Report No. PID9120 Project Name Kosovo-SME Credit (Kosovo Trust Fund) Region Europe and Central Asia Region Sector Other Finance Project ID XKPE69629 Borrower(s) UNITED NATIONS INTERIM ADMIN.(UNMIK) Implementing Agency Address UNITED NATIONS INTERIM ADMINISTRATION IN KOSOVO (UNMIK) Prestina, Kosovo Contact Person: Tel: 381 38 500 223 Fax: 873 732 154 522 Environment Category F Date PID Prepared February 10, 2000 Projected Appraisal Date April 4, 2000 Projected Board Date September 22, 2000 1. Country and Sector Background The proposed pilot project has been conceived as a joint effort of the European Agency for Reconstruction (EAR) and the World Bank. If proven successful, the project is expected to facilitate channeling additional donors' funds to SMEs. The proposed project is being closely coordinated with ongoing efforts to identify and implement the recently approved IFC participation in the BEF. Both initiatives are expected to be highly complementary.Background to Enterprise sector: As of 1996, privately owned enterprises contributed to 47 percent of total GDP . However, given the present collapse of state enterprises, Kosovo's economy is now predominantly private in orientation at about 80 percent of total economic activity. According to some local research estimates, there were about 1,700 SMEs operating in some manner in Kosovo in late 1999 (17,000 SMEs were estimated to operate before the conflict). A more comprehensive survey is being conducted at the moment to better assess the SME sector and their credit needs . In essence, general features that characterize the current situation of the enterprise sector in Kosovo include: n There is limited industrial production. Thus, Kosovo's emerging private sector does not include any significant ongoing industrial production or processing activities; n There is virtually no access to credit for enterprises. Only one micro-enterprise bank (MEB-Kosovo) has obtained a license, and this was in late January 2000 (MEB-Kosovo). However, MEB has not started lending activities, and it is still establishing its operations while doing basic account management and money transfers. A second micro-finance institution is also permitted to operate, but loans are not expected to exceed DEM 2,000 per business; n A new formal registration system of enterprises has only recently been created. At present very few enterprises have been registered, and the distinction between formal and informal sectors is virtually non-existent. The overall framework of property rights and contract enforcement remains highly underdeveloped. Growth in the enterprise sector is expected to be driven almost completely by privately-owned SMEs, old and new. Therefore, UNMIK's private sector development strategy relies on the implementation of a regulatory environment that results in making the costs of operating legally significantly less than the costs of operating illegally. Further, the legal regime is expected to provide for and promote the availability of credit by protecting private property rights, allowing for the use of collateral for lending, and ensuring that contracts are enforced. Therefore, the strategy will (i) promote the development of private enterprises already within the official economy, (ii) attempt to embrace the parallel economy and bring it within the official economy through a combination of inducements and requirements, and (iii) seek ways to transfer potentially viable public enterprises to private ownership/management as well as free up the assets of non-viable enterprises through liquidation.Background to Banking sector Prior to the war, Kosovo had four "major" banks and a reported 44 bank branches of Serbian banks. The four "major" banks were Bank Kos, Ekonomik Bank, Yugobanka, and Vojvidanska Bank, none of which is operating in any meaningful way in Kosovo today nor has received a license from Kosovo's newly established Banking and Payment Authority (BPK). The main weaknesses of the banking sector include:I the absence of licensed banks capable of competing along commercial lines;I the inadequacy or non-existence of meaningful financial information and management systems in the banking (and enterprise) sector;i the lack of adequate banking sector infrastructure (e.g., laws and regulations, functioning judicial capacity, accounting/audit framework) to provide the needed guidelines and parameters for a well-managed and viable banking sector;I the lack of an adequate framework for the development of secured lending transactions;i the absence of financial intermediation (deposit-taking or lending) resulting from a lack of public confidence, past resource misallocation and politicization of bank lending.Some progress has been made in recent months. UNMIK has drafted two banking regulations that create a banking agency (for licensing and supervision), define banking activities, establish prudential guidelines and governance and management requirements, provide for corrective actions, and outline bank resolution/liquidation guidelines. Thus, basic regulations and an institutional set-up have recently been introduced for banking and for the functioning of a revamped payments system, which is now beginning to operate.However, given the prevailing political risks and the small size of Kosovo's market, it is unlikely that any prime-rated banks would invest in Kosovo any time soon. Furthermore, even if there were interest, experience from neighboring countries indicates that banks are generally unwilling to lend in conditions of such high risk. Most banks would provide services to selected companies, but would not lend or assume risk. Thus, it is unlikely that any meaningful bank lending to the SME sector will occur. This has prompted the need for an interim vehicle to ensure that viable SMEs are able to access needed credit until the banking sector has the funds, inclination and capacity to lend to SMEs. The Proposed Grant The proposed project is of an emergency and pilot nature aiming to quickly restore and expand operations of about 60-100 viable SMEs without waiting for more time-consuming legal and institutional reforms in the banking and enterprise sectors. In this context, while the project is not a policy-driven vehicle to further financial or enterprise reform in Kosovo, it is designed to be consistent with what those reforms would encompass under more normal circumstances. Therefore, consistent with its stated objective, the proposed project is expected to:I Provide timely and efficient access to credit to eligible SMEs;I Provide an - 2 - additional incentive to SMEs to become part of the formal system;I Promote the development of financial information and management systems in the banking (and enterprise) sectors;I Foster the development of basic intermediation skills;n Foster public confidence in financial institutions 2. Objectives The primary objective of the proposed EAR/World Bank line of credit for SMEs would be to serve as a pilot project to provide financing to SMEs on market-based terms in an effort to jump-start production and economic activity of the private sector. Loans to eligible SMEs would be for much needed inputs and repairs, which in turn are expected to revive some industrial production and finance an increased proportion of high value-added services. The secondary objective would be to foster the incipient incentive structure and institutional framework of the financial sector that exists currently in Kosovo, to re-establish basic credit management capacity and loan administration skills of newly emerging banks, and to indirectly assist SMEs with cash management, budgeting, and planning, through discipline imposed by the credit process. 3. Rationale for Bank's Involvement Given the importance of having a functioning financial sector to the reconstruction and recovery of Kosovo, the Bank is supporting UNMIK with the preparation of a framework for lending to SMEs as part of the overall program to support private sector development and economic reconstruction. The Bank is playing a major role on development of the framework. 4. Description The proposed project will have two main components:Component A. Pilot SME Line of Credit Facility which will be administered by the Interim Credit Unit (ICU)Component B. Project Management and Technical assistance in SME line of credit facility, which will comprise of the following sub-components.n Administration/Management*n Credit management (direct lending to SMEs)n Training and technical assistance (lending through banks) 5. Financing Total ( US$m) GOVERNMENT IBRD IDA 5 EUROPEAN UNION 5 SPECIAL FINANCING Total Project Cost 10 6. Implementation Implementation Period: Project implementation will take place over three years with an expected completion date of June 30, 2003. And grant closing date of Dec 30, 2003. Project management and implementation: Because of the dire state of the banking system in Kosovo, the use of local banks at the outset of the project as a delivery mechanism for credit to SMEs is considered unfeasible. Therefore, UNMIK has legally established an operationally autonomous entity in the form of an Interim Credit Unit (ICU) to implement the project, and to directly lend to -3 - qualifying SMEs until emerging banks demonstrate capacity to assume this role. It is also recommended and built in to the project concept that the ICU would phase out as a direct lender as quickly as possible so as to not impede market development of the banking system. It is the project's objective to reduce direct lending to SMEs as promptly as is feasible, to experience a proportional shift in lending to/through stable banks (apex role), and then to be able to exit all together from the credit market. The proposed ICU would perform the following functions:I serve as an interim source of direct lending to qualified SMEs;I serve as a source of on-lending" to banks on a limited basis initially, and increasingly over time as bank capacity and willingness to manage credit risk increases;I supply needed bankers/credit analysts from market economies to work with Kosovars in developing market-based credit risk evaluation and monitoring systems to assess and process loan applications, monitor performance, and provide written accounts of performance for internal purposes as well as to bank supervisors at the BPK. 7. Sustainability The proposed ICU (and participating banks when qualified) would measure prospects for sustainability and return on investment financed by the project through prior sub-loan analysis. For lending made directly by the ICU to enterprises, this would be done by the ICU's credit advisors and analysts before being approved for disbursement. It is expected that parallel efforts to set up advisory assistance to SMEs would help to streamline the application process up front, and that actual requests for financing from the ICU would be easier to process due to the higher quality of loan applications. Coordination between the EAR-Bank-supported ICU and complementary business advisory service will be important for successful and effective implementation. For on-lending through participating banks, initial prospects would be evaluated by the banks themselves, but would then be subject to the ICU's credit risk evaluation process and approval. It is assumed that banks would also be interested in IFC services for prospective real sector clients over time. Ultimately, sustainability of the revolving credit line beyond the first sub-loan cycle would depend on timely and full repayment of the sub-loans by borrowers and participating banks. Beyond the third year of implementation (after project completion), it is expected that Kosovar authorities would "privatize" the credit portfolio and credit advisory sections. The latter course is envisioned from the beginning, and is expected to begin to occur well before project completion in the form of increased on-lending to banks, increased technical assistance and training through banks, and the sale of the ICU loan portfolio when conditions are appropriate. These are discussed in the exit strategy below. Exit Strategy: Over time (e.g., two-three years), the portfolio of the ICU would be expected to devolve to the banking system. This could begin immediately on a partial basis if there are licensed banks willing and able to lend. However, at the outset, bank capacity is only expected to be able to cover a fraction of the range of loans under the project at most. Thus, the ICU is expected to process a significant portion of the loans to SMEs under the project during the first year or so. As a pilot project envisioning no more than 60 first-cycle loans, it is anticipated that banks would slowly emerge and show an interest in SME lending around Year 2 of the project. By Year 3, the project would expect to originate fewer direct loans to SMEs, and to play a more "apex"-type role in on-lending through the banks. At this juncture, the project would expect - 4 - to determine a strategy for selling its portfolio, effectively transferring it to the banking sector. 8. Lessons learned from past operations in the country/sector There are no lessons from previous World Bank/IDA implementation of similar projects in Kosovo. However, the Bank's experience in supporting a line of credit in the Federation of Bosnia-Herzegovina under the Emergency Recovery Project (ERP)-along with assistance from the Governments of the Netherlands, Germany and Italy-helped provide a model, which could be adapted for replication in Kosovo. This project combined lending resources (from IDA, a Dutch Trust Fund, and later Italy) and intensive technical assistance (mainly provided by GTZ of Germany) in an independent special purpose finance unit to achieve 95 percent repayment rates and operational viability that was transferable to the banking sector. The ERP line of credit provided loans of up to DEM 300,000 per borrower to SMEs in combination with bank training to improve credit risk evaluation and credit management (some training and lending was coordinated in conjunction with a USAID bank-training project.). The project was successful in contributing to banks' capacity to assess credit and manage risk, and to structure such analysis in conjunction with the introduction of new prudential regulations utilized by the banking supervisory authorities to assess the financial condition of banks. The design of the SME line of credit in Kosovo takes into account these special circumstances, and is structured to evolve as if it were operating in a business climate featuring competitive and market-based commercial banks. Meanwhile, it is also designed to avoid "crowding out" emerging banks, and seeks to work with them on an increasing basis as their capacity develops. This includes:I Designing simple loan products;I Setting interest rates to cover the operational costs of start-up;I Recruiting adequate numbers of bankers and credit advisors; I Providing incentives to staff consistent with performance objectives;I Providing technical assistance for bankers (in banks) and credit analysts; Providing business advisory services to enterprises (via IFC). 9. Program of Targeted Intervention (PTI) N 10. Environment Aspects (including any public consultation) Issues : It is proposed that (i) sub-loan agreements specify required information addressing environmental assessment issues; (ii) the ICU and participating banks compile necessary information to ensure each enterprise is operating in accordance with local and EU/World Bank environmental guidelines; and (iii) the ICU monitor enterprises and banks for compliance with environmental requirements. This arrangements would be part of the Operational Guidelines in the Project Implementation Plan. 11. Contact Point: Task Manager Gerardo M. Corrochano The World Bank 1818 H Street, NW Washington D.C. 20433 Telephone: 202 473 3568 Fax: 202 522 0005 -5- 12. For information on other project related documents contact: The InfoShop The World Bank 1818 H Street, NW Washington, D.C. 20433 Telephone: (202) 458-5454 Fax: (202) 522-1500 Web: http:// www.worldbank.org/infoshop Note: This is information on an evolving project. Certain components may not be necessarily included in the final project. Processed by the InfoShop week ending May 12, 2000. - 6 -