Report No. PIC1775 Project Name Moldova-Structural Adjustment Loan (&) Region Europe and Central Asia Sector Economy-wide Project ID MDPA8554 Public Disclosure Authorized Principal Responsible Entity Ministry of Economy Date PID Prepared March 21, 1995 Appraisal Date September 10, 1994 Board Date December 8, 1994 Country Background I. In the USSR economy, Moldova was a producer of raw and processed foodstuffs (primarily grapes, grains, wines, fruit, vegetables and livestock). The country derives its comparative advantage from the Public Disclosure Authorized fertile soil and temperate climate. Agriculture accounted for about 40 percent of Net Material Product (NMP), while agro-industry contributed approximately half of the aost 40 percent of NMP accounted for by the industrial sector. The economy was designed to be highly interdependent with other FSU countries, and trade continues to be a significant proportion of GDP. In particular, Moldova is 99 percent dependent on imports for primary energy resources. Characteristic of the FSU, the economy is extremely energy-intensive. II. As a result of the price liberalization which accompanied the breakup of the FSU and exposure to world prices, Moldova experienced a large terms of trade shock accounting for 30 percent of GDP in 1992 prices. Its economy was also hit by the disruption in payments and declining trade within the FSU. In addition, Moldova was afflicted by Public Disclosure Authorized severe drought in 1992. In 1994, the sharp decline in FSU aggregate demand has brought aost 70 percent of industry to a standstill, while another severe drought, followed by hurricanes and floods, inflicted significant losses of crops, herds, and infrastructure, compounding Moldova's economic problems. Initial estimates of losses amount to $345 million, close to the estimated level of total current public expenditure in 1994 of $374 million. III. The cumulative decline in GDP since 1990 is over 60 percent. Living standards have fallen sharply, with a fall in real average wages of 53 percent between December 1992 and January 1994, and further declines since then. The fall in output has not been reflected in significant open unemployment, but the use of forced vacations is widespread, and wage arrears for time actually worked are estimated at around one-third of wages due for the economy as a whole; wage arrears Public Disclosure Authorized are much higher in agriculture. IV. Since late 1993, Moldova has been following a tight monetary policy supported by the IMF's Systemic Transformation Facility (STF) and a Stand-by arrangement. The program supported by the IMF includes market allocation of credit, substantial declines in the rate of expansion in base money and in net domestic assets, and strict ceilings on credit to Government from the National Bank of Moldova (NBM) and the banking system. The program allows for an increase in government expenditure on the social sectors, but requires large savings in subsidies, together with increases in tax revenue derived from removal of tax exemptions and better compliance. The program has been successful in reducing inflation from a monthly average of 20 percent in 1993 to 2-3 percent on a monthly basis in the second half of 1994. The Country's Adjustment Program V. Parliament adopted the concept and main principles of transition to a market economy in successive sessions during 1990 and 1991. Since then, the Government has set out its objectives and strategy for comprehensive economic reform in documents presented to Parliament each year and, since late 1992, has made considerable progress in creating the conditions for structural change. Under the program supported by the Bank's Rehabilitation Loan, the Government removed all export taxes and aost all quantitative restrictions on exports,(see 1/) introduced a new, generally much lower, import tariff, eliminated direct price controls with few exceptions,(see 2/) and raised margin controls. A new currency, the leu, was introduced in November 1993 and the exchange rate is freely determined at regular inter-bank auctions held by the Chisinau Interbank Foreign Currency Exchange (CIFCE). The autonomy of the NBM has been strengthened; the authorities have tightened banking laws and prudential regulations, and are starting on a program of institutional development for the NBM and the commercial banks. VI. The authorities have enhanced the environment for private sector development through the improvements noted above in the trade and price regime and regulatory framework. Progress has been less impressive in some other aspects of the program. Privatization of small scale businesses began in October 1993, but the program was initially subject to delay for both political and technical reasons, and measures to strengthen public enterprise governance are also lagging. The Government has made efforts towards better targeting of social protection, but further work is needed to restructure the social safety net within existing fiscal limits. Despite the NBM's leadership in reform, the commercial banks are slow to adjust, and existing credit allocations to traditional clients have shown little change. VII. On the other hand, there has been substantial progress in hardening the budget constraint on enterprises, with extremely tight conditions for new credit from the banking system and the withdrawal of aost all government subsidies to enterprises. However, with the success of the stabilization efforts, pressures broke out through other channels. Financial constraints on enterprises were relieved through loan rollover and capitalization of interest owed, through an outgrowth of arrears - to suppliers, employees, banks, and the budget - and through default on government guaranteed loans. Political pressures exerted by enterprises for trade protection also resulted in the imposition of excessive import tariffs on sensitive products including wine and carpets. The combination of evasion of the hard budget constraint and slow ownership change has tended to perpetuate past patterns of resource allocation and output, with the result that change in the real economy remains incipient. -2- The Proposed Loan or Credit VIII. The loan of US $60 million is made to the Republic of Moldova represented by the Ministry of Finance as Borrower. The loan is providing quick-disbursing balance of payments support on evidence that imports of eligible goods have taken place. Disbursements are made to the National Bank of Moldova (NBM) and an account of the Ministry of Finance at the NBM is credited with the leu equivalent at the official exchange rate of the day;(see 3/) the Government thereby receives non- inflationary budget support. The foreign exchange proceeds of the loan are sold by the NBM or held in reserves, in accordance with the objectives of monetary policy.(see 4/) The loan has a maturity of 20 years including a five year grace period, at the Bank's standard variable interest rate. IX. The program supported by the Loan comprises a set of key measures needed to induce a quick response in the real economy to macroeconomic tightening and sharp relative price movements. The program is thus designed to produce the reallocation of resources needed to promote a recovery in sustainable export-led growth, while providing for the most vulnerable groups. The main foci of the program are: privatization; hardening the budget constraint on enterprises; creating a competitive environment; and better targeting of social benefits within fiscal constraints. X. The program supported by the loan is also intended as a catalyst for balance of payments support and provision of technical assistance by other donors. Such support would be sought in the framework of a Consultative Group meeting on Moldova. XI. Poverty category: Poverty-focused. The loan supports improved targeting of the social safety net through a reorientation of public expenditures towards minimum benefits for pensioners and other beneficiaries without other income from employment; a freeze on earnings-related and minimum-wage related benefit entitlements; and Government provision of severance pay and unemployment benefit for unemployed workers in bankrupt or liquidated enterprises. XII. Environmental category: The project will have no direct impact on the environment. For the purposes of OD 4.01, it has been placed in Category U which does not require an environmental assessment. XIII. Benefits: The operation supports the development of a competitive private market-based economy that promotes the efficient allocation of resources for economic growth and improvement in living standards. Such a response is essential in order to reverse the output decline and induce structural change. XIV. Risks: The main risks attached to the program are (i) potential divisions within the Government and Parliament on the speed and depth of politically sensitive reforms (the Government has a track record on reform and now also has a majority in the Parliament; however, the deepening of the reform process may revive this risk); (ii) the disjunction between progress on stabilization and the delay in the restoration of growth (this risk will be addressed by the structural -3 - reform program supported by the loan); (iii) capacity within the administration may not be reinforced quickly enough to permit timely implementation of the program (technical assistance is being mobilized against this risk); (iv) sufficient balance of payments support may not be forthcoming to sustain the program, forcing a lower