Document of

The World Bank

FOR OFFICLAL USE ONLY

Report No: 18015

IMPLEMENTAT.ION COMPLETION REPORT

REPUBLIC OF MOZAMBIQUE

SMALL AND MEDIUM SCALE ENTERPRISE DEVELOPMENT PROJECT(Credit 2082-MZ)

June 16, 1998

Private Sector and FinanceAfrica Region

This document has a restricted distribution and may be used by recipients only in theperformance of their official duties. Jts contents may not otherwise be disclosed withoutWorld Bank authorization.

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CURRENCY EQUIVALENTS

Currency Unit = Metical (MT)US$1.0 = 11,850 (April 1998)

ABBREVIATIONS AND ACRONYMS

BM Bank of MozambiqueBCM Banco Comercial de Mo,ambique/Commercial Bank of MozambiqueBIM Banco Internacional de Mo,ambiqueBPD Banco Popular de Desenvolvimento/Popular Development BankBSTM Banco Standard Totta de Mo,ambique/Standard Totta BankCFD Caisse Fran:aise de DeveloppementERP Economic Rehabilitation ProgramPFI Participating Financial IntermediarySMEDP Small and Medium Scale Enterprise Development ProjectULC United Leasing Company

FISCAL YEAR

January 1 - December 31

Vice President Callisto MadavoDirector Phyllis PomerantzSector Manager Thomas AllenTeam Leader Arnold SowaTeam Member Gabrielle Rooz

FOR OFFICIAL USE ONLY

IMPLEMENTATION COMPLETION REPORT

REPUBLIC OF MOZAMBIQUE

SMALL AND MEDIUM SCALE ENTERPRISE DEVELOPMENT PROJECT(Credit 2082-MZ)

TAE,LE OF CONTENTS

PagePreface

Evaluation Summary ..................................................................... i-v

Part I: Project Implementation Assessment .................................................................... 1IA. Introduction ................ 1B. Background ............................................................ IC. Statement of project objectives and evaluation ......................................... . 4D. Major factors affecting the project and implementation record .......................... . 5 E. Project documentation and data ............................ ................................ 5F. Achievement of objectives ........................................................... S5

1. Relieve scarcity of term finance to viable enterprises to develop theindustrial sector ............. .............................................. S5

2. Rehabilitating the banking system's intermediary role for termn lending 13G. Project sustainability ............................................................ 14H. Bank performance . . . 15E. Borrower performance . . . 16J. Assessment of outcome ............................................................ 16K. Future operations . . . 17L. Lessons learned ................................................................... 17

PartII: StatisticalAnnexes ..................................................................... 19

AppendixesA. Mission's aide-memoire ................................................................... 25B. Borrower's contribution to the ICR ................................................................... 28C. Cofinancier contribution to the ICR ................................................................... 34D. Borrower's comments on draft ICR ................................................................... 35

This document has a restricted distribution and may be used by recipients only in theperformance of their official duties. Its contents may not otherwise be disclosed withoutWorld Bank authorization.

IMPLEMENTAT][ON COMPLETION REPORT

REPUBL][C OF MOZAMBIQUE

SMALL AND MEDIUM SCALE ENTERPRISE DEVELOPMENT PROJECT(Credit 2082-MZ)

Preface

This is the Implementation Completion Report (ICR) for the Small and Medium Scale EnterpriseDevelopment Project in Mozambique, for which Credit 2082-MZ in the amount of SDR 25.1 million(US$32.0 million equivalent) was approved in December 1989, and became effective in June 1990.Parallel financing was provided by the European Investment Bank and Caisse Franqaise deDeveloppement.

The Credit was closed in December 1997, one year after the original closing date of December1996. Final disbursements were made on April 17, 1998. Total Credit disbursement was estimated tobe SDR 22.4 million (US$32.0 million equivalent), and an estimated SDR 2.7 million (US$3.6 millionequivalent) will be canceled.

The ICR was prepared by Gabrielle Rooz, and the Team Leader was Arnold Sowa, AFTP1. Itwas reviewed by Ms. Phyllis Pomerantz, Country Director, CD2, Mr. Paul Murgatroyd, Financial SectorLead Specialist, AFTP1, Mr. Brian Falconer, Principal Operations Officer, OS2, and the previous taskmanagers. The Sector Manager is Mr. Thomas Allen. The borrower and Caisse Franqaise deDeveloppement provided their own evaluation that are included as appendixes to the ICR.

Preparation of this ICR was begun during IDA's final supervision mission in September 1997.The ICR mission took place in December 1997 during which the mission discussed the effectiveness ofthis operation with staff of the apex unit, the participating financial intermediaries, and a sample of eightfirn beneficiaries selected at random. The mission members would like to thank them for their kindcooperation and assistance in the preparation of this report. The report is based to a large extent on theirinputs. The report is also based on material in the project file. The report was sent to the borrower andcofinanciers for comment. The borrower contributed to preparation of the ICR by commenting on thedraft ICR.

IMPLEMENTATION COMPLETION REPORT

REPUBL][C OF MOZAMBIQUE

SMALL AND MEDIUM SCALE ENTERPRISE DEVELOPMENT PROJECT(Credit 2082-MZ)

Evaluation Summary

Introduction

1. The Small and Medium Scale Enterprise Development Project (SMEDP) was prepared in 1988to support and complement the Government's Economic Rehabilitation Program (ERP) launched in1987. The project was designed to rehabilitate the industrial andfinancial sectors. The project built onthe short-term import support assistance provided to the industrial sector by external aid and started toaddress the longer-term issue of industrial investment and rehabilitation. To complement this objective,the project sought to rehabilitate the banking sector and to revive prudent investment lending toenterprises. The SMEDP focused on the small-scale enterprises. An ongoing Industrial EnterpriseRestructuring Project was approved in parallel in 1989 and focused on larger scale enterprises.

2. The ERP was the first comprehensive reform program implemented by IDA to assist theGovernment transform a command economy into a market-oriented one. The measures wereimplemented through two Rehabilitation Credits (1987 and 1989) to first address macroeconomicdistortions, sectoral allocations of expenditures, and credit policy. Prior to the ERP, IDA providedassistance to the country through an Economic Action Program initiated in 1984 which was essentiallyviewed as a "quick-fix"-type lending operation and had a limited content policy.

Project Objectives

3. The project's main objectives were to:

* Relieve scarcity of term finance to financially viable enterprises in the industrial, mining, agriculture,transport, and construction sectors.

* Rehabilitate the banking sector's capability to provide term lending.* Assist the Government in formulating an industrial policy.

4. The project included two related components:

* An Enterprise Financing Component (LTS$28.6 million equivalent) for a line of credit to be on-lentby the central bank, through an apex unit, to the participating financial intermediaries (PFIs)

* An Institutional Strengthening Component (US$3.4 million) for technical assistance and training tothe PFIs and staff of the apex unit in the areas of project appraisal and processing.

5. Cofinancing or parallel financing included Caisse Fran aise de Developpement and theEuropean Investment Bank for a total amolnt of US$4.5 million equivalent for the credit line. Thecofinanciers financed eight sub-loans in total, of which one was cofinanced with IDA. Prior toeffectiveness, UNDP financed a pre-operational training program which was continued under the projectfor staff from commercial banks, the apex unit, and IDIL, the public business services agency.

6. The objectives of the SMEDP were relevant but untimely. The project supported theGovernment's first attempts to introduce fundamental changes to transform the economy, revitalize and

develop the industrial sector, and rebuild the banking sector. In this context, the objectives werejustified.

7. Their achievement was, however, largely impaired by two main factors: (a) the difficult politicaland economic environment in which the Government had to manage the transition from a centrallyplanned to a market-driven economy; and (b) weak financial institutions and lack of key reforms in thebanking,sector which were initiated only in 1992. The likelihood of a reversal in macro and interest ratepolicies was then high.

8. Also, the potentially high cost to the financial institutions, which were to channel termn financingto high-risk sub-borrowers under highly unstable political and economic conditions and lacked therequired skills, was not sufficiently recognized. Finally, the adverse effects of the economicliberalization policy on domestic producers during the transition years were not sufficiently taken intoconsideration. Nor were the infrastructure deficiencies caused by an ongoing civil war during the firstyears of implementation with enduring effects throughout implementation.

9. lhe design of the SMEDP reflected the same lack of sequencing found in the different elementsof the enterprise reform policy of the ERP, as well as inadequate attention to their linkages. Two ofthese elements were: (a) the commercial and legal framework, in particular lack of enforcement ofcommercial contracts, as reflected in the accumulation of bad debt in the productive sector and betweenthat sector and the financial sector, because of past commercial practice and state credit provisions; and(b) delayed reform of the banking sector. The legacy of the former contributed to the high default rate onsub-loans. Delayed reform of the banking sector led to the macroeconomic instability which dominatedduring much of implementation. Monetary leakages through the two former state-owned banks generatedmonetary instability and the consequent macroeconomic instability. The combined effect of a weakbanking sector and macroeconomic instability was one of the major factors contributing to the project'spoor results.

Implementation Experience and Results

10. Overall, the project did not achieve its objectives. Although most of the funds from the creditline were disbursed, IDA's transferred resources did not finance viable investments, based on a currentlyhigh default rate of 73% on the sub-loans. Training to upgrade commercial bank staff skills in projectappraisal and processing techniques did not yield the expected results, also as evidenced by the highdefault rate.

11. The credit line financed a total of 134 sub-projects, of which 63% were new projects. Thelargest share of total investment and number of sub-loans were in the industry and manufacturing sectors(27% each), with a 55% concentration in Maputo. Investmnents were expected to generate a totalemployment of 5,029 jobs, at a cost of US$5,627/job (ex-ante). Based on actual data from onecommercial bank and an 8-firm sample visited as part of the ICR mission, a combined total number of664 jobs were created, for a total sub-loan amount of US$3,044,419, at an average investment cost/jobof US$4,585. Thus, 10% of IDA funds created 664 jobs. If all loans were good loans, the actual jobcreation would be close to the appraisal estimate of 6,000. However, although firms' performance couldimprove if the current economic trends continue, the present uncertain status of many firms tends tomake the overall employment creation questionable.

12. Initially, three commercial banks participated in the on-lending program--two state banks whichwere privatized towards the end of the project, and a private bank. Two additional PFIs, one privatebank ancl one leasing company, participated in the program toward the end of the project. The twoformer state banks on-lent 87% of IDA funds and together accounted for almost all defaulting sub-loans.

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13. The project was implemented in an unstable political and economic environment and duringperiods of high inflation. Although interest rates were liberalized in 1994, they remained at fixed andnegative levels until end of 1996, as the necessary pre-conditions for a market-driven financial systemwere absent. One of the major causes was the predominance in the banking system of state-owned bankswhich had operated for years with relatively poor commercial cultures in a non-competitive environmentand under a system of state-directed credit allocation.

14. Lending rates, both on commercial loans and sub-loans, were negative in real terms during mostof project execution. Real negative rates resulted in attractive subsidies for the sub-borrowers. If themajority of problem sub-projects does not prove financially viable overtime, these implicit subsidiescould add to the country's already excessive debt burden, further worsening its debt service paymentcapacity. Finally, negative rates discouragedl domestic resource mobilization, which in turn perpetuateda scarcity situation and adversely affected the project's sustainability.

15. Achievement of the institutional strengthening component, which accounted for only 11% oftotal Credit, was unsatisfactory. Skills of commercial bank staff in accounting, project appraisal andprocessing were deficient and did not improve significantly. The pre-operational training program wasinsufficient, both in scope and duration. Of a total of 50 staff who received training, only three were leftin the banks' credit department, two in one bank, and one in the other. Financial assistance provided tothe firms for assistance in developing business plans, but without the adjunct ongoing technicalassistance, resulted in poor appraisal of the financial viability of the sub-projects contributing to the highdefault rate. Local private and public entities did not have the required skills in this area to providemeaningful support services to the firms. The objective of establishing an apex unit to create a long-termstructure for future IDA or other donor credit lines was not achieved.

16. Project Sustainability. The project was implemented under highly uncertain conditions. Theproject, as designed and carried out under thlese conditions, is not sustainable. Changes which wouldpave the way for macroeconomic stabilizatiion started to take place in 1995, with 1996-1997 as thetransition years. It remains to be seen how the firm beneficiaries will perform over a given time horizon,or the survival rate, under the current much improved economic conditions. Only then can true rates ofreturn, both financial and economic, be measured, hence the project's impact on the firm beneficiaries.The project's sustainability in terms of financing productive capacity is thus uncertain. However, whilenot quantified, a large number of sub-projects may have had negative returns, and those sub-projectswhich will survive are likely to have low returns because of the long delays in project benefits. Theproject's sustainability in terms of building the PFIs' capacity to provide ongoing term lending isunlikely.

17. Bank performance. The project was prepared and implemented during a period of fundamentaleconomic and institutional reforms. The Bank's assistance to the country was hindered by a highlyuncertain political situation following the aftermath of 16 years of a civil war which ended in 1992.However, in the rush to provide term lending to help the Government relieve a scarcity in term financingto small firms, and in the absence of a developed private sector, the Bank over-relied on state-owned orcontrolled public entities as participating agencies. While the Staff Appraisal Report (SAR) correctlyhighlighted the limitations of the Business Environment Study which provided the basis for projectdesign, the project was nonetheless prepared on the Bank's optimistic assumptions as to the pace of thereform program. Neither the study nor the SAR were complemented by sufficient financial sector work.One fundamental flaw in the project design, which was also found in the overall reform program, was tohave failed to recognize the crucial linkages between the financial and real sectors. BecauseMozambique was considered a strategic country at the time, recommendations of the Levy report werenot taken fully into account. Neither were OD 8.30 during implementation. With the benefit ofhindsight, the project should have been substantially delayed and/or designed as a small pilot operation,as opposed to a full-fledged investment pn)ject, given the uncertainty as to the pace of the reform

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program, lack of knowledge about the SME sub-sector, and the country's very low institutional capacity.Supervision tended to focus on improving the slow disbursement rates, at the expense of project impact.While corrective actions were taken following a change in task management at the end of the project, bysuspending on-lending of funds through the two state banks, these actions failed to have an effectiveremedial impact, as most funds were already disbursed, and the project was about to close. Borrowerperformance. Until their privatization, the Government's inadequate control over the two state bankswas largely responsible for its failed monetary policy, resulting in high inflation. Project performancewould have benefited from the apex unit's greater involvement in the monitoring and supervision of sub-projects, especially given the poor recovery rate on the sub-loans.

Assessment of Outcome

18. Based on project results, project outcome is unsatisfactory.

Future Olperations

19. Measures to build on reforms already achieved under prior adjustment operations are part of theproposed Economic Management Reform Credit (FY99). The EMRC will particularly focus on fiscalreforms and on improving the business environment to foster private-sector-led growth. Fiscal reformswill include financial deepening and better coordination between monetary and fiscal policies, andprivate sector measures will aim to establish a legal and administrative framework in line with market-driven economic structures. A follow-up investment operation is also slated for FY99.

20. Notwithstanding substantial achievements in macroeconomic policy and privatization programsover the last five years, private-sector growth response has been modest, especially with respect to localMozambican-owned firms. The proposed Mozambique Enterprise Development Project (the PoDE) willaim to improve the business environment and accelerate broad-based economic growth through capacitybuilding of private firms and institutions. Particular emphasis will be placed on developingMozambican-owned firms' export potential and linking domestic suppliers with foreign investors.Specifically, the project will: (a) assist enterprises in raising the technical skills of their management andworkers; (b) provide financial resources for export development and enterprise technology upgrading;and (c) improve private and Government institutions' capability to deliver support services to thebusiness community.

Key Lessons Learned

21. The key lessons learned are:

* Implementation of this project confirms the validity of OD 8.30 which were not rigorously followedduring project implementation, particularly with respect to term lending under high inflationaryperiods and by weak institutions, and distortions created by directed credit and targeted creditsubsidies, in particular interest rate subsidies. Lines of credit are not useful tools when implementedunder unstable economic and business conditions because risks associated with new investments aretoo large.

* Lines of credit are not the appropriate instruments to address sectoral policies. Lines of credit aremost likely to be adversely affected by macro and sectoral distortions which are best addressed in anoverall macroeconomic policy framework. Continuing commitments under FILs should be linked tothe effective implementation and maintenance of a satisfactory policy framework, a justifiable pre-condition for an IDA line of credit as well as for its successful implementation.

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+ It is very difficult to stop commitments under a project which has no clearly established ongoingconditionalities once the project has been launched. Ongoing sub-project commitments should beexplicitly linked to project performance. Project implementation design should include explicitmonitoring performance indicators to assess the continued eligibility of financial institutions andother entities, public or private, sub-project performance, and technical assistance impact.

* The financial sector should not be viewed essentially as a "non-real" delivery mechanism to supportthe real sector, with little inherent importance in itself. Prospects for success are poor when PFIs areunsound and lack the skills and commercial orientation necessary to make good credit decisions.

+ It is very difficult to take a financially poorly performing bank with non-commercial objectives andweak management--characteristics most likely to be found in state-owned than private banks--andturn it into an effective financial interme,diary.

* Interest rates should be variable to allow the pricing of capital to be market-determined and to reduceinterest rate risk for lenders and borrowers. During high inflationary periods, an indexingmechanism might be best, as opposed to Government-adjusted rates, although experience such as inBrazil has shown that indexing tends to perpetuate inflation. An indexing mechanism might also beapplied to Government's fee for currency risk coverage, if the Government is to bear the cost offoreign exchange. Proceeds from the fee should be deposited in a fund in a commercial bank to earninterest.

* Implementation of the project raises the usefulness of "quick-fix"-type lending operations in highlyuncertain conditions. When local capacity is low, and/or fundamental economic and sectoral reformsare underway, a small pilot project and more prolonged training programs are more suitable than afull-scale operation to fully take into account the time factor during the transition years, and adaptand build knowledge about the (sub)sectors involved. The pilot project should include a simple,straightforward, and focused approach to reduce the final costs to the banks and firms. The approachshould also be sufficiently flexible to allow for changes as needed in project execution.

* Technical assistance to build SMEs' capacity is as important as their access to capital. This technicalassistance need not be a supplement to sub-loans, but could be a stand-alone component. It shouldbe demand-driven.

* The apex unit should be managed under a management contract arrangement. This is especiallycrucial if the objective of setting up an apex unit is to transfer the monitoring and supervision aspectscloser to the financial intermediaries ancl final beneficiaries. Monitoring indicators should be set toassess the unit's operating performance. Finally, in addition to monitoring a database on sub-loansand projects, the apex unit should possess or develop an analytical capability to assess the project'simpact on an ongoing basis. This would allow introducing needed changes in the project scopeand/or design throughout implementation. Under this project, the apex unit is meant to be a "sunsetorganization".

PART 1: PROJECT IMPLEMENTATION ASSESSMENT

A. Introduction

1. The Small and Medium Scale Enterprise Development Project (SMEDP) was prepared in 1988to support and complement the Government's Economic Rehabilitation Program (ERP) launched in1987. The project was designed to rehabilitate the industrial andfinancial sectors. The project built onthe short-term import support assistance provided to the industrial sector by external aid and started toaddress the longer-term issue of industrial investment and rehabilitation. To complement this objective,the project sought to rehabilitate the banking sector and to revive prudent investment lending toenterprises. The SMEDP focused on the small-scale enterprises. An ongoing Industrial EnterpriseRestructuring Project was approved in parallel in 1989 and focused on larger scale enterprises.

B. Background

2. In the years preceding preparation of the SMEDP, the effects of years of civil war and a centrallyplanned economy since the country's independence from Portugal in 1975 were devastating. Socialindicators were among the worst in the world. An estimated 60-70 percent of the population lived inabsolute poverty, the agriculture sector was below subsistence levels, and internal fighting and sabotagehad destroyed much of the rural infrastructure, Real GDP declined by an estimated 12.8 percent p.a. onaverage in 1980-87, and share of industry, as a % of GDP, by 22 percent on average over the sameperiod. As a result of a deterioration in the country's export and import capacity, Mozambique becameoverly dependent on emergency assistance and external aid, with an external debt stock equal to 3.5times GDP and 45 times exports. Finally, the country's extremely weak institutional capacity could beimproved only by training an entire new generation, "a task that would take more than a decade".'

3. The adjustment process to overhaul the economy from centrally planned to market-oriented wastackled by successive adjustment programs and credits, supported by the IMF and other donors. The firstIDA Credit to Mozambique was the Rehabililation Program in 1984. The Credit had a limited policycontent and was viewed essentially as a "quic]k-fix"-type lending operation. It supported some specificproducer price reforms and changes in Mozambique's import procurement procedures. The Credit wassuccessful in establishing a Bank/Government dialogue on, and commitment to, structural adjustmentand the Bank's central role in the process. It was followed by the more comprehensive EconomicRecovery Program (ERP), 1987-89. The program's adjustment measures were included in the SecondRehabilitation Credit (1987) (SRC) and the Third Rehabilitation Credit (1989) (TRC).

4. The ERP's broad objective was to create greater reliance on market mechanism, reduce stateintervention in economic activity, and integrate the national economy within the international economicenvironment. The reform program's primary strategy was to re-establish a market-based incentivestructure in the productive and distributive sectors. Initial reforms of price and import controls weresupported by the SRC and TRC, as well as the first Credit. All three Credits were largely effective inimplementing these reforms and maintained the impetus for change, despite the adverse effects of theinsecurity situation until the signing of the FPeace treaty in 1992, and the severe drought of 1991-92which devastated the agricultural sector. Anothler external shock was the country's loss of key markets inEastern Europe when aid from, and trade with, the former Soviet Union stopped in 1991, resulting in lossof foreign exchange of over 8 percent of GDP.

5. In 1987, at the start of the ERP, as in 1989 when the TRC and the SMEDP were prepared, theprimary problem faced by the Bank and the Government was to design a set of reforms in the context of

' World Bank. Mozambique, Financial Sector Study, Report No. 10269-MOZ, September 1992.

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an ongoing war situation. It was recognized that the uncertain situation would markedly impact on theresponsiveness of changes to the reforms. Consequently, the reform program was designed based on agradualist approach to take into account the war situation, the time required to allow the population toadjust to a fundamentally different economic and social environment, and the severe constraints on thesupply side, including infrastructural deficiencies.

6. Throughout the 1989-95 adjustment period, major progress was made towards relaxation ofpricing controls and adoption of prices more closely linked to international prices. However, this processled to domestic industry facing increasingly intense international competition for which it was not wellprepared. ]First, the obsolete production processes and grossly distorted financial structure placed it in aweak positiion. Also, although domestic prices had been realigned with the international price structureto a considerable extent, the effectiveness of the reform program was seriously hampered by the failureto unite the parallel and official product markets. This failure was caused by the influx of emergencyassistance, of which a large percentage was illegally finding its way to parallel markets; the increasedflow of illegal imports from neighboring countries; the tax evasion in the parallel markets, both oninternational trade and domestic transactions, rendering domestic producers uncompetitive (and reducingthe revenue flow to the government); the continuing, although not as large, overvaluation of the localcurrency. Substantial imports into the domestic economy through parallel market channels werefacilitated by the ineffectiveness of the national customs system and the fiscal system's deficiencies.

7. Effectiveness of the reform program in the areas of enterprise and financial sector reforms wasalso limited. State ownership of the productive enterprises and financial institutions was still dominant.Reforms in the financial sector had been viewed as less of a priority as reforms in the enterprise sector,and were delayed as a result. Failure to recognize the crucial linkages between the two sectors was toseverely imipact on successfully reforming the enterprise sector. The banking sector was supporting loss-making state enterprises. The design of the SMEDP was based on the same oversight of the linkagesbetween the financial and real sectors as in the reform program. Delayed reforms of the banking sectorled to the imacroeconomic instability which dominated during much of the execution of the SMEDP.Monetary leakages through the two state-owned banks generated monetary instability and the consequentmacroeconomic instability. The combined effect of a weak banking sector and macroeconomicinstability was one of the major factors contributing to the project's poor results.

8. The next adjustment operation was the Economic Recovery Credit (FY92) which supported theearly phases of financial sector reforms, and further integration and liberalization of the exchange rate.This Credit was followed by the Second Economic Recovery Credit (SERC) (FY94) and the ThirdEconomic Recovery Credit (TERC) (FY97). The SERC focused on strengthening fiscal and monetarypolicy and an interlinked program of enterprise and financial sector reforms. One of the majorachievements of the SERC was to establish macroeconomic stability and low inflation throughsuccessful reforms in the financial sector--privatization of state banks, opening up of the sector to anincreasing number of private banks, bringing in more competition and resulting in more and betterfinancial services. Macroeconomic stability was also achieved through the privatization of stateenterprises which represented the large, non-performing borrowers from the banking system. Theongoing Industrial Enterprise Restructuring Project was restructured in 1994 to provide more focusedtechnical assistance to privatized firms which also contributed significantly to the acceleration of theprivatization program. The privatization program in turn contributed to a faster eco-iomic growththrough increased industrial output.

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9. Macroeconomic Indicators, 1987-1997'

. A ------_ ---------Actua --------------------- 997 Estimates1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 DNP* INE*

Real GDP Growth Rate (%) 4.6 8.2 6.5 0.9 4.9 -0.8 18.8 4.5 1.4 6.4 7.9 7.9Inflation (end-period) (%) - 49.4 35.0 47.1 35.2 54.5 43.6 70.2 54.1 16.6 5.8 5.8Private Investment/GDP 18.8 21.1 18.9 23.7 26.0 31.1 38.0 30.1 32.2 31.5 25.8 13.6Public Investment/GDP 17.3 22.2 21.46 20.9 19.7 17.6 16.4 20.9 19.0 16.8 19.3 14.3GrossDomestic SavingslGDP -2.4 -2.1 -6.7 1.5 4.5 5.5 10.4 5.7 18.0 19.9 22.5 11.1Gross National Savings/GDP 2.2 12.4 3.2 15.2 12.5 15.8 19.6 15.7 17.7 17.5 21.7 11.3Public Sector Surplus -22.9 -27.0 -24.8 -29.2 -24.9 -26.3 -22.2 -29.7 -20.8 -17.0 -20.1 -14.9(Deficit)/GDP /1Real Effective Exch. Rate/2 -61.0 -36.0 3.0 0 -16.0 -24.0 -1.0 -1.0 -4.0 4.0 10.0 10.0Exports (GNFS)/GDP 13.0 15.7 16.0 16.0 21.8 23.7 21.3 24.3 27.4 27.6 26.4 19.5Imports (GNFS)/GDP 51.4 61.1 63.:3 59. 63.0 66.9 65.3 69.6 60.6 56.0 49.0 36.2Cuffent Account /GDP /3 -25.4 -23.3 -28.2 22.0 -16.5 -18.6 -21.9 -20.5 -22.7 -22.4 -13.4 -9.9Total Debt Service/GDP /4 40.5 43.2 37. 34.6 34.1 40.7 34.1 32.0 28.4 21.8 18.1 13.4

Source: CAS 1997. /1 = excl. grants; /2 percent change; (-) = devaluation; /3 = after grants. /4 = total debt service due before debt relief, including IMF.DNP = National Planning Commission; INE = National Statistics Institute.

10. Economic growth. Real GDP growth hides important annual and sectoral variations. In 1993,the year following the peace accord, GDP growth is estimated at 19 percent p.a. as the influx of refugeeswere returning to the rural areas and resumed agricultural production. By contrast, in the same year,industrial production fell sharply. The declining trend was reversed in 1995 when manufacturing outputincreased by 18.5 percent following the privatization of large, loss-making state enterprises. Thetransport and commercial sectors also experienced strong growth over the same period, estimated to be6.4 percent in 1996 and 7.9 percent in 1997.

11. The financial sector. At the time the SMEDP was prepared, the financial sector included theBank of Mozambique (BM); Banco Popular de Desenvolvimento (BPD), a second state-owned bankwhich was largely directed to the agriculture sector; Banco Standard Totta (BSTM), a private bank; anda state insurance company. The Bank of Mozambique was the central bank as vvell as the largestcommercial bank. Its primary function was to meet the needs of the centrally planned economy.Banking services were limited to accepting deposits, to be lent out to Government and state enterprises.The Bank undertook the first sector study in 1992 which served as a basis for outlining a reformprogram. The study stated that as far as the financial sector of Mozambique was concerned, it was morea matter of forming, rather than reforming one.

12. One of the first priorities was to separate BM's central and commercial banking functions. Theseparation was completed in 1992 by establishing the Bank of Mozambique as the central bank and theseparate Commercial Bank of Mozambique (BCM). While this measure resulted in producing a cleanbalance sheet for the central bank, it did riot address structural problems, and the accumulated non-performing loans from state enterprises for the period 1987-1992, representing 4 percent of GDP, weretransferred to BCM. Measures to rehabilitale, restructure, and privatize BCM and BPD were supportedunder the Second Economic Recovery Program in 1994. BCM was first restructured owing to itsextremely poor financial condition: the bank's losses were equivalent to 12 percent of GDP. It waseventually privatized in July 1996 when it became difficult to keep its lending operations within agreedcredit ceilings. BPD was privatized in September 1997. Prior to their privatization, the Government'sinadequate control over the state banks was largely responsible for its failed monetary policy. In 1996,immediately before their privatization, a substantial financial deterioration in the two banks caused themto run excessive overdrafts.

2 Statistical data (level of GDP and ratios to GDP) from the National Planning Commission (DNP) tend to be somewhat misleading due toinadequacies in the national accounts. The Govemment has, recently adopted statistics from the National Statistics Institute (INE) as officialdata, starting with the year 1991. Statistics from DNP are used in this report for time series purposes, but [NE 1997 estimates are also shown.

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13. Over the life of the project, Mozambique's financial sector gradually evolved from apredominantly state-controlled system to one which is now fully private. These changes wereprogressively reflected in the type of financial intermediaries participating in IDA on-lending program.By project completion, two additional private intermediaries were channeling funds from the line ofcredit (Banco International de Mozambique (BIM) and United Leasing Company (ULC)). However, theimpact of an emerging competitive financial market had relatively little effect on the project's outcomeas these changes took place towards the end of the project. Hence, with respect to the participatingfinancial intermediaries, the focus of the report is on the three commercial banks which participated inthe on-leiading program from the outset: BCM, BPD, and BSTM.

C. Statement of Project Objectives and Evaluation

Overall objective * Support and complement the ERP reforms by rehabilitating the financial and industrial sectors.

Main objectives + Relieve scarcity of term finance to viable enterprises, building on the short-term importfinancing assistance provided so far by the donor community

* Rehabilitate the banks' capability to provide term lending+ Assist the Government in formulating an industrial policy

Line-of-caedit * US$28.6 million equivalent (Enterprise Financing Component)* Funds on-lent by the apex unit to PFIs.

Technical assistance * US$3.4 million equivalent (Institutional Strengthening Component).and trainingCofinanciers * Caisse Franaaise, European Investment Bank, for a total of US$4.5 million equivalent.

14. The objectives of the SMEDP were relevant but untimely. The project supported theGovernment's first attempts to introduce fundamental changes to transform the economy, revitalize anddevelop the industrial sector, and rebuild the banking sector. In this context, the objectives werejustified.

15. Their achievement was, however, largely impaired by two main factors: (a) the difficult politicaland economic environment in which the Government had to manage the transition from a centrallyplanned to a market-driven economy; (b) weak financial institutions and lack of key reforms in thebanking sector which were initiated only in 1992. The likelihood of a reversal in macro and interest ratepolicies was then high.

16. Also, the potentially high cost to the financial institutions, which were to channel term financingto high-risk sub-borrowers under highly unstable political and economic conditions and lacked therequired skills, was not sufficiently recognized. Finally, in addition to infrastructure deficiencies, theadverse effects of the economic liberalization policy on domestic producers during the transition yearswere not sufficiently taken into consideration.

17. As stated in para. 7, the design of the SMEDP reflected the same lack of sequencing found in thedifferent elements of the enterprise reform policy of the ERP, as well as inadequate attention to theirlinkages. Two of these elements were: (a) the commercial and legal framework, in particular lack ofenforcennent of commercial contracts, as reflected in the accumulation of bad debt in the productivesector and between that sector and the financial sector, because of past commercial practice and statecredit provisions; and (b) delayed reform of the banking sector.

5

D. Major Factors Affecting the Project and Implementation Record

18. The major factors undermining the project's success were then, to a large extent, the combinedeffects of the above factors:

* An unstable political and economic environment.* Failure to take into account in the project design the gradualist approach of the ERP.* Failure to recognize the linkages between the financial and real sectors in the preliminary sector

work3 which provided the basis for project design. This resulted in lack of financial sector work tocomplement the preliminary study

* Because Mozambique was viewed at the tirme as a strategic country, recommendations from the 1989Report of the Task Force on Financial Sector Operations4, and subsequently OD 8.30, were not takenfully into account, especially with respect to term lending in high inflationary periods and distortionscreated by directed subsidized credit.

+ The Bank's over-reliance on state-owned or controlled public entities as participating agencies: state-owned banks, as financial intermediaries vhich did not have the incentives to make proper decisionsin the allocation of capital; and IDIL, a state-run business advisory services, in the rush to provideterm lending to help the Government relieve a scarcity in term funds to small firms, and in theabsence of a developed private sector.

+ The Bank's emphasis on disbursement rates to measure project performance, rather than actualimpact.

19. The project was appraised in April 1989 and negotiated in June 1989. The Credit was approvedby the Board in December 1989, signed in February 1990, and became effective in June 1990. Theclosing date was extended by one year, from December 31, 1996, to December 31, 1997 to allow fordisbursements on committed funds.

E. Project Documentation and Data

20. During implementation, the apex uniit maintained a large database of basic raw data on thelending program: sources and uses of funds, sectoral and regional distribution, and expected jobcreation. Unfortunately, data on file were not updated after the sub-loans were approved and disbursed,and no data were kept on the status of sub-loans or on the actual performance of the firms. Statisticalinformation presented in this report is based on these ex-ante data, as well as available data collectedfrom the PFIs during the ICR mission, and interviews with the PFIs and a sample of eight firms selectedat random. The PFIs (mainly the former two state banks whose combined shares represented 87 percentof total lending from IDA funds) did not monitor their internal costs associated with the sub-loans. TheICR mission was not able to obtain financial statements from the PFIs, especially the former state banks,to calculate basic financial ratios, such as earnings performance and exposure, or age of, and trend in,arrears. Visited firms did not produce financial statements or records to permit a re-assessment of ratesof return on their sub-projects.

F. Achievement of Objectives

(a) Relieve scarcity of term foreign exchange financing to viable enterprises to developthe industrial sector

3World Bank. Mozambique - The Development of Industrial F'olicy and Reform of the Business Environment, Report No. 7795, May 1990.

4World Bank. Report of the Task Force on Financial Sector Operations, No. R89-163, August 1989.

6

21. The credit line under the Enterprise Financing Component was to provide foreign exchangefor fixed asset investment; associated incremental permanent working capital; and consulting services forproject preparation. The following table shows the financing arrangements under the project for the lineof credit:

Financing Arrangements

Disbursement Mechanism On-lending Mechanism Repayment Mechanism

Terms: 40 years, standard100 percent FE -70 percent LC IDA Grace period: 10 years

Interest rate: 0.75 percent_ ~~~bears cuffency nsk

refinance 90-80 percent * Central Ban fee to PFIs: 73/65 % PFI current account debit mechanismn0 Apex Unit on final on-lending rate same due dates as those on individual sub-loans

l ~~~changed to 50% in 1993

30 percent of LC bears credit risk on full1 ~~~sub-loan value

Sub-loan denominated and repaid in local currency10-20 percent equity Firms Maturity: 3-12 years

On-lending Interest Rate: payable every 3 monthsGrace period: : 1-4 years

FE= foreign exchange; LC = local costs. 4 90 percent for expansion/rehabilitation projects. 80 percent for new projects.

22. Resource Transfer. About US$28.8 million, outof an initial allocation of US$28.6 million equivalent, IDACreditAllocationMbPFIwere disbursed under this component.

23. Participating Financial Intermediaries (PFIs).IDA Credil; allocation among the PFIs closely reflected BCM 20%

the banks' relative share in the banking sector: BCM 67 67%percent, B]PD 20 percent, and BSTM 5 percent. Bycontrast, lILC's 6 percent share was relatively high,especially given the leasing company's late participationin the on-lending program, in the last year of the project.On the other hand, BIM's 2 percent participation was lowrelative to the bank's size in the sector. Source: Apex unit.

24. The enterprise financing component of US$28.8 million equivalent supported a total investmentof about M4ts. 431.8 billion, or US$81.4 million equivalent. Of this amount the EIB and CaisseFranqaise de Developpement financed in parallel about US$4.5 million equivalent, or 6 percent, the PFIsabout Mts 76.7 billion from their own funds, or 18 percent, and the firms about Mts. 115.1 billion, or 27percent. Thus, total local contribution to the credit line represented 44 percent of total investment. Firms'participation was their equity contribution to total investment costs, of 10-20 percent. PFIs'contribution, as recorded by the apex unit at the time of sub-loan approval, represented the local costscomponent of the sub-loan: the working capital portion of the sub-loan, and/or IDA 30 percent localcosts requirement when not covered by the firms. Under the project, PFIs were not required to havedirect exposure, although their participation was estimated at appraisal to be about 7 percent.

25. In reality, the banks' contribution was greater. Additional loans from the PFIs to the firms, atcommercial rates higher than the subsidized on-lending rates, resulted from frequent cost overrunsexperienced by the sub-projects, compounded by unpredictable inflation. The cost overruns were in largepart due to lengthy (one year on average) procedures in the complete approval/disbursement cycle. Theywere also due to additional financing needs for working capital requirements resulting from

7

underestimated initial investment costs. BCM reported an average 30 percent increase beyond its initialcontribution. Requiring a greater equity participation from the firms was seldom a workable alternativesolution as they did not have the resources. Most of them had already found the 20 percent equityrequirement difficult to meet. (Normally, new investment projects should not have leverage higher than2:1, except in very unusual low-risk situations. New, very risky sub-projects, such as those financed byIDA line of credit, had very high debt/equity ratio, which was likely to undermine the financialconditions of the PFIs.) In no case was the sub-borrower's equity investment re-assessed after the sub-loan was approved, nor was the debt/equily ratio recalculated. Finally, because of exceptions to theglobal credit ceilings in effect under the IMF program granted to "special" programs, including the IDAline of credit, the 1992 sectoral study raised the issue of leakages through the banking system contributedby the line of credit (and other donors) adding to an already difficult monetary control situation.

26. The effect of this increase on the PF'Is' portfolio was mitigated by the small proportion the creditline represented as a percentage of their overall lending portfolio: BPD 9 percent and BSTM 6 percent.BCM's figure was not available for preparaltion of the report, but was also assumed to be low. While thebanks indicated that IDA funds relieved a scarcity in term credit to credit-constrained enterprises, theyshowed a mixed response to the on-lending program for the reasons explained below.

27. First, as stated above, since the PFIs were allowed to circumvent credit ceilings by lending fromthis credit line, they used the IDA line of credit only to complement the ceilings--although not alwaysadhered to by the former state banks, nor reinforced by the Government for state banks. The banks wereinclined to sidestep this credit to offer more attractive short-term commercial loans to their customersbecause of higher spreads on commercial loans and lending restrictions associated with the directedfunding element of the credit line. In doing so, they were able to take advantage of the substitutability,albeit limited and distorted, in the local financial markets. This was certainly the case for BSTM, theprivate bank and the only bank to abide by credit ceilings.

28. Second, PFI use of their own resources resulted in a term mismatch of their balance sheet,given the short-term nature of deposits in Mozambique.

29. - --Third, the banks indicated that, without the IDA line of credit, they would not have channeledresources to small sub-borrowers because of- inadequate collateral, high risks, and high transaction costsrelative to the size of the loans. Added incentives resulted from the Government assuming the currencyrisk and sub-loan repayments in local currency.5 BSTM circumvented high transaction costs associatedwith high-risk sub-borrowers by lending only to long-time customers with an established track record.This practice largely eliminated the need for' project evaluation for which the bank did not have staffingresources.

30. Fourth, poor loan collection under the line of credit reduced the banks' profitability. Reducedprofitability could only reinforce the banks' bias against small firms and will make it difficult for themto include these firms into their normal lending portfolio. This in turn affected the program'ssustainability.

31. The fifth and last factor was the relatively high fee charged by the central bank on the PFIs' finalon-lending rates to the firms to cover the apex unit's operating costs and the Government's currency risk,resulting in unfavorable spreads to the PFIs. This spread was initially set at 73 percent of the final on-lending rate for sub-loans up to seven years, and 65 percent above seven years. It was later changed to

5Since the banks did not monitor their internal costs associated with the sub-loans, it was not possible to deterninethe magnitude of costs related to the processing and supervision of sub-loans and risks, if any.

8

50 percent for all new sub-loans following the project mid-term review in November 1993, when thehigh spread was recognized as a major deterrent to PFI participation. As no market-determined interestrates existed at the time, this method was used as opposed to the central bank charging the PFIs theirmarginal (or average) cost of capital. The banks indicated that this fixed cost, even amended, contributedto their negative returns.

32. In 1996, the central bank established, as its minimum on-lending rate, a reference base ratewhich closely followed the discount rate, but which was always set below the discount rate. Should thefinal on-lending rate charged by the PFIs to the firms be lower than the reference rate, the central bank'sfees were charged on the reference rate in order to ensure an adequate cost coverage for the central bank.At Credit closing, the reference rate was 12 percent, compared to the discount rate of 12.95 percent.

33. On-lending Rates. Under the terms of the project, on-lending rates on sub-loans were to bevariable and market-determined. On-lending terms and conditions, and progress in achieving positiveon-lending rates in real terms were to be reviewed annually by IDA and the Government if review of thegeneral interest rate structure was no longer undertaken under an ongoing IMF program.

34. UJntil 1994, when interest rates were liberalized, the Government followed a policy ofadministratively fixed rates, which were adjusted in 1991 to positive real levels and fluctuated betweenpositive and negative in real terms in 1992-1993. However, even when fully liberalized, interest ratesdid not respond to market forces because the pre-conditions for a market-driven system to work were notin place. A major cause was the predominance in the banking system of state-owned banks which hadoperated for years in a non-competitive environment and under a system of state-directed creditallocation.

100-90 CAmual Inflationso * * w~ ;;;; Ct ~ ~ ~ Subloan Rate7060 - Commercial Rate5040

20 ~~~~~~~~~~~~~~~~~~~~~~~~- - - Subloan Rate10

-10-20 - - - Subloan real rate-30-40-so-60 -- 2Commercial real

91 A J 0 92 A 3 0 93 A J 0 94 A 3 0 95 A J 0 96 A 3 0 97 A J 0 rateMonth

Sources: Commercial banks, Bank ofMozambique, National Statistics Institute.

35. Thus, during the 1994-96 transition period from a state-controlled to market-oriented system,commercial rates remained fixed and negative in real terms. IDA sub-loans (and other donors' lines ofcredit) benefited from a preferential rate, fixed by the Government below the commercial rate, to induceborrowing by the targeted small firms. The result was an attractive subsidy for small firms as theirborrowing cost did not reflect the true opportunity cost of capital. At the end of 1996, with a substantialfall in inflation, real rates turned positive. Small firms who contracted their debt when rates were heavilysubsidized saw an unexpected real increase in their debt-servicing obligations contributing to collectiondifficulties.

36. Given rising inflation and real negative rates on average during project implementation, thebanks would have found it difficult to earn a positive rate of return on their assets and maintain a real

9

return on their capital (not only on the credit line but on their overall portfolio as well), resulting in anerosion of their capital base, even if high bad debt had not caused losses. Losses resulting from a highpercentage of bad loans (on their overall portfolio, including the line of credit) contributed to adeterioration of their portfolio.

37. At the end of 1996, BSTM which had 100 percent good sub-loans indicated it was able to earn anominal profit margin of 5 percent, which it found adequate. On the other hand, BCM and BPD reportedthat they could not post positive margins on the sub-loans which were transferred to them when theybecame private banks as the two banks on-lent the majority of bad sub-loans. At Credit closing, on-lending rates charged by the commercial banks still followed closely the commercial rates of 19-25percent. BCM's gross spread on on-lending rate was 10 percent, BPD 12.5 percent, and BSTM 9percent. BCM was negotiating with the central bank a reduction in the 50 percent servicing fee.

38. Currently, the 19-25 percent commercial rates in Mozanbique are high relative to the estimatedlow inflation rate of 5.8 percent. This is because, although a number of reforms have been put in place,the banking sector is still underdeveloped and cash-based. Banks, which have weak treasurymanagement, tend to hold a high percentage of non-earning assets (equal to about 30-40 percent ofdeposits) as excess reserves to respond to the cash needs of their clients. This increases the spread theyrequire between deposits and lending rates. Another factor is the relative lack of competition amongbanks.

39. Recovery Performance. The arrears situation remained serious, as shown in the table below.

Total no. of No. Paying No. Rescheduled/ No. in No. inPFIs active sub-projects Regularly Paying Irregularly No. Defaulting Grace Period Collection Process

BCM 89 6 37 41 3 2BPD 23 2 4 9 4 4BIM 1 - - - 1 _

BSTM 8 6 - 2ULC 13 8 1 - 4

Total 134 22 42 50 14 6

40. The overall default rate of 73 percent (excluding sub-loans in grace period) was mainly theresult of poor lending by the former state banks, with a higher concentration in BCM, given the bank'shigher lending share relative to the other banks. No data were available from BCM and BPD regardingthe age and accumulation of arrears, or their proportion as a percentage of their total outstandingportfolio. The negative impact of the large number of problem sub-loans on the banks' overall portfoliowas assumed to be relatively small because they constituted a small proportion of their total portfolio.The two banks estimated about 67 percent of sub-loans in arrears were collectable. In contrast, BSTMhad a recovery rate of 100 percent, and ULC 99 percent.

41. The repayment situation resulted from a number of factors. The firms' inability to repayreflected the difficult economic environment prevailing during implementation. A large proportionproduced for the local markets. The low recovery rate was also due to poor appraisal of sub-projects,lack of ex-post supervision by the PFIs leading to an inability to trace some sub-borrowers, a culture ofnon-repayment of loans, reinforced by poor loan collection from the banks and a virtually non-functioning legal enforcement system.

42. The recovery performance also reflected a flaw in project design in that IDA did not have theexplicit power to suspend new commitments by PFIs who experienced poor loan collection performance.Although the Project Agreement required independent annual audits of the banks, this requirement,which was a legal covenant, was only complied with twice, once in 1992 and again in 1994 when IDA

10

first attempted to stop lending through the forner state banks. The first unqualified audits wereproduced in 1996.

43. Because of poor loan recovery, the rediscount mechanism set up under the project to recyclerepaid funds was never used, thereby increasing the small firms' dependency on the original credit line.

44. The PFIs were responsible for assessing the sub-borrowers' creditworthiness and bore the creditfull risk. This was meant to ensure a thorough credit analysis and ex-post supervision of sub-projects.Staff did not perform this normal commercial lending task satisfactorily because of insufficient staffingresources and serious lack of technical skills, a legacy from years of state-directed credit allocation.Staff compensated for this lack of skills by relying on IDA's or the apex unit's prior review of creditapplications.

45. Neither assumption of full credit risk nor potential losses from bad loans were incentives strongenough to ensure adequate credit risk assessment and commercially oriented lending from the banks. Thetwo largest lenders of the credit line were state entities which, for most of project execution, theGovernment kept bailing out until their privatization. Total assumption of their losses by theGovernment amounted to the equivalent of US$93 million in 1993 under the IMF's program. TheGovernment injected an additional US$80 million equivalent to cover BCM's losses when the bank wasprivatized. The amount of BPD's non-performing loans and other bad assets assumed by the Governmentis not yet fully known, as it will be fully determined once the one-year period in which the new privateowners can turn over to the Government any losses discovered during that year has been completed.

46. Characteristics of Sub-projects and Sub-loan Realization.

Appraisal Estimates Actual Estimates* Number of Sub-projects 110-120 134* Type of investment:

- new 85 (63 percent)- expansion 10 (7 percent)- rehabilitation 39 (29 percent)

* Job creation: 6,000 5,029 (ex-ante)- maintained 1,046- new 3,983

* Average investment cost/job(US$) 4,800 5,627 (ex-ante)* Average sub-loan size (US$) 250,000 211,194

Sub-loan size (US$'000) No. of sub-loans1-49 29

50-99 37100-249 36250-499 17500-999 12>1,000 3

* Average maturity 7 years* Average grace period 2 years

47. Sub-Project Achievements. Based on a sample of 30 sub-projects, ex-ante financial rates ofreturn were high in nominal terms, averaging 42 percent, compared to an appraisal estimate of 12percent in real terms. A minimum economic rate of return of 12 percent (in constant terms) was to beachieved for sub-projects above US$250,000. Neither the PFIs nor the apex unit calculated realizedreturns and were not required to do so. Given the high number of problem sub-projects, the majoritymay not be financially viable and expected returns may not be achieved.

11

48. Firm Size. To qualify as a smalland medium enterprise, firms were to % f i Total no. of sub-loans and value by firm sizeemploy no more than 200 workers (before 35%

expansion). About 76 percent of sub- 30% r-nOota.lOvasue -F

borrowers employed no more than 50 25% |total -L

workers (after expansion), with 40 percent 20% mmof their sub-loans adding to less than o 1 fn100,000 each. Total value of their share 5% I_was 68 percent. Very small-scale 0v l Aborrowers (with 10-19 employees) - g 0 0 Oo A

accounted for a total of 41 sub-loans (31 irm size

percent), but only 18 percent share of thefunds. It is interesting to note that this Source: Apex Unit.

group's repayment performance tended to be better.

Amott Credit Denmnd b Year (in US$ illion) 20 - . .8G 157.0- 106.0- 55.0 _ 0 4.0- F]5.0-20 -n;

1.0 l20.0. +C-m2sieR

1991 1992 1993 1994 1995 1996 -25Year lo93 2994 295 19

Source: Apex Unit.

49. There seemed to be a positive relationship (correlation coefficient = .8) between credit demandand the level of real interest rates, with a time lag. That is, higher subsidized rates resulted in higherdemand for investment in the following year. The time lag could be due to a delayed response tochanges in interest rates by the firms, the time required to prepare business plans, credit rationing, anddelays by the banks in processing firms' sub-loan requests. However, due to so few observations, this isnot statistically significant. Also, lack of a 1:1 relationship may be due to (a) firms' uncertainty withrespect to future changes in inflation and on-lent rates, and (b) firms not expected to repay. In this case,firms made business decisions irrespective of the level of interest rates.

50. Sectoral Impact. The manufacturing and industry sectors each accounted for 27 percent of bothtotal investment and the number of sub-loans. Agriculture and fishing accounted for 16 percent,transport 14 percent, services 6 percent, tourism 9 percent, and mining 1 percent.

Inh.a b..e Z.m bezi,

6% a ~~~~~~~~~~~~~~~za~~2

/-Tanspor l2Y/ 9 14% AS&FWh Mining . p

1%~~~~~~~~~~~~~1nd us 0M a f 1%N11

Sectoral Distribution ofSubloans Regional Distribution of Subloans

Source: Apex unit.

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51. Regional Impact. About 55 percent of total sub-loans, both in terms of value and number, were inMaputo. This seemingly high concentration ratio is in fact lower than might have been expected, giventhat, traditionally, economic activities in Mozambique have tended to be highly centralized in or aroundthe capital city. To some extent, the project's decentralization objective was achieved.

52. Employment Generation. By sector,expected job creation was the highest in the %ofdorindustrial and manufacturing sectors, za oaccounting for a total of 1,733 (of which 1601,357 new jobs) and 1,430 jobs (of which i,xo1,231 new jobs), respectively. Expected job wocreation, by type of sub-project, was 4*consistent with uses of funds. Newinvestments accounted for 63 percent of total sew Tomn T an.

investment and were expected to generate 50percent of total jobs. However, the high creditdemand for new investments was not ExpectedJobCreation byLoan Size

consistent with the state of the economy for no. of jobs (in US$ '000)

which a higher investment demand for 1,60

business expansion or rehabilitation should -4.200 -

have been expected. With respect to borrower soosize, expected job creation was the highest in 400- [ Hthe 100-249 employee range, with a total o 0l

1-49 50-99 100-249 250-499 500-999 >1,000estimate of 1,404 jobs. Loan size

Source: Apex Unit.

53. UJnfortunately, no ex-post figures were available, except from BSTM which confirmed that theestimatedl number of jobs created was realized. The combined total of the bank's figures and an 8-firmsample visited by the ICR mission gives an actual number of jobs created of 664, for a total sub-loanamount of US$3,044,419, making an average investmnent cost/job of US$4,585. Thus, about 10% of IDAfunds created 664 jobs. If all loans were good loans, the actual total number of jobs created would beclose to the appraisal estimate of 6,000. While it remains to be seen how the total number of firmbeneficiaries will perform over a longer period of time under the current much improved economy, thepresent uncertain status of many firms tend to make the overall employment creation questionable.

54. Environmental Issues. There were no major environmental issues related to the implementationof sub-projects. In the few sub-projects where this could have been the case, the issues were dealt withby IDA either during the prior review process or the supervision missions to ensure compliance withproject requirements.

55. Current Status of sub-Projects. Of a total of 134 firm beneficiaries, 22 (16 percent) areconsidered profitable, 92 (69 percent) are operating with difficulty, and six (4 percent) went out ofbusiness and are in judicial collection. 18 firms have negotiated an extension of the grace period becauseof cash flow problems.

56. VVhile economic and infrastructure conditions were important contributing factors, the majorproblems faced on the firm level were lack of technical know-how, lack of production management andmanagerial skills, and poor market assessments. Technical appraisal of sub-project applications tended toemphasize the mechanics of pro-forma balance sheets and cash flow analysis and did not give sufficientweight to more qualitative factors, such as adequate management skills and market assessments, and the

13

applicant's ability to operate a small business. Firms' problems in these areas are confirmed by thebanks in their latest supervision report.

57. In some cases, however, there appears to be little correlation between firms' profitability andtheir loan repayment performance. Non-repayment of sub-loans tended to be encouraged by lax loancollection by the former state banks and irnplicitly encouraged by a virtually non-functioning legalenforcement system. In other cases, overleveraged firms, unable to obtain additional loans, included aspart of their retained earnings for expansion or working capital what should have been used to servicetheir debt.

58. Of the eight firms visited as part of the ICR mission, four were considered profitable, of whichthree were larger, well-established enterprises. Of these firms, two were making payment on their sub-loan--one refinanced its sub-loan with a short-term commercial loan at more advantageous terms. Theother two were financing their business expansion or working capital with their loan payments. Theother four firms were new, smaller businesses operating with difficulty and unable to service their debtobligations on a regular basis. All four were experiencing market-related and/or management problems.Furthermore, the firms complained of the lack of transparency in the sub-loan approval process,suggesting possible corruption.

(b) Rehabilitating the banking system's intermediary rolefor term lending

59. The Institutional Strengthening Component (US$3.43 million equivalent) was designed torebuild the banking system's capability for term financing, and help establish (a) a local capacity forbusiness advisory services to SMEs, and (b) a local permanent structure to monitor IDA or other donorfuture lines of credit. Total disbursement for this component was US$3.23 million equivalent. It isinteresting to note the imbalance between the credit line component, which represented 89 percent oftotal credit, and this component, on which the project's success critically depended, which representedonly 11 percent.

60. Provisions for the training of banking staff were clearly inadequate, in light of their low level ofskills identified at preparation. The training program, while useful, was not sufficient in duration, as thePFIs received, prior to effectiveness, a total of only six-week training and three workshops of two weekseach, in the areas of project appraisal and processing. The training program was funded by UNDP.US$0.5 million was provided for additional training under the project for a total of 50 staff fromcommercial banks, the apex unit, and IDIL. Commercial bank staff indicated they found the traininguseful, but those who received training were subsequently transferred to other positions within the banks.Of the 46 staff trained, only two are left in B3PD credit operations department, and one at BCM. Of thetwo people trained in the apex unit, only one is left, the other staff was transferred to another division ofthe central bank. The project provided for early, limited pre-operational training programs, but nothingto correct the actual problems that emerged during implementation. Furthermore, to provide trainingonly to credit department staff when the two state banks had many serious weaknesses outside the creditdepartment could only impair their ability to iimplement the line of credit.

61. A banking institute was established, in 1994 under the ongoing Financial Sector CapacityBuilding Project. The institute includes on-going training support to commercial bank staff as part of itsactivities, with mixed success.

62. The project also provided financial cassistance to enterprises to prepare business plans. Firmscould use the services of private local consultants or IDIL, the Government's already establishedbusiness services bureau. Fees charged for services could be financed by sub-loans. Provisions for thisfundamental aspect were also clearly inadecluate. Lack of local capacity in this area reinforced the

14

banks' dependency on IDA or the apex unit's prior review. Low quality of IDIL services was the majorfactor for low demand for its services.

63. In 1995, IDA suspended disbursement in support of IDIL, pending an independent audit of itsoperations. In line with project requirements, IDIL was to charge an up front fee for its services. Thesefees were to gradually cover its operating costs for the bureau to become self-sufficient. After five yearsin operation, IDIL could not account for the cash revenues received, hence IDA request for the audit, towhich IDIL never agreed. IDIL is currently operating on a government-funded budget.

64. An apex unit was established in the central bank to manage the credit line with the objective tocreate a long-term structure for future IDA lines of credit, or those of other donors. The unit was initiallyindependent, operating with its own budget and staff, and was later absorbed by the central bank in 1994.Throughout project execution, the apex unit confined its role to that of an administrator of funds. In linewith project requirements, the apex unit devoted most of its time to evaluating applications and ensuringconformity with Bank procurement guidelines. These responsibilities which duplicated normal day-to-day functions of commercial banks represented an additional step in the approval process, causingfurther delays and increasing the sub-borrowers' final costs. Because the PFIs bore the credit risks, theapex unit did not see sub-project monitoring and supervision as part of its responsibilities. Anotherreason was the automatic debit mechanism built into the project which allowed the central bank to debitthe PFIs' current account on the same due dates as those on individual sub-loans, irrespective of thefirm's capacity to repay. Currently, the apex unit is managing sub-loans of the ongoing IndustrialEnterprise Restructuring Project and other donors' lines of credit.

65. Procurement. In line with project requirements, firms were to obtain three independentquotations for goods to be procured under the IDA Credit. Given the small size and nature of theirrequirements, and the limited local market, small firms found it difficult to meet IDA's procurementrequirement. This requirement proved neither economic nor efficient, as firms sought the requiredquotations in neighboring countries or abroad, resulting in delayed processing. The requirement alsotended to add to costs, as suppliers charged for price quotations.

G. Project Sustainability

66. The project was implemented under chaotic conditions, both at the macroeconomic level and interms of disruptions of key infrastructure (roads, utilities, market distribution channels, etc.) The project,as designed and carried out under these conditions, is not sustainable. Changes which would pave theway for macroeconomic stabilization started to take place in 1995, with 1996-1997 as the transitionyears. It remains to be seen how the firm beneficiaries will perform over a given time horizon, or thesurvival rate, under the current much improved economic conditions. Only then can true rates of return,both financial and economic, be measured, hence the project's impact on the firm beneficiaries. Theproject's sustainability in terms of financing productive capacity is thus uncertain. The project'ssustainability in terms of building the PFIs' capacity to provide ongoing term lending is unlikely.

67. Sustainability of future operations rests on three main areas. (a) sustained macroeconomicstability to remove the need for Government subsidies to guarantee interest and exchange rate stabilityand promote longer term growth; (b) sustained progress in financial sector development to furthercompetition, to improve banking supervision, and to increase efficiency in domestic resourcemobilization and allocation. SMEs' increased reliance on internal resources (their own equity and retailbank contributions), as opposed to external resources (IDA, Government subsidies), will ultimately attestto sustainabiility; and (c) further actions in private sector development in the legal and administrativeframework to change outdated pre-independence laws and regulations.

15

H. Bank Performance

68. Preparation and Appraisal. The project was prepared and implemented during a period offundamental economic and institutional reforms, as well as a highly uncertain political situationfollowing the aftermath of 16 years of a civil war which ended in 1992. Results of the BusinessEnvironment Study, which provided the basis for project design, were thus highly tentative. While theStaff Appraisal Report (SAR) correctly higlhlighted the study's limitations, the project was neverthelessprepared on the Bank's optimistic assumptions as to the pace of the reform program, and neither thestudy nor the SAR were complemented by sufficient financial sector work. With the benefit ofhindsight, the project should have been substantially delayed and/or designed as a small pilot operation,as opposed to a full-fledged investment project, given the uncertainty as to the pace of the reformprogram, lack of knowledge about the SME sub-sector, and the country's very low institutional capacity.

69. During appraisal, emphasis was placed on setting up the credit line, settling BM's lendingarrears, recapitalizing the banking system as a whole, and establishing the apex unit. The fact that it wasnecessary to recapitalize the banks to be eligible to participate in the line of credit was symptomatic oftheir uncertain status. Project preparation and appraisal was unsatisfactory.

70. Major weaknesses in project design were (a) failure to take into account the country's unsuitablemacroeconomic and business environment; (b) lack of explicit links between project performance andsectoral policies and IDA ongoing commitments; (c) lack of monitoring performance indicators for thecommercial banks and for sub-projects; and (d) training and technical assistance inputs which were notcommensurate with the country's institutional capacity requirements. In addition, project design wouldhave benefited from experiences and lessonis drawn from other Bank lines of credit elsewhere, to theextent these can be transferred.

71. Supervision. Project supervision tended to focus on improving the slow rate of disbursement.The two main causes identified during the November 1993 project mid-term review were unduly longapproval processes and unfavorable spreads for the PFIs. At that time, only 27 percent of total projectfunds, compared with projected 48 percent, had been disbursed. Amendments were introduced to correctthe slow rate by: (a) increasing the free-limit ceiling, from US$250,000 to US$500,000 to decentralizemore approvals of sub-projects to the apex unit, and (b) reducing the central bank's servicing fee tocorrect earlier disincentives to the banks. Steps were also taken to address an accumulation of non-performing loans. However, little emphasis was placed on the commercial banks' continued eligibility toparticipate in the IDA on-lending program.

72. IDA's decision to increase the free limit on sub-projects to improve slow disbursements on thesub-loans at a time when the quality of the sub-projects, as evidenced by poor repayment records, wasrelatively poor reflected a blatant disregard for the impact of the line of credit on the PFIs. The bankingsector's role was then essentially viewed as a "non-real" delivery mechanism to support the real sector,with little inherent importance in itself. For the first five years of project implementation, IDAsupervision was deficient overall.

73. In the last years of implementation, following a change in task management, focus of supervisionstarted to shift from disbursement rate to PF][s' portfolio performance. Measures were introduced with aview to improving that performance. IDA requested, with little success, that the two former state banksdevelop action plans to improve and monitor collections of non-paying loans. In 1996, IDA suspendedtheir participation pending achievement of a 10 percent recovery rate. Delays in sub-loan approvalswere also reduced, thereby reducing the final costs of funds to firms. These measures, although soundand needed, came too late as, by then, 75 percent of total funds had been disbursed, and the project wasin its last year. Closing the project then was< discussed but did not materialize because the Government

16

argued of an adverse impact on the small firrns, given the scarcity of term credit. As more private banksand two leasing companies were entering the banking sector and expressed interest or participated in theon-lending program, the project was kept open. Other ways of providing term finance to SMEs, otherthan through the formal banking sector, were also explored. For the last two years of projectimplementation, IDA supervision was satisfactory.

E. Borrower Performance

74. ThrougL3ut implementation, the Government's inadequate control over the former two statebanks was largely responsible for the macroeconomic instability, as well as their poor loan recoveryperformance, which prevailed until project closing. This instability in turn contributed to the widefluctuations in inflation, leading to the need to subsidize interest rates on the sub-loans, and torecapitalize the banks. Project performance would have benefited from the apex unit assuming astronger monitoring and supervision of sub-projects and, to this end, establishing better coordinationwith the PFIs. Finally, frequent changes in management adversely affected the unit's proper functioning,as each new director had to learn about its operations.

75. Comp?liance with legal covenants and audits. Compliance with legal covenants was generallysatisfactory, except with respect to interest rate policy and submission of annual audits. However,although most covenants sought to address major issues in the banking system (settlement of banks'lending arrears, action program to rehabilitate the banking system and upgrade the banks' accountingcapabilities), these issues were addressed only once and after Credit effectiveness, or no concrete actionswere implemented beyond preparing the action plan. The end result was that, despite satisfactory one-time compliance with the covenants, the problems kept re-surfacing since generic issues and causes ofthe banking sector's poor performance were not addressed. The commercial banks' lending arrears werea recurrent problem throughout project execution, including under the IDA line of credit, althoughsomewhat masked by grace periods on loans. The Government recapitalized the banks three times.Bank staff accounting skills were deficient. Compliance with financial statement audits was notsatisfactory in terns of timely submission of audit reports. Qualified audit reports were not dealt with bythe Government, despite IDA's expressed concerns.

J. Assessment of Outcome

76. Overall project outcome is unsatisfactory.

* Relevance. The project was relevant but untimely as the objectives were unsuited to the country'sconditions.

* Efficacy. 1. The project's transferred resources to relieve a scarcity in term funds did not supportviable investment projects, as evidenced by the currently high default rate on the sub-loans.

2. T}e project's institution-building objective was not achieved. Impact of technicalassistance and training provided to: (a) PFIs, to develop skills in credit risk assessment and projectappraisal, was limited; (b) apex unit, to build a permanent local structure, although more successful,was nonetheless not sustainable; and (c) IDIL, to build a local capacity for business advisoryservices, was limited.

3. The project did not assist the Government in achieving a more rational interest ratestructure. Throughout most of project execution, in the absence of the necessary pre-conditions inthe banking system for interest rates to be market-determined, rates remained administered, andnegative in real terms, discouraging domestic resource mobilization, perpetuating a scarcitysituation., and adversely affecting the project's sustainability. Subsidized rates may also have had the

17

effect of leading to larger loans than necessary, attracting marginal borrowers, and eliminatingnecessary spreads for making lending viable to the PFIs.

4. Because of poor project results, the project did not assist the Government informulating an industrial policy. Although progress of policy reform was to be monitored as part ofthe annual project implementation review, funds earmarked for studies were never used for thatpurpose.

* Cost-Effectiveness. Implementation of the project came at a significant net cost to the economy.Negative real interest rates on sub-loans resulted in a net transfer of resources to firms. If themajority of problem sub-projects does not prove viable investments, the resulting subsidies couldadd to the country's already excessive debt burden, further worsening its debt service paymentcapacity. While not quantified, a high number of sub-projects may have had negative rates of return,and even those which will survive are likely to have low, if not negative, rates of return because ofthe long delays in project benefits. The former state banks would have incurred substantial losses onthe sub-loans had it not been for Government's recapitalizations before their privatization. If thebanks' estimated recovery rate of 670/o on the sub-loans does not rmaterialize, and if the Governmentno longer covers their losses, they stand to sustain substantial losses on the sub-loans.

+ Ratings. Financing of viable projects: unsatisfactoryInstitution-building: unsawisfactoryInterest rate policy: unsatisfactoryIndustrial policy: unsatisj2ctory

K. Future Operations

77. Measures to build on reforms already achieved under prior adjustment operations are part of theproposed Economic Management Reform Credit (FY99). The EMRC will particularly focus on fiscalreforms and on improving the business environment to foster private-sector-led growth. Fiscal reformswill include financial deepening and better coordination between monetary and fiscal policies, andprivate sector measures will aim to establish a legal and administrative framework in line with market-driven economic structures. A follow-up i:nvestment operation is also slated for FY99.

78. Notwithstanding substantial achievements in macroeconomic policy and priivatization programsover the last five years, private-sector growth response has been modest, especially with respect to localMozambican-owned firms. The proposed Mozambique Enterprise Development Project (the PoDE) willaim to improve the business environment and accelerate broad-based economic growth through capacitybuilding of private firms and institutions. Particular emphasis will be placed on developingMozambican-owned firms' export potential and linking domestic suppliers with foreign investors.Specifically, the project will: (a) assist enterprises in raising the technical skills of their management andworkers; (b) provide financial resources for export development and enterprise technology upgrading;and (c) improve private and Governmerit institutions' capability to deliver support services to thebusiness community.

L. Lessons Learned

* Implementation of this project confirms the validity of OD 8.30 which were not rigorously followedduring project implementation, particularly with respect to term lending under high inflationaryperiods and by weak institutions, and distortions created by directed credit and targeted creditsubsidies, in particular interest rate subsidies. Lines of credit are not useful tools when implementedunder unstable economic and business conditions because risks associated with new investment aretoo large.

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* Lines of credit are not the appropriate instruments to address sectoral policies. Lines of credit aremost likely to be adversely affected by macro and sectoral distortions which are best addressed in anoverall macroeconomic policy framework. Continuing commitments under FILs should be linked tothe effective implementation and maintenance of a satisfactory policy framework, a justifiableprecondition for a IDA line of credit as well as for its successful implementation.

* It is very difficult to stop commitments under a project which has no clearly established ongoingconditionalities once the project has been launched. Ongoing sub-project commitments should beexpliciltly linked to project performance. Project implementation design should include explicitmonitoring performance indicators to assess the continued eligibility of financial institutions andother entities, public or private, sub-project performance, and technical assistance impact.

* It is very difficult to take a financially poorly performing bank with non-commercial objectives andweak management--characteristics most likely to be found in state-owned than private banks--andturn it into an effective financial intermediary.

* The financial sector should not be viewed essentially as a "non-real" delivery mechanism to supportthe real sector. Prospects for success are poor when PFIs are unsound and lack the skills andcommercial orientation necessary to make good credit decisions.

* Implementation of the project raises the usefulness of "quick-fix"-type lending operations in highlyuncertain conditions. When local capacity is low, and/or fundamental economic and sectoral reformsare underway, a small pilot project and more prolonged training programs are more suitable than afull-scale operation to fully take into account the time factor during the transition years, and adaptand build knowledge about the (sub)sectors involved. The pilot project should include a simple,straightforward, and focused approach to reduce the final costs to the banks and firms. The approachshould also be sufficiently flexible to allow for changes as needed in project execution.

* Technical assistance to build SMEs' capacity is as important as their access to capital. This technicalassistance need not be a supplement to sub-loans, but could be a stand-alone component. It shouldbe demand-driven.

* Interest rates should be variable to allow the pricing of capital to be market-determined and to reduceinterest rate risk for lenders and borrowers. During high inflationary periods, an indexingmechanism might be best, as opposed to Government-adjusted rates, although experience such as inBrazil has shown that indexing tends to perpetuate inflation. An indexing mechanism might also beapplied to Government's fee for currency risk coverage, if the Government is to bear the cost offoreign exchange. Proceeds from the fee should be deposited in a fund in a commercial bank to earninterest.

* The apex unit should be managed under a management contract arrangement. This is especiallycrucial if the objective of setting up an apex unit is to transfer the monitoring and supervision aspectscloser ito the financial internediaries and final beneficiaries. Monitoring indicators should be set toassess the unit's performance. Finally, in addition to monitoring a database on sub-loans andprojects, the apex unit should possess or develop an analytical capability to assess the project'simpact on an ongoing basis. This would allow introducing needed changes in the project scopeand/or design throughout implementation. Under this project, the apex unit is meant to be a "sunsetorganization".

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Table 1: Summary of Assessments

A. Achievement of Objectives Substantial Partial Negligible NotApplicable

Macro Policies

Sectoral Policies

Financial Objectives i

Institutional Development

Physical Objectives

Poverty Reduction i

Gender Issues

Other Social Objectives i

Environmental Objectives

Public Sector Management

Private Sector Development

Other (specify)

B. Project Sustainability Likely Unlikely Uncertain

C. Bank Performance Highly Satisfactory DeficientSatisfactory

Identification

Preparation Assistance

Appraisal

Supervision

D. Borrower Performance Hlighly Satisfactory DeficientSatisfactory

Preparation

Implementation

Covenant Compliance

Operation (if applicable)

E. Assessment of Outcome Ilighly Satisfactory DeficientSatiisfactory

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Table 2: Related Bank Programs, Credits, and Sectoral Studies

Credits Purpose Year Status

Preceding Operations

* Economic Action Program * Restore investment and economic 1984 Completedservices for immediate production results.

* Economic Rehabilitation Program 1987 Completed(ERP) (1987-89)* Second Rehabilitation Credit * Reduce macroeconomic imbalances and 1987 Completed

price, and exchange rate distortions.

* Thi rd Rehabilitation Credit * Improve foreign exchange allocation, 1989 Completedbudgetary policy, price and distribution policy,reform trade tariff structure, and restructurestate enterprises.

Following Operations

* Industrial Enterprise Restructuring * Restore production and efficiency in a 1989 OngoingProject selected group of major industrial and

agro-industrial enterprises.* Economiic Recovery Credit * Improve foreign exchange allocation and 1992 Completed

management, establish a legal andregulatory framework to restructurebanking sector and initiate privatization ofstate enterprises.

* Second Economic Recovery * Strengthen fiscal and monetary policy, 1994 CompletedCredit support interlinked program of enterprise

and financial sector reforms.

* Financial Sector Capacity Building * Support the overall enterprise and financial 1994 OngoingProject reform program.

* Third Economic Recovery Credit * Support the privatization of state-owned 1997 Ongoingbanks, rationalization of the tariff andindirect tax regime, budget managementreform, liberalization of the cashew market,and private concessioning of CFM.

Sector Studies

* Development of Industrial Policy * Study of broad industrial policy within the 1990 Completedand Reform of the Business context of the changed business environmentEnvironment following the ERP reforms.

* Financial Sector Study * Study on financial sector to recommend 1992 Completedimprovements and outlines sequence ofreforms.

* Impediments to Industrial Sector * Study to identify impediments to industrial 1995 CompletedRecovery recovery, assess growth potential, and

propose strategy.

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T'able 3: Project Timetable

Steps in Project Cycle Planned Actual

Identification - Initial IEPS 4/26/88 4/26/88

Final EPS 1/18/88 1/18/88PreparationPreappraisalAppraisal 4/20/89 4/20/89Negotiations 10/5/89 10/5/89Letter of Development Policy (if applicalble) n.a. n.a.Board Presentation 12/20/89 12/20/89Signing 2/5/90 2/5/90Effectiveness 6/8/90 6/8/90Mid-term Review 8/94 8/94Project Completion 6/30/96 12/31/96Credit Closing 12/31/96 12/31/97

Table 4: IDA Credit Disbursements - Cumulative Estimated and Actual(in US$ million)

FY90 FY91 FY92 FY93 FY94 FY95 FY96 FY97 FY98 TotalAppraisal 0.25 4.68 4.5 6.0 6.0 7.0 3.57 - 32.0Estimate

Actual 2.5 0.4 0.7 3.0 6.1 6.9 4.8 7.2 0.4 32.0Actual as a % of 1,040% 9% 16% 50% 102% 100% 134% - 100%Estimated . _

Date of FinalDisbursement April 17,1998

Table 5: Key Indicators for Project Implementation

Ky ImplementtinIndict r in >SA R A.-.-l Es0timate Aictua EstimatesA. Credit Component

2. No. of Sub-projects 110-120 1343. Employment generation 6,000 5,029 (ex-ante)4. Repayment rates on sub-loans 16%

B. TA Component1. Training of PFI Participants 50 50

Table 6: Key Indicators for Project Operation

(see above table)

Table 7: Studies Included in Project

none carried out.

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Table 8A: Project Costs

: . , -Itemns -- - Appraisal Estimates /I Actuial'2-___.-;___-__.__.__--.____-__.__. (US$ million) ( -lUS$milion)

Local Foreign Total Local Foreign Totalcosts costs costs costs costs costs

A. Enterprise Financing Component 10.5 35.57 46.07 56.7 20.2 76.9IDA - 28.57 28.57 8.6 20.2 28.8EIB, UTNDP /2 - 7.0 7.0 - - -

Enterprises 5.5 - 5.5 22.0 - 22.0PFIs 3.0 - 3.0 26.1 - 26.1

Government /3 2.0 - 2.0 n.a. - -

B. Institutional Strengthening Component 0.2 3.93 4.13 - 3.7 3.7IDA 3.43 3.43 - 3.2 3.2UNDF' 0.5 0.5 - 0.5 0.5Government 0.2 - 0.2 - - -

TOTAL 10.70 39.50 50.20 56.7 23.9 80.6/1 Includes donors' cofmancing./2 Includes only UNDP. EIB and Caisse Fran,aise provided parallel financing./3 n.a.: not available. Government's contribution to project costs (salaries of apex personnel, and the operatingcosts of the unit when it became part of the central bank) was not available for preparation of the ICR.

Table 8B: Project Financing

| -7-:S,our,ce -- Appraisal Estimates Actual Estimates;:__ '_E__ -_'_'__ -_.__ ._._'__'_-_' ______(USS million) ( -US$ million)

Local Foreign Total Local Foreign Totalcosts costs costs costs costs costs

IDA 32.0 32.0 8.6 23.4 32.0European Investrnent Bank, UNDP - 7.5 7.5 - 0.5 /1 0.5Enterprises, PFIs 8.5 - 8.5 48.1 - 48.1Government 2.2 - 2.2 n.a. - -

TOTAL 10.7 39.5 50.2 56.7 23.9 80.6/1 Includes UNDP only.

Table 9: Economic Costs and Benefits

Indicator Appraisal Estimate Latest Estimate1. Line of Credit: ERR - All sub-projects with ERR above 12% not available

FRR - minimum 12% not available

Table 10: Status of Legal Covenants

Original Revised Description of CovenantCovenant Present Fulfillment Fulfillment

Section Type Status Date Date l CommentsCredit Agreenmnt

3.04 10 C 06/30/91 - Bank of Mozambique to prepare an action program for separationof central and commercial banking functions and implement itthereafter.

3.05 9 C 12/31/91 - Govemment to complete an action program to settle lendingarrears of commercial banks, and implement it thereafter.

3.05 9 CD 06/30/92 06/30/93 Government to complete an action program for the rehabilitation12/31/94 of the banking system, including its recapitalization, performance

benchmarks, and extension of competition, and implementthereafter

3.06a 2 C 3/31/91 - Government and BM to review jointly with IDA progress on Interest rates were brought to positiveachieving positive weighted average real lending interest rates. levels in 1991, but fluctuated between

positive and negative levels in real terms,until their liberalization in 1996.

4.01 1 C March of - Government to furnish IDA external audit report of statement of 1996 audit received.I I | each year _ [ expenditures and special account transactions.

Project Agreement2.08a I C 03/31/91 - Review of PFIs' accounting capabilities. _

2.08 b I C 03/31/91 - BM to prepare action program to strengthen PFIs' accounting W

capabilities, including work required, resources needed, design oftraining program, and list of equipment and materials.

2.08c l C 03/31/91 BM to review jointly with IDA progress in implementation ofabove action program.

3.01b 1 C 09/30/92 BM to furnish IDA certified copies and audit report of PFIs' Not consistently complied with by theI_________ I________ I________ _________ _________ financial statements. PFIs, nor reinforced by BMAIDA.

Covenant types: Present status:I . Accounts/audits C = covenant complied with.2. Financial performance/revenue generation for beneficiaries CD = complied with after delay3. Flow and utilization of project funds. CP = complied with partially4. Counterpart funding. NC = not complied with.5. Management aspect of the project or executing agency.9. Monitoring, review and reporting.10. Project implementation not covered by categories 1-9.11. Sectoral or cross-sectoral budgetauy or other resource allocation.12. Sectoral or cross-sectoral policy/regulatory/institutional action.

24

Table 11: Compliance with Operational Manual Statements

Statement number and title Describe and comment on lack of complianceOD 8.30: Financial Sector Operations Lack of compliance with:

- macroeconomic environment- fihancial sector policies, in particular interest rates and

targeted subsidized credit- legal and regulatory framework

Table 12: Bank Resources: Staff Inputs

Stage of Project Cycle Planned (weeks) Actual (weeks)Weeks US$ '000 Weeks US$ '000

Through Appraisal n.a. n.a. 38.3 109.0Through Board n.a. n.a. 6.4 17.0Supervision n.a. n.a. 202.3 515.8Completion 15.0 35.2 15.0 35.2n.a.: notavailable.

Table 13: Bank Resources: Missions /1

ProjectActivity Month/Year Days in fields No. of Persons Specialized Staff Skills Ratings

Pre-apprafisal n.aAppraisal - - - n.a.Supervision 1 11/90 5 2 SSupervision 2 3/91 10 I E SSupervision 3 8/91 5 2 E SSupervision 4 12/91 5 2 E SSupervision 5 11/92 15 3 E SSupervision 6 3/93 10 1 E SSupervision 7 6/93 25 3 E,F SSupervision 8 11/93 25 4 E,F SSupervision 9 7/94 n.a. 2 E SSupervision 10 3/95 15 2 PSD, F SSupervision 11 7/95 5 1 PSD SSupervision 12 12/95 15 3 PSD SSupervision 13 3/96 15 2 PSD USupervision 14 8/96 10 2 PSD USupervision 15 3/97 20 1 PSD USupervision 16 5/97 18 1 PSD USupervision 17 9/97 19 2 PSD, 0 UCompletion 12/97 14 2 PSD, 0 UE = Economist N.A. = not applicableF = Financial Economist U= Unsatisfactory0 = Operations Officer/Analyst S = SatisfactoryCO = Country Officer/I Best estimates based on Form 590s.

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APPENDIX A

AIDE-MEMOIRE

SMALL AND MEDIUM SCALE ENTERPRISE DEVELOPMENT PROJECT,(Credit 2082-MZ)

IDA Mission - Implemeintation Completion Report - December 1L997

This is a draft evaluation summary of the Implementation Completion Report on the Smalland Medium Scale Project (Cr. 2082-M[Z). [Note: figures are preliminary estimates and subject torevisions.]

Obje,ctives

The Small and Medium Scale Project was designed to support the Government ofMozambique's policy to develop the industrial sector by stimulating long-term investment,starting with small and medium sized enterprises. The project was an integral part of the ERPand sought to fill a credit supply gap for term financing (mostly for imported capitalinvestments) while reforms of the financial sector were underway. This credit was to be directedto specific sectors through a two-tier mechanism and subsidized by the Government. Tocomplement that objective, the project also sought to rehabilitate the capacity of the bankingsystem to channel resources to productive sectors.

Achievement of Objectives

Participation and collection performance of the Financial Institutions (PFIs). At thetime the Credit was approved in 1989, Mozambique's banking sector was dominated by state-owned banks, mainly BCM and BPD. Since then, the banking sector has been privatized. To thethree original PFIs--BCM, BPD and BSTM, two others have recently been added, BIM andULC. The PFIs' lending share is: BCM (70%), BPD (16%), ULC (8%), BSTM (5%), and BIM(1%). BCM's predominant lending share may be explained by the fact that it was the bankwhich traditionally serviced the selected sectors. The banks' collection performance is poor forthe former state-owed banks and satisfactory for the privately owned PFIs. BCM has the highestconcentration of bad loans, since it absorbed the majority of the funds and given its low loanrecovery (52% are defaulting). BCM's new management is currently reviewing the situation todecide on a course of action on a case-by-case basis. BPD's performance seems to beimproving, and the bank's new management has started to take legal action against defaultingfirms.

As of now, approximately US$32.5 million of the total IDA Credit has been disbursed,leaving of a balance of about US$3.3 million. The Credit is expected to be fully disbursed atthe time of closing.

26

The causes of BCM's and BPD's arrears situation vary, ranging from long averageprocessing time for subprojects (it takes about 6-9 months from the time a client presents asubproject proposal to a bank for financing until the subproject actually starts implementation,resulting in rescheduling of grace periods which increases the client's interest payments),inadequate technical appraisal of subprojects, irregular supervision, and no efforts in loancollection from non-paying customers when the banks were still state-owned. In the case ofBPD, this was reinforced by the bank's former management's decision not to invest any of thebank's own funds in a subproject. The processing time situation applies not only to BCM andBPD, but to the other PFIs as well. Here too, the causes are many, ranging from the country'sown customs procedures to lengthy import process from abroad, and also the Bank's ownprocurement and disbursement requirements.

The DCA should have included monitoring and performance indicators, a clearlystipulated maintenance of loan collection ratio and conditions under which disbursements fromthe line of credit would be suspended, and action plans for improved performance. The fact thatthe Central Bank debited the banks' account automatically was not an effective measure, in andof itself, to ensure that the banks adopt a more commercially oriented approach to credit-riskmanagement, as BCM and BPD were state-owned banks.

Firm-level and Subproject Achievements. An estimated 61% of the sub-loans were madefor new projects, 31% for rehabilitation, and 8% for expansion. It is difficult to assess if thesubprojects have achieved their projected economic and financial rates of return because none ofthe PFIs calculates ex-post rates of return. The same applies for job creation, so that anyassessment to estimate the social impact of the project in terms of employment generation wouldbe based on estimates at the time of subproject appraisal. There is nonetheless some consensusamong the PFIs and the PMU that the social impact objective has been met to some extent, andthat the bad loans situation of BCM and BPD, by far the problem banks, does not necessarilymean that defaulting firms are not operating or even profitable.

Sectoral and Regional Impact. The sectoral distribution is as follows: 46% of totallending went to industry, 14% to transport, 13% to services, 7% to tourism, 9% to fishing, 5% toagro-industry, 2% to mining, and 4% other. In terms of regional distribution, Maputo benefitedfrom about 70% of total lending, Sofala 12%, and the remaining 18% went to the other regions.An attempt was made during project preparation to reach the Beira region with the establishmentof one of the two small business advisory services units. This did not materialize due in part toIDIL's poor performance and the resulting low demand for its services.

On-lending Rates, Credit Ceilings, and Government Subsidies. Under the terms of theproject, on-lending rates were to be variable market rates, the Government was to bear theforeign exchange risk, and the commercial banks the credit risk on on-lent funds. During projectnegotiations, the Government agreed to review annually with the Bank progress on achievingpositive real on-lending interest rates, terms and conditions. A controlled lending rates andforeign exchange rates regime prevailed in Mozambique until 1996. From 1990-94, commerciallending rates could not exceed 48%, and 46% from 1994 until the liberalization of interest ratesin 1996. Those rates were below inflation rates. At the same time, the Government imposedcredit ceilings on the banks. The Government gave the IDA line of credit, as well as otherdonors' lines of credit, a preferential rate below the market lending rates to induce firms toborrow from those lines. The banks used the line of credit to either complement their creditrestrictions, or more recently to have access to local currency in short supply. However, the IDA

27

line of credit did not prove attractive at first to the commercial banks because the spread was nothigh enough to cover their administrative costs for the sub-loans, after the PMU had retained itspercentage for management fee and to cover the Government's "insurance" on foreign exchangefluctuations. The split was later changed to 50:50, when the Bank complained of slowdisbursements on the credit line.

Any benefits derived from this project should be weighted against the implicit costs tothe Government associated with the subsidies on interest rates and foreign exchange. The needto subsidize those two rates to spur investment may have been warranted at the time the Smalland Medium Enterprises project was designed, but should be reassessed in the current economiccontext. Since the Government may abscrb all or part of the losses of the previously state-ownedbanks as part of the negotiations of the privatization process, that cost should also be added tothe subsidies costs.

PMU/commercial banks relationship, and PMU's performance. The PMU maintains agood relationship with the commercial banks and assumes its responsibility of record checkingand keeping satisfactorily. However, the PMU should have been more active in ensuring that itreceives regularly the supervision reports from the commercial banks, especially when the banksstopped sending them altogether.

World Bank's Special Account (S'A) and procurement procedures. The SA was openedwith Citibank-New York for the letters of credit for imports. As already mentioned above, thisarrangement was one of the factors which added to the lengthy process. Another factor was theBank's three quotations requirement, since in the majority of cases when this requirementapplied, there was only one local supplier, and in order to comply, the firm had to inquire outsideof Mozambique, often in neighboring countries, which led to additional delays and costs. TheBank's internal procedures should be flexible enough so that they easily adapt to the needs of theprivate sector. As they stand now, those internal procedures are too slow and cumbersome forthe fast pace characteristic of the private sector, and the client is the only one to ultimately bearthe cost.

Maputo, December 1997

28

APPENDIX B

SMALL AND MEDIUM SCALE ENTERPRISE DEVELOPMENT PROJECT(Credit 2082-MZ)

Borrower's contribution to the ICR (translated version)

IMPLEMENTATION REPORT ON THE SMALL AND MEDIUM SCALE ENTERPRISEDEVELOPMENT PROJECT (PDPME)'

Introduction

The Small and Medium-Scale Enterprise Development Project was approved in 1990 aspart of ithe series of current economic and social policy measures designed to rehabilitate thenational economy. The specific objective of the project was to ensure the active participation ofeconomic operators throughout the country, which was to be promoted via the government's planto offer a system of incentives to small and medium-sized businessmen and small and medium-scale enterprises to make them more dynamic. The project was intended to finance the mining,agro-food, and manufacturing industries, and the tourism, transportation, equipment repair,canning, and services sectors. Since this project ended on December 31, 1996, negotiations wereundertaken with the World Bank to extend the period for using this line of credit for anotheryear, to enable the project disbursements to be completed. This report aims to provide acomprehensive survey of the impact of the project during its implementation period.

1.1. Project Objectives

The overall project objectives consisted essentially in the following:

* Increase domestic production and reduce dependency on the outside world, by importsubstitution and the growth and diversification of exports;

* Increase the number of jobs, and thereby reduce delinquency, especially on the periphery ofurban areas;

* Renovate, modernize, and expand the installed productive capacity and facilitate theemergence of new industries;

* Mobilize private savings, and promote their use in productive sectors;* Inform and educate the country's business community, the only way to guarantee that they

will play an active part in the national reconstruction effort;* Improve the performance of institutions capable of providing support for small and medium

scale enterprises, and especially public institutions and the banking system;* Identify the sectoral economic policy instruments best suited to attain the goals indicated

earlier, among others.

1 Includes all donors' lines of credit.

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1.2. Sources of Financing

To finance the Project in question, the government, through the Bank of Mozambique,received assistance from international financial institutions, and especially the World Bank andIDA, the European Investment Bank (EIB), and the Caisse francaise de developpement (CFD).* On February 7, 1990, the World Bank made approximately US$36 million (SDR 25.1

million) available for this purpose;* As of July 18, 1990, about US$7 million (ECU 6 million) were provided by the EIB as

cofinancing. Use of these funds was canceled on July 18, 1994, in view of the fact that theline of credit had barely been used.

The primary reasons why these funds were not used to a greater extent are as follows: (i)The length of the process of evalualting and approving subprojects; it took nearly a year and ahalf to approve a subproject, and this created serious problems for the Bank of Mozambiquein its dealings with commercial banks and their customers; (ii) the EIB funds covered. only50% of the overall needs of each subproject, which meant that alternative sources always hadto be found to cover the remainder;

- The CFD made about US$9.5 million (FF 50.0 million) available to finance the foreigncurrency component for support for private sector investment. The use of those funds wassuspended on March 11, 1993. This action was taken on the heels of the decision made bythe French government to suspend credit operations to poor countries, as a way of halting thecontinuous growth in the external debt service of those countries.

1.3. Operational Instruments

To achieve these objectives, the Bank of Mozambique, in its capacity as the central bank,was designated as the institution responsible for implementing and coordinating the project. Anappropriate structure (the former UGP), abolished in February 1994, was created for the purpose,and was later incorporated into the DOC, forming the Investment Projects Core Group [Nuicleode Projectos de Investimento] (NUPI).

NUPI spared no efforts, whelther in organizing courses to train credit analysts forcommercial banking, or promoting senninars to circulate information on the available lines ofcredit in the business community in Maputo as well as in the rest of the provinces. FACIM andthe mass media also served as a vehicle for disseminating information.

Commercial banks were invited to play a major role. They proved to be increasinglyactive participants in the economic recovery process. To this end, the following banks signed acontract of participation in the line of credit referred to: the Banco Comercial de Mocambique(BCM); the Banco Popular de Des envolvimento (BPD); the Banco Standard Totta deMocambique (BSTM); the Banco de Fomento e Exterior (BFE); the Banco Portugues doAtlantico, which is now part of the BIM; the Banco Internacional de Mocambique (BIM); theULC Mocambique (Leasing Company); and Credicoop, which is responsible for selecting thebest customers and the most deserving subprojects to receive financing.

The Institute for the Development of Local Industry (IDIL) has been receiving specificassistance under the Project. This has enabled it to provide these and other services to small and

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medium-scale enterprises. This does not mean, however, that other firms providing technicaland financial assistance cannot operate in this area at the same time.

1.4. Project Evaluation Seminar

On July 4, 1994, a Seminar was held in Maputo in the form of an informal brainstormingsession, to accomplish the following objectives: (i) to assess the effectiveness of the line ofcredit and to determine how its accessibility and use could be improved; and (ii) to identify waysto improve the business climate, especially for small and medium-scale enterprises.

The seminar was organized at the request of the World Bank, following a study of thenational business community in the form of a survey prepared and conducted by EduardoMondlane University in October and November 1993. The purpose of the survey was to identifythe priimary problems encountered by SME's and how those problems affected their ability to setup in business and operate. This would make it possible to determine systematically theprincilpal constraints they encounter.

Of the 125 businesses interviewed that (i) had submitted bids for the line of credit forsupport to SME's and (ii) were listed in the survey provided by the National PlanningCommission (CNP), 39 were chosen at random from the survey provided by the CNP, 58 wereselected on the basis of the information on bidders for the line of credit, and 28 were businessesin the informal sector. In the conclusions of the document, the obstacles that were found tohave a serious adverse effect on small and medium scale enterprise development were dividedinto three categories of descending importance:

(i) In the first group, the obstacles regarded as most serious were financial problems andproblems related to inflation and price volatility. As far as financial problems are concerned,difficulties in gaining access to working capital were the primary constraint for these businesses,followed by access to investment financing and problems encountered in loan negotiations withbanks. As for problems related to price instability, the businesses interviewed indicated that thegreatest obstacles were the high costs of raw materials and capital replacement.

(ii) The businesses put the following problems in the second category:* Expenses incurred as a result of taxes and mortgage recording fees;* The uncertainty surrounding economic and political strategies;* Access to foreign currency.

Heavy emphasis was placed on macroeconomic problems. The businesses interviewed indicatedthat economic stability and the functioning of the financial system were of critical importance todevelopment of the private sector in Mozambique. It is difficult for SMEs affected by theseissues to get beyond them in order to focus on matters related to their own operations. Theimportance attached to access to foreign currency, in the context of the current economicliberalization policy, could be interpreted as a difficulty in obtaining financial resources to payfor imports of raw materials;

(iii) The problems ranked in the third group had to do with procurement, infrastructure, andtechnology. Problems related to regulations and laws governing the operations of SME's werealso placed in this category.

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Despite the seminars organized by NUPI (the former UGP) to disseminate information incertain provinces, they seem to have had little impact in business circles. The poor performanceof commercial banks in providing information on this facility to the public is also largely toblame for this situation.

The economic sector which has made the most active use of the proceeds of the Credithas been industry, since 154 of the applications filed, or 53.55% of total demand, was from thatsector. It is followed by the transportation sector with 46, services with 41, fisheries with 29,tourism with 22, agro-industry with 17, mining with 8, and other sectors accounted for 13applications.

In terms of amounts of financing, industry absorbed US$65.4 million, followed by thetransportation sector at US$17.9 million, services at US$12.1 million, tourism at US$10.3million, fishing at US$5.8 million, agro-industry at US$2.9 million, mining at US$2.4 million,and others at US$5.0 million.

Applications to finance new businesses or ventures numbered 187, which put thiscategory in first place with 40.26% of total requests. One hundred and three (103) of theapplications, or 36.34%, were to renovate already existing enterprises, and 40 requests weresubmitted to expand operations, equivalent to 10.69% of the total.

1.6. Disbursements

The following table shows the actual behavior of yearly disbursements up to December1997.

Table 1.3. Comparative Chart of Proiected and Actual Disbursements (in millions of US$)

Years I1990 1991 1992 1993 1994 1995 1996 1997 TotalActual 2.5 0.6 1.0 5.9 5.6 5.2 8.7 4.0 33.5

The relatively low level of disbursements shown in Table 1.3 is attributed to thefollowing factors: (i) The inefficiency of the specialists involved in all levels of the importprocess, as a result of their lack of experience during the first two years of the project; (ii) thecomplexity of the procedures to be performed, especially with regard to procurement foroperators located outside the city of Maputo; and (iii) various bureaucratic proceduresresponsible for delays both in approval of letters of credit by local and foreign bankinginstitutions and in delivery of the goods by suppliers outside the country.

1.7. Repayments

Of the 147 subprojects approved, 137 are already in the collection phase. Of theremaining 10, 4 are in the grace period and 6 have been canceled. Generally speaking, the loanrecovery rate has not been satisfactory. The following table presents a general picture of the debtservice, by bank:

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Table 1.4. Current Debt Service Status of Commercial Banks (Dec. 1996)

Projects/Banks BCM % BP % BSTM % ULC % BIM %Total approved 102 100 24 100 8 100 I 100 I 100Paying regularly 12 11.8 5 20.8 2 25 0 0 0 0Paying irregularly 11 10.8 3 12.5 0 0 0 0 0 0Defaulting 59 57.9 12 50 0 0 0 0 0 0In grace period 4 3.9 1 4.2 6 7.5 1 100 1 100Rescheduling 10 9.8 2 8.3 0 0 0 0 0 0requestedCancelled ?6 5.8 1 4.2 0 0 0 0 0 0

The reasons for the poor recovery rate vary, but the following are some of the primaryones:(i) Poor performance on the part of certain commercial banks, especially in monitoringduring the period following approval of the subprojects;(ii) Inability of customers to pay, as a result of the change in the business climate (lack of amarket for finished products);(iii) Deliberate default by customers as a result of diversion of their earnings to otherpurposes (in some cases, they used their revenue for re-investment);(iv) Deliberate refusal to pay (bad faith), on the basis of allegations that the funds were fromthe World Bank and so no payments were owed to the bank in question (this is related to thesituation indicated in (i)).

As a result of these factors, banks, including the BCM and the BPD, were alreadyprevented from using all the lines of credit financed by the World Bank, unless they achieved atleast (i) a 10% recovery rate, in order to conclude any applications they may have pending; and(ii) 90%, in order to once again be eligible for the lines of credit.

With a view to minimizing the portfolio of non-performing loans associated with thisline of credit, commercial banks decided to pursue one of the following courses of action: (i) goto the courts and file suits: (ii) invite their customers to reschedule their debt paymentsaccording to the payment capacity of each customer; and (iii) promote activities to makecustomers aware of the need to honor their commitments with banks.

However, in accordance with the terms of the participation contracts, regardless of theperformance of the customers or final beneficiaries in making timely payments of the amountsdue, the commercial banks in question must reimburse the Bank of Mozambique the capitalowed in addition to the interest payable on the due date. Thus, as of December 31, 1997, theBank of Mozambique was charging the following amounts for annual interest (in millions ofmeticais):

Table 1.5. Trend in Interest Rates Charged by the Bank of Mozambigue(in millions of meticais)

1991 1992 1993 1994 1995 1996 1997 TotalBCM 0 0 22 2 259 2 584 22 051 22 484 49 380BPD 0 0 55 244 388 4 382 10 230 15 209BSTM 0 0 0 174 230 118 611 1 131BIM 0 0 0 0 0 0 0 0ULC 0 0 0 0 0 0 719 719Total 0 O 77 2 677 3 202 26 548 34 024 66529

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1.8. Special Account

The special account was closed on March 31 of this year. The unused balance ofUS$853,592.43 was returned to the World Bank on March 26, 1998. The amounts incorrectlycredited and debited to this account, which balance out to US$32,118.90, will be transferred tothe account of the exchange fund at Bankers Trust in New York.

1.9. Accounting of the Operations

Generally speaking, all operations are entered in the accounts and reconciled regularly,on a monthly basis, with the DCO. The accounts were audited by external auditors, Ern'st&Young, up to December 31, 1996.

1.10. Social Impact

According to statistics for investment applications submitted during the period underanalysis, at least 4,340 new jobs were created, and 12,102 workers were guaranteed work as aresult of the rehabilitation of the companies where they were already employed.

The average amount in foreign currency requested for each subproject is US$250,000.With regard to the demand for this line of credit and how it was distributed, the most frequentapplicants were businesses with 50 or less employees, as shown in Table 1.6. below:

Table 1.6. Distribution of Demand by Beneficiary Businesses(By size or number of employees) i

Size of Staff No. of Businesses % of Funds AllottedFrom 0 to 50 employees 107 73From 51 to 100 employees 23 16From 101 to 200 employees 12 8Over 200 employees 5 3

Total 147 100

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APPENDIX C

SMALL AND MEDIUM SCALE ENTERPRISE DEVELOPMENT PROJECT(Credit 2082-MZ)

Cofinanciers' contribution to the ICR

Assessment of sub-projects financed by the Caisse Francaise de Developpement

* Transports Cassamo: Provided parallel financing in the amount of FF 3,610,200 to add sixRenault trucks to the truck fleet of a freight company to meet an increasing demand. Thecompany also received financing from the World Bank project in 1992 to buy four Volvovehicles.

Assessment: The objectives of the project have been met, and the project is being implementedon schedule, despite the closing of the Volvo auto shop in Maputo.

* Linga Turist Lta.: Provided parallel financing in the amount of FF1,500,000 to build anocean-front resort on the peninsula of Linga Linga.

Assessment: The project did not achieve its objectives and implementation would be completedonly if the investor can find 1,300,000 rands to complete works. Major factors contributing tothe unfinished project can be attributed to legal weakenesses in the establishment of the twoshareholding companies and in the equity contribution, as well as the total lack of supervision ofthe works. The investors are for a large part responsible for the failed project because of theirinabilily to meet the financing requirements which were too ambitious. This project, which wasfinanced through an inefficient banking system, is testimony to the limitations of the exercise.Despite the availability of virtually risk-free foreign exchange which was then in very shortsupply, the project did not achieve its objectives.

* Hotel Moqambique: Provided parallel financing in the amount of FF 3,800,000 to renovatethe Hotel Macambique.

Assessment: An assessment of the financial viability of the project cannot be made at this stagebecause of lack of accounting and financial statements. Also, the project is still in the graceperiod phase.

* Ginwala: Provided parallel financing in the amount of FF 2,275,622 to help this oil-producing company establish a unit to manufacture plastic bottles for the cooking oil to amore marketable size.

Assessment: The project objectives were achieved.

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APPENDIX D

SMALL AND MEDIUM SCALE ]ENTERPRISE DEVELOPMENT PROJECT(Credit 2082-MZ)

Borrower's comments to draft ICR (translated version)Maputo, June 8, 1998

TO: Private Sector Finance (Fax No.: (202) 522-1198)Africa Regional OfficeWorld BankWashington, D.C.

Attn: Gabrielle M. Rooz

FROM: Bank of Mozambique, MaputoCredit Operations DepartmentInvestment Projects Bureau (Fax No.: (258) 1 42 34 65)

RE: COMMENTS: THE WORLD BANK REPORT ON THE PDPME

We have received the Implementation Report on the Small and Medium-ScaleEnterprise Development Project (PDPME), in response to which we wish to make thefollowing comments.

Overall, the report is very thorough, and presents the main problems encounteredsubsequent to the signing of the Credit Agreement, approval of the subprojects, and theimplementation of the latter up to recovery of the subloans. In particular, it identifiessome key lessons learned from the project, and these will be of great help in improvingour operations in the future.

We have identified some discrepancies, such as the following:

The report quotes the Credit numiber as 1794-MZ, instead of 2082-MOZ.

There are also a number of mistakes, such as the following:

The World Bank states that the closing date was December 1998, even though theyear 1998 is not yet over. Furthermore, closure was in December 1997, a year later thanthe date originally scheduled (December 1996).

The European Investment Bank (EIB) and the Caisse francaise de developpement(CFD) financed eight subprojects, not seven as the report states, even though one of thesewas financed simultaneously by EIB and IDA (i.e. that relating to UGC).

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There are also some discrepancies in amounts, but these are not very important,because, whereas your report bases its analysis on PDPME subprojects financedexclusively by the World Bank, the NUPI report reflects the overall position, involving asit does three international financial institutions: the World Bank (IDA), the Agencefrangaise de developpement (AFD, the former Caisse fran9aise de developpement, orCFD), and the European Investment Bank (EIB).

This accounts for the differences in the numbers of subprojects approved, workersemployed and jobs created, the regional distribution of subprojects, their breakdown bytype of economic activity, their classification into "new"v, "rehabilitation", or"expansion", etc.

In our view, the NUPI version is accurate, and this is reflected in the title of thereport: Relat6rio de Execuqdo do PDPME ("Report on the Implementation of thePDPME"); i.e. the project in general, rather than "Report on the Implementation of thePDPME (IDA/World Bank)".

However, if the World Bank does decide that NUPI should prepare a reportrefening exclusively to the IDA-financed aspects of PDPME, it should call for it and wewill produce it, although at the time that Ms. Gabrielle M. Rooz was preparing the WorldBank report, she asked us for the addresses of EIB and CFD, and we inferred from thisthat the approach she was adopting was general and not restricted, because otherwise itwould have made no sense to forward the report to the cofinancing agencies.

We find it difficult to comment on the percentage (82%) that the World Bankquotes for arrears unrecovered by BPD (Banco Popular de Desenvolvimento) and BCM(Banco Comercial de Mocambique), because since December 1996 we have received noinformation from these banks regarding their lending from this and other lines of credit.

As regards the relationship between the Bank of Mozambique and the commercialbanlcs, the repayment rate for the Credit proceeds has been 100%, since this issafeguarded under the Participation Contract, which authorizes BM to debit the accountsof these banks on the days that repayments fall due.

These are all the comments we wish to make on the report.

Sincerely,

/s/ [Illegible]Mrs. Irene C. Mauricio