PROJECT INFORMATION DOCUMENT (PID) APPRAISAL STAGE Report No.: PIDA1224 Public Disclosure Copy Project Name Promoting Innovation for Inclusive Financial Access (P146244) Region MIDDLE EAST AND NORTH AFRICA Country Egypt, Arab Republic of Sector(s) Microfinance (50%), SME Finance (50%) Theme(s) Micro, Small and Medium Enterprise support (60%), Other Financial Sector Development (40%) Lending Instrument Investment Project Financing Project ID P146244 Borrower(s) Arab Republic of Egypt Implementing Agency The Social Fund for Development Environmental Category F-Financial Intermediary Assessment Date PID Prepared/Updated 09-Jan-2014 Date PID Approved/Disclosed 11-Feb-2014 Estimated Date of Appraisal 26-Dec-2013 Completion Estimated Date of Board 31-Mar-2014 Approval Decision Public Disclosure Copy I. Project Context Country Context This document outlines a proposal for a US$ 300 million loan to the Arab Republic of Egypt for the proposed Promoting Innovation for Inclusive Financial Access Project, in response to the official request from the Social Fund for Development (SFD) dated September 27, 2012, and the Ministry of Planning and International Cooperation, dated May 27, 2013. One and a half years after the revolution of January 25, 2011, Egypt is undergoing major political, economic and social transformation. Political tensions over President Morsi's tenure began to mount, a grassroots campaign led by the Tamarrod youth movement started to collect citizens' signatures in May 2013 to force him to call for early elections. The campaign culminated in massive demonstrations on June 30, 2013, with calls for President Morsi to step down. In the wake of these demonstrations, President Morsi was removed and a new transition period was ushered in July 3rd in a televised speech by the Defense Minister, General Abdel Fattah al-Sissi, in the presence of clergy leaders, youth representatives, the political opposition of the National Salvation Front, and representatives of the Islamic Al Nour party. Since then, Egypt has witnessed a rapid succession of political events. The security situation since June 30, has been occasionally volatile, due to sporadic confrontations between security forces and supporters of the Muslim Brotherhood Page 1 of 9 and its allies. The Egyptian economy has been in a deteriorating tailspin since the 25th of January revolution. Public Disclosure Copy Real GDP growth reached 2.1 percent in FY13, which is a slight decline from the previous year’s growth that was recorded at 2.2 percent. In FY14 real growth is expected to hover around 3.2-3.4 percent, provided that the government swiftly implements its announced fiscal stimulus package with a magnitude of 4.2 billion. The fiscal deficit has surged to reach 13.7 percent of GDP in FY13, which increased from last year’s deficit that amounted to 10.6 percent in FY12. Inflation is picking up and has hit the double-digits, reaching 10.15 percent in September 2013, after it had decreased sharply in 2012. This was mainly due to the weaker currency (which depreciated around 15 percent during the first half of 2013) and food inflation that rose to 12-13 percent (y-o-y) during the first quarter of FY14. The overall economic and political instability has adversely affected investments, and the growth of the private sector. Domestic investment fell to 16.7 percent of GDP in FY12, and is expected to decrease further in FY13. Foreign direct investments (FDI) have fallen to 0.8 percent of GDP in FY12. The business environment and the security situation have also discouraged the establishment of new enterprises. Micro and small enterprises (MSEs) were disproportionally affected by the deteriorating business climate and the security situation. The widening deficit has also led to the crowding out of private sector credit, further diminishing the already low financing available. Banks opted for purchasing less risky, high-yield Government bonds and Treasury bills that represent 41 percent of the banking system assets, accounting for 58 percent of GDP, leaving very little loanable funds available. Claims on the government-to-total domestic credit has been rising to reach 60 percent, while claims on private sector credit dropped to 37 percent in June 2013, as opposed to 54 percent and 42 percent in June 2012, respectively. At the same time, Egypt’s credit rating has been downgraded several times by international rating institutions (Fitch. Moody’s and Standards & Poor’s). Accordingly, the cost of financing has Public Disclosure Copy increased, further hindering enterprises access to finance. Another important implication for the increase in cost of funding due to the crowding out effect is the higher required rate of return required by private equity and venture capital companies, which again exacerbates the problems witnessed by smaller firms in terms of accessing finance. All this has contributed to the increase in unemployment and poverty rates. Unemployment is on the rise, reaching 13.3 percent in Q2 2013, up from 8.9 percent in Q4 2010 and is projected to reach around 13.5 percent for FY13. This is especially striking among women at 25 percent, and youth at 42 percent. The poverty rate also increased to reach 25 percent in FY11 up from 21.6 percent in FY09, where Upper Egypt is the most vulnerable region with a poverty rate of 50 percent in FY11. Not only has economic growth been well below its potential, but, more importantly, it has failed to create sufficient job opportunities. Moreover, growth has not been inclusive, creating grievances and unrest among many segments of society. Most recently, the interim Egypt set a minimum wage of LE 1200 (US$ 170) a month for the public sector, effective starting January 2014—this is expected to add to the pains of unskilled workers, as it might lead to a surge in layoffs among their category. Besides the anemic macroeconomic environment, governance and transparency remain pressing issues. Egypt s rank is low, and deteriorating in almost all governance indicators. According to the World Bank Worldwide Governance Indicators, government effectiveness, regulatory quality, and Page 2 of 9 rule of law rankings have all declined in the past two years, and have remained below the 50th percentile compared to other countries. Weak governance, privileged lending, lack of a level playing field and unequal access to markets, contributed to limited economic opportunities, an Public Disclosure Copy underdeveloped private sector, and have ultimately hindered job creation. Strengthening governance will be crucial to support the transition, enhancing credibility of public institutions. Giving equal access to markets, and opportunities is essential for restoring citizens confidence. It is critical to move towards a fairer and more competitive, merit based economy that utilizes market mechanisms, and adopts efficiency as the main benchmark for access, which is a prerequisite for generating equal opportunities and creating productive jobs. In that context, the government announced an ambitious program that primarily targets sustainable growth and social equity, with an emphasis on the development and support of smaller firms. In a ten-pillar program announced on the July 17, 2013 by the Prime Minister, a key pillar is micro, small, and medium enterprises (MSMEs) development, to enhance their role in creating jobs, with a focus on youth. Another important pillar is empowering, and restructuring SFD, the apex institution, to strengthen its developmental capacities. All this is in response to a clear demand, made by the public, for attaining an inclusive system, and shared economic prosperity. Sectoral and institutional Context According to empirical evidence, small and young firms are the main creators of new job opportunities in Egypt. MSEs that account for more than 98 percent of enterprises, generate more than 85 percent of employment in non-agriculture private sectors, and 40 percent of total employment. Entrepreneurship and new business formation is a linchpin to the process of innovation and creative destruction. Young firms are five times more likely to be ‘gazelles’ which are estimated to be 3.5 times more likely to grow (measured by employment) than other firms. Yet, Egypt has a very low business entry rate. Public Disclosure Copy Evidence demonstrates that microenterprises are critical for low income households to smooth consumption, manage risks, invest productively, and respond to financial shocks. Although Egypt boasts the largest microfinance market in the Arab world in terms of client outreach, with approximately 1.1 million borrowers and 263 million loans outstanding, the sector is only 8 percent of total possible market size. Access to financial services amongst micro businesses and households in Egypt is very low. According to Findex data, only 10 percent of adults have an account at a formal financial institution. This is significantly lower than the Middle East and North Africa (MENA) region-wide average (18 percent adult account ownership), as well as, other lower middle income countries around the world. Microfinance institutions (MFIs) have in recent years had difficulty weathering the ongoing economic and political transition in the country. However, there have been recent improvements with the increase in the number of microfinance borrowers from 991,610 in 2011 to 1.1 million in 2013, and potential for future growth. Despite this crucial role that MSEs play, they are confronted with numerous challenges. Limited access to finance is one of the main obstacles facing entrepreneurs. Egypt’s rank in the 2014 Doing Business Report for ‘Getting Credit’ deteriorated from 82nd in 2013 to 86th in 2014. Consistently, a recent Investment Climate Rapid Assessment Survey (2012), reveals that only 23 percent of MSEs have received a bank loan, while only 2.5 percent tap on non-bank financial Page 3 of 9 institutions (NBFIs). More than 70 percent of the surveyed firms raised concerns regarding the surge in the cost of finance post revolution. Most MSEs resort to alternative sources of finance, relying on personal savings (79 percent) or inheritance (15 percent) to raise capital, and only four Public Disclosure Copy percent access the formal market. Although sectoral analysis shows that there is no liquidity crisis in the banking sector, MSEs have limited access to finance. In fact, liquidity ratios have increased for both local and foreign currencies from 43.3 percent and 41 percent in June 2009 to 59.7 percent and 57.2 percent in 2013, respectively. However, financial intermediation has been low, as evident in the loans-to-deposit ratio that declined from 50 percent in 2011 to reach 47 percent in June 2013. Moreover, there is lack of term funding, which especially hampers sectors that are the main creators of jobs, such as manufacturing. This is compounded by the increase in the banking sector risk aversion, as evidenced by the low banking intermediation, reflected in the decline of private sector credit-to- GDP from 36.1 percent in June 2009 to 28.6 percent in June 2013. In addition, the opportunity cost of capital for any equity financing (through private equity and venture capital companies) increased significantly as a reflection of the high interest rates on government papers, which escalated due to the high budget deficit witnessed during the past fiscal year. MSEs suffer disproportionately from low financial intermediation, and are offered limited financial products. Only 11.1 percent of micro firms, and 17.4 percent of small firms have bank loans, as opposed to 38 percent for large firms. On the supply side, banks are reluctant to lend to MSEs, especially young and new ones, due to the perceived associated risk. Furthermore, banks continue to lend based on collateral as opposed to cash-flow, narrowing the opportunities for MSEs that often do not have sufficient collateral. The value of collateral needed for a loan compared to the total loan size is 88 percent for small firms. Collateral requirements, such as these, significantly hamper the ability of small firms to have access to bank loans. Effectively, banks in Egypt are serving large well established firms. These micro and small firms also face problems obtaining finance from other capital market Public Disclosure Copy vehicles. Venture capital and angel investors have a limited, yet growing presence in the Egyptian market. Their operations are not easily tracked in terms of magnitude, due to lack of a comprehensive regulatory and reporting framework governing their operations. Financial leasing and factoring are not yet fully developed but have witnessed significant legislative amendments that made these financing tools more operational and appealing for MSEs that are having limited services of NBFIs, besides that; there is a need to widen their network to serve a wider base of MSEs especially in less developed regions, as bank loans remain the main source of debt financing to MSEs (50 percent). Another challenge that prevents entrepreneurs from tapping on financial markets is the limited access to Shari’a-compliant financial products. According to the Investment Climate Survey (ICS), 28 percent of those who did not apply for a loan, despite their need, did not want to deal with interest rates. According to the recently launched World Bank database on financial inclusion (Global Findex), of those who cited religious reasons for not holding accounts with formal financial institutions, 40 percent were female, and 90.8 percent were from low and middle-income quintiles. Expanding access to Islamic financial services will unleash opportunities for a significant segment of entrepreneurs, especially those in rural areas. However, Islamic financial services offered remain modest with limited options. Murabaha (mark up commodity based finance) dominates Islamic financial instruments, accounting for almost 85 percent of Islamic banks’ financing. There are currently three Islamic banks operating in Egypt, and eleven conventional banks with dedicated Page 4 of 9 Islamic windows. Nevertheless, Islamic banking assets amount to only LE 95 billion (US$ 14 billion) as of June 2013, accounting for approximately 6.6 percent of the system’s assets. Public Disclosure Copy Disparities in Egypt also exist in access to finance both between and within regions. Upper Egypt is the lowest region in terms of distribution of financing, within which, there are large disparities among Governorates. For example, Giza has the highest share of firms with access to credit (11.8 percent), while the other Governorates’ shares do not exceed three percent. Regarding the urban metro regions, the share of firms with access to loans in Cairo is almost double that of Alexandria, which has the second highest access in the country, while the percentage in the other Governorates does not exceed 1.5 percent. There is an urgent need to reach out to these underserved districts, and poor villages. Gender disparities are also prevalent, with women entrepreneurs facing more challenges in accessing finance than men. Traditions, in some cases, give women little control over their own assets, and in many cases they are unable to use them as collateral, being under the guardianship of a male member of the family. In addition, banks impose higher collateral requirements for women, as they are perceived as more risky, particularly due to the traditions that place them as the key family members responsible for taking care of the household, leaving them with little time for work. Moreover, cultural barriers and norms, limit women’s mobility, constraining their entrepreneurship opportunities. Enhancing women’s access to finance and providing them with an equal opportunity is critical as funds should be allocated to their most productive uses with no discrimination by gender. On the demand side, the weak financial intermediation of MSEs is attributed to various institutional factors. One of the main challenges is enterprises’ lack of transparency, their inability to hold regular bookkeeping records, and their inadequate capacity to issue audited financial statements. Financial institutions are unwilling to lend to firms that do not have audited financial statements or concrete well-prepared business plans. Moreover, smaller firms often do not have sufficient Public Disclosure Copy collateral, which is required by banks. There is often lack of physical access in poor villages, as it is not cost-effective for financial institutions to establish branches in areas where the client base in small. In response to these challenges, efforts have been made to improve the enabling environment for financial intermediation and to strengthen the financial infrastructure. The first private credit bureau was established, improving significantly the information on clients’ credit worthiness. The payments system was modernized, in terms of operations, policies, and regulations, creating a more supportive institutional framework. Moreover, the Central Bank of Egypt (CBE) issued the Code of Corporate Governance, enhancing transparency and governance of the banking sector. All these efforts to strengthen the financial infrastructure have led to the promotion of a more enabling business environment, making it more conducive to MSE lending. Key regulators and market players have been more recently investing at strategic and operational levels to increase access and usage of formal financial services to underserved segments of Egyptian society. The Microfinance Law is currently being drafted by the Egyptian Financial Supervisory Authority (EFSA) championed by the Deputy Prime Minister, in order to address key regulatory gaps, including opening a window for non-governmental organizations-micro finance institutions (NGO-MFIs) to own companies. This will increase the ability of MFIs to operate sustainably through greater leverage and diversification of funding base, as well as, an improved Page 5 of 9 framework for risk management, including corporate governance and internal controls. The CBE is developing a financial inclusion strategy that would streamline operations for MSE lending, as well as strengthen the credit guarantee schemes. The Social Fund for Development (SFD) has gone Public Disclosure Copy through major restructuring and modernization, under the new management, improving its performance and governance structure. The Egypt Post, is under its new leadership, has reinvigorated its commitment to be the “bank for the poor” by providing important savings services, payments and insurance, as well as, expanding linkages with MFIs to provide credit and other financial services at its more than 3,000 branches across the country. Additionally, non-traditional actors have begun providing financial services to low-income segments. For example, Vodafone, after years of working with regulators to fulfill licensing requirements, has begun offering a virtual wallet product that allows for money transfers and payment services. Other mobile network operators are likely to follow. With this momentum of reforms, with the objective of attaining a more inclusive financial system, the proposed operation comes at an opportune time. The dire political and economic situation in Egypt calls upon innovative approaches to incentivize economic growth and job creation. One important solution is unleashing the potential of MSEs, especially fast-growing ones, which empirical evidence has shown to be the most significant employment generators. This entails improving their access to finance through leveraging financial innovation and spanning financial services. In that context, the recently appointed interim-Government has set MSE development as a priority in the reform agenda. The World Bank was asked to support the sector through this operation, focusing on addressing one of the key challenges, access to finance, which is hindering their development and constraining their potential to create new job opportunities. This is an opportunity for the World Bank Group to step in, and support Egypt, during critical times of transition, when citizens are demanding decent jobs, a level playing-field, social stability, and equal access to markets, which would ultimately lead to poverty eradication and shared economic prosperity—the twin goals of the World Bank Group. Public Disclosure Copy II. Proposed Development Objectives The project development objective (PDO) would be to expand access to finance for MSEs in Egypt, using innovative financing mechanisms, with a special focus on youth and women, as well as underserved regions. III. Project Description Component Name Lines of Credits to MSMEs Comments (optional) IV. Financing (in USD Million) Total Project Cost: 300.00 Total Bank Financing: 300.00 Financing Gap: 0.00 For Loans/Credits/Others Amount Borrower 0.00 International Bank for Reconstruction and Development 300.00 Page 6 of 9 Total 300.00 Public Disclosure Copy V. Implementation The Ministry of International Cooperation, representing the Government of Egypt, has designated the SFD as the implementing entity for the project, which will be responsible for coordinating and managing the overall operation. SFD is the apex institution, mandated by Law 141 of 2004, as well as the Prime Ministerial Decree No. 318 of 2013, to lead and coordinate the MSE development sector in Egypt. SFD already has a successful track record in implementing MSE operations, consistent with the Bank’s policies and procedures. This has been evident in the recent smooth execution of the Egypt Enhancing Access to Finance for Micro and Small Enterprises Project. The quick and quality disbursement projects SFD’s capacity to implement the proposed operation. The SFD benefited throughout the preparation and implementation of previous Bank operations in improving its internal control procedures including updating the Financial Management (FM) Manual and the Internal Audit (IA) risk-based approach strategy. On procurement, it also gained experience, evident in the procurement practices of the project beneficiaries that are in line with the commercial best practices mandated by the Bank. Past preparation of an Operational Manual (OM), in line with Bank guidelines and procedures which has been useful in laying the groundwork for the proposed operation, and in preparing an updated OM, reflecting the new project design. It is worth noting that SFD, post-revolution, has undergone major institutional and governance- related reforms. Under the leadership of the new management that took office in October 2011, a modernization process has started. The Board composition has significantly changed from having five Ministers, to now include representatives from the private sector, financial sector, think tanks, civil society, and youth groups. New and experienced staff were recruited and new units were established (Governance, Gender, and M&E). Governance and transparency have been significantly improving—SFD is currently posting its financial statements on their web page, enhancing the accountability of public entities. As such, SFD has evolved to become a prominent and credible developmental finance institution with a competent Board, strong management capacity, market Public Disclosure Copy knowledge and a good governance structure, tremendous experience in project implementation, and hence is well equipped to implement this proposed operation. A project OM acceptable to the Bank has been prepared by SFD. The OM includes, among other things, the agreed FM and disbursement arrangements; procurement arrangements; guidelines on Preventing and Combating Fraud and Corruption in Projects Financed by IBRD Loans and IDA Credits; and a detailed framework for the continuous measurement and monitoring of outcomes, a key element in ensuring effective implementation. For implementation, the SFD established a Project Implementation Unit (PIU), whose capacities are being developed in parallel under the MSME TA Facility, mandated to oversee and implement the project in line with the implementation arrangements detailed in the OM. SFD will be responsible for ensuring compliance of project activities to the fiduciary and safeguards arrangements for the project. Funds will be channeled through SFD, which will then on-lend to eligible financial institutions that would ultimately reach the end beneficiaries, namely MSEs, as well as young firms. Given its financial capacity and track record, SFD is well placed and has the capacity to implement the project and ensure compliance during implementation. Arrangements will be put in place to ensure adequate project implementation support, covering fiduciary and safeguards aspects, with semi-annual implementation missions. The implementation support team will draw on expertise Page 7 of 9 from the Bank as well as external experts, where necessary. Meetings with other concerned stakeholders engaged in MSE finance, including donor agencies, will be undertaken during implementation missions. Public Disclosure Copy The project is consistent with international good practice for wholesale MSE lending facilities, and is in compliance with OP 10.00 and Bank guidelines and standards for lines of credit. The proposed line of credit would be on-lent on market terms, without creating market distortion. SFD‘s on- lending rate is similar to or more expensive than the cost of alternative sources of funds for NGOs and banks. SFD sets on-lending rates to cover cost of funds, operating costs, and currency risk, and also to be competitive with market rates and ideally to ensure a real positive interest rate. Interest rates are due to be revised accordingly by SFD. SFD loans would charge an interest rate to cover SFD repayment to the Bank, its operational expenditures, and foreign exchange risk. The loan interest rates charged to banks and NGOs will be based on the costs of SFD funding and its credit rating of the banks and NGOs. At a minimum, these rates will be positive in real terms and provide reasonable rates of return to SFD and cover the currency risk on the Bank loan. VI. Safeguard Policies (including public consultation) Safeguard Policies Triggered by the Project Yes No Environmental Assessment OP/BP 4.01 ✖ Natural Habitats OP/BP 4.04 ✖ Forests OP/BP 4.36 ✖ Pest Management OP 4.09 ✖ Physical Cultural Resources OP/BP 4.11 ✖ Indigenous Peoples OP/BP 4.10 ✖ Involuntary Resettlement OP/BP 4.12 ✖ Public Disclosure Copy Safety of Dams OP/BP 4.37 ✖ Projects on International Waterways OP/BP 7.50 ✖ Projects in Disputed Areas OP/BP 7.60 ✖ Comments (optional) VII. Contact point World Bank Contact: Sahar Ahmed Nasr Title: Lead Economist Tel: 5772+215 / 2 Email: snasr@worldbank.org Borrower/Client/Recipient Name: Arab Republic of Egypt Contact: Mohamed Hammam Title: Assistant Minister Tel: 202-2391-2815 Email: mhammam@mic.gov.eg Page 8 of 9 Implementing Agencies Name: The Social Fund for Development Contact: Ms. Ghada Waly Public Disclosure Copy Title: Managing Director Tel: 37622255 Email: ghada.waly@sfdegypt.org VIII. For more information contact: The InfoShop The World Bank 1818 H Street, NW Washington, D.C. 20433 Telephone: (202) 458-4500 Fax: (202) 522-1500 Web: http://www.worldbank.org/infoshop Public Disclosure Copy Page 9 of 9