Document ofThe World Bank

FOR OFFICIAL USE ONLY

Report No. 19949

IMPLEMENTATION COMPLETION REPORT

CROATIA

CAPITAL MARKETS DEVELOPMENT PROJECT

(Loan No. 3999-HR)

December 17, 1999

Private and Financial Sector developmentEurope and Central Asia Region

This document has a restricted distribution and may be used by recipients only in the performance oftheir official duties. Its contents may not otherwise be disclosed without World Bank authorization.

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CURRENCY EQUIVALENTS

US Dollars Equivalents(Kunas per US$)

Average Annual1995 5.231996 5.431997 6.101998 6.361999 (end-October) 7.32

ABBREVIATIONS AND ACRONYMS

CAS Country Assistance StrategyCROSEC Croatia Securities and Exchange CommissionECA Europe and Central AsiaEFSAL Enterprise and Financial Sector Adjustment LoanGDP Gross Domestic ProductGOC Government of CroatiaICR Implementation Completion ReportIOSCO International Organization of Securities CommissionsMOF Ministry of FinanceMOP Ministry of PrivatizationMPP Mass Privatization ProgramPMU Project Management UnitPSAL Public Sector Adjustment LoanSDA Securities Depository AgencyZAP Institute for Payment Transactions

FISCAL YEAR

January 1 - December 31

Vice President: Johannes LinnCountry Director: Arntraud HartmannSector Manager: Ilham ZuraykTeam Leader: Gerardo Corrochano

FOR OFFICLIL USE ONLYTABLE OF CONTENTS

IMPLEMENTATION COMPLETION REPORT

CROATIA

Capital Markets Development ProjectLoan 3999-HR

CONTENTSPreface ----------------------------------------Evaluation Summary -------------------------------------- iPART 1. Project Implementation Assessment---------------------------------------------------------------------------------- 1

A. Statement of Objectives--------------------------------------------------------------------------------------------------- 1B. Major Factors Affecting Project----------------------------------------------------------------------------------------- 2C. Achievement of Objectives----------------------------------------------------------------------------------------------- 3D. Project Sustainability-------------------------------------------------------------3-------------------------------- 3E. Bank Performance----------------- 4F. Borrower Performance ---------------------------------------------------------------------------------------------------- 4G. Detailed Assessment of Outcome---------------------------------------------------------------------------------------- 5H. Future Operations---------------------------------------------------------------------------------------------------------- 91. Key LessonsLeamed----------------------------- 9

Part II. Statistical Tables---------------------------------------11----------- I ITable 1: Summary of Assessments ------------------------------------------------------------------------------------------ 12Table 2: Related Bank Loans/Credits --------------------------------------------------------------------------------------- 13Table 3: Project Timetable---------------------------------------------------------------------------------------------------- 14Table 4: Loan/Credit Disbursements: Cumulative Estimated and Actual---------------------------------------------- 14Table 5: Studies Included in Project----------------------------------------------------------------------------------------- 14Table 6: Status of Legal Covenants------------------------------------------------------------------------------------------ 15Table 7: Bank Resources: Staff Inputs ------------------------------------------------------------------------------------- 16Table 8: Bank Resources: Missions----------------------------------------------------------------------------------------- 16

Appendix 1: Review of the Capital Markets Development Project From the Borrower's PerspectiveAppendix 2: ICR Mission Aide MemoireAppendix 3: Project Indicators

This document has a restricted distribution and may be used by recipients only in theperformance of their official duties. Its contents may not otherwise be disclosed withoutWorld Bank authorization.

IMPLEMENTATION COMPLETION REPORT

CROATIA

CAPITAL MARKETS DEVELOPMENT PROJECT - LOAN 3999-HR

Preface

This is the Implementation Completion Report (ICR) for the Capital MarketsDevelopment Project in Croatia, for which a loan in the amount of DM 14.2 million equivalentwas approved on February 29, 1996 and made effective on July 22, 1996. DM 14.2 million wasdisbursed. The Loan was closed on June 30, 1999.

The ICR was prepared by Hiran Herat, Senior Financial Analyst, ECSPF, and reviewedby Julius Varallyay (Acting Country Director - ECC02), Ilham Zurayk (Sector Manager -ECSPF), and Gerardo Corrochano (Program Team Leader - ECSPF). The Borrower providedcomments that is included as an appendix to the ICR.

Preparation of this ICR began during the Bank's final supervision/completion mission,May 26-28, 1999. It is based on the mission's findings and material in the project file. TheBorrower contributed to the preparation of the ICR by preparing its own evaluation of theproject's execution and commenting on the draft ICR.

CROATIA

IMPLEMENTATION COMPLETION REPORT

CAPITAL MARKETS DEVELOPMENT PROJECT

Loan 3999-HR

Evaluation Summary

Introduction

(i) Under difficult circumstances, during the five years that followed the 1993 stabilization program,Croatia attained good results in stabilizing the economy, resuming growth, and commencing structuralreforms. Yet macroeconomic imbalances that became evident since early 1988 and continued into 1999have affected mainly the external and fiscal sectors. Throughout this entire period the Government hasremained committed to supporting policies airned at the development of the private sector and thestrengthening of the capital markets. Accordingly, the three components of the Capital MarketsDevelopment Project (CMPD), policy support, infrastructure development, and public awareness, wereentirely consistent with the long term strategic direction of the Government. To a large extent, thedevelopment of the basic regulatory and institutional infrastructure to support capital markets would havebeen likely outcomes of the Government's strategy. The Bank's involvement was to largely facilitate themore timely, coherent and effective development of these important capital market features.

Project Objectives

(ii) The overall aim of the CMDP was to support the Government's economic transformationprogram, by facilitating the privatization and restructuring processes and, more specifically, by helpingdevelop the capital markets institutional and regulatory infrastructure required for a modern market-basedeconomy. In particular, the Government wanted to strengthen: (a) the policy framework for the capitalmarkets, mainly focusing on the regulation of securities markets; (b) the operational capabilities of keycapital markets entities, especially the securities depository, registry, clearing and settlement functions;and (c) the public's comprehension of the capital markets and their roles as shareholders.

Achievement of Objectives

(iii) The project met all of its main objectives. Moreover, it successfully targeted key initiatives withthe objective of facilitating Croatia's economic transformation and building the necessary operational andregulatory capacity to meet the new investment requirement of the emerging private sector. Thebasicregulatory and policy framework for the capital markets is in place with the establishment and theoperation of the Croatian Securities and Exchange Commission (CROSEC), and the passage of theSecurities and Investment Fund Laws in December 1995. The central securities depository, registry,clearing and settlement agency (SDA) has been established and went into operation in July 1999. A massmedia public awareness campaign to improve the general public's understanding of the capital marketsand their role and rights as participants was launched with educational TV and radio series, road showsand written materials.

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(iv) At the same time, from a sectoral point of view, the overall development of the capital markets inCroatia has been slower than expected. Compared to other countries in Central Europe, foreigninvestment has been very low, and important structural reforms have been delayed. Privatization basedon insider buy-outs and concentration of residual ownership in the Pension Fund have resulted in weakenterprise governance. In the absence of effective bankruptcy enforcement, insolvent companies haveoften been transferred into a "shell", without formal closure or asset reallocation. Given the weak judicialsystem, contracts are not enforced and the culture of chronic non-payments continues. Arrears amongenterprises have increased rapidly. In sum, hampered by weak institutional capacity to enforcecontractual obligations, payments and bankruptcy, a competitive market system does not yet fullyfunction in Croatia. The project concentrated on a few selected priority areas that aimed at havingimmediate benefits to the capital markets at this early stage. Yet itwas not intended to resolve all of theshortcomings identified above, which are being addressed by the ongoing reform program of theGovernment and supported by complementary Bank operations.

Sustainability

(v) The issue of sustainability of project investments differs among the three project components.The Public Awareness Component involved a "one-time" effort to educate the general public on capitalmarkets concepts. Accordingly, continued input of resources is not required to sustain the investment.The Policy Framework Component led to the creation of the Croatian Securities and ExchangeCommission. CROSEC is a public agency funded by the General Budget. Notwithstanding the currentdifficult fiscal environment, CROSEC has been more-or-less adequately funded. CROSEC is widelyregarded as an essential element of the national financial system and is performing its function well.Additional technical assistance, focussing specifically on improving public access to information andmarket surveillance is been provided to the CROSEC under the recently approved Technical Assistance]]Loan (HR-4460).

(vi) The sustainability of the Securities Depository Agency created under the InfrastructureComponent is subject to greater uncertainty. SDA's financial resources are derived from user fees for itsservices. Thus, it is tied to developments in the capital markets and the economy as a whole.Accordingly, it is reasonable to assume that its financial viabilitywill be assured in the medium to longterm (i.e., three years out). However, SDA's financial viability is uncertain in the immediate to shortterm period during which it will initiate operations and transition tobecome the comprehensive providerof capital markets infrastructure services. This period of vulnerability has been exacerbated by the highdegree of distress in the Croatian economy that resulted from the economic downturn that stated in 1998.With limited latitude to adjust costs, accelerate service volumes or increase fees, SDA's only option forimmediate survival is term debt finance. SDA has reached agreements, in principle, with two of thelargest commercial banks for a syndicated loan, which is expected to be covered by a governmentguarantee. During this interim period, the Government recognizes that its support will be crucial toenable SDA to operate and maintain the infrastructure established under this project. It is also fair tomention that the Government's continued commitment to the sustainability of the SDA is also evidencedby the fact that additional technical assistance is been provided to the SDA under the TechnicalAssistance II Loan (see v above).

Bank and Borrower Performance

(vii) The overall performance of the Bank and the Borrower in all aspects of the project cycle wassatisfactory. The project was implemented on time and the Loan was fully disbursed. There were nosignificant deviations in Bank policies or procedures in project implementation, and project supervision was

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adequate with about two main missions per year and frequent brief follow-up visits by the project team, inconjunction with other missions to Croatia and the region. Through close monitoring of the project, theproject team was able to support the Croatian counterparts and their consultants through the challengingprocess of institution creation and building.

Assessment of Outcome

(viii) Croatian Securities and Exchange Commission. The CROSEC was established with thepassage of the Securities Law in December 1995. The CROSEC consists of five Commissioners and 20staff members (para 12). The Commissioners and staff of the CROSEC received substantial training in avariety of fields, including enforcement, corporate disclosure, market manipulation, public relations andstock exchange regulation. The commission has: (a) approved prospectuses for 31 private placementsfor a value of over HRK 4.1 billion and 22 public offering prospectuses concerning the issues of HRK3.13 billion in securities; (b) licensed 19 management companies and 13 investment funds; (c) conducted77 open investigations involving possible violations of the Securities Law, takeover Code, PrivateInvestment Funds Law and Investment Funds Law; and (d) provided training for 172 brokers.

(ix) Securities Depository Agency: The SDA was licensed to operate by the regulator on April 29,1999 (para 13). This has also been supported by the decision of Pliva d.d., one of the countries largestcompanies with international investors, to appoint the SDA as its primary registrar effective July 19,1999, when the SDA went "on line". Two other companies have also agreed to appoint the SDA asprimary registrar which translates into more than 42,000 securities accounts holding more than 36.5million shares with a total market value of over HRK 8.5 billion (or US$1.2 billion) in the centralregistry. This "on line" date represents the successful end of a pilot project with the three initialissuers.During this period, the SDA maintained a parallel set of shareholder records reflecting changes inownership and account maintenance activity as recorded by the issuers. There also were seven brokeragefirms and five custodian banks involved in a simulation test of the SDA Depository System for Trade-for-Trade Settlements.

(x) Public Awareness Component. Implementation of this component, which commenced inDecember 1996, was intertwined with the support campaign for the mass privatization program (para 19).Technical assistance under this component provided for the elaboration of a strategic plan and a detailedmedia communications development plan, market research on the population's attitude towardsprivatization and share ownership, and development and airing of an intensive media relation campaignwith educational TV and radio series, and printed materials. The program was concluded by end-1997.

(xi) In order to implement this project, a project management unit (PMU) was established, as therequired capacity was not available within the MOF. Although funding was provided under the project tohire staff for the PMU, the MOF opted to use grant financing for this purpose. With the assistance of anItalian trust fund, a project manager was hired and an additional staff member was provided by the MOF.The successful implementation of the project can also be attributed to the professionalism and hard workof the PMU staff, who became well versed in Bank procedures.

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Future Operations

(xii) Future Bank's assistance to Croatia is expected to blend lending and non-lending services. Theproposed assistance will provide support for urgent macro stabilization and financial sector reforms, aswell as for deeper structural measures required for sustainable growth. Operations will be geared towardsachieving the following objectives: (i) reducing the size of the public sector and increasing efficiency; (ii)improving governance of enterprises; (iii) creating conditions for competitive real sector development;and (iv) containing poverty. The recently approved Technical Assistance 11 Loan and the proposedProperty Rights and Cadastre Pilot Project are expected to assist the development of the private sector.The IFC is also expected to provide support for private sector development and privatization, thusmobilizing FDI and external financing for technology and modernization.

Key Lessons Learned

(xiii) Government's commitment to the overall policies to support the development of capital marketswas, in essence, the cornerstone to the success of this operation. Furthermore, the implementation andcompletion of the CMDP highlights key lessons in four main areas (i) adequate project management, (ii)strong counterpart commitment and project ownership, (iii) clear project design, and (iv) properidentification of project risks.

(xiv) Project management. Government's commitment was made particularly effective by themanagement and implementation expertise that was developed in the Project's Management Unit (PMU).This key element, which was made possible with the financing of a trust fund, proved to be a criticalingredient to the successful implementation of the project. The efficient operation of the PMU greatlyfacilitated the relationship between the Bank and the MOF. Further, the MOF now has a core group oftrained staff who are already contributing to the implementation of other Bank financed projects.

(xv) Counterparts commitment and project ownership. In addition to counterparts commitment atthe policy level, project ownership of the implementing agencies also proved to be critical to the successof the CMDP. As a result, decisive steps towards achieving project objectives were quickly evidenced bythe diligence and professionalism of key counterparts. Moreover, initial short comings and inexperiencein implementation were promptly reinforced by out side experts who also made major contributions to thesuccess of this project. Another important ingredient that helped maintain the commitment of theimplementing agencies was the frequent (albeit brief) in-country presence of Bank staff to help thevarious agencies reach practical agreements on the many topics of common concern. As a trusted,neutral party, the Bank played a key role by helping bridge communication gaps between participants inthe domestic arena.

(xv) Project design. The project components should be clearly defined, kept simple, and have well-written terms of reference, as was the case in this project. This resulted in awell-executed selection ofcompetent consultants, who contributed a lot to the success of the project. Furthermore, the main projectobjectives of the CMDP were highly complementary to the overall policy reform program of theGovernment, which was in turn supported by various Bank operations. While keeping a well-targetedfocus in its components, the CMPD was fully coherent and an integral part of this agenda. Experience inthe design of this project, also shows that contracts with long implementation periods can be subject toshort fall in financing if they are denominated in currencies other than the currency of the Loan anddepreciation between the two currencies occur.

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(xvi) Project risks. Political risks highlighted at the time of project preparation stated the need toclosely monitor ongoing tensions in the region and the way this will affect the pace of the overall reformprogram. Yet the degree to which these developments, combined to other internal and external events,have affected Croatia's transition to a fully functioning market economy - and thus the slow pace ofdevelopment of capital markets - was certainly not fully anticipated. In this context, the implicitassumption that SDA could become a self-sustained revenue earning entity in a relatively short period oftime, proved to be unrealistic. Nevertheless, while the establishment of basic institutional and regulatoryelements in Croatia's capital market was a necessary step in the transition, the current state of Croatia'scapital markets is perhaps evidence that a great deal of the impact of this project is hopefully yet to berealized in the near future.

IMPLEMENTATION COMPLETION REPORT

CROATIA

CAPITAL MARKETS DEVELOPMENT PROJECTLoan 3999-HR

PART 1. PROJECT IMPLEMENTATION ASSESSMENT

A. Statement of Objectives

1. Background. Prospects for economic growth in Croatia had improved decidedly by the timeproject preparation began in 1995. The improvement followed a steep economic decline and nearhyperinflation in the wake of the dissolution of former Yugoslavia and the ensuing war which followedCroatia's declaration of independence in 1991. The stabilization program launched in October 1993 haddelivered impressive results, with a drastic reduction in inflation. The resumption of growth, as well asthe positive prospects for further growth, at the time largely reflected the dynamism of the private sector,which included both new ventures and those transferred from the state sector, and generated about 45percent of GDP. However, further private sector growth was hampered by insufficient access to financialresources, exacerbated by a still weak and state owned banking sector, and illiquid capital markets. Inthis context, Croatia was establishing its capital market from almost a zero base. In the short term, thefundamental missing pieces were: (i) an adequate regulatory framework, including a securities law, asecurities market regulator and an investment funds law; and (ii) trading mechanisms and infrastructurerequired for the proper functioning of a capital market, including a depository, clearing and settlementsystem. In the medium to long term, the critical requirements were: (iii) tradeable instruments, such asbonds and asset-backed securities; and (iv) institutional investors, a critical mass of modern brokeragefirms, credit rating agencies, and other parts of the capital market infrastructure.

2. Rationale for Bank Involvement. In 1995, Croatia's transition from stabilization toward sustainedgrowth was at a critical stage and considering prevailing constraints on external financing, strong supportfrom the Bank was expected to play a vital role, not only in terms of lending, but also in the form ofpolicy work and technical assistance. The Bank's CAS at the time, supported three main areas ofemphasis in the GOC's multi-year reform and investment program, namely: (i) reforming public finance;(ii) rebuilding and upgrading key infrastructure; and (iii) fostering private sector lead growth. In pursuitof these goals, in particular that of private sector lead growth, the Croatian authorities had madesignificant efforts to introduce capital markets reforms, while simultaneously pursuing both a majorreform of the banking sector and restructuring and privatization of enterprises. While covered in depth inthe Enterprise and Financial Sector Adjustment Loan (EFSAL) and Technical Assistance Project thatwere under preparation, the reforms were also strongly related to future capital markets development.

3. Project Objectives. The overall aim of the Capital Markets Development Project was to supportthe Government's economic transformation programs, by facilitating the privatization and restructuringprocesses and, more specifically by helping develop the capital markets institutions required for a modernmarket-based economy. In particular, the Government wanted to strengthen:

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a. the policy framework for the capital markets, especially the regulation of securitiesmarkets;

b. the operational capabilities of key capital markets entities, especially the securitiesdepository, registry, clearing and settlement functions; and

c. the public's comprehension of the capital markets and their roles as shareholders.

4. Project Description. The Capital Markets Development Project provided technical assistance,training, information technologies and various office-related equipment and resources. The total cost ofthe Project was estimated at US$21.0 million equivalent, including physical and price contingencies,taxes and duties, and recurrent expenses for the three and one half years of the project. The World Bankfinanced US$9.5 million equivalent of the project cost.

5. The Project has three basic components:

(i) The Policy Support Component supported the development of a legal and regulatoryframework. It comprised: (a) regulatory and organizational development of the CroatianSecurities and Exchange Commission (CROSEC) and establishment of essential capitalmarkets legislation; (b) restructuring of illiquid government obligations in the form oftradeable securities; and (c) development of a satisfactory strategy for managing theinvestment portfolio being transferred to the pension fund.

(ii) The Infrastructure Development Component provided technical assistance andinvestment resources to establish and strengthen the key capital markets institutions,including modern information systems to support essential capital markets functions, inparticular the securities depository, registry, clearing and settlement function.

(iii) The Public Awareness Component provided technical assistance to devise and createmass media, public awareness vehicles. The component also provided financing for theexecution of the public awareness campaign to improve the general public'sunderstanding of the capital markets and of their roles and rights as participants.

B. Major Factors Affecting Project

6. The original focus of the project was aimed at minimizing the negative impacts of settlement riskin the advent of expected substantial international capital inflows and a relatively rapidly growingsecondary market following the Government's privatization programs. However, compared to othercountries in Central Europe, important structural reforms have been delayed, a more favorable climate forinvestment has remained uncertain, and the level of foreign investment has been low. Privatization basedon insider buy-outs and concentration of residual ownership in the Pension Fund has resulted in weakenterprise governance. Given the weak judicial system, contracts are not enforced and the culture ofchronic non-payments continues. Arrears among enterprises have increased rapidly. With weakinstitutional capacity to enforce contractual obligations, payments and bankruptcy, the competitivemarket system does not yet fully function in Croatia.

7. There have also been a number of external factors that have negatively impacted the Croatianmarket. These include the Asian and subsequent Russian financial crises. Related to, and compounding,

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these dampening effects on both international and domestic business prospects has been a severedomestic liquidity crisis and political uncertainty. Thus, the project, which was designed to manage theeffects of an "upside" scenario, faced instead a severe "downside" scenario. In particular, tradingvolumes and prices have declined dramatically, and substantial capital inflows have not materialized,trends which have been reflected in the stock exchange experiencing a major downturn and thusoperating losses. Although this has had less of a negative impact on the newly created CroatianSecurities and Exchange Commission (CROSEC), it has created severe short-term financial problems forthe newly created and just operational Securities Depository Agency (SDA). This reflects SDA'sdependence on revenues from its transactions-based clearing and settlement and share registry services.As a result, in the interim, continued government support, such as loan guarantees and forbearance ofdebt service, is required to prevent the loss of the institution-building investments in this key element ofthe capital market infrastructure. The market downturn can also be seen as diminishing somewhat theimpact of the public awareness campaign that also formed part of the project.

C. Achievement of Objectives

8. The main objective was to develop the capital markets institution infrastructure required for amodern market-based economy. The project focused on a few key initiatives in these areas, with theobjective of facilitating the ongoing economic transformation in Croatia and building the necessaryoperational and regulatory capacity to meet the growing investment requirement in the private sector.The project met all of its main objectives. The regulatory and policy framework for the capital marketsare in place with the establishment and the operation of the Croatian Securities Commission (CROSEC),and the passage of the Securities Law and Investment Funds Law. The CROSEC has rapidly built up abody of essential regulations and guidelines, among other things, licensing requirements for exchangesand brokers, approval of new trading, settlement, delivery and registry mechanisms, as well as otherurgent issues as insider trading and securities fraud. The central securities depository, registry, clearingand settlement agency (SDA) has been established and became operational in July 1999. A mass mediapublic awareness campaign to improve the general public's understanding of the capital markets and theirrole and rights as participants was launched, and played an important role in the popular success of thevoucher privatization launched in 1998. In essence, the project concentrated on a few selected priorityareas that aimed at having immediate benefits to the capital markets at an early stage. Yet it was notintended to resolve all of the shortcomings identified in Croatia's nascent market system.

D. Project Sustainability

9. The issue of sustainability of project investments differs among the three project components.

* The Public Awareness Component involved a "one-time" effort to educate the general public oncapital markets concepts. Accordingly, continued input of resources is not required to sustain theinvestment. Nevertheless, some more narrowly targeted follow-on awareness activities aimed at theprofessional capital market community will be financed under the recently approved TechnicalAssistance II project.

* The Policy Framework Component led to the creation of the Croatian Securities and ExchangeCommission. CROSEC is a public agency funded by the General Budget. Notwithstanding thecurrent difficult fiscal environment, CROSEC has been more-or-less adequately funded. CROSEC iswidely regarded as an essential element of the national financial system and as having performed its

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function well. It has achieved international recognition, as demonstrated by its acceptance intoIOSCO, the international association of securities commissions. There is relatively little reason todoubt continued support and future funding. Additional technical assistance financing will beprovided under the Bank's second Technical Assistance (TA II) project, focussing specifically onimproving public access to information and market surveillance.

* The sustainability of the Securities Depository Agency created under the Infrastructure Component issubject to greater uncertainty. SDA's financial resources are derived from user fees for its services -and very much determined by the volume of transactions effected on the securities market. Thus, it istied to developments in the capital markets and the economy as a whole. SDA is a regulated, not-for-profit, joint-stock company with a legal mandate to perform registry services for all Croatiansecurities, as well as clearing and settlement services for the organized markets. Accordingly, itsfinancial viability is more-or-less assured in the medium to long term (i.e., three years out).However, SDA financial viability is uncertain in the immediate to short term, during which it willinitiate operations and effect the transition to the role of comprehensive provider of capital marketsinfrastructure services. This period of vulnerability has been greatly exacerbated by the high degreeof general financial distress in the Croatian economy. In this context, neither the brokeragecommunity nor the issuers can be expected to provide an adequate source of revenues to coverSDA's costs (which are predominantly fixed in nature). Moreover, the shareholders of SDA (thebrokers, the commercial banks, the MOF and ZAP) are not in a position to provide additional capitalgiven the current economic and fiscal situation. With limited latitude to adjust costs, accelerateservice volumes or increase fees, SDA's only option for immediate term financial survival is termdebt finance. SDA has reached agreements, in principle, with two of the largest commercial banksfor a syndicated term loan, which is expected to be covered by a government guarantee. Inanticipation of such bridge financing, follow up technical assistance for continued institutionalsupport and on-the-job training for the SDA is being provided under the TA II project.

E. Bank Performance

10. Bank's performance in all aspects of the project cycle was satisfactory. There were no significantdeviations in Bank policies or procedures in project implementation, and project supervision was adequatewith about two missions per year and frequent, brief follow-up visits by the project team, in conjunctionwith other missions to Croatia and the region. The project also benefited from the continuity of havingthe same task manager and technical specialist from its inception to Loan Closing. Through closemonitoring of the project, the project team was able to support the Croatian counterparts and theirconsultants through the challenging process of institution creation and building. It also meant that theteam was able to propose adjustments to the Legal Agreement to reflect the evolving needs of projectimplementation and ensure that the resources were directed to best achieve the project's objectives. Theproject team benefited from excellent support and guidance throughout the project implementation periodfrom the Disbursements, Procurement and Legal Departments.

F. Borrower Performance

11. The overall performance of the Borrower and the concerned government agencies was satisfactoryin all phases of the project cycle, and was in compliance with all main loan covenants. The cooperation andexchange of information between the Bank and MOF, through its project management unit (PMU) wasexcellent. The PMU worked closely with the Bank to modify the Legal Agreement as needed, as the project

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was implemented. The PMU which was established for this project and which is well versed in Bankprocedures will be used to implement several of the Bank projects that are managed by the MOF

G. Detailed Assessment of Outcome

12. Croatian Securities and Exchange Commission . The CROSEC was established with thepassage of the Securities Law in December 1995. The CROSEC consists of five Commissioners and 20staff members. The Commissioners and staff of the CROSEC received substantial training in a variety offields, including enforcement, corporate disclosure, market manipulation, public relations and stockexchange regulation. Executive and institutional management training was also received by thecommissioners. In turn, CROSEC expended substantial resources training market participants inportfolio management, security valuation, and risk management. In March, 1999, the CROSECsuccessfully sponsored a seminar on the topic of detecting, preventing and prosecuting securities marketmanipulation. The CROSEC held the conference on behalf of IOSCO Emerging Markets CommitteeWorking Group Number Four. Sixty-three representatives of the securities regulatory bodies fromnineteen emerging and developed countries attended the seminar. During the annual conference ofIOSCO, held in Lisbon, Portugal during May 1999, the CROSEC received international recognition forits efforts. Listed below are some of the highlights of the operational achievements of the CROSEC as ofmid 1999:

Corporate Disclosure:

* The CROSEC has approved prospectuses for 31 private placements for a value of over HRK 4.1billion and 22 public offering prospectuses concerning the issue of HRK 3.13 billion in securities.Approval of all prospectuses was based upon principles of full financial disclosure. During thereporting period, the CROSEC has also rejected several prospectuses for not meeting the standards offull disclosure.

* The CROSEC continues to implement the Takeover Code. Forty-one offerors have submitteddisclosure statements revealing their intention to buy out a target issuer. Twenty-five of thoseofferors have launched full takeover bids.

Regulation of Managed Investing:

* The CROSEC/Ministry of Privatization program of privatization investment funds ("PIF's") is beingclosely supervised by the CROSEC. All of the seven PIF's have had their proposed portfoliovaluations reviewed by the CROSEC for adherence to the Valuation Regulation and for sufficientlyjustifying the valuation determined for illiquid securities in their portfolios.

* The CROSEC has licensed 19 management companies and 13 investment funds. CROSEC's crucialrole in the licensing process has prevented the emergence of unprofessional management groups inthe voucher/PIF program and avoided abuses experienced earlier in other transition countries whichdid not have an operational securities commission when they launched voucher privatizationprograms. The CROSEC has also licensed an open-end mutual fund that is making periodicdisclosure and valuing its portfolio in accordance with International Accounting Standards.

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Enforcement:

* Enforcement by CROSEC continues to be a priority. The CROSEC has tripled the number of openmatters bringing the total number to 57. Open investigations involve possible violations of theSecurities Law, Company Law, Takeover Code, PIF Law, and Investment Fund Law.

* The Division of Enforcement has referred 31 investigations to the public prosecutor and Court forenforcement action.

Market Regulation:

* To date, 172 brokers have received CROSEC sponsored training, and 202 brokers have passed thecertification examination..

* The CROSEC has licensed the SDA, and it has approved the Rules of the Zagreb Stock Exchangeand the Varazdin OTC market. The CROSEC has completed a survey to determine the net workingcapital of securities brokers in order to develop a net capital regulation.

Relations With The Public and Industry:

- The Commissioners of the CROSEC have delivered various speeches and articles on financialdisclosure, accounting, capital markets and securities regulation. The Commissioners have beenactive participants in the media and in local conferences of securities industry participants.

13. Securities Depository Agency: The SDA was granted a license to operate by the regulator onApril 29, 1999. This has also been supported by the decision of Pliva d.d., one of the countries largestcompanies with international investors, to appoint the SDA as its primary registrar effective July 19,1999, when the SDA went "on line". Two other companies have also agreed to appoint the SDA asprimary registrar which translates into more than 42,000 securities accounts holding more than 36 millionshares with a total market capitalization of over HRK 8.5 billion in the central registry (or about US$1.2billion). This "on line" date also represents the successful end of a pilot project with the three initialissuers. During this period, the SDA maintained a parallel set of shareholder records reflecting changesin ownership and account maintenance activity as recorded by the issuers. This pilot enabled the SDA totest its registry system and demonstrate both its technical ability and operational ability to provideregistry services to issuers. There also were seven brokerage firms and five custodian banks involved ina simulation test of the SDA Depository System for Trade-for-Trade Settlements. This simulationcontinued until July 19, 1999 at which time these twelve market participants started clearing and settlingof trades in the initial three depository eligible securities through the SDA. Additional marketparticipants have been invited to join according to their own schedule and needs.

14. The SDA provides three classes of service to its member participants within the Croatian capitalmarkets. These three classes of service are:

1. Registry Services. The SDA maintains an electronic shareholders register for thedematerialised shares of eligible companies. Book entry changes in ownership are entered inthe share registry. Before the SDA can provide an issuer with its registry services, it is firstnecessary to import the shareholder registry records currently maintained by the issuer intothe SDA Depository System;

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2. Clearing Services. Clearing is the preparation of trades for settlement within the SDADepository System. Clearing includes trade reporting and calculation of the net money valueof trades due for settlement; and

3. Settlement Services. Trade settlement is the actual exchange of securities and money whichoccurs on the settlement date (T+4). SDA offers settlement services either on a contractualbasis where the SDA guarantees (for qualified market participants) the settlement or on atrade-for-trade basis where settlement is the broker's obligation.

15. While the success of the SDA in receiving its operating license in April, 1999 is significant, thisis tempered by the fact that this date was a full three months later than originally planned. The reasonsfor this delay continue to create problems for the SDA in fully meeting its institutional goals andmilestones. Up until December, 1998 all signs pointed to a launch date for SDA operations in January,1999. However, serious disputes arose in December with the market participants andwith CROSEC overthe SDA's proposed fee structure and proposed membership rules. These disputes introduced substantialuncertainty about the licensing of the SDA for the next 3 months. Only after the substantial reworking ofthe proposed fee schedule and the rules was the SDA able to achieve consensus among all of the partiesinvolved.

16. In order to address the concerns expressed by market participants regarding the proposed feeschedule it was necessary for the SDA to substantially reduce the fees charged to brokers and custodianbanks. In order to do this the SDA had to move its target of achieving full operating cost recovery by theend of its first full year of operations to the end of its third year of operations. The burden of fees wasalso shifted from a 50/50 split between issuer-related fees and trade-related fees to a 70/30 split. Thisshift in strategy will only be possible if the Ministry of Finance continues to excuse the SDA fromservicing its investment costs and if a government guaranteed bank loan to cover operating deficits overthe next three years is provided.

17. In examining this issue further, it is instructive to review the factors that caused the problem.These factors can be divided into issues within the agency's control and those factors outside theagency's control. Those factors outside of the agency's control include negative environmental factorsthat seriously dampened the development of Croatian capital markets and the economy as a whole.Factors within SDA's control primarily relate to having not fully grasped the challenge of managingclient relations on financial matters (as compared with technical matters) in the face of the downturn inthe market. In defense of SDA management, however, it needs to be pointed out the SDA's client are infact represented on SDA's governing board. Also, the clients tend not to be deeply experienced with thecomplexities of contemporary clearing, settlement and registry practices. Moreover their individualinterests do not coincide with the interest of the market taken as a whole (e.g., broker's individual interestis to avoid costs and maintain less than full transparency of their activities). These combined factorsresulted in SDA trying to launch itself in a relatively hostile environment, i.e., just as the domesticsecurities market went into a highly depressed state and most of SDA's clients started suffering extremefinancial distress.

18. Whereas the original project objectives foresaw an "upside" scenario with growth in the marketsand continued international capital inflows, what occurred in reality was a severe "downturn" scenariowith reduced trading volumes, lower prices and significant operating losses for the exchange and OTCmarkets. The fees originally proposed by the SDA were seen as highly unrealistic given the severelydepressed market conditions. This created a strong push-back by SDA's clients and CROSEC, which

8

might have been mitigated by better preparation of the client community. As a result, the SDAabandoned its original strategy of working towards full cost recovery in its first year of operation and willnow focus on full cost recovery by the end of its third year of operation. In order to do this, the agencywill require interim financing over the next three years to cover its operating deficits. SDA has reachedagreements, in principle, with two of the largest commercial banks for a syndicated loan, which isexpected to be covered by a government guarantee. During this critical period, the Governmentrecognizes that its support will be crucial to enable SDA to operate and maintain the infrastructureestablished under this project. It is also fair to mention that the Government's continued commitment tothe sustainability of the SDA is also evidenced by the fact that additional technical assistance has beenprovided to the SDA under the recently approved Technical Assistance II Loan (HR-4460).

19. Public Awareness Component. Implementation of this component, which commenced inDecember 1996, also included, support for the campaign for the mass privatization program (MPP), at therequest of the Government. In effect the two sub-components were intertwined. Technical assistanceunder this component, provided the following: (i) elaboration of a strategic plan and a detailed mediacommunications development plan for both components, (ii) market research on the population's attitudetowards privatization and share ownership and market research on the MPP gauging the degree ofdemand and the eligible population's expectations, (iii) creating theMPP's identity (with selection of acampaign logo) and production of a range of print ready materials (vouchers, leaflets, posters, etc), and(iv) development of an intensive media relation campaign with educational TV and radio (local andnational series), phone-in lines and written materials, and of an advertising campaign with pressconferences, press releases, briefings, television/radio commercials, road-shows and written pressmaterials. In total, twelve radio programs and several television episodes were broadcast, and printedmaterial was distributed to the general public. The program was concluded at the end of 1997.

Other issues

20. The anticipated short term assistance from USAID to the Pension Fund for its portfoliomanagement unit and to the MOF for the management of government debt did not materialize. However,the US Treasury Department provided a long term consultant to the MOF for the management ofgovernment debt, and additional Bank assistance was provided through a Japanese Grant for the proposedPublic Finance Management Project, which was subsequently cancelled. For better coordinationpurposes, it was decided to pursue assistance for the Pension Fund through a separate Public SectorAdjustment Loan (PSAL). The latter has not in fact materialized, though the preparation of a technicalassistant program to support pension reform efforts is fairly advanced.

21. The CMDP was a single currency, DM denominated Loan. One hardware and three technicalassistance contracts accounted for a major part of the Loan. These contracts were signed relatively earlyin the project implementation cycle, were denominated in US dollars, and had implementation periods ofbetween 12-20 months. The sharp depreciation of the DM against the US dollar (about 17%) during thisperiod had adverse consequences on the original budgeted amounts for both the CROSEC and the SDA,and led to a funding short fall. In consultation with the Bank, the Borrower requested and was providedwith additional financing from the on-going Technical Assistance Project, which was complementary tothis project in the development of the private sector. The CMDP was completed on time and the Loanwas fully disbursed.

9

H. Future Operations

22. The Bank's assistance strategy will blend lending and non-lending services. The proposedassistance will provide support for urgent macro stabilization and financial sector reforms, as well as fordeeper structural measures required for sustainable growth. Operations will be geared towards achievingthe following objectives: (i) reducing the size of the public sector and increasing efficiency; (ii)improving governance of enterprises; (iii) creating conditions for competitive real sector development;and (iv) containing poverty. Given the expanding role which the private sector is expected to play inCroatia, the IFC will provide support for private sector development and privatization, thus mobilizingforeign direct investments and external financing for technology and modernization. In order to maintainthe momentum achieved under this project and to further develop the capital markets, a specific follow upcomponent was included in the TA II Loan that was recently approved. Further, the CAS for Croatiaenvisions a follow up adjustment operation aimed at sustaining macroeconomic stability and thecompletion of pending structural reforms. Both elements that in the long run are also supportive of thedevelopment agenda of the capital markets.

I. Key Lessons Learned

23. Government's commitment to the overall policies to support the development of capital marketswas, in essence, the cornerstone to the success of this operation. Furthermore, the implementation andcompletion of the CMDP highlights key lessons in four main areas (i) adequate project management, (ii)strong counterpart commitment and project ownership, (iii) clear project design, and (iv) properidentification of project risks.

24. Project management. Government's commitment was made particularly effective by themanagement and implementation expertise that was developed in the Project's Management Unit (PMU).This key element, which was made possible with the financing of a trust fund, proved to be a keyingredient to the successful implementation of the project. The efficient operation of the PMU greatlyfacilitated the relationship between the Bank and the MOF. Further, the MOF now has a core group oftrained staff who are already contributing to the implementation of other Bank financed projects.

25. Counterparts commitment and project ownership. In addition to counterparts commitment atthe policy level, project ownership of the implementing agencies also proved to be critical to the successof the CMDP. As a result, decisive steps towards achieving project objectives were quickly evidenced bythe diligence and professionalism of key counterparts. Moreover, initial short comings and inexperiencein implementation were promptly reinforced by outside experts who also made major contributions to thesuccess of this project. Another important ingredient that helped maintain the commitment of theimplementing agencies was the frequent (albeit brief) in-country presence of Bank staff to help thevarious agencies reach practical agreements on the many topics of common concern. As a trusted,neutral party, the Bank played a key role by helping bridge communication gaps between participants inthe domestic arena.

26. Project design. The project components should be clearly defined, kept simple, and have well-written terms of reference, as was the case in this project. This resulted in a well-executed selection ofcompetent consultants, who substantially contributed to the success of the project, . Furthermore, themain project objectives of the CMDP were highly complementary to the overall policy reform program of

I 0

the Government, which was in turn supported by various Bank operations. While keeping a well-targetedfocus in its components, the CMPD was fully coherent and an integral part of this agenda.

27. In the case of single currency loans, where the currency is not the US dollar, the prudent courseof action would be to denominate all contracts in the currency of the Loan and not the US dollar.Experience under this project (para 21), shows that contracts with long implementation periods can besubject to short fall in financing if they are denominated in currencies other than the currency of the Loanand depreciation between the two currencies occur.

28. Project risks. Political risks highlighted at the time of project preparation stated the need toclosely monitor ongoing tensions in the region and the way this will affect the pace of the overall reformprogram. Yet the degree to which these developments, combined with other internal and external events,have affected Croatia's transition to a fully functioning market economy -and thus the slow pace ofdevelopment of capital markets- was certainly not fully anticipated. In this context, the implicitassumption that SDA could become a self-sustained revenue earning entity in a relatively short period oftime, proved to be unrealistic. Nevertheless, while the establishment of basic institutional and regulatoryelements in Croatia's capital market was a necessary step in the transition, the current state of Croatia'scapital markets is perhaps evidence that a great deal of the impact of this project is hopefully yet to berealized in the near future.

I1

Part II. Statistical Tables

Table 1: Summary of AssessmentTable 2: Related Bank Loans/CreditsTable 3: Project TimetableTable 4: Loan/Credit Disbursements: Cumulative Estimated and ActualTable 5: Studies Included in ProjectTable 6: Status of Legal CovenantsTable 7: Bank Resources: Staff InputsTable 8: Bank Resources: Missions

12

Table 1: Summary of Assessments

A. Achievement of Proect Substantial Partial Negligible Not applicableObjec ives

Macro Policies 0

Sector Policies LI 0 L0

Financial Objectives O 1=1 [iI

Institutional Development Z [z 0 0

Physical Objectives ZI LI 0

Poverty Reduction LI 0 0I

Gender Issues Z IZI

Other Social Objectives L LI Environmental Objectives n I IZIPublic Sector Management aoPrivate Sector Development LIOther (specify) C L LI

(Continued)

B. Project Sustainability Likely Unlikely Uncertain(V) (/) (/)

C. Bank Performnance Satisfactory Satisfactory Deficient

IdentificationLI

Preparation Assistance fl LAppraisal F7 L

Supervision FEF]

13

HighlyD. Borrower Perfonnance Satisfactory Satisfactory Deficient

(1) (i) (/)

Preparation El f3 m

Implementation % e I

Covenant Compliance i:i

Operation (if applicable) F7

Highl HighlyE. Assessment of Outcome Satisfactory Satisfactory Unsatisfactory unsatisfactory

(10 (10() /

Table 2: Related Bank Loans/Credits

Loan/credit title Purpose Year of approval Status

Technical Assistance Loan Private Sector Institution 1996 Will close in December,Development 1999

Enterprise Financial Private /Banking Sector 1996 Will close in June 2000Sector Adjustment Loan Development

Technical Assistance 11 Private Sector Institution 1999 On-goingLoan Development

Investment Recovery Private Sector 1998 On-goingProject Development

14

Table 3: Project Timetable

Steps in Project Cycle Date Planned Date Actual

Identification (Executive Project Summary) 02/15/1995 03/02/1995

Preparation 05/01/1995 05/07/1995

Appraisal 06/15/1995 06/23/1995

Negotiations 10/16/1995 02/15/1996

Board Presentation 12/05/1995 04/04/1996

Signing 04/15/1996 04/23/1996

Effectiveness 07/15/1996 07/23/1996

Project Completion 12/31/1998 06/15/1999

Loan Closing 06/30/1999 06/30/1999

Table 4: Loan/Credit Disbursements: Cumulative Estimated and Actual

(US$ thousands)

1996 1997 1998 1999

Appraisal Estimate 1.7 5.5 8.6 9.5Actual 0 2.7 8.0 9.5Actual as % of Estimate 0 49 93 100Date of Final Disbursement September 17, 1999

Table 5: Studies Included in Project

Purpose as DefinedStudy at Appraisal/Redefined Status Impact of Study

Strategic Study for the To select the most optimal Completed in 1996 Based on the study, theDevelopment of the Securities configuration of the proposed optimal configuration forDepository Agency depository the SDA was chosen by the

Government.

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Table 6: Status of Legal Covenants

Agreement Section Covenant Present Original Revised Description of Commentstype status fulfillment fulfillment covenant

date date

LA 3.01(a) M C Borrower declare its commitment Compliedto the objectives of the Project asset forth in Schedule 2 to thisAgreement

LA 3.01(b) M C Borrower shall carry out the CompliedProject in accordance with theImplementation Plan set forth inSchedule 5 to this Agreement

LA 3.02 M C Procurement to be governed by CompliedSchedule 4 to this Agreement

LA 4.01(a) F C Borrower to maintain satisfactory Compliedrecords and accounts inaccordance with soundaccounting practices.

LA 4.01(b) F C Borrower to have records and Compliedaccounts, including those for theSpecial Account audited no laterthan 5 months after the end ofeach year

GA 3.01 M C Guarantor shall carry out and Compliedcause to be carried out Part C ofthe project with due diligenceand efficiency.

GA 4.01 F C Guarantor shall maintain or cause Compliedto be maintained records andaccounts adequate to reflect inaccordance with soundaccounting practices theoperations, resources andexpenditure in respect of Part Cof the Project

Covenant types:

I. = Accounts/audits 8. = Indigenous people2. = Financial performance/revenue generation from 9. = Monitoring, review, and reporting

beneficiaries 10. =Project implementation not covered by categories 1-93. = Flow and utilization of project funds 11. = Sectoral or cross-sectoral budgetary or other resource4. = Counterpart funding allocation5. = Management aspects of the project or executing 12. =Sectoral or cross-sectoral policy/

agency regulatory/institutional action6. = Environmental covenants 13. = Other7. = Involuntary resettlement

Present Status: CP = complied with partiallyNC = not complied with

C = covenant complied withCD = complied with after delay

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Table 7: Bank Resources: Staff Inputs

Stage of Actual (US$ 000)Project Cycle Actual_(US$_____

SW US$

Preparation to Appraisal 51.1 148.5

Appraisal-Board 24.5 81.5

Negotiations through Board Approval 2.3 8.1

Supervision 61.7 122.1

Completion 7.0 17.7

TOTAL 146.6 377.9

Table 8: Bank Resources: Missions

Performance Rating

Number Specialized Implemen- Develop-Stage of Month! of Days in Staff Skills tation ment Types of

Project Cycle Year Persons Field Represented Status Objectives Problems

Through Appraisal 03/95 4 10 FA,T,,E,O

Appraisal through FA, T, L ,OBoard Approval

Supervision 07/96 3 7 FA,T,E S S

04/97 2 7 FA,T S S

08/97 2 5 FA,T S S

04/98 2 6 FA,T S S

11/98 2 5 FA,T S S

Completion 05/99 3 3 FA,T,E S S

E= EconomistFA = Financial AnalystT= TechnicalL= Legal0 = Operations Officer

17

Appendix A

Review of the

Capital Markets Development Project

From the Borrower's Perspective

1. BACKGROUND

The overall aim of the Capital Markets Development Project was to support the Government'seconomic transformation programs, by facilitating the privatization and restructuring processes and,more specifically by helping develop the capital markets institutions required for a modern market-based economy. In particular, the Government wanted to strengthen:

a. the policy framework for the capital markets, especially the regulation of securities markets;

b. the operational capabilities of key capital markets entities, especially the securities depository,registry, clearing and settlement functions; and

c. the public's comprehension of the capital markets and their roles as shareholders.

The Capital Markets Development Project provided technical assistance, training, informationtechnologies and various office-related equipment and resources. The total cost of the Project wasestimated at US$ 21.0 million equivalent. The World Bank financed US$ 9.5 million equivalent ofthe project cost and the Borrower participated with local funds corresponding to the US$11.5million. The Loan was actually effected in German Marks.

2. SPECIFIC COMMENTS OF THE BORROWER ON THE CMDP IMPLEMENTATION

When evaluating the CMDP, it should be noted that the practical objectives of the project were toestablish and make operational the main institutional and regulatory elements of the Croatian'scapital markets, and to embed created institutions into the global macro-economical movements ofthe Croatian economy.

From that point of view, the project has fully met its objectives.

a) Project design

With the help of the World Bank's team of dedicated specialist, the Technical Annex was verywell developed, clearly identifying each of the components together with the relevant budgetcomponents. Such approach helped, to the great extent, to understanding of the local teamsimplementing the project components, what and how needs to be done. Consequently, theunderstanding of the clearly set objectives and of the available resources resulted with theproject "ownership" by the implementing agencies.

18

b) Project implementation

As stated in the ICR, the Project had three basic components:

(i) The Policy Support Component supported the development of a legal and regulatory framework. Itcomprised:

E regulatory and organizational development of the Croatian Securities and Exchange Commission(CROSEC) and establishment of essential capital markets legislation;

* restructuring of illiquid government obligations in the form of tradable securities; and,

* development of a satisfactory strategy for managing the investment portfolio being transferred to thepension fund.

(ii) The Infrastructure Development Component provided technical assistance and investment resourcesto establish and strengthen the key capital markets institutions, including modern information systems tosupport essential capital markets functions, in particular the securities depository, registry, clearing andsettlement function.

(iii) The Public Awareness Component provided technical assistance to devise and create mass media, publicawareness vehicles. The component also provided financing for the execution of the public awareness campaign toimprove the general public's understanding of the capital markets and of their roles and rights as participants.Project teams involved in implementation in all of above mentioned components strictly followed the objectives setin the Technical Annex and extensively used the assistance provided by the dedicated team of the World Bank. Thisclose (literary day-to-day co-operation) resulted in a very productive project implementation and timely closure ofthe loan.

The key points of the project implementation are:

* the World Bank's project support team, rendered, practically, on-line support in all on-goingtechnical and procurement issues. Such support resulted in good and timely selection ofappropriate and competent consultants with a rather fast turnover of major consultancy andhardware/software procurement contracts within the Bank's approval process;

• the Task Manager succeeded in obtaining additional support to the project management, throughensuring Italian trust grant funding (in kind) for the MoF's Project Management Unit (PMU).Based on this funding (cca 500 k$ in technical assistance), an experienced project manager andseveral short term consultants were added (at no charge) to the PMU;

* the selected Croatian Team Leaders, both for the CROSEC and for the SDA, were very competentindividuals. They succeeded, (with the support of the World Bank's team and selected consultants),to build-up their respective entities from scratch to full size organizations, during the CMDPProject. That included the complete institutional development and the development of theinfrastructure;

* although starting somewhat late and the Borrower being heavy penalized with imposed currencyexchange losses (some 17% - the Loan in DEM, with expenditures in US $), the Project wascompleted and the loan disbursed on time, with all elements specified in the Technical Annex, fullyimplemented;

* by the end of the project, the CROSEC became fully staffed and well organized Regulatory Bodytaking very active role in the development of Croatian capital markets;

19

* equally, the institutional development as well as the installation of very sophisticated equipment,made the SDA one of the most advanced depositories in this part of Europe;

* the Public Awareness Campaign met its primary objectives. However, it became obvious thatcapital markets issues are rather new prospective of economical thinking within wider layers of theCroatian public. Consequently, more effort needs to be invested in the future to further educatesome 700.000 small shareholders;

* taking the above into account, under given circumstances, it could be stated that the project wasimplemented in line with the World Bank's rules and policies, creating a solid base for furtherdevelopment of the Croatian capital markets. Due to other macro economic reasons, such as theshortfall of expected international capital inflows, the actual trading activities are considerablylower than expected. As a direct result of such situation, the Government will have to furthersupport the initial project objectives in order to overcome the transition phase between creation andsteady state operation of mentioned institutions.

c) Bank performance

The performance of the World Bank's team assigned to the Capital Markets DevelopmentProject, headed by Mr. Hiran Herat, the Task Manager, can be described as highly cooperativeand supportive. Each member of the team demonstrated the sensitivity and good understandingof the Croatian specific business environment. It should be highlighted that they were available,practically at all times, for consultations and assistance in resolution of ongoing issues. TheTask Manager continuously followed the work of the PMU and of the working groups, whichhelped avoiding problems in advance.

Probably one of the main points in the Bank's staff performance was the accessible continuity ofthe individuals assigned to the project, their cooperative attitude and their familiarity with thelocal specifics of the country.

2. PROJECT SUSTAINABILITY

Having reached its objectives, the CMDP created the right framework for further development of theCroatian capital markets.

On behalf of the Government it is well understood that additional actions need to be taken in order tojustify the current investment and to over-come the transition period between the creation and thesteady-state operation of institutions established as a result of the CMDP. This particularly concernsthe SDA, which under the ruling of the Securities Law needs to "dematerialize" shares of more than2,000 share holding companies, currently existing in Croatia. This, in-itself, is an enormouschallenge, which needs to be implemented in next five years. Although being a troublesome process,it has been already initiated by granting the operating license to the SDA by the Regulator on April29, 1999.

This has also been supported by the decision of Pliva d.d., one of the countries largest companieswith international investors, to appoint the SDA as its primary registrar effective July 19, 1999,when the SDA went "on line".

20

Two other companies have also agreed to appoint the SDA as primary registrar. This translates intomore than 42,000 securities accounts holding more than 36 million shares with a total market valueof over HRK 8.5 billion in the central registry (or about US$ 1.2 billion).

Efforts to convert additional companies, as specified by the Securities Law, are ongoing, and willtake some time, until SDA fully loads its registries.

It is to be mentioned that the Government fully understand the current situation and demonstrated itscontinued commitment to the sustainability both of the CROSEC and of the SDA.

3. FUTURE OPERATIONS

Within the action plan to support the entities created under the CMDP (CROSEC & SDA), and tofurther develop the Croatian capital markets, the Government in cooperation with the World Bank,has already taken specific steps. The additional technical assistance has been ensured both to theCROSEC and to the SDA under the recently approved Technical Assistance Project for Institutionaland Regulatory Reform for Private Sector Development (Loan No. 4460-HR) - TAL II Project. Thedetailed action plans and the corresponding budget for each of the mentioned agencies could befound in the Loan Agreement and the Project Implementation Plan of the TAL II Project.Additionally, the Government is also making efforts to support the SDA during the start-up phase byfacilitating appropriate loans for covering the shortfalls in the SDA's current income, until the pointof the SDA's self-financing.

4. CONCLUSIONS

Summarizing the above comments, the following could be said about the Capital MarketsDevelopment Project:

* it is essential to have well designed Project Technical Annex (including estimates for each of theproject components), as a guideline for all parties involved;

* the understanding of the World Bank's team of the local circumstances, and the continuity of theWorld Bank's staff on the project is one of the keys to the success of the project;

* election of appropriate individuals for heading specific project components, in the Borrower'sscope, is equally important for the success of the project;

* the project management function (PMU) could greatly contribute to the project success. Withinthe CMDP, the PMU demonstrated to be a useful bridge between the Bank's team and theimplementing agencies. It particularly helped in implementing the World Bank's policies andprocedures;

* within its scope and objectives the CMDP fully met its objectives, implemented with activeBorrower's support and participation in line with the World Bank's policies and procedures,within the allocated budget and within the perceived schedule.

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Appendix B

CROATIA: Capital Markets Development ProjectSupervision Mission

May 26, 1999

-- Aide Memoire --

I. A World Bank mission comprising Messrs. Hiran Herat, Craig Neal, Hemant Shah and ZdravkoKuzmic visited Zagreb between May 26-28, 1999 to supervise and to initiate the ImplementationCompletion Report (ICR) for the Capital Markets Development Project (CMDP). The mission met withrepresentatives of the Ministry of Finance (MOF), Croatian Securities and Exchange Commission(CROSEC), Securities Depository Agency (SDA) and the Project Management Unit (PMU). The missionwishes to extend its thanks to the Croatian authorities for the cooperation and courtesies extended to it.

Project Objectives

The project objective, as set out in the Loan and Project Summary of the relevant Staff Appraisal Reportdated February 29, 1996 (Report No: T-6704-HR), was to support the Government of the Republic ofCroatia's economic transformation programs, by facilitating the privatization and restructuring processesand, more generally, developing the capital markets institutions required for a modern market-basedeconomy. In particular, the Government wanted to strengthen:

(i) the policy framework for the capital markets, in particular the regulation of securitiesmarkets; including the organizational development of the Croatian Securities andExchange Commission (CROSEC

(ii) the operational capabilities of key capital markets entities, in particular the securitiesdepository, clearing and settlement functions; and

(iii) the public's comprehension of the capital markets and their roles as shareholders, viamass media, public awareness vehicles

3. Project Status and Anticipated Activities. Both the CROSEC and SDA components continue toprogress satisfactorily. The work on the public awareness campaign has been completed. CROSEC isestablished and active, with the initial institutional development technical assistance (TA) completed, andthe second phase to be completed by June 30, 1999. Similarly, SDA is established. Its operationalsystem is expected to go on line in July 1999. SDA's institutional development TA will also becompleted by end June.

4. Total Loan amount of 14.2 million DEM loan has been committed, and about 81 percentdisbursed. The audit of the project accounts are underway and is expected to be completed shortly.

5. Following are a summary of accomplishments made by CROSEC over the last few months. Theclear inference from the list of accomplishments set forth below is that this component is meeting itsobjectives:

22

* CROSEC presented its first annual report to Parliament on March 5, 1999.

* Enforcement continue to be a priority. CROSEC has opened 36 over the past three months, bringingthe total to 57 investigations of possible violations of the Securities Law, Company Law, TakeoverCode, PIF Law, and Investment Fund Law. At present, the Enforcement Division has 25 activeinvestigations.

* CROSEC has licensed 18 management companies and 5 open-end investment funds, 2 closed -endfunds and 7 PIFs.

* The CROSEC/Ministry of Privatization program of privatization investment funds (PIF's) is beingclosely supervised by the CROSEC, and the program is progressing rapidly. All seven PIFs have hadtheir proposed portfolio valuations accepted by the CROSEC. In addition, the PIFs have been listedfor trading on the Varazdin OTC market.

* The CROSEC has approved prospectuses for 31 private placements valued at over 4.1 billionHRK and 22 public offering prospectuses concerning the issues of 3.1 billion HRK insecurities.

6. After discussions with all market participants, the CROSEC issued SDA its operating license onApril 30. The SDA will require approximately 10 weeks to prepare for production services, includingthe additional training and simulation program for market participants. The SDA expects to be ready to"'go live" on July 6, 1999 with Trade for Trade Settlement services in the three depository eligiblesecurities currently in the system. They expect to hold another round table discussion after six weeks ofTrade for Trade Settlement services to determine if the market is prepared to start Contractual Settlementservices together with the implementation of the Guarantee Fund.

Issues

7. The following issues would need the close attention of the MOF in order to sustain the progressthat has been made on the project so far:

(i) CROSEC Offices. CROSEC's inability to move to the new premises at Ksaver, has retardedtheir ability to staff up and realize its responsibilities in some of its functional areas -- mostnotably enforcement. The mission urged the MOF to seek closure on all open issues that areperpetuating this delay.

(ii) Bride Financing for SDA. Although SDA's long-term financial viability is not in question,under current market conditions and with the recently-approved fee structure, SDA must financeprojected losses over the next three years. With no prospects for fresh capital, little to no latitudeto increase fees, expand service volumes or shrink its predominantly fixed cost base, SDA'sfinancial survival in the interim depends on term debt finance. SDA has reached agreement, inprincipal, for a syndicated bank loan. However, it must have a government guarantee to obtainthese funds. This must be arranged immediately, since SDA's initial capital is exhausted and itsdebts are already accumulating. Continued cash drain is very likely to lead to staff losses, aserious disruption of SDA's operations, and, even more critical, a hard-to-repair loss ofconfidence in the Croatian capital market by domestic and foreign participants )or prospectiveparticipants)

23

Operational Plan

8. The Bank's revised guidelines ( April 1994) on preparation of ICRs requires the preparation of anoperational plan by the Borrower and the implementing agencies, indicating actions and measures to betaken by the Borrower, the relevant Government agencies, and the project entities, to ensure satisfactoryfuture implementation and operations under the project, and the achievement of the project s objectives.The draft operational plan should include:

* the Government's views on the continued relevance of the project's objectives;

* actions and measures to be taken to ensure sustainability and continued satisfactory operation ofinstitutions and technical assistance programs under the project;

* actions and measures to be taken in the case of subprojects and subborrowers facing financialdifficulties, including enterprises that continue to be under state ownership.

9. The operational plan should be supported by a table that indicates clearly, for each major itemunder the technical assistance component, the following:

* major issues/problems;

* major actions/measures already take, being taken or to be taken;

* schedule and timing of each major action/measure; and

* the main Government and /or project agencies responsible for the actions/measures.

Borrower's Evaluation Of Project Implementation

10. The Borrower's responsibilities in the preparation of the ICR are indicated in the Bank'sOperational Manual Statement and Good Practices for ICR Preparation (GP 13.55 of April 1994.paras 4and 5). Copies of the Bank's BP 13.55 and relevant parts of GP 13.55 were given earlier to the Borrower(PMU)

11. As indicated in BP 13.55 and GP 13.55, the Borrower's ICR should include a summary notexceeding 10 pages, together with the supporting background information and annexes.

Project Cost and Financing Plan

12. To enable a comparison of appraised and actual project costs and financing plans, the Borrowershould update the relevant tables (Tables 2 and 4 on pages 10 and I I of the Staff Appraisal Report No. T-6704-HR).

Information to be sent to the World Bank

13. To enable the Bank to complete the draft of Part I of the ICR, it was agreed that the Borrowerwould ensure that the information in relation to the technical assistance component indicated in AnnexesI is sent to the Bank together with the updated project costs and financing table.

24

14. To enable the timely submission of the final ICR, including both the Borrower's and the Bank'sparts to the Bank's Board of Directors by December 31, 1999, as required, it was agreed that thefollowing timetable would be followed:

PMU to send the Bank by August 31, 1999

(i) The updated project cost and financing tables;(ii) The draft operational plan(iii) Updated project indicators; and(iv) A status report on SDA's financial situation and its loan application.

Coordination of ICR Preparation

15. The following persons would coordinate the preparation of the Borrower's and the Bank's preparationof ICR:

For the Borrower Hrvoje Radovanic, Assistant Minister, MOFSanja Flegar, Manager, PMU

For the World Bank Hiran Herat, Task Manager

Zagreb, CroatiaMay 28, 1999

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Appendix 3

CAPITAL MARKETS DEVELOPMENT PROJECT (Loan 3999HR)Project Indicators

INTRODUCTIONThe objectives of the Capital Markets Development Project was to facilitate the transformation of the Croatianeconomy, primarily supporting capital markets institutions which lower the risks associated with securities market.An overview of measurable and quantifiable categories, which have a direct impact on the changes in the Croatianeconomy, are given below. The overview of the investments in terms of contracted technical assistance (staff-months), training programs/study tours, and equipment procurements as compared to delivered reports, installedsystems/equipment and actually realized study tours, attendance at different conferences and training sessions isgiven in a table format.

OUTCOME INDICATORSa. Policy Development (Securities regulations and operational procedures - development of

CROSEC)

The elaboration of key securities regulations and operational procedures, includes:i. by-laws of the CROSEC; The "By-law of the Securities Commission of the Republic of

Croatia" was issued on June 23, 1997 (Narodne Novine # 75 ).

ii. implementation of regulations based upon the Securities Act; In addition to the Regulationreferenced above, the CROSEC has issued the following regulations: Regulation for the

Conditions and Process of Issuing licenses to do Business With Securities and for Authorized

Agents to Trade Securities (Narodne Novine #56, May 28, 1997 as amended Narodne Novine

#60); Regulation on Stock Broker's Examination (Narodne Novine #69, July 2, 1997); Decisionon Administrative Fees (Narodne Novine #62, May 22, 1997); Regulation on the Content ofAbridged Prospectuses and Conditions for Private Placements of Securities (Narodne Novena#61, June 4, 1997 as amended Narodne Novena #65, June 18, 1997); Regulation of PrivatizationInvestment Funds to Participate in Privatization (Narodne Novine #125, October 17, 1997),Regulation on the Accounting Records and Financial Reports of Investment Fund ManagementCompanies and Investment Funds (March 24, 1999, The Regulation is based upon InternationalAccounting standards and modern techniques of mutual fund bookkeeping and reporting),Regulation on the Obligatory Form and Content of Periodic Reports (March 24, 1999 asamended, April 27, 1999 - The Regulations sets forth the standardized forms that issuers shouldfile with the public reference room. The Regulation makes substantial strides in increasing theamount of financial disclosure that Croatian enterprises are required to make public), Regulationon Securities Companies Trading Off-exchange and Trading in PIF Shares (April 27, 1999. TheRegulation is aimed at stemming an arising situation in which market participants with fraudulentintent canvass the regions of Croatia and purchase PIF shares for a fraction of their marketvalue).

iii. guidelines for CROSEC staff conducting inspection of investment firms, stock exchanges,brokers, dealers, depositories, etc. The "Procedures Manual for CROSEC Operations" wasdelivered to the CROSEC on December 11, 1997. These operating procedures have beenimplemented in part by the CROSEC staff. As the development and training of the CROSECstaff progresses, more provisions of the operating procedures, or a variation of the procedures,are adopted by the staff.

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iv. regulations and guidelines for confidentiality by CROSEC staff; Article 14 of the SecuritiesAct prohibits present or former CROSEC Commissioners or staff from divulging material orprivileged facts which they learn in the course of their duties regardless of the source of theinformation. Such disclosure may only be made when authorized by law and is otherwiseconsidered to be a state secret. Moreover, Article 14 prohibits CROSEC Commissioners or stafffrom providing advice or opinions on the merits of securities traded in the territory of Croatia. Inaddition, Paragraph 1.1.9 of the Procedures Manual contains a procedure for specialconfidentiality requests by issuers, and paragraph 5 of the CROSEC's Code of Ethics (deliveredApril 20, 1997 and presently under review) provides further restrictions on the use anddissemination of non-public information.

v. Drafting of Legislation and Amendments; The CROSEC has successfully drafted, submitted tothe Government, and lobbied through the Parliament two pieces of legislation that stimulatedevelopment of the capital market: The Takeover Code (Narodne Novena # 124, November 7,1997) and The Law on Privatization Investment Funds (NarodneNovine #109, October 10,1997).In addition, the CROSEC provided comments to the laws on pension fund reform in June of1997. Furthermore, on July 6, 1998, the CROSEC submitted to the Government proposedamendments to the Securities Law. The CROSEC is also drafting and reviewing amendments tothe Investment Fund Law. The CROSEC has successfully amended the Securities Law (NarodneNovine # 142, October 28, 1998).

vi. Enforcement Activities; During the project, the CROSEC opened 57 investigations of possibleviolations of the Securities Law and Investment Fund Law, of which 22 has been closed. Thirty-one referals have been made to the Public Prosecutor. There are currently 25 enforcement actioninvestigations in process. The investigations concern a variety of possible violations, includingmarket manipulation, failure to disclose material information, insider trading, conductingunregistered brokerage activity, and fraud

vii. Regulation of Investment Funds; The CROSEC has licensed 19 management companies and 13investment funds. The CROSEC has also licensed an open-end mutual fund which is makingperiodic disclosure and valuing its portfolio in accordance with International AccountingStandards. In addition, the CROSEC has been conducting oversight and inspections of theactivities of seven privatization investment funds. This oversight includes a review of all fundadvertising to ensure that advertisements do not contain unrealistic statements. Finally, theCROSEC drafted a model disclosure document that funds must provide voucher holders beforeinvesting. The CROSEC/Ministry of Privatization program of privatization investment funds(PIF's) is being closely supervised by the CROSEC, and the program is progressing rapidly. ThePIF's have all been listed for trading on the Varazdin OTC market.

viii. Corporate Finance Regulation; The CROSEC has approved prospectuses for 31 privateplacements for a value of over 4.06 billion HRK and 22 public offering prospectuses concerningthe issue of 3.13 billion HRK in securities. Approval of all prospectuses was based upon theprinciples of full financial disclosure. The CROSEC is implementing the Takeover Code.

ix. Market Regulation; The CROSEC has registered 51 brokerage companies to date. In addition,the CROSEC has organized two training seminars for individual securities brokers. The seminarshave included lectures on ethics, domestic securities regulations, modern portfolio theory, and

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international and domestic trading practices. To date, 172 brokers have received training, and 202have passed the certification examination.

x. The Parliament accepted, on March 5, 1999, the first annual report of the CROSEC.

xi. During the period of March 22-25, the CROSEC successfully sponsored a seminar on the topic ofdetecting, preventing and prosecuting securities market manipulation. The CROSEC held theconference on behalf of the International organization of Securities Commissions, Emergingmarkets Committee Working Group 4. Sixty-three representatives of the securities regulatorybodies from 19 emerging and developed countries attended the seminar.

xii. The CROSEC is in the final phase of establishing the Public Reference Room in cooperation withZAP:

xiii. The CROSEC is actively involved in a working group that is integrating Croatian laws with thoseEU Directives that involve securities.

b. The impact of depository on securities activities (Infrastructure - development of the SecuritiesDepository Agency and its facilities)

The development of infrastructure of the Securities Depository Agency is advanced to the point thatthe target date of going "alive" with the Clearing and Settlement services is set for the January I 9 th,1999. The current loading level of the operating system, as well as planned loading are given in thetables below.

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Current

Number of Accounts Number of Shares Market Capitalization (Ka)39,097 3 82-7,276 47 0,z2 373 40

Domestic individuals , ,8, 4

Domestic companies 1,995 16,700,387 3,012,103,835Foreign individuals 907 1 55,302 3,889,642Foreign companies 118 15.565,184 4,930,875,877Treasury shares 10 296,869 71,244,084Totals 42,127 36,445,018 8,488,436,898

c. The impact of the public awareness campaign

The results of the public awareness campaign could be summarized as follows:1. IO minutes education TV episodes, covering elements of the capital markets in general (4) and

coupon privatization broadcasted in four cycles during prime time on the Croatian nationaltelevision. The total broacasting time was approximately 3,5 hours.

II. 12 radio series of 10 minutes each, covering all aspects of the capital markets, broadcasted insome 20 local radio-stations. Each broadcast included a phone-in program of about one hour. Thetotal brodcasting time could be estimated at 40 hours total.

11. About 500 video tapes containing education TV episodes distributed to different interestedparties.

Planned

Curr. Dee 99 Jan 00 Feb 00 { Mar 00 Apr00 | Maw 00No. of securities 12 16 20 25 30 36No. of accounts 42,000 45,000 60,000 70,000 75,000 80,000 85,000No. ofmarketparticipants 21 23 25 27 29 31 33Market Value (billion kuna) 8.5 Not possible to predict. Market value will depend on prevailing market

conditions and the bring-on sequence for the various securities.Daily turnover (thousand kuna)' 130 Not possible to predict. Subject to prevailing market conditions outside

|________ _ >of the control of the SDA.

l________________________ _ Jun 00 Jul 00 Aug 00 Sep 00 Oct-00 I Nov-00 Dec 00No. of securities 42 50 60 70 80 90 100No. of accounts 90,000 340,0002 345.000 350,000 355,000 360 365,000No. of market participants 35 37 39 41 43 45 ! 45Market Value (billion kuna) 8.5 Not possible to predict. Market value will depend on prevailing market

conditions and the bring-on sequence for the various securities.Daily turnover (thousand kuna)3 130 Not possible to predict. Subject to prevailing market conditions outside of the

| control of the SDA.

In depository-eligible securitie2 Introduction of the Privatization Investment Funds (PIFs)

In depository-eligible securitie

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CAPITAL MARKETS DEVELOPMENT PROJECT (Loan 3999HR)Project Input - Output Indicators

COMPONENTsub-component

INPUTIOUTPUT CY1 997 CY 1998 CY 1999 TOTAL

POLICY SUPPORT

CROSEC institutional Develop.INPUTS

foreign TA months (major TA cont.) ............ ...... 28 . 10 4 42

OUTPUTSmajor reports ......... ... 3 .......... 1 1 25

periodic reports . 7. 3 2 12 training progam months ......... Note (1) Note (1) .... Note (1) .. Note (1)

study tours .2..............2 6 10 .. 3General:

Regulations Published 5 0 4 9 Note (4)Laws Drafted 2 0 0 2 Note (4)

Laws Submitted to Government 2 0 0 2 Note (4)Amendments Drafted 2 0 0 2

Amendments Submitted to Governement 0 1 0 1Laws/Amendments Passed by Sabor 2 0 0 2

Employees Hired 19 4 5 27Enforcement Division:

Investigations Opened 0 20 37 57 Note (4)Investigations Closed 0 2 20 22 Note (4)

Investment Management Division:Management Companies Licensed 14 4 1 19 Note (4)

Investment Funds Licensed 0 3 10 13 Note (4)Corporate Finance Division:

Public Offering Prospectuses Approved 15 1 6 22 Note (4)Pvt. Placement Prospectuses Approved 22 5 4 31 Note (4)

Market Regulation Division:Brokerage Companies Registered 24 10 17 51 Note (4)

Individual Brokers Trained 172 0 0 172 Note (4)Individual Brokers Certified 0 154 48 202 Note (4)

INFRASTRUCTURE DEVELOPMENT

SDA Institutional DevelopmentINPUTS

foreign TA months (major TA cont.) 14 25 6 45foreign TA months (other TA cont.) 3.5 10 7 20.5

OUTPUTSmajor reports 3 9 6 18

periodic reports 1 2 2 5newsletters 4 3 7study tours 2 2 0 4

SDA Infrastructure DevelopmentINPUTS

foreign TA months (major cont.) Note (2) Note (2) Note (2)domestic TA months Note (3) Note (3) Note (3)

major computer systems 2 0 2

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OUTPUTSmajor reports/business specifications 0 5 5

training progam months Note (2) Note (2) Note (2)business and operational sys. 0 2 3 5

# of other equipment procurements 4 6 10

PUBLIC AWARNESS

INPUTSforeign TA months ......... 9.............. ... 2.5 ... ...... 11.5

domnestic TA months .6 . .1 .... .......... 7

OUTPUTSmajor reports .2 . .1 ..........3

periodic reports . ........ ............ 1 9.......... . 9camera-ready printing pkgs .................. 10 . 0 .. ........ 10.broadcast-ready video pkgs ................... 5. .0 .... 5broadcast-ready audio pkgs .................. 12 ......... 0 .. 12.

(1) - Traninig program months integrated in the main TA contract(2) - Training & TA months and included in the contract for the equipment supply(3) - Domnestic TA months included in the main contract for the Public Awarness Campagn(4) - Denotes ongoing activity of the CROSEC

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