) (0.00) (0.00) 6. Miscellaneous 0.00 0.00 0.00 0.00 0.00 (0.00) (0.00) (0.00) (0.00) (0.00) Total 0.00 0.00 0.00 0.00 0.00 (0.00) (0.00) (0.00) (0.00) (0.00) Project Costs by Procurement Arrangements (Actual/Latest Estimate) (US$ million equivalent) 1 Procurement Method Expenditure Category ICB NCB 2 N.B.F. Total Cost Other 1. Works 0.00 0.00 0.00 0.00 0.00 (0.00) (0.00) (0.00) (0.00) (0.00) 2. Goods 0.00 0.00 0.00 0.00 0.00 (0.00) (0.00) (0.00) (0.00) (0.00) 3. Services 0.00 0.00 0.00 0.00 0.00 (0.00) (0.00) (0.00) (0.00) (0.00) 4. Miscellaneous 0.00 0.00 0.00 0.00 0.00 (0.00) (0.00) (0.00) (0.00) (0.00) 5. Miscellaneous 0.00 0.00 0.00 0.00 0.00 (0.00) (0.00) (0.00) (0.00) (0.00) 6. Miscellaneous 0.00 0.00 0.00 0.00 0.00 (0.00) (0.00) (0.00) (0.00) (0.00) - 25 - Total 0.00 0.00 0.00 0.00 0.00 (0.00) (0.00) (0.00) (0.00) (0.00) 1/Figures in parenthesis are the amounts to be financed by the Bank Loan. All costs include contingencies. 2/Includes civil works and goods to be procured through national shopping, consulting services, services of contracted staff of the project management office, training, technical assistance services, and incremental operating costs related to (i) managing the project, and (ii) re-lending project funds to local government units. Project Financing by Component (in US$ million equivalent) Percentage of Appraisal Component Appraisal Estimate Actual/Latest Estimate Bank Govt. CoF. Bank Govt. CoF. Bank Govt. CoF. - 26 - Annex 3. Economic Costs and Benefits Not applicable - 27 - Annex 4. Bank Inputs (a) Missions: Stage of Project Cycle No. of Persons and Specialty Performance Rating (e.g. 2 Economists, 1 FMS, etc.) Implementation Development Month/Year Count Specialty Progress Objective Identification/Preparation 01/25/1999 11 SECTOR LEADER (1) PROGRAM TEAM LEADER (1); FIN SCT SPEC (1); PRINCIPAL PRIV SCT DVLP SPEC (1); PRIV SCT DVLP SPEC (1); MACROECONOMIST (1) CONSULTANT (5); 06/21/1999 3 PROGRAM TEAM LEADER (1); SR. FIN SCT SPEC (1); OPERATIONS OFFICER (1); 10/18/1999 5 PROGRAM TEAM LEADER (1); PRINCIPAL FIN SCT SPEC (1); SR. FIN SCT SPEC (1); SR. PSD SPECIALIST (1), OPERATIONS OFFICER (1); Appraisal/Negotiation 06/08/2000, 12 PROGRAM TEAM LEADER (1); SR. COUNSEL (1) SR. FIN SCT SPEC (1); SR. PSD SPECIALIST (1), ADVISER (2) OPERATIONS OFFICER (1); FMS (1) MACROECONOMIST (1) CONSULTANT (3) 08/28/2000 12 PROGRAM TEAM LEADER (1); SR. COUNSEL (1); COUNSEL (1) LEAD FIN SCT SPEC (1); SR. PSD SPECIALIST (1); SR. DISB. OFFICER (1); OPERATIONS ANALYST (1); FMS (1) CONSULTANT (3); TEAM ASSISTANT (1) Supervision 01/26/2001 6 PROGRAM TEAM LEADER S S (1); LEAD FIN SCT SPEC (1); SNR PRIV SCT DVLP SPEC (1); CONSULTANT (2); OPERATIONS OFFICER (1) 12/13/2002 6 SR. PVT.SCTR.DEV.SPEC. (1); S S PRIVATE SCTR.DEV.SPEC. (1); CONSULTANT (4) - 28 - 06/27/2003 3 SR. PSD SPECIALIST (1); PSD S S SPECIALIST (1); CONSULTANT (1) 11/06/2003 4 PRINCIPAL FIN. ADVISOR (1); S S SR. FSD SPECIALIST (1); SR. PSD SPECIALIST (1); PSD SPECIALIST (1) ICR 04/2004 1 PSD SPECIALIST (1) S S (b) Staff: Stage of Project Cycle Actual/Latest Estimate No. Staff weeks US$ ('000) Identification/Preparation NA 492,185.25 Appraisal/Negotiation Supervision NA 524,769.84 ICR Total 1,016,955.09 - 29 - Annex 5. Ratings for Achievement of Objectives/Outputs of Components (H=High, SU=Substantial, M=Modest, N=Negligible, NA=Not Applicable) Rating Macro policies H SU M N NA Sector Policies H SU M N NA Physical H SU M N NA Financial H SU M N NA Institutional Development H SU M N NA Environmental H SU M N NA Social Poverty Reduction H SU M N NA Gender H SU M N NA Other (Please specify) H SU M N NA Private sector development H SU M N NA Public sector management H SU M N NA Other (Please specify) H SU M N NA - 30 - Annex 6. Ratings of Bank and Borrower Performance (HS=Highly Satisfactory, S=Satisfactory, U=Unsatisfactory, HU=Highly Unsatisfactory) 6.1 Bank performance Rating Lending HS S U HU Supervision HS S U HU Overall HS S U HU 6.2 Borrower performance Rating Preparation HS S U HU Government implementation performance HS S U HU Implementation agency performance HS S U HU Overall HS S U HU - 31 - Annex 7. List of Supporting Documents Project ducuments: Loan Agreement, Credit Agreement, Presidents report, Aide Memoires, PSRs, Tranche release documents FSAP (IMF/World Bank Financial Sector Assessment Program Report, 2003 ) ROSC on Accounting and Auditing, 2003 NBRM Reports and Data - 32 - - 33 -