Document of

The World Bank

Report No: 25064-YU

PROJECT APPRAISAL DOCUMENT

ONA

PROPOSED CREDIT

IN THE AMOUNT OF SDR 8.4 MILLION

(US$ 11.0 MILLION EQUIVALENT)

TO

FEDERAL REPUBLIC OF YUGOSLAVIA

FOR A

PRIVATIZATION AND RESTRUCTURING OF BANKS AND ENTERPRISES TECHNICALASSISTANCE PROJECT

NOVEMBER 12, 2002

Private and Financial Sector DevelopmentfCCO4Europe and Central Asia Region

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CURRENCY EQUIVALENTS

(Exchange Rate Effective October 2, 2002)

Currency Unit = Yugoslav DinarI Din. = US$0.0163

US$ = 61.17 Din.

FISCAL YEARJanuary 1 -- December 31

ABBREVIATIONS AND ACRONYMS

BRA - Bank Rehabilitation AgencyCAS - Country Assistance Strategy

DEM - Deutsche MarkDFID - Department for International DevelopmentEAR - European Agency for Reconstruction

EBRD - European Bank for Reconstruction and DevelopmentERTP - Economic Recovery and Transition Program

EU - European UnionFDI - Foreign Direct Investment

FMR - Financial Management ReportFMS - Financial Management SystemFRY - Federal Republic of YugoslaviaFSD - Financial Sector Development

FY - Fiscal YearIAS - International Accounting Standards

IC - Individual ConsultantIDA - International Development Association (World Bank)

IFI - International Financial InstitutionIS - International Shopping

LACI - Loan Administration Change InitiativeLLME - Large Loss-Making EnterpriseMOEP - Ministry of Economy and Privatization

MOF - Ministry of FinanceNBY - National Bank of Yugoslavia

NS - National ShoppingPA - Privatization Agency

PAD - Project Appraisal DocumentPAS - Procurement Accredited Specialist

PFSAC - Private and Financial Sector Adjustment CreditPIP - Project Implementation Plan

PMU - Project Management UnitPPF - Project Preparation FacilityPSD - Private Sector Development

QCBS - Quality and Cost Based SelectionSA - Special Account

SAC - Structural Adjustment CreditCQ - Selection Based on Consultant Qualifications

SME - Small and Medium EnterpriseSOE - Socially Owned EnterpriseTOR - Terms of ReferenceTSS - Transitional Support Strategy

Vice President: Mr. Johannes LinnCountry Manager/Director: Mr. Christiaan Poortman

Sector Manager/Director: Mr. Khaled SherifTask Team Leader/Task Manager: Mr. Alexander Pankov

FEDERAL REPUBLIC OF YUGOSLAVIAPRIVATIZATION AND RESTRUCTURING OF BANKS AND ENTERPRISES TECHNICAL

ASSISTANCE PROJECT

CONTENTS

A. Project Development Objective Page

1. Project ueveloprent oUjecti ve 2-2. Key performance indicators 2

B. Strategic Context

1. Sector-related Country Assistance Strategy (CAS) goal supported by the project 32. Main sector issues and Government strategv 33. Sector issues to be addressed by the project and strategic choices 9

C. Project Description Summary

1. Project components 102. Key policy and institutional reforms supported by the project 123. Benefits and target population 124. Institutional and implementation arrangements 13

D. Project Rationale

1. Project alternatives considered and reasons for rejection 142. MaJor relateu projects finanieu Dy thu adri aiuu other developmuent agencies

3. Lessons learned and reflected in the project design 164. indications of borrower comnitnent and ownersnip 175. Value added ofBank support in this project 18

E. Summary Project Analysis

1. Economic 18I Finrnial 18

3. Technical 194. fituioa 195. Environmental 207. Sicial 217. Safeguard Policies 21

F. Sustainability and Risks

1. Sustainability 222. Critical risks 233. Possible controversial aspects 24

G. Main Credit Conditions

1. Effectiveness Condition 242. Other 24

H. Readiness for Implementation 24

L. Compliance with Bank Policies 25

Annexes

Annex 1: Project Design Summary 26Annex 2: Detailed Project Description 28Annex 3: Estimated Project Costs 35Annex 4: Cost Benefit Analysis Summary, or Cost-Effectiveness Analysis Summary 36Annex 5: Financial Summary for Revenue-Earning Project Entities, or Financial Summary 37Annex 6: (A) Procurement Arrangements 38

(B) Financial Management and Disbursement Arrangements 44Annex 7: Project Processing Schedule 51Annex 8: Documents in the Project File 52Annex 9: Statement of Loans and Credits 53Annex 10: Country at a Glance 54

MAP(S)General Map of Federal Republic of Yugoslavia

FEDERAL REPUBLIC OF YUGOSLAVIAPRIVATIZATION AND RESTRUCTURING OF BANKS AND ENTERPRISES TECHNICAL

ASSISTANCE PROJECT

Project Appraisal DocumentEurope and Central Asia Region

ECSPF

Date: November 12,2002 Team Leader: Alexander PankovSector Manager/Director: Khaled F. Sherif Sector(s): General industry and trade sector (50%),Country Manager/Director: Christiaan J. Poortman Banking (50%)Project ID: P077732 Theme(s): State enterprise/bank restructuring andLending Instrument: Technical Assistance Loan (TAL) privatization (P)

1 Loan [X] Credit 1 Grant 1 Guarantee 1 Other:

For Loans/Credits/Others:Amount (US$m): 11.00

Proposed Terms (IDA): Standard Credit

Grace period (years): 10 Years to maturity: 20

Commitment fee: 0.00-0.50% Service charge: 0.75%

BORROWER 2.49 1.49 3.98IDA 0.62 10.38 11.00

Total: 3.11 11.87 14.98

Borrower FEDERAL REPUBLIC OF YUGOSLAVIAResponsible agency: PRIVATIZATION AGENCY / BANK REHABILITATION AGENCYPrivatization Agency of the Republic of Serbia (PA)Address: Terazije 23, Belgrade, Federal Republic of YugoslaviaContact Person: Mr. Vladimir Cupic, Director, Privatization AgencyTel: 381 (11) 3020 800 Fax: 381 (11) 32 48 375 Email: vcupic@pa-serbia.co-yu

Other Agency(ies):Bank Rehabilitation Agency of the Federal Republic of Yugoslavia (BRA)Address: Trg Nicole Pasica 10/Ill, Belgrade, Federal Republic of YugoslaivaContact Person: Ms. Vesna Dzinic, Executive Director, Bank Rehabilitation AgencyTel: 381 (11) 32 42 987 Fax: Email: info@bra.gov.yu

Estimated Disbursements Bank FY/USm):

Annual 1.10 4.10 4.20 1.60Cumulative 1.10 5.20 9.40 11.00

Project implementation period: 02/15/2003 to 10/31/2005 - 32.5 months (FY03-FY06)Expected effectiveness date: 02/15/2003 Expected closing date: 04/30/2006

OCII PAO Fat ' am

A. Project Development Objective

1. Project development objective: (see Annex 1)

The objective of the proposed project is to facilitate private sector-led economic growth in the Federal

Republic of Yugoslavia (FRY) and the Republic of Serbia' through: (i) launching and implementation ofrestructuring and privatization of large problematic socially-owned enterprises (SOEs); and (ii)implementation of a comprehensive banking sector restructuring strategy aimed at creating a more viablefinancial sector. Specifically, the project will:

* establish a consistent approach and methodology for the restructuring and subsequentprivatization of large problematic SOEs;

* support the restructuring and subsequent privatization of large loss-making enterprises byfunding expert "restructuring agents" to prepare and implement "restructuring programs",privatize the saleable business units using internationally accepted transparent sales techniques,and put the unsaleable business units into bankruptcy;

* increase the capacity of the Privatization Agency (PA) to work with the restructuring agents tocarry out the above mentioned restructuring programs; and,

* support the restructuring or liquidation of insolvent banks under the control of BankRehabilitation Agency (BRA) and the privatization of most majority state-owned banks.

2. Key performance indicators: (see Annex 1)

Progress in achieving the development objective will be assessed on the basis of:

* the number and value of large enterprises restructured, and business units and assets sold, or ifnecessary, put into bankruptcy;

* a comprehensive qualitative assessment of progress in implementation of restructuring programswith respect to SOEs and parts thereof, for which privatization, restructuring or bankruptcy wasnot completed, and reasons for delays, if any;

* improved performance and competence of the PA to implement complex privatization throughrestructuring strategy, as measured by the use of best practices, the number of restructuringagents hired, and the number of auctions and tenders held;

* selection of banks for rehabilitation/privatization or liquidation track; number of majoritystate-owned banks privatized or put in liquidation; and,

* qualitative assessment of progress in implementation of bank liquidation, rehabilitation andprivatization.

/ Due to the highly devolved nature of the Yugoslav federation (most areas of economic policy are in the competence of therepublics), Serbia and Montenegro have experienced different starting points, needs and pace of reforms. Moreover, most recentreforms initiated at the federal level and implemented by the federal institutions such as the National Bank of Yugoslavia andBank Rehabilitation Agency have a direct impact on Serbia only. Therefore, the project documents specifically refer to theRepublic of Serbia as the project's primary beneficiary.

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B. Strategic Context

1. Sector-related Country Assistance Strategy (CAS) goal supported by the project: (see Annex 1)Document number: 24476 Date of latest CAS discussion: August 8, 2002

The proposed project is consistent with the Transition Support Strategy (TSS) for the Federal Republicof Yugoslavia, reviewed by the Board on May 8, 2001, and its update considered on August 8, 2002. Thestrategy identifies the stimulation of near-term growth as one of the key challenges facing the FRYauthorities on the path to a market economy. The TSS recognizes that growth will be led by the privatesector and calls for rapid privatization of all viable SOEs and comprehensive financial sector reform.The project is also consistent with the PSD and FSD strategy for Serbia, as discussed with the FRY andRepublic of Serbia governments and relevant local stakeholders, as well as the IMF, EU, EBRD, USAID,and other donor partners.

The proposed operation is a logical extension of the International Development Association's (IDA;henceforth referred to as "the Bank") recent efforts to support Serbia's enterprise sector reforms thatfoster private sector growth and job creation, facilitated by a healthier and more developed financialsystem. The initial technical assistance for the FRY and Republic of Serbia governments' reformprogram was provided by two Technical Assistance Grants for Private and Financial Sector Development(PSD and FSD TA Grants) approved in mid-2001. In recent months, the FRY and Republic of Serbiaauthorities have made impressive progress in meeting the TSS' Private Sector Development (PSD) andFinancial Sector Development (FSD) Performance Benchmarks in the context of the Private andFinancial Sector Adjustment Credit (PFSAC I). The proposed project will lay the groundwork for theSecond Private and Financial Sector Adjustment Credit (PFSAC B), scheduled for 2003, which wouldfocus, inter alia, on restructuring and the subsequent privatization of large SOEs, and privatization andliquidation of the remaining troubled majority state-owned banks.

RelevantDocuments: WB TSS (May 2001, updated in August 2002); IMF SBA (June 2001) and EFF(May 2002); PSD and FSD TA Project Appraisal Documents (June 2001); PFSAC I President's Report(May 2002); Structural Adjustment Credit (SAC I) President's Report (January 2002); The World Bankand the European Commission (EC), Economic Recovery and Transition Program (ERTP) (May 2001).

2. Main sector issues and Government strategy:

a. Large Socially-Owned Enterprises

As stated in the TSS, the real sector in Serbia is in very poor condition. The past decade brought aboutmacroeconomic instability, loss of markets, and isolation from technological advances. The mass ofproductive assets tied up in socially- or state-owned firms requires a change of ownership and, in manycases, restructuring if these firms are to survive and compete in open, global markets. The Republic ofSerbia Ministry of Economy and Privatization (MOEP) and the PA have the mandate to offer for sale thecapital or property of about 4,500 SOEs over the next four years. Among these SOEs, some companiescan be privatized in their current state, most likely those acquired as going concems by strategicinvestors. However, the assets and employees of many more companies will play a productive role in thenew economy only if they are reconfigured into a new corporate structure, with companies decomposedinto smaller and leaner parts.

In particular, the MOEP has identified 47 large industrial conglomerates with many subsidiaries,henceforth referred to as large loss-making enterprises (LLMEs), that require legal and financial

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restructuring before they or their successor parts can be successfully offered for sale through tender orauction (henceforth referred to as the "list of 47"). The criteria used to select the LLMEs have been asfollows: number of employees, strategic importance for national/local economy, sectoral diversificationwithin the enterprise, etc. Above all, the main selection criteria were the extremely poor financial andoperational condition of a large enterprise and the associated social implications.

Most LLMEs have suffered from years of economic mismanagement as can be seen from the chroniclosses, high level of indebtedness and large excess capacity of both physical assets and labor. Overall,the LLMEs exemplify the problems of the Serbian enterprise sector at its worst.

* Operational diffculties. Most LLMEs operate at a very low capacity. Their activities aremainly in heavy industry (steel, copper, chemicals, metallurgy). Most of these enterprises losttheir share of export markets during disintegration of the former Yugoslavia and the ensuingsanctions.

* Excess labor. The LLMEs are among the largest employers in the country. As of early 2002,the number of registered employees in these enterprises was more than 170,000 (a quarter of thetotal employment in socially-owned enterprises). The copper mining conglomerate RTB Bor,one of the largest LLMEs, employed more than 13,000 people. A significant proportion of theemployees are on administrative leave and employed in the informal sector.

* Heavy indebtedness. All LLMEs are burdened with an unsustainable level of debt (total of Euro3,900 million at the end of 2001), most of it overdue. In the past decade, they managed to stayafloat through bank loans or inter-enterprise credit (including directed credit), and non-paymentof current obligations. The average liability per employee was Euro 22,970 at the end of 2001.For comparison, total liabilities per employee in other large enterprises amounted to Euro 6,750.Enterprise liabilities can generally be broken down into the following four categories.

o Bank debt. Approximately 58 percent of the LLMEs' liabilities are owed to banks, althoughthis debt is not evenly distributed across the "list of 47." Preliminary estimates suggest that99 percent of bank liabilities are overdue. Most of this debt is owed to the four largeinsolvent banks currently under the administration of the BRA.

o Foreign debt. LLMEs are heavily indebted to foreign creditors but a large portion of thisdebt is state-guaranteed, as it was channeled through the banks to those enterprises.

o Debt to suppliers. Approximately 21 percent of total liabilities are owed to suppliers, mostlyto utilities (electricity, power, water). Most of this debt is also overdue.

2/ The current list should not be considered as final as the Govermnent is likely to include additional enterprises in it based on thesame criteria, as it had already done in the past few months.

/ MOEP/PA are only responsible for large socially-owned enterprises, not for the state-owned ones. Due to the long history ofsocial ownership in Serbia, the state directly owns only public utility companies. These enterprises will be privatized at a laterstage, after appropriate price adjustments, introduction of proper regulatory bodies for natural monopolies etc. The policytowards these enterprises is coordinated by the Ministry of Finance and various line ministries.

4/ The latter fact may be an important mitigating factor regarding the social consequences of restructuring.

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o Tax arrears and other public debt. Despite the fact that the tax collection rate is fairly high

in Serbia, LLMEs have large outstanding liabilities to tax authorities and various public

funds. These enterprises account for approximately one-third of outstanding debt to taxauthorities in the entire economy.

Impact on fiscal discipline. The LLMEs have been incurring losses for a number of years and have

relied on direct and indirect state subsidies in order to operate. Even though the volume of subsidies has

declined dramatically after the new Republic of Serbia Government came into office in early 2001, the

direct subsidies to SOEs still account for 5.5 billion dinars (0.8 percent of GDP) in the Republican 2002

budget, most of it going to LLMEs on the "list of 47." In addition, the SOEs benefit from even greater

indirect subsidies through the national electricity company (EPS) and the Ministry of Transport and

Telecommunications. Total subsidies to the SOEs (mostly to LLMEs) thus amount to at least 2 percentof GDP.

b. Banking Sector'

As in the case of the SOE sector, the present condition of Serbia's banking system reflects the extreme

conditions of state interference and instability under which it operated during the last decade. Pervasivedefaults and widespread arrears, aggravated by economic sanctions, resulted in significant portions of

bank assets becoming either immobile or non-performing. Mismanagement of the largest banks led to

directed credit decisions and was exacerbated by the ownership or control exercised over these banks by

some of the large and troubled SOEs. As a result, the size, level of intermediation and overall

significance of the banking system steadily declined during the 1990s. Excluding some DEM 7.4 billion

of foreign exchange deposits that have been frozen mainly in the largest state banks since 1991, deposits

in the banking system stood at less than DEM 100 per capita by end-2000, one the lowest figures

recorded in the region. By late 2000, around 90 percent of the banking assets were deemed insolvent.

As a result of resolute actions by current FRY and Serbian authorities over the last eighteen months,

including the initiation of a liquidation procedure for the four large state banks (see the section on

Government's strategy below), the Serbian banking system has significantly improved. New deposits are

flowing into the system, increasing more than tenfold between June 2001 and March 2002. This indicates

that the banking system will be in a better position to support enterprises, once prudent lendingopportunities are available.

The authorities estimate, however, that there is still some Euro 3.5 billion held outside the banking

system. A number of small- and medium-sized troubled banks have been placed under the care of BRA

for future liquidation or rehabilitation. The entry of foreign capital has been limited, and the system still

has a strong presence of majority state-owned banks, including the recently established National SavingsBank, all of which are part of a far-reaching restructuring strategy supported by the FRY and Serbian

authorities and NBY.

/ More detailed description of the state of the Serbian financial system and the Government's banking sector restructuring

strategy can be found in the President's Report for PFSAC I, including the Letter of Development Policy.

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c. Government Strategy

Large Loss-Making' SOEs

The MOEP has recently submitted to the Bank (under the policy program of PFSAC I) a draftrestructuring strategy focusing on the following five elements.

1. Legal Framework.2. The Restructuring Model.3. Financial Restructuring and Linkages with Bank Resolution.4. Dealing with Social Costs.5. Target Companies.

Legal Framework. The Serbian restructuring strategy is based on the new Privatization Law adoptedwith the Bank support in June 2001. The Law on Privatization promulgates three methods ofprivatization: (i) privatization tenders of large enterprises; (ii) auctions of medium enterprises; and (iii)restructuring and subsequent tenders and/or auctions of large loss-making enterprises and/or partsthereof. Tender privatization is used for companies that are sufficiently large, important and attractive torequire a case-by-case approach for their privatization. Companies that are not sufficiently large orcommercially attractive to be sold under the tender process will be offered for sale through a publicauction process. Enterprises which cannot be sold through auction or tender are required under thePrivatization Law to undergo "restructuring for privatization" (Article 19, 20). These articles allow theMOEP/PA to instruct the company to prepare a restructuring program.

The legal framework for the Republic of Serbia Government's restructuring strategy is further detailed inthe by-law on restructuring. The by-law provides the procedures for reorganization, dealing withcreditors and debt, management of the company during restructuring and deadlines for third parties tomeet the requirements of the articles. In addition, amendments to the Law on Enterprises have beenadopted (supported by PFSAC 1) which allow the PA to assume the powers of the managing bodies ofenterprises which hinder or block the privatization process. A modem Bankruptcy Law has also beendrafted (supported by PFSAC I) and is expected to be adopted shortly.

Based on the lessons from the first cases of restructuring, such as of the Zorka holding company(financed by USAID), the Republic of Serbia Government might introduce additional amendments to thePrivatization Law and other relevant regulations by the first quarter of 2003, and the Bank could supportthese amendments under the forthcoming PFSAC II. In particular, it is proposed that, to mitigate the riskthat court challenges by minority (non-state) creditors delay the process, the above amendments addressthe problem of dealing with creditors of enterprises under restructuring if the out-of-court restructuringprovision in the Privatization Law (Article 23) does not prove to be sufficiently robust.

The Restructuring ModeL The Republic of Serbia Government's restructuring model is based on thesegmentation (in a typical case) of the company, incorporation of new companies created from parts ofthe old one and sale of these new companies and assets remaining after the break up.' The underlyingpremise of this exercise is that various subsidiaries and/or assets of LLMEs can be viable and attractiveto potential investors even if as a whole these conglomerates are presently non-viable and non-saleable.This model is based on a transaction oriented approach, where the ultimate sale of the enterprise or itsvarious viable parts drives the restructuring effort. There will be no attempt to continue operating theseenterprises in their present conglomerate form as either socially- or state-owned entities.

/ It should be noted that, after extensive consultations with the Bank and other donors, the European Agency for Reconstruction(EAR) is now sharing the same approach and is willing to finance the privatization through restructuring of a number of LLMEs.

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According to the government strategy, the privatization through restructuring model will include

identification of independent business units (IBU) in each enterprise, their transformation into saleable

business units (SBU), and the sale of SBUs. This process will consist of three stages: (i) a feasibilitystudy and a due diligence report, serving as the basis for preparation of the restructuring program; (ii) the

implementation of organizational and financial restructuring, including (if necessary) the incorporation of

the new companies created from parts of the old one and negotiations with creditors; and (iii) the

privatization of the SBUs by tender or auction, and disposing of all other assets remaining after the

reorganization through bankruptcy procedures. The PA plans to engage external restructuring agents such

as investment banks, qualified consultancies, and workout companies to undertake these three stages. In

most cases, the restructuring task will be led by the company responsible for sale, leading a consortium

of experts, as required.

Financial Restructuring and Linkages with FSD. Following the liquidation of the four major banks,the loans made by these banks to enterprises represent the non-performing portfolio to be administered

by the BRA in its capacity as bankruptcy administrator of these four banks. At the same time, as notedabove, the overdue loans burden the balance sheets of the SOEs so that their restructuring and

privatization is hindered. In the absence of a joint resolution, the potential conflict of interests betweenthe BRA and PA could hamper the restructuring and privatization process and may even result in the

liquidation of companies that could be sold as going concerns. In view of the high level of indebtednessof most LLMEs, the process of debt workout is key to ultimate success of restructuring, i.e., the sale of

the company.

The FRY and Republic of Serbia governments, assisted by the Bank, have recently come up with a

framework under which the debts owed to the BRA banks and to the Ministry of Finance and Economy(primarily tax arrears, but also health, pension, unemployment and other public funds) by SOEs will be

settled from privatization proceeds, and will not be the obligation of the buyer. The recovery of these

categories of debt from privatization proceeds is expected to be more than or equal to the present value ofliquidating the company through bankruptcy given assumptions that: (i) the privatization process is faster

than court administered liquidation; and (ii) the value of a company's assets is higher as part of a going

concern. The crucial condition of the scheme is that settlement of debts occurs only as an integral part of

the closing transaction; if the enterprise is not sold, then the debt write off does not occur. Only at theclosing of the sale transaction does the BRA and MOF debt, which is not assumed by the buyer, cease tobe an obligation of the enterprise.

Dealing with Social Costs. An integral part of the Republic of Serbia Government's strategy will be toaddress the social impact of restructuring and privatization. The break-up and sale of the LLMEs are

likely to entail major labor displacement. The Republic of Serbia Law on Labor (passed in 2001) and

Law on Employment (currently in draft form) set the minimum levels of severance payment and

unemployment benefits for displaced workers. In addition to the above laws, the recently adopted

Republic of Serbia Government's Social Program deals specifically with employees dismissed duringrestructuring, privatization, and liquidation of LLMEs. The program provides a unified approach for

dealing with the social costs of LLMEs' reform and minimizes the prospects of ad hoc settlements for

dismissed workers at various enterprises. Retrenched workers may choose between: (i) a lump-sumpayment equivalent to Euro 1,000 or Euro 100 per year of service (whichever is higher), and (ii) payment

for up to two years, depending on length of service, at 40 to 80 percent of the average wage in Serbia.

Displaced workers may also seek additional support, including training and requalification benefits, and

financial support to set up a new private business.

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A detailed diagnostic for each enterprise prepared by the restructuring agent will include a laborredeployment plan for an enterprise, which will outline severance or other packages for redundantworkers and receive financing from the Republic of Serbia budget. The 2002 budget includes a specialallocation to provide the payments to companies covered by the Social Program, and a comparableallocation will be included in next year's budget. Given the significant fiscal cost of the program, effortsare being coordinated between the MOEP, Ministry of Labor and Employment, Ministry of Finance andEconomy, and other relevant government agencies to prioritize the payment of retrenchment benefits toworkers from those companies that are undergoing credible pre-privatization restructuring. The Bankwill continue to monitor the implementation of the Social Program in the context of forthcomingadjustment operations (SOSAC and PFSAC II).

Target Companies. As noted above, the list of 47 identified LLMEs represents a diverse universe ofcompanies. Some of them, like the car maker Zastava or mining combinate Bor, are large conglomeratesof companies, while others are much smaller entities with one or a few productive facilities. Some arepotentially attractive and will appeal to buyers after limited restructuring. Others are in perilous financialshape with few attractive assets and will require substantial restructuring before any buyers can beattracted, and then possibly only for sale of some assets. The total cost of expert help to restructure the 47LLMEs could be as high as US$20-30 million, not including social cost which will be much higher, andthe process would take a number of years.

With the help of the Bank, the PA has engaged consultants to conduct a preliminary assessment andranking of the list of 47 LLMEs using the following criteria for each enterprise: (i) market potential ofthe company and its SBUs; (ii) expressed interest from potential foreign investors; (iii) current level ofoperations; (iv) degree of financial distress, including the creditors' profile; and (v) existence of SBUswithin the company. Based on this analysis (including on-site visits), the potential candidates forprivatization through restructuring have been identified.

It is evident from the initial diagnostic work that some of the companies on the "list of 47" of may neverbe suitable for any serious attempt at privatization and should eventually be subject tobankruptcy/liquidation procedures. It is also understood that the list is by no means exclusive, as othersuitable candidates for privatization through restructuring may be identified from the existing populationof unprivatized socially-owned enterprises.

Bankingi Sector

Following the 2000 elections, the FRY and Serbian governments decided that restructuring the financialsector at an early stage in transition was an utmost priority. Under the leadership of the NBY, theauthorities started with assessment of the conditions of troubled banks, followed by a launching of acomprehensive banking sector reform program. At the core of this program is a far reaching bankingrestructuring strategy that aims to eliminate deep insolvency of the system, reestablish public confidenceand adequate intermediation, and attract new capital into what is envisioned to be a privately-ownedmodem banking system. Some 23 banks were closed by the end of 2001 and, most importantly, the fourlargest banks, representing more than 60 percent of the book assets of the system, were closedsimultaneously on a single day in the first week of January 2002. The latter step can be considered of anunprecedented nature in the region, and demonstrated the determination of the FRY authorities to reformthe financial sector. Resolution efforts are also accompanied by improvements in the regulatory andsupervisory framework of the banking system and an aggressive program of institution building at theBRA, supported by the Bank and other donors.

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As agreed with the Bank in the context of the agenda for PFSAC II, the authorities intend to largely

complete restructuring and privatization of the banking system by the end of 2003. The program calls for

the following key actions to be taken:

* privatization or liquidation of the five small troubled banks now under BRA control;* privatization or liquidation of up to 13 additional banks that became majority state-owned in fall

of 2002 following the debt conversion of their Paris Club liabilities, which have been assumed by

the Republic of Serbia; and,* privatization or liquidation of most remaining majority state-owned banks, including the National

Savings Bank.

3. Sector issues to be addressed by the project and strategic choices:

Enterprise Sector

The proposed project provides technical assistance (consultant services) and equipment to support the

Republic of Serbia Government's program to undertake the urgent organizational and financial

restructuring of a number of failing SOEs, focusing on the very large ones and those of acute social

importance. Given the dire financial and operational condition of these enterprises, as well as the present

investment climate in Serbia, it is clear that these firms will not be able to attract buyers in their current

state. Such firms will play a productive role in the Serbian economy only if they are reconfigured into

smaller parts, with the objective of extracting and selling viable business lines and putting into

bankruptcy/liquidating (including the sale of assets) the rest. The process of break-up and spin-offs of

LLMs will not only release assets to the emerging private sector, but also strengthen fiscal discipline

and improve the business environment by weakening the grip of the large un-restructured SOEs. If these

SOEs are allowed to preserve their existing structures without privatization, they will continue to use

their size and political power to evade financial discipline, demand non-competitive regulation and

otherwise block (potential) competition from the private sector.

Banking Sector

The project will also provide technical assistance for the implementation of the second phase of the

authorities' banking sector restructuring program. Specifically, the project will address the following

issues:

* the need to liquidate insolvent banks currently in the portfolio of BRA.

* the need to decide whether any of the most viable majority state-owned banks can be privatized

by sale to strong strategic partners in the short term, and what type of pre-privatization

restructuring will be needed.* the need to define a workout solution for assets carved out of the banking system integrated with

the broader workout of claims and arrears in the economy, including in LLMEs.

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C. Project Description Summary

1. Project components (see Annex 2 for a detailed description and Annex 3 for a detailed costbreakdown):

Part A. Privahzation through Restructuring of Socially-Owned Enterprises

Under this component, technical assistance will be provided to the PA or other relevant agencies, tosupport privatization and restructuring, and, when appropriate, bankruptcy of a number of large SOEsusing intemationally reputed restructuring agents hired through competitive tenders. The component willbe implemented in accordance with the Republic of Serbia Govermment's Enterprise PrivatizationFramework, as defined by the relevant laws, regulations, and institutions, as well as in accordance withthe specific policy commitments undertaken by the FRY and Republic of Serbia governments in theLetter of Development Policy (LDP) for PFSAC I.

In accordance with the govermment strategy, the proposed project will focus on the select group ofcompanies in which saleable successor companies, units, parts or assets can be identified forprivatization. In other words, in view of the limited financial resources and the importance of havingearly successful cases in the process, the project will concentrate on LLMEs which have assets or SBUswith a higher potential for successful privatization transactions. The project will focus on, but will notbe limited to, the group of 47 SOEs identified by the Republic of Serbia Govermment as potentialcandidates for privatization through restructuring. The list of SOEs to undergo privatization throughrestructuring with the help of credit funds will be agreed upon between the PA and the Bank at the earlystage of project implementation.

A.]. Privatization through Restructuring of Socially-Owned Enterprises

Under this sub-component, technical assistance to the Republic of Serbia, operating through the PA orother relevant agencies, to support privatization and restructuring, and, when appropriate, bankruptcy, ofa number of large SOEs, using case-by-case and pool privatization techniques, on the basis of transparentand competitive procedures and assistance of restructuring agents through the provision of services. Thissub-component will cover the major part of costs (namely, the retainer fee) of engaging the expertrestructuring agents-investment banks, consulting companies, workout firms and other financialadvisors-to implement each of the above-mentioned three stages of restructuring using transparentinternationally accepted procedures. Companies may be offered to agents either individually or in small"pools" of two to four companies. The success fee of the restructuring agents, based on the sale of thesuccessor companies and the remaining assets will be paid by the Republic of Serbia Government.

A.2. Building the Institutional Capacity of the PA

This sub-component will provide technical assistance to build up institutional competence of the PA tosupervise the restructuring agents in the preparation and implementation of the above-mentionedrestructuring programs. The assistance will cover the following:

i. advisory services for establishing the Restructuring Unit within the PA capable of monitoring therestructuring agents' perfornance, dealing with the enterprise creditors and employees, andnegotiating with potential investors; and,

ii. consulting services to enhance institutional capacity of the PA with foreign and local expertadvice and technical know-how for the restructuring and privatization process, including

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preparation of the company profiles, development of TORs, facilitation of contracting andbidding process for restructuring agents, organizing the creditors' meetings, and advising onlegal issues.

A.3. Project Management and Implementation

This sub-component will support the work of the Project Management Unit (PMU), already establishedin the PA, in the management, implementation and monitoring of Parts A. l and A.2 of the project,through the provision of services, including the audit of records, accounts and financial statements,goods, and fimancing of incremental operating costs, including PA staff salaries.

FHar B. Ba '1 estrncenring program

This component will support the continued implementation of the bank restructuring and privatizationprogram by the BRA. The component will be implemented in accordance with the FRY Government'sBank Resolution Framework, as defmed by the relevant laws, regulations, programs and institutions, aswell as in accordance with the specific policy commintments undertaken by the FRY and Republic ofSerbia governments in the LDP for PFSAC 1.

B.]. Bank Liquidation, Rehaabilitation and Privatization

This sub-component will cover the following:

i. consulting services to provide operational support for receiverships for insolvent bankscurrently in the BRA portfolio;

ii. consulting services to undertake the implementation of stabilization, rehabilitation andpre-privatization activities for majority state-owned banks in BRA portfolio that have beenselected for privatization; and,

iii. services of financial advisors to undertake the marketing and imnplementation ofprivatization tenders for majority state-owned banks under the control of the BRA.

B.2. Project Management and Implementatioin

This sub-component will support the work of the PMU, already established at the BRA, in themanagement, implementation and monitoring of Part B.1 of the project, through the provision ofservices, including the audit of records, accounts and financial statements, and financing of incrementaloperating costs.

Indicative Bank- % ofComponent . Costs %o financing

_ (US$M) Total (US$M) . .'fiiancingPart A. Privatization through Restructuring of 10.88 72.6 8.00 72.7Socially-Owned EnterprisesPartB. Bank RestructuringProgram 4.10 27.4 3.00 27.3

Yatal ea cCeto 14.98 100.0 11.00 100.0

¶'otdll cF aimcmg Eequined 14.98 100.0 11.00 100.0

2. Key policy and institutional reforms supported by the project:

Serbia embarked on its renewed transition with a socially-owned enterprise sector that is accustomed tosoft budget constraints and, as a result, is inefficiently organized, loss-making and excessively indebted.To address the severely deteriorated situation at large SOEs, the Republic of Serbia Govermnentprepared an ambitious privatization through restructuring strategy, dealing with companies that must berestructured before sale because they are too complex in organization (e.g., having disparate lines ofbusiness attracting different buyers), encumbered with heavy debt, and generally unattractive to investorsin their present state. At the same time, the FRY and Serbian authorities launched an ambitious bankingsector restructuring strategy aimed at facilitating economic recovery by creating a healthy banking sectorcapable of providing financial intermediation services on a sustainable basis. This technical assistanceproject aims to support the FRY and Republic of Serbia governments' reform program by: (i) financingthe qualified financial advisors to undertake restructuring and subsequent privatization of a number oflarge SOEs across a wide spectrum of sectors; (ii) improving the capacity of PA to manage theprivatization through restructuring process; and (iii) supporting liquidation of insolvent banks and therestructuring and subsequent privatization of a number of majority state-owned banks. Very importantly,the proposed project will support the development of the local institutional capacity, thus creating thefoundation for the restructuring and privatization of other SOEs and banks not directly financed from thiscredit.

3. Benefits and target population:

The main benefit of the proposed project would be faster private sector growth and job creation,supported by a healthier and more developed financial system. Overall enterprise and financial sectorperformance is expected to improve. This improvement will come partly through the privatization andliquidation of banks, and the sale of large loss-making SOEs or, more likely, their successor parts and/orassets to local and foreign investors with strong management capacity, and partly through improvedfinancial discipline facilitated by the segmentation and sale of the companies, and more productive use ofassets as a result of restructuring. At the same time, a well-functioning, transparent and cost-effectivefinancial system would allow an adequate mobilization of resources and better allocation into productiveinvestments. It is important to note that privatization and, in some cases, liquidation of some of thelargest loss-making SOEs, as well as majority state-owned banks will reinforce sustainability of Serbia'smacroeconomic stabilization and fiscal discipline by removing a long-standing source of budget drain.

In the medium term, the formation of new private sector fimns is expected to accelerate in response to anincreased supply of productive assets that will be released from loss making firms as part of therestructuring effort. Such a reconfiguration and the spin-off of functions are important for thedevelopment of the formnal SME sector and the formalization of the vibrant informal one. In the long run,the reforms supported by the proposed operation are expected to have an overall positive impact onpoverty reduction in Serbia as crowding out of the private sector by large loss making firms will cease,financial intermediation will significantly increase, and the Serbian economy will embark on a steadygrowth path.

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4. Institutional and implementation arrangements:

The project will be implemented over a three year period. The PA and BRA will be the main

counterparts for Parts A and B of the project, respectively. The general policy guidance will be provided

by the MOEP and NBY for Parts A and B of the project, respectively. The project implementation will

be effected by the two PMUs, which have been established in the PA and the BRA in Spring 2001 to

implement the ongoing Bank's PSD TA and FSD TA Grants. The two PMUs will be fully separate, and

responsible for the implementation and administration of their respective components. Both PMUs are

expected to finance their components through two separate Special Accounts. The two PMUs will be

responsible for monitoring the use of funds for their respective components, including procurement and

disbursement, and reporting on the use of project funds to the FRY and Republic of Serbia governments

and to the Bank.

Each PMU is headed by a Director, who will have overall responsibility for his/her respective component

of the proposed project. The PMU Directors will ensure that all project objectives and targets that can be

monitored, as specified in the Project Implementation Plan (PIP), are on track and achieved. He/she will

be assisted by a Project Administrator, who will oversee day-to-day operations. Technical expertise on a

short-term basis will be provided to the Project Administrators as required. Each PMU will include

procurement, disbursement and financial management specialists who will work on the proposed project.

Financial Reporting

Each PMU will prepare a quarterly Financial Management Report (FMR) for its respective component of

the project, in accordance with formats agreed upon with the Bank, which will then be consolidated by

the PA PMU and forwarded to the Bank. The FMRs will include the following areas: (i) Financial

Report; (ii) Project Progress Report; and (iii) Procurement Management Report. These financial reports

will be submitted to the Bank within 45 days of the end of each quarter. The first FMR is expected to be

submitted for the period ending 31 March 2003. In order to facilitate consolidation of both sets of

reports, each PMU should preferably establish a common chart of accounts built on a common reporting

platform.

Audit Arrangements

The audit would include both a project audit, and an audit of both implementing agencies (an "entity

audit"). The project audit would include a separate opinion by the auditor on the operation of the Special

Accounts and the adequacy of SOE procedures. The audit of the Agencies should be completed for the

year ending December 31, 2002 (as the Agencies are currently managing other Bank projects). The PIP

indicates that only a small amount of funds will be disbursed during 2002 and hence the first project

audit will likely cover the period from credit effectiveness to December 31, 2003. These audits should be

carried out by an independent auditor acceptable to the World Bank, and the audit reports should be sent

to the Bank within six months of the end of the fiscal year. It is expected that the cost of the entity audits

will not be financed from the credit but will be financed from the agencies' own income.

Disbursements

Disbursements from the proposed credit will be made based on traditional disbursement methods (i.e.,

from the Special Account with reimbursements based on Statements of Expenditures (SOEs) and full

documentation, and direct payments from the Credit Account). The Borrower will establish, maintain

and operate (through PMUs), under conditions acceptabale to the Bank, two separate Special Accounts

for Parts A and B of the project, separate from the Special Accounts currently used for other

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Bank-financed projects. There are currently three banks in Serbia which are considered satisfactory forthe maintenance of Special Accounts. Where the Borrower considers it efficient to open a local currencyaccount, these should be opened in the same bank as the Special Account and should be used only forfunds related to this project. The local currency accounts will be primarily transaction accounts andbalances should be kept to a minimum.

D. Project Rationale

1. Project alternatives considered and reasons for rejection:

Two alternative methods for enforcing financial discipline on and dealing with large loss-making SOEswere considered and rejected:

* Privatization "as is" without prior restructuring, or bankruptcy. This strategy calls forimmediate privatization of these enterprises without attempting first to restructure them.According to this approach, if privatization "as is" does not succeed, creditors shouldimmediately file a petition for bankruptcy in court. This approach may take a very long time inview of the limited capacity of the courts, lack of trustees and, above all, the pro-debtor cultureof the courts and other key stakeholders. The team does not believe this strategy will work underpresent conditions in Serbia; neither has it worked elsewhere in ECA (with the exception ofHungary and Estonia). First, given the poor condition of most LLMEs and weak interest frompotential investors, these companies clearly cannot be privatized as they are. Second, bankruptcyand total liquidation of all LLMEs are very risky due to the potential major social falloutassociated with massive bankruptcies. Even if the authorities were to bankrupt the largeenterprises, as already mentioned, the current weakness of the Serbian bankruptcy regime wouldseverely delay the process. Meanwhile, in the absence of action, the LLMEs would continue tobe a drain on the state budget and an impediment for economic growth.'

* Restructuring without privatizationl"Isolation" approach. Several governments in transitioneconomies (e.g., Romania, Albania, Bulgaria, Macedonia, Kyrgyz Republic) have implementedisolation programs that combine features of reorganization under bankruptcy but without theobjective of sale of assets or privatization of viable units. Despite substantial costs, theoperational performance of only few enterprises has improved as a result of these efforts, andeven then the improvement did not last and these SOEs collapsed again due to low levels ofproductivity and investment, weak (and unchanged) corporate governance, corruption, lack ofany meaningful financial discipline and slow response to market information. Worse still, suchprograms may have delayed further restructuring and privatization because the isolatedenterprises became a cohesive political lobby for more subsidies. In general, as demonstrated bythe experiences in other transition economies, unless the sale of productive assets is seen as anultimate goal of restructuring, restructuring does not produce the expected results and thetroubled enterprises remain a drain on the budget and a social liability.

/ A third alternative approach to restructuring is the bank-led restructuring of SOEs which has been attempted, e.g., in Poland.This model was not seriously considered by the team due to the weakness of the Serbian banking sector.

/ A new Bankruptcy Law is being drafted with the Bank's support, combined with an effort to put in place a bankruptcyframework. In particular, PFSAC II will support licensing of trustees and establishing a special Trustee Agency in the MOEP toassist in the administration of trusteeship of SOEs (sinilarly to the appomting the BRA as receiver of banks). Once thesereforms are implemented, the bankruptcy courts may exert pressure on the remaining SOEs to restructure and sell themselves inorder to pay off the claims and avoid liquidation procedure.

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The project team also considered an alternative to bank rehabilitation represented by an immediateprivatization, presumably at negative sale prices, in which prospective investors could have taken thelead in restructuring the banks. This scenario was rejected due to the view that the level of insolvency ofthe state-owned banks was considered high and therefore it would have been nearly impossible to findsuch investors. Another alternative that was considered was immediate liquidation of insolvent banks.This scenario was rejected since the BRA estimates that many of these banks are "privatizable", providedan adequate process of rehabilitation is undertaken. In any case, success in rehabilitation of the troubledbanks remains hard to anticipate; therefore the BRA remains conscious of the need to shift into aliquidation process if necessary.

2. Major related projects flnanced by the Bank and/or other development agencies (completed,ongoing and planned).

I } . ^Latest SupervisionSector Issue Project (PSR) Ratings

.______________ ______________ __________________ _ l (Bank-financed projects only)Implementation Development

Bank-financed Progress (IP) Objective (DO)

Privatization of SOEs Private Sector Development S STechnical Assistant Grant(SF-P074145-LEN-BB)

Bank resolution Financial Sector Development S STechnical Assistant Grant(SF-P074145-LEN-BB)

Privatization and Restructuring of Private and Financial Sector S SSOEs, Bank Resolution, Bankruptcy Adjustment Credit (PFSAC I)

and Second Private andFinancial Sector AdjustnentCredit (under preparation)

Other development agencies -

Privatization and Enterprise Financing restructuring study ,.

Restructuring and restructuring agents for one -company (IFC)Financing restructuring studies -7

and restructuring agents for 13companies (EAR) `7i s

Financing restructuring studies ,and restructuring agents foreight SOEs (USAID)Financing restructuring studiesfor five companies (UK DFID)

Bank Restructuring Program Support to BRA management -

of bank liquidation andrehabilitation (US Treasury) -' '5

Support to BRA managementof bank rehabilitation/ -privatization process (UKDFID) -. - -

IPIDO Ratings: HS (Highly Satisfactory), S (Satisfactory), U (Unsatisfactory), HU (Highly Unsatisfactory)

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3. Lessons learned and reflected in the project design:

Transition experience elsewhere has shown that dealing with country's large loss-making politicallysensitive enterprises is one of the most difficult steps in the reform process and almost always requiresspecial arrangements. As proposed in this project, large politically sensitive enterprises can be dealt withby breaking them into smaller business units, each based on a core business activity. This approach hasbeen successfully applied in many transition economies, and in most cases the fragmentation ofenterprises greatly reduced their political power and ability to resist changes." For example, a stateshipping company in Lithuania was broken up into two parts as a result of restructuring, with one IBUsuccessfully sold to a strategic investor, and another one undergoing further privatization at the moment.In Czech Republic, the Government engaged financial advisors to develop and implement financial andoperational restructuring of TATRA and ZETOR industrial conglomerates prior to privatization of theircore units. Skopje steel works in Macedonia was broken up into around 12 enterprises and the core steelmaking assets were eventually sold to a foreign strategic investor. At the same time, the enterprisereform program in Macedonia was stalled in the cases of large enterprises, like the smelters, that were notor could not be broken into many smaller companies.

Another lesson is the need for an integrated approach to reform private and financial sectors. The realsector cannot operate without an effective banking sector encouraging domestic savings and generatingthe working capital and investment finance. At the same time, a financial sector cannot gain acceptablereturns or diversify its risks between retail and corporate credit without a functioning real sector. Onlyan efficient financial sector is capable of ensuring financial discipline and channeling resources towardsgood investment opportunities. Practically, this means stopping direct political loans and allocatingloans based on return considerations. The linkages between the PSD and FSD sector reforms supportedunder PFSAC I and II will be crucial to the success of bank and enterprise privatizations under theproposed project.

In this respect, a key lesson in real sector reform in other transition countries (e.g., Croatia, CzechRepublic and Slovenia) has been that the use of state-sponsored asset management companies or similarinstitutions to work out the debts of enterprises to banks has proven almost entirely ineffective. InCroatia, debts carved out of the large banks in the course of rehabilitation were "parked" in the BankRehabilitation Agency where no attempt was made to use debt leverage to force firms to restructure (thedebt was often converted to equity in any case). As a result, a large number of state-controlled firms nowhave to be restructured and privatized, at the very late stage in the transition process and after ten years ofunder-investment in new technology as a result of preferring to use cash to maintain employment.

The proposed project also takes into account another crucial lesson from the Bank's experience withenterprise and bank restructuring in transition economies, i.e., the importance of having an adequateinstitutional capacity in place to undertake such a complex exercise. This includes establishedPrivatization Agency and Bank Rehabilitation Agency staffed with top-quality professionals assisted byforeign resident advisors.

/ In fact, many large state-owned companies in developed economies (UK, New Zealand) underwent some form oforganizational and/or financial restructurng prior to privatization.

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Because of the emphasis on sales in the proposed project, the use of competent restructuring agents that

are capable of selling is key to the success of the program, as shown by the experiences with case-by-caseprivatizations throughout the world. Where companies are relatively large and, after restructuring, are

saleable as a whole or have significant units that can be sold, investment banks will be hired to undertake

the restructuring and sale. For less attractive enterprises, workout companies and consultanciesexperienced in restructuring and workout will be used. Compensation will be based on a retainer fee

which will cover the preparation and implementation of restructuring program, outlining both legal and

financial restructuring, and a success fee to be paid from the proceeds of sale. A similar approach has

been successfully used in Romania with two large firms and is being extended to cover ten firms

tendered in four small pools to workout finns and experienced consultancies.

The Bank's previous experience with TA projects also indicates that projects with a sizable amount of

technical assistance should have:

i. active support of ministry and government officials to ensure properly considered and timelydecision making on crucial issues;

ii. donor coordination to avoid duplication of efforts and leverage available resources in the mostefficient way;

iii. a well defined procurement plan, including terms of reference for consultants and studies draftedand agreed upon with the borrower prior to negotiations; and,

iv. PMUs with well qualified and competent staff who are properly compensated for their work.

4. Indications of borrower commitment and ownership:

The FRY and Republic of Serbia governments requested support for privatization and restructuring of

banks and enterprises through this project in October 2001 and confirmed the need for support during the

PFSAC I negotiations in April 2002. The proposed project is consistent with the FRY and Republic of

Serbia govermnents' Enterprise Privatization Framework and Bank Resolution Framework. As noted in

the LDP for PFSAC I, the restructuring, privatization and/or liquidation of large SOEs and majority

state-owned banks will be at the core of reforms supported by PFSAC II, the Bank's next adjustmentoperation planned for 2003.

The FRY and Republic of Serbia govermnents' commitment is also reflected in recent actions taken by

the MOEP and PA to pass relevant legislation, including the Privatization Law and the by-law onrestructuring, and to prepare the draft restructuring strategy for the "list of 47". Furthermore, the

Republic of Serbia Government initiated, using its own funds, the restructuring process for several large

SOEs, including the car-maker Zastava. The Serbian authorities, supported by the Bank, organized aseries of training seminars for managers of SOEs subject to privatization through restructuring. On the

banking sector side, the bold steps taken in early 2002 that have resulted in the closure of the four largest

state banks can be considered unprecedented in the region, and demonstrated the determination of the

FRY authorities to reform the financial sector. Meanwhile, institutional capacity of PA and BRA to

undertake complex restructuring and privatization programs has been strengthened by the hiring of local

staff and foreign advisers.

5. Value added of Bank support in this project:

The Bank's strategy is based on two principles: (i) investing in areas where the Bank has a comparative

advantage; and (ii) investing in key reform areas, including private and financial sector development.

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The Bank has extensive knowledge and experience in bank and enterprise privatization and restructuringin former socialist countries, including in Serbia (Bank's PSD and FSD TA Grants). It is thus in a uniqueposition to provide best practice advice on how to deal with large loss-making SOEs and majoritystate-owned troubled banks. The Bank will also assist in implementation of the project through hands-onsupervision and imparting knowledge of project management methods to Serbian counterparts.

The key rationale for Bank intervention in the reform of large SOEs is the urgent need for donorcontribution to designing the restructuring model (as described above) and successfully launching theprogram. Until now, the Bank has had no funding available for restructuring activities, leaving theauthorities dependent on limited donor financing and scarce internal resources of the PA for hiringnecessary staff and experts. Several donors, including EAR, USAID, and DFID, have indicated awillingness to fund diagnostic studies and, in some cases, restructuring agents for the privatizationthrough restructuring of a number of companies, but there remains a significant need for additionalcapacity building at the PA. There is a clear need for the Bank funding to provide full support to theRepublic of Serbia Government's restructuring strategy in all its three stages, finance a major capacitybuilding effort at the PA, and serve as a catalyst for attracting meaningful assistance from other donors.The team anticipates that other donors will share the model supported by the proposed credit as a resultof the demonstration effect from the first successfil cases of privatization through restructuring.

E. Summary Project Analysis (Detailed assessments are in the project file, see Annex 8)

1. Economic (see Annex 4):O Cost benefit NPV=US$ million; ERR = % (see Annex 4)O Cost effectiveness* Other (specify)

As described in greater detail in Section C.3 of this document, the potential economic benefits ofrestructuring and privatizing the LLMEs and majority state-owned banks, though difficult to quantifywith certainty, are likely to be significant. As experience in many transition countries in the regionshows, output and profits have risen in privatized companies after a period of adjustment. At the sametime, the level of financial intermediation increases with the appearance of strategic investors in thebanking sector.

2. Financial (see Annex 4 and Annex 5):NPV=US$ million; FRR = % (see Annex 4)

Not applicable

Fiscal Inpact:

The sale of SOEs and banks with the help of expert agents will generate budgetary revenues. Moreimportantly, the project will have the following financial impact: (a) newly privatized enterprises will nolonger receive direct and indirect subsidies described in section B.2 of this document; and (b) the statewill be free of potential future liabilities for any losses incurred by the enterprises or banks.

/ The Bank's tender privatization program supported by the PSD TA Grant (approved in June 2001) is ahready being supportedby other donors' assistance programs (Dutch and Swedish cofinancing TFs).

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3. Technical:

Successful restructuring and privatization require high-quality advice and expertise in a number of areas.These technical skills are currently weak in Serbia. The project would ensure that the Government ofSerbia has access to the necessary expertise, through top-level advisors and consultants, to facilitate the

achievement of its reform objectives in a timely manner. An important element of the project will be forthe hired experts to train and transfer these skills to their in-country counterparts.

4. Institutional:

4.1 Executing agencies:

The PA will deal with privatization through restructuring of SOEs, while the BRA will be responsible forprivatization and liquidation of majority state-owned banks. The PA will adhere to the principles laid outin the Implementation Agreement between the PA and Republic of Serbia, which will serve as a

disbursement condition for Part A of the project. Since the legal and operational status of the BRA isone of a government controlled agency, there will be no need for an implementation agreement for Part B

of the Project.

The Project will seek reassurances that adequate funding to the PA and BRA is available for the durationof the project, either from donor funds or from the FRY budget. In this regard, the project team hasreceived confirmation from the FRY and Republic of Serbia authorities on the provision of adequatefunding for the continued operation of the PA and BRA. These funds are reflected as counterpart fundsfor the project, and their provision and use will be monitored accordingly.

4.2 Project management:

The overall coordination of the project would rest with the PMU, which has been established in the PAand the BRA. Each PMU is currently headed by a Director, who will have overall responsibility forPMU's respective component. He/she is assisted by a Project Administrator who will oversee theday-to-day operations. Each of the PMUs will include procurement, disbursement and financialmanagement specialists working specifically on the proposed project. The PMUs will be responsible forday-to-day operations of their respective parts of the project, procurement, and financial management,including reporting to the FRY and Republic of Serbia governments and to the Bank.

4.3 Procurement issues:

A review was undertaken in July 2002 to determine whether the procurement arrangements within eachof the PMUs are acceptable to the Bank. The PMUs already have substantial procuremenetadministration and financial management experience acquired through their ongoing management of WBPSD TA and FSD TA Grants, as well as a number of co-financing grants and trust fund grants. As notedabove, specific procurement and disbursement/accounting specialists will be assigned to work on theproject components in both PMUs.

4.4 Financial management issues:

A review was undertaken in August 2002 to determine whether the financial management arrangementswithin each of the PMUs are acceptable to the Bank. It was concluded that the PA and BRA PMUs havefinancial management systems which meet the Bank's minimum financial management requirements.

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Financial flows

The Bank will make funds available to the Federal Republic of Yugoslavia under the Credit Agreement,governing the terms and conditions of the proposed credit. The FRY Government will on-lend the fundson IDA terms to the Government of the Republic of Serbia for implementation of component A, based onthe Subsidiary Credit Agreement with termns and conditions satisfactory to the Bank.

Financial Risks

From a financial management perspective, the project is considered a moderate risk operation.

Project Financing Plan

The project's financing plan, which includes the credit from the Bank and counterpart contribution, andthe project's planned expenditures have been realistically estimated.

5. Environmental: Environmental Category: C (Not Required)5.1 Summarize the steps undertaken for environmental assessment and EMP preparation (includingconsultation and disclosure) and the significant issues and their treatment emerging from this analysis.

The proposed technical assistance project is likely to have minimal or no adverse environmental impacts.In accordance with the Bank's Operational Directive on Environmental Assessment (OD 4.01 Annex E),the proposed project has been placed in Category "C" and does not require an environmental assessment.

5.2 What are the main features of the EMP and are they adequate?

An Environmental Management Plan is not needed; however, the ternis of reference for environmentalaudits have been prepared and will be included in the overall TOR for the restructuring agents.

5.3 For Category A and B projects, timeline and status of EA:Date of receipt of final draft:

Not applicable

5.4 How have stakeholders been consulted at the stage of (a) environmental screening and (b) draft EAreport on the environmental impacts and proposed environment management plan? Describemechanisms of consultation that were used and which groups were consulted?

Not applicable

5.5 What mechanisms have been established to monitor and evaluate the impact of the project on theenvironment? Do the indicators reflect the objectives and results of the EMP?

Not applicable

6. Social:6.1 Sumnarize key social issues relevant to the project objectives, and specify the project's socialdevelopment outcomes.

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The break-up and sale of the LLMEs are likely to entail significant labor displacement. As described inmore detail in section B.2.c, an integral part of the Republic of Serbia Government's strategy will be tomitigate the social impact of restructuring and privatization. With regard to the SOEs to berestructured/privatized under the proposed project, it was agreed during the negotiations that theRepublic of Serbia funds for payments to be made to redundant employees under applicable laws of theRepublic of Serbia, shall be transferred to an appropriate account in the Republic of Serbia Ministry ofLabor and Employment, in a timely manner, and in accordance with the requirements of the relevantrestructuring program.

6.2 Participatory Approach: How are key stakeholders participating in the project?

The PA and MOEP (as agencies responsible for privatization of SOEs), and the BRA and NBY (asagencies responsible for bank resolution) are the primary stateholders. Representatives of theseinstitutions have participated closely in the design of the proposed project. The Republic of SerbiaMinistry of Finance, Ministry of Labor and Employment, and the business community are other keystakeholders who have also been involved in the design of the proposed project. The views on the modelsupported by the proposed project were sought during the series of seminars attended by the senior andmid-level management of large loss-making SOEs.

6.3 How does the project involve consultations or collaboration with NGOs or other civil societyorganizations?

Not applicable

6.4 What institutional arrangements have been provided to ensure the project achieves its socialdevelopment outcomes?

Not applicable

6.5 How will the project monitor performance in terms of social development outcomes?

Not applicable

7. Safeguard Policies:7.1 Do any of the following safeguard policies apply to the project

I --.- -, .- ' - I .". - Policy , ,, . .. .. <, !- I Applicability

Environmental Assessment (OP 4.01, BP 4.01, GP 4.01) * Yes () No

Natural Habitats (OP 4.04, BP 4.04, GP 4.04) (9 Yes * No

Forestry (OP 4.36, GP 436) U(9 Yes * No

Pest Management (OP 4.09) U Yes * No

Cultural Property (OPN 11.03) U Yes * No

Indigenous Peoples (OD 4.20) ( Yes * No

Involuntary Resettlement (OP/BP 4.12) U Yes * No

Safety of Dams (OP 437, BP 4.37) (9 Yes * No

Projects In International Waters (OP 7.50, BP 7.50, GP 7.50) (9 Yes * No

Projects in Disputed Areas (OP 7.60, BP 7.60, GP 7.60)* () Yes * No

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7.2 Describe provisions made by the project to ensure compliance with applicable safeguard policies.

Although the proposed project is likely to have minimal or no adverse environmental impacts,and does not require an environmental assessment, due attention will be given to environmentalliability and compliance issues during the privatization process. As in the case of the tender privatizationprogram undertaken by the Privatization Agency under WB PSD TA Grant, it was agreed with theRepublic of Serbia Government that environrmental assessment studies would be undertaken by qualifiedexperts for each company that is to be sold under the proposed project. In each case, environmentalassessment will ascertain past liabilities and future environmental obligations, and its results will bemade available to potential investors as part of the information memorandum for each enterprise put onsale. Under the proposed amendments to the Privatization Law, prepared in coordination with theMinistry of Environment, the state will be responsible for environmental remediation for pastenvironmental damage. While subject to negotiation, it is expected that in most cases the upgrading offacilities to meet Serbian environment regulations, where necessary, will be the responsibility of buyers.The planned PFSAC 11 will address the larger policy issues related to environmental liabilities andconsider ways to get the Republic of Serbia Government's commitment to remediation of pastenvironmental damages.

F. Sustainability and Risks

1. Sustainability:

The FRY and Republic of Serbia governments are fully committed to the transformation of Serbia into afull-fledged market economy and to its integration into the European Union. Recognizing difficulties andrisks involved, the authorities are determined to help Serbia's enterprise and financial sectors adjust tothe new market economy environment by completing the ownership transformation of inefficient andinsolvent SOEs and establishing a more competitive and service-oriented banking system that canmobilize a rising level of financial resources and provide for the credit needs of a growing economy. Thestriking difference in profitability (and by implication, productivity) between private and non-privatesectors provides a key rationale for the proposed strategy of enterprise reforrm.

The proposed project focuses on the most difficult part of this strategy, the restructuring and privatizationof the large loss-making SOEs. In addition to broad macroeconomic benefits, the unlocking of assetsheld in this vast segment of the Serbian real sector and putting them to productive use will promotedevelopment of a market-based economy with stronger governance, management, transparency, andparticipation, which will all lead to sustainable economic growth. As in the case of the enterprise sector,the reform of the financial sector aims to transfer assets of the state-owned troubled banks to new ownerswho could use them productively. The second Private and Financial Sector Adjustment Credit plannedfor first half of 2003 will support these reforms at the policy level.

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2. Critical Risks (reflecting the failure of critical assumptions found in the fourth column of Annex 1):

>:'; '>'-,-'Risk- . -Risk'Mlitig-aton-Mea'sureFrom Outputs to ObjectiveWeakening commitment of the FRY and S Additional government revenue fromRepublic of Serbia governments to privatization sales; in the longer term, reducedrestructure and privatize and/or liquidate fiscal burden as a result of resolution of largelarge loss-making SOEs and majority loss-makers; in general, the authorities' desirestate-owned banks to create full market economy and bring Serbia

to European Union. Specific objectives ofbank and SOE sector reforms have been laidout in the LDP for PFSAC I and will beincluded in Policy Matrix for PFSAC II

Parliamentary approval of new legislative M Legislative amendments to be included inamendments may be problematic and Policy Matrix for PFSAC IIdelayed

Labor opposition to the implementation S Government's framework Social Programof restructuring program supported by adequate allocations from

republican budget

Political uncertainty at both the federal S Continuation of the policy dialogue at theand republican level (unclear timing of federal and republican levelsrealization of future union of Serbia andMontenegro; upcoming elections inSerbia) could paralyze thedecision-making capacity on various keypolicy issues instrumental to achievingthe project objectivesFrom Components to OutputsInadequate implementation capacity, M Project components to strengthen the capacityconstrained by shortage of prior of implementing agencies by financing localexperience in bank and enterprise and foreign expert advisorsrestructuring

Creditors' opposition to the enterprise S Memorandum of understanding between therestructuring program PA and BRA; discussions held with MOF to

ensure coordination of state creditors; passageof relevant amendments to the PrivatizationLaw and the new Bankruptcy Law

Lack of interest from potential investors S Sustained public information campaignsupported by Bank and other donors

Overall Risk Rating S

Risk Rating - H (High Risk), S (Substantial Risk), M (Modest Risk), N(Negligible or Low Risk)

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3. Possible Controversial Aspects:

Not applicable

G. Main Credit Conditions

1. Effectiveness Condition

* Development Credit Agreement is duly ratified and effected by the Federal Republic ofYugoslavia, as confirmed by the receipt of satisfactory legal opinion by the Bank.

Disbursement Conditions:

* Subsidiary Agreement is signed between the FRY Government and the Government of theRepublic of Serbia. The effectiveness of the Subsidiary Agreement will serve as adisbursement condition for Part A of the Project.

* Part A Implementation Agreement is signed between the Govenmment of the Republic ofSerbia and the PA. The effectiveness of this agreement will serve as a disbursementcondition for Part A of the Project.

2. Other [classify according to covenant types used in the Legal Agreements.]

* The PMUs are to maintain satisfactory FMSs, including records and accounts, and to preparefinancial statements in accordance with accounting standards satisfactory to the Bank; thePMUs are to provide annual project accounts and institutional audits to the Bank within sixmonths of each fiscal year (with the audit to be carried out by independent auditors inaccordance with International Standards on Auditing, and TORs satisfactory to the Bank).

* A mid-term review to be conducted by March 31, 2004 based on satisfactory TORs.

H. Readiness for Implementation

L0 1. a) The engineering design documents for the first year's activities are complete and ready for thestart of project implementation.

[ 1. b) Not applicable.

2 2. The procurement documents for the first year's activities are complete and ready for the start ofproject implementation.

1 3. The Project Implementation Plan has been appraised and found to be realistic and of satisfactoryquality.

0 4. The following items are lacking and are discussed under loan conditions (Section G):

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1. Compliance with Bank Policies

1 1. This project complies with all applicable Bank policies.rO 2. The following exceptions to Bank policies are recommended for approv .he project complies

with all other applicable Bank policies.

Alexander Pankov Khaled F. SheJi Christia'an J. PoortmanTeam Leader Sector Manag /Director Country Manager/Director

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Annex 1: Project Design Summary

FEDERAL REPUBLIC OF YUGOSLAVIA: PRIVATIZATION AND RESTRUCTURING OF BAN)KSAND ENTERPRISES TECHNICAL ASSISTANCE PROJECT

Key Performance Data Collectroa StrategyHierarchy of Objectives Indicators' CritiI al Assurmptiioni

Sector-related CAS Goal: Sector Indicators: Sector/ country reports: (from Goal to Bank Misslon)Promote structural reform Increase in private sector-led National statistics o No mnajor extemal shocksand private sector-led economic industrial growth s Assets released fromgrowth loss-making SOEs and banks

will be put to productive usethrough successfulprivatization

c Availability of domestic andintemational capital andentrepreneurial skills

Project Development Outcome I Impact Project reports: (from Objectve o Goal)Objective: Indicators:Facilitate private sector-led * Number and value of large * Judgment by task team, * Continuing commitment of theeconomic growth through enterprises restructured, and confirmed by compliance with authorities to reform of largelaunching and implementing the business units and assets or, if respective PFSAC nI conditions loss-making SOEsrestructuring and privatization necessary, put into bankruptcy * Review of policies, procedures, * Continuing commnitment of theprocess of large * Comprehensive qualitative etc. emerging from and being authorities to banking sectorproblematic SOEs and assessment of progress in applied under the project reformimplementing a comprehensive implementation of restructuringbank restructuring strategy programs with respect to SOEs

and parts thereof, for whichprivatization, restructuring orbankruptcy was not completed,and reasons for delays, if any* Improved performance andcompetence of the PA toimplement complex privatizationthrough restructuring strategy, asmeasured by the use of bestpractices, the number ofrestructuring agents hired, and thenumber of auctions and tendersheld* Selection of banks forrehabilitation/privatization orliquidation track; number ofmajority state-owned banksprivatized or put in liquidation* Qualitative assessment ofprogress in implementation ofbank liquidation, rehabilitationand privatization

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* 4 .11 .r <.ttw ncq ) .DataiColfection Strategy |Hierarchy ofObje ie o -1 -' ndlcatorc .,ret,,; rial Assumptions

Output from each Output Indicators: Project reports: (from Outputs to Objective)Component:

Restructuring,and subsequent * Use of internationally * Consultant reports; * Sufficient interest fromprivatization, or, if necessary, accepted best practices, the * Bank supervision reports potential buyersbankruptcy, of a number of number of restructuring agents * Creditors accept thelarge SOEs and/or part thereof hired, and the number of restructuring plans

auctions and tenders held * Effective control and* Number of business units monitoring of the activities ofand assets sold the banks selected for

pre-privatization restructuringLiquidation and/or * Use of internationally * Adequate budget forrehabilitation/privatization of accepted best practices, and operation of the Privatizationa select number of majority the quality of financial Agency and Bankstate-owned banks advisors hired Rehabilitation Agency

Project Components I nputs: (budget for each Project reports: (from Components toSub-components: component) Outputs)Privatization through US$ 8.0 million * Progress reports submitted * Timely appointment ofRestructuring of by the PMUs at the PA and the restructuring agentsSocially-Owned Enterprises BRA to the Bank * Timely recruitment of new

Bank supervision reports qualified staff for theRestructuring Unit at the PA* PMUs' capability to

Bank Restructuring Program US$ 3.0 million perform procurement andFMS activities required by theproject

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Annex 2: Detailed Project Description

FEDERAL REPUBLIC OF YUGOSLAVIA: PRIVATIZATION AND RESTRUCTURING OFBANKS AND ENTERPRISES TECHNICAL ASSISTANCE PROJECT

The proposed project will consist of the two major parts:

By Component:

Project Component 1 - US$8.00 million

Part A: Privatization through Restructuring of Socially-Owned Enterprises

The objective of this component is to provide urgent assistance to the Republic of Serbia for launchingand implementation of restructuring and privatization process for the most problematic large SOEs inSerbia. Specifically, the component will seek to:

* establish a consistent approach and methodology for the restructuring and subsequentprivatization of large problematic SOEs that cannot be sold in their current state;

* support the restructuring and subsequent privatization of a number of large loss-makingenterprises by funding expert "restructuring agents" (i.e., investment banks, workout companies,and consultancies) to prepare and implement "restructuring programs", privatize the saleablebusiness units using internationally accepted transparent sales techniques, and put the unsaleablebusiness units into bankruptcy;

* increase the capacity of the Privatization Agency to work with the restructuring agents on thepreparation and implementation of the above-mentioned restructuring programs.

The Serbian restructuring strategy is an integral part of the Enterprise Privatization Framework agreedwith the Bank in the FRY/Republic of Serbia Letter of Development Policy for the PFSAC I. The aboveframework is based on the Republic of Serbia Privatization Law adopted, with the Bank support, in June2001. Under the Law, enterprises which cannot be sold through auction or tender are required to undergo"restructuring for privatization" (Article 19, 20). These articles allow the PA to instruct the company toprepare a restructuring program. The legal framework for the Republic of Serbia Govermnent'srestructuring strategy is further detailed in the by-law on restructuring. The by-law provides theprocedures for reorganization, dealing with creditors and debt, management of the company duringrestructuring and deadlines for third parties to meet the requirements of the articles. In addition,amendments to the Law on Enterprises have been adopted (supported by PFSAC I) that allow thePrivatization Agency to assume the powers of the managing bodies of enterprises which hinder or blockthe privatization process. A modern Bankruptcy Law has also been drafted (supported by PFSAC II) andis in the process of being distributed for comments.

With the help of the Bank, the MOEP and PA developed a restructuring model based on the segmentation(in a typical case) of the company, incorporation of new companies created from the parts of the old one,and sale of these new companies and of assets remaining after the break up. The underlying premise ofthis exercise is that various subsidiaries and/or assets of LLMEs can be viable and attractive to potentialinvestors even if as a whole these conglomerates are presently non-viable and non-saleable. This modelwill be based on a transaction oriented approach, where the ultimate sale of the enterprise or its variousviable parts drives the restructuring effort. There will be no attempt to continue operating theseenterprises in their present conglomerate form as either a socially- or state-owned entities.

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According to the government strategy, the privatization through restructuring model will includeidentification of independent business units (IBU) in each enterprise, their transformation into saleablebusiness units (SBU), and sale of SBUs and/or putting of unsaleable business units into bankruptcy. Theprocess can be divided into three stages: (i) a feasibility study and a due diligence report, serving as thebasis for preparation of the restructuring program; (ii) implementation of organizational and financialrestructuring, including (if necessary) the incorporation of new companies created from parts of the oldone and negotiations with creditors; and (iii) privatization of the SBUs by tender or auction, anddisposing of all other remaining assets through bankruptcy.

A.l. Privatization through Restructuring of SOEs

This sub-component will cover the major part of costs (namely, the retainer and professional fees) ofengaging the expert restructuring agents (investmnent banks, consulting companies, workout companiesand other financial advisors) who will implement each of the above-mentioned three stages ofprivatization through restructuring for a select number of SOEs. Companies may be offered torestructuring agents either singly, or in small "pools" of two to four companies, with the objective ofcapturing economies of scale and attracting top-rate international advisors. In most cases, therestructuring task will be led by the company responsible for the ultimate sale, leading a consortium ofexperts, and working under close supervision of the Restructuring Unit of the PA. The success fees forthe restructuring agents, based on the sale of the successor companies and the remaining assets, will bepaid by the Republic of Serbia Government.

In accordance with the government strategy, the proposed project will focus on the select group ofcompanies in which saleable successor companies, units, parts or assets can be identified forprivatization. In other words, in view of the limited financial resources and the importance of havingearly successful cases in the process, the project will concentrate on LLMEs which have assets or SBUswith a higher potential for successful privatization transactions. The project will focus on, but will notbe limited to, the group of 47 SOEs identified by the Republic of Serbia Government as potentialcandidates for privatization through restructuring. The list of SOEs to undergo privatization throughrestructuring with the help of credit funds will be agreed upon between the PA and the Bank at the earlystage of project implementation ("the List"), and may be modified from time to time, but only upon theexplicit agreement of the Bank.

The SOEs on the List shall be restructured and privatized in accordance with the following terms andconditions:

i. When the PA receives a proposed restructuring program for each SOE, it shall make a decisionwith respect to such a program within a timeframe provided under the Enterprise PrivatizationFramework, and shall inform the Bank of its decision and rationale.

ii. For each SOE to be restructured and privatized, the PA shall submit to the Bank for review andapproval the following documents, which shall be prepared with the assistance of therestructuring agents: (a) the restructuring program; (b) a list of potential bidders who haveexpressed interest in bidding on all or parts of the SOE being restructured; (c) the draftinformation memoranda, which shall include proposed criteria for pre-selection of bidders, andproposed criteria for bid evaluation; (d) a report prepared by the restructuring agent on thetender; and (e) auction privatization program for the SOEs, or parts thereof, that would be soldthrough the auction procedure.

iii. The PA shall compare and evaluate all bids, and select the winner based exclusively onestablished evaluation criteria, and price quotations with respect to auctions. Direct

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negotiations with respect to prices or other price related variables shall not be undertaken,except in cases where a properly conducted international tender results in only one qualifiedbid.

iv. At least 70 percent of the total capital of each SOE, or part of the SOE, on the List shall beoffered for sale to a strategic investor; the term "strategic investor" shall mean a legal entitythat: (a) is not, directly or indirectly, owned or controlled by the managers or employees of theenterprise; and (b) has the required experience, resources and reputation, as determined by therestructuring agent, and agreed upon by the MOEP/PA and the Bank.

v. The capital of the SOE to be transferred or made available, directly or indirectly, to theemployees or managers of the enterprise shall not exceed fifteen percent (15 percent) of thetotal capital of the SOE, and shall not be so transferred until at least fifty percent (50 percent)of the total capital of the SOE has been sold to the strategic investor;

vi. Republic of Serbia funds for payments to be made to redundant employees of the SOEs on theList, to be made under applicable laws of the Republic of Serbia, shall be transferred to an

appropriate account in the Republic of Serbia Ministry of Labor and Employment, in a timelymanner, and in accordance with the requirements of the relevant restructuring program.

TOR for Restructuring Agents

The PA has developed general Terms of Reference (TOR) for the advisory work, which will be adaptedto each of the proposed candidate companies/pools of companies from the List. The objective of eachconsulting assignment will be to assist the PA with preparation and implementation of the enterprise

restructuring and privatization by:

i. carrying out a comprehensive diagnostic and viability assessment of the company and its

subsidiaries/units, including due-diligence, and assessment of future prospects forcompetitiveness, profitability and overall market potential of final products in order to identifywhich units could operate independently (IBUs), and could have the required viability to operateas going concems under private ownership;

ii. preparing a restructuring program for the company, designed to convert a maximum number ofidentified IBUs into Saleable Business Units (SBUs) for privatization as going concerns. Therestructuring program will include: (a) a financial restructuring plan; (b) valuation according toestablished principals of IBUs and other assets as appropriate, as this will impact on subsequentrestructuring and privatization decisions; (c) an organizational plan indicating optimalemployment levels and skills for the IBUs; (d) a legal plan identifying necessary measuresrequired to give the SBUs proper legal status for sale of their shares as going concerns; (e)recommendations for the marketing and privatization mode (tender or auction) of each SBU; (f)

formulation of a strategy, for all other IBUs or other assets not identified 'as SBUs, that willdispose of assets and shares through asset sale, liquidation, bankruptcy and/or other methodsappropriate for non-going concems; and (g) identification of any legal, regulatory or other factorslimiting the attractiveness of one or all of the selected SBUs to potential investors, including theassessment of past enviromnental liabilities; and,

iii. finally, undertaking the agreed program of marketing and privatization, including signing of Sale

and Purchase contracts for successful tender sales, and providing appropriate support for the saleof SBUs and surplus assets through public auctions.

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A.2. Building the Institutional Capacity of the Privatization Agency

The Republic of Serbia Government has requested assistance to build the institutional competence of thePA to carry out the privatization through restructuring of SOEs financed under the proposed project, aswell as by other donors. The PA is a nongovermmental body authorized to channel trust funds and grantsfrom donors and loan funds from the international financial institutions. In particular, the restructuringagents engaged by the PA to implement the privatization through restructuring strategy would need to besupervised by a competent professional staff within the PA, assisted by experienced foreign and localadvisors.

The PA management estimates that as the restructuring process gets fully underway, the newlyestablished Restructuring Unit within the PA would need to employ 10 to 12 project managers and 20 to24 support staff. Given limited supply of relevant skills in the local market, the PA will actively solicitinterest from qualified Yugoslav nationals currently working abroad, as well as implement theorganizational restructuring measures to increase efficiency and facilitate internal growth within theAgency. The PA has already engaged two senior international resident advisors on enterpriserestructuring using existing Bank grants.

This sub-component will provide technical assistance to build up institutional competence of the PA tosupervise the restructuring agents in the implementation of the above-mentioned restructuring programs.The assistance will cover the following:

i. advisory services for establishing the Restructuring Unit within the PA capable of monitoring therestructuring agents' performance, dealing with the enterprise creditors and employees, andnegotiating with potential investors; and,

ii. consulting services to enhance institutional capacity of the PA with foreign and local expertadvice and technical know-how for the restructuring and privatization process, includingpreparation of the company profiles, development of TORs, facilitation of contracting andbidding process for restructuring agents, organizing the creditors' meetings, and advising onlegal issues.

A.3. Project Management and Implementation

This sub-component will support the work of the PMU already established in the PA, in the management,implementation and monitoring of Parts A.1 and A.2 of the project, through the provision of services,including the audit of records, accounts and financial statements, goods, and financing of incrementaloperating costs, including PA staff salaries. The PMU will be responsible for carrying out the followingtasks:

i. plan, schedule and direct project activities in accordance with the Credit Agreement andreferenced documentation, and maintain an open and effective dialogue with Bank staff to realizethe efficient utilization of resources and timely achievement of project outcomes and objectives;

ii. monitor project expenditures and costs (local and foreign), process Credit disbursementapplications and track disbursements of the Credit and counterpart funding; maintain projectrecords and accounts; prepare physical and financial forecasts of future activities required toimplement the components and for inclusion in budgetary proposals;

iii. develop a procurement plan and ensure compliance with the Bank's procedures for theprocurement of goods and services, and the securing and administration of suppliers' andtechnical assistance contracts in accordance with the Credit Agreement and World BankProcurement Guidelines;

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iv. finalize TORs for the specialist services required in their respective areas of the project, prepare,clear and issue solicitation documentation, prepare advertisements in local international mediafor the recruitment of consultants, appoint bid evaluation committees, evaluate proposalsreceived for consulting services, obtain Bank approvals where required, and negotiate andadminister the award of supply contracts;

v. monitor the receipt of goods and services, identify and tap expertise, as needed, to assist inactivities such as preparation of detailed operating and financial control procedures, and updateimplementation schedules; and,

vi. ensure preparation and distribution of consolidated periodic reports (Progress Report) to therelevant government and other participating institutions, including the World Bank, reflecting:(a) the status of implementation progress, problems encountered and corrective actions needed;and (b) current costs of component and estimated costs of completion; quarterly Financial

- Management System (FMS) reports, including annual and final audit reports of projectexpenditures and the Special Account.

Project Component 2 - US$3.00 million

Part B: Bank Restructuring Program

This component is designed to support the bank restructuring strategy adopted by the FRY authorities inMay 2001 and confirmed in April 2002 during the negotiations for PFSAC I. The component will beimplemented in accordance with the FRY Government's Bank Resolution Framework, as defined by therelevant laws, regulations, programs and institutions, as well as in accordance with the specific policycommitments undertaken by the FRY and Republic of Serbia governments in the LDP for PFSAC I.

The restructuring strategy has three main elements: (a) liquidation of a large number of insolvent banksimplemented by the BRA, which is now a designated bankruptcy administrator (or receiver) for ninebanks (four of these banks were formerly the largest banks in Serbia); (b) privatization of a small number(most likely no more than three) of the five banks which are presently in rehabilitation; and, (c)privatization or liquidation of up- to thirteen additional banks which recently became majoritystate-owned as a result of the conversion of Paris and London clubs debts into equity owned by theSerbian state. The strategy is being implemented by the BRA which is expected to have about 25 banksin various stages of resolution process (liquidation or privatization) under its control by end-2002.

The BRA has utilized significant quantities of consulting and technical assistance services in theperformance of its activities to date and is also assisted by a large team of resident advisers (provided bydonors) and through support provided from the Bank's FSD TA Grant. As a result the Agency hasdeveloped significant experience in the effective management and use of consulting services. It intends tomake further use of such -services in order to complete its resolution tasks in a timely and efficientmanner. The proposed credit will continue to support the above-mentioned strategy by providingtechnical assistance and operating resources to the BRA to execute the orderly and transparentliquidation of insolvent banks, carry out the pre-privatization restructuring and management of banksselected for privatization, and provide investment banking and legal support services for the privatizationprocess.

B.l. Bank Liquidation, Rehabilitation and Privatization

Given the tight timeframe (first quarter of 2003) for initiation of the restructuring process for all of thebanks concerned, it is essential that the BRA be able to respond quickly to the specific resolution strategy

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adopted for each bank. Due to the difficulty of determining in advance the privatization potential of thebanks which became become majority state-owned as a result of debt conversion and, simultaneously, thestrong possibility that the NBY will take actions which will result in additional banks being designatedfor liquidation by the BRA, the technical assistance under this component will be provided through anIndefinite Delivery Type contract in order to ensure the maximum flexibility in the use of resources bythe BRA. Under this type of contract, the Consultant/Consortium would be- capable of offering for thedecided tasks a series and/or combination of services, thus allowing the BRA to alter the mix ofresources in accordance with rapidly evolving needs. These services, provided by a mix of local andforeign consultants, will be of four main types outlined below.

Pre-Privatization Support

Consulting services will be provided to conduct comprehensive diagnostic and statutory audits of banksin BRA portfolio. These audits will serve as the basis for developing a plan for resolution of each bank(e.g., immediate privatization, restructuring with subsequent privatization, or liquidation) with therequirement that resolution of all banks begins in the first quarter of 2003. Accordingly, some assetseparations and/or consolidations within the bank portfolio may be required to create more attractivefranchises for potential investors.

Support for Privatization of Select Banks

Financial advisers will be engaged to handle all aspects of the privatization process for selected banksthat are deemed saleable. Contract funding under the credit will cover retainer fees and pre-privatizationexpenses. The performance-based incentive fees would be paid by the BRA from the proceeds ofprivatization transactions. Services to be provided by the financial advisers will include:

* conducting market surveys to determine investor interest in the banks and preparation of a salesstrategy defining the recommended timing of the privatization process for selected banks;

* supporting Bank management in day-to-day activities and decision-making leading to eventualsale;

* preparation of all required documents to launch the tender privatization process (informationmemoranda, etc.),-

* coordination and execution of the marketing and tender process for each bank;* providing advice to the BRA throughout the tender evaluation and selection process; and,* advice and assistance to the BRA during negotiations with investors.

Legal Support for the Bank Resolution Process

Local and/or international legal services will be required to support either the privatization orliquidation of banks. Services to be provided will include:

* for banks being privatized: legal due diligence; review of tender documentation (informationmemoranda, tender notices, etc.), and clearance for compliance with applicable FRY and otherlaws; and preparation and execution of the contract between the investor and the BRA/state forthe privatization of each bank; and,

* for banks being liquidated: advice regarding receivership and BRA compliance with legalrequirements for receivership operations; ad hoc legal services to the BRA and receiverships inareas such as civil and commercial law; conduct of legal defense and/or lawsuits on behalf of thereceiverships and the BRA; and, legal support for the sale of receivership assets.

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Receivership Support for Banks in Liquidation

Services would be provided to support the BRA in its role as designated receiver of banks in bankruptcyand liquidation. These services would include administration of the receiverships' consolidation process,and assisting in takeovers of banks newly designated for bankruptcy and/or liquidation. Specifically, suchservices will be used for:

* Securing bank records and property and prepare an accurate inventory of the assets and liabilitiesof the bank;

* Preparing a plan and budget for the operation of the receivership;* Dismissing bank staff not required for effective operation during the projected receivership;* Preparing and implementing an asset disposition plan for the receivership;* Executing the orderly and transparent sale and/or disposal of the receivership's assets; and,* Maintenance of accurate records of all aspects of the operation of the receivership in compliance

with applicable laws.

B.2. Project Management and Implementation

Part B will be implemented by the PMU, already established at the BRA. This sub-component willfinance the incremental operational expenses of the PMU, including the consulting fees and audit costs.Consultants financed by the credit will include project director, project administrator, procurementspecialist, and two disbursement/accounting specialists who are generally familiar with Bankprocurement, disbursement and reporting requirements from their previous work on WB FSD TA Grant.They will carry out the following tasks:

i. plan, schedule and direct project activities in accordance with the Credit Agreement andreferenced documentation, and maintain an open and effective dialogue with the Bank staff torealize the efficient utilization of resources and timely achievement of Project outcomes andobjectives;

ii. monitor project expenditures and costs (local and foreign), process Credit disbursementapplications and track disbursements of the Credit and counterpart funding; maintain projectrecords and accounts; prepare physical and financial forecasts of future activities required toimplement the components and for inclusion in budgetary proposals;

iii. develop a procurement plan and ensure compliance with the Bank's procedures for theprocurement of goods and services, and the securing and administration of suppliers' andtechnical assistance contracts in accordance with the Credit Agreement and World BankProcurement Guidelines;

iv. finalize TORs for the specialist services required in their respective areas of the project, prepare,

clear and issue solicitation documentation, prepare advertisemcens in, e.g., intemational media,for recruitment of consultants, appoint bid evaluation committees, evaluate proposals receivedfor consulting services, obtain Bank approvals where required, and negotiate and administer theaward of supply contracts; and,

v. ensure the preparation and distribution of consolidated periodic reports (Progress Report) to therelevant government and other participating institutions, including the World Bank, reflecting:(a) the status of implementation progress, problems encountered and corrective actions needed;and (b) current costs of component and estimated costs of completion; quarterly FinancialManagement System (FMS) reports, including annual and final audit reports of projectexpenditures and the Special Account.

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Annex 3: Estimated Project CostsFEDERAL REPUBLIC OF YUGOSLAVIA: PRIVATIZATION AND RESTRUCTURING OF BANKS

AND ENTERPRISES TECHNICAL ASSISTANCE PROJECT

Local Foreign TotalProject Cost By Component US $million US $million US $million

A. Privatization through Restructuring of Socially-Owned 2.58 8.31 10.89EnterprisesB. Bank Restructuring Program 0.53 3.56 4.09Total Baseline Cost 3.11 11.87 14.98Physical Contingencies 0.00 0.00 0.00Price Contingencies 0.00 0.00 0.00

Total Project Costs1 3.11 11.87 14.98Total Financing Required 3.11 11.87 14.98

Local Foreign TotalProject Cost By Category US $million US $million US $million

Goods 0.05 0.00 0.05Services 0.69 9.71 10.40Incremental Operating Costs 2.03 0.00 2.03PPF 0.34 2.16 2.50

Total Project Costs 3.11 11.87 14.98Total Financing Required 3.11 11.87 14.98

Identifiable taxes and duties are 2.83 (US$m) and the total project cost, net of taxes, is 12.14 (US$m). Therefore, the project cost sharing ratio is90.59% of total project cost net of taxes.

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Annex 4: Cost Benefit Analysis Summary

FEDERAL REPUBLIC OF YUGOSLAVIA: PRIVATIZATION AND RESTRUCTURING OF BANKSAND ENTERPRISES TECHNICAL ASSISTANCE PROJECT

Not applicable

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Annex 5: Financial SummaryFEDERAL REPUBLIC OF YUGOSLAVIA: PRIVATIZATION AND RESTRUCTURING OF BANKS

AND ENTERPRISES TECHNICAL ASSISTANCE PROJECT

Not applicable

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Annex 6(A): Procurement Arrangements

FEDERAL REPUBLIC OF YUGOSLAVIA: PRIVATIZATION AND RESTRUCTURING OF BANKSAND ENTERPRISES TECHNICAL ASSISTANCE PROJECT

Procurement

All Bank-financed procurement would be in accordance with Bank's Guidelines for Procurement underIBRD Loans and IDA Credits (January 1995 as revised in January and August 1996, September 1997,and January 1999). Procurement of consulting services would follow Bank Guidelines for Selection andEmployment of Consultants by World Bank Borrowers (January 1997 as revised in September 1997,January 1999 and May 2002).

Procurement Responsibility

The procurement will be carried out by the PMU at the PA for Component A, and by the PMU at theBRA for Component B. The responsibilities of the procurement specialists will include: (a) preparationof procurement documents which require the Bank's prior review; (b) carrying out other procurementactions; (c) preparation and submission of annual detailed procurement schedule; (d) annual update ofGeneral Procurement Notice and preparation of Expressions of Interest; and (e) ensuring that theprocurement process is conducted based on principles of efficiency, economy and transparency.

Procurement Capacity Assessment of the Agencies

During the project preparation an assessment of the PA and the BRA capacity to conduct procurementwas carried out taking into consideration the Country Procurement Assessment Report findings of June2002. Both the PA and the BRA have been implementing Bank's TA Grants (Private SectorDevelopment and Financial Sector Development Grants, respectively) since July 2001, and thus haveacquired sufficient knowledge of the procurement process. In addition, these agencies have alsoimplemented a PHRD grant given for the preparation of PFSAC I. The PA is also implementing twoco-financing grants from the governments of Netherlands and Sweden to support complementaryactivities of the above-mentioned PSD TA Grant. The implementing agencies have sufficient staffearmarked for procurement and have demonstrated a good track record to date.

The proposed procurement activities under the new project are more of a continuation of the activitiesunder the earlier grant, and it is expected that the work would go on in a seamless manner. In bothagencies, the capacity has been augmented with additional staff to match the increase in work load.

Most of the staff in both agencies have received training from ILO (Turin center) on public procurement.It is recommended that the new staff should also be sent for such training as and when the courses areavailable.

Notification of Business Opportunities

A General Procurement Notice will be published by the end of November 2002 to announce biddingopportunities under the project and invite interested eligible suppliers and consultants to express interestand request additional infornation from the two implementing agencies. The General ProcurementNotice will be updated annually.

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Procurement methods (Table A)

Procurement methods described below and their estimated amounts are summarized in Tables A and Al.Threshold estimated contract values defining applicable procurement methods are indicated in Table B.

ComponentA (PA)

(i) Goods

Shopping (IS and NS) would be used to procure goods for contracts estimated to cost less thanUS$50,000 each, up to an aggregate amount of US$50,000. For International Shopping, the PA shallobtain quotations from at least three suppliers from at least two different countries, which may includethe home country. For National Shopping, the PA shall obtain price quotations from at least three localsuppliers before deciding on the award of the contract.

Prior and post review by the Association of goods contracts. All contracts for the supply of goodsestimated to cost the equivalent of US$10,000 or more, the first three contracts irrespective of value, aswell as all contracts awarded without competition will be subject to prior review. All other contracts willbe subject to post review.

(ii) Consulting Services

Quality and Cost Based Selection (QCBS, Para 3.17/-Banks" (Guidelines for Selection andEmployment of Consultants by World Bank Borrowers) would be used to hire consulting firms forprivatization through restructuring of socially-owned enterprises.

Selection based on Consultants' Qualifications (CQ) would be used for the selection of consultants forCapacity Building of the PA, with each contract less than US$100,000 up to an aggregate amount ofUS$200,000.

Selection based on Least Cost (LCS) would be used for the selection of consultants to conduct audits ofPMU and project accounts, up to an aggregate amount of US$30,000.

Individual Consultants would be used for some of the activities for capacity building of the PA. Theselection would be in accordance with Section V of the Guidelines up to an aggregate amount ofUS$310,000. The selection of individuals should be pursuant to seeking expressions of interest throughadvertising in local press, and through the UN Development Business website for internationalconsultants.

(iii) Incremental Operating Costs

Incremental operating costs, including remuneration for the staff of PA, would be procured in accordancewith an annual budget and schedule agreed with the Bank in advance.

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Component B (BRA)

(i) Consulting Services

Quality and Cost Based Selection (QCBS, Para 3.17/"Banks" (Guidelines for Selection andEmployment of Consultants by World Bank Borrowers) would be used to hire a consulting firm forBank Restructuring and Privatization Services.

Selection based on Least Cost (LCS) would be used for the selection of consultants to conduct audits ofPMU and project accounts, up to an aggregate amount of US$30,000.

(ii) Incremental Operating Costs

Incremental Operating Costs, including remuneration of the staff of PMU, would be procured inaccordance with an annual budget and schedule agreed with the Bank in advance.

Prior and post review by the Association of the Consultant Contracts

All contracts estimated to cost the equivalent of US$50,000 or more per contract with finrs andUS$25,000 with individuals, will be subject to prior review.

All Terms of Reference will be subject to prior review.

Procurement Implementation Schedule and Advance Procurement Actions

The agreed procurement plan will be used as a basis for procurement monitoring. The key sets of TORfor restructuring agents (Component A) and indefinite delivery type contract for bank resolution services(Component B) have been drafted and agreed upon with counterparts. These draft TOR can be found inthe Project Implementation Plan.

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Table A: Project Costs by Procurement Arrangements(US$ million equivalent)

I ' - Procurement Method=< r Category 4 Ic aNCEt . Other Na.F. f TtCost

1. Works 0.00 0.00 0.00 0.00 0.00(0.00) (0.00) (0.00) (0.00) (0.00)

2. Goods 0.00 0.00 0.05 0.00 0.05(0.00) (0.00) (0.05) (0.00) (0.05)

3. Services 0.00 0.00 8.27 2.12 10.39(0.00) (0.00) (8.27) (0.00) (8.27)

Incremental Operating Costs 0.00 0.00 0.69 1.34 2.03(0.00) (0.00) (0.69) (0.00) (0.69)

Unallocated 0.00 0.00 0.00 0.00 0.00(0.00) (0.00) (0.00) (0.00) (0.00)

PPF 0.00 0.00 1.99 0.51 2.50(0.00) (0.00) (1.99) (0.00) (1.99)

Total 0.00 0.00 11.00 3.97 14.97(0.00) (0.00) (11.00) (0.00) (11.00)

"Figures in parenthesis are the amounts to be financed by the IDA Credit. All costs include contingencies.2 Includes civil works and goods to be procured through national shopping, consulting services, services of contracted

staff of the project management office, training, technical assistance services, and incremental operating costs relatedto (i) managing the project, and (ii) re-lending project funds to local government units.

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Table Al: Consultant Selection Arrangements (optional)(US$ million equivalent)

; : ift * - : . , ~~~~Selection, Method ... Consultant Services leo Method

Expenditure Categqry ;.QCBS. QSS 5FB , LCS CQ ;Other -S. a 7ostA. Firms 7.70 0.00 0.00 0.06 0.20 0.00 1.99 9.95

(7.70) (0.00) (0.00) (0.06) (0.20) (0.00) (0.00) (7.96)B. Individuals 0.00 0.00 0.00 0.00 0.00 0.31 0.13 0.44

(0.00) (0.00) (0.00) (0.00) (0.00) (0.31) (0.00) (0.31)Total 7.70 0.00 0.00 0.06 0.20 0.31 2.12 10.39

___________________ (7.70) (0.00) (0.00) (0.06) (0.20) (0.31) (0.00) (8.27)

Including contingencies

Note: QCBS = Quality- and Cost-Based SelectionQBS = Quality-based SelectionSFB = Selection under a Fixed BudgetLCS = Least-Cost SelectionCQ = Selection Based on Consultants' QualificationsOther = Selection of individual consultants (per Section V of Consultants Guidelines), CommercialPractices, etc.N.B.F. = Not Bank-financedFigures in parenthesis are the amounts to be financed by the Bank Credit.

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Prior review thresholds (Table B)

Table B: Thresholds for Procurement Methods and Prior Review'

. , .w7Contract valu:: t', '6ntacts Subject to'." a ... .... .Threshold Procurement Pjior Review

: xpenditugeCateg ory (U$$ thousands) MUethod iUS$ millons)1. Works

2. Goods >100,000 ICB All<50,000 Shopping (NS and IS) First three+over US$1 OK

3. Services4. (a) Individual >25,000 Indiv. All

<25,000 Indiv. TORs

5. (b) FirTns >100,000 QCBS All<10,000 LC TOR>50,000 CQ All<50,000 TOR

6. Miscellaneous

Total value of contracts subject to prior review:Overall Procurement Risk Assessment: High

Frequency of procurement supervision missions proposed: One every 6 months(includes special procurement supervisionfor post-review/audits)

Given the high risk rating, post review will cover all contracts. The intensity may decrease in the

subsequent years depending on the progress of the project.I\

Thresholds generally differ by country and project. Consult "Assessment of Agency's Capacity to ImplementProcurement" and contact the Regional Procurement Adviser for guidance.

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Annex 6(B) Financial Management and Disbursement ArrangementsFEDERAL REPUBLIC OF YUGOSLAVIA: PRIVATIZATION AND RESTRUCTURING OF

BANKS AND ENTERPRISES TECHNICAL ASSISTANCE PROJECT

Financial Management

1. Summary of the Financial Management Assessment

Financial Management Assessment Report (August 2002)

Executive Summary and Conclusion

The draft FRY CFAA report notes that there are a number of risks on the management of publicfunds in the FRY. The risks to the public funds include: (a) poor public sector financial management inthe past; (b) unfinished reforms - while the new governments have initiated a major reform program, it isstill too early to say whether the reforms will be successful; (c) capacity constraints in both the FRY andRepublic of Serbia governments; (d) weak banking sector; (e) weak audit capacity; (f) poorimplementation capacity in line ministries; and (g) the lack of recent Bank implementation experienceswithin the FRY. Since re-joining the membership of the World Bank, FRY has been using individualimplementation units for each investment project (traditional PMU model), located within the relevantline ministries or project beneficiaries, to mitigate some of these risks. This arrangement is acceptable tothe Bank and the Bank has provided training on financial management and disbursements to the projectstaff in March 2002.

It has been determined that the PMUs currently satisfy the Bank's minimum financial managementrequirements. The PMU's financial management systems are considered capable of satisfactorilyrecording all transactions and balances and supporting the preparation of regular and reliable financialstatements. However, while the PA PMU has installed an integrated accounting software package, theBRA PMU records project accounting data in both an Access database and on Excel spreadsheets andmanually combines the data to produce financial reports. The latter is inefficient and does not generatean automatic audit trail.

Financial Management Assessment Rating Comments1. Implementing Entity Satisfactory Each of the two implementing agencies is currently managing

a number of credits/grants for Bank-assisted projects

2. Funds Flow Satisfactory Each PMU will operate its own Special Account Funds flowswill be similar to projects currently under implementation

3. Staffmg Satisfactory Expenenced financial team4 Accounting Policies and Procedures Satisfactory Adequate financial manuals and policies. However, it has

been agreed that the manuals will be updated as part of aplan to further strengthen financial management

5. Internal Audit NA No reliance placed on internal audit6. Extemal Audit Satisfactory TORs for extemal audits have been agreed with each PMU7. Reporting and Monitoring Satisfactory Both PMUs have prepared FMRs for current projects

8. Information Systems Satisfactory The PA uses PAIS software. The BRA is currentlydeveloping an in-house system. The BRA will evaluate thebenefits of continuing development of the in-house systemor of purchasing a system compatible with the systeminstalled at the PA

9. Disbursement Satisfactory Both PMUs are, m respect of on-going project, compliantwith Bank disbursement requirements.

Overall Financial Management SatisfactoryRating

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Detailed financial management assessment questionnaires and Financial Management Supervisionreports relating to the implementation of current Bank projects are included in the project files.

Financial Management System Assessment

Project Management and Coordination

The project implementation will be coordinated by two PMUs, which have been established in the PAand the BRA in Spring 2001 to implement the ongoing Bank's PSD TA and FSD TA Grants and anumber of other grants. The PMUs at the PA and the BRA will be separate and responsible for theimplementation and administration of their respective components. Both PMUs will finance theirrespective components through two separately-established Special Accounts, and be responsible for themonitoring of the use of funds for their respective components, including procurement and disbursement,and reporting on the use of project funds. Each of the PMUs is headed by a Director, who will haveoverall responsibility for the proposed project. The PMU Directors will ensure that all project objectivesand targets that can be monitored, as specified in the Project Implementation Plan (PIP), are on track andachieved. He/she is assisted by a Project Administrator, who will oversee the day-to-day operations ofthe project. Technical expertise on a short-term basis will be provided to the Project Administrators asand when required. Each of the PMUs, apart from the Project Administrator, will include procurement,disbursement and financial management specialists who will focus on the proposed project. The PMUswill be responsible for the day-to-day operations of the project, procurement, and financial management,including reporting to the FRY and Republic of Serbia governments and to the Bank.

Conclusion: The PMUs within the PA and the BRA have effective organization structures, which arecapable of managing the Project efficiently.

Staffing of the Accounting/Finance Function

The Finance Manager of the PA, who is also the head of the finance section of the PMU, is familiar withfinancial and accounting systems as well as with Bank requirements. He, together with the disbursementofficer, will be responsible for all aspects of financial management and accounting for component A,including managing the special accounts, maintaining books of accounts and reporting day-to-daytransactions. The BRA PMU accountant is familiar with financial and accounting systems as well as withBank requirements. Together with the disbursement officer, she will be responsible for all aspects offinancial management and accounting for component B, including managing the special accounts,maintaining books of accounts and reporting day-to-day transactions.

Conclusion: The level and experience of staff within the PMUs is acceptable to the Bank.

Accounting and Internal Controls

As explained above, both PMUs have experience with Bank financed projects. They have established keyinternal control mechanisms on the commitment and use of funds (preventative controls) but have not yetfully implemented formal ex-post (detective) controls. Each PMU has an operations manual for theiron-going projects, describing the functions of each member of the PMU and the internal control structure(including authorization limits, segregation of duties, regular reconciliation, etc.).

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Conclusion: Ex-ante (preventative) internal controls over funds are adequate. The systems will befurther strengthened by the introduction of ex-post (detective) controls over accounting and reporting.

Computerized Accounting Systems

The PA PMU has recently completed the installation of the PAIS accounting system which meets theminimum reporting requirements of the Bank and is capable of automatically generating FMRs. Thesystem currently is currently installed on a single laptop computer; however, it has been agreed that thedatabase will be transferred to the PA's server to improve data security. The PMU will purchase anadditional license for the PAIS software for the new project.

The BRA is working towards completing an in-house system based around an Access database. In theinterim period, the PMU records project accounting data in both the Access database and on Excelspreadsheets and manually combines the data to produce financial reports. This is not efficient and willbe further complicated by the need to consolidate the FMRs of the two PMUs for presentation to theBank. BRA will therefore evaluate the benefits of continuing the development of its in-house system orpurchasing a software package compatible with the system used by the PA PMU.

Conclusion: The PMUs have adequate accounting systems. However, the BRA's project accountingsystem is inefficient and unable to generate standard reports. The BRA should evaluate the benefits ofcontinuing the development of its in-house system or purchasing a software package compatible with thesystem used by the PA PMU.

Audited Financial Statements and Management Letters

The BRA, which was established at the beginning of the 1990s, received an unqualified audit opinionfrom Deloitte&Touche on its 2001 financial statements. Though not legally required to do so, the PA hascontracted with Ernst&Young to audit its 2001 financial statements; the results are expected duringSeptember 2002. As part of the negotiations for the PSD TA and the FSD TA projects, the agencies haveagreed TORs for the audit of the project financial statements for the year ending 31 December 2002(2001 audits were waived by the Bank due to the immateriality of transactions in that year).

Financial Manual

Both the BRA and the PA prepared financial manuals as part of the preparation and implementation ofthe FSD TA and PSD TA projects. The manuals were reviewed by an FMS and were acceptable to theBank. However, as part of the preparation for the PRBE Project, the PMUs have revisited the manualsand have further strengthened them through the introduction of "detective controls", including the use ofcontrol checklist, regular reconciliation, etc.

Conclusion: The financial manuals have been reviewed by the bank and are satisfactory.

Conclusion

The PMUs have financial management systems which will meet the Bank's minimum financialmanagement requirements.

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Accounting and Financial Flows

The Bank would make funds available to the Federal Republic of Yugoslavia under the CreditAgreement, governing the terms and conditions of the proposed credit. The FRY Government wouldon-lend the funds on IDA terms to the Government of the Republic of Serbia for implementation ofcomponent A, based on the Subsidiary Credit Agreement with terms and conditions satisfactory to theBank.

Financial Monitoring Reports

It has been agreed that the PMUs will prepare financial monitoring reports (FMRs) on a quarterly basis.The reports will include:

* Project Sources and Uses of Funds* Uses of Funds by Project Activity* Special Account Statement Plus Local Bank Account Statement* Project progress report* Procurement report

Draft FMR formats have been included in the PIP. The first full set of FMRs is expected to be producedfor the period ending 31 March 2003.

Financial Risk Analysis

The overall financial management risk of this project is considered to be moderate. A summary of theconsolidated risk assessment for the project is as follows:

Risk Rating CommentsInherent Risk

1. Country Financial Management Risk Substantial Based on draft CFAA, there is generally low financialmanagement capacity and accountability in the public sector

2. Project Financial Management Issues Moderate Low transaction volume. Primarily consultant contractsOverall Inherent Risk Moderate

Control Risk

1. Implementing Entity Low Existing PMUs currendy implementing projects2. Funds Flow Moderate3. Stafflng Moderate4. Accounting Policies and Procedures Moderate

5. Internal Audit N/A6. External Audit N/A First audits due for end 20027. Reporting and Monitonng Moderate8. Information Systems Moderate

Overall Control Risk Moderate

Costs and Financial Performance

The project's financing plan, which includes the IDA Credit, and the project's planned expenditures,have been realistically estimated.

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2. Audit Arrangements

The PMUs will be responsible for ensuring that project financial statements, special accounts, andStatement of Expenditures (SOEs) are audited by an independent international auditor, a member of aprofessional body that is a member of the International Federation of Accountants (IFAC) and acceptableto the Bank, in accordance with standards on auditing that are acceptable to the Bank. The annual projectaudit will be carried out in accordance with the Guidelines for Financial Reporting and Auditing ofProjects Financed by the World Bank (March 1982). The audit report shall be in a format in accordancewith the International Standards on Auditing promulgated by the International Federation of Accountants(IFAC). The audited financial statements of the implementing agencies and of the project will be sent tothe Bank within six (6) months of the end of the Republic of Serbia Government's fiscal year.

3. Disbursement Arrangements

It is expected that the proceeds of the credit will be disbursed over a period of 3.5 years, which includessix months for the completion of accounts and the submission of withdrawal applications. The proposedcredit would be disbursed against the project components as shown in Table C. The project completiondate is October 31, 2005 and the closing date is April 30, 2006. The estimate of the volume ofcounterpart funds required to fully implement the project is based on the standard disbursement profilefor Serbia.

Disbursements from the IDA credit will follow the transaction-based method (i.e., the traditional Bankprocedures including reimbursements with full documentation, Statements of Expenditure, directpayments and special commitments).

Allocation of credit proceeds (Table C)

Table C: Allocation of Credit Proceeds

Expenditure Category Aiount in U5$million Financing PercehtageGoods under Part A of the Project 0.05 100%-local expenditures

95%-foreign expendituresConsultants' services, including 80% for services by firmsauditing services 70% for services by individuals

a) under Part A of the Project 5.39b) under Part B of the Project 2.88

Incremental Operating Costs 87% until January 1, 2004;70% thereafter

a) under Part A of the Project 0.57b) under Part B of the Project 0.12

Refunding of Project Preparation 1.99 Amount due pursuant to Section 2.02 (c)Advance of this Agreement

Total Project Costs 11.00

Total 11.00

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Project Preparation Facility

Due to the immediate need to start a number of preparation activities in order to ensure a smooth andsuccessful implementation of privatization through restructuring of large enterprises once- the projectbecomes effective, the FRY received an advance through the Project Preparation Facility (PPF) Advancein the amount of US$1,988,000. The PPF Letter of Agreement has been signed on July 5, 2002. Theclosing date for the PPF will be February 28, 2003. The amount of the Advance withdrawn, togetherwith interest or service charge accrued thereon, as the case may be, shall be repaid by the Recipient to theBank from the credit proceeds. The refinancing of the PPF will occur after the effectiveness of thecredit. Any amounts not used for this purpose would be reallocated to other disburserment categoriesfollowing standard reallocation procedures.

Use of statements of expenditures (SOEs):

Some of the proceeds of the credit are expected to be disbursed on the basis of Statement of Expendituresas follows: (a) goods costing less than US$10,000 equivalent for each contract with the exception of thefirst three contracts; (b) service contracts for individuals costing less than US$25,000 equivalent eachwith the exception of the first contract; (c) service contracts for firms costing less than US$50,000equivalent each with the exception of the first contract; and (d) all incremental operating costs, all undersuch terms and conditions as the Bank shall specify by notice to the Recipient. Disbursements againstgoods and services exceeding the above limits will be made against full documentation and respectiveprocurement guidelines. Statements of expense will be certified locally by the PA for Component A andby the BRA for Component B. Related documentation in support of statement of expenses will not besubmitted to the Bank, but will be retained by the PMUs for at least one year, after receipt by the Bank ofthe audit report for the year in which the last disbursement is made. The PMUs will make thesedocuments available to the auditors and supervision missions for review. If ineligible expenditures,including those not justified by evidence furnished, are financed from the Special Account (SA), theBank will have the right to withhold further deposits in the SA. The Bank may exercise this right untilthe Recipient has refunded the amount involved; or (if the Bank agrees) submitted evidence of othereligible expenditures that can be used to offset the ineligible amounts.

Special account:

To facilitate timely project implementation, the Borrower will establish, maintain and operate, underconditions acceptable to the Bank, two separate Special Accounts in Euro in local banks, satisfactory tothe Bank. One SA will be opened in the name of the PA, and will be used for implementation ofComponent A; another SA will be opened in the name of the BRA and will be used for implementationof Component B. The authorized allocation of the Special Accounts held by PA and BRA will be Euro300,000 and Euro 100,000, respectively, representing approximately four months of eligible expendituresof each PMUs. Upon effectiveness of the Credit Agreement, the initial deposits for the PA and BRA willbe Euro 150,000 and Euro 50,000, respectively. Further disbursements will need to have reached Euro450,000 and Euro 150,000 for the PA and BRA respectively to be able to draw the authorized allocationfor the Special Accounts. Replenishment applications are to be submitted at least every three months andmust include reconciled bank statements as well as other appropriate supporting documents.

Where the PMUs consider it efficient to open a local currency account, these should be opened in the

-49 -

same bank as the Special Account and should be used only for funds related to this project. The localcurrency accounts will be primarily transaction accounts and balances should be kept to a minimum

Agreed Action Plan for PMUs

It has been determined that the PMUs currently satisfy the Bank's minimum financial managementrequirements. There are however a number of actions that the PMUs have agreed to take to improve theirfinancial management processes.

Action - PA Deadline

1. Update the financial manual, with supplementary section for this project, to Completedinclude a more comprehensive description of preventative and detectiveinternal controls2. The PA will appoint an independent auditing firm, acceptable to the Bank, Completedto perform the annual audits of its financial statements3. Begin the process of purchasing an additional licence for financial End-November 2002management software4. Finalization of 2003 PA Budget, to include sufficient allocation of funds to End-November 2002the Project to meet the counterparts obligations under the Credit Agreement

Action - BRA Deadline

1. Populate the Access database with all transactions to date under the FSD CompletedTA project, prepare a full set of FMRs for that project and reconcile thetransactions and balances to extemal data sources (bank statements andtransaction summaries from the Bank)2. Update the financial manual, with supplementary section for this project, to Completedinclude a more comprehensive description of preventative and detectiveintenal controls3. Complete the implementation of the PMU's in-house accounting system OR End-November 2002begin the process of purchasing a system compatible with that used by the PA4. Finalization of 2003 BRA Budget, to include sufficient allocation of funds End-November 2002to the Project to meet the counterparts obligations under the Credit Agreement

Supervision Plan

The reports of the progress of the project implementation will be monitored in detail during supervision

missions. FMRs will be reviewed on a regular basis by the Belgrade-based FMS and the results or issues

followed up during the supervision missions. Financial audit reports of the project and the implementingagencies will be reviewed and issues identified and followed up. The field-based FMS would monitor the

agreed action plan to ensure appropriate actions have been implemented by the agencies.

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Annex 7: Project Processing Schedule

FEDERAL REPUBLIC OF YUGOSLAVIA: PRIVATIZATION AND RESTRUCTURING OF BANKSAND ENTERPRISES TECHNICAL ASSISTANCE PROJECT

Project Schedule Planned Actual

Time taken to prepare the project (months) 8 9

First Bank mission (identification) 04/01/2002 04/01/2002

Appraisal mission deparure 07/01/2002 07/01/2002

Negotiations 09/01/2002 09/25/2002

Planned Date of Effectiveness 02/15/2003

Prepared by:The World Bank, Privatization Agency, and Bank Rehabilitation Agency

Preparation assistance:None

Bank staff who workced on the project Included:- - [ ,kame - s;- ! Speciality

Core TeamAlexander Pankov (ECSPF) Task Team Leader, Operations Analyst

Gerardo Corrochano (ECSPF) Program Team Leader (FSD), Lead FSD Specialist

Itzhak Goldberg (ECSPF) Program Team Leader (PSD), Lead PSD Specialist

Jame R. Dick Welch (ECSPF) Senior Privatization Specialist

Robert Gourley (ECSPF) Senior Restructuring Specialist

Anna Sukiasyan (ECSPF) Operations Analyst

Andrew Lovegrove (UK DFID) Senior Bank Resolution Specialist

Gennady Pilch (LEGEC) Sr. Counsel

Rama Chandran (ECSPF) PASMichael Gascoyne (ECSPS) FMS, Sr. Financial Analyst

Joseph Formoso (LOAG3) Sr. Finance Officer

Quality Assurance

Paul Siegelbaum (ECSPF) Sector Director

Khaled Sherif (ECSPF) Sector Manager

Ira Liebernan (ECSPF) Senior Advisor

Peer Reviewers

Charles E. Woodruff (Consultant) Senior PSD Specialist

William Mako (EASPS) Senior PSD/FSD Specialist

-51 -

Annex 8: Documents in the Project File*FEDERAL REPUBLIC OF YUGOSLAVIA: PRIVATIZATION AND RESTRUCTURING OF BANKS

AND ENTERPRISES TECHNICAL ASSISTANCE PROJECT

A. Project Implementation Plan

The Project Implementation Plan includes the Terms of References for the implementation of technicalassistance.

B. Bank Staff Assessments

Aide Memoire Identification Mission April 2002Aide Memoire Pre-Appraisal Mission July 2002Procurement Capacity Assessment August 2002Financial Management Assessment August 2002

C. Other

Proposed Timeline for Privatization through Restructuring of SOE on the "list of 47" (prepared by thePA in October 2002).*Including electronic files

- 52 -

Annex 9: Statement of Loans and Credits

YUGOSLAVIA, FED. REP. OF: PRIVATIZATION AND RESTRUCTURING OF BANKS AND ENTERPRISESTECHNICAL ASSISTANCE PROJECT

As of Date 11/06/2002Diference between expected

and actualOriginal Amount In USS Millions disbursements

Project ID FY Purpose IBRD IDA SF GEF Cancel. Undisb. Orig Frm Rev dP075189 2 EDUCIMPROVMT 1000 000 10.62 070P074136 2 EMG ELEC POWER RECN 0 00 6 00 3 39 2 70P077473 3 EMG POWER LIC 500 0.00 4.99 0 00P074484 3 EXP FIN FAC 1150 000 12.03 000P074127 1 FIN SEC DEVT TA GRANT 0.00 6.00 3.23 200P074618 2 MONTENEGRO ENV INFR. 0.00 2.00 2 00 0 00P074145 1 PRIV SECT DEVT TA 0 00 600 3 64 2 50P076764 3 SAC(MONTEGNEGRO) 1500 000 1564 000P074124 2 SOC ASST 0 00 10 00 060 0.60P074090 2 TRADE & TRANSPORT FA 6 76 0.00 7 36 0 10

Total: 48.26 30.00 63 41 8 60

YUGOSLAVIA, FED. REP. OFSTATEMENT OF IFC's

Held and Disbursed PortfolioAs of 6/30/2002

In Millions US Dollars

Committed DisbursedIFC IFC

FY Approval Company Loan Equity Quasi Partic Loan Equity Quasi Partic

2002 Fresh & Co. 7.17 0.00 0.00 0.00 4.78 0.00 0.00 0.001982/87 Igalo 8.06 0.00 0.00 0.00 8.06 0.00 0.00 0.001985 Jugobanka 4.06 0.00 0.00 0.87 4.06 0.00 0.00 0.871980 Monte Hotels 2.00 0.00 0.00 0.00 2.00 0.00 0.00 0.001980 Radoje 1.17 0.00 0.00 0.00 1.17 0.00 0.00 0.002002 Raiffeisen Yug 0.00 2.33 0.00 0.00 0.00 0.94 0.00 0.001980 SMSE Yugo 1.08 0.00 0.00 0.00 1.08 0.00 0.00 0.002002 Tigar Tyre 14.89 0.00 3.72 0.00 5.59 0.00 0.00 0.001987/89 Vojvodjanska 38.09 0.00 0.00 18.94 38.09 0.00 0.00 18.94

Total Portfolio: 76.52 2.33 3.72 19.81 64.83 0.94 0.00 19.81

Approvals Pending Commitment

FY Approval Company Loan Equity Quasi Partic

2002 MFB Yugoslavia 4.00 1.00 0.00 0.00

Total Pending Comunitment: 4.00 1.00 0.00 0.00

- 53 -

A½ne2 lO: C rtnerM a CancsFlEDlEPL 1R1EPUBUC90 OF VUGO3UVh%SD: 1P'RUAMATWS(A MD11 1R1E$1RUCTURSHG OC)F 13AMNG

A1 ETR1RMD$E 3TCH=DAL A$Sg$TACIE PROJECT

- . Eu70o a Le~r-:. -- -POViERTY anld SOCL4-LDEb* Con@d id<' MI,:

-Fc. sop. _-oa -t!ncemo Dovolop=nt dlmond`200iPopulation, mid-year (mlillons) -10.6 475 Z2046 LUfe expectancyGNPpetrcaplta(Atlasnwftho, US$) 1.: - 980 '2,010 1,140GNP(Alfasmsth,'US$bllOnsM) llx 10.S 956 2,327

Av6rcso cnnud Broftfi, S9S64S.1

Populabtion (%) 0.1 0.1 1.0 GLabor force(%) 0.5 :0.6 1.3 GNI /Jj. Grss

.: .. .. I' . per primaryMoct rca ootlmcro (IC=o y-ro vfkl!o, %89-9) - capita enrollment

Poerty(% of ppwulati bslx.'nalonalpovaflylhe)s -=- -, , .Urban population (% of total popudatoh,) .52 67 - 42Lib' xpectancyat.blrth'(yaa&r) , . : ..-- .- - 72 69 69.InJantmortality (par 100I bIh2 hs) 13 21 32'Chliid'malnutHtion (% hidffSf tmda-r5); *2 .. Aco1ss to Improved water sourceAccess to an improved watar source (1% of populllo,n) - .-O 80

literacy aofpopulaIon eV 15D) ' - 3 15Gross primary enrolmant (%ofschopuleon) 69 10iO0 114 -ugoelava.FR (Serb. Wont.)

' Mala-6 ,- , 89 - 101 116 Lower-middle-ncoms grmupiemab ' -- 70 99 114

KEY ECOXOtLC RQTtOS cnd LONG-712M TR1END5loci 195i 2cu3 2001

- Economtc rcrtfooGDP (US$blillOns) A- . - 8. '10.9Goss domastIcInvestmentIG1,P 14.5. -- 13:5Exorts of goods and srvioas/GODP ,-- 31.6 2. -,4Gfossrdomastlc savln9s/GDP .- ; 5 -8.6Gross,nat!onalsaevngsGD.P 10.3. . 0

Cur ent account balanbslGDP, - - ' -5.0 -5.5 -Dmc ' .Inteest payments/GDP. 2/ 0..6 07 estic Inv0stmentsavigTotal dabyGDP - ;1414- 106.8<: ngTotaidebt srvicelexports 2 1--' : 22 1.0Preseant value of debt/GDPPr6einivalua daebUfporta r ; ; +v.! p Lntvatueo~debtMi~poe 1 ! . ,' ! i ' 'Indebtedness

-- * . IeGI-CI 1~14¶e,As-' 2 200 200145

GDP , _ ,o,:,.) .. 5. .5 . Yugosavia, FR (SerbJAont.)GDP psr pte . 49 -.-I -.4' 3.8 Lowa,r4rdddo-income groupExports of goodsandsc -, e. ' 34.8 9.A ,:_ tO

-54-

STRUCTURE of the ECONOMY1981 1989 2000 2001 Growth of Investrnent and GOP (%)

(% of GDP)Agriculture .. 10.1 17.6 10

Industry .. 43.1 37.6 ..

Manufacturing .. .. .. *10 9a 97 98 oo 0 0

Services .. 46.8 44.8 .. -20

Private consumption .. .. 85.0 90.2 -40

General government consumption .. 18.5 18.4Imports of goods and services .. 49.6 47.5 GDI GDP

1981-41 1991401 2000 2001 Growth of exports and tmpoarts (%)(average annual grwth)Agriculiture .. .. -20.0 25.0 40Industry .. .. 10.9 0.0 20

Manufacturing .. .. .. ..

Services .. 0. .. .. 80 87 98 00 01

Private consumption .. .. 20.0 14.8 -40General government consumption .. .. -24.5 5.2 zoGross domestic Investment . .. 17.5 5.8 -ENqfl -, ImponsImports of goods and services .. .. 28.6 30.0

Note: 2001 data are preliminary estimates.

The diamonds show four key indicators In the country (In bold) compared with its Income-group average. Itf data are missing. the diamond will

be Incomplete1/ Estimate for 2000; excludes Kosovo and Is calculated using the market exchange rate. 21 On a cash basis.

- 55-

MAP SECTION

IBRD 31506

I 180 190 20 210 220 230

HUN ARY FEDERAL REPUBLICPecse rT7 _sa *r _Arod OF YUGOSLAVIA

Pecs o

460 Mo~~~h6cs anioEUROPEAN HIGH-WAYS A460

Bodca k RAILWAYS

So > /mbor PT p Adoo Timi1ooro AIRPORTS

0 TOWNS

in t Srbo 0D/ ® REPUBLIC OR PROVINCE CAPITALS

/~~~~~~~~~~~~

- 'fS ; k t-/ toS <s ri^9t 69 ~~~~~~~~~~~~~NATIONAL CAPITALS

- 450) e l0 45° P

fBOSNIA AND tooHERZEGOVINA Plank INERATO B

/ ek ~~~~~~~~~~~~~~~~~~~~~16nac ,

430 Bi1elo P,>la

__s ~ 4i- .iBr k FYR MACEDO NIA

Edo A e-- S A .. ;; 212

DECEMBER 2001

NNMANG

Report No.: 25064 YUType: PA