Public Disclosure Authorized. Public Disclosure Authorized. Public Disclosure Authorized. Public Disclosure Authorized. Report No.

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1 Public Disclosure Authorized Report No. PID4180 Project Name Latvia-Rural Development Project (+) Region Europe and Central Asia Sector Agriculture/Rural Project ID LVPA44804 Borrower Republic of Latvia Public Disclosure Authorized Implementing Agency Government of Latvia Environment Category B Date PID Prepared December 12, 1997 Date PID Updated July 30, 1998 Projected Appraisal April 1998 Projected Board Date July 30, 1998 Public Disclosure Authorized Public Disclosure Authorized 1. Country and Sector Background Since Latvia regained independence in 1991, it has successfully implemented a vigorous program of stabilization policies which were complemented by a series of structural measures aimed at a fast transformation of the economy. From the outset, most price and trade regimes were liberalized. These steps were complemented by efforts to restructure the banking system, privatize the economy, and demonopolize large state-owned enterprises. These policies, which were supported by the IMF and the World Bank, allowed Latvia to reduce macro-economic imbalances quickly and substantially and to accumulate a significant amount of foreign exchange reserves. Tight fiscal and monetary policies led to near-balanced budgets through 1993 and a sharp decline in the annual rate of inflation to 9% in Agriculture Sector Before independence, agriculture was the second largest sector in the Latvian economy, accounting for nearly a quarter of the GDP and employing 18% of the labor force. While its relative share in the economy has declined, the agricultural sector continues to be the main source of income and employment and provides a valuable supplementary income to a large number of the rural population. The agricultural and food sectors have become increasingly important exporters, accounting for over 11% of the total value of exports in third in value only to the forestry and textile sector. 3. As Latvia pursued macro-economic reform policies, it has also undertaken rigorous reform-oriented agricultural policies which led to significant restructuring of the sector. By mid 1995, Latvia completed the most difficult tasks of transition, including: (a) near-complete liberalization of prices; (b) elimination of most agricultural subsidies, with only modest direct subsidization remaining; and (c) privatization of most of the agro-processing and input-supply enterprises. In the area of land reform, achievements were even more impressive; most of the land was returned to private individuals who either farm it themselves or rent it to others. The number of private farms increased from just 7,500 in 1992 to over 130,000, and the area occupied

2 by these farms increased over 13 times. These farms, together with household plots, accounted for over 80- of total agricultural production in The Project 4. Introduction The project is the first of a two phase Adaptable Program Lending (the Program) and follows the first Agricultural Development Project (ADP) that the Bank has approved in The ADP has been completed with successful outcome. The Program is designed to help transform Latvia's rural sector become compatible with EU standards. The Program includes: (a) investing in the institutions necessary to implement policy reforms; (b) providing the public infrastructure necessary to support private growth both on- and off-farm; (c) ensuring adequate financing for agriculture and off-farm business development; and (d) providing a framework for participatory community development that will empower rural residents while reducing incentives for urban migration. While the details of the first phase project are well defined, specificity of the second phase of the Program remains to be defined during the implementation of the first phase project. 5. Objectives The development objective of the first phase project is to lay the groundwork for increasing income levels and improving living standards of the rural population by promoting diversification and growth of economic activities in the rural areas. The proposed project would achieve the stated objective through:(a) strengthening policy formulation capacity for rural development strategies at national, regional, and local levels of government; (b) introducing participatory approaches to rural development to increase stake-holders' ownership and commitment; (c) providing credit and technical assistance to generate employment and income earning opportunities in rural areas; (d) further strengthening rural banking practices and rural business development service network consistent with principles applied in the EU; and (e) expanding support for the development of the emerging land market and legal registration system of private land and real estate. 6. Description The project has three components as follows: A. Rural Development Policy Component (US $1 million) 7. The component aims to assist the Government, through technical assistance, in the development of a comprehensive rural strategy and human resource capacity at the national, regional, and local levels. The component would provide training, workshops, study tours, organize policy forums, and help create new policy instruments and measures through promoting and coordinating policy dialogues among ministries, the central government and local level authorities and increasing public awareness and support. This component will closely coordinate with the EU supported "Rural Diversification Project" which provides technical assistance in selected Pagasts. B. Rural Finance Component (US $15.5 million) 8. This component will provide a credit line to eligible participating financial institutions (PFIs) to on-lend for working capital and investment loans at prevailing market interest rates and commercial terms. Intended beneficiaries are those who have commercially viable and bankable projects with adequate collateral, adequate financial rates of return and demonstrated repayment capacity. Borrowers applying for credit will have to meet strict eligibility requirement related to their ownership, share holding, and - 2 -

3 management. PFIs will maintain full autonomy in selection of borrowers, approval of sub-projects, and determination of lending terms 9. This component will have a sub-component which will provided small size loans to private entrepreneurs in the rural areas. A maximum cumulative loan to one single borrower will be limited to LAT 2,000. A combination of a partial credit guarantee scheme, a complementary capital grant, and transaction cost support will be provided. This component will help overcome the problems of inadequate collateral by giving individuals opportunities to accumulate assets for future collateral and encourage commercial banks to lend to rural entrepreneurs. C. Institutional Development Component (US $2.5 million) 10. This component will provide technical assistance to strengthen rural business development, marketing, and other private sector development support services in rural areas. Potential partners include Latvian Agricultural Advisory Services, Small Enterprises development centers, NGOs, etc. TORs have been prepared for this component. 11. This component will also provide institutional support to address constraints on credit flows to rural sectors through capacity building in the Mortgage and Land Bank (MLB), strengthening of other PFIs, and TA and training to develop the registration of security interests. 12. A sub-component will expand the already on-going land reforms in Latvia. Operations in the Cadastre and Land Book will be expanded to expedite the title registration and reduce the backlog between Cadastre and Land Book registration. A related TA will be provided to improve the MIS system and the valuation of land, and to create a "Real Property Registration and Credit System" which can provide services to financial institutions on collateral, liens, and other debt obligations of potential borrowers. 13. Financing The total project cost of the first phase project is US $19 million which will be implemented during 30 months. The project financing includes a Bank loan of US $10.5 million which will be complimented by US $1.0 million from the Government of Latvia, US $3.8 million from PFIs, US $ 1.0 million from prospective donors, and US $2.7 million from beneficiaries selfcontributions. The financing plan for the second phase project (US $14.5 million) will be determined at a later stage. 14. Implementation The Ministry of Finance (MOF) will on-lend the credit line funds to eligible PFIs, which in turn, will extend sub-loans to the ultimate intended project beneficiaries. During implementation, a Project Management Unit (PMU) will coordinate overall project implementation and report to the Inter-Ministerial Working Group. The PMU will: (a) serve as the main communication point with the Bank and will also ensure that all requirements pertaining to the agreed Loan Agreement will be implemented on a timely basis; (b) oversee and coordinate project activities and ensure that project implementation is consistent with stated project objectives; (b) be responsible for preparing and overseeing implementation of annual work programs, monitoring, evaluation and reporting project performance, accounts and audits, operation of the special account and procurement of goods and services and; (c) be responsible for implementation of the institutional development component including coordination with the Ministries of -3 -

4 Agriculture, Economy, Regional Development, Justice, and Finance and other donors. 15. The PMU will also have responsibility for monitoring implementation of the Special Credit Line for small-scale rural enterprises, and ensure that intended beneficiaries are receiving support. Business support to rural clients will be provided through a network of service providers such as Latvian Agricultural Advisory Services, Small Business Development Center, NGOs, private consulting companies, and marketing and distribution companies, etc. 16. Sustainability Sustainability of the project would depend on multiple factors: at the sub-project level. For the credit line component, financial analysis should confirm sustainability of each sub-project, and PFIs must maintain a quality portfolio through prudent operations. Appropriate TA will be provided to enhance the sustainability. At the policy level, consistent and well designed rural development policies need to be implemented in a coordinated manner with all concerned agencies. At the local level, sustainability of the project would be linked to improvement in labor productivity and job opportunity, and the project's participatory approaches to promote community involvement would enhance the sustainability. The concept has been well received in most rural areas in Latvia. In addition, the principle of rural development which broadly fits with the concept of rural development of depressed areas in the EU has been accepted by the GOL. The Government of Latvia (GOL)'s commitment to provide counterpart funding for the special support for small-scale entrepreneurs is likely to ensure a high level of sustainability of sub-project benefits. 17. Lessons learned from past operations in the country/sector. - Bank experience with rural development projects indicates that centralized and top-down approaches to rural development often fail; the RDP is based on a bottom-up participatory approach in which the local population would have a voice. - Directed Credit to a specific sector often fails, and often benefits relatively well-off farmers rather than the poor. The RDP would have an earmarked credit support for small scale rural entrepreneurs who would otherwise not have access to commercial credit. - A matching grant approach to local and community-driven development with built-in flexibility, participatory, and cost-effective features are effective (e.g. Northeast Brazil) - focused poverty alleviation schemes such as credit guarantee schemes to increase access to credit and possible investment capital grant schemes are being incorporated in the RDP. - A community based approach to resource allocation, enforcement, and maintenance has proven successful (e.g. Burkina Faso, Egypt, Brazil) - Local Action Group (LAG) design under the RDP is consistent with this principle. the - In rural finance, the main emphasis should not merely be providing credit, but to stimulate savings as well, and be based on a broad-based clientele - PFIs under the RDP will be banks with large networks of branches in rural areas which mobilize resources from multiple sources, including savings

5 - Excessive constraints put on PFIs do not necessarily improve efficiency (e.g. the Latvia ADP with the Agricultural Finance Company) and PFIs should have multiple sources of funds to reduce their cost of funding. - There should be multiple PFIs involved in a credit project to increase competition among banks and reduce the cost of borrowing to ultimate borrowers- at least three PFIs are expected to participate in the RDP. - A credit line operation must be accompanied by complementary TA support to enhance risk assessment of loan officers and other institutional development support for PFIs, as well as support to clients in developing "bankable" projects - a comprehensive TA support is being included in the RDP. - Improvement of collateral system based on legal ownership of property is a prerequisite to a successful credit operation. The RDP will continue to provide TA and financial support to advance land registration as did the ADP. - The Government has recognized that it does not have comparative advantages in selecting investments which will help alleviate poverty in rural areas. The Government will, instead, earmark a specific loan amount to provide special support to small-scale entrepreneurs and rely on the commercial banking system to appraise, approve, and supervise investment loans. - As incentives to commercial banks to lend to rural poor, the Government will provide partial credit guarantees, transactions cost support, and complementary grant schemes. Past experience with credit guarantee schemes were generally too expensive to maintain, or demand was often too low due to duplication of risk assessment. Recognizing this, rather than creating a separate Credit Guarantee Agency, the RDP will introduce a simplified version of a credit guarantee scheme. 18. Poverty Category This project belongs to a program of targeted intervention to reduce poverty. Economic restructuring in Latvia has had mixed results and the benefits have not been equally distributed. Policies in general have been urban-biased and the conditions in rural areas are getting worse, with ever increasing unemployment, poverty, and declining living standards. Major income disparities exist in rural Latvia between rich and poor, and these disparities are increasing. A special program is included in the RDP to train rural unemployment or underemployed people in alternate skills, and help them start their own businesses, as well as providing increased access to credit. 19. Environmental Aspects The project has been rated as environmental screening category "B." No major environmental issues are expected. The proposed operation is expected to have positive environmental effects through the promotion of improved land use practices, farming methods, and agricultural product processing. Each sub-project will be subject to review based on an environmental checklist. Loan officers of PFIs, PMU and LAAS staff will receive training courses on environmental screening of loan applications based on Bank's Environmental Guidelines for Financial Intermediary Loans. In addition, a leaflet on the use of agricultural chemicals will be distributed to PFIs. The proposed project is consistent with the Latvia's environmental assessment procedures and the provisions of Operational Directive 4.01 'Environmental Assessment.' 20. Program Objective Categories The Board approved the updated CAS for Latvia in May The latest CAS identifies the priority areas for Bank - 5-

6 assistance as: (a) strengthening the macro-economy and financial sector; (b) accelerating development of the private sector; (c) reshaping the role of the State; (d) promoting environmentally sustainable regional development; and (e) strengthening the financing and delivery of social services. It also identifies poverty reduction as one of the key development objectives. The project relates directly to the Bank's objectives in supporting private sector and financial sector development. The targeted program would alleviate rural poverty by creating alternative income generation opportunities through training, enhanced information flows for business opportunities, and provision of investment credit. 19. Project Benefits The project would increase the provision of financial services to small scale farmers and rural entrepreneurs, and provides alternative job opportunities to unemployed which in turn help generate income and employment and improve living standards of the rural population. In addition to the poverty alleviation effect, the project would: generate financial and economic benefits in the form of increased agricultural productivity and output through credit-led modernization and continuous restructuring of the agricultural sector; and increase incomes and employment opportunities through the diversification of economic activities into nonagricultural sectors. The project would present a new approach to rural development based on local participation, and create a pilot rural finance scheme which will be meant for those who lack collateral or capital for selffinancing hence providing access to credit to those previously excluded 20. Project Risks Some of the main risk that the project may face are: (a) recurrent macro-economic instability and possible reversal of sectoral policies; (b) possible political instability; (c) market and exchange rate fluctuations; (d) weakness of the emerging financial sector; and (e) financial risk inherent in new, private farming, i.e. farmers' limited capacity to repay credit. Although political instability is beyond the control of the proposed operation, given a commitment by the Government of Latvia to continue economic reform, as evidenced by the currently effective agreement with the IMF on an Extended Fund Facility (EFF) and the on-going policy dialogues with the Bank, the policy risks would be somewhat mitigated. The strengthening of financial intermediaries' institutional capacity to assess credit risks and market analysis, as well as farm and business management advisory services, would counteract some market and financial risks. Contact Point: Hoonae Kim, ECSSD The World Bank 1818 H Street N.W. Washington, DC Telephone No.: (202) Fax No.: (202) Note: This is information on an evolving project. Certain activities and/or components may not be included in the final project. Processed by the InfoShop week ending August 14,

7 Annex Because this is a Category B project, it may be required that the borrower prepare a separate EA report. If a separate EA report is required, once it is prepared and submitted to the Bank, in accordance with OP 4.01, Environmental Assessment, it will be filed as an annex to the Public Information Document (PID). If no separate EA report is required, the PID will not contain an EA annex; the findings and recommendations of the EA will be reflected in the body of the PID. -7-