Document of The World Bank

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1 Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Document of The World Bank STAFF APPRAISAL REPORT REPUBLIC OF LATVIA ENTERPRISE AND FINANCIAL SECTOR RESTRUCTURING PROJECT AUGUST 16, 1994 Privatization and Enterprise Development Division Country Department IV Europe and Central Asia Region Report No LV

2 Currency Equivalents (as of July 20, 1994) Currency Unit = Latvian lati (introduced May 1993) Ls I = US$1.79 US$1 = 0.56 Ls Average Exchange Rates per US$1 Rate 1993 May April June Fiscal Year January 1 - December 31 Weights and Measures Metric System Abbreviations and Acronyms BOL CEM CLRM CPL DM EA EBRD EC PHARE FSUB GDP GOL ICB IBL IMF LCB LIB LPA Ls MEBO MIS MOF MPP OPTU PFI PCR PMU POS PPP RU SCL SOE SPA SPF TA TOR TU UKKH US$ Bank of Latvia Country Economic Memorandum Credit Line Regulation Manual Currency Pool Loan German currency unit (deutsch mark) Environmental Assessment European Bank for Reconstruction and Development European Community Assistance Program for Eastern Europe Former Soviet Union and Baltics Gross Domestic Product Government of Latvia International Competitive Bidding Investment Bank of Latvia International Monetary Fund Local Competitive Bidding Limited International Bidding Latvian Privatization Agency Latvian currency unit (Latvian Lati) Management/Employee Buy-Out Management Information System Ministry of Finance Mass Privatization Program Operating Procedures of the Technical Unit Participating Financial Institutions Project Completion Report Project Management Unit Point of Sale Pilot Privatization Project Restructuring Unit Single Currency Loan State-owned enterprise Separate Project Summary State Property Fund Technical Assistance Terms of Reference Technical Unit UK Know-How Fund United States currency unit (United States dollar)

3 STAFF APPRAISAL REPORT LATVIA ENTERPRISE AND FINANCIAL SECTOR RESTRUCTURING PROJECT Table of Contents LOAN AND PROJECT SUMMARY... i-iii 1. BACKGROUND A. Introduction B. Stabilization Program and Structural Reforms... 1 C. Project Background... 3 II. ENTERPRISE AND FINANCIAL SECTOR ISSUES... 4 A. Enterprise Sector Status... 4 B. Issues in the Enterprise Sector... 7 C. Financial Sector Status... 9 D. Issues in the Financial Sector Ill. THE PROJECT A. Rationale for Bank Involvement B. Objectives and Scope C. The Credit Component... I D. Institutional Development Component E. Financial Infrastructure Investment Component F. Project Cost and Financing Plan IV. PROJECT IMPLEMENTATION AND ONLENDING ARRANGEMENTS A. Project Organization and Implementation B. The Credit Component C. Institutional Development Component D. Financial Infrastructure Investment Component E. Procurement F. Disbursements G. Project Accounting, Financial Reporting, Auditing and Supervision V. BENEFITS AND RISKS A. Project Benefits B. Project Risks VI. AGREEMENTS AND RECOMMENDATION A. Agreements B. Recommendation This report is based on the findings of an appraisal mission in February Members of the appraisal team included Messrs./Mmes. Fleming (mission leader), Bereza (FSD), Jedrzejczak (EMTPS), Kreacic (EDIFP), Pardo (consultant), Leskinen (EC4BS), and Talley (consultant). Mr. Siegelbaum and Mr. Kavalsky are the managing Division Chief and Department Director, respectively, for the operation. Ms. Coffey had primary responsibility for processing the report.

4 TABLES IN TEXT Table Distribution of Equity Funds in the Productive Sector Table Changes in Value of Production by Industry Branch Table Privatization of Enterprises Owned by the Central Govermnent Table Privatization of Municipal Property Table Structure of Latvian Financial System Table Loan Assistance for Privatization: Use of Loan Proceeds Table Project Cost and Financing Plan Table Detailed Financing Plan Table Summary of Proposed Procurement Arrangements ANNEXES 1. The Swedish Capital Fund 2. Program of Enterprise/Financial Sector Reforms and Loan Implementation Measures 3. Projected External Credit Line Disbursements in 1994/95 4. Privatization Technical Assistance: Terms of Reference 5. Environmental Technical Assistance: Terms of Reference 6. Matrix of Technical Assistance for Privatization Program 7. Institutional Development Plan for Unibank 8. Organization of the PMU and TU 9. Implementation Plan 10. Participating Banks' Accreditation Standards 11. Detailed Supervision Plan 12. IBRD Disbursements CHARTS Annex 3 Chart 3.1 A Privatization through open auctions: Project Timetable - Sequencing of Activities Chart 3.1 B Privatization through open auctions: Timetable for One Cycle of Auctions Chart 3.2 Credit Line Component Implementation Plan Chart 3.3 Financial Infrastructure Investment Component

5 LATVIA ENTERPRISE AND FINANCIAL SECTOR RESTRUCTURING PROJECT Loan and Project Summary Borrower: Republic of Latvia Executing Agency: Ministry of Finance (MOF) Beneficiaries: Amount: Terms: Onlending Tenrs: Objective: The Government of Latvia, Bank of Latvia, Latvian Privatization Agency, private enterprises, and participating commercial banks Two loans, in the following amounts, aggregating about US$35 million equivalent: (a) US$20 million equivalent (b) US$10 million equivalent and DM8.5 million equivalent (about US$5.0 million) Two loans, each repayable over 17 years, including 5 years' grace: (a) a US$20 million equivalent currency pool loan at the Bank's standard variable rate; (b) a single currency loan of two tranches: a US dollar tranche in an amount of US$10 million equivalent at the Bank's standard US$ LIBOR-based rate; and a deutsche mark tranche in an amount of DM8.5 million equivalent at the Bank's standard DM LIBOR-based rate. From the Government to the financial intermediaries in Latvian lati, US dollars and deutsche mark; from the financial intermediaries to individual borrowers in the same currencies and maturities at freely determined interest margins. Depending on the subproject requirements, the maturity for subloans granted to finance fixed capital formation would vary from 1 to 12 years, with a maximum grace period of 3 years. Associated permanent working capital subloans would be for a maximum of 2 years, with a 6-month grace period. The principal objective of the project is to support the Government's reforms in the enterprise and financial sectors, focussing, in particular, on enterprise privatization and bank restructuring. An important aspect of the project is the design and implementation of a coordinated strategy of reform for both sectors. These reforms will pave the way for improved intermediation through the banking sector. The credit component of the loan will act as an incentive to the development of intermediation at the medium- and long-term end of the maturity spectrum.

6 _jj- Description: Project Benefits: Project Risks: The project will have three components: (i) a credit line component (US$29.6 million') that would provide resources for commercial banks to make medium- and long-term loans to recently privatized and other private sector Latvian enterprises for investment and related permanent working capital needs; this will be supplemented by a US$10 million Capital Fund provided by the Government of Sweden that would be dedicated to the capitalization of the banking sector; (ii) an institutional development component (US$3.4 million) that would support the Latvian Privatization Agency by financing, in part, an accelerated privatization track through open auctions, and also support the development of a Project Management Unit and a Technical Unit (for channeling the credit line component); (iii) a financial infrastructure investment component (US$2 million) for computer hardware and software for payments system development. The project will assist the marshalling and efficient allocation of resources in Latvia by enabling improved intermediation. The heavy emphasis in the project on the restructuring of the banking system, coupled with the strengthening of the financial infrastructure (through the upgrading of the payments system), will place the financial system in a better position to support an enhanced level of activity in the real sector. The project will also encourage new investment in the emerging enterprise sector through the provision of medium- and long-term credit. By acting as a catalyst to the privatization process, the project will improve the supply response in the economy and quicken the transition to a market-based economic system. Undergirding all of the loan components is a major effort to support the development of institutions--and the associated skill transfers--that will be vital to the success of the transition. The choice of single currency loan terms for a portion of the credit line will enable the onlending of that currency which is best suited to the needs of the subborrowers without requiring the government or the commercial banks to take the foreign exchange risk. The project is being developed against the backdrop of a fragile coalition government. This increases the risk that project objectives could be undermined by a sudden change in government. Another risk is the development of unacceptably high budgetary costs associated with enterprise and financial restructuring that might act as a drag on the reform process. With regards to the channeling of the credit component, any resurgence of inflation would curtail the trend towards lower nominal interest rates. This could undermine the credit line by reducing the demand for credit by the private sector. Similarly, there is some risk that the highly profitable trade transactions (involving trading in Russian commodities and metals stimulated by Russian prices below international levels), which have been financed at very high rates of interest, will not run down quickly. This type of financing is dominating bank lending and distorting the interest rate structure at present. A specific risk to the bank restructuring effort is that a further deterioration in the economy will lead to a significant future build-up in non-performing loans that would undermine the stability of the banking system. The LIBOR basis of the single currency loan component may create interest risk for those subborrowers whose revenues do not have the same interest rate sensitivity: credit appraisals should take into account the capability of subborrowers to manage this risk. 1. This amount includes US$980,000 of unallocated funds under the currency pool loan that are expected to be deployed in the credit line.