ASIAN DEVELOPMENT BANK RRP: PAK 36075

REPORT AND RECOMMENDATION

OF THE

PRESIDENT

TO THE

BOARD OF DIRECTORS

ON

PROPOSED LOANS

TO THE

ISLAMIC REPUBLIC OF PAKISTAN

FOR THE

RURAL FINANCE SECTOR DEVELOPMENT PROGRAM

November 2002

CURRENCY EQUIVALENTS (as of 27 September 2002)

Currency Unit – Pakistan rupee (PRe/PRs)

PRe1.00 = $0.02 $1.00 = PRs60.00

For the purpose of calculations in this report, the rate of $1.00 = PRs60 was used.

ABBREVIATIONS ADB – Asian Development Bank CB – commercial bank EA – executing agency IA – implementing agency IPRSP – Interim Poverty Reduction Strategy Paper IT – information technology KB – Khushhalibank LIBOR – London interbank offer rate MF – microfinance MFI – microfinance institution MIS – management information system MOF – Ministry of Finance MSDP – Microfinance Sector Development Program NBF – New Bank Fund NGO – nongovernment organization NPL – nonperforming loan OCR – ordinary capital resources PCB – provincial cooperative bank p.a. – per annum PIU – program/project implementation unit PMU – project management unit RF – rural finance or rural financial RFI – rural finance institution RFSDP – Rural Finance Sector Development Program SBP – State Bank of Pakistan ZTBL – Zarai Taraqiati Bank Limited

NOTES

(i) The fiscal year (FY) of the Government ends on 30 June. FY before a calendar year denotes the year in which the fiscal year ends.

(ii) In this report, "$" refers to US dollars.

This Report was prepared by a team consisting of A. Sharma (Team Leader), M. Good, and M. Mongiorgi.

CONTENTS

Page

LOAN AND PROGRAM SUMMARY iii

I. THE PROPOSAL 1

II. THE SECTOR: PERFORMANCE, PROBLEMS, AND OPPORTUNITIES 1 A. Sector Description and Performance 1 B. Issues and Opportunities 3

III. THE PROPOSED SECTOR DEVELOPMENT PROGRAM 10 A. Objectives and Scope 11 B. The Program Loan 11 C. The Project Loan 19

IV. PROGRAM BENEFITS, IMPACTS, AND RISKS 23 A. Benefits and Impacts 23 B. Risks 26

V. ASSURANCES 27

VI. RECOMMENDATION 28

APPENDIXES 1. Sector and Subsector Analysis 2. Development Policy Letter, Policy Matrix, Rural Finance Sector Plan 3. Program Framework 4. Zarai Taraqiati Bank Limited (former Agricultural Development Bank of Pakistan) 5. Microfinance Institutions 6. Development Coordination Matrix 7. Implementation Schedule 8. Ineligible Items 9. Cost Estimates 10. Financial and Economic Analysis 11. Summary Initial Environmental Examination 12. Summary Poverty Reduction and Social Strategy

SUPPLEMENTARY APPENDIXES (available upon request) A. Detailed Financial Analysis - Zarai Taraqiati Bank Limited B. Detailed Financial Analysis - Microfinance Institutions C. Detailed Cost Tables D. Financial and Economic Analysis E. Poverty Reduction and Social Strategy G. Chronology

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LOAN AND PROGRAM SUMMARY

Borrower Islamic Republic of Pakistan Classification Poverty intervention

Thematic: Economic growth, good governance Environment Classification

Category B. An initial environmental examination was undertaken and the summary is a core appendix.

Rationale Despite the comprehensive structural reforms and a stabilizing

macroeconomic situation, the high incidence of rural poverty remains a major concern in Pakistan. Widespread lack of affordable rural financial services constrains rural growth and employment. The potential client base for rural finance (RF) is estimated at 9 million households comprising both the poor and nonpoor. The demand and supply in the stratified RF markets mirrors the inequitable rural socioeconomic structure, landholding, and employment pattern. While credit demand is estimated at PRs240 billion-PRs260 billion per annum, the supply from formal financial institutions is only PRs56 billion. Most of this amount does not reach the middle and lower segments of the RF markets consisting of rural entrepreneur, small and subsistence farmers, and the landless. Informal sources such as landlords and input suppliers provide intermittent short duration loans at very high interest rates that reflect the weak bargaining power of the borrowers. Over the last 4 decades the RF markets in Pakistan could only provide limited accessibility and poor-quality services. Emphasis on agriculture ignored the demand from the nonfarm sector, which accounts for half the rural income. Reliance of RF institutions on soft budgetary resources depressed savings mobilization and undermined financial discipline. Overt politicization and weak governance eroded the sustainability of RF institutions and this created the perception that RF per se is nonviable. This perception inhibited commercial banks from extending their RF portfolio and discouraged the emergence of private RF institutions. The role of RF in expanding income and reducing poverty remains unfulfilled. Weak RF markets in Pakistan perpetuate poverty, depress the rate of rural economic growth, and distort income distribution. The Government, therefore, aims to develop the RF sector to attain self-reliance in agricultural commodities, ensure food security, and generate employment.

The Program Loan Objectives The Rural Finance Sector Development Program (RFSDP) has

been designed to assist the Government in accelerating rural economic growth by addressing key constraints in RF. The program goals are to ensure permanent access to institutional

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program goals are to ensure permanent access to institutional financial services for a majority of rural households at minimal transaction cost and to encourage private sector participation in RF sector. The specific objective is to develop a sustainable RF system for providing affordable services, primarily to the middle and lower segments of the RF markets for a significant income expansion and poverty reduction impact.

Components and Outputs

The program loan consists of 4 components: (i) creating a favorable policy environment, (ii) institutional restructuring and reforms, (iii) new bank fund (NBF), and (iv) product and process innovations. The policy reforms introduce a new RF paradigm where the Government will (i) complement, facilitate, and improve the functioning of the RF markets; and (ii) limit its direct intervention only to identifiable market failures. The policies will fundamentally alter the governance and operations of Zarai Taraqiati Bank Limited (ZTBL), the key RF institution. The NBF will encourage the emergence of private or public-private microfinance institutions (MFIs).

Financing Plan Asian Development Bank (ADB) will provide a loan of $225 million

from its ordinary capital resources with a 15-year term, including a grace period of 3 years; an interest rate to be determined in accordance with ADB’s London interbank offer rate (LIBOR)-based lending facility; a commitment charge of 0.75% per annum; a front-end fee of 1% of the loan amount, and such other terms and conditions set forth in the Loan Agreement.

Program Period and Tranching

The loan will be released in 4 tranches over a 3-year period. The first tranche of $100 million will be released upon loan effectiveness; the second tranche of $50 million, expected after 7 months of the first tranche; the third tranche of $50 million expected within 12 months of the second tranche; and the fourth tranche of $25 million, expected within 17 months of the third tranche, in each case subject to compliance with the conditions for their release.

Executing Agency and Implementation Arrangements

The Ministry of Finance (MOF) will be the Executing Agency and will also implement the Credit Union Plan and Pilot Insurance Plan. State Bank of Pakistan (SBP), the central bank, will be the implementing agency (IA) for strengthening supervision and regulation, NBF, and RF Resource Center. ZTBL will be the IA for ZTBL restructuring. The National Credit Consultative Council consisting of a broad array of stakeholders will ensure wider consultation on policy matters.

Procurement The loan proceeds will be used to finance the foreign exchange

cost of items produced and procured in ADB member countries, excluding ineligible items.

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Counterpart Funds

Counterpart funds generated from the program loan will be used for ZTBL restructuring, NBF, RF Resource Center, Credit Union Plan, and Pilot Insurance Plan.

The Project Loan Objective The project loan will provide institutional strengthening support to

ZTBL, SBP, and the project management unit at MOF. Financing Plan ADB will provide a loan of $25 million from its ordinary capital

resources, with a 24-year term, including a grace period of 4 years; an interest rate to be determined in accordance with ADB’s LIBOR-based lending facility; a commitment charge of 0.75% per annum; a front-end fee of 1% of the loan amount; and such other terms and conditions set forth in the Loan Agreement.

Executing Agency and Implementation Arrangements

MOF will oversee and coordinate implementation. ZTBL will be the IA for ZTBL restructuring. SBP will be the IA for the NBF, RF Resource Center, and institutional strengthening for RF regulation.

Procurement Procurement of goods and services will be in accordance with

ADB’s Guidelines for Procurement. Expenditure procedures will be in accordance with ADB’s Loan Disbursement Handbook. Consultants to be financed from the proceeds of the ADB loan will be recruited in accordance with ADB's Guidelines on the Use of Consultants and other arrangements satisfactory to ADB for engaging domestic consultants. A total of 438 person-months of international and 651 person-months of domestic consulting inputs will be required. Where possible and appropriate simplified procedures will be applied.

Benefits and Beneficiaries

The shift in the RF policy paradigm with emphasis on good governance will permit sustainable RF markets to develop. The hitherto segmented RF markets will be integrated with the mainstream financial sector, thus opening up the possibility of arresting the flow of resources from the rural sector. Gains from institutional reforms will be captured in improved governance, substantial cost savings through rightsizing, and greater outreach. Increased rural financial intermediation will lead to income expansion by addressing the growing demand from the rural nonfarm sector through product and service diversification. Strategic initiatives with incentives for promoting private sector participation in RF provide greater prospects for reaching the middle and lower segments of the RF markets. Pilots for crop insurance and credit union will establish innovative cost-effective solutions to reduce risk and expand outreach. Outreach is expected to increase by about 200,000 by the end of the RFSDP period of 3 years.

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Social and Environmental Issues

Increased rural financial intermediation will stimulate linkages within the rural economy and with urban areas. Employment opportunities are expected to increase for the rural unemployed and underemployed as a result of emphasis on rural nonfarm activities. While the full benefits from a strengthened RF system are likely to occur in the medium term, the reformed institutions will target the middle and lower segments of RF markets from the outset. Taken together, these developments are expected to improve rural economic growth that translates into higher income for rural producers, including the poor. The promotion, development, and strengthening of MFIs through private-public partnership will ensure that the poverty reduction impact is felt beyond the life of the RFSDP. Appropriately designed and priced services that consider asset and consumption buildup requirements are expected to raise household income above the poverty threshold after 4-5 credit cycles.

Risks The major risks relate to commitment to reforms, private sector

perception of investment opportunities, and the short implementation period. The reform agenda was arrived at after sustained policy dialogue. The reforms are phased to show tangible outreach results that will strengthen sociopolitical acceptance and minimize the risk of any rollback of reforms. Investor response is likely to remain positive because of up-front reforms, transparent positive incentives, and central bank supervision for good governance. The loan will be released in 4 tranches to permit greater dialogue between ADB and the Government and allow sufficient time for implementation. The risk of incomplete or delayed institutional reform is mitigated by prior actions on governance, financial restructuring, and rightsizing. Support to RF institutions is contingent upon achieving a defined performance level. Risks associated with loan remissions and waivers are mitigated by the Government’s commitment that it will not pardon outstanding loan repayment or discourage debt recovery.

I. THE PROPOSAL 1. I submit for your approval the following report and recommendation on two proposed loans to the Is lamic Republic of Pakistan for the Rural Finance Sector Development Program (RFSDP).

II. THE SECTOR: PERFORMANCE, PROBLEMS, AND OPPORTUNITIES A. Sector Description and Performance 2. The comprehensive structural reforms initiated and accelerated over the past 3 years have stabilized the macroeconomic situation. However, the high incidence of rural poverty1 remains a major policy concern. Government objectives for the rural sector, therefore, include attaining self-reliance in agricultural commodities, ensuring food security, and generating rural employment. Widespread lack of rural financial services from institutional sources at reasonable terms constrains the realization of these objectives. Rural finance (RF) in Pakistan constitutes delivery of financial services including savings, credit, insurance, and payment services to poor and nonpoor rural households. Microfinance (MF),2 targeting the poor, is an integral part of RF. Appendix 1 presents the sector and subsector analysis. 3. Preponderant Poor and Low-Income Client Base. The rural sector consists of 97 million people, or two thirds of the total population, in 14.3 million households. Of the 5.07 million farm households,3 44% belong to subsistence farmers and 36% to small farmers. The rest are nonfarm households including the landless. The rural population includes 35 million poor, or three fourths of the total poor population, in 5.15 million households. Nearly two thirds of the workforce are engaged in rural jobs. Agriculture,4 including livestock, provides half the rural income. Nonfarm income comes from rural enterprises5 and nonfarm employment. 4. Stratified Market with Diverse Needs. The RF market consists of formal sources including RF institutions (RFIs): Zarai Taraqiati Bank Limited (ZTBL),6 cooperatives, rural branches of commercial banks (CBs), licensed microfinance institutions (MFIs), insurance and leasing companies, and post offices. While State Bank of Pakistan (SBP)—the central bank—supervises CBs, ZTBL, and MFIs, the provincial cooperative departments supervise the cooperatives. Nongovernment organizations (NGOs) are classified as semiformal sources and are not subject to formal supervision. The informal sources comprise input suppliers, traders, moneylenders, landlords, relatives, and friends. The structure of the RF markets mirrors the socioeconomic structure of the rural society, landholding patterns, and nature of employment. Accordingly, the demand for RF services is heterogeneous.

1 Rural poverty incidence is 36.3% as against 22.4% in urban areas. The official poverty line is PRs670 per capita

per month or 2,450 calories per rural adult per day. ADB. 2002. Pakistan Poverty Assessment. Manila. 2 Considering the demographics of Pakistan, MF is primarily rural even though MF institutions also target the urban

poor. RF, including MF, as argued in this document is part of the broader financial sector. 3 Farmers are classified as subsistence (up to 2 hectares of landholding); small (above 2 and up to 5); medium

(above 5 and up to 10); and large (above 10). Farmers include owners, owner-cum-tenants, and tenants. About one third of the operational farms have tenant farmers, most of whom are poor.

4 Agriculture production and marketing, farm mechanization, land development, irrigation, livestock, forestry, etc. 5 Rural enterprises include both agriculture-related and nonfarm enterprises. Agriculture-related enterprises include

small-scale processing of agriculture produce and byproducts into semifinished and finished goods, and production and supply of agricultural inputs. Nonfarm enterprises include transport, warehousing, handicraft, and weaving.

6 Former Agricultural Development Bank of Pakistan. ZTBL was incorporated on 23 October 2002 as part of the RFSDP reform agenda. Reference to ZTBL in this document is made both for discussing the issues with regard to the Agricultural Development Bank of Pakistan and the restructuring plan of ZTBL.

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(i) Upper. This segment comprises primary processors of agriculture commodity, food processors, large agriculture-based industries, agriculture produce wholesalers, and farmers with large landholdings (above 20 hectares). The CBs cater to the requirements of this segment that include high-end financial services such as letters of credit, export guarantee, and long-term investment capital.

(ii) Middle. This segment comprises the nonpoor nonfarm households and better-

off farmers (landholding of 10-20 hectares) engaged in rural enterprises, agribusiness services, and agriculture input supply. CBs and RFIs partially meet the needs for working capital, trade finance, investment credit, and crop loans. Significant reliance is on reinvestment of business surpluses and family sources.

(iii) Lower Middle. This segment comprises medium farmers, (landholding of 5-

10 hectares), small rural enterprises, agriculture produce retailers, and commercial dairy. While often mandated to receive RF services from formal sources, they have to rely primarily on household savings and informal sources.

(iv) Lowest. This segment comprises the landless poor and small, subsistence, and

tenant farmers (landholding up to 5 hectares). Informal sources meet the credit needs for consumption, subsistence agriculture, and microenterprises. This segment is a natural MFI clientele with a significant demand for savings facilities.

5. Immense Untapped Potential Demand. Estimates of rural credit requirements from all sources range from PRs240 to PRs260 billion per annum (p.a.) for a potential clientele base of 9 million rural households. Of this number, nearly 3 million are poor households with an estimated credit demand of PRs68 billion p.a. Half the credit demand is for agriculture, and one fourth each for rural enterprises and consumption. The savings potential of the rural poor and nonpoor households on average is estimated at PRs4,000 and PRs22,000, or about 20% of the household income. This amounts to around PRs268 billion annually. Savings comprise self-financing for investments, livestock, cash, and bank deposits. The demand is mainly for savings and credit, although the need for crop and calamity insurance is widely felt. 6. Inadequate Supply Response. Rural household borrowings from all sources were estimated at PRs180 billion in FY2001. Formal sources accounted for PRs56 billion to 786,000 borrowers, nearly 6% of the rural households and one fifth of the estimated demand. Among the formal sources, ZTBL provided 49% of the credit; CBs 37%; cooperatives 11%; and MFIs 3%. NGOs had about 100,000 clients. The balance was provided primarily by informal sources. Most of the credit was for short-term agriculture production. The requirements of rural enterprises were largely unmet. CBs held nearly 90% of rural savings with the formal institutions, estimated at PRs200 billion. Post offices provided some savings, remittance, and insurance services. All other sources did not mobilize savings in any significant manner. 7. Inverted and Inequitable Access. The upper segments of the RF markets have access to formal sources of credit, leasing, and insurance services. Informal sources meet bulk of the demand from the middle and lower segments. Among the poor who borrow, 90% have recourse only to informal sources, as they lack collateral to access formal sources. Half the informal credit is for consumption and loan sizes are nearly one fourth of the formal sources. The prevailing interest charges from formal sources, 13-15% p.a., on average are half to one third of the informal sources. In the absence of safe and liquid savings facilities, the savings from the poor households remain locked in nonfinancial assets.

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8. Inappropriate Policy Paradigm. The goal to accelerate agriculture production influenced the evolution of the RF market during the last 4 decades, ignoring rural enterprises. Government intervened through directed credit, state-owned RFIs, concessional refinance, and loans at below-cost interest rates. On the other hand, policies relating to agriculture repressed farm income potential. Production and marketing bottlenecks due to weak rural infrastructure increased risks, volatility, and uncertainties in the rural sector. 9. Inefficient Institutions. Repressive policies along with lack of autonomy and weak governance eroded institutional sustainability and constrained the outreach potential.

(i) Zarai Taraqiati Bank Limited. ZTBL, the key RF institution (RFI), provides savings

and collateralized loans through its nationwide network of 343 branches. ZTBL disbursed PRs27.6 billion in 417,000 loans at an average of PRs66,187 per loan during FY2001. Loans mainly went to medium and small farmers. Poor repayment rate,7 high transaction costs, and profitability are major concerns.

(ii) Cooperatives. Five provincial cooperative banks (PCBs) with 205 branches

spread over 118 districts provide credit to 62,861 primary societies with 3.5 million members. During FY2001, PRs6 billion was disbursed to 66,000 borrowers, or PRs90,909 per loan. Savings services are sparse.

(iii) Commercial Banks. Despite 3,183 rural branches, rural disbursements of CBs during FY2001 was PRs21 billion to 256,000 clients or PRs82,031 per loan. Loans for agriculture purposes were primarily to meet mandatory credit requirements and were confined to financing of marketing operations with commodity stocks as collateral.

10. Minimal Income Expansion Through Informal Sources. Interest rate charges of 40-50% p.a. by traders, input suppliers, and landlords reflect the weak bargaining power of the poor. The interest rate is even higher where competition from the formal sector is weak. Moreover, because of its intermittent and short-term nature, credit from informal sources covers mainly temporary gaps in consumption and immediate unforeseen contingencies. 11. Initial Success in Microfinance. With exclusive focus on the poor, MF is a new subsector comprising Khushhalibank (KB) with 30 branches and First Microfinance Bank with 3 branches. The Pakistan Poverty Alleviation Fund provides wholesale onlending funds to NGOs. Short-term noncollateralized loans of PRs2,500-PRs10,000 at 18-22% p.a.8 are delivered to groups of poor. Viable interest rates, emphasis on savings, assured repeat loans, and building of clients’ capacity ensure gender outreach and loan repayment. B. Issues and Opportunities

1. Systemic Weaknesses 12. The Government’s role in RF market development (para. 8) was to increase lending by reducing the costs and risks for RFIs in making loans to preferred clients because of perceived market failures. Government farm development projects treated credit as inputs like seed and fertilizers, ignoring that credit cannot compensate for unprofitable activities. The policy and institutional framework did not recognize the challenges in RF: low population density, isolated

7 Repayment rate in this document refers to collection as a percentage of loans due. 8 Some MF providers charge higher interest rates.

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markets, lack of traditional collateral, high income fluctuation in poor households, and limited opportunities for risk diversification. Seasonality of operations and high risks particularly due to droughts and floods increased transaction costs. Despite some success in credit expansion and food production in the 1990s and 1980s, the availability of term credit was limited and the volume of agriculture credit fell compared with credit for manufacturing. Weak governance affected both the quality and continuity of services. Destructive effects on CBs and RFIs overshadowed any positive impacts. 13. The weak sector performance confirms the lessons learned internationally that (i) directed credit remains concentrated among a few; (ii) the benefits of cheap interest rates are captured by rural elite, thus crowding out the poor and resulting in misallocation of resources and production inefficiencies; (iii) prolonged dependence on subsidy undermines sustainability9 and integration with the financial markets; and (iv) repressive agriculture and exchange regime policies, weak extension, and inadequate rural infrastructure depress rural incomes thus adversely affecting RF markets. Ignoring the expansion of nonfarm income reduces the possibility of diversifying risk and income for rural households. The crucial benefits of rural monetary savings are not realized due to perceptions of the nonbankability of the rural poor. Politicization of RF increased the tolerance for loan defaults, waivers, and postponements in Pakistan. As a result, repayment rates remained low. RFIs designed in pursuit of and operated under this paradigm were inevitably nonviable. Weak governance exacerbated their problems. Where the state-owned RFIs failed, the private sector has not stepped in to fill the vacuum. 14. Persistence of these trends led to a situation where the upper segments of the RF market can access the rapidly modernizing urban financial markets, but others have to rely largely on household savings and informal sources. The investments in establishing CBs and RFIs thus bypassed large parts of the RF market, and the envisaged economic transformation in an equitable manner could not happen. In the process, RF markets remain exposed to fundamental issues relating to: (i) immense demand and sparse coverage; (ii) underserved middle and lower segments of the RF markets, with lack of access for the poor; (iii) inconsistency of products with demand profile; and (iv) poorly governed unsustainable RFIs.

2. Opportunities

15. The objectives of the Government’s Ten-Year Perspective Development Plan 2001/2011 and the Interim Poverty Reduction Strategy Paper (IPRSP) are to accelerate gross domestic product growth, reduce unemployment, eliminate poverty, and encourage the private sector. The aim is to reduce absolute poverty to 15% in 2011, among others, through increased economic opportunities and greater access to physical and social assets, and safety nets. The strategy is to revive economic activity through reliance on 4 key sectors: agriculture, small- and medium-scale enterprises, information technology, and energy. Supporting the expansion of MF through a range of institutions and initiatives and restructuring ZTBL, both part of IPRSP, are consistent with the target to create 11.3 million jobs during 2001-2011 by promoting growth in labor-intensive sectors of agriculture and small- and medium-scale enterprises. Realization of this aim requires stakeholder consensus and commitment for a properly sequenced integrated approach to RF sector development that involves: (i) adopting a new paradigm with a redefined government role, (ii) determining expectations from RF, (iii) continuing consistency and commitment to reforms, (iv) reforming institutions for sustainability and outreach, and (v) introducing product and delivery innovations. 9 Sustainability in this document refers to gaining client acceptance and ability to provide quality financial services to

existing and potential clients on a permanent basis without the need for government or external support. Commercial basis refers to adoption of for-profit orientation in administration and operations to attract equity investments and mobilize resources from the market through savings and borrowings (also refer to footnote 28).

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a. New Paradigm with a Redefined Government Role 16. Lessons learned in RF (paras. 12-14) adapted to Pakistan’s context translate into a new RF paradigm (i) where RF market development is placed in the broader perspective of financial sector development; (ii) that prioritizes interventions to complement, facilitate, and improve the functioning of the RF markets; and (iii) where government role is limited to direct interventions where identifiable market failures exist and cost-effective transparent means to address them are available. Government interventions should primarily relate to (i) creating conducive policies, (ii) promoting strategic initiatives with incentive programs that promote private sector role in RF to supplement the efforts of existing RFIs, (iii) strengthening supervision and regulation, (iv) restructuring potentially viable RFIs that were weakened pursuing the old paradigm, and (v) relaxing credit controls. Government concurs with the new RF paradigm. From the client’s perspective, the new paradigm creates opportunities and options hitherto unavailable due to lack of access to RF services. The marginally higher financial cost that may result due to the reforms is both affordable and way below the interest rate charged by informal sources. 17. Healthy and competitive RF markets will be best served by strengthening supervision and regulation and resolving conflict of interest in terms of central bank ownership of RFIs. The Government must avoid the temptation of using financial institutions for alleviating broader social and developmental problems following floods, droughts, and natural disasters. Addressing policies and institutional deficiencies involve significant costs10 as well as political and social resistance that can only be overcome by the Government and, hence the significance of its sustained commitment to reforms and continuity of RF in public policy domain.

b. Determination of Expectations from RF

18. Income Expansion. Changes in the rural economic profile brought about by fast-growing rural cities and towns, and the emergence of a heterogeneous nonfarm economy create new opportunities for RF markets and demand for RF services. The rise of farm and nonfarm income contributed to the gradual transformation of the rural economy. As incomes rose, the increased demand for products and services produced in the nonfarm sector contributed to the emergence of rural enterprises. This development led to a range of activities: supplying seed, fertilizers, household utensils, clothing, and farm equipment; manufacturing; and establishment of repair shops and foundries. Transport and trade become important with marketable farm surpluses. Moreover, some of these rural enterprises produce goods sold in urban and export markets. 19. The expansion of rural income requires complementary development of RF and nonfinancial markets. The Asian Development Bank (ADB)-funded Agriculture Sector Program II11 is supporting fundamental reforms, with emphasis on promoting the private sector through market-oriented policies, openness to international trade, and strengthening agriculture extension. ADB-funded ongoing rural development, infrastructure, and energy sector projects aim at enhancing access to infrastructure and strengthening social capital. Complementarity necessitates that RF markets (i) enable clients to save and borrow to maximize enterprise

10 These include direct costs of building, equipping, and staffing banks. The borrower transaction cost includes value

of time in accessing services, travel, and other noninterest costs. Even closing of banks involves significant costs. 11 ADB. 2001. Report and Recommendation of the President to the Board of Directors on a Proposed Loan to

Pakistan for the Agriculture Sector Program II. Manila. The loan intends to phase out government interventions in the markets that brought the prices of many agricultural commodities below international prices. Low prices and productivity make it difficult for the agriculture sector to compete for investment capital compared to urban industrial projects. These resulted in an agriculture growth of only 3% p.a. during 1990-1999, hardly sufficient for a population growth of 2.5% p.a.

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benefits, (ii) reduce transaction costs, (iii) support private initiatives, and (iv) raise resources by integrating with broader financial markets. Financial institutions must efficiently allocate resources to small and medium-scale farmers and rural enterprises, “the missing middle,”12 which remain grossly underserved by both RFIs and CBs and are not a natural MFI clientele.13 20. Poverty Reduction. Robust financial markets are correlated with rural growth through efficient resource allocation, savings mobilization, risk mitigation, and facilitation of the exchange of goods and services. Efficient RF markets contribute to poverty reduction by enabling the rural households to respond to economic and technological opportunities that generate employment in farm and rural enterprises and establish forward and backward linkages in the rural economy. Efficient RF markets are critical for increasing rural incomes in Pakistan where widespread poverty exists and the current outreach of RF is minimal. However, the increasing average income may not be equitably shared due to unequal wealth and skill endowments. Moreover, given the high rural poverty incidence, large numbers of poor households will continue to have inadequate or no access to formal sources of RF, as retail institutional capacity can only be built over the medium term. In the rural economy, the poor produce mainly for subsistence, except for some export crops. Food sufficiency is the primary objective, most inputs are nontradable (labor, manure, and seeds), production is low and mostly consumed, and little cash income is generated. As a result, poverty is perpetuated. Vulnerability to risks remains high with significant underemployment and unemployment. Lack of access to financial services impairs the ability of the poor to respond to market opportunities. 21. A poverty reduction goal for RF, therefore, is proactive promotion of the MF subsector to maximize the poverty reduction impact in combination with the income expansion strategy. This is the rationale for the ongoing ADB-funded Microfinance Sector Development Program (MSDP).14 The MF Institutions Ordinance 2001 promulgated under MSDP enables the establishment of sustainable MFIs targeting the poor households under a conducive policy framework. The ordinance defines and categorizes MFIs (national, provincial, and district); and describes their licensing procedures and equity requirements, and supervisory and regulatory framework. Support to MFIs, particularly in their initial start-up phase, can yield high social returns through greater outreach, provided that the support is transparent, time bound, and linked to performance. The Government strongly supports and encourages the establishment of MFIs as an appropriate public-private partnership in poverty reduction.

c. Consistency, Commitment, and Continuity of Reforms

22. Banking sector problems in Pakistan are rooted in political interference in lending, loan collection, and loan write-offs. Much like the repressive policies of the past, weak governance, and lack of competition equally affected the CBs as they did the RFIs. Ongoing CB reforms, therefore, aim to improve governance, supervision, and enforcement of banking courts. The World Bank has supported restructuring, downsizing, and privatization of CBs, and reducing nonperforming loans (NPLs).15 Distortions implicit in managed interest rates have been

12 Rural Financial Markets in Asia: Policies, Paradigms and Performance. This is part (volume 3) of ADB. 2000. Study

of Rural Asia. Oxford University Press. New York. 13 MF is more suited to clients with regular cash flows that require small short-term noncollateralized loans, not

farmers with seasonal cash flows and rural enterprises with large medium -to-long-term credit requirements. While RFIs also provide MF, in essence RFIs and MFIs complement each other by addressing segments of the broader RF markets. RFIs are more affected by farmer exposure to risks of floods and droughts.

14 ADB. 2000. Report and Recommendation of the President to the Board of Directors on a Proposed Loan to Pakistan for the Microfinance Sector Development Program. Manila. KB and the First Microfinance Bank have been established under the MSDP framework.

15 Financial Sector Deepening and Intermediation Project (1994); Banking Sector Adjustment Loan (1997); Banking Sector Restructuring and Privatization Project (2001); and Banking Sector Technical Assistance (2002).

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removed. The CB reforms were extended to state-owned development finance institutions to reduce their number and consolidate operations.16 These development finance institutions will initially be retained in the public sector due to the time required to (i) remedy the effects of decades of politicization and misdirected subsidies, and (ii) generate private sector alternatives and investments. Similarly, closure of nonviable RFIs and strengthening of weak RFIs should be pursued with emphasis on good governance, sustainability, depoliticization, and privatization. Aid agencies should refrain from credit only interventions and shift to projects that emphasize policy and governance issues. External support is essential for institutional building, the need for which is pervasive.

d. Institutional Reforms for Sustainability and Outreach

23. Maximizing sustainability and outreach is critical for meeting expectations from RF. Lessons learned in banking reforms emphasize in-depth financial and institutional analysis; upfront commitment to good governance, institutional autonomy, and lending discipline; phasing of reforms on the capacity to manage and institutionalize changes; and sequencing to minimize service disruption. Evaluation of ADB-funded credit projects through development finance institutions strongly suggests more direct assistance for institutional strengthening and operational efficiency.17 Considering the time required for building consensus for fundamental RFI reforms, preparatory measures for RFI reforms were initiated under the MSDP in 2001. 24. Zarai Taraqiati Bank Limited. The period from the early 1970s to mid-1990s saw extensive external support for ZTBL. The World Bank, International Fund for Agricultural Development, and ADB18 provided 16 projects worth $987 million during 1965-1991. These first generation projects prioritized agriculture credit over governance and sustainability. Donor interest in ZTBL waned due to financial and liquidity problems, unsatisfactory accounting practices, poor repayment rate, and frequent loan waivers. This led to the cancellation of the Agriculture Credit Project in 1994.19 SBP refinance that replaced project credit lines weakened financial discipline and depressed savings, which is less than 2% of the liabilities. Poorly targeted subsidized loans encouraged rent-seeking behavior that was exacerbated by poor governance. Limited accountability led to lack of motivation to pursue viable operations and resist politicization. Notwithstanding the marginal improvements noted lately, difficulties are compounded by profligate practices and overheads accumulated during the 1990s, particularly the increase in staff that raised transaction costs without efficiency gains. 25. Despite weaknesses, ZTBL remains the key RFI with the largest borrower base. Empirical evidence shows that when the financial sector is liberalized and repressive policies lifted, CBs close rural branches, minimize small transactions, and thereby restrict access of small clients with negative overall consequences.20 This is true for Pakistan (para. 28). 16 Federal Bank for Cooperatives, Bankers Equity Limited, and National Development Finance Corporation have

either been closed or are under liquidation. National Investment Trust and Investment Corporation of Pakistan are being wound up.

17 ADB. 1987. Project Performance Audit Report on the Third Development Financing Project in Pakistan. Manila. 18 ADB. 1982. Report and Recommendation of the President to the Board of Directors on a Proposed Loan for

Pakistan for the Agricultural Development Bank of Pakistan. Manila; ADB. 1986. Report and Recommendation of the President to the Board of Directors on a Proposed Loan to Pakistan for the Agricultural Development Bank of Pakistan. Manila; ADB. 1990. Report and Recommendation of the President to the Board of Directors on a Proposed Loan to Pakistan for the Agriculture Credit Project. Manila. The latter was cofinanced by the World Bank ($150.0 million) and the International Fund for Agricultural Development ($25.0 million).

19 ADB. 1995. Project Completion Report on Agriculture Credit Project in Pakistan. Manila; ADB. 1990. Report and Recommendation of the President to the Board of Directors on a Proposed Loan to Pakistan for the Agriculture Credit Project. Manila. All the three cofinancers canceled the loan on 30 June 1994 after about 50% disbursement (refer to the preceding footnote).

20 Steel. 1997. Informal Financial Markets Under Liberalization in four African Countries.

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Considering the client profile, nature of business, and the status of rural infrastructure, it does not appear likely that RF will attract large private commercial interest immediately or without incentives. Therefore, RFIs with probability of turnaround need to be strengthened through good governance, a core theme of the ADB Country Strategy and Program (2002-2006). This will promote institutional diversity to provide quality and quantity of services and increase options for the clients. Therefore, in response to stakeholder consensus21 MSDP funded a portfolio audit and the preparation of a restructuring plan for ZTBL. 26. The Government opted for ZTBL restructuring considering the demand and supply gap for institutional RF services and the growing rural-urban income disparities. Cost-effective and realistic alternatives that could substitute for ZTBL outreach are not immediately available. Majority of clients repay their loans and ZTBL’s nationwide network provides greater capacity to withstand effects of localized shocks and can provide the liquidity needed by affected households. The cost of liquidating ZTBL, both financial and political, is significantly higher than the estimated restructuring cost (para. 58). Undefined pension liabilities, staff redundancy, plummeting prospects of recovery of uncovered NPLs in view of liquidation, and the concurrent impact on SBP balance sheet could exceed $1 billion. Liquidation will also result in opportunity loss in terms of income and employment for both existing clients and for potential clients.22 27. There is little justification for closing ZTBL and establishing another state-owned RFI, for which additional costs will have to be incurred. Private sector capacity or interest to acquire ZTBL and continue its rural operations does not exist. Increasing the mandatory credit quota of CBs instead of closing ZTBL was considered inconsistent with the banking reforms. Unless preceded by restructuring, dividing ZTBL into provincial entities would simply divide the problems into smaller packets. Merger with a CB is not feasible, as distinct orientations within a single entity will be difficult to assimilate in view of ZTBL’s size and the depth of issues. 28. Commercial Banks. Although half the branches of CBs are located in rural areas, the rural credit-to-deposit ratio is 12.5% and rural credit is only 6% of the total CB advances. Reverse resource flow occurs since three fourths of the total CB credit is concentrated in 7 cities. This is natural from CB perspective, as returns on rural investment projects are lower than those from the urban trading or manufacturing sector. While under Government directions CBs had to establish rural branches, their institutional design and orientation remained urban. Nearly 500 loss-incurring branches, mostly rural, have been closed as part of CB restructuring and privatization. Rural service delivery could be further affected, as more branches could be closed. Nevertheless, unlike RFIs that have functioned as disbursing windows, CBs have mobilized rural savings for lending. Their reluctance to extend rural credit stems from the vitiated RF markets due to the overt politicization of RFIs. CBs have, therefore, not invested in successful RF technologies. Strengthening of the rural operations of CBs could bring substantial outreach gains. The CBs are also open to portfolio diversification due to the pressure on their margins in densely banked urban centers.

29. Cooperatives. Cooperatives met with little success and have been mired in financial misappropriations due to politicization and domination by the rural elite (para. 44). Cooperatives suffer from (i) uneven coverage, with no presence in two thirds of the villages; (ii) lack of accountability and professional management; (iii) poor portfolio management; and (iv) weak supervisory capacity of the provincial cooperative departments. Ineligibility of those without immovable properties excludes the poor and women. Nearly two thirds of the 65,000 societies 21 ADB. 1995. Project Completion Report on Agriculture Credit Project in Pakistan. Manila; World Bank. 1996. Rural

Finance for Growth and Poverty Alleviation. Washington, D.C.; and SBP. 2002. Draft Report of the Committee on Rural Finance. Karachi.

22 Indicative benefits quantified in para. 92.

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are fictitious and three fourths of the loans are reportedly bogus.23 Many societies were set up by the rural elite as fronts to usurp subsidized resources. MSDP therefore supported the closure of the Federal Bank for Cooperatives, the apex of the three-tier cooperative credit structure. PCBs and cooperative societies are the second and third tiers. Refinance to PCBs was anchored to treasury-bill rates for instilling financial discipline. This strategy paid off, as nonviable PCBs have been closed or are in the process of being closed. Except for Punjab PCB, the rest have little prospect of viability.

e. Product and Delivery Innovations

30. Leasing and Insurance. The legal, policy, and institutional frameworks for leasing and insurance are well developed. However, leasing and insurance services have not made a dent in rural areas because of limited opportunities for viable operations, scant client information to assess risks, high administrative costs due to widely dispersed clients, and weak contract enforcement. Most insurance and leasing experiments in rural areas in the past were linked to CBs and RFIs. Like in other countries in the region, crop and calamity insurance schemes initiated in Pakistan failed to become viable. SBP guarantee for CB rural loans also could not cover credit risks and administrative costs. The associated moral hazards and general decline in RFI performance dampened the response of potential service providers. 31. While leasing can expand in rural areas through linkages with CBs, ZTBL, and MFIs, no sustainable mechanism for crop and calamity insurance has emerged. Parts of the country remain under successive droughts24 that affect the rural households as well as the banks. Private and public response for expanding insurance services in rural areas is contingent upon an efficient ZTBL and expanded rural portfolio of CBs. It will, thus, be proper to prioritize the reforms to enhance the outreach of the primary demand for savings and credit. In the interim, a pilot insurance scheme drawing on successful international practices should be launched in selected districts.25 32. Lessons from Informal Sources. Decreasing the role of moneylenders and increasing the role of commercial interests represented by traders, input suppliers, and land-based arrangements characterize the informal sources.26 These commercial classes could possibly provide limited retail onlending services by borrowing from formal sources and in the process overcome the limitation of scale, risk, and term diversification. However, this is not a practical option in view of the supervisory issues involved. The interest charges may yet remain exorbitant. There are a few, if any, activities that can absorb interest charges from informal sources and yet leave sufficient household surplus (para. 10). The larger issue though relates to social equity. The commercial classes largely represent the rural elite. A banking role will further consolidate their dominance reflected in the disproportionate share of and continued preferential access to resources. In view of this, it is preferable that formal sources extend their RF outreach, drawing on the low transaction cost and short transaction time dimensions of the informal sources. The resulting competition will better serve both the poor and nonpoor clients.

23 Muhammad Jameel Khan. 1997. A Study of Semi-formal Institutions (Cooperative Credit). Punjab Economic

Research Institute. Lahore.; Mazhar-ul-haq. 1986. Evaluation of Cooperative Credit Programme in Punjab . Punjab Economic Research Institute. Lahore.

24 ADB. 1995. Report and Recommendation of the President to the Board of Directors on a Proposed Loan to Pakistan for the National Drainage Sector Project. Manila; ADB. 2001. Report and Recommendation of the President to the Board of Directors on Emergency Assistance for Drought Impact Mitigation and Recovery in Pakistan. Manila.

25 The experience from Risk Mitigation Fund under the MSDP for providing microinsurance for KB clients could also be useful. However, so far this has not been utilized since repayment is quiet good even in drought-affected areas.

26 Saeed Qureshi, Ijaz Nabi, Rashid Faruqe. 1996. Policy Research Working Paper on Rural Finance and Growth and Poverty Alleviation. World Bank, Agricultural and Natural Resources Division. Washington, D.C.

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3. Overall Rationale 33. Rural households have bankable demand for credit and savings. The large unmet demand for RF services constrains the adoption of new technologies in agriculture and rural enterprises. Yield gaps are significant between farmers that have access to institutional credit and those that do not.27 Rural enterprises that have access to savings and credit have been able to allocate resources to potential investment with highest returns, a step that is especially significant for diversifying income and risks in view of the seasonality of agriculture. Continuous access to financial services at affordable prices28 is critical for the poor to cross as well as remain above the poverty threshold. Due to lack of access to RF, the prospects of the majority of rural households to benefit from an improving economic climate remain constrained and rural employment generation stunted. Poverty incidence, in all probability has gone beyond the stated 32.2% due to successive droughts in many parts of the country in the last 2 years. Rural incomes are one third less than those in urban areas. 34. Healthy and well-functioning RF markets are directly related to achieving the two key national policy objectives: accelerating rural and agriculture growth, and reducing poverty. The realization of these objectives depends on the simultaneity of developments in RF and nonfinancial markets to foster the creation of diverse sources of RF, build sustainable financial institutions, and stimulate product and capital flows in the rural sector. For this, RF must be seen as an integral part of equitable development within a framework of macroeconomic stability as enumerated in the IPRSP. The ongoing structural adjustment lays the basis for fundamental reforms for RF market development. The recurring financial drain in pursuing the old RF paradigm and the narrowing fiscal space have also prompted a shift in Government strategy that now seeks viable intermediaries for enhancing outreach. For the majority, access to affordable RF services is also important to enable them to compete in the post-World Trade Organization scenario. Inability to compete because of high financial costs could reduce income of the majority of farmers, particularly the small and subsistence farmers. Lack of access to affordable RF services will also prevent them from switching to nonfarm activities.

III. THE PROPOSED SECTOR DEVELOPMENT PROGRAM 35. The Poverty Reduction Partnership Agreement signed by the Government and ADB on 16 September 2002 includes employment generation, pro-poor asset creation, promoting RF intermediation, and increasing private sector role for sustainable growth with emphasis on agriculture and rural development. Support for RF is also part of the ADB Country Strategy and Program (2002-2006) for promoting growth and stability of rural income and employment. To accomplish this, an integrated package of policy and institutional strengthening is needed. The sector development program modality was, therefore, chosen to foster a long-term, sectorwide perspective that can yield considerable benefits. Following CB and capital market29 reforms and the successful MSDP implementation, the Government submitted a RF Action Plan and sought ADB support for strengthening the RF sector. The Rural and MF Committee of ADB discussed the RF Action Plan in March 2002. Program formulation was closely coordinated with various stakeholders including SBP, the private sector, and development partners. The agreements on RFSDP are reflected in the Government’s development policy letter and the attached policy matrix and RF Sector Plan (Appendix 2). The program framework is in Appendix 3.

27 International Food Policy Research Institute, Pakistan Panel Survey, cited in Von Barun, Malik and Zeller (1993). 28 Financial intermediaries determine lending interest rate based on cost of resources, efficiency, scale of operations,

risk perception, and competition. In the context of Pakistan the interest rate charged by KB at 18-20% p.a. is the best available proxy for a reasonable or affordable as well as institutionally viable lending interest rate.

29 ADB.1997.Report and Recommendation of the President to the Board of Directors on a Proposed Loan to Pakistan for the Capital Market Development Program and Capacity Enhancement of the Securities Market. Manila.

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A. Objectives and Scope 36. The Program is designed to assist the Government in accelerating rural economic growth by addressing key constraints to RF. The goal is to enhance the outreach of RF services. The objective is to establish a sustainable RF system that can enable the clients to benefit from economic opportunities for increasing incomes and employment. RFSDP will help diversify the sources of income of rural households thereby reducing their vulnerability to risks. A range of services will help RF clients, especially the poor, to monetize their savings and simultaneously increase the lendable resources of RFIs. The private sector will be provided with incentives to increase investment in RF. Good governance will be at the core of the reforms to ensure equitable access for those hitherto excluded. The reform measures have natural synergy with the agriculture sector reforms and MSDP interventions. 37. The RFSDP consists of two components with common objectives: (i) a program or policy reform loan, and (ii) a project or institutional strengthening loan. Policy reforms for strengthening RF markets are required to achieve the key objectives of the Government’s Ten-Year Perspective Development Plan 2001-2011 and the IPRSP. The project loan for institutional strengthening will enhance institutional capacity to channel investments in the rural sector. The reforms will cover policy, governance, institutions, and operations. From a sector perspective, the RFSDP will cover SBP, CBs, ZTBL, cooperatives, and MFIs. B. The Program Loan

1. Objectives 38. The program goals are to ensure the majority of rural households permanent access to institutional financial services at minimal transaction cost and to encourage private sector participation in the RF sector. The specific objective is to develop a sustainable RF system for providing affordable services, primarily to the lower segments of the RF markets to significantly raise their income and reduce poverty. Increased financial intermediation will give RF clients opportunities to increase incomes and employment and improve their quality of life through access to a strengthened and responsive RF system.

2. Components and Outputs

39. The program loan has 4 components: (i) creating a favorable policy environment, (ii) institutional restructuring and reforms, (iii) new bank fund, and (iv) product and process innovations.

a. Creating a Favorable Policy Environment

40. The reforms in Pakistan aim to develop a market-oriented, predominantly private-owned financial sector, performing efficient intermediation through innovative products and services.30 The reforms will allow a fair return to shareholders and promote sustainable and equitable growth. While RF in general is subject to these reforms, the following will be continued and extended as part of the RFSDP.

(i) Savings and credit, and rural instead of agriculture, will be the policy goal for meeting the heterogeneous demand for RF services.

30 Dr. Ishrat Hussain, Governor, SBP. 2002. Financial Sector in Pakistan: Future Strategic Direction. Karachi.

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(ii) RFIs will not be subject to lending interest rate ceilings. 31 (iii) The Government will not intervene for pardoning outstanding loan repayments,

discouraging debt recovery, and granting interest remissions. (iv) The mandate of the Agriculture Credit Department of SBP will be reviewed by

SBP to ensure active participation in RFSDP. The existing MF Support Division of SBP will be enlarged to Rural and MF Support Division.

(v) SBP will not hold equity in RFIs to avoid conflict of interest. SBP equity in ZTBL

will be converted to subordinated debt (tier 2 capital). (vi) SBP will only be the lender of last resort to RFIs and not a refinancing agency

using its own resources.32

(vii) MFIs under the MFI Ordinance, as a subset of the RF, targeted at poor households, will be the preferred institutional form for extending outreach. MFI licenses will be granted to investors that meet the eligibility criteria.33

(viii) RFIs will be subject to prudential regulations on par with CBs.34

(ix) The business judgment of CBs on their portfolio exposure will be respected. SBP

will phase out the mandatory credit quotas on agriculture credit for CBs.

(x) Magisterial powers delegated to ZTBL for collecting overdue loans will be phased out. Like other banks, ZTBL will use the provisions of the Banking Companies Ordinance for collection of overdue agriculture loans as arrears of land revenue.

b. Institutional Restructuring and Reforms

41. Restructuring ZTBL. Broader structural reforms and a shift in the RF paradigm do not automatically result in the emergence of sustainable RFIs. Concerted efforts are required to reform RFIs with emphasis on removing the causes of weaknesses rather than their effects. With the right policies and strategies,35 openness to learn from mistakes, and stakeholder coordination and commitment, it is possible to reform ZTBL. With these preconditions, the Bank Rakyat Indonesia (Unit Desas) was restructured into a highly profitable entity from a politicized and loss-incurring credit agency for rice farmers. Other successful cases include Bank Pertanian Malaysia and the Bagricola in the Dominican Republic. In contrast, the strategy to close RFIs in Latin America and West Africa resulted in a situation where rural and agricultural credit all but dried up. Experience is negative when reforms do not accompany financial liberalization and stakeholder commitment is not maintained. 36

31 While no interest rate ceilings apply, this is to ensure that pricing autonomy of RFIs is maintained. 32 In the interim, already committed refinance facility could continue. 33 For expanding outreach in rural areas, new MFIs with rural focus will be permitted as a special case. 34 MFIs under MFI Ordinance 2001 will be subject to the supervisory and regulatory framework prescribed by SBP. 35 These include good governance, management autonomy, staff policies that stress accountabil ity and incentives,

low transaction costs, flexible product design, effective risk management and monitoring, savings emphasis, positive real lending rates, diversified portfolio, and advanced information systems.

36 Hans Dieter Seibel. 2000. Rural Finance Working Paper No. A7a on Agriculture Development Bank Reform , International Fund for Agricultural Development. Rome. With reform technologies available, RFI restructuring is possible, provided conducive policies and commitment to reform exist.

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42. Created and operated under the old paradigm that repressed viable financial intermediation through inexpensive funds under weak governance, ZTBL had large overheads and systemic inefficiencies. While these constraints seemed intractable in the past, in the context of the ongoing financial sector reforms it is possible to restructure ZTBL by fundamentally altering the norms of governance and operations. The sunk costs represented by a nationwide branch network, often at remote rural areas, could be put to efficient use by reengineering and implementing a strict program for reaching financial targets. Restructuring will be cost-effective compared with the significant political and financial cost of closing ZTBL (para. 26). ZTBL’s success on outreach goals is important for the rural sector to catalyze private investment in RF by demonstrating that the rural clients are bankable. 37

43. The following actions have been initiated as part of the RFSDP. They incorporate the recommendations of the portfolio audit and restructuring plan prepared with MSDP support, and demonstrate Government commitment to a sustainable ZTBL.

(i) Governance. ZTBL was incorporated under the Company Law on 23 October

2002 with an authorized capital of PRs25 billion ($417 million). The Articles of Association for ZTBL provide for a majority private sector board drawn from qualified professionals. The Memorandum of Association of ZTBL state operational viability, farm and nonfarm scope, and small farmer and gender focus. A new team will replace the current management of line departments.

(ii) Financial Restructuring. Financial restructuring is meant to provide for

uncovered bad and doubtful debts estimated at PRs12 billion ($200 million)38 and other assets of about PRs6.8 billion ($114 million), identified by the portfolio audit, to ensure that the capital adequacy ratio of ZTBL remains above 10% of risk-weighted assets. Government debt of PRs16.4 billion ($274 million) to ZTBL has been converted into ZTBL equity after adjusting ZTBL claims on the Government.39 Further, the Government will provide cash equity of PRs10 billion (about $170 million) in 3 tranches provided ZTBL meets agreed performance indicators. SBP equity in ZTBL (PRs3.2 billion) has been converted into subordinated debt.40 Restated balance sheet of ZTBL is in Appendix 4 (Tables A4.3 and A4.4).

(iii) Organization. Closing top-heavy administrative units and deploying staff at

branches will reduce administrative costs. Staff with inconsistent skills will be gradually phased out to reduce the cost of service delivery. Already 2,000 staff, about one fourth of the total staff, have opted for a golden handshake scheme. Significant investments will be made in human resource development and staff incentives will be modified to recognize and reward performance.

(iv) Institutional Strengthening. Reorienting, redesigning, and repackaging

products and services, and systems and procedures will ensure minimal transaction cost. Information technology (IT) and management information

37 The Bank for Agriculture and Agricultural Cooperatives (Thailand) reaches about 85% of the rural households and

Viet Nam Bank for Agriculture and Rural Development about 40%. Most of the rural households save with the Unit Desa System of Bank Rakyat Indonesia. It also provides credit facilities to nearly one fifth of the rural households.

38 Uncovered provisions are over and above the provisions already made in compliance with SBP prudential guidelines. Other adjustments mainly relate to loans waived under Government directives.

39 These mainly relate to loan waivers granted on Government directives. 40 At 30 June 2002, ZTBL equity after adjustments is PRs8.74 billion (Appendix 4, Tables A4.3 and A4.4).

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system (MIS) architecture will be upgraded to support good governance in line with international best practices in business processes.

(v) Business Strategy. The aim is to reach 600,000 clients by end-2005 compared

with the current 417,000 by adopting efficient practices, undertaking due diligence in loan appraisal, maintaining satisfactory portfolio quality, and mobilizing deposits. Improvements in loan collection will be the key criteria for viability. Management and control of risks, especially delinquency, will be strengthened. Lending will be from repayments and deposit mobilization until ZTBL significantly improves its repayment rate. ZTBL will aim to serve more new clients as against the practice of rolling over existing loans.

(vi) Performance Benchmarking. ZTBL will be evaluated based on agreed

performance indicators (Appendix 4, Table A4.5), including implementation of the restructuring plan. Achievement of performance indicators is related to the tranche-release conditions (Appendix 2).

(vii) Privatization. The Government will divest a reasonable number of shares of

ZTBL through an initial public offering or other methods of sale to the private sector within 3 years.

(viii) Anticorruption. Forensic accounting capability will be installed to support the

audit committee of ZTBL in tracking and minimizing corruption cases. Wherever necessary, ZTBL will involve the National Accountability Bureau, an anticorruption body, to pursue willful defaulters and corrupt staff.

44. Reforms in Cooperatives. The RFSDP supports attrition for institutions that have no turnaround prospects and remain terminally dependent on budgetary transfer. Cooperatives are provincial subjects with differing expectations. The depth and breadth of issues involved and provincial variations are too numerous and intractable for instituting a restructuring plan with a reasonable chance of success. For instance, the cooperative societies need to mobilize savings for sustainability. This, however, is neither permissible nor desirable due to domination of vested interests, history of misappropriations, and lack of sound regulatory structure. The present situation calls for a selective second-look at the cooperative societies, the essential building blocks, rather than restructuring of largely dormant PCBs. The RFSDP will therefore support

(i) transformation of PCBs into provincial MFIs under the MFI Ordinance 2001. This

will enable upfront introduction of RF best practices, broaden the scope from agriculture credit to RF, and introduce SBP supervision. These MFIs can use the eligible cooperative societies for service delivery; and

(ii) preparation of the Credit Union Plan to leverage the network of genuine

cooperative societies for greater outreach.41 The Credit Union Plan will include a framework for modifications in structure, constitution, accreditation criteria, systems, by-laws, and supervisory arrangements of cooperative societies. The Credit Union Plan will be implemented on a pilot basis in up to four districts.

45. Strengthening Commercial Bank Rural Operations. By the end of 2003, it is expected that three fourths of the CBs will become privately owned. An improved RF environment will

41 Credit unions are formal sector, member-owned nonbank financial institutions that mobilize savings and make

loans to members. ADB has supported credit unions in Kyrgyz Republic, Mongolia, Tajikistan, and Uzbekistan.

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enable CBs to capitalize their rural presence and natural strength in catering to the upper segments of the RF market. As part of the RFSDP, a RF Resource Center will be established at the National Institute of Banking and Finance, an SBP subsidiary, to strengthen CB rural operations by (i) creating awareness of the possibilities, prospects, and risks in RF; (ii) improving governance of RF operations; (iii) developing demand adapted products and services, with recognition of gender dimensions; (iv) instituting enhanced portfolio management capability; and (v) installing systems and procedures for reducing costs. c. New Bank Fund 46. The lowest market segment (para. 4) constitutes nearly half the farm holdings and nearly half of the rural microenterprises. These, as well as subsistence nonfarm activities such as livestock and fishery have little access to institutional credit. Because of limited assets and skills, the landless and tenant farmers remain unemployed or underemployed. As a result, self-perpetuating poverty afflicts nearly half the people in these categories. The slow transformation of economic growth into household gains can only be overcome by interventions that directly reach the lowest segment of the RF market for (i) reducing poverty, (ii) slowing rural-urban migration, and (iii) promoting broad-based rural growth. 47. The consensus is to leverage the MSDP framework through incentives designed to (i) overcome barriers to financial intermediation such as lack of institutions; (ii) accelerate and support institutional development; and (iii) provide limited onlending support until new MFIs have established credibility and a track record to borrow from the market. The public-private partnership for poverty reduction established under MSDP (para. 21) will be extended by establishing a New Bank Fund (NBF), worth $15 million, with SBP to encourage the emergence of MFIs in rural areas, especially at the provincial and district levels, and to facilitate the delivery of MF services to the lowest segment of the RF markets (Appendix 5). 48. SBP Act of 1956 provides for the creation of and management of funds by SBP. SBP will prepare detailed rules for operating NBF. The rules will include (i) fund description and definitions, (ii) objectives and purposes, (iii) contributions and investments, (iv) governance and administration, (v) annual reports and audits, (vi) eligible institutions, and (vii) qualifying criteria. The eligible MFIs will abide by SBP-approved business plan including gender outreach targets. NBF will provide institutional strengthening loans at soft terms not exceeding half the initial equity investment by the promoters. The loans will be converted into subordinated debt after 3 years provided that MFIs attain a predetermined self-sufficiency standard. MFIs eligible to draw on NBF resources will also have access to the credit line and specialized funds42 under MSDP provided they meet the requirements. 49. NBF and its linkages with MSDP will ensure the gender orientation of MFIs, their products, and delivery mechanisms. The institutional strengthening support from NBF is meant to meet the costs for enhancing women’s access to MF, which are significantly higher due to constraints on mobility and social interaction. The institutional strengthening component will help up-front investments in mobile units to enable MF service delivery to remote rural communities, and recruit, train, and retain women staff. Further, the eligibility of MFIs to access the specialized long-term funds for social mobilization and community investment under MSDP will ensure that social intermediation and access to basic infrastructure precede as well as accompany MF services.

42 MF Social Development Fund, Community Investment Fund, Deposit Protection Fund, and Risk Mitigation Fund.

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50. Interest in establishing MFIs originates from private investors including overseas agencies, large NGOs with substantive interest in MF, CBs that wish to corporatize clusters of rural branches into MFIs, provincial governments that would like to transform PCBs, local/district governments, and other public-private sources. ZTBL may also invest in MFIs. Interest in district level MFIs is positive and is considered consistent with the ongoing devolution process.

d. Product and Process Innovations43

51. Because of the mixed experience worldwide in crop insurance introducing any nationwide scheme runs the risk of adverse selection and failures. However, reducing the vulnerability of the rural households is important. Absence of insurance services forces households to forego opportunities, save in nonfinancial assets, borrow at usurious rates, and remain unemployed or underemployed. Only those with access to formal sources have the option to save and borrow in times of emergencies. Risk management should, therefore, be looked into at farm and bank levels and efforts to manage risk could be made through income diversification, savings, emergency funds, and insurance, and reinsurance. Some schemes can be developed to reduce if not totally eliminate the impact of natural risks. It is commonly accepted that the Government often need to share the cost of insurance schemes for small and subsistence farmers. As part of the RFSDP, a Pilot Insurance Plan for up to four districts will be prepared in consultation with sector specialists. With preferential access to ZTBL borrowers, the Pilot Insurance Plan will (i) cover drought and floods, (ii) adopt actuarial rates, (iii) link and activate claims after declaration by a competent authority, and (iv) restrict indemnity to verifiable instruments. It may on an as-needed basis include subsidies and define the role of the Government in replication.

3. Important Features

52. The RFSDP design contributes to the goals of the Poverty Reduction Partnership Agreement, the Government’s Ten-Year Perspective Development Plan, and IPRSP (paras. 15 and 34). The RFSDP integrates the key elements of ADB’s poverty reduction strategy, private sector strategy, MF development strategy, and rural sector analysis.44 The RFSDP will strengthen ADB’s role in RF, which is critically linked to a range of rural sector interventions. 53. Simultaneity and Linkages. Given the multidimensional nature and causes of poverty, the RFSDP has been timed to coincide with (i) structural adjustment projects to create better conditions for a market-based financial sector, (ii) agriculture sector policies that enhance agricultural income potential; and (iii) infrastructure projects that break production bottlenecks, reduce production risk, and bolster the return to capital. The RFSDP is well anchored with the reforms in the banking sector and is consistent with the proposed ADB projects relating to agribusiness export and small- and medium-scale enterprises (Appendix 6). 54. Sustainable Paradigm. The Government has redefined its role as complementing, facilitating, and improving the functioning of RF markets. Heterogeneity of the demand (para. 4) is recognized and so are the expectations from RF in terms of income expansion and poverty 43 Savings and loan products will be developed as part of the institutional strengthening of ZTBL, MFIs, and CBs.

Credit expansion will be facilitated by legal, regulatory, and institutional reforms relating to titling and registering land, secured transactions, and lowering the cost of foreclosures. Addressing these issues within the scope of RFSDP though will not be possible, as the focus is on enhancing outreach from its existing narrow base through sustainable institutions. The proposed 2003 technical assistance for RF could explore some of these issues.

44 ADB. 2000. Fighting Poverty in Asia and the Pacific: The Poverty Reduction Strategy of the Asian Development Bank . Manila; ADB. 2000. Promoting the Private Sector to Support Growth and Reduce Poverty: Private Sector Development Strategy. Manila; ADB. 2000. Finance For the Poor: Microfinance Development Strategy. Manila; and the five volume ADB. 2000. Study of Rural Asia. Oxford University Press. New York.

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reduction (paras. 18–21). This enabled introduction of an integrated approach where demand from the middle and lower segments are linked with corresponding institutional forms. Considering the evolutionary nature of reforms, the RFSDP incorporates successful international and local practices and MSDP experience. Reform options were evaluated in terms of cost-effectiveness, probability of success, and sustainability. 55. Maximizing Long-Term Impact Through Good Governance. The RFSDP fundamentally alters the norms for governance and institutional design. Candid assessment of corruption and remedial actions indicate the resolve to deal with sensitive issues. By shifting emphasis to systemic issues that have so far segmented the RF market and affected sustainability, the RFSDP represents a generational change from RF projects that prioritized credit lines. Within the key institutions, the RFSDP emphasizes optimizing financial and human resources, improving repayment rates, designing demand-adapted products and services, and encouraging resource mobilization through savings and borrowings. Savings mobilization provides greater prospects for sustained outreach compared with a finite credit line. Financing loans out of savings will diminish the patronal relationship that exists between borrowers, RFIs, and the Government. Investing in IT and MIS will lay the basis for better portfolio quality. 56. Encouraging Private Sector Role. The RFSDP emphasizes enhanced private sector contributions to poverty reduction by proactively creating enabling conditions, generating business opportunities, and catalyzing private investments. Synergy with MSDP interventions has been integrated in RFSDP design. The NBF capitalizes on the framework developed under MSDP to encourage the establishment of new MFIs through positive incentives for institutional strengthening and outreach expansion.45 The NBF signals Government’s long-term commitment in MF to potential local and international investors. The public-private partnership provides transparent incentives with focus on the poor, especially poor women.

4. Financing Plan 57. It is proposed that ADB provide a loan of $225 million from its ordinary capital resources (OCR) for the RFSDP, with a term of 15 years, including a grace period of 3 years, with interest rate to be determined in accordance with ADB’s London interbank offer rate (LIBOR)-based lending facility; a commitment charge of 0.75% per annum; a front-end fee of 1.0% of the loan amount; and such other terms and conditions set forth in the Loan Agreement. 58. The use of ADB funds is in support of reforms that address complex long-standing and sensitive issues relating to (i) dismantling the repressive RF paradigm so as to enhance the flow of resources to the rural sector, (ii) enhancing governance and institutional norms for the benefit of the middle and lower segments of the RF markets, (iii) reducing misdirected and nontargeted subsidies, and (iv) encouraging sustainable public-private partnerships to enhance employment and income-generating opportunities for the poor. The estimated adjustment cost of $547 million for implementing the RFSDP includes: conversion of Government loan to ZTBL ($274 million) into ZTBL equity after settling ZTBL claims on the Government; performance-linked cash equity from the Government to ZTBL (about $170 million); rightsizing of ZTBL through a voluntary golden handshake scheme funded by the Government ($84 million);46 NBF ($15 million); and RF Resource Center ($1 million), Credit Union Plan ($1 million), and Pilot Insurance Plan ($2 million). The International Monetary Fund has factored in expenses up to $100 million for

45 MSDP does not include incentives for es tablishing new MFIs. 46 Estimated 3,000 out of the 7,692 staff are expected to eventually avail of the facility. Nearly 2,000 have already

applied.

18

RFSDP related costs during FY2003 under the quantitative targets of the ongoing Poverty Reduction and Growth Facility.

5. Implementation Arrangements

a. Program Management 59. Ministry of Finance (MOF) will be the Executing Agency (EA) and will coordinate with SBP on policy reforms. A program/project management unit (PMU) has been set up at MOF with a project director and 1 full-time officer, to coordinate, monitor, and supervise program implementation. One more full-time staff will be recruited from among qualified professionals. SBP will be the Implementing Agency (IA) for the NBF and RF Resource Center, and ZTBL for ZTBL restructuring. The Rural and MF Support Division within SBP will serve as a project implementation unit (PIU) and has been strengthened with 1 additional officer. Additional staff will be provided with growing volume of work. ZTBL has set up a PIU with 2 full time officers. The National Credit Consultative Council comprising a broad array of stakeholders will ensure wider consultation on policy matters.

b. Period of Implementation 60. Implementation period is 3 years, and to be completed by December 2005 (Appendix 7).

c. Procurement and Disbursement 61. The loan proceeds will be used to finance the foreign exchange costs of items produced and procured in ADB member countries, excluding ineligible items (Appendix 8). The Government will certify that (i) if the loan proceeds will finance goods already imported, the value of eligible imports in the period concerned will exceed the amount of the requested withdrawal; or (ii) if the loan proceeds finance items to be imported, the value of eligible imports in the immediately preceding 1-year period will be equal to or greater than the amount of the requested withdrawal plus all other amounts expected to be withdrawn during the period. Simplified disbursement procedures and related requirements will be adopted.

d. Accounting, Auditing, and Reporting 62. The use of the loan proceeds will be audited if ADB so requests. ADB retains the right to (i) audit any account, and (ii) verify the validity of the certification issued by the Government for each withdrawal application. Prior to withdrawal, the Government will open an account at SBP to receive all loan proceeds. The account will be managed, operated, and liquidated in accordance with terms satisfactory to ADB. The PMU will send quarterly progress reports to ADB on the policy reform measures including ZTBL restructuring, RF Resource Center, Credit Union Plan, Pilot Insurance Plan, and NBF including all entities that avail of NBF.

e. Counterpart Funds 63. As part of RFSDP, it has been agreed that the Government will contribute the entire counterpart funds for ZTBL restructuring ($206 million), NBF ($15 million), RF Resource Center ($1 million), Credit Union Plan ($1 million), and Pilot Insurance Plan ($2 million). The Government and ADB will monitor the use of counterpart funds. Precise and monitorable dedication of counterpart funds through explicit expenditure commitments directly supports RFSDP reforms and contributes to the Government’s and ADB’s poverty reduction goals. The allocation of counterpart funds is in the context where resource requirement for poverty

19

reduction is immense. Use of counterpart funds outside the Government budget structure will enable flexibility to adapt to changing sector requirements.

f. Tranching and Monitoring

64. The program loan will be released in 4 tranches over 3 years to meet the expected occurrence of associated costs and subject to ZTBL performance. The first tranche of $100 million will be released upon loan effectiveness; the second tranche of $50 million, after 7 months of the first tranche; the third tranche of $50 million, within 12 months of the second tranche; and the fourth tranche of $25 million, within 17 months of the third tranche, in each case subject to compliance with the conditions for their respective releases. 65. Monitorable and time-bound actions are reflected in the policy matrix attached to the development policy letter (Appendix 2). Both the Government and ADB will regularly and closely monitor RFSDP implementation. Special reviews and audits will conducted periodically. Specific performance indicators with regard to ZTBL have been developed (Appendix 4, Table A4.5). g. Program Performance Management System 66. PMU will establish and maintain a program performance management system including a database on the status of policy reform measures and program indicators based on the policy matrix. This will be linked with the project performance management system (para. 86).

h. Program Review

67. The Government, SBP, ZTBL, and ADB will conduct a comprehensive midterm review at the end of year 2 to evaluate the progress of the reform measures and their impact on the sector. ADB will also monitor implementation through periodic reviews and progress reports. ADB will conduct annual reviews throughout the implementation period to identify further measures necessary for the continued development of the RF markets. C. The Project Loan

1. Objectives 68. The project loan will strengthen key institutions to help them provide affordable financial services for increasing rural incomes, employment, and investments. Institutional diversity and strengthening will increase the access of the rural households to financial services.

2. Components and Outputs 69. ZTBL Restructuring. The project loan will support implementation of the ZTBL restructuring plan covering the following (i) governance: establish an environment that facilitates good governance and accountability; (ii) systems: modernize operations through use of technology, networking, and communication tools; (iii) business processes: streamline products and delivery systems so as to reduce transaction costs, simplify operations, and increase outreach; (iv) products and services: introduce products and services that are financially and economically viable; (v) human resource development: improve standards and skills of management and staff and strengthen training capacity; and (vi) IT: establish new hardware and software platform to support MIS, accounting system including forensic accounting, and risk management functions. Hiring of a management team and functional specialists, both domestic and international, and study visits will also be supported.

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70. SBP Institutional Strengthening for RF Regulation. Institutional strengthening support for SBP will include (i) reviewing the prevailing supervisory and regulatory policy, systems, and framework for RF; (ii) upgrading and formulating guidelines, operational procedures, and standards for off-site and on-site inspection, supervision, and reporting; (iii) assessing human resource, skills, and IT requirements; (iv) installing basic IT infrastructure, facilities and equipment; and (v) providing training and skills development. The RF Resource Center will be assisted in terms of staffing, library, equipment, and partial support for costs of recurring training and study visits. The Agriculture Credit Department and Rural and MF support Division will also be strengthened. 71. MOF Institutional Strengthening. The PMU will receive capacity building support for (i) implementing the program and the project and (ii) preparing the Credit Union Plan and Pilot Insurance Plan and skills, equipment, and facilities support for implementing these plans.

3. Important Features

72. Strengthening ZTBL will produce a stream of benefits that include efficiency, sustainability, and greater outreach. The project cash flows and profitability pay off the investments within the RFSDP duration. Emphasis on IT, both at ZTBL and MFIs, aims to provide quality services to rural households. The RF Resource Center institutionalizes knowledge management and dissemination. As autonomous institutions with a significant private sector stake, MFIs will provide a broad range of financial services to the poor, especially women. Access to the MSDP credit line will facilitate outreach expansion through MFIs.

4. Financing Plan 73. The estimated project cost of $29.6 million equivalent (Table 1), comprises $17.2 million (58%) in foreign exchange and $12.4 million equivalent (42%) in local currency (Appendix 9 and Supplementary Appendix C). The financing plan is in Table 2.

Table 1: Project Cost Estimates ($ million) Item Foreign

Exchange Local

Currency Total Cost

A. Base Cost 1. ZTBL Restructuring 2. SBP Institutional Strengthening 3. MOF Institutional Strengthening Subtotal (A) B. Contingencies 1. Physical Contingencies 2. Price Contingencies

Subtotal (B) C. Service Charges

1. Interest During Implementation 2. Commitment Charges

3. Front-end Fee Subtotal (C) Total

10.4

2.0 1.3

13.7

1.4 0.8 2.2

0.9 0.2 0.2 1.3

17.2

8.7 1.2 0.6

10.5

1.1 0.8 1.9

0.0 0.0 0.0 0.0

12.4

19.1

3.2 1.9

24.2

2.5 1.6 4.1

0.9 0.2 0.2 1.3

29.6

Source: Asian Development Bank estimates. 74. The Government has requested that ADB provide a loan of $25 million from its OCR. The Borrower will be the Government of the Islamic Republic of Pakistan. The OCR loan will have a 24-year term, including a grace period of 4 years; an interest rate to be determined in

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accordance with ADB’s LIBOR-based lending facility; a commitment charge of 0.75% per annum and a front end fee of 1% of the loan amount; and such other terms and conditions set forth in the Loan Agreement. 75. The provision of the local currency cost is warranted from the objective of creating institutional capacity for greater outreach. Country considerations justify the provision of local currency cost financing. Concerted efforts have been made to maintain domestic investment levels to sustain growth, but the country faces persistent budget pressures. Moreover, the program loan only partially meets the cost of implementing the reforms.

Table 2: Summary of Financing Plan

($ million) Source Foreign

Exchange Local Currency Total

Cost Percent

Asian Development Bank Government

16.86 0.38

8.12 4.26

24.98 4.64

84 16

Total 17.24 12.38 29.62 100

Source: Asian Development Bank estimates. 5. Implementation Arrangements

a. Project Management

76. As the EA, MOF will oversee and coordinate implementation and will directly implement the Credit Union Plan and Pilot Insurance Plan. ZTBL will be the IA for ZTBL restructuring and SBP will be the IA for strengthening supervision and regulation, NBF, and the RF Resource Center. The Rural and MF Support Division of SBP will be the PIU. ZTBL has set up a PIU with 2 full-time staff at Islamabad. Drawing on the MIS of ZTBL, the PIU will submit information and analysis to the PMU and coordinate the fielding and work of consultants. The PMU will ensure submission of periodic reports and will adopt sound accounting and internal control systems. 77. Flow of Funds. The foreign exchange risk will be borne by the Borrower. The proceeds will be passed on in the following manner: (i) equipment and capacity building support to ZTBL as a grant from the Borrower; and (ii) funds for NBF, RF Resource Center, Credit Union Plan, and Pilot Insurance Plan as a grant from the Borrower.

78. Management of NBF. NBF will be governed by NBF Rules (para. 48). The Rural and MF Support Division of SBP will be responsible for investing, managing, and operating NBF. NBF will be invested only in approved government securities, and the incomes will be reinvested. Independent auditors will annually audit NBF and the reports will be made public. SBP will install a web page for wider dissemination about NBF facility.

b. Period of Implementation

79. Implementation period is 3 years, and to be completed by December 2005 (Appendix 7).

c. Procurement

80. Goods and services will be procured subject to the provisions of ADB's Guidelines for Procurement. Vehicles and office equipment will be procured through international competitive bidding procedures for packages exceeding $500,000 equivalent, and through international

22

shopping procedures for packages between $100,000 and $500,000 equivalent. For packages below $100,000 equivalent direct purchase may be used. Most of the equipment relates to software and hardware, which depending upon the requirements of ZTBL will be procured either in one package or several packages as appropriate.

d. Consulting Services 81. The project loan will finance 438 person-months of international and 651 person-months of domestic consulting services. All consultants to be financed from the proceeds of the ADB loan will be recruited in accordance with ADB’s Guidelines on the Use of Consultants and arrangements for engaging domestic consultants satisfactory to ADB. Consultants will be recruited by SBP for strengthening supervision and regulation, NBF, and RF Resource Center; and by the PMU for all other aspects including ZTBL restructuring. Where firms are to be engaged, the quality-based selection method will be used for selecting consultants. Simplified procedures will be used wherever appropriate.

e. Disbursement Arrangements 82. On behalf of the Borrower, SBP will open at National Bank of Pakistan, within 1 month of loan effectiveness, an imprest account denominated in US dollars. The imprest account will be operated and maintained in accordance with ADB’s Handbook on Loan Disbursements dated January 2001 and ADB’s Interim Guidelines for Disbursement Operations–LIBOR Based Loan Products dated July 2002. ADB will advance 3 months of estimated expenditures (about $2.5 million) into the imprest account. Foreign exchange payments or letters of credit, as well as local currency expenditures may be paid out of the imprest account. The ADB statement-of-expenditure procedure will be used to liquidate and replenish the imprest account for individual payments not exceeding $50,000. 83. SBP, ZTBL, and MFIs will maintain separate records and accounts adequate to identify goods and services financed out of the loan proceeds and the NBF to disclose their use following sound accounting principles. Such accounts and records will be audited annually by auditors acceptable to ADB. Within 6 months of the close of the financial year, certified copies of the audit report together with the auditor’s opinion will be submitted to the Government and ADB. The audit reports will include a separate opinion on the use of the imprest account.

f. Accounts, Audits, and Reports 84. The PMU will submit reports to ADB concerning the use of the loan proceeds, project administration, and financial management. The reports include quarterly, semiannual, and annual project implementation reports, a midterm review report, a project completion report including program and project components, within 3 months of project completion. The reports will cover (i) expenditures; (ii) activities financed by NBF; (iii) highlights of audit reports, of ZTBL, MFI, and RF operations of CBs; (iv) training activities and their impact; and (v) performance of Credit Union Plan and Pilot Insurance Plan. These topics will be discussed in greater detail in the annual reports. ZTBL will prepare quarterly reports analyzing the overall financial and operational aspects including the implementation of the ZTBL restructuring plan. 85. The Government will maintain separate records and accounts for the imprest fund and project expenditure in accordance with sound accounting principles and will have such accounts and records audited annually by auditors acceptable to ADB. The Government will ensure that the submission of project reports, audited accounts, and financial statements comply with ADB's revised guidelines introduced in 1998. Audited annual accounts of ZTBL will be submitted to

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ADB within 6 months of the reporting period. SBP will also provide the key findings of its inspection report on ZTBL and MFIs. Independent auditors acceptable to ADB will audit NBF annually and will also inspect physical activities. In addition, 3 annual management audits of ZTBL will evaluate management autonomy, business strategy, organizational structure, credit policy and procedures, service delivery systems, MIS, and training policies and programs.

g. Project Performance Management System 86. ZTBL will establish and maintain a project performance management system that will generate monthly, quarterly, and annual reports. The reports will comprise (i) financial reports covering loan portfolio growth and performance, liability growth and management especially of savings deposits, and financial performance indicators concerning earnings and liability structures; (ii) details of the number of borrowers by gender, poverty classification, type of services, and size of transactions; (iii) information on the performance of staff measured by financial volume, number of customers, and earnings ratios; (iv) information showing planned and actual levels of activities; and (v) annual financial statements. A format for assessing poverty reduction impact of services will be developed. Audited financial and operational information will be made available on the ZTBL website. For MFIs, a system equivalent to that for KB will be mandatory (Appendix 5, Table A5.1). h. Project Reviews 87. ADB and the Government will periodically review project implementation. The reviews will include evaluation of the project scope; implementation arrangements; consultation with ZTBL, MFIs, CBs; implementation of ZTBL restructuring plan; progress with the policy reform agenda; and capacity building measures. ADB will also field regular review missions, including midterm; and project completion review missions. A comprehensive midterm review at the end of year 2 will be undertaken to evaluate actual physical and financial progress. Based on this review, modifications and improvements will be considered.

IV. PROGRAM BENEFITS, IMPACTS, AND RISKS A. Benefits and Impacts

1. Policy

88. Increasing agricultural productivity and diversification and increasing rural nonfarm employment for higher economic growth have a cause-and-effect relationship with increased RF intermediation. Financial institutions can respond to growth opportunities created by the ongoing structural reforms only when they operate in a favorable policy environment and are appropriately governed, organized, and equipped. RFSDP-supported reforms provide this critical linkage and support the ongoing financial sector reforms.

(i) Altering the policy environment that shapes the norms and incentives in which financial institutions operate will enable sustainable RF markets to grow and develop. Robust RF markets are correlated with rural growth, thus opening the possibility of arresting the flow of resources from the rural sector.

(ii) Emphasizing good governance and sustainability and strengthening supervision

will permit the integration of the hitherto segmented RF markets with the mainstream financial sector. This will reduce pressure on budgetary sources and improve fiscal space for investment in human development.

24

(iii) Undertaking institutional restructuring, rationalization, and closures premised on

cost-effectiveness and probability of success will give correct incentives for addressing weaknesses that impede sustainable financial intermediation.

(iv) Developing demand-adapted products and services will permit effective response

to the heterogeneous demand profile, growing significance of the rural nonfarm sector, and immense savings potential.

(v) Implementing strategic initiatives and incentives for promoting private sector

participation in RF markets specifically aimed at the lowest market segment extends the successful MSDP interventions through more MFIs with good governance and sustainability as core values.

89. ZTBL reforms have a reasonably good chance of success by adhering to rigorous credit appraisal and risk management. Gains from restructuring will be captured in improved governance, substantial cost savings through rightsizing, and greater outreach. ZTBL restructuring will establish a positive market setting to allow savings mobilization and demand led rural lending. In the process, CBs will overcome their apprehension of increasing their rural portfolio. A better climate for private sector investment in RF in response to NBF will be created. While it is difficult to predict the number of new MFIs that will emerge, it is likely that four investors will eventually meet SBP licensing criteria during the RFSDP duration. The increased outreach of new MFIs at provincial and district levels will further increase RF intermediation. 90. The RFSDP strengthens ADB’s lead role in RF. Continuous sector analysis by the RF Resource Center will facilitate policy dialogue. RFSDP-initiated reforms can also establish cost- effective means to link the vast network of cooperative societies with sustainable sources of finance (Credit Union Plan) and introduce a viable crop and calamity insurance system (Pilot Insurance Plan). The success of these pilots can facilitate the medium-term goals (2002-2006) of the Poverty Reduction Partnership Agreement. International dissemination about NBF facility will enhance ADB’s profile in promoting MFIs.

2. Institutional

91. Financial projections (Appendix 4 and Supplementary Appendix A) indicate operating self-sufficiency due to improved repayment rate, reduction in staffing expenses, and additional cash equity. ZTBL’s initial equity of PRs8.7 billion increases to PRs10 billion at the end of year 2 (ending June 2004). For breakeven in year 1 (ending June 2003), the provision for probable loan loss will need to be considered as allowable deductions from the operating income and the interest rate on loans will also have to be higher. Maintaining the prevailing rate of interest rate on loans, by the end of year 2 (ending June 2004), ZTBL is expected to disburse PRs37 billion, meet tax and interests liabilities, generate profit, and increase capital adequacy to above 10% of risk weighted assets. During year 4 (July 2005 - June 2006), the expected return on equity is 9% and capital adequacy ratio is 16%. At this level, the Government can begin divesting its equity in ZTBL to the private sector. Projections also indicate viability of MFIs (Appendix 5 and Supplementary Appendix B) aided by NBF incentives. Breakeven period for the provincial and district level MFIs is 5 years, at interest rates of 18% and 20%, respectively.

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3. Economic and Financial

92. The estimated ZTBL outreach of 600,000 clients p.a. at the 2005-end is premised on small farmer focus and resource generated through improved repayment rate and savings mobilization. The increased outreach (about 180,000) creates the equivalent of 80,000 full-time jobs. The economic internal rates of return for sample farm and nonfarm activities range from 21% to 54%, with a weighted average of 37%. The range in financial internal rate of return is 17% to 75%, with a weighted average of 45% declining to 33% after allowing for enterprise failure. The profiles show moderately attractive investments available to the rural poor. The MFIs are expected to reach 20,000 poor households during the RFSDP duration, and potentially much more thereafter. Annually, the lending will result in the equivalent of 12,500 full-time jobs. The weighted average economic internal rate of return and financial internal rate of return for typical income-generating activities financed by MFIs are, respectively, 34% and 27% (Appendix 10 and Supplementary Appendix D).

4. Environmental 93. An initial environmental examination of farm and nonfarm activities was made and the results were grouped into two broad classes representing larger loans from ZTBL and smaller MFI loans to determine their impact on the environment. None of the representative farm or nonfarm activities require a category A assessment. There are no negative environmental impacts that cannot be mitigated. However, emphasis at ZTBL to effectively deal with environmental issues is modest. As part of the ZTBL institutional strengthening, staff skills in environmental impact assessment will be enhanced. The summary initial environmental examination is in Appendix 11.

5. Social and Poverty

94. The RFSDP supports poverty reduction and pro-poor growth with agriculture and rural emphasis enumerated in the Poverty Reduction Partnership Agreement. At the macro level, the poverty reduction goal is supported through greater access to affordable financial services and their effective use to increase rural household income. NBF represents a direct pro-poor intervention aimed at the lowest segment of the RF market. Appropriately designed and priced services that consider the asset and consumption buildup of households will enhance household income above the poverty threshold after 4-5 credit cycles. Increased rural financial intermediation will help farmers to increase their productivity and support private enterprises, both farm-related and nonfarm, that will generate employment for the rural poor. 95. Increased availability of RF services will stimulate linkages within the rural economy and between the rural and urban economy. The new RF paradigm and NBF incentives create an environment conducive to private sector participation and investment in RF. Intertemporal assessment of the institutional reforms suggests that, while the full benefits from a strengthened RF system are likely to occur in the medium term, ZTBL and MFIs will target the middle and lower segments of the RF markets from the outset. The RFSDP will not have any adverse impact on indigenous peoples and, thus will not trigger actions dictated by ADB’s policy on indigenous peoples and the policy on involuntary settlement. The summary poverty reduction and social strategy is in Appendix 12 with further details in Supplementary Appendix E.

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B. Risks

1. Program Loan 96. The success of the RFSDP depends on a number of assumptions that are subject to variable degrees of risk. Mitigating measures have been put in place as appropriate and possible. 97. Consistency and Commitment to Reform. RF development requires consistency with the financial sector reforms. The Government has shown unwavering commitment to good governance, autonomy, and privatization of CBs and has adhered to similar expectations under MSDP. The reform agenda under the RFSDP was arrived at after sustained policy dialogue and is phased to show outreach results for facilitating sociopolitical acceptance for minimizing the risk of any rollback of the reforms. Nevertheless, the sociopolitical situation will be closely monitored against RFSDP objectives and continuous policy dialogue maintained. 98. Private Sector Perception. Private sector investment in RF depends on the perception of private investors. The measures under the RFSDP to improve investor confidence are up-front reforms, transparent positive incentives that reflect government commitment, and strong SBP supervision for ensuring good governance. While the Government has managed to stabilize the economy and the outlook is positive, vulnerability to exogenous risks such as worsening global outlook, regional conflict, and terrorist attacks remains. 99. Short Implementation Period. This risk is reduced through the following measures: (i) the ADB loan will be released in 4 tranches to provide greater dialogue between ADB and the Government, allow more time for the Government to implement the reforms, and enable various stakeholders with different interests to maintain ownership of the policies; (ii) consulting services will be provided to strengthen implementation capacity; and (iii) the National Credit Consultative Council will oversee broader stakeholder coordination (para. 59).

2. Project Loan

100. ZTBL has been a politicized financial institution with staff values that could affect the restructuring. Autonomy could be eroded and expected improvements in repayments may not materialize. Factors that mitigate the risks include (i) up-front agreement on the governance framework, autonomy, and a professional board and management team; (ii) financial restructuring for capitalization and funds for making provisions for the portfolio affected by political waivers and remissions; (iii) redefining the mission and vision with sustainability as the key objective; (iv) reducing overheads including redundant staff with inappropriate skill set; and (v) significant investments in IT and MIS. The risk of weak managerial capability has been reduced by making the selection of a qualified management team a tranche condition and providing funds to attract the best talent. The private sector board of directors and independent committees to the board will facilitate good governance and institutionalize commercial orientation. 101. Support is contingent upon performance. Support for restructuring rather than onlending will alter ZTBL behavior and orient it to attract deposits and enhance eligibility for raising resources from money markets. Tightening of credit standards, more attention to credit risk, and rigorous credit appraisal will improve the portfolio quality. These actions will drive up cost in the short term and could even require higher provisioning and draw down the equity. However, in the medium to long run they will strengthen viability. Risks associated with loan remissions and

27

waivers are mitigated by the Government’s commitment that it will not pardon outstanding loan repayment or discourage debt recovery. 102. Improvement in loan collection is also premised on (i) stricter powers available to banks under the Financial Institutions (Recovery of Finances) Ordinance 2001, (ii) establishment of an asset management company, the Corporate and Industrial Restructuring Corporation, and (iii) Government efforts for improving the banking courts. Redesigned business processes and upgraded MIS are expected to significantly enhance appraisal, credit risk management, and delinquency monitoring. It is likely that natural calamities during the RFSDP duration may adversely affect the portfolio quality, for which no immediate protection is available. The Pilot Insurance Plan is expected to provide practical solutions.

V. ASSURANCES 103. In addition to the standard assurances, the Government has given the following assurances, which have been incorporated in the legal documents: 1. Program Loan

(i) The Government will (a) maintain the policies adopted and actions taken prior to the date of the Loan Agreement for the program loan, as described in the development policy letter and the policy matrix, for the duration of the RFSDP and subsequently; (b) promptly adopt the other policies and the other actions included in the RFSDP as specified in the development policy letter and the policy matrix; and (c) ensure that such policies and actions continue in effect for the duration of the RFSDP and subsequently.

(ii) Notwithstanding any other provision of the RFSDP Program Loan Agreement

and Project Loan Agreement if there is a significant shortfall in the achievement of agreed performance indicators by ZTBL, ADB will carry out a special financial and operational review of ZTBL and reach agreement with ZTBL and the Government regarding implementation of the recommendations of the review and until such agreement has been reached, no disbursements will be made.

(iii) The Government will assist the private sector participants in identifying and

promoting small MFIs, ensure resources are provided to SBP and MFIs in a timely manner, and review the Microfinance Institutions Ordinance 2001 in light of the NBF experience in promoting MFIs.

(iv) The Government will ensure that the Credit Union Plan and the Pilot Insurance

Plan will be implemented to the satisfaction of ADB. (v) ZTBL will promptly inform ADB of any change in its board of directors or its

senior management team, and ensure that any such change will be made in accordance with good corporate governance.

2. Project Loan (i) In case of natural calamities and unforeseen circumstances that affect the equity

and liquidity of ZTBL, MFIs that avail of NBF, and CBs under the RFSDP, ADB will be consulted immediately and a remedial action plan acceptable to ADB prepared within one month thereafter.

28

(ii) External auditors will be engaged to audit project accounts, including imprest account, ZTBL, MFIs, and NBF. The annual audited accounts and financial statements, together with audit reports, in English, will be submitted within 6 months following the end of the relevant Government fiscal year. In addition, 3 special management audits of ZTBL will be carried out.

(iii) ZTBL will ensure that the lending operation will be carried out in accordance with

all applicable environmental laws and regulations of the Government and with ADB’s environmental policies and procedures.

(iv) The provision of para (ii) above (program loan) also applies to the project loan.

VI. RECOMMENDATION 104. I am satisfied that the proposed loans would comply with the Articles of Agreement of ADB and recommend that the Board approve:

(i) the loan of $225,000,000 to the Islamic Republic of Pakistan for the Rural Finance Sector Development Program from ADB’s ordinary capital resources with interest to be determined in accordance with ADB’s LIBOR-based lending facility; a term of 15 years, including a grace period of 3 years and such other terms and conditions as are substantially in accordance with those set forth in the draft Loan and Program Agreements presented to the Board; and

(ii) the loan of $25,000,000 to the Islamic Republic of Pakistan for the Rural Finance

Sector Development Project from ADB’s ordinary capital resources with interest to be determined in accordance with ADB’s LIBOR-based lending facility; a term of 24 years, including a grace period of 4 years; and such other terms and conditions as are substantially in accordance with those set forth in the draft Loan and Project Agreements presented to the Board.

26 November 2002

Tadao Chino President

Appendix 1 29

SECTOR AND SUBSECTOR ANALYSIS 1. Rural financial (RF)1 markets in Pakistan are characterized by low and decreasing availability of financing for both farm and nonfarm activities. The shallow RF markets lack variety, breadth, and range in the services they provide. RF markets have not expanded to provide savings services, credit products tailored to purpose, crop insurance, or remittance services. Access to formal financial services is extremely limited. The high incidence of self-perpetuating poverty in rural areas, growing income inequalities between urban and rural markets, and concerns for food security and population vulnerability in rural communities are the emerging consequences of the failure to establish RF markets consistent with the needs of the rural communities. 2. Rural Economy. The estimated 97 million rural population of Pakistan is spread over 14.3 million households. Nearly 80% of the households earn less than a $1 per person per day. The head count estimate of rural poverty is 36.3% and that of urban poverty is 22.4% (1998-1999). The estimates show that poverty increased in depth and severity during the 1990s. Overall inequality also increased.2 The country experienced successive and severe droughts in the last 3 years. It is, therefore, highly likely that the incidence of poverty, particularly rural poverty, today is significantly higher than estimated. The inelastic supply of agricultural land, higher population growth, and gradual mechanization of agriculture have transferred rural labor from agricultural to nonfarm activities in rural and urban sectors. Nearly two thirds of the workforce is engaged in rural jobs, of which 64% are in agriculture, 12% in services, and 24% in rural enterprises,3 construction, and trade. The total agricultural income accounted for only 48% of the rural income in the country, the rest came from nonfarm activities including remittances. 3. RF Market Structure. The demand profile stratifies the market in 4 broad categories: (i) upper: agriculture commodity processors, food processors, large agriculture-based industries, agriculture produce wholesalers, and farmers with large landholdings; (ii) middle: the non-poor nonfarm households and better-off farmers supplying agriculture inputs, operating rural enterprises, and providing agribusiness services; (iii) lower middle: medium farmers, agriculture produce retailers, and smaller rural enterprises; and (iv) lowest: landless poor, tenant, subsistence, and small farmers. The segments are interdependent and have inherent overlaps. On the supply continuum, the upper segments have more access to formal financial sources and the lower segments rely on informal sources. 4. Demand. Nearly 60% of the rural households have borrowed either from formal or informal sources, and about one third have outstanding debt. Given the limited access to credit, the rural households have been restricted to borrowing levels that are substantially below their needs. Estimates4 show that the poor and non-poor households in the rural areas have, on average, borrowed loans to the level of PRs22,000 and PRs42,000, respectively, from all sources. Relaxing the constraints imposed by high effective rate5 of borrowing and limited

1 ‘RF’ also indicates rural finance in this Appendix. 2 Annual Review 2001. Social Development in Pakistan, 3 Rural enterprises include both agriculture-related and nonfarm enterpris es. Agriculture-related enterprises include

small-scale processing of agriculture produce and byproducts into semifinished and finished goods, and production and supply of agricultural inputs. Nonfarm enterprises include transport, warehousing, handicraft, and weaving.

4 Government of Pakistan. 1985. Rural Credit Survey; Government of Pakistan. 1990. The Agriculture Census; Applied Economic Research Center, Karachi University. 1998. Rural Financial Markets Study; State Bank of Pakistan (SBP). 2002. Report of the Committee on Rural Finance; and SBP. Annual Estimates for Agriculture Credit (from formal sources).

5 Most borrowings are from informal sources at interest charges between 40-50% per annum.

Appendix 1

30

access, the estimated demand for credit could be PRs240 billion-PRs260 billion annually. With the expansion of the RF market, the effective rate of borrowing will decline due to lower transaction costs, which may raise the demand for credit even further.6 Within the RF market, some households do not borrow because of strong risk aversion, while others cannot borrow as much as they need. Those in the lowest group perceive that they are highly unlikely to have access to reasonably priced credit. 5. Whereas the transitory gaps in income generating activities of the rural households, particularly the farm households, raise the demand for credit largely for consumption purposes, the rural households also tend to generate net savings. The poor and non-poor households, on average, are estimated to annually generate net financial savings of PRs4,000 and PRs27,000, respectively. This amounts to around PRs268 billion annually. Since banks in rural areas primarily focus on disbursements, the forms and pattern of rural household savings are still traditional and inefficient. Commercial banks’ (CBs) rural deposits are only a fraction of the potential. CBs generally do not accept small savings.

6. Supply. The formal RF sector in Pakistan consists of Zarai Taraqiati Bank Limited (ZTBL)7 with 343 branches; CBs (3,183 branches); five provincial cooperative banks (PCBs, 205 branches); the newly established Khushhalibank (KB) with 30 branches; and the First Microfinance Bank (3 branches). There are about 10 nongovernment organizations with interest in microfinance (MF), a subset of RF. During the year ended June 2001, the formal sources jointly disbursed a total of 786,000 loans amounting to PRs56 billion i.e., an average loan size of PRs71,246. The nongovernment organizations have disbursed about 100,000 loans. The nominal interest rates charged ranged between 13% and 22%. The outreach is merely 6% of the total rural households and the amount disbursed is 21% of the estimated demand. On average, ZTBL disbursed about 1,215 loans per branch annually and the comparable figure for CBs was 80 loans. CBs are reluctant to expand their rural outreach and have, on occasions, preferred to pay penalties to the State Bank of Pakistan (SBP)—the central bank—for non-compliance with the mandatory credit quota. The limited outreach by formal sources has not helped to reduce the dependence on informal sources where the cost of borrowing is very high. This leaves very little for asset buildup and consumption. The large market share of the informal sources at 70% of total loans borrowed in rural areas indicates their dominance. 7. Funding Sources for RF. Previous projects funded by the World Bank and Asian Development Bank (ADB) essentially focused on credit expansion, with ZTBL as the key delivery channel. Despite impressive onfarm achievements, the project outcomes were rated unsatisfactory because institutional development was negligible and sustainability was unlikely. Serious financial and liquidity problems, increased dependence on subsidies, unsatisfactory accounting practices, and frequent government interventions were considered as major reasons for project failure. The main lessons learned were that deposit mobilization, loan recovery, autonomy, and stable professional management were critical for a viable ZTBL. With the rapid increase in rural poverty during the 1990s and ineffectiveness of formal sources of credit in the rural hinterland, ADB assisted in establishing KB with the aim of enhancing accessibility of sustainable MF services to the landless, subsistence farmers, and the poor. KB has been able to maintain portfolio quality, rapidly increase outreach, and establish a network in 30 districts.

6 Every additional 1% agricultural growth is associated with investment requirement of 2% of agricultural gross

domestic product. 7 Former Agricultural Development Bank of Pakistan.

Appendix 1 31

The policy, legal, and supervisory framework for the establishment of MF institutions (MFIs)8 facilitated the establishment of the First Microfinance Bank. 8. Major Issues in RF. A financial paradigm of directed rural credit to promote agriculture technology, stimulate agricultural production, and help the poor has persisted in Pakistan for 4 decades. RF policies, institutions, and programs adopted a supply-led approach for expanding agriculture credit. It meant promoting institutions within government control, expanding their branch network, and directing them to extend credit under various targeted programs. While the targeted beneficiaries, i.e., small farmers and the rural poor could not receive the major part of the benefits, dependence on subsidized credit was perpetuated. Inadequate emphasis was given to savings and insurance. The government, both as a source of repressive policies and provider of poor-quality RF services, dominated the RF markets. Its direct involvement resulted in allocation of credit without due care, as it has often been determined by administrative dictates rather than bankability. Consequently, institutions suffered recurring financial losses. Due to political interference nonperforming loans remain high in the banking sector. Inefficiently run government-owned financial institutions,9 including ZTBL and PCBs, were subject to considerable political interference and are characterized by poor portfolio quality, substantial overstaffing, and weak human capital. 9. A cumbersome system of land titling raises transaction costs and inefficiencies, which constrains the collection of bad loans. The information asymmetries between borrowers and lenders contribute to the problem of poor loan recovery and selecting creditworthy borrowers. Collateral orientation has helped in increasing investment and output. However, insecure tenants, sharecroppers, and agricultural laborers have received very little benefits from expanded credit disbursements. They have to rely on informal sources where prices are higher and loan durations short. The costs of physical distance and procedural complexities for borrowers in effect suppress the true demand for formal financial services. 10. Conflicts in ownership and regulation prevail. Supervision and regulation by SBP failed to prevent systemic weaknesses in the banking sector. The supervision of PCBs by provincial cooperative departments has been dismal. Except Punjab PCB, the others are nearly dormant. The perceptions of risk and low profitability have limited CBs exposure in rural areas despite a wide branch network. The resulting overdependence on ZTBL constrains the options for potential clients. Limited outreach of formal sources is also concentrated in periurban areas, while hilly and mountainous areas are sparsely covered. 11. Lessons Learned. The development of the RF markets in Pakistan has been considerably distorted resulting in fragmented markets that vary in development and density by region.10 However, during the last 2 years there has been a visible shift in financial sector policies. Focus on macroeconomic stability and prudential supervision of financial institutions has replaced repressive interest rate controls. Financial markets are deepening with product innovation, institutional restructuring, and expansion. However, financial liberalization has not yet eased the flow of resources in the rural areas where returns are relatively low because of low agriculture productivity and inadequate infrastructure. CBs remain concentrated in urban

8 ADB. 2000. Report and Recommendation of the President to the Board of Directors on the Proposed Loan to

Pakistan for the Microfinance Sector Development Program. Manila. 9 The performance of the state-owned CBs prior to the reforms was nearly the same. 10 Mellor, John, W. 1995, Some Issues in Institutional Finance for Agricultural Development: International Evidence

and Implications for Pakistan, Pakistan Development Review (34) 4:497-532.

Appendix 1

32

centers. While the intention to expand rural operations is emerging, the skills, technology, and orientation are lacking. 12. Lessons in RF, essentially derived from agriculture credit projects, suggest that price- driven credit programs ignored institutional sustainability. Price restrictions inhibited the ability of RF markets to develop internal sources of capital supply. This, coupled with high transaction costs, limited the depth and scale of outreach. Institutional expansion based on a refinancing facility on soft terms proved to be short-lived and nonviable, as it impaired the ability to raise resources from money markets. Highly inefficient supply-driven applications of capital and weak non-market-driven management are generally regarded as the basic reasons for the failure of ZTBL and PCBs. Specific causes of failure revolve around high operating costs, losses, and decapitalization. Poorly designed credit guarantee and insurance programs led to moral hazard resulting in repayment disincentives and losses. 13. The experience of MF 11 on one hand provided a tool for covering the excluded or ignored segments of society, and on the other hand, provided alternative approaches to cater to the financial needs of the lower segments of the RF markets i.e., microenterprises, the landless, and subsistence farmers. High turnover and short loan periods have given microenterprises the capability to pay higher interest rates for gaining access to financial markets.12 MF has shown its relevance to credit delivery and lending innovations to cover risk analysis and credit screening through peer pressure. 14. The lessons learned also suggest that removing repressive agriculture sector taxes and exchange regime policies enables farmers to increase agricultural production and incomes through improvements in production technology. Increased farm profitability increases credit absorption capacity. A more focused approach for expanding nonfarm income activities in rural areas will significantly enhance the prospects for more efficient financial markets. 15. Strengthening RF Markets. Structural reforms in Pakistan are eliminating price controls and subsidies, liberalizing interest rates, and reducing repression of the financial markets.13 They set the basis for fundamental RF reforms that require dealing simultaneously with the policy environment, financial infrastructure, institutional reforms, and innovations in products and services. In the context of ongoing financial sector reforms, the old RF paradigm has come under severe criticism in Pakistan as loan collection problems reached alarming levels, outreach remains limited, and transaction costs for both borrowers and lenders are high.14 16. Considering the multitude of deep-seated problems, changes can be expected only over the medium term and, therefore, priorities need to be decided for phasing and sequencing interventions. The first step is a well-defined role of the Government that is conducive to the establishment of a favorable policy environment. The core elements of the strategy are two- 11 Based on experience gained in the implementation of ADB. 2000. Report and Recommendation of the President to

the Board of Directors on the Proposed Loan to Pakistan for the Microfinance Sector Development Program. Manila.

12 These though still remain much below the interest charged by informal sources. 13 The reform agenda aims at raising growth to 6% p.a. while ensuring the benefits are widely shared by the poor.

The strategy centers around the continued pursuit of sound macroeconomic policies, in particular sustained fiscal adjustment, while increasing the share of poverty-related public spending; strengthening governance, with specific focus on efficiency, transparency, and accountability in public resource management; tax policy and administration reform; public enterprise restructuring and privatization; and financial sector and foreign exchange market reforms. The implementation of the 3-year Poverty Reduction and Growth Facility, approved by the International Monetary Fund in December 2001 for SDR 1.03 billion, to date is generally on track (www.imf.org).

14 ADB. 2000. Pakistan Rural Finance Sub-Sector Review, (TA 3229-PAK: Agricultural Sector Program, Annex No.4)

Appendix 1 33

pronged. The first set of components constitutes (i) improving the policy environment by extending the relevant financial sector policies to RF, (ii) improving the supervisory and regulatory environment, (iii) improving financial governance and institutional capacities, and (iv) promoting institutional diversity. The second set relates to: (i) improving outreach and client options, and (ii) implementing institutional restructuring. 17. Empirical evidence shows that when the financial sector is liberalized and repressive policies lifted, CBs close rural branches, minimize small transactions, and thereby restrict access of small clients, with negative overall consequences.15 Considering the client profile, nature of business, and the status of rural infrastructure, it does not appear likely that RF will attract large private commercial interest immediately or without incentives. Therefore, RF institutions with probability of turnaround need to be strengthened through good governance and efficiency. This will promote institutional diversity to provide quality and quantity of services and enhance institutional options for the clients. 18. The reforms initiated to restructure ZTBL show a strong Government commitment. Sustained application of the practices adopted by successful RF institutions will be required for restructuring. These practices relate to (i) good governance, (ii) autonomy to develop and price products; (iii) effective methods to reduce transaction costs; (iv) product mix with due emphasis on savings and loans for nonfarm activities; (v) transparent and competent financial, accounting, and management systems; and (vi) innovative staff development and incentive systems. As noted in the case of CBs in Pakistan, ZTBL can make a turnaround with improved regulation and supervision, good governance, and institutional strengthening support. 19. While the general direction of reform should be to enhance economic growth through income expansion, poverty reduction emphasis will require specific support for institutions to address the lowest segment of the market. The returns on rural investment projects for subsistence are lower than those in the urban trading or manufacturing sector. However, the social rate of return on such investments, positive nonpecuniary externalities of poverty reduction, and female employment is high. Given the low level of development, borrowers in this sector cannot offer any form of financial collateral. This worsens the risk perception of lenders and further lowers the expected financial rate of return. Ways and means must therefore be identified to enhance access. ADB’s ongoing Microfinance Sector Development Program has a comprehensive framework that can be leveraged to address the demand emanating from the lowest segment of the RF market with support for institutional strengthening and outreach.16 In view of the high incidence of rural poverty, the Government accords high priority to this. 20. The strategic components (paras. 16-19) are expected to significantly improve the environment for RF services, encourage new entrants, and strengthen the existing ones. Both the Government and funding agencies recognize the problems in the RF sector. Supporting expansion of MF through a range of institutions and initiatives and restructuring ZTBL are consistent with the target to create 11.3 million jobs during 2000-2011 by promoting growth in labor-intensive sectors of agriculture and small and medium-scale enterprises.17 To succeed, the Government, the private sector, and funding agencies must coordinate and balance their priorities.

15 Steel, F. W. 1997. Informal Financial Markets Under Liberalization in four African Countries. 16 Profit maximization of CBs, including those privatized by the Government, prompts them to direct financial

resources to investments with the highest rates of return. While desirable in a capital-scarce situation, this reduces the supply of RF.

17 Government’s Ten-Year Perspective Development Plan and the Interim Poverty Reduction Strategy Paper.

Appendix 2 34

Appendix 2 35

Appendix 2 36

37

POLICY MATRIX

Objectives Rationale First Tranche/Actions Complied with May to October 2002

Second Tranche: after 7 months of first tranche

Third Tranche: Within 12 months of second

tranche

Fourth Tranche: Within 17

months of third tranche

The goals of the Rural Finance Sector Development Program (RFSDP) are to ensure permanent access to institutional rural financial services for a majority of rural households at minimal transaction cost and to encourage private sector participation in rural finance (RF). The objective is to develop a sustainable RF system for providing affordable services, primarily to the middle and lower segments of the RF markets for a significant income expansion and poverty reduction impact. Increased financial intermediation will provide opportunities to clients to increase incomes and employment and improve quality of life through access to strengthened and responsive RF system. A. Creating a Favorable Policy Environment Adopt a progressive RF policy

The negative impact of government interventions through directed credit, weakly governed RF institutions (RFIs), refinance at soft terms, and loans at below cost interest rates necessitated that a new RF paradigm be adopted. Under the new paradigm the Government’s role should be to complement, facilitate, and improve the functioning of the RF markets. Focus shall be on creating conducive policies, promoting strategic initiatives for private sector participation, restructuring potentially viable RFIs, and relaxing mandatory credit controls.

•Rural Finance (savings and credit) and rural credit (nonfarm and farm) shall be the policy and institutional orientation for Zarai Taraqiati Bank Limited (ZTBL). (Policy Letter and ZTBL Memorandum of Association)

•ZTBL will provide services at commercial basis and will not be required to give any concessions, write-offs, or waivers pursuant to any government directions or policies. (ZTBL Memorandum of Association)

•No markup rate ceiling shall apply on RFIs. (State Bank pf Pakistan (SBP) letter)

•The Government will not pardon outstanding loan repayments. In case this becomes inevitable, RFIs will be compensated adequately and up-front.

•Microfinance Support Division at SBP will be upgraded as Rural and Microfinance Support Division. (SBP Letter)

•Phasing out of special magisterial powers for recovery of agriculture loans. (Agricultural Development Bank of Pakistan (ADBP) Repeal

•RFIs will be subject to prudential norms at par with commercial banks. (SBP Letter)

•SBP will only be a lender of last resort for RFIs and not a refinancing agency using its own resources. (SBP Letter)

•The mandate of the Agriculture Credit Department of SBP will be reviewed to ensure active participation in RFSDP. (SBP Letter)

•Rules for New Bank Fund (NBF) will specify RF (savings and credit) orientation for microfinance institutions (MFIs). (NBF Rules-SBP)

•MFI license will be made available to eligible investors under the Microfinance Institutions Ordinance 2001. (NBF Rules-SBP)

•Review of mandatory agriculture credit requirements for commercial banks. (SBP Study) •Phasing out of mandatory agriculture credit requirements for commercial banks. (SBP Letter)

•Policy review in consultation with ADB. (Ministry of Finance {MOF], SBP, ZTBL)

•Address other emerging sector issues in consultation with Asian Development Bank (ADB) within the scope of the RFSDP.

Appendix 2 37

38

Objectives Rationale First Tranche/Actions Complied with May to October 2002

Second Tranche: after 7 months of first tranche

Third Tranche: Within 12 months of second

tranche

Fourth Tranche: Within 17

months of third tranche

Bank of Pakistan (ADBP) Repeal Ordinance).

•SBP equity in ADBP converted into Tier 2 Capital in ZTBL. (Transfer Order)

of the RFSDP. (MOF, SBP, ZTBL)

B. Institutional Restructuring and Reforms (i) Zarai Taraqiati Bank Limited (ZTBL) Transform ZTBL into a sustainable and efficient RFI.

Despite significant investments over the last four decades, the outreach of RF from institutional sources is less than 6% of the rural households. Government has recognized that outreach cannot be extended through inefficient institutions. ADBP will, therefore, be restructured to become ZTBL for providing sustainable RF services. Fundamental changes in the mission, statute, governance, organization, human resources, business processes, and products and services will be undertaken.

• Repeal of ADBP Ordinance. (Cabinet Decision) • Incorporation as ZTBL. (Certificate of Incorporation) • Constitution of Board, appointment of Chairperson, and Pres ident in accordance with Articles of Association. (MOF Notification and ZTBL Board Resolution) • Swapping of Government debt into equity. (Transfer Order) • Adoption of Restructuring Plan and performance indicators. (ZTBL Board Minutes and Restructuring Plan) • Golden handshake scheme for release of first batch of surplus staff. (ZTBL- Golden Handshake Scheme) • Commencement of staff separation following the Golden Handshake Scheme. (ZTBL Letter) • Acceptance of portfolio audit recommendations. (Policy Letter) • Provision of PRs3 billion for bad and doubtful advances based on portfolio audit recommendation. (ZTBL Audit

•Additional cash equity of PRs3 billion. (MOF notification and ZTBL Audit Report) •Appointment of new ZTBL senior management with specific terms of reference in consultation with ADB. (ZTBL Letter)

•Removal or relocation of existing senior management. (ZTBL Letter)

•Adoption of code of good governance satisfactory to ADB. (ZTBL Board Minutes)

•Constitution of the Audit Committee and Compensation Committee of the Board as well as other committees in line with SBP guidelines. (ZTBL Board Minutes)

•Completion of first phase of golden handshake. (ZTBL Progress Report) •Completion of transfer and adjustments of assets and liabilities. (ZTBL Audit Report)

•Achievement of Restructuring Plan milestones. (ZTBL Progress Report) •Achievement of performance indicators (Appendix 4 Table A4.5). (ZTBL Progress Report)

•ZTBL shall make a provision of PRs3 billion for bad and doubtful debts based on portfolio audit recommendation. (ZTBL Audit Report) •Review of ZTBL performance by MOF and SBP prior to injecting equity corresponding to provisions made by ZTBL. (MOF Report)

• Report on progress of dealing with misappropriation cases. (ZTBL Progress Report)

•Provision for the balance amount of bad and doubtful debts based on portfolio audit recommendation. (ZTBL Audit Report)

• Review of ZTBL performance over the last three years by MOF and SBP to ascertain the necessity of injecting any equity. (MOF Report) • Completion of Restructuring Plan implementation. (ZTBL Progress Report) • Attainment of Performance indicators (Appendix 4 Table A4.5). (ZTBL Progress Report)

38 A

ppendix 2

39

Objectives Rationale First Tranche/Actions Complied with May to October 2002

Second Tranche: after 7 months of first tranche

Third Tranche: Within 12 months of second

tranche

Fourth Tranche: Within 17

months of third tranche

audit recommendation. (ZTBL Audit Report)

liabilities. (ZTBL Audit Report) •Review of implementation of the Restructuring Plan by ZTBL Board in consultation with ADB. (ZTBL Board)

•Achievement of Restructuring Plan milestones reflected in the Restructuring Plan. (ZTBL Progress Report)

•Achievement of performance indicators (Appendix 4 Table A4.5). (ZTBL Progress Report)

•Notification of commencement of second phase of golden handshake. (ZTBL letter)

• Completion of second phase of golden handshake scheme. (ZTBL letter)

• Offer of divestment of reasonable number of shares of ZTBL through an initial public offering or other methods of sale to the private sector. (ZTBL Letter) • ZTBL to join a deposit insurance scheme if such scheme is in place. (ZTBL Letter)

(ii) Commercial Banks Encourage commercial bank participation in RF for enhancing outreach

Commercial banks have extensive rural branch network and they have mobilized rural savings. However, their rural credit-to-deposit ratio is only 12.5%. As part of the RFSDP the strengthening of rural operations of commercial banks could bring substantial outreach gains.

• Establishment of a Rural Finance Resource Center at the National Institute for Banking and Finance (NIBAF) and designate/appoint the head of the center. (SBP Letter)

• Strengthen the staff resources of the Rural Finance Resource Center. (SBP Letter) • Development plan for training, curriculum, course materials , library, training of trainers, and equipment. (SBP Letter) • Commencement of training and development of model operating manuals. (SBP Letter)

• Review of operations and impact of Rural Finance Resource Center. (SBP Report)

Appendix 2 39

40

Objectives Rationale First Tranche/Actions Complied with May to October 2002

Second Tranche: after 7 months of first tranche

Third Tranche: Within 12 months of second

tranche

Fourth Tranche: Within 17

months of third tranche

(iii) Cooperatives Strengthen provincial cooperative banks through changes in organization and management of cooperative societies.

Cooperatives are provincial subjects with differing expectations. The depth and breadth of issues involved and provincial variations do not permit a standard solution. The situation calls for a re-look at the cooperative societies at selective locations on a pilot basis.

Constitute an interprovincial group for outlining the scope of the ‘Credit Union Plan’. (MOF Letter)

• Develop a ‘Credit Union Plan’ for strengthening cooperative societies. The plan will include a framework for modifications in structure, constitution, accreditation criteria, financial systems, by-laws and supervisory arrangements of cooperative societies. (Credit Union Plan - MOF) • Select up to four districts for implementing the Credit Union Plan on a pilot basis. (MOF, Provincial Governments) • Commence implementation of Credit Union Plan. (MOF, Provincial Governments)

• Review of impact of Credit Union Plan. (MOF, Provincial Governments) • Explore the replication possibility of the ‘Credit Union Plan’. (MOF, Provincial Governments, ADB)

C. New Bank Fund Promote private sector financial institutions in rural areas to enhance outreach, especially to the rural poor.

Only a fraction of the demand for financial services from the rural poor is met. The continued demand and supply gap and negligible reach to the rural poor makes it imperative to establish MFIs under the framework already put

• Establish a New Bank Fund at SBP for actively promoting the establishment of MFIs in rural areas through institutional strengthening. (SBP Letter)

• Finalize, and notify the rules for the New Bank Fund in consultation with ADB . The rules will include: (i) fund description and definitions; (ii) objectives and purposes; (iii) contributions and investments; (iv) governance and

•Establishment of MFIs in rural areas and finalization of participation agreement. (SBP) •Institutional development support to MFIs in accordance with

40 A

ppendix 2

41

Objectives Rationale First Tranche/Actions Complied with May to October 2002

Second Tranche: after 7 months of first tranche

Third Tranche: Within 12 months of second

tranche

Fourth Tranche: Within 17

months of third tranche

framework already put in place by the ADB-funded Microfinance Sector Development Program.

governance and administration; (vi annual reports and audits; (vi) eligible institutions; and (vii) qualifying criteria. (NBF Rules - SBP)

accordance with NBF Rules. (SBP) • Review of NBF impact. (SBP, MOF and ADB)

D. Product and Process Innovations Reduce the risk of lenders and borrowers through sustainable insurance mechanisms

Reducing the vulnerability of the rural households is important. Absence of insurance cover forces households to forego economic opportunities, save in nonfinancial assets, borrow at usurious rates, and remain unemployed or underemployed. The risk perception of financial institutions is reduced significantly when the borrowers have insurance cover.

Constitute an expert group for outlining the scope of the ‘Pilot Insurance Plan’. (MOF Letter)

• Develop and finalize a Pilot Insurance Plan in consultation with ADB and ZTBL. Accessible to the ZTBL borrowers, the pilot will (i) cover defined calamities, (ii) adopt actuarial rate, (iii) activate claims after declaration by competent authority, and (iv) restrict indemnity to verifiable instruments. (Pilot Insurance Plan- MOF) • Implement the pilot in up to four districts. (Progress Report)

• Review Pilot Insurance Plan and its replication prospects. (SBP, MOF, ZTBL, and ADB)

Appendix 2 41

42

RURAL FINANCE SECTOR PLAN

Phase I (2002)

Phase II (2003-2005)

Phase III (2006-2007)

VISION: Establish a viable and effective rural finance system for providing affordable financial services to enable the rural households to enhance rural income and reduce poverty

Implement the policy and institutional framework Increase small farmer orientation Enhance outreach

Rural Finance Policy The Government will facilitate the development of the rural financial markets that provide the economic actors with sustainable financial services with significant outreach in terms of clients served and services offered. The ultimate aim will be to bring private sector investments and build public-private synergies. To avoid the mistakes of the past, the Government will not intervene directly in granting loans, setting interest rates, pardoning outstanding loan repayments, and discouraging debt recovery.

Implement policy actions • Extend financial liberalization

policies to rural finance sector • Link rural finance with Microfinance

Sector Development Framework

Policy review and coordination • Review rural finance measures in

the context of the ongoing financial sector development measures

• Coordinate rural finance sector

development with interventions in poverty reduction, agriculture, rural infrastructure, irrigation, and agricultural research and extension.

Policy review and coordination

• Policy review and coordination will continue as in phase II.

• Continue as in phase II

Strengthen Supervision and Regulation

Strengthen supervision and regulation • Apply supervision system for rural

finance institutions (RFIs) consistent with the overall framework for the banking sector

Improve application of prudential regulations • Strengthen the implementation of

supervisory and regulatory system

Review prudential regulations • Review and update prudential

norms

42 Appendix 2

43

Phase I (2002)

Phase II (2003-2005)

Phase III (2006-2007)

VISION: Establish a viable and effective rural finance system for providing affordable financial services to enable the rural households to enhance rural income and reduce poverty

Implement the policy and institutional framework Increase small farmer orientation Enhance outreach

Build Rural Financial Infrastructure

Facilitate institutional transformation linkages, and services delivery • Facilitate transformation of existing

institutions into viable units

Establish range of service providers • Promote RFIs in the private sector • Establish framework for small

farmer-owned credit unions and cooperatives

• Enhance access of insurance services in rural areas

• Promote the development of forward and futures trading in commodities

• Enhance interagency and formal and informal linkages

Establish a comprehensive institutional network • Review the institutional setup • Continue as in phase II for all other

measures

Enhance institutional network • Deepen and broaden linkages

between RFIs, and other institutional rural finance sources

• Enhance flow of term finance for agriculture through resource support and enhanced presence of commercial banks in rural areas

• Adopt incentive system for banks to expand in rural areas

• Provide support for establishment of smaller RFIs

• Continue as in Phase II for all other

measures

Appendix 2

43

44

Phase I (2002)

Phase II (2003-2005)

Phase III (2006-2007)

VISION: Establish a viable and effective rural finance system for providing affordable financial services to enable the rural households to enhance rural income and reduce poverty

Implement the policy and institutional framework Increase small farmer orientation Enhance outreach

Create Institutional Capacity Build sustainable institutions • Strengthen Zarai Taraqiati Bank

Limited (ZTBL) • Introduce specialized skills for off-

site and on-site supervision • Improve collection, collation, and

analysis of rural finance data

Enhance effective intermediation and supervision • Continue strengthening ZTBL • Give comprehensive capacity-

building support for RFIs • Strengthen or develop specialized

rural finance training centers • Strengthen rural finance

orientation of commercial banks • Introduce rural finance

specialization in commercial banks

• Introduce specialized skills for off-site and on-site supervision for RF in SBP

• Improve collection, collation, and analysis of rural finance data

Update and upgrade skills • Establish linkages with regional

training centers • Continue as in Phase II for all other

measures

Ensure Small Farmer Orientation

Promote innovative pilot projects • Establish pilots in resource-poor

areas to provide adapted and affordable services

Enhance outreach to special groups • Replicate successful pilots • Enlarge coverage of risk mitigation

efforts

• Reduce risk of small farm

households • Continue as in Phase II for all other

measures

44 A

ppendix 2

Appendix 3

45

PROGRAM FRAMEWORK

Design Summary

Measurable Indicators

Monitoring Mechanisms

Assumptions and Risks

Sector/Area Goals

Establish a sustainable rural finance (RF) system

Increase the viability of rural finance institutions (RFIs) and microfinance institutions (MFIs)

-Project Reports (RFI, MFI Reports) -Project Reviews (semiannual, annual, and midterm) -Audit Reports (including State Bank of Pakistan [SBP] review reports) -Project Completion Report -Asian Development Bank (ADB) review missions

The Government pursues a RF paradigm that enables RFIs and MFIs to operate autonomously within a liberalized financial policy regime. There are no politically motivated interventions that affect lending, loan collection, and postponement of debts.

Improve resource flow to the rural sector and equitable resource allocation through improved governance

RFIs and MFIs responding to their business judgment in lending decisions, not to government or political directives Increase in the number of rural households that receive reasonably priced RF services by 200,000 Half of the increase in outreach comprise of small, subsistence, and tenant farmers; and the landless and the poor Higher rural loan disbursement Increase in the amount of rural savings mobilized by RFIs and MFIs

Project reports Project reviews ADB review missions

RFIs and MFIs focus on the lower segments of the market, especially the poor, and maintain performance standards to attract resources for outreach expansion. Weak RFIs are appropriately restructured with staff, skills, and facilities and operate in a framework that supports good governance.

Economic growth and poverty reduction through access to affordable RF services

Targeted gross domestic product increase and reduced number of people below poverty line

Country economic report and poverty indicators

Specific Purposes Develop the RF sector to efficiently provide affordable financial services for economic growth and poverty reduction

Expansion of RF sector in terms of number of RFIs, MFIs, and active participation of commercial banks (CBs) and their increased outreach

Government and ADB closely monitor the implementation and impact of the Rural Finance Sector Development Program (RFSDP)

Macroeconomic growth and market opportunities will continue to improve the profitability of rural economic activities.

(i) Create a favorable policy environment

Extend liberalized financial sector framework for RF sector development

Government- provided policy framework

The RF policy is pursued and implemented.

(ii) Introduce institutional reforms and restructuring

Increased financial services, viability, and meeting performance targets through extensive institutional strengthening support

Project reports Project reviews Audit reports ADB review missions

No pressure to provide below-cost services or politically motivated loans. RFIs and MFIs develop adequate capacity.

Appendix 3

46

Design Summary

Measurable Indicators

Monitoring Mechanisms

Assumptions and Risks

Cooperative societies exposed to best international practices in cooperative management

The framework encourages transformation of nongovernment organizations (NGOs) into MFIs.

RF Resource Center to help strengthen rural operations of CBs

CBs voluntarily extend their outreach in response to favorable policies.

(iii) Establish more MFIs

Establishment of MFIs and institutional development support from the New Bank Fund (NBF)

Project reports Project reviews ADB review missions

Private sector responds to incentives provided through the NBF.

(iv) Initiate a crop insurance scheme to reduce the risks in RF

Insurance coverage for farmers in selected districts to mitigate the effects of verifiable risks such as floods and droughts

Project reports Project reviews Audit reports

The scheme is client-driven and farmers are willing to pay the insurance premium.

Outputs Favorable policy framework for RF development

RF pursued as market-based activity on a sustainable basis with emphasis on savings and credit to enhance outreach and generate private sector participation in RF

The Government provides RF policies through the policy matrix. Policy dialogue

The Government maintains its commitment to facilitate and improve the working of RF markets and accordingly evolves RF policies.

Institutional reforms and restructuring

Strengthened corporate governance at Zarai Taraqiati Bank Limited (ZTBL) by implementing policy attributes that emphasize on sustainability and autonomy

The Memorandum of Association, and Article of Association of ZTBL SBP monitoring and supervision reports

ZTBL will maintain good corporate governance. SBP will effectively supervise ZTBL.

1. Agricultural Development Bank of Pakistan restructured into ZTBL (i) ZTBL board of directors effectively managing and controlling operations

Restructuring plan adopted Directors, chairperson, president, and management team appointed, and restructuring plan approved by the board

ZTBL reports and documents Project reports Project reviews ADB review missions

Capable board of directors and management team. Continuous emphasis by the SBP on good governance. Systems and procedures are properly phased and institutionalized.

(ii) Systems developed and staff trained

Systems documented in operating manual

Operating manuals Project reports

Staff are committed to reorientation.

(iii) Organization rationalized and rightsizing undertaken

Organization de-layered, severance pay paid to about one third of the staff

Project reports Project reviews

Rural enterprise and farm activities are commercially viable.

(iv) Efficient sys tems and procedures and management information system implemented

ZTBL staff trained, operating manuals prepared, physical infrastructure installed

Project reports Project reviews

Close coordination between ADB and stakeholders.

Appendix 3

47

Design Summary

Measurable Indicators

Monitoring Mechanisms

Assumptions and Risks

(v) Outreach backed by improved loan appraisal

Improved credit appraisal and monitoring system installed

Repayment record Portfolio quality

Operating procedures reflect the local context.

(vi) Repayment rates and profitability enhanced

Staff incentives linked to repayment performance, and enhanced credit risk management system installed

Repayment record Portfolio quality

Delinquency is within manageable limits.

(vii) Staff trained

Staff trained to meet new job specifications

Productivity and performance indicators

2. Strengthen rural operations of CBs

RF Resource Center at National Institute for Banking and Finance notified and (i) director appointed; (ii) course design finalized; (iii) training materials developed; (iv) trainers trained; and (v) training conducted RF Resource Center provide training and advisory services to CBs

SBP to provide the details Project reports Project reviews Audit reports ADB review missions

SBP is proactive in strengthening rural operations of CBs. SBP earmarks adequate human resources. CBs maintain interest in expanding their rural portfolio.

3. Credit Union Plan to streamline the management and operation of cooperative societies

Credit Union Plan prepared and discussed with provincial governments Credit Union Plan operationalized

Government to furnish the Credit Union Plan Project reports Project reviews ADB review missions

Provinces find the plan acceptable. The plan empowers the cooperative societies and encourages the emergence of genuine societies.

4. New Bank Fund for institutional diversity

Rural and Microfinance Support Division constituted at SBP

Adequate skilled human resources provided by SBP

The Rural and Microfinance Support Division is effective.

Detailed NBF rules to include (i) fund description and definitions (ii) objectives and purposes (iii) contributions and investments (iv) governance and administration (v) annual reports and audits and (vi) eligible institutions and qualifying criteria

SBP provide the rules

The rules are consistent with those applied under the Microfinance Sector Development Program NBF is effectively used to enhance access of the poor to affordable microfinance.

5. Establishment of new MFIs

Effective promotion of NBP concept by SBP

Project reports Project reviews ADB review missions

Procedures developed for Khushhalibank are applied or modified.

Four investors establish licensed MFIs and avail NBF resources

Project reports Project reviews

MFI institutional strengthening Effective governance and supervision of new MFIs ensured

MFI board of directors operate with autonomy. MFIs offer appropriate and timely services to the poor.

Appendix 3

48

Design Summary

Measurable Indicators

Monitoring Mechanisms

Assumptions and Risks

6. Pilot Insurance Plan to mitigate borrower and lender risks in RF

Pilot Insurance Plan prepared and presented to insurance service providers Pilot Insurance Plan operationalized

Government to furnish guidelines Project reviews ADB review missions

Cost of premium is affordable and reinsurance is available. Economic growth is maintained.

7. Effecti ve supervision of RFIs and MFIs by SBP

Supervisory and regulatory system revised and equipment installed. SBP staff trained on supervision and regulation of RFIs

Project reviews ADB review missions Trainer’s report

SBP takes a proactive role in RF sector development. The environment for RF remains conducive

8. Outreach expanded through ZTBL and new MFIs

Coverage for about 180,000 over the current level by ZTBL, and additional 20,000 by 4 new MFIs

Project reports Project reviews ADB review mission

MFIs are viable within 5 years and delinquency is within manageable limits.

9. Effective project management

A project management unit (PMU) is established in the Ministry of Finance and project implementation units (PIUs) at SBP and ZTBL. Credit Union Plan and Pilot Insurance Plan are developed by PMU.

Project reports Project reviews ADB review mission

Capable and adequate PMU/PIU staff are appointed. Cooperation between PMU and PIU is complete and effective.

Inputs Program Component ZTBL Restructuring

$225 million to meet adjustments costs $206 million

Project reports ADB review mission

New Bank Package

$15.0 Million

Project reports ADB review mission

Rural Finance Resource Center

$1.0 million

Project reports ADB review mission

Credit Union Plan

$ 1.0 million

Project reports ADB review mission

Pilot Insurance Plan

$ 2.0 million

Project reports ADB review mission

Institutional strengthening

Training, equipment, project management assistance, and consulting services $25 million

Project reports Project reviews ADB review mission

Government is willing to borrow at commercial rates for institutional strengthening.

Total Cost $250.0 million

Appendix 4 49

ZARAI TARAQIATI BANK LIMITED

(former Agricultural Development Bank of Pakistan) A. Legal Framework, Ownership, and Basic Objectives 1. Agricultural Development Bank of Pakistan (ADBP)1 was established in 1961 by merging Agricultural Development Finance Corporation and Agriculture Bank of Pakistan. On behalf of the Government, the State Bank of Pakistan (SBP) — the central bank— holds 99% of ADBP equity and the provincial governments hold the balance. ADBP Ordinance 1961 categorizes ADBP as a specialized banking company. ADBP is allowed to perform all banking and allied business, such as accepting deposits, pledges, and mortgages; and investing in securities of corporate bodies and the Government. However, ADBP’s main function is to provide credit for agriculture to improve farm household income. In carrying out agricultural lending, ADBP is required to focus on small farmers with landholdings of less than 5 hectares. B. Management 2. The chairperson cum chief executive officer of ADBP heads a seven-member board of directors (BOD). ADBP Ordinance 1961 provides for the appointment of federal and provincial officials and members of national and provincial assemblies to the BOD and its subcommittees. A management team of two senior executive directors and eight executive directors assists the chairperson in day-to-day operations. Government influence on ADBP operations has been direct and pervasive. Distinction between ownership and management diminished, as successive governments required ADBP to implement directives, such as loan waivers, below- cost lending, and loans for nonviable projects. Means available to the management for assessing liquidity, interest rate, and credit risks are weak. C. Organization, Staffing, and Personnel Administration 3. From its head office in Islamabad, ADBP operates 49 regional offices that are administrative units for branch control, and 343 branches. The overall staff of 7,692 comprises 59% officers and 41% support staff. Around 1,134 (15%) staff work at the head office, 1,277 (16%) in regional offices, and 5,281 (69%) at branches. Career progression is not based on any objective performance criteria. The system of performance evaluation encourages personal biases, as job descriptions are not available. While ADBP has two training colleges, no systematic training needs assessment has been done. Staff motivation and skills are low. Productivity, at loans per staff, is the lowest in the region for similar banks. D. Lending Policies and Procedures 4. ADBP provides short-term, medium-term, and long-term loans. The short-term loans, called production loans range from 6 to 18 months, repayable at the end of the term, and are provided mainly for fertilizer, seed, pesticides and working capital. The medium-term loans are development loans with maturities up to 5 years and are for livestock, fisheries, dairy, poultry, tractors, tubewells and other farm implements. Long-term loans with maturities of 5-15 years are mainly for plantation crops. Bes ides agricultural credit, ADBP also undertook project lending with World Bank and Asian Development Bank (ADB) support and financed 537 projects, of

1 In this Appendix, ADBP has been referred to till the incorporation of ZTBL.

Appendix 4 50

which 229 (43%) are in default. These are large agribusiness loans for which ADBP has little appraisal, monitoring, and technical skills. Project lending is suspended for the last 3 years. 5. Sanctioning powers have been delegated for loan applications to be processed at branches. Various collateral arrangements are admissible. In case of agricultural loans, land is taken as security through passbooks, issued by revenue authorities that reflect ownership and value of land in terms of produce index units. Project lending was based on mortgage of land and machinery. There are a number of lending schemes including supervised credit scheme, one-window operation, credit to women, and microfinance loans. Supervised credit is processed by mobile credit officers (MCOs). Loan applications are processed, credit disbursed with technical advice, and monitoring carried out by a team of 1,460 male and 23 female MCOs. In the one-window operation, the concerned provincial revenue officers along with ADBP staff issue passbooks and approve credit disbursements. MCOs can approve short-term loans of PRs60,000 under the one-window program. Microcredit and credit to women are negligible. Most of the MCOs were hired in the early 1970s as agricultural graduates. They have no formal training in credit appraisal and management. 6. There is no mechanism for offering differential interest rates to clients based on their credit rating or type and term of products. All clients are charged a 14% markup, with an additional up-front processing fee of 1%. Reliance on collateral precludes cash flow analysis or assessment of the ability of borrowers to adjust to price and income risks. The business process and operations manuals have not been updated for more than a decade. Although the charter provides for leasing, no effort has been made to develop a leasing business. E. Operations and Loans Portfolio 7. Total assets increased marginally by 4.19% over the last 5 years (1977-2001) and stood at PRs78.1 billion at the end of financial year (FY) 2001.2 Savings from the public at PRs1.4 billion is only about 2% of the liabilities due to inadequate emphasis on savings mobilization. Government and the SBP refinance almost the entire loan portfolio. The interest payable on refinance is capitalized or shared on a profit-and-loss basis, as ADBP is not in a position to service debts. A summary of operations for FY1997–FY2001 is in Table A4.1.

Table A4.1: Summary of Assets and Liabilities (PRs million)

Item 1997 1998 1999 2000 2001

Average Growth

(%) Total Assets 66,480 69,403 76,349 78,025 78,143 4.19

Gross Advances 63,991 74,483 87,278 91,396 93,972 10.28 Provisions for Bad Loans 13,344 22,829 25,009 28,942 30,003 25.00 Net Advances 50,647 51,654 62,269 62,454 63,970 6.32 Deposits from Customers 1,494 2,059 2,466 1,636 1,428 2.81 Borrowings 52,799 60,562 61,221 60,012 62,524 4.50 Equity 6,890 3,194 4,954 5,190 5,063 0.95 Source: ZTBL

2 The financial year for ADBP is July-June. FY before a calendar year denotes the year in which the financial year

ends.

Appendix 4 51

8. At the end of FY2001, net loans stood at PRs63.9 billion. During FY2001, ADBP disbursed PRs27.6 billion to 417,000 clients. This is nearly half the agriculture credit disbursed by the formal sector. Punjab accounts for 71% of the disbursements, followed by Sindh (20.5%). Azad Jammu and Kashmir and other provinces3 account for the balance. The average loan size at disbursement is PRs 66,187. Disbursements increased at a rate of 27% over the last 5 years. Since the last 3 years, ADBP has restricted disbursements to 90% of the loan collections. The ratio of short- term and long- term loans is 68:32 for FY2001. Of the disbursements during FY2001, 37% was for purchase of fertilizer, 19% for tractors, 14% for seeds, 13% for pesticides, and 6% for tubewells and 4% for working capital requirements. The balance 7% was disbursed for poultry, dairy, fisheries, livestock, farm equipment, orchards, and farm transportation. F. Portfolio Infection and Provisioning 9. ADBP’s income recognition and provisioning for bad debts are in compliance with SBP prudential regulations.4 No income is accrued if the account is delinquent for more than 90 days. For loans more than 90 days overdue, the income accrual is suspended and the loans are categorized as ‘other assets especially mentioned’. Accounts delinquent for more than 180 days are classified as substandard, 270 days as doubtful, and above 1 year as loss or nonperforming loan (NPL). SBP requires that provisions be made for 25% of substandard accounts, 50% for doubtful, and 100% for loss category. Out of the gross loan portfolio of PRs93.9 billion, PRs53 billion (56%) is performing and PRs41 billion (44%) is NPL. The provisioned loan losses amount to PRs30 billion, 73% of the NPLs or 32% of the gross loan portfolio. The entire project loan portfolio (para. 4) of PRs12 billion is considered as NPL. Provisioning grew by an average annual rate of 25% during FY1997-FY2001, while gross advances grew at an average annual rate of 10.28%. 10. ADBP portfolio quality has been affected by (i) weak loan appraisal, (ii) absence of credit risk management, (iii) inadequate internal audit controls, and (iv) political interference in loan collections. ADBP’s own efforts for collection of overdue loans have been modest. Repayment rate (percentage of collection to demand) for loans disbursed during FY2001 is 70% and the aggregate repayment rate 55%. Recurring droughts and floods have accentuated the problem. Relief packages announced by the Government that allowed remissions and write-offs also affected repayment. G. Financial Statements and Ratios 11. Profits have fluctuated significantly. ADBP incurred a loss of PRs3.8 billion in FY1998 due to provisioning of PRs9.6 billion. In FY1999 owing to a net increase in gross loans of PRs12.8 billion, ADBP posted a profit of PRs1.7 billion. Since then net profit has decreased and in FY2001 ADBP incurred a loss of PRs127 million. As a result, the return on equity has dropped from 5% in FY2000 to 2% in FY2001. Capital adequacy ratio as percent of risk weighted assets for FY2001 at 7% is below the SBP-prescribed limit of 8% (Table A4.2). ADBP will have to charge approximately 21% on its loans to become subsidy independent.5.

3 Baluchistan, Northwest Frontier Province, and Federally Administered Northern Areas. 4 Same as those applied to commercial banks. 5 The formula is from Yaron, J. 1992. Assessing Development Finance Institutions: A Public Interest Analysis. World

Bank Discussion Paper no. 174, Washington, D.C.

Appendix 4 52

Table A4.2: Net Profit/Loss and Key Ratios

Item 1997 1998 1999 2000 2001 Net Profit/Loss (PRs million) 196 -3,822 1,761 236 -127

Ratios a (%) Return on Total Assets - -6 2 0 0 Return on Equity - -76 36 5 -2 Expenses to Revenue - 143 84 97 98 Capital Adequacy 12 5 7 7 7

Subsidy Dependence Indexb - 36 23 24 23 a Based on average figures. b Lending rate required to eliminate all subsidies. H. Accounting and Management Information System 12. Consistent with the requirements for the banking industry, ADBP follows international accounting standards. The income, borrowing costs, interest on deposits, and other expenses are accounted on an accrual basis. The accrued interest for a loan that is delinquent for more than 90 days is reversed from the income and transferred to a suspense account. Independent external auditors audit the annual accounts. However, completion of audit is always delayed, as record keeping is weak and inaccurate. The management information system (MIS) and information technology (IT) platform are primitive and cannot cater to the information needs for risk management and business analysis. In the absence of networked information systems, the information gathering methodology from branches to the regional offices and further to the head office causes delays and inaccuracies. This diminishes the real time and relational database capabilities and restricts analytical reporting that is essential to support good governance. I. Incorporation of Zarai Taraqiati Bank Limited (ZTBL)

13. Within the context of ongoing financial sector reforms, initial measures for ADBP restructuring were initiated by the ADB-funded Microfinance Sector Development Program (MSDP).6 Reform of ADBP was considered necessary, as (i) its weaknesses deterred investments in rural finance (RF), and (ii) there is a need to meet the demand for affordable financial services in a grossly underserved market. Accordingly, the MSDP included a portfolio audit to assess the key reasons for the poor portfolio quality of ADBP and, subsequently, to prepare a restructuring plan for addressing institutional inadequacies. 14. The portfolio audit7 indicates that the basic reason for poor asset quality was the dual roles of ADBP as a development agency and a financial institution. The roles affected the norms, values, and expectations both within and outside ADBP. Successive attempts to achieve broader development goals8 instead of efficient financial intermediation ultimately led the clients to believe that ADBP was not comparable with a commercial bank. As such, ADBP was expected to be tolerant when the credit cycle, in terms of timely repayments, remained incomplete. The audit also found deficiencies in (i) loan appraisal, sanctioning, and disbursements; (ii) loan classification and provisioning;9 (iii) supervision and monitoring;

6 ADB. 2000. Report and Recommendation of the President to the Board of Directors on the Proposed Loan to

Pakistan for the Microfinance Sector Development Program. Manila. 7 Undertaken by the local affiliate of an international audit firm. 8 Ameliorating social issues in wake of droughts and floods, providing below-cost credit, etc. 9 The MIS declassifies NPLs in the years in which such loans are rescheduled.

Appendix 4 53

(iv) MIS; (v) policies and procedures; (vi) loan rescheduling process; and (vii) staff skills and orientation. In addition, problems in realization of securities, natural calamities, deficiency in terms of segregation of responsibilities in loan approval and management; and lack of preventive controls contributed to low repayments and huge accumulation of infected portfolio. The portfolio audit therefore recommended the following provisioning requirements over and above made in pursuance of SBP regulations.

Loan Portfolio (PRs12 billion)

(i) PRs1.0 billion for loans where the first installment is due after 3 years. (ii) PRs1.0 billion for short-term loans (not exceeding 18 months) where there has

been no repayment in the last 2 years. These loans are yet to be classified as loss category on the basis of time requirements under the prudential regulations.

(iii) PRs2.8 billion for development loans (medium-to long-term loans) where there

has been no repayment in the last 3 years. (iv) PRs4.0 billion for adjustment lending where successively smaller loans are

issued to the same borrower on the payment of the current loan. While prima-facie it appears that this will not hurt ADBP as both the principal and markup are recovered, if this cycle is discontinued the possibility of repayment will be remote.

(v) PRs1.5 billion due to information inadequacies. (vi) PRs1.7 billion for disbursements made during 2001 based on recovery trend.

Other Assets (PRs6.8 billion)

(i) PRs6.8 billion for government claims receivable on account of past loan waivers,

branch adjustments, and presumptive tax recoverable. 15. The Government agreed to restructure ADBP after evaluating a number of options (paras. 24-27 and 41-43 of the main text). The decision was influenced by the need to address the grossly underserved rural sector, the realization that RF will not attract private commercial interest immediately, and the experience gained in reforming the commercial banks. ADBP was incorporated on 23 October 2002 as ZTBL, with an authorized equity of PRs25 billion and a mandate to become a sustainable RF institution (para. 43 of the main text). The Articles of Association provide for a 10-member board with private sector majority. Members of parliament, provincial assembly, and persons holding membership of political parties are ineligible to become a director of ZTBL. 16. ZTBL has adopted a restructuring plan at its second board meeting on 12 November 2002. The restructuring plan to be implemented over 3 years emphasizes (i) good governance; (ii) effective methods to reduce transaction costs; (iii) product mix with due emphasis on savings services and loans for nonfarm activities; (iv) transparent financial, accounting, and management systems; and (v) innovative staff development and incentive systems. The key aspects of the restructuring plan were presented to the Economic Coordination Committee of the Cabinet on 4 November 2002.

Appendix 4 54

16. On 18 November 2002 the Government issued an order specifying 14 December 2002 to be the effective date on which all the assets, contracts, liabilities, proceedings, and undertakings of the former ADBP will be transferred to ZTBL. Financial restructuring is meant to provide for uncovered bad and doubtful debts estimated at PRs12 billion ($200 million) and other assets of about PRs6.8 billion to ensure that the capital adequacy ratio of ZTBL remains above 10% of risk-weighted assets. The restated balance sheet and shareholding of ZTBL after adjustments are in Tables A4.3 and A4.4. The Government loan of PRs16.4 billion to ZTBL has been converted into ZTBL equity after adjusting ZTBL claims on the Government. SBP equity in ZTBL (PRs3.2 billion) has been converted into subordinated debt of ZTBL. Further, cash equity of up to PRs10 billion will be released in 3 tranches provided ZTBL meets the agreed performance indicators (Table A4.5). J. Projected Performance of ZTBL 17. Financial projections 10 (Supplementary Appendix A) indicate operating self-sufficiency due to improved repayment rate, reduction in staffing expenses, and additional cash equity. ZTBL’s initial equity of PRs8.7 billion increases to PRs10 billion at the end of year 2 (ending June 2004). For breakeven in year 1 (ending June 2003), the provision for probable loan loss will need to be considered as allowable deductions from the operating income and the interest rate on loans will also have to be higher. Maintaining the prevailing rate of interest rate on loans, by the end of year 2 (ending June 2004), ZTBL is expected to disburse PRs37 billion, meet tax and interests liabilities, generate profit, and increase capital adequacy to above 10% of risk weighted assets. During year 4 (July 2005 - June 2006), the expected return on equity is 9% and capital adequacy ratio is 16%. At this level, the Government can begin divesting its equity in ZTBL to the private sector. 18. Improvement in loan collection is premised on (i) stricter powers available to banks under the Financial Institutions (Recovery of Finances) Ordinance 2001, (ii) establishment of an asset management company, the Corporate and Industrial Restructuring Corporation,11 (iii) Government efforts for improving the banking courts, and (iv) discontinuation of loan waivers at the expense of financial institutions. Redesigned business processes and upgraded MIS are expected to significantly enhance appraisal, credit risk management, and delinquency monitoring. Lending has been confined to 90% of the collections during the first 3 years. Savings mobilization will increase liquidity substantially in the medium-term.

10 The projections are indicative and subject to change not only because of changes in assumptions, but also due to

changes in policies and operating environment. The audited account of ZTBL for FY2002 changed some of the assum ptions used for developing the performance indicators (Table A4.5). Therefore, marginally different set of assumptions have been used in the financial projections (Supplementary Appendix A) for breakeven in year 1 (ending June 2003) and profitability in year 2 (ending June 2004).

11 Some large project loans of ZTBL are with the Corporate and Industrial Restructuring Corporation for resolution.

Appendix 4 55

Table A4.3: Net Asset Valuea of ADBP as of 30 June 2002

and ZTBL Opening Balance (PRs Million)

Account Title Audited Closing

Amount Adjustments ZTBL Opening

Balance

ASSETS

Cash and balances with treasury banks 899 0 899 Balances with other banks 6,447 0 6,447 Investments 2,416 0 2,416 Net advances 61,503 0 61,503 Other assets 2,889 0 2,889 Property and equipment 1,143 0 1,143 Deferred tax credit 7 0 7 Total 75,304 0 75,304

LIABILITIES AND NET WORTH

Bills payable 78 0 78 Borrowing from SBP 51,257 0 51,257 Deposits and other amounts 1,580 0 1,580 GOP funds 16,143 (16,143) 0 Subordinated debt, SBP 0 3,204 3,204 Other liabilities 10,444 0 10,444 Total Liabilities

79,502 (12,939) 66,563

Net Worth (4,198) 0 8,741 Total 75,304 75,304 SBP=State Bank of Pakistan Source: ZTBL Transfer Order, Ministry of Finance a The net asset value will be subject to change based on the findings of the special audit being conducted to determine the net asset value of ADBP for the period 1 July 2002 up to the effective date of transfer. The change in the net worth during this period will be on account of the ZTBL.

Table A4.4: Shareholding in ZTBL

Name of Institution Number of shares of PRs 10.00 each

Federal Government 873,172,600 Government of Punjab 277,100 Government of Sindh 119,000 Government of Northwest Frontier Province 68,000 Government of Balochistan 35,900 Government of Erstwhile East Pakistan 500,000 Total 874,172,600

Source: ZTBL Transfer Order, Ministry of Finance Note: The allotments of shares will be subject to change in accordance with changes in net worth. SBP equity of PRs3.2 billion in ADBP has been converted into subordinated debt.

Appendix 4 61

Table A4.5: Performance Indicators for Zarai Taraqiati Bank Limited

Sr. No.

Performance Indicator As of 30 June

2002

30 June 2003

31 December

2003

30 June 2004

31 December

2004

30 June 2005

31 December

2005 1 Repayment Rate (current dues) (%) 70 70 75 80 80 85 90 2 Repayment Rate (past dues) (%) 22 35 40 45 50 55 60 3 Profitability (-) Breakeven 5% 5% 5% 5% 5% 4 Capital Adequacy Ratio (%) 7 >10 >10 >10 >10 >10 >10 5 Deposit Mobilization (PRs in billion)

during the period 1.5 0.5 0.5 1.0 1.0 2.00 2.0

6 Loans issued during the year (number) 417,000 300,000 350,000 470,000 500,000 550,000 600,000 7 Disbursement (as % of loan collection) 90 90 90 90 90 90 90 8 Number of Staff 7,668 5,700 5,550 5,550 5,550 5,550 5,550 9 Number of Regional Offices 49 49 39 25 20 20 10 Financially Viable Branches

(as % of total number of branches) _ >50 >70 >80 >90 >90 >90

11 Restructuring Plan Milestones - not available/applicable Notes: Repayment Rate : Collection as percentage of recoverable (or demand). Current dues are those that fall due during the year. Past dues reflect the overdue at the beginning of the year. The figures exclude overdue relating to past project loans. Profitability: Reflected in terms of breakeven and return on equity. Capital Adequacy Ratio: As percentage of risk-weighted assets. Deposit Mobilization: The modest targets reflect the need to prioritize strengthening of back-office systems to provide secure savings facilities. Loans Issued During the Year: Number of loans disbursed will slightly decline during the period when organizational changes are being made. Disbursements: With improved repayment rate, disbursements can increase through deposit mobilization, borrowing, and additional equity. Number of Staff: These are net staff positions. Number of Regional Offices: Regional offices are administrative units. Their reduction will serve to reduce costs. Financially Viable Branches: Viability is calculated on the basis of a predetermined transfer pricing formula. Restructuring Plan Milestones: As per the restructuring plan. Note: The indicators for capital adequacy (item 4) differ from that presented to the Economic Coordination Committee of the Cabinet, as the audited accounts of ZTBL for the year ending June 2002 has changed the underlying assumptions. To achieve the Performance Indicators as presented to the Economic Coordination Committee of the Cabinet appropriate additional measures have to be implemented.

56 A

ppendix 4

Appendix 5 57

MICROFINANCE INSTITUTIONS 1. The developments in microfinance (MF) supported by the Asian Development Bank (ADB) funded Microfinance Sector Development Program (MSDP)1 in Pakistan have set in motion a process that changed MF as an activity that was thought to be welfare to one that can be a viable business. Khushhalibank, the first microfinance institution (MFI) to be set up, has shown its capability in savings mobilization, credit delivery, and lending innovations to cover risk analysis and credit screening through peer pressure. 2. MF Institutions Ordinance 2001 mandates the establishment of MFIs under the supervision of the State Bank of Pakistan (SBP), the central bank. A New Bank Fund (NBF) is being established as part of the Rural Finance Sector Development Program for encouraging the establishment of sustainable MFIs at provincial and district levels under the MSDP framework. NBF incentives relate to institutional strengthening at soft terms. The general outline of the MFIs expected to be established in response to the NBF is as follows. 3. Objective and Strategy. The MFIs will provide affordable but sustainable services including savings, credit, and leasing to poor households. Social intermediation2 will precede and accompany MF services to ensure that social and gender dimensions of poverty are adequately addressed. Of the MFI clients, 25% are expected to be women. 4. Ownership and Corporate Governance. The authorized share capital will be PRs250 million for provincial MFIs and PRs100 million for district MFIs. If convinced of the merits of the application, SBP will issue a license allowing the MFI to accept deposits from the public and extend a wide range of services to poor households.3 Incorporation and governance will be in accordance with the provisions of Companies Ordinance,1984. SBP will ensure that members of the board and the chief executive officer of MFIs are qualified persons of integrity. 5. Organization. The promoters of eligible MFIs will have the flexibility to adopt an institutional design that responds to geographic and demographic contexts. However, to be eligible for NBF resources they will need to have their business plans approved by SBP to ensure that core values of sustainability and good governance are mainstreamed. Broadly, the decentralized structure and systems of Khushhalibank will be the reference point. 6. Operating Procedures. Operating procedures designed for efficiency and cost reduction will determine the methodology for delivery. The MFIs could opt for either a group-based or individual client delivery methodology, a combination of the two, or start with a group-based methodology and migrate to individual clients. Social intermediation support for developing client skills will be available from the Microfinance Sector Development Fund and Community Investment Fund set up under the MSDP for those MFIs that agree to abide by the rules, including contributions. MFIs will also have access to the refinance facility under MSDP. 7. Products and Services. MFIs will develop savings products that will be attractive to rural communities. Depositors will be paid competitive interest rates and deposits mobilized will be partly protected by the depositor protection fund required by MFI Ordinance 2001. 1 ADB. 2000. Report and Recommendation of the President to the Board of Directors on a Proposed Loan to

Pakistan for the Microfinance Sector Development Program. Manila. 2 Improving the conditions for the excluded to access finance, for example, through grassroots training in group

formation, and vocational and financial skills. 3 MFI Ordinance 2001 Part I define the poor (Section 1) and lists the range of services (Section 6).

Appendix 5 58

Additionally, MFIs can also join the Deposit Protection Fund set up under MSDP. In particular, small-size short-term loans for income-generating activities will be promoted, but MFIs could also give consumption smoothening loans. From the Khushhalibank experience, the first loan size could be about PRs9,000—12,000 ($150-200). MFIs could join the Risk Mitigation Fund set up under MSDP to provide partial risk cover to their customers. 8. Projected Performance. Provincial and district MFIs breakeven at year 5 by factoring the incentives of NBF. While a provincial MFI could breakeven by charging 18% per annum (p.a.) and a service fee of PRs400, a district MFI will need to charge 20% p.a.4 In both cases, at breakeven, two thirds of the loan outstanding is financed from equity and deposits and one third from borrowings. Detailed projections are in Supplementary Appendix B. 9. Risks and Safeguards. MFIs are vulnerable to increases in loan losses and reductions in loan revenues. The risk of delinquency is being mitigated through social collateral, continuous monitoring, adoption of successful practices, loan loss provisions, and autonomy in operations. As a positive incentive for better performance access to NBF and funds under MSDP will be contingent upon attainment of agreed upon performance indicators (Table A5.1).

Table A5.1: Performance Indicators for Microfinance Institutions

Indicatora Value Definition Gender

Targets Outreach Number of clients Business plan Depositors and borrowers >25% Loans disbursed Business plan Amount during the period >25% Efficiency Ratio Operating expense ratio Business plan expenses/ average total assets Salary-expense-to-portfolio ratio Business plan Staff expenses/ average total assets Portfolio Quality Repayment rate 90% On-time collection as % of demand Loan loss provisions and write-off As prescribed by SBP To be independently assessed Profitability Return on equity Business plan Net profit to equity Return on assets Business plan Net profit to assets Solvency/Liquidity Capital adequacy ratio As prescribed by SBP Cash reserves As prescribed by SBP Reserves Reserve Fund 20% of net profit Depositor Protection Fund 10% of net profit

ª For purposes of eligibility, indicators will be applied on year-end data, as the determination of some of them requires audited financial statements. The indicators will become part of the monitoring mechanism to be reported periodically. In the event that MFI fails to meet most of the performance indicators, a provisional eligibility could be given upon submission of an institutional development plan. SBP will be required to review the plan semiannually.

4 The projections are conservative. The assumptions include (i) cost of refinance at 7% p.a., and deposit at 7% p.a.;

(ii) lending interest rate of 18% and 20%, respectively, for provincial and district MFIs; (iii) loan loss provision of 11% of net outstanding loans, and write-off after 2 years; (iv) statutory liquidity and cash reserve of 5% of deposit at no interest and 15% of deposit at 7% p.a.; (v) income tax at 50% of net profit; (vi) provision for inflation at 6% p.a.; and (vii) part of the fixed assets financed by NBF. Deposits are projected to increase by an amount equal to 10% of the annual loan disbursement.

59

DEVELOPMENT COORDINATION MATRIX

Rural Development Agriculture Microfinance Financial Sector Small and Medium Enterprises

Asian Development Bank Infrastructure, community development, social capital, and some rural finance. • Bahawalpur Rural Development

Project ($38 million) • Dera Ghazi Khan Rural

Development Project ($36 million) • Malakand Rural Development

Project ($41 million) • NWFP Barani Area Development

Project Phase II ($52 million) • Sindh Rural Development Project

($50 million) • Provincial Highways Project ($150

million) • Road Sector Development Program

($205 million) • Punjab Road Sector Development

Program ($150 million) Others European Community, International Fund for Agricultural Development, Islamic Development Bank, Japan Bank for International Cooperation (JBIC), Swiss Agency for Development Cooperation, and World Food Programme

Asian Development Bank Efficient markets for major commodities including wheat, cotton, rice, sugar, fertilizer, and seeds. Support for small farmer extension and training; and research and regulation for improving quality. • Agriculture Sector

Program II ($350 million)

• Proposed (2004): Agribusiness Export Development Project ($100 million)

World Bank • National Drainage

Program (cofinanced with ADB and JBIC)

Others Department for International Development (United Kingdom), International Fund for Agricultural Development, JBIC, and United Nations Development Programme

Asian Development Bank Microfinance policy, microfinance ordinance, supervisory and regulatory arrangements, institutional strengthening, and onlending support. Support for community organization, skills development, and community infrastructure. • Microfinance Sector

Development Program ($150 million)

World Bank Wholesale funds to nongovernment organizations for microcredit community organization, capacity building, and rural infrastructure • Pakistan Poverty Alleviation

Project ($90 million) Others Canadian International Development Agency, Department for International Development (United Kingdom), Swiss Agency for Development Cooperation, and United Nations Development Programme

Asian Development Bank Strengthening capital markets, regulatory framework for capital markets, insurance sector, and state-owned mutual funds. • Capital Markets

Development Program ($250 million)

• Financial Markets and Governance Program ($267 million)

World Bank Improving financial markets, legal framework, banking regulation, banking court system, and regulatory and market mechanisms. • Financial Sector Deepening

and Intermediation Project ($216 million)

• Banking Sector Restructuring and Privatization Project ($300 million)

• Banking Sector Technical Assistance ($26.5 million)

Asian Development Bank Improving export finance mechanism to extend availability of credit to small and medium enterprises • Small and Medium

Enterprises Trade Enhancement Facility ($150 million)

• Proposed (2003): Small and Medium Enterprise Development Project ($100 million)

International Monetary Fund: Higher allocations for poverty reduction, revenue enhancements, restructuring and privatization of public enterprises, and governance and transparency. The Interim Poverty Reduction Strategy Paper includes restructuring of Zarai Taraqiati Bank Limited and delivery of microfinance. Rural Finance Sector Development Program Enhanced access to credit will complement improved infrastructure and greater access to markets.

Efficient rural financial intermediation will enable maximization of household benefits from higher farm productivity and commodity prices .

Establishment of new microfinance institutions will extend outreach to the lowest segment of the rural finance (RF) markets.

Reforms in RF markets will enhance the flow of resources in the rural sector. Pilot crop insurance will serve to reduce risk in RF for lenders and borrowers.

RF services for rural enterprises will help rural households to diversify income sources.

Note: Only major interventions.

Appendix 6

59

Appendix 7 60

IMPLEMENTATION SCHEDULE

60 A

ppendix 7

A. Loan Effectiveness

B. Tranche Payments

C. Program Components1. Creating a Favorable Policy Environment 2. Institutional Restructuring and Reforms

Zarai Taraqiati Bank LimitedRural Finance Resource CenterCredit Union Plan

3. New Bank Fund4. Product and Process Innovations

Pilot Insurance plan

D. Project Components Institutional Strengthening/Restructuring

Zarai Taraqiati Bank LimitedState Bank of PakistanMinistry of Finance

E. Monitoring and Review

F. Consulting Services

2003 2004 2005Pre-project

Appendix 8 61

INELIGIBLE ITEMS No withdrawals shall be made in respect of (i) expenditures for goods included under the following Harmonized System1 chapters or

headings:

Chapter Heading Description of Items

22 22.03 – 22.08 Alcoholic beverages

24 24.01 Tobacco, unmanufactured; tobacco refuse 24 24.02 Tobacco, manufactured (whether or not containing tobacco substitutes) 28 28.50 – 28.52 Radioactive and associated materials 71 71.01 – 71.04 Pearls; precious and semiprecious stones, unworked or worked

71 71.05 – 71.06 Jewelry of gold, silver or platinum group metals 71.09 – 71.15 (except watches and watch cases); and goldsmiths

or silversmiths wares (including set gems) 71 71.07 – 71.08 Gold, nonmonetary (excluding gold ores and concentrates)

84 84.59 Nuclear reactors and parts thereof, fuel elements (cartridges), nonirradiated for nuclear reactors.

(ii) expenditures for goods intended for a military or paramilitary purpose or for luxury

consumption; (iii) expenditures for pesticides categorized as extremely hazardous or highly hazardous in

Class 1a and 1b, respectively, of the World Health Organization’s Classification of Pesticides by Hazard and Guidelines to Classification;

(iv) expenditures for goods supplied or to be supplied under any contract that a national or

international financing institution or any other financial agency has financed or agreed to finance, including any contract financed or to be financed under any loan from Asian Development Bank; and

(v) expenditures incurred more than 180 days prior to loan effectiveness.

1 Harmonized system means the Harmonized Community Description and Coding System of the Borrower, which is

based on Customs Co-operation Council Nomenclature (CCCN) established by the Convention for the Classification of Goods in Customs Tariffs, concluded at Brussels in June 1983.

Appendix 9 62

COST ESTIMATES AND FINANCING PLAN Table A9.1: Expenditure Accounts-Project Cost Summary

(US$ million)

Note: Figures may not add up to total due to rounding. The price contingencies are based on the 5 year average of local inflation (gross domestic product deflator) and on the manufacturing unit value index projections for the foreign inflation for years 2003, 2004, and 2005. For investment and recurrent costs the physical contingencies have been taken at 10%.

% % Total

Local Foreign Foreign Base

Currency Exchange Total Exchange Costs

I. Investment Costs

A. Equipment 2.83 2.82 5.65 50 23

B. Vehicles 0.16 0.16 0.32 50 1C. Training 1.58 0.86 2.44 35 10

D. Studies, Surveys and Audits 0.38 0.13 0.51 25 2

E. Consulting Services

1. International Consultants 0.70 9.34 10.04 93 42

2. Domestic Consultants 3.28 - 3.28 - 14Subtotal Consulting Services 3.98 9.34 13.32 70 55

Total Investment Costs 8.93 13.31 22.24 60 92

II. Recurrent Costs

A. Staff Expenses 0.20 - 0.20 - 1

B. Vehicle and Equipment Expenses 0.39 0.13 0.52 25 2

C. Communication Expenses 0.57 0.19 0.76 25 3D. Office Expenses 0.39 - 0.39 - 2

Total Recurrent Costs 1.55 0.32 1.87 17 8

Total BASELINE COSTS 10.48 13.63 24.11 57 100

Physical Contingencies 1.08 1.36 2.44 56 10

Price Contingencies 0.82 0.81 1.63 50 7Total PROJECT COSTS 12.38 15.80 28.18 56 117

Interest During Implementation - 0.93 0.93 100 4

Commitment Charges - 0.26 0.26 100 1

Front-end fees - 0.25 0.25 100 1Total Costs to be Financed 12.38 17.24 29.62 58 123

Appendix 9 63

Table A9.2: Expenditure Accounts by Financier (US$ million)

Appendix 9 63

Asian Development % Total Local Duties

The Government Bank Total Base Foreign (Excluding and

Amount % Amount % Amount Costs Exchange Taxes) Taxes

I. Investment Costs

A. Equipment 0.85 15 4.80 85 5.65 23 2.82 1.98 0.85

B. Vehicles 0.08 25 0.24 75 0.32 1 0.16 0.08 0.08

C. Training 0.24 10 2.20 90 2.44 10 0.86 1.34 0.24

D. Studies, Surveys and Audits 0.03 6 0.48 94 0.51 2 0.13 0.36 0.02

E. Consulting Services -

1. International Consultants 0.70 7 9.34 93 10.04 42 9.34 - 0.70

2. Domestic Consultants 0.16 5 3.12 95 3.28 14 - 3.12 0.16 Subtotal Consulting Services 0.86 6 12.46 94 13.32 55 9.34 3.12 0.86

Total Investment Costs 2.06 9 20.18 91 22.24 92 13.31 6.88 2.05

II. Recurrent Costs

A. Staff Expenses 0.20 100 - - 0.20 1 - 0.17 0.03

B. Vehicle and Equipment Expenses 0.52 100 - - 0.52 2 0.13 0.23 0.16

C. Communication Expenses 0.76 100 - - 0.76 3 0.19 0.34 0.23

D. Office Expenses 0.39 100 - - 0.39 2 - 0.33 0.06 Total Recurrent Costs 1.87 100 - - 1.87 8 0.32 1.07 0.48

Total baseline cost 3.93 16 20.18 84 24.11 100.0 13.63 7.95 2.53

Physical and Price Contingencies 0.71 17 3.36 83 4.07 17 2.17 1.48 0.42

Total Project Costs 4.64 16 23.54 84 28.18 117 15.80 9.43 2.95

Interest During Implementation - - 0.93 100 0.93 4 0.93 - -

Commitment Charges - - 0.26 100 0.26 1 0.26 - -

Front-end fees - - 0.25 100 0.25 1 0.25 - - 4.64 16 24.98 84 29.62 123 17.24 9.43 2.95 Total Disbursement

Appendix 10 64

FINANCIAL AND ECONOMIC ANALYSIS

A. Introduction

1. Financial and economic analyses of indicative subborrower investments were made to ensure that they have the potential to generate sufficient income to allow the subborrowers to repay their loans and generate surplus income. B. Methodology

1. Price Assumptions

2. For the analysis, the prevailing interbank exchange rate (PRs60/$/1) was used, and a discount rate of 12% adopted for net present value assessments. The financial returns and costs are estimated in constant year 2001-2002 terms, while the prices of farm and nonfarm outputs as well as inputs are based on published prices adjusted to the farmgate levels.1 World Bank Commodity Price Projections were used to estimate the economic prices of traded outputs and inputs. Prices for wheat, rice paddy, and seed cotton are based on the export parity, while those for sugarcane, milk, urea, and diammonium phosphate are based on import parity. To reflect underemployment and seasonal unemployment in the labor market, a shadow wage factor of 0.75 was used, while other nontraded inputs were adjusted by a standard conversion factor of 0.90 to account for the general distortions in the economy.

2. Farm and Enterprise Models2

3. Detailed crop models were prepared for the major and most minor crops in the cropping pattern. The only exception is in case of orchards. Due to their longer gestation periods and with the focus on marginal, subsistence, and small farmers, it is not likely that new orchards will be established through a medium-term loan. Along with the provincial cropping patterns, these crop models were the basis for farm models for average marginal, subsistence, and small farms. 4. Detailed livestock activity models were prepared for common types of livestock. Milk, cull animals and young stock were assumed as the main products. It was further assumed that the entire produce is disposed off and any on-farm consumption is bought with cash. The models assume that the milking animals will have a 5-year milking life and that the replacements will be purchased and not reared on the farm. Typical herding patterns were used to develop various types of livestock farm models. 5. Enterprise models for likely rural income generation activities are for a period of 5 years and are the basis for determining the financial and economic performance of the respective activities.

3. Financing Assumptions

6. Based on the recent literature3 and surveys on other Asian Development Bank (ADB) projects, it was assumed that all the cash costs are paid for by borrowing from informal sources at 5% per month or at 30% for the cropping season. While the lending through Zarai Taraqiati

1 Pakistan Year Book 2001, Federal Bureau of Statistics, 2001. 2 Detailed crop, livestock, farm and enterprise models are presented in the Supplementary Appendix D. 3 Khandker, S R et al, Impact of Farm Credit in Pakistan . The World Bank.; and ADB. 2001. Small-Scale Technical

Assistance to Pakistan for Additional Preparatory Work on the Sindh Rural Development Project. Manila

Appendix 10

65

Bank Limited (ZTBL) and microfinance institutions (MFIs) will be at the prevailing commercial rates, an annual interest rate of 20% was assumed for the purposes of this analysis. The loan term for the seasonal lending for crop production was assumed to be 6 months and that for the new enterprises was assumed to be 1 year. C. Analysis of Financial, Economic, and Employment Impacts

7. Detailed assessments of the financial and economic performance as well as employment creation from typical investment options in the rural economies were made and are presented in Supplementary Appendix D.

1. Seasonal Lending for Crop Production

8. Depending on the farm size and the cropping patterns, the loan disbursements through ZTBL will be in the range of PRs7,500 ($125) to PRs51,000 ($850). When the lower cost of capital is the only benefit, resulting increase in the household income is in the range of 34% to 46%. However, it is more realistic to anticipate that, as a result of lower capital costs, farmers will no longer be constrained to reduce the levels of inputs such as fertilizers and as a result will use some of the savings to improve crop productivities. An increase of 10% in yields is anticipated to improve the financial farm incomes by 70% to 114%, while the improvement in the economic farm income is estimated to average at about 15%. Annual incremental employment generation is estimated to be equivalent to 5,000 full time jobs.

2. Lending for New Enterprises

9. Middle segment of the rural finance market will be served by the ZTBL and loan disbursements are anticipated to range from PRs20,000 ($333) to PRs75,000 ($1,250). Farm-related enterprises typical of the rural sector are anticipated to generate financial internal rates of return (FIRRs) ranging from 38% to 69%, while the corresponding economic internal rates of return (EIRR) are expected to range from 25% to 53%. Sensitivity analysis taking into account a 20% enterprise failure rate shows that the weighted average FIRR declines from 71% to 53% and weighted average EIRR from 32% to 19%. For the nonfarm enterprises, the FIRRs for the typical activities are expected to range from 17% to 75% while the EIRRs from 23% to 54%. Sensitivity analysis shows that failure of 20% of the enterprises reduces the weighted average FIRRs from 42% to 29% and weighted average EIRRs from 42% to 33%. 10. Overall for the ZTBL lending for new enterprises, the FIRRs are anticipated to range from 17% to 75% and have a weighted average of 45%, which declines to 33% with a 20% enterprise failure. Corresponding EIRRs range from 21% to 54% and have a weighted average of 37%. Incremental employment generation from the annual lending for the new enterprises is expected to be equivalent to 75,000 full time jobs. 11. MFIs will serve the lowest but the largest segment of the rural finance market. It is anticipated that the average loan size will be less than PRs10,000. The weighted average FIRR is expected to be about 34%, while the weighted average EIRR is about 27%.4 In case 20% of the enterprises fail, the weighted average FIRR is expected to decline to about 25% 4 The borrowers and the enterprises in this category will be the same as in case of the ADB-financed ADB. 2001.

Report and Recommendation of the President to the Board of Directors on a Proposed Loan to Pakistan for Microfinance Sector Development Program (MSDP). Therefore, no new analysis was undertaken for the microenterprises and the anticipated performance reported for such activities in the MSDP (Appendix 18) was adopted.

Appendix 11 66

Table A11.1: Summary Initial Environmental Examination

Zarai Taraqiati Bank Limited

Environmental FactorA B C D E F G

Site Location ProblemsNuisance to neighbors 1 2 2 2 2 2 2Effects on adjacent property values 1 2 2 2 1 1 1Hazards to traffic 1 2 2 2 2 2 2Effects on precious ecology 2 2 2 2 2 2 2Socioeconomic impacts 1 1 1 1 1 1 1

Design ProblemsWaste emissions 1 1 1 1 1 1 1Handling hazardous materials 1 1 1 1 1 1 1Noise and vibration 1 2 2 1 1 1 1Inefficiency of energy use 1 1 1 2 1 1 1Drainage 2 1 1 1 1 1 1

Construction ProblemsAccess 1 1 1 1 1 1 1Hazards to workers 1 1 1 1 1 1 1Soil erosion 2 1 1 1 1 1 1Dust and fumes 1 1 1 1 2 1 1

Operational ProblemsAccess 1 1 1 1 1 1 1Pollution from wastes 1 2 2 1 2 1 1Nuisance/hazards for neighbors 1 2 2 2 2 2 2Worker hazards 1 1 1 2 1 2 2

Critical Overall Environmental ReviewUnacceptable resource losses 1 1 1 1 1 1 1Depletion of natural resources 1 1 1 2 1 1 1Hazards to endangered species 1 1 1 1 1 1 1Excessive use of energy 1 1 1 1 1 1 1Unacceptable levels of public nuisance 1 1 1 1 1 1 1

Environmental Impact Analysis Required no no no no no no noa1=no significant effect or not applicable, 2=small significant effect, 3=moderate significant effect, and 4=major significant effect

bA=improved cropping, B=dairy farm, C=fish farm, D=poultry farm, E=carpenter enterprise, F=motorcycle/tractor workshop, G=flour machine,

Ratinga of Models

b Evaluated

Appendix 11 67

Table A11.2: Microfinance Institutions

Environmental FactorA B C D E F G

Site Location ProblemsNuisance to neighbors 1 2 2 1 1 1 1Effects on adjacent property values 1 2 2 1 1 1 1Hazards to traffic 1 2 2 1 1 1 1Effects on precious ecology 2 2 2 1 1 1 1Socioeconomic impacts 1 1 1 1 1 1 1

Design ProblemsWaste emissions 1 1 1 1 1 2 1Handling hazardous materials 1 1 1 1 1 1 1Noise and vibration 1 2 2 1 1 2 1Inefficiency of energy use 1 1 1 1 1 1 1Drainage 2 1 1 1 1 2 1

Construction ProblemsAccess 1 1 1 1 1 1 1Hazards to workers 1 1 1 1 1 1 1Soil erosion 2 1 1 1 1 1 1Dust and fumes 1 1 1 1 1 2 1

Operational ProblemsAccess 1 1 1 1 1 1 1Pollution from wastes 1 2 2 1 1 1 1Nuisance/hazards for neighbors 1 2 2 1 1 1 1Worker hazards 1 1 1 1 1 1 1

Critical Overall Environmental ReviewUnacceptable resource losses 1 1 1 1 1 1 1Depletion of natural resources 1 1 1 1 1 2 1Hazards to endangered species 1 1 1 1 1 1 1Excessive use of energy 1 1 1 1 1 1 1Unacceptable levels of public nuisance 1 1 1 1 1 1 1

Environmental Impact Analysis Required no no no no no no noa1=no significant effect or not applicable, 2=small significant effect, 3=moderate significant effect, and 4=major significant effect

bA=cropping, B=livestock:goats, C=livestock:milking cows, D=embroidery/tailoring, E=stall/trading goods, F=tubewell irrigation, G=internet services

Ratinga of Modelsb Evaluated

Appendix 12 68

SUMMARY POVERTY REDUCTION AND SOCIAL STRATEGY

A. Linkage to the Country Poverty Analysis

Sector identified as a national priority in Country Poverty Analysis? Yes. To reduce absolute poverty from 32% in 2001 to 15% in 2011, one of the Government’s strategies is to accelerate growth in four critical sectors: agriculture, small and medium -scale enterprises, information technology, and energy. The Government’s plan is to promote rural economic growth through increased access to sustainable rural finance and microfinance.

Sector identified as a national priority in Country Poverty Partnership Agreement? Yes. Asian Development Bank’s (ADB’s) medium -term development goals are to promote economic growth and stability of income and employment in rural Pakistan, increase nonfarm employment opportunities, expand rural economic infrastructure, promote financial intermediation, and enhance access to credit in the rural areas.

Contribution of the sector to poverty reduction in Pakistan In Pakistan, 75% of the poor live in rural areas; a large proportion of them are pushed into poverty because of the volatility of income. The rural sector accounts for two thirds of employment. Majority of the employed rural population depend on agriculture for their livelihood either directly or indirectly. Formal institutions meet less than one fifth of rural credit demand. The development of a sustainable rural finance market and credible financial institutions will help promote rural economic growth and subsequently reduce rural poverty, through (i) increased food security, (ii) increased diversification and development of nonfarm activities, (iv) lower production costs leading to improved competitiveness of farm production, (iv) stronger export of agricultural products, and (v) income and employment generation in the rural sector. B. Poverty Analysis Improved Governance/ Economic Development

Rural Poverty. Poverty is widespread in the country, but it has historically been higher in the rural than in the urban areas. Pakistan has no official poverty lines. As a result, several studies undertaken to enumerate poverty have used different figures. Federal Bureau of Statistics (using the expenditures necessary for intake of 2,550 calories as the poverty line) reported incidence of poverty at 32% overall and at 36% in the rural areas in 1998-99. It is likely that the incidence of poverty has risen since then, due to the decline in growth of nonfarm activities and public sector development spending. Inequality also increased in Pakistan during the 1990s. Pakistan does not have gender-disaggregated poverty-related data. However, it is increasingly evident from various studies that women bear a disproportionately high share of the burden of poverty within the family and the society. Women’s access to and control over productive resources are extremely limited. Women’s mobility is restricted and gender segregation and female seclusion are common. Poverty in Pakistan is characterized by both economic vulnerability (households do not have diversified sources of income to smooth out consumption expenditure in response to exogenous shocks) and social vulnerability (denial of basic rights, social exclusion, corruption, manipulation of regulatory controls, and insecurity). Other characteristics of the poor in Pakistan are their low education, larger than average household size, few physical assets, and a disproportionate reliance on informal sector employment opportunities.

Rural Poverty and the Agriculture Sector. One of the root causes of poverty in the rural areas is heavy dependence on the agriculture sector, which has been marred by low growth in the last decade. Due to a dearth of opportunities other than in agriculture, the impact of low growth in agriculture on the rural economy was severe: incomes declined and unemployment and underemployment increased. The reasons for low growth in agriculture are multidimensional and include distorted commodity markets, weak research and extension services, and lack of access to formal credit. Agricultural Sector Program II1 aims to rid the economy of distortions in the commodity markets and to make both research and extension more responsive to farmers’ needs and more effective in service delivery. However, little has been done so far to improve farmers’ access to credit. A 1995 survey2 found that only 60% of the farmers had been able to take loans to finance their operations. Of those who were able to borrow, only 6% borrowed from banks and other formal sources. The very little formal borrowing is limited to larger and better-off farmers and access of marginal and subsistence farmers is minimal. In the past, Government-programmed credit tended to target inefficient and politically connected producers. These loans discouraged agricultural modernization and diversification. In addition, a grant mentality discouraged the development of financial services and institutions.

1 ADB. 2001. Report and Recommendation of the President to the Board of Directors on a Proposed Loans to Pakistan for the

Agriculture Sector Program II. Manila. 2 Applied Economic Research Center, Karachi University. 1998. Rural Financial Markets Study; Karachi; State Bank of Pakistan

(SBP). 2002. Report of the Committee on Rural Finance, Karachi.

Appendix 12

69

Surveys show that the informal sources of credit not only charge annual interest rates of 40-50%, but also stipulate that the produce is sold to the lender who manipulates prices to where farmers end up getting paid 5-10% less than the market price. In addition to low prices, very high capital costs affect the farmers’ production decisions: fertilizer application rates are lowered and pest control is considered a luxury in case of most crops, which leads to lower than the potential yields. In addition, when buying agricultural inputs on credit, the farmers have no choice but to buy substandard and adulterated fertilizers and pesticides from suppliers that would extend credit to them. This further reduces crop productivity.

Rural Poverty and Land Ownership. The prevalence of an unequal land distribution system is another major cause of rural poverty. In general, areas where sharecropping arrangements are structured to favor the landowner tend to have higher levels of rural poverty. Pervasive inequality in land ownership intensifies the degree of vulnerability of the poorest sections of the rural society. Ownership of even small landholdings can significantly increase not only the owner’s capacity to absorb economic shocks but also access to credit from the formal banking sector.

Rural Poverty and the Nonfarm Subsector. Slow growth in agriculture combined with lack of access to credit has led to virtually no growth in nonfarm rural income sources. Employment opportunities in the nonfarm subsector have at best remained unchanged and have led to higher levels of rural unemployment and underemployment. Most affected are the landless that due to lack of access to credit depend entirely on farm and nonfarm sources for employment. Due to lack of collateral, the risk of lending to the landless is perceived to be greater; thus the credit through the informal sources is even more expensive, which ensures that the most disadvantaged rural population has no opportunity to escape poverty. Over half of the rural population depend on nonfarm sources for their livelihood. While Agriculture Sector Program II addresses the issues relating to agriculture sector, similar measures for the rest of the rural economy have been few, which has led to the situation where the rural economy is highly dependent on agriculture. High dependence on the agricultural sector has meant that in the event of natural calamities and exogenous shocks, such as drought or widespread pest attacks (as in case of leaf curl virus on cotton), there was nothing for the rural economy to fall back on. Inadequate supply of credit from formal sources has meant that the rural economy lacked access to credit required to diversify into sources of income other than in agriculture. In areas where income sources are not diversified, coping strategies for vulnerable households are very limited and credit could be an important means of sustaining consumption. C. Participation Process Stakeholder analysis prepared? Yes Participation Strategy Yes Stakeholder Groups. Four stakeholder groups were analyzed: general public, government, private sector, and civil society. The Rural Finance Sector Development Program will involve participation of stakeholders at different levels and from different sectors. Being the primary focus, marginal and subsistence farmers, women, and the rural poor will be active participants. Small, medium -scale and large farmers, who are the current focus of Zarai Taraqiati Bank Limited (ZTBL) lending, will continue to have access to credit from the commercial banks as well as from ZTBL and hence remain active participants. In addition, rural labor will benefit from increased employment opportunities in the rural economy and will hence play an important role as well. At the Government level, Ministry of Finance, State Bank of Pakistan, provincial governments, ZTBL, and the provincial cooperative banks will be involved in implementing the proposed policy and investment interventions, and hence will be actively involved. In addition, the proposed policy and investment options complement the reforms planned under Agriculture Sector Program II and hence require coordination with the Ministry of Food, Agriculture, Livestock and Cooperatives. Improved terms and trade volumes resulting from the proposed interventions under this loan and the ongoing reforms under Agriculture Sector Program II necessitate an indirect but active role on the part of the Ministry of Commerce and Industry. Among the private sector, the efforts to improve the coverage of formal sources of credit will have a direct but inverse impact on the inform al sources of credit that will not be able to exploit the rural communities as much as now. On the other hand, since these informal sources are mostly input suppliers, the increased demand for the inputs and resulting increases in production will mean some gains for them as well. Similarly, agriculture-related industry through indirect involvement would benefit from the gains from the proposed interventions. Among the civil society, the employees that will become redundant due to rightsizing will be directly affected and their participation will be essential. Nongovernment organizations will be yet another participant who will help implement the social intermediation process in coordination with microfinance institutions using the resources of the Microfinance Social Development Fund established under the ADB-funded Microfinance Sector Development Program.3

3 ADB. 2000. Report and Recommendation of the President to the Board of Directors on the Proposed Loan to Pakistan for the

Microfinance Sector Development Program. Manila.

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Planning, Implementation, and Monitoring. During implementation, the proposed policy and investment interventions will follow an integrated participatory approach. Involvement of stakeholders from various levels and sectors will ensure that the approach is adhered to. An important aspect will be participation of the target population in planning, implementation, and monitoring. D. POTENTIAL ISSUES

Issues Significant/ NonSignificant/ Uncertain/ None

Strategy to Address Issues Output Prepared

Resettlement None No adverse issues are anticipated. However, there may be some positive impacts on resettlement due to improved productivity in agriculture, greater employment, and more diversified employment opportunities in the rural economy.

No

Gender None No adverse issues are anticipated. In contrast, there will be a number of positive impacts such as improved access of women to formal credit, as the new microfinance institutions will be mandated to provide 25% of loans to women. Improved access to lending along with necessary mobilization and training will encourage entry of women entrepreneurs in the rural economies. Increased access for women will require that additional women staff be inducted. This will have the beneficial impact of job creation for women and women empowerment.

Yes Gender emphasis included in ZTBL Memorandum of Association Mandatory gender targets for microfinance institutions that seek New Bank Fund support

Affordability None No adverse issues are anticipated. In contrast, reduced dependence on very expensive and exploitive informal sources of credit will not only reduce farmers’ price of inputs, and cost of production, but also ensure that the farmers are able to get market price for the produce. In addition, farmers will have the option to choose the supplier offering the best quality inputs. The reduced costs of production along with productivity improvements resulting from these will create a more competitive farming sector that will help reduce dependence on subsidies and tariffs on imports to stay afloat.

No

Labor Significant As a result of the proposed restructuring of ZTBL, about 3,000 staff are expected to be retrenched. A retrenchment plan has been prepared to ensure that the adverse effects are properly mitigated. The loan, through the establishment of new microfinance institutions, is expected to create employment opportunities, which will absorb the capable staff made surplus by the restructuring of ZTBL. In contrast, the implementation of the proposed interventions is expected to annually produce 1 million person days of incremental employment opportunities in the agriculture and equivalent of 75,000 full time jobs in the nonfarm subsector of the rural economy. The rural poor, rural labor, and women will benefit from such job opportunities.

Yes

Indigenous People

None No adverse issues are anticipated. No

Other Risks/ Vulnerabilities

None No other adverse issues are anticipated. No