Document of The World Bank FOR OFFCIAL USE ONLY Repoct No. P-4906-HU MEMORANDUM AND RECOMMW.NDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN IN AN AMOUNT EQUIVALENT TO US*140 MILLION TO THE NATIONAL BANK OF HUNGARY WITH THE GUARANTEE OF THE HUNGARIAN PEOPLE'S REPUBLIC FOR A THIRD INDUSTRIAL RESTRUCTURING PROJECT JANUARY 13, 1989 This document has a restricted distibtflou and may be used by reipients only in the performance of their official duties. Its contents may not otherwise be disclosed without Wold Bank authorization. CnuSCY 5EOUA S Currency Unit - Forint (Ft.) AVERAGE EXCHANGE RATES (Forints per US$) 1983 1984 1985 1986 1987 1988 US$1.00 - Ft. 42.7 48.0 50.1 45.8 47.0 52.0 WEIGHTS AID MASURES Metric System ABRZIATIONS GDP - Gross Domestic Pro iwt ISAL - Industrial Sector Adjustment Loan NBH - National Bank of Hungary RPO - Restructuring Program Office FISCZX YEAR. January 1 - Decenber 31 FOR OFFICIAL USE ONLY THIRD INDUSTRIAL RESTRUCTURING PROJECT joan and Project Sumary Borrower: National Bank of Hungary (NBH). Guarantor: Hungarian People's Republic. Beneficiaries: Direct and indirect industrial exporters; small business firms; firms in regions affected by emerging unemploy- ment; commercial banks; Government agencies and county councils. Amount, US$140 million equivalent. Terms: Fifteen years, including a five-year grace period, at the Bank's standard variable interest rate. Onlending Terms: NBH will onlend US135.7 million equivalent in Forints to the participating banks (including the unallocated part of the Bank loan), and US$4.15 million equivalent in i?orints to the Government for technical assistance, at maturities not exceeding 15 years including five years of grace, at its prevailing refinancing rate or at the prevailing Bank rate plus a mark-up of 20 percent, whichever is higher. Participating banks will onlend to beneficiaries in Forints for periods not exceeding 12 years, including three years of grace, at rates determined pursuant to their lending policy statements agreed with the Bank, which would allow adequate spread, be positive in real terms, and not include a subsidy. The remaining US$0.15 million will be used by NBH for technical assistance. NBH will bear the foreign exchange risk. Financing Plan: IBRD US$ 140.0 million Domestic Loans US$ 87.5 million Sub-borrowers' Contribution US$ 98.8 million Government Contribution USS 16.5 million TOTAL USS 342.8 million Staff Appraisal Report: Report No. 7456-HU dated January 13, 1989. IBRD - 21148R 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 w,j0: Sank authorizatiom MEMORANDUM AND RECOMMENDATION OF THE PRESIDETT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO THE NATIONAL BANK OF HUNGARY WITH THE GUARANTEE OF THE HUNGARIAN PEOPLE'S REPUBLIC FOR A THIRD INDUSTRIAL RESTRUCTURING PROJECT 1. The following memorandum and recommendation on a proposed loan to the National Bank of Hurngary for US$140 million equivalent is submitted for approval. The proposed loan would have 15 years maturity with five years grace and carry the Bank's standard variable interest rate, and help finance a third industrial restructuring project. 2. Background. Industry is the leading sector in the Hungarian economy, representing about one third of GDP, employment and investment, and 85% of exports. Sector growth, productivity and exports to convertible currency markets stagnated in the first half of the 1980s, while its structure, dominated by large vertically-integrated enterprises, did not sufficiently shift to activities with competitive advantage. Most dynamism has been demonstrated by the small business sector which grew rapidly from a small base in the early 1980s. Industry sector performance, including exports, improved during 1987 - 88. Constraints to better performance include: restricted domestic and international competition, limited resourca mobility, and lack of financial discipline and autonomy of enterpris- es. To address the above issues the Government has engaged since 1985 in a medium-term program of industrial restructuring, developed jointly with the Bank, including comprehensive policy reforms and support for specific restructuring investments. To strengthen economic performance and accelerate the policy reforms, the Government adopted in 1987 a medium- arm economic stabilization and structural reform program supported in 1988 by n IMF Standby Arrangement, and a Bank-financed Industrial Sector Adjustment Loan (ISAL). Small business development is being encouraged through broadening of the private sector, and rationalization of the tax and association framework. Parliament approved a law of economic associations and a unified company profit tax law which have become effective on January 1, 1989. The Government has initiated measures to address emerging unemployment due to restructuring, including support for productive new job creation activities, and development of employment and retraining services. 3. Rationale for Bank Involvement. The project contains two novel features in the Bank's assistance program for Hungary in line with the country's drive for reform. These are: (i) support for small business and entrepreneurial development, including the private sector, and (ii) development of measures for efficient employment creation and new employment services as a means of alleviating the social costs of restructuring. Support in these areas would help accelerate the restructuring program. The Bank has played an important role in the analysis of issues related to the small business sector and designed an appropriate small business credit component for the project. Further, the Bank's review of the Government sponsored schemes for addressing emerging unemployment problems has led to adjustments being made in the schemes. The pro4ect provides for further development of the policy and institutional framework in this area. Also, Bank involvement would help improve the institutional framework for industrial restructuring, particularly the banking system, and improve the - 2 - feedback from enterprises on the impact of the reforms which facilitates the formulation of necessary adjustments to the reform process. 4. Project Obiectives. To support the restructuring of the industrial sector in order to enhance its international competitiveness, the project aims to help: (i) redirect the product/market mix of the sector to competitive areas suitable for convertible currency exports, (ii) improve enterprise management practices and capabilities, (iii) stimulate the establishment and growth of small business firms, including the private sector, (iv) alleviate the adverse employment impact of industrial restructuring, and (v) strengthen the institutional capabilities in support of industrial restructuring. 5. Project Description. The project includes three enterprise credit components, to be onlent through the participating banks, to support enterprise investments for: (a) increased direct and indirect exports to convertible currency markets (US$110 million of the Bank loan); (b) growth of entrepreneurs and small businesses (US$10 million); and (c) efficient employment creation in regions affected by emerging unemployment due to industrial restructuring (US$15 million). An additional US$0.7 million would be onlent to enterprises for preparation of business plans. Eligible manufacturing subprojects under the first credit component should export to convertible currency markets at least 601 of output directly or at least 70X directly and indirectly combined (of which at least 401 indirectly) and pay back foreign exchange investment costs within f ive years from direct or indirect foreign exchange revenues, or should be carried out by firms with convertible currency exports of at least 301 of total sales to help increase or maintain convertible currency exports of such enterprises. Subprojects should be viable from commercial (including export marketing plans), technical, financial and economic (including minimum rates of return of 181 in real .erms) points of view. Implementing enterprises should prepare restructuring programs for their entire operations, and be financially healthy. Maximum subloans would be US$10 million for direct exporters, and US$4 million for indirect exporters. 6. The second credit component would support growth of proprietorships, partnerships, small cooperatives and limited liability companies engaged in manufacturing or related business services, with employment up to 60 persons prior to investment. A firm's eligibility will be evaluated based on its past performance, business plan, creditworthiness, and ability to service the proposed credit, while subproject viability would be assessed in simplified fashion, regarding commercial, technical and financial aspects, for which criteria will be developed by each participating bank in an operations manual for small business credit to be reviewed and agreed by the Bank. Subloan limits would be US$150,000 (for a maturity up to three years). To stimulate the build up by the banks of small business portfolios and flexibility, they can borrow for such purpose for a maturity up to fifteen years, and maintain up to 30X of funds onlent to them in short term working capital financing of small firms. 7. Eligibility under the third credit component would be for employment creating investments in manufacturing, agro-processing and business services in regions suffering employment problems due to industrial restructuring. Project support initially would be for three counties in North Hungary affected by unemployment due to restructuring of the steel and coal mining industries. Subprojects should be eligible under the Gover:tment supported investment promotion program for job creation which is being revised following a review by the Bank, including actions to stimulate the development of small firms in manufacturing, tourism, construction, trade ard business services, while the commercial, technical and financial viability will be assessed along criteria similar to those for the other credit components. Minimum financial and economic rates of return would be 12% in real terms. The subloan limit would be US$2 million. The subprojects supported by the project should be undertaken in accordance with the country's safety, health and environmental standards, which are considered satisfactory. 8. Onlending would be based on a refinancing facility in the National Bank of Hungary (NBH) to which fourteen participating banks have access on a first-come first-served basis. The participating banks would take the final credit decision on each subloan, based on appraisal carried out by the banks with assistance from consultants and/or the Restructuring Program Office (RPO) which has been established. The institutional, operational, and financial aspects of the participating banks have been assessed as satisfactory by the Bank, and will continue to be monitored. 9. The project also includes technical assistance: to strengthen the participating banks in the area of small business credit; to prepare subsector restructuring programs; to carry out a comprehensive study of the performance and constraints facing the small business sector; and to help improve the Govern- ment measures for addressing unemployment. The latter includes assistance for improving appraisal skills for productive employment projects and preparation of a strategic plan for an area facing unemployment, and assistance and investment support for development of new employment and retraining services. Procurement will be based on Bank guidelines. The establishment of a revolving fund of US$6 million and retroactive financing of up to US$7 million (5% of the Bank loan) are recommended. A breakdown of costs and the financing plan are shown in Schedule A. The disbursement schedule is shown in Schedule B. (Due to the nature of the project largely involving support to subprojects which have not been preappraised, no detailed breakdown of project expenditures by procurement method is available.) A timetable of key project processing events and the status of Bank Group operations in Hungary are given in Schedules C and D, respectively. The Staff Appraisal Report No. 7456-HU dated January 13, 1989, and a map are also attached. 10. Agreed Actions. Industry-wide policy issues regarding the incentive framework for industrial restructuring are addressed in the recent ISAL, including incentives for convertible currency exports, and for entry of new firms, including the private sector. Signing of a subsidiary loan agreement between NBH and the State, and of subsidiary financing agreements between NBH and at least three participating banks would be a condition of Bank loan effectiveness. For the small business credit component, completion of a satisfactory small business credit manual by each bank is a condition of disbursement to such bank. At negotiations, the following salient agreements were obtained from the Government, NBH and the participating banks: (i) implementation of agreed actions to improve the export credit and insurance system; (ii) implementation of agreed adjustments to the investment promotion program for regional employment creation; (iii) ensuring prompt availability of - 4 - funds to beneficiaries for project implementation including foreign exchange; (iv) monitoring compliance of participating banks with eligibility criteria for their continued participation in onlending, including satisfactory policies, procedures, staffing, and financial situation; (v) maintenance of interest rates which would allow adequate spread, be positive in real terms and not include a subsidy; (vi) lending in accordance with agreed eligibility criteria, and on agreed terms and conditions (paras 5-7); (vii) appraisal and supervision of subprojects in accordance with agreed policies and procedures; and (viii) procurement along Bank guidelines and following agreed reporting and auditing procedures. 11. Benefits. The project would help to strengthen the ongoing restruc- turing efforts in the industrial sector, and lead to increased exports to convertible currency markets in support of the country's trade balance. It would also help balance the structure of the sector by promoting the establishment and growth of small, including private, firms which would stimulate domestic competi - tion, innovation and employment creation. The project would help accelerate enterprise restructuring and assistance to dislocated workers through its support for employmeni creation and development of suitable employment and retraining services in regions severely affected by restructuring. 12. Risks. The main risk is the uuncertainty perceived by enterprise and small business managers about Hungary's future macro-economic situation and possible further changes in the industrial policy framework, which may affect the incentives for enterprise restructuring and small business development, and the level of credit demand under the project. This risk is reduced by the strong support that the new Government and political leadership give to the economic reform and by the policy actions agreed to by the Government with the IMF, and with the Bank under the recent ISAL, which are aimed at creating a stable business environment, conducive to restructuring and development of entrepreneur- ship. Another risk concerns the capacity of the participating banks to promote and appraise restructuring and small business investments. The project addres- ses this risk with technical assistance measures and project coordination and supervision arrangements. 13. Recommendation. I am satisfied that the proposed loan would comply with the Articles of Agreement of the Bank and recommend that the Executive Directors approve the proposed loan. Barber B. Conable President Attachmeats Washington, D.C. January 13, 1989 Schedule HUNGARY THIRD INDUSTRIAL RESTRUCTURING PROJIT ESTIMATED COSTS AND FINANCING PLAN Estimated Costs: Local Foreian Total ---- (US$ million) ---- 10 Enterprise Investment Export-oriented 135.0 110.X) 245.0 Small Business 15.0 10.0 25.0 Employment Creation 45.0 15.0 60.0 Technical Assistance Small Business Credit Training 0.1 0.2 0.3 Restructuring Studies: - Subsector 0.2 0.8 1.0 - Enterprise 0.2 0.7 0.9 Small Business Sector Study 0.1 0.1 0.2 Employment: - Regional Plan and Appraisal Skills 0.1 0.3 0.4 - Employment Services 0.1 0.5 0.6 - Retraining Center 2.4 9-4 Total 202.8 140.0 342.8 Financing Plan: Local Foreiin Total -- ----(US$ million)*----- IBRD 140.0 140.0 Domestic loans 87.5 - 87.5 Sub-borrowers' Contribution 98.8 98.8 Government Contribution 16.5 - 16.5 Total 202.8 140.0 342.8 _- -_ -6- Schedule B HUNAR THIRD INDUSTRIAL RESTRUCTURING PROJECT DISBURSEMENTS Loan Catejorv Amount X Financing (US$ million) Eligible Enterprises: - Technical Assistance 0.70 100% of foreign expenditures. - Export-oriented 104.00WJ 100% of foreign exp. & 100% - Employment Creation 13.OO/ of local exp. (ex-factory) for goods; and 100% of foreign exp. for consultants' services and training. - Small Business 8.00aJ For goods, 100% of foreign exp. & 100% of local exp.(ex-factory), or 75% of local expenditures for off-the-shelf purchases; and 100% of foreign exp. for consultants' services and training. NBH 0.15 100% of foreign expenditures. (Small Business Credit Training) Government 4.15 100% of fcr-ign exp. & 100% (Small Business Study, of local exp. (ex-factory) for Subsector Study, goods; and 100% of foreign exp. Employment Assistance) for consultants' services and tadnirg Unallocated 10.00 Total 140.00 W/ For purpose of project financing, it has been assumed that the unallocated part of the Bank loan be distributed among enterprise components as follows: export-oriented (to increase to US$110 million); employment creation (to increase to US$15 million); and small business (to increase to US$10 million). Estimated IBRD Disbursements IBRD Fiscal Year 198 1990 1991 1992 1993 1994 1995 - ---------- (US$ million)------------- Annual 3.0 12.4 32.2 36.4 33.6 15.4 7.0 Cumulative 3.0 15.4 47.6 84.0 117.6 133.0 140.0 -7 Schedule C HUNGARY THIRD INDUSTRIAL RESTRUCTURING PROJECT Timetable of Key Project Processing Events (a) Time taken to prepare: 18 months (b) Prepared by: Government with Bank Assistance (c) First Bank Mission: June 1987 (d) Appraisal Miision Departure: May 1988 (e) Negotiations: December 12-16, 1988 (f) Planned Date of Effectiveness: April 1989 (g) List of Relevant PCRs and PPARs: None -8- Schedule D Page 1 of 2 THE STATUS OF BANK GROUP OPERATIONS IN HUNGARY A. STATEMENT OF BANK LOANS A' (As of September 30, 1988) US$ Million Loan Fiscal (Less Cancellations) No. Year Borrower Purpose Loan Undisbursed One loan and six B-Loans loans fully disbursed 266.5 - 2317 '983 HPR /b Industrial Energy Conservation 109.0 11.6 2397 1984 NBM /c rnd. Exports and Restructuring 110.0 6.5 2398 1984 OKGT/d Petroleum 90.0 4.9 2510 1985 NBH Integrated Livestock 80.0 53.9 2511 1985 NBH Fine Chemicals 73.0 13.0 2557 1985 HPR Transport (Rail/Road) 75.0 21.0 2697 1986 NBH Power 64.0 57.1 2700 1986 NBH Industrial Restructuring 100.0 41.7 2709 1986 NBH Industrial Energy Cons. IT 25.0 16.8 2738 1987 NBH Crop Production Improvement 100.0 42.0 2834 1987 NBM Industrial Restructuring IT 150.0 85.9 2847 1987 NBH Telecommunications 70.0 57.5 2936 1988 NB8 Agroprocessing Modernization 70.0 65.0 2966 1988 NBI Technology Development 50.0 50.0 2965 1988 NBH Industrial Sector Adjustment 200.0 124.0 Total 1,632.5 Of which repaid 56.6 Total now held by Bank 1,575.9 Total Undisbursed 650.9 a/ The status of these projects is described in a separate report on all Bank/IDA-financed projects in execution, which is updated twice yearly and circulated to the Executive Directors on April 30 and October 31. b/ Hungarian People's Republic. c/ National Bank of Hungary. d/ National Oil and Gas Trust. -9- Schedule D Page 2 of 2 B. STATEMENT OF IFC LOANS (As of September 30, 1988) Fiscal Type of US$ million Year Obligor Business Loan Equity Total 1988 Dunament Polistirolgyart Chemical 29.78 4.13 33.91 1988 Salgotarjan Glass Wool Glasswool 3.44 1.39 4.83 1987 UNIC Bank Banking - 3.21 3.21 1987 Huni Fermentation Limited Lysine Manuf. 8.55 2.70 11.25 Total Gross Commitments 41.77 11.43 53.20 Less cancellations, terminations, repayments and sales - - - Total Covaitments now held by IFC 41.77 11.43 53.20 Total undisbursed 11.29 0.33 11.62 HUNGARY IBRD 211481 HUNGARY k - . THIRD INDUSTRIAL RESTRUCTURING PROJECT _ Moinrwoyd CZECHOSLOVAKIA f,i- 6tq U. S. S, R.l _ Railroads _Conols IV.S8AJ s--A KIAIO?R$ 0 tO 10 *0 *0 iD 70 60 r o w Notional capitol NGRAD C Koihs wuLrso lo io 0 do so * Megyn capitat ri -*Moeyo (coury) boundarie -f^s^cCKi I t - Elevations in motem 196 ~ ~ ~ ~ ~ ~ ~ ,nnn.-# * nk AUGOSLAVIA 200 11 ,GOSt00Ia t _ _ Above 40A e9# RO AN ANRY18