Document of The World Bank Report No: 19366-KG PROJECT APPRAISAL DOCUMENT ONA PROPOSED CREDIT IN THE AMOUNT OF SDR 11.1 MILLION (US$15 MILLION EQUIVALENT) TO THE KYRGYZ REPUBLIC FORA SECOND RURAL FINANCE PROJECT JUNE 1, 1999 Environmentally and Socially Sustainable Development Europe and Central Asia Region CURRENCY EQUIVALENTS (Exchange Rate Effective June 1, 1999) Currency Unit = Som I Som= US$ 0.023 US$ 1 = 43.52 Som FISCAL YEAR January 1 to December 1 ABBREVIATIONS AND ACRONYMS ACC Agricultural Consumer Cooperatives APEAC Agriculture Privatization and Enterprise Adjustment Credit ASSP Agricultural Services Support Project EA Environmental Assessment FDF Farm Development Fund GOK Government of the Kyrgyz Republic LAS International Accounting Standards IDA International Development Association IFAD International Fund for Agriculture Development ISA International Standards of Auditing KAFC Krygyz Agricultural Finance Corporation LACI Loan Administration Change Initiative M&E monitoring & evaluation MEP Ministry of Environmental Protection MIS management information system MOF Ministry of Finance NBK National Bank of the Kyrgyz Republic NGO non-governmental organization PESP Private Enterprise Support Project PFI participating financial institution PMU Project Management Unit RCG Rural Credit Guidelines RFP I (First) Rural Finance Project RFP II Second Rural Finance Project SA social assessment SCFI State Committee for Foreign Investments and Economic Development (GOSCOMINVEST) SDR Special Drawing Rights SFCOP Small Farmer Credit Outreach Program SHG self help group SME small and medium enterprises SOE statement of expense Vice President: Johannes Linn Country Director: Kiyoshi Kodera Sector Director: Kevin M. Cleaver Task Team Leader: Hoonae Kim KYRGYZ REPUBLIC SECOND RURAL FINANCE PROJECT CONTENTS A. Project Development Objective Page 1. Project development objective 4 2. Key performance indicators 4 B. Strategic Context 1. Sector-related Country Assistance Strategy (CAS) goal supported by the project 4 2. Main sector issues and Government strategy 5 3. Sector issues to be addressed by the project and strategic choices 7 C. Project Description Summary 1. Project components 8 2. Key policy and institutional reforms supported by the project 11 3. Benefits and target population 11 4. Institutional and implementation arrangements 11 D. Project Rationale 1. Project alternatives considered and reasons for rejection 13 2. Major related projects financed by the Bank and other development agencies 14 3. Lessons learned and reflected in proposed project design 15 4. Indications of borrower commitment and ownership 16 5. Value added of Bank support in this project 1 7 E. Summary Project Analyses 1. Economic 17 2. Financial 18 3. Technical 19 4. Institutional 20 5. Social 21 6. Environmental assessment 21 7. Participatory approach 22 F. Sustainability and Risks 1. Sustainability 24 2. Critical risks 24 3. Possible controversial aspects 26 _j- G. Main Loan conditions 1. Effectiveness conditions 26 2. Other 26 H. Readiness for Implementation 27 1. Compliance with Bank Policies 27 Annexes Annex 1: Project Design Summary 28 Annex 2: Detailed Project Description 31 Annex 3: Estimated Project Costs 41 Annex 4: Cost Benefit Analysis Summary, or Cost-Effectiveness Analysis Summary 42 Annex 5: Financial Summary for Revenue-Earning Project Entities, or Financial Summary 46 Annex 6: Procurement and Disbursement Arrangements 49 Annex 7: Project Processing Schedule 56 Annex 8: Documents in Project File 57 Annex 9: Statement of Loans and Credits 59 Annex 10: Country at a Glance 61 Annex 11: Financial Management 63 Annex 12: Social Issues and Social Assessment 66 Annex 13: Environment Assessment - Summary of Assessment Results 80 MAP(S) IBRD 30171 _jj_ KYRGYZ REPUBLIC Rural Finance II Project Appraisal Document Europe and Central Asia Region (ECSSD) Environmentally and Social Sustainable Development Date: May 31, 1999 Team Leader: Hoonae Kim Country Manager/Director: Kiyoshi Kodera Sector Manager/Director: Kevin M. Cleaver Project ID: 64585 Sector(s): AC - Agricultural Credit Lending Instrument: Financial Intermediary Loan (FIL) Theme(s): Rural Development Poverty Targeted Intervention: Yes Project Financing Data O Loan M Credit EL Grant O] Guarantee O Other (Specify) For LoanslCredits/Others: Amount (US$m) US$15 million equivalent (SDR 11.1 million) Proposed Terms: L To be defined 3 Multicurrency O Single currency Z Standard Variable OI Fixed LI LIBOR-based Grace period (years): 10 Years to maturity: 35 Commitment fee: 0.5% Service charge 0.75% Government 1.50 0.00 1.50 IBRD 0.00 0.00 0.00 IDA 5.00 10.00 15.00 BENEFICIARIES 3.80 0.00 3.80 PARTICIPATING FINANCIAL INSTITUTIONS 2.60 0.00 2.60 Total: 12.90 10.00 22.90 Borrower: Kyrgyz Republic Guarantor: Responsible agency: Ministry of Finance Implementing agency(ies): Kyrgyz Agricultural Finance Corporation Address: 50, Pushkin Str., 720011, Bishkek c., Kyrgyz Republic Contact Person: Baktygul Jeenbaeva Tel: 996 312 22 63 35 Fax: 996 312 61 06 64 Email: kafc@infotel.kg Estimated disbursements ( Bank FYIUS$M): Annual 1.00 2.50 4.00 4.50 3.00 Cumulative 1.00 3.50 7.50 12.00 15.00 Project implementation period: FY2000-FY2004 Expected effectiveness date: 10/30/99 Expected closing date: 06/30/2004 OCS PAD F-: S.obe 9199 INTRODUCTION First Rural Finance Project The proposed project is a follow-up to the first Rural Finance Project (RFP I) that the International Development Association (IDA) approved for SDR 11.9 million (US$16 million equivalent) in June 1997. The RFP I (Cr. 29590-KG) was designed at a time when limited institutional and human resources were available to support the transition from a centrally-directed command economy to a market economy and the newly emerging capital markets were insufficient to meet the needs of a market system rapidly developing in response to enterprise privatization. In the years immediately following independence, the Government was the primary provider of credit to the agricultural sector, intermediated mostly by Agroprombank. There were almost no other bank s involved in the agricultural credit at that time. Agroprombank, despite its extensive rural branch network, lacked the experience in commercial loan appraisal and suffered from a high default rate. In 1996 the Government undertook a comprehensive financial sector reform (Financial Sector Adjustment Credit, Cr. 2890-KG) designed to address the serious lack of confidence in the sector, the oligopolistic nature and insolvency of commercial banks and the substantial bad debt problem. As part of this reform program, Agroprombank was liquidated and placed under receivership. Other commercial banks, however, were not prepared to fill the void created by the closing of Agroprombank. Existing banks had no rural branch network, no expertise in agricultural lending, and no understanding of the type of assets available as collateral in the countryside. Their technology and expertise were geared toward large-scale industrial and trade finance. Moreover, the banking sector was generally weak and not in a position to expand and move into new markets. Against this backdrop, RFP I established a non-bank financial institution--the Kyrgyz Agricultural Finance Corporation (KAFC)--to serve the newly emerging private farmers and rural enterprises. KAFC was intended as a temporary institution that would serve the rural sector for a limited period of time and then be absorbed into the commercial banking sector. KAFC was designed to function primarily on a commercial basis--extending credit based on rigorous financial appraisal, taking full collateral, and fully covering its cost of funds, administrative margin, and provisioning with its on-lending rates. It was also intended to develop a Small Farmer Credit Outreach Program (SFCOP) aimed at reaching groups of farmers who could offer joint and several liability (i.e. social collateral) in lieu of physical collateral. As part of the Government's strategy to increase financing to the sector, a number of other programs were also initiated, including the development of rural credit unions which are receiving support from the Asian Development Bank. KAFC was designed to succeed where commercial banks could not and performance to date has exceeded expectations. Since its creation, KAFC has established itself as a major financial institution that lends predominantly to agricultural and associated borrowers. Credit officers were explicitly trained to understand agricultural markets for outputs, inputs, and rural assets offered as security. Repayment rates have been good, and KAFC's lending portfolio has expanded. Credit disbursements are well ahead of the appraisal estimate. Experience with this project shows that the demand for rural credit not only exists but is strong and urgent. -2- Implementation Summary of Rural Finance Project (as of May 31, 1999) During the 26 months of operation since starting in March 1997, KAFC has: * approved 1,672 sub-loans by KAFC, and 137 sub-loans by SFCOP * approved a total sub-loan amount of around 10.6 million SDR (about 89% of the credit), of which 9.0 million SDR (US$12.2 million equivalent) has been disbursed from the Credit Account * built a total outstanding loan portfolio amounting to 137 million Soms * set 1999 lending targets at 200 million Soms (about 20% growth per annum) * on-lent in local currency at interest rates between 28-30% per annum which are substantially positive in real terms (vs. 1998 inflation of 18%) and fully cover the cost of funding, administration cost, and risk premium * received the Subsidiary Loan in Soms from the Government. KAFC pays interest rates which are based on actual inflation rates, and-current interest rates to ultimate borrowers cover the cost of funding, administrative costs and foreign exchange premiums * maintained satisfactory repayment performance Project impact to date has: * filled a critical gap in agricultural finance * provided access to funds for small-scale borrowers, including outreach to small private farmers * facilitated the phasing out of publicly administered, subsidized credit * induced changes in borrowers' understanding of prudent borrowing and obligation to repay * established a good initial foundation for comnnercial crediting in the agricultural sector * dernonstrated the financial viability of commercial lending to the agricultural sector Need for Continuous Support The Government of the Kyrgyz Republic (GOK) has requested a second Rural Finance Project (RFP II) to strengthen the rural financial system during the transition, and to expand and diversify the agricultural lending base and clientele. The proposed second project will support the strengthening of KAFC and further develop the practice and usage of social collateral. In its request, the GOK stressed the urgency of preparation of this project in order to ensure a seamless and timely flow of critical agricultural sector finance and appropriate institutional strengthening in the aftermath of the recent regional financial turmoil, while at the same time safeguarding the successful implementation of RFP I. While the RFP I is achieving its intended development objectives and has successfully demonstrated that agricultural financing can be commercially viable, its design and scope were deliberately limited in order to fully test the concept. KAFC has only reached 10 percent of the potential credit-worthy clients with business plans and adequate physical collateral to date. The demand of the remaining 90 percent of commercial farmers, processors, and other potential rural entrepreneurs remains unsatisfied. KAFC has lent mostly for working capital to private farmers and has only recently begun lending long-term credit for agro-processing and other agri-business. The SFCOP component in RFP I was intended to extend credit to borrowers who lack physical collateral or other assets required as security by accepting joint and several liability through group lending based on social collateral. In practice, however, this component has been slow to develop and group-lending remains heavily based on full physical collateral, with the same terms and conditions KAFC offers to and demands of individual borrowers. Therefore, the objective of increasing access to credit based on social collateral has not yet been achieved. This may have been due in part to the overloading of KAFC with the responsibility for group formation and support and to a lack of trained staff who fully understand the concepts of group borrowing and social collateral. There is also a lack of understanding among rural people of the benefits and responsibilities of being a group member. The proposed RFP II will address these gaps by combining SFCOP with the Farm Development Fund (FDF)--funded by IFAD (as part of the Agricultural Service Support Project jointly financed by IDA)--by providing support to potential group members, and by providing meaningful support for sustainable group formation and the establishment of a -3- social collateral system. A: Project Development Objective 1. Project development objective: (see Annex 1) The main development objectives of the proposed Second Rural Finance Project are to: (a) strengthen and expand a sustainable rural financial system that will serve a broad range of beneficiaries, including small-scale farms and rural entrepreneurs; (b) contribute to the reduction of poverty in rural areas by supporting the development of viable economic activities (on- and off-farm) to generate income; and (c) expand access to credit for those with limited collateral. 2. Key performance indicators: (see Annex 1) Progress toward project objectives will be monitored through a monitoring and evaluation (M&E) system of key performance indicators. These include: (a) increases in institutional lending to rural clients; (b) soundness of portfolio quality with minimum repayment rates of at least 85 percent; (c) demonstrated improvement in the profitability of major agricultural commodities as estimated by random sample analysis; and (d) demonstrated increases in income levels in rural areas. Items (a) and (b) will be a part of regular M&E of KAFC's operations, while items (c) and (d) will be measured by follow-up social impact assessments which will be carried out during project implementation. An initial social assessment has been completed to establish a baseline reference for future monitoring and evaluation of the project impact. Other measurable indicators of project performance include: the diversity of activities financed (in terms of number, wider outreach of clients, and types and sizes of sub-loans); improvement in business support services, e.g. availability of information, preparation of business plans, and other consulting services for small-scale enterprises in rural areas; and improvements in performance and sustainability of groups as demonstrated by on-time repayment and repeated borrowing by the same group. When other participating financial institutions (PFIs) join the project, a similar set of indicators will be developed for measuring their perfornance. These performance indicators will be an integral part of semi-annual progress reports that will be submitted to IDA. B: Strategic Context 1. Sector-related Country Assistance Strategy (CAS) goal supported by the project: (see Annex 1) Document number: 17641-KG Date of latest CAS discussion: 05/07/98 The proposed continued investment in rural finance is consistent with the Bank Group's country assistance strategy for the Kyrgyz Republic, as outlined in the IBRD, IDA, and IFC Joint Country Assistance Strategy Memorandum dated April 14, 1998. The country strategy emphasizes the establish ment of long-term sustainable growth to reduce poverty, to provide the Government with the means necessary to improve basic human services and institutional capacity, and to improve Government finances. RFP II, which is consistent with the Government's overall reform program, will contribute to: (a) the deepening of a fiscally sustainable rural finance system that will provide critically needed capital for production inputs and capital investment to foster economic growth in the agricultural sector; (b) accelerated development of private-sector activities in rural areas; (c) improvement in the efficiency of the rural sector to compete in a market economy; and (d) implementation of effective, well-targeted, and commercially viable private investment which should generate increased employment and income, reduce poverty, and improve the living standards of the rural population. The proposed project is also consistent with the strategic objectives of the Comprehensive Development Framework for which the Kyrgyz -4- Republic is a pilot country. 2. Main sector issues and Government strategy: General Issues. Despite significant policy achievements, including the virtual elimination of government intervention in commercial markets, many reforms are still on-going, and the private sector faces considerable constraints that prevent it from fully responding to the new market environment. The economy depends heavily on agriculture, which accounts for more than 45 percent of GDP and employment. About 75 percent of the population (excluding Bishkek) lives in rural areas, and almost two-thirds of the rural population is below the poverty line. However, the sector's growth is constrained by high population density and low -productivity, outdated technology, poor extension services, a deteriorating irrigation system which services 80 percent of the arable land, and finally by lack of financial resources. The rural population is also faced with limited access to transportation and information, and with cultural and social traditions that have deterred many people from actively seeking out alternative economic activities to generate income. Government Strategies Long-term Sustainable Growth. Following the successful completion of the Agriculture Privatization and Enterprise Adjustment Credit (APEAC, Cr. 27500-KG) which laid the foundation for sector reform, the Government's over-arching objective is to establish long-term sustainable growth. The two broad directions of the Government's development strategy are (a) private sector development and (b) poverty reduction. For private sector growth, priority is given to agriculture and the revitalization of agro-industry. This is appropriate in view of the large part of the population that depends on agriculture for its livelihood and the country's comparative advantage in agriculture. The Government has acted quickly to protect banks from the effects of fnancial instability, to strengthen systems and human capital; and to provide the institutional development to support the expansion necessary for the growing real sector needs in agriculture. Emphasis is also placed on improving the regulatory environment for business. For poverty reduction, the Government is pursuing a complementary strategy of increasing agricultural productivity and economic rates of return from their currently depressed levels, raising the incomes of the majority of the population that live in rural areas, together with improving the targeting of social assistance. The strategy for viable rural growth was discussed and agreed with the Government, local stakeholders, NGOs and donors during the Second International Agricultural Conference in Bishkek in December 1997. It encompasses a combination of specific investments to provide public goods in agriculture, policy reform and institutional development. A large part of the Government's investment program concentrates on the rehabilitation of the irrigation system, initially at the main canal level and subsequently at the on-farm level through the establishment of water user associations that will assume responsibility for the operation and maintenance of irrigation systems within their areas. Appropriate water pricing policies are being developed as part of this strategy. Public investment also focuses on adaptive research and on rural advisory services, livestock and pasture management, rural infrastructure, and market information systems to increase the efficiency of input and commodity markets. Policy reforms in support of farm restructuring and the issuance of land ownership certificates to private farmers continue. A nationwide land registration system is being established to help foster the development of land markets (in both rural and urban areas) which will enable farmers to increase their access to credit through collateralization of land. Institution building focuses on human resource development in the institutions dealing with agriculture, improving the quality and accessibility of information relevant to the sector, -5- promoting exports of agricultural commodities, and creating/strengthening institutions that support private agriculture, particularly agricultural inputs supply. In support of GOK's strategy, the Bank Group has supported six agriculture based operations to date and is preparing an On-Farm Irrigation Rehabilitation Project and a Land Registration Project. The proposed RFP II complements and supports these efforts. Financial Sector Issues. In 1996, the Government initiated a comprehensive reform program to improve the efficiency and profitability of the financial system. The two largest state-owned banks were liquidated, and two former state-owned banks were restructured and recapitalized by private investors. As part of this program, the NBK introduced a new regulatory and supervision framework. As a result, a small core of well-managed private commercial banks is emerging. Despite this progress, financial intermediation in general remains very low (the ratio of deposits to GDP is only six percent, of which more than half is dollar denominated), and banks have only recently begun to extend term loans for investment. As of December 31, 1998, there were 20 commercial banks in the Kyrgyz Republic, which have all been adversely affected by the 1998 Russian financial crisis and other external and domestic shocks. As a result there has been a notable deterioration in the quality of the banks' portfolios. Loans in NBK's "under supervision" classification have increased from 9.1 percent to 21 percent in the one-year period from December 1997 to December 1998, and three of the five largest banks were recently put under the administration of NBK due to weak financial positions. KAFC has not been completely shielded from the global and regional financial sector events, and there is ar. urgent need to strengthen its capacity by improving the quality of the management information system (MIS), its internal auditing and control, financial management, asset and liability management, and forecasting. To date, the impact of the recent turmoil in the regional banking sector on KAFC has been limnited, but unless precautionary steps are taken, the risk of default remains high. The rapid expansion of KAFC's portfolio and the introduction of term-lending is straining its capacity and has brought to light the need for further training in risk assessment and term loan analysis. To address these needs, RFP II will provide substantial capacity building support through technical assistance and training to bolster KAFC's commercial lending capacity. nimited Rural Finance Intermediation. Recent developments in the banking sector seem to reinforce the continued need for KAFC's activities. Commercial banks are unlikely to fill the critical gap in providing credit to the farmers and small-scale enterprises scattered throughout the rural areas of the country for some time. For the most part, they are in a period of consolidation and are not at a point where the investments in new branches that would be required to move from the rural sector would be advisable. Over time, however, it is expected that several of the stronger banks would gain both the capacity and the interest to move into the rural sector. KAFC is poised to serve this function and is expected to continue to be the main financial intermediary to the rural sector, delivering small loans efficiently to a large number of rural clients. This is possible because KAFC: (a) knows the sector well; (b) already has an extensive lending network through small local offices in rural areas and mobile credit officers; (c) has an established roster of clients with demonstrated sound borrowing records who are likely to borrow again; and (d) has gained strong public support and confidence through active public awareness campaign work. -6- 3. Sector issues to be addressed by the project and strategic choices: Against the above background, the following specific areas will be addressed under the proposed project: (a) strengthening the rural financial system and stimulating the flow of commercial financing to rural areas for agricultural and off-farm business development; (b) improving the efficiency and self-sustainability of financial institutions through TA; (c) supporting group formation and increasing access to credit based on a social collateral system; (d) supporting business development capacity in agriculture; (e) fostering economic growth in agriculture and other rural sectors, contributing to poverty reduction in rural areas; and (f) gradually reducing the (implicit) subsidy on the cost of capital to KAFC. One of the key constraints on sector development is the lack of a rural financial system for fnancing working and investment capital. This project aims at addressing this issue directly by providing term capital and strengthening the key lending institution to the sector--KAFC--and indirectly by strengthening borrowers' ability and capacity to borrow (by providing technical assistance to individual borrowers by helping to form borrowers' group which can offer social capital in lieu of physical collateral as security on their loans). Ultimately the project will contribute to stronger financial and rural sectors by building institutions that serve the lower end of the financial spectrum. Although commercial banks are presently not interested in participating in the project, after concrete demonstration that lending to rural enterprises can be profitable, some of them may later become participating financial intermediaries. Another key issue in rural areas is poverty. Just over one-half of the total population lives in poverty. Rural poverty rates are more than twice those of urban areas, while extreme poverty rates in rural areas are four times what they are in urban areas. This project aims explicitly at reaching rural populations and directly targets the relatively poorer segment through the Special Credit line for SFCOP. The Government is committed to moving lending rates progressively toward market rates, although there are differences of view as to what constitutes a market rate for term capital. Government treasury rates were as high as 42 percent at the end of March 1999, due to instability in the economy caused by domestic and external shocks in the region. The interbank market is extremely thin and volatile. It is expected that both of these markets will stabilize and develop and may become more indicative of market rates over time. At present, the Government receives IDA funds at 0.75 percent and on-lends to KAFC at a rate no less than the rate of inflation (currently 18 percent). This means there is an implicit subsidy in the current arrangement, amounting to the difference between the "market cost of capital" and the rates at which KAFC will borrow under the project. This modest institutional subsidy is justifiable--because the bulk of it represents IDA funds which will go through the GOK budget and then be transferred to KAFC, mainly for institutional capacity building for KAFC itself, and because KAFC's lending is directed at clients which constitute the relatively poorer populations of the Kyrgyz Republic. All subsidies will be explicitly accounted for. As market interest rates decline (as they are expected to) and/or adjustments to the on-lending rates are made, this implicit subsidy is expected to be eliminated. During the implementation of RFP II, the Government has committed itself to progressively reducing the subsidies by adjusting the on-lending rates to KAFC every six months to gradually approach a benchmark for market rates. The specific rate will be agreed on by IDA and the borrower six months after effectiveness and every six months thereafter. KAFC will establish its on-lending rates to fully cover its cost of funds, administrative costs, provisioning, and risk. One of the mechanisms which will be used for monitoring and quantifying subsidies is the Subsidy Dependence Index (SDI). -7- C: Project Description Summary 1. Project components (see Annex 2 for a detailed description and Annex 3 for a detailed cost breakdown): A. Rural Finance Component (Component cost - US$20.4 million, of which IDA US$14 million) A.1 Commercial Credit Line (Sub-component cost - US$16.1 nullion, of which IDA US$11 million) This sub-component will provide a credit line to KAFC (and other commercial banks when they become eligible) to on-lend for working capital and investment under commercial terms and conditions. On-lending will be at rates that will progressively approach market rates and will start at no less than inflation plus a margin for KAFC that covers all administrative costs, the cost of provisioning, and a risk premium relevant for each borrower. Anticipated sub-projects would include, among others: on-farm investment for development of agricultural production, including the provision of seasonal working capital as appropriate; investment for development of processing, storage, packing, marketing, and other off-farm agri-business and service sectors; and other rural income-generating activities that have proven positive cash-flows supported by sound business plans. Intended ultimate beneficiaries for the regular credit line are those who have commercially viable and bankable projects with adequate collateral, adequate financial rates of return, and demonstrated repayment capacity. Borrowers will have to meet strict eligibility requirements related to their ownership, share holding, and management. There will be a system of prior review to assure that eligibility criteria are enforced; KAFC and other eventual PFIs will be required to submit the first three sub-loans and any sub-loan greater than US$200,000 equivalent for IDA's prior review. KAFC (and in future other participating financial institutions) will maintain full autonomy in the selection of borrowers, approval of sub-projects, and determination of lending terms, and will bear all of the lending risks. The Government will also subscribe in KAFC's share capital to ensure that KAFC can maintain the capital adequacy ratio required by the prudential rules set by NBK. It was agreed during negotiations that the similar practices to those employed under RFP I will be maintained, i.e. 15 percent of each withdrawal made for sub-loans will be registered as GOK's share in KAFC. IDA funds earmarked for technical assistance and for the GOK share capital in KAFC will not be on-lent. As agreed under the RFP I, KAFC is eventually to be privatized, and this remains an institutional objective under RFP II. The timing of the privatization process will depend, however, on how quickly the current regional financial crisis is resolved and on the ability of the private financial sector in the Kyrgyz- Republic to invest in KAFC and take over its functions and portfolio. The appropriate timing for KAFC privatization will also be closely linked to the capacity and willingness of the commercial banks to lend to small-scale enterprises, including farmers. A plan for KAFC privatization will be developed during the Mid-Term Review, which will take place when disbursement from the credit line reaches 50 percent, or around December 2001, whichever is earlier. Future Role of Commercial Banks. Commercial banks are expected to play a key role in the future in providing financial intermediation services for rural areas. However, in recent months commercial banks have experienced difficulties due to the external and domestic shocks buffeting the economy. They, therefore, have been unprepared to venture into new lending activities in the rural sector without the proper tools and experience. The timing is not right at present for the participation of -8- commercial banks. It was therefore agreed that KAFC would be the sole participating intermediary until the Mid-Term Review, at which time commercial bank participation will be considered. In this regard, the NBK will closely monitor the actual performance of the commercial banks in the other IDA-supported credit line under the PESP, before encouraging them to engage in agricultural credit. To ensure that KAFC sustains its positive track record and remains sound in the face of the present regional financial sector problems, the Government has requested that the project focus first on strengthening the institutional and human capacity of KAFC. Once the banking sector stabilizes and commercial banks express interest in participating in the project, specific arrangements will be made to assess their eligibility to participate. Subsidiary Loan A greements will be concluded with the newly qualified PFIs according to the prevailing terms and conditions for all IDA credit lines. These eligibility criteria will include full compliance with NBK's regulations, sufficient capital adequacy, sound financial policies, and institutional capacity with professional staff adequately trained and specialized in medium- and long-term lending for investments and a sufficient network of branches in rural areas (see Annex 2). A.2 Special Credit Line for Small-Farmers Credit Outreach Program (Sub-component cost - US$4.3 million, of which IDA US$3 million). This sub-component will provide credit for group lending based on "social collateral" to allow those with inadequate physical collateral but with sound bankable projects to receive loans. Group lending relies on peer pressure to guarantee repayment. Currently, KAFC is implementing two different group-lending schemes under different terms and conditions. Under this sub-component, these schemes will be consolidated, and improved implementation modalities will be introduced. B. Institutional Development Component (Component cost - US$2.5 million, of which IDA US$1 million) B.1 Capacity building support for KAFC (Sub-component cost - US$2.0 million, of which IDA US$0.5 million) This sub-component will support comprehensive capacity building in KAFC to improve its operating efficiency and ensure that it can survive as a self-sustaining financial intermediary. This effort will include: (a) improving KAFC's capacity in loan appraisal; financial, asset, and liability management; accounting and internal audit and control; and other areas covering the full spectrum of KAFC's operations as well as personnel management and training of staff; (b) simplifying loan processing procedures and streamlining legal and documentary requirements for loan processing; (c) upgrading KAFC's management information system (MIS); (d) adopting a corporate governance and supervisory structure that would give KAFC full autonomy in its lending activities; and (e) developing medium-term corporate strategies and business plans with financial projection. In addition, legal advice will be provided regarding the introduction of moveable property and fixed-assets as collateral, streamlining current legal clearances for loan processing, etc. KAFC will also receive practical training in assessing the markets for various products that it may finance. Completion of KAFC's lending manual acceptable to IDA, completion of the first round of new training programs for lending staff andfinal selection of the IT/MIS system will be conditions of disbursement of the credit line component. Other eligible PFIs, in the future, will also receive similar training. Recognizing that a lack of transportation is one of the key constraints faced by the rural population, RFP II will establish mobile credit officers to implement both A. I and A.2 credit lines. This -9- innovation has proved to be the keystone of other rural finance projects supported by the Bank/IDA. Approximately ten vehicles will be included in the project financing for this purpose. B.2. Other TA support (Sub-component cost - US$0.5 million, 100% IDA.) This sub-component will provide institutional support to address constraints due to lack of collateral and understanding about uses of credit and the prerequisites to obtain it. TA and training to develop group lending, based on social collateral (US$0.3 million) will be provided to enable the project to reach a wide spectrum of rural people, including those near and below the poverty line. Specific assistance will be provided for group formation and to enhance group sustainability. This component will be designed to empower local groups to successfully deal with financial issues related to obtaining and using credit, as well as to obtain technical information and support needed to become profitable farmers and entrepreneurs. To minimize duplicative initiatives, this sub-component will be coordinated with other on-going TA, including the UNDP-supported Poverty Alleviation Project which provides support for group formation at village level and the group development activities of the Rural Advisory and Development Service (RADS) recently established under the Agricultural Support Services Project (ASSP) with funding from IFAD, IDA, and the Swiss Government. The project will also explore the opportunity to work with other existing agencies, e.g. NGOs and other donor-funded agencies, that are already active in the rural areas to provide group formation support. The main emphasis will be given to training local trainers and establishing local agencies for the sustainability of this type of support. Development of small-scale rural business development services (US$0.2 nullion). TA will be provided to establish institutional capacity to promote small-scale economic activities in the rural areas through the dissemination of information on (a) the availability of credit and terms and conditions of borrowing, (b) preparation of loan applications and supporting documents, (c) marketing, (d) opportunities for training, and (e) other private sector development support services in rural areas. Ultimately this support would lead to the development of bankable projects that can be financed through the credit line component and increase credit flow to rural areas. There will be partial cost recovery for these services through fees based on the client income levels. Other costs would be covered by the Borrower or donor grants. Potential partners include SME development centers, Rural Advisory and Development Centers (supported under ASSP), NGOs, and other donor supported private agencies. A. CREDIT LINE COMPONENT AC - Agricultural 20.40 89.1 14.00 93.3 Credit B. INSTITUTIONAL DELOPMENT FS - Financial 2.50 10.9 1.00 6.7 COMPONENT Sector Development Total Project Costs 22.90 100.0 15.00 100.0 Total Financing Required 22.90 100.0 15.00 100.0 -10- 2. Key policy and institutional reforms supported by the project: The Government has undertaken far-reaching policy reforms in the agricultural sector, removed most distortions in pricing, marketing and trade, and implemented privatization programs for farms and agri-businesses. The proposed project builds on the progress already made by assisting farmers and rural enterprises through credit-led restructuring to help them adapt to the new market-oriented environment. In particular, RFP II will: (a) facilitate interest rates moving to market rates; (b) further strengthen a sound, commercially oriented financial intermediary - KAFC; (c) expand group lending operations through a participatory approach and social cohesion; (d) encourage participation by other PFIs by demonstrating that rural finance can be viable; and (e) induce changes in borrowing culture and behavior. 3. Benefits and target population: The principal benefits of the project will be (a) financial and economic benefits in the form of increased agricultural productivity and output through new investment and continued restructuring of the agricultural sector; and (b) an increase in incomes and employment opportunities including diversification into non-agricultural economic activities in the rural areas. Local participation and self-empowerment are cornerstones of the project, which is designed to facilitate and expand access to credit for those previously excluded from capital markets. While the project will increase the provision of financial services to small farmers and small-scale rural entrepreneurs, it would also yield financial sector benefits such as creation of self-sustainable rural finance intermediation capacity and development of human capital. Beneficiary Targeting. The target population will be rural inhabitants (who make up 75 percent of poor in the country) and the bankable rural poor. The SFCOP sub-component will finance the lower end of the financial spectrum that is normally too insignificant or without sufficient collateral for commercial banks. It will serve small-scale rural entrepreneurs who lack sufficient collateral and self-financing but have viable project proposals. Rural social assessments carried out during project preparation (see Annex 12) indicate that the target population has a substantial credit demand and there are numerous viable activities for financing. These potential borrowers lack credit experience, however, and have a high level of mistrust for all financial institutions. Of all institutions, KAFC has achieved the highest level of trust. Typically, the rural poor are engaged in labor-intensive activities for which the addition of small amounts of capital generates very high rates of return. Experience with the SFCOP and other donor-supported micro-credit schemes has led to the decision to increase the availability of credit to groups based on social collateral. It has been found in the Kyrgyz Republic and elsewhere that groups of inexperienced borrowers require substantial support and training to ensure that the social bonds are strong and group responsibilities are honored. The SFCOP will thus be complemented by a group organizing and training facility to support and help villagers to create self-help groups and prepare them to become KAFC clients. Geographical Targeting. The project will be implemented nationwide and will include all viable economic activities in the rural areas. SFCOP's support to small-scale borrowers will be accessible to potential borrowers throughout the country, but group formation support and training will focus initially on areas with relatively high population density and high concentration of rural poor, and with the most proactive participation of local community. 4. Institutional and implementation arrangements: Implementation Period. Project implementation will take place over approximately five years with an expected completion date of December 31, 2003 and a Credit closing date of June 30, 2004. -11- Project Executing Agency. KAFC will be the sole project executing agency until other PFIs qualify to participate in project implementation. Participation by eligible commercial banks will be revisited during the Mid-Term Review. Although KAFC is not a bank, it underwent a thorough assessment by the NBK which affirmed that KAFC is in full compliance with relevant prudential guidelines and in sound financial condition to on-lend under RFP II. In addition, during project preparation, the IDA team has also assessed the KAFC's financial, operational and institutional capacity and confirmed that it fully satisfies the eligibility criteria for PFIs (with the exception of the banking license requirement as KAFC is not a bank). The State Committee for Foreign Investment and Economic Development (SCFI) will oversee the implementation of the TA component. Project Management. Under RFP I, KAFC performed a dual function as a financial intermediary and a project management unit (PMU). All required functions such as monitoring, evaluation, reporting, and carrying out an audit, etc., were performed satisfactorily. Under the RFP II, KAFC will continue to perform the day-to-day project implementation and management functions. Specifically, KAFC will: (a) prepare statements of expenditures and manage the Special Account; (b) submit a quarterly summary report to NBK of its progress in lending operations; (c) maintain all relevant data on project implementation including disbursement from the Credit Account, on-lending activities such as amount and quality of its loan portfolio; (d) prepare and submit semi-annual progress reports to IDA; and (e) engage independent auditors to audit KAFC and the Special Account and submit audited financial statements to IDA within six months from the closing of the calendar year. KAFC will regularly report on the status of the project to the State Committee on Foreign Investments and Economic Development on a monthly basis. KAFC will appoint designated staff to fulfill the project management responsibilities, and they will receive the necessary training in IDA requirements on project implementation including procurement, disbursement and environmental clearance. When other commercial banks join as PFIs, responsibility for overseeing and ensuring that project implementation is consistent with stated project objectives will shift from KAFC to another appropriate agency. At negotiations, an agreement was reached that KAFC will provide the PMU functions until a decision is reached with respect to commercial bank's role in the project. The PMU will be maintained with appropriate staffing andfunding support throughout project inplementation. Implementation of the Credit Component. The Ministry of Finance (MOF) will on-lend the credit line funds to eligible PFIs, which will, in turn, extend sub-loans to the ultimate intended project beneficiaries. Participating PFIs will have to satisfy agreed eligibility criteria (see Annex 2). PFIs will lend in domestic currency (Som), with the Government bearing the foreign exchange risk. Currently the cost of the Government bearing this foreign exchange risk is adequately covered in the difference between IDA's terms and the rate at which the Government will lend to PFIs (a margin currently more than 18 percent). Over time, the on-lending rate will move toward market rates. PFIs will bear the full credit risk. Accounting, financial reporting and auditing arrangements. KAFC will carry out financial accounting and will maintain separate project accounts and records for project related expenditures in accordance with International Accounting Standards (IAS). KAFC will be responsible for the preparation of Statements of Expenditures (SOEs) and financial reports. Accounts will be audited annually according to IAS by independent auditors acceptable to the Bank and to the Government. Audit reports will be submitted to the Bank within six months of the end of the fiscal year (calendar year of the Kyrgyz Government). These functions will be transferred to a new implementing agency if and when other PFIs join the project. Monitoring and Evaluation: Monitoring and evaluation of project implementation will be the -12- primary responsibility of KAFC and the SFCI. SFCI will design and implement a simple monitoring and reporting system to gather information on the activities of KAFC, the institutional development component and the borrowers supported by the project. The monitoring results will be consolidated into half-yearly reports and submitted for Bank review. The M&E system will be guided by the logical framework presented in Annex 1, and specific output and impact indicators to be monitored will be agreed upon. The system will also evaluate progress in implementing the annual work programs to be prepared by KAFC. The M&E system will be key in providing the lessons of experience needed for changes to the design for the second half of the project. A Mid-Term Review for the project will be held by December 31, 2001 or when disbursements have reached 50 percent of the credit line, whichever is first An Implementation Completion Report will be prepared, within, six months after the final disbursement of the credit (estimated June 2004). As above, these functions will be undertaken by the new implementing agency if and when other PFIs join the project. The SFCOP component will be closely monitored to assess the results of group lending, the strengths and weaknesses of groups, their support mechanisms, and the sustainability of groups. A follow-up social assessment will be undertaken prior to the Mid-Term Review, using the baseline data established during project preparation. This will assess the experience of project initiatives, including public information and awareness-raising activities, and determine which elements or approaches should be modified to increase project effectiveness. D: Project Rationale 1. Project alternatives considered and reasons for rejection: (a) Project timing. The acceleration of RFP II, originally foreseen for FY2002, was carefully considered in light of problems associated with the regional financial sector crisis. It was decided that the need and justification for a follow-up project which emphasizes the institutional strengthening of KAFC is particularly strong. The need to strengthen the institutional and human capacity to deal a difficult financial environment and to continue to provide necessary support to meet the real sector's needs and promote further growth is urgent if the substantial gains achieved under RFP I are to be sustained. (b) General or directed credit. A general credit line to be channeled through commercial banks was considered as an alternative and rejected. The credit line through KAFC is broadly directed at the rural sector because existing market failures make rural lending by commercial banks highly problematic at this time. These failures include lack of information about rural clients and rural lending opportunities, the perceived riskiness of agricultural loans, and the high transactions costs of lending to large numbers of small and geographically scattered borrowers. KAFC will fill the void in lending to the rural sector until there failures are better addressed and commercial banks are better able to expand their lending to a rural clientele. However, while the credit is directed to rural activities, those activities are broadly defined to include a well diversified portfolio of rural economic activities. In parallel, technical assistance support for small farmers and small-scale rural entrepreneurs will be provided to address some of the current constraints that prevent commercial banks from lending to rural clients and from mobilizing savings in rural areas. (c) Financial Intermediation through KAFC or commercial banks. As an alternative to the current project design, on-lending through commercial banks was considered. At present, however, most banks are in an unstable condition, exacerbated by the regional financial crisis. None of these banks have any knowledge of the agricultural sector, particularly sector specific risks or agricultural collateral markets, nor any of the skills, technology or extensive rural network for such lending. - It is not considered -13- prudent, therefore, to make investments in these areas until banks have regained their financial soundness. It was agreed that participation of commercial banks will be one of the main topics of discussion during the Mid-Term Review. Efforts will be made to involve as many eligible commercial banks as possible in RFP II. Kyrgyz banks need to diversify their lending activities to include rural clients. The project will help overcome the "misperception" of undue risk of lending to rural clients, help diversify the portfolios of commercial banks, and strengthen their corporate governance and management and loan appraisal skills in agriculture. KAFC, meanwhile, has established a sound reputation in the agricultural community and demonstrated that lending to agriculture can be profitable while maintaining a sound fnancial position. Therefore, it was decided to maintain KAFC as the main fnancial intermediary while expanding the scope and magnitude of the first project. (d) A Credit-led Poverty Alleviation program or a Public Sector Support Program. The alternative of developing a rural poverty project focused on public works, community development, and rehabilitation of rural community infrastructure was considered and rejected for the time being. In RFP I the Government chose to focus on a credit-led approach and launched a special private credit window - the Small Farmers Credit Outreach Program (SFCOP) in KAFC to provide small loans to groups. Such an approach has proven elsewhere to be an effective means of reducing poverty among a large segment of mostly poor rural inhabitants who are able to use loans productively. Such small loans help to build the experience, skills and discipline required for small borrowers to participate eventually in more formal credit markets. The experience to date with SFCOP, although somewhat mixed, has demonstrated that well-targeted credit on commercial terms for groups of small borrowers does have an important role in reducing poverty by providing a kick-start to well-conceived business concepts and in building a core group of experienced and disciplined borrowers. The proposed project will build on the efforts under RFP I and will include a more concerted effort in group formation, business advise and support, and group lending as a means to assist this important segment of the rural poor. The focus on a credit-led approach in the current project does not, however, preclude other interventions aimed at the rural poor. Investments that focus on community works and rural infrastructure complement the initiatives supported by the proposed project and are being considered in the ongoing country dialogue for inclusion in the future lending program. 2. Major related projects financed by the Bank and/or other development agencies (completed, ongoing and planned). Implementation Development Bank-financed Progress (IP) Objective (DO) Agriculture Sheep Development Project S U ** Agriculture Agricultural Support Services S S Project Environment Irrigation Rehabilitation Project S S Agriculture Rural Finance S S Agriculture Agriculture Privatization and S S Enterprise Adjustment Credit (completed) -14- Finance Private Enterprise Support U U Project (PESP)* Agriculture Flood Emergency S S Finance Financial Sector Adjustment S S Credit (completed) Other development agencies Asian Development Bank ADB's Credit Union Project ACDI/VOCA AFC Project: Osh Farm Credit Association Swiss Development Fund Caritas project/Helvetas project Mercy Corps Production, machinery, food processing loans Meerim Foundation 5 groups of low income women IP/DO Ratings: HS (Highly Satisfactory), S (Satisfactory), U (Unsatisfactory), HU (Highly Unsatisfactory) * Restructured in late 1998 $* Project objectives affected by changed sectoral conditions and world markets. A Mid-Term Review is scheduled for July 1999. 3. Lessons learned and reflected in the project design: The experience of IDA and other donors in credit operations, including RFP I and PESP in the Kyrgyz Republic, demonstrates the following lessons: * Macro-economic stabilization, market liberalization and privatization are all pre-requisites for effective financial interventions. These basic conditions are satisfied in the Kyrgyz Republic. * Rural finance projects often face difficulties because: (a) profitable opportunities for lending are lacking; (b) banks are unaccustomed to rural lending and do not know the clientele; and (c) borrowers do not know how to prepare business plans which allow them to accurately assess the profitability of borrowing and to interface productively with banks. The project will address these issues by supporting an institution that has knowledge of the agricultural and rural sectors and has a cost structure that allows it to have broad geographic reach (one-room rural branches, mobile offices). In addition, the project will provide business development support services to farmers and small business owners aimed at making the changes required to create profitable lending opportunities. * The loan portfolio should be diversified in terms of size, types of economic activities, clients and geographical areas. RFP II will support on-farm as well as off-farm activities in rural areas. * There should be multiple financial institutions involved in a credit line project to increase competition among banks and to reduce the cost of borrowing to ultimate borrowers. Although in the first half of the project only KAFC is expected to participate, other interested and eligible commercial banks will be encouraged to participate in the second half of RFP II. * The relatively high transaction cost of making small-size loans in rural lending could be compensated by low-cost lending technology such as group lending, mobile banks, decentralized -15- loan processing at local branches. * Improvement of the collateral system based on legal ownership of property is a prerequisite to a successful credit operation. The recent decision to allow private ownership of land in the Kyrgyz Republic will enhance development of the collateral system. * Group lending can be sustainable if members of the groups share common visions and goals, i.e. credit groups should be meaningful borrowers and community institutions, rather than empty structures that meet the needs of an influential member of the community, and achieving sustainable group lending requires substantial technical assistance and training at community levels. Under RFP II, group development will be supported through financial and technical assistance both for lenders as well as borrowers. * Credit line operations must be accompanied by substantial technical assistance for potential borrowers for generating bankable projects, preparation of business plans. Under RFP II, group development will be supported through financial and technical assistance both for lenders as well as borrowers. 4. Indications of borrower commitment and ownership: The Government's strong commitment has been demonstrated by a series of actions: * Following the November 1998 request by the President of the Kyrgyz Republic for a Second Rural Finance Project, the GOK issued several resolutions to facilitate project preparation. * The GOK has reaffirmed its commitment to continue reforms in the agricultural sector and credit-led sector reform. It was agreed to: (a) improve the MIS system of KAFC; (b) provide priority technical assistance to realize the MIS improvement; (c) provide a permanent home for KAFC as a part of the overall institutional restructuring and reorganization in order to make KAFC more effective; (d) provide support for creating mobile credit officers; and (e) include the annual audit costs in the project financing. * The GOK has agreed to provide counterpart funding for RFP II in cash and in kind, and has already pledged a headquarters building for KAFC. * The Govermnent has agreed to all the principal terms and conditions of the IDA credit and subsidiary loan to KAFC and agreed to on-lend to KAFC in local currency. * The Government has established a committee comprised of officials from all key ministries and departnents, which has coordinated the preparation of RFP II, carried out all locally required actions and obtained the necessary endorsements in order to present REP II to the Board of Directors of IDA on schedule. * The Government has carried out and continues to engage in active media campaigning to disseminate information about RFP II. * The GOK took decisive action to restructure the Private Enterprise Support Project so as to strengthen the banking sector and private sector development; the restructured project became effective in December 1998. -16- 5. Value added of Bank support in this project: Since its operations commenced in the Kyrgyz Republic in 1992, IDA has supported the Government in the design, analysis, and realization of its development strategies through specific lending and non-lending operations. Among non-lending activities, IDA has completed an Agricultural Sector Review (FY95) and a follow-up Agriculture Policy Review and Strategy for Rural Growth and Poverty Alleviation (FY98). This latter report examined the current state of Kyrgyz agriculture and the status of agricultural policy reform programs during the transition from a centrally planned economy to a market economy. It outlines a strategy for accelerating rural development by deepening policy reforms, increasing public investment, promoting institutional development, and strengthening the information base. The report served as the centerpiece for the December 1997 National Agricultural Conference. On the lending front, the successfully completed Agricultural Privatization and Enterprise Adjustment Credit (FY95) supported the policy underpinning for sector reform. The CAS clearly identifies support to the agricultural sector as critical for economic growth. The project directly complements on-going IDA support for agricultural revitalization through the Sheep Development Project, the ASSP, the Irrigation Rehabilitation Project, and the Flood Emergency Project, all of which will improve the productivity, profitability, and bankability of private farming and related rural businesses. IDA has drawn upon its extensive experience in poverty alleviation and natural resources management from many other countries, most recently from Latvia, Albania, and Bosnia. Specifically, lessons learned from these operations confirm that a well targeted poverty alleviation intervention through a rural finance project which is based on market principles can be effective and should be supported. IDA will continue to collaborate with other donors in designing rural development strategies and institutional capacities that are compatible with a market economy. IDA also draws on its own experience and the experience of the World Bank and other bilateral and multilateral agencies dealing with group lending and directed credit support in many countries. Within the Kyrgyz Republic, there is also considerable experience in group credit which is being brought to bear on this project after careful analysis of the difference between commercial lending and informal non-commercial lending, which is generally unsustainable. Through the cross-fertilization of knowledge and experience, IDA was able to ensure that the proposed RFP II is consistent with the fmdings of the aforementioned economic and policy work and the experience and lessons learned from similar projects elsewhere in the ECA Region. E. Summary Project Analysis (Detailed assessments are in the project file, see Annex 8) 1. Economic (supported by Annex 4): O Cost-Benefit Analysis: NPV=US$ million; ERR = % O Cost Effectiveness Analysis * Other Methodology. Because of the demand driven nature of a credit line operation, it is not possible to pre-determine sub-projects which will be financed. Therefore, no attempt has been made to estimate financial and economic rates of return of the overall project. However, according to the lending guidelines for participating financial institutions, each sub-loan approved will be required to have rates of return above on-lending rates of interest and demonstrate the repayment capacity of the borrower. Economic and financial analyses have been carried out on randomly selected farms and enterprises -17- typical in the Kyrgyz Republic from KAFC's actual and potential clients. Each model compares "with and without project" situations and illustrates possible changes induced by the project on costs and productivity. The sample analysis demonstrates that there is a wide range of viable business activities in rural areas, and that they are generally remain robust in face of adverse changes in key parameters. Detailed results of this analysis are in the project file. A similar quantitative analysis will be used to provide practical hands-on training for loan officers of KAFC. In credit operations, loan officers exclusively rely on financial rates of return, and have very little understanding of economic rates of return or opportunity cost of capital. However, in the Kyrgyz Republic, the Government has been pursing reform-oriented policies which have largely eliminated distortions in the economy. The price and trade regimes are virtually control-free, and agricultural subsidies are minimal. Therefore, it is expected that financial rates of returns (FRRs) will deviate very little from economic rates of returns (ERRs). 2. Financial (see Annex 5): NPV=US$ million; FRR = % The overall financial rate of return and net present value (NPV) for the project have also not been estimated. During sub-loan appraisal, loan officers will carry out a cash-flow analysis to ensure that the FRR of each sub-loan is above the opportunity cost of capital. While it is difficult to estimate the "real opportunity cost of capital" in an imperfect capital market, KAFC will make sure that its lending rates will be substantially positive in real terms to cover all costs, including provisions for bad loans and reasonable returns on equity. Financial analysis of sub-projects: Crop and livestock budgets have been prepared to determine potential yields and net income from various activities. The financial analysis includes: (a) gross and net returns per hectare and per head for each of the crops and for livestock; (b) the individual financial NPV's for the farm models and rural enterprises which indicate the potential viability and attractiveness of farming and small scale rural business; (c) the repayment capacity of each sub-project. A standard project analysis model, specifically suited for the Kyrgyz credit market, is being developed and will include a sensitivity analysis. Loan officers will continue to receive training in loan appraisal and monitoring fmancial prerformance of sub-loans. Financial analysis of PFIs: Each PFI will be subject to a due-diligence evaluation before it will qualify to participate in the project. Although KAFC is not a bank, the NBK has carried out a comprehensive evaluation of the institution and has issued an official letter stating that KAFC is in full compliance with prudential regulations. KAFC meets the criteria for eligibility. Future selection of commercial banks for participation in the project will be based on: (a) full compliance with prudential regulations, including capital adequacy; (b) the competence and independence of the bank's management and appropriate corporate governance structure; (c) the adequacy of its lending polices; (d) the reliability of its reporting; (e) its financial position, including the health of its portfolio; and (f) compliance with audit requirements. PFIs' eligibility will have to be maintained throughout project implementation. It is expected that some new PFIs may gain eligibility and some may lose it over the course of the project. Each PFI will be required to undergo an annual audit, which will include a review of the portfolio, by an international auditing firm. Details of the eligibility criteria for PFIs have been established and are included in Annex 2. At present, KAFC fully satisfies the eligibility criteria and will be required to maintain the compliance in order to retain its status as an eligible PFI. -18- Fiscal Impact: Overall, the project is expected to have a positive net fiscal impact as income growth will yield higher tax revenues. The GOK will provide its counterpart funding support to the project in-kind in the form of a headquarters building. The market value of the building is estimated to be US$1.5 million, which will be subscribed as Governrnent's equity contribution to KAFC. In addition, the GOK will utilize about US$1 million equivalent from the IDA Credit proceeds for the technical assistance component, and 15 percent of each sub-loan (aggregate of US$2.1 million) withdrawn from the Credit will be subscribed as the Government's share in KAFC. The Government's total contribution over the project life is estimated to be US$4.6 million (US$1.5 million in kind and US$3.1 million from the Credit proceeds). The Government will receive the IDA Credit at standard terms and conditions and will on-lend to participating financial institutions at a rate no less than official inflation rates projected and confirmed by the NBK. The current spread of around 18 percent gives the Government approximately US$6 million during the five years of project implementation. These resources will be used to provide foreign exchange risk coverage and to cover administrative costs, TA costs, and capitalization of KAFC by the Government. The initial on-lending rate to KAFC, based on the projected inflation rate, includes an implicit subsidy. This rate will be progressively adjusted to a market rate. When the banking sector stabilizes enough to determine a relevant market rate, this rate will become applicable for comparable operations in the country. Capital subscription by the GOK in KAFC from the Credit proceeds also represents an implicit subsidy to KAFC, which is justifiable since many of KAFC's activities are aimed at the rural poor and it is still in a development stage requiring substantial institutional and human capacity building. In addition, the Government's special support to develop group lending is justifiable because group lending and social collateral concepts are still relatively new in the country and substantial institutional capacity development is needed to make group lending sustainable. On the other hand, by supporting viable economic activities, there will be an increase in tax revenues and a reduction in the rural population's dependence on public support through the welfare system. The GOK has reduced agricultural subsidies from the budget and eliminated costly and unsustainable publicly administered credit to the sector. These reforms have led to a substantial reduction in budgetary allocations for agricultural subsidies. Although it is difficult to quantify the overall impact on the treasury, it is expected that the net fiscal impact of the project will be positive for the treasury. 3. Technical: KAFC staff will receive training in technical subjects such as appraisal and supervision of sub-projects, accounting procedures, management of cash flows, internal control, etc. On the client level, Rural Advisory and Development Centers (established under the ASSP) will build a network of technical specialists to support adoption of appropriate technologies, prepare simple business plans, maintain simple revenue/cost accounting, etc., by borrowers. -19- 4. Institutional: a. Executing agencies: During the first half of implementation, the credit line will be executed exclusively by KAFC. At Mid-Term, the possible participation by commercial banks will be considered. At that time, the project executing modalities will have to be revised. KAFC has been implementing the first Rural Finance Project since mid-1997. Implementation results to date are satisfactory. For project management, at least three additional staff will be hired for environment, procurement, and disbursement and M&E. For credit operations, KAFC's staff will increase according to increases in the volume of lending and number of clients. Staff training will be conducted regularly. KAFC has been audited by an international audit firm acceptable to IDA and has been assessed to have an adequate fnancial management and control system. Under RFP II, the MIS system of KAFC will be upgraded, and its headquarters and branches will be on-line, allowing for prompt data processing and timely management decisions. KAFC has received substantial technical assistance from the Swiss and TACIS, and additional TA is being planned for KAFC by TACIS as well as under the RFP II. The institutional development component will be executed by KAFC under the supervision of the SCFI. A Japanese PHRD grant will provide specific support to SCFI to identify high-priority TA, prepare terms of reference, and assist in the preparation of a TA implementation plan with performance indicators to monitor and evaluate the impact of the component. SCFI will also receive training in project management supported by the grant. b. Project management: Management of the project will be the responsibility of KAFC. Until commercial banks join the project, KAFC will continue to perform the dual function of a PFI and a PMU. KAFC has now developed the experience to manage RFP II; it will designate three full time staff for project management, and they will receive extensive training in such topics as project management, accounting, procurement, disbursement, financial management, and environmental compliance. KAFC management and key staff are familiar with IDA requirements and will continue to receive reinforcement in project management. Financial Management: The current financial management practices for the project comply with the relevant Bank requirements (OP/BP 10.02). The initial project implementation agency, KAFC, is being audited by independent auditors acceptable to the Bank. Internal controls and procedures are adequate to safeguard the assets of the agency. The financial information systems are capable of reporting the financial condition and performance of the agency in accordance with local requirements and of reporting project transactions and performance in accordance with World Bank requirements. Disbursements will initially be made using the procedures laid down for the RFP I. During the first two quarters following loan effectiveness, KAFC, in conjunction with IDA, will develop reporting tables appropriate to both the first and second projects and submit these to the IDA's Loan Department in parallel with the existing reports. It is anticipated that during the second half of project implementation, KAFC could switch to the Loan Administration Change Initiative (LACI) disbursement procedures. A more detailed review of financial management issues is given in Annex 11. -20- 5. Social: A rapid social assessment was carried out during preparation that confirmed the value of forming groups to access credit, with or without collateral, but found existing application procedures to be far too complicated and expensive to reach a broad rural population. The assessment identified a number of issues related to group credit that were explored subsequently to provide inputs into project design. Some of the most important issues were lack of experience with credit, perceived constraints to obtaining credit and inexperience in forming credit groups. Subsequently, a more comprehensive Social Assessment was undertaken by Kyrgyz social scientists, with the active support of KAFC staff. The SA was designed to investigate the issues described above, to learn more about the experience of group lending through Agriculture Consumer Cooperatives (ACCs), to ascertain feasible selection criteria, and to establish a baseline for social monitoring and impact evaluation. The SA confirmed that a social collateral (group guarantee) system is a feasible way to reach small farmers and entrepreneurs in the Kyrgyz Republic. There is significant credit demand and a large number of people that is willing to join credit groups. The SA concluded that SFCOP has been remarkably successful in starting its group lending program (albeit not as it was originally intended) given its very limited resources and institutional capacity; however, the program needs to be revised in order to reach a broad spectrum of possible borrowers efficiently and effectively. A number of measures were identified to: (a) make credit information available in the rural areas; (b) organize and strengthen groups to ensure that they meet the needs of members and ensure repayment obligations; (c) provide training and support to group members and SFCOP staff; and (d) help SFCOP improve its processing and evaluation procedures. Stakeholder workshops were held after the completion of the SA to discuss findings and implications and to obtain the views of a wide range of stakeholders regarding conclusions and project concepts. Findings of the SA were used to establish selection criteria for group borrowing, to develop a training and support program for credit groups, and to develop a social monitoring program. Implications of the SA will be developed further during the early phases of project implementation to learn from ongoing experience to fine tune group formation and training approaches and to strengthen the interface between SFCOP and its clients. A follow-up SA will be undertaken during the Mid-Term Review to address the impact and targeting questions and to deal with new issues that emerge during implementation. 6. Environmental assessment: Environment Category F A El C 1XB 1FI The project is classified as Category Fl, because it involves on-lending of IDA funds through a financial intermediary (FI). During RFP II preparation, international and local consultants: (a) reviewed the existing Kyrgyz environmental regulations; (b) identified the subset of the regulations that are relevant for RFP II and KAFC; (c) categorized KAFC's typical lending into nine groups; (d) listed applicable Kyrgyz environmental requirements for each group, identified potential environmental impacts, and recommended mitigating activities; and (e) prepared an operational checklist for KAFC loan officers so that KAFC officers can verify that all necessary permits, license, etc., are included in the loan application. An application will not be processed until all the necessary requirements have been fulfilled. Furthermnore, KAFC has agreed to employ an enviromnental officer who will participate in the loan appraisal process and make certain that loan officers are fully aware of the requirements. In addition, the KAFC environmental officer will be trained on the IDA/Bank environmental guidelines, including classification of A, B, and C, so that appropriate actions can be taken before and after sub-loan approval including -21- submission to the IDA for prior-review. Based on the environmental guidelines and checklist, KAFC staff will receive training on applying environmental standards in their appraisal and supervision of sub-projects. This will assure that loan proceeds are used in a manner consistent with Kyrgyz environmental laws and regulations and Bank policy. Loan officers will verify that sub-projects are in compliance with applicable environmental regulations, and a summary of environmental issues will be included in the semi-annual progress report to IDA. Loans for agro-chemicals will only be provided to farmers who have received adequate training in their use. For pesticides, an authorized list of products approved for financing has been developed. Although not expected, any sub-projects with major environmental issues (category A) will be subject to prior review by IDA, in accordance with OP 4.01. Appropriate training of loan officers will be carried out during a project launch workshop. The environmental guidelines will be provided to commercial banks when/if they join the project, and their staff will also receive training on environmental screening of sub-loans. 7. Participatory Approach (key stakeholders, how involved, and what they have influenced or may influence; if participatory approach not used, describe why not applicable): a. Primary beneficiaries and other affected groups: Primary Stakeholders: There are three sets of direct beneficiaries of the project: rural borrowers, consisting of individuals and credit groups, and the staff of KAFC. Farmers and rural entrepreneurs who have viable business plans and collateral may apply for loans from KAFC directly. Access to KAFC varies from one oblast to another. The project will increase overall access by establishing offices in rayons that currently do not have offices and by reducing transaction costs by simplifying procedures, providing more direct assistance in the field (e.g. loan application, preparation of simple business plans, etc.) and recovering the cost of making loan disbursements and repayments. Smallfarmers and entrepreneurs theoretically can access KAFC credit by forming Agricultural Consumer Cooperatives (ACCs). In practice, coverage is limited by the existing difficulties in creating groups, documenting resources, providing physical collateral, and so on. Consequently, many institutional constraints limit participation of such potential borrowers in the project, in addition to their other financial and technical constraints. Many prospective and current borrowers have expressed their dissatisfaction with current arrangements, and this was confirmed by the SA. The project has taken a number of important steps to promote the participation of small farmers and entrepreneurs. In addition to the measures described above, the project will provide the following provisions to encourage the participation of potential small-scale borrowers: provide support to create and strengthen credit groups that can obtain loans through social collateral; simplify procedures, documentation and loan requirements to reduce transaction costs; improve access to SFCOP by delivering services at the village level; assist ACCs and S elf-Help Groups (SHGs) to form confederations of credit groups and develop their capacity to serve the interests of member groups directly; and conduct periodic field assessments of borrower satisfaction to enable even remote borrowers to have a voice in the operation of KAFC. KAFC nanagement and staff are also primary stakeholders because they will benefit from the capacity building elements of the project. During project preparation, KAFC staff were consulted individually and in groups to assess their needs, learn from their experience, solicit their ideas and obtain their feedback on various project design issues. During implementation, all KAFC staff will be encouraged to contribute to -22- various capacity building efforts by identifying their constraints and opportunities and developing appropriate training activities to meet their needs. They will also benefit both directly and indirectly from the capacity building components, which will result in increased work effectiveness and satisfaction, as well as increased support and loyalty of clients, who benefit from greatly improved service. If other financial institutions join the project, they will participate in similar ways. Secondary Stakeholders: Government officials at the national and oblast levels participated in designing the project by articulating the needs and special characteristics of their constituents and offering advice regarding lessons learned from KAFC experience to date. They will continue to have roles in project oversight committees throughout implementation. Private and public sector enterprises and financial experts have been consulted to assess the needs of potential clients for business advice and planning as well as credit. Their participation in the project will continue to be based on market demand. b. Other key stakeholders: Other stakeholders: The project has a wide range of other stakeholders including the multilateral and bilateral agencies engaged in rural credit operations, either directly or through NGOs and other institutions of civil society. Their advice and collaboration have been sought during project preparation to learn from experience and to set project parameters in such aspects as credit limits, interest rates, collateral requirements, group creation and support mechanisms and others. These stakeholders consist of collaborators and supporters of KAFC as well as field-level competitors. IDA has encouraged the Government to take an active role in coordinating the efforts of such stakeholders both to reduce the confusion of rural residents and to enforce general principles that aim to ensure the sustainability of investments in rural finance institutions and protect the interests of rural borrowers. It is expected that other new projects and programs designed to promote rural development will emerge over time and they, too, will be brought into mechanisms designed to promote cooperation and mutual learning. During appraisal, a workshop was held in Bishkek that brought together a wide range of stakeholders to discuss the fndings and implications of the SA. The workshop achieved common understandings of the needs of different groups and their roles in project design and implementation. This mechanism not only obtained stakeholder views and promoted ownership but also served as an initial vehicle for disseminating information to the media, local organizations and local authorities. -23- F: Sustainability and Risks 1. Sustainability: The sustainability of the project is closely linked to the sustainability of KAFC, its main executing agency. Although the KAFC is Government owned, it functions on a commercial basis with an independent accounting and internal control system audited by an internationally accredited auditing company. KAFC maintains a quality portfolio through prudent lending operations, reducing overall operating costs while enhancing its revenue earning capacity through active marketing efforts. Interest rates charged by KAFC will cover all costs and risks of lending. The cost of funds to KAFC will start at no less than the rate of inflation and will be adjusted every six months toward market rates. Even at the rate of inflation the difference between the cost of IDA funds and the lending rate to KAFC is more than adequate to cover the Government's administrative costs, a premium for bearing the foreign exchange risk, and contribution to TA and KAFC capitalization. In order to maintain sound portfolio quality, the proposed project will substantially improve KAFC's institutional capacity; KAFC staff will be trained in risk assessment, asset and liability management, financial control, internal control and auditing, etc. One of the project components is designed to strengthen KAFC's capacity which includes installation of commercial bank-compatible MIS system for quality loan data collection, tracking and for timely management decision making. At the sub-project level, financial analysis will confirm the sustainability of each sub-project. Support will also be provided at client level for appropriate and efficient use of inputs, marketing, etc., to enhance the productivity and profitability of each sub-loan. For group lending, special efforts are being made to understand cultural, social and economic barriers and incentives, so that specific technical assistance at the grass-root level can be provided to form groups that share common objectives and goals and be will sustainable. Specific monitoring indicators are being developed to measure the effectiveness of group formation and its sustainability. 2. Critical Risks (reflecting assumptions in the fourth column of Annex 1): Risk i X kRating ;isk Minimizaton Measure From Outputs to Objective Inadequate financial intermediation S Technical assistance and training for capacity in PFIs KAFC to build capacity. This assistance and training to be extended to other PFIs as and when they join the project Government intervention in credit S Continuous Policy dialogue, random decisions review of credit decisions New Government schemes will emerge M Continuous Policy dialogue, IMF to subsidize agriculture or rural program businesses Outreach to groups will remain limited S Targeted support, animation and public awareness campaign, training to improve absorption capacity, sustainability of groups -24- Cultural and Social Conditions in rural S Training and public awareness areas make group formation difficult campaigns that highlight successful credit groups help to demonstrate benefits of group formation Adverse exogenous event negatively S Diversified portfolio in terms of affects the sector profits (e.g. drought, geographic, types of clients and flood, bad weather, etc.) reducing investments across sub-sectors plus clients' ability to repay promotion of off-farm rural economic activities No demand and willingness to pay for S Training and technical assistance business support services provided to assure relevance and quality of business services. Fees to be phased in over time as the services prove their worth From Components to Outputs Credit Line fails to disburse due to: (a) S (a) Training for PFI staff, design of insufficient capacity in PFI's; and, (b) credit line that avoids bureaucracy and Government decisions to reintroduce assures full autonomy in loan appraisal; subsidized credit schemes (b) continued policy dialogue with Government, IMF program High loan default rates S TA and training for improved loan appraisal and risk assessment included Law enacted to ensure PFIs' ability to seize collateral, bankruptcy law enacted Strict supervision and regulations by the National Bank Moral hazard problem of group lending H Clear eligibility criteria for group and related collateral issues under the lending, and succinct loan agreement, Special Credit Line for Group Lending training of loan officers and small-scale potential borrowers; and community level training and stake-holders meetings to enhance group cohesion and incentives KAFC staff and Technical Assistance S Competitive hiring practices and not capable of improving KAFC intensive training for new KAFC staff capacity or fostering adequate both for commercial and group lending formation of credit groups activities, and intensive supervision of consultant selection process and implementation of TA. -25- Overall Risk Rating S Regular supervision, low prior-review threshold for sub-loans, institutional capacity building, focused support at client level Risk Rating - H (High Risk), S (Substantial Risk), M (Modest Risk), N(Negligible or Low Risk) 3. Possible Controversial Aspects None. G: Main Loan Conditions 1. Effectiveness Condition * Signing of a Subsidiary Loan Agreement between KAFC and MOF 2. Other [classify according to covenant types used in the Legal Agreements.] Negotiations Conditions: All negotiation conditions have been satisfied: * GOK has provided its financing commitment for RFP II financing for priority TA for a total of US$1 million equivalent * GOK has submitted to IDA its agreement on: (a) the on-lending terms to KAFC including the GOK's capital contribution of 15 percent of each withdrawal and periodic adjustment of the on-lending rate toward the market rate; and (b) GOK assuming the foreign exchange risks of the IDA credit * GOK has submitted a detailed project implementation plan (PIP) with a clearly defined implementation schedule for each project component, including TA * GOK has prepared specific performance indicators to be included in the semi-annual progress reports to be submitted to IDA Board Conditions: None Disbursement Conditions for the Credit Line: * Completion of KAFC's operational manual acceptable to IDA * Completion of the first round of new training programs for lending staff * Completion of technical evaluation of the IT/MIS system and preparation of a timetable, acceptable to IDA, that indicates the timing of MIS installation, staff training, and full transfer of the current accounting information into the new system Audits and Accounts: * Standard auditing covenants will apply * The Borrower will open and properly maintain a Special Account -26- Project Management: * The Borrower shall maintain project management capacity in KAFC with adequate funding and staffing Monitoring, Evaluation and Reporting: * Standard reporting covenants will apply * To ensure adequate planning of project activities, KAFC will no later than January 30 of each year prepare and furnish to IDA for review and approval an annual work program that includes targets for implementation of each component, an assessment of technical assistance requirements and training to be undertaken during the reporting period * An in-depth Mid-Term Review will be undertaken by December 2001 or when the disbursement of the credit line reaches 50 percent, whichever is earlier H. Readiness for Implementation El 1. a) The engineering design documents for the first year's activities are complete and ready for the start of project implementation. 1 1. b) Not applicable. l 2. The procurement documents for the first year's activities are complete and ready for the start of project implementation. El 3. The Project Implementation Plan has been appraised and found to be realistic and of satisfactory quality. El 4. The following items are lacking and are discussed under loan conditions (Section G): A set of conditions of disbursement of the Credit lines have been discussed and agreed with the GOK. 1. Compliance with Bank Policies 0 1. This project complies with all applicable Bank policies. L 2. The following exceptions to Bank policies are recommended for approval. The project complies with all other applicable Bank policies. Hoonae Kim Kevin M. Cleaver Kiyoshi Kodera Team Leader Sector Manager/Director Country Manager/Director -27- Annex 1: Project Design Summary KYRGYZ REPUBLIC: Rural Finance II Sector-related CAS Goal: Sector Indicators: Sector/ country reports: (from Goal to Bank Mission) 1. Attain sustained growth 1. Increased in agricultural 1. Sales statistics on land, Agriculture will remain a with priority in agriculture GDP and its contribution to commodities, and inputs, priority in terms of its total and the revitalization of the overall economy verified during annual review contribution to GDP and agro-industry of IBRD/IDA lending and employment non-lending activities and CPPR exercise 2. Develop private sector 2. Improvement in production 2. Farm production efficiency Government will remain activities; and efficiency, productivity (cost structure and yields) committed to continue policy reforms 3. Reduce poverty 3. Growth in rural income 3. Income statistics, rural and increases in employment employment statistics opportunities Project Development Outcome I Impact Project reports: (from Objective to Goal) Objective: Indicators: 1. To establish a sustainable 1. Sustainable fmancial 1. Monitoring and progress Central and local govermnents rural finance system position of financial reporting by participating are committed to supporting intermediaries with sound financial institutions including comprehensive rural portfolio and high repayment performance records of development and banking rates; increased access for participating rural bank sector reforms rural people to commercial branches banking, credit unions, etc., in rural areas; increased lending 2. Estimation of Subsidy (in volume and number) to Dependence Index (SDI) to small-scale borrowers; and monitor reduction of implicit participation of commercial subsidies banks in agricultural lending 2. To reduce poverty 2. Increased income levels and 2. PMU semi-annual progress Rural people are committed to reduction in proportion of reports, audit reports, and improving their conditions; people living in poverty ex-post random sampling and adequate management analysis of sub-loans made capacity in agricultural enterprises exists or can be developed 3. Statistics on rural income, The incentive structure employment; periodic survey - (prices, markets) is conducive to be agreed with the GOK to innovation and new investment by private entrepreneurs -28- Output from each Output Indicators: Project reports: (from Outputs to Objective) component: 1. Financially sustainable 1. A number of commercial Implementation as monitored No major shift in financial institutions in rural banks involved in lending to by PFIs goverrnent's agricultural areas including commercial agricultural and rural sectors policies particularly on banks with demonstrated subsidized credit for increased lending in rural agriculture areas exogenous shocks to sector profits (such as adverse weather) are manageable 2. Availability of 2. Sound portfolio with Implementation as monitored Adequate financial financial/banking services to repayment ratio above 85% at by PMU intermediation capacity exists rural people in terms of: positive real interest rates - in PFIs lending to small-scale clients; this is an increase from the and increased awareness of 75% required in the first rural people about commercial project. In reality, the opportunities repayment rate is likely to be higher 3. Improved portfolio quality 3. Sound portfolio with Successful utilization of credit No Government intervention of KAFC independent audit and line, and evaluation of in lending decisions made by portfolio review savings accounts and loan KAFC portfolio of participating rural A large number of borrowers fnance institutions (representing at least 25% of registered private farmers) with a diversified loan portfolio in terms of loan sizes and types 4. Provision of support for 4. Formation of groups and A number of groups being Cultural and social behavior group formation and lending to groups based on formed and sustained - patterns conducive to group introduction of social social collateral measured by repeated formation, trust and collateral borrowing by the same group sustainability. Progress report by KAFC on a Outreach to foster group range of accepted collateral formation is effective 5. Availability of quality 5. Registered NGOs and Progress report by PMU Adequate demand for support business support services in consulting groups providing services and ability to pay for rural areas support services to private the services entrepreneurs -29- Projeot Components I Inputs: (budget for each Project reports: (from Components to Sub-components: component) Outputs) 1. 1. Credit lines through US$16.1 million equivalent, Quarterly disbursement PFIs have capacity to handle KAFC and through (IDA US$11 million) reports for each component anticipated credit demand and commercial banks (in future) government maintains for private farmers and Semi-annual progress report commitment not to entrepreneurs reintroduce subsidized credit Audit reports to the agricultural sector Repayment performance of commercial credit line improves 1.2. Special Credit line for US$4.3 million (IDA $3 Repayment performance of Small-Farmers Credit million) group loans not affected by Outreach Program moral hazard problems in group lending 2.1. TA for KAFC capacity US$2.0 million (IDA US$0.5 Ability to recruit competent building (and in future, for million) staff in KAFC and quality commercial banks) consulting support 2.2. TA for introducing social US$0.3 million (IDA US$0.3 Ability to recruit competent collateral system and million) local staff and quality formation of groups for consulting support sustainable borrowing 2.3. TA for establishing rural US$0.2 million (IDA US$0.2 Ability to recruit competent SME business development million) local staff and quality support services consulting support -30- Annex 2: Project Description KYRGYZ REPUBLIC: Rural Finance II The Project Objectives. The Government has reiterated that the main objectives to be achieved under RFP II are: (a) to further develop a sustainable rural financial system that will serve a broad range of the rural population including small-scale rural entrepreneurs and farmers; and (b) to reduce poverty in rural areas by providing opportunities to access credit to those who do not have adequate physical collateral but have proposals for viable economic activities. In order to achieve these objectives, the project will focus on strengthening KAFC's capacity for rural lending through training and technical assistance (TA), and stimulating the flow of commercial credit to rural areas. Specific TA will also be provided to develop local capacity in group formation. RFP II will be implemented over a five-year period and will build on the lessons learned from the first project by expanding and deepening KAFC's activities to date, and expanding the scope of the institutional development component. These changes will help increase the amount of financing for the rural population and assist the government in its effort to support the rural poor. The Project will have two main components. tts~~~i A. CREDIT LIN 20.40 89.0 14.00 69.0 COMPONENT A. I Commercial Credit Line AC - Agricultural 16.10 70.3 11.00 73.3 Credit A.2 Special Credit Line AC - Agricultural 4.30 18.8 3.00 20.0 (SFCOP) Credit B. INSTITUTIONAL 2.50 11.0 1.00 40.0 DEVELOPMENT COMPONENT B. 1 Strengthening of KAFC FS - Financial 2.00 8.7 0.50 3.3 capacity in loan appraisal, risk Sector management, etc. Development B.2 Other TA 0.50 2.0 0.50 100 --Support for group formation SY - Other Social 0.30 1.3 0.30 2.0 and group lending based on Sector social collateral --Support for small-scale IL - Small Scale 0.20 0.9 0.20 1.3 rural business development Enterprises ___ Total Project Costs 22.90 100.0 15.00 100.0 Total Financing Required 22.90 100.0 15.00 100.0 By Component: Project Component I - US$20.4 million The Rural Finance Component will have two sub-components: -31- (a) A Commercial Credit line to KAFC to be on-lent to commercial clients based on full collateral (Sub-component cost -- US$16.1 million) This sub-component will provide a credit line to KAFC (and other commercial banks when they become eligible) to on-lend for working capital and investment under commercial terms and conditions. On-lending will be at rates that will progressively approach market rates and will start at no less than inflation plus a margin for KAFC that covers all administrative costs, the cost of provisioning, and a risk premium relevant for each borrower. Anticipated sub-projects would include, among others: on-farm investment for development of agricultural production, including the provision of seasonal working capital as appropriate; investment for development of processing, storage, packing, marketing, and other off-farm agri-business and service sectors; and other rural income-generating activities that have proven positive cash-flows supported by sound business plans. Intended ultimate beneficiaries for the regular credit line are those who have commercially viable and bankable projects with adequate collateral, adequate financial rates of return, and demonstrated repayment capacity. Borrowers will have to meet strict eligibility requirements related to their ownership, share holding, and management. There will be a system of prior review to assure that eligibility criteria are enforced; KAFC and other eventual PFIs will be required to submit the first three sub-loans and any sub-loan greater than US$200,000 equivalent for IDA's prior review. KAFC (and in future other participating financial institutions) will maintain full autonomy in the selection of borrowers, approval of sub-projects, and determination of lending terms, and will bear all of the lending risks. Reference Rates for On-lending: There are no clearly established and accepted market reference rates for KAFC's operation. Commercial banks are not extending small loans to farmers. The loans that they do extend are very limited with terms no longer than 3-6 months, and there are no long term deposits. Therefore, it will be a challenge to determine the appropriate market rates relevant to KAFC and its clients. The project will start with the cost of funding to KAFC at no less than the rate of inflation. This rate will be adjusted every six months to progressively approach the opportunity cost of capital. KAFC's interest rates to ultirnate borrowers will be floating, based on the cost of funding to KAFC, administration costs, and a risk premium which will adequately cover loan loss provision. The Government will also subscribe in KAFC's share capital to ensure that KAFC can maintain the capital adequacy ratio required by the prudential rules set by NBK. It was agreed during negotiations that the similar practices to those employed under RFP I will be maintained, i.e. 15 percent of each withdrawal made for sub-loans be will registered as GOK's share in KAFC. IDA funds earmarked for technical assistance and for the GOK share capital in KAFC will not be on-lent. As agreed under the RFP I, KAFC is eventually to be privatized, and this remains an institutional objective under RFP II. The timing of the privatization process will depend, however, on how quickly the current regional financial crisis is resolved and on the ability of the private financial sector in the Kyrgyi Republic to invest in KAFC and take over its functions and portfolio. The appropriate timing for KAFC privatization will also be closely linked to the capacity and willingness of the commercial banks to lend to small-scale enterprises, including farmers. A plan for KAFC privatization will be developed during the Mid-Term Review, which will take place when disbursement from the credit line reaches 50 percent, or around December 2001, whichever is earlier. Future Role of Commercial Banks. Commercial banks are expected to play a key role in the future in providing financial intermediation services for rural areas. However, in recent months commercial banks have experienced difficulties due to the external and domestic shocks buffeting the economy. They, therefore, have been unprepared to venture into new lending activities in the rural sector without the proper tools and experience. The timing is not right at present for the participation of -32- commercial banks. It was therefore agreed that KAFC would be the sole participating intermediary until the Mid-Term Review, at which time commercial bank participation will be considered. In this regard, the NBK will closely monitor the actual performance of the commercial banks in the other IDA-supported credit line under the PESP, before encouraging them to engage in agricultural credit. To ensure that KAFC sustains its positive track record and remains sound in the face of the present regional financial sector problems, the Government has requested that the project focus first on strengthening the institutional and human capacity of KAFC. Once the banking sector stabilizes and commercial banks express interest in participating in the project, specific arrangements will be made to assess their eligibility to participate. Subsidiary Loan Agreements will be concluded with the newly qualified PFIs according to the prevailing terms and conditions for all IDA credit lines. These eligibility criteria will include full compliance with NBK's regulations, sufficient capital adequacy, sound financial policies, and institutional capacity with professional staff adequately trained and specialized in medium- and long-term lending for investments and a sufficient network of branches in rural areas (b) Special Credit Line for Small-Farmers Credit Outreach Program (Sub-component cost - US$4.3 million) This sub-component will provide credit for group lending based on "social collateral" to allow those with inadequate physical collateral but with sound bankable projects to receive loans. Group lending relies on peer pressure to guarantee repayment. Currently, KAFC is implementing two different group-lending schemes under different terms and conditions. Under this sub-component, these schemes will be consolidated, and improved implementation modalities will be introduced. Project Component 2 - US$2.5 million Institutional Development Component will have three sub-components: 1. Institutional capacity building supportfor PFIs (Sub-comnponent cost - US$2.0 million.) This sub-component will support comprehensive capacity building in KAFC to improve its operating efficiency and ensure that it can survive as a self-sustaining financial intermediary. This effort will include: (a) improving KAFC's capacity in loan appraisal; financial, asset, and liability management; accounting and internal audit and control; and other areas covering the full spectrum of KAFC's operations as well as personnel management and training of staff; (b) simplifying loan processing procedures and streamlining legal and documentary requirements for loan processing; (c) upgrading KAFC's management information system (MIS); (d) adopting a corporate governance and supervisory structure that would give KAFC full autonomy in its lending activities; and (e) developing medium-term corporate strategies and business plahs with financial projection. In addition, legal advice will be provided regarding the introduction of moveable property and fixed-assets as collateral, streamlining current legal clearances for loan processing, etc. KAFC will also receive practical training in assessing the markets for various products that it may finance. Completion of KAFC 's lending manual acceptable to IDA, completion of thefirst round of new training programs for lending staff, andfinal selection of the IT/MIS system will be conditions of disbursement of the credit line component. Other eligible PFIs, in the future, will also receive similar training. Recognizing that a lack of transportation is one of the key constraints faced by the rural population, RFP II will establish mobile credit officers to implement both A. 1 and A.2 credit lines. This innovation has proved to be the keystone of other rural finance projects supported by the Bank/IDA. Approximately ten vehicles will be included in the project financing for this purpose. -33- 2. TA and training to developing group lending, based on social collateral (US$0.3 million) will be provided to enable the project to reach a wide spectrum of rural people, including those near and below the poverty line. Specific assistance will be provided for group formation and to enhance group sustainability. This component will be designed to empower local groups to successfully deal with financial issues related to obtaining and using credit, as well as to obtain technical information and support needed to become profitable farmers and entrepreneurs. To minimize duplicative initiatives, this sub-component will be coordinated with other on-going TA, including the UNDP-supported Poverty Alleviation Project which provides support for group formation at village level and the group development activities of the Rural Advisory and Development Service (RADS) recently established under the Agricultural Support Services Project (ASSP) with funding from IFAD, IDA, and the Swiss Government. The project will also explore the opportunity to work with other existing agencies, e.g. NGOs and other donor-funded agencies, that are already active in the rural areas to provide group formation support. The main emphasis will be given to training local trainers and establishing local agencies for the sustainability of this type of support. 3. Development of small-scale rural business development services (US$0.2 nillion). TA will be provided to establish institutional capacity to promote small-scale economic activities in the rural areas through the dissemination of information on (a) the availability of credit and terms and conditions of borrowing, (b) preparation of loan applications and supporting documents, (c) marketing, (d) opportunities for training, and (e) other private sector development support services in rural areas. Ultimately this support would lead to the development of bankable projects that can be financed through the credit line component and increase credit flow to rural areas. There will be partial cost recovery for these services through fees based on the client income levels. Other costs would be covered by the Borrower or donor grants. Potential partners include SME development centers, Rural Advisory and Development Centers (supported under ASSP), NGOs, and other donor supported private agencies. ELIGIBILITY CRITERIA FOR PARTICIPATING FINANCIAL INSTITUTIONS (PFI) 1. In order to be a PFI, banks and other financial institutions, must at all times meet a set of financial and management criteria and have signed a Subsidiary Loan Agreement. Potential PFIs are individually appraised by NBK jointly with IDA, with particular attention given to their overall lending capabilities, and fmancial and loan-portfolio performance. The evaluation process focuses on: (a) capital adequacy; (b) asset quality; (c) management effectiveness; (d) earning performance; and (e) liquidity. 2. For participation in the project, a potential PFI will be required to meet the following criteria, namely that such institutions have: (a) a valid banking license and in compliance with all banking laws and regulations of the Kyrgyz Republic including the regulatory and reserve requirements of the National Bank of the Kyrgyz Republic (NBK) - an exception applies for KAFC as it is not a bank; (b) an audit report acceptable to IDA covering the most recent full year of operations, including a portfolio review, prepared by an internationally recognized auditing firm in accordance with International Standards of Auditing (ISA); (c) a satisfactory management and financial structure, determined, inter alia, on the basis of satisfactory risk-based capital adequacy, satisfactory asset quality and lending performance; satisfactory liquidity position; and has the organization, management, technical staff and other resources required for the efficient execution of its operations, including an adequate network of -34- branch offices in the rural areas; (d) a sound business plan and appropriate budgeting and budget control procedures; (e) sound lending policies and procedures, and satisfactory internal control and audit procedures and the capacity for its internal reporting and management information systems provide sufficient information necessary for managing its operations, performance and risks; (f) adequate governing bodies (Council, Board etc.) which set overall bank policy and perform appropriate oversight over the bank's operations; and (g) an expressed interest and experience in lending to the agricultural and rural sectors. PRINCIPAL TERMS AND CONDITIONS OF THE SUBSIDIARY LOAN AGREEMENT 3. Principal Amount. The principal amount of the Subsidiary Loan which shall be due and repayable by a PFI shall be in SOM, determined on each date of withdrawal, of the aggregate amount of withdrawals made by the PFI from the Credit Line. 4. Interest Rate and Repavment Terms. The Subsidiary Loan shall be charged, on the principal amount thereof, withdrawn and outstanding from time to time, a variable (floating) interest rate equivalent to the annual inflation rate (consumer price index) published by the National Bureau of Statistics. During each year the interest payable will be based on the inflation rate projected by NBK and any differences between the projected and actual rate will be payable no later than 30 days after the actual rate has been officially announced. Any overpayments will be adjusted and deducted from the first interest payment payable on the Subsidiary Loan in each financial year. The on-lending rate to KAFC will be adjusted every six months to progressively approach the opportunity cost of capital. 5. The principal amount of the Subsidiary Loan shall be repaid by PFIs over a period of 15 years, inclusive of a grace period not exceeding 3 years. Any amount repaid by sub-borrowers on account of sub-loans made under the project, which is not immediately needed for repayment of the subsidiary loan to MOF, will be kept by PFIs in a separate "roll-over" account. The funds accumulating in the "roll-over" account should be utilized by PFIs to finance additional sub-projects aimed at pursuing the objectives of the Project, and which conform to the agreed terms, conditions and eligibility criteria for the Project, as detailed in the Subsidiary Loan Agreement and the Rural Credit Guidelines (RCG). 6. Maximum Financing Rate (declining percentage). The maximum amount to be made available by the Borrower to each PFI from the proceeds of the Credit line will be equivalent to 100 percent of eligible sub-loans disbursed by each PFI before June 30, 2001, and 80 percent thereafter. 7. Sub-loan Limits. Total cumulative outstanding sub-loans to any beneficiary financed from the Second Rural Finance Project credit facility and the credit facility under the first Rural Finance Project combined should not exceed US$500,000 equivalent. 8. Portfolio Limits. In each PFI the composition of the total outstanding balance of sub-loans financed from the credit facility should be comprised of no more than 20 percent of loans for working capital and no less than 80 percent of loans for financing investments. Compliance will be reviewed at the -35- end of each financial year (December 31) by MOF and IDA. ELIGIBILITY CRITERIA, APPROVAL PROCEDURES PRINCIPAL TERMS AND GENERAL CONDITIONS OF SUB-LOANS A. Commercial Credit Line 9. This sub-component will fnance regular sub-loans for investment and working capital at prevailing market interest rates and commercial terms with customary collateral, as determined by PFI. 10. Eligibility Criteria for Sub-projects. In order to achieve project objectives, eligible sub-projects will include: (a) on-farm investments for development of agricultural and livestock production, including the provision of seasonal working capital, as appropriate; (b) investments (including working capital) for development of agro-processing, storage, marketing and other related agricultural service sub-sectors; (c) investments (including working capital) in any other economic activity in the rural areas, including industrial, commercial, tourism, handicrafts, etc. enterprises, provided that the potential sub-projects are supported by sound business plans and can demonstrate satisfactory cash-flows and loan repayment capacity. 11. The purchase or lease of land, dwelling construction or improvement, or the refinancing of any existing debts will not be eligible for financing from the Credit Line. 12. PFIs, when evaluating sub-project proposals for off-farm economic activities in the rural areas, should accord priority to sub-projects that are expected to generate additional employment opportunities and to proposals that include "innovative" ideas to utilize locally available raw materials. 13. Eligible Beneficiaries. Eligible beneficiaries will include farmers, small- and medium-scale (SME) agricultural processing, marketing and service enterprises, operating as individuals, joint stock companies, farmers' associations, cooperatives or partnerships, and any other private SMEs or entrepreneurs engaged in economic activities in the rural areas. 14. Criteria for Selection and Appraisal of Sub-projects. PFIs are responsible for identifying prospective sub-borrowers and for determining the type of sub-project to be financed, and for following the eligibility criteria for investments and sub-loan beneficiaries described in the Subsidiary Loan Agreements and RCG. Except as indicated below regarding free-limit sub-loans, PFIs will have full autonomy in sub-loan approval and will bear the lending risks. Sub-loans shall be for sub-projects, selected by PFIs on the basis of detailed feasibility studies and careful appraisal by the PFI, will, inter alia, cover the following: (a) verification that sub-projects are technically feasible and economically, fnancially and commercially viable, and designed with appropriate health, safety and environmental standards, in full compliance with all laws and regulations of the Kyrgyz Republic; (b) the economic justification of the proposed investment, including an assessment of the -36- competitiveness of the end-product compared to imports; (c) an evaluation of the proposed scale of the sub-project, the need and adequacy of the civil works and equipment to be procured, the location of the enterprise, its layout and design, and the estimated costs in domestic and foreign currencies, and an assessment of compliance with pollution control and other environment laws, regulations and guidelines set by the local and/or national authorities; (d) an evaluation of the borrower's ownership structure, creditworthiness, organization, management and financial position, and an evaluation of the technical staff and know-how available for implementing the sub-project and its operations; and (e) confirmation that the proposed sub-project meets all environmental laws and standards in force in Kyrgyz Republic and that no safety hazards or environmental deterioration will result, directly or indirectly, from the investment sub-project to be financed from the Credit Line under the Project. 15. Simplified appraisal procedures could be applied to sub-projects with an estimated cost not exceeding US$ 50,000 equivalent for machinery and equipment, or for modernization, rehabilitation or small expansion of existing enterprises. Such procedures include, as applicable: (a) review and assessment of the viability and financial soundness of the potential borrowing enterprise and its capacity to service the sub-loan; and (b) the technical verification that the equipment, materials, spare parts, etc. to be procured are appropriate and are intended to be used in the existing production process to alleviate any existing production bottlenecks, increase efficiency of the existing process, or contribute to improving quality and meet higher product standards. 16. Sub-borrowers' Participation. Sub-borrowers should be required to make the following contributions from their own resources towards sub-project costs: no less than 10 percent in cash or in kind for individual farmers and small-scale rural entrepreneurs (excluding sub-loans financed under the Group Credit outreach program), and no less than 20 percent in cash or in kind for all other types of sub-borrowers. For new investment sub-projects, the self-contribution, in cash or in kind, will be no less than 30 percent of total sub-project cost. 17. Repayment Terms and Interest Rates of Sub-loans. Repayment schedules of sub-loans financed under the Credit Line will have terms of up to 12 years, inclusive of grace periods of up to 3 years. Grace and amortization periods will be based on the type of investment financed and the projected (estimated) cash flow and will be commensurate with the repayment capacity of the borrower. However, in no case will repayment periods exceed the useful life of the investment financed. In this connection it should be noted that appraisal projections made by PFI should demonstrate a debt service coverage ratio of at least 1.5 over the life of the sub-loan, calculated on the basis of borrower's total debts. 18. PFIs should charge interest on the principal amounts of sub-loans outstanding from time to time at the prevailing interest rate under the Subsidiary Loan Agreement (cost of funds from the Credit Line based on the variable (floating interest rate) plus a market -based spread determined by the PFI based in each case on PFI's risk assessment of the sub-project financed, PFI's lending costs (administrative expenditures) and other banking considerations. 19. Currency of Sub-loans. All sub-loans financed from the Credit Line will be denominated and -37- repayable in domestic currency (Som). 20. Eligible Area. All sub-projects eligible for financing from the Credit Line must be located outside the official municipal boundaries of the following major cities of the Kyrgyz Republic: Bishkek, Osh, Tokmok and Jalal-Abad. 21. Approval Procedures for Sub-loans above the Free-limit. Each PFI will be required to submit to IDA the first three sub-project proposals irrespective of the amount of the proposed sub-loan and any sub-loan proposal in an amount exceeding US$200,000 equivalent (or any sub-loan proposal which exceeds US$200,000 when added to the outstanding balance of sub-loans fnanced from the Credit Line under this Project and under the first Rural Finance Project). For that purpose, PFIs will furnish to IDA an application, which will include (a) a description of the prospective borrower including financial information, (b) information on the appraisal of the sub-project, including a detailed description with cost estimates of the expenditures proposed to be financed out of the proceeds of the Credit Line, (c) the proposed terms and conditions of the sub-loan, (d) the Procurement Plan and Environmental Assessment, and (e) any other information that the PFI considers useful for the review of the sub-project proposal. 22. Accounts and Record-keeping. PFIs will establish in their accounting systems appropriate accounting codes to permit identification of sub-loans made under the project, including those fnanced from the "roll-over" account. PFIs will retain, until at least one year after IDA has received the audit report for the fiscal year in which the last withdrawal from the Credit Line account was made, all records pertaining to the subsidiary loan and the sub-loans made by each PFI, including accounts, contracts, orders, invoices, bills, receipts and any other documents evidencing sub-loan expenditures. 23. General Conditions Applicable to all Sub-loans. All sub-loan agreements signed between the PFI and the sub-borrower, shall include, inter alia, the following provisions to protect the PFIs' interests and those of the Kyrgyz Republic and IDA. Sub-borrowers shall be required to: (a) carry out the sub-project with due diligence and efficiency and in conformity with appropriate technical, economical, financial , environmental and commercial practices, to maintain adequate records and to provide, promptly as needed, the funds, facilities and other resources required for the purpose; (b) procure the goods and works to be financed out of the proceeds of the sub-loan in accordance with instructions of the PFI in compliance with World Bank/IDA Procurement Guidelines, and use such goods and works exclusively in the carrying out of the sub-project; (c) permit the PFI's authorized representatives, by themselves or jointly with representatives of IDA, to inspect the goods and the sites, works, plants and construction included in the sub-project, the operation thereof and any relevant documents, accounts and records; (d) take out and maintain such insurance, against such risks and in such amounts, as shall be consistent with sound business practices, including such insurance to cover hazards incident to the acquisition, transportation and delivery of goods financed out of the proceeds of the sub-loan to the place of use or installation, any indemnity thereunder to be made payable in a currency freely usable by the sub-borrower to replace or repair such goods; (e) provide the PFI or IDA with such infonnation, as shall be reasonable to request, relating to the foregoing and to the administration, operation, and financial condition of the sub-borrower's -38- enterprise and to the benefits to be derived from the sub-project; and (f) recognize that the PFI shall preserve its right to tenninate the right of the sub-borrower to the use of the proceeds of the sub-loan upon failure by the sub-borrower to perform its obligations under sub-loan agreement with the PFI. Sub-Component B - Special Credit Line for Group-Lending 24. Sub-loans will be made to groups of beneficiaries selected according to the following eligibility criteria: (a) Minimum number of members: 5 (b) Minimum age of member: 18 years (c) All members must live in the same village (d) Members must be free of debt (e) Members should have similar household income (plus/minus 25 percent of members' average income) (f) Members should have prior experience in the field of economic activity for which the loan is sought (g) Members should establish a savings fund into which individuals contribute the same monthly amount. The first two months of savings are placed into a Joint Guarantee Fund. To become eligible for a second loan, the group members must continue monthly savings (h) Members must each contribute to a Joint Guarantee Fund. Each member shall contribute the same amount, which will determine the maximum loan amount available to individual members: Loan Range Required Guarantee Amount per Member l to5,000 3% 150 5,001 to 10,000 5% 500 10,001 to 20,000 7% 1,400 25. Collateral. Loans will be secured by social collateral - i.e. joint/mutual guarantee by group members. Beneficiaries will not be required to provide physical collateral - i.e. pledges of assets. 26. Repayment Terms and Interest Rates. Repayment terms for short-term loans will not exceed 18 months. Repayment of medium-term loans financing investments will be up to three years, including a grace period not exceeding one year. PFIs should charge interest at the rates prescribed for the commercial credit line. 27. Sub-loan Limit. The maximum amount of a loan to an individual member of a group shall not exceed Som 20,000. The maximum amount of a sub-loan to a group shall not exceed Som 500,000; in case a group has an outstanding balance of an earlier sub-loan, the limits indicated in this paragraph shall apply to the cumulative outstanding balance of sub-loans. 28. Members'/Beneficiarv Contribution. Group members shall be required. to contribute from their -39- own resources, in cash or in kind, no less than 10 percent of sub-project cost. 29. General. Provisions detailed in the Rural Credit Guidelines and relating to procurement, compliance with environmental standards, location of sub-projects, criteria for selection of sub-projects, and the general conditions application to all sub-loans, shall equally apply to all sub-loans financed under sub-component B. -40- Annex 3: Estimated Project Costs KYRGYZ REPUBLIC: Rural Finance 11 .'~~~~~ a i.''.iM''g.=m 21W A - CREDIT LINE COMPONENT 0.0 0.0 0.0 A. 1 - Commercial Credit Line 7.8 8.3 16.1 A.2 - Small Farmers Outreach Program 3.3 1.0 4.3 B. - INSTITUTIONAL DEVELOPMENT COMPONENT 0.0 0.0 0.0 B. I - Strengthening of KAFC's capactity in loan appraisal, 1.5 0.5 2.0 risk management, etc B.2a - Support for group formation and group lending based 0.2 0.1 0.3 on social collateral B.2b - Support for small-scale rural business development 0.1 0.1 0.2 Total Baseline Cost 12.9 10.0 22.9 Physical Contingencies 0.0 0.0 0.0 Price Contingencies 0.0 0.0 0.0 Total Project Costs 12.9 10.0 22.9 Total Financing Required 12.9 10.0 22.9 -41- Annex 4 KYRGYZ REPUBLIC: Rural Finance 11 Financial Analysis of Farm Models Introduction: Several farm studies, including the Farm Profitability Assessment Study prepared by a TA team funded by a donor, and a random sample analysis of actual investment carried under RFP I, indicate that the Kyrgyz Republic has comparative advantage in the production of its major commodities. These include, wheat, maize, barley, other fodder crop such as Alfalfa, cotton, and livestock products such as wool, meat, and dairy cattle. Although farmgate prices for most of these commodities are still well below international parity prices, farmers' profitability in the production of these commodities has been generally improving. Mixed farming of crop and livestock production is a common pattern, except in mountainous areas where sheep farming is most predominant. Mixed farming system provides farmers reasonable risk diversification, balanced cash flow, and flexibility in responding to changes in market signals. No attempt was made to derive overall financial rate of return and net present value for the project as it is a demand driven credit line and it is not possible to foresee in advance what types of farm and off-farm projects will be financed under the project. However, in order to illustrate the financial impact of those entities receiving credit, six models were developed. The "without" situation is represented by the current production structure, yields and costs of selected farms which face credit shortage. The "with" situation stipulates farmers' having access to credit, and be able to procure modern inputs, and other productive modes, with which, increases in yields and cost efficiency can be achieved Six Representative Models: These six farm and enterprise models analyzed are typical agricultural activities in the Kyrgyz Republic. They are: Farm 1: A large mixed crop farm investing in the rehabilitation of on-farm irrigation systems; Farm 2: A mid-size wheat farm increasing sown area by buying a new tractor; Farm 3: A mid-size mixed crop farm changing cropping pattern towards more profitable crop by buying a new tractor; Farm 4: A mid-size wheat farm saving on hired harvesting services by buying a new tow harvester; * Farm 5: A dairy farm increasing its herd by building a new shed and purchasing extra animals; Model 6: A construction of a new slaughterhouse. Assumptions: The underlying crop/livestock budgets are presented in Table 1. The analysis is based on the constant 1998 farm-gate prices. Financing is assumed at 15 percent annual rate for 10 years with 20 percent self-financing. Results of the Analysis The detailed financial models for each farm are available in the project file and are summarized in Table 2. All models show profitable investments with NPVs ran!gigfrom Som 18, 192 to Som 30,869,334 and IRRs -- from 14 to 37 percent. The Table alsoThcontains sensitivity analysis based on switching values for the major inflow and outflow items. The models are rather resilient to changes in revenue/cost estimates with the exception for the two models with tractor purchase. It is evident that the project, through combination of making credit available to various private -42- farms, and support for small-business development, and other TA, would lead to substantial improvements in farm profitability. The FRRs are particularly sensitive to increase in both inputs and product prices. The switching value analysis shows that costs and reduction of revenues have to be substantial before each sub-project becomes financially unsustainable. Kyrgyz Republic RFP II Table 1: Crop/Livestock Budgets With project - Benefit and Cost Analysis Winter Maize Dairy (Per ha) Unit Wheat Barley Silage Alfalfa Sunarbeet (Per 50 heads) Farm FINANCIAL BUDGET Revenue Sub-total Revenue Som 5,640 4,923 6,092 2.675 16,614 Milk 506,000 Input costs calves 40,675 Seeds Som 618 633 390 22 1,833 culls 60,754 Urea Som 180 180 390 36 360 Sub-total 607.430 Revenue Water Som 30 30 60 30 60 Input costs Harvesting Som 1,172 1,250 1,180 643 5.400 Replaceme 151,163 nts Transport Sam 171 183 217 114 2,311 Concentrat 32,040 es Taxes and social Som 762 762 762 762 762 Salt 1,050 security Overheads Som 194 332 223 97 1,031 Medicines 778 Sub-total Input Som 3,128 3,370 3,222 1,704 11,757 Inseminatio 6,000 costs n Income (Before Som 2,512 1,552 2,870 970 4,856 Silage 23,904 Labor Costs) Labor costs Hay 77,750 Labor Som 240 300 380 140 4,120 Labor&ss 50,000 Income (After Som 2.272 1,252 2,490 830 736 Fuel 40,000 Labor Costs) Sub-total 382,685 costs Income 224.744 YIELDS AND (After Labor INPUTS Costs) Main Production Output Kg 2,564 2,735 16,900 2,140 23,600 Main Production Operating Milk I 100.000 Inputs Calves ko 1,179 Seeds Kg 206 211 50 n.a. 10 Culls ka 1,761 Urea Kg 60 60 130 12 120 Operating Inputs Water # of 2 2 4 2 4 Concentrat cn 178 irrigation es Labor Manday 12 15 19 7 206 Salt cn 5 Silage cn 664 PRICES Hay cn 622 Output Som/kg 2.2 1.8 0.360 1.250 0.704 PRICES Operating Milk I 5.06 Inputs Calves ka 34.5 (meat) Seeds Som/kg 3.0 3.0 7.8 n.a. 183 Culls ka 34.5 (meat) -43- Kyrgyz Republic RFP II Table 1:Crop/Livestock Budgets(Contd.) Urea Som/kg 3 3 3 3 3 Concentrat cn 180 as Water Som/irriga 15 15 15 15 15 Salt cn 210 -tion Labor Som/man- 20 20 20 20 20 Silage cn 36 day Hay cn 125 44- Kyrgyz Republic RFP II Table 2:Financial indicators and switching values (before financing) Appraisal Percent (In Local) Value Switchinq Value Change Model 1: Irrigation IRR = 27%, NPV = 1,385,423 Incremental inflows 3,454,389 1,999,472 -42.1 Incremental outflows Investment costs 1,196,428 2,651,345 121.6 Operating costs 645,512 2,100,430 225.4 Other Costs 157,531 1,612,448 923.6 Total outflows 1,999,472 3,454,389 72.8 Model 2: Tractor (A) IRR = 14%, NPV = 18,191 Incremental inflows 1,553,811 1,400,949 -9.8 Incremental outflows Investment costs 446,428 599,290 34.2 Operating costs 954,520 1,107,382 16.0 Total oufflows 1,400,949 1,553,811 10.9 Model 3: Tractor (B) IRR = 18%, NPV = 27,377 Incremental inflows 889,977 789,690 -11.3 Incremental outflows Investment costs 446,428 546,716 22.5 Operating costs 343,261 443,549 29.2 Total outflows 789,690 990,265 923.6 Model 4: Harvester IRR = 19%, NPV = 260,929 Incremental inflows - 234,174 - Incremental oufflows Investment costs 200,892 435,067 116.6 Operating costs 435,067 200,892 - Total outflows 635.959 - - Model 5: Shed for dairy farm IRR = 21%, NPV = 201,307 Incremental inflows 3,248,251 2,760,708 -15.0 Incremental outflows Investment costs 714,285 1,201,828 68.3 Operating costs 2,046,423 2,533,966 23.8 Other Costs Total outflows 2,760,708 3,248,251 17.7 Model 6: Slaughter house IRR = 32%, NPV = 30,869,333 Incremental inflows 274,693,105 220,597,687 -19.7 Incremental oufflows Investment costs 12,053,571 66,148,989 448.8 Operating costs 208,544,115 262,639,534 25.9 Other Costs - - - Total outflows 220,597,687 274,693,105 24.5 -45- Annex 5: Financial Summary KYRGYZ REPUBLIC: Rural Finance If KAFC - Status of Current Operation & Financial Statements (as of December 31, 1998) Introduction 1. The Kyrgyz Agricultural Finance Corporation (KAFC) was established by a Government Decree No. 303 of July 2, 1996 and was formally registered as a joint stock company in December 1996, with Government being the sole shareholder. Although not licensed as a bank, KAFC is supervised by the National Bank of the Kyrgyz Republic (NBK) as a non-bank financial institution. KAFC was created in order to serve as the sole financial intermediary for the IDA financed Rural Finance Project (Cr. 29590-KG) Corporate Governance 2. KAFC's Board of Directors is elected annually at the Shareholders' Meeting; according to the charter, the Board consists of seven members, three representing the Government and three representing the private sector. Those representing the Government are the Minister of Finance, the Minister of Agriculture and Water Resources, and the Chairman of the State Property Fund. The seventh member is the Executive Director of KAFC. The Board convenes two or three times a year and its principal role is providing policy direction, approving the annual business plan and supervising the corporation's activities. The Executive Director, appointed by the Board for a period of three years, has full powers to manage the affairs of the Corporation. Organization and Staffing 3. Currently, KAFC has its head office in Bishkek, three main oblast branch offices (established in September 1998) in Osh, Issyk-Kul and Jalal-Abad, and 31 small representative offices, mostly at rayon level. The establishment of two additional oblast branches, in Chui and Talas is planned for April 1999. With the opening of the oblast branches, KAFC has just started to decentralize operations and authorized branch loan committees to approve and process loans up to 40,000 Som for individuals and 50,000 Som for group lending. Total staff of KAFC is 181, with 73 staff in the head office and the remaining 108 in the branches and representations. Lending Operations - 1997 and 1998 and Plan for 1999 4. The first Rural Finance Project provides funding for regular KAFC short-, medium- and long-term loans, at commercial terms, for investments and working capital, for on-farm development, agro-processing and other agribusiness activities, and for a pilot " Small Farmer Credit Outreach Program" (SFCOP) targeted at rural households at, or slightly above the poverty line. 5. KAFC's regular lending activities started in spring of 1997. During the first year of lending operations (to December 1997) KAFC succeeded to make about 340 loans with total disbursements of about Som 34 million. During 1998, KAFC made 1,317 loans totaling 110 million Som. As was envisaged at appraisal of the first RFP, the major portion of the loans made during the first two years was in short-term working capital loans, repayable within one year. About 65 percent of the amount of loan disbursements financed agriculture and livestock production and the remaining 35 percent financed -46- agro-processing and agri-business activities. Until December 31, 1998 total repayments of principal amounted to about Som 40.6 million and the cumulative loan recovery rate, at that date, was 85.6 percent. The total outstanding balance (before provisions), as of December 31, 1998, was about 100 million Som. 6. SFCOP lending started one year later than the regular KAFC operations. Beginning in March 1998, KAFC organized 137 Farmers' Self-help Groups, legally registered as Agricultural Consumer Cooperatives (ACC) which received short-term (one year) loans totaling about 27.6 million Som. The number of group members/borrowers was 1,650 and the maximum loan amount per individual member was set at 20,000 Som (equivalent to US$670 at the present exchange rate). Repayments of the first batch of loans has already started and by December 31, 1998 the recovery rate (principal and interest) was about 85 percent. 7. KAFC's business plan for 1999 projects a modest increase in the volume of lending operations with estimated disbursements of about Som 140 for regular lending (110 Som in 1998) and about 40 million Som for SFCOP (Som 27 million in 1998). KAFC management is aware that the very rapid growth of lending operations since inception in early 1997, coupled with the setting up of 34 branch offices and representations, induction of about 200 staff and testing of various operational procedures has over-stretched the institution's capacity. Although sufficient funding is available for a much larger than projected volume of lending, KAFC needs a period of consolidation, to focus its attention on strengthening its organization, the operating systems and procedures, revamping its accounting system and installing a new management information system, and raising the professional capabilities of its staff through intensive training. Financial Position 8. Attached are the 1998 financial statements audited by Price Waterhouse Coopers Total assets amounted to and the income statement shows Operational expenditures Total equity amounted to of which about Som 75 million was financed from the proceeds of the first RFP credit. KAFC fully satisfies the capital adequacy ratio. Collections from Government Agricultural Credit Programs 9. In connection with the first Rural Finance Project it was agreed that KAFC will be involved in the recovery of loans made to the agricultural sector between 1992 to 1996 and financed from budgetary resources. All loan recoveries will become Government's share capital contribution to KAFC. In 1997 and 1998 KAFC has collected Som 7.8 million, as shown in paragraph 8 above describing the sources of the equity capital. -47- Financial Statements of KAFC BALANCE SHEETS AT 31 DECEMBER 1998 AND 1997* ASSETS 1998 1997 Cash and short term funds 12,870 14,848 Marketable Securities 56,959 9,976 Loans to customers - net 113,027 30,969 Other assets 13,783 4,846 Property and equipment 27,498 19,742 Total Assets 224,137 80,381 LIABILITIES 115,214 2,808 Due to Government Other liabilities 4,020 8,708 Total Liabilities 119,234 11,516 Shareholders Equity Share capital 98,437 59,089 Adjustment to share capital 15,411 13,114 Accumulated deficit (8,945) (3,338) Total shareholders' equity 104,903 68,865 Total Liabilities and Shareholders Equitv 224.137 80.381 INCOME STATEMENT FOR THE YEARS ENDED 31 DECEMBER 1998 and 1997 Interest income 39,616 4,411 Interest expense (8,192) Not interest income 31,424 4,411 Fees and commission income 801 171 Fees and commission expense (114) Net fees and commission income 687 171 Foreign exchange gains 1,746 Other operating income 5,303 6,477 Admninistrative expenses (25,406) (10,750) Operating income 13,754 309 Provisions for loan losses (12,623) (874) Monetary loss (10,515) (1,492) Loss before tax (9,384) (2,057) Deferred income tax 3,777 (1,281) Net loss for the year (5.607) (3.338! *Amounts expressed in thousands of Kyrgyz Som (Som) in terms of the purchasing power of Som at 31 December 1998 -48- Annex 6: Procurement and Disbursement Arrangements KYRGYZ REPUBLIC: Rural Finance 11 Procurement Procurement of goods will be done in accordance with World Bank Guidelines: Procurement under the IBRD Loans and IDA Credits (issued in January 1995, revised January and August 1996, September 1997, and January 1, 1999). Consulting Services, technical assistance and training will be procured in accordance with the Guidelines Selection and Employment of consultants by World Bank Borrowers, January 1997 revised September 1997, and January 1999. The Bank's Standard Bidding Documents, Request for Proposals and Forms of Consultants' Contract will be used. Goods and technical assistance to be financed by the Government/co-financiers will be procured in accordance with the public procurement regulations or the regulations and practices of each co-financier. A general procurement notice will be published on the Development Business in July 1999. Procurement responsibilities For the investment part of the project- mainly Management and Information Systems, procurement will be the responsibility of KAFC. For sub-projects financed under the credit line and executed by sub-borrowers, procurement procedures will comply with those customary for operations through financial intermediaries (at present only KAFC). Procurement will be the responsibility of sub-borrowers who will have access to technical assistance in this work from KAFC (and later commercial banks). KAFC will have at least one additional experienced procurement officer and a procurement assistant fully trained in procurement under Bank-financed projects (to be hired prior to the effectiveness). A project launch workshop will be held close to effectiveness (currently scheduledfor July 1999). The project launch workshop will include training sessions on procurement specifically for the staff of KAFC, Rural Advisory Centers (being established in IDA supported Agricultural Support Services Project), and other interested commercial banks, if any. KAFC will be responsible for ensuring that sub-borrowers adhere to Bank procurement guidelines. An assessment of the procurement capacity of KAFC and random sample of private enterprises (potential borrowers) has been conducted and the report has been finalized. As a result of the assessment, it has been determined that although KAFC has some procurement knowledge because of its experience with procurement under the IDA financed First Rural Finance Project, its staff needs additional training. Furthermore, the environment in which private enterprises operate is not fully conducive to transparent, competitive and economic procurement. Therefore, the assessment report will recommend that procurement under the credit line estimated to cost equivalent or less than 300,000 per contract may be awarded in accordance with the established commercial practices of sub-borrowers, provided that such practices include obtaining quotations from more than one supplier or contractor. The procurement arrangements discussed below reflect those thresholds. -49- Kyrgyz Rural Finance Project II Summary of Proposed Procurement Arrangements (US$ million equivalent) Category Elements Procurement Methods Total ICB NCB Other' N.B.F. Cost A Credit Line component Al.Credit Line 20.4 20.4 (14.00) (14.00) B Institutional Development Component B1. TA for KAFC MIS equipment 0.23 0.23 (0.23) (0.23) Vehicles 0.18 0.18 (0.18) (0.18) Office equipment 0.05 0.05 (0.05) (0.05) Consultants 0.05 1.50 1.55 (0.05) (0.05) B2.0ther TA Group Lending 0.30 0.3 Program Development (0.30) (0.3) SME Development 0.20 0.20 (0.20) (0.20) Total 0.23 21.18 1.50 22.9 Bank/IDA (0.23) (14.781 (15.00) Note: Goods and works to be procured under the credit line estimated to cost equivalent or less than 300,000 per contract may be awarded in accordance with the established cormmrcial practices of sub-borrowers, provided that such practices include obtaining quotations from more than one supplier or contractor. Procurement of vehicles, office equiprnment and other goods estimated to cost less than US $200,000 should be done on the basis of International Shopping (total estirrated value US $280,000) Consultants for assignments related to MIS (US $50,000) will be selected using QCBS. Group Lending and SME Developrnnt components will consist of 2 consultant assignments selected through QBS. Individual experts for the above components (10 contracts for each of components over period of three years) wIll be selected in accordance with Part V of the consultant guidelines. NBF: 1.40 million from EU-TACIS. 'Explain exception Procurement methods (Table A) I. CREDIT LINE Funds from the credit line (US$14) million will be utilized by a large number of sub-borrowers for procuring various types of goods, equipment, civil works, and on-site technical assistance. The majority of sub-loans are expected to be less than US$10,000 equivalent for a large number of farms and rural enterprises mostly for working capital and small-scale hardware. In order to allow sub-borrowers the use of commercial practices in procurement of goods, the IDA has reviewed the procurement practices in the Kyrgyz Republic and has determnined that reasonably acceptable -50- commercial practices are applied by the private sectors that Kyrgyz private farms and enterprises do seek competitive prices from different suppliers. Therefore, for contracts estimated to cost US $300,000 sub-borrowers will conduct all their purchases through the commnercial practices provided that such commercial practices include obtaining quotations from more than one supplier or contractor. Contracts between $300,000 and $500,000 will be procured following the international shopping procedures (IS). In this regard, the assessment report includes an action plan to further familiarize the sub-borrowers with economic purchasing practices. II. OTHER PROCUREMENT The investment part of the project include procurement of MIS system for the KAFC accounting and loan portfolio tracking, MIS related technical assistance services and sets of small-scale equipment. These will be procured as follows: (a) Goods (estimated value US $450,000). Procurement of cars, office equipment and other goods estimated to cost US $225,000 should be done on the basis of International Shopping (IS). MIS banking system (network program-estimated to cost 225,000) should be procured through International Competitive Bidding (ICB). For the purchase of goods to be awarded through ICB, the Borrower may grant a margin preference of 15 percent or the amount of applicable customs duties, whichever is lower, to qualified domestic manufacturers of goods in accordance with the Guidelines referred to above. The aggregate for each procurement method is given in the footnotes under Table A. (b) Consultants' Services (estimated value US $550,000). Consultants for assignment related to the selection and implementation of MIS (estimated to cost US$50,000) will be selected using consultant qualification selection method. Group Lending and SME Development components will consist of 2 consultant assignments for firms (US $100,000 each) selected through the quality based selection method (QBS). Individual experts for the above components (10 contracts for each of components over period of three years) will be selected in accordance with Part V of the consultant guidelines. For the aggregates, See the footnotes under Table A. All ICB contracts will be subject to prior review by the IDA. With respect to Services, prior IDA review will be required of all terms of reference, irrespective of the contract value. The prior review will follow the sub-project review requirement that every three first packages from any bank and every package exceeding US $200,000 should be reviewed. For contracts under investment part (other than credit line), first contract awarded on the basis of IS will be subject to prior review. All other contracts will be subject to ex-post review by the IDA. For contracts with consulting firms estimated to cost less than US$100,000, the IDA will review the terms of reference. For contracts with individual consultants costing US$20,000 or more the qualifications, experience, terms of reference and terms of employment shall be furnished to the IDA for its review and approval prior to contract signature. All other contracts will be subject to ex-post review by the IDA Prior review thresholds (Table B) All ICB contracts will be subject to prior review by the IDA. With respect to Services, prior IDA review will be required of all terms of reference, irrespective of the contract value. The prior review will follow the sub-project review requirement that every first three sub-loans from any bank and every package exceeding US $200,000 should be reviewed by IDA. All other contracts will be subject to ex-post review by IDA. For contracts with consulting firms estimated to cost less than -51- US$100,000, IDA will review the terms of reference. For contracts with individual consultants costing US$20,000 or more the qualifications, experience, terms of reference and terms of employment shall be furnished to IDA for its review and approval prior to contract signature. All other contracts will be subject to ex-post review by IDA. Table B Kyrgyz Republic Rural Finance II Procurement Information Nl _ 1I 1Y 1-4___ __ __ ___ __ ___ __ ___ __ __ Element ICB NS Commercial practices (Goods/Works) I Procurement method Credit Line>US $0.5mill n.a. Credit LineUS$0.2mill Other than CL US$O. Imill Yes, >US$0.02mill n.a. all 5. Ex-post Review Explain briefly the ex-post review mechanism: The Bank will monitor procurement activities, contract I management and project record keeping during periodic supervision missions. 6. Brief statement: Primary responsibility for overseeing implementation of procurement procedures will rest with the staff of the KAFC. 7. Country Procurement Assessment Report or Country Procurement 8 Are the bidding documents for the procurement actions Strategy Paper status: Country Procurement Strategy Paper has been prepared of the first year ready by negotiations? Yes in 1998., 9. Estimated date of Project 10. I1. Indicate if contracts are 12. Domestic 13. Domestic Preference Launch Workshop: July 1999 Estimated subject to mandatory SPN in Preference for for Consultant Services: date of Development Business: Yes Goods/Works:Yes No GPN /No publication July 1999. 14. Retroactive financing No J 15. Advanced Procurement No 16. Explain briefly the Procurement Monitoring System and Information System: KAFC will develop a monitoring/reporting system for timely implementation of the procurement. 18. El be th e d rl of th Fe Oi in Procurement: 17 Indicate name of Procurement Staff as part of Project Team: Snezana Mitrovic, Procurement Specialist, ECSSD Ext. x321t2 IS. Explain briefly the expected role of the Field Office in Procurement:l Field Office will provide back-up on procurement issues to project team. -52- Procurement Plan 1 2 3 4 5 6. Estimated dates Description Type Number of Estimated Procurement Pre-qual/SL (BD/RFP) Bidding Contract Contract slices/items Method I .Preparation Process signing Completion A. Credit Line Component Al. Credit Line Other 25.1 Commercial n.a. Jun 99 through project life practices/ Intemational Shopping B. Instit. Dev. Component B I. TA for KAFC MIS equipment G 1 0.225 ICB n.a. July 99 Sept 99 Nov Feb 00 99 Vehicles G 1 0.175 IS n.a. July 99 Aug 99 Sept Nov 99 99 Office equipment G 1 0.05 is n.a. July 99 Aug 99 Sept Nov 99 99 Consultants CF 1 0.05 CQ June 99 June 99 July 99 Oct 99 June 00 B2.Other TA Group Lending CF/Cl 1/10 0.30 QBS/IND Jun 99 through project life SME CF/Cl 1/10 0.20 QBS/IND Jun 99 through project life Development Total 26.1 Disbursement Allocation of loan proceeds (Table C) The project is expected to be disbursed over a period of 5 years. The anticipated completion date is December 31, 2004 and the closing date is June 30, 2004. Disbursement will follow normal IDA procedures and will be made against eligible expenditures. Table C shows allocation of credit proceeds. The financing percentages in Table C are net of any taxes as the activities under the project are tax-exempt. Use of statements of expenditures (SOEs): Statements of Expenditures (SOE) will be used for: (a) all sub-loans under Part A-Credit Line of the project; (b) goods contracts under Part B of the project with estimated costs of less than -53- US$200,000 each; (c) consultants contracts with firms less than US$100,000; and (d) individuals costing US$20,000 equivalent or less each. For all contracts financed under the credit line, full documentation in support of the SOE will be retained by the KAFC for at least two years after the closing date of the credit. This information will be made available for review by IDA missions during project supervision and by auditors, the minimum application size for payments directly from the credit account or for issuance of Special Commitments is 20 percent of the special account authorization. Special account: To facilitate disbursements, KAFC will open a Special Account before credit effectiveness and maintain it until project completion. The Special Account will be established in the same commercial bank where the Special Account for the first Rural Finance Project is located on terms and conditions satisfactory to the Bank. The Special Account will be drawn upon to meet payments to contractors, suppliers and consultants under the project. Disbursement for sub-loans to final beneficiaries will be based on the terms of payment in the sub-loan agreements and according to the actual expenditures incurred. The selected bank should have: (a) significant foreign correspondence network covering all currencies; (b) reasonable capacity and experience for issuing letters of credit, for making direct foreign payments and other international transactions; (c) capacity to perform a wide range of banking services at local branches, including cash payments, transfers to other domestic or regional banks, issuance of debit notes, application of conversion rates from foreign currencies; (d) the capacity of maintain adequate accounts for the Special Account as required by the World Bank and provide monthly bank statements to PMU; (e) willingness to issue a Comfort Letter to ensure that amounts deposited in the SA will not be set off or otherwise seized or attached to satisfy amounts due to a commercial bank by the Borrower; and (f) willingness to charge competitive rates for their services and provide reasonable interest income to the balances held. The initial allocation to the Special Account will be limited to US$1.0 million. The initial allocation may be increased up to the authorized allocation of US$2.0 million once aggregate disbursement of US$5.00 million are reached by submitting the relevant withdrawal applications. Replenishment applications should be submitted at least every three months and must include reconciled bank statements as well as other appropriate supporting documents. Project accounts will be operated for discrete activities and funded from the Special Account based on disbursement applications signed by the authorized officials. -54- Table C: Allocation of Loan Proceeds re%b As =o_ t rr,~Ul~r~ V1n0 ,w Credit Line (Part A) 14.0 100% of eligible sub-loans disbursed by the PFIs on or before June 30, 2001 and 80% disbursed thereafter Institutional Development (Part B) 0.0 -goods 0.5 100% of foreign expenditures 100% of local expenditures (ex factory cost) 80% of local expenditures for other items procured locally -consultants 0.5 100% Total Project Costs 15.0. Total 15.0 -55- Annex 7: Project Processing Schedule KYRGYZ REPUBLIC: Rural Finance 11 P~O N E40 7 _1 Time taken to prepare the project (months) First Bank mission (identification) 02/01/99 02/01/99 Appraisal mission departure 04/25/99 04/30/99 Negotations 05/11/99 05/11/99 Planned Date of Effectiveness 10/30/99 Prepared by: The Government of Kyrgyz Republic and the IDA Preparation assistance: Bank staff who worked on the project included: , _..N... ,Sec milit Hoonae Kim Team Leader Michael Nelson Operations Analyst S. Leigh Hammill Program Assistant Stan Peabody Social Analysis Michael Gascoyne Financial Management Asyl Undeland Operations - Resident Mission Orunbeck Shamkanov Operations - Resident Mission Joseph Goldberg Peer reviewer - Overall Project Design Alexander Fleming Peer Reviewer - Financial Sector Jacob Intrator Consultant - Rural Banking Maija Treija Consultant - Rural Finance Hermine De Soto Social Anthropologist Snezana Mitrovic Procurement Laura Tuck Quality Assurance -56- Annex 8: Documents in the Project File* KYRGYZ REPUBLIC: Rural Finance 11 A. Project Implementation Plan Being prepared. B. Bank Staff Assessments 1. Environmental Assessment 2. Social Assessment 3. Financial Assessment 4. Procurement Assessment C. Other KIAFC KAFC Business Plan 1999, 1998-2000 KAFC Balance Sheet, KAFC Statement of Income, SFCOP Statement of Income KAFC Volume of Credits Approved, Disbursed and Repaid in 1997-1998 (Table) Lending Agreement Business Plan Form for Loans Under 40,000 Soms (13 pages in English) KAFC Regional Network and Organizational Structure SFCOP SFCOP 1998 Report (agr. Sector, program and donors, exec. Agency, targeted group, objectives and aims, review of activity, training of farmers, strategy for development) SFCOP Statement of Income, January 1, 1999 Group Development Strategy of SFCOP (Chart in English from Bakyt), February 1999 SFCOP Grant Administration Agreement SFCOP Credit Agreement SFCOP Conditions of Borrowing SFCOP Credits by Client, Rayon, and Oblast SFCOP Types of Activities by Client, Rayon and Oblast FDF Equity Investment Agreement (English and Russian, signed) Framework Agreement (Agriculture Support Services Project) between Kyrgyz Republic, UNDP, and KAFC Operational Manual for Farm Development Fund Under ASSP (Russian) Credit Programs and TA in Agriculture National Microcredit Summit, Agency Report of UNDP Poverty Alleviation Project, May 1998 ACDI/VOCA Food for Progress Rural Finance Activity, Microfmance Summit Helvetas Kyrgyzstan for UNDP Microcredit Summit UNDP Participatory Poverty Alleviation Programme, Phase 2, Semi-Annual Report July- December 1998 -57- Ministry of Agriculture and Water Resources - List of Agriculture Sector Projects by Donor Summary of Kyrgyz Rural Credit Programs, Prepared by Leigh *Including electronic files -58- Annex 9: Statement of Loans and Credits KYRGYZ REPUBLIC: Rural Finance 11 Difference between expected and actual Original Amount in USS Millions disbursements Project ID FY Borrower Purpose IBRD IDA Cancel. Undisb. Orig Frm Revd Number of Closed Projects: 6 KG-PE-38569 1999 GOVT. OF KYRGYZ REPUBLIC SOCIAL SEC. ADJUST. 0.00 36.50 0.00 18.11 -0.40 0.00 KG-PE-62682 1999 KYRGYZ REPUBLIC FLOOD EMERGENCY 0.00 10.00 0.00 9.90 0.46 0.00 KG-PE40721 1998 GOVT. OF KYRGYZ REPUBLIC AGRIC. SUPPORT. SERV 0.00 14.98 0.00 14.35 0.94 0.00 KG-PE46042 1998 GOVT. OF THE KYRGYZ REPUB IRRIGATION REHAB. 0.00 35.00 0.00 32.58 -0.44 0.00 KG-PE-8520 1997 KYRGYZ REPUBLIC RURAL FINANCE 0.00 16.00 000 5.03 -3.74 0.00 KG-PE-45631 1996 THE KYRGYZ REPUBLIC FINANCIAL SEC. TECH. 0.00 3.40 0.00 1.63 1.53 0.00 KG-PE-8513 1996 GOVT OF KYRGYZ SHEEP &WOOLIMPROV. 0.00 11.60 0.00 6.68 1.76 0.00 KG-PE-8519 1996 GOVT. OF KYRGYZ REPUBLIC POWER& DIST. HEAT 0.00 35.00 0.00 31.72 11.77 19.37 KG-PE-8523 1996 GOVT OF KYRGYZ REPUBLIC HEALTH 0.00 18.50 0.00 5.50 -1.60 0.00 KG-PE-8524 1995 GOVT OF KYRGHYZSTAN PRNV. ENTERP. SUPP. 0.00 15.00 0.00 12.83 12.36 0.00 Total: 0.00 195.98 0.00 138.33 22.64 19.37 Active Closed Projects Projects Total Total Disbursed (IBRD and IDA): 68.52 269.04 337.56 of which has been repaid: 0.00 0.00 0.00 Total now held by IBRD and IDA: 213.98 269.00 482.98 Amount sold: 0.00 0.00 0.00 of which repaid: 0.00 0.00 0.00 Total Undisbursed: 138.33 1.36 139.69 Actual disbursements to date minus intended disbursements to date as projected at appraisal. -59- KYRGYZ REPUBLIC STATEMENT OF IFC's Held and Disbursed Portfolio 3 1-Mar-1999 In Millions US Dollars Committed Disbursed IFC IFC FY Approval Company Loan Equity Quasi Partic Loan Equity Quasi Partic 1995 Kumtor Gold 27.50 10.00 0.00 0.00 27.50 10.00 0.00 0.00 Total Portfolio: 27.50 10.00 0.00 0.00 27.50 10.00 0.00 0.00 Approvals Pending Commitment FY Approval Company Loan Equity Quasi Partic Total Pending Commitment: 0.00 0.00 0.00 0.00 -60- Annex 10: Country at a Glance KYRGYZ REPUBLIC: Rural Finance II Europo & 5/28199 POVERTY and SOCIAL Kyrgyz Centrai Low- R-public Asia income Development diamond' 1997 Populaon, mid-year (millions) 4.6 476 2,048 Life expectancy GNP per capita (At!as method, USS) 440 2,320 3S0 GNP (Atlas method, VS$ billions) 2.0 1 106 722 Averaqe annualt growth, 1991497 Population l%) 0.7 0.2 2,1 G Gr Labor force (%) 1,2 0.6 2.3 GNP Z/ \ Gross Labor force M ~~~~ ~ ~~~~~~~per a 000primary Most recent estimate (latest year avalhable, 199147) pit enrollment Poverty (% of poputetialt below national poverty line) S1 Jrban paPulation (% of tot& pOpulation) 30 67 28 Liti expectancy atbirth (Ye"rs) 67 69 59 Infarnt mortality twr 1, 000 ive births) 32 25 78 Chikd malnutrition f% of childrern under 5) - Access to safe water Access to safe water (% of population) 75 71 Illiteracv 1% of populatfion age f`5+) , , 47 Gross primarv enrollment 1% of school-age population) KyrgyzIRepublic Male 110 100 Low-income group Female 111 I1 KEY ECONOMIC RATIOS and LONG-TERM TRENDS 1976 198s 1996 1997 Economic ratios' GDP (US$ billions) ,. ,, 1.8 1.8 Gross domesticinvestment/GDP , 25.2 21 . Exports of goods and services/GDP . 30.7 38.3 Trade Gross domestic savings/GDP .. .. -0.6 13.8 Gross national savinAs/GDP -8.8 . 7 Current account balancelGOP .. . -233 -9.1 Domestic Interest pavments/GDP , . 1,9 3.3 +aig nvsmn Total debt/GDP - 64,4 81.0 Savings Total debt servicelexports, 19.2 14.7 Debt/GDP - 64.0 810 Debt/exports 20S.0 2t2.0 Indebtedness 1976-86 1987497 1996 1997 1998-02 (average annual growth) GDP 8 5 7.1 10.4 20 Kyrgyz Republic GNP per capita 8.6 B .8 -22.8 1.0 Low-income group Exports of goods and services - 20.0 0.0 STRUCTURE of the ECONOMY 1976 19S6 1996 1997 Growth rates of output and Investment (%) (% of GDP) 4 Aqriculture 46.3 45.2 40 Industrv 17.0 20.8 20 . Manufacturing. 11.1 16.2 0 Services 29.8 27.9 -20 g 5 37 Private consumption 82.1 76.2 -40 General government consumption 18.5 17.1 - GDI GOP Imports of goods and services 56.6 48.9 (average annual growth) 1976-86 1987-97 1996 1997 Growth rates of exports and Imports (#) Agriculture 15.1 7.0 Go Industry 2.7 5.0 40 Manufacturina 3.9 39.7 20 Services -3.1 9.9 o Private consumption 15.3 6.4 -20 92 93 54 11i 97 General government consumption 21.2 6.5 -40 Gross domestic investment 36.2 6.5 -eo Imports of goods and services 54.3 10.3 Exports 0 Imports Gross national product 9 0. 4.1 Note: 1997 data are preliminary estimates. The diamonds show four key indicators In the country (in bold) compared with its income-group average. If data are missing, the diamond will be incomplete. f tall In 1997 is related to the phase out of the Atlas svnthetic methodolocy -61- Kyrgyz Republic PRICES and GOVERNMENT FINANCE Domestic prices 1976 1986 1996 1997 Inflation (%) (% change) 1,000. Consumer prices .. .. 35.0 14.7 600 -- Implicit GDP deflator .. .. 35.3 13.3 .3 o / 400- Government finance 200 (% of GDP, inctudes current grants) o Current revenue .. .. 13.8 15.2 92 93 94 s5 9s 97 Current budget balance .. .. -7.2 4.3 - GDP detlator e CP1 Overall surplus/deficit (accrual) .. .. -9.4 -8.9 TRADE (US$ millions) 1976 1986 1996 1997 Export and Import levels (USS millions) Total exports (fob) .. .. 531 633 1.000 Electric Energy .. .. 74 83 Boo Gold and gold products .. .. 0 185 600 Manufactures .. .. 298 209 600 Total imports (cif) 901 781 400 Food . . 98 79 Fuel and energy .. .. 251 239 200 Capital goods .. .. 183 110 o Export price index (1995=100) .. .. 96 89 el 92 93 94 95 96 97 Import price index (1995=100) .. .. 101 97 M Exports * Imports Terms of trade (1995=100) . .. 95 91 BALANCE of PAYMENTS (US$ millions) 1976 1986 1996 1997 Current account balance to GDP ratio (%) Exports of goods and services .. .. 562 695 0- Imports of goods and services .. .. 926 754 51 92 _ X Resource balance .. .. -364 -59 -s- Net income .. .. -148 -143 -10-- Net current transfers .. .. 89 65 I5 Current account balance .. .. -423 -137 Financing items (net) . 462 171 -20 Changes in net reserves .. .. -39 -34 -25 yemo: Reserves including gold (US$ millions) .. .. 132 200 Conversion rate (DEC, local/US$) .. .. 8.5 13.7 EXTERNAL DEBT and RESOURCE FLOWS 1976 1986 1996 1997 (USS millions) Composition of total debt, 1997 (USS millions Total debt outstanding and disbursed 0 0 1,174 1,432 IBRO 0 0 0 0 G12 IDA 0 0 204 266 s: 266 Total debt service ° ° 89 82 F: 373 IBRD 0 0 0 0 IDA 0 0 1 2 Composition of net resource flows _ _ c.170 Official grants .. .. 112 112 Official creditors .. .. 268 225 Private creditors .. .. 182 8 Foreign direct investment .. .. 46 60 E: 313 Portfolio equity .. .. 0 0 0:29s World Bank program Commitments 0 0 99 60 A- I1RD E - Bilateral Disbursements 0 0 61 66 B - IDA D - Other multilateral F - Private Principal repayments 0 0 0 0 C - IMF G - Short-term Net flows 0 0 61 66 Interest payments 0 0 1 2 Net transfers 0 0 60 65 Development Economics 11/5/98 -62- Additional Annex No.: 11 Financial Management Audit compliance 1. For the period ended 31 December 1997, KAFC's first period of operation, the corporate financial statements were audited by Coopers and Lybrand. The auditor issued an unqualified opinion on the financial statements. The auditor did not provide an opinion on the operation of the Special Accounts, accuracy of Statements of Expenditure or the use of Bank funds. 2. For the year ended 31 December 1998, the auditor's Terms of Reference were again limited to an audit of the corporate accounts. This has been discussed with KAFC and Coopers and Lybrand and it was agreed that, in addition to an opinion on the corporate financial statements, an opinion on the operation of the Special Accounts, accuracy of Statements of Expenditure and the use of Bank funds will be issued before the end of April 1999. 3. KAFC was established as the primary mechanism for the delivery of the first rural finance project i.e. KAFC was the PIU. The second rural finance project, leaves open the option of delivering credit via the commercial banking sector. If commercial banks do join the project it would be inappropriate for KAFC to continue to function as the PIU and hence it is necessary to maintain the records related to the second rural finance project in such a way that they may be stripped out of the accounting system at a later date, should it be necessary to form an independent PIU. KAFC's information systems are capable of maintaining separate records for activities performed under the terms of the second rural finance project; KAFC currently maintains records of transactions and balances associated with SFCOP as a separate income/cost center within the accounting system. Financial performance 4. KAFC has operated for approximately two years. At 31 December 1997 the corporation had a risk weighted capital adequacy ratio of 120 percent. At 31 December 1998 the ratio was 73 percent (based on unaudited financial statements), well above the covenanted ratio of 33 percent. 5 . The debt service ratio for the year ended 31 December 1998 was 1. 16, considerably below the ratio of 1.5 stipulated in the subsidiary loan agreement. The corporation has placed an emphasis on building an infrastructure capable of supporting its lending activities. Thus, current operating expenses are high in relation to total income. Assuming the quality of the loan portfolio does not deteriorate, the debt service ratio should improve as the loan portfolio grows. 6. The quality of the loan portfolios of the commercial banking sector have been impacted by the Russian financial crisis and the subsequent devaluation of the Som in the latter half of 1998. As KAFC's customers borrow exclusively in Som, they have not been directly effected by the devaluation. The corporation is maintaining the loan recovery ratio above 80 percent. The covenanted limit is 75 percent. 7. The corporation has a highly liquid portfolio of assets and, subject to clarification of the terms of the subsidiary loan agreement, has no foreign exchange exposure. 8. By its nature, an agricultural finance corporation/bank has a highly concentrated loan portfolio. KAFC has attempted to mitigate some of this risk by diversifying its portfolio geographically and by -63- segmenting the agricultural sector into arable farming, livestock and agro-processing. However, it must be accepted that a poor harvest would have a very detrimental impact on primary producers and also effect the downstream processing industry. The quality of KAFC's loan portfolio could deteriorate very quickly. Financial systems 9. The corporations underlying financial management systems and processes are generally robust, being sufficient to safeguard the corporations assets and providing timely and accurate financial data. However, there are a number of areas where improvements could be made. For example: 10. There are two separate loans databases, one used by the loan department and the other by the accounting department. Inherent in this approach to information management is the risk that these systems contain conflicting data. Other members of the review mission have performed a detailed study of the loan accounting systems and will present recommendations for improvements. 11. There are some banking operations for which there are no clear written policies, for example there are no written counterparty limits for deposits with banks. Budgeting 12. The Board of directors approves the annual development budget, which defines broad targets for the size of the loan portfolio, staff numbers and fixed asset acquisitions. The more detailed income and expenditure budget is prepared by the finance department. This is not reviewed by the Board, nor are amendments to the budget which are made during the year. The development budget is not updated to reflect changes in the detailed budget. 13. The finance department prepares, using a spreadsheet, a weekly forecast of cash requirements. In order to transfer to LACI disbursement procedures the budget system must be capable of forecasting the corporations funding requirements, under each credit line, for the coming two quarters. It will be necessary to integrate information from the loan accounting system (loan repayments), information regarding the loans under preparation (loan pipeline) and information from the cost accounting system. Until the budget system is upgraded and the format of the reports defined, the project should not transfer to LACI style disbursements. Staffing 14. Staff in the accounting and finance function are generally well educated and experienced. All senior staff are educated to university standard and have several years prior banking experience, either in the commercial sector or with the NBK. Internal audit 15. The internal audit department currently comprises only one member of staff. It is envisaged that this will rise to three before the end of 1999. The current staff member has considerable banking experience but has no formal training in modern internal audit philosophy or methodology. An annual audit plan has been developed and agreed with the executive director. Internal audit working papers are comprehensive but focus solely on adherence to bank procedures and accounting issues. -64- R0z.-n l he Asse ntl of ProEWct or PMR-Bsc DisbUrsments rin½aciaI Manemel S swm: I ture mw wmed the %incW mname syiem Mating t this prvj.t. The ojeciv oft. review was to dermlnekAtwter the pr t has in te an aduate ftnaria mnanaement systm as requied by the (.A. under OlPlP W0M. My review, which includd vidts to the project impkmendng ageny, was basd or. ib1 BaIs gdelLs Air 'Review oof flnncial Managemen System and ectsed ott Che iof de projecVs wountig sytm, inut cot, plwnin, budgeting and rfncial reponing sytm ad selecWon of an auditor I cfim that the pmie ctiisfles te Bk,s mainimum ftraioial maagement rcqretnmts ad the prcfet has: in placen adeuuat ptojec fincial mnag;nmet s-ystemthat a provit wihth reasnable asne.. acute and lirmly informaton on the status of the project (PMR) as reqired by the DA thrPMR i3ad Disbursemwns. However 1 do not reommend die prjct for PMR band disbursement Ns trnx Sumrtsb PMR's will be developed howcvr and fT pjm could swtltch to PMR based c-ks tsanments at a ler date subjet to hejcint approval oflhe IDA and the borrower- Sisnedby M16chael Ciaseone: Finaial Managcment S (fas-OPR) -kLLLi!?1 NarneE flptiliv. -65- Additional Annex No.: 12 Social Issues and Social Assessment Background The Second Rural Finance Project (RFP II) will increase the emphasis on reaching small farmers and entrepreneurs begun under RFP I, primarily through group credit based on social collateral or group guarantees. A Social Assessment (SA) was undertaken in the Kyrgyz Republic as part of project preparation in order to derive lessons from RFP I on group lending, to find ways to strengthen group lending mechanisms, and to increase access to rural credit for a much broader spectrum of small farmers and entrepreneurs. To prepare for the SA, and to provide some initial social inputs in project design, social scientists on the Project Task Team carried out a rapid assessment during the preparation/pre-appraisal mission. The main objective of the rapid assessment was to discuss with rural producers the strengths and weaknesses of the structure and operations of existing small-scale credit programs. Some of the issues discussed included obstacles to accessing credit, credit use and experience, problems in documenting and applying for credit, the quality and quantity of institutional support available, and new approaches or components that should be introduced in RFP II. This annex discusses the small-scale credit operations of the Kyrgyz Agricultural Finance Corporation (KAFC), findings of the rapid assessment, the objectives and scope of the SA, findings of the SA, results of the first stakeholder workshop, and implications for the project. Small-Scale Credit KAFC has two windows for group lending, the Small Farmers Credit Outreach Program (SFCOP), and the Farmers Development Fund (FDF). In the SFCOP program, borrowers are required to form Agriculture Consumer Cooperatives (ACCs), which must be registered in the Ministry of Justice, and must provide collateral to secure the group loan. SFCOP credit officers travel to villages to meet with ACC groups to explain credit requirements, and to review documentation and collateral, but do not give advice on aspects of group organization or operation. KAFC credit officers do, however, maintain contact with ACCs to ensure that they repay loans. Most ACCs appear to have a stable core of members, but some revise their membership while applying for a second loan to weed out unreliable members and add new ones. Although the ACCs are created as vehicles for credit, often by a local leader, KAFC officials believe that they have potential as multi-purpose organizations. Associations of ACCs have already been created in two rayons to assist smaller groups, but it is not clear to what extent this idea will develop more broadly. The FDF program was designed to lend to low income populations who have few resources. It requires no collateral, but it does require savings. The FDF is funded by IFAD, in association with the Agricultural Support Services Project and is based on "social collateral," or group guarantees, in the form of Self-Help Groups (SHGs). Group formation and training are supported by technical assistance from UNDP. Self-Help Groups go through a two- to five-month program, during which members are required to mobilize savings to lend to group members on a rotating basis. They also receive training in developing business plans, marketing, accounting, and financial management, as well as group dynamics. Advisors take members through a participatory group formation process, and help prepare and screen loan applications. The first generation of groups completed the training and obtained loans- in the spring of -66- 1999. FDF staff are pleased with the outcome, but because international and local UN Volunteers deliver the technical assistance to groups, local people identify the FDF with UNDP rather than KAFC. Rapid Assessment The rapid assessment included field visits to ACCs and SFGs in Chui and Issik-Kul Oblasts, as well as regional staff of KAFC. In Bishkek, the assessment focused on the rural credit experience of UNDP, Mercy Corps and the Rural Entrepreneurial Credit Program, as well as staff of KAFC, SFCOP and FDF. The first SFCOP group loans had not matured at the time of the rapid assessment, and the first FDF loans had not been granted, thus most fndings and conclusions were seen as tentative and subject to confirmation. Given such caveats, the rapid assessment identified six principal sets of fndings regarding group credit through SFCOP. First, the process of obtaining group loans is complicated and bureaucratic, with transaction costs that are high both in absolute terms and in relation to the resources of small farmers and entrepreneurs. The costs and time required to register an ACC, to document ownership, use rights and financial status, and to negotiate with various offices, discourage all but a relative handful of the most energetic and educated people from organizing groups. Second, the low level of information available about credit requirements and conditions, even among members of ACCs, limits access to credit of those who might meet eligibility requirements. Third, the language of the many required forrns is difficult to understand, even for educated people, thus members of most groups are fully dependent on their leaders. Fourth, prospective borrowers rarely have access to the kind of financial, technical and management skills required to prepare viable business plans and carry them out, or to create viable ACCs. Fifth, the one-year repayment periods are suitable for cropping, but not animal husbandry, thus many groups are required to repay loans before they realize the benefits of the credit. Sixth, although villagers maintain many traditional social bonds, which are promising for the creation of viable credit groups, the need for an energetic, educated leader often results in the creation of groups based on patron-client relations and wide social and economic differences between members, thus they are inherently unstable and unsustainable. In contrast, FDF Self-Help Groups were established in 42 villages selected on poverty criteria. In the selected sites, villagers were encouraged to form groups and were provided with significant organizational and moral support with UNDP funding. The rapid assessment concluded that the SHGs are more homogenous, better informed and more self-aware than ACCs. Nonetheless, it appeared that the training period is perhaps too long and the support program is too extensive to replicate on a broad scale. SHGs are required to establish a regular savings program, the proceeds of which constitute a revolving credit fund. The savings thus serve both to strengthen group solidarity and mutual accountability and to meet specific financial needs of individual members. Social Assessment Objectives and Methods The SA was designed to find ways to gain a better understanding of the local conditions, needs and opportunities that could be used to develop a more effective, efficient group credit program for RFP II. It focused on a number of specific questions regarding KAFC's group lending programs (SFCOP and FDF), their clients, and potential clients. The principal questions addressed were as follows: Based on experience so far, what social factors account for the success or failure of ACCs and, if KAFCcontinues to promote ACCs, what should be done to make them stronger and more effective? What are the social characteristics and credit needs of prospective clients, especially small farmers and entrepreneurs who cannot meet KAFC's collateral requirements? What are the attitudes of different target groups toward credit in general and toward KAFC in -67- particular, and how should these attitudes be factored into KAFC's operations? What changes-in organizational structure, procedures or field practices-should KAFC make to enable it to reach a broader spectrum of prospective clients? In addition, the SA established a socio-economic baseline which can be used to monitor project implementation and assess social impact. The SA aimed to understand and give voice to the needs, aspirations and social and economic constraints and opportunities of rural people in the Kyrgyz Republic, including income levels and sources, standard of living, consumption patterns, access to goods and services, as well as standard social and demographic characteristics. Given project objectives, the SA specifically focused on: credit experience and use, credit demand, perceived and real access to credit, transaction costs of obtaining credit, the nature of the interface between credit providers and rural people, strengths and weaknesses of existing group credit arrangements, and the nature of social bonds that can promote or inhibit participation in group credit schemes. The SA was carried out by a team consisting of Kyrgyz social scientists led by the Team Director, Anara Tabyshalieva, Institute for Regional Studies, Bishkek, Kyrgyz Republic, with the assistance of an external World Bank Consultant, Hermine G. De Soto, under the supervision of Stan Peabody, World Bank Social Scientist. The team used two principal research methods to gather data to answer the questions, each of which is described briefly below: a) focus groups; and b) a household demographic and credit history survey of rural households. In addition, community economic profiles were developed in the sample areas. The team was responsible for designing the sampling frame and survey instruments, conducting focus groups, processing and analyzing data, reporting results, and formulating practical recommendations for project design. Focus Groups. Focus group methodology was used to understand the strengths and weaknesses of a sample of ten ACCs by comparing the social characteristics and experiences of five ACCs that KAFC staff consider to be "effective," with five ACCs that are considered to be "ineffective." Members of the ACCs were brought together in order to discuss the history, social composition and gender status of their groups, focusing on aspects related to: group formation, functioning, and leadership; preparation for applying for group credit; transaction costs associated with obtaining and using SFCOP credit; perceptions regarding the social costs and benefits of obtaining and using credit through ACCs; information constraints and lack of information flow; initiative taking; issues of training for group formation; credit application procedures, documentation and record keeping; timeliness of training and information flow, and participation or lack of participation of group members. Household Survey. Eight hundred interviews were carried out with heads of households in 16 villages in four oblasts: Osh, Chui, Naryn, and Talas. The survey obtained data on agricultural information flow, demographic and socio-economic data of households, as well as information focusing on the following project-related issues: credit history and needs; knowledge about credit sources and requirements; interest and experience in group credit; individual and group experience with KAFC, ACCs and SHGs; household activities; standard of living; access to credit and credit-related information; aspirations; decision-making patterns within households; informal and formal group involvement; reasons for wanting to join or not join a credit group. The data was analyzed to understand differences between households related to income, resources, gender, age, nationality, clan, education, credit experience and other variables. Community Economic Profiles. Community-level data were gathered to develop profiles of the -68- communities to establish a social and economic context for the analysis of survey and focus groups. In each community or neighborhood selected for the household survey, the Team prepared a profile of economic activity consisting of a brief description of all enterprises in the area. For each enterprise, the profile described the size of the workforce, products, market, sources of materials, access and use of credit and other factors that would affect potential demand for the project or its impact. The profile also identified any basic types of commerce or services that are needed in the community but not available through existing enterprises. Finally, the profile assessed the extent to which the local economy is actually privatized, as opposed to being dominated by major enterprises--agricultural or other-that persist from the Soviet era, or their commercial or other affiliates. After completing preliminary analysis of the field data, the SA Team conducted four stakeholder workshops in different parts of the country. The objectives of the workshops were to inform and verify with various stakeholders the research findings, to assist in developing communication channels to improve information flow in both directions among local, regional, and national stakeholders, both by serving as a model and by addressing the issues directly. Stakeholder participants included KAFC staff, ACC and SHG members, potential clients, village council members, notaries, rayon and oblast officials and representatives of different local and international groups involved in rural credit. Social Assessment Findings ACC Assessment. The analysis of ACCs, based on focus groups, confirmed much of the impressions gained during the rapid assessment. Credit Demand. The ACC Focus Group Assessment confirmed a high level of demand for credit at the prevailing interest rates. A majority of the ACCs intended to apply for a second loan through the SFCOP. For most farmers, the main objective of getting credit is to improve their living conditions and to develop and improve farming operations. While farmers in the Chui Oblast would use credit for land cultivation as well as for cattle breeding, farmers in Talas and Naryn Oblasts would use credit more for cattle breeding, rather than land cultivation. However, farmers in all of the sample oblasts tend to prefer to work with livestock, because they perceive livestock breeding to be more stable in regard to market and price, less costly and more profitable, and less dependent on the weather. Discussants mentioned a wide range of activities which would require credit, from vegetable processing, vegetable oil, facilities for processing meat and canned goods, to repair shops, service stations, mills, sewing workshops, and tourism development. Credit Use. Most members of the ACCs, both strong and weak, used their loans as specified in the business plan they submitted to KAFC, with exceptions such as substituting the purchase of one type of animal for another. Some farmers were frustrated by the need to follow the business plan precisely, however. In some cases, the result was a loss. For example, in Naryn members of an ACC planted potatoes as planned, even though they preferred to use their loan to purchase cattle. Because of a bad crop and unexpected competition, these ACC members suffered severe losses. Some ACCs apparently require members to market their production collectively, which ultimately causes some disaffection. At the time of the field study, nearly all ACC members were convinced that they would be able to repay their loans when they were due, and expected to do so, especially because they were afraid to lose their homes, which served as collateral. Actual experience verified such intentions. ACC repayments were high, although not fully on time, and KAFC rigorously followed each loan. Although many borrowers felt that they did not achieve significant profits from their first loan, most expected to do so withtheir second loan, when the up-front transaction costs would be lower. In such circumstances, for example, the groups expected to invest in machinery, such as tractors, during the second round. -69- Transaction Costs. Most ACC members felt that transaction costs were far too high. Major expenses include fees associated with documenting house ownership and other certifications related to establishing collateral. Most people also said they were frustrated by the poor information available, which meant that they did not know ahead of time how much they would need to pay in fees, the types of documents required, or the many steps required to obtain documents. Travel to the KAFC regional offices and to Bishkek also consumed considerable time and cost. Constraints. Potential borrowers lack information about how to obtain credit, especially during the first attempt to do so. They know little about credit sources and requirements, up-front costs, fees, and the time needed to process an application. They know even less about the many associated business aspects, ranging from technical details of crop production to developing creditworthy business plans. As a result, the application process is more prolonged, expensive and confusing than anticipated, and many loans were granted too late in the agricultural season to achieve maximum benefits. Lack of markets, numerous customs check points, and hidden travel fees greatly reduced profitability as well. Collateral. In most cases, collateral consisted of a house, cattle or car of an individual ACC member or relative, although some wealthier members provided the collateral for others. Younger villagers especially found it almost impossible to provide physical collateral, thus many prospective ACC members could not join the groups. The majority of ACC members preferred to obtain credit based on social collateral, although it is clear that many who expressed this desire did not fully understand the concept of group liability. Social (Group) Bonds. Generally, people said they benefited from joining ACCs, primarily because the group gave them access to credit. In many cases, group participation was seen as leading to an opportunity to obtain higher levels of credit to purchase machinery during subsequent credit cycles. Members claimed that they would support each other regardless of the economic activity they pursued. Such members often reported that ACC membership was based on social bonds among clan members or on vestiges of collective relations from the former kolkhozes and sovkhozes where they worked. Summary. The ACC assessment concluded that ACC groups cover a wide spectrum ranging from relatively unstable coalitions surrounding a local leader to nascent cooperatives, and that they are so new that an attempt to compare the qualities of effective ACCs to ineffective ones must be seen as preliminary at best. Nonetheless, a constellation of qualities appeared to emerge from the focus group discussions. In brief, members of effective ACCs are relatively homogeneous in terms of wealth and social status: they live in the same village, they have a long-term vision of the future of the ACC, they have common work experiences, and they are relatively few in number. In contrast, members of the ACCs that were considered to be ineffective were more heterogeneous, more deferential to the decisions of the leader, had few shared responsibilities, less common work experience, and larger numbers. Survey of Prospective Borrowers. In most respects, the household survey confirmed commonly held impressions regarding rural attitudes toward rural credit. In addition, the survey provided a broader picture of the rural context that demonstrates the magnitude of the challenge facing both rural people and institutions like KAFC that try to serve them. Credit Experience. Exceedingly few rural residents have experience with commercial credit. Only five percent of the household sample said they had such experience. This is not surprising, given the nature of credit during the Soviet period, which was confined to enterprises, sovkhozes and kolkhozes, and generally ended up being a subsidy, rather than a loan, and given the collapse of most financial institutions -70- that previously served rural areas. In consequence, few people understand the nature of financial institutions and the inherent obligations in commercial credit transactions. On the other hand, 21 percent of the sample knew others who had received credit, and 15 percent had borrowed money during 1998, usually from relatives or friends. Half of the respondents who had received credit, had already repaid their loans by the time of the survey. Respondents borrowed an average of 16,000 soms for a one-year period. Most had borrowed through ACCs, and their loans were still not mature, thus this early repayment is a promising sign. However, most of those who had repaid their loans claimed that they had made little or no profit. This response appeared to be due to three principal reasons: first, the high up-front cost of documentation and associated travel costs and fees; second, a high incidence of borrowing to purchase animals, which would not be expected to yield profits until after the 12-month loan period; and third, crop losses due to the weather or late receipt of loans. Credit Demand. Although few people have direct credit experience, 40 percent of the respondents said they badly needed credit and 80 percent said they would increase their production if they had access to loans for inputs. Fifty-six percent of the respondents wanted to borrow at the prevailing interest rate to buy livestock and fodder for their animals, or buy inputs for crop production (17 percent). Twelve percent said they needed loans to cover family expenditures. These results confirm both the high level of demand and the anticipated use of credit for productive purposes, rather than consumption. Constraints. The three principal reasons why people who want credit are prevented from applying for it are a lack of information, high transaction costs, and mistrust of financial institutions. Those who had applied unsuccessfully for loans felt that the rejection was due to the difficulty they had in understanding the process and to their lack of collateral. Only seven percent of the respondents said they knew much about the process of obtaining credit; 25 percent said they knew a bit about the process; and 69 percent said they knew virtually nothing about credit. Almost 45 percent said they do not know where to go to get credit. Twenty-five percent of respondants said they receive no information on credit from any source. The quality of available information is poor. The information given on television is very limited and the reports of friends, neighbors and relatives is also limited and imprecise. Seventy-two percent of the respondents had no idea about eligibility requirements for loans, and over 75 percent said they were unaware of the amount of credit available. Almost half of the respondents (49 percent) had no idea what sort of documentation is required to obtain loans, and when asked what is needed for a loan, only 7 percent mentioned that documents are as important as business plans when applying for credit. People in the rural areas mistrust institutions, especially those dealing with financial matters, both because of the widespread collapse of such institutions and because new ones have yet to prove themselves worthy of confidence. When asked which institutions or people they trust in financial matters, friends, relatives and acquaintances ranked highest, with 23 percent, followed by state banks (19 percent), credit foundations (10 percent) and KAFC (10 percent) The highest levels of "do not trust" were registered for private banks (48 percent), private money lenders (44 percent) and credit unions (33 percent). KAFC has a major challenge to overcome this high level of mistrust, but other evidence suggests that it is doing so successfully. Collateral. Of the limited number of respondents who had obtained loans, 40 percent had no collateral, 22 percent had used their houses as collateral, 13 percent used vehicles and equipment, and 9 percent used cattle. Although virtually all rural households have houses, many are afraid to use them for -71- collateral. Many other prospective borrowers were prevented from using their houses as collateral because they had no legal ownership documents and were dissuaded from obtaining the documents by the transaction fees charged by state architecture agencies, the BTI and lawyers and notaries. In addition, property is systematically undervalued for collateral purposes, which discourages people from using valuable assets for this purpose. In addition, in many families it is difficult to get all members to agree to sign collateral documents, even if the head of the household wants to do so. Social Bonds. Forty-five per cent of the survey respondents said they would be willing to join credit groups with relatives. A sizable proportion also indicated they would only work with people from their villages whom they know and trust. Nineteen percent said they did not want to join credit groups at all. Of those, 36 percent said they preferred to conduct their financial affairs individually. Thirty per cent said they were afraid of the risk, and 22 percent had too little information or knowledge about how a group would function to be able to respond positively. This indicates a large reservoir of potential credit group members, which can be expected to grow as the experience becomes more common and the results more visible. Other Needs. Most respondents were surprisingly confident that they were prepared to use credit effectively to increase production. Sixty-two percent said they have the technical information they need to do so, and 74 percent said they had access to storage facilities or other means to hold their production if they cannot sell it immediately after harvest. Respondents felt confident that they can manage animal husbandry and marketing effectively without significant assistance. Nonetheless, marketing of most products is seen as a major problem and many felt constrained by the lack of markets, in general, and severely disadvantaged by the low farmgate prices they receive for their crops. Consequently, many rural people think about establishing small-scale processing facilities to enable them to increase their share of the value of their products. Despite their confidence in basic agricultural and animal husbandry, respondents in the survey and in other discussions strongly expressed the need for assistance in preparing business plans and managing farm finances. Major Problems. The survey respondents reported that they are faced with many major challenges. When asked what are the most important problems their families face, 42 percent said they did not have enough income to buy basic food. Other responses were as follows: lack of employment (12 percent); lack of gas, coal and wood for cooking and heating (nine percent); poor water supply (eight percent), and unpaid salaries (six percent). When asked about salaries, however 59 percent of the respondents said that their pensions and salaries were from one to three months late and 15 percent said payments were between four and seven months late. One-fifth of the respondents have access to gas, while 91 percent cook with wood and 40 percent with dung. The high use of wood has obvious serious environmental consequences, manifest in the rapid disappearance of wood lots near villages. The use of dung for cooking is also a problem, as it reduces the amount of organic fertilizer available for crops. Summary. The survey strongly highlighted a number of problems in the countryside and demonstrated that the prospects of benefiting from RFP II are very good. Demand is great, although information levels are low; technical preparation is adequate, but major gaps remain in the production/consumption cycle; and people are both disposed to using credit for productive purposes and to joining credit groups to overcome collateral constraints. Stakeholder Workshops A major stakeholder workshop was held in Bishkek during the appraisal mission to discuss the findings of the SA and implications for RFP II. Subsequently, workshops were held in Issik-Kul, Osh and -72- Jalal-Abad. Around seventy participants attended the first workshop, including survey respondents and focus group participants from Chui and Talas Oblasts, Akims of the oblasts, officials, headquarters and field staff of KAFC, Bank staff and representatives of NGOs and the media. Following presentations about the project and the SA, the participants broke up into small groups to discuss salient implications of the SA for their particular group: farmers, officials and rural finance people. The discussions were lively and constructive, echoing a common objective to make credit available to a wide spectrum of rural people, to empower them to obtain credit easily and use it effectively, and to instill the repayment discipline needed to sustain the KAFC and other institutions that deliver rural credit. Participants in the workshop strongly endorsed the principal concepts of RFP II and the work of the KAFC. They enthusiastically supported the group credit program based on social collateral, or group guarantees, and explored ways to facilitate the group formation process and strengthen groups. Many specific recommendations emerged from the workshop, but three general recommendations were given special emphasis. First, credit demand is high, but greatly tempered by a general mistrust of financial institutions. Most rural residents lack access to credit and virtually no information is available to help them determine where and how to objain credit. Second, KAFC is well known and more highly regarded than other financial institutions; nevertheless, KAFC field staff should receive training in how to deal effectively and respectfully with rural people. Third, the lack of credit is imnportant, but access to markets is considered to be one of the greatest weaknesses in the agricultural sector; thus this issue should be dealt with on three fronts: (a) through the training given during group formation to help borrowers understand various market principles and their role in markets; (b) by encouraging some groups to specialize in marketing to serve others; and (c) by strengthening linkages between RFP II and other rural initiatives that have marketing components. Subsequent workshops ratified these conclusions, with some adjustments for regional differences. Project Implications The Social Assessment, including the initial rapid assessment, focus groups, household survey, and many formal and informal interviews, produced a number of important insights that have implications for project design. Many of the implicit recommendations of the SA have already been incorporated into the project; others will shape the group training and support activities and provide the basis for social monitoring. The implications are discussed in terms of the "four pillars" of social assessment: context and social development issues; stakeholders and participation, institutional analysis, and monitoring and evaluation. Social Development Issues. The principal social issues in the project context are related to rural poverty and the social processes which either exacerbate the poverty of some groups or limit their access to the financial and institutional resources that could help them improve their condition. The project will address a number of important social issues although, inasmuch as its objective is to make rural credit available on a sustainable basis through viable financial institutions, it will do so in ways that are consistent with its mandate. The most important issues to be addressed are inequity, social exclusion, social cohesion and social capital, which are discussed briefly in turn. In short, the group lending component of the project is designed to reduce inequity and social exclusion by increasing social capital and strengthening social cohesion. EQuity. Inequity has increased in the rural areas with independence, the dissolution of sovkhozes and kolkhozes, and the transformation and/or collapse of many of the enterprises serving the large farms that were the nucleus of the agriculture sector. This inequity is manifest within rural areas, as mountainous and remote areas fall farther behind other areas, and between rural and urban areas. Both normative and -73- actual inequity are inevitable in a market system, but much of the inequity in the rural areas of Kyrgyz Republic is due less to market forces than to the mismatch between existing institutions and relationships and emerging institutions, and between old institutions and a new clientele. On the one hand, people with important roles in the previous regime and continuing ties to transformned old elites have used their positions to consolidate a large share of productive assets from the unrestructured remains of sofkhozes and kolkhoz es, which continue to be served by what remains of the input supply, financial, transport, storage and marketing enterprises that were created to serve major farms. The regular KAFC window serves the credit-worthy members of this group. On the other hand, the numerous independent farmers who liquidated their land and property shares and established individual and group farms, are essentially adrift with few and deteriorating resources and even fewer off-farm institutions to serve them. Most families rely on their home garden plots for subsistence and struggle to find ways to make their farms viable. The small loan window of RFP II will increase inequity by providing access to credit to farmers and entrepreneurs who currently have no access, allowing them to invest in their operations. Access to KAFC loans must be equitable, transparent and consistent, based on well defined eligibility criteria rather than position and relationships. KAFC must therefore resist all attempts by officials and other influentialpeople to direct credit to their relatives andfriends. A strong public information program is a critical element in establishing transparency and accountability, thus it is will be a prominent defining characteristic of RFP II. Social Inclusion. As individuals and groups, small farmers are systematically excluded from dynamic rural networks and resource flows. On the one hand, old established institutions were created to serve large units, and have not adjusted to meet the needs of small producers, who remain relatively isolated. On the other hand, emerging support institutions like KAFC, which are demand driven, inevitably deal with the most aggressive, energetic and mobile rural people. For the most part, these traits are associated with higher education levels, and both information flows and institutional demands accentuate the advantages of educated people, further exacerbating the exclusion of the less educated. For example, complicated application procedures require many forms of documentation, some of which consist of registration and certification, which involve notaries, various officials, and sometimes even judges. Much of the process is either already familiar to farm managers and other people with resources who, based on prior experience, quickly learn how to move through the system. In addition, even seasoned bureaucrats say that KAFC's application forms, which are only available in Russian, are unnecessarily hard to understand and complete. Consequently typical Kyrgyz-speaking rural people with secondary school education cannot complete the forms without help. K14FC will contribute significantly to increasing social inclusion by simplifying loan application requirements, especiallyfor group loans, and developing simple, straightforward application forms in Kyrgyz as well as Russian. Social Cohesion. Evidence is mounting that as poverty becomes more widespread and severe in the Former Soviet Union, there is a discernible weakening of traditional resource sharing and other social support mechanisms based on the family, clan, and village. Newly poor families find themselves unable to contribute to the communal pot, thus they withdraw from mutual obligations. An important aspect of group lending, particularly that based on social collateral, is that it draws on forms of social solidarity and strengthens them at the same time. This quality is very important for an institution like KAFC, which depends on repayment for its survival, but it is even more irnportant for villagers and their future. Although most credit groups form on the basis of family, clan or work bonds, it can be expected that group membership will eventually become more selective as less dependable members are weeded out during successive group loans. The group formation and training process will thus emphasize the importance of group bonds and shared responsibility. Social Capital. Small farmers and rural entrepreneurs in Kyrgyz Republic are virtually without -74- organizations that serve their needs or articulate their interests. Over time, these must emerge. SFCOP's experience with ACCs, although limited, has demonstrated that there is great potential for credit groups to develop into either multi-function associations or more specialized nascent enterprises. It is not clear to what extent the need to formalize and register an ACC prompts members to develop a more comprehensive, long-term view of their organizations than would otherwise occur. It is too early to determine whether or not SHGs have the same potential to develop into organizations with more sophisticated, operational roles, or to understand to what extent a formal registration process, such as that for ACCs, would foster the development of a long-term vision for a group. Regardless of the roles they assume, the creation of mutual obligation credit groups in itself enhances social capital in the rural areas. The group formation and training process will thus focus on immediate issues related to mutual repayment responsibilities of the credit groups, as well as potential long-term roles of such groups. Gender. Gender does not appear to have a significant role in determnining access to credit either through ACCs or SHGs, but distinct patterns appear to be emerging in different parts of the country. There appear to be few, if any, ACCs with an all-women membership, although this is not uncommon among SHGs. Focus groups revealed distinct regional differences regarding the actual and perceived role of women in financial management. In general, both men and women claimned that women are more conscientious about handling money than men and would be more likely to meet repayment requirements. The perception was stronger in the south than in the north, and women in the south most frequently desired credit for petty commerce or animal husbandry, rather than crop production. Credit access and use will be monitoredfor gender differences, and group formation and training programs will be adjusted to meet gender related demands as they emerge. Stakeholders and Participation. RFP II has a number of stakeholders, ranging from KAFC to individual and group borrowers and various officials. This section briefly assesses the needs and priorities of major and minor stakeholders and describes the steps taken to ensure that key stakeholders participate actively in project design and implementation. Primary Stakeholders. RFP II has three primary beneficiary stakeholders: KAFC, individual borrowers and group borrowers. As the principal institutional beneficiary, KAFC will obtain financial resources for technical support to strengthen its capacity to provide credit to farmers and rural entrepreneurs in a manner that is financially sound and sustainable. Individual borrowers directly benefit from KAFC support. They appear to have the skills needed to articulate their needs and to meet the collateral and business planning requirements of KAFC. This is demonstrated by the rapidly growing demand and repayment. Group borrowers--members of ACCs and SHGs--are also growing in number, as are their expectations for continued access to increasing amounts of credit. Other Stakeholders. Officials at different levels, from the central government to villages, strongly support project objectives. They want to make credit available to farmers and entrepreneurs, although their enthusiasm may be selective, directed toward specific enterprises or individuals, or to increase production of particular commodities. Other organizations also offer rural credit programs, often in specific areas and for specific purposes, many of which receive external support. They can complement KAFC's role, but see themselves as competitors whose interests may be jeopardized by KAFC's prevailing interest rates. Input and machinery suppliers see themselves as beneficiaries, whose interests are served by increasing cash flows in rural areas through KAFC, and as competitors who currently profit from in-kind seasonal loans to producers. Staff of the BTI and other registration facilities, notaries and lawyers all profit from KAFC's collateral documentation procedures, and may lose part of their respective incomes if the documentation requirements are reduced, simplified or, in the case of group loans, abolished. Finally,- NGOs, such as ACCs, are likely to increase in number and assume more important roles as the result of project -75- interventions. Participation. On the one hand, participation in RFP II is relatively simple. The project is demand driven, thus KAFC needs to make information available to realize the potential demand for rural credit. On the other hand, poor information flows, insensitivity to the needs of particular groups and onerous transaction costs have undoubtedly reduced effective demand, which will greatly increase once these obstacles have been overcome. At the same time, however, there is a real danger that reducing current constraints on demand could easily lead to a high level of demand that could overwheln KAFC and cause it to lose credibility by appearing to be unresponsive. Given this caveat, the project's participation strategy will consist of four elements, which are described below. 1. Remove constraints. A major element of the strategy is to reduce or remove obvious constraints which disproportionately affect potential small borrowers. First, documentation procedures will be simplified and made more transparent to remove uncertainties about transaction costs and processing time. Second, simpler, user friendly application forms will be issued in at least two languages, increasing access to less educated people. Third, the criteria used to decide whether or not to issue a loan will be made public, and rejected applicants, both group and individual, will immediately be told why their application was not accepted. Finally, loan decisions will be decentralized, speeding the process and moving it closer to clients. 2. Make information available. A major effort will be made to prepare and distribute information materials that will inform potential borrowers about credit requirements, documentation, procedures, costs, loan conditions, interest rates, processing times, direct and indirect application costs and fees, appeal mechanisms, support sources and other relevant issues. This information will enable people of all education levels to know how to prepare for credit, where to go to get it, and what is expected of both borrowers and lenders once the loan is issued. Such information will enable prospective borrowers to plan effectively, to carry out the application process efficiently, and to estimate accurately the time and cost required to get loans. The outcome of the information campaign will be to increase transparency, establish accountability, generate reasonable expectations and empower clients to protect their interests and articulate their needs. The campaign will be targeted to meet the needs of clients while keeping demand from overwhelming KAFC. 3. Train and mobilize prospective clients. Regardless of the amount of latent demand, effective and dependable credit groups will emerge automatically. It takes time and resources to create viable credit groups that can serve both members and KAFC. A specific non-budget subsidiary or branch of KAFC will be established that provides support to help villagers organize viable credit groups; to offer training to develop solidarity and mutual accountability among group members and to help clients obtain the information and other support they need to maximize the returns on their loans. This branch of KAFC will work closely with other organizations involved in rural credit or rural support to share resources, consolidate training and coordinate field-level initiatives to minimize overall costs and maximize synergy. 4. Monitor progress and address emerging issues. An ongoing monitoring program will be established to assess the adequacy and effectiveness of information campaigns, to articulate lessons learned from group formation and training programs, to assess the client orientation of KAFC field staff, to document repayment patterns and problems and to identify opportunities to consolidate and improve the efficiency and effectiveness of KAFC's group lending program. The monitoring will use regular reporting channels as well as employ focus groups for more in-depth exploration of specific issues, as appropriate. Institutional Analysis. In a short time, KAFC has established itself as an effective, credible rural -76- finance institution. It started as a focused, central organization and then started to establish a national network of oblast and rayon offices, to which it is in the process of decentralizing responsibilities. As is the case of most nascent institutions, KAFC is going through a development process that is characterized by three major stages, each of which presents a different set of challenges. The first stage is that of establishment, of defining itself, of simply creating a visible presence and carving out a unique role. This has occurred. The second stage is to become effective, to actually accomplish its objectives, demonstrating that it can carry out its chosen role. This is underway now, and is culminating with major increases in the volume of individual lending, the growth of group lending services, with and without physical collateral, and the serious pursuit of repayment, to collect all arrears. The latter step is especially important both for the survival of KAFC as an institution and for the symbolic re-definition of the role of a credit institution from that of a veiled deliverer of subsidies to that of a serious commercial organization. The next step is to become efficient, to increase the volume of lending, the number and the loyalty of clients, the relative impact of its investments while reducing unit costs. RFP II will enable KAFC to move to the third stage by focusing on five tasks that are essential to carry out. These are described briefly in turn. 1. Remove blockages and impediments. Some of the challenges that fall under this category are internal technical and procedural changes; others require inputs from clients, some of which have been discussed above. Among the technical changes are to establish an efficient MIS system, decentralize decision making and cut processing time. Some other changes must be made in consultation with clients and other agencies, based on a clear understanding of the needs and characteristics of clients, such as reducing documentation requirements, simplifying application forms, issuing application forms in new languages, standardizing decision-making criteria and providing feedback on rejected applications. Some of these essential changes are in the process of being implemented. 2. Increase institutional capacity. KAFC can increase institutional capacity by working on three fronts. The first front is largely internal, consisting of steps such as reorganizing and speeding internal processes, increasing skill levels, improving commnunications and data management and, all of which may lead to changes in staffing patterns by retooling or releasing employees. The second front is that of the client. KAFC cannot become more effective and efficient unless its clients are better informed, better organized, particularly for group lending, and more adept at dealing with KAFC's specific institutional characteristics and requirements. The public information component and support to group organizing will help on this front, and will need to be updated as clients become more experienced and more demanding. The third front is the support system that enables clients to understand and articulate their credit needs and to make good use of the loans they obtain. The support consists of two levels: the technical knowledge and content needed to define productive and profitable investment opportunities, such as new cropping or animnal husbandry practices, or an agro-processing facility; and the transformation of that knowledge and aspirations into a viable business plan that justifies the loan requested. Such support must come from outside organizations and/or investment projects, which KAFC should conscientiously mobilize. KAFC can increase its efficiency only if improvements are made on all three fronts, as planned RFP II. 3. Establish clear, socially relevant selection criteria and apply them systematically. Experience with group lending in Kyrgyz Republic and elsewhere has shown that there are a number of characteristics which increase the likelihood that groups function effectively as intended, for the mutual benefit of group members and the lending institution. For example, groups must be relatively homogenous socially and economically; members must be from the same immediate area; and members should share experience or other bonds; groups should mobilize resources regularly that serve common and individual interests, such as a revolving fund based on individual savings. These criteria will be used both to advise prospective -77- group members during the formation and training process, and to enable KAFC staff to ascertain the relative creditworthiness of applicants. They are included in the KAFC Operations Manual. 4. Improve the KAFC/client interface. KAFC is a new style organization with a relatively young, enthusiastic and dedicated staff and a growing field presence. Staff appear to have a good understanding of the needs and challenges of their individual clients. Nevertheless the SA identified a clear need to improve the interface between the KAFC and its clients, especially those in credit groups. A number of references in focus groups and individual interviews led to the conclusion that small farmers characterize KAFC staff as young, urban oriented and frequently condescending. More specifically, in field discussions some KAFC staff treat credit group members as children, rather than clients. In many locations, KAFC is the only active rural credit organization, thus farmers will tolerate such behavior. When competition develops, however, clients will be less tolerant and may turn to another institution that is available. To reduce the likelihood that KAFC will lose customers to new competition, field staff must develop new ways to relate to small farmers, either by fiat or by broadening their own experience. The latter is most likely to have a lasting effect, thus KAFC has a vested interest in pursuing that approach. To increase exposure of KAFC staff to rural clients, and to increase their appreciation of the strengths and challenges of their rural clients, KAFC field staff will participate in some group formation training exercises, as well as receive special in-house training designed to increase their communications skills. 5. Develop links to other resources. The impact of KAFC loans depends on many factors, ranging from the weather to choices in technology and the existence of marketing channels. Many of the factors are beyond the control or the technical competence of KAFC staff. Nonetheless own their success depends on improving their clients' ability to deal with such issues. Consequently, KAFC will develop direct and indirect links with other resource people and institutions working in the rural sector. This will help clients increase access to the skills and information they need to make good use of KAFC loans. Immediate opportunities exist to link with other rural initiatives supported by the Bank, NGOs and other organizations for joint training efforts and for technical resources. Other opportunities should also emerge in the process of creating the CDF. Social Impact Monitoring. RFP II is expected to increase access to rural credit to a wide spectrum of rural people, enabling them to make productive investments that will increase their incomes and standard of living. Small scale loans will be issued through credit groups which have immediate responsibility for repayment and long term potential to evolve into broader or more specialized rural organizations. Social impact monitoring will focus on a number of aspects which are expected to change over time, reflecting the multi-dimensionality of social aspects of the project. The major topic areas, and the types of changes to be assessed are as follows: Role of groups. Do groups meet their collective and individual obligations? Do groups acquire new roles and meaning consistent with their original mandate, or on other dimensions? Benefits. Does the credit have a discernible impact on household incomes Satisfaction. Are members satisfied with their function and impact? Leadership. What leadership characteristics promote or impede group success? Membership. What qualities of members promote group success? What impedes success? Social Bonds. Does the type of social bond (family, clan, work) affect group success? Access. Are groups perceived to increase access to credit and/or other resources? Impediments. What external factors promote/impede group formation and cohesion? Interface. To what extent does the quality of interface with KAFC affect group success? Context. What is the influence of the village social context on group success? Linkages. Does group membership increase access to other resources, information or -78- opportunities? Graduation. Does group lending progress to individual lending over time? -79- Additional Annex No.: 13 Environment Assessment Summary of Assessment Results A. Environmental Review - Summary Introduction An environmental review of the RFP II was carried out in March 1999. The purpose of the review was to meet the requirements of the World Bank as set out in Operational Directives 4.01 for financial intermediary projects. Of particular concern was the possibility that loans could be provided for activities that would include World Bank category projects A and B. The Environment . general Kyrgyz Republic is characterized by a mountainous environment with the Tien Shen and Pamirs comprising approximately 90 percent of the country. It has a temperate continental climate. The country is comprised of 22 different ecosystems, most of which have been affected by man's activities. The mid-mountain meadows, mid-mountain steppes, and the glacier and sub-glacier ecosystems together make up about 45 percent of the country's area. . biodiversity A number of the 22 ecosystem types are very fragile and threatened by human activity, prirnarily over-grazing. The country's forests have been drastically reduced over the last few decades with the fir and juniper forests having declined by over 35 percent and the pistachio and almond forests having been reduced dramatically. Biodiversity of Kyrgyz is substantial and the country displays a species richness of above average for the Central Asia Region. . land use Agriculture is important to the Kyrgyz economy and accounts for about 30 percent of GDP and approxiniately one-third of all employment. Irrigated agriculture covers 80 percent of the arable land and pasture resources are extensive, covering 8.8 million ha of land or about 45 percent of the country. . environwental issues There are two main environmental problems: one is related to natural forest and pasture land degradation which results in soil erosion and a modified hydrological regime. The other is related to soil and water pollution as a result of agricultural activities and mining. Both degradation and pollution contribute to the loss of biodiversity and destabilization of the general environment. Policies and Legislation Kyrgyz Republic has a number of pieces of legislation that relate directly or indirectlyto the environment -80- and which are taken into account during project planning. Key legal instrumentation is the recent environmental legislation which was read in Parliament on 10 March 1999. Essentially, any project that will have an effect on the environment must be examined by the Ministry of Environmental Protection (MEP) and it has the mandate to carry out all assessments. The MEP approves all development projects and has the responsibility to ensure that mitigation is undertaken in the case of potential impacts. Fourteen other pieces of relevant legal instrumentation are in force. Project Assessment . general All loan applications were placed into nine types or categories for purposes of assessment. These included: . crop production - pedigree seed purchase . crop production - fertilizer . crop production - pesticides* . crop production - land preparation l livestock production - pedigree stock for breeding l livestock production - animals for finishing . market facilities and amenities . processing . procurement * to date, no application for a pesticide loan has been made benefits The project provides a number of benefits, the primary one being the contribution to the alleviation of rural poverty by improving the socioeconomic conditions of small farmers. . impacts A number of potential impacts from the nine types of projects for which loans would be provided have been identified. All impacts are relatively insignificant with the exception of those which could be expected from the use of pesticides, if loan applications are made and loans granted for these chemicals. Impacts related to pesticides would include risk to human health, contaminated soil and water systems, modification of ecosystems and loss of biodiversity. Many loans are provided for the purchase of livestock for finishing. The significant potential impact related to this type of loan would be the effect that increased stocking could have on ground cover, soil erosion and waterway sedimentation. As well, anirnals that are grazed near forested areas could pose a threat to an already dwindling forest cover. This is particularly important since the nation's forests represent 50 percent of the country's biodiversity wealth. Other impacts from other types of projects supported by the loan program will include water contamination, soil contamination, soil loss, overgrazing, and social disruption. . cumulative impact The potential cumulative impact that the project could have on the environment is far more important than all of the individual impacts. Each project is relatively small and full impacts from any one project, even -81- allowed to go unchecked, would not be very significant. However, a number of projects in the same area could have a significant cumulative effect on the environment. An example would be the approval of a large number of loans within one particular watershed for livestock purchase. The cumulative effect of small amounts of soil loss through overgrazing on downstream water quality could be significant - even possibly at the international level since the country is landlocked and its river systems all flow into adjacent countries. The same effect could hold true for projects involving the purchase of fertilizers and other chemicals, and for a number of agro-industry projects within the same area. . mitigation Mitigation for all impacts can be achieved at little or no cost. Most mitigation would require management input advice from extension workers and others in order that the project is implemented in an effective and environmentally acceptable manner. Mitigation for the cumulative impact will be achieved through the mitigation of all of the small impacts created by the individual small projects. . residual impacts Residual impacts are those impacts that remain once all mitigation has taken place. These are the trade-offs for the benefits to be realized through the project. Assuming that full mitigation is carried out, residual effects will be few and insignificant. Only those projects involving seed purchase, fertilizer purchase, pesticide application, land preparation and agribusiness are seen as to have some residual effect but the effect will be insignificant with the possible exception of projects involving pesticide application. Environmental Management . personnel KAFC will be hiring an environmental specialist in the near future. The specialist will be responsible for all environrmental concerns, but particularly, to ensure that: projects have the environmental permits in place, projects which require EAs have a proper EA conducted by the licensed bodies; EAs are adequate; mitigative measures are carried out; no unforeseen environmental impacts occur. He/she will monitor project activities on a random basis. . management procedure KAFC has received a blanket exemption (for EAs) from the MEP on a number of types of projects. All projects, however, require the loan applicant to obtain a permit for the proposed project from MEP. The environmental permit is only one of many different permits that the applicant must hold, and without the required permits in place KAFC will not consider the application. The onus for ensuring that all permits are in place rests with the loan applicant. If MEP indicates that an EA is required for the project, the proponent must obtain the services of one of the country's licensed bodies for conducting EAs. The EA requires MEP approval. Detailed environmental assessment guidelines are available through MEP. Until recently guidelines from the former Soviet Union were in use, however, a similar set has been recently prepared for Kyrgyz. The Kyrgyz guidelines include, in addition to the contents of the former Soviet guidelines, provision for notifications of intentions to the public, and provisions for the application of the guidelines to policies, plans and programs. -82- The environmental specialist of KAFC will ensure that all project loan applications have the required permit in place. He/she will also ensure that the project does not require an EA under the guidelines of MEP. He/she will determine whether or not the project proposal will fall into Bank Category A or Category B project list. Once the loan has been approved and is dispersed, the environmental specialist will monitor a selection of projects to ensure that mitigation is being carried out, and that there are no unforeseen impacts. The specialist will liaise with both the MEP field staff and head office staff, particularly when it is not clear whether or not an EA will be required. . Category A and Category B Projects During the first phase of the project (RFP I) there were no Category A or Category B projects. The only possible project applications in the future that would fall into these two categories are for the purchase of pesticides (Category A) or for small scale agro-industries (Category B). In the event that an application to support a project that would fall into either of these categories is made, KAFC would ensure that the applicant has conducted an EA that would meet national EA guidelines and has been approved by MEP. To determine whether or not the application is for a project of either category, the KAFC environmental specialist will consult the World Bank operational directives in order to make a determination. The sectors for each category are quite clear, however, making this determination will require some judgment since the O.D. suggests that: ... it is the extent of the impacts, not the sector, that determines the extent of the environmental assessment and, hence, the category. He/she may consult with the World Bank if the categorization is questionable. An example of a questionable categorization would be the possible use of pesticides. Although for Category A, one of the projects is .... Manuficture, transportation, and use of pesticides or other hazardous and/toxic materials ... If a loan is being used for the purchase of several tons of pesticide for use on a large farm, then an EA would definitely be required. However, if a small farmer requires five kgs. of pesticide only, an EA probably would not be required. However, instruction in the handling and application of the pesticide, from a safety point of view, should accompany the loan. . monitoring The KAFC environmental specialist will be responsible for preparing monitoring guidelines and procedures, and ensuring that effective monitoring is carried out on the projects for which loans have been provided. Due to the large number of projects, a random sample of projects will be monitored to ensure that mitigation is carried out and that there are no unforeseen impacts. In addition, World Bank supervisory missions could also conduct spot monitoring on a few randomly selected projects. . training KAFC currently has no capacity for environmental analysis or environmental assessment. However, the Corporation will be hiring an environmental specialist in the near future. The specialist, along with the loan officers of KAFC, will receive environmental training. Training for the loan officers will focus on a set of environrental guidelines that have been prepared, to help the officers identify potential impacts that projects may have on the environment, and generally to make loan officers more environmentally aware. Training for the environmental specialist will be more intense and will cover such topics as legal requirements for EAs, World Bank EA guidelines, and recognition of the Bank's category system and how to categorize projects. B. Environmental Checklist An environmental checklist consists of two sets of tables to be used as a guide by KAFC loan officers. The -83- first set is a sub-set of nine tables (Tables 1-9) - one for each loan type. These indicate potential impacts, consequences of impacts, suggested mitigative measures, and related legal instrumentation. The second set is a single table (Table 10) which indicates the level of potential impacts by agricultural activities on environmental components. Table 10: Agricultural Activities Affecting Different Components of the Environment Horizontal Axis 1. increase cropping areas* 6. dryland farming 11. sheep dips 2. soil cultivation 7. increased livestock 12. forage production 3. irrigation 8. confined livestock 13. storage 4. chemical fertilizers 9. open grazing 14. transportation 5. 2esticides, herbicides 10. nomadic cattle rearing 1 15. orocessinn Micro climatem __ __ 1 _ _ Air qalit___y ____ Water quality - chemical mr m in Water quality - physical m m Soil qualiwy - chemical i Soil quality physical - m I _ Soil Erosion M m Soil Fertility m m Salinization Waelossgofnatrleog tm n Increased surface drainage |miwt |Groundwater losses _ _._lmi_m mt m ____ fSurface water losses_ t L1b~ IBiodiversity loss__ p m I m Loso naua coyterms l ||I m ml < Natural forest loss m Other natural vegetation ___m in Weed invasion m n,I I Invasion ofnew s ecies m i i I | Biodiversit loss I I Modif. of natural ecosystems 3 4 kh m h I heed indiatsiareaivlnhg poeta imac Hum an h ealth and safetively m r pe mimpact Food contamination i}||1 IIncreased flooding m 7N |]l Increased mudflows/ landslides ||m IDesertification '.LII Lml h - indicates a relatively high potential impact m - indicates a relatively moderate potential impact I - indicates a relatively low potential impact -84- MAP SECTION 704 ~~~~~~~~~~~~~~~~~~~~~~~~~~~~7, EA0 KAZAKHSTAN ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~./ A\-ly KAZAKHSTAN TDJ,bI ) vi \ v 5 J g g m W w ~~~~~~~~~~~~~~~~~~~C H I N A Ok X X ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~T X#s#gS, T- 40-gW 1 KYRGYZ REPUBLIC T. A J I K I 5 T, A ¢ WR Lt X wo S ID E W.Y RURAL FINANC~~~~~~~~~~~~~~~~E IIS.;X I 1~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~12 ® NALETENA CAPTAES 2000-2999 .A/ ; \ R A-~ SeF9t5FSATUON] | \ l l ~-- RAYON xDISTRICT) BOUNDARIES 15I0-199 rARRAAAJI G - KAZKAZAKHSTAN OBLAST (REGION) BOUNDARIES 0 | < X . > -;slE g da A C - ! MOs00~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~50-9 ~~~~A~~~~~A [A - - - ~~~~~~~~~~~~~~~~~~~~~~INTERNATIONAL SOUNDARIES | 0 X : v P& i t t - > ~ --~ / | [ ^ l KILOMETERS 1 1~ @> JXEYRSYZ REP 7 |__|_______0_50 __100_______| $ * * (_ *_ l l r~~~~~~~~~hi, m Lp w rdcd6y t M.p De.iqn Unil ofThe World B.An. | |IStAMIC Th. b-d-i-- id T-K- As 0 25 O 75 1O 4 REP1LtIC ys _.- C H I N A l l on ,his m,p do no7 im7ply o7 Ahe p1rsofThe WorldSonf GAoup any - T MILES JUNE 1999