RESTR ICTED

Report No. P-944

FILE ryThis report was prepared for use within the Bank and its affiliated organizations.They do not accept responsibility for its accuracy or completeness. The report maynot be published nor may it be quoted as representing their views.

INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

REPORT AND RECOMMENDATION

OF THE

PRESIDENT

TO THE

EXECUTIVE DIRECTORS

ON A

PROPOSED LOAN

TO THE

SOCIALIST FEDERAL REPUBLIC OF YUGOSLAVIA

FOR THE

IBAR MULTIPURPOSE WATER PROJECT

May 18, 1971

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INTERNATIONAL BANE FOR RECONSTRUCTION AND DEVELOPP'ENT

REPORT AMMD RECCMMENDATION OF THE PRESIDENTTO THE EXECUTJIVE DIRECTORS

ON A PROPOSED LOANTO THE SOCIALIST FEDERAL REPUBLIC OF YtSOSLAVIA

FOR THE IBAR MULTIPURPOSE WATER PROJECT

1. I submit the following report and recommendation on a proposed loanin an amount in various currencies equivalent to US $45.0 million to theSocialist Federal Republic of Yugoslavia for a multipurpose water project.

2. The proposed loan would be the fifth lending by the Bank for aproject with a power component in Yugoslavia but the first for water supplyor agriculture. Following completion of a feasibility study and detaileddesign of most of the project elements by Yugoslav consultants, a Bankreconnaissance mission visited the project area in April 1969. FAO/IBRDCooperative Program missions helped prepare the agricultural component of theproject in September 1969 and January 1970. The project was appraised byBank and FAQ/IBRD staff in May/June 1970.

3. Negotiations were held in Washington in March 1971. The Yugoslavdelegation was headed by Ifr. Gavra Popovic, Assistant Federal Secretary forFinance, and included representatives from the Federal Government, theGovernment of the Socialist Autonomous Province Kosovo, the Ibar-LepenacEnterprise (ILE), and the Bank of Kosovo (Banka Kosova).

PART I - HISTORICAL

4. Yugoslavia has had an active relationship with the Bank since August1949, when a mission visited the country in connection with a loan application.The following October the Bank made its first loan of $2.7 million for timberprocessing equipment. By the end of 1970, the Bank had made 16 loans toYugoslavia totaling $h75.5 million, making Yugoslavia the Bank's largestborrower in Europe and the seventh largest overall. The largest portion,$415 million, has been lent in the last decade and most of this ($270 mill-ion) has been for transportation. The railways, which form the backboneof the transport network, have received $155 million to assist in financingtheir modernization and expansion. To help relieve congestion on theequally important highways, four loans totaling $115 have been made. Thetwo most important highways, the Central Highlway, which extends 720 milesfrom the Austrian to the GJreek border, and the Adriatic Highway, which runs465 miles along the Dalmatian coast, have both received Bank assistance. Inaddition, loans of $60 million for power generation and transmission, and$40 million for telecommunications have contributed to meeting other in-frastructure needs. Finally, three industrial loans totaling $45 million haveprovided imported equipment for twenty of Yugoslavia's major industrial enter-prises. The proposed loan is one of four which are expected to be presentedto the Executive Directors before the end of this fiscal year; two are for

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tourism, one for roads, and one for the multipurpose Twater and pow*er project.A list of past loans to Yugoslavia is to be found in Annex I.

5. Execution of all projects has been satisfactory except for thesecond and third railway projects. Progress on the third railway project(Loan 531-YU) for the construction of the main line from Belgrade to Barhas been slowed down by cost increases and by engineering delays caused byunforeseen geological conditions. Potential solutions to these problemshave been discussed at length with representatives of the Governments andthe railways. The authorities are now attempting to resolve the financialproblem by a bond issue to cover increased oosts.

6. At present, the most urgent problems arise in connection with thesecond railwfay project (Loan 395-YU) for the modernization of main lines.Execution of this project has been delayed by financial, planning, andtechnical difficulties which were summarized in my Memorandum to the Exe-cutive Directors of May 28, 1970 (R70-99). At that time, and in order toexpedite the execution of the project, the Bank and the Government agreedon a financing plan for 1970 and the Bank agreed to postpone the closingdate to March 31, 1973. Although all the railway enterprises made profitslast year, cash shortages have persisted, despite serious efforts to improvethe situation. The financing plan for the railways in 1971, which wasreceived by the Bank in April, provided for substantial rate increases aswell as for the continuation of measures taken in 1970. The main out-standing issue was the lack of provision for financing past deficits. As aresult of decentralization of governmental responsibilities, the FederalGovernmentls obligation to meet the railwfays' deficits has been transferredto the Republics and Autonomous Provinces. The latter have not yet beenable to assume this responsibility in full because the division of respon-sibilities and resources between the Federation and its constituent parts hasnot been finally determined. The railways have been particularly affectedby this situation whereas in other fields, such as highways, the respon-sibility of the Republics and Provinces to provide financing is alreadyfully established. It is expected that this question will be resolved withinthe next few months but it has meanwhile become apparent that the railways1971 financing plan is inadequate to prevent a further deterioration intheir financial position. This is principally because the latest estimateof the cost of the modernization program has increased by 30 percent overthe previous estimate, which may have been too low, due to the recentcurrency devaluation and to current and forecast domestic price increases.It now seems probable that the railway enterprises will not make the sub-stantial profits forecast in the 1971 plan. The accounts payable by therailways have doubled since May 1970. Suppliers and contractors are nowreluctant to extend further credit and due to the lack of funds, work onthe modernization program and related investments has been interrupted insome areas. Execution of the project is thus likely to be further delayedbeyond the new closing date. The matter is under continuing review and itis intended to examine the situation in depth with the assistance of a teamof consultants in the next six months. This detailed examination of therailways will be followed towards the end of this year by a Bank study ofthe Yugoslav transportation sector as a whole.

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7. Yugoslavia became a member of IFC in July 1968. Since then, IFCmade a venture capital investment through Fiat of $8 million in the Fiat/Zavodi Crvena Zastava joint venture (for which the Bank also lent $10 million),and a $2 million equity commitment to the International Investment Corpora-tion for Yugoslavia. The latter was formed by 15 Yugoslav and 39 foreignbanks to provide a channel for foreign capital. IFO has too other invest-ments under consideration.

PART II - DESCRIPTION OF THE PROPOSED LOAN

8. Borrower: Socialist Federal Republic of Yugoslavia

Beneficiary: Preduzece za Izgradnju i IskoriscavanjeHidrosistema "tIbar-Lepenac" u Osnivanju(Ibar-Lepenac Enterprise)

Amount: The equivalent in various currencies ofUS $45.0 million

Purpose: To assist in financing construction works,equipment and related studies for thedevelopment of the Ibar River for watersupply, irrigation, and power generationpurposes

Amortization: In 30 years including a six-year periodof grace, through semi-annual install-ments beginning Nay 1, 1977 and endingNovember 1, 2000

Interest Rate: 7-1/4 percent per annum

Commitment Charge: 3/4 of 1 percent per annum

Relending Terms: Bubstantially the same as the terms ofthe Bank 'loan

Estimated Economic Returnon the Project: 16 percent

PART III - THE ECONOMY

Introduction

9. Yugoslavia's adherence to basically socialist economic and socialpolicies has produced a mixed economy in which social ownership of the in-frastructure and the means of production in the industrial sector coexistswith a predominantly private agricultural sector occupying about half theeconomically active population. Socialism, however, has been applied in arealistic and pragmatic way and full employment and equitable income distri-bution have been given lower priority at least in recent years than rapideconomic growth and increased exports.

ANNiEX I

SU1'RY STATEiINT OF BANK LOANS TO YUGOSLAVIA AS AT APRIL-30, 1971

Amount (US$ million)No. Year Borrower Furpose Bank Unrdisbursed

8 loans fully disbursed 200.7

395-YU 19614 Yugoslav Investmaent Bank Railways 70.0 31.6

504-YU 1967 Yugoslav Iinvestment Bank Industry 10.5 2.0

531-YU 1968 Yugoslav Investment Bank Railways 50.0 31.2

554-YU 1968 Yugoslav Investment Bank Industry 16.0 7.1

608-YUT 1969 Socialist Federal Republicof Yugoslavia Highways 30.0 19.6

654-Yu 1970 Yugoslav Investment Bank Industry 18.5 11.4

657-YU 1970 Yugoslav Investment Bank Telecommuni-cations 40.0 40.0

678-YU 1970 Socialist Federal Republicof Yugoslavia Highways 140.0 40.0

Total (less cancellations) 475.5of which has been repaidto Bank and others 6o.8

Total now outstanding 441.7

Amount sold 6.2of which hasbeen repaid 4.0 2.2

Total now held by Bank 412.5

Total undisbursed 162.9

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10. Pragmatism and flexibility have, however, not led to the abandonmentof the basic principle of Yugoslav philosophy - decentralization, or, inYugoslav terms, self-management. This implies a division of society intoa great number of social, political and economic units, each of which isresponsible for its own management. Its adoption has been the essence ofthe change from the early postwar regime which was characterized by a com-plete centralization of decision-making in the hands of the Federal Govern-ment, to a decentralized system in which the Federal Government oftenplays an unusually small role. One of the most striking political featuresof Yugoslavia is the extent to which, as voters, wTorkers or officials,people participate in decision-making.

11. Paradoxically, decentralization has also resulted in a new form ofconcentration of power in the economic field. The freedom of action of theenterprises has led to the emergence of a strong managerial class, in whichmanagers actively seek out opportunities to broaden the scope of theiroperations through mergers and acquisitions. AnoUher aspect of economicconcentration is the strong position of the banks, which,partly because thereis no capital market in the western sense of the term, provide long-termcapital for industry and play a significant roLe in investment decisions.

12. Application of the principle of decentralization has created a numberof difficulties to the effective carrying out of coherent national eccnomicpolicies. Thus, after a long period of rapid groifth, Yugoslavia is facedwith a number of major problems. Market forces, for which the Yugoslav5ystem envisages a majorrole, are partially still weak. Imperfections suchas immobility of factors of production, price controls, ceilings on interestrates, and monopolistic tendencies of big enterprises and banks are impedi-ments. Income inequalities between regions are larger today than in 1955.Despite large-scale emigration high unemployment in some regions coexistswith labor shortages in others. Most of the private agricultural sectoris under-developed and has a labor surplus.

13. Decentralization has sharply reduced the instruments available tothe Federal Government for economic management, especially demand control.Decision-making powers on important questions, such as external borrowingand the allocation of investible funds, are to arn increasing extentexercised by the larger banks.,. Moreover, decentralization has had anegative effect on total savings which is likely to continue until privatesavings have increased sufficiently.

14. Although the role of planning in resource allocation is small, itssignificance in focusing attention on basic problems is great. However,continued discussion on the extent of transfer of political and economicresponsibilities and on fundamental economic policies has delayed the newlong-term plan, which would otherwise have come into force at the beginningof 1971.

15. It is apparent that a balance between decentralization, political aswell as economic, and that degree of coordination at the national levelwhich is indispensable in modern society, has yet to be found. However, in

the face of the problems noted above, the Yugoslavs continue to exhibit aspirit of innovation >and seriousness of purpose in attacking these problemsthat might be envied by less experimental societies. Operating in a frame-work uniquely their oln, and with no precedents to guide them, they havedeveloped a number of innovations in the organization of economic activity.In the past, when problems became too difficult for existing institutionsto handle, they have been willing to undertake major structural changes.The current period is again one of change. Within the context of a majorreform of the constitution, all aspects of political and economic life arebeing rigorously debated.

Recent Economic Growqth

16. The Yugoslav economy has had a high average rate of growth over along period, although with rather sharp fluctuations. Industry has been themain force in the development process, growing at over 8 percent per annum(at constant prices) between 1960 and 1970, while agriculture, particularlyprivate agriculture, has lagged. The Economic Reform of 1965 was followedby restrictive monetary and other policies which brought the economy tonear stagnation until the middle of 1968. This was the price paid for theradical change in the economic structure. Relaxation of the stabilizationmeasures in mid-1968 once again led to faster growth (over 9 percent in1969 and about 5 percent in 1970), but at the same time prices and thedeficits in the current account of the balance of payments increased sharply.Despite vigorous action taken between June and December 1970 to curb pricesand the deficit, devaluation became unavoidable and on January 23, 1971,the dinar was devalued from 12.5 to 15 to the US dollar. This was thefourth devaluation since 1948, reducing the dinar to one-thirtieth of itsvalue at that time.

Resource Allocation and Mobilization

17. Before the 1965 Economic Reform, the transfer of savings betweenregions and sectors was largely effected through Federal institutions. Withthe Federal role diminished, capital mobility decreased significantly asthe decentralized economy did not provide adequate mechanisms to overcomeregional compartmentalization. There was a pronounced drop in domesticsavings, from 32.7 percent of GDP in 1965 to 27.2 percent in 1970: thedecrease in public savings caused by the change in the tax structure wasnot offset by an increase in savings by enterprises and individuals. Onthe other hand, investments were encouraged by the Reform and gross invest-ment rose slightly from 32 percent of GDP in 1965 to 33 percent in 1970. Asa result, the resource gap, negative in 1965, was equivalent to 2.9 percentof GDP in 1969 and (partly due to speculative stock build-up) to 5.7 per-cent in 1970. Although fast growing factor income receipts (mostly workers'remittances) now finance a large part of this gap (42 percent in 1970), aproblem of domestic resource mobilization is emerging.

Demand 2anagement

18. The recent inflationary process is a consequence of the structural

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changes that have occurred under decentralization rather than short-termpressures. The most important of these is a marked increase in the propensityto consume in recent years. Even when output growth has been sluggish,the pressure to raise consumption levels has proved irresistible. Theproblem in Yugoslavia (as elsewhere) arises from the desire to combine in-creasing consumption iwith the high investment necessary to modernize in-dustry and achieve economic growth. Thus, long-term policies for the controlof inflation require either a reduction in investment or a substantial im-provement in savings; for both, central control or even central coordinationis difficult with the present system. The system also lacks adequate toolsfor short-term demand control. In the absence of precedents, Yugoslaviahas had to experiment, but so far its experiments have proved only partiallyeffective. It would seem that Yugoslavia will be compelled to devise addi-tional means of coordinating, if not controlling, fiscal and incomespolicies.

Regional Development

19. From the mid-1950ts to the end of the 1960's growth rates variedconsiderably between the component Republics and Provinces. Serbia properand Macedonia grew fastest (6.3 percent and 6.0 percent annually, respective-ly), while Bosnia-Hercegovina and Kosovo, both of which are among the lesser-developed regions, grew at only 4.0 percent and 5.3 percent annually. Thisdifference is largely the result of differences in population growth rates,the relative size of the social sector (where income per worker is at aboutthe same level in all Republics) and the extent of the private agriculturalsector in each region.

Employment

20. Yugoslav growth strategy has assumed that increases in employmentwould take place as a function of overall growth. Realizing that this hasnot provided a satisfactory solution, Yugoslav authorities have encouragedexternal migration. Over the five years since 1965, employment increasedby only 5.2 percent. In mid-1970, the number of registered unemployed(339,000) stood at its highest level of the decade, despite substantialmigration of Yugoslav workers to various vIestern European countries (a totalof 850,000 by 1970). External labor mobility has been, in the last fiveyears, significantly larger than internal mobility and serious laborsurpluses in some regions of Yugoslavia coexist with shortages in others.Thus, there is considerable need not only for increased transfers of capitalto labor surplus areas (mainly the lesser-developed regions), but also fora more labor-intensive type of investment and the encouragement of serviceindustries, such as tourism, in these areas.

International Economic Relations

21. Three main factors have influenced the balance of payments in recentyears. First, a deliberate reorientation of trade from the bilateral-agreementcountries to the convertible currency area. Coimmodity exports to this arearose from 48 percent of the total in 1965 to 63 percent in 1970 and importsincreased from 61 percent to 74 percent. Second, the liberalization of the

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foreign trade and foreign exchange regimes, resulting in an actual liberal-ization of trade to over 80 percent in 1970. Third, the modernization andincreased efficiency of Yugoslav firms which led to greater competitivenessof Yugoslav goods in Western markets and thus influenced the grow^th ofexports. The net effect of these factors has been to increase the currentaccount deficit.

22. In 1970 the deterioration of the balance of payments became the focalpoint of economic policy discussions and measures. It reflected difficultyin reconciling two major objectives of the Economic Reform - the furtherdecentralization of economic decision-making and the liberalization offoreign trade with a view to integrating the Yugoslav economy with theworld market. The former produced strong tendencies towards excess demandwhile the latter increased the vulnerability of the balance of payments tosuch tendencies. Yoreover, the considerable need for modernization ofcapital equipment was immediately translated in an upsurge of imports.While 1970 commodity exports rose by 13 percent, the increase in imports,partly due to speculative stock accumulation as a result of devaluationfears, amounted to 33 percent, increasing the trade deficit from $600 millionin 1969 to $1,175 million in 1970. The deterioration in the balance ofpayments was, however, mitigated by the sharp rise of workers' remittances(from $206 million in 1969 to $415 million in 1970) and further improvementsin services.

Development Objectives

23. At this point the Yugoslav Government does not have clearly definedand quantified development objectives. The formulation of the 1971-75Plan has been delayed mainly because decentralization has set in motionimportant crosscurrents of opinion on the country's economic goals and onthe division of responsibilities. The following main themes are under dis-cussion:

(a) constitutional reform, including the Presidency, and the divisionof responsibilities between the Federal Government, Republics, and lower-level socio-political entities:

(b) self-management and its further elaboration within the new con-stitutional framework;

(c) principles on which the foreign trade, foreign exchange andprotection regimes should be based;

(d) the volume of funds to be provided by developed to developingregions, and the mechanism by which these funds will be channeled;

(e) fiscal, incomes and price policies;

(f) location of major infrastructure and industrial investments.

The outcome of these discussions will have a direct impact on the strategyof the new Five-Year Plan and on future economic developments. The Federal

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authorities expect that solutions will be found within the next f e monthsand that the draft Plan will be submitted to Parliament before September1971. In the meantime, ccnflicts between basic policy objectives must beresolved.

2h. Unless countervailing policies are adopted, increased decentralizationwill result in a further weakening of demand control. Traditional economictools and policies cannot easily be adapted to the Yugoslav system. Theauthorities are aware of this and make serious political and intellectualefforts to find solutions, e.g., attempts to coordinate fiscal policies bet-ween the Republics and the Federation, and to introduce an incomes policybased on social agreements between enterprises, trade unions and Republics.However, the extent of the economic role Left to the Federation as a resultof the forthcoming constitutional reform, will be crucial to future develop-ments.

25. Further decentralization could lead to more distortion in resourceallocation. This distortion could result from the absence of capitalrationing based on agreed priorities, market criteria determining the priceof capital, a mechanism to reallocate surplus labor to labor-deficit areas,or incentives for transfers of capital to the poorer regions. The develop-ment of a capital market consistent with the Yugoslav system, and the en-couragement of capital and labor transfers between regions,are requirementsfor relieving these distortions.

26. The decrease in savings is likely to continue. This trend willaffect the GDP growth rate unless counterbalanced by a more efficient useof capital. For example, investment in labor- rather than capital-intensivesectors and activities could be encouraged by an increase in the price ofcapital (higher interest rates and reduced capital subsidies). The savingsdecline could be arrested, or at least moderated, by tax incentives, anefficient incomes policy, and better savings incentives and channels.

27. The size of the feasible import surplus is limited by its effects onthe size and atructure of the external debt, and on the debt service ratio.To avoid a further aggravation of debt problems, the Yugoslav authoritieswill have to keep the growth rate of impcrts, over the medium-run, at alevel slightly lower than that of exports. This would imply either bettermanagement of demand or stricter import ccntrols. Unless there is an im-provement in the tools of economic management, present trends towardsfurther foreign trade liberalization may force a choice between a lower GDPgrowth rate and further exchange rate adjustments. The present high growthrate of factor income receipts, which is expected to continue, and an increasein direct foreign invest:-.ent-tou1d both contribute to relaxation of thebalance of payments constraint and allow faster overall growth.

Capital Inflows

28. The major change in the composition of the capital inflow since1965 (which has averaged about $200 rillion, net, a year) has been thedecline in official loans and their replacement by suppliers' credits. Aidfrom official sources fell from about g5 percent of the net inflow in 1965

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to 23 percent in 1969. The shift to suppliersI credits as a consequence ofthe limited availability of official aid was assisted by measures whichdecreased the Federal Government's control of foreign trade and allowedcommercial banks to guarantee loans from abroad without government guarantee.

29. The role of Eastern European countries in the external aid made avail-able to Yugoslavia is amall. The principal source of official aid has beenthe United States, mainly through agricultural commodity credits. Thesecredits, which reached about $100 million in 1966, are presently beingrepaid: this has resulted in recent years, given the small amount of otherbilateral loans, in a small outflow of capital to bilateral sources. Inter-national loans on the other hand constituted a stable inflow. The WorldBank was the major source, contributing 34 percent to the net officialinflow and 11 percent to the total net inflow between 1965 and 1969.

30. An additional source of private foreign capital became availablethrough the 1967 law permitting direct investment by foreigners in Yugoslavia.Initial results were not as successful as Yugoslav authorities hoped andrevisions to the law are under consideration. Agreements totalling some$45 million in foreign currency contributions were concluded in 1968-69.

31. For the future, no difficulty is expected in financing the requiredcapital inflow in non-convertible currencies. New official loans in con-vertible currencies expected may result in a small gross inflow ($30 millionp.a.) in the medium-term. The gross inflow from multilateral sources shouldincrease between 1970 and 1976 from a level of about $40 million to about$80 million. Official sources would then provide, over the period, onlybetween 10 and 15 percent of the needed gross inflow.

32. Until now., Yugoslavia has been unable to make an official bond issue onthe world's capital markets,apparently due to unfamiliarity of the marketwith aunique economy in which Federal powers are diminishing. With modifications inthe law affecting foreign investment now being enacted, and with better know-ledge by investors of Yugoslavia's internal conditions, direct investment mayincrease from its present level to a net inflow of about $50 million p.a. by1976. On the other hand, Yugoslavia itself exports capital (as export credits)in an amount which roughly balances the present direct investment inflow.

33. Suppliers' credits would then have to fill the rising gap. Presentavailability of suppliers' credits is high, but the rate of interest has beenrising. However, further rapid increases in the size of the external debt andof the debt service ratio may eventually begin to affect foreign lenders. Pru-dent management will be required if the country is to avoid such difficultyin the future. The debt service ratio on total debt was 17 percent in 1970and is expected to increase to 20 percent in 1976, but to decline thereafter.Yugoslavia has favorable growth prospects, particularly for export earningsfrom the convertible currency areas, and remains creditworthy for Bank lending.

34. A report entitled "Current Economic Position and Prospects ofYugoslavia" (EMA-33a) dated May 14, 1971, is being circulated to the ExecutiveDirectors separately. A basic data sheet is attached.

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PAhT IV - THE ROLE OF THE BANK

35. Yugoslavia's development problems indicate that, in lending forhigh priority development projects, the Bank should try:

(a) to support structural refonrs in major sectors of theeconomy, and better coordination of develop-ment;

(b) to accelerate development in the lesser-developed regions,and

(c) to alleviate the shortage of convertible foreign exchange,a major constraint to economic growtuh, by providing a signi-ficant portion of the required inflow of external capital.

These objectives are consistent with the Bank's efforts in the past andthe political and economic events that have occurred in the intermediateperiod have only strengthened their importance.

36. The trend towards decentralization has considerably weakened thepossibilities for coordination of development. Even if market forcesbecame fully operative, there would still be an urgent need for cooperationin general economic and sectoral policies, especially those concerninginfrastructure. The Republics and Autonomous Provinces will play a largerrole in the economic decision-making process, and there is some evidencethat they are beginning to cooperate in such fieLds as infrastructure.The Bank could play a useful role in assisting country-wide coordinationand improving sectoral policies.

37. It is the Federal Governmentts policy to decrease the economicdifferences between the lesser developed regions, which account for 35 per-cernt of the countryts population, and the more advanced republics. However,estimates of the capital requirements of the lesser-developed regions arelacking. The present mechanisms (the Fund for Developing Regions and directbudgetary allocations) have not been able to transfer sufficient capitalfrom the richer to the poorer areas. The discussions that are presentlytaking place on the draft Five-Year Development Plan (1971-75) and on con-stitutional changes might draw attention to the problems of the lesserdeveloped regions, but there is little prospect that the capital flow tothese regions can be substantially increased. Yugoslavia's lack of capitalmobility and the limited powers of the Federal Government contribute tothe problem.

38. In view of the likelihood that no substantial increase in the flowof capital from domestic sources to the less developed regions can beachieved, the Yugoslavs have recently begun to discuss the possibility ofdirecting foreign capital towards these areas. The regions concerned arenot only short of capital but also of the administrative and professionalcapacity to prepare projects. In order to help in this effort the Bankmay have to expend considerable manpower in identifying, preparing andsupervising projects.

39. The shortage of convertible foreign exchange is still a majorimpediment to economic growth and substantial amounts of foreign capitalare needed. For the immediate future there is little prospect thatYugoslavia will be able to raise the required funds on the world's capitalmarkets or through bilateral aid. The Bank will therefore remain for thenext few years the major external contributor of long-term capital.

40. High priority projects in Yugoslavia, especially those designed toimprove infrastructure and accelerate development in the less developedregions, may have relatively low foreign exchange components due to therelatively advanced stage of Yugoslav industry and the increasing competi-tiveness of Yugoslav contractors. Were the Bank to confine its lendingto the foreign exchange costs of these projects, the desirable level ofBank investment in Yugoslavia could be achieved only by financing projectsof lesser priority or by spreading the lending over a large number of pro-jects. Scme local currency finanoding is, therefore, justified.

I4. The Bank could also try to assist Yugoslavia in raising capital framother sources. Already, the IFC-supported International Investment Corpo-ration for Yugoslavia (IICY) has enhanced the prospects for an increasedinflow of private foreign capital.

Future Operations

42. Given the objectives described above, lending to Yugoslavia couldbe concentrated on infrastructure, export-oriented industry, tourism andprojects in the less-developed regions. The choice of these foci of con-centration has an element of arbitrariness: the absorptive capacity forloans is virtually unlimited and in each sector of the economy suitableprojects could be identified without great difficulty. The sectors chosenhave several advantages: they are of crucial importance to future economicgrowth and most in need of assistance that goes beyond the provision offinance.

PART V - THE PROJECT

43. A report entitled "Appraisal of the Ibar Ilultipurpose WJater Project -Yugoslavia" (PU-58a) dated April 19, 1971 is attached. (No. 1).

44. The Province Kosovo in which the proposed project is located is theleast developed region in Yugoslavia with an average per capita income ofabout $170 or only one-third the national average. Its population growthrate of 2.8 percent is double that of the overall national rate and itsmain problems are high unemployment and underemployment. Expansion ofmineral-based industry and increased agricultural production are the mainvehicles for the development of the Province. The further expansion ofthe principal industries which have been developed primarily during thelast decade and are concentrated in the Kosovo plain, depends largely onincreased supplies of water. The Provincial Government, therefore, initiat-ed engineering studies ten years ago to determine the optimum developmentof the available water resources. The result of these studies is a masterplan to develop the principal rivers in the region, Ibar and Lepenac, toprovide water for industry, communities, irrigation and power generation.

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45. To implement this naster plan, the Provincial Assembly created in1967 a new entity, the Ibar-Lepenac Enterprise (ILE). ILE will have allcharacteristics of an enterprise under the Yugoslav system of workers'self-management. However, during the current phase it is being directedby a General Mahnager appointed by the ProvinLcial Goverrment. During con-struction, ILE will be directed by a Founders' Council. One-half of thetwelve members of this Council will be nominated by the Provincial Govern-ment; the other half will be elected by the workers. After completion of

construction, ILE will have a Workers' Council, like every other Yugoslaventerprise, wzhich will be elected by ILE's workers, and which will in turnappoint a Board of Directors to set policy to be implemented by the GeneralI'ianager appointed by the Board.

46. The proposed Ibar project would be the first phase in the implementa-tion of the master plan. The second phase, the Lepenac project, whichwould provide water mainly for irrigation, is not expected to start beforecompletion of the Ibar project in 1975. The Ibar project would provide awater supply of 8.8 m3 /sec. to industry and about 0.2 m3 /sec. to communi-ties, together wfith wvater to irrigate 30,000 hectares and generate 95 Gwhof peak power annually. Its main elements are the construction of two dams,a 34 111 hydroelectric plant, 147 km of main water conduits, two pumpingstations, irrigation and drainage networks, feeder roads and engineeringservices. The total cost of the project is estimated at $93.3 million.Related project facilities to be implemented without Bank assistance wouldcost about $8.9 miillion.

47. ILE wizlU be responsible for the construction of the project andoperate as an independent utility and a wholesaler of wlater and electricity.More than 70 percent of its estimated future revenue will be assured byfirm contracts with the main industrial users. ILE will gradually build upits staff at the time of project completion and be responsible for operationand maintenance of all project facilities except the hydroelectric plant.This plant will be operated by Kombinat Kosovo, a big mining and power plantand the main industrial customer, on the basis of a contract with ILE. Mostof ILE's permanent staff will be used for operation and maintenance of theirrigation system.

48. The economic rate of return of the whole Ibar project is estimated.at about 16 percent. To ensure that implementation of the individual com-ponents of the project is warranted, the incremental costs of the threemajor components (water supply, irrigation and power) and the combinationsthereof were conpared with their benefits. The analysis indicates thatinclusion of all proJect components, as proposed, is justified since therate of return on incremental costs and benefits in all cases is at least11.5 percent (for the irrigation component) and ranges up to 68 percent(for industrial water supply). Development of the Ibar river would be theleast costly solution to supplying the industrial demand for water, whichis expected to triple in the next 15 years. The provision of an adequateand dependable supply of unpolluted water to corDunities would contributeto improving sanitary conditions and public health in the project area.

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49. The intended irrigation of 30,000 ha. would cause the net valueof agricultural production from the area to rise from about $1.6 millionat present to about $10.4 million at full development in 1983 as a resultof higher cropping intensity and increased yields. The irrigation partof the project would benefit farmers in both the private (cultivating about78 percent of the land in the area) and public sectors. It would allowthose private sector farmers, who now support a farm population of about65,ooo to enter the cash enanomy from subsistence farming and reduce under-employment in the agricultural sector. Arrangements would be made betweenfarmers, service cooperatives and the large agricultural kombinat operat-ing in the region to improve integration of their activities with regardto supply, processing and marketing of produce. Assurances have been ob-tained from the Provincial Government that it will implement a program forthe coordination and expansion of agricultural extension services for allfarmers in the project area and take all appropriate measures, includingthe provision of the necessary funds, to ensure that these will have accessto credit, farm inputs and farm machinery services.

50. The Bank loan of $45 million would finance about $38.8 million or41.5 percent of project costs ($93.3 million) and about $6.2 million forinterest during construction. Depending on whether local or foreign con-tractors would carry out the project, the foreign exchange component inthe total project costs could range from 18 to 32 percent. Based on ex-perience with previous projects, it has been assumed in estimating theprobable foreign exchange component that the largest single civil worksceontract would be won by a foreign contractor and that Yugoslav contract-ors would win all other contracts. This would result in a foreign ex-change component of 25 percent or about $23.0 million. The proposed loanwould cover this $23 million of foreign expenditures, $6.2 million of in-terest on the Bank loan, and $15.8 million of local currency expenditures.Financing part of the local currency expenditures is justified for thereasons given in paragraph 40 above.

51. ILE's financing requirements for the project construction, whichwill not be met by the Bank loan, will be covered by a loan from the BankaKosova ($46.3 million), by a grant ($4.6 million) from -the Djerdap enter-prise for the construction of the Gazivode dam and from internal cash gene-ration ($7.4 million). The "Federal Fund for Financing Econoric Develop-ment of Eoonomically Under-developed Republicsand the Socialist AutonomousProvince Kosovo" is expected to be the principal source of funds for theloan from the Banka Kosova which will also finance any cost overruns- Thekey role of the Federal Fund in domestic economic development is generallyrecognized in Yugoslavia. In a period in which the Federal Governnenttsrole is being reduced, financing of the Fund is to continue at an increasedrate. DuLring the period 1966-70, a target of 1.85 percent of the SocialProduct was to be transferred by the Federal Government as a grant to theFund.

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The amount actually transferred during 1966-69 amounted to I'D 5,588 million($372 million equivalent) or about 1.25 percent of the Social Product. Thetarget for resource transfer through the Fund during 1971-75 has been in-creased to 1.94 percent of the Social Product but it is now proposed thatthis be increasingly done through long-term loans.

52. Contracts for civil works and for the supply of equipment would beawarded in accordance mith the Bank's guidelines on international competi-tive bidding. Domestic manufacturers of equipment would be accorded a mar-gin of preference for purposes of bid comparison which would be the existingrate of customs duty applicable to competing imports or 15 percent of c.i.f.costs, whichever is the lower.

I2-1T VI - L3GAL LTSTRU.ITi£S AND AUTHO?LITY

53. The draft Loan Agreement between the Socialist Federal Republic ofYugoslavia and the Bank, the draft Project Agreement between the Bank on theone hand, and the Province Kosovo and ILE on the other hand, the draft Lend-ers' Agreement between the Bank and the Banka Kosova, the Report of theCommittee provided for in Article III, section 4 (iii) of the Articles ofAgreement and the text of a Resolution approving t1he proposed loan are beingdistributed separately to the Executive Directors.

54. The draft Loan Agreement contains the Borrower's obligation to enterinto a Subsidiary Loan Agreement with ILE for the purpose of relending theproceeds of the loan. The substantive undertakings regarding the carryingout of the project by ILE are set forth in the Project Agreement which, inaddition, contains the Province Kosovo's obligations to carry out a numberof additiornal works and studies related to the project. The Lender's Agree-ment contains Banka Kosova's obligation to finance cost overruns as well asthe usual provisions on cooperation and exchange of information between theBank and the Banka Kosova as co-lenders. The execution of the SubsidiaryLoan Agreement, the execution of a loan agreement between Banka Kosova andILE on the financing of the project cost not covered by the loan, the exe-cution of a number of long-term power and water supply agreements betweenTIE and its industrial customers as well as the employment of engineeringconsultants by ILE will be conditions of effectiveness of the Loan Agreement.

55. I am satisfied that the proposed loan would comply with the Articlesof Agreement of the Bank.

PART VII - RECOMINDATION

56. I recommernd that the Executive Directors approve the proposed loan.

Robert S. AcNamaraAttachments PresidentMay 18, 1971 by J. Burke Knapp

YUGOSLAVIA ANNEY I

BASIC DATA

Area: 256,000 square kilometers

Population: 20.5 million (1970)Current growth rate: 0.9%Density per square kilometer: 80

Gross Domestic Product (at 1966 factor cost) 1968 1969 1970

Total (US $ billion) 8.4 9.1 9.6Rate of growth 3.3% 9.3% 4.7%Per capita GNP (US dollars) 510 575 625

Gross Domestic Product by Branch Percent1965 1970

Agriculture, forestry and fishing 23 21kining and Manufacturing 31 32Construction 10 11Transport and communications 7 8Trade and Banking 9 10Public services and defense 11 10Other sectors 9 8

Balance of Payments (US $ million) 197c/a Increase (p.a.) 1966-1970

Commodity exports (f.o.b.) 1,670 10Commodity imports (c.i.f.) 2,845 17Net invisibles (including transfers) 805 25Current account balance - 370Net capital inflow 242Change in reserves (increase = - ) 128

Investment and Savings (% of GIlP) 1969 1965-69 (average)

Gross investment 30 32National savings 28 30Savings gap 2 2

Money and Credit 1970 (Sept.) Rate of Change (percent)D billion 1965 1969 1970 (Jan.-Sept.)

Money supply 39 + 24 + 12 + 21Time and restricted deposits 29 + 11 + 18 + 6Short-term credit 62 + 12 + 16 + 12

(Pr oducers 0 + 3 +9Prices (Retail + 6 + 7 + 10

/a Preliminary

ANNEX IIPage 2

Public Sector Finances 1970 1969 1970(D billion) l=9 6g69-

Budgetary receipts 27.2 + 12% + 15%Budgetary expenditures 22.3 + 13% + 15%

Balance + 4.9 + 9% +17%Extrabudgetary receipts 29.5 + 20% + 17do(including social security funds)

Extrabudgetary expeniditures 33.4 + 19% + 15%Balance - 3.9 - 12%o - 5%

Gross Convertible Reserves (US $ million) 1969 1970(end of yea-r

Total 342 280In months of commodity importsfrom the convertible currency area 2.7 1.6

fvlF Position (US $ million) December 31, 1970

Quota 207Drawings outstanding 40

Bank Position (US $ million) Deceaber 31, 1970

Total loans (less cancellations) h75Repayments 53

Total loans outstanding TZof which: undisbursed 174

Total disbursed and outstanding 24dof which: to Bank 242

to others 6

External Debt Position (US $ million)(in convertible currencies only)

Total debt outstanding on December 31, 1969(including undisbursed) 2,268

Estimated debt service payments (1970) 475Ratio of debt service to gross foreignexchange earnings (1970) 22

Exchange rate: Before January 23, 1971:

US$.' = D 12.5D = 8 US cents

Since January 23, 1971:

US$ 1 D 15.0D 1 = 6.67 US cents

May 18, 1971