Document o f The World Bank

FOR OFFICIAL USE ONLY

.Report No. 50482-ECA

PROJECT PAPER

ON A

PROPOSED ADDITIONAL FINANCING CREDIT

IN THE AMOUNT OF SDR 15.4 MILLION

(US$24 MILLION EQUIVALENT)

FOR

THE REPUBLIC OF MOLDOVA

ADDITIONAL FINANCING AND RESTRUCTURING OF THE COMPETITIVENESS ENHANCEMENT PROJECT

September 25,2009

Finance and Private Sector Development (ECSPF) Belarus, Moldova and Ukraine Country Unit (ECCU2) Europe and Central Asia (ECA)

This document has a restricted distribution and may be used by recipients only in the performance o f their official duties. I t s contents may not otherwise be disclosed without World Bank authorization.

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Moldova - GOVERNMENT FISCAL YEAR January 1 - December 3 1

BCP CLD CODB CPAR AF CPS CEP CFAA EMF EU EUR FM GDP GNP GoM GPN IBRD ICB IDA IFC IF1 IMF I S 0 ISR JSAN LDP LOC MDL MDGs MGF MoET MoF MSTQ MTEF

CURRENCY EQUIVALENTS (Exchange Rate Effective as o f September 25, 2009)

Currency Unit Currency Unit US$l .oo MDL 11.70

Weights and Measures Metric System

ABBREVIATION AND ACRONYMS

Base1 Core Principles Credit Line Directorate Cost o f Doing Business Country Procurement Assessment Review Additional Financing Country Partnership Strategy Competitiveness Enhancement Project Country Financial Accountability Assessment Environment Management Framework European Union Euro Financial Management Gross Domestic Product Gross National Product Government o f Moldova General Procurement Notice International Bank for Reconstruction and Development International Competitive Bidding International Development Association International Finance Corporation International Financial Institution International Monetary Fund International Standards Organization Implementation Status Report Joint Staff Advisory Note Letter o f Development Policy Line o f Credit Moldovan Leu Millennium Development Goals Matching Grant Facility Ministry o f Education and Trade Ministry o f Finance Metrology Standards, Testing and Quality Medium-Term Expenditure Framework

FOR OFFICIAL USE ONLY

NBM OECD OM OP8.30 PDO PFI PIU PER PHRD PSD RISP ROSC SDR SFA SPN UNDP U S $

National Bank o f Moldova Organization for Economic Co-operation and Development Operational Manual Operational Policy for Financial Intermediary Operations Project Development Objective Participating Financial Intermediaries Project Implementation Unit Public Expenditure Review Japan Policy and Human Resources Development Trust Fund Private Sector Development Rural Investment Services Project Report on the Observance o f Standards and Codes Special Drawing Rights Subsidiary Financing Agreement Specific Procurement Notices United Nations Development Program United States Dollar

Vice President: Country Director: Martin Raiser

Sector Director: Fernando Montes-Negret Sector Manager: Lalit Raina

Philippe H. L e Houerou

Task Team Leader: Alexander Pankov

This document has a restricted distribution and may be used by recipients only in the performance o f their off icial duties. I t s contents may not be otherwise disclosed without Wor ld Bank authorization.

MOLDOVA Additional Financing and Restructuring o f Competitiveness Enhancement Project

Table o f Contents

I . Introduction ..................................................................................................................... 1 I1 . Background and Rationale for Additional Financing in the amount o f $24 million ..... 1 I11 . Proposed Changes .......................................................................................................... 3 IV . Consistency with Country Partnership Strategy (CPS) ................................................. 5 V . Appraisal o f Restructured or Scaled-up Project Activities ............................................ 6 VI . Expected Outcomes ...................................................................................................... 8 VI1 . Benefits and Risks ........................................................................................................ 9 VI11 . Financial Terms And Conditions For The Additional Financing ............................. 11 Annex 1 : Revised Results Framework .............................................................................. 12 Annex 2: Enterprise Sector Access to Finance - Demand Analysis ................................. 13 Annex 3: Line o f Credit Component - Detailed Description ............................................. 16 Annex 4: Line o f Credit Component - Detailed Implementation Arrangements .............. 21 Annex 5: Procurement Arrangements ............................................................................... 24 Annex 6: Financial Management Arrangements ............................................................... 28 Annex 7 : Credit Line Component - OP 8.30 Compliance Review ................................... 30 Annex 8: Appraisal o f PFI eligibility ................................................................................ 33 Appendix 8.1 : Banking Sector Environment ..................................................................... 36 Annex 9 : Potential for Cooperation with Other IFIs ......................................................... 39

MOLDOVA

ADDITIONAL FINANCING AND RESTRUCTURING OF THE COMPETITIVENESS ENHANCEMENT PROJECT

PROJECT PAPER

EUROPE AND CENTRAL ASIA

ECSPF

Project ID: PO89124 Project Name: Competitiveness Enhancement Project Expected Closing Date: June 30,20 12 Lending Instrument: Specific Investment Loan Joint IFC: Joint Level:

Team Leader: Alexander Pankov Environmental category: C

-~

Basic Information (Additional Financing) ~

Date: July 17,2009 Country Director: Martin Raiser Sector ManagedDirector: Lalit Raina

Team Leader: Alexander Pankov Sectors: Banking (50%); General industry and trade sector (30%); Micro- and SME finance

Themes: Export development and competitiveness (67%); Small and medium enterprise support (33%)

Project ID: P116187 Environmental category: F I Lending Instrument: Specific Investment Loan Additional Financing Type: Restructuring

Joint IFC: Joint Level:

(20%)

For Loans/Credits/Others: Total Bank financing: SDR 15,400,000 (US$24,000,000 equivalent)

0.00 24.00 (IDA)

24.00 Total:

Borrower: Republic o f Moldova

Responsible Agency:

Ministry o f Economy and Trade 1 Piata Marii Adunari Nationale Governmental House Chisinau Moldova MD 2033 Tel: +(373) 22 250-626 tbesliu@,mec.aov.md -

Fax: +(373) 22 234-064; 250-672

Annual Cumulative

Ministry o f Finance 7 Cosmonautilor street Chi sinau Moldova

Tel: 373 22 -212-077 Fax: 373 22 -212-077 ematveeva@minfin.moldova.md

MD-2005

0.50 0.87 1.36 2.60 11.40 15.80 5.77 0.50 1.37 2.73 5.33 16.73 32.53 38.30

Estimated disbursements (Bank FY/US% mln) FY I 2006 I 2007 I 2008 I 2009 I 2010 I 2011 I 2012 I

I. Introduction

1. This Project Paper seeks the approval o f the Executive Directors to provide an additional credit in the amount o f SDR 15,400,000 (US$24 million equivalent) to the Republic o f Moldova for Additional Financing (AF) and Restructuring o f the Moldova Competitiveness Enhancement Project (CEP) (PO891 24), supported, inter alia, by IDA Credit #4 1 19 and IDA Grant #H 1870.

2. The proposed additional credit w i l l help finance the costs associated with activities aiming to enhance the impact and development effectiveness o f CEP in the economic and financial crisis environment. The AF wi l l aim to maintain and enhance the competitiveness o f the Moldovan enterprise sector through a combination of: (i) scaling up o f the existing matching grant component in order to assist enterprises with upgrading their labor ski l ls and management practices, and introducing new products; and (ii) a new Line o f Credit (LOC) component that wi l l support the investment and working capital needs o f exporting enterprises. The main expected outcome o f the proposed AF wi l l be the improved access o f private enterprises to credit and business development services. A secondary outcome will be the improved ability o f Moldovan banks to provide term financing to the enterprise sector.

3. While no formal co-financing with other donor agencies i s envisioned, it i s expected that parallel financing wi l l be extended by the International Finance Corporation (IFC), the European Bank for Reconstruction and Development (EBRD) and the Millennium Challenge Corporation (MCC) for activities complementary to the CEP (see Annex9).

11. Background and Rationale for Additional Financing

4. Project Background. The CEP was approved by the Board on October 27‘h, 2005, and became effective on February loth, 2006. The financing for the original project amounts to US$14.3 million, including a SDR 3.35 million (US$4.9 million equivalent) IDA credit, a SDR 3.35 million (US$4.9 million equivalent) IDA grant, and a US$4.5 million PHRD grant. The original Development Objective for the CEP i s “to assist Moldova in enhancing competitiveness o f enterprises through improvements in the business environment and making adequate standards, testing, and quality improvement services available to enterprises” (as worded in the Credit Agreement).

5. The CEP i s making satisfactory progress towards achieving i ts Development Objective. Major accomplishments under each o f the four original components are as follows:

Business Environment Improvement (US$2.2 mln). The main objective under this component has been to assist the Government o f Moldova (GoM) in implementing i t s regulatory reform agenda for the enterprise sector. The systematic review o f existing legislation affecting business (so-called Guillotine exercise) was completed by Spring 2008, resulting in major simplifications in the legal framework for business entry and operations. At the same time, the

1

Regulatory. Impact Assessment methodology became mandatory for preparation o f all new regulatory acts affecting business operations, with the CEP supporting capacity building activities in various line ministries. The latest annual Cost o f Doing Business Survey o f the Moldovan enterprise sector has registered a substantial reduction in the time spent by firm management on compliance with regulatory requirements (from 17 percent in 2004 to 1 1.2 percent in 2009).

0 Modernization of Metrology, Standards, Testinn and Quality (MSTQI System {US$9.6 mln). The objective o f this component has been to strengthen the capacity o f the national MSTQ system to provide internationally acceptable (especially, EU-compatible) MSTQ services. Specifically, the project currently provides financing for: (i) the modernization o f ten national metrology laboratories; (ii) the creation o f a national standards body consistent with the European Union’s (EU) best practice; and (iii) building the capacity o f the National Accreditation Center. The renovation o f laboratory premises, has been completed, and the procurement o f metrology equipment i s presently underway. The Moldovan authorities have agreed in principle with the Romanian counterparts on acquiring the EU compliant body o f most needed standards for adoption in Moldova. Enterprise access to MSTQ services (US$1.4 mln). This component helps promote the acquisition o f internationally recognized certificates o f quality management system (ISO, etc.) by Moldovan private enterprises by co-financing a portion o f related expenditures through the Matching Grant Facility (MGF). As o f March 2009, more than 200 applications from eligible companies have been approved. Approximately half o f these f i rms have already received the quality management certificates. Most beneficiaries have reported better access to export markets, including EU ones, once the international certificate o f quality had been obtained.

0 Access to Finance (US$0.3 mln). The main objective o f this component i s the establishment o f a functioning credit bureau in Moldova. Following the enactment o f relevant legislation in mid-2008, two private credit bureaus have been established.

0

6. As o f end-May 2009, approximately 37 percent o f total financing resources, or US$5.36 million had been disbursed, including US$l.88 million disbursed under IDA Credit. The disbursement lag with regard to IDA resources stems from somewhat delayed project effectiveness, but more importantly from the original project design, under which the PHRD grant was f i rs t used to engage consulting services for due diligence and preparation o f technical specifications for goods packages under the MSTQ component, to be then financed by the IDA CredidGrant. The disbursement lag has started to shrink in FY2009, as the procurement o f large equipment packages for metrology laboratories i s gradually being finalized. .

7. Notwithstanding the disbursement lag, the Project remains well on track in meeting i t s Development Objective and related outcomes. The last supervision mission visited Chisinau in June 2009, and agreed with the Ministry o f Economy and Trade on the time- bound action plan for accelerating the implementation, with special attention given to the MSTQ component due to i ts complexity. On the basis o f the progress made since the previous supervision visit in November 2008, it i s proposed that the Implementation

2

Status Report (ISR) rating for the progress toward achievement o f the Project Development Objective (PDO) be upgraded from Moderately Satisfactory to Fully Satisfactory.

8. The CEP has maintained compliance with al l legal covenants, and has not faced any safeguard, environmental, or fiduciary problems. N o changes to the original objectives, design, or scope have been proposed to date. The current closing date for the Project i s December 3 1,2009.

9. Rationale for AF. The CEP is based on the inherent assumption that the banking sector, in combination with foreign capital inflows, would be able to provide the funding needed by the enterprise sector to finance investments related to improving competitiveness. This assumption has recently been challenged by the global and regional economic downturn. The global liquidity squeeze means a drastic reduction in the already limited external financing options for banks and enterprises alike in Moldova.

10. The sensitivity o f banks in Moldova to remittances based-lending and remittances-based fee income i s significant, as confirmed in the latest Financial Sector Assessment Program (FSAP) Update (2007) and the associated stress tests. Adverse economic conditions and stricter regulation in Russia, Ukraine and the EU-the main destinations for Moldovan migrants - are already causing the inf low o f remittances to significantly slow down. At the same time, private capital inflows have practically stopped. In response to these trends, Moldovan banks have been restricting the f low o f credit to the real sector in recent months in an attempt to preserve liquidity and minimize the credit risks. As a result, even strong exporters find it increasingly difficult to raise external financing even for working capital purposes (see demand analysis in Annex 2). The reduced access to finance could lead to loss o f markets, triggering bankruptcies with a ripple effect in the economy. This might ultimately undermine the expected development effect o f the CEP.

1 1. The new operating environment calls for pro-active restructuring supported by the AF that would enable Moldovan export-oriented enterprises to effectively address the challenges arising from the economic crisis. Through the L O C instrument, the authorities would like to help banks raise term funding at a reasonable cost, to be able to provide credit to the enterprise sector o n affordable terms. In parallel, the expansion o f a successful MGF would al low the private f i r m s to pursue the business development activities in these changed circumstances.

111. Proposed Changes

12. Development Objective. To reflect the additional activities, the Development Objective will be slightly modified as follows (modifications shown in italics): “The Project will assist Moldova in enhancing competitiveness o f enterprises through improvements in the business environment, enhancing access to finance, and making adequate standards, testing, and quality improvement services available to enterprises.”

13. Component Allocations. The AF will be used to finance the fol lowing activities:

3

0

0

14.

Component

Regulatory Component

MSTO ComDonent

Scale-up of the existing Matching Grant Component of the CEP (US$l.S mln). Up until now, this successful component was only co-financing the costs o f the international certification o f the quality management system (ISO, etc.) by eligible enterprises. As foreseen in the original project design, the expanded facility would reimburse beneficiary enterprises up to 50 percent o f expenditures (but not more than US$lO,OOO equivalent in Moldovan L e i (MDL)) in the fol lowing two broad areas: (i) consulting services for preparation o f business plans, feasibility studies, marketing, and development o f new products and services; and (ii) on-the-job training o f management and personnel.

New Line of Credit component (US22.5 mln) which will provide funding to qualified banks for on-lending to eligible exporting enterprises in support o f their working capital and investment financing needs. The addition o f the L O C represents proactive project restructuring given that the original credit amount i s insufficient to cover this activity, which has become highly relevant in the crisis conditions. A detailed description o f this component can be found in Annex 4.

I D A I D A Credit Credit A F I D A Grant

500,000 200,000

3.150.000 3.450.000

The revised project financing table is shown below.

Matching Grants Facility

Facilitation o f Access to Finance

Project Management

New Line o f Credit

Unallocated

T O T A L

700,000 1,500,000 700,000

150,000 150,000

275,000 275,000

22,500,000

125,000 125,000

4,900,000 24,000,000 4,900,000

300.000

15. Implementation Arrangements. The Ministry o f Finance (MoF) will be the Recipient and will delegate project coordination at the pol icy level to the Ministry o f Economy and Trade (MoET). The existing Project Implementation Unit (PIU) o f the CEP, working under the auspices o f the MoET, will be responsible for the overall project implementation, including disbursement, financial management, procurement, monitoring and evaluation.

16. The day-to-day responsibility for implementation o f the N e w L O C component will l ie with the Credit L ine Directorate (CLD), a special institution which operates under the auspices o f the MoF. The C L D was established in 1995 with the World Bank Private Sector Development I (PSD I) Project support specifically for the purpose o f administering credit l ine resources financed by the International Financial Institutions

Original component allocations in US$ are given in this Table. These allocations are subject to 1

fluctuations in SDR/US$ exchange rate.

4

(IFIs). I t currently administers half a dozen credit lines, including the one provided under the Bank's Second Rural Investment Services Project (RISP 11). The CLD has an experienced team which i s well versed in standard World Bank credit l ine administration related requirements. Annex 4 provides more details about implementation arrangements and the related functions.

17. The MoF, with the help o f the CLD, will negotiate and sign Subsidiary Financing Agreements (SFAs) with eligible Participating Financial Intermediaries (PFIs). Eligibility criteria and terms for on-lending to PFIs are given in Annex 3. The subsidiary finance to PFIs will be extended to refinance PFIs' loans to private beneficiary enterprises using the procedures described in the Operational Manual for Credit Line Component. The decision to extend a sub-loan to a beneficiary enterprise will be left to a PFI and will be based on thorough financial appraisal o f a borrower's financial condition and prospects.

18. Disbursement. The AF i s proposed at this time because the current demand for funding from the private enterprise sector cannot be met from the existing financing sources under the CEP which have either been utilized or committed. The current CEP disbursement profile will be changed to reflect the utilization o f AF. Additionally, some reallocations will be effected between disbursement categories both in the original IDA Credit and IDA Grant in response to the evolving Project financing needs.

19. Retroactive Financing. To meet any immediate financing needs, retroactive financing will be allowed for eligible expenditures under sub-loans totaling up to SDR 3,065,000 and for payments made after April 30, 2009, as long as the sub-loans meet the eligibility criteria.

20. Closing Date. The AF proposed Closing Date i s June 30, 2012. To allow for full completion o f ongoing and planned activities, it i s also proposed that the Closing Dates o f the Development Credit Agreement (Credit No. 41 19 MD), the IDA Grant Agreement (Grant No. H187 MD) and the PHRD Grant Agreement (TF055175) be extended by 2.5 years to June 30,2012.

IV. Consistency with Country Partnership Strategy (CPS)

21. The activities proposed under the AF are consistent with the new CPS for Moldova (approved on January 29, 2009), which aims, inter alia, at improving economic competitiveness to support sustainable economic growth. Specifically, the AF CEP would support the export-oriented real sector with higher value added in Moldova during and beyond the current economic crisis. The credit l ine would also help the banking sector maintain intermediation services by providing long term funding at an affordable cost. The AF CEP i s expected to have a highly positive impact on poverty reduction as it will help competitive firms to weather the present crisis, and, in the medium term, make a larger contribution to employment and economic growth.

5

V. Appraisal of Restructured or Scaled-up Project Activities

A. Economic and Financial Analysis

. 22. Demand for finance among potential beneficiary enterprises has been assessed with the help o f a questionnaire conducted in March 2009. The results are presented in Annex 2.

23. The financial analysis o f potential PFIs was undertaken in early June 2009 as part o f the project preparation process. Potential PFIs were assessed from the point o f profitability, capital adequacy, asset quality, prudential compliance, corporate governance and risk management. The assessment will enable the determination o f which banks could be eligible to participate in the Project. More details on the PFI assessment i s provided in Annex 8.

24. As there i s no clear way o f defining the credit line project costs up-front, financial appraisal will be performed by PFIs, with monitoring f rom CLD o n a subproject-by- subproject basis as part o f the appraisal o f eligibility o f individual borrowers and subprojects. Financial soundness o f subprojects will be based on financial analysis derived from: (i) financial rate o f return; and (ii) incremental financial benefits and costs to the final beneficiary based on "with-subproject" and "without-subproject" analysis. To assess the risk, a sensitivity analysis will be performed for each subproject, including sensitivity to exchange rate devaluation, price decreases in the expected producthervices market, demand decreases, and increases in operating costs. Implementation risks will also be assessed for each subproject.

25. In addition, financial soundness will be assessed for each beneficiary enterprise. This will include the assessment o f a beneficiary's financial condition based on historical and projected financial statements using financial ratio analysis and comparisons with relevant industry standards. It will also include an assessment o f its business plan, investment programs, market position and sources o f competitiveness and stability in the relevant markets. Finally, there will also be an assessment o f exposure to the enterprise, potentially assumed by the bank, comprising the total shares o f the borrower in the Project and the amount and quality o f the pledged collateral.

B. Technical Analysis

26. The scale-up o f the MGF will require an update o f the existing Matching Grant Manual to reflect the expanded range o f services eligible for refinancing. The responsibility for the technical implementation will l ie with a qualified administrator reporting to the PIU.

27. compliance with OP 8.30 requirements. The detailed results are reported in Annex 7.

The technical aspects o f the credit line component have been appraised to ensure

28. Eligibility Criteria for Sub-Borrowers. Access to Bank-financed sub-loans will be open to al l enterprises in private ownership, registered in Moldova, that currently generate foreign exchange revenue from the export o f goods and services, or plan to start

6

exporting based on a credible business plan. Eligible sub-borrowers should be in a financial position that will allow them to meet al l existing and projected financial obligations in a timely manner. The projected financial position will need to show that the enterprise will maintain i t s profitability and adequate liquidity once the PFI sub-loan i s extended, and that its overall leverage will remain reasonable. More details can be found in Annex 3.

29. Eligibility Criteria for Sub-Projects. Since the primary objective o f the credit l ine i s to help the exporters deal with the effects o f the global economic crises, there will be no specific eligibility criteria for sub-projects - other than that the subprojects should be technically feasible and economically, financially and commercially viable. Both investment and working capital sub-loans will be available.

30. Sub-Loan Terms. Sub-loans will be available in EUR, US$, and MDL. The currency risk could be distributed between the Government, the PFIs and the final borrower. Exporting enterprises will be partially hedged against foreign currency risk through their foreign currency earnings. For the sub-loans to final borrowers, PFIs will add a spread to cover their cost and risks. In principle, the PF I sub-loans will be priced based on competitive domestic market terms.

31. Sub-loan'amounts will be subject to limits, depending on the sub-loan type. Investment sub-loans will have a maximum size o f EUR 800,000 equivalent with maturities and grace periods determined by the PFIs, based on the sub-project being financed. The maturity will be up to eight years. The working capital sub-loans will be up to EUR 500,000 equivalent with up to four years maturity.

C. Fiduciary Analysis

32. Financial Management (FM). The financial management systems for the AF have been assessed by the task team. The details o f the FM arrangements can be found in Annex 6.

33. the task team and the details can be found in Annex 5.

Procurement. The procurement arrangements for the AF have been assessed by

D. Social

34. The proposed AF i s expected to have a positive social impact. Increasing access to finance should have a positive effect for maintaining and increasing employment in the private enterprise sector, even in the midst o f economic downturn.

35. N o social safeguards are triggered by the AF. The credit l ine component will not finance any investments involving the involuntary acquisition o f land or the displacement o f persons. Suitable screening language will be incorporated into the OM for Credit L ine component for use by the C L D and PFIs.

7

E. Environment

36. In accordance with the Bank’s safeguard policies and procedures, including OP/BP/GP 4.01 Environmental Assessment, the Project is placed into the Bank’s FI Category, which i s applied to al l proposed projects that involve the investment o f Bank funds through a participating financial intermediary (PFI) to be used for subprojects, the environmental impact o f which cannot be determined during the appraisal o f the World Bank Project. For an FI operation, the Bank requires that each FI screens proposed subprojects and ensures that subproject beneficiaries carry out the appropriate environmental assessment for each subproject. Using the existing World Bank Safeguard Policies and Procedures for FI projects, an Environment Management Framework (EMF) was prepared by an independent local consultant.

3 7. The EMF outlines environmental and social assessment procedures and mitigation requirements for the subprojects which will be supported by the AF CEP. It provides details on procedures, criteria and responsibilities for subproject screening and preparing, implementing and monitoring o f subproject specific environmental safeguard requirements. The document also includes Environmental Guidelines for proposed subprojects, containing an assessment o f potential impacts and generic mitigation measures to be undertaken at al l stages: from identification wd selection, through the design and implementation phase, to the monitoring and evaluation o f results.

38. The potential participating PFIs are already familiar with the World Bank’s standard requirements for an environmental review from their experience under the ongoing RISP I1 credit line. Also, the C L D has received adequate training to conduct screening o f sub-loan applications for compliance with safeguard procedures. Per World Bank disclosure policy, the draft EMF was disclosed in the country, with public consultation conducted. The final version o f the EMF was posted on the web site o f the M o E T on June 17, 2009, provided to the World Bank and will be used by the Borrower during project implementation.

39. The environmental assessment documentation for al l sub-projects assigned Category A, and the f i rst two Category B sub-projects from each PFI, will be subject to prior review and approval by the World Bank. I t i s important to note that sub-projects, which might involve resettlement, land acquisition, effect on natural habitats or cultural property, or impact on international waterways will not be eligible for financing under the AF CEP.

F. Policy Exceptions and Readiness

40. The AF requires no exceptions from standard policies and i s ready for implementation.

VI. Expected Outcomes

41. The AF is expected to enhance the Project’s outcomes by: (i) improving access o f private enterprises to long-term investment and working capital finance; and (ii) improving the ability and sk i l ls o f local banks for financing real sector projects. These

8

outcomes will be monitored through specific indicators, including the volume and number o f sub-loans disbursed, and quality o f the sub-loan portfolio. The Revised Results Framework for CEP can be found in Annex 1.

VII. Benefits and Risks

42. Moldovan private ente’rprises and banks are expected to be the primary beneficiaries o f the AF CEP. In the immediate term, the new L O C and expanded MGF will provide financing resources to qualified enterprises to help them remain competitive during the crisis environment. In the longer term, by encouraging investment in new equipment, technology, and workers’ skills, the AF will facilitate the development o f higher value added production capacity in Moldova, that in turn will provide new sources o f employment and result in increased exports and more diversified trade flows. At the same time, through the demonstration effect, the L O C is expected to improve the overall ability o f Moldovan banks to provide not only more but better lending products to the real sector.

43. Critical risks that may impede successful project implementation are as follows:

Risk factors

:inancia1 Sector Lisks

Macroeconomic Environment

Credit Demand

Description of risk

Solvency o f PFIs may come under strain as a result of the effect of global and regional financial crisis in Moldova’s economy. Deposits may decline due to the reduction in remittances and reduced confidence in the banking system, which i s also vulnerable to currency fluctuations, and a downturn in key sectors o f the economy.

The generally sound macroeconomic framework has been under increasing strain lately due to the direct and indirect consequences o f the global and regional economic downturn

Continuous economic problems in export markets andor a hrther slowdown will affect exporters’

Mitigation measures

Due to high prudential norms set by the National Bank o f Moldova (NBM) and relative isolation from global financial markets, Moldova’s banking system has a larger safety cushion than some o f the neighboring countries, with CAR and liquidity ratios of >30percent in May 2009. The apparent sector vulnerabilities will be monitored and mitigated through the policy dialogue led by the International Monetary Fund (IMF) and the World Bank.

Thorough due diligence wil l be conducted by the Bank to help the CLD determine the eligibility of interested banks. Only strong, well-capitalized, profitable PFIs will be selected for participation in the LOC. The condition o f PFIs will be monitored by the CLD and the Bank on a regular basis, in consultation with the NBM. The Bank and the IMF are in close contact with the authorities on the macroeconomic framework. Both institutions stand ready to provide additional budget and balance of payments support to Moldova authorities in case o f any financing need. While credit demand might decline, the shortage o f attractive long/medium term hnds in the market should maintain

Rating of Risk after Mitigation Substantial

Substantial

Moderate

9

PFI Credit Demand

Technical Design

Implementation Capacity

Financial Management

Procurement

Social and Znvironmental Safeguards

performance, with negative consequences on demand for credit.

Improved financing conditions for PFIs and the loss o f interest for the Bank funding.

Credit risk with the enterprise sector may increase as the economy slows.

The implementation unit might not be sufficiently resourced to provide PFIs with guidance, as needed, to regularly monitor performance or otherwise determine banks’ adherence to the Operational Manual. Financial management capacity for the Project may not be adequate.

Weak procurement capacity o f the CLD staff and capacity o f beneficiary enterprises to apply sound commercial practices.

Undue pressures with theselection o f sub-projects and procurement by sub-borrowers.

Sub-loans could raise social and znvironmental issues

10

significant unmet demand for the Bank’s funds. In addition, the technical design o f the operation, which utilizes a number o f PFIs to channel funds to the real sector, remains another mitigating factor. In this case, the development objective wi l l be served directly by alternative funding o f commercial banks, and therefore the development objective i s not at risk, but i t creates a risk to the project implementation. The Borrower wi l l be advised to negotiate mutually acceptable financing terms with potential PFIs. PFIs have been trained in credit appraisal techniques to properly assess the potential sub-borrowers. The sub- borrowers’ financial statements and investment plans wi l l also be assessed by qualified staff at the CLD and, in case of larger sub-loans, by the WB. The CLD has 10 years o f experience with several different I F I M LOC facilities, has strong existing resources and i s committed to ensuring i ts quality o f service and reporting.

Both the CLD and the PIU at the MoET have received extensive training in the Bank’s F M procedures. The O M will reflect the financial management and procurement policies and control procedures applicable to the Credit Line that wi l l be strictly followed. Close supervision by the Bank team will be required. The CLD staff wi l l attend the ECA Regional procurement training to equip themselves with knowledge on Bank’s procurement procedures, including International Competitive Bidding (ICB).

Discuss anticorruption guidelines with the CLD at negotiations and further at the project launch workshop. Include provisions related to the disclosure o f conflict o f interestsand the code o f ethics for the evaluation committee inthe Operational Manual. The policy on Involuntary Resettlement wi l l not be triggered because there wi l l be no acquisition o f land by public sector institutions nor wi l l the Bank funds support loans to fund any sub-borrower who would invest in an enterprise which would require the involuntary displacement o f existing occupants or

Low

Moderate

Low

Moderate

Substantial

Low

OVERALL RISK

VIII. Financial Terms and Conditions for the Additional Financing

economic users o f any plot o f land, regardless o f its current ownership. The OM for the Credit Line wil l clearly lay out other social and environmental requirements and these will be regularly monitored by the PIU, and by the Bank through periodic supervision missions.

Moderate

44. Specific effectiveness conditions wi l l include:

The CEP AF wi l l be supported by the IDA Credit o f US$24 million equivalent.

Signing and entering into force o f Subsidiary Financing Agreements (SFAs) between the MoF and at least two PFIs, in form and substance satisfactory to the Association; and, Approval by the Recipient o f the Operations Manual for Credit Line Component, in form and substance satisfactory to the Association.

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The Project will assist Moldova in enhancing the competitiveness of enterprises through improvements in the business environment, enhancing access to finance, and making adequate standards, testing, and quality improvement services available to enterprises.

I Environment Improvement

Reduced regulatory compliance costs Component B: Modernization of MSTQ System The National Institute for Standardization and Metrology (NISM) and Accreditation Center has acquired the ability to monitor and evaluate business sector needs for MSTQ services and develop strategies.

Reduced costs o f compliance with standardization and certification requirements as the result of upgraded MSTQ infrastructure. Component C: Facilitation of Enterprise Access to MSTQ Services and Business Development Services Improved access to business development services Component F: LOC Improved access to term finance for investment and working caDital loans.

Annex 1: Revised Results Framework for CEP

Demonstrated capacity of the Government to coordinate and implement regulatory reforms, and deliver selected public services in compliance with the Organization for Economic Co-operation and Development (OECD) principles;

Decrease o f regulatory compliance costs for enterprises (measured by Cost of Doing Business (CODB) Indicators);

MSTQ system development meeting the World Trade Organization (WTO) commitments (measured by periodic surveys of progress as per the WTO agreement); and

Amount of term credit disbursed through the LOC and the number o f matching grants disbursed through the matching grant facility.

Number o f inspections per year per firm reduced to maximum 12.

Number o f EU compatible standards adopted reaching at least 1,700.

Number o f accredited testing facilities available to enterprises reaching 170.

Number of international certifications received by Moldovan enterprises increasing from 70 (2005) to 170.

Number of matching grants approved

Number of sub-loans approved to beneficiary enterprises

Percentage of non-performing loans (target: <5 percent of Dortfolio).

Guide Government’s efforts to further improve business environment and MSTQ regime.

Determine impact o f Project on beneficiary enterprises.

mediate

The results of annual CODB enterprise surveys will be used for adjusting the regulatory reform program.

Internal statistics and results of customer surveys are used by the MSTQ institutions to: (i) adjust service delivery, procurement plans for new equipment, and scope and content o f training programs; and (ii) guide the drafting of the development strategy of each institution.

Statistics and results of customer surveys are used by MGF to adjust its procedures.

Periodic reports are used to monitor progress and adjust implementation arrangements if necessarv.

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Annex 2: Enterprise Sector Access to Finance - Demand Analysis

1. A survey o f 50 f i r m s chosen at random by commercial banks and from beneficiaries o f the Matching Grant Component o f CEP (reasonable proxy for export-oriented f i rms) was conducted in March 2009. The aim was to understand the level o f access to bank credit and the f i rms ’ needs in terms o f working capital and investment for the next two years.

2. The survey used the following sample: The vast majority o f firms surveyed, namely 60.78 percent, were medium sized, providing jobs for 50-250 employees. Large enterprises, employing over 1,000 workers, accounted for only 3.92 percent in our sample.

0 55 percent o f the firms surveyed benefited from a matching grant under the CEP. More than hal f o f the companies surveyed are in the food and beverage industry, both being traditional Moldovan export industries. For a more detailed breakdown by sectors, please see

Figure 2.1: Sector Distribution o f Firms Surveyed

~ m i t u e Production

0 Mechwical engmeenng

E Medical son ices

rn Postal Sen ice

0 Sum lndustq

Figure 2.1, on the right. Source: ECSPF AF Questionnaire, March 2009

0 The firms surveyed are concentrated in the cities and towns, which i s typical o f the economy as a whole. The respondents to the AF survey were heavily concentrated in the center o f the country (58.82 percent), most o f them having their headquarters and the bulk o f their business in the capital, Chisinau (33.3 percent). The Northern region was represented only by 27.45 percent o f the f i r m s in the sample, while the South by a mere 13.73 percent. There i s also a vast urban vs. rural area divide even in terms o f economic activity, with 76.47 percent o f economic activity being undertaken in urban areas. 90 percent o f the f i r m s surveyed export their goodshervices. Less than 5 percent o f them did not have plans o f expanding beyond Moldova’s border in the near future. Circa 57 percent o f the respondent firms are looking to enter new export markets in the coming 2-3 years, while 24 percent will focus on investing in the existing market. Over ha l f o f the survey respondents, i.e. 55 percent, had received a CEP matching grant in the past.

0

0

3. Ma in findings were as follows:

During the past 12-24 months companies have relied primarily on internal funddretained earnings, as wel l as on loans f rom banks, for their working capital needs and for their investment plans (see Table 2.1 below).

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Source of Funding

Source: AF Questionnaire, March 2009

Bank loans are an important source o f financing. Historically bank loans accounted for approximately 1/3 o f the sources o f finance. Businesses surveyed anticipate that the importance o f bank lending will grow, particularly as the customers appear to be less willing to pay in advance. Access to finance in the last 12 months has been especially difficult for f i r m s in the wine and spirit production sector. Respondents from the wine and spirit production sector (25.5 percent o f the sample) reported that they were not able to receive any loans in the last 12 months. Additionally, Russia’s ban on Moldovan wines had increased the risk profile o f wine-making companies. The fact that 58.7 percent o f the loans were offered in MDL suggests that the lending offered i s relatively unhedged. It i s important to note that 90 percent o f f i r m s surveyed are exporters. EUR denominated loans were the second-most popular currency, denoting the orientation o f exporters to European market. Only 14 percent o f the loans were in US$. After adjusting for inflation, the interest rates offered are on par. Nevertheless, the effect o f appreciating MDL towards the end o f 2008 made the MDL denominated loans at 20.54 percent, which i s prohibitively expensive for the borrowers. The transaction costs to obtain a loan were rather high. Namely, the average time to get the loan approved was 1.5 months (or 5.5 weeks) and the cost o f processing the loan, mostly consisting o f legal fees, amounted to 1.05 percent o f the loan. Currently, companies seeking external financing need to present to either a local branch or to the headquarters an exhaustive l i s t o f documents, including notarized information about the collateral, audited financial reports, etc. An exporters’ future financing needs are unlikely to be met by the’ local financial market. 76 percent o f firms plan to make investments in the coming 24 months to meet the expansion objectives mentioned above. Of these f i rms, 93 percent plan to invest in equipment and less than 10 percent are interested in acquiring land. In order to carry out these investments, firms are interested in taking out loans from

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the banks (the most important source o f investment financing for Moldovan exporters, see Table 2.1 above) for an average duration o f 55 months and maximum interest rates o f 13.85 percent for MDL loans, 8.95 percent for EUR loans and 9.08 percent for US$ loans. However, the financial institutions are not able to meet neither price nor required maturities (Table 2.2 below).

Table 2.2: Mismatch between Demand and Supply o f Finance for Firms for Investment and

Source: AF Questionnaire, March 2009

0 Working capital is financed overwhelmingly through retained earnings. In fact, this represents another opportunity the banks can utilize using the LOC. Banks will now be able to offer working capital financing, leaving the retained earnings to be used for investment purposes.

4. Recipients o f the CEP matching grants have seen their exports increase as a result o f implementing quality assurance and food safety systems. Such dynamics were confirmed by 60.7 percent o f MGF beneficiaries surveyed. The vast majority o f the recipients, accounting for 75 percent, implemented a quality management system ( I S 0 9001 or alike). Approximately 46 percent implemented a food safety assurance system, thus reflecting the importance o f the food processing and wine and spirit production sectors in Moldova’s economy and exports.

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Annex 3: Line o f Credit Component - Detailed Description

1. The additional finance includes a new L O C component o f US$22.5 mil l ion equivalent to be extended through PFIs to creditworthy exporters for viable projects. The financing will include working capital and investments loans for the export-oriented enterprises.

2. The M o F will borrow from the Bank and on-lend funds to eligible PFIs under the SFAs. The L O C will be administered through an apex arrangement. The apex wil l be placed with the CLD, a specialized entity operating under the MoF. The C L D has ample experience with the Bank’s l ines o f credit, and has also administered credit l ines o f a number o f other international institutions. Further details on implementation arrangements are provided in Annex 4.

PFI Eligibility Criteria

3. PFI Pre-Qualification Process. All banks licensed in Moldova will be able to participate in the Project, providing that they meet the eligibility criteria. Banks that wish to be considered for participation are requested to confirm that they:

A l l o w the C L D and the Bank access (on a need-to-know basis) to privileged information necessary to appraise whether the interested financial institution meets and/or continues to meet the agreed eligibility criteria; Agree to fo l low the rules as prescribed in O M for the Credit Line Component and to undertake annual external audits by reputable auditors according to the international accounting and auditing standards; and, Agree to devote adequate resources to the Project, including to appoint specific staff for the Bank project implementation, with al l necessary technical profiles and to provide the necessary training.

0

0

0

4. Eligibility criteria for PFIs fol low principles recommended by the Bank’s Operational Policy for Financial Intermediary Operations (OP8.30). The eligibility criteria used to assess banks’ qualification for participation are as follows:

a) The bank must be duly licensed and at least two years in operation; b) The bank’s owners and managers must be considered “ j t andproper”. It must

have good governance, qualified and experienced management, adequate organization and institutional capacity for i t s specific risk profile;

c) The bank must be in “good standing” with its supervisory authority (i-e., i t should meet all pertinent prudential and other applicable laws and regulations) and remain in compliance at al l times;

d) The bank must have well defined policies and written procedures for management of all types offinancial risks (liquidity, credit, currency, interest rate and market risk, as wel l as risks associated with balance sheet and income statement structures) ;

e) The bank must maintain capital adequacy prescribed by prudential regulations, with the minimum risk-based capital adequacy o f 12 percent (NBM regulation);

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f ) The bank must have adequate liquidity and meet the minimum liquidity prescribed by prudential regulations. (NBM’s regulation requires a minimum o f 20 percent);

g) The bank must have positive profitability and acceptable risk profile. It must maintain the value o f i t s capital2;

h) The bank must have adequate portfolio quality3, proper classification o f i t s assets and off-balance-sheet credit risk exposures, and must make adequate provisions;

i) The bank must have adequate internal audits and controls for i t s specific risk profile;

j) The bank should have annual unqualified audit o f i ts financial statements according to IFRS available for at least two previous years; and,

k) The bank must have adequate management information systems.

5. Interested banks wi l l be appraised by the Bank to confirm that they meet the eligibility criteria. Thereafter, they wi l l be subject to continuous scrutiny by the supervisory authorities, which will share the findings with CLD. As the Base1 Core Principles (BCP) compliance assessment prepared as part o f the FSAP Update (performed in 2007) indicated, the National Bank o f Moldova (NBM) i s to a large extent compliant with the BCP principles. This includes the key prudential regulations. Therefore, a “good standing” with the NBM would mean that the bank meets the critical parameters o f a stable financial condition. Annual external audits and regular supervisory data submitted to NBM wi l l be reviewed during supervision missions to confirm that a PFI continues to meet the eligibility criteria. PFIs will be asked to authorize the sharing o f NBM supervisory reports with the Bank on a quarterly basis.

On-lending Terms from the MoF to PFIs

6. Eligible PFIs will sign Subsidiary Financing Agreement (SFA) with the MoF. The SFA will specify terms o f access to the Bank’s financing, mutual responsibilities and roles in project implementation. Once signed, it will allow eligible PFIs access to finance on specified terms for eligible beneficiaries and eligible projects. The CLD, in coordination with the Bank, may set a limit on the total outstanding loans made available to an individual PFI as a share o f i t s capital.

7. Currency Risk. Subsidiary finance to PFIs would be denominated in Euros, US Dollars and Moldovan lei . The Government, PFIs and final borrowers will, to a larger or smaller extent, share any currency risks.

8. Interest Rate Risk. Interest rates for on-lending from the MoF to PFIs wi l l be variable, adjusted semiannually to reflect international market terms. The reference rate will be based on 6-month LIBOR plus a margin covering the credit risk, front-end fee (if

“Maintaining the value” o f i t s capital means that the bank i s adequately provisioned for the level o f risk it

In general, a bank should not have more than 10 percent o f criticized assets (i.e., classified as substandard,

17

i s taking and that the bank’s retained earnings are at least at the level o f inflation.

doubtful and loss) in i t s portfolio. 3

applicable) and CLD’s operational costs. The margin will be reviewed and may be adjusted from time to time by the Recipient in coordination with the Bank.

9. Credit Risk. PFIs will assume the full credit risk o f all final borrowers and sub- loans that they have financed. The credit risk may be higher than initially appraised, due to currency and interest rate risks potentially carried by final borrowers.

10. Subsidiary Finance Service by PFIs. PFI Subsidiary Finance amount will be equivalent to the aggregate amount o f principals o f all PFI Sub-loans made by the respective PFI. PFIs are required to make payments regardless o f whether or not they have received payments from their borrowers. A PFI that i s delinquent in i t s payments may be charged penalty interest on the full outstanding principal balance, until payments are again current. Payment arrears are a ground for suspension o f participation.

The PFIs wi l l repay interest and principal semiannually.

1 1. Suspension. A PFI i s expected to continue to meet the eligibility criteria in order to maintain access to the Association’s funds. A PFI that does not follow the rules or experiences financial problems may be suspended. The PFI may be re-accepted once the problems that have prompted i t s suspension have been adequately addressed. The reasons to suspend the PFI are as follows:

A PFI i s found to breach the established eligibility criteria or other participation rules; A PFI i s delinquent on i t s payment o f interest and principal due; and, A PFI utilizes project funds for ineligible expenditures or does not obey project procedures.

0

0

Sub-Loan Terms and Eligibility

12. Sub-loans will be available for new investment and for working capital finance. The terms o f PFI sub-loans will be the following:

PFI Sub-Loan Currency. As noted above, the MoF will on-lend the credit l ine proceeds to PFIs in Euro, US$, and MDL. Sub-loans to end beneficiaries will also be denominated in US$, MDL or EUR; Limits on Sub-Loan Amounts. Working capital sub-loans will have the maximum amount o f EUR 500,000 equivalent. Investment sub-loans will have a maximum amount o f EUR 800,000 equivalent. The aggregate amount o f all Sub-loans provided to any one Beneficiary Enterprise, or group o f connected Beneficiary Enterprises, shall not exceed the equivalent o f Euro 1,000,000; Maturities o f investment loans would be up to maximum eight years, with grace period determined by the PFI. Maturities o f working capital loans would be up to four years; and, Interest rates will be freely determined by the PFIs. The CLD will be informed about the interest to be charged by individual PFIs.

0

0

0

0

13. PFIs wi l l determine the principal, amortization and interest payment schedules for PFI sub-loans on a case-by-case basis, based on cash-flow projections. Sub-loan service payments by borrowers to PFIs would generally be made monthly, or according to typical

18

repayment schedules used by the respective PFI. There will be no sub-loan prepayment penalties, and interest will be charged on a declining balance formula.

14. Eligibility of Beneficiary Enterprises. To be eligible for financing under CEP, a beneficiary enterprise must present evidence that:

it has been in existence for at least two years; it operates in Moldova and i s registered with Moldova tax authorities; it is engaged in exports related to agriculture, agro-processing, manufacturing or other economic activity that provide goods or services directly related to generation o f foreign exchange export revenues; i t i s a private enterprise, with more than 75 percent o f the shares and other equity interest thereof held by persons or companies other than the Recipient, any agency or subdivision thereof, or any local governmental authority, or entities controlled by the Recipient or such agencies or subdivisions; and, it has a financial position that would allow it to meet all existing and projected financial obligations in a timely manner. The projected financial position should show that the borrower will maintain i t s profitability and adequate liquidity once the PFI sub-loan i s extended, and that i t s leverage will remain reasonable. Specifically, after receiving the sub-loan, beneficiary enterprise would be required to maintain a debt/ equity ratio o f no more than three to one (defined as total debt, including the sub-loan, divided by registered equity); and minimum debt service coverage ratio o f 1.2 (defined as cash earnings after a l l operating expenses before interest and principal due divided by principal and interest payments) until sub-loan maturity.

15. Eligibility o f Sub-Projects. Potential sub-projects will be requested to meet the following criteria:

Subprojects should be technically feasible and economically, financially and commercially viable; and, Subprojects should be in compliance with applicable environmental standards and in compliance with al l applicable regulations relating to health, safety and environmental protection. Goods and works on the Bank’s negative l i s t will not be eligible for financing. The Bank’s pol icy on environmental assessment must also be followed.

0

0

16. On-lending Process from PFIs to Beneficiary Enterprises. Sub-loans will be made based on an application o f a PFI, which wishes to extend a loan to a creditworthy exporter for an eligible sub-project. In each case, credit proceeds will be extended to a PFI back-to-back to PFIs’ loans to final borrowers with the same amount, maturity and grace period. The decision to extend a sub-loan will be made by a PFI based on analysis o f client’s creditworthiness and project viability. In practical terms, financial risk taken by the PFIs i s the credit r isk o f the final borrower and i t s sub-project. The credit risk comprises the commercial risk inherent in the enterprise and the project being financed, enlarged by the interest rate and currency risk that are carried by the final borrower. In principle, a borrower should be in a financial position that would allow him to meet al l existing and projected financial obligations in a timely manner. The projected financial

19

position should show that the borrower wi l l maintain i t s profitability and adequate liquidity once the PFI sub-loan i s extended, and that i t s leverage will remain reasonable.

17. The CLD will evaluate each application to ensure that the PFI’s sub-loan appraisal and approval conform with the O M and with principles o f sound banking. For the first two sub-loans for each PFI and all sub-loans above an agreed amount specified in the OM, a prior review and a no-objection by the Bank will be required. The Bank may establish, in consultation with the MoF, a free limit for experienced PFIs which: (i) are familiar with Bank procedures; and (ii) have a proven track record o f sound credit decisions. The sub-loans below the free limit will not require prior review by the CLD.

18. Each time a principle or interest due on a PFI sub-loan i s late, or the PFI has classified the respective sub-loan as substandard, doubtful or loss, the PFI will be required to provide to the CLD a quarterly report on the performance o f the sub-loan, the reason for adverse classification and the subsequent developments, and the up-dated financial condition o f the borrower. The PFI would agree to keep the credit history o f the borrower on fi le.

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Annex 4: Line o f Credit Component - Detailed Implementation Arrangements

1. Figure 4.1 below shows the new implementation arrangements for the Project after the proposed restructuring. This Annex presents detailed implementation arrangements for a new Credit L ine Component.

Figure 4.1: New CE

Project Implementation Unit Directorate

Participating Financial

Institutions Comp F:

Credit Line

Cornp. A: Regulatory

Reform Finance MSTQ Facilit

2. The LOC will be administered through an apex arrangement. The apex will be placed with the CLD, a specialized entity operating under the MoF. The CLD has ample experience with the Bank's LOC, and has also administered credit l ines o f a number o f other international institutions. The CLD wi l l utilize the Operational Manual (OM) developed for the Credit Line component, which wi l l specify details about implementation arrangements and the related functions.

3. CLD Functions. The apex functions o f the CLD wi l l include: Preparing and disseminating information about the Project to eligible beneficiaries; Reviewing and approving sub-loan applications received from PFIs; Signing SFAs for approved subprojects with PFIs confirmed as eligible PFIs to refinance the PFI sub-loans to final beneficiaries (clients); Preparing necessary documentation for PIU at the MoET to effect payments under the Credit Line component; Monitoring inflow o f interest and principal from the participating banks; Monitoring compliance o f PFIs with terms and conditions o f Subsidiary Finance Agreement; Preparing, in a format acceptable to the Bank, monthly and quarterly progress reports. Facilitating external audits o f the project accounts and records for LOC Component; and, Assisting the Bank supervision missions.

4. PIU Functions. functions:

The PIU operating under the MoET will have the following

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0 Maintaining the Designated Account (DA), preparing withdrawal applications, maintaining the local project account, and maintaining summary records o f the f low o f resources;

0 Preparing, in a format acceptable to the Bank, monthly and quarterly progress reports; 0 Disbursement o f credit line related payments reviewed and cleared by CLD; and 0 Making arrangements for external audits o f the project accounts and records,

including the Designated Account, local project account, etc., as requested by the Bank financial management rules.

5. PFI Responsibilities. The PFIs’ responsibilities will include: 0 Preparing and disseminating information about the Project to eligible beneficiaries; 0 Review o f sub-loan requests from borrowers (i.e., final beneficiaries);

Appraisal o f the sub-project to be financed and o f the creditworthiness and financial status o f the potential borrowers; Approval o f sub-loan application by the Credit Committee once the application has been endorsed by the PIUs/Bank, as applicable;

0 Assisting borrowers in the application o f efficient procurement practices under close supervision o f CLD;

0 Making sub-loan related payments to borrowersibeneficiaries in a timely manner against appropriate documents (to evidence use o f funds, procurement aspects);

0 Ensuring that payments o f interest and principal are made as due. O n due-dates o f interest and/or principal, the participating bank will provide C L D with a written report on sub-loan performance, deviation o f payments o f PFIs’ borrowers from agreed terms, and an updated and credit history o f the borrowers;

0 Submitting annual external audits prepared by reputable external auditors on the basis o f International Financial Reporting Standards (IFRS) financial statements, to be submitted to the C L D and the World Bank no later than six months after the end o f each financial year; and

0 Keeping all necessary records and payment evidence, as specified in legal documents.

Functional Responsibilities and Arrangements

6. Financial Management and Reporting. The C L D will take responsibility for the technical implementation o f the L O C Component. The C L D has extensive experience with a number o f Bank-financed projects credit lines. The C L D will submit monthly reports on commitments, payments, collection and arrears under the Project to M o F and PIU. P I U will prepare quarterly financial management report (FMR) for the Project, in accordance with formats agreed with the Bank. These financial reports will be submitted to the Bank within 45 days o f the end o f each quarter. More details on FM arrangements for the Component F can be found in Annex 6.

7. PFI Monitoring. The PFI monitoring functions will include: (i) monitoring that the qualified banks continue to meet the qualification criteria; (ii) a-priori evaluation and clearance o f PFIs’ appraisals o f eligibility and creditworthiness o f final borrowers for subprojects above the free limit and o f the first three presented by a newly qualified PFI, and on a sampling basis during normal supervision missions for the subprojects below the free limit; (iii) a-priori evaluation and clearance o f PFIs’ appraisals o f subproject eligibility and o f economic and financial analysis for al l subprojects above the free limit

22

and o f the first three presented by a newly qualified PFI, and on a sampling basis during normal supervision missions for subprojects below the f iee limit; (iv) monitoring and a- priori clearance o f minimum three procurements under the commercial practices for each new PFI, and supervision o f all other commercial practice procurements on a sampling basis during normal supervision.

8. Monitoring and Evaluation o f OutcomeslResults. The Bank wi l l evaluate progress on the proposed indicators as part o f supervision missions and through regular project related reporting by the CLD and PIU. PIU will produce quarterly reports, based on information collected by the CLD and from regular reports provided by the PFIs. The CLDPIU will also submit detailed annual reports covering all output and all agreed outcome indicators.

9. Disbursements wi l l be made by PIU based on traditional disbursement methods, Le., from the Designated Account with reimbursements made based on statements o f expenditures or full documentation, or using direct payments from the Credit Account. For the LOC component, the PIU wi l l disburse funds based on CLD’s requests.

Disbursements.

10. The CLD wi l l open separate Revolving Fund Account for repayment o f the PFI subsidiary loans, which would be used for repayment o f Bank loan or to extend new subsidiary loans to PFIs. The PFIs should be required to repay interest and principal o f subsidiary loans semiannually, on March 1 and September 1. (The semi-annual repayments are easier to administer and should coincide with adjustment o f interest rates on subsidiary loans to PFIs.) The PFIs wi l l be required to make payments regardless o f whether or not they have received payments from their borrowers.

Repayment o f Subsidiary Loans by PFIs.

11. Procurement. Procurements will be the responsibility o f the PFIs’ final borrowers under close supervision o f the CLD. In general, goods, works and services under LOC component should be procured in accordance with commercial practices; Annex 5 to this PP provides more details in this regard.

12. The project audit wi l l be performed by reputable external auditors according to the terms o f reference agreed with the Association. I t would include a separate opinion by the auditor on the operation o f the related DA. These audits will include a statement that the CLD and the PFIs are in compliance with the financial covenants agreed under the Project. The audit report would be sent to the Bank within six months o f the end o f the fiscal year.

Audits.

13. PFIs wi l l be required to provide annual external audits o f IFRS financial statements (balance sheet and income statement) and o f capital adequacy, to be prepared by reputable external auditors. The external audits will form a basis for re-appraisal o f financial condition and eligibility o f PFIs, in order to confirm their continuous qualification.

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Annex 5: Procurement Arrangements

A. General 1. Procurement for this AF o f CEP will be carried out in accordance with the World Bank's "Guidelines: Procurement under IBRD Loans and IDA Credits" dated M a y o f 2004 and revised in October o f 2006 (Procurement Guidelines); "Guidelines: Selection and Employment o f Consultants by World Bank Borrowers" dated May o f 2004 and revised in October o f 2006 (Consultants Guidelines); and the provisions stipulated in the Credit Agreement (CA).

2. The General Procurement Notice (GPN) o f the CEP will be updated to include this AF. Specific Procurement Notices (SPN) will be published for al l I C B procurement as per corresponding bidding documents become ready and available.

B. Current Procurement Arrangements and Experience under CEP 3. The current CEP i s managed by the P I U at the MoET. It f u l f i l l s i t s management, procurement and financial management functions through i t s current staff composed by PIU Director, Deputy Director/Financial officer, Procurement officer and Accountant/Secretary. On procurement side, the P I U performance has been considered satisfactory so far, as recorded in the post review mission report o f November o f 2008.

C. Assessment o f the Agency's Capacity to Implement Procurement 4. A Country Procurement Assessment Review (CPAR) was conducted for Moldova in June 2003. This assessment included al l relevant aspects o f procurement operations such as legislative framework, effectiveness o f regulatory institutions, etc. This Law was later supplemented by government decrees, resolutions and articles. In view o f the CPAR findings, Moldova i s ranked as a high-risk country in respect to its public procurement system. The CPAR also concluded that private sector has weak commercial practices. Since both components are focused on lending to the private sector, the three quotations comparison will be recommended under this additional financing. Such commercial practices will be discussed in more details in the Project Operational Manual.

5. An assessment o f the capacity o f the C L D in the M o F to implement procurement under this AF was carried out in M a y o f 2009. While procurement will be carried out by the credit l ine beneficiary in collaboration with the respective PFI, the C L D will supervise such process. The experience o f the CLD, created under the PSD I and financed by the Association, stems from carrying out this function in three other Association financed projects as wel l as from the currently on-going sub-lending component o f RISP I1 Project. W h i l e procurement experience has been accumulated in sub-lending supervision, in regard to procurement, the CLD's experience is l imited to shopping procedures (i.e. three quotations comparison). The C L D has no experience in other Bank's procurement procedures, including I C B and other competitive procedures used by the Bank's projects.

The C L D currently has seven credit l ine managers.

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6. In regard to the PIU o f the MoET, main findings o f a procurement post review conducted on November o f 2008 are reflected (i.e. where procurement risk i s suggested as “High”).

D. Procurement Risk Assessment

7. In the overall procurement capacity o f the implementing agencies, the project i s rated as “Substantial”. The risks associated with procurement and the mitigation measures are identified in the procurement capacity assessment report and are summarized in Table 5.1 below:

Table 5.1: Summar Risk Assessment Note: H=High; S=Substantial; M= Moderatt Description of Risk

Weak or limited procurement capacity o f the CLD staff; need for close supervision o f the whole sub-lending applications and process, including shoppinglthree quotations comparisons. Possibility o f artificially breaking a credit line application in small amounts in order to fit each o f them under shopping procedures (rather than using ICB procedures for the whole aggregate).

Potential interference by high officials in the applications for credit line (or even in shopping process, including selection and contract award).

m d L = Rating of Risk

H

IW. Mitigation Measures

The CLD staff wi l l attend the ECA Regional procurement trainings to equip themselves with knowledge on Bank’s procurement procedures, including ICB. Also, the CLD will exercise i ts supervisory role especially on shopping to make sure that such procedures complies with economy and efficiency standards, as well as with the Bank’s guidelines.

Discuss anticorruption guidelines with the CLD at negotiations and hrther at project launch workshop. Include provisions related to disclosure o f conflict o f interests and code o f ethics for evaluation committee into the Operational Manual. Close supervision by the Association team o f lines o f credit, including (but not limited to) procurement selection used.

Rating of residua 1 risk

S

8. Action Plan to build up the Agency’s Capacity would include the following: The CLD staff will attend training on Bank Procedures organized in the region by ECA Regional Procurement Manager’s office, and keep particularly close contacts with the Bank procurement staff assigned for the Project; and A project Operational Manual (OM) for LOC Component wi l l be prepared by the Recipient in consultation with the Association and it wi l l be discussed at the initial stages o f project implementation.

E. Procurement Implementation and Arrangements

9. The responsibility for implementation o f the LOC component (of US$22.5 million) will l ie with the CLD within the MoF. The CLD has been originally established in the late 1990s with the World Bank support (Le. under the Bank financed PSD I Project), specifically for the purpose o f administering credit l ine resources financed by international financing institutions, including ones by the Association. The CLD currently administers half a dozen credit lines, including the Association’s Second Rural

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Investment Services Project (RISP 11). The CLD has an experienced team familiar with the Association’s standards o f financial management, disbursement, and procurement requirements. The CLD has proven under RISP I1 Project that it has administration capacity on sub-lending.

10. CLD’s functions will include: (a) evaluating sub-loan appraisal practices and refinancing o f PFI sub-loans to final beneficiaries; (b) monitoring o f the use o f Association funds, including procurement and disbursement; (c) administration o f the disbursements and collection (repayment) o f advanced funds; (d) monitoring the financial condition o f PFIs; and (e) reporting to the Association on the use o f project funds and other matters related to implementation o f the Project.

1 1. The existing PIU o f CEP Project in the MoET will continue to bear responsibility for implementation o f the Matching Grant Component (of US$1.5 million under this AF). It i s expected that the AF will be disbursed within two and half years o f the date from which the Project becomes effective, tentatively by June 30, 2012.

12. Goods/equipment and works under LOC component ofAF, estimated US$1 million and above will be procured through ICB.

Procurement o f Goods, Works and Services (other than consultant services).

13, Gooddequipment and works contracts below US$l million will follow commercial practices acceptable to the Association (Le. comparison of at least three quotations). These commercial practices are described in details in the OM.

14. Direct Contracting: Goods/equipment under LOC component o f proprietary nature or available from only one source not exceeding an amount o f US$250,000 may be procured following direct contracting provided respective justification i s recorded by beneficiary and approved by the CLD.

15. Under the matching grant component, technical services estimated to cost less than US$25,000 equivalent per contract wi l l be procured in accordance with commercial practices acceptable to the Association as described in existing O M (i.e. through three quotations comparison).

16. Selection o f Consultants. Under matching grant and LOC components, consulting services assignments costing less than US$25,000 for review and feasibility studies related to quality upgrading, preparation o f business plans and professional services to assess new business practices or products will be procured using commercial practices acceptable to the Association (i.e. comparison o f qualifications o f at least three f i rms following CQ method, or o f three CVs o f individual consultants where applicable).

F. Procurement Plan 17. Since both components’ activities under AF are o f demand driven nature, a procurement plan would not be applicable at this stage. Each sub-project should include a procurement plan, which will be reviewed by the PFI and CLD before it i s carried out. Details in this regard would be included in the OM.

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18. Prior Review Provisions. All ICB contracts will be subject to Association’s prior review. Also contracts under the f i rs t two sub-loans applications for each PFI, will f i rs t be reviewed by the Association.

19. In addition to the prior review supervision to be carried out by the Association team, the capacity assessment of the Implementing Agencies recommends post reviews to be carried on at least 20 percent o f the contracts subject to post review. It i s expected that a supervision mission in the field will be conducted at least once a year during which post reviews will be conducted. At minimum one post review report, which will include physical inspection o f sample contracts - including those subject to prior review, will be prepared each year. Not less than 10 percent o f the contracts will be physically inspected.

Frequency of Procurement Supervision.

20. Anti-Corruption Measures. The Bank’s Anti-Corruption Guidelines (“Guidelines on Preventing and Combating Fraud and Corruption in Projects Financed by the IBRD Loans and IDA Credits and Grants”) dated October 15, 2006 will be adopted by the Government for the implementation o f the Project.

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Annex 6: Financial Management Arrangements

1. Existing FM Arrangements. The financial management arrangements o f the CEP were satisfactory since the Project start. The latest FM onsite supervision was undertaken in June 2009. The financial management arrangements o f the Project continue to be satisfactory and the control procedures are in place. The accounting software used by the Project has adequate security levels and its outputs are used to prepare quarterly financial reports o f the Project. The quarterly un-audited interim financial reports (IFRs) have been submitted to the Association on a timely basis in agreed content and format. The audited financial statements for FY2008 were submitted on time with unqualified (clean) audit opinion and no issues mentioned by auditors in the management letter. There i s one recommendation agreed upon as a result o f current supervision on disbursement matters. The recommendations o f previous FM review were appropriately addressed.

2. The FM arrangements for AF will be similar to the main Project, except for some additional procedures related to the new activity, credit line. Specifically, the arrangements for the Credit line will have additional control procedures and arrangements, such as: (i) defining eligible beneficiaries o f the sub-loans; and (ii) defining eligible financial institutions (banks) and their continuous monitoring. The C L D will be responsible for pre-screening applications for sub-loans from participating commercial banks and provide the respective payment requests to P I U for sub-loans allocations. Once the contracts under the sub-loans are paid from the designated account, the information will be passed to C L D so that it can maintain further settlements with the participating commercial banks. Similar arrangements are in place for other bank funded credit lines.

Activities o f the AF and their impact on FM Arrangements.

3. Institutional Arrangements. The CEP P I U will have the overall responsibility for financial management using existing procedures and systems. The role o f C L D will be limited to sub-loans screening and assessment according to eligibility criteria set in the operational manual, and to monitoring o f participating commercial banks. The C L D was not assessed from FM point o f view on the basis that: (i) it will not be involved in the funds flow, accounting and reporting; (ii) C L D has the adequate capacity to manage the revolving funds once disbursed from designated account and this i s proved under other ongoing investment operation funded by the Association. The aspects o f sub-loans screening and banks monitoring are dealt with separately by the project team and do not require full FM assessment o f the C L D as an entity.

Project accounting and reporting arrangements - the same procedures will apply as for the original Project. Intermediate un-audited financial reports (IFRs) will have the same formats expanded to capture the additional funding source; the frequency o f IFRs will be the same - quarterly, submitted within 45 days after the end o f the quarter. Staffing and Internal Control procedures -the same staffing arrangements will be used, with the PMU and financial staff in place; C L D will use the existing capacity to perform respective controls over the sub-loans applications and

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e

e

4.

manage the credit line once disbursed; the O M for L O C component will describe in detail the respective procedures and responsibilities. Planning and budgeting - the same procedures as for the main Project, C L D will have to provide inputs for budgets o f credit l ine disbursements. External audits - the same arrangements will apply with annual audits. The TORS will be expanded to: (i) cover the additional funding source; (ii) to cover visiting C L D and perform respective tests o f controls and/or substantive tests for L O C component.

FM Action Plan. It has been agreed that the OM for L O C component will describe the FM procedures acceptable to the Association. The procedures should cover the following areas: (i) defining eligible beneficiaries o f the credits; (ii) selection o f eligible financial institutions (banks) and their monitoring; (iii) describing FM related responsibilities o f the PIU and C L D with respect to decision making on credits allocations and funds flows.

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Annex 7: Line o f Credit Component - OP 8.30 Compliance-Review

1. The Project i s compliant with the requirements o f OP 8.30, related to objectives, coordination with the IFC , policy framework, on-lending rates, subsidies, eligibility criteria for PFI and use o f Association funds.

2. Project Objective. The original development objective o f the Project, which in substance remains intact, was to assist Moldova in enhancing competitiveness o f enterprises through improvements in the business environment and making adequate standards, testing, and quality improvement services available to enterprises. The original Project did not include an L O C as it was expected that the country’s financial sector would be able to provide funding needed by the enterprise sector to finance investments related to improving competitiveness.

3 . However, realization o f this expectation i s now seriously in doubt because o f the ongoing global financial crisis and consequent liquidity squeeze on Moldova. Traditionally, banks in Moldova are highly sensitive to remittances, as also confirmed by the most recent Financial Sector Assessment Program Update (2007). The adverse economic conditions in Russia, Ukraine and the EU - the main destinations for Moldovan migrants - are causing the inf low o f remittances to significantly slow down. The country experienced over 22 percent decline in remittances in the fourth quarter o f 2008. At the same time, the total bank deposits in Moldova shrank by 10 percent between October 2008 and May 2009. Consequently, Moldovan banks have been restricting the f low o f credit to real sector in recent months, in an attempt to preserve liquidity and minimize the credit risks so much so that even established exporters find it increasingly difficult to raise external finance. A major risk associated with the reduced access to finance i s that it could lead to loss o f markets, triggering bankruptcies with ripple effect in the economy, ultimately jeopardizing the expected development effect o f the Project.

4. In view o f these developments and to mitigate the adverse effects o f significantly reduced availability o f finance, the proposed additional IDA financing will be used for a L O C to provide working capital as well as investment finance. In parallel, the MGF would be expanded to allow the private f i r m s to continue the business development activities in the new business environment. The project development objective i s proposed to be slightly modified to reflect the inclusion o f an LOC, but in substance i t will remain unchanged4.

5. Coordination between the Association and IFC. OP 8.30 stipulates that “in countries where the Association and IFC are active in the financial sector, they coordinate the nature and design o f their respective activities”. Accordingly, the task team has already consulted IFC , which has indicated willingness to cooperate with the CEP initiative by extending direct funding to banks for on-lending to large exporters.

The amended project development objective would read: “...to assist Moldova in enhancing competitiveness o f enterprises through improvements in the business environment, enhancing access to finance, and making adequate standards, testing, and quality improvement services available to enterprises” (underlined words are the additions).

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6. Policy Framework. Since early 2000, Moldova has been characterized with a stable and improving macroeconomic framework, including relatively high economic growth, market oriented policies, and a strong financial regulatory regime. In the second hal f o f 2008, the global financial crisis and the on-set o f economic crises in the EU have negatively affected the economic and market environment in Moldova, and the market conditions have deteriorated markedly in 2009. According to the IMF’s most recent estimate (May 2009), Moldova’s GDP may contract by as much as 9 percent in 2009, due to export contraction and sharp decrease o f remittances. The Bank and the IMF are monitoring the situation closely, and stand ready to provide additional support to Moldovan authorities in the form o f development policy loans and stand-by facility, respectively. These policy operations would help ensure that Moldova maintains a sound macroeconomic strategy to withstand the current adverse external conditions.

7. OP 8.30 requires an adequate banking sector framework. The FSAP Update (reports completed in April 2008) noted the authorities’ success in improving the macroeconomic performance, confidence in the financial system, and an expansion in financial intermediation. The structure o f the banking sector has improved with entry o f international banks, which have introduced EU standards for in a number o f critical areas, such as improving quality o f financial services, broadening the range o f financial instruments offered to the economy and the population, improving risk management practices, strengthening auditing standards and practices (external and internal) and improving information technology used by banks.

Financial Sector Framework.

8. However, the crisis impact i s l ikely to aggravate the situation. Since August 2008, there has been no increase in credit portfolio and maturities seem to have become shorter, as the banks face problems with deposit structure and stability as wel l as access to funding sources. There i s a general tightening o f borrowing terms. Borrowing from foreign commercial sources has become extremely difficult, if not outright impossible. The banks’ cost o f funding has increased. Independent o f CEP, the IMF and the Bank are actively monitoring developments in Moldovan financial sector and advising the authorities on crisis mitigation strategy. Meanwhile the availability o f funding under the proposed L O C will to some extent ameliorate the shortage o f funding in the country.

9. OP 8.30 allows Bank’s support to directed credit programs provided they are accompanied by reforms to address underlying institutional problems and market imperfections, which inhibit the market-based f low o f finds to the target sector. The financial sector o f Moldova has made a good progress towards enhancing i t s intermediation capabilities. In fact, it was because o f the good progress o f the financial sector that it was not considered necessary to include an L O C in the original design o f CEP. However, because o f the ongoing global financial crisis, the conditions have changed and there i s a good justification for L O C on emergency grounds5. I t i s most likely that once the international financial conditions are stabilized, in future Moldova might not need this kind o f finding (a state intervention in the financial markets).

Directed Credit.

A recent FPD Guidance Note states that LOC projects as part o f the Bank’s crisis response would be o f a special nature in that they would be short-term emergency interventions to sustaidenhance the availability o f resources for investment purposes, an economic priori.ty under crisis conditions. Therefore, they would meet the spirit o f the requirements o f OP 8.30 for directed credits.

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10. Lending Rate. OP 8.30 states “Bank funds are priced to be competitive with what the participating FIs and their sub-borrowers would pay in the market for similar money, taking into account, as relevant, maturities, risks, and scarcity o f capital.” For the Project, this policy has two implications: (a) The cost o f IDA funds to PFIs should be on market terms; and (b) The PFIs should be free to charge their sub-borrowers market rates. The proposed lendindon-lending terms for LOC comply with both these requirements. The Government would on-lend IDA funds in US$, MDL or EUR and the cost wi l l be, accordingly, based on respective LIBORs for US$ and EUR, and a domestic market rate for the MDL, with a reasonable margin (up to 200 basis points). This i s consistent with general cost o f such funds. At the PFI level, lending terms will be totally market-based as each PFI wi l l determine i t s terms based on i ts assessment o f credit risk.

1 1. Subsidies. There i s no subsidy issue associated with the proposed LOC. IDA funds would be passed on to the PFIs and ultimate borrowing enterprises on market-based terms.

12. Eligibility Criteria for Financial Institutions. OP 8.30 requires an assurance that financial institutions acting as the on-lenders o f Bank funds are viable institutions.

13. The eligibility criteria for PFIs (see Annex 8) directly address all aspects noted in the OP 8.30. The PFI appraisal process will ensure the viability o f the PFIs and they will be monitored regularly. PFIs which do not meet the eligibility criteria at all times wi l l be suspended from participation. There i s keen interest on the part o f a reasonable number o f potential PFIs to participate in the proposed LOC. Each PFI will be required to qualify a very comprehensive set o f eligibility criteria and will be required to remain in compliance. Therefore, there i s no issue with regard to PFIs.

14. Use o f Bank Funds. The Bank funds will be used for procurement o f equipment, material, works and services. These uses are consistent with the provisions o f OP 8.30.

15. Monitoring Arrangements. The monitoring and implementation arrangements proposed for the project satisfactorily comply with OP 8.30 requirements. A l l aspects of OP 8.30 will be monitored throughout the lifetime o f the Project.

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Annex 8: Appraisal o f PFI eligibility

1. The success o f a credit line operation critically depends on the effectiveness and quality o f the PFIs. Strong and capable PFIs, which are the major players in the export sector, are more l ikely to deliver funds effectively and efficiently to viable subprojects, which are consistent with project objectives and are able to absorb the associated credit risk. This i s especially important for operations in the time o f a crisis.

2. All larger banks licensed in Moldova that have actively participated in Bank’s earlier credit l ine projects in Moldova, and other banks active in enterprise sector finance, have been invited in May 2009 to express interest for participation in the Project. Nine banks have confirmed their interest for participation and submitted necessary documentation. This includes: Moldova AgroInd Bank, Victoria Bank, MoldIndCon Bank, Bank de Economii, Mobias Bank (of Societe Generale Group), Energ Bank, Exim Bank (of Veneto Banking Group) and FinCom Bank (FCB) and Sociala Bank. The Bank team conducted field appraisal o f these banks in early June 2009.

3. In deciding how to proceed with the appraisal process o f interested banks, one had to take into account the challenging macroeconomic and financial market environment. More detailed discussion o f recent developments in the business and market environment o f the banking sector in Moldova i s provided in Appendix 8.1.

4. At the time o f project appraisal, Moldova’s banking system remained highly liquid, with an average liquidity ratio o f 29 percent. All banks interested in participation maintained liquidity higher than mandated by the NBM regulations (20 percent). As o f end May 2009, all interested banks continue to comfortably meet the capital adequacy requirements. Recent NBM stress tests (May 2009) indicate that none o f the banks’ capital would fal l below zero under any scenario, including worst case scenarios simulating the 1998 banking crisis. See Table 8.1.

Table 8.1: Performance Indicators of Interested PFIs

Notes: From statistics o f NBM and reported by banks to CLD (i) Share o f total banking system assets (ii) All banks in the Table have only Tier 1 capital in their capital structure at this time. (iii) Problem loans include past due loans and loans where interest has been suspended (including loss loans). (iv) CAR - capital adequacy ratio.

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5. However, the quality o f loan portfolio deteriorated substantially in 2009, and it i s not yet clear if the worst i s over. Loans classified as substandard, doubtful and loss had increased to 1 1.35 percent for the banking system at the end o f March and 12.87 percent at the end o f May, 2009, from 5.49 percent at the end o f 2008 (and 4.67 percent at the end o f 2007). Among the banks that expressed interest in participation, the problem loans were well below ten percent for AgroInd and Sociala; around ten percent for the two small banks (Eximbank and Energbank); and over ten percent for the other five banks.

6. The Bank team assessed: (i) whether the level o f problem loans has a trend to further deteriorate or has it begun to improve; (ii) was the bank able to make adequate provisions; and (iii) how profitable i s the bank and what i s the trend o f the net profits. Profitable banks would be able to weather high percentage o f impaired assets for some time without jeopardizing i t s capital adequacy. Review o f profitability trends in the last six months indicated that:

FinCom Bank had zero or negative profits in 2009. It was able to make the necessary provisions (ultimately against capital). The level o f problem loans has stabilized for now, but at a relatively high level o f around 12 percent. The issue i s that the deterioration affected some larger loans, and that the bank has high credit concentration, Although the level o f problem loans i s not that high, Exim Bank and Energ Bank have experienced negative income for March 2009 and about zero for April 2009. Energ Bank was hesitant to make any assumptions about the problem loans’ trend, and agreed to defer i t s interest in the Project until the situation becomes more stable. Exim Bank expects Veneto Group assistance and also asked for appraisal to be postponed. Mobias Bank has experienced negative net income since February 2009. A rather dramatic deterioration o f i t s credit portfolio was partly due to worsening financial condition o f i t s borrowers, and partly because the bank instituted more stringent credit classification rules. It i s not yet clear when the bank will be able to reach a stable financial condition. I t was agreed that full appraisal wi l l be conducted at a later stage.

Consequently, only four banks were deemed to be ready for appraisal. Sociala Bank would have been appraised, if it had expressed interest to participate in due time. Banks that have not been appraised and remain interested will be appraised before AF effectiveness.

8. Banks’ appraisal included a detailed assessment o f whether a bank meets the eligibility criteria (above). Appraisal process included interviews with senior management covering bank’s business strategy, review o f ownership and governance (structure o f the Board and bank’s management and supervisory bodies, governance policies and practices, Board meeting agendas, Board reports, follow-up reports), review o f all key banking and risk management functions and review o f key documentation, including externally audited financial statements as o f the end o f 2008, interim financial statements as o f the end o f March 2009 and April 2009, capital adequacy calculations, licensing information, written policies and procedures related to the lending and management financial risks (cash and liquidity risk management, credit risk, currency risk, interest rate risk, price risk), internal controls manual and sample o f internal audit

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reports (detailed reports, as well as reports prepared for the Supervisory Board, follow-up reports) and review o f IT systems used by the bank.

9. The conclusion o f the appraisal i s that AgroIndBank currently fully meets the eligibility criteria and could be asked to sign the Subsidiary Finance Agreement. Comparatively, it i s the best bank o f the large banks in Moldova. The bank’s assets were reduced by 5 percent in 2009, but i ts liquidity remained high and the CAR o f about 25 percent. While the credit quality has worsened in 2009, the bank i s profitable enough to be able to make the necessary provisions. I t s financial condition i s reasonably stable.

10. The other three banks (Victoria, MoldIndCon and Economii), while being profitable enough to make provisions for impaired loans (classified as substandard, doubtful and loss), have the level o f impaired loans higher than the 10 percent limit established by the eligibility criteria. The recent credit quality trends show that the level o f problem loans has leveled off. This wi l l have to be verified before asking the banks to sign the Subsidiary Finance Agreement. Overall status for these banks i s as follows:

Victoria Bank generally meets eligibility criteria. The bank has high liquidity o f 29.5 percent and CAR o f 28.35 percent. Victoria i s one o f the most profitable banks in Moldova. Whi le problem loans reached 16.9 percent o f i t s credit portfolio, it has been able to make the necessary provisions and remain profitable. Review o f bank’s credit quality trends indicates that the level o f problem loans has leveled of f and the situation should start to improve as o f June 2009. Another issue to note i s that the percentage o f equity capital in i t s capital structure i s too small (only 3.93 percent). The bank will be asked to increase the equity share in total capital by the end o f 2009. MonIndCon Bank generally meets eligibility criteria. I t s CAR i s 22 percent and the liquidity at 26.23 percent i s adequate. However, 12.7 percent, equity i s a relatively small as percentage o f total capital, and this percentage needs to be improved. The level o f problem loans i s an issue - at 16.2 percent, it i s higher than the Moldova average as well as the 10 percent limit set by eligibility criteria. The bank i s a profitable bank and has been able to make the necessary provisions and maintain positive profitability. The bank feels that the problem loan trend i s reversing. Another issue i s that this i s the only bank o f the banks that are interested in participation where the NBM combined credit-cum-interest rate and currency stress tests indicate CAR reduction below the prudential norm o f 12 percent. The bank i s also sensitive to scenarios involving credit risk for loans in construction and retail, whereby i t s CAR falls to 7.15 percent. Economii Bank generally meets eligibility criteria. The CAR i s very high 49.14 percent and i ts liquidity ratio i s also very high at 39.5 percent. The level o f problem- loans as o f end March (8.44 percent) was better than the averages for the banking sector. However, the situation quickly deteriorated and at the end o f May 2009 the bank reported problem loans at 15 percent level. The issue i s whether this trend wi l l be reversed. The bank has reported close to zero income in April 2008, which was due to extraordinary expenses, that is, the bank’s contributions for elections and charitable contributions to a number o f NGOs to which the bank had committed to before the crisis. The May 2009, again, was a profitable month. Another issue i s that the percentage o f equity capital in i ts capital structure i s too small (only 3.49 percent).

0

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Appendix 8.1: Banking Sector Environment

1. Despite i t s relatively weak integration in global financial markets, Moldova’s banking system has come under serious strain since October 2008, as the effects o f the regional economic downturn spilled over to the local economy. This has affected all aspects o f banking markets: deposits, credits and financial services. I t has also increased the level o f risk and made risk appraisal and risk management more challenging.

2. Deposit withdrawals started in October 2008, due to reduction in remittances and negative rumors from abroad. With prompt increase o f liquidity o f practically all banks in Moldova to around 30 percent o f total assets, banks were able to avoid an immediate bank run. However, although deposit rates were increased by all banks, remittances continued to decline and the steady outflow o f deposits continued until March 2009. The total reduction o f deposits from September 2008 to May 2009 amounted to more than 10 percent, with deposit base in local currency being hit especially hard. At the same time, the level o f term deposits has fallen rather dramatically as the clients, even if they kept their deposits in the bank, chose to switch to shorter maturities deposits. With remittance inflows declining dramatically and the corporate sector under pressure, it i s very likely that the deposit drain will continue.

3. Access to credit has become more difficult, even for profitable f i rms, and the cost o f funding has increased. Banks’ domestic (deposits) and foreign (e.g., credit from parent banks) sources o f funding had declined, even short-term loans for working capital have become prohibitively expensive, not to mention term credit (over 12 months) for investment purposes. In 2007, credit was already rather expensive, with average rates o f 18- 19 percent - in an environment with inflation in the range o f 10.5 - 14 percent. Since August 2008, interest rates for loans in MDL fluctuated from 22.5 to 23 percent, although the inflation rate was steadily falling. The growing credit crunch may lead to loss o f markets for Moldovan enterprises, triggering bankruptcies with ripple effect in the economy and the banking system.

4. Economic crisis has led to deterioration o f credit quality. Credit portfolio quality in Moldova has traditionally been high. Loans classified as substandard, doubtful and loss accounted for 3.7 percent and past due and the non-accrual loans of interest status were 2.4 percent o f the total credit portfolio as o f end 2007. By the end o f 2008, these ratios had deteriorated to 5.2 and 5.5 percent, respectively. This trend has continued in 2009, with classified loans reaching 8 percent and the past due loans and loans in non-accrual status reaching 11.3 percent o f the total credit portfolio, as o f end March 2009. The situation further deteriorates and problem loans reached 12.87 percent as o f end May 2009. It i s not yet completely clear, if and when this trend will slow down or reverse.

5. However, tight prudential regulations and effective supervision by the NBM have so far preserved the stability o f the banking sector. Since the FSAP Update took place in October 2007, stress tests were used as a risk management tool to identify key risk exposures and to understand the banking system’s risk profile6. The key objective o f

Stress tests were designed to simulate the impact on the banking system’s capital adequacy and earnings o f severe macroeconomic conditions such as those experienced during the 2007 drought, the 2006 twin shocks, or the 1998-99 Russian crises. Apart from considering the effects o f severe (but plausible)

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stress test exercise i s to establish potential capital shortfall in case the worsening economic situation (lower growth and exports, exchange rate fluctuations, decline in remittances) leads to substantial deterioration o f banks’ balance sheets.

6. The NBM stress tests included sensitivity analysis o f the banking sector’s vulnerability to credit, liquidity, interest rate, and foreign exchange rate risks, as well as scenarios involving a combination o f shocks. The results were not bad, at least as o f end o f M a y 2009. There are only three banks sensitive to liquidity risk’. Sensitivity to interest rate shocks was relatively l ow due to the banking system’s dominant asset and liability structure, which is short-term. There was also l o w sensitivity to direct foreign exchange risk. Stress tests o f credit risk indicated that no bank would fal l below 11 percent capital adequacy (The minimum C A R is 12 percent). The combined shock scenario affected CARS o f only three banks (of which MoldIndCon was the only bank that applied for participation*).

Table 8.2 - Banking System Ratios (09/30/2008 to 04/30/2009)

7. Overall, more than eight months after the crisis had started, the banking sector seems to be holding on. The key parameters are summarized in Table 8.2. The deposit withdrawal seems to have stabilized. The liquidity remains high. The credit quality has deteriorated, but the non-performing loans in the banking system have stayed at the same level since March 2009. Moldovan banks are s t i l l able to carry this level o f problem loans due to accumulated safety cushion’. The banks that are under pressure are banks with significant exposures to the construction sector, which was hard hit by the crisis, and with consumption related retail loans. Most banks have introduced crisis risk management procedures. Mismatches o f any kind are not tolerated and credit risk is

macroeconomic events, mild and medium stress conditions were considered to test the resilience of the banking system. ’ The combined test assumed 10 percent reduction of deposits of physical persons, 11 percent of legal persons and 58 percent of interbank deposits. Large banks remained at over 20 percent liquidity. Three banks fall below the regulatory minimum of 20 percent of which one became illiquid - a bank that i s already under NBM scrutiny MoldIndCon CAR fe l l to 3.64 percent for combined effects o f credit, interest rate and currency risks and

to 7.15 percent for dramatic worsening o f credit quality for the construction industry, imports enterprises and trade houses and retail loans.

Moldovan banks have traditionally kept CAR that i s significantly higher than the statutory minimum of 12 percent. At the end of March 2009, the average CAR for the banking system was 32.83 percent as o f end March 2009 (32.23 end 2008). Similarly, most banks continue to maintain the liquidity ratios that are significantly higher than the minimum level set by NBM regulations (20 percent).

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managed more carefully. decisions - al l has been transferred to headquarters.

For example, branch offices are not making any credit

8. Although the system turned out to be more stable relative to financial sectors in some neighboring economies, critical vulnerabilities in the short to medium term are s t i l l present. Sensitivity to remittances-based fee income remains significant and to remittances based-loan service i s s t i l l present lo. The remittance inflows have been significantly reduced and it i s not clear when the trend will be reversed. With the questionable remittance inf low and corporate sector under pressure - deposit increase i s not l ikely and the pressure on deposits i s likely to continue. Deterioration o f credit quality remains serious vulnerability and it i s not yet clear when the trend will be reversed. Finally, the system remains vulnerable to the likely fluctuations in exchange rate.

’

9. Moldovan authorities seem to be cognizant o f the above-mentioned risks and are implementing a crisis mitigation strategy. Stress - testing o f banking system i s being conducted by NBM on a regular basis. Special diagnostic assessment o f Moldovan banks by external auditors i s also currently being considered by NBM, following the model implemented earlier in Ukraine and other economies.

10. NBM has announced temporary liquidity support to the banking system in order to maintain the stability o f the system. It i s crucial that the support i s awarded to banks in a transparent fashion, on a temporary basis, and with a clear understanding how NBM resources will be used toward more permanent improvement in banks’ financial position.

11. Authorities have also started to prepare tools to intervene in the problem banks, if needed. The Law on Financial institutions was amended in June 2009 to give NBM powers to oversee liquidation o f insolvent banks. This authority was immediately put to practical test when NBM initiated liquidation process for Investprivatbank, a medium- sized institution suffering from heavy exposure to construction industry and inadequate management practices.

12. Future actions that might be useful include a review, keeping in mind potential reduction, o f prudential limits for credit concentration, in order to reduce the credit risk. Also, careful consideration i s needed in reviewing the capital structure. W h i l e banks in Moldova have primarily Tier 1 capital, there is too little o f equity capital. The capital o f most o f larger banks i s primarily composed o f retained earnings, which could ultimately be unsafe - in case shareholders decide to distribute the amounts over the prudential requirement for CAR.

7 out of 16 banks have made losses so far this year (May 2009), due to both sharply falling interest and noninterest income as well as higher loan provisioning.

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I O

Annex 9: Potential for Cooperation with Other IFIs

1. Discussions with a number o f IFIs, such as EBRD, IFC and EU Fund for South Eastern Europe indicated their preference to use direct funding o f individual banks, rather than to enter into a formal co-financing arrangement with CEP. Direct funding typically does not involve specific project objectives that are directly related to broader economic or social objectives, or that include measurable indicators. I t i s simply extended to improve the funding structure o f selected banks, often in the context o f equity investments.

2. Table 9.1 summarizes direct funding o f banks in Moldova in the 2006-2008.

SD 64.3 million

SD 23.7 million

Source: NBM and bank interviews

3. At the same time, several IFIs have expressed willingness to provide parallel financing that wi l l complement CEP AF efforts to help Moldova’s bank and enterprise sector cope with the crisis, and build long-terms competitiveness.

4. o f banks in 2009.

EBRD has announced a general intention to provide additional funding to a number

5. IFC i s ready to cooperate with the CEP initiative by extending direct funding to banks ,for on-lending to large exporters that have working capital and investment finance needs. IFC wi l l focus on needs that cannot be addressed by the Bank credit line, that is, by providing working capital loans o f over US$700,000 and investment loans o f over US$l million. IFC initially plans to focus on Mobias Bank and AgroInd Bank and would plan to extend loans to these banks in the next 6-12 months. Other banks may also be considered.

6. currently supported by CEP.

In the future, IFC may consider taking equity stakes in some o f the larger enterprises

7. Millennium Challenge Corporation (MCC) i s considering a project entitled Transition to High Value Added Agriculture (T-HVA), and will coordinate i t s activities closely with CEP AF. The project will include three components: (a) rehabilitation o f 26 central irrigation systems which are either non-operational or are only partially operational; (b) a financing facility supporting agricultural producers to purchase

39

irrigation equipment and to finance post-harvesthahe chain infrastructure; and (c) technical assistance to support producers to convert to high-value agriculture.

8. M C C T-HVA project financing will focus on: (i) small and medium farm operations, needing T-HVA equipment (irrigation systems, tunnel greenhouses, small specialized tractors, etc.), with financing requirements for a medium to long- te rm credit and a loan size o f US$3,000-25,000; and (ii) post-harvesthalue chain developers/investors with demand is for medium to long te rm credit o f US$50,000-500,000 for the post harvest and processing equipment.

9. The M C C T-HVA financing component will have implementation arrangements that are compatible with the CEP Project. M C C plans to use an apex-based model, whereby the apex would be placed with the CLD. Access to finance will be open to al l interested financial intermediaries that meet the eligibility criteria. M C C apex arrangement will include three windows: (i) for banks, focusing on S-M-L agricultural producers; (ii) for savings and credit associations with the type B license, focusing on micro and small producers; and (iii) for other institutions active in agriculture finance that are well managed, have sound financial condition, have good payment record and have not experienced losses (e.g., some o f the microfinance institutions or leasing company).

10. M C C also plans to offer loss guarantees for cases where there appears to be a market failure making access to finance difficult, such as for the first-time borrowers who do not have any credit history, or with cash flows that are difficult to evaluate, or which operate in a segment of agriculture that had recently been subject to stress (e.g., wine industry), and therefore 'financial institutions are more conservative when appraising the cash flows.

11. The specific focus on primary agriculture, relatively small size o f sub-loans, and wider selection o f eligible PFIs make M C C T-HVA fully complementary with CEP AF.

40

Grigoriopol

Rîbnita

Camenca

Ceadîr-Lunga

Tiraspol

Slobozia

Moghiliov-Podolski

Chiperceni

Balatina

Costesti

Sculeni

Leuseni

Vulcanesti˘

Lapusna˘

Stauceni˘

Edinet Soroca

Balti

Ungheni

Hîncesti

Orhei

Comrat

Cahul Taraclia

Criuleni

Rezina

Drochia

Donduseni

OcnitaBriceni

Rîscani

Glodeni

Nisporeni

Telenesti

Floresti

Sîngerei

Ialoveni

Cimislia

AneniiNoi

Leova

Bender(Tighina)

Cantemir

Basarabeasca

Dubasari˘

Falesti˘

Soldanesti˘

CHISINAU˘

˘ ˘GAGAUZIA

˘ ˘GAGAUZIA

TRANSNISTRIA

Be

ss

ar

ar

ab

ia

Bu

geac

P lain

Mt. Balanesti(430 m)

Grigoriopol

Rîbnita

Camenca

Ceadîr-Lunga

Tiraspol

Slobozia

Moghiliov-Podolski

Chiperceni

Balatina

Costesti

Sculeni

Leuseni

Vulcanesti˘

Lapusna˘

Stauceni˘

Edinet Soroca

Balti

Ungheni

Hîncesti

Orhei

Comrat

Cahul Taraclia

Criuleni

Rezina

Drochia

Donduseni

OcnitaBriceni

Rîscani

Glodeni

Nisporeni

Telenesti

Floresti

Sîngerei

Ialoveni

Cimislia

AneniiNoi

Leova

Bender(Tighina)

Cantemir

Basarabeasca

Dubasari˘

Falesti˘

Soldanesti˘

CHISINAU˘

˘ ˘GAGAUZIA

˘ ˘GAGAUZIA

TRANSNISTRIAROMANIA

UKRAINE

UKRAINE

Prut

Prut

Dnestr

Nistru

Nistru

B lackSea

ToChernivtsi

To Chernivtsi

To Vinnytsya

To Vinnytsya

To Voznesens'k

To Zhmerynka

To Odesa

To Artsyz

To Imayil

To Bucharestand Constanta

To Birlad

To Birlad

To Pascani

Be

ss

ar

ar

ab

ia

Bu

geac

P lain

Mt. Balanesti(430 m)

27°E

27°E

48°N

47°N

46°N

48°N

47°N

46°N

28°E 29°E 30°E

28°E 29°E 30°E

MOLDOVA

This map was produced by the Map Design Unit of The World Bank. The boundaries, colors, denominations and any other informationshown on this map do not imply, on the part of The World BankGroup, any judgment on the legal status of any territory, or anyendorsement or acceptance of such boundaries.

0 10 20 30

0 10 20 30 Miles

40 Kilometers

IBRD 33448R

MAY 2007

SELECTED CITIES AND TOWNS

AUTONOMOUS TERRITORIAL UNITCAPITALS

RAIONS OR MUNICIPALITIESCAPITALS*

NATIONAL CAPITAL

RIVERS

MAIN ROADS

RAILROADS

AUTONOMOUS TERRITORIAL UNITBOUNDARIES

RAIONS OR MUNICIPALITIESBOUNDARIES

INTERNATIONAL BOUNDARIES

*Names of the raions or municipalitiesare identical to their capitals.

Cainari˘ Causeni˘

Stefan-Voda

Straseni˘

Calarasi˘˘

MOLDOVA