Document of The World Bank

Report No.: 26687

PROJECT PERFORMANCE ASSESSMENT REPORT

ROMANIA

INDUSTRIAL DEVELOPMENT PROJECT (LOAN 3735)

PRIVATE SECTOR ADJUSTMENT LOAN (LOAN 4489)

September 3,2003

Sector and Thematic Evaluation Operations Evaluation Department

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Currency Equivalents (annual averages) Currency Unit = Romanian Leu (plural Lei)

1994 US$l.OO 1,655 1998 1995 US$l.OO 2,033 1999 1996 US$l.OO 3,083 2000 1997 US$l.OO 7,168 200 1

Abbreviations and Acronyms

ALPROM

ALRO

APAPS

AVAB

BA BCR BCR BE C A S C P I EBRD

EIB E S EU Exim

F E S A L

F I A S

GOR I A S

IBRD

Aluminum Products Company o f Romania Aluminum Company o f Romania Authority for Privatization and Management o f State Ownership Agentia de Valorificare a Activelor Bancare Bank Agricola Banca Comerciala Romana Romanian Commercial Bank Business Environment Country Assistance Study Consumer Price Index European Bank for Reconstruction and Development European Investment Bank Evaluation Summary European U n i o n Export Import Bank o f Romania Financial and Enterprise Structural Adjustment L o a n Foreign Investment Advisory Service Government o f Romania International Accounting Standards International Bank for Reconstruction and Development

ICR

I D P IFC

IMF MOF M O P F NBR NGO

NPL OED

PFI

PIBL

PPAR

P S A L

RDB

S A R S I D E X SMEs

SOEs SOF TAROM TA WTO

Fiscal Year

US$1 .oo 8,876 US$1 .oo 15,333 US$l.OO 21,709 US$l.OO 29,061

Implementation Completion Report Industrial Development Project International Finance Corporation International Monetary Fund Ministry o f Finance Ministry o f Public Finance National Bank o f Romania Non-Governmental Organization Non-Performing loans Operations Evaluation Department Participating Financial Institution Private Sector Institution Building L o a n Project Performance Assessment Report Private Sector Adjustment Loan Romanian Bank for Development Staff Appraisal Report Romanian Steel Company Small and Medium-sized Enterprises State-owned Enterprises State Ownership Fund Romanian State Ai r l ine Technical assistance W o r l d Trade Organization

Government: January 1 - December 31 Director-General, Operations Evaluation : Mr. Gregory K. Ingram Act ing Director, Operations Evaluation Department : Mr. N i l s Fostvedt Manager : Mr. A l a i n Barbu Task Manager : Ms. K r i s Hallberg

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OED Mission: Enhancing development effectiveness through excellence and independence in evaluation.

About this Report

purposes: first, to ensure the integrity of the Bank's self-evaluation process and to verify that the Bank's work is producing the expected results, and second, to help develop improved directions, policies, and procedures through the dissemination of lessons drawn from experience. As part of this work, OED annually assesses about 25 percent of the Bank's lending operations. In selecting operations for assessment, preference is given to those that are innovative, large, or complex; those that are relevant to upcoming studies or country evaluations; those for which Executive Directors or Bank management have requested assessments; and those that are likely to generate important lessons. The projects, topics, and analytical approaches selected for assessment support larger evaluation studies.

A Project Performance Assessment Report (PPAR) is based on a review of the Implementation Completion Report (a self-evaluation by the responsible Bank department) and fieldwork conducted by OED. To prepare PPARs, OED staff examine project files and other documents, interview operational staff, and in most cases visit the borrowing country for onsite discussions with project staff and beneficiaries. The PPAR thereby seeks to validate and augment the information provided in the ICR, as well as examine issues of special interest to broader OED studies.

Each PPAR is subject to a peer review process and OED management approval. Once cleared internally, the PPAR is reviewed by the responsible Bank department and amended as necessary. The completed PPAR is then sent to the borrower for review; the borrowers' comments are attached to the document that is sent to the Bank's Board of Executive Directors. After an assessment report has been sent to the Board, it is disclosed to the public.

The Operations Evaluation Department assesses the programs and activities of the World Bank for two

About the OED Rating System The time-tested evaluation methods used by OED are suited to the broad range of the World Bank's work.

The methods offer both rigor and a necessary level of flexibility to adapt to lending instrument, project design, or sectoral approach. OED evaluators all apply the same basic method to arrive at their project ratings. Following is the definition and rating scale used for each evaluation criterion (more information is available on the OED website: http://world bank.org/oed/eta-mainpage. html).

Relevance of Objectives: The extent to which the project's objectives are consistent with the country's current development priorities and with current Bank country and sectoral assistance strategies and corporate goals (expressed in Poverty Reduction Strategy Papers, Country Assistance Strategies, Sector Strategy Papers, Operational Policies). Possible ratings: High, Substantial, Modest, Negligible.

Efficacy: The extent to which the project's objectives were achieved, or expected to be achieved, taking into account their relative importance. Possible ratings: High, Substantial, Modest, Negligible.

Efficiency: The extent to which the project achieved, or is expected to achieve, a return higher than the opportunity cost of capital and benefits at least cost compared to alternatives. Possible ratings: High, Substantial, Modest, Negligible. This rating is not generally applied to adjustment operations.

Unlikely, Highly Unlikely, Not Evaluable.

to make more efficient, equitable and sustainable use of its human, financial, and natural resources through: (a) better definition, stability, transparency, enforceability, and predictability of institutional arrangements and/or (b) better alignment of the mission and capacity of an organization with its mandate, which derives from these institutional arrangements. Institutional Development Impact includes both intended and unintended effects of a project. Possible ratings: High, Substantial, Modest, Negligible.

achieved, efficiently. Possible ratings: Highly Satisfactory, Satisfactory, Moderately Satisfactory, Moderately Unsatisfactory, Unsatisfactory, Highly Unsatisfactory.

supported implementation through appropriate supervision (including ensuring adequate transition arrangements for regular operation of the project). Possible ratings: Highly Satisfactory, Satisfactory, Unsatisfactory, Highly Unsatisfactory.

quality of preparation and implementation, and complied with covenants and agreements, towards the achievement of development objectives and sustainability. Possible ratings: Highly Satisfactory, Satisfactory, Unsatisfactory, Highly Unsatisfactory.

Sustainability: The resilience to risk of net benefits flows over time. Possible ratings: Highly Likely, Likely,

lnsfitutional Development Impact: The extent to which a project improves the ability of a country or region

Outcome: The extent to which the project's major relevant objectives were achieved, or are expected to be

Bank Performance: The extent to which services provided by the Bank ensured quality at entry and

Borrower Performance: The extent to which the borrower assumed ownership and responsibility to ensure

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Contents

Principal Ratings ................................................................................................................ v Key Staff Responsible ........................................................................................................ v

.. Preface .............................................................................................................................. v11 Summary ........................................................................................................................... i x 1 .

2 .

3 .

4 .

Introduction .................................................................................................................. 1 Background .............................................................................................................. 1

Industrial Development Project .................................................................................. 3 Implementation Experience ......................................................................... 6 Outcome ..................................................................................................... 11 Sustainability .............................................................................................. 14 Institutional Development Impact .............................................................. 14 Bank Performance ...................................................................................... 15 Borrower Performance ............................................................................... 16

. . .

Private Sector Adjustment Loan .............................................................................. 17 Implementation Experience ....................................................................... 19 Outcome ..................................................................................................... 19 Sustainability .............................................................................................. 24 Institutional Development Impact .............................................................. 24 Bank Performance ...................................................................................... 24 Borrower Performance ............................................................................... 25

Lessons Learned ......................................................................................................... 25

. . .

Industrial Development Project ................................................................. 25 Private Sector Adjustment Loan ................................................................ 26

Annex A . Basic Data Sheet .............................................................................................. 28 Annex B . Private Sector Institution Building Loan (PIBL): Project Components ... 31 Annex C . Outline o f Action Plan to Improve the Business Environment ................... 33 Annex D . L i s t o f Persons M e t ......................................................................................... 36

This report was prepared by K r i s Hallberg and Elliot Hurwitz (Consultant). based on a mission to Romania in December. 2002 . Helen Phillip provided administrative support .

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Box

Box 1 : Policy-related Measures Achieved During Project Preparation ............................. 8

Tables

Table 1 : Table 1.1 : Selected Macroeconomic Indicators ................................................... 2 Table 2: : Participating Financial Institutions for Investment Lending ............................. 9

Table 4 . Credit to the Private Sector. percent o f GDP ...................................................... 14 Table 3: Aggregate Balance Sheet o f Romanian Banks. 1998-2002 ................................ 13

Figures

Figure 1 : Two PPAR Projects and Related Loan ........................................................... 3 Figure 2: IDP Disbursements-Estimated vs . Actual ......................................................... 7 Figure 3 . Romania: Credit to the Private Sector, 1996-2002 ............................................ 14 Figure 4 . Fiscal Defici t as a Percent o f GDP. 1992-2002 ................................................. 22

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Principal Ratings Industrial Development Project (Loan 3735)

ICR* ES* PPAR Outcome Satisfactory Unsatisfactory Unsatisfactory Sustainability Likely Unlikely Likely Institutional Modest Development Impact

Negligible Negligible

Bank Performance Satisfactory Unsatisfactory Unsatisfactory Borrower Performance

Satisfactory Unsatisfactory Unsatisfactory

Private Sector Adjustment Loan (Loan 4489) ICR* ES* PPAR

Outcome Satisfactory Sustainability Likely Institutional High Development Impact Bank Performance Satisfactory

Satisfactory Likely

Substantial

Satisfactory

Satisfactory Highly Likely Substantial

Satisfactory Borrower Satisfactory Satisfactory Satisfactory Performance

* The implementation Completion Report (ICR) is a self-evaluation by the responsible operational division of the Bank. The Evaluation Summary (ES) is an intermediate Operations Evaluation Department (OED) product that seeks to independently verify the findings of the ICR.

Key Staff Responsible Industrial Development Project (Loan 3735) Project Task ManagedLeader Division Chief/ Country Director

Appraisal Sonja Brajovic- Fred Levy Michael Wiehan

Completion Marcelo Bueno Paul Siegelbaum Andrew Vorkink

Sector Director

Bratanovic

Private Sector Adjustment Loan (Loan 4489) Project Task Manager/Leader Division Chief/ Country Director

Appraisal Khaled Sherif Yasuo lzumi Andrew Vorkink Comdetion Khaled Sherif Yasuo lzumi Andrew Vorkink

Sector Director

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Preface This i s the Project Performance Assessment Report (PPAR) for the Private Sector

Adjustment Loan (PSAL) for US$300 million, and the Industrial Development Project (IDP), in the amount o f US$175 million. The PPAR i s based on the President’s Report for the PSAL and the Staff Appraisal Report (SAR) for the IDP, legal documents, the project files, related economic and sector work, as wel l as interviews with Bank staff and Romanian officials, other donors, and the Implementation Completion Reports for the two projects, prepared in October, 2000 for the PSAL and in June, 2001 for the IDP.

The IDP was approved by the Board in the amount o f US$175 mi l l ion in May, 1994 (later reduced to US$120 million), and closed in December, 2001, two years later than planned after disbursing US$96.9 million.

The P S A L was approved by the Board in June, 1999, and disbursed i t s f i rst tranche o f US$lSO mi l l ion upon effectiveness, in August, 1999. The second tranche o f an equal amount disbursed after completion o f specified reforms shortly before the project closed as planned in June, 2000.

An OED mission visited Romania in December, 2002, to discuss the two projects with Romanian officials, donors, Resident Mission staff, and other stakeholders. Their cooperation and assistance i s gratefully acknowledged.

Fol lowing standard OED procedures, copies o f the draft PPAR were sent to the relevant government officials and agencies for their review and comments, but none were received.

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Summary The Romania Industrial Development Project (IDP was approved in May, 1994,

and closed in December, 2001), and the Private Sector Adjustment Loan (PSAL was approved in June, 1999, and closed in June, 2000).

The main objectives o f the Industrial Development Project (IDP) were to promote private sector growth, particularly by advancing enterprise privatization and restructuring; and to facilitate transformation o f credit markets and introduce safe and sound banking practices. This was to be done mainly by the use o f two credit lines, together with technical assistance. Prior to 1999, progress on structural reforms had been limited, and a Financial and Enterprise Sector Adjustment Loan (1 995-98) had achieved only limited success.

The PPAR finds that the design o f the IDP was not well-suited to the achievement o f i t s objectives. The project envisioned transforming credit markets by bolstering the capacity o f participating financial institutions (PFIs) using a “learning by doing” approach as they utilized the credit lines, along with a relatively small TA program. This approach was insufficient to deal with a sector s t i l l dominated by structures and practices from the time o f central planning. Quality at Entry was unsatisfactory, considering that the IDP was undertaken in an unstable macroeconomic environment. Disbursement o f the project’s two credit l ines was much slower than envisioned, and by project close 79 percent o f funding intended for investment finance and 18 percent o f funds to support exports had been disbursed. More than two-thirds o f investment lending under the IDP was made by three state-owned banks, which had large portfolios o f non-performing loans. Overall, non-performing loans comprised 46 percent o f a l l lending under the IDP. Credit to the private sector declined during the implementation o f the IDP, and Romania remains lower by this measure than most other transition economies.

The objectives o f the Private Sector Adjustment Loan (PSAL) were to support reforms in the enterprise, financial, and social sectors, as well as to improve the environment for private business. The PSAL was intended to accelerate privatization- especially o f medium and large-sized firms-restructure state-owned banks to facilitate their privatization or liquidation, and mitigate the employment impact o f privatization. The PSAL was largely successful at putting into place a framework for privatization o f many of the country’s largest loss-making f i rms, and thereby reducing the fiscal burden o f the enterprise sector. Many o f the sales occurred within a year after the project closed. The country’s fiscal deficit declined from 5.5 percent o f GDP in 1997 to 2.8 percent o f GDP in 2002. The project also established a framework for the resolution o f problem banks (e.g., sale, restructuring, liquidation), and made major progress in privatizing large state-owned banks. Bank supervision and accounting and auditing standards were also strengthened. In the social sector, the impact o f the structural changes was mitigated by the provision of unemployment and severance benefits as wel l as other assistance to laid- o f f workers. Progress was made in laying a foundation for an improved business environment. A law on collateral was passed and a registry established that facilitated i t s use in secured transactions; tax reform, as well as accounting and audit reform, were

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implemented, and an Action Plan to improve the business environment-based on FIAS recommendations-is being implemented.

The PPAR rates the outcome o f the IDP, and Bank and Borrower performance, as unsatisfactory. Institutional Development Impact (IDI) i s rated as negligible. Sustainability i s rated as likely, compared to unlikely in the ES, based mainly on the more favorable macroeconomic performance o f the last three years, the accelerated privatization that has occurred subsequent to project completion, and the prospect o f EU accession, which serves as a powerful incentive to maintain and extend reform.

The PPAR rates the outcome o f the PSAL, and Bank and Borrower Performance, as satisfactory. ID1 i s rated as substantial. Sustainability i s rated as highly likely.

Key findings and lessons for the IDP included: Financial sector operations should be undertaken only in a conducive macroeconomic environment; for a project whose goal i s to advance structural transformation o f the enterprise sector, a more suitable instrument might have been an adjustment operation; the size o f the l ine o f credit was too large given the r isks and uncertainties o f the macro and business environment. For the PSAL, lessons included: Timing and government commitment are critical to the success o f an ambitious reform program; ready access to technical assistance was key to project achievement.

Gregory K. Ingram Director- General Operations Evaluation

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1. Introduction BACKGROUND

1.1 Romania was ruled by Communists for more than four decades until the December, 1989, revolution. The governments that followed were cautious in their approach to structural reforms, and consequently by 1999 much o f the legacy o f central planning remained. Many loss-making enterprises-both in the enterprise and financial sectors-remained in state hands, and their budgetary and quasi-fiscal burden was large (see Table 1.1). Elections in late 1996 brought reformers to the fore, with a mandate to liberalize the economy, privatize state-owned banks and enterprises, and put the country into a position where i t could be considered as a candidate for entry into the European Union (EU).

1.2 aimed to spur reforms in these areas, the Financial and Enterprise Sector Adjustment Loan (FESAL) achieved only limited success. Whi le the FESAL achieved success in deregulation o f foreign exchange, prices, and trade, i t was less successful in privatization o f banks and industrial enterprises, which remained largely state-owned. An OED Performance Audit Report rated outcome as moderately unsatisfactory and Bank and Borrower performance as unsatisfactory. Government commitment was lacking, and financial discipline in the enterprise sector was undermined by the accumulation o f arrears, provision o f loans to weak enterprises and rollover o f loans to such firms, and an insufficient environment o f the “rule o f law” which made i t difficult for banks to collect on loans through the legal system.

However, privatization progress remained slow. An earlier Bank project which

1.3 business. Businessmen reported that the application o f laws and regulations was unpredictable, the labor code was inflexible, and obtaining a permit was cumbersome. Private f i r m s sometimes faced competition from businesses that benefited from state- guaranteed borrowing.

During the same period the business environment (BE) was unfriendly to private

1.4 Macroeconomic Environment-Immediately fol lowing the revolution, output fell, but recovery started in 1993 and growth continued until 1996 (Table 1.1). However, this growth was accompanied by large fiscal and quasi-fiscal deficits, high and variable inflation, and a large current account deficit. There were subsidies to favored enterprises, and accumulation o f arrears by many f i r m s to banks, utilities, and social funds. This reached a peak in the first half of 1996 when the 150 largest State-owned Enterprises (SOEs) posted losses twice as high as the entire year 1995. In 1997, inflation reached over 150 percent, and output from 1997 to 1999 contracted by nearly 13 percent. At one point in 1997, the government’s foreign exchange reserves reached a perilously l o w level (US$700 million) and it was feared that the country might default on i t s foreign debt obligations. The country was out o f compliance with i t s International Monetary Fund (IMF) Stand-by Arrangements for much o f the period from 1994 to 1998, and was able to

1. OED, Performance Audit Report (PAR), Financial and Enterprise Sector Adjustment Loan, and Social Protection Adjustment Loan, February, 2001. The loan for U S 2 8 0 mil l ion was approved by the Board in January 1996, however, US$lOO million remained undisbursed, and the project closed in April 1998,4 months later than envisioned.

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draw only SDR214.5 mi l l ion out o f SDR622 million, or 34.5 percent, o f the amount approved during that time.

1.5 banking sector crisis in 1999. Inflation has gradually fallen to 34.5 percent in 2001, and an estimated 19.8 percent in 2002.2 Real GDP growth turned positive in 2000, growing by 5.3 percent in 2001, and estimated to grow by 4.5 percent in 2002. During the period 1994-2000, when the IDP and PSAL were implemented, the country experienced considerable macroeconomic volatility.

Since 1997, macroeconomic performance has gradually improved, despite a

Table 1 : Table 1.1 : Selected Macroeconomic Indicators Year 1990 1991 1992 1993 I994 1995 1996 1997 1998 1999 2000 2001 2002

hnualRea1GDPgrowth-5.6 -12.9 -8.8 1.5 3.9 7.2 3.9 -6.1 -4.8 -1.2 1.8 5.3 % change 4.5

92.3 GDP index (1990=100’ 100 87.1 79.4 80.6 83.8 89.8 93.4 87.7 83.5 82.4 84.0 88.4 %) 170.2 210.4 256.1 136.7 32.5 38.8 154.8 59.1 45.8 45.7 34.5 22S Annual (CPI) inflation, 5,1 ave, %

Exports (US$, millions) 4.9 6.1 7.9 8.1 8.4 8.3 8.5 10.3 11.4 13.7 FDI ,net ’ (mil. USD) ... 40 77 94 341 419 263 1,215 2,031 1,041 1,040 1,157 1,100 Budget deficit, as % o f GDP Tax revenues, as % GDP . . . ... 33.5 31.3 28.2 28.8 26.9 26.5 28.2 30.1 29.4 28.3 Current Account, as % o f GDP Total employed

-2.8 ... ... -4.6 -0.4 -2.2 -3.4 -4.8 -5.2 -5.5 -3.6 -4.0 -3.3

-4.3 ... ... -8.0 -4.5 -1.4 -5.0 -7.3 -6.1 -7.0 -4.1 -3.7 -5.8

10839 10786 10458 10062 10011 9493 9379 9023 8813 8420 8629 ... (000’) . , 22.4 76.4 307.9 760.0 1655.1 2033.3 3082.6 7167.9 8875.6 15332.9 21692.7 29060.9 Exchange rate, year average, ROVUS$

1/ Net Foreign Direct Investment in Romania 2/ Employment : includes, in accordance with NIS methodology used for the labor force balance, all persons who, during the reference year, carried out a socio-economic profitable activity, excepting military staff and similar, political and community staff. Source: Romania Country Department, IMF, Intemational Financial Statistics, August 2000 and IMF Staff Report 2002.

1.6 declined since then and was 2.8 percent in 2002. In addition to the fiscal deficit shown above, i t is important to consider the country’s non-energy quasi-fiscal deficit, as well as the implici t subsidies and quasi-fiscal deficit o f the energy sector, which also placed a substantial burden on the state treasury. (It was the aim o f the PSAL to privatize many large loss-making f i rms, and thus lessen the fiscal drain o f the enterprise sector; PSAL 11-not the subject o f this PPAR-addressed the energy sector). One study estimates that the deficit o f 86 major loss-making f i r m s was around 1.1 to 1.4 percent o f GDP in 2000 and 2001 .3 After rapid increases in energy sector losses in 2000, energy prices were raised s~bstant ia l ly ,~ which resulted in a rapid decline in energy usage and in the sectoral quasi-fiscal deficit (from 4.9 to 2.7 percent o f GDP between 200 and 2002).

The budget deficit, which reached a high o f 5.5 percent o f GDP in 1998, has

2. IMF, Staff Report for 2002 Article IV Consultation, December, 2002, p. 7.

3. OECD, “Economic Surveys: Romania,” October, 2002, p. 46.

4. Between mid-2001 and mid-2002, the gas price for households was raised by over 85 percent, the heating price was doubled, and the price o f electricity was raised by 42 percent (all in US dollar terms). IMF, December 2002 Staff Report.

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Figure 1 : Two PPAR Projects and Related Loan RWO PPAR P roiects and Kelated Loan I ]$-original I $-actual I 1994 1995 1996 1997 1998 1999 2000 I I I

Proiect included in this PPAR

2. Industrial Development Project Objectives

2.1 The objectives o f the Industrial Development Project (IDP) were to (a) promote growth o f the private sector and create conditions for an effective supply response from viable private industrial enterprises; (b) advance structural transformation o f the enterprise sector-specifically privatization and restructuring; and (c) facilitate transformation o f credit markets and introduction o f safe and sound banking practices. These objectives were to have been achieved by: (a) improving access to foreign exchange credit for investment and export finance to viable private enterprises; (b) assisting in the design o f the necessary policies and strengthening the institutional fi-amework for privatization and restructuring; (c) strengthening the capacity o f participating financial institutions (PFIs) to efficiently allocate resources and improve financial services to the corporate sector.

2.2 be allocated in the fol lowing manner:

Components and Design-It was envisioned that the US$175 mi l l ion loan would

Finance component-US$l72 million 0 Investment finance-US$lO2 mi l l ion 0 Export finance-US$70 mi l l ion

Technical assistance (TA)-US$3 mi l l ion (later raised to US$7 mil l ion)

2.3 The project design provided for the Ministry o f Public Finance (MOPF) to lend through an apex organization, ini t ial ly the MOPF Treasury Department, to PFIs, which would then on-lend the funds to sub-borrowers. However, the MOPF was unable to serve this function as a result o f a legal opinion that Parliamentary approval would be needed, and consequently, prior to project effectiveness, Export Import Bank o f Romania (Eximbank) was appointed as the apex. (This change added to project delays) Funds were provided to PFIs based o n a reference rate based on LIBOR plus a market-based spread (0.5 percent) to cover Exim Bank’s costs.

2.4 program, with a term o f from 3-17 years, with a maximum o f US$8 mi l l ion (investment

Sub-loans were denominated in U S dollars under the Bank’s single currency

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lending), and with lending rates set at the reference rate plus a market-determined margin set by each P F I (generally around 2-3 percent). PFIs assumed credit risk, while sub- borrowers assumed the foreign exchange risk. Loans to final borrowers were to be made on a first-come, first-served basis.

2.5 Funds were also available for export finance, for which the borrower had to meet the fol lowing criteria: possession o f an irrevocable letter o f credit or confirmed purchase order, and relevant export experience. The maximum loan size for an export loan was US$5 million, and the maximum length was one year.

Relevance of the Objectives

2.6 The IDP objectives were o f modest relevance because they did not reflect a completely accurate diagnosis o f the development barriers confronting the country. The project was based, in part, on the presumption that the lack o f availability o f term lending was a major constraint to enterprise expansion. This presumption turned out to be unrealistic, because even when funds from the IDP did become available, many f i r m s did not have the expertise or resources to develop the feasibility studies required by lenders (i,e,, they did not a ~ p l y ) , ~ or they did not utilize the funds successfully if they did secure a loan (leading to a large proportion o f non-performing loans, or NPLs, as described below).

2.7 effort to advance structural transformation o f the enterprise sector was dependent on the sufficiency o f policy-related measures achieved during project preparation, along with financial support to private enterprise restructuring. Whi le these actions were helpful, they fel l far short o f being suficient to ensure progress in this very difficult area (see B o x 1).6 Similarly, the project envisioned transforming credit markets and introducing safe and sound banking practices by uti l iz ing a relatively small program o f technical assistance, and then bolstering PFI capacity to appraise and manage loans using a “learning by doing” approach. The use o f this approach for a sector dominated by large state-owned banks that were routinely providing extensive loans to large SOEs, in many cases on a politically-directed basis, also fe l l short o f being sufficient to assure progress.’

In addition, theproject design was insufficient to achieve its objectives. The

2.8 one o f the five “main areas o f reform emphasis,” privatization and private sector development, i t did not meet the CAS requirement that lending in this area “be conditioned on an overall adequate macroeconomic framework,” (see next para).

The IDP was inconsistent with the 1994 partial CAS. While it clearly fit within

2.9 undertaken in a unstable macroeconomic environment (Table 1 .1).8 Inf lat ion was 137

Quality at Entry-Quality at entry was unsatisfactory. First, the IDP was

5. Based on interviews with project and RM staff.

6. One o f the lessons drawn in this PPAR i s that an adjustment operation would probably have been a more suitable instrument.

7. The difficulties o f achieving change in the financial sector are described in the OED Performance Audit Report of the FESAL, February, 2001.

8. T h i s was acknowledged in the ICR: “The project was executed when Romania’s macroeconomic and business environment were very volatile.” ICR for Industrial Development Project, June 28,2001, p. 11.

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percent in 1994, the year o f project approval, over 200 percent in the two years prior to project approval, and over 30 percent and rising in the years following approval. Other macroeconomic indicators were also highly unstable.

2.10 such circumstances:

The Operational Directive 8.30 o f 1992 was clear on the approach to be used in

“[in unstable macroeconomic situations] economic actors become more concerned with protecting the value o f their assets and less interested in identifying productive investments.

In advance o f any financial sector operation, therefore, an explicit assessment should be made o f the conduciveness o f the country’s macroeconomic environment to realizing the operation’s goals. In particular, where inflation currently exceeds or i s projected to exceed 30 percent per year, or the rate o f inflation exceeds 20 percent and has shown an accelerating trend in the current year, a proposal to go ahead with financial sector lending should include an analysis o f expected inflation trends and their effects on financial decisions in the economy generally, and on the likelihood o f the operation’s achieving i t s intended objectives.”

2.1 1 macroeconomic environment to the realization o f project goals.9 The unstable macroeconomic environment acted to reduce the demand for credits under the project. However, other factors also acted to constrain the demand for credit: delays in project effectiveness, (see para 2.13, below); a poor business environment, which made it difficult for private f i r m s to operate; and the relatively small number o f banks that met IDP eligibility criteria.

The project documents do not reflect an assessment o f the conduciveness o f the

2.12 A second factor in quality at entry, the capacity of thefinancial sector to support the IDP, was weak. Many state-owned banks accredited as PFIs consistently made problematic loans, and so the government had to recapitalize weak banks to the extent o f 1.5 percent o f GDP in 1996, 1.7 percent in 1998, and 2 percent in 1999.” Further, the capacity o f the National Bank o f Romania (which had a key role in the accreditation o f PFIs-see para 2.24) in bank assessment and supervision was deficient: ‘‘. . .the ability o f the National Bank o f Romania’s (NBR’s) banking supervision staff to perform the most basic risk-based supervision, and to obtain an accurate picture o f the financial condition o f banks, i s questionable.””

2.13 during project preparation (see B o x 1) would advance privatization and restructuring o f enterprises and serve as a catalyst for private sector growth. This presumption also proved unrealistic, as the measures fell well short of what was needed to achieve the

Third, the project design presumed that the policy-related measures undertaken

9. Except that macroeconomic instability was recognized as a risk: “. ... the macroeconomic environment and the progress-in-transition programs and in project implementation will be thoroughly reviewed one year after loan effectiveness, with an option to cut oflfurther commitments in case of seriously adverse developments or to redesign the proposedproject.” SAR, para. 7.06 (italics added).

10. OED, Performance Audit Report, Romanian FESAL, February, 2001, p. 2.

11. Romania Financial Sector Review, op. cit., p. 33.

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objective in this area. In the event, support from Government was uneven, the State Ownership Fund retained a majority stake in many large enterprises, and overall progress in privatization and restructuring was disappointing.” I t was not until 1999, with the advent o f the PSAL, that major progress was made in these areas. Indeed, if the project goal was to advance structural transformation, a more suitable instrument might have been an adjustment or technical assistance operation.

2.14 such a risky and unstable environment. The Bank might have utilized smaller credit lines in an init ial effort to gauge the market, and then developed a larger facility if demand was strong and subloans proved to be o f good quality.

Fourth, the project was over-dimensioned, Le., the credit lines were too large for

2.15 Afifth element o f quality at entry was the confusing process established for initial accreditation and ongoing review o f PFIs (discussed in detail in para 2.24). This process diffused responsibility between the apex, the Bank, and the NBR.

2.16 This i s explained more fully in the next paragraph.

Finally, the project was not ready for implementation at the time o f approval.

Implementation Experience

2.17 slowly than envisioned. Board consideration was delayed by the time taken to reach agreement on policy-related measures (Box 1). After Board approval, effectiveness was delayed by factors including: the need to make detailed arrangements for Exim Bank as the apex; difficulty in recruiting qualified PFIs and in training their staffs; and reaching closure on other project administrative arrangements. When the project did become effective, disbursements were delayed by the time needed to consummate sub-loan agreements with PFIs. Meanwhile, other multilateral and bilateral financial institutions (EBRD, EIB, bilateral export credit agencies) entered the market, resulting in less demand for loans under the IDP. Figure 2, below, shows the loan’s estimated versus actual disbursements. Over the term o f IDP, macroeconomic turbulence and the availability o f more attractive outlets for P F I investments also hindered lending to enterprises.

I D P start-up was substantially delayed,13 and the project disbursed much more

12. OED, FESAL PAR, p. 6-7.

13. It took around two years from the start of project identification until Board approval in May, 1994. IDP became effective in July, 1995, and the first commitment was made in March, 1996.

7

Figure 2: IDP Disbursements-Estimated vs. Actual

90 80 70 6 60

I 50 'E 40 6 5 30

20 10 0

IDP Disbursements: Estimated vs. Actual

I 1994 1995 1996 1997 1998 1999 2000 2001

lgi estimated

2.18 investment finance was disbursed, and 18 percent o f the US$70 mi l l ion disbursed to support exports. O f the technical assistance funds, US$4.1 mi l l ion o f the US$7 mi l l ion was spent, or 5 1 percent. One consequence o f the slow disbursement was that the apex organization, Exim Bank, lost money on the IDP from 1994 through 2000-when it began to earn a profit-because it had to pay the commitment fee on the undisbursed balance (0.5 percent per year). I t i s estimated that Eximbank (and ultimately i t s owner, the GOR), paid a commitment fee on the IDP o f US$1.7 million.

By the end o f the project 80 percent o f the US$102 mi l l ion originally intended for

2.19 make loans directly to enterprises, Le., act as a PFI. Because o f the numerous conflicts o f interest that this would bring, a Bank mission discussed this question with the Ministry, and MOPF withdrew the request. However, Eximbank was permitted to lend reflows from loan repayments on i t s own account, subject to the same criteria as al l other lenders. While this resolution permitted Eximbank to recover some o f i t s losses, i t shifted Eximbank's role away from the agency and administrative functions originally intended, and permitted it to assume credit risk for the sub-loans.

Eximbank Role-In 1998, the MOPF requested that Eximbank be permitted to

2.20 the long run the private banking system should be able to provide export and export- related financing, and there i s a question whether a public bank should be the position o f competing with these private banks. I t may be useful to reconsider the role o f Eximbank and potentially limiting it to providing insurance, export guarantees, and other products traditionally provided by similar institutions.

The question o f Eximbank's ultimate role in the banking system is problematic. In

8

Box 1: Policy-related Measures Achieved During Project Preparation

Privatization

Complete development o f legal and institutional framework o o

Finalize State Ownership Fund by-laws and initiate staffing Finalize Private Ownership Fund by-laws

Speed up Privatization o o o

Start distribution o f certificates o f ownership Finalize draft procedure for privatization o f small f i r m s Adoption o f 1993 privatization program

Enterprise Reform

Improve Corporate Govemance o Pass amendments on corporate boards o Submit to Parliament draft law on public accountants

o Agreed SME Loan Guarantee Program Create Enabling Environment for PSD

2.21 that time, an effort was made to recruit additional banks as PFIs, additional emphasis was placed on extending loans to small and medium enterprise^,'^ local currency lending was offered, and loan approval procedures were streamlined. It was at this time that the TA component was expanded from US$3 mi l l ion to US$7 million. In September, 1999, the project was hrther restructured, with the loan amount reduced from US$175 mi l l ion to US$120 million, and the closing date extended two years to December, 2000.

Because o f the generally slow progress, the project was restructured in 1998. At

2.22 making 74 loans (to 55 enterprises) totaling US$80.4 million, or U S $ l .l mil l ion per loan. As shown in Table 2, below, an additional six PFIs were accredited, but did not participate. The four banks accredited in 1999 reflect efforts to increase utilization o f project funds-efforts that were modestly successful. Lending under the investment component was highly-concentrated: more than two thirds of investment lending was made by three state-owned banks: Romanian Commercial Bank (BCR), Bankorex, and the Romanian Bank for Development (RDB).

Investment Component-Eight PFIs participated in the investment component,

14. Small and medium enterprises had been eligible since project inception, but few had the resources or sophistication to develop successful loan applications. In the 1998 restructuring, PFIs were encouraged to seek business from SMEs, and lending terms were eased to facilitate their participation.

9

Ownership (at time o f accreditation)

Romanian Public Commercial

Table 2: : Participating Financial Institutions for Investment Lending

Accreditation Percent o f total Percent non-performing Disposition IDB lending loans (as percent o f total

IDB lending) 2196 48.4 33.7 Privatization i s a

olw 27.3 Bankorex condition o fPSAL I1 Bank(BCR)* I olw 6.4 BCR Development Bank (RDB) I o n Tiriac Private 6195 9.5 Unknown, but thought bank to be negligible Demir Bank Private 4199 6.1 Twko- Private 1197 5.5 Bankrupt 2102; MOPF to Romanian pay obligations Bank The Romanian Private 6199 5.0 Bank

"

"

"

" Private 11195 2.2 Suspended as PFI, 7197; I Bankcoop Bankorex

bankrupt 2100; MOPF paid obligations to IBRD

BCR in 1999, which took Public 6195 (included in Closed and absorbed by

BCR total)

Bucharest Bank Franco- Romanian

over i t s assets Private 8/95 Merged into BCR 9199

Private 8/95 Accredited, but did not participate in project

Societe I Private I 7195

I participate in project *Includes Bankorex assets transferred in 1999. In 2002, two unsuccessful attempts were made to sel l BCR, and then in February, 2003, the government announced that 25% would be sold to the EBRD and IFC, and a majority stake would be divested to a strategic investor at a later date.

I Accredited, but did not

2.23 dollars, and many potential borrowers received payment in different currencies, and were unwilling to take the foreign exchange risk. In addition to the business and macro environment described above, other factors limiting demand included f i rms ' inability to prepare bankable projects; onerous requirements for collateral; a cumbersome loan

Part o f the reason for the lack o f demand was that the loan proceeds were in U S

General 1 participate in project BankPost I Public I 9196 I Accredited, but did not

RoBank

participate in project; suspended, 7197

Private 6199 Accredited, but did not

Citibank I Private I 11199 I Accredited, but did not

10

approval process (especially prior to the 1998 project restructuring); a lack o f interest on the part o f some PFIs in utilizing IDP funds.”

2.24 PFIs was confusing insofar as some institutional roles and responsibilities were overlapping.16 The S A R states that the process was to have been performed in the fol lowing manner:”

Accreditation of PPIs-The process o f ini t ial accreditation and ongoing review o f

e e

e

e

e

e

2.25

Prospective PFIs submit application to NBR NBR screens applications according to specified criteria, including capital adequacy ratio (CAR), profitability, satisfactory loan classification and provisioning, and “satisfactory operational performance, especially concerning past-due and N P L s and collection ratios regarding total loan portfolio and Bank’s portfolio” (see para. 2.27) NBR issues opinion, and, if positive, Bank appraises prospective PFI For PFIs approved by the Bank, Apex issues accreditation NBR continues to monitor soundness o f PFIs, including their capacity to appraise loans and status o f their financial and operating condition Apex has primary responsibility for operational functions, including disbursements to and repayments from PFIs, and monitoring PFIs to assure their continued qualification. However, the Bank also retained a role in reviewing the init ial qualification o f PFIs as well as periodic updates

While the financial condition o f PFIs was reviewed regularly by Bank supervisory missions, and a number o f PFIs were disqualified during the project because o f poor financial performance, there is no record of a systematic effort to identi& and report NPLs-a critical omission (see next para). I t would have been important to require systematic reporting o f N P L s since that was a key element o f PFI financial performance, and was also an indicator o f the extent to which enterprises benefited from the project.

2.26 Non-performing loans-The proportion o f non-performing loans under the IDP was very high. The mission was able to identify 11 N P L s from the three largest lenders (BCR, Bankorex, and RDB), totaling US$42.4 million, or 45.8 percent o f a l l lending under the investment component.” Sixty percent o f a l l RDB investment lending was comprised o f NPLs, and 69.6 percent o f B C R lending (including Bankorex). These 11 NPLs are now in the portfolio o f the Asset Recovery Agency, AVAB, which in the years 2000-2002 was able to recover between 23 and 47 percent o f the assets transferred to it.

15. A major reason for the lack o f PF I interest in uti l izing the loan was the availabil ity o f more profitable and less r i s k y uses for their funds during much o f the project: “Given the h igh volati l i ty o f interest rates.. . .It was rational behavior for the banks to invest increasingly in l o w r isk and highly remunerative government securities and in deposits w i th the NBR, and to withdraw concomitantly f rom the r isky and uncertain business o f f inancing enterprises in the real sector.” Romania, Financial Sector Review, March 31, 1999, p. 5. (this is already pointed out in footnote 10)

16. For example, the Apex organization, NBR, and the Bank a l l had some measure o f responsibility for monitoring PFIs to assure their continued qualification.

17. SAR p. 29-30 and Annex 5.

18. To put this into perspective, a financial institution that recovered 85 percent o f its outstanding loan principal annually would need to collect a real interest rate o f 17.65 percent per annum just to restore the lost capital and without considering the additional interest income necessary to cover its operational and financial costs. Fred Levy, “World Bank Assistance for Financial Sector Development in the ECA Transition Economies” (Draft).

11

One additional technical assistance loan o f US$0.9 mi l l ion f i om Bankorex i s also non- performing and has been turned over to AVAB.

2.27 Accreditation Criteria-The criteria used to accredit PFIs seem adequate, on paper. l9 However, in practice, they were not sufficient to ensure that the banks selected were well-managed and could avoid making bad loans. In retrospect, i t i s difficult to understand how an institution l i ke Bankorex became accredited and was permitted to participate for such a long time: ‘‘. . ..the largest state-owned bank in Romania, Bankorex, long the source o f unsound financing o f non-viable enterprises and dubious private interests.’ y20

2.28 Export Finance Component- As noted earlier, this $70 mi l l ion component was the least utilized o f the IDP, with just US$12.4 mi l l ion disbursing in 23 sub-loans, mainly because o f the reluctance o f f i r m s to assume the foreign exchange r isk. Repayment was relatively good for the export component, with only one loan being designated as a NPL (the PF I eventually repaid the loan).

Outcome

2.29 relevant because they did not reflect a completely accurate diagnosis o f the country’s development barriers and because the project design was insufficient to achieve i t s objectives. With regard to the f i rst objective-promote growth o f the private sector and create conditions for an effective supply response from viable private industrial enterprises-as discussed earlier, nearly 46 percent o f lending under the investment component consisted o f non-performing loans. This demonstrates that enterprises were able to make only limited use o f funds loaned under the IDP. Whi le time series data showing the proportion o f economic activity in the private sector were not available, data are presented below (Figure 3) showing that credit to the private sector declined over most o f the period o f the IDP, and that Romania remains below many other transition economies in that regard.2’ Achievement o f this objective was unsatisfacto ry.

Outcome was unsatisfactory. As noted above, the objectives were only modestly

2.30 With regard to the second objective, advancing enterprise privatization and restructuring, as noted above, progress in this area during the period o f the IDP was quite limited, and so IDP achievement was unsatisfactory. The 2001 CAS states:

“While many small enterprises were privatized in the early years o f the transition, including al l shops and service outlets, nearly al l large industrial enterprises remain under state ownership. As a result, the state s t i l l holds shares in around 6,000 enterprises and accounts for about three-quarters o f industrial output. W h i l e the private sector accounts for around 60 percent o f GDP, most o f i t s activities are in the service sector.”22

19. CAR had to be at least 8 percent, o f which 4 percent primary capital; profitability and performance were required to be “satisfactory;” loans to single borrowers were subject to quantitative limits; and the PFI must have satisfactory credit appraisal policies and capacity.

20. ICR for PSAL project, October 12,2000, p.5

21. O f course, it i s recognized that many factors beyond the IDP affect the issuance ofprivate credit

22.2001 CAS, p. 9.

12

2.31 practices, some participating banks interviewed by the mission reported benefits from informal training received in the context o f the IDP, and also cited the positive experience o f appraising sub-loans under the project. However, other institutions which participated in the IDP fared poorly. Bankorex, the largest PFI-which provided 40 percent o f a l l IDP investment lending-was “subject to undue political influence, had misguided management, and suffered serious credit losses.’y23 Approximately 60 percent o f Bankorex loans under the IDP were NPLs, and the bank was closed in 1999, with i t s productive assets absorbed by another bank, and N P L s transferred to AVAB. The Romanian Commercial Bank and Romanian Development Bank also had weak portfolios (Table 2). And two smaller PFIs were declared bankrupt.

Finally, with regard to the third objective o f facilitating safe and sound banking

2.32 IDP for that purpose was not provided (Para 2.36). I t had been intended that TA would be provided to “Strengthen the capacity to appraise credit., ..administer credit lines and develop loan supervision capacity.. ..develop monitoring and reporting systems.. ..and assist in init ial appraisal and loan supervision o f sub-loans extended under the However, project TA h n d s were used for other purposes and no formal capacity-building assistance under IDP was provided to PFIs. 25

One factor in the failure o f PFIs to perform better was that TA intended under the

2.33 restructuring the banking sector, the project could have played a complementary role in facilitating better banking practices. However, during the term o f the IDP, progress in reforming the sector was slow. The FESAL, approved in January 1996, envisioned privatization o f two o f the country’s four state-owned banks. But by April, 1998, when FESAL was closed, none had been sold (although progress was made the following year).

Also, if IDP implementation had proceeded in parallel with substantial progress in

2.34 and no assessment o f the overall sector was done between the 1998 assessment and March, 2003 . Table 3 shows the findings o f the March, 2003, mission on the overall condition o f the banking sector. As shown, the overall profitability o f the sector improved over the time period, and the return on equity and loan to deposit ratios seem to indicate a healthy banking sector. However, given the very high number o f NPL among the IDP sub-loans, the improvements cannot be attributed to the IDP. They are l ikely due mainly to the privatization or removal o f insolvent banks, mostly state-owned, a process not directly connected to the IDP.

Data o n the financial condition o f individual Romanian banks were not available,

23. Romanian Financial Sector Review, p. 23.

24. SAR, p. 41.

25. As discussed below, informal training was provided to PFIs by Bank and RM staff.

13

Table 3: Aggregate Balance Sheet o f Romanian Banks, 1998-2002 Aggregate Balance Sheet

Return on Equity -12.0% 16.7% 27.2% 22.4% Loan/Deposit Rat io 43.9% 44.7% 48.2%

Source: Financial Sector Mission, March, 2003

2.35 introducing better banking practices.

From the available evidence, i t can be seen that the IDP had a negligible effect on

2.36 because o f the perception that skill deficiencies and lack o f institutional capacity (both in the financial sector as well as in enterprise privatization strategies) were among the main reasons for the country’s lack o f reform progress. I t was envisioned that sectoral studies would facilitate privatization and restructuring, and that TA to financial institutions would bolster their ability to appraise and manage loans, while maintaining a sound financial position.

TA Component-TA was deemed very important for the success o f the project,

2.37 In the event, the TA component was not implemented as planned. The GOR was generally unwilling to use borrowed funds for training and capacity development. While some sectoral studies were completed-financed by other donors-TA funds under the IDP were used only to upgrade the MIS (hardware and software) o f three PFIs and Eximbank. Training was provided to PFIs by the Bank on an informal basis, as wel l as by other donors. Seminars were organized by Eximbank, and by the project staff and Resident Mission to bolster PFI knowledge o f credit appraisal and o f the specific features o f the IDP, however, they were only modestly successhl in increasing utilization o f the loan. Achievement o f the TA component was therefore modest.

2.38 The purpose o f the IDP was to increase lending to the private sector, an area where Romania trails other transition countries (see Table 4). Figure 3 below shows credit to the private sector during the period o f the IDP. Although many factors affect credit availability, if the credit l ine had substantial development impact, and if the activity had had a catalytic effect as envisioned, then we might have seen private credit rising. However, between project effectiveness in mid-1995 and its closure at end 2001, credit to the private sector declined overall (in contrast to the pattem in other transition countries), but seemed to rise in 2002, after te project closed, which coincided with improved macroeconomic performance and the privatization o f several o f the country’s largest state-owned banks.

14

Figure 3. Romania: Credit to the Private Sector, 1996-2002

14%

12%

n 10% 0 (3 c 8% 0 E Q) 6% CI

; n 4%

2%

0% 1996 1997 1998 1999 2000 2001 2002

(est)

Source: Der ived from IMF, International Financial Statistics, January 2003, and August 1999. Data were not available for 1994 and 1995. Data are for deposit money banks only.

Table 4. Credit to the Private Sector, percent o f GDP 1995 2001

Romania 12 8 Russia 8 15 Estonia 15 28 Poland 12 25 Source: Derived from IMF, International Financial Statistics, January 2003 , and August 1999 (Romania data are for 1996)

Sustainability

2.39 toward achievement o f most project objectives. However, some banks did report that the IDP strengthened their capacity to appraise and manage loans to the enterprise sector. In particular, a number o f smaller private banks probably emerged from the IDP in a stronger position: I o n Tiriac bank, Demir Bank, Turko-Romanian Bank, and The Romanian Bank. With the more favorable macroeconomic performance o f the last 3 years, reductions in the fiscal and quasi-fiscal deficits, accelerated privatization, and the prospect o f EU accession, the progress achieved by these banks i s l ikely to be sustained.

Sustainability i s rated as Likely. As discussed above, l i t t le progress was made

Institutional Development Impact

2.40 Outcome, l i t t le progress was made in achieving the institutional objectives o f the IDP, which were: advance structural transformation o f the enterprise sector-specifically privatization and restructuring; and facilitate transformation o f credit markets and

Institutional Development Impact was negligible. As discussed above in

15

introduction o f safe and sound banking practices. With respect to privatization and restructuring, as noted earlier, progress was minimal until the advent o f the PSAL.

2.41 With respect to the transformation o f credit markets, most o f the technical assistance envisioned under the project did not get delivered-except for informal efforts made by project and RM staff-and the record in appraising and managing loans o f the PFIs that played the largest roles in the IDP was poor. As noted earlier, a number o f small private banks seemed to have benefited from participation in the IDP, but in the context o f the overall sector, progress was limited.

Bank Performance

2.42 unsatisfactory, principally due to the following factors:

Bank Performance was unsatisfactory. As noted earlier, Quality at Entry was

0

0

0

0

0

IDP was undertaken in an unstable macroeconomic environment, which hindered lending The institutional analysis o f the capacity o f the financial sector to support this operation was weak, and deficiencies in PFIs hindered project performance The size o f the loan was too large for such an unstable and uncertain environment The project was not ready for implementation at the time o f approval The presumption that the achievement o f policy-related measures would advance enterprise privatization and restructuring and serve as a catalyst for private sector growth was unrealistic, and fel l well short o f what was needed in this area.

2.43 the suspension or disqualification o f some PFIs, i t i s dif f icult to understand how the number o f N P L s was permitted to reach nearly ha l f o f a l l investment lending.

Supervision was unsatisfactory. Despite regular reviews o f PFI performance, and

2.44 Prior to 1998, supervisory reporting was consistently over-optimistic, e.g.,

0 “Promote introduction o f safe and sound banking practices-Technical assistance to PFIs has been provided, PFIs were trained in the use o f project implementation management system and loan appraisal software; the objective i s fully accomplished.”26 “Improve lending practices-rated SATISFACTORY. The quality o f submissions o f participating banks i s very high. Unsatisfactory subproject applications are rejected. Banks have improved appraisal practices in general, and their loan portfolio quality and collection performance continues to i m p r ~ v e . ” ~ ’

26. Supervision report, November 17, 1995

27. Supervision report, November 12, 1996

16

0 “The PFIs are elite Romanian banks. Compared to other members o f the banking sector, they are characterized by solid institutional and managerial capacity, above average profitability and better than average risk profile, and robust risk-weighted capital adequacy.. . .”28

2.45 cancelled, but no rationale for these actions could be found in the project documentation. Although considerable informal training was provided to PFIs by project and RM staff, i t is s t i l l difficult to understand how the project Task Managers made the decision to proceed with disbursement o f project hnds in the absence o f this important augmentation o f institutional capacity.

As noted earlier, about $3 mi l l ion o f the technical assistance component was

2.46 Starting in 1998 a strong effort was made to improve project performance by restructuring the project (para 2.21). This effort was modestly successful insofar as it was able to promote the IDP, recruit several additional PFIs, and maintain lending at between US$15 mi l l ion and US$20 mi l l ion per year despite an inauspicious economic environment.

Borrower Performance

2.47 Borrower Performance was unsatisfactory. While the implementing agency (Eximbank) executed i t s responsibilities efficiently, the Borrower’s implementation performance had the fol lowing deficiencies:

0 The Borrower did not maintain macroeconomic conditions that were conducive to the achievement o f project goals. In fact, policies led to a highly inflationary environment that provided an incentive for banks to avoid lending to the productive sector at a l l and instead to focus o n investing in government securities State-owned entities-Bankorex, BCR, and RDB-provided large loans that proved to be ill-advised The Borrower did not accelerate privatization and restructuring to the extent envisioned at project inception.

0

2.48 In addition, there was tension between GOR agencies involved with the project that probably hindered project performance. A 1997 supervision report stated that the MOPF carried out a financial audit that “was not conducted in good faith,” tied up the staffs o f Eximbank and o f the PFIs, and diverted their attention f rom lending. Before tensions were defused, Eximbank announced i ts intention to exit the project, but mediation by the Bank mission avoided that outcome. There was also tension between Eximbank and the MOPF over who was to bear the risk o f loans that defaulted. This was eventually resolved in a February 1998, MOU which clarified that MOPF would be responsible.

28. Supervision report, July 24, 1997

29. TA was to have included sector studies and consulting assistance for privatization strategies, assistance to strengthen PFI credit, r isk management, appraisal, and loan administration capacity. SAR, p. 25. (this is no t the place to present what the component was supposed to include)

17

3. Private Sector Adjustment Loan

Objectives

3.1 reforms in the enterprise, financial, and social sectors, as wel l as to improve the environment for private business. In the enterprise sector, i t was intended to accelerate privatization o f state-owned enterprises (SOEs), enforce hard budget constraints on remaining SOEs and close specified large loss-makers-including major coal mines (highly concentrated in the Jiu Valley). In thejkancial sector, the loan was intended to strengthen the banking system, ensure that state banks were properly restructured as a prerequisite for their privatization or liquidation; improve bank regulation, and further develop the government securities market. In the social sector, the aim was to mitigate the employment impact o f privatization through employment support programs, job training, social assistance programs, and job information. And in the area o f improving the business environment, the project was intended to strengthen the legal environment, improve accounting standards, and implement an action plan to stimulate private sector development.

The objectives o f the Private Sector Adjustment Loan (PSAL) were to support

3.2 The PSAL was accompanied by a US$25 mi l l ion technical assistance project, the Private Sector Institution Building Loan (PIBL), which provided complementary support across al l areas o f P S A L activity. (Activities under P I B L are summarized in Annex C)

3.3 reforms that could substantially reduce the pressure on the government’s finances. The project tackled many o f the country’s largest loss-making companies; i t was the intent o f the PSAL to put into place a framework for privatization o f these f i r m s and begin the process. Their actual sale was expected to (and largely did) occur soon after the closing o f PSAL. The project also aimed to privatize or liquidate banks that were themselves a drain on the treasury, and which-by making problematic loans-facilitated the continuing existence o f loss-making f i rms.

The PSAL was an ambitious attempt to effect enterprise and financial sector

3.4 conditions to be met before disbursement. There were two major factors that greatly motivated the government to undertake wide-ranging reforms. First, in 1997-98, GDP contracted by more than 1 1 percent (Table 1.1), and the budget deficit increased for the fifth consecutive year to 5.5 percent o f GDP. These factors, along with an unstable current account balance and mounting external repayment obligations, increased pressure on the GORY which moved in late 1998 to initiate an ambitious reform program. A second major factor was (and is) the prospect of accession to the EU in 2007. PSAL conditions were well-coordinated with the milestones set out by the EU, and the government-and a broad segment o f society-support the effort to ‘‘join Europe”, reinforced by NATO’s decision in November, 2002, to invite Romania to j o i n the alliance. Once the government signaled that i t understood the severity o f the macroeconomic situation, and wished to proceed with reforms, the Bank moved quickly to prepare the project (see para 3.1 1).

PSAL was structured in two tranches of US$l50 mi l l ion each, with specific

18

Relevance of the Objectives

3.5 PSAL objectives were highly relevant to the country’s development needs. Despite numerous reform efforts during the previous 10 years, many large firms with little or no prospect o f viability remained in state hands, causing a substantial fiscal drain (para 1.6). W h i l e the FESAL had sought to apply financial pressure through banking and financial service reforms to serve as a catalyst for enterprise privatization and restructuring, two broad weaknesses undermined efforts to achieve many FESAL objectives: government support and commitment were lacking; and the imposition o f financial discipline in the real sector was undermined by the run-up o f arrears, rollover o f loans that were not serviced, the provision o f new loans to loss-makers, and the inadequate support infrastructure (e.g., efficient court procedures, market-based valuation standards, professional liquidation companies) which made i t difficult for banks and other intermediaries to collect on loans. Government commitment to PSAL was high, and the project was aimed squarely at the development problems that had vexed the country for nearly a decade. With regard to the business environment, the PSAL program acknowledged that privatization and liquidation in the Statement o f Expenditures (SOE) sector would not be sufficient to develop sustainable growth. Therefore, PSAL also focused o n making the environment more conducive to private sector growth by concentrating on secured interest in personal property, tax reform, bankruptcy, accounting and audit, and the overall enabling environment.

3.6 this area. Bank management envisioned that energy would be addressed in a later operation,3o and made the explicit judgment that seeking to include additional reforms in PSAL could have made the project politically infeasible. This PPAR concurs with that judgment and the limited nature o f the PSAL objectives.

Despite the large quasi-fiscal deficit o f the energy sector, PSAL did not address

3.7 lessons from the shortcomings o f the FESAL. The CAS envisioned a new operation that would “more closely target the large loss-makers, simplify mainstream methods o f privatization, and provide a renewed impetus to privatization o f state-owned banks.”

The PSAL was consistent with the 1997 CAS, which seemed to have absorbed the

3.8 QAG. P S A L was well grounded in analytical work, and adequately established the linkage between the problems diagnosed and the reforms supported by the project. The project was fully consistent with the country strategy, and borrower commitment was strong, although narrowly-focused. The project team consulted with a variety o f major stakeholders. The project was prepared quickly-in less than 8 months-when the govemment signalled that i t was ready to consider a significant reform program. The project design was sound, squarely addressed the identified development obstacles, and utilized an innovative approach (“pool privatisation”) to the privatization o f medium and large enterprises.

Quality at Entry-Quality at Entry was satisfactory, the same rating given by

3.9 the I C R for the FESAL was written. The main lessons identified were:

The PSAL was being readied for Board consideration at around the same time as

30. Energy sector reform i s a main focus o f PSAL 11, approved by the Board in September, 2002.

19

1. FESAL had too many conditions and too many tranches; future adjustment operations should be shorter and simpler

2. Many conditions were process-oriented; future conditions should be based on fewer, but more easily verified, outcomes

3. There was insufficient government ownership; a high-level counterpart group should be established to design and monitor implementation

4. Institutional capabilities were too weak; the availability o f TA should be assured 5. The legal and regulatory framework for enterprise and bank privatization was

weak; the legal framework should be strengthened 6. Greater attention should be paid to public awareness o f the reform program

3.10 and 5-which were key to i t s success. PSAL did, however, have a large number o f conditions, some o f which were process-oriented, and it did not implement a public awareness pro gram.

PSAL took into account the most important o f these lessons-including 1 , 3,4,

Implementation Experience

3.1 1 the reforms that would form the conditions o f the loan. All f i rst tranche condition were met by June, 1999, when the project was approved by the Board, however, a Fund program was not in place at that time. In August 1999, the Fund approved a Stand-by Arrangement o f SDR 400 mi l l ion to support the government's stabilization and reform program, and the f i rs t PSAL disbursement o f US$150 mi l l ion was made soon after. The second tranche o f an equal amount disbursed in June, 2000, after al l remaining conditions were met.

The PSAL team worked intensively with the government to develop the details o f

Outcome

3.12 PSAL activity:

Outcome was satisfactory, with significant progress made in al l four areas o f

Financial Sector

3.13 Performance in this area was satisfactory, with al l conditions met, although progress in the establishment o f a legal and institutional framework for asset resolution was not made as rapidly as had been hoped. The f i rs t area dealt with privatization o f state banks. In June, 1999, B C R was subjected to an audit and loan portfolio review, which facilitated development o f a satisfactory restructuring plan prior to privatization. Privatization advisors were appointed to help implement restructuring and privatization. B C R has not yet been sold; i t i s the subject o f PSAL I1 conditionality, and in 2002, two unsuccessful attempts were made to sell the bank. Then in February, 2003, the government announced that 25% would be sold to the EBRD and IFC, and a majority stake would be divested to a strategic investor at a later date.

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3.14 assessment o f Bank Agricola (BA) led to an NBR takeover o f the bank to contain losses, transfer o f a majority o f non-performing assets to AVAB, the asset resolution agency, and preparation o f BA for privatization or liquidation. Bank Agricola has now been privatized. In the third area, Bancorex’ license was withdrawn in July, 1999, and i t s name removed from the official company registry, and i t s assets transferred either to AVAB or to BCR. Bancorex has ceased to exist, shutting down the largest source o f loss-making activity in the Romanian economy; i t s closure would have been inconceivable a few years before and was a milestone in the country’s reform progress.

In the second area, dealing with Bank Agricola, the financial and operational

3.15 In the fourth area dealing with strengthening bank supervision and regulatory compliance, activity had started before PSAL. NBR had already established minimum reserve requirements at 15 percent o f al l deposits, and during PSAL NBR introduced stricter risk-weighted capital adequacy requirements to bolster bank solvency. Along with higher minimum reserve requirements, these measures enabled NBR to identify problem banks earlier.

3.16 banking supervision activities into one department focused o n on-site inspection, off-site surveillance, strategic/policy coordination, and legal matters. Improved compliance with prudential norms is demonstrated by regular reports based o n Basle Core Principles, external audits, and monthly reports related to specific provisioning requirements.

In the fifth area, the GOR strengthened supervisory capacity by reorganizing NBR

3.17 In the sixth area, strengthening accounting and audit standards and practices, the government had already begun this effort prior to PSAL with adoption o f a chart o f accounts consistent with International Accounting Standards (IAS), introduction in 1998 o f a new Banking L a w requiring that al l banks appoint independent external auditors, and that banks produce quarterly statements. As part o f PSAL, NBR also introduced tighter provisioning standards on a monthly pre-tax basis in the currency o f exposure. These measures were subsequently strengthened by new NBR regulations for better risk classification. The condition that loss loans overdue more than 360 days be written o f f was substantially complied with, while al l others were fully complied with.

3.18 the one area where government performance lagged through most o f the PSAL. The main issue was that AVAB was slow to appoint needed management, staff and advisors. However, this situation was rectified in Apri l-May 2000, and AVAB now has needed management, staff and advisors in place.

The seventh area, focused on creation o f a legal framework for asset resolution, is

3.19 established a plan for computerized clearing and settlement o f Government securities transactions, and it has offered at least four different maturities.

With regard to development of a Government securities market, the government

Enterprise Sector

3.20 PSAL achievement in the enterprise sector was satisfactory, as the government met or exceeded loan objectives. The main goal in enterprise reform was to strengthen financial discipline in the state enterprise sector, liquidate non-viable loss-making

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enterprises (e.g., mines), privatize most remaining state enterprises (including utilities), and cut losses and subsidies in the state enterprise sector by 22 percent. These objectives were al l met.

3.21 landmarks in the country’s reform progress, and had a substantial impact o n the country’s fiscal situation. In the area o f large-scale case-by-case privatization, 64 large companies were selected for case-by-case privatization, with 14 advised individually and the remaining 50 grouped into five groups o f ten f i r m s linked to one a d v i ~ o r . ~ ’ These 14 f i r m s were the largest loss-making f i r m s in the country (outside the energy sector). At the time o f the mission, 35 o f the 64 f i r m s had been sold, with an additional seven in negotiation, and four more s t i l l considering offers.

P S A L set into motion the sale or closure o f a number o f f i r m s which became

3.22 In the f i rst group o f nine f i r m s (case-by-case), four were sold, including the huge SIDEX steel and ALRO aluminum firms.32 Negotiations are well advanced for the sale o f another large aluminum firm, ALPROM. One firm was offered for sale, but received no offers; the govemment plans to reoffer it. Another firm was restructured, with some constituent parts liquidated and negotiations underway for sale o f the others.

3.23 the Bank, and i t i s intended that two wil l be sold by their branch ministries. The national airline, TAROM, was “shopped” by i t s advisor but found an inhospitable market for airline sales. T A R O M currently has a contract with Lufthansa under which i t s operations are being restructured. Additional attempts will be made to sell the remaining 15 f i r m s o f the 64 large case-by-case privatizations.

Three f i r m s were withdrawn from this privatization process, with the consent o f

3.24 P S A L benchmarks were generally exceeded.33 SOF privatized 45 large SOEs and 717 Small and Medium-sized Enterprises (SMEs) (vs. target o f 15 and 600, respectively), sold residual shares in 255 companies (vs. target o f 160), and reduced losses and subsidies by more than 15 percent (vs. target o f 12 percent). In the fourth program area focused on loss reduction in the mining sector, benchmarks were also exceeded as loss reductions averaged more than 47 percent (vs. target o f 25 percent), and 14 contracts were signed for technical closure and environmental clean-up (vs. target o f six).

In the area o f privatizations undertaken by the State Ownership Fund (SOF),

3.25 however the sale was not successful. The govemment outlined an action plan for the establishment o f an independent regulatory agency for electricity and heat. Similar progress was made in developing an action plan for the liberalization and regulation o f the electricity, telecommunications, railways, and o i l and gas sectors, al l o f which will receive EU assistance.

In the power and utilities sector, a 35 percent stake in Petrom was offered for sale,

3 1. Investment banks were provided with a small retainer and a larger success fee. The presumption was that there would be economies of scale with one firm advising 10 clients. Whi le this was apparently the case in most instances, some officials interviewed believed that advisors mostly concentrated their efforts on the most salable firms.

32. The mission was told that SIDEX alone was losing US$600-900 million per year

33. Firms privatized by SOF were generally sold to local investors, whereas the 64 large f i r m s described in the preceding section were “shopped” internationally (although some were sold to local investors).

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3.26 Figure 3.1 below shows the fiscal deficit from 1994 to 2002. The decline in the deficit from 1999 onwards coincides with the divestiture o f money-losing state-owned banks and enterprises under the PSAL.

Figure 4. Fiscal Deficit as a Percent of GDP, 1992-2002

Fiscal Deficit, as %of GDP

0

-1 n n 8 -2

s u) -3

‘3 -4

-5

-6

r 0

m c

ic a2 U

~~

Source: Romania Country Department

Business Environment

3.27 less dramatic than performance in the banking and privatization areas. Priorities in this area were to strengthen the legal framework for secured transactions, reform the law regulating the Court o f Accounts, improve the tax code, modernize accounting standards, and launch a study to determine ways to reduce administrative obstacles to private sector growth. These objectives were broadly achieved.

Progress in improving the business environment was satisfactory, though perhaps

3.28 prohibited lending by non-bank entities-and was superceded by a L a w on Secured Transactions. This was complemented by implementing regulations and an automated registry for personal property, and permitted a broader range o f financial transactions, including factoring and leasing, and greatly facilitated use o f ~ o l l a t e r a l . ~ ~ The mission was told that nearly 200,000 loans had been guaranteed by collateral registered on the system created under PSAL.

In the f i rs t area, Article 57 o f the Banking L a w was abrogated-which had

3.29 pensioners’ incomes were made subject to personal income tax, and the government withdrew profi t tax exemptions for exporters from the corporate tax base. (However, existing investment tax holidays remain because these legal commitments will be respected.) Overall, tax legislation i s now more consistent with Wor ld Trade Organization (WTO) and EU norms, i s more acceptable to the Bank and the Fund, and i s backed by a program o f implementation support (e.g., public awareness, IT, training).

In the second area, tax reform, significant progress was achieved. Farmers’ and

’

34. The registry permits individuals to check to see if an object may be used as collateral in another transaction, and also greatly facilitates seizure in case o f default.

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3.30 established a reform commission, which developed recommendations (later than envisioned) which as o f end-2002 s t i l l needed to be acted upon.

In the third area o f bankruptcy reform, the govemment amended the law and

3.3 1 issued an ordinance to bring accounting standards in l ine with IAS, and acceptable by- laws were adopted by the Audit Chamber. However, institutional capacity in the audit field i s weak, which undermines the quality o f management information generated by firms, raising the cost o f credit and investment due to higher risks.

In the fourth area o f accounting and audit reform, Ministry o f Finance (MOF)

3.32 Investment Advisory Service (FIAS) surveyed 526 companies and provided recommendations encompassing regulatory reform, corruption, company and tax registration, foreign exchange, property rights, standardization, employment, land and site development, and customs and international trade. Based on these recommendations, in September, 2001, the government approved an Action Plan which i s now being used as a roadmap for measures to improve the business environment (an outline o f the Action Plan i s in Annex D).35 To implement the Action Plan, the government set up an implementation group with representation from the Chamber o f Deputies, the Chamber o f Commerce, Non-Governmental Organizations (NGOs), the business community, c iv i l society, importers, and exporters. Businessmen and representatives o f business groups report that the business environment i s considerably better than i t was a few years ago, i s gradually improving-for example in the effort required to register a business-but that Romania s t i l l needs to accelerate progress and become more business-friendly to meet Westem European norms. The involvement of the World Bank in addressing the BE was thought to be a very positive development.

In the fifth area o f assessing the business (or investment) environment, Foreign

Mitigation of Social Impact

3.33 Achievement in the area o f social cost mitigation was satisfactory. The key priority in the social sphere was to protect those most vulnerable to the negative effects o f downsizing and enterprise closure by providing unemployment benefits, severance pay and a new law for micro-credits for new business start-ups. These objectives were achieved, and close coordination was maintained with the EU’s RICOP program which complemented P S A L and provided financial and retraining assistance to those laid off.

3.34 conditions were broadly met. The framework Law for Collective Dismissals was passed in June, 1999, and the government provided satisfactory evidence that al l eligible workers were paid severance and unemployment benefits. In the area o f targeting assistance to laid o f f workers, pre-layoff services are being rendered, participation i s increasing, and N G O intermediaries are now permitted to provide micro-credits in affected geographic areas. And a communications strategy was implemented to raise public awareness o f the need to actively search for altemative employment.

In the area o f providing sustainable income support to laid o f f workers, PSAL

35. Business groups reported that the process o f implementing the Act ion Plan has given the bus