Document of

The World Bank

Report No. 15078-E

STAFF APPRAISAL REPORT

THE FORMER YUGOSLAV REPUBLIC OF MACEDONIA

PRIVATE SECTOR DEVELOPMENT PROJECT

April 18, 1996

Industry, Trade and Finance Operations DivisionCountry Department IEurope and Central Asia Region

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CURRENCY EOUIVALENTS

Currency Unit = Macedonian Denar

US$1.00 = 23.3 on December 31, 1993US$1.00 = 43.3 on December 31, 1994US$1.00 = 36.8 on December 31, 1995

ABBREVIATIONS AND ACRONYMS

BRA - Bank Rehabilitation AgencyCMEA - Council of Mutual Economic InterestDM - Deutsche MarkEU - European UnionFESAC - Financial and Enterprise Sector Adjustment CreditFX - Foreign ExchangeGDP - Gross Domestic ProductGSP - Gross Social ProductIBRD - International Bank for Reconstruction and DevelopmentIDA - International Development AssociationID/NBM - International Department, National Bank of MacedoniaIMF - International Monetary FundIRR - Internal Rate of ReturnMOF - Ministry of FinanceMKD - Macedonian DenarNBM - National Bank of MacedoniaPA - Privatization AgencyPFI - Participating Financial IntermediariesPSD - Private Sector DevelopmentSAC - Savings and Credit AssociationsSAL - Structural Adjustment LoanSCL - Single Currency LoanSME - Small and Medium Scale EnterprisesSOE - Statement of ExpendituresSRP - Special Restructuring ProgramSTB - Stopanska BankaTA - Technical AssistanceUSAID - United States Agency for International Development

FYR OF MACEDONIA - FISCAL YEAR

January 1 - December 31

THE FORMER YUGOSLAV REPUBLIC OF MACEDONIA

PRIVATE SECTOR DEVELOPMENT PROJECT

LOAN AND PROJECT SUMMARY

Borrower: The Former Yugoslav Republic of Macedonia

Loan Amount: DM 18 million

Beneficiaries: Private enterprises, including private farmers, participating financialintermediaries.

Loan Terms: Single currency loan (SCL) in Deutsche Mark (DM) for twentyyears, including five years grace, at Bank's standard LIBOR-basedvariable rate for SCLs denominated in DM.

On-lending Terms: The NBM will rediscount the subloans of the participating financialintermediaries (PFI) in DM at the cost of Bank funds plus a marginof 100 basis points to cover the cost of administration and the creditrisk associated with lending to PFIs. The PFI subsidiary loans willbe extended on a first-come first-served basis, back-to-back to PFIsubloans to final beneficiaries. The PFIs will bear the full credit riskof their subloans. The subloans for private enterprise andpermanent working capital finance will be provided with 1-10 yearmaturities including up to 3 years grace. The subloans to farmerswill be provided with up to five year maturities including up to twoyears grace period. The PFIs subloans to the beneficiaries will bedenominated in DM with variable interest rates based on the Bank'slending rate plus the 100 basis points, plus a market-based PFIspread. The final beneficiaries will bear the currency and theinterest rate risk.

Project Objective: (a) promote growth of the private sector and improve conditions foreffective supply response from private enterprises and farmers;(b) facilitate adoption of safe and sound banking practices; and(c) promote credit market competition.

Project Description: (a) Private Sector Finance (DM 14 million) for projects of privateenterprises to improve profitability by increasing output orimproving efficiency; and (b) Private Farmer Finance (DM 4million) for projects of private farmers to expand agricultural output.

Benefits and Risks: The expected benefits include: improved conditions for effectivesupply response of private enterprises, including private farmers;increased efficiency, value-added and profitability of privateenterprises and farmers; improved institutional capacity ofparticipating financial institutions to appraise subprojects and to

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assess and manage risk; and increased competition in the creditmarkets.

Institutional weaknesses and skill deficiencies of banks and privateenterprise management is the main project-specific risk. It isaddressed through technical assistance to improve PFI's capacity toassess and manage risk, by keeping open access to eligible PFIs, andthrough increased supervision. There is also a risk concerning PFIintermediation capacity -- macroeconomic volatility and uncertainprospects may adversely affect PFIs' willingness to engage in termlending. The PFI credit risk and the foreign exchange risk of finalbeneficiaries has been decreased by extending a single currency loan.On the macro level, the macroeconomic instability is the main risk,which is addressed by the FESAC and the SAL, which is currentlyunder preparation, and through on-going policy dialogue with theIMF. There is also a geo-political risk because of instability in theBalkan region.

Estimated Cost:

---------------------- (DM Million)------- ------------

Local Foreign Total

Private Investment Finance 6.0 14.0 20.0Private Farmer Finance 1.0 4.0 5.0

Total 7.0 18.0 25.0

Financing Plan:

----------------- (DM Million)---).

Local Foreign Total

IBRD 0.0 18.0 18.0Private Enterprises and Farmers 3.0 0.0 3.0Financial Intermediaries 4.0 0.0 4.0

7.0 18.0 25.0

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Estimated Disbursement:

--------------------- (DM million)------------------

FY97 FY98 FY99

Annual 2.50 6.5 9.0Cumulative 2.50 9.0 18.0

Rate of Return: Expected minimum rate of return is 15 percent, which is based on the rate of returnexpected on individual subprojects.

STAF1F APPRAISAL REPORT

THE FORMER YUGOSLAV REPUBLIC OF MACEDONIA

PRIVATE SECTOR DEVELOPMENT PROJECT

Table of Contents

Page No.

I. INTRODUCTION . ................................................ 1

H. ECONOMIC AND SECTOR ENVIRONMENT ................. 2A. Macroeconomic Developments ................................... 2B. Structural Reforms ........................................... 4C. Private Sector Development ..................................... 5

Im. BANKING SECTOR ............................ 8A. Regulatory and Institutional Framework ............................. 8B. Banking Sector Structure ....................................... 9C. Credit Markets ............................................ 12

IV. PROJECT RATIONALE .................... ...................... 14A. The Bank Group Strategy for Assistance ............................ 14B. Rationale for Bank Involvement ................................. 15

V. THE PROJECT ................................................ 16A. Objectives and Scope of the Proposed Project ......................... 16B. Project Components ......................................... 16C. Project Cost and Financing Plan ................................. 20D. Environmental Aspects ....................................... 20

VI. PROJECT IMPLEMENTATION AND ONLENDING ARRANGEMENTS .......... 21A. Loan Terms and Conditions .................................... 21B. Lending Arrangements ....................................... 22C. Loan Administration ........................................ 25

VII. BENEFITS AND RISKS ......... .................................. 27A. Benefits . ................................................ 27B. Risks ................................................... 27

VII. AGREEMENTS AND RECOMMENDATION ........................... 28

This project has been prepared by a team comprising S. Brajovic-Bratanovic (EC1IT, as task manager), T. Uyanik(EC1AE) and Y. Tzvetkova, V. Barrios and V. Polizato (Consultants). The preparation was initiated in the finalstages of the Financial and Enterprise Sector Adjustment Credit, which was presented to the Board on May 16, 1995and the appraisal mission took place in July 1995. Peer reviewers: 1. Zurayk (EC2CO) and A. Ewing (PSD).Managers: Franco Batzella, Chief (EC11T); Kenneth Lay, Director (EC1DR)

AiNNEXES

Annex 1: Procedure for Accreditation of Banks and Criteria for Banks QualificationAnnex 2: Participating Financial InstitutionsAnnex 3: Disbursement ScheduleAnnex 4: Project Implementation ScheduleAnnex 5: Terms of Reference for Operational Audits of Participating BanksAnnex 6: Development IndicatorsAnnex 7: Selected Documents Available in the Project File

Map. No. IBRD No. 27711

THE FORMER YUGOSLAV REPUBLIC OF MACEDONIA

PRIVATE SECTOR DEVELOPMENT PROJECT

I. INTRODUCTION

1.01 The former Yugoslav Republic of Macedonia became a sovereign state in April 1992 anda member of the World Bank in December 1993. It is a small, landlocked, mountainous country of about26,000 square kilometers and two million people. The rate of population growth is just under one percentper year and the country's income per capita was US$790 in 1994. Nearly half the area of the countryis devoted to agriculture, split about equally between cultivated area and pastures. Industry is thedominant sector, accounting for 43 percent of GSP and for 48 percent of the total employment.

1.02 Although overshadowed in recent years by the difficult process of transition to a marketeconomy, the former Yugoslav Republic of Macedonia possesses a diversified and potentially soundeconomic base. Legal and institutional frameworks are being strengthened to better suit a marketeconomy and the policy framework has been substantially liberalized. Recognizing the difficulties ofachieving an adequate supply response and efficiency gains in enterprises owned and operated by thepublic sector, the Government plans to privatize the socially-owned enterprises. About 705 companieshave been privatized by March 1996 under the 1993 Privatization Law, in addition to about 440enterprises privatized under the former Yugoslav legislation. The privatization program under theFinancial and Enterprise Sector Adjustment Credit (FESAC) envisages the privatization of about 1,200enterprises by end-1996.

1.03 The ownership reform of the state sector is supplemented by a broad program to supportgrowth of indigenous private sector enterprises. About 77,000 new private firms were registered by May1995, of which about 38 percent have already opened for business. In agriculture, there are about177,000 privately-owned farms. In the 1990-1994 period, employment in the private sector enterprisesincreased from about 60,000 to 100,000 employees, with a similar increase of employment in privateagriculture. The private sector participation in GDP has grown from about 10 percent in 1990 to anestimated 20 percent in 1995.

1.04 The growth of the private sector has been inhibited by several factors, including crowdingout by the public sector from access to capital, raw materials and infrastructure. The proposed Projectis expected to have a meaningful impact on the overall transition process by promoting development ofthe private sector by providing financial support to private enterprise investment programs. Investmentsfinanced by the proposed Project will yield positive effects regarding employment and income generationcapacity of the private sector, including private farmers. It will also contribute to further transformationof the banking system by encouraging competition. Through hands-on involvement with individual banksin the process of banks and projects appraisal, it will help to improve banks' operational policies andbusiness practices.

1.05 To support the proposed Project, the Government has requested a Bank loan of DM 18million. The proposed Loan would include: a private sector finance component of DM 14 million forinvestments of private enterprises active in the manufacturing and services sectors; and a private farmerfinance component of DM 4 million for investments of private farmers.

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II. ECONOMIC AND SECTOR ENVIRONMENT

A. Macroeconomic Developments

2.01 Against the backdrop of the loss of markets, as the CMEA and the Yugoslav Federationbroke up, the economy of the former Yugoslav Republic of Macedonia took a hard hit. In the 1992-93period, attempts to stabilize the economy failed owing to a rapidly shrinking revenue base and the veryhigh inflation. In 1994, however, the Government implemented strict budgetary discipline with tightwage and monetary policies to turn the economy back from the brink of hyperinflation. Thus, the fiscaldeficit, which had averaged 12 percent of GDP in 1992-93, was cut to 3 percent of GDP by 1994. Therate of (December-on-December) inflation, peaking at 1,925 percent in 1992, was brought down to 230percent in 1993, 55 percent in 1994 and about 9.2 percent in 1995. There was also a significant priceliberalization. In early 1992, price controls covered about 40 percent of items in the retail price index.By late 1994, the direct price controls covered about 19 percent of items in the retail price index and thelist continues to be revised downwards. At present, price controls cover mostly public utilities. Itemsnot subject to price controls, but closely monitored, include milk, heating and urban transport.

Table 2.1: Real Growth Rates 1990-94(Annual Percentage Changes) l

AverageGrowdh

1990 1991 1992 1993 1994 (1990-94)

GDP -9.7 -9.8 -12.4 -12.0 -5.7 -10.4

Industry and Mining -13.2 -16.8 -15.7 -14.4 -10.5 -14.6Agriculture Forestry and Fishing -19.4 17.3 0.0 -20.0 7.9 -3.3Trade -18.8 -14.7 -19.4 -12.0 -7.6 -14.9Catering and Tourism -8.8 -15.4 -9.1 20.0 -8.3 -4.3Conatruction -15.0 -18.6 -14.3 -13.3 -11.5 -14.9Transport and Communication -18.9 -19.4 -20.0 -15.0 -11.8 -17.4

Econonmc Report ly 1995

2.02 The period since independence has also been characterized by sharp and sustained fall inGDP (Table 2.1). GDP fell by about 12 percent in 1992 and 1993, the decline slowed down to about6 percent in 1994 and to about 2 percent in 1995. Industry and mining recorded a 42 percent fall in realterms between 1990 and 1994, but the decline slowed to 10.7 percent in 1995. Heavy industry wasextremely affected by the loss of traditional export markets (in the SFRY and the CMEA area) and thesevering of traditional links with sources of supply. The construction sector also took a hard hit due tothe loss of overseas markets for construction services and the sharp decline in domestic investment.Value added in the sector fell by 46 percent, in real terms, between 1990 and 1994, in addition to the21 percent drop in activity over the period 1986-89. Sectors directly affected by regional tensions, suchas trade, tourism, transport and communication also contracted, in real terms, by 36, 15 and 48 percent,respectively, in the 1990-94 period. The agriculture sector with an average 3.3 percent contraction wasthe least affected.

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2.03 Gross domestic investment declined from about 32 percent of GDP in 1990 to around 18percent in the 1993-94 period due to uncertainties facing the economy. In addition, as the crisis in thebanking sector intensified, investment decisions became difficult because of high and volatile rates ofinflation. Investment financed by the central government stagnated below 1 percent of GDP during 199 1-93 and rose to 2.7 percent in 1994. Gross investment of the enterprise sector averaged 14 percent ofGDP in the 1991-94 period.

2.04 The registered unemployment rate increased steadily from 17 percent in 1990 to about20 percent in 1994. Employment in socially-owned and mixed enterprises fell by 22 percent between1990 and 1994; or about 112,000 jobs were lost, of which 56 percent were from industry. Theretrenchment continued in 1995 with additional 15,000 jobs shed under the FESAC program.Employment in the private sector nearly doubled, from 60,000 to 100,000, but not enough to fully offsetthe decline.

2.05 Some trade liberalization has taken place since independence with the removal of severalquantitative restriction, and many goods are subject to free trade. Nevertheless, distortions remain,including the presence of import quotas on a number of agricultural products, such as wheat, the use ofexport subsidies, and the imposition of various duties and special levies which can thwart the published(apparently low) tariff rates. Reforms of the trade regime are currently being considered by theGovernment in the context of a proposed Structural Adjustment Credit/Loan.

2.06 Exports from the former Yugoslav Republic of Macedonia have typically comprised semi-processed manufactured goods, such as ferrous metal components, iron and steel, and textiles andconsumer manufactures, primarily footwear and clothing. Merchandise exports averaged US$1.2 billionannually in 1992-94, and increased by about 11 percent in 1995. The loss of export markets in easternEurope and the Middle East has been largely responsible for the disproportionate fall in manufacturedexports, while exports of goods has risen as markets in western Europe gained greater importance.Consumer goods (food, beverage and tobacco) accounted for 22 percent of the value of goods exportedin 1992-94 minerals and manufactures were close to 65 percent and the rest, 12 percent, were machineryand capital goods.

2.07 In 1992, total imports of goods and non factor services were US$1.23 billion, down fromUS$1.63 billion in 1990. During 1993 imports rose marginally to US$1.3 billion, increasing to US$1.64billion in 1994, and producing a current account deficit of US$370 million or about 10 percent of GDP.The total merchandise imports, consumer goods accounted to roughly 20 percent, mineral andmanufactures to roughly 65 percent, and capital goods to 15 percent.

2.08 Medium-Term Outlook. Economic management in the former Yugoslav Republic ofMacedonia has been continuously improving since independence, leading to better macroeconomic balanceand substantially reduced inflation (about 6 percent projected for 1996). The contraction of economicactivity appears to be levelling off. With the prudent macroeconomic management, the economic declinecould feasibly be reversed to an average growth of about 3 percent per year in the 1996-1999 period.The growth of total consumption, however, needs to be kept in check, since the domestic savings wouldbe needed to finance critical investments, for the debt service payments and to restrain the externalborrowing requirements.

B. Structural Reforms

2.09 Complementing economic stabilization, a structural adjustment program was adopted in1993. The program's objectives were to address the macroeconomic constraints and create an enablingenvironment for private sector development, speed up the restructuring of the socially-owned enterprisesector and achieve sustainable growth in the medium-term. The main components of the program were:(a) strengthening the legal and regulatory environment to suit the emerging market economy;(b) streamlining and speeding up the privatization process; (c) reforming the enterprise and bankingsectors; and (d) enhancing mobility in the labor market. The structural reform program execution wasinitially slow, in part because of the need for exhaustive consensus building and practical preparations.

2.10 The Government's reform efforts in the 1993-94 period were assisted by the Bank'sEconomic Recovery Credit. As part of the initial program, most prices were freed, import tariffs loweredand non-tariff barriers to trade removed. Some reforms were introduced in the enterprise and bankingsectors to cap the expansion of credit and hasten the restructuring of the enterprise sector. Labor marketreforms were also initiated, as were reforms of the social safety net. These initial reforms were followedby a more comprehensive reform programs in the enterprise, financial and social sectors which theGovernment adopted in early 1995, along with a program of additional stabilization measures. The 1995program is supported by the Bank's FESAC program, which was approved by the Board in May 1995.

2.11 Enterprise Reform. The Government's strategy for enterprise reform in the medium-term centers on privatization and private sector development. In the short-term, the reform program aimsto force the socially-owned enterprises'/ to restructure by imposing hard budget constraints. Theircontinued operations are to be based on their viability, and there will be no government subsidies orbailouts. Consequently, the rediscounts by the National Bank of Macedonia (NBM), which has been thecustomary way of financing enterprise losses, were abolished as of March 1994, and the governmentguarantee program for loans to enterprises was discontinued as of October 1994.

2.12 For the largest 25 politically sensitive loss-makers2/, the Government has introduced theSpecial Restructuring Program (SRP). The losses of these enterprises accounted in 1993 for about 13percent of GDP, or more than 80 percent of the total losses in the enterprise sector and over 60 percentof the bad debts in the banking system. Under the SRP, the enterprises are isolated from their creditors,including the banking system, and provided with technical assistance to develop consolidation plans thatwould restore a positive cash flow. The enterprises which are not able to generate the positive cash flowin the specified time period are to be liquidated. By end-1995, the 16 loss-makers were broken up intoabout 135 successor enterprises, of which 115 filed for privatization, and the liquidation decision wasmade for four enterprises. A Mining Law, to be submitted to the Parliament by mid-1996, is expectedto help with the final resolution of issues concerning the remaining three enterprises which operate in themining sector.

1/ However, socially-owned enterprises in the agricultural sector are not included in the FESAC program and will beaddressed by the Structural Adjustrnent Credit/Loan.

2/ The list includes 23 large conimercial enterprises and two public utilities, railways and electricity generation anddistribution.

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C. Private Sector Development

2.13 Like most other reforming economies of Central and Eastern Europe, the formerYugoslav Republic of Macedonia has followed a two-pronged approach to increasing the share of theprivate sector in the economy: (a) implementation of an extensive program for the privatization of thesocially-owned enterprises; and (b) an open entry policy for the private sector reinforced by the creationof an enabling environment for the sector. The supply response of the private sector has beenencouraging. From 1990 to mid-1995, the number of private enterprises in the former Yugoslav Republicof Macedonia has drastically increased to about 77,000 from 5,800.

2.14 iLal. Institutional and Policy Framework. In the 1992-1995 period the Governmenthas made notable progress in completing the regulatory framework generally following the model of EUcountries, which will create a favorable legal and regulatory enviromnent for private sector developmentand growth. The most important elements of the legal framework, which are being put in place, include:(a) a Commercial Companies Law, which is in its final draft to be presented to the Parliament in May1996; (b) a Bankruptcy Law, including a US Chapter-11 type of financial restructuring and a cleardefinition of the right of creditors, to be presented to the Parliament in June 1996. The Government alsointends to amend the regulation on collaterals and to build up the capacity of the court system. In arelated effort, the Government plans to strengthen the role and capacity of the Land Cadastre Office andto introduce other measures which will clarify the treatment of land as a collateral and improve efficiencyof the agricultural land market; (c) a Law on Denationalization and Restitution, which is submitted to theParliament, and is expected to resolve the issues currently deterring privatization of urban properties; and(d) modernization of the Law on Standards and Intellectual Property Rights is also in progress.

2.15 Progress has been also made in developing an appropriate institutional framework forprivate sector development. A Privatization Agency, established in 1993, is the principal institution incharge of implementing the privatization. The role of the Chamber of Commerce, with mandatorymembership for all registered companies, has been expanded to include functions needed by the privatesector, including private sector promotion. The private companies are currently in the process ofestablishing a voluntary membership organization akin to the Chamber of Commerce, which would bespecialized to deal with issues specific to the private sector. An Industrial Property Protection Office hasbeen established in the Ministry of Development and a Department of Standardization has been establishedin the Ministry of Economy. Both Ministries have also expanded their functions to include private sectorpromotion aspects. The Government is receiving technical assistance to complete and strengthen theregulatory and institutional framework for the private sector from a number of bilateral and multilateraldonors.

2.16 The policy environment is changing and has been made more favorable to the privatesector. Entry to the economy has been liberalized, and there is no legal discrimination against the privatesector. Economic policies, including price policy, have also been liberalized. A new, non-discriminatingTax Law has been enacted in lanuary 1994. It introduced a flat corporate tax rate of 30 percent.Dividends are exempt from taxation. Since interest income is taxed, this measure specifically promotesprivate ownership. Accelerated depreciation is allowed for up to 25 percent of profits before taxation,and carry-over of capital losses is permitted. Imported production equipment is eligible for tax deductionand equipment related to environmental protection is tax exempt. These measures aim to stimulate privateinvestment and the development of private initiatives in industry, transport and tourism sectors.

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2.17 The Government considers foreign investment to be an important means to raise additionaldevelopment resources. It has liberalized entry for foreign capital and provided tax and other incentivesto foreign investors, which are comparable to or better than those offered by other countries in the region.The new Tax Law offers automatic three-year tax holiday and tax holiday without time limits forinvestments made in areas declared as underdeveloped, flat 30 percent corporate tax rate and free taxstatus if the 30 percent of taxable income is reinvested, exemption from custom duties for importedequipment and services, and 90 percent repatriation of dividends. Nevertheless, foreign investment inthe former Yugoslav Republic of Macedonia, including joint ventures, has been low compared to otherrefbrming economies in the region. Of the 3,500 letters of intent received by the Ministry of ForeignAffairs, only few have materialized. The foreign investments, including joint ventures, accounted forabout 1.8 percent of the total private investments as of mid-1995. To address this problem, theGovernment intends to streamline the institutional framework for approval of foreign investments and tointroduce well-focussed foreign investment promotion programs. Technical assistance has been requestedfrom a number of bilateral donors.

2.18 Privatization. Socially-owned and mixed-ownership enterprises in the former YugoslavRepublic of Macedonia comprised 1,856 enterprises in early 1994 and employed about 324,000 workers,primarily in the trade, construction, agriculture and textile sectors. In an attempt to address theshortcomings of social ownership, former Yugoslavia introduced legislation in 1989 (the Law on SocialCapital) for the transformation of social ownership. Implementation of this law was left to the republicsand the former Yugoslav Republic of Macedonia partially or fully privatized about 440 enterprises byallowing employees to buy "internal shares".

2.19 The current privatization program is governed by the Law for Transformation of Socially-Owned Enterprises (the Privatization Law), which was approved in June 1993. The Government hastargeted 1,200 enterprises for privatization under the law, representing 79 percent of all socially-ownedand mixed ownership enterprises, 78 percent of employment, and 53 percent of assets. Banks,monopolies Oargely confined to public utilities) and agricultural cooperatives-- a total of 388 enterprises-are not subject to the Privatization Law. Of the enterprises targeted for privatization, 100 are large, 263are medium and 837 are small, representing only 5 percent of assets. The Government intends tocomplete the program by the end of 1996.

2.20 The privatization program is based on a case-by-case approach. However, theGovernment has also introduced a version of the mass privatization scheme through the asset-to-assetswap program. The Privatization Law allows the use of frozen foreign exchange deposits, which havebeen removed from the banks' balance sheets, for purchase of enterprise shares, housing and businesspremises. The asset-to-asset swap at the same time reduces the claims on the Government created by itsassumption of foreign exchange deposit related liabilities. Technical instructions, which define theguiding principles of swaps of frozen foreign deposits for shares and other socially-owned assets, wereissued by the Ministry of Finance in December 1994, and the scheme is now operative. Certificatesissued to depositors are generic (i.e., they can be applied toward the purchase of shares in any enterpriseand the purchase of business premises), but are restricted to exchange for shares or assets targeted forprivatization (to prevent the creation of quasi money).

2.21 After initial difficulties, privatization (under the FESAC auspices) has gained momentumin 1995. By the first tranche release in May 1995, about 147 enterprises have been privatized; 114 small,18 medium and 15 large enterprises. By mid-March 1996, privatization was completed for 705enterprises, of which 67 are large, 120 medium and 518 small enterprises. For the FESAC second

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tranche release, a total of 791 enterprises should be privatized (or liquidated). This target is expectedto be achieved by mid-1996.

2.22 Private Sector. The private sector has witnessed considerable growth sinceindependence. By May 1995, there were about 77,000 registered private enterprises, a more than 13 foldincrease since end-1990. About 29,000 private enterprises are active and about 10,000 are handicrafts.Most private activity is in trading due to the opportunities presented by the disruption of formal tradecaused by the embargoes, the lower risk and smaller capital required, the quick return, and the traditionof trading among the people. Manufacturing and related activities account for less than 10 percent of thetotal private enterprise activities. They typically employ labor intensive technologies, and the productionfunctions are typically assembly and basic, low value-added activities. About 25 percent of privateenterprises are engaged in services of which transport, tourism and personal services are the mostimportant.

2.23 While a significant progress has been made to create an enabling business environmentfor the private sector, a number of surveys have shown that there are still some areas of concern,especially regarding the lack of business premises, inadequate market information and rudimentarymarketing techniques used by the private sector, skill deficiencies concerning business planning and book-keeping and the inadequate access to finance. The private sector needs for business premises is beingmet by the program for business premises privatization launched in early 1995. About 150,000 squaremeters of business premises are to be offered to the private sector through an asset-to-asset swap schemeunder the FESAC program. The Government intends to sell all business premises without legalencumbrances by the end of 1996. Legal encumbrances on the rest are to be resolved after the adoptionof the Restitution Law and completion of the scheme is expected in 1997. In a parallel effort with IDA'stechnical assistance, the Government is building a new legal framework concerning ownership and theright of use of business premises including leaseholds.

2.24 Access to working capital finance for private companies is difficult due to the crowdingout by the large socially-owned enterprises. Difficulties in access to finance are further complicated bythe general unwillingness of banks to extend term-credits due to the perceived uncertainties in theeconomy. This attitude is exacerbated by the lack of skills in the banks to assess price and managefinancial risk associated with private sector borrowers and their projects, and to efficiently collect oncollaterals. As a result, investment finance with medium-to long-term credit maturities is practically notavailable. The majority of private companies finance new investments exclusively from retained earnings,which limits their growth potential. The proposed Project aims to address this problem by providinginvestment and working capital financing on non-discriminating terms and with adequate maturities.

2.25 Private Farming. Agricultural sector in the former Yugoslav Republic of Macedoniaaccounted for about 20 percent of GSP and 16 percent of exports in 1994. Almost 45 percent of thecountry's population lives in rural areas and the welfare and incomes of rural population are closelylinked to agriculture. Agriculture is based on about 662,000 hectares of arable land and a further640,000 ha of pasture (together accounting for about 50 percent of the total country's area). The arableland is used to produce a variety of crops including cereals, industrial crops, fruits and vegetables. Thepastures support a substantial sheep industry, including profitable lamb exports.

2.26 Agricultural production has traditionally been a predominantly private sector activity.As a result of the downsizing of the socially-owned enterprise sector, farming is expected to assumeincreasing importance in the medium-term. About 30 percent of the total arable land is cultivated by

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about 217 agricultural enterprises, which account for about 9 percent of the total enterprise employment.The remaining 70 percent is owned and cultivated by some 177,000 farmers with farms of an average2.6 hectares. Farms are operated almost exclusively by labor of the extended family, and women areoften the primary managers of the family's home-based livestock and vegetable/fruit production units.

2.27 The presence of private sector activity in farming has helped the agriculture sector adjustto the country's changing macroeconomic environment in recent years. Some policy reforms in the sectorhave taken place, for example, direct financial support from the budget has been reduced from 10 percentof agricultural GSP in 1991 to a projected 3 percent in 1996. Nevertheless, a significant furtherliberalization remains on the agenda. For example, the market for certain important agriculturalcommodities, such as wheat, sugar and dairy products, are still subject to price distortions. In the contextof the proposed Structural Adjustment Loan, the Govermnent is preparing additional policy reformmeasures to be introduced in 1996 and 1997, including substantial reduction of agricultural subsidies,removal of trade protection and other trade distortions, and deepening of privatization in agriculture.

2.28 Parallel to the agricultural policy reforms, the Government intends to strengthen theassistance to private farming, including improved access to investment finance to increase agriculturaloutput and earnings in rural areas. The Government program for private farmers is supported by thePrivate Farmer Support Project and by the proposed Project.

1II. BANKING SECTOR

A. Regulatory and Institutional Framework

3.01 Legal Framework. A new legal framework for the financial sector is mostly in place.The National Bank Act was adopted in April 1992, and amended in May 1993, together with theenactment of the new Banking and Savings Institutions Law. Further amendments to the National BankAct and the Banking Law, aiming to harmonize the existing legislation with internationally acceptedstandards, have been submitted to the Parliament in early 1996, as part of the FESAC second trancherelease conditions. A Securities Act, a Financial Transaction Law and an Insurance Law were adoptedin 1992, and a Foreign Exchange and International Transactions Law in 1993. An Accounting Law wasenacted in 1992 and amended in 1994, and new amendments, which are expected to fully harmonize thelaw with the internationally accepted standards, are being prepared. This will include a new chart ofaccounts for the banking sector. Existing legislation encourages the entry of new, well capitalized bankswith sound managers and reputable owners. Sound and efficient private banks, along with theimprovement of existing banks through the effective enforcement of prudential regulations, and morecompetitive market conditions will yield a healthier and more efficient banking system.

3.02 National Bank or Macedonia. NBM was established as the country's central bank inApril 1992, following the enactment of the National Bank Act. NBM is independent and responsible tothe Parliament which appoints the Governor and the eight other Board members for a seven-year term.The National Bank Act mandates NBM to be responsible for the stability of the national currency, theregulation of money supply, the payment system and the supervision of the banking sector. The buildingof NBM's institutional capacity started in 1993 with technical assistance from the International MonetaryFund (IMF), the United States Agency for International Development (USAID) and other donors toimprove its organizational structure, monetary operations, banking regulation and supervision, bank

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reporting and accounting, and information technology. This has yielded major improvements in monetaryand foreign exchange policy management, including abolishment of interest rate controls and of automaticrefinancing, liberalization of the exchange rate and of exchange rate markets, introduction of monetaryprogramming and increasing use of indirect mechanisms for central bank interventions.

3.03 On the banking supervision side, NBM is in charge of: (a) issuing bank licenses;(b) issuing prudential regulations; (c) exercising off-site and on-site supervision; and (d) applyingsanctions on banks that fail to comply with the regulations. In order to be licensed, banks have to havea minimum capital of DM 3 million (DM 1 million for the branch of a foreign bank) and to submit toNBM a comprehensive and well-documented application file. Special licenses are required for a bankto engage in foreign exchange and international transactions. For these operations, the minimum capitalrequired is DM 9 million. According to the new amendment to the Banking Law under considerationby the Parliament, the minimum capital will be increased to DM 7 and DM 21 million, respectively.

3.04 Prudential regulations cover liquidity position and the capital adequacy of banks, largeexposures and loans to connected parties, level of term transformation and loan concentration,classification of risk portfolios and the level of provisions, foreign exchange risk exposure, and internalcontrol systems of banks. The prudential regulations concerning liquidity, capital adequacy, assetclassification and provisioning and exposures to connected parties have already been issued by NBM inthe 1992-1994 period. Under the FESAC auspices, the regulations were amended in November andDecember 1995 and are now fully harmonized with international standards. With the latest amendmentsthe prudential regulatory enviromnent in the former Yugoslav Republic of Macedonia is fully satisfactoryto the Bank.

3.05 The development of on-site and off-site supervision is a long-term process. NBM isdeveloping its supervision capacity with training and technical assistance from the IMF and the USAID.The special audits of the four largest banks, which were completed by international auditors under theBank's Economic Restructuring Loan, have provided a good baseline information, as well as the modelsfor future annual audits. By mid-1995, NBM has developed prudential reporting standards and is alreadyreceiving monthly reports from banks and performing off-site supervision. The on-site supervision startedfrom March 1995 according to the established supervision schedule. The Supervision Department hasplayed a major role in restructuring Stopanska Banka.

3.06 Bank Rehabilitation Agency. Bank Rehabilitation Agency (BRA) was established inearly 1994. In coordination with NBM, it is empowered to intervene in a failing bank, invest onGovernment's behalf, appoint a new board and managers, and sell the bank as a whole or in parts. TheBRA is headed by a General Manager under a supervisory board. The General Manager was appointedin April 1994, and he has now 20 professional staff and foreign technical assistance. BRA's role underthe FESAC program focuses on administration and collection of the non-performing assets removed fromthe banks' balance sheets.

B. Banking Sector Structure

3.07 The banking sector in the former Yugoslav Republic of Macedonia, as inherited from theformer Yugoslavia, was recognizably similar to that of market economies although with significantstructural distortions. At end-1994, the structural problems, which became severe enough to bring thebanking sector to the edge of banking crises, were affecting about 63 percent of the total banking sector

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balance sheet, including the frozen foreign exchange deposits of households3 /, the non-performing foreignexchange denominated loans'/ and the non-performing domestic currency loans5/. The market-relatedstructural problem was the excessive concentration, including Stopanska's dominance of about 65 percentin the domestic deposit and credit markets. The banking system stability was also threatened by theprotracted agony of Foreign Trade Bank, with about 20 percent share in both domestic and creditmarkets.

3.08 These structural problems have been addressed by the FESAC. The non-performingassets (in domestic and foreign currencies) and the foreign exchange deposits related claims on NBM,including the corresponding liabilities, have been removed from balance sheets of banks and placed withthe BRA. The market concentration problem was addressed by substantially reducing the size ofStopanska Banka (bringing its market share to less than 40 percent) and by creating five smaller regionalbanks from its largest (and formerly independent) branches in Bitola, Kumanovo, Ohrid, Prilep andTetovo. Foreign Trade Bank was orderly liquidated, thereby creating a space for growth of new privatebanks. Other important aspects of the FESAC banking sector reform program included a program tostrengthen prudential regulations and their harmonization with international standards, and the change incorporate governance and incentives through full privatization of the banking sector.

3.09 For the most part, the implementation of the banking reform supported by the FESAChas been successful. New prudential regulations have been issued thereby creating a regulatoryenvironment comparable to international standards. The balance sheet of the banking sector has beensuccessfully cleaned from problems inherited from the former Yugoslavia. The banking sector has beenfully privatized and the market dominance of Stopanska has been reduced. Some problems, however,remain. The privatization of Stopanska has been accomplished, but the corporate governance has notsufficiently improved, due to the lack of strategic investor, fully independent from government'sinfluence. In addition, Stopanska remains undercapitalized and is still experiencing occasional liquidityproblems. A search for a suitable foreign investor, capable of providing effective corporate guidance,is under way. The remaining problems with Stopanska, however, will not affect implementation of theproposed Project, as the bank will not be accepted for participation until it is able to meet thequalification criteria.

3.10 Selected indicators from the aggregated balance sheet of the banking sector are shown inTable 3.1. The situation on May 31, 1995 shows the results of the implementation of reforms due as theFESAC first tranche conditions. After the removal of the frozen foreign exchange deposits and of theParis Club loans, the exit of Foreign Trade Bank and the removal of the part of the non-performing assetsfrom the Stopanska Banka balance sheet, the total banking sector assets contracted from US$4.2 billionto US$1.5 billion, of which Stopanska Banka accounted for 65 percent. The share of loans to economicagents increased to about 37 percent of the total banks' assets, of which Stopanska accounted for 56percent. The situation on December 31, 1995 shows further transformation of the banking sector.

3/ About 1.3 million accounts in four banks amounting to about US$1 billion, and accounting for about 30 percent of thebalance sheet of the banking system and balanced by claims on NBM.

4/ The non-perfonning foreign exchange loans were funded by foreign borrowings, amounting to about US$900 millionor about 28 percent of the banking sector balance sheet.

5/ These amounted to US$220 million or about 5.5 percent of the banking sector balance sheet.

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Stopanska's share of assets contracted to about 40 percent of the total assets, its loan portfolio to 29percent of the total loans, and its capital to 21 percent of the total capital in the banking systems.

Table 3.1: Selected Indicators(in million US dollar)

As of 05/31/95 As of 05/31/95

Total Total|____________ . Stopanska Banks Stopanska Banks

Total Assets 965 1,474 917 2,279% Total Banking Syst. 65 100 40 100

Total Loans 307 544 103 353% Total Assets 32 37 11 15% Total Banking Syst. 56 100 29 100

Total Domestic Deposits 288 497 108 301% Total Liabilities 30 34 12 13% Total Banking Syst. 60 100 36 100

Total Capital 75 242 98 469% Total Banking Syst. 31 100 21 100

Source: NBM

3.11 There are, however, new reasons for concerns indicating that some fragility remains inthe sector and that it will take some time until the situation is fully stabilized. The immediate concernis a significant drop of the share of loans in the total assets of the banking system from 32 percent as ofMay 31 to about 15 percent as of December 31, 1995. There is a similar problem in terms of resourcemobilization, as the share of deposits in the total banking liabilities dropped from 30 percent to 13 percentin the same period. The reasons for the disintermediation trends are not entirely clear. Another problemis a worsening of the loan portfolio quality, as the percentage of loans in arrears in the banking systemincreased to about 30 percent. This is likely a consequence of the enforcement of hard budget constraintsunder the FESAC, which was primarily targeted to large socially-owned lossmakers. The protection fromcreditors afforded to lossmakers under the SRP, however, effectively passed-on the shock to theirprivately-owned suppliers. The worsening of the financial position of the private suppliers has, in turn,negatively affected the credit relations with their banks.

3.12 The proposed Project will address these problems by carefully scrutinizing banks whichhave applied for participation and by maintaining high banks qualification standards. At the subprojectlevel, the risk will be addressed by training the participating banks in projects and credit risk appraisaland by introducing sophisticated computer-supported analytical tools developed by the Bank. Initially,there will be no free limits, and the free limits will be set on a bank-by-bank basis once a bank hasclearly demonstrated the satisfactory quality of its appraisal process.

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C. Credit Markets

3.13 Market Conditions. Liberalization of interest rates in the banking markets of the formerYugoslav Republic of Macedonia took place in 1992. As a matter of policy, the NBM discount rate hasbeen always positive in real terms, with liquidity credits being priced significantly above the discountrate, and the interest rates on compulsory reserves and T-bill subscriptions very significantlyunderpriced6 /. Against the background of December-on-December inflation of about 55 percent in 1994and 9.2 percent for 1995, the deposit rates in the first half of 1995 were in the 6-12 percent range fordemand deposits and in the 30-45 percent range for term deposits. The lending rates were in the 75-95percent range (50-70 percent positive, in real terms), with an average lending margin of about 40 percent.

3.14 The inflation expectations were adjusted in mid-1995. The positive results of bankingrefbrms under the FESAC also started to be felt. NBM increased informal pressure on banks to lowertheir lending spreads. As a result, the deposit rates fell to a level of 10-12 percent for shorter than three-month deposits, and 17-22 percent for term deposits, with an average of 16 percent. The lending ratesfell to a level of 25-30 percent for both short- and long-term loans, (about 15-20 percent positive, in realterms), with the lending spreads averaging about 15 percent. Overall, the conditions in the bankingsector markets in the second half of 1995 showed notable improvement and the markets seem to be ona good track to be fully stabilized.

3.15 In order to avoid introducing the credit market distortions, the Bank funded subloans tothe private sector and farmers are to be freely priced by the participating banks according to prevailingmarket conditions. For the subsidiary loans extended by the apex to the PFIs, there were no fullysatisfactory benchmarks. Therefore, the price of funds extended to large banks by the foreign exportcredit agencies was used as an approximation. The Bank funds are likely to be of somewhat longermaturities; average maturity of three years is expected for the private farmer finance and about four tofive years for the private sector finance, as compared to one to three years maturities of the typical exportcredits. The use of Bank funds entails, however, a significantly higher transaction cost. As a result, thesubsidiary finance to PFIs was priced within 10-15 basis points range of the cost of benchmark funds.

3.16 Credit Market. The banking markets in the former Yugoslav Republic of Macedonia aresmall even when taking into account the small size of the economy. The total deposit market volume asof end-1995 was about US$301 million and the credit market volume about US$353 million. On thedemand side, the market has been traditionally dominated by socially-owned enterprises. On the supplyside, the major player in the market was Stopanska Banka followed by another two large banks, whichtogether accounted for over 90 percent share of the total credit market. The unstable macroeconomicenvironment and structural problems in the economy, compounded by the lack of capacity of banks toanalyze and properly price their risks, have brought very conservative lending practices and exorbitantlyhigh spreads. The maturities of available investment credits have shortened to below two years, andcredit for capital investments involving imports is practically not available, other than funds provided bythe foreign export agencies.

§V The NBM discount rate in July to December 1995 was 15 percent (expected inflation 8 percent), the interest oncompulsory reserves was 5.8 percent and on liquidity credits 30 percent with interest penalty rate of 45 percent.

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3.17 Parallel to the main-stream market dominated by large banks and socially-ownedenterprises, there is an active market used by private enterprises. It is funded by the private banks' ownfunds and is not larger than about US$20-30 million. The typical terms are one to two month maturitieswithout grace period and the collection rates have traditionally been about 90 percent. Term finance isgenerally unavailable. Small- and medium-size private enterprises, including export-oriented enterprisesand the new private enterprises which have grown to employ over ten people, are the most negativelyaffected by the lack of term-finance. This is particularly problematic because the supply response fromthese types of enterprises holds a potential for reversing the country's current economic decline.

3.18 The situation is even worse in the credit market segment catering to farmers and smallprivate agrobusinesses. The main channel for agriculture finance has traditionally been Stopanska Banka.The conservative lending climate coupled with liquidity and solvency problems experienced by StopanskaBanka in the period since independence have practically closed the credit market for farmers and privateagrobusinesses. In the 1992-1995 period, the total volume of the segment catered by the private bankswas in the US$1-2 million range. The proposed Project aims to overcome the credit supply problemsin this market segment. Of the proposed DM 18 million Bank loan, DM 4 million has specifically beentargeted for loans to private farmers hoping to encourage diversification by new banks into theagricultural finance. Specific measures will be taken to expand the outreach of participating banks toinclude the rural areas.

3.19 Credit Demand. During the preparation of the proposed Project a demand survey wasundertaken to assess the investment and financing needs of the private sector. The survey included anumber of large banks which have applied for participation. The survey has found that there is anappreciable level of private sector capital formation, which can serve as an indicator of the potentialdemand for medium- to long-term credit at reasonable terms. The total private sector investment in fixedassets in the 1992-1994 period are estimated to be about US$139 million, with construction of businesspremises accounting for US$79 million and production equipment for US$51 million. Most of the totalprivate sector investments has traditionally been funded by their own funds, and the remainder by bankcredits. Since the average medium-term loan maturity was about 18 months in the 1992-1994 period,and the interest rates were very high, the viable demand has obviously been depressed. With recentchanges in credit market conditions, the investment demand is expected to substantially increase. Thesurveyed banks have estimated an increase in the total credit demand for investment loans of the privatesector to about US$60 million annually, excluding the newly privatized or soon to be privatizedenterprises.

3.20 The expectations concerning increase in private sector credit demand were confirmed ininformational interviews with senior managers of a number of large, profitable, recently privatizedenterprises. All interviewed managers shared the opinion that there is a high (and currently hidden)future demand for investment loans. Investment in socially-owned enterprises has been suppressed sofar due to the delay in privatization, since investments would have increased the value of enterprisesthereby making the internal privatization more costly. Managers of privatized enterprises were confidentthat the investment demand would pick-up and grow with the pace of privatization.

3.21 Subsidized Credits. With the abolition of selective credits as of March 31, 1994, asagreed under the Economic Recovery Credit, explicit credit subsidies in the former Yugoslav Republicof Macedonia were significantly reduced and the remaining subsidies mostly confined to agriculture. Inthe agricultural finance area, the most important forms of subsidy were the directed credit and the interestrebate scheme. The volume of directed credit was about US$14 million in 1994, but the subsidy was

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thereafter abolished. The interest subsidy scheme, totalling about US$18 million in 1994, included a 15percent rebate on interest paid on loans for wheat, corn and tobacco storage, and for milk and wheatproduction. The rebate for storage loans was paid to the storage enterprises, and that for milk and meatproduction directly to producers. In the 1995 budget, the allocation for interest subsidies was reducedto around US$4 million, and no money has been earmarked in the 1996 budget. Other significantsubsidies still persist in the sector, including rebates on seed purchase, price support and premiums paidon selected agricultural commodities and various trade protection measures. These other forms ofsubsidies are also being reduced. Explicit planned budget subsidies for agriculture in 1996 amount toaround US$26 million, which is about half of the 1994 amount. Further subsidy reductions andliberalization in the sector are a key part of the dialogue with the Government under the proposed SAL/C.

IV. PROJECT RATIONALE

A. The Bank Group Strategv for Assistance

4.01 The reform strategy in Former Yugoslav Republic of Macedonia is similar to that of othercentral planning economies trying to make a transition to a market economy. The reform prioritiesinclude: (a) macro-economic stabilization; (b) accelerating the transfer of ownership to the private sector;(c) rationalization of productive sectors to make them efficient and internationally competitive; and(d) providing social protection to the affected segments of the population. The Government remainscommitted to moving decisively and coherently across a broad front to sustain the reform effort.

4.02 In intensive dialogue over the past three years, the Government and the Bank have foundconsiderable agreement on the priorities for adjustment and development. The Bank's country assistancestrategy, which was presented to the Board on May 16, 1995, comprises several strategic themes asreference points for guiding the overall program in support of the reform effort. The Bank aims to:(a) facilitate and support the structural reform and the transformation to a market economy; (b) contributeto financing balance-of-payments requirements; (c) support sectoral adjustment and development efforts;and (d) help mobilize resources from both official and private sources.

4.03 The initial support to the Government's reform program was provided through theEconomic Recovery Credit/Loan of US$80 million, which has been fully utilized. The SDR 54.7 millionFESAC, approved in May 1995, aims to advance critical elements of the market reform, including:(a) comprehensive reform of the banking sector and banking markets; (b) isolation of largest loss-makingenterprises, including hard budget constraints, leading to liquidation or privatization of major lossmakers; (c) comprehensive privatization program; and (d) social safety net reform program. A StructuralAdjustment Credit/Loan, aiming to support further policy changes in the transition to a market economy,is currently under preparation. The specific SAC/L objectives are to further the trade reform, to reduceinterventions and subsidies in the agricultural sector, thereby reducing distortions in the agriculturalproducts markets, and to privatize the socially-owned agroenterprises.

4.04 The proposed Project is in concordance with the country assistance strategy. Continuedsupport to privatization and private sector development is critical to the success of transition. Fully awareof the pressing needs for investment and permanent working capital finance, which will allow the privatesector to effectively utilize its development potential, and facing difficulties in mobilizing resources underthe terms and conditions which effectively meet the private sector demand, the Government has requestedthe Bank's support. The Bank intends to deliver this support through the proposed Project which is fully

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consistent with the Bank's assistance strategy and supports development of the private sector activities,including private agriculture. The proposed Project is processed in tandem with the proposed PrivateFarmer Support Project, which seeks to promote institutional changes in the agricultural sector. Thisproject will develop agricultural extension services, private veterinary services and design an agriculturalalready covered wholesale market system and promote agricultural research. Thus, the two projects arehighly complementary, with the proposed Private Farmer Support Project seeking to create an enablingenvironment for the private agriculture and the private farmer finance component of the proposed Projectaiming at facilitating investments of private farmers.

B. Rationale for Bank Involvement

4.05 Since its independence, the Government has successfully established the legal andinstitutional framework necessary for a market economy. The role of the state in both macro- and micro-economic management has changed. On the macro level, the new policies emphasized liberalization(e.g., price, foreign trade, interest rates, entry and exit policies), decentralization and competition (e.g.,in banking, industry, agriculture), and market and private sector orientation. At the micro-level, theGovernment has already disengaged from the operational management of enterprises. It is enforcing theirfinancial discipline, and plans to fully divest the socially-owned holdings in the near future. Financialpolicies and entry to the banking sector and markets have been liberalized, resulting in the emergence ofnew private institutions.

4.06 At the macro level, the Bank has been involved in the transition process in the formerYugoslav Republic of Macedonia from the very beginning. Since the framework for the developmentof a market economy and the structural reforms are at an advanced stage of implementation, the Bank'sfocus is now shifting to the micro level to promote growth of the private sector and to support the processof transition through institution-building work and by providing well-calibrated financial assistance,through banks already operating on sound financial and commercial principles, to competitive privateenterprises. The proposed Project aims at addressing critical needs which impair the supply response ofthe private sector in manufacturing, services and agriculture.

4.07 The lessons from the Bank operations in other countries also point to the need that amajor financial sector reform operation with macro objectives, such as the FESAC in the formerYugoslav Republic of Macedonia, should be followed by a credit line operation to solidify thetransformation of the financial sector on a bank-by-bank basis thereby helping to build the banks'institutional capacity. The proposed Project will provide an opportunity to assist the banks, throughtraining and hands-on consulting, and to improve their lending, risk-management, supervision and loanadministration practices. This is especially important for the new, smaller private banks which normallydo not have access to high quality technical assistance. Participation of many banks will also stimulatecompetition in the credit market.

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V. THE PROJECT

A. Objectives and Scone of the Proposed Project

5.01 The principal objectives of the proposed Project are to: (a) promote growth of the privatesector and create conditions for an effective supply response from viable private enterprises and farmers;(b) facilitate the adoption of safe and sound banking practices; and (c) stimulate competition in the creditmarket. The proposed Project will provide an opportunity for the Bank to follow-up on the level ofindividual banks with its assistance, initiated under the FESAC, to transformation and strengthening ofthe banking sector.

5.02 The proposed Project would be supported by a DM 18 million IBRD loan. The loanwould be used to provide:

(a) Private Sector Finance to creditworthy private industrial and agricultural enterprises toimprove profitability by increasing output or improving efficiency; and

(b) Private Farmer Finance to viable private farmers to increase their output.

5.03 The loan will be initially divided into DM 14 million for private enterprise finance andDM 4 million for private farmer finance. The new private banks, which are expected to be the mainintermediaries for the credit line, have little or no experience with private farmer finance. The crowdingout of the private farmers from access to the Bank credit line, was therefore, a potential problem whichneeded to be addressed. To ensure the private farmers access to finance and, at the same time, encouragethe private banks to diversify into this sector, the DM 4 million has been preallocated for credit to privatefarmers. This initial allocation will be regularly reviewed once the implementation starts, and thenecessary adjustments to reflect the apparent market demand for Bank funds will be made, if and whennecessary. After the first use of Bank funds, with financing to be continued from the roll-over fund,there will be no specific allocations and the utilization of Bank funds will be on a first-come first-servedbasis.

5.04 The proposed Project does not have a technical assistance component. However, acomprehensive technical assistance program of US$1.25 million, of which US$300,000 under theproposed Private Farmer Support Project was financed by IDA, has been developed in coordination witha number of bilateral and multilateral donors. The technical assistance program would address issuesimpeding the flow of credit to the private sector and provide training and hands-on consulting servicesto participating banks in the areas critical for the*successful implementation of the proposed Project.

B. Project Components

5.05 The Private Sector Finance ComRonent would provide investment and permanentworking capital loans to private enterprises, including agricultural enterprises. Due to the lack ofmedium- to long-term foreign exchange financing in the former Yugoslav Republic of Macedonia,provided on terms and conditions attractive to the private sector, the growth of private sector activitiesin the former Yugoslav Republic of Macedonia has been less than satisfactory. The Bank finance istargeted to the most viable private enterprises aiming at improving their efficiency and profitability, and

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at increasing their output. On the average, the funds would revolve about three times during the 20-yearmaturity of the proposed Loan. As a result, the DM 14 million component for the private sector financewould mobilize financing of about DM 45 million during the life of the proposed Loan.

5.06 Access to private sector finance would be open to viable private enterprises'/, includingagricultural enterprises. Eligibility of enterprises and subprojects would be determined based upon:

(a) financial viability of a subproject, with the expected financial rate of return of minimum15 percent. The economic rate of return, which must be minimum 15 percent, will bechecked by the Participating Financial Intermediaries (PFIs) and the Bank for allsubprojects affected by the significant price or tariff distortions;

(b) satisfactory financial condition of the prospective borrower and capacity to bear theforeign exchange risk;

(c) presentation of a satisfactory business plan and financing plan for components of thesubprojects which are not covered under the PFI subloan, including adequate assurancesfrom cofinanciers or a proof that the enterprise has enough own funds to be able toimplement the project; and

(d) clearance by competent authorities concerning environmental aspects.

5.07 The subloans will be denominated in DM to match the prospective export revenues offinal beneficiaries. Interest rates would be variable, based on the Bank's lending rate, plus a spread tocover administrative expenses and the PFI related credit risk, plus a market-based PFI spread, so as notto introduce the credit market pricing distortions. Proceeds of the subloans would be used to fund capitalinvestments, including permanent working capital needs. For the private enterprises in the manufacturingsector, the subprojects will typically aim to improve quality, packaging or to address other productdeficiencies; to improve production cost structure; to address production bottlenecks; or, when havinga reasonable prospect to increase exports, to increase capacity to produce exportable products. For thetourism and services sector, the subprojects will typically aim at improving quality, value-added, or coststructure of services; to address bottlenecks in service delivery; or to increase the capacity to provide theforeign exchange earning services.

5.08 The Private Farmer Finance Component. Access to this component will be open onlyto private farmers. The DM 4 million has been specifically earmarked for farmers, because there is ahigh likelihood that they would be otherwise crowded out from access to Bank funds. The averagematurity of the subloans is expected to be about three years. With an assumption that the private farmerwill turn out to be efficient users of Bank funds, and therefore, manage to stay within the initiallyallocated range, the DM 4 million earmarked for the private farmer finance would mobilize financing ofabout DM 25 million during the 20-year maturity of the proposed Loan.

7/ The term private refers to enterprises which were established by private entrepreneurs and enterprises originally inpublic ownership which have been privatized to have at least 51 percent private ownership and are independentlyoperated by the private owners. The 51 percent privatc ownership is deemed satisfactory, since the remaining 49percnt will be socially owned. The social ownership in the specific former Yugoslav Republic of Macedoniacircumstances is usually fmgrnented, it does not allow for state interference and the 51 percent majority is enough toascertain a decisive vote in enterprise management.

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5.09 The interest rate will have the same basis as that for the private investment financecomponent. The eligibility of subprojects will be determined based on their financial viability, with anexpected financial rate of return of minimum 15 percent, in real terms, and a satisfactory repaymentcapacity of the prospective borrowers. For all subprojects having as production input or outputagricultural commodities subject to price or tariff distortions, economic rate of return of minimum 15percent will be required. Eligibility criteria, which include the economic rate of return, currently applyto wheat, sugar and dairy products.

5.10 The subprojects will finance investment and working capital related to production of cropand livestock. Incremental short-term credit would be provided for production inputs such as landpreparation, seed, fertilizer, agrochemicals, animal feed, hired labor and transportation. Investment creditwould be provided for farm mechanization, livestock and horticulture. Livestock subprojects wouldinclude sheep and pig breeding and fattening, beef fattening, dairy and poultry (broilers and eggs).Investment inputs financed would include machinery, equipment, civil works (e.g., barns, feed storagefacilities), planting material and breeding stock.

5.11 Financial Rate of Return. Since the interest rate on subloans is to be variable and thefinal borrowers are to bear the interest rate risk, the minimum acceptable financial rate of return of asubproject has been set to ensure that the subproject would always generate enough income to service thesubloan. Because the subloans are to be denominated in DM, the financial rate of return will becalculated on a DM basis. The minimum rate of return will be 15 percent annually in nominal DMterms. This reflects the sum of: the highest average historical interest rates for LIBOR-based DM loanswith six month maturities in the period 1986-1995; the apex institution margin over the Bank's lendingrate, i.e., 75 basis points net; and the average bank margin taken by the banks in the former YugoslavRepublic of Macedonia when intermediating DM denominated funds.

5.12 Economic Rate of Return. Calculation of the economic rate of return will not berequired, unless requested by the Bank based on a presumption of the existence of price or tariffdistortions affecting a subproject. Prices in the economy of the former Yugoslav Republic of Macedoniahave been liberalized and now reflect the market supply and demand. Notable exceptions are the pricesof certain agricultural commodities. Furthermore, the shadow wage rate in certain sectors of theeconomy is somewhat below the current market rate. Therefore, in practical terms, the differencebetween the financial and the economic rate of return can generally be safely ignored.

5.13 For subprojects using as production inputs goods subject to known price or tariffdistortions, or where the price of output is subsidized, the calculation of the economic rate of return willbe required. For such subprojects to be eligible for Bank finance, the economic rate of return must beminimum 15 percent, in real terms. At this time,, significant policy induced price distortions still persistin agricultural markets and apply to wheat, dairy and sugar producers. Therefore, until the subsidiesissues have been sorted out under the SACIL, the eligibility of subprojects involving these commoditiesas input or output will be subject to the explicit calculation of the economic rate of return using borderprices.

5.14 Technical Assistance. While the proposed Project does not have a technical assistancecomponent, a comprehensive technical assistance package directly related to the implementation of theproposed Project has been agreed and will be funded by a number of bilateral and multilateral sources.The technical assistance program of about US$1.25 million comprises the following components, to beprovided by:

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(a) the Bank, before the proposed Project effectiveness: (i) installation, including trainingof participating banks, of an interactive project implementation management system,which comprehensively covers Bank funds management, subloan administration,collection and billing, procurement and disbursement management, trouble shooting,implementation forecasting and full reporting capacity; and (ii) training of participatingbanks in techniques of credit risk appraisal and subproject appraisal, including the useof computer-based tools with full financial statements and financial ratio analysis features,cash flow projections and analysis, calculation of financial and economic rate of returnand sensitivity analysis;

(b) the proposed Private Farmer Support Project (US$300,000) includes: (i) a program toimprove management information systems of participating banks; and (ii) assistance indeveloping a training program for the private sector and farmers to facilitate access ofthe private sector to the formal financial sector, including courses to improve accountingand bookkeeping skills; provide information on regulatory framework applicable toSMEs, including applicable tax and custom laws and regulations; prepare creditapplications for investment and working capital finance; and improve their technologyskills'/.

(c) U.S. Agency for International Development (US$250,000), including: (i) a review ofpertinent regulations and court practices related to credit collateral and the effectivenessof collection on collateral, to recommend modifications to the existing or issuance ofmissing laws and regulations and other measures that will effectively address thecollateral issue; and (ii) a training program for the responsible court officers and forother programs to implement recommendations of the review under point (i);

(d) EU Phare Program through EBRD (US$400,000), covering: (i) training of banks inasset/liabilities management and risk management, including methods in identifying,analyzing, managing and pricing various types of financial risks, and methods andpolicies for asset/liabilities and risk management; and (ii) training of banks in project andcredit risk appraisal, including lending policies, credit risk and project appraisalprocedures, loan administration and project supervision;

(e) U.K. Know-How Fund (US$50,000), including: training of banks in environmentalappraisal of projects and environmental reviews management; and

(f) the Government of Netherlands (US$250,000): external audits of banks to assist in banksappraisal process and which should serve as a benchmark for future audits to beperformed by domestic auditing firms.

The background to develop the training program for the private sector will be provided by a study, currently underpreparation, which aims at providing an assessment of the business, regulatory and market environment applicable toSMEs. The study will review the applicable regulatory framework, markcets and market conditions, access totechnology and technology utilizer, pricing, earning and financing aspectB of their operations, etc. The study willalso provide specific recommendations on measures to be taken to create an enabling environnment for SME growth.

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C. Project Cost and Flnancing Plan

5.15 An estimate of the total cost associated with the proposed Project is shown in Table 5.1.This cost does not include the cost of subprojects which will be funded after the closing date of theproposed Loan from repayments of subloans financed by Bank funds.

Table 5.1Estimated Total Project Cost

l _______________________________ (USS M illion)

Amount

Local Foreign Total

Private Sector Finance Component 6.0y' 14.0 20.0Private Farmer Finance Component 1.07' 4.0 5.0

Total 7.0 18.0 25.0

1/ Enterprises' funds and PFI FundsZ/ Private farmers' funds and PFI funds

5.16 Based on the discussions held with prospective PFIs and final beneficiaries, it is expectedthat the line of credit will largely finance foreign costs and that the local costs of the private sectorinvestmnent projects will be funded by the beneficiaries themselves from retained earnings and by the PFIcredits. This results in a financing scheme under which the Bank financing would cover DM 18 millionequivalent, or about 70 percent of the total cost of the project. The financing plan developed with theseassumptions is presented in Table 5.2.

Table 5.2Proposed Financing Plan

(DM Million)

Amount

l ________________________ Local Foreign Total

IBRD 0.0 18.0 18.0Private Enterprises and Farmers 3.0 0.0 3.0PFis 4.0 0.0 4.0

Total 7.0 18.0 25.0

D. Environmental Aspects

5.17 The former Yugoslav Republic of Macedonia has an Environmental Law, which setsstandards generally comparable to those in EU and which is soon to be amended with the Bank'sassistance. The proposed Project has been classified in Category B. Environmental aspects would beaddressed on a subproject-by-subproject basis. In order for subprojects to be financed from the Bank

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credit line, clearance by competent authorities concerning the environmental impact of the proposedinvestment would be required. Environmental impact analysis would have to be prepared for allinvestment projects that so require under the Environmental Law. It is expected that the equipment tobe purchased from subloan proceeds will be mostly with environmentally sound technology of foreignmake and, therefore, will not post environmental issues. While reviewing the subprojects submitted bythe PFIs, the Bank will ensure that the subprojects are environmentally sound and that the clearance bycompetent authorities has been received. The PFIs will monitor compliance with environmentalregulations in the course of normal subproject supervision. The Bank would also check, on a samplingbasis, environmental compliance of larger subprojects during its supervision missions.

5.18 A manual for Environmental Review Procedures has been developed by the authoritiesin agreement with the Bank and would be used by PFIs in the process of subproject appraisal forscreening environmental issues. It is expected that the manual would also be used by the PFIs whenappraising other projects, as a means to assess the risk of potential environmental liabilities which mightaffect the borrowers' credit rating.

VI. PROJECT IMPLEMENTATION AND ONLENDING ARRANGEMENTS

A. Loan Terms and Conditions

6.01 The proposed Loan of DM 18 million will be made to the former Yugoslav Republic ofMacedonia for a period of 20 years, including five years of grace. It will be a standard LIBOR-basedvariable interest rate single currency loan (SCL) in DM. In order to provide quick and efficient supportfor the development of the private sector (including private farmers), a phased formula for extendingBank finance is proposed. Once the DM 15 million of the proposed Loan has been committed, Boardapproval would be sought for additional financing of DM 18 million under the same terms and conditionsas the proposed Loan.

6.02 NBM will rediscount eligible loans of PFIs, which would channel these resources toeligible subborrowers for eligible subprojects. Lending arrangements include: (a) Loan Agreementbetween the Bank and the former Yugoslav Republic of Macedonia; (b) Subsidiary Financing Agreementsbetween NBM and the PFIs; and (c) Subloan Refinancing between NBM and the PFIs, back-to-back toSubloan Agreements between the PFIs and the final borrowers. Subsidiary Financing Agreements by atleast two PFIs satisfactory to the Bank is a condition of effectiveness. The Subsidiary FinancingAgreement will include: (i) terms and conditions of subsidiary loans extended to a PFI; (ii) terms andconditions of PFI subloans to final borrowers; (iii) commitment by a PFI to follow agreed appraisalprocedures and eligibility criteria; (iv) agreement to establish or strengthen a technical appraisal unit;(v) agreement to establish a Credit Committee; (vi) agreement to undertake external audits and toimplement auditor's recommendations; and (vii) agreement to provide periodic reports on the portfoliofinanced from Bank funds. Subloan Agreements will refer to particular subprojects and must be of aform and content satisfactory to the Bank.

6.03 The NBM's subsidiary to PFIs ("subsidiary loans") will be extended on a first-come first-served basis and back-to-back to the PFI subloans to final beneficiaries, with identical amounts, maturitiesand repayment schedules. The subsidiary loans to PFIs will be made in DM at the variable interest rateequivalent to the Bank's lending rate, plus a NBM spread of 100 basis points. The NBM spread is tocover the credit risk associated with subsidiary finance plus the real NBM cost, including administration

- 22 -

cost, commitment fees, applicable interest charges and other incidental expenses. The spread will bereviewed by the Bank from time to time, and may be adjusted to better reflect the actual cost and risksof the apex.

6.04 The PFIs would onlend the funds to eligible final borrowers for eligible projects. ThePFIs will assume the full credit risk. The subloans will be made in DM at variable interest rates pricedon the basis of the Bank's lending rate plus the NBM margin, plus a market-based PFI spread. Thebeneficiaries will assume the currency risk and the interest rate risk. Subsidiary and subloans terms andspreads will be reviewed by the Bank from time to time.

6.05 The PFIs, which will bear the full credit risk, will apply their own risk exposure limitson the total financing for subprojects as decided by their Board and codified in their operations and creditpolicies. The average exposure of banks in the former Yugoslav Republic of Macedonia is currentlyabout 70 percent of the total project cost. The maximum exposure of any PFI will not exceed the limitsset by NBM prudential regulations.

6.06 Private Sector Finance. Maturities of subloans for the private sector will range fromone to ten years, including a grace period of up to three years. Grace periods and repayment scheduleswill be flexible to suit requirements of individual projects and enterprises. Maximum subloan size willbe DM 800,000. Exceptions may be authorized by the Bank on a case-by-case basis based onsignificantly increased foreign exchange earning potential of a particular project and/or final borrower.This maximum will be reviewed and may be adjusted from time to time.

6.07 Private Farmer Finance. Maturities of subloans for private farmers will be of up tofive years, with a grace period of up to two years. Grace periods and repayment schedules will beflexible to suit requirements of individual projects and borrowers' cash flow and overall repaymentcapacity. Maximum subloan size will be DM 200,000. Exceptions may be authorized by the Bank ona case-by-case basis.

6.08 Repayments. Repayments by the PFIs to the NBM will match the repayment schedulesof subloans to the final borrowers. Should the final borrower prepay all or part of the subloan prior tomaturity, the PFI would be required to immediately prepay its subsidiary loan to NBM. In case ofarrears in principal or interest repayment on any due date from a final borrower, the PFI will neverthelessbe liable for the payment to NBM. NBM will establish a rollover fund with resources generated byrepayments of all subloans under the Project. Resources from the rollover fund will be available tofinance additional subprojects, which meet the same eligibility criteria, or to service the Bank loan.

6.09 Free Limit. Initially, a free limit for both types of finance will not be established. TheBank will continue to review subloans proposed by each PFI until a PFI's appraisal capacity is deemedsatisfactory. At this time, a free limit for the particular PFI will be established. This free limit will bePFI specific and may be adjusted from time to time.

B. Lending Arrangements

6.10 The Apex Arrangements. Financing for both components would be provided throughan apex arrangement to allow open access of new PFIs. The apex functions would include: (a) appraisaland qualification of the PFIs; (b) refinancing of PFI loans to final beneficiaries; (c) monitoring of the use

- 23 -

of Bank funds; (d) administration of the disbursements and collection (repayments) of funds advanced toor received from PFIs; (e) monitoring of PFIs to ensure their continued qualifications; and (f) reportingto the Bank on all aspects of Project implementation.

6.11 Initially, the Bank would retain the responsibility for the appraisal and qualification ofthe PFIs and for periodic evaluation of their eligibility. This function would be discharged in closecooperation with NBM. In particular, in accordance with agreed criteria (Annex 1), the SupervisionDepartment of NBM would screen financial institutions which have applied to participate inintermediation of the Bank funds and propose to the Bank financial institutions which are deemed capableto qualify. As part of the normal supervision process, NBM will continue to monitor soundness of PFIsincluding their capacity to appraise subprojects, inform the Bank of any deterioration of their financialand operating conditions, and ensure that the PFIs subject their financial statements for external auditingon a regular basis. If a PFI, due to the deterioration of its financial condition, ceases to meet thequalification criteria, it will be disqualified. The decision on the PFI disqualification will be made bythe Bank, upon appraisal of its financial condition.

6.12 The International Relations Department of NBM, or another entity selected in agreementwith the Bank, would have the primary responsibility for operational functions, including: (a) providingsubsidiary finance to PFIs; (b) monitoring the use of Bank funds, including procurement anddisbursement; (c) collecting from PFIs; (d) repaying to the Bank; and (e) reporting on the use of projectfunds and other matters related to the implementation of the proposed Project9/. A unit having specificresponsibility to administer the Bank loan funds (called Project Implementation Unit or Apex Unit) willbe established in the International Department of NBM or in another institution satisfactory to the Bank.The unit should be staffed with experienced, adequately trained individuals. Establishment of this unitand adequate staffing with well-trained and experienced professionals is a condition of effectiveness.

6.13 Monitoring and reporting would require a good accounting and management informationsystem in order to track disbursements and collection of funds and to provide the necessary reports inaccordance with Bank procedures (e.g., procurement, reporting). Such a system is being developed inthe Bank and will be installed in the apex unit and in all PFIs. The system is a computerized, interactivedatabase system with full capacity for loan accounting and loan service administration. The systemincludes modules for procurement and disbursement management and monitoring, and has troubleshootingand forecasting capacities and the full reporting capacity.

6.14 Participating Banks. The developmental objectives of the proposed Project are to:(a) encourage competition in the credit markets; (b) strengthen the delivery system for private investmentand agricultural finance; and (c) promote adoption of safe and sound banking practices. It is, therefore,desirable that as many eligible banks as possible participate in intermediating Bank funds. The privatebanks have been encouraged to participate as PFIs, in order to increase the competition and to spread therisk.

6.15 All banks operating in the former Yugoslav Republic of Macedonia are eligible toparticipate provided that they meet the qualification criteria (Annex 1). The qualification criteria includethe following:

2/ Note that the project implementation unit will not be involved in credit decisions and/or in rationing credit among thePFIs.

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(a) satisfactory fnancial position and capital adequacy meeting international standards, asevidenced by external audits performed by auditors satisfactory to the Bank and accordingto international accounting and auditing standards;

(b) full compliance with NBM prudential regulations and other applicable legislation;

(c) satisfactory financial policies and operating procedures, especially concerning loanclassification and provisioning and project appraisal, and adequate funding structure;

(d) adequate profitability and satisfactory operational performance, especially concerningpast-due and non-performing loans and collection ratio for the total loan portfolio ofminimumrr 85 percent; and

(e) satisfactory technical capacity to identify, appraise and supervise utilization of Bankfunds.

6.16 The PFIs' responsibilities include: (a) promotion and building of the project pipeline;(b) subproject and borrower appraisal; (c) subloan administration and collection; (d) subprojectperformance supervision; and (e) periodic reporting to the project implementation unit and the Bank. ThePFIs would be required to establish a technical unit, specialized in long-term project lending and properlystaffed. The unit will perform the appraisal and supervise all subprojects financed by a PFI. Appraisalsshould be cleared by the respective PFI Credit Committee. A PFI is also expected to introduceappropriate internal audits and controls.

6.17 To address possible inadequacy of the branch networks of PFIs, in terms of ability toeffectively reach individual farmers in rural areas, the PFIs will be allowed to use marketing, retail orcollecting agents, including savings institutions'°/. The relationship between a PFI and its agent willbe contractual, whereby an agent will receive a fee, and the PFI will continue to appraise the subloans,make credit decisions, bear the credit risk and keep the loan in its portfolio until repaid. When actingas marketing agents, the savings institutions will provide and disseminate information about the proposedProject and on terms and conditions of borrowing. When acting as a retail agent, the savings institutionswill solicit subloan applications, prepare initial documentation and forward it to the respective PFI.

6.18 Ten banks have expressed interest in participating so far. These include: KomercijalnaBanka, Makedonska Banka, Almako, Kreditna Banka, Balkanska Banka, Invest Banka, Ohridska Banka,Stopanska Banka Bitola, Tetovska Banka Tetovo and Stopanska Banka Skopje. At the outset, a minimumof two eligible PFIs would be sufficient to start the proposed Project implementation.

6.19 Details on banks qualification process and the qualification criteria are provided inAnnex 1. In addition to a clean audit opinion on all financial statements given by reputable andindependent external auditors satisfactory to the Bank and based on full external audit (standard terms ofreference for external audits are provided in Annex 5), the Bank appraisal is based on two types ofcriteria: (a) level of capitalization and capital adequacy, using international standards as qualification

10/ The savings institutions are privately owned savings and loan agencies which are, by their charter, limnited in dealingwith individualm and households. They are regulated by NBM. For the rural areas, they may have comparativeadvantage over banks in terms of access to potential borrowers.

- 25 -

criteria; and (b) qualitative criteria showing that a bank has a satisfactory capacity to intermediate Bankfunds. Annex 2 discusses the process of appraisal and provides details on banks' financial position andappraisals.

6.20 The appraisal of banks which have expressed interest in participation will start as soonas a bank is able to present a full external audit as of December 31, 1995 completed by external auditorssatisfactory to the Bank, according to the terms of reference provided in Annex 5. For banks which arenot able to pay for the full external audit because their boards are not willing to approve such expenses,the external audits will be paid by the trust fund established by the Government of Netherlands.According to the preliminary unaudited financial statements, at least four PFIs are deemed capable ofmeeting the qualification criteria for participating in the proposed Project.

C. Loan Administration

6.21 Procurement. Procurement will be performed by final beneficiaries. For items whichcost less than DM 150,000 equivalent, procurement will follow normal commercial practices satisfactoryto the Bank1̀/. The aggregate amount of such procurement will not exceed DM 7 million. Items whichcost DM 150,000 to DM 1.5 million equivalent would be procured through international shopping on thebasis of at least three competitive quotations obtained from suppliers in two eligible countries. Theaggregate amount of such procurement will not exceed DM 8 million. For items which cost more thanDM 1.5 million equivalent, international competitive bidding would be followed. For proprietary items,direct contracting will be used. For technical assistance to help with preparation or implementation ofthe subprojects, the final beneficiaries would follow the Bank Guidelines for the Use of Consultants (BankGuidelines). The Bank would review and clear all contracts above DM 150,000 for the employment ofconsulting firms and above DM 75,000 for the employment of individual consultants. The smallercontracts will be reviewed on a sampling basis during regular supervision missions.

6.22 The PFIs will be required to maintain records of the procurement made under the Project,with summaries of offers received and awards made under each subloan. These records would be usedby external auditors in auditing the PFIs' statement of expenditures. The first contracts cleared by a PFIand all contracts above DM 1.5 million equivalent will be subject to prior review by the Bank. Reviewof other contracts will be on a sampling basis during regular supervision missions. The Bank willorganize a procurement seminar for PFIs to assist them in acquiring the necessary procurement skills.The first such seminar for the PFIs will be organized prior to loan effectiveness. In addition, consultingassistance in procurement matters would be made available to PFIs. From time to time, procurementseminars will also be organized for the final borrowers.

6.23 Disbursement. Disbursements for the private sector finance component will cover:(a) up to 100 percent of foreign exchange expenditures (cif) for directly imported goods; (b) up to 80percent of locally produced goods, as well as for other items procured locally; (c) up to 100 percent ofexpenditures for engineering, consultant services for the preparation of enterprise business plans andrestructuring programs, for the preparation of subproject applications and for subproject implementationassistance, and for the development of management information systems; and (d) foreign expendituresfor technology transfer, licenses and other payments for specialized technology and associated equipment

II/ These typically include selection from a number of suppliers of the beat offer bawed on predefined selection criteria.

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of proprietary nature. For the private farmer finance component, disbursements will cover up to 100percent of foreign exchange expenditures under the subproject and up to 80 percent of local costs and/orof items and services procured locally.

6.24 Due to the great number of small disbursements expected under the proposed Project,disbursements under DM 750,000 million for expenditures for goods and training, DM 150,000 undercontracts for consulting firms and DM 75,000 under contracts for individual consultants will be madeagainst a certified statement of expenditures (SOE), for which appropriate documentation would beretained by the PFIs and the apex. Disbursements above DM 750,000 million for goods and services,DM 150,000 for consulting firms and DM 75,000 for individual consultants will be made on the basisof full documentation. The Bank's reimbursement will be limited to expenditures made by a subborrowernot more than 180 days prior to the Bank's receipt of the request for reimbursement. A disbursementseminar will be organized by the Bank at the time of loan effectiveness to familiarize the PFIs and theimplementing agencies with the disbursement procedures.

6.25 Special Account. Since the proposed Project would involve the financing of many smallitems, a special account would be created in a mutually agreed bank to facilitate disbursements. Mostexpenditures under the project (which are approved by the PFIs and subsequently authorized by the Bank)would be met out of the funds in the special account. When appropriate, special commitments or directpayment to foreign suppliers may also be used. The Bank would disburse an initial amount ofDM 750,000 into the special account upon effectiveness of the proposed Loan and would periodicallyreplenish the account on the basis of reimbursement requests. The replenishment amount would beincreased to DM 1.5 million after cumulative disbursements have reached DM 2.5 million. Theminimum application size for direct payments, reimbursement and Special Commitments until theaggregate disbursements reach DM 2.5 million will be DM 150,000; thereafter, it will be DM 300,000.

6.26 Disbursement Schedule and Closing Date. The estimated disbursement schedule forthe project is contained in Annex 3. The expected disbursement of the loan is based on ECA/MENAexperience with similar operations and adjusted for specific circumstances in the former YugoslavRepublic of Macedonia. A review of the proposed Project implementation performance will be made onor about September 30, 1997, i.e., about one year after loan effectiveness. If the implementationperformance is deemed unsatisfactory, the Bank will have an option to cancel the remaining loan amount.The commitment amount which would indicate satisfactory implementation performance is DM 3 million,and at least two PFIs should maintain their qualification. If, on the basis of performance review, theBank is satisfied with the performance record, the commitment period will be extended to September 30,1998. The closing date for the loan is June 30, 1999.

6.27 Reports and Audits. The PFIs would submit to the Bank semi-annual reports oncommitments, disbursements, collections and arrears under the project to the Bank. In addition, the PFIswould maintain proper accounts for subloans, including supporting procurement and disbursementdocuments, which would be audited annually by external auditors acceptable to the Bank. Since mostsubloans would be disbursed on the basis of SOEs, the regular annual audit of the PFI wouid have toinclude a special opinion on the adequacy of SOE procedures. Audit reports have to be submitted to theBank no later than six months after the close of a PFI financial year. These audits should include acertification that the PFI is in compliance with the financial covenants agreed under the proposed Project.

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VI. BENEFITS AND RISKS

A. Benefits

7.01 The proposed Project is expected to contribute to reversing the country's economic declineand to increasing the private sector's share in the economy, thereby facilitating the transition to a marketeconomy. Its objectives and development indicators are summarized in Annex 6. The proposed Projectwould support viable private enterprises. Investments financed by the proposed Project would increasetheir earnings and profitability, and yield positive effects regarding employment and income generationcapacity of the private sector. Through the demonstration effect, it may stimulate more open access tothe credit market for the private sector.

7.02 The farm investments and production inputs financed under the proposed Project wouldenable farmers to intensify cultivation and animal husbandry and thereby increase agricultural output.Short-term crop production credit would assist farmers to purchase improved seeds, fertilizers, and pest-control chemicals, as well as finance land preparation and labor costs, as elements of improved technicalpackages for crop production. Medium/long-term credit for investments in livestock production wouldassist farmers to provide housing and stores for breeding, feeding and fattening operations, and improvedgenetic stock for higher yields of milk, meat and wool. Investments in modern farm equipment wouldenable farmers to achieve early and better crop plowing and sowing, better soil moisture infiltration andstorage, and reduced cultivation costs. These benefits would be further supported by the proposed PrivateFarmer Support Project, which is being processed in parallel, and which will fund technical assistanceto further improve the enabling environment for the development of private agriculture.

7.03 The proposed Project will also contribute to the strengthening of the banking sector ina number of aspects. Encouraging participation of small but financially viable new private banks willpromote competition in the credit markets. The process of bank appraisal, with the participation ofNBM, will help to practice on-site supervision; the discussions with senior banks management will helpin assessing the strengths and weaknesses of each institution. The rigorous subproject appraisal requiredby the proposed Project is expected to yield positive demonstration effects on banks, thereby helping tobetter assess and manage financial risk, to improve banks' lending policies and appraisal procedures andto improve their loan accounting.

B. Risks

7.04 The recent reopening of the country's borders should help in stimulating trade and privatesector development. General instability in the Balkan region, however, remains an overhanging risk forthe implementation of the proposed Project. The macroeconomic instability, which could re-emergeduring the period until the transition to a market economy is completed, is also a risk. The reformssupported by the FESAC, together with the ongoing dialogue with the IMF and the Bank's proposedStructural Adjustment Loan should, however, minimize the risk of policy slippage which could lead tomacroeconomic instability.

7.05 The main project specific risk results from general institutional weakness, including skilldeficiencies of banks and private enterprise managements. This risk has been addressed by arrangingtechnical assistance for all participants in the proposed Project and covering the most important aspectswhere skills deficiencies might jeopardize the Project's success. Close supervision of about 20 staffweeks

- 28 -

during the first year of implementation and 16 staffweeks per year thereafter, rather than the Bank'saverage of 12 staffweeks, will help to contain this risk.

7.06 Volatility and uncertain prospects can adversely affect the PFIs willingness to engage inlong-term lending to private enterprises or to diversify into agricultural lending. A general increase innon-performing assets would decrease the PFIs capacity to take the credit risk associated with theproposed Project. This risk is contained by a technical assistance to the PFIs to better manage risks, andby strengthening their capacities to assess credit risk associated with particular borrowers and projects.Credit risk of the PFIs and currency risk of the final beneficiaries has been decreased by extending a

single currency loan rather than the Bank's standard pooled loan.

VIII. AGREEMENTS AND RECOMMENDATION

8.01 During negotiations, final agreements were reached on the following: (a) the singlecurrency loan terms, including loan currency and interest rate basis (para. 6.01); (b) the interest rate andon-lending terms of PFIs (para. 6.03); (c) terms and conditions of subloans to the private sector andfarmers (paras. 6.06 and 6.07); (d) eligibility criteria for subproject to be financed of the private sector(para. 5.06) and of farmers (para. 5.09); (e) eligibility criteria for PFI participation (para. 6.15); (f) thecontent and form of Subsidiary Financing Agreements with PFIs (para. 6.02); (g) the apex arrangementsto implement the proposed Project (paras. 6.10-6.12); (h) procurement arrangements (paras. 6.21-6.22);(i) disbursement arrangements and special accounts (paras. 6.23-6.25); (j) the content and schedule ofaudit reports and on other reporting requirements (para. 6.27); (k) enviromnental review procedures(para. 5.17); and () targeted commitment amount after the first year of implementation (para. 6.26).

8.02 Agreed Actions. At negotiations agreements were reached on the following:

(a) Condition of Effectiveness, including: (i) signing of Subsidiary Financing Agreementsby at least two PFIs; and (ii) establishment of an apex unit for project implementationsatisfactory to the Bank; and

(b) Implementation Performance Condition. The initial commitment cut-off date will beSeptember 30, 1997. At that time the Bank will review the implementation performance,and, if satisfied, extend the loan commitment date to September 30, 1998.

8.03 Subject to the above agreements, the proposed Project constitutes a suitable basis for asingle currency loan to the Government of the former Yugoslav Republic of Macedonia in the amountof DM 18.0 million at a Bank's standard variable interest rate for single currency loans for a period of20 years, including five-year grace period, under terms and conditions outlined in Chapter VI.

m:\Asbb\mac\sr\grmar\April 17, 1996U3:40pm

- 29 - Annex IPage 1 of 6

FORMER YUGOSLAV REPUBLIC OF MACEDONIA

PRIVATE SECTOR DEVELOPMENT PROJECT

Procedure for Accreditation of Banks andCriteria for Banks Oualification

1. Application for Participation. An application for participation of a financial institutionin the intermediation of the World Bank financed credit lines shall be filed with the Department of BankSupervision, National Bank of Macedonia.

2. Papers Required. An application for participation should be accompanied by: (a) a fullset of documents and tables as listed in Attachment 2 of this document; (b) an outline of operationalpolicies and guidelines as specified in Attachment 3; (c) a brief corporate strategy outline as explainedin Attachment 4; and (d) a statement, signed by the Chief Executive Officer, that the financial institutionagrees to be subject to the Bank's appraisal process.

3. Screening. Upon submission of the application supported by the above listeddocumentation, the National Bank of Macedouia (NBM) will review the application. According to thequalification criteria listed in Attachment 1, the NBM would decide whether a bank qualifies for fullappraisal or not. If the opinion is positive, both the World Bank and the applicant bank should benotified. A bank, which, according to the opinion of the NBM, does not meet the qualification criteriawill be informed in writing, including specific reasons for refusal of their application and adviceregarding necessary improvements before it could re-apply.

4. Appraisal. The World Bank would appraise only banks for which a positive opinion bythe NBM has been received. If the appraisal shows that the bank's financial condition and intermediationcapacity is satisfactory to the World Bank, the bank would be advised to submit the papers necessary foraccreditation. Otherwise, the bank would be informed in writing as to why it has not been able toqualify.

5. Accreditation. The accreditation would be effected upon presentation of the followingdocuments:

(a) Board Resolution - A copy of the resolution of the Board of Directors of a bankauthorizing the bank to sign a Subsidiary Financing Agreement (i.e., agree to takesubloans financed by the World Bank to refinance credits that it has extended to eligibleborrowers for eligible projects and expenditures), and designating two authorizedsignatories (at least one signatory shall have the rank of vice president or officer ofequivalent rank to sign on behalf of the PFI all papers pertaining to the subloans);

(b) Letter of Understanding, accepting for the World Bank financed projects and transactionsto: (i) adhere to the Operating Policy guidelines for World Bank financed credit lines;(ii) establish a unit or an identifiable group to be responsible for approval and supervisionof Bank financed projects; (iii) establish a Loan Review Committee; and (iv) providetraining for the unit or group staff as advised by the World Bank; and

(c) Agreement for the World Bank financed projects and transactions to: (i) adhere toprocurement and disbursement procedures of the World Bank; (ii) maintain loan accountsand documentation; and (iii) submit annually externally audited financial statements

- 30 - ~~~~~Annex I- 30 - Page 2 of 6

concerning the World Bank related portfolio for as long as the bank continues toparticipate in the World Bank financed credit lines.

6. Suspension/Termination of Accreditation. In case when a subsequent evaluation of theeligibility of a participating financial institution (PFI) shows that the PFI has not maintained compliancewith the qualification and accreditation criteria and/or with the Operational Policy Guidelines applicablefor Bank financed credit lines, the PFI accreditation will be suspended. Once the reasons for suspensionhave been satisfactorily addressed, the bank would be able to re-apply for participation.

Annex 1- 31 - Page 3 of 6

ATTACHMENT 1

Oualification Criteria

l. A financial institution that seeks to participate in the Bank-financed credit lines shouldbe in a sound financial condition and have a satisfactory performance reflective of a healthy loan andinvestment portfolio, and should adhere to sound operating policies and procedures. Specifically, afinancial institution must comply with the following qualification criteria:

(a) The ratio of total capital to risk weighted assets should not be lower than 8percent, of which minimum 4 percent should be primary capital.

(b) It must have demonstrated satisfactory performance, including profitableoperations, for at least a year immediately preceding the date of application foraccreditation.

(c) It must have satisfactory financial policies and operating procedures, includingsatisfactory risk management, as a minimum including loan classification andprovisioning on an asset-by-asset basis, and diversified funding. Own funds,including capital, should cover minimum 50 percent of the total loan portfolio.

(d) It must be in compliance with the ceilings and limitations on loans to directors,officers, stockholders, and related interests in accordance with the existingregulations. A bank would be obliged to report to the National Bank ofMacedonia all assets where the exposure to a single borrower and affiliatedparties exceeds 10 percent of bank's capital.

(e) The total past due loans must not exceed 15 percent of the total loan portfolio ofassets acquired after April 20, 1992. A financial institution whose level ofarrears exceeds the 15 percent ceiling may still apply for participation, providingthat the unimpaired capital and reserves are sufficient to meet the minimumcapital requirements. Appraisal of such a bank should finally determine whetheror not it will be allowed to participate.

(f) It must have satisfactory credit appraisal policies and an organization,management and staff with the requisite expertise to identify, appraise andsupervise the utilization of loans.

(g) It must be in good standing with the National Bank of Macedonia, and be insatisfactory compliance with all pertinent laws, rules and regulations to thesatisfaction of all regulatory authorities.

(h) It must have a business strategy.

- 32 - Annex 1Page 4 of 6

ATTACHMENT 2

Documents and Data to be Provided with Application for Participation

I. Documents

1. Financial statements for minimum two years immediately preceding the date of application,including Balance Sheet, Income Statement and Sources and Uses of Funds Statement.

2. Articles of Establishment and By-Laws.

3. Number of branches/subsidiaries, their relationship with head office, their authorizations.

4. List (including very short biography) of Board members and Senior Management.

5. Manuals on different policies and procedures specifically including: income accrual, loanclassification, provisioning, project appraisal, project supervision and risk exposure limits

6. Two samples of project/credit appraisal.

7. Business plan including assumptions of financial market demand.

8. List of and exposure to 20 largest clients.

9. Technical Assistance or staff capacity building program currently in progress or planned.

II. List of Tables

Table 1: Organizational Chart including number of professional staff

Table 2: Main Products. List of main products on- and off-balance sheet,including loans (terms and interest rate) and other productsoffered to clients

Table 3: Loan Classification, including net exposure and provisionsLoans in Arrears, including number, volume and age of arrears(e.g., 1-3 months, 3-6 months, etc.)

Table 4: Funding Position, showing sources of funds

Table 5: Actual (2 years) and Projected (3 years) Income Statements

Table 6: Actual (2 years) and Projected (3 years) Balance Sheets

Table 7: Actual (2 years) and Projected (3 years) Cash Flow Statements

Table 8: Sources of Funding including average cost of funding for eachtype of funding source

- 33 - Annex 1Page 5 of 6

ATTACHMENT 3

Outline of Policy Statements

1. Institutional Policies

1.1 Portfolio quality1.2 Appraisal standards1.3 Exposure limits: single enterprise, industry/subsector, business groups, affiliates1.4 Relationship vis-a-vis directors, officers, shareholders and related interests

2. Asset-Liability Management Guidelines

2.1 Liquidity management2.2 Currency matching2.3 Maturity matching2.4 Matching of variable vs. fixed rate assets and liabilities

3. Rate of Return required for Loans to be extended by the Bank

4. Borrower Creditworthiness Appraisal Guidelines

4.1 Minimum current ratio4.2 Maximum debt/equity ratio4.3 Minimum debt service coverage ratio4.4 Profitability4.5 Return on assets

5. Financial Ratios/Guidelines for Risk Management

5.1 Capital adequacy5.2 Adequacy of provisions5.3 Rules to calculate net exposure5.4 Minimum collection ratio

6. Environmental Review Policies

7. Relations with Branch Network

7.1 Nature of branch and quarters relationship7.2 Lending authorities

8. Internal Audit and Controls

8.1 Audit policies8.2 Internal audit plan

Annex 1Page 6 of 6

ATACHMENT 4

Outline of Corporate Strateay

1. Relations with Corporate Sector, Financial Sector and Government

2. Strategies to Strengthen the Balance Sheet

2.1 Portfolio quality2.2 Capital adequacy2.3 Balance sheet vs. off-balance-sheet growth2.4 Diversification of asset mix and funding base

3. Business Strategies

3.1 Product line development/diversification, including time-bound targets3.2 Relative importance of various asset/liability product lines3.3 Marketing strategies3.4 Target market shares

4. Re-source/Funding Strategies

5. Operational Strategies

5.1 Improvements in internal control5.2 MIS development5.3 Automation5.4 Planning and budgeting5.5 Financial management systems5.6 Project finance: appraisal and supervision standards and procedures

6. Operations, Profitability and Balance Sheet Projections

6.1 Profitability of product lines, relative growth and importance over time6.2 Relative contribution to profit by product lines6.3 Relative magnitude and composition of assets and liabilities on the balance sheet

7. Human Resource Development

7.1 Training policies and training programs7.2 Promotion policies7.3 Salaries and Incentives

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Annex 2Page 1 of 7

FORMER YUGOSLAV REPUBLIC OF MACEDONIA

PRIVATE SECTOR DEVELOPMENT PROJECT

Participating Financial Institutions

1. The proposed Project has generated a very strong interest in participation by banks in the formerYugoslav Republic of Macedonia. The summary of banks and of their appraisal status is shown in TableA2.1.

Table A2. 1: Financial Intermediaries

Bank Ownershi2 Interest 3/ Appraisal 4/ Comments

Komercijalna (KBS) Mixed Both 07/95 T/B Qualified

Makedonska (MBS) Private 2/ Both 07/95 T/B Qualified

Stopanska, Skopje (SBS) Mixed Both 06/96 T/B appraised after rehabilitation

completed

Balkanska (BBS) Mixed Both 07/95 To submit asset portfolio audit

Invest (IBS) Mixed SMA 01/96 To submit asset portfolio audit

Almako (ABS) Private 2/ SMA 01/96 To present external audit

Kreditna (KRS) Private 2/ SMA 01/96 To present external audit

Ohridska (OBO) Mixed SMA 01/96 T/B appraised after settlement with STB

Stopanska, Bitola (SBB) Mixed SMA 01/96 T/B appraised after settlement with STB

Tetovska (TBT) Mixed SMA 01/96 T/B appraised after settlement with STB

Notes:

1/ All banks are majority private owned. The ownership of 'mixed' banks includes certain percentage of shares of socially-owned

enterprises.2/ Includes foreign capital.3/ Bank has an interest to participate under the private sector component only (SMA); under both components or Both

4/ Scheduled appraisal.

2. The qualification decision is based on the level of capitalization and capital adequacy, profitabilityand general financial condition of a bank and using international standards as qualification criteria, andon qualitative criteria. The description of the appraisal and qualification process and the details onqualification criteria are provided in Annex 1. The following qualitative aspects are studied at appraisalin detail:

- quality of management, managerial structure and human resources;

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Annex 2Page 2 of 7

general risk management - risk profile and exposure policies of the bank, policies andmethods used for asset/liability management, portfolio mismatches and gaps, fundingstructure;

operationalization of risk management - existence of risk committee and loan committee,their functions and responsibilities, rationale for and the disposition of lending authorities;

credit risk management - identification of risks, lending policies and procedures, assetclassification loan loss provisions, quality of credit appraisal;

information systems - data bases, computerization level and quality of managementinformation systems;

internal control and auditing systems;

-business strategy and future growth/diversification plans;

plans for external auditing (by international auditing firms) in the near future;

in the case of new private banks, their accumulated experience in banking business andoperations; and

staff training programs.

3. For qualitative criteria, minimum standards acceptable to the Bank, rather than standards forbanks operating in developed market economies, are used. Quality of management is given majorimportance at appraisal. Specific concerns include management appreciation of risks in the currentbusiness environment and of financial market conditions, existence of a coherent growth anddiversification program, and management understanding of bank's major deficiencies and existence ofplans to address them. Staff skills and relevant experience are also appraised. However, because of thedevelopmental role of the proposed Project, willingness to develop such skills, if currently less thansatisfactory, is also acceptable for participation. Staff training and massive technical assistance wouldbe provided under the proposed Project and the proposed Private Farmers Support Project and supervisedby the PSD project team, to build the skill capacity to a fully satisfactory level. A summary of bankappraisals is provided in Table A2.2

Table A2.2: Appraisal Summary(As of June 30, 1995)

Criteria KBS MBS SBS 3/ BBS IBS ABS KRS OBO SBB TBT

Capital adequacy Yes Yes No TBD TBD Yes Yes [/ 1/ [/

Fin. performance satisfactoryduring lat two years Yes Yes No Yes Yes Yes Yes Yes 2 Yes V Yes 2t

Fin. policies med minimum Yes Yes Yes Yes Yes Yes Yes Yes Yes Yesstandards 4/

Satisfactory loan classification Yes Yes No TBD TBD TBD Yes Yes Yes Yesand provisioning I/ I

Standard credit appraisal Yes Yes Yes LFS LFS TBD Yes Yes Yes LFSpolicies

Skils sufficient for agriculture Yes LFS Yes LFS LFS N/A N/A N/A N/A N/Afinance

Good standing with NBM Yes Yes No Yes Yea Ycs Yes TBD TBD TBD

External audits 6/ Yes Yes Yes LFS LFS No No No No No

Notes: YES means positive finding; NO means negative finding; TBD means to be determined; LPS means less than fuly satisfactory; N/A means not applicabk.

1/ Ohridska Banka (OBO), Stopanska Banka Bitola (SBB) and Tetovska Banka Tetovo (TBT) are new banks which were spun-off from Stopanska Banka Skopje underthe FESAC program. Their capital adequacy cannot be established until the issue of internal accounts with the core Stopanaka is fully resolved and replaced with formalcontractual obligations and until the issue of frozen foreign exchange deposits paid from banks own funds is satisfactorily resolved.

2/ OBO, SBB and TBT operated as an integrl part of Stopanska Banka Skopje. On a branch basis, the financial performance was adequate.

_/ Stopanska Banka Skopje (SBS) is currently undergoing financial restructuring under the FESAC progam. The bank wil be fully appraised after the progrmm iscompleted.

4/ Financial policies were required to meet minimum standards. The banks will be provided technical assistance as described in Annex 5 to improve financal policiesand bring them to a fuiUy satisfactory level.

5/ Asset clasification and provisions as required by the applicable prudential regulations of the NBM. The regulations wil be brought to intenational standards as acondition for the FESAC second tanche releaw and as a condition of effectiveness for the proposed Loan.

PFuU exernal audits by auditors satisfactory to the bank and by international auditing sandards. AU banks are required to prent aisctory external audits as acondition for Bank appraisl to be finalized.

- 38 - - 38 - ~~~~~~~Annex 2

Page 4 of 7

4. One of the objectives of the proposed Project is to promote participation of new, smaller privatebanks and be instrumental in increasing their institutional capacity. The banks which have applied forparticipation, other than the core Stopanska, accounted as of December 31, 1995 for about 55 percentof the total assets in the banking system, for about 75 percent of the total capital in the banking system,for about 69 percent of the total commercial sector loans in the banking system, and for about 50 percentof the total loans to households. The developmental objectives of the project will be measured againstselected development indicators, as explained in Annex 6.

Participating Banks

5. Komerciaalna Banka, the second largest bank in FYR of Macedonia, has been established in 1992,from the former Skopje branch of Stopanska Banka. Its capital amounted to US$165 million as ofDecember 31, 1995. The bank is now fully private with 11.2 percent of its capital owned by socially-owned enterprises, about 56.4 percent owned by private enterprises, and the remainder by mixedenterprises with majority private ownership. In terms of numbers, the banks ordinary stock is owned by84 socially-owned enterprises, 179 mixed-ownership enterprises and 1,650 private shareholders. Thepreferred stock is owned by 2,737 owners of which 2,663 are private. The total asset as ofDecember 31, 1995 amounted to US$419 million, of which about US$85 million is the loan portfolio.The net profit before taxation as of end-September 1995 amounted to US$4.5 million. The interestexpense is about 22 percent of the interest income.

6. The bank has experienced a very strong growth since its establishment. It has restructured itsportfolio over the past five years. In 1990, the bank's credit portfolio showed a 79 percent share formanufacturing, 2 percent for agriculture and agroindustry, and 19 percent for other subsectors (trade,handicrafts and others). In mid-1995, the portfolio mix showed a significantly different profile, withagriculture and agroindustry accounting for 66 percent, manufacturing 27 percent, and other subsectors7 percent. Komercijalna Banka has a tradition of extending funding for fixed investments and workingcapital, accounting for 61 percent and 39 percent, respectively, the loan portfolio as of mid-1995. Thebank reports no export finance activity or loans in foreign currency.

7. The bank was fully appraised in July 1995, after it has presented externally audited financialstatements by Coopers and Lybrand with a clean audit opinion. Its financial condition, assuming thereis a satisfactory resolution concerning frozen foreign currency deposit payments from bank's own fundsand the work-outs involving exposures to enterprises under the FESAC program, is fully satisfactory.The bank is, therefore, deemed able to qualify as a PFI.

8. Makedonska Banka, the third largest bank in FYR of Macedonia, has been established in 1992,from the former branch of Ljubljanska Banka from Slovenia. Its total capital as of December 31, 1995was US$29 million. Its share holders include Ljubljanska Banka for 51 percent, and the remaining 49percent is held by domestic private enterprises and individuals. Ljubljanska Banka has recentlyannounced its intention to withdraw its ownership and its shares are now being offered to other investors.The total assets as of December 31, 1995, amounted to US$490 million. Its net credit portfolio isequivalent to US$43 million, with an orientation toward services (24 percent), manufacturing (20 percent)and other subsectors (56 percent). The portfolio currently shows minimal exposure to agriculture andagroindustry. The interest expense for the bank is 19.4 percent of interest income. The net profit beforetaxation as of September 30, 1995 was about US$318,000.

- 39 -Annex 2

Page 5 of 7

9. The bank's credit portfolio is predominantly short-term in nature, the medium-term to 17 percentof the total credit portfolio. The bank's operational emphasis is on export finance and working capital,which represent 60 percent and 40 percent, respectively, of total portfolio. The bank has no outstandingcredits for fixed investments. It has a 44 percent-56 percent mix between foreign currency and localcurrency loans. The loan portfolio is spread over small (57 percent), medium-sized (23 percent) andlarge (20 percent) borrowers. The bank's management reports conservative leverage ratios prescribedfor borrowers, with average total debt/equity ratios of 1:2 and average long-term debt/equity ratios of1:1.5 as of year-end 1994.

10. The bank pursues very conservative lending policies. Its potential profitability is the highest inthe banking sector. The bank is regularly audited by foreign external auditors, and was able to get cleanaudit opinions for 1993 and 1994. It will be appraised as soon as the end-1995 external audit iscompleted. The bank is deemed able to meet the qualification criteria.

11. Balkanska Banka is a new bank which is much smaller than Komercijalna Banka and MakedonskaBanka with the total capital of US$7.43 million as of December 31, 1995. The total assets amount toabout/US$15 million, and the loan portfolio to US$7.6 million with 55 percent trade, 34 percentmanufacturing, 4 percent agriculture and agroindustry and 7 percent other subsectors. The bank projectsa sustained build-up of its portfolio over the medium-term, with a balanced mix between agriculture andagroindustry, manufacturing, and trade. The bank's short-term loans represent 97 percent of total credits,with 3 percent having a medium-term maturity.

12. All of Balkanska Banka's credits are for export finance, with no exposure in investment andworking capital loans. In mid-1995 portfolio indicated a 48 percent - 52 percent ratio between foreigncurrency and denar loans. The concentration on export finance yielding high interest rates reflects thebank's current strategy of financing trade. The borrowers of Balkanska Banka show a much higheraverage leverage position compared to those of Makedonska Banka. Bankers explain the higher leverageratios for borrowers of newer banks as flowing from the observation that newer banks tend to cater tonew or less established entrepreneurs who generally have modest equity resources. In spite of relativelyhigher risk profile compared to other banks, the level of provision is only about 4.7 percent of its totalloan portfolio.

13. The bank was appraised in July 1995, but its audit report was not satisfactory to the Bank. It wasasked to provide a new audit which meets the Bank standards before it can be qualified.

14. Invest Banka, with the total capital of US$6.9 million and total assets of US$20 million as ofDecember 31, 1995, has been in operation since the former Yugoslavia, but it has substantially changedits profile since independence. The shareholders of Invest Banka consist of 113 legal entities and 60individuals. The highest percentage of shares held by a single entity is 9.73 percent. The Board ofDirectors consist of five members which represent either fully private enterprises (three members-including the Chairman of the Board), or enterprises of which at least 70 percent of the ownership isprivate. With the total loan portfolio of about US$6 million, the bank is predominantly oriented onbanking services and trade financing. Almost 95 percent of its credit operations consist of short-termloans with a maturity of up to three months. As of end of 1994, more than 65 percent of its revenuesconsist of income generated in the form of fees and commissions.

- 40 -

Annex 2Page 6 of 7

15. The bank is fairly small, and its business concentrates on off-balance sheet financial services,possibly due to funding difficulties. The application for participation is an indication that its managementintends to position a bank on a higher growth path. The bank was appraised in July 1995, but the finalopinion was not reached because its capital adequacy is uncertain. The bank does not classify its assets,and has no provisions. The appraisal will be finalized when the bank was able to provide a full reviewby external auditors of its credit portfolio.

16. Ohridska Banka has been established under the banking sector restructuring program undertakenunder the FESAC. It has operated as an independent bank in the 1979-1992 period, and was originallyspecialized in the small scale private sector, and households finance and in deposit taking. During the1980s it has also developed the capacity for working capital and investment finance in domestic currencyof larger socially-owned enterprises. In 1992, the bank was integrated with Stopanska Bank, albeitkeeping independent internal accounts. In order to reduce the market dominance of Stopanska, a decisionhas been made to spin-off its larger branches which are able to operate as independent banks, if theirshareholders decide to exercise such a option. The Ohrid branch applied, and the NBM granted thebanking license in March 1995. The bank is currently owned by a large number of small owners andabout 100 somewhat larger enterprises. The Ohridska assets as of December 31, 1995 amounted toUS$37 million, making it the fifth largest bank in FYR of Macedonia, with a capital of about US$11million. Its loan portfolio totalled about US$6.3 million. It has been originally appraised under theFESAC, when assessing its capacity to operate independently. The bank has applied for participation,but the formal appraisal is pending: (a) the satisfactory resolution of internal accounts with the ccreStopanska; (b) the resolution of the issue concerning the frozen foreign exchange deposits payments madefrom bank's own funds; and (c) completion of the first external audit by auditors satisfactory to the Bank.It is expected that the bank will be ready for formal appraisal by May 1996. The bank is expected to beable to quality.

17. Stopanska Banka. Bitola. The background of the Stopanska Bitola is the same as for OhridskaBanka. The NBM license was issued in May 1995. The bank is now the fourth largest bank in FYR ofMacedonia with assets amounting to about US$58 million as of Decmeber 31, 1995, its capital to aboutUS$17.8 million, and the total loans US$18.2 million. It has applied for participation, but has not beenappraised due to the reasons also cited for Ohridska. The bank is expected to be ready for appraisal byMay 1996. It is expected to be able to qualify.

18. Tetovska Banka. Tetovo. The bank has total assets of US$29 million as of end-1995, and capitalof US$10.6 million. It has received its license in May 1995. The background of this bank as well asits appraisal prospects is the same as for Ohridska and Stopanska Bitola.

19. Kreditna Banka, with the capital of US$10.3 million, as of December 31, 1995, is one of thenew private banks established after independence by a number of independent entrepreneurs and backedby a single large foreign private shareholder. The bank's main business since its establishment is theprovision of off-balance sheet financial services to entrepreneurs and private sector enterprises. The feescurrently account for about two times the total interest income. Other main line of activity is deposittaking; the bank is almost exclusively interested in foreign currency deposits (US$9.1 million). The totalassets amounted to US$22.4 million as of December 31, 1995, and its loan portfolio is small (US$5.7million) and of recent origin. The bank aims to specialize in foreign currency banking activities, andwould like to become more serious in foreign currency lending. It has recently expressed interest to

- 41 - Annex 2

Page 7 of 7

participate in the private sector finance component. Its appraisal will take place as soon as the bank isable to present externally audited financial statements with clean audit opinion satisfactory to the Bank.

20. Almaco Banka, with the total capital of US$11 million as of December 31, 1995, is one of thenew private banks established after independence with private MKD capital. Its assets totalled US$43.2million as of December 31, 1995. The bank has initially focussed on off-balance sheet external traderelated services. It has changed its business policy in 1994, and is now aggressively trying to expand itsloan portfolio and specialize as a lender to small private businesses. With loan portfolio of about US$15million, it is now the fifth largest competitor in the credit market. Successful realization of its businesspolicy critically depends on whether the bank is able to increase and diversify its funding sources. Thiswas the reason that the bank applied for participation. Its appraisal is pending completion of its firstexternal audit. The bank is expected to be ready for appraisal in May 1996, and it is expected to be ableto qualify.

- 42 -

Annex 3

FORMER YUGOSLAV REPUBLIC OF MACEDONIA

PRIVATE SECTOR DEVELOPMENT PROJECT

Disbursement Schedule

Estimated Schedule

Calendar Year Fiscal Year Cumulative % ofand Semester and Semester Amount Amount Total

- -----------DM Million----

1996 II FY97 I 1.0 1.0 5.551997 I FY97 II 1.5 2.5 13.881997 II FY98 I 2.5 5.0 27.771998 I FY98 II 4.0 9.0 50.001998 n FY99 I 6.0 15.0 83.331998 I FY99 II 3.0 18.0 100.00

The Loan is expected to be effective in the first quarter of FY97. The disbursement dynamics in FY97and FY98 are expected to be dominated by the private enterprise investments. The disbursements inFY99 include the tail of private enterprise investment component and mostly the private agrobusiness andfarmer investments.

- 43 -

Annex 4Page 1 of 2

FORMER YUGOSLAV REPUBLIC OF MACEDONIA

PRIVATE SECTOR DEVELAOPMENT PROJECT

Project Implementation Schedule

Approximate Dates Expected SkilIReguirements Staff Input(Month/Year) Activity (Staff Weeks)

Supervision Mission

06/96 ImplementationLaunching Mission

Procurement Specialist- Conduct Procurement Disbursement Specialist 8

Seminar Banking Specialist- Conduct Disburse-

ment Seminar09/96 - Set Project Imple-

mentation Facilities/Tools

Banking Specialist- Accreditation of PFIs Disbursement Specialist 10- Review apex

arrangements Procurement Specialist- Review PFI invest- Engineer

ment appraisalarrangements

- Project promotion

03/97 Supervision Mission

- Accreditation of PFIs Banking Specialist 10- Review appraisal Financial Specialistprocedures

- Review TA to PFIs Engineer

09/97 - Review investment Financial Specialist 803/98 pipelines Engineer 809/98 - Review procurement/ 8

disbursement

- 44 -

Annex4Page 2 of 2

Approximate Dates Activity Expected SkillRLguirements Staff Input(Month/Year) (Staff Weeks)

Supervision MissionFinancial Specialist

03/99 - Review investment Economist 8pipelines

- Review SpecialAccounts

- Review Procurement/Disbursement

- Review outstandingissues

- Agree on Projectclosing date

06/99 Project Completion Engineer 8Report Financial Specialist

EconomistPreparation of ProjectCompletion Report atHeadquarters

Total Missions Total Staff Weeks

FY96 1 8FY97 2 20FY98 2 16FY99 2 16PCR 8

68

Annex-545 - Page 1 of 9

FORMER YUGOSLAV REPUBLIC OF MACEDONIA

PRIVATE SECTOR DEVELOPMENT PROJECT

Terms of Reference for Operational Audits of Participating Banks

A. BACKGROUND

l. During the past year, the Government of Macedonia has instituted a number of economic reformsaiming to reverse the economic decline. Although some of these measures are expected to yield positiveresults in the short-term, their potential benefits in the medium- to long-term cannot be realized withouta strong and active financial system. At present FYR of Macedonia banking institutions still suffer fromdistortions inherited from past policies and practices, in particular, a lack of autonomy, a general lackof banking skills necessary in a market environment, and an inadequate financial structure. As one ofthe initial steps for strengthening the financial sector, the Government has decided to undertake a programfor the strengthening of existing banks. The Government has also initiated a number of actions aimingat strengthening the National Bank of Macedonia including its bank supervisory function, the drafting ofprudential regulations and the development of a new accounting plan for banks.

B. OBJECTIVES

2. The Operational Audits are expected to provide an accurate assessment of the financial conditionand operational capabilities of the audited banks, including the evaluation of their organization, policiesand procedures. These Operational Audits will serve as a basis for banks' strengthening programsincluding their recapitalization to the level in accordance with sound international banking practice andprovision of technical assistance to improve their banking practices. The audits will also be used as abackground for the appraisal process to qualify banks for participation in the World Bank credit lines.The audits should cover both financial and organizational aspects.

The financial aspect of the Operational Audit should cover:

(a) the adjustment of the balance sheet as of December 31, of previous year (starting with1995), and the related statements of operations for the year then ended to a format basedon Generally Accepted Accounting Principles for banks; and

(b) the examination of financial data as specified.

The organizational aspect of the Operational Audit should cover:

(a) assessment of the bank(s) present functioning. including:

(i) internal organization;

(ii) asset and credit management;

(iii) resource mobilization and funding;

Annex IPage 2 of 9

- 46 -

(iv) treasury, and asset and liability management;

(v) internal controls and internal audit; and

(vi) management information systems.

(b) assessment of the bank's future performance based on review of a strategic businessdevelopment plan prepared by banks' senior managements.

C. SUBJECTS

3. The operational audit will be applicable to commercial banks participating or interested inparticipation in the Private Sector Development Project.

D. ADJUSTMENT OF FINANCIAL STATEMENTS

The Financial Aspect of the Operational Audit

4. The FYR of Macedonia banks to be audited intend to convert their present accounting system toa system based on internationally accepted standards in 1996. However, in 1995, the banks were stillusing the old accounting model. For the year ended December 31, 1995, the auditor has to adjust theannual financial statements in such a way as to establish the balance sheet as of December 31, 1995, andthe related statements of operations, retained earnings and changes in the financial position of the bank,for the year ended, in a format which is in accordance with Generally Accepted Accounting Standardsfor banks.

5. Reports to be Provided. The consolidated annual financial statements, after appropriateadjustments, for the year ended December 31, 1995. This should include Balance Sheet, Profit and LossStatement, State of Changes in Shareholders' Equity, Statement of Sources and Application of Funds,Statement of Provisions for Losses, Write-offs and Recoverables, and Statement of Past Due, Non-performing and Renegotiated Loans and Advances. The accounts should be accompanied by notes,explanations and back-up schedules. These working papers will be important for the bank in itsunderstanding of the process of international accounting and the adjustments made to the bank's ownaccounts to achieve this.

E. PORTFOLIO REVIEW AND DETERMINATION OF PROVISIONS

6. To support an overall assessment of the current financial conditions of the credit portfolios andprojections regarding the extent of ultimate loss potential, detailed portfolio reviews are to be performed.The portfolio reviews have to:

(a) determine the credit quality of all major borrowers and debtors under loans, investmentsand off-balance sheet commitments;

(b) classify all significant loans, investments and off-balance sheet commitments, accordingto established classification criteria based on repayment capacity and collateral; and

Annex 5- 47 ~ Page 3 of9

(c) determine the appropriate level of current provisions for all such assets based onestimated loss potential.

7. In devising the plan of work for the portfolio reviews, the auditors should take into considerationthe effectiveness and reliability of accounting and administrative systems and internal controls in orderto determine the degree of reliance to be placed upon them.

8. The evaluation of asset quality should identify problems assets and classify them according tocriteria for substandard, doubtful and loss categories '/. All commercial extensions of credit 2/ exceedingthe cutoff amount are to be individually reviewed. The cutoff amount is defined as those extensions ofcredit exceeding 0.5% of total assets or a sufficient number to encompass about 70% of the total amountof commercial credits. Commercial credits below the cutoff amount are to be reviewed on a samplebasis. The sample should be of sufficient size to enable statistically valid statements regarding the below-cutoff portfolio. Non-commercial extensions of credit (such as consumer loans and residential mortgages)are to be reviewed based on a statistical sample of sufficient size to allow a valid audit opinion.

9. The review of individual credits must entail an analysis of the obligor's capacity to service interestpayments at market interest rates based on existing levels of debt, and their capacity to repay principal,under existing market conditions. For credits in amounts exceeding 5 % of the bank's equity, the analysisrequires an assessment of the obligor's business, plans, the potential for success of those plans, and theirpotential consequences on debt service capacity and principal repayment.

10. Based on the credit analysis and classification, the auditor should recommend an appropriate levelof provisions for losses. Estimates should be made for the specific reserves appropriate for each creditreviewed. The analysis upon which these estimates are based should be included in the supportingdocumentation.

11. Reports to be Provided. At a minimum, the final report of the portfolio review should includethe following information. However, the auditor is encouraged to submit additional information relevantto his findings which will serve to inform and educate the reader. All specified reports are due for theDecember 31, 1995 audit.

(a) A description of the lending authorities, a flow chart of the credit approval process, andother information considered necessary to provide an understanding of the bank's credit,appraisal and supervision process and lending activities.

(b) A written assessment of lending activities based on your findings. This assessmentshould address the following: (i) the quality of assets and its impact upon the soundnessof the institution; (ii) the quality of management with respect to the lending andinvestment functions; (iii) the quality and effectiveness of loan and investment policies,practices, procedures and internal controls; (iv) concentrations of credit; (v) loan pricingpolicies; (vi) other matters of importance requiring attention such as foreign exchange,

1/ Definitions for these categories should follow internationaL standards.

V1 Defined as Loans, investments or off-balance sheet commitments to individual borrowers and theirrelated entities.

- 48 - Annex 5Page 4 of 9

liquidity, or interest rate risks; and (g) near term expectations concerning the quality andadministration of the loan and investment portfolios.

(c) A statement describing the method by which the required classification criteria wereapplied in the FYR of Macedonia context, including any unusual factors that served toinfluence the classifications assigned, should be provided.

(d) A summary schedule of the number and volume of credits reviewed individually and bysample, expressed in nominal terms and as a percent of one and off-balance sheet creditsoutstanding.

(e) Summaries of criticized assets by: (i) category of classification; (ii) economic sector; and(iii) currency (for those loans denominated in foreign currencies).

(f) Written loan comments for all classified problem assets with dues exceeding theequivalent of 5 % of bank's equity. These written comments should provide a breakdownof total extensions of credit to the enterprise and its related entities, indicating the amountclassified; a description of the credit including the history of the indebtedness, therepayment plan and actual performance; a description of the collateral and/or guarantees(if any); and the reasons for the chosen classification for the credit.

(g) A summary statement of all past due, non-performing, and renegotiated credits, bycategory or type of credit expressed: (i) in domestic currency; and (ii) as a percentageof total outstanding credits in that category. The criteria to be used to determine pastdue, non-performing, or renegotiated status should be clearly stated.

(h) A listing of large 3/ past due, non-performing, and renegotiated loans. You shouldindicate the name of the borrower, the amount outstanding, the number of days paymentsare in arrears (if appropriate), and any other pertinent information.

(i) A listing of loans not supported by current and satisfactory financial information orlacking a satisfactory definition of the loan's purpose and repayment plan. The listingshould include the name of the borrower, the outstanding balance of the loan, and thenature of the credit file exception.

(j) A listing of loans not supported by complete collateral documentation. The listing shouldinclude the name of the borrower, the outstanding balance of the loan, and the nature ofthe collateral exception. This listing should also highlight collateral which is judged tobe worth less than its stated value, e.g. inventories of finished goods no longer saleablein the new market economy.

12. To the extent that other auditors are involved in the portfolio reviews of other FYR of Macedoniafinancial institutions, you are required to coordinate your activities and agree upon standards, with NBMconsent, to be used in evaluating the quality of assets and in assessing the adequacy of services. In thisregard, it may be necessary to agree on common interpretations of the standard classification definitionsfor the FYR of Macedonia context. For the purpose of credit classification, you should also agree on

3/ GeneraLLy, these wouLd include Loans which exceed to cut-off amount.

Annex5- 49 - Page 5 of 9

the treatment and handling to be accorded to: (i) guarantees and collateral; and (ii) debt which has beenrescheduled, rolled-over, extended, or otherwise refinanced to hide delinquency.

F. EXAMINATION OF THE CONSOLIDATED ACCOUNTS

13. The auditor is required to perform an examination of the consolidated accounts of the bank witha view to expressing an opinion on the financial condition of the bank as at December 31, 1995.

14. Reports to be Provided. The auditor has to provide reports as follows:

(a) The opinion of the auditor on the financial statements.

(b) A statement of commitments and contingencies itemizing and quantifying all contingentliabilities, to include, inter alia, undrawn loan commitments, guarantees, documentaryand standby L/C's and forward foreign exchange contracts.

(c) A report on all extensions of credit, loans, investments and commitments, consistent withthe portfolio review, indicating:

* Breakdown of items on balance sheet as between local currency and foreigncurrency

* Breakdown of items off-balance sheet as between local currency and foreigncurrency

* Portion of each subcategory above which is Past Due, Non-Performing orRenegotiated

c Total of uncollected interest (if this calculation is feasible).

(d) An opinion on the adequacy of the reserve for loan losses and all other reserves. In theabsence of loan loss reserves, recommendations should be made as to specific provisionsrequired, consistent with the findings of the portfolio review.

(e) An enumeration and quantification of the adjustments considered necessary to fairlypresent the financial statements.

(f) The identification and quantification of concentration of credit and large exposuresdefined as representing 25% or more of the bank's capital funds. These concentrationsmay result from credit (in the form of loans, investments, or other instruments) extendedto a single borrower or related group or to an economic or industrial subsector, or assetsdependent upon a single factor that could affect repayment prospects for the entire groupof assets. It is recognized that in the FYR of Macedonia context, a large proportion ofthe banks' portfolios will comprise loans to entities owned by the government and/orguaranteed by the government, either explicitly or implicitly. An attempt should be madeto identify which loans are formally guaranteed by the government and which are coveredby informal arrangements.

- 50- Annex 5Page 6 of 9

(h) An opinion on the adequacy of capital.

(i) An opinion on the funding structure of the bank.

(j) An opinion on the total risk exposure in FYR of Macedonia context.

15. The following items should be specifically included:

(a) notes on each item of the balance sheet and income statement, explaining its nature andany clarifications considered useful;

(b) a description of significant accounting policies, criteria and practices applied by theauditors in preparation of the financial statements;

(c) itemization of each adjustment and reclassification deemed necessary by the auditors;

(d) a statement of the effects of non-application of any International Accounting standardsby the auditors;

(e) a statement summarizing the major items which have contributed to the adjustment inearnings and net worth of the bank in the international accounts when compared with thebank's accounts;

(f) itemization of all credit extended to the Members of the Board, Managers or other partiesconnected with the bank; and

(g) any significant events affecting the bank which occurred between the account date anddate of the audit report.

16. It is recognized that owing to the precarious state of accounting in FYR of Macedonia, some ofthe requirements under paragraphs 18 and 19 above will present the auditors with a difficult task. In suchcases the auditors should use their judgement and state clearly which items above cannot be satisfactorilyanswered or addressed in this initial short audit.

G. ASSESSMENT OF THE BANK'S PRESENT FUNCTIONING

The Organizational Aspect of the Operational Audit

17. The auditor should analyze the present internal organization and functions of the bank, includingthe internal control and internal auditing function and the quality of management reporting. The auditorshall give his opinion on the accuracy and reliability of the present accounting system, and on theadequacy of the bank's internal organization, controls and operating procedures. In undertaking theanalyses of the above mentioned present organizational aspects the auditors are expected to visit both thehead office of the bank and a number of representative branches and sub-branches.

-51 - Annex SPage 7 of 9

18. Report to be Provided. The report on the present organization has to cover the following areas:

(a) Asset and Credit Management. The auditors should review and comment on the bank'sobjectives, strategy, operations and performance in the area of general asset managementand in particular credit management. The key results from the portfolio review and shortaudits as at December 31, 1995 to be undertaken concurrently should be analyzed andconmmented upon in the light of their strategic importance to the bank (in terms of size,effect on earnings, etc.) and the underlying market fundamentals.

(b) Treasury and Asset and Liability Management. The auditors should review and commenton the bank's objectives, strategy, operations and performance in the areas of treasury,and asset and liability management. The key results from the financial analysis of assetsand liabilities (both on- and off- balance sheet) undertaken in the portfolio review andshort audits as at December 31, 1995 should be analyzed and commented on in the lightof their strategic importance to the bank (in terms of size effect on earnings, etc.) and theunderlying market fundamentals. particular attention should be given to interest rate,foreign exchange and maturity mismatches.

(c) Resource Mobilization and Funding. A review of the bank's plan, policies andprocedures for resource mobilization and funding should be included. The review shouldexamine whether the bank has and successfully operates a suitable resource mobilizationstrategy and discuss implications of the current funding policy and structure on its riskexposure and future growth perspectives. Recommendations for improvements shouldbe made.

(d) Management Information System. The auditor should review the existing managementinformation system and indicate areas for possible improvements in order to enhance itseffectiveness as a tool for management.

(e) Internal Audit Function. The auditor should review and give an opinion on internalcontrols and procedures, which must be analyzed with a view to determine theireffectiveness in ensuring that the bank's assets are being safeguarded, transactions havebeen executed in accordance with management's directives, and that transactions havebeen adequately recorded to permit the timely preparation of the organization's financialstatements in accordance with generally accepted accounting principles. The study shouldindicate whether the bank has a manual that incorporates sound audit policies andpractical audit procedures, and whether the level of audit skills needs to be upgraded andexpanded.

(f) Organizational Review. The organizational structure of the bank should be reviewed todetermine whether it provides for effective and efficient realization of the bank'sobjectives. The audit should take into account and comment on the grouping of mainfunctions, delegation of authority, clear definition of responsibilities and the relationshipof head-office with branch offices.

(g) Financial performance and Management. The auditor should review and comment on thefinancial performance of the bank in terms of the profitability of its overall operations,its products, branches and departments and its financial strength.

- 52 - Annex 5Page 8 of 9

(h) Training. The auditor should review and comment on whether the bank has definedspecific skill requirements for management, specialist and key clerical positions, assessedand prioritized skills shortfalls, and developed practical plans to meet these shortfalls.The auditor should recommend a training and other programs for skills enhancement.

(i) Automation. The bank's systems of automation should be reviewed in the light ofrequirements, and recommendations should be made as to the needs for improvement.

H. BANK'S FUTURE PERFORMANCE

19. The auditor should cover the following aspects in assessing the bank's strategic plan:

(a) Review of the Bank's Present Strategic Plan. A review should be conducted to determinewhether the purpose for which the institution was established and the activities originallyset out in the enabling legislation remain realistic and relevant in the prevailing economicenvironment. The review would determine and discuss if the bank has an adequatestrategic plan that discusses its objectives, target markets, products and services, the basicstrategies and actions it needs to take to meet these objectives, and an operational andfinancial plan that projects resource requirements and financial outcomes of the strategicplan.

(b) Strategic Parameters and Options. From the previous analysis the auditor should reviewand comment on the important strengths, weaknesses, opportunities and threats of thebank. Based on their conclusions the auditor should examine and discuss the mainstrategic options for the bank with the bank's management and staff and provide a briefsummary of the discussion.

(c) Training. Based on this review and the Strategic Plan Review undertaken as part of thisassignment a training plan should be developed with the bank's management.

I. COUNTERPARTS

20. The banks undergoing operational audits will establish counterpart teams to work in closecollaboration with the auditors assigned to the task. The auditors will be expected to provide the staffof the banks with on-the-job training in portfolio assessment, accounting and auditing techniques. Theobjective is to use this initial operational audit at December 31, 1995, as a springboard to establish apractice of yearly full audits. This will require an effective skills transfer from the external audit staffto the banks' counterpart teams.

J. CONFIDENTIALITY

21. This exercise is being carried out primarily for the purpose of appraising the financial conditionsand developing a program for strengthening of the concerned banks. Accordingly, the auditors willneither discuss with, nor distribute to parties outside the management of the relevant bank, the BankingSupervision Department of the National Bank. of Macedonia and the World Bank, without their explicitauthorization, any aspects or details of their work ad findings.

Annex 5- 53 - Page 9 of 9

Independence and Impartiality

22. The consultants must be independent of any member of the Board of Directors, Executive Officeror Senior Manager of the bank. Independence implies that the senior managing partner, other partneror staff member who would be involved in the portfolio review and short audit, is neither serving as adirector of the bank nor has any personal, financial or close business relationship except as anindependent professional advisor during the course of an audit.

K. STAFFING

23. For carrying out the required tasks, the team must include banking auditors with internationalexperience. Given the importance of the task to be undertaken, it is anticipated that the audits would becarried out by a reputable firm drawling on high-level staff with international experience and having asuitable skills mix. The team would be expected to work with a small counterpart team from the bankbeing audited.

24. Curriculum vitae (CVs) of the principals who would be responsible for providing the opinionsand reports should be provided, together with the CVs of other personnel proposed for the audit. CVsfor audit personnel should include details on audits carried out by these staff, including ongoingassignments.

25. It is anticipated that an auditing firm would undertake the analysis of more than one bank, andthat the whole process could be carried out by about 2-3 auditing firms.

- 54 - Annex6Page 1 of 1

FORMER YUGOSLAV REPUBLIC OF MACEDONIA

PRIVATE SECTOR DEVELOPMENT PROJECT

Development Indicators

Objective Action Indicator

* Promote growth of the * Improve access to * Amount of creditprivate sector including investment and working committed and disbursed.farmers capital finance through

credit line intermediated by * Increase in earning anda number of participating profitability of individualbanks final beneficiaries.

* Facilitate adoption of safe * Training of participating * Improved banks' riskand sound banking practices banks in asset/liabilities profile

management and projectappraisal * Improved collection

performance* Assistance in the use ofadvanced project appraisal * Improved asset qualitymethods and computerizedappraisal tools

e Assistance in loanadministration

* Promote credit market * Qualify smaller, new * Increased participation ofcompetition private banks new, smaller private banks

in SME credit market* Assist such banks inmeeting the qualificationcriteria

- 55 -Annex 7

Page 1 of 1

FORMER YUGOSLAV REPUBLIC OF MACEDONIA

PRIVATE SECTOR DEVELOPMENT PROJECT

Selected Documents Available in the Project File

1. FYRM, An Introductory Economic Report, No. 14576-MK, July 1995.

2. FYRM, Agriculture and Private Sector Development Project. Review of Demand fora Generalized Line of Credit, June 1995.

3. Back-to-Office Reports, include Aide Memoires, when applicable, dated July 14 andJuly 15, 1994, February 1995, July 1995 and January 1996.

4. Update on Private Sector Development in FYRM, EBRD, September 1995.

5. Stimulating Investment Activities in Macedonia: An Overview of TechnicalAssistance Needs of the Government of FYRM, UNIDO, June 1995.

6. Audited Financial Statements and External Audit Reports of various FYRM bankswhich have applied for participation.

7. Banking Statistics and Supervisory reports issued by National Bank of Macedonia in1994 and 1995.

8. Project Implementation Management System. System Documentation and UsersManual. Developed in ECIIT, April 1996, Version 1.

9. Subproject and Loan Appraisal Package, User Manual. Developed in ECIIT, April1996, Version 1.

10. Environmental Review Procedures, User Manual. Developed in EClIT withassistance from EMTEN, January 1996.

11. Prudential Regulations Applicable to Banks Participating in the Credit LineIntermediation, National Bank of Macedonia, November-December 1995.

I

MAP NO. 27711

IBRD 27711

FED. REP. OF YUGOSLAVIA FORMER YUGOSLAV REPUBLIC OFMACEDONIA

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Report No: 15078 MKType: SAR