Document of The World Bank FOR OFFICIAL USE ONLY Report No. 77556-MZ INTERNATIONAL DEVELOPMENT ASSOCIATION PROGRAM DOCUMENT FOR A PROPOSED DEVELOPMENT POLICY CREDIT IN THE AMOUNT OF SDR 8.1 MILLION (US$12.5 MILLION EQUIVALENT) AND A PROPOSED DEVELOPMENT POLICY GRANT IN THE AMOUNT OF SDR 8.1 MILLION (US$12.5 MILLION EQUIVALENT) TO THE REPUBLIC OF MOZAMBIQUE FOR A FIRST PROGRAMMATIC FINANCIAL SECTOR DEVELOPMENT POLICY OPERATION June 16, 2014 Finance and Private Sector Development Southern Africa Country Department 2 Africa Region This document is being made publicly available prior to Board consideration. This does not imply a presumed outcome. This document may be updated following Board consideration and the updated document will be made publicly available in accordance with the Bank’s policy on Access to Information. REPUBLIC OF MOZAMBIQUE – GOVERNMENT FISCAL YEAR January 1 – December 31 CURRENCY EQUIVALENTS (Exchange Rate Effective as of April 30, 2014) Currency Unit: Metical US$1.00 30.94 MZN Weights and Measures: Metric System ABBREVIATION AND ACRONYMS ABC BANK African Banking Corporation AfDB African Development Bank AGDPO Agriculture Development Policy Operation AML Anti-Money Laundering BCI Banco Comercial de Investimentos BdM Banco de Moçambique BOM Banco Oportunidade de Moçambique BT Bilhetes do Tesouro BVM Bolsa de Valores de Moçambique CA Current Account CEL Sistema de Compensação Electrónica CFT Combating the Financing of Terrorism CPI Consumer Price Index CPS Country Partnership Strategy CSD Central Securities Depository CUT Conta Unica do Tesouro DFID Department for International Development DGF Deposit Guarantee Fund DNEAP Direcção Nacional de Estudos e Análise de Políticas DPO Development Policy Operation DSA Debt Sustainability Analysis DVP Delivery Versus Payment ECA Europe and Central Asia ELA Emergency Liquidity Assistance EMATUM Mozambican Tuna Company e-SISTAFE Sistema de Administração Financeira do Estado FDI Foreign Direct Investment FIRST Financial Sector Reform and Strengthening Initiative FS Financial Sector FSAP Financial Sector Assessment Program FSDPO Financial Sector Development Policy Operation FSDT Financial Sector Deepening Trust FSTAP Financial Sector Technical Assistance Project GBM Governor of Bank of Mozambique GCR Global Competitiveness Report GDP Gross Domestic Product GIZ Gesellschaft für Internationale Zusammenarbeit GOM Government of Mozambique GTZ Gesellschaft für Technische Zusammenarbeit ICA Investment Climate Assessment IDA International Development Association IFC International Finance Corporation IFMIS Integrated Financial Management Information System IMF International Monetary Fund IGEPE Instituto de Gestão das Participações do Estado KfW Kreditanstalt für Wiederaufbau LOLR Lender of Last Resort MFSDS Mozambique Financial Sector Development Strategy MICOA Ministério para a Coordenação da Acção Ambiental MINAG Ministry of Agriculture MoF Ministry of Finance MOU Memorandum of Understanding MPD Ministry of Planning and Development MSME Micro, Small and Medium Enterprises MTDS Medium-Term Debt Management Strategy MZN Mozambican Metical NPL Non-performing Loan OT Obrigações de Tesouro PARP Plano de Acção para Redução da Pobreza PDO Project Development Objective PEDSA Plano Estratégico do Desenvolvimento do Sector Agrário PEFA Public Expenditure and Financial Accountability PFM Public Financial Management PFMIs Principles for Financial Market Infrastructures PRSC Poverty Reduction Support Credit PQG Plano Quinquenal do Governo PSI Policy Support Instrument RENAMO Resistência Nacional Moçambicana RTGS Real Time Gross Settlement System SDR Special Drawing Rights SEA Strategic Environmental Assessment SME Small and Medium Enterprise SOEs State Owned Enterprises SOM Market Operations System TA Technical Assistance UNCDF United Nations Capital Development Fund USD United States Dollar WB World Bank Regional Vice President: Makhtar Diop Country Director: Mark R. Lundell Sector Director: Gaiv Tata Sector Manager Irina Astrakhan Task Team Leader: Mazen Bouri/Yira Mascaró REPUBLIC OF MOZAMBIQUE FIRST PROGRAMMATIC FINANCIAL SECTOR DEVELOPMENT POLICY OPERATION TABLE OF CONTENTS SUMMARY OF PROPOSED CREDIT AND PROGRAM ........................................................ ..i  I. INTRODUCTION AND COUNTRY CONTEXT (INCLUDING POVERTY DEVELOPMENTS) ............................................................................................................... ..1  II. MACROECONOMIC POLICY FRAMEWORK ................................................................... ..3  2.1 RECENT ECONOMIC DEVELOPMENTS .......................................................................... ..3  2.2 MACROECONOMIC OUTLOOK AND DEBT SUSTAINABILITY.................................. ..7  2.3 IMF RELATIONS .................................................................................................................. ..9  III. THE GOVERNMENT’S PROGRAM ................................................................................... 10  IV. PROPOSED OPERATION .................................................................................................... 11  4.1. LINK TO THE GOVERNMENT PROGRAM AND OPERATION DESCRIPTION .......... 11  4.2. PRIOR ACTIONS, RESULTS AND ANALYTICAL UNDERPINNINGS ......................... 12  4.3. LINK TO CPS AND OTHER BANK OPERATIONS .......................................................... 19  4.4 CONSULTATIONS, COLLABORATION WITH DEVELOPMENT PARTNERS ............ 19  V. OTHER DESIGN AND APPRAISAL ISSUES ..................................................................... 20  5.1. POVERTY AND SOCIAL IMPACTS ................................................................................. 20  5.2. ENVIRONMENTAL ASPECTS........................................................................................... 21  5.3. PFM, DISBURSEMENT AND AUDITING ASPECTS ....................................................... 22  5.4. MONITORING AND EVALUATION ................................................................................. 24  VI. RISKS AND RISK MITIGATION ........................................................................................ 24  ANNEX 1: POLICY AND RESULTS MATRIX………………….... ........................................ 26  ANNEX 2: LETTER OF DEVELOPMENT POLICY…………………….... ............................ 29  ANNEX 3: FUND RELATIONS NOTE………………….... ..................................................... 41  Table 1: Key Macroeconomic Indicators, 2011-2016……………….….……………...……… . ..3  Table 2: Balance of Payments Financing Requirements and Sources, 2011-2016 ...................... ..4  Table 3: Fiscal Framework, 2011-2016………............................................................................ ..6  Table 4: Examples of MFSDS Objectives and Actions Related with FSDPO Series Reforms… 11  Table 5: DPO Prior Actions and Analytical Underpinnings ........................................................ 13  The First Programmatic Finance Development Policy Loan was prepared by an IDA/IFC team consisting of: Mazen Bouri, Senior Private Sector Development Specialist, AFTFE; Yira Mascaró, Lead Financial Sector Development Specialist, AFTFE; Valeria Salomao Garcia, Senior Financial Sector Development Specialist, FFSAB; Carlos Leonardo Vicente, Financial Sector Specialist, FFSDR; Paola Granata, Consultant, AFTFE; Alejandro Alvarez de la Campa, Global Product Leader, Access to Finance Advisory Services, IFC; Chabir Hassam, Operations Officer, IFC; Fredes Montes, Senior Infrastructure Finance Specialist, FFIFI; Marilyne Goncalves, Senior Financial Sector Specialist, FFSFI; Rosario Marapusse, Private Sector Officer, AFTFE; Douglas Pearce, Practice Manager, FFIDR; Bujana Perolli, Financial Sector Specialist, FFIDR; Johanna Jaeger, Financial Sector Development Specialist, FFIDR; Cigdem Aslan, Senior Financial Officer, FABDM; Rodrigo Silveira Veiga Cabral, Senior Financial Officer, FABDM; Anderson Caputo Silva, Lead Securities Market Specialist, FCMSM; Alice Zanza, Senior Financial Sector Specialist, FFIFI; Jose María Garrido, Senior Counsel LEGPS; Magalie Pradel, Program Assistant, AFTFW; Julio Revilla, Lead Economist, AFTP1; Enrique Blanco Armas, Senior Economist, AFTP1; Furqan Saleem, Financial Management Sector Leader, AFTFM; Cheikh Sagna, Senior Social Development Specialist, AFTCS; Jose Janeiro, Senior Finance Officer, CTRLA; Luz Meza-Bartrina, Senior Counsel, LEGAM. SUMMARY OF PROPOSED CREDIT AND PROGRAM REPUBLIC OF MOZAMBIQUE FIRST PROGRAMMATIC FINANCIAL SECTOR DEVELOPMENT POLICY OPERATION (FSDPO I) Borrower Republic of Mozambique (GoM). Implementing Ministry of Finance (MoF); Banco de Moçambique (BdM). Agency Financing Data 50 percent IDA Credit and 50 percent IDA Grant. Currency is SDR. Amount: SDR 16.20 Million (US$25 million equivalent). The Credit will be on IDA terms, and will have a final maturity of 38 years, inclusive of 6 years of grace period. Operation Programmatic DPO. The series has two single-tranche operations and this is Type the first. Pillars of the The three pillars of the operation are: (I) Financial Stability; (II) Financial Operation And Inclusion; (III) Long-Term Financial Markets. The development objective of Program this operation is to reinforce financial stability, increase access to finance by Development households and firms, and enhance the development of long-term financial Objective(s) markets. Result Pillar I: (i) percentage of banks classifying their Non-Performing Loans (NPLs) Indicators according to the new regulation; (ii) percentage of banks implementing the new risk management guidelines; (iii) percentage of deposits balances and accounts covered by the Deposit Guarantee Fund (DGF); (iv) criminalization of terrorism financing. Pillar II: (i) number of e-money accounts; (ii) percentage of the population with access to formal banking services, including “formal-other”; (iii) call for proposals from service providers to apply for a private credit bureau license or operate the bureau on behalf of BdM; (iv) percentage of banks disclosing to consumers the effective cost of banking services; (v) number of days to clear a cheque; (vi) percentage of transactions settled through the Real Time Gross Settlement System (RTGS). Pillar III: (i) number of short- and medium-term bonds issued and reopened in the domestic market through competitive auctions; (ii) Level of dematerialization and immobilization of all medium- and long-term debt securities listed in Central Securities Depository (CSD). The complete list and details of the baseline and targets can be found in Annex 1: Policy and Results Matrix. Overall Risk The overall risk rating is moderate. The three main risks to this operation are Rating related to implementation capacity, macroeconomic management, and sustainability of commitment to reform in the run-up to general elections in 2014. Operation ID P133687 IDA PROGRAM DOCUMENT FOR A PROPOSED FIRST PROGRAMMATIC FINANCIAL SECTOR DEVELOPMENT OPERATION TO THE REPUBLIC OF MOZAMBIQUE I. INTRODUCTION AND COUNTRY CONTEXT (INCLUDING POVERTY DEVELOPMENTS) 1. The First Programmatic Financial Sector Development Policy Operation (FSDPO I) is a programmatic operation, the first in a series of two DPOs that seek to promote financial sector (FS) development. Both operations in the series will be single tranche. The amount for FSDPO I is US$25 million. Its main objective is to reinforce financial stability, increase access to finance by households and firms, and enhance the development of long-term financial markets. 2. Mozambique’s economic performance has been very strong since the end of the Civil War in 1992. The country’s gross domestic product (GDP) growth from 1993 to 2013 averaged 7.4 percent. Its strong performance was made possible by sound macroeconomic management, a number of large- scale foreign-investment projects (“megaprojects”), and significant donor support. These factors contributed to robust growth across most sectors of the economy, especially mining, electricity and services. Although the relative growth rates of different sectors were highly uneven, overall growth has been stable and consistent. Mozambique has received massive foreign direct investment (FDI) inflows for extractive industries in the past few years, and these are likely to continue in the future. Developments in coal and gas sectors could turn Mozambique into a key global player in these markets. 3. Over the past decade, rapid growth has not translated into significant poverty reduction. With a population of 23.9 million, per capita income in 2012 was US$565 (less than 40 percent of the average for Sub-Saharan Africa).1 Economic growth in the 1990s was accompanied by a decline in poverty rates, but since the early 2000s the link between growth and poverty reduction has weakened. The poverty headcount fell by an estimated 12 percentage points between 1997 and 2003 to 56 percent, but between 2004 and 2009 poverty fell by only four percentage points.2 The weakening correlation between economic growth and the poverty rate suggests that growth has become less inclusive in recent years, the result of recent patterns of growth driven by capital intensive mega projects. This pattern of growth is also reflected in labor markets, which continue dominated by relatively low productivity jobs in the agricultural sector, with the rest of the economy failing to create better jobs for the 300,000+ people entering the work force every year. 4. FS development matters not only for economic growth but also for poverty and income inequality. Evidence strongly indicates that if effectively regulated and supervised, FS development spurs economic growth, reduces income inequality, and helps to lift households out of poverty (World Bank 2008).3 This leads to strong positive impact on economic growth over long-term periods (Demirguc-Kunt and Levine 2008).4 Moreover, FS development is also pro-poor, reduces income inequality by disproportionately boosting the income of the poor and is associated with a decline of extreme poverty (Beck, Demirguc-Kunt and Levine 2004 and 2007).5 1 World Development Indicators 2012. 2 Alfani, Federica, Carlo Azzarri, Marco d’Errico and Vasco Molini (2012); “Poverty in Mozambique: New Evidence from Recent Household Surveys”, World Bank Policy Research Paper No. WPS6217. 3 World Bank (2008); “Finance for All?: Policies and Pitfalls in Expanding Access”. 4 Demirgüç-Kunt, Aslı, and Ross Levine (2008); “Finance, Financial Sector Policies, and Long Run Growth”; World Bank. 5 Beck, Thorsten, Asli Demirgüç-Kunt and Ross Levine (2004); “Finance, Inequality and Poverty: Cross Country Evidence”; Policy Research Working Paper 3338; World Bank. Beck, Thorsten, Asli Demirguc-Kunt and Ross Levine (2007); “Finance, Inequality and the Poor”; Journal of Economic Growth. 1 5. In order for Mozambique to achieve broad-based growth and for the private sector to generate jobs, it is imperative to deal with the ongoing challenges of access to finance for firms and households. Access to finance remains one of the defining challenges for the private sector in Mozambique, particularly for smaller enterprises. The 2013-2014 Global Competitiveness Report (GCR), which ranked Mozambique 137 out of 148 countries, found that access to financing was the top constraint for doing business in the country. Similarly, a 2012 survey of manufacturing firms shows that access to finance is the top constraint for business growth, with over 50 percent of firms identifying access to credit as a constraint and only 14 percent of firms having a bank loan.6 The 2009 Investment Climate Assessment (ICA) found that smaller firms are more constrained as only 13 percent of firms - typically large and able to provide collateral– reported having a loan or a line of credit from a financial institution. Financial inclusion for individuals is also limited. The 2009 Finscope Household Survey for Mozambique found that only 13 percent of the population had access to formal financial services. The problems of access to finance are most severe in rural areas where only 5 percent had access to formal financial services. While the 2012 Global Findex Database shows an important increase in access to bank accounts (40 percent of adults) in recent years, the active use of these accounts is still limited.7 Most recently, a 2013 Finscope Survey Report found that 75% of micro, small and medium enterprises (MSMEs) are financially excluded. 6. Further financial development in Mozambique also implies continuing reforms to promote FS stability (crucial to promote access to finance). In the last ten years, Mozambique has implemented notable reforms to promote FS stability. These reforms enabled substantial progress in the strengthening and development of the FS, as highlighted in the 2009 Financial Sector Assessment Program (FSAP) Update. Nevertheless, there still are important pending reforms to promote FS stability, including in the areas of banking regulation and supervision, and the banking safety net and crisis management frameworks. 7. The Government recognizes the importance of FS development to reduce poverty and improve the business environment. Towards that end, a number of FS reforms have been initiated and the Mozambique Financial Sector Development Strategy 2013-2022 (MFSDS) was adopted to provide a vision and a comprehensive and detailed roadmap for reforms in the FS. 8. This DPO directly contributes to the realization of the MFSDS and the Country Partnership Strategy (CPS) for FY12-FY15 by focusing on three pillars: (i) Financial Stability; (ii) Financial Inclusion; and (iii) Long-Term Financial Markets. Actions to promote financial stability include improvements in banks’ risk management and asset soundness as well as safety net and crisis management resiliency frameworks. Actions to promote financial inclusion focus on the credit reporting system, branchless banking (key to promote access in rural areas), consumer protection, payment systems and the insolvency framework. Pillar III promotes the development of money, debt, and capital markets. The three main risks to this operation are related to: (i) implementation capacity; (ii) macroeconomic management, with a high current account deficit, rising public external debt to finance infrastructure investment and a more expansionary fiscal policy; and (iii) sustainability of commitment to reform in the run-up to general elections in 2014. Related mitigating measures for these risks have been put in place. 6 The survey was conducted by the Ministry of Planning and Development and University of Copenhagen. 7 The difference between Finscope and Findex emerge from the timing and methodological and terminology differences. 2 II. MACROECONOMIC POLICY FRAMEWORK 2.1 RECENT ECONOMIC DEVELOPMENTS 9. Mozambique has grown over 7 percent in the past two years, quickly recovering from the impact of the global crisis in 2009. Growth in 2013 slowed to 7.1 percent as the effects of the February flooding across much of the country diminished agricultural production and damaged basic infrastructure. Agriculture, which employs about 78 percent of the active population, accounts for about 25 percent of GDP, followed by trade and retail services at 12 percent. Manufacturing continues to decline in relative terms and accounted for just 10 percent of GDP in 2012, compared to 17 percent 10 years ago. 10. The extractive industries form the country’s most dynamic sector, with sectoral growth estimated at 40 percent in 2013 from 2012. Over the next decade, natural-resource extraction will alter the structure of the Mozambican economy. Significant investments will be necessary over the coming few years, both in facilities to extract and process minerals and gas, as well as in infrastructure. There are no signs that strong growth in the extractive industries has affected competitiveness, as the real effective exchange rate is today at a similar level as it was four years ago. This is not surprising given that FDI has been very import intensive. Table 1: Key Macroeconomic Indicators, 2011-2016 2011 2012 2013 2014 2015 2016 Act. Act. Est. Proj. Proj. Proj. GDP (nominal – million meticais) 365 408 461 528 603 689 Consumption (% of GDP) 93.7 93.2 95.0 -- -- -- Investment (% of GDP) 36.0 48.3 48.7 -- -- -- Net exports (% of GDP) -29.7 -41.5 -43.7 Real GDP growth rate (%) 7.3 7.2 7.1 8.3 8.2 8.2 CPI inflation (%, annual average) 10.4 2.1 4.2 4.6 5.6 5.6 CPI inflation (end of period) 5.5 2.2 3.0 6.0 5.6 5.6 Base Money (% change) 8.5 19.7 15.7 17.0 15.1 14.9 Credit to the economy (% change) 6.4 19.9 28.7 20.7 16.4 16.3 Policy lending rate (end of period) 15.0 9.5 8.25 -- -- -- Gross domestic savings, excluding grants (% of GDP) 5.7 -1.1 7.5 -0.5 7.8 7.5 Gross domestic investment (% of GDP) 37.0 48.0 50.1 49.8 57.4 53.6 Government 14.9 13.4 15.5 18.3 16.3 16.0 Other sectors 22.1 34.5 34.5 31.5 41.2 37.6 Total Government Revenues 20.8 23.3 27.5 27.3 25.0 25.7 Total Government Expenditure and net lending 33.7 32.6 35.6 41.6 36.6 35.8 Overall balance (after grants) -5.3 -4.1 -2.8 -9.2 -7.5 -6.6 Terms of trade (% change) 2.5 -5.2 -9.2 -2.6 -0.4 0.5 Current-account balance, including grants (% of GDP) -24.4 -45.4 -39.5 -46.9 -47.0 -43.8 Real exchange-rate change (% change) 19.7 5.4 -- -- -- -- Sources: BdM, IMF and Bank estimates and projections. 11. The export basket remains limited, reflecting the narrow scope of the economy, with seven products registering annual exports in excess of US$100 million and accounting for almost 75 percent of exports in 2012. Mozambique’s exports have increased at an average annual rate of 12 percent from 2004 to 2012. Much of this growth was driven by foreign-financed megaprojects in the aluminum, coal and gas industries. Coal production, which only started in mid-2011, has risen rapidly and is expected to become Mozambique’s largest export product by 2014. Coal production is likely to continue to grow over the short and long term as producers expand capacity and infrastructure constraints are removed. Gas exports will be significantly larger than total current exports and will start at the end of the decade. The concentration of exports is likely to continue as coal and gas exports pick up. 3 12. The current account (CA) deficit fell to 40 percent of GDP in 2013. The high current account deficit is a result of large imports related to investments in the mining and megaproject sectors and is likely to remain above 40 percent in the medium term. Despite the sustained growth of megaproject exports, especially coal, megaproject-related imports are also rising rapidly, resulting in persistent CA and trade deficits. The CA deficit poses some medium-term risk to the external balance, as public external debt has also been increasing to finance infrastructure investment. Despite this assessment, the CA deficit does not reflect a fundamental imbalance in the economy as it is the reflection of rapid growth fueled by large FDI flows (approximately US$5 billion in both 2012 and 2013 or around one third of GDP, compared to US$1.3 billion in 2010). High rates of FDI, primarily related to the extractive industries sector, are currently financing more than 80 percent of the CA deficit. Table 2: Balance of Payments financing requirements and sources, 2011-2016 2011 2012 2013 2014 2015 2016 Act. Act. Est. Proj Proj. Proj. (US$ million) Trade balance (goods) -2,249 -4,048 -4,393 -4,990 -5,839 -5,395 Exports, f.o.b. 3,118 3,856 4,179 4,920 5,673 6,712 Of which: megaproject exports 2,015 2,219 2,430 3,071 3,675 4,571 Imports, f.o.b. -5,368 -7,903 -8,572 -9,910 -11,512 -12,107 Of which: megaproject imports -1,547 -2,143 -2,319 -3,111 -4,125 -3,994 Trade balance (services) -1,482 -3,273 -2,969 -3,950 -3,737 -4,021 Income balance -190 7 13 -176 -284 -797 Of which: dividend payments by megaprojects -157 0 -6 -166 -173 -558 Current account balance (before grants) -3,844 -7,022 -6,523 -8,592 -9,286 -9,578 Current transfers 863 829 1,300 1,109 1,079 1,106 Of which: External grants 785 538 475 585 505 470 Current account balance (after grants) -3,059 -6,484 -6,048 -8,007 -8,781 -9,108 Financial account balance 3,364 6,748 6,3888 8,407 9,005 9,270 Net foreign borrowing (general government) 531 546 1,017 1,776 1,307 1,317 Net foreign borrowing (nonfan. private sector) -39 516 -99 902 1,875 2,021 Net Foreign Direct Investment 2,599 5,215 5,055 4,883 4,935 5,006 Other investments -159 14 44 264 297 318 Memorandum items: Current account balance (in % of GDP) -24.4 -45.0 -39.5 -46.9 -47.0 -43.8 Excluding grants -31.3 -49.1 -42.6 -50.3 -49.7 -46.1 Gross international reserves ( in US$ million) 2,428 2,799 3,192 3,591 3,781 3,905 In months of projected imports 2.4 2.6 2.5 2.6 2.5 2.2 Sources: BdM, IMF and World Bank estimates and projections. 13. Inflation has slowed due to the adoption of tighter monetary policy. After a spike in inflation in 2010 that led to a tightening of policy by Banco de Moçambique (BdM), inflation has been relatively low in the past few years. Inflation fell rapidly in 2011 and has been below the BdM target of 5-6 percent for two years. The low inflation and a weak external environment allowed BdM to ease monetary policy, with policy rates now at a record low of 8.25 percent. The interest rate transmission channel remains weak, with little response to the lowering of policy rates, and credit growth remains slow although it accelerated during 2013. With an expansionary fiscal policy in 2014, it will be necessary to closely monitor inflation and coordinate fiscal and monetary policy. 14. Despite the impact of successive external shocks, the Government has succeeded in managing exchange-rate volatility primarily through fiscal policy actions and domestic interest- rate adjustments, without compromising the integrity of the flexible exchange-rate regime. Exchange-rate stability has been supported by the progressive de-dollarization of the economy, with the share of foreign currency in broad money falling from 50 percent to 35 percent over the past decade. The authorities remain committed to bolstering macroeconomic stability in the context of flexible exchange rate by encouraging the use of domestic currency in financial transactions and by deepening the FS. 4 15. Relevant indicators suggest a very healthy FS. The Mozambican banking sector is highly concentrated and profitable. The three largest banks own 85 percent of total assets of the banking system, down from 100 percent in 2004. Credit to the economy has accelerated to 33 percent of GDP by 2013, led by credit to households and a large increase in credit to State-Owned Enterprises (SOEs). The average profitability of the banking sector, as measured by return on equity, has declined from 61 percent in 2006 to 20 percent in 2012, but it remains somewhat higher than the Sub-Saharan African average. The system reported a high level of capitalization, with a regulatory capital ratio of 18 percent in 2012 and Tier 1 capital ratio at a robust 17 percent (well above the regulatory minimum of 8 percent). Liquidity is abundant as demonstrated by a ratio of liquid assets to total liabilities of 33 percent in 2012, in a banking system largely funded by deposits. NPLs –measured by local definition— are low at 3.2 percent but have been rising steadily, albeit slowly, since 2009. 16. A revised 2013 State Budget was approved by the National Assembly in August 2013, to account for the negative impact of the January flooding on economic activity and public expenditure and to incorporate significant capital gains taxes. Overall, spending rose by 23 percent (in nominal terms), while domestic revenues were projected to increase by 34 percent, and external resources by 46 percent (both grants and loans). The main reasons for the budget revision were a slowdown in GDP growth, unexpected capital gains taxes received by the Government, and additional expenditures related with post-floods reconstruction and the salary bill. As a result, the deficit declined to 2.8 percent of GDP. The State Budget is published by the GoM and accessible to the general public in printed form and through the website of the MoF’s Budget Office. According to the most recent Open Budget Survey, Mozambique’s Open Budget Index has risen significantly, from 28 in 2010 to 47 in 2012. 17. Fiscal policy has become more expansionary in the past few years as expenditure growth has accelerated. Mozambique’s tax revenues have been growing at a rapid pace, from 18 percent of GDP in 2011 to a projected 23.3 percent in 2013, reflecting significant efforts to improve tax administration and capital gains taxes related to gas fields. This rapid increase in domestic resources has compensated for a decline in aid flows to the country, which now finance around 30 percent of expenditure. Expenditures have been growing at a fast pace, reaching almost 36 percent of GDP in 2013. The fiscal expansion is reflected in large spending increases across the board, with the public sector wage bill projected at 11 percent of GDP in 2014, up from 9.8 percent in 2011. This expansionary policy stance is expected to be temporary, with a significant decline in expenditure and a narrowing of the overall deficit in the medium term. 18. The public-sector wage bill has risen in recent years, but its growth is expected to slow over the medium term as hiring decelerates. The wage bill rose to 10.7 percent of GDP in 2012. Most of this increase was due to additional hiring in priority sectors of the poverty reduction strategy (i.e. the Plano de Acção para Redução da Pobreza, PARP), especially, in education and public health, as well as moderate real-wage increases. However, due to the gradual decompression of the pay scale, significant salary increases in mid-2013, and the implementation of a new salary policy supported by the rapid expansion of the electronic payment system (e-FOLHA), the wage bill is expected to be 11.0 of GDP in 2014 and is projected to slowly decline to 9 percent of GDP toward the end of the decade. 5 Table 3: Fiscal Framework, 2011-2016 2011 2012 2013 2014 2015 2016 Act. Act. Est. Proj Proj. Proj. (Percentage of GDP) Total revenues 20.8 23.3 27.5* 27.3 25.0 25.7 Tax revenue 18.1 19.8 23.3 23.3 21.0 21.7 Income and profits 6.8 9.0 12.1 10.8 8.2 9.0 Taxes on goods and services 9.1 8.2 8.3 9.4 9.6 9.6 International Trade 1.8 1.9 2.2 2.1 2.1 2.1 Nontax revenue 2.6 3.4 4.1 3.9 3.9 3.9 Grants received 7.8 5.4 5.4 5.2 4.2 3.5 Total expenditures and net lending 33.7 32.6 35.6 41.6 36.6 35.8 Current expenditures 18.8 19.2 20.1 23.3 20.4 19.8 Compensation to employees 9.8 10.2 10.7 111.0 10.5 10.0 Goods and Services 3.3 3.7 4.4 7.1 4.6 4.5 Interest payments 1.0 1.0 0.9 1.3 1.3 1.4 Transfers 4.7 4.3 4.1 3.9 4.0 3.9 Domestic primary balance (before grants) -2.9 -1.0 0.9 -3.0 -1.2 -0.2 Capital expenditures 13.9 12.3 13.4 15.9 13.5 13.1 Externally financed 8.3 6.3 6.1 7.7 6.4 5.8 Domestically financed 5.6 6.1 7.3 8.2 7.0 7.2 Overall balance (before grants) -13.1 -9.5 -8.3 -14.3 -11.6 -10.1 Overall balance (after grants) -5.3 -4.1 -2.8 -9.2 -7.5 -6.6 Total financing External (net) 3.7 3.4 5.9 9.2 6.9 6.6 Domestic (net) 1.6 0.7 -3.0 -0.1 0.5 0.0 Memorandum items: Total public debt 39.6 42.7 53.1 56.5 58.3 58.3 External 32.9 36.9 44.2 49.2 51.4 52.3 Domestic 6.7 5.8 8.9 7.3 6.0 5.3 Sources: GoM, IMF and World Bank estimates and projections * Note: Mozambique collected US$400 million in capital gains taxes in August 2013. While GoM incorporated this revenue in the 2014 budget, this table incorporates these taxes in the year they were actually collected (2013). This means that revenue and also overall balance figures differ slightly with those used by the Government of Mozambique 19. Public debt has been growing rapidly, reaching 53 percent of GDP in 2013. Public debt has rapidly risen to 53 percent of GDP, from around 40 percent in 2008. The rise has been led by rapid growth in external debt. A large share of this debt has been contracted in non-concessional terms. While in 2010 non-concessional loans accounted for only 9 percent of all new external debt, in 2012 this was over 70 percent. This rapid increase led to a worsening of the debt risk rating for Mozambique in a joint 2013 WB-IMF debt sustainability analysis for Mozambique from low to moderate. This risk rating was confirmed in the latest joint WB-IMF DSA published in May 2014. This revision of the risk rating was the result of: (i) a lower discount rate; (ii) a significant increase in debt contracted in the last two years related to an ambitious public investment program aimed at narrowing the infrastructure gap and facilitating the development of natural resources; and (iii) large movements in the underlying balance of payments with the onset of coal exports and significant commercial investments in natural gas exploration and liquefaction. All public and external debt indicators remain below their threshold levels, but they come closer to the thresholds and the thresholds are breached under a number of stress scenarios. A large share of the new debt is financing a significant increase in infrastructure spending aimed at closing Mozambique’s infrastructure gap. There is limited information on contingent liabilities and recent developments with the Mozambican Tuna Company (EMATUM) raise concerns on the management of fiscal risks. 6 Figure 1: Indicators of Public and Publicly Guaranteed External Debt Under Alternative Scenarios, 2013-33 Source: “Staff Report for the 2013 Article IV Consultation, Sixth Review under the Policy Support Instrument, Request for a Three- Year Policy Instrument and Cancellation of Current Policy Support Instrument”, IMF Country Report No.13/200 20. In September 2013 a Government owned company, EMATUM, issued bonds with a Government guarantee worth US$850 million. The bonds were reportedly to finance investments and operations in the tuna fishing industry. A large share of the operation will finance coast guard and maritime security services that are not commercial in nature, despite being included in the operation as commercial activities. The guarantees provided were significantly higher than the amount approved by Parliament in the 2013 budget (around US$7 million). The operation is within the non-concessional borrowing limit foreseen in the IMF Policy Support Instrument (PSI) program and it does not significantly affect the Debt Sustainability Analysis (DSA) results described above. 21. The EMATUM operation raised concerns about the lack of transparency regarding the use of funds and the manner in which the project was evaluated, selected and implemented outside the Government’s macro-economic strategy and PARP priorities. Following presentation of the budget proposal to Parliament, the Government of Mozambique (GoM) submitted a revised budget proposal for 2014 that incorporated the non-commercial part of this operation (US$350 million). The Government has committed to subject EMATUM to strict financial controls and audits and to revise the Organic Budget Law to require an annex on fiscal risks. The GoM and development partners have agreed on an action plan focused on the management of public investments and fiscal risks. Discussions are ongoing on reforms to address identified weaknesses. Some reforms are already included in the Mozambique Poverty Reduction Support Credit (PRSC) series (on debt management, public investment management) and others will be added as needed. 2.2 MACROECONOMIC OUTLOOK AND DEBT SUSTAINABILITY 22. Mozambique’s medium-term macroeconomic outlook remains positive. Growth is projected above 8 percent during 2014-16 driven by extractive industries, agriculture, construction, and transportation and communications. In the short run, megaproject production, particularly the growth of coal exports, megaproject-related FDI, and investments in infrastructure are expected to remain among the most important contributors to growth. Inflation is anticipated to remain between 5 and 6 percent through 2016. Current external conditions could adversely affect Mozambique through weaker export demand, lower commodity prices and tighter global financial markets. A weaker outlook for commodities could affect large planned investments in the coal and gas sectors. In the last year, there was deterioration in the country’s security situation as the armed wing of the opposition party RENAMO has clashed repeatedly with the Government’s security forces. Prolongation or worsening of this current impasse may affect growth prospects through a variety of channels, including delays in investment plans by large investors in the minerals and gas sectors. 7 23. The CA deficit is projected to remain above 45 percent in 2014-15. While exports (traditional and from mega projects) are projected to grow rapidly, so are imports related to the large investments in the minerals and gas sectors, which will result in a continuation of the large CA deficits until the end of the decade. The CA deficit will be financed by large FDI inflows, projected at around US$5 billion per year in 2014-16, and foreign borrowing by investors in the mining and gas sectors. The anticipated rise in megaproject exports would significantly improve the CA balance toward the end of the decade, when gas exports start. 24. BdM will continue to maintain a position consistent with holding inflation to single digits. After significant easing of monetary policy over the past few years, BdM will maintain a position consistent with a low inflation environment in 2014. The outlook for import prices is favorable for a low inflation environment. The monetary policy framework is expected to be strengthened as BdM builds capacity to develop an inflation targeting regime. In 2012, BdM started publishing a quarterly monetary policy report to anchor price expectations based on a more transparent and efficient communication of recent economic developments and monetary policy decisions. 25. The 2014 state budget continues the expansionary fiscal policy stance by GoM, with public expenditure reaching 42 percent of GDP. Total revenues will continue to grow in the next few years, reaching 26 percent of GDP by 2016. Grant financing will decline from 7.8 percent of GDP in 2011 to 3.5 in 2016. Large public expenditure in 2014, at 42 percent of GDP, will result in an increase in the overall balance (after grants) from 2.8 percent in 2013 to 9.2 in 2014. The balance will be financed through an increase in external and internal financing. Public expenditure is projected to decline to 36 percent of GDP in 2016, with the overall balance (after grants) falling to 6.6 percent of GDP. 26. It will be important to tighten fiscal policy in the short term to ensure its sustainability. The expansionary policy stance in 2014, in the context of a booming economy and a large push to invest in infrastructure, will be temporary, as it is the result of a number of one-off activities, including post-flood reconstruction, the financing of the general elections and the large increase in defense and security spending related to EMATUM. This fiscal framework incorporates the capital gains taxes collected in 2013 in the same year, while GoM has included them in the 2014 budget, which would result in an overall balance over 2 percentage points lower. Longer term projections bring the overall balance to 5 percent of GDP by 2019. The authorities are aware of the need to gradually tighten fiscal policy and this is part of the dialogue that the World Bank Group (the Bank) and the International Monetary Fund (IMF) are having with the authorities, which will also be supported by the Mozambique Public Expenditure Review now being prepared. 27. Public debt will reach close to 60 percent of GDP by 2016. Public debt will continue to increase over the 2014-16 period to almost 60 percent. Over the next 3 years, around 40 percent of all new public external debt is projected to be on non-concessional terms. This increase in debt is partly the result of large infrastructure projects currently under implementation. The issuance of bonds by EMATUM has raised concerns around transparency and the evaluation and selection of investment projects. To address these concerns, the Ministry of Finance will monitor EMATUM operations on a quarterly basis and publish its audited accounts. The GoM has also expressed its intention to moderate public external borrowing compared to its recent accelerated pace to contain increased risks to debt sustainability. It will be important to closely monitor debt dynamics and support efforts by the Government to improve its capacity to manage debt and public investments as well as improve fiscal transparency, reforms being supported by a number of development partners, including the Bank through technical assistance (TA) and the new PRSC series. 8 28. The Bank, the IMF and other development partners are working with the GoM to improve the efficiency of public spending to mitigate risks emerging from higher Government expenditures and public debt. In particular, the larger wage bill and the increase in public debt are part of the Bank’s ongoing dialogue with the Mozambican authorities. There are risks involved in accelerating public investments, particularly if financed through debt. To better manage these risks the GoM is strengthening Government systems through: (i) improved debt management;8 (ii) improved public investment management;9 and (iii) stronger PFM systems.10 Additionally, the Government is strengthening the oversight and governance of SOEs, including though the improvement of the Instituto de Gestão das Participações do Estado (IGEPE) with Bank support.11 29. Despite its positive overall economic outlook, the Mozambican economy faces significant downside risks, such as a large decline in commodity prices or a worsening of the country’s security situation. External developments that result in a pronounced decline in commodity prices could dampen investment plans in the coal and gas sectors. Internal developments such a deterioration of the security situation could also affect the development of the coal and gas sectors. A delay in projected investments in coal and gas could lower Mozambique’s rate of growth. Expected investments and coal and gas exports would benefit external and fiscal balances in the medium term, but investment delays would not necessarily result in large imbalances that jeopardize macroeconomic stability. 30. Overall, Mozambique’s macroeconomic framework provides an adequate basis for FSDPO I. The Bank’s view is based on the country’s strong macroeconomic performance over the past decade and the expectation that robust growth will continue in a stable and supportive policy context. GoM remains committed to implementing a prudent monetary and fiscal policy, as suggested in the latest review of the IMF PSI. This overall assessment assumes that fiscal policy will be tightened in 2015 and onwards and that the pace of public external borrowing is moderated, as agreed by authorities and the IMF. A number of reforms in economic management, including on fiscal transparency, debt and public investment management, are being supported through TA and the PRSC series. These reforms will also contribute to a continuation of prudent monetary and fiscal policies. 2.3 IMF RELATIONS 31. Mozambique started a new Policy Support Instrument (PSI) with the IMF in mid-2013. Its first review (January 2014) stated that the PSI program is on track. The PSI will focus on public financial management (PFM), tax administration, investment planning, financial sector (FS) 8 The GoM has enhanced debt management capacity in recent years and additional improvements are expected with TA being provided by the Bank and the IMF. Recent reforms on public debt management include the adoption of a Medium Term Debt Management Strategy 2012-2015, the issuance of the first annual domestic borrowing plan for 2013, the publication of quarterly debt reports and the overhaul of the MoF’s debt database. Additional reforms will receive support from FSDPO series (Pillar III), PRSC series (Objective III on improvement of PFM) and FIRST. 9 Reforms to improve public investment management have included: institutional capacity building; improvements at the technical level with support from the IMF and the Bank (e.g. adoption of a manual in 2013 for the appraisal and evaluation of public investment projects) and preparation of a second Integrated Investment Program (supported by the Bank and the IMF) to improve the prioritization of public investments. Further improvements are expected with TA from the Bank (including the Growth Poles Project) and other development partners (such as DFID). 10 Mozambique has made significant strides in improving the quality of PFM, particularly in terms of procurement efficiency and the auditing of public accounts. Improvements have been multidimensional, encompassing multi-year planning, annual budgeting, procurement accounting, internal controls, auditing and public access to fiscal information. Additional reforms will be supported by the PRSC series. 11 The Bank is planning to provide support to build the capacity of IGEPE, which was created to manage investments of the state. IGEPE is working on a new business plan and investment strategy and is seeking related Bank TA. The GoM is keen to reduce the number of SOEs in its portfolio and is conducting a review of its portfolio to determine which SOEs to liquidate, sell to private investors and/or employees or maintain while improving their performance. 9 development, and macro-management as a resource-rich country. The PSI will maintain limits on the contracting of commercial borrowing by GoM to maintain debt sustainability, currently estimated at US$1.2 billion for the duration of the program (2013-16). The Bank and the IMF cooperate closely in supporting the GoM to promote financial development, including through the provision of joint TA. FSDPO is aligned with the MFSDS, which drew heavily on the 2009 FSAP Update and is included in the PSI as a structural benchmark. III. THE GOVERNMENT’S PROGRAM 32. Following a broad and inclusive preparation process, the Council of Ministers approved in April 2013 the MFSDS for 2013-2022. The Government initiated the preparation of this Strategy following the conclusions of the 2009 FSAP Update. Through a Financial Sector Reform and Strengthening Initiative (FIRST)-funded Project, the Bank has supported the Strategy development process. The adoption of the Strategy sends a strong signal to the market and donors of the Government's commitment to keep engaging in serious reforms in the FS. 33. The goal of the MFSDS is to promote the development of a sound, diverse, competitive, and inclusive FS which provides citizens and businesses with convenient access to a range of appropriate and high quality financial services at affordable prices. The policies and actions of the MFSDS are organized into three groups of strategic objectives: maintaining FS stability, improving financial access and increasing the supply of private capital to support development. In order to reach its objectives, the implementation of MFSDS will be guided by four principles: maintenance of macroeconomic and financial stability; encouragement of innovation; fostering competition in the financial system; and improvement of access to finance and inclusive growth. 34. MFSDS is an integral part of the Government’s overall vision for inclusive growth and poverty reduction. The PARP, Mozambique’s third poverty reduction strategy paper, has as one of its three pillars employment generation with a focus on SME development. The Five Year Government Strategy for 2011-2015 (Plano Quinquenal do Governo–PQG) emphasizes the importance of private sector led growth and the need for the private sector to have access to finance. These policy documents provided the framework for the MFSDS and other complementary sector specific initiatives. Specifically, MFSDS complements the following sector specific policies of the GoM: (i) the Strategic Plan for Agricultural Development 2010-19 (PEDSA), which emphasizes the importance of agricultural and agribusiness finance; (ii) the Business Environment Improvement Strategy 2013-2017, which aims to simplify the operating environment for businesses; and (iii) the Rural Finance Strategy, which focuses on measures to promote rural savings and credit. 35. The proposed operation series is closely aligned to the MFSDS and will support its implementation. MFSDS strategic objectives overlap with the three Pillars of the FSDPO series. MFSDS includes a detailed Results Framework that specifies policy objectives, specific objectives and strategic actions. FSDPO I and II have chosen to support the objectives and actions that will have the greatest impact on the PDO (and the Strategy’s vision). 36. More recently, the Government prepared a draft National Development Plan which envisages the creation of a development bank. Few details are available at this stage about the structure of this bank. While a development bank (if well governed and managed) can contribute to increased access to finance, its establishment should take into account the risks involved to avoid threatening financial access gains. To contribute to this dialogue, the Bank has prepared a policy note for the GoM, discussing best practices and limitations. The policy note concludes that a development bank 10 may contribute to addressing market gaps in SME, agriculture, and long term finance as long as the risks related to governance and potential overlap with existing private financial institutions are adequately addressed through a proper regulatory regime, clear business plan, and robust management structures.12 IV. PROPOSED OPERATION 4.1. LINK TO THE GOVERNMENT PROGRAM AND OPERATION DESCRIPTION 37. The pillars of the FSDPO series overlap with the strategic objectives of the MFSDS. Thus, the FSDPO series will support reforms to: (i) maintain FS stability (FSDPO Pillar I: Financial Stability), improve financial inclusion (FSDPO Pillar II: Financial Inclusion); (ii) and increase the supply of private capital to support development (FSDPO Pillar III: Long-Term Financial Markets). Moreover, the FSDPO series is also aligned with MFSDS specific objectives and actions, as shown in the table below. Table 4. Examples of MFSDS objectives and actions related with FSDPO series reforms MFSDS Policy MFSDS Specific Objectives and Strategic Actions Objective MFSDS Strategic Objective I: Financial Sector Stability Monetary stability Government debt market development: improve information on public debt, increase the stock of outstanding OTs to stimulate market development without increasing domestic debt. Banking system Loan classification and provisioning: bring loan classification and provisioning rules in line with international stability best practice and make them more risk based. Anti-money laundering: complete the process of developing an effective AML function. Implementation of Basel II: finalize the adoption and implementation process of Basel II. FS safety nets Crisis management: develop a crisis management plan; conduct crisis simulation; establish a deposit insurance system. MFSDS Strategic Objective II: Financial Access Develop FS Payment & securities settlement systems: develop the legal framework for e-banking and mobile financial infrastructure services; promote e-payments. Credit information systems: increase scope and coverage of the system; increase ease of access to credit information; liberalize the sector to allow for private credit registries. Increase access to Consumer protection program: strengthen consumer protection in the financial system through increased finance transparency, fair treatment, and effective recourse. FS outreach: increase financial services providers outside major urban areas. Increase access to formal financial service: provide a bridge between rural commercial clients and the commercial finance system; facilitate commercial bank loan access. MFSDS Strategic Objective III: Supply of Private Capital Develop capital Medium-Term Debt Management Strategy: guarantee regular and scheduled issues of domestic debt markets instruments within a well disseminated process; harmonize the exchange and monetary markets policies with capital market policies. 38. The FSDPO series has incorporated lessons from FSDPOs in Africa, Europe and Central Asia, and Latin America as well as country-specific lessons, such as: ensuring cooperation at all levels of government, including TA and strong analytical underpinnings; considering the political economy and timing of reforms; and collaborating closely with donors to ensure a coordinated approach. Implementation capacity is limited in Mozambique and most FSDPO reforms fall under two institutions. Thus, the number of reforms supported by the FSDPO series has been kept at a manageable level (considering timing and sequencing issues) and complementary TA has been mobilized to support the implementation of reforms. The GoM has demonstrated commitment to the implementation of FS reforms over the last decade (as evidenced by the implementation of FSAP recommendations) and FSDPO is closely aligned with MFSDS. 12 Vicente, Carlos Leonardo (2014); “Elements to Consider When Establishing the Envisaged Development Bank of Mozambique”; World Bank Policy Note No. 86083. 11 4.2. PRIOR ACTIONS, RESULTS AND ANALYTICAL UNDERPINNINGS 39. Annex 1 details prior actions for DPO I, indicative triggers for DPO II, and related results. Reforms in the policy matrix have been classified in the three pillars: financial stability, financial inclusion and long-term financial markets. All prior actions of FSDPO I have already been implemented. Some of these have been in the making for the last 2-3 years. In some cases, the DPO is boosting the reform momentum to complete the last step in the approval process of key FS reforms. The implementation of some FS reforms will also take place beyond the timing of DPO II. The World Bank Group will keep supporting this reform process through TA as described in the following paragraph. 40. The FSDPO series is providing TA for reforms in each of its three pillars and is coordinating further TA by the World Bank Group and other donors. Under Pillars I and III, reforms related with the development of debt and capital markets and cash flow management are receiving TA from the FSDPO team and a recently-launched, FIRST-funded project for debt market development. Additionally, the IMF has been providing TA on AML/CFT regulations and banking sector supervision. Reforms related with financial inclusion (Pillar II) are receiving TA from DFID, KfW, GIZ and the Bank’s Financial Inclusion Unit. The Bank has been working with leading donors (e.g. DFID and KfW) on the establishment of a Financial Sector Deepening Trust (FSDT) to support the development and implementation of reforms on financial inclusion launched in May 2014. The Bank’s Financial Inclusion Unit, working with colleagues from IFC Advisory Services, has been preparing a multi-year package of TA and capacity building under the Financial Inclusion Support Framework, which is expected to be launched in July 2014 and has already provided advice in the development of a Financial Inclusion Strategy. 41. The design of this operation is supported by extensive FS analytical work conducted by the Bank, the GoM, and other donors. FSDPO series benefited from the FS analysis reported in the 2009 FSAP Update, which provided detailed recommendations and helped to identify FSDPO reforms. Strategies prepared by the Government were key inputs for the FSDPO, the most relevant being MFSDS. The Medium Term Debt Management Strategy (MTDS) provided inputs for the reforms in FSDPO-Pillar III. The Rural Financial Strategy highlights the need to increase financial inclusion in rural areas and let to the inclusion of this policy area in the policy matrix. The 2012 Diagnostic Report for Consumer Protection and Financial Literacy prepared by the Bank provides detailed analysis on the lack of consumer protection and financial literacy and led to inclusion of this reform area in the matrix. The study “Challenges of Financial Inclusion in Mozambique: An Analysis of the Supply” by BdM (2013) helped to identify Pillar II reforms (e.g. reforms to increase access in underserved areas and financial information to consumers). The “Mapping of Retail Payment Services Landscape” (FinMark Trust 2012) highlighted the need to strengthen the regulatory framework of e-money. The Finscope Mozambique Survey Report (FinMark Trust 2009) provides data on financial inclusion in Mozambique and related recommendations, which are in line with FSDPO reforms (e.g. promoting rural pro-poor financial products, financial literacy and cell-phone banking services). 12 Table 5: DPO Prior Actions and Analytical Underpinnings PRIOR ACTIONS ANALYTICAL UNDERPINNINGS PILLAR I: FINANCIAL STABILITY Banking regulation & supervision; FSAP Update; MFSDS; IMF Reviews Under the PSI for Mozambique; FIRST project Banking safety net & crisis management on Contingency Planning analytical work. frameworks AML/CFT framework FSAP Update; MFSDS. PILLAR II: FINANCIAL INCLUSION Improving access to financial products in FSAP Update; MFSDS; Diagnostic Report for Consumer Protection and Financial underserved sectors/areas Literacy; Mapping of Retail Payment Services Landscape; Challenges of Financial Inclusion in Mozambique; Finscope Mozambique Survey Report; An Overview of the Constraints to the Development of Housing Finance Sector. Increasing efficiency of borrowers’ FSAP Update; MFSDS. collateral to promote access to credit MFSDS; Diagnostic Report for Consumer Protection and Financial Literacy; Challenges Enhancing transparency of financial of Financial Inclusion in Mozambique: An Analysis of the Supply. information and protecting consumers Strengthening and broadening access to FSAP Update; MFSDS; Diagnostic Report for Consumer Protection and Financial payment systems Literacy; Mapping of Retail Payment Services Landscape. PILLAR III: LONG-TERM FINANCIAL MARKETS Strengthening government securities FSAP Update; MFSDS; Medium Term Debt Management Strategy; Government Debt primary markets Management Performance Report. Pillar I: Financial Stability Enhancing banking regulation and supervision 42. DPO I is supporting (as a prior action) the new regulation on loan classification that revises the definition and recording of NPLs bringing it more in line with international best practices. In line with recommendation of the 2009 FSAP Update, BdM has sought to address the shortcoming of its definition of NPLs and passed a Notice (Aviso) on December 31, 2013 updating NPL regulations. The previous regulation on asset classification and provisioning allowed banks to classify as NPL only the past due amounts of principal and interest while the new regulation requires banks to classify the full amount of the loan outstanding as NPL once past dues are over 90 days. This is an important enhancement, better aligning BdM regulations with international practices, and contributing to sounder balance sheets and financial stability. 43. DPO I also supports (as a prior action) the issuance by the BdM of risk management guidelines for banks fostering better risk management practices in line with international practices. Risk management guidelines were approved by the BdM Board on May 24, 2013. The risk management guidelines encompass credit, liquidity, interest rate risk in the banking book, foreign exchange, operational, strategic, reputational risk and compliance, and provide guidance on banks’ overall risk management. These guidelines are aligned with international best practices aiming at establishing a minimum set of elements that banks are expected to cover in monitoring and managing risks. Such framework is an important element in fostering the establishment of more effective risk management frameworks among banks, contributing to banks’ soundness and FS stability. 44. DPO II will support (as a trigger) BdM’s efforts to increase minimum capital levels for banks. This includes increasing the minimum capital required to open a bank, which is currently lower in Mozambique in comparison to other Sub-Saharan Africa countries. While the most direct effect of increasing minimum capital concerns stability, there are also expected benefits in terms of financial access given that well-capitalized banks are in a better position to provide sustainable access. The World Bank team will discuss with the regulator options being considered for smaller institutions, paying attention to access and stability considerations. 13 45. BdM has been working towards implementing Basel 2 with a simplified standardized approach. This is more risk-sensitive in comparison to the current framework but still suitable to Mozambique’s banking sector state of development. This should encompass, a review of the capital requirements for credit risk and an additional capital requirement for operational risk, which increases the buffer in the banking system fostering financial stability. DPO II will support (as a trigger) incorporating capital requirements for operational and foreign exchange risk (following a Basel-2 simplified standardized approach). Strengthening the banking safety net and crisis management frameworks 46. Over the last few years the BdM has put effort on the development of a crisis management framework, supported by TA provided by the WB and the IMF. Achievements include the approval of regulation for Emergency Liquidity Assistance (ELA), issuance of a decree establishing a deposit insurance scheme through the DGF, issuance of guidance to the BdM on how to deal with systemic events and problem banks and deciding to establish a crisis management committee within the BdM. 47. DPO I supports (as a prior action) the development and approval by BdM of regulations pertaining to ELA for banks enabling it to act as a lender of last resort. The regulation was drafted by BdM, and its Board approved it on March 3, 2013. It is a first important step towards establishing an effective and fully operational Lender of Last Resort (LOLR) facility for banks operating in Mozambique. The availability of ELA is an important tool in reducing the probability of bank failure due to liquidity shortages and therefore minimizing costs arising from a potential banking crisis. DPO II will support (as a trigger) the strengthening of the crisis management framework by BdM by, for example, conducting a simulation exercise to identify remaining weaknesses and developing a surveillance framework. 48. DPO I supports the establishment of a DGF. Currently there is no deposit guarantee scheme in operation in Mozambique, which is crucial for the development of a financial safety net. In the absence of such an explicit scheme, depositors and banks assume that the Government will reimburse deposits in the event of bank failure, meaning that there is an implicit system-wide guarantee for all deposits. This represents a large unfunded contingent liability on the state. In recent years, Mozambique has undertaken a number of steps to introduce a DGF. These steps include a 2010 Council of Ministers Decree to establish the DGF (as a “pay-box”). The decree envisages that the BdM will act as the Fund manager, stipulates the minimum Government contribution, and the membership of the Management Committee that would oversee the Fund. 49. DPO I supports (as a prior action) the nomination of the members of the DGF Management Committee, and DPO II will support (as a trigger) the capitalization of the DGF by the MoF with initial Government contribution based on the existing decree. Per the DGF decree, the Fund will be overseen by a three-member Management Committee consisting of representatives from the MoF, BdM, and the Association of Bankers. The nominations have already taken place with a despacho issued by the Minister of Finance on May 31, 2013 and an aviso issued by the Governor of BdM on June 10, 2013. This is an essential step for the operationalization of the DGF, and it was pending from 2010. The capitalization will take place following guidance incorporated in the Ministry Diploma, which relates to aspects such as the coverage threshold for deposits, the contribution from banks and the investment criteria for managing the resources of the DGF. These efforts are receiving TA from the Bank team, KfW, and will also receive support from the IMF. 50. The reforms supported by this DPO to enhance banking regulation and supervision, strengthen the banking safety net and crisis management framework, and improve government securities markets will enable the FS to better manage FDI inflows. In particular, measures to 14 strengthen banking regulation and enhance bank’s risk management capabilities will contribute to the resilience of the FS and its ability to withstand banking shocks, including those to emanate from expected capital inflows. Similarly, more developed money and government securities market will enhance the capacity of BdM to sterilize capital inflows. Improving the AML/CFT framework 51. The DPO I supports (as a prior action) the approval of a new AML/CFT Law by Parliament. A new law on AML/CFT was enacted in the Parliamentary session ending in May 2013. It was promulgated on June 28, 2013 and published in the Buletim da Republica on August 12, 2013. This law represents a major improvement in the AML/CFT legal framework and, as a result, Mozambique is in a much better place to fight money laundering and terrorism financing, which the law now criminalizes. The law allows the Republic of Mozambique to bring its AML/CFT regime into closer compliance with international standards and supports the work of Mozambique’s Financial Information Center, which had been hampered by the lack of an appropriate legal framework. In addition, the implementation of this new framework will help Mozambique abide by good-governance standards. This includes the environmental sector, as the law broadens the scope of underlying offences for money laundering to include organized crime, corruption, and environmental crimes, and facilitates international cooperation in money laundering cases. Given the transnational dimension of illegal logging and wildlife trafficking, as well as their well-established links to organized crime syndicates and corruption, this new law can now be used to trace, locate and recover illicit revenues from these crimes, including illegal sales and exports of timber, ivory, and rhino horn. Pillar II: Financial Inclusion Improving access to financial products in underserved sectors/areas 52. DPO II will support reforms to promote branchless banking. Related triggers for DPO II are: the issuance by BdM of the e-money custody accounts regulation (Aviso Conta Custodia) and the development by BdM of regulations for branchless banking (e.g. e-banking, mobile financial services) covering the provision of financial services through different channels or institutions as well as risk management aspects. 53. A conducive regulatory framework is needed to further develop branchless banking in Mozambique. Branchless banking cuts across several regulatory domains, such as prudential supervision, consumer protection, payment systems oversight, and financial integrity. The regulation of innovative products such as mobile payment services and e-money must be in line with regulation of other retail payment instruments. Thus, a comprehensive and cohesive retail payments strategy and regulatory framework is needed that takes into account various components of retail payments. The framework should encourage the development of innovative delivery channels while protecting consumers, the integrity of the financial system, and financial sector stability. Recognizing this gap, a multi-disciplinary Electronic and Mobile Banking Task Force (which includes mobile financial services) is proposing appropriate regulations. The Bank will provide TA on branchless banking, including on AML issues and the pricing of mobile transactions. 54. Mobile financial services and agency banking are promising areas for expanding FS access in Mozambique. Mobile financial services were recently introduced in Mozambique, and the Electronic and Mobile Banking Task Force has submitted to the Board of the BdM a justification for the development of a regulation on e-money trust accounts. In laying the groundwork for the regulation to govern e-money and mobile payment services, the Task Force has drawn from experiences of other countries, made specific proposals for the Mozambique environment and noted the importance of protecting customers while ensuring confidence in the system. This regulation seeks to increase 15 confidence on e-money, protect consumers and fill a relevant regulatory gap. A regulatory gap is also preventing the development of agency banking in Mozambique. Banks are not using retail agents given the regulatory uncertainty on whether agents are allowed in the banking sector. Increasing the efficiency of borrowers’ collateral to promote access to credit 55. DPO I supports (as a prior action) the approval of a draft Insolvency Law by the Council of Ministers. Parliament reviewed an Insolvency Bill and issued a legislative authorization for the Council of Ministers to pass it on its behalf on March 1, 2013. The Council of Ministers has already passed the Insolvency Law with this authorization. The Insolvency Law is expected to complement and strengthen the insolvency legal framework in Mozambique. It includes two main procedures (liquidation and reorganization) and seeks to preserve viable businesses and the orderly and swift liquidation of businesses that are not viable. The scope of the law covers virtually all enterprises. The Law provides a reasonable framework for dealing with business insolvency but important work lies ahead for establishing the capacity and institutional arrangements for its effective implementation, and broadening the scope of the legal framework to deal with problems (e.g. cross-border insolvency or insolvency of enterprise groups). 56. The credit reporting system is underdeveloped in Mozambique. Credit reporting is limited to the existence of a credit registry managed by BdM, and there are no credit bureaus. The main limitations of this system include issues with the quality and completeness of data (e.g. information is limited to regulated financial institutions), lack of alternative data and an efficient dispute resolution system, and cumbersome and time consuming processes (to send data to the registry and retrieve it). BdM has started the process to strengthen credit information systems. A Law on Credit Bureaus has been drafted and discussed by the Council of Ministers in December 2013. DPO II will support (as a trigger) the submission by Council of Ministers of the draft law to Parliament for the creation of Credit Bureaus in line with international principles. A number of implementation challenges will remain even if the legal framework for credit bureaus is adopted, and the Bank is expected to support further reforms in this area. Enhancing the transparency of financial information and protecting consumers 57. The financial consumer protection framework needs to be strengthened considerably. Financial literacy is low and mechanisms to protect consumers are weak. Many consumers lack awareness about financial services and knowledge to make informed decisions about the benefits and risks of basic financial services. The Bank’s “Consumer Protection and Financial Literacy Diagnostic Report” made recommendations to strengthen the framework for financial consumer protection. These include, establishing a financial consumer protection unit at BdM and enhance its capacity for market supervision, improving transparency and disclosure by requiring financial institutions to disclose all costs of financial products to consumers and requiring financial institutions to proactively inform consumers of the right to complain. 58. DPO II will support strengthening of consumer protection and financial information. DPO II will support (as a trigger) a regulation to be passed by BdM to establish a standard methodology for financial institutions to disclose the total price/cost of financial products to consumers (“effective interest rate”). The Bank team will also explore the possibility of providing support to the establishment of a financial consumer protection unit by the BdM. BdM has prepared a draft regulation on bank cards, which among other things, sets minimum requirements on the content of service contracts, disclosure of terms and conditions, charges, consumers rights, and minimum services expected. DPO II will support (as a trigger) the passage of this regulation (i.e. the Aviso on bank cards) by BdM (Regulamento de Cartões Bancários). This will enhance protection and the transparency of information of a key financial product in the consumer market. 16 Strengthening and broadening access to payment systems 59. The oversight of financial market infrastructures remains a challenge. Given that the BdM is also the regulatory authority for the Mozambique Stock Exchange (BVM), its oversight mandate is broader than what normally prevails in other countries. With a staff complement of seven, the oversight capacity is inadequate. The complete separation of the payment systems oversight function from the banking operations function, and its adequate staffing, will ensure that undivided attention is paid to payment systems issues. DPOs I and II will support further strengthening of the oversight function (following the passage of the oversight Policy Strategy in March 2012). DPO I will support (as a prior action) the decision by BdM to separate the oversight and operational functions of payment systems, and DPO II will support (as a trigger) the strengthening of the oversight function of the payment systems by: (i) the establishment of a fully-fledged oversight unit; and (ii) implementation of an oversight manual. 60. The authorities are implementing measures to improve payment systems but there are several pending challenges. The latter include the lack of full implementation of the RTGS system, lack of risk management in CEL (Sistema de Compensação Electrónica), manual and paper based processes in the cheque clearing stream and inadequate capacity at BdM to handle payments system oversight. Importantly, the RTGS system is still to achieve full operational status and connectivity of all banks in the country. Currently, the system is used for high value transactions and eight banks (accounting for approximately 80 percent of banking system assets) have joined. Additionally, the critical link with the Central Securities Depository (CSD) is not in place. These challenges, coupled with the fact that participation in the system is voluntary for banks, erode the benefits of RTGS processing and pose serious risk. The CEL continues to be the main system for handling payments and settlement obligations arising from the interbank transactions but it faces cheque clearing cycles and settlement risks. The Central Bank revised the CEL System Regulations to reduce settlement risk. The Bank will provide TA on these areas. DPO II will support (as a trigger) the introduction of failure-to-settle arrangements in the CEL system and addressing risks remaining in the current RTGS system. Pillar III: Development of Long-Term Financial Markets Strengthening government securities primary markets 61. The Government wishes to develop the domestic bond market, which in the medium/long term would provide an important anchor for deepening capital markets. Recent measures to strengthen debt management practices include establishing a debt management committee, publishing for the first time a medium-term debt management strategy, preparing the first annual borrowing plan for Government bonds and issuance by MoF of a decree and related legislation that establishes primary dealership system for Treasury Bonds (OTs) in primary and secondary markets. The Medium-Term Debt Management Strategy (2011-2015) is an important milestone, based on cost and risk trade-off with clear guidance on domestic debt and reference to the development of a domestic yield curve. The 2013 domestic borrowing plan has the calendar and issuance strategy of OTs. 17 62. DPO I supports (as a prior action) the implementation of at least two competitive bond (OT) auctions by the MoF following the 2013 annual borrowing plan and in line with the recent primary dealership legislation (Decreto of March 2013 and Diploma of April 2013) and the public announcement of the auction results on the BVM website. The first two competitive auctions were conducted in April 2013 and July 2013 and have been published in the official Gazette of BVM and updated in the website of the BVM. The April auction allowed the market to set the price for the first time and was oversubscribed 3.8 times. Three additional competitive auctions were completed in 2013 (one in September and two in December), the results of which have been published in the official Gazette of BVM. In the long-term, a well-developed, communicated and implemented borrowing plan is expected to improve the functioning of the primary market and promote better price discovery for other issuers. 63. DPO I supports (as a prior action) the passage by MoF of a Diploma on the operational norms of the CSD for the BVM. A CSD is being established at the BVM. The Ministerial Diploma was signed by the Minister of Finance on July 4, 2013 and is based on the legal mandate authorizing the establishment of the CSD (Article 4 of Decree 25/2006). The Diploma recognizes the powers of BdM as the regulatory authority to oversee the CSD, identifies participants and the role of other players in the CSD. In line with Article 5 of the recently signed Diploma, the BVM has also compiled draft operational procedures to further elaborate the standards laid down in the Diploma. The procedures will be approved after their consultative process is completed. As the GoM and the BVM continue to work on the regulatory framework to enhance the CSD operations, the Bank is ready to support it. 64. A number of implementation challenges will remain going forward for the authorities and the market players. The World Bank will provide technical assistance to address the segmentation of the BT and OT markets, which will set the basis for providing reliable price references in primary markets, improving the communication with the various market players, revising the primary dealership system based on knowledge and standard practices, and ensuring that CSD regulations and operational standards conform to the new PFMIs and ensuring consistency with other existing regulations. DPO II will support this pending agenda through the following triggers: (i) the MoF implements the bond issuance calendar envisaged in the 2014 annual borrowing plan by conducting at least four competitive auctions (one per quarter), and, starting in 2015, begin the process of reopening the OTs to reach levels consistent with gradually creating benchmark securities; and (ii) The BVM approves the procedures for the CSD to enable delivery versus payments (DVP). 65. DPO I supports (as a prior action) the issuance by BdM of a comprehensive set of norms to update money market regulation including on: (a) interbank markets; (b) repos/reverse repos in the interbank money market; (c) money market operations amongst banks and between BdM and banks; and (d) primary and secondary markets of treasury bills. This includes four Notices (Avisos) issued on June 6, 2013: (i) on the Market Operations System – SOM (Aviso No. 5/GBM/13); (ii) on repo/reverse repo transactions (Aviso No. 6/GBM/13); (iii) on procedures for transactions and reporting in the interbank money market (Aviso No. 7/GBM/13); and (iv) on the primary and secondary markets of BTs (Aviso No. 8/GBM/13). This package paves the way for stronger interbank activity, which could leverage reforms for longer-term financing. An active money market is a critical pillar in the overall development of Government bond markets and longer-term financing. Improved liquidity management and price discovery in money markets allow market participants to fund longer-term portfolio allocations. 18 4.3. LINK TO CPS AND OTHER BANK OPERATIONS 66. FSDPO contributes to the three pillars of Mozambique’s CPS: (i) Competitiveness and Employment; (ii) Vulnerability and Resilience; and (iii) Governance and Public Sector Capacity. FSDPO is included under Pillar I of the CPS to promote access to financial services while consolidating achievements in financial sector stability and soundness. FSDPO series supports the overarching goal of the CPS of broad-based inclusive growth by enhancing financial inclusion and stable financial markets. More developed financial markets also boost productivity by improving capital allocation and promoting entrepreneurship. FSDPO contributes to CPS Pillar II by promoting financial stability and better access to financial products (e.g. payments, savings and credit) that boost the resilience of individuals and enterprises to shocks. Recent financial crisis have made evident their potential to inflict large economic and social costs, proportionally larger for poorer segments. In particular, the DGF supported by FSDPO provides assurance to small savers on the recovery of their deposits in case of bank failure. CPS Pillar III is supported through reforms related with public debt management, AML and FS transparency. 67. FSDPO series builds on previous FS projects and complements ongoing projects to reach CPS goals, having the IFC as an integral part of the team. FSDPO builds on the achievements of the Financial Sector Technical Assistance Project (FSTAP) and FIRST TA, which promoted FS stability and supported reforms that will be deepened by FSDPO. This DPO will also benefit from the 2009 Competitiveness and Private Sector Competitiveness Project (P106355) and the 2013 Integrated Growth Poles Project (P127303), which contribute to CPS Pillar I by seeking to improve the business environment, strengthen SMEs’ capacity, and improve the performance of enterprises. Finally, three DPOs approved in 2013 complement the proposed FSDPO to achieve CPS goals. The first DPO is PRSC-9, the first in a series of three operations that seeks to improve business licenses and registration, transparency in the management of extractive industries, social protection programs and PFM. The second DPO is the First Agriculture DPO (AGDPO-1), which is the first in a series of three operations to promote private sector led growth in order to improve food and nutrition security. AGDPO supports CPS Pillar I in a policy area that is not covered by FSDPO. The third DPO is the First Climate Change DPO, the first in a series of three DPOs, which seeks to build effective institutional and policy frameworks for climate resilience development. This contributes to CPS Pillar 2 by working in a policy area that is not included in the FSDPO series. Finally, the IFC Advisory Team is participating in missions and contributing to the development reforms, especially in the area of access to finance. FSDPO also complements existing IFC initiatives in the country to promote lending to SMEs (SME Banking Program with BCI – Fomento and Banco ABC) and build SMEs’ capacity. 4.4 CONSULTATIONS, COLLABORATION WITH DEVELOPMENT PARTNERS 68. Cooperation with other donors active in the FS is strong. The FSTAP left a legacy of a strong cooperation between the Bank, AfDB, KfW, and GTZ. A Memorandum of Understanding (MoU) was signed in 2009 between the Government and the 19 donors providing general budget support (including the Bank). The Bank, DFID, and KfW are designing a FSDT, which seeks to replicate the success of Kenya’s FSDT in promoting access to finance and will provide TA for policy reforms under this operation. The Bank has also been liaising closely with the UNCDF on their forthcoming program for promoting greater financial inclusion. Consultations with other donors take place regularly through the Financial Sector Working Group, which brings together leading donors in the FS for periodic updates, exchange of information, and coordination of policy dialogue. The Bank is an active member of the Private Sector Working Group, which promotes a more enabling business environment for private sector development, including greater access to finance for MSMEs. 19 V. OTHER DESIGN AND APPRAISAL ISSUES 5.1. POVERTY AND SOCIAL IMPACTS 69. Mozambique remains one of the poorest countries in the world despite high GDP growth and it is increasingly recognized that growth has become less pro-poor over time (Jones and Tarp 2012; DNEAP 2010; Arndt et al 2012).13 As a result, consumption poverty rates have remained persistently high. This is especially true in the rural sector, suggesting a widening urban-rural gap and upward pressure on income inequality. While Mozambique has continued to experience a general decrease in poverty, this has been heavily concentrated in urban areas, where only 30 percent of the population resides (Alfani et al 2012). Poverty is concentrated most heavily in the country’s Central and Northern regions. 70. Rapid macroeconomic growth has not been accompanied by a transformation of the labor market (Jones and Tarp 2012). The economy has failed to generate sufficient high quality jobs that effectively translate macroeconomic growth into welfare gains. Mozambique’s population tends to be young and rural and is growing rapidly. The majority of Mozambicans earn a living from smallholder agriculture, and the very low productivity of these activities is a key reason why poverty remains high. Productivity gaps between sectors are large and widening and this is largely due to the slow productivity growth in agriculture. Spatial differences in the distribution of labor are large with the central and northern regions having the bulk of the agricultural workforce and overall population. 71. The proposed operation is expected to have positive social and poverty impacts by promoting FS development and none of its prior actions is expected to have negative effects on the poor. Evidence strongly indicates that, when effectively regulated and supervised, financial development spurs economic growth, reduces income inequality and helps to lift households out of poverty (World Bank 2008). Well-developed financial systems have a strong positive impact on economic growth over long-term periods (Levine 2005; Demirguc-Kunt and Levine 2008). FS development is also pro-poor and is associated with significant declines of extreme poverty (Beck, Demirguc-Kunt and Levine 2004 and 2007). While not conclusive, empirical evidence suggests that there is a strong beneficial effect of financial development on the poor and that poor households and smaller firms benefit more from financial development. For households, financial development facilitates consumption smoothing and human capital investment. For firms, increased access to finance is associated with higher returns and better performance. Similarly, theory indicates that financial development facilitates entrepreneurship by people with promising ideas but little collateral and income and provides access to risk management among others (Demirguc-Kunt and Levine 2009).14 FS development reduces income inequality by disproportionately boosting the income of the poor and evidence suggests that the indirect effects of finance on inequality are substantial (Demirguc-Kunt and Levine 2004 and 2009). 72. FSDPO Pillar I will contribute to a stable financial system, thereby benefiting the poor to a greater extent. Financial crisis harm the poor disproportionately, affecting poverty and income distribution through a variety of channels (Baldacci, de Mello and Inchauste 2002).15 Financial crisis 13 Jones, Sam and Finn Tarp (2012); “Jobs and Welfare in Mozambique: Country Case Study for the 2013 World Development Report”; United Nations University, World Institute for Development Economics Research. DNEAP (2010); “Pobreza e bem-estar em Moçambique: Terceira avaliação nacional”; Technical report; Ministry of Planning and Development, Government of Mozambique. Arndt, C., Hussain, M.A., Jones, E.S., Nhate, V., Tarp, F. and Thurlow, J. (2012); “Explaining the evolution of poverty: the case of Mozambique”; American Journal of Agricultural Economics. 14 Demirguc-Kunt, Asli and Ross Levine (2009); “Finance and Inequality: Theory and Evidence”; Policy Research Working Paper 4967. 15 Baldacci, Emanuele, Luiz de Mello and Gabriela Ichauste (2002); “Financial Crisis, Poverty and Income Distribution”; IMF Working Paper. 20 typically lead to a slowdown in economic activity and, consequently, rises in unemployment and/or falls in real wages. If there is also fiscal retrenchment, this often leads to cuts in public outlays on social programs and transfers to households among others. Thus, financial crisis are associated with deterioration in poverty indicators. Specifically, the DGF supported by the FSDPO series is expected to minimize the fiscal costs associated with the resolution of financial institutions and protect the savings of smaller depositors. 73. Under Pillar II, better financial inclusion will benefit the poor. Modern development theory sees the lack of access to finance as a critical mechanism for generating persistent income inequality and slower growth (Demirguc-Kunt and Levine 2008). Small enterprises and poor households face much greater obstacles in their ability to access finance all around the world but more so in developing countries like Mozambique. Reforms under Pillar II will benefit lower income individuals, smaller enterprises and rural areas in particular. First, credit bureaus should contribute to increased access and affordability of financial services (Demirguc-Kunt and Levine 2008). Better credit information is particularly beneficial for individuals and enterprises with little or no collateral. Second, reforms to expand mobile banking and e-money will have a positive impact on vulnerable groups by expanding financial services in rural areas and reducing transactions costs (e.g. traveling costs) through electronic systems. Third, reforms on consumer protection and financial information will be particularly helpful for less sophisticated consumers. 74. This operation is expected to contribute to increasing women’s access to finance. For example, promoting innovations and improvements in financial products and delivery models (such as mobile and agency banking) would benefit women in particular since they have more time and mobility constraints than men. Policy, legal and regulatory frameworks for mobile banking (for both banks and telecommunication providers) and for agent banking can minimize women´s difficulty to interact with financial service providers through the promotion of remote transactions. Addressing constraints on the demand side begins with reinforcing the ability of women to act as informed and capable financial consumers. Therefore, reforms to strengthen financial consumer protection would also benefit women, who are more vulnerable than men and have lower financial knowledge and skills. Finally, reforms to increase the efficiency of collateral (such as credit bureaus and collateral registries) which allows women to establish a credit history and use a broader set of assets would improve their access and usage of financial services. 75. FSDPO Pillar III will contribute to the diversification of funding sources for business, thereby stimulating private investment, economic growth, and poverty reduction. Actions to strengthen government debt markets are critical for reducing costs and increasing efficiency in the banking sector. For instance, regular supply of government bonds will improve predictability and transparency in the FS; auctions of government securities and their announcement will improve efficient pricing of financial instruments. 5.2. ENVIRONMENTAL ASPECTS 76. This operation is not expected to have any negative environmental impacts given the policy areas and reforms covered. FSDPO prior actions seek to enhance financial stability (Pillar I), promote financial inclusion (Pillar II), and develop long-term financial markets (Pillar III). Reforms to promote financial inclusion can increase access to credit, particularly for smaller firms. This could generate the creation/growth of localized and easy to implement businesses (small scale income generating activities, such as flower growing, horticulture, agriculture, etc.). These efforts will be easily accompanied by the Government, particularly the Ministry of Agriculture (MINAG) and the Environment Ministry (Ministério para a Coordenação da Acção Ambiental-MICOA). MICOA oversees the implementation 21 of the Environment Law and coordinates all aspects related to environmental management. It has both a set of environmental and social regulation, as well as sufficient technical capacity to accompany such micro-projects likely to be funded by financing services. 77. The Bank undertook a Strategic Environmental Assessment (SEA) of the Climate Change DPO Series in 2013.16 The assessment of Mozambique’s environmental safeguards system focused on the Government’s ability to deal with the potential environmental impacts emanating from the Climate Change DPO series reforms. It followed the equivalence analysis and acceptability assessment approach used by the World Bank in its pilot country safeguard systems project, which was governed by OP/BP 4.00 (“Piloting the Use of Borrower Systems to Address the Environmental and Social Safeguard Issues in Bank-Supported Projects”). The equivalence analysis indicated a substantial degree of equivalence between the Mozambique environmental safeguards procedures and the environmental assessment safeguard policies of the World Bank (OP/BP 4.01). The only significant area of concern in relation to impacts that by the Climate Change DPO reforms was the lack of a regulatory instrument that can deal with cumulative effects from the future development of many small projects. In this context, a draft Ministerial Diploma on SEA was produced, and underwent consultation. 5.3. PFM, DISBURSEMENT AND AUDITING ASPECTS 78. Mozambique’s PFM system is considered adequate to support the FSDPO series. While there have been successful PFM reforms in the country, there are still challenges, particularly in terms of application of internal controls at decentralized levels, the flow of funds to and information gathering from remote districts, lack of PFM staff, delayed budget releases and high levels of off-budget spending. On-going PFM reforms are fully geared up to respond to these challenges. Hence, the FSDPO I will be disbursed following standard IDA procedures. 79. PFM improvements have been a cornerstone of reforms towards good governance and sound macroeconomic management. Public Expenditure and Financial Accountability (PEFA) indicators show a trajectory of improvement since 2006. These improvements have been in all dimensions, including multi-year planning, annual budgeting, procurement, accounting, internal controls, auditing, and public access to key fiscal information. SISTAFE legislation (2002), along with new PFM policies and procedures, provided a solid foundation for the PFM structure, and a government-wide IFMIS (e-SISTAFE) has been implemented progressively as the information technology platform for implementation of the legislation. Approved budgets and key financial reports are made public on the Ministry of Finance's website. 80. Substantial progress has been achieved in institutional and regulatory procurement reforms, but gaps remain between these and the procurement performance of sector delivery systems affecting transparency and accountability. The Government has established the legal framework and institutional architecture of a public procurement system that generally meets international standards of efficiency and accountability. However, the lack of an independent complaint system is an issue that has yet to be tackled and little has been achieved on integrity and making the public procurement systems functional. 81. Going forward, the updated PFM Vision 2011-2025 is the guiding tool for PFM improvements in Mozambique. Implementation of this Vision is supported by development partners and an amount in excess of US$157 million is planned for five years. The Bank is supporting PFM 16 World Bank (2013) Strategic Environmental Assessment of the Climate Change Development Operation Series. Mozambique Climate Change Technical Assistance Project. October 2013. 22 reforms through various projects, including the PRSC 9, the National Decentralized Planning and Finance Program and the Cities and Climate Change Project. 82. Anti-fraud and corruption measures in Mozambique are established through various laws and regulations (including an outdated penal code; more recent anti-corruption laws; and a Defense of the Economy Law from 1982). The Anti-Corruption Law, adopted in 2004 (Law No. 6/2004 dated June 17 and Decree No. 22/2005)17 and limited to corruption involving bribes, is being revised and strengthened. The Anti-Corruption Package, adopted by the Council of Ministers in July 2011, and submitted to Parliament for approval in December 2011, is yet to be approved in its entirety. Nonetheless, some important anti-corruption legislative pieces have been recently been approved, including (i) Whistle-blower and Witness Protection Law, which came into effect December 13, 2012; (ii) Public Probity Law, which includes conflict of interest and asset declaration requirements; (iii) Organic Law of Prosecution Service, which allows the Anti-Corruption Agency (Gabinete Central de Luta contra a Corrupção - GCCC) to investigate and prosecute corruption crimes, including embezzlement, illicit enrichment, and conflict of interest. The amendment of Anti-Corruption Agency competences is already in effect, but whistle-blower and witness protection legislation will take time and resources to be fully implemented. If fully implemented, then new legislation would provide Mozambique a strong anti-corruption framework consistent with best practices. 83. The proposed financing will be disbursed following standard IDA disbursement procedures. The financing will be disbursed as a single tranche after effectiveness and fulfilment of the tranche release conditions and upon submission of acceptable withdrawal applications from the Ministry of Planning and Development (MPD). IDA will deposit the funds in a dedicated foreign exchange account of BdM in Frankfurt. The funds will not be used for Excluded Expenditures in accordance with the Financing Agreement. Within two working days, the BoM will credit the Metical equivalent of the funds to the Transit Account of the MoF. The Metical equivalent funds will be transferred from the dedicated account to the CUT and will be used as State budget revenue and recorded in the State accounts as such. Within 30 days of the BoM being credited, the Government of Mozambique will provide confirmation to IDA that the amount of the Credit and Grant has been credited to the MoFs CUT and that the funds are available to finance eligible expenditures. In line with noted improvements in PFM, particularly in oversight and follow-up mechanisms, an audit report will not be mandatory under the series. However, IDA will reserve the right to request an audit should it feel there is a need for such. Should an audit be requested, a legally registered, private and independent audit company meeting international standards on auditing and qualifications of the auditors assigned will perform the annual audit in accordance with Terms of Reference to be agreed upon with the GoM. Audit costs will be met by the GoM. 84. The IMF concluded a Safeguards Assessment of the Mozambique Central Bank in mid- 2011, which confirmed that its control, accounting, reporting, and auditing systems are adequate and aligned with international standards. The assessment made recommendations to further strengthen the governance structure of the BdM, notably by opening the Central Board and the Audit Board to independent experts from outside the BdM and MoF. It also recommended that the Audit Board should ensure more systematic follow-up of audit recommendations and the audit charter be subject of an external quality assurance review in accordance with international standards. The authorities are in the process of implementing the action plan that was drawn-up as a result of the safeguards assessment. In the context of the IMF PSI, the government agreed to follow up on the recommendations of the Assessment and implement a series of related measures. According to the most 17 Law No 1/79 dated January 11 and Law No 9/87 dated September 19 covered anti-corruption issues before the revised legislation in 2004-05. 23 recent IMF review, the exchange rate is in line with the economy’s fundamentals18. Mozambique has a de jure and de facto floating exchange rate arrangement, being largely determined in the interbank foreign-exchange market. No assessment of fiscal performance has been conducted. 5.4. MONITORING AND EVALUATION 85. MoF will be responsible for the overall oversight and implementation of the DPO. Within MoF, the lead department will be the National Treasury. The BdM is a key partner in implementation as many of the actions under the inclusion and stability pillars fall under its purview. BVM will be the main technical agency for the actions related to capital markets, coordinating closely with MoF and the BdM. MoF and BdM, as the lead implementing agencies, have extensive experience and are fully versant with Bank policies and procedures through investment lending and policy based operations. 86. A results framework has been developed for the Operation (Annex 1). The results framework is consistent with the goals set out in the MFSDS and the broader Five Year Government Plan. The monitoring of FSDPO will benefit from the Government’s monitoring and evaluation mechanisms for the implementation of the MFSDS. The achievement of targets will be assessed based on market players and household surveys and will draw on the regular supervision function of the BdM, national level data, and specialized surveys on access to be conducted. The World Bank will play a supporting and monitoring role, reviewing progress and making needed adjustments. The FSDPO team will monitor overall progress achieved towards the expected outcomes of the DPO series. The review will be based largely on the monitoring indicators and the goals of the program. VI. RISKS AND RISK MITIGATION 87. The overall risk rating for FSDPO is moderate. The three main risks to this operation are related to implementation capacity, macroeconomic management, and sustainability of commitment to reform in the run-up to general elections in 2014. 88. FSDPO has an implementation capacity risk given the range and relevance of reforms covered and the concentration of these reforms in two implementing agencies. The concentration of efforts helps to streamline and focus the dialogue and the two lead agencies possess relatively well trained staff and advanced systems. However, there are several measures to be implemented by the MoF and BdM and some require numerous technical decisions. To ameliorate the implementation capacity risk the team is: (i) maintaining an ongoing dialogue with the authorities on the reform package; (ii) providing targeted TA on supported reforms and coordinating further TA to be provided by Bank/IFC experts and other donors; and (iii) considering the political economy of reform while following a pragmatic approach, understanding that some complex financial sector reforms take more time to materialize. Implementation capacity risk is moderate. 89. The second risk is the maintenance of a stable macroeconomic environment due to: worsening CA deficits, a more expansionary fiscal policy, rising public external debt and downside risks. The CA deficit is mostly financed by FDI, but it exceeded 40 percent of GDP in 2013. There is also rising external debt to finance infrastructure investment. If these investments are not productivity- enhancing, the higher levels of debt will hinder macroeconomic stability. Fiscal policy has also become more expansionary in the last few years as expenditure growth has accelerated but the expansionary policy stance is expected to be temporary as it is the result of one-off activities. The Mozambican economy also faces significant downside risks such as declines of commodity prices and the worsening of the country’s security situation, which could affect the development of coal and gas sectors. 18 Republic of Mozambique: Staff Report for the 2013 Article IV Consultation, IMF Country Report No. 13/200, July, 2013. 24 Government capacity needs to be strengthened: (i) in the medium term given the expected increase in government revenues from natural resources; and (ii) in the short term to manage government debt and public investment related with infrastructure investments. Prior actions included in this DPO (Pillar III), PRSC 9 and the IMF PSI will ameliorate risks related with this lack of government capacity. The GoM has a stable working relationship with the IMF anchored by a PSI, which has contributed to ensuring sound macroeconomic management. Macroeconomic management risks are moderate. 90. There are political risks associated with the run up to the presidential, legislative, and provincial elections. Specifically, there is the risk of growing political uncertainty in the run-up to general elections in October 2014 and the resultant diversion of focus of policy makers from the reform process. This risk is mitigated by the highly participatory process through which the new MFSDS was developed, which strengthened the ownership of the strategy by stakeholders in government, the private sector and financial institutions. The continuation of FS reforms in prior election cycles and stability of the technical staff in the relevant implementing agencies are also mitigating factors of political risk. To mitigate these risks, the DPO series focused on prior actions that were advanced and supports the Government to prepare triggers. The government’s overall commitment to the reform process is solid. However, the upcoming political transitional period poses a risk to the swift implementation of FSDPO reforms. Political risks remain moderate. 25 ANNEX 1: POLICY AND RESULTS MATRIX PRIOR ACTIONS UNDER DPO I TRIGGERS FOR DPO II RESULTS PILLAR I: FINANCIAL STABILITY (PDO I: Reinforce financial stability)  The BdM has issued a loan The BdM continues to strengthen Percentage of banks classifying their NPLs according to classification regulation that revises bank regulation and supervision by: (i) the new regulation the definition and recording of non- increasing minimum capital levels for Baseline: Regulation not yet issued (March 2013). performing loans (NPLs) to bring banks; (ii) incorporating capital Source: BdM them more in line with international requirements for operational and Target (2016): At least 85 percent of banks, representing best practices. foreign exchange risk (following not less than 90 percent of the total bank assets Basel 2 simplified standardized approach). Percentage of banks implementing the new risk The BdM has issued risk management guidelines management guidelines for banks Baseline: Risk management guidelines have not been fostering better risk management issued (March 2013). Source: BdM practices in line with international Target (2016): At least 85 percent of banks, best practices. representing not less than 90 percent of total bank assets BdM has developed and approved The BdM strengthens the crisis regulations pertaining to emergency management framework (e.g. liquidity assistance (ELA) for banks conducting a simulation exercise to enabling it to act as lender of last identify remaining weaknesses and resort. developing a surveillance framework). The MoF and BdM have concluded The MoF capitalizes the DGF with Percentage of deposits balances and accounts covered the nomination of all members of the initial Government contribution based by the Deposit Guarantee Fund (DGF) Management Committee of the on the existing decree. Baseline: 0 percent (March 2013). Source: DGF Deposit Guarantee Fund (DGF). Target (2016): The DGF covers 100 percent of insured deposit balances, which account for at least 80 percent of the total deposit accounts The AML/CFT Law has been Criminalization of terrorism financing. enacted by Parliament. Baseline: Existing AML/CFT law does not criminalize terrorism financing (March 2013). Source: ESAAMLG Target (2016): Revised AML/CFT law criminalizes terrorism financing demonstrated by Mozambique's progress reports validated by ESAAMLG Source: ESAAMLG 26 PILLAR II: FINANCIAL INCLUSION (PDO II: Increase access to finance by households and firms) The BdM issues the e-money custody Number of e-money accounts. accounts regulation (Aviso sobre Baseline: 135,000 (March 2013). Source: BdM. Protecção de Fundos Resultantes da Target (2016): 150,000. Source: BdM. Emissão de Moeda Electrónica). The BdM develops regulations for Percentage of the population with access to formal branchless banking (e.g. e-banking, banking services, including “formal-other”. mobile financial services) covering the Baseline: 12.7 percent in 2009. Source: FinScope. provision of financial services through Target (2016): 25 percent. Source: FinScope different channels or institutions as and planned WB Financial Capability Survey. well as risk management aspects. The Council of Ministers has Council of Ministers submits the draft Call for proposals from service providers to apply for a approved a draft Insolvency Law. Law to Parliament for the creation of private credit bureau license or operate the bureau on Credit Bureaus in line with behalf of BdM. international principles. Baseline: Law not yet passed (March 2013). Source: BdM/MoF. Target (2016): Call for proposals issued. Source: BdM. The BdM passes a regulation that establishes a standard methodology for financial institutions to disclose the total cost of financial products to consumers (‘effective interest rate‘). The BdM passes the Aviso on bank Percentage of banks disclosing to consumers the cards (Regulamento de Cartões effective cost of banking services. Bancários) to establish minimum Baseline: 0 percent (March 2013). Source: BdM. requirements on the content of service Target (2016): 80 percent. Source: BdM. contracts, disclosure of terms and conditions, charges, consumer rights, and minimum services expected. The BdM has strengthened its BdM strengthens its oversight Number of days to clear a cheque. national payment system by carrying function of payment systems by: (i) Baseline: two days in Maputo City and six days outside out an organizational separation staffing the oversight unit and (ii) the Maputo City. (March 2013). Source: BdM. between the oversight and the implementation of an oversight Target (2016): one day in Maputo City and four days operations functions. manual. outside Maputo City. Source: BdM. The BdM introduces failure- to- settle Percentage of transactions settled through RTGS. arrangements in the CEL system and Baseline: Less than 5 percent in December 2012. addresses risks remaining in current Source: BdM RTGS system. Target (2016): 70 percent. Source: BdM. 27 PILLAR III: LONG-TERM FINANCIAL MARKETS (PDO III: Enhance the development of long-term financial markets). The MoF has conducted at least two The MoF implements the bond Number of short and medium term bonds issued and competitive bond (OT) auctions issuance calendar envisaged in the reopened in the domestic market through competitive following the 2013 annual 2014 annual borrowing plan by: auctions. borrowing plan published in January (i) conducting at least four Baseline (January 2013): At most 1-2 non-competitive 2013 and in line with Decree No. 5 competitive auctions (one per OT issuance per year; no re-openings. dated March 22, 2013 and quarter), and (ii) starting in 2015, Target (2016): At least one issuance and one re-opening Ministerial Diploma No. 90/2013 begin the process of reopening the by maturity bucket (short and medium term) issued dated April 16, 2013 and has OTs to reach levels consistent with through competitive auctions. publicly announced the auction gradually creating benchmark results on BVM’s website. securities. Level of dematerialization and immobilization of all The MoF has approved the medium and long term debt securities listed in CSD. operational norms of the Central. The BVM approves the procedures Baseline (January 2013): Only listed securities fully Securities Depository for the BVM. for the CSD to enable delivery versus dematerialized. payments (DVP). Target (2016): Full dematerialization and immobilization of all securities listed in CSD. BdM has issued a comprehensive set of norms updating money market regulations, including on: (a) interbank markets; (b) repos/reverse repos in the interbank money market; (c) money market operations amongst banks and between BdM and banks; and (d) primary and secondary markets of treasury bills, as evidenced respectively by Notices 5 through 8 all dated June 6, 2013. 28 ANNEX 2: LETTER OF DEVELOPMENT POLICY 29 ID finance to craate jobs. 4. FSOPD l has been designed within the contex1 of the Memorandum af Understanding (MoU} between the Government of thl! Republic of Mozamhique and the international aid partners. including the World Bank Grnup, signed in March 2009. The MaU outlines the partici~ant's approach to the provision of budget support. among other related measures. Macraeconamlc context 5. /.fo:umoique's economy remuins roousl despite a still-fragile world economic environment restlting from the financial crisis that shook the international economy and was exacerbated by the Eura zone soverl!ign debt crisis: • In 20l3economk activity grew by 7.Dpercent. lower than the gruwth forecast due tc the negative impa~t of floods in early 2Dl3. Growth has been strong. supported by the sxpansioo and rapid rise in coal prochJ1:tron as well as in financial services. transport and c::ommunicaUans. and agriculture. the last making a major coolrihutian ta SOP. We expect the economy to growby Bpercent this year. • The year-end inHiltion rate remained relativelylow at 3 percenl, Wfll below t:fMl target of the Gentral Bank. Inflation is expec1ed ta ramain between 5.5-6 this veer. supported by a relatively weak Soutn African Rand and strong agricultural production. Mozambican