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1 Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Document of The World Bank FOR OFFICIAL USE ONLY STAFF APPRAISAL REPORT MOROCCO PILOT PROJECT FOR THE COMMUNAL INFRASTRUCTURE FUI April 1, 1983 Industrial Development and Finance Division Projects Department Europe, Middle East and North Africa Regional Office Report No MOR This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.

2 CURRENCY EQUIVALENTS (October, 1982) US$ 1.00 = Di 6.25 DR 1.00 = US$ 0.16 GLOSSARY OF ABBREVIATIONS BNDE - Banque Nationale de De'veloppement Economique CDG - Caisse de Depot et de Gestion CIH - Credit H8telier et Immobilier CNCA - Caisse Nationale de Credit Agricole FDCL - Fonds de Developpement des Communaute's Locales FEC - Fonds d'equipement Communal ICB - International Competitive Bidding LC - Local Commune MOI - Ministry of Interior ONE - Office National d Electricit6 ONEP - Office National de l'eau Potable FISCAL YEAR JANUARY I - DECEMBER 31

3 MOROCCO FOR OFFICIAL USE ONLY PILOT PROJECT FOR THE OOMMUNAL INFRASTRUCTURE FUND (FEC) STAFF APPRAISAL REPORT TABLE OF OONTENTS Page No. I. INTRODUCTION II. SECTORAL CONTEXT... 2 A. Background.. 2 B. Local Administrative Setting.. 3 C. Regional and Local Planning Process.. 4 D. Communal Development Financing.. 5 E. Service Delivery Systems.. 7 F. Bank Role and Sector Lending Strategy.. 9 G. Cost of Capital in Morocco III. THE COMMUNAL INFRASTRUCTURE FUND A. Legal Status and Ownership B. Objectives and Functions C. Management D. Policies E. Procedures F. Organization and Staff G. Management Information System H. Operations and Finances IV. THE PROJECT ANNEXES A. Project Objectives B. Project Scope C. Main Features of the Loan D. Benefits and Risks V. RECOMMENDATIONS.. 28 I. FEC - CDG's Organization Chart II. FEC - Projects Appraisal Criteria III. FEC - Policy Statement IV. FEC - Projections of Operations and Finances V. FEC - Terms of Reference for Advisor(s) VI. FEC - Project File This project was prepared by Samir El Daher and Frangois Ettori from the IDF Division of the EMENA Projects Department. This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.

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5 MOROCCO PILOT PROJECT FOR THE COMMUNAL INFRASnHUCTURE FUND - (FEC) STAFF APPRAISAL REPORT I. INTRODUCTION 1.01 Tlis report appraises ttie Pilot project for the Communal Infrastructure Fund (Fonds d'eguipement Communal) for a proposed Bank loan of $16 million. The FEC was established in 1959 as a public autonomous financial agency administratively managed by the Caisse de Dep8t et de Gestion (CDG). In addition to a small capital base, its resources, largely public, include mainly discounts from the CDG, rediscounts from the Central Bank, and limited local borrowings (bond issues) guaranteed by the Government. It provides financing to the local communes (LCs) and public utility authorities for a broad range of infrastructure projects in water supply and sewerage, electricity distribution and urban development, and productive facilities such as warehouses, markets, and slaughterhouses The Government of Morocco requested in early 1980, the Bank's assistance to strengthen FEC, and expand its role in regional development as a financier of communal investment throughout the country. Several Bank missions visited Morocco to review the Government's objectives and plans of action regarding its communal development strategy, as well as FEC and its proposed expanded role. The project was appraised in July In view of the multisectoral scope of the project, its novelty in Morocco, and the existing weaknesses in investment practices of many of the LCs and of FEC itself, the proposed Bank loan is designed on a pilot basis, focussing on the institution building of FEC through technical assistance to strengthen its internal organization including staff development, and improve its policies and quality of project financing, on the basis of rigorous operating procedures and criteria. If successful, this pilot operation could lead to an expanded role for FEC, including eventually full legal autonomy and financial independence, so that it can become a genuine financial institution for the development of the LCs, able to mobilize on their behalf new resources to meet their large investment requirements, and provide another source of finance in addition to the central Government budget The proposed loan includes a line of credit of $15 million to finance projects in the sectors eligible for FEC's assistance, and a technical assistance component of up to $0.96 million to strengthen FEC's procedures in project preparation, appraisal and follow-up. The capitalized front-end fee of $0.04 million is also financed under the loan amount. The line of credit would cover about 15% of the borrowing needs projected for FEC during The technical assistance component will finance advisory and consultancy services to assist FEC in the preparation and appraisal of specific projects, to provide training to FEC's staff, and to develop and implement new operating policies and procedures.

6 - 2 - II. SECTORAL CONTEXT A. Background 2.01 Since the beginning of this century, Morocco has undergone rapid economic transformations. Differences in natural factor endowments have been at the origin of a growing concentration of population and economic activity in the central, western and northwestern parts of the country. In the past, concentration of urban population took place in large agglomerations, mainly along the Atlantic coast of the country's northwest. By the end of 1980, Morocco's population was approximately 20 million, with about 8.8 million, or 44% living in urban areas, which ranks Morocco as one of Africa's most urbanized nations. Most of the urban population is concentrated in the six major cities of Casablanca with 3,000,000 inhabitants, Rabat-Sal4 with 800,000, Marrakech with 440,000, Fez with 460,000, Meknes with 335,000, and Tanger with 285,000. A new trend has recently emerged in which the growth rates of these large cities are lower than the overall growth rate of the country's urban population, as many mid-sized cities have experienced fast population increases in response to local factors such as the growth of production in modern agriculture, industry and administrative services Regional economic and social imbalances remain substantial. A study on regional development in Morocco showed that the urban areas accounted for about 80% of the growth in GDP between 1960 and 1971, while the northern regions generated three-quarters of the value added in industry and more than half the value added in services. Per capita GDP in Casablanca was 60% higher than the national average while in the east, south and southwest of the country, per capita GDP only represented 74%, 55% and 50%, respectively of the national average. The primary school enrollment rates are five times lower in the south than in the central region. Regional disparities can also be found in public services, such as health, where there are 10,000 inhabitants per doctor in the central and western regions in comparison to 20,000 in the other regions, and in infrastructure, where the density of highway networks in the central and northwestern regions is twice higher than the national average, while in the south it is only 38% of the national average. While most of the urban population has access to potable water, only 25% of the rural population are provided with this service. About one-half of the urban population has access to electricity compared to 6% of the rural population. There are indications that these disparities are growing. Since 1960, the per capita consumption expenditure of rural workers has been falling. The consumption of the poorest 10% of households accounted for only 1.2% of total consumption in 1970 as compared to 3.3% in The limited success of the industrial decentralization measures combined with the concentration of physical infrastructure in the central and northwest regions tend to perpetuate this trend. The Government has long recognized the growing regional disparities, and since the mid-seventies has embarked upon a program of regional development which includes further decentralization of the regional and local planning procedures, and a reform of the financing of communal development. This project is designed to contribute in part to this effort.

7 - 3- B. Local Administrative Setting 2.03 The Government has delineated the country into administrative units called "provinces", each province consisting of several local communes (LCs). a) Provinces are the overall key units of the local administrative structure. There are now 47 provinces. Responsibilities for the affairs of provinces are split between an elected Provincial Assembly and the Governor. The Provincial Assembly which includes elected officials and representatives of professional organizations is vested with extensive responsibilities. The province, however, has no financial resources of its own and is entirely funded through Government subsidies. The Province maintains a limited number of technical staff to assist in identifying and implementing projects at the provincial level as well as at the local commune level. The Governor is the Government's representative and reports to the Ministry of Interior (MOI). The Governor has extensive responsibilities, among which the coordination of regional delegations from the technical ministries, supervision of communes and of expenditures financed by the "Local Community Development Fund". Further, as a result of recent decentralization measures, the Governor has been assigned the added responsibility of executing projects on behalf of ministerial departments, in order to hasten the implementation of construction works and in this manner avoid lengthy administrative procedures. The MOI provides provinces with the personnel needed to man their technical departments. b) Communes are the basic local government units. Their role was further strengthened through the enactment of the "Communal Charter" in The existing 849 communes now include 763 rural communes, 40 autonomous centers, 45 urban communes called municipalities, and the Communaute Urbaine of Casablanca. The key responsibilities to manage communes are vested in the elected communal or municipal councils. The commune's administrative structure consists of a council, a chairman and local executive officials. The law bestows large decisionr-making powers upon -these councils, ranging from formulating the communes' social and economic development plans to approving the budget and establishing, organizing and operating local public services. The communes' operating modalities in managing local affairs and development are characterized by a strong dependence on the MOI which funds the communes' capital budgets, routinely subsidizes their operating deficits ancl approves all their borrowings. The communes' functional responsibilities include the provision of public services such as sewerage, garbage collection and street cleaning, and other typical urban facilities such as bus stations, slaughterhouses and markets. Utility services are generally delivered through specialized public municipal agencies (regies). The regies are defined by Moroccan law a-s i-inancially and administratively autonomous enterprises entrusted with the distribution of water and electricity within an identified urban perimeter. The principal criterion for the creation of a regie :Ls its ability to ensure proper

8 -4- technical services and maintain financial autonomy. Technically the regies are well organized with separate departments for power and water and a combined unit for administrative and accounting services. Financially, autonomy is defined as the capability of the regie to cover its operating costs from services (water and electricity sales) and finance a large part of its development program without budgetary transfers from the Government. There have been also regies for public urban transportation and for cold storage facilities. Since the creation of the first regie in Casablanca in 1962, the number of regies has increased to 20, all under the administrative control of the MOI Yet, the lack of resources and staff have hindered the development of communes, particularly in the rural communes and the smaller municipalities. The bulk of the communes' own resources stems from the urban and development taxes, which, however, only cover about 50% of the communes' operating expenditures. The gap between current income and expenditure of communes is financed by the central Government's budget, as is the investment budget of communes in most cases. Furthermore, the capacity of most LCs to identify, prepare, implement and supervise their own investment projects remains seriously limited. The communes are thus dependent upon the central Government (MOI and technical ministries) for technical assistance as they encounter difficulties in attracting and retaining qualified staff. Most investment works that are financed by communes are therefore prepared, and implemented by engineers from the technical units of the province, with the occasional help of consulting firms. The Government is striving to provide more administrative and financial autonomy to the communes, to further decentralize economic responsibilities, with more active participation from the LCs and reliance on their own initiatives for the preparation, financing and technical management of their investment programs. The implementation of such a policy will require specific measures to strengthen the local administrative, technical and financial structures. In this context, and according to the Government plans, some 400 engineers, 1200 technical agents, and 1400 administrative agents, would be available by 1985 to start filling the LCs' estimated needs. These plans however, even if achieved, would not be sufficient to fully meet these needs. For the more immediate term, use of private consulting firms will thus have to be increased. In addition, the MOI has begun to seek foreign experts through bilateral aid programs to fill existing vacancies and provide a source of training for local staff. Other mediumrterm measures planned by the government to enhance local development relate to (i) a fiscal reform, which is under preparation, to increase local financial resources, and (ii) the expansion of the lending operations of the Communal Infrastructure Fund (FEC) to the LCs. C. Regional and Local Planning Process 2.05 The Government's concern for regional planning dates back to the preparation of the Plan. Although many institutions have been set up to provide a framework for regional planning, the weight of the central Government in the planning process was still overriding. The Central Planning Department through the "National Commissions" identified the basic options

9 regarding regional development. At the same time, proposals for sector and regional development were defined at the provincial level through the "Regional Commissions". These proposals originated partly from the provinces and partly from the communes which, every third quarter of the fiscal year, sent to the province a list of investment projects known as the "Communes' Wishes". The "National Commissions" endeavored Lo reconcile the national options with the provincial proposals by eliminating as many projects as necessary to fit the budget defined by the Central Planning Department. Further cuts were made to fit the budget defined by the Central Planning Department with the fiscal year budget defined by the Ministry of Finance Although such project selection process generally followed the overall priorities set out at the macro level in the national Plan, it did not always cater to the particular needs and priorities of individual LCs. Thus, at the local level, some high priority projects have been left out of the list of investment projects to be financed in a given fiscal year, whereas unimportant projects have been kept on the list. To avoid such a situation, the Central Planning Department has designed a planning system with higher degree of local autonomy. First, the local communes establish a list of local investment priorities; the list will then be scrutinized and approved by the Provincial Assembly and the Governor. On the basis of this list and the framework of national and regional priorities, the budget limits are defined for each province and commune The main change from the previous planrling procedure is that the "National Commissions" leave to the local goverrments the definition of investment priorities at the local level. The reconciliation between regional and national options is done mainly through the definition of budget limits for each province and commune. Since this planling procedure has been newly introduced, and data from communes are still being processed, it is too early to assess the efficiency of this procedure. Wnile the increased participation of the communes in the planning process will enhiance the effectiveness of the plan, the new procedure will face several constraints. First, the detailed operating arrangements to implement these procedlures remain to be worked out and applied by the local authorities; second, the local communes lack planning experience; and third, the success of this procedure is very dependent upon the allocation of funds which, at present, is still being decided at the central level. Within this planning framework, there are several sources of communal project financing which are described in the following section. D. Communal Development Financing 2.08 The LCs have large infrastructural investment requirements. In effect, based on a 1979 survey of LCs' demands, the projections of MOI for the 5-year Plan show an investment envelope for all LCs of DH 12,620 million ($2,019 million) increasing from DH 1,943 million ($311 million) in 1981 to DH 3,400 million ($544 million) in These investment projections, however, exceed the existing absorptive capacity of the LCs, particularly the shortage of local administrative and technical staff, and were subsequently revised downwards by the MOI to be translated into less ambitious investment programs. These investment requirements would be financed under one of the

10 - 6 - three following sources: i) the LC's own resources; ii) budgetary allocations through the Local Community Development Fund (FDCL) and Special Regional Development Fund (FSDR); and iii) the Communal Infrastructure Fund (FEC). The share of each of these types of funds in the financing plan of the LCs' annual investment program is proposed each fiscal year by the LC and the province at the time of the budget preparation, for approval by the MOI. After budget approval on a global basis, the LCs select projects suitable for each type of financing. There is one criterion to observe: FEC's resources are exclusively reserved to finance projects with a cost-recovery, revenue-generating element for which allocations under other sources of grant financing have not been made by the Provinces and the LCs, and after the LCs have committed all their own resources and budgetary allocations. To finance operating expenditures, the LCs depend on permanent budget resources which flow from revenues either collected by the LCs at the local level or by the Central Government for subsequent channelling to the LCs. Around 70% of these resources are from property taxes collected by the LCs or the Central Government. The remaining share is mostly generated from local excise taxes. Capital expenditures are financed primarily by Central Government grants from the FDCL and by loans from the "Communal Infrastructure Fund (FEC)". The size and stability of the permanent resources greatly affect the development of the LCs, as they are essential for the operation of their basic services, and as they also determine the LC's borrowing capacity to fund their capital investments, since the debt service must be met through operating budgets. At present, the permanent resources are still limited, and the Government is working towards a fiscal reform which would ensure a more stable collection and redistribution of resources. The main sources of finance for LCs are briefly described below: i) Local Communes' own resources: This item refers to the LC's self financing capacity. It includes the local property tax (taxe urbaine) and the urban vacant land tax levied by the LCs, as well as the LC's income from ongoing revenue-generating projects. These resources are used to finance a share (about 50%) of the LCs' operating expenditures. ii) Budgetary allocations; In the Moroccan fiscal system, budgetary allocations - made to LC's on per capita basis and on grounds of specific economic and geographic situations - are essentially local revenues which are collected by the Central Government on behalf of the LCs and redistributed back to them. This is the case of the "taxe d'edilite", a property tax based on rental income, and of the levy on products and services, They are not thus considered as subsidies to compensate for shortfalls in the LC's income, although an element of subsidy (revenue sharing) may be implied. Before 1976, these budget funds were allocated to various ministries, to finance regional or local development projects falling directly within their responsibilities. In 1976, however, the Local Community Development Fund (FDCL) was created to be the sole recipient of all these budgetary funds. This Fund, operated by MOI, has received an initial contribution of DH 1,000 million ($160 million), of which DH 400 million ($64 million) for 1979 and DH 600 million ($96 million) for The Government has entrusted the provinces with the local distribution of these funds, strengthening in this process the planning and

11 - 7 - financial role of the provinces. Projecltions for this fund through 1985 are as follows: DH 600 million ($96 million) in each of 1982 and 1983, and DH 650 million ($104 million) in each of 1984 and In addition, the Special Regional Development Fund (FSDR) established in 1973 to finance special programs in the most disadvantaged provinces, had an inital appropriation of DH 300 million ($48 million), later raised to DH 2.7 billion ($432 million). Most of the FSDR funds went to finance small-scale infrastructure, in the fields of education, health, rural electrification, feeder roads, water supply and sewerage. The FSDR is no longer active as it has been overshadowed by the FDCL. iii) The Communal Infrastructure Fund: The Fonds d'equipement Communal (FEC) was created in 1959 as an autonomous agency to extend loans to individual, and groups of, local communes, and municipal public utility authorities. Recently, with the objectives of alleviating the reliance on national budgetary allocations in certain types of local development financing, the Government ha.s decided to expand the role of FEC as financier of the communes. FEC's financing share of the total LCs' 5-year investment envelope is projected by the MOI to increase from DH 280 million ($45 million) in 1981 to DH 800 million ($128 million) in These annual levels of investment appear very ambitious when measured against FEC's processing capacity, and have been revised downwards in the Bank's projections (para 3.33). It is projected that over the Plan period , about 65% of LCs' investment requirements would be financed by the FDCL and FSDR, 20% by FEC and 15% by the LCs' own resources and regies' internal cash generation. E. Service Delivery Systems 2.09 The service delivery systems and the institutional setting relating to water supply, sewerage and electricity, the main sectors of FEC's infrastructure operations, are described below a. Water Supply: Water is scarce in Morocco with 6% of the exploited resources being used for domestic and industrial purposes, and 94% for agriculture. Production and distribution of potable water are assured by different agencies depending on whether the demand is in urban, semi-rural or rural areas. The most prominent is the Office National de l'eau Potable (ONEP), established in 1972 as an autonomous public enterprise in charge of development, production and transmission of water to the urban centers. It is managed along priniciples of commercial undertakings, and has built up managerial skills and a well-experienced staff in the technical fields to adequately run its operations. It has also initiated development of water services including distribution in those smaller towns where financially selfsufficient regies could not yet be created. ONEP has so far received 3 Bank loans. Furthermore, the second and third water supply projects (loans 1724 and 2006 MOR) contain a program of house connections where the local counterpart funds are made available by FEC. FEC is thus providing in the sector,

12 - 8 - DH 35 million and DH 68 million respectively under the second and third projects. These two house connection programs, which would allow financing of approximately 150,000 house connections, are now in operation. They cover the low income population in medium and large cities of Morocco and have the support of the local authorities The r 6 gies assure water distribution in about 30 urban agglomerations that comprise more than 75% of the urban and semi-rural population. Water distribution for the remaining urban population is generally assured by ONEP and occasionally by a municipal water service. In the administratively chartered semi-rural centers, with about 1.5 million inhabitants (1980), water services are operated by ONEP, while, in the unchartered rural centers with a population of about 11 million, operation and maintenance of the water systems are assured by the communes which can call upon the technical services at the provincial level for assistance. This arrangement, though adequately conceived, still needs strengthening to ensure that these rural systems are properly designed and operated b. Sewerage% Sewerage exists in all of the mediumrsized and large cities. As the systems have not been extended to keep up with the rapid growtll of population and industry, they are presently insufficient. In the coastal communities, most of the collection systems discharge at the shoreline, causing contamination of coastal waters and beach pollution. Sewerage collection and disposal is presently assured by municipal services. A special commission within the MOI is in charge of supervising studies for the construction and operation of sewerage, including sewage treatment. Studies for a number of urban areas are presently under preparation. In the past, operation and maintenance have been unsatisfactory due to a lack of adequate institutions and a shortage of trained staff. Furthernore, a clear cost-recovery policy is not yet formalized in the sewerage sector. The Government is now taking measures to ensure that future sewerage operations will be entrusted to the regies, presently only in charge of water and electricity distribution, while the question of cost-recovery is also under study. These issues are being addressed under the first Bank proposed sewerage project in Morocco, now in preparation c. Rural Electrification% Increasing the rural population's access to electricity has been an important objective of the Government's rural development plans. Since 1950, the rural electrification program connected over 460 centers to the public grid and installed small generators and rudimentary distribution networks in remote centers. Progress of the program has been slow, because of its total dependence on the availability of public funds. The weaknesses have however been improved as a result of the reorganization of the flow of funds to the program and the strengthening of the staffing and planning capabilities of the implementing agency, the Office National d'electricite (ONE) (para 2.14) and of the MOI. In the phase spanning over the period , the village electrification program would extend electric service to about 220 village Centers with about 350,000 potential beneficiaries. These are financed by the MOI from its budget for municipal equipment, and by FEC. Daily operation is ensured by local authorities while maintenance is entrusted to ONE. ONE has also been the recipient of Bank loans.

13 While the Ministry of Energy and Mines has broad power for the overall development planning of the Energy Sector, tnd has administrative control over ONE, responsible for most of the electricity generated in Morocco, the MOI supervises the overall performance of the r6gies responsible for the distribution of electricity in the large urban areas. The MOI participates in formulating the plans for the development of in rastructural facilities including village electrification in the rural areas, and heads the commission for rural electrification composed of representatives from the Ministries of Energy, Agriculture, Finance, Housing and Plann:ing and ONE. The commission has been responsible for defining the Governmentl's yearly programs for village electrification, the implementation of which was entrusted to ONE. ONE's overall performance has been satisfactory and its technical standards for construction and operations are good. It has regional offices responsible for the operation and maintenance of the distribution network including rural distribution. F. Bank Role and Sector Lending Strategy 2.15 The Bank's lending strategy in the basic infrastructure and urban development sectors aims essentially at supporting the Government's objectives of improving the efficiency of existing investments, extending services to rural and low-income urban groups and promoting more balanced regional development through more equitable distribution of public services and facilities. The Bank is already involved in providing financial and technical assistance for the development of local infrastructure and social services in Morocco through urban development projects in Rabat (FY 1978) and Meknes-Kenitra (FY 1981); a rural electrification project (FY 1979) to help bring power to over a hundred small towns and villages; water supply projects (FY79, FY81) to provide access to safe water in small towns and semi-rural areas; highway projects to support the Government's road maintenance efforts and to improve rural access roads (FY80 and FY83); and a housing finance project for lowincome housing through the CIH (FY83). In addition, a project to upgrade the sewerage system in Casablanca is under appraisal. The proposed FEC project would widen the distribution of infrastructure and services and, above all, strengthen the capacity of local communes to prepare and implement their own development programs. This will be the first multisectoral project dealing simultaneously with financial and technical assistance to LCs. G. Cost of Capital in Morocco 2.16 The Government determines interest rate ceilings for financial institutions on both deposits and loans. Following an interest rate increase in October 1980, the rates were again revised upward in April 1982 in consultation with the IMF. The latest revision led, on average, to an interest rate increase of one percent on term deposits, while lending rates were raised by 2% to reflect the higher costs of borrowing by financial institutions as well as higher inflation. The recent restructuring is expected to further the trend of increase in term deposits which grew by 26% in 1980 and Rates on local currency deposits with commercial banks vary widely depending on maturities. Thus, sight aeposits yield no interest, except for workers' remittances (3% p.a.) and insurance company funds (4% p.a.), while time

14 deposits yield from 4.5% p.a. for one-month deposits, to 10.5% for eighteenmonth deposits with no official ceiling for deposits maturing beyond eighteen months. The cost of Central Bank rediscount facilities ranges from 4% in the case of commercial paper for agriculture, to 5% for medium-term paper, with a 7/. basic rediscount rate. Local currency bonds, which can only be issued by specialized financial institutions (CIH, BNDE, FEC, CNCA) and large public enterprises, carry interest of up to p.a. External borrowings by specialized institutions must be approved by the Government which usually assumes the attached foreign exchange risk. With regard to lending rates, the maximum rates charged by commercial banks on rediscountable loans were increased in April 1982 from 9% to 10% p.a. for short-term loans, and from 10% to 11% for medium-term loans, while long-term loans (BNDE and CIi) now carry nominal rates from 14% to 15% p.a. However, taking into account the interest subsidies provided by the various investment codes (Industry, Tourism, etc.) and the indirect taxes charged on interest payments, the effective cost of borrowing for industrial customers falls to 11% in the case of rediscountable medium-term loans from commercial banks, and to 14% for BNDE loans Inflation, as measured by the cost-of-living index, remained below 10% during the period Inflationary pressures, however, developed in 1981 when inflation rate exceeded 13.2%, and is estimated at 13% for 1982, 11% in 1983 and 9% in Thus, with the exception of 1981, interest rates have been positive in real terms over the past five years and, in light of the lending rate increases of April 1982, are expected to remain positive as of III. THE COMMUNAL INFRASTRUCTURE FUND A. Legal Status and Ownership 3.01 The Communal Infrastructure Fund (FEC) is a public institution with legal status and financial autonomy, established by Law No of June 13, 1959, as amended by Decree No of March 2, Its administrative and financial management is entrusted to the Caisse de D4pat et de Gestion (CDG). FEC was initially managed as a division of CDG and, since 1980, as a department. As such, FEC has no proven track record of its own, and its image and creditworthiness are strongly linked to CDG's. With an equity capital, including retained earnings, of DH 65 million ($10.4 million) at the end of 1981, its resources so far include discounts from the CDG and rediscounts from the Central Bank of Morocco, as well as Government grants and local borrowings (bonds) guaranteed by the Government. It enjoys, however, autonomous financial status, as its accounts are separate from those of CDG, and can borrow with Government guarantee The CDG was established in 1959 as an autonomous public institution with the objective of managing various public funds and deposits received as administrative and judiciary consignments, or as collateral payments for guarantees. It also administers, in addition to the FEC, the National Insurance and Retirement Fund. CDG's resources include deposits from the National Savings Fund, the Pension Fund, various mutualist societies, and agricultural and handicraft cooperatives. The interest rates it pays on deposits are fixed

15 - 11 by the Government. CDG's operations cover various sectors and activities, including housing, tourism, industry, transportation, insurance, and communal development for which it extends financing mainly in the form of equity and bond subscriptions. Its total assets amounted to DH 3,510 million ($562 million) in 1980, and DH 3,946 million ($631 million) in CDG is headed by a General Director who is appointed by dahir, and holds broad executive powers. A "Supervisory Commission" is also set up under the provisions of the law, mainly to exercise financial control over CDG's operations and administrative expenditures. It is consulted by the General Director on general policy matters. The "Commission" consists of two members of Morocco's Supreme Court, the Ministers of Economy and Finance, and the Governor of the Central Bank. CDG has also a General Secretary who mainly follows on administrative matters, and a General Cashier who oversees financial affairs. They are both appointed by decrees. CDG is a well managed and profitable institution with well trained staff. CDG's organization chart is given in Annex I. Documents on CDG's organization, operations and finances are available in the Project File. B. Objectives and Functions 3.03 In support of the Government's policy oe regional development, the principal objective of FEC is to assist the LCs in their efforts to fulfill their basic infrastructural needs by channelling resources for their development projects. Thus, it provides loans for the financing of infrastructure works and productive facilities, to the prefectures and provinces, the urban and rural communes as well as to their associatidns (syndicats) and public utility authorities (regies). FEC may also channel to these entities, funds it manages on behalf of the Government. As an arm of Government and financier of the LCs, FEC's activities fall within the framework of national, regional and sectoral priorities established by the Government. In the past, most of FEC's lending benefitted the wealthiest regions and the large cities. Recently, with the objective of reaching further down the provincial level and of slowly reducing the role of national budgetary allocations in certain types of local development projects, the Government has decided to expand the role of FEC as financier of the local communes with a special focus on less developed ones. C. Management 3.04 FEC is managed by CDG, and in practice FEC's chief executive is the General Director of the CDG. He holds substantial control over the policy and operations of FEC and is involved, through loan approvals, in FEC's daily management. Furthermore, as head of CDG - the main supplier of resources to FEC - he practically retains overall control on FEC's financial policy. In addition, the administrative tasks for FEC (recruitment, payroll, staff regulations, benefits, etc.) fall within the responsibilities of CDG The Director responsible for FEC - a department director in the CDG - reports to the General Director through CDG's Secretary General. He has, however, responsibility for internal processing of work, namely the organization of work teams, study of financing requests, follow-up on loan

16 disoursements and repayments, and preparation of budget. The Director of the FEC Unit is knowledgeable in administrative, public finance and local commune matters. Throughout the long period of preparation of the Bank loan, he has been closely involved in the project design, had a valuable exposure to Bank's operating methods, and become a strong advocate of their application by FEC. Moreover, in the context of the Bank project, the management of FEC will be strengthened by availing, for 2 years, the services of one or more advisors (para 4.06) who - though mainly concerned with project analysis and staff training - would also assist FEC in streamlining internal procedures, and developing a management information system. The appointment of the technical advisor(s) responsible for project appraisal and supervision, with terms of reference, qualifications and experience acceptable to the Bank is a condition of Loan effectiveness. D. Policies 3.06 At present, FEC lacks formalized policies and operating procedures, which limits its potential impact on the quality of the LCs' projects. FEC's annual project pipeline is selected from a list of projects which had been proposed by the communes, and approved by the MOI for possible FEC financing (para 2.08). Thus, it lends to projects in two categories: i) projects, the cost of which may be directly and fully recovered from their operating revenues, such as markets, storage facilities, refrigerated warehouses, slaughterhouses, bus terminals, and r6gies' projects in electricity and water distribution; and ii) projects, the cost of which may be recovered either indirectly or partially because of their social/collective nature, through users' charges or taxes; these are projects related to rural water supply and distribution, rural electrification, public transportation, sewerage, streets, etc., under the responsibility of the local governments or autonomous public utility authorities A Statement of Policy was drafted in consultation with the Bank, spelling out FEC's operational and lending policies, providing the list of projects eligible for FEC's assistance and referring to the specific appraisal criteria (Annex II) prepared by the relevant Projects Divisions in the Bank applicable to FEC assisted projects in each sector. The Statement of Policy (Annex III) was approved by CDG and the Government on March 16, With regard to FEC's operating and project financing criteria, the Policy Statement provides that FEC's activities fall within the framework of national, regional and sectoral plans and priorities established by the Government. Projects would be financed on the basis of their social merit, economic priority, financial viability and technical performance, according to criteria adopted in each sector and agreed with the Bank. FEC would also provide, to the extent possible, technical assistance to its borrowers in the preparation and execution of their projects, and ensure during project implementation that funds are used in accordance with the objectives and conditions agreed to in the respective loans. Furthermore, in line with the Government's plans to intensify assistance to the less endowed rural communes, FEC would assign priority to smaller projects (requiring loans of less than DH 6.5 million (Ol million)).

17 With regard to its operational policy, EEC would continue to extend financial aid to the LCs in the form of medium and long-term loans, with maturities determined in accordance with the requireraents of the projects. The borrower's financial capacity may also be taken into account. The maturities, however, would not exceed 15 years, including grace periods of up to 3 years. FEC may also manage on behalf of the Government, funds earmarked to the LCs for specific development projects Finally, FEC's financial policy aims at developing its borrowing capacity to meet the LC's needs, consolidating ils financial base, increasing its reserves and setting up adequate provisions on its unsecured (regies') portfolio. Thus the interest rates on FEC's loans would be function of the cost of its borrowed resources, with an adequate spread (about 3%) ensuring FEC's financial viability. In addition, FEC would charge a commitment fee of up to 1% p.a. on the undisbursed portion of its commitments. E. Procedures 3.11 FEC has yet to formulate operating principles for project financing, on the basis of rigorous preparation, appraisal and supervision standards and criteria. Decisions on lending had so far been mnade on the basis of informally established operating principles and cursory appraisals of the projects' technical and financial feasibility. Project preparation and implementation are essentially carried out by the local governments and the personnel of the technical ministries seconded to the provinces. Little supervision has been done so far by FEC to follow-up on its assisted projects. The content and quality of FEC's appraisals in all sectors could, in general, despite a noticeable recent effort, be substantially improved. The reports often lack demand analysis and justifications for size and capacity. The financial analysis is generally incomplete and suffers from the absence of reliable estimates of revenues and operating costs A main focus of the proposed loan is to assist FEC in setting up coherent operating procedures, particularly with. respect to project financing, where the modalities of FEC's interventions, from receipt of financing requests to project approvals and supervision, should be formalized. These tasks have already been initiated during the preparation of the proposed loan. The agreed procedures would be completed and incorporated in an operational manual, to be prepared with the assistance of an advisor (para 4.06), detailing all the steps of project cycle. More specifically, the strengthening of FEC's procedures with respect to project financing relates to project preparation, appraisal and supervision Project Preparation: The assistance of FEC to LCs in project preparation should be stepped up. Given however FEC's limited staffing and experience, its activity in this respect, during the implementation period of the Bank's project, should mainly revolve around the intervention of technical consultants (firms or individuals) who would review and complete feasibility studies for projects in various sectors. With respect to planning and project selection, FEC, as an arm of Government for local development finance, is cognizant of the planning mechanism and rationale for project selection at the

18 regional and local levels though it has formally no role therein. Nonetheless, in the course of project appraisal, FEC satisfies itself that its financing is being extended to high priority projects, consistent with the national, regional and sectoral development plans. In particular, consistency with existing sectoral master plans established by the relevant public agencies in each of the water supply, sewerage, electricity, and transportation sectors, is a salient concern under FEC's appraisals (para 3.14). A request for project financing by a commune may thus be rejected when justification is dubious as to the project priority among the investment options open to the commune. Moreover, the mechanism through which FEC would ensure that its assisted projects respond to regional and local priorities, would be further developed as FEC strengthens its institutional capabilities, expands its role in the provision of technical assistance to the LCs, increases the number and volume of its operations and deepens its knowledge of the LCs' conditions and requirements Project Appraisal; To guide its future lending activities, FEC has formulated with Bank's assistance a set of eligibility and appraisal criteria with detailed guidelines and procedures applicable to water supply, sewerage, electricity, road, urban transportation, urban development and productive projects (Annex II). Particular emphasis has been given to the appropriateness of the project's design and standards, its cost-recovery capacity, its financial viability and, where relevant, its justification vis-a-vis the financial position of the borrowing LC. Satisfactory arrangements by the borrowers for project implementation and subsequent operation and maintenance will also be part of the issues addressed by FEC in its appraisals. The highlights of FEC's appraisals in the sectors of its activities are given below a. Water Distribution: The feasibility study required by FEC would include the description of the project area, its main economic activities, and the existing water system including, resources, quality of service, and population connected. The study would provide cost estimates for the various components of land, civil works, equipment and assembly, broken down into foreign exchange and local currency costs, taxes and fees. In addition a master plan (for projects costing over DH 5 million) would be required ensuring sufficient water production for the next twenty years and providing the successive stages of execution and costs estimates in comparison to technical alternatives. It would also include projections of water supply and demand based on data of total population, population connected, daily consumption of household and industrial users, and system losses. The financial analysis would cover (i) the projections, on an incremental basis, of capital and operating costs divided into manpower, energy, materials, overheads and financial expenses, and revenues from water sales and connection fees; (ii) the calculation of the marginal cost of water relative to the project and the discounted project cost per additional consumer; and (iii) an estimate of the project's internal rate of return, for which a minimum, depending on project size, is required. FEC's appraisal would demonstrate that the eligibility and approval criteria, including ceiling on unit costs and required rates of return, have been met, that the alternative selected is the lowest-cost solution, and that the project will be technically efficient and financially viable.

19 b. Electricity: The feasibility study required by FEC would include the description of the project area, its main economic activities and the existing distribution system including substations capacity, service quality and population connected. The study would include relevant technical data (loads, and critical periods) on the network and project cost estimates broken down into local and foreign currency costs, and taxes for the various components of land, civil engineering, supplies, metering and other equipment, and installation. In addition, FEC would require a master plan for the next 10 to 15 years (for projects costing over DR 5 million), referring to ONE's electricity supply forecasts, with the successive phases of execution, cost estimates per annum, and projected electricity supply and demand in the area of influence. Projections of demand and sales would. be based on data of total population and population connected, daily consumlption of residential and industrial users, and losses of power and energy in the network. The financial analysis would cover (i) the projections of capital and operating costs divided into manpower, energy, equipment, spare parts, materials, administrative and financial expenses, and the revenues from sales of electricity and connection fees; (ii) the calculation of the marginal cost of electricity under the project, and of the discounted project cost per additional consumer; and (iii) the calculation of the project's internal rate of return. FEC's appraisal would demonstrate that the eligibility and approval criteria have been met, that the alternative selected is the lowest-cost solution, and that the project will be technically efficient and financially viable c. Productive Facilities: The feasibility study required by FEC would include a description of the project area, its main economic activities, and comparable existing facilities, including capacity and service level. In addition it would include a demand analysis over a period depending on the type of project, and based upon data of projected consumption and population served. The technical study would provide an execution schedule for civil works, including supply and assembly of project'rs facilities and the technical specifications of the equipment, the identification of the operating unit and qualifications required for the project construction and operation. The project cost estimates would be broken down into land, site preparation, civil works and equipment. The financial analysis of the project will include the estimated capital and operating costs and project revenues as well as the calculation of the financial rate of return (for projects costing more than DR 2.5 million) FEC's appraisal of the project would address the project's objectives within the framework of communal development, and ascertain the soundness of the project proposal and its impact on the commune's financial situation, with estimates of direct and indirect effects on the commune's operating budget d. Urban Transportation; These projects relate to the purchase by the regies of buses, service vehicles and equipment for maintenance as well as to the construction and expansion of workshops, maintenance buildings and bus shelters. The studies required by FEC for its appraisal would include preliminary engineering designs and detailed cost estimates for buildings. The appraisal would show the impact of the project on the regie's financial situation and the improvement in the regie's cash flow over an appropriate period of time. It would also demonstrate that the organization, management and personnel of the regie would allow the satisfactory implementation of the project.

20 e. Urban Development: These projects mainly relate to sites and services projects for the communes to develop housing plots for commune employees who own no dwelling. The technical study would include preliminary engineering designs of infrastructure networks with costs estimates, and address the availability of land and beneficiaries, and the analysis of housing supply in the commune. The financial analysis including financing plan, projections of capital costs and receipts from sale or lease, and project cash flow would show that the principle of cost-recovery will be observed and that the project expenditures will not impose constraints on the commune's finances as to jeopardize other priority investments or the sound operation of other communal projects. FEC 's appraisal would ensure that the agreed eligibility criteria are met, particularly with regard to ceilings on investment and unit costs of serviced land f. Sewerage: FEC's appraisal of the project will, on the basis of an appropriate feasibility study, cover (i) the physical and economic characteristics of the project area, the population recorded and the forecast of future population; (ii) the arrangements to be concluded concerning project execution and supervision, and operation and maintenance of the system; (iii) the sewerage charges, connection fees and other related revenues; (iv) the existing sewerage facilities, quality of service, estimates of per capita and total water consumptions, and number of connections for various types of usage (domestic, industrial, commercial, public and tourism); and (v) the forecast of future water consumption and the number of water and sewerage connections over a 10-year period. The appraisal will also discuss the feasible alternatives for sewerage networks and ways of improving and expanding the existing system. It will provide the calculation of the estimated costs of the selected alternatives, their economic comparison and the justification of the proposed least cost solution with a detailed cost estimate and program of the investments. The project's financial analysis will include a forecast of income statements, cash flow statements and balance sheets. The calculation of the marginal cost of sewerage for the project will also be provided. The eligibility criteria would relate to the marginal cost of sewerage for the center under consideration expressed as a cost per cubic meter of consumed water Project Supervision% FEC would follow-up on all its assisted projects during the execution stage in order to monitor the effectiveness of its financial assistance to the LCs, and provide them with further advice as necessary and feasible. During negotiations, FEC's supervision procedures were reviewed and agreement was reached concerning the coordination of this activity by FEC and MOI. The agreement was recorded in a Supplemental Letter to the Loan Agreement Loan Approvals and Disbursements. Loan approvals are decided by the General Director of CDG upon recommendation by a "Technical Committee" which includes two ex-officio members from the Ministry of Interior and two from the Ministry of Finance. Commitments of FEC's loans are also decided by the General Director of the CDG, who can also decide of subsequent amendments to

21 the initial objectives of these loans. FEC's loans, which norinally cover 100% of projects cost, are disbursed in four equal portions, the first one as advanced payment upon start of works, and the sut,sequent three only upon receipt of all certified evidences of expenditures incurred under the previous portion. This system is satisfactory Procurement% Procurement under FEC assisted projects is carried out along the 1976 Government unified regulations for public sector's tendering for goods and services. These regulations providle for procurement of works and equipment through bidding and awarding procedures ensuring efficient allocation of public funds. They are broadly in line with the general practices observed under World Bank operations, as they mainly consist of open or limited competitive bidding (with pre-qualifications); calls for tender are advertised two weeks in advance in the official gazette, offers are evaluated and contracts are awarded under the control and with the approval of various concerned Government departments, including - for contracts over DH 200,000 ($32,000) - the Ministry of Finance. The regulations provide also for direct orders, however in limited and well specified instances, which besides the case of proprietary procurement, standardization or extension of contracts, generally fall beyond the scope of FEC's operations. These regulations are satisfactory to the Bank, and throughout its association with local government projects, FEC has developed experience in checking invoices and cost estimates as well as in monitoring the compliance of expendiitures on account of its assisted projects with Government regulations. The appraisal reports of Bank sub-projects would make it explicit that procuremnent procedures have duly been reviewed by, and are satisfactory to, FEC. Procurement under Bank subprojects would be a particular focus of sub-project reviews as well as of Bank supervision missions. International Competitive Bidding (ICB) under Bank subprojects would not be warranted given the typical small or moderate size of contracts, as average project total cost is below 31 million equivalent, and no individual contract is likely to exceed $1.5 million equivalent. F. Organization and Staff 3.24 The FEC management unit, initially a small division of CDG, became a department in The staff report to the Director of FEC to whom internal management powers are delegated by the General Director of CDG. The FEC unit is broadly organized along two main functional lines. One unit is concerned with project financing and one unit is handling the accounting tasks. However, the distribution of functions between the two units needs further streamlining. With proper staffing - and once the projects appraisal and follow-up functions are more clearly separated from FEC's overall financial management and accounting tasks - such a simple organization would be adequate to meet FEC's needs at this stage. A small Statistics and Research Unit may also be set up, as suggested by the Bank, to update information on, and monitor activities of, the borrowing communes. FEC's administrative tasks would still fall within the responsibilities of CDG. An agreement was reached during negotiations that a staffing and reorganization plan for FEC would be submitted to the Bank by October 31, 1983 and implemented thereafter.

22 The FEC management unit has no sufficient personnel, in number or experience, to carry out its functions effectively. In June 1981, its staff totalled 20, including 12 professionals. Its future staffing requirements were estimated in light of the expected volume of operations and the required standards for project processing. Budget allocations have been made to increase the existing total staff to 25 in 1982 and 35 in The bulk of the recruitment, started in 1982 and expected to be completed in 1983, would mainly strengthen the projects unit. During 1983 the accounting and clerical staff would also be strengthened. The recruitment objectives of the FEC management unit, including the employment during 1983 of five additional economist/financial analysts, two engineers and three technical aides, were confirmed at negotiations, and reflected in the Loan documents. Thus, with four appraisal teams, each including a half-time engineer, one technical aide and one economist/financial analyst - assumed to be trained by end CDG's FEC management unit manpower needs should be adequately covered to process in 1983 (excluding any project preparation work) an estimated number of 60 projects, the average size of which would be around DH 3 to 3.5 million ($0.5 to 0.6 million). The two remaining technical aides, with the assistance of two accountants, would handle the supervision activities on the basis of two visits per project and per year, thus covering the estimated 120 projects under construction in FEC's portfolio (assuming a disbursement period of two years per project) The training requirements for the FEC unit's staff have also to be addressed, as an intense effort would be required to familiarize the staff with the new procedures of project appraisal and follow-up. A first step could be to call on the Banque Nationale de Developpement Economique (BNDE) to provide technical advice and training to FEC unit's project officers. Training, with EDI's help, would also be considered after reviewing the recruits backgrounds. Furthermore, the advisor(s) and technical consultants whose utilization is foreseen under the project to define and implement the new policies and operating procedures, would also be responsible for providing formal and on-the-job training to FEC unit's staff in project preparation and appraisal. It was agreed during negotiations that a program of training for FEC unit's staff, will be submitted to the Bank by January 1, 1984, for its approval The FEC unit's staff are subject to the uniform salary scale of CDG which, including various benefits (housing, retirement, etc...), provides an acceptable remuneration package, reasonably in line with that of the other development banking institutions in Morocco. The aggregate salaries and benefits remain, though, well below those of the private sector. G. Management Information System 3.28 The small size of the staff has allowed FEC's management to follow up on and monitor operations without recourse yet to a formal management information system. The staff have direct access to the Director, with whom they work closely. Written reports and statements currently prepared by FEC are limited to notes presenting projects to the "Technical Committee", and annual

23 financial statements. Limited forecasting of operations and finances was so far done, but FEC has agreed with the Bank to prepare hence, on regular basis, five-year projections of its operations and finances as initiated in conjunction with the Bank project. In addition, the advisor(s) whose recruitment is foreseen under the project (para 4.06), would assist FEC in setting up internal monitoring procedures and developing a management information system. H. Operations and Finances 3.29 Past operations: The growth rate of FEC's operations has been impressive during the past years. Between 1977 and 1980, FEC's loan approvals grew at an average annual rate of 70% increasing froma DH 35.4 million ($5.5 million) for 7 projects in 1977, to DH 171 million ($27.5 million) for 37 projects in Total approvals fell in 1981 to DH 103 million ($16.5 million) for 47 projects, with the decline in the level of operations mainly attributable to a temporary shift in the order of Government priorities towards the agriculture and food sectors as a result of the severe droughts in Morocco. Loan approvals increased again to DH 160 million ($25.7 million) in The percentage of FEC financing directed to the rdgies averaged 48% during the period , declining from 57% in 1977 to 50% in 1980 and 28% in 1981, a trend resulting from the new Government policy of gradually increasing the investment share of the less endowed small and rural communes. The sectoral distribution of FEC's financing does not show a clear pattern which could be traced year-by-year. However, the sectoral breakdown of FEC's financing over the period , was as follows: (i) in the case of the local communes: 48% of the financing went for sewerage, 30% for productive facilities, 20% for various infrastructure works and 2% for water supply; and (ii) in the case of the r6gies: 51% for water supply, 23% for electricity and 26% for transport. Detailec. information on the regional distribution of FEC's activities is available irt the Project File Financial position: By the end of 1981, FEC's total assets amounted to DH 523 million ($83.7 million) including a loan portfolio of DH 503 million ($80.5 million). Current assets - excluding the current portion of the loan portfolio - amounted to DH 18 million ($2.9 million). These assets have been mainly funded by CDG's discount and Central Bank's rediscount notes (DH 392 million) ($62.7 million),, other advances from CI)G (DR 23 million) ($3.7 million), and a long-term loan (DH 43 million) ($6.9 million), corresponding to a local bond issue guaranteed by the Government. The balance of FEC's resources has been made up of DH 65 million ($1t0.4 million) in equity and retained earnings. Provisional accounts for the end of 1982 indicate a small decrease in total assets to DR 511 million, due to the temporary decline of FEC's operations in The financial structure of FEC's balance sheet remained practically unchanged in 1982, with equity including retained earnings, increasing to DH 69 million. The comparison of the maturities of FEC's resources and uses clearly shows an imbalance in FEC's financial structure with a long-term loan portfolio mainly funded by short-term discount notes. FEC is also undercapitalized, with a debt-equity ratio of about 7, which is excessive for an institution with no proven track record. Such an imbalanced financial structure is, however, acceptable as long as FEC's

24 financial liability and creditworthiness is an integral part of CDG. The financial structure of FEC at this stage is therefore not an issue relevant to the successful implementation of this pilot project. Under the present conditions, it would be difficult to give full financial independence to FEC, and given CDG's sound financial management and situation, there is no need to press under this pilot project for full financial independence for FEC. However, recognizing that FEC's financial structure is weak, the loan would be made to the Government (para 4.07) With a current lending rate of 8.5%, FEC has been able to generate moderate annual surpluses, given the low overall cost (5.8%) of its borrowed resources. It has so far no provisions for risk on its portfolio as the LCs' borrowings are Government guaranteed. The regies - which account for about 50% of FEC's portfolio - do not benefit from a similar guarantee, but their deficits are in principle covered by budgetary allocations. The financial quality of FEC's portfolio is good with only one loan, to the regie of transport of Rabat, in arrears of payment of DH 7 million ($1.1 million). FEC has suspended all future loans to this regie until settlement of the amounts due. Under the financial projections of FEC, provisions for risk are made gradually as of 1984 on the unsecured (regies) part of the portfolio Auditing: FEC's accounts were audited for the first time in 1980 upon the Bank's request. The auditing firn was selected with the Bank's approval, and is satisfactory. The audit of the 1981 accounts has yet to be prepared. During negotiations, agreement was obtained on the scope of the audit and the preparation of an audit report to be sent to the Bank within 6 months of the end of FEC's fiscal year Forecasts of operations: In view of the expanded functions with which FEC will be entrusted, the growth of its business volume, as projected by the MOI (para 2.08) for the 5-year plan period ( ), is ambitious and will be difficult to achieve particularly when taking into account FEC's and the LCs' technical and absorptive capacities. Revised projections for FEC's operations, well below the targets of the Plan, and more in line with FEC's processing capability, were jointly prepared with the Bank. These forecast a loan approval level of DH 210 million ($33.6 million) in 1983, growing thereafter by 20% pea. in current terms, to reach DH 360 million ($57.6 million) in 1986 (as compared to DH 800 million ($128 million) projected for 1985 in the Plan). With regard to regional distribution of future activities, FEC intends to focus more on the rural communes, increasing its lending to them from an insignificant share in the past to an annual average of 35% over The urban communes would receive 38% of FEC's lending while the balance of 27% would go to the public utility authorities (regies). Sectorally, 25/. of FEC's lending would be for sewerage projects, 22% for water supply, 22% for productive facilities, 14% for electrification, and the balance for urban development projects. On tiie basis of estimated approvals and average loan amounts, the number of projects would increase from 47 in 1981 to 105 in 1986, reflecting FEC's increased focus on smaller operations in rural communes. Given, however, FEC's current project pipeline, the number of projects is unlikely to

25 exceed 60 in 1983, but would still reach about 100 in These targets which were discussed with the Bank, provide a reasonable basis for the projected operations of FEC. The staffing requirements of the FEC unit through 1983 have been estimated in line with the proposed increase in volume and number of operations, taking due account of training needs Financial forecasts and resource reguirements: Over the period , FEC's loan portfolio is expected to grow from DH 794 million (127 million) to DH 1,333 million (0213 million.). The evolution of FEC's financial position would still have to be viewed in the context of FEC's legal status as a department within CDG, heavily relying on CDG's financial support. However, stemming from a longer-term concern to strengthen FEC's financial base, Government concurrence was obtained during negotiations to a limited financial restructuring through additional capital payments by the Treasury, and/or provision of long-term subordinated loans at moderate cost by the CDG. The amounts of equity or (quasi-equity) would be contributed in equal annual installments of DH 20 million ($3.2 million) in 1984, 1985, and 1986 and - account taken of the earnings accumulated during the period - would more than double the present DH 69 million ($11 million) level of FEC's equity. With regards to the composition of its borrowings, FEC would gradually reduce its reliance on low-cost, short-term (revolving) discount and rediscount notes from CDG and the Central Bank, while increasingly resorting to less concessionary sources of finance on local and foreign markets. Thus, between 1982 and 1986, the share of it's borrowings on such markets is forecast to grow from 15% to 45% of FEC's overall borrowings, while in the same period Central Bank rediscount notes are forecast to fall from 65% to 35%, and CDG's discount notes from about 25% to 20%. The average cost of borrowings would thus increase from less than 6% in 1982 to 8.5% in As of 1984, provisions for risk would build up from 0.25% of FEC's unsecured regies' portfolio - not subject to a straightforward Government guarantee - to 0.5% in 1985 and 1%. in 1986 until they reach 3% of such portfolio. This build-up of provisions was agreed during negotiations. If FEC's lending rcte, under these conditions, were to remain at its current level of 8.5%, FEC's profitability between 1982 and 1986 would be marginal and steadily deteriorating, despite insignificant administrative expenses (less than 0.3% of total assets) as FEC's administrative tasks are performed by CDG. Therefore, if FEC is to strengthen its finances and build up adequate reserves, the increase of its lending rates to more realisitic levels in line with the cost of its resources will be required. Thus, in line with the projected increase in the cost of FEC's borrowings, agreements was reached during negotiations for the increase of FEC's lending rates to at least 10% by December 31, 1983 and for their subsequent revision on an annual basis with the aim of achieving a marginal spread of 3% over the average cost of FEC's overall resources as of 1984, and ensuring FEC of a satisfactory profitability. This and other agreements referred to in this paragraph with respect to financial performance of FEC were recorded in a supplementary letter to the :.oan Agreement. The projections of FEC's operations and finances for the period are given in Annex IV. Under the assumptions of these projections, FEC's net profit would

26 amount to DR 3.8 million (0.6 million) (6% of average net worth) in 1983, increasing to DH 15.5 million ($2.5 million) (10% of average net worth) in Gross income as percentage of average total assets would be around 8.3 in 1983, increasing to 9.7 in Financial expenses as percentage of average total assets would amount to 7.3 in 1983 and 7.6 in 1986, with low interest coverage ratios of 1.1 in 1983 and 1.3 in A. Project Objectives IV. THE PROJECT 4.01 In support of the Government's regional and communal development policy, the objective of the project is to assist the LCs in their efforts to meet their basic infrastructural needs. A manageable approach to achieving the project's objective would be to channel to the LCs financial resources and technical assistance through FEC, and strengthen FEC into a more effective financier of the local communes, thus enhancing their prospects to implement their development projects in an economic manner. This institutional upgrading of FEC will apply not only to sub-projects financed under the proposed loan, but to all projects financed by FEC. In view of the multisectoral scope of the project, and the existing weaknesses of many of the LCs in preparing and implementing projects, and of FEC in appraising and supervising projects, the Bank loan, designed on a pilot basis, will focuss on the institution building of FEC through technical assistance to enhance its internal organization including staff development, and formalize its policies and procedures to improve its potential impact on the quality of the LCs' projects. The project would more specifically assist FEC in foraulating operating principles for project financing, on the basis of rigorous preparation, appraisal and supervision standards and criteria, and improving the efficiency of its staff in the performance of their functions The pilot project should be viewed as a first stage of a broader institution building process, which in the medium-term could enable FEC to accede to an expanded and eventually full legal autonomy and financial independence, able to mobilize on behalf of the LCs new resources on a wider scale to meet their large investment requirements, and complement the financing provided under central Government budgets. B. Project Scope 4.03 The proposed loan to FEC, in an amount of $16 million, would include a line of credit of 315 million for project financing, and a technical assistance component (including contingencies) of about million to improve FEC's internal organization and procedures, with particular emphasis on project preparation, appraisal and follow-up. The proposed amount would also finance the capitalized front-end fee of about $0.04 million on the loan. The line of credit would cover about 15% of FEC's projected borrowing needs during Undisbursed funcds under the technical assistance component would be reallocated to the line of credit for sub-project financing.

27 Allocation of Bank Loan Amounts (in $ million) Line of Credit Technical Assistance and Contingencies 0.96 Front-end Fee 0.04 Total Loan Amount a. Line of Credit for Project Financing: The line of credit wiil be used to finance about 30 sub-projects in the sectors eligible for FEC's assistance, as provided in FEC's Statement of Policy. These relate to specific categories of infrastructure and productive revenue-generating projects. The sub-borrowers will be the urban and rural communes, groupings of communes, and the public utility authorities (regies). All FEC's projects, irrespective of the source of finance, will be subject to the appraisal criteria developed with Bank assistance in each of the eligible sectors; this was confirmed during negotiations and recorded in a supplementary letter to the Loan and Project Agreements. In most sectors, except for sewerage and sub-projects costing less than DH 500,000 ($80,000), the users' charges and/or the taxes charged by the LCs will normally cover fully the capital, operation and maintenance costs. Under this first pilot loan, however, and pending resolution of sector policy issues being discussed through :he proposed Casablanca Sewerage project now under preparation in the Bank, sewerage projects (which represent around 25% of FEC's operations) would be financed by the Bank on a case-by-case basis, if the cost-recovery element is adequately addressed and the Bank is satisfied as to the arrangements regarding execution, supervision, operation and maintenance of each project. Furtalermore, Bank's financing would be initially restricted, in the water and electricity sectors, to those projects operated or managed by the public utility authorities (r4gies, or ONEP or ONE) which generally have the technical capability to prepare and execute such projects. Thus, assuming that the sectoral distribution of Bank funds would be similar to that of FEC's overall operations, around 2/3 of the loan amount would finance sub-projects operated or managed by the public utility authorities. The proposed appraisal standards and procedures are consistent with Bank policies for direct lending in those sectors and were agreed during negotiations b. Technical Assistance: Allocation is made under the loan to cover the foreign exchange costs and up to 75% of local expenditures of institutional strengthening pertaining to staff training ($50,000), advisory ($200,000) and consultancy ($250,000) services. The use of one or more advisors for an aggregate period of two years, and technical consultants (individuals or firms) for about 20 to 24 man-months (S10,000 per man-month), will be needed to define and implement the new policies and operating procedures and was agreed at negotiations. The conditions of employing the technical consultants, in terms of size and type of sub-projects, were equally discussed and agreed at negotiations. Agreement: was furthermore reached at

28 negotiations for the employment by January 1, 1984, of the technical consultants, all in accordance with the guidelines for the use of consultants by World Bank borrowers, and with qualifications and terms of reference satisfactory to the Bank. The advisor(s) and technical consultants would also be responsible for providing formal and on-the-job training to FEC's staff in project preparation, appraisal and supervision. As outlined in paras 3.12 to 3.21, the emphasis of the technical assistance scheme will be put on (i) project preparation, where the assistance of FEC to the LCs in reviewing and completing feasibility studies would be stepped up, in particular for small/ rural projects, for water and electricity projects costing more than DH 5 million ($0.8 million) and for sewerage projects; (ii) project appraisal, where a set of criteria and detailed financing procedures and guidelines have been developed by the Bank to ensure the adequacy of the project design, costrecovery capacity and financial viability, as well as arrangements for project implementation and subsequent operation and maintenance; and (iii) project supervision, where systematic follow-up on all FEC's projects during the execution stage will be carried out to monitor the effectiveness of FEC's financial assistance to the LCs, and provide them with further advice as necessary and feasible As part of the process of strengthening its organization, structure and operating procedures, FEC will employ advisor(s) with qualifications, experience and terms of reference satisfactory to the Bank for an initial period of two years. Enployment of one technical advisor responsible for appraisal and supervision of projects (tasks (i), (ii) and (iii) below) is made a condition of loan effectiveness. Other advisor(s) which may be required for tasks (iv) to (vii) below would be employed by October 1, 1983 as agreed upon during negotiations. The Terms of Reference of the advisor(s) (Annex V), who will report to the Director of FEC, were agreed upon during negotiations, and would inter alia include assistance to FEC in: (i) The review of the content and quality of feasibility studies received by FEC and completion, as required, of studies to allow the appraisal by FEC of project proposals. (ii) The appraisal of projects in accordance with technical, financial and economic criteria, adopted in consultation with the Bank by FEC for various infrastructure and productive projects, with particular emphasis on lowest-cost solutions, cost-recovery, and financial viability. (iii) The follow-up on the execution of FEC-assisted projects and design and implementation of appropriate supervision procedures. (iv) The preparation of an operational manual including detailed formats for financing applications and appraisal and supervision reports, as well as technical notes on the methodology of project analysis and ratios. (v) The design of training programs for FEC staff in project analysis and follow-up, particularly the organization of seminars to be conducted by experts from consulting tirms or training institutes.

29 (vi) The preparation of staff recruitment plans, including description of required profiles. (vi i) The development of internal monitoring procedures and of a management information system. C. Main Features of the Loan 4.07 Lending arrangements: Given the status of FEC existing in practice as a unit within the CDG, the loan is proposed to be made to the Government and on-lent to FEC. The loan to the Government would be made at the standard Bank terms and on-lent to FEC at a fixed-interest rate of 11.5%, equal to the present cost of FEC's (alternative) borrowings oni the local bond market. In addition to relating the cost of Bank funds to the marginal cost of FEC's borrowings on the local bond market, the proposed rate of 11.5%o would also be positive when compared to the Bank interest rate prevailing at the time of Board approval. The impact of the cost of Bank :funds on FEC's finances in , would be marginal in view of the small share that these funds would represent among FEC's total borrowings during the period. In addition to the interest rate risk, the foreign exchange risk att:ached to Bank funds will be borne by the Government. Agreement on the on-lending terms of the proposed loan to FEC was reached during negotiations, and will be incorporated in a Financing Agreement between the Government and FEC, satisfactory to the Bank and specifying, in addition, all the agreed on-lending conditions of Bank funds. Execution of the Financing Agreement is a condition of loan effectiveness FEC's on-lending rates: In view of FEC's increased reliance on less concessionary borrowings (para 3.34), its lending rates are proposed to be increased from 8.5% to 10% by end of 1983, and be annually reviewed with the Bank as of 1983, to provide FEC with a minimum spread of 3% over the cost of its overall resources. Agreement to this effect was reached during negotiations and recorded in a supplementary letter to the Loan Agreement. The increase to 10% in 1983 would yield a positive spread on FEC's overall borrowings, yet a negative spread on Bank funds in With inflation rates for Morocco projected at 9% in 1983 and 9X. in 1984, FEC's lending rate to the r4gies, which bear the full interest cost on their loans is thus expected to be positive as of This, however, may not be the case for the LCs which receive, as Government contribution to their social and economic development, a 3/. interest subsidy on their FEC's loans, bringing their effective borrowing rate from 8.5% to 5.5%. Given the need to maintain the concept of FEC's financial viability and hence autonomy, the principle of continued interest subsidy provided by the Government to the LCs should be accepted at this stage even if the proposed interest rate increase is to be itself covered by an increase in subsidy. Such an increase in subsidy would amount during the period to less than 0.7% of the Govermnent budgetary allocations to the LCs. Furthermore, as the overall envelope of Government financial allocations to the LCs is fixed each year, an increase in interest subsidy would imply a decrease in other forms of Government subsidies to the LCs, thus putting no additional burden on Government finances.

30 Commitment of the loan and limits on sub-loan and sub-project size: The Bank loan is estimated to be committed over a two to three year period starting mid The Bank loan should cover the sub-project's estimated (direct and indirect) foreign exchange component. This percentage, averaged over all sectors, and weighted by the shares of the loan projected to be used in each of the sectors is estimated at around 50%. Thus, and in view of the proposed modalities of disbursement of Bank funds (para 4.10), the Bank's line of credit is proposed to finance up to 50X of any sub-project cost, which will overall, ensure that the aggregate foreign exchange components of the subprojects submitted for Bank financing are covered under the loan. Furthermore, limits on sub-loan and sub-project size are introduced to ensure that the line of credit would be used for an adequate number of sub-projects allowing, through the sub-project review process, a meaningful transfer of the Bank's technical assistance. The limits introduced bear (i) on the sub-project size (DH 6.5 million) ($1.0 million) - allowing a maximum sub-loan of DH 3.25 million ($0.5 million) - when the sub-borrower is a local commune, and (ii) on the sub-loan size (DH 5 million) ($0.8 million) when the sub-borrower is a regie (as for r6gies, project sizes are larger and vary within a very broad range which is difficult to forecast). Agreement on these modalities was confirmed at negotiations. Thus, based on FEC's project pipeline as of June 30, 1982 (DH 65 million ($10 million) for 30 requests pending), and on the limits on Bank financing so set, the Bank loan would finance about 30 subprojects Disbursements under the Loan; Disbursements under the loan would be made as follows; Category and Amount Allocated % of Expenditures Description Us$ to be Financed 1 - Line of Credit 15,000,000 50% of FEC disbursements 2 - Technical Assistance 960, % of foreign expenditures and contingencies and 75% of local expenditures. 3 - Front-End Fee 40,000 Amount due TOTAL AMOUNT 16,000,000 In view of the small size of many of the contracts under the sub-loans on which the Bank will be requested to disburse - covering, inter alia, construction works - it would be administratively cumbersome to require the submission of standard documentation of expenditures under the line of credit (category 1). Disbursements on FEC's sub-loans would be made under the certified Statement of Expenditure system. Drawings will be made periodically on a reimbursement basis covering up to 50% of FEC's own financing for the project (generally 100% of the project cost) upon receipt of statements of expenditures submitted by FEC and certified by the Director of FEC. The standard supporting documentation will be kept with FEC for inspection on request by Bank supervision missions. In addition to the normal audit of accounts, formal arrangements will be made with FEC's auditors for such inspection, under terms of reference acceptable to the Bank. Disbursements would be fully documented under the other categories.