World Bank Document · document of the world bank report no 22225 az project appraisal document ona proposed credit in the amount of sdr 4.3 million (us$5.4 million equivalent)

Document ofThe World Bank

REPORT No 22225 AZ

PROJECT APPRAISAL DOCUMENT

ONA

PROPOSED CREDIT

IN THE AMOUNT OF SDR 4.3 MILLION(US$5.4 MILLION EQUIVALENT)

TO THE AZERBAIJAN REPUBLIC

FOR A

FINANCIAL SECTOR TECHNICAL ASSISTANCE

PROJECT

Private and Financial Sector DevelopmentEurope and Central Asia Region

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CURRENCY EQUIVALENTS

(Exchange Rate Effective February 22, 2001)

Currency Unit = Manat1,000 Manat = US$0.218

US$1 = 4,587 Manat

FISCAL YEARJanuary 1 - Decemnber 31

ABBREVIATIONS AND ACRONYMS

AIB - Agroprom BankANB - Azerbaijan National BankAPL - Adaptable Program LoanAZM - Azeri ManatsBUSbank - United Universal Joint Stock BankCAS - Country Assistance StrategyDCA - Development Credit AgreementEBRD - European Bank for Reconstruction and DevelopmentFSTA - Financial Sector Technical AssistanceGDP - Gross Domestic ProductGoA - Govermnent of AzerbaijanlAS - International Accounting StandardsIBA - International Bank of AzerbaijanIBTA - Institutional Building Technical AssistanceIDA - International Development AgencyIMF - International Monetary FundIT - Information TechnologyLIL - Learning and Innovation LoanNBFI - Non-Bank Financial InstitutionMoF - Ministry of FinancePIB - Prominvest BankPIU - Project Implementation UnitPMR - Project Management ReportPPF - Project Preparation FacilityPRGF - Poverty Reduction and Growth FacilityPSR - Public Sector ReformRTGS - Real Time Gross SettlementSAC - Structural Adjustment CreditSOE - Statement of ExpenditureSvB - Savings BankTA - Technical Assistance

Vice President: Johamnes LinnCountry Director Judy O'Connor

Sector Manager/Director: Alexander Fleming/Paul SiegelbaumTask Team Leader: Rochelle Hilton

AZERBAIJANFINANCIAL SECrOR TECHNICAL ASSISTANCE

CONTENTS

A. Project Development Objective Page

1. Project development objective 22. Key performance indicators 2

B. Strategic Context

1. Sector-related Country Assistance Strategy (CAS) goal supported by the project 32. Main sector issues and Government strategy 43. Sector issues to be addressed by the project and strategic choices 6

C. Project Description Summary

1. Project components 72. Key policy and institutional reforms supported by the project 83. Benefits and target population 84. Institutional and implementation arrangements 8

D. Project Rationale

1. Project alternatives considered and reasons for rejection 102. Major related projects financed by the Bank and other development agencies 113. Lessons learned and reflected in proposed project design 114. Indications of borrower commitment and ownership 125. Value added of Bank support in this project 12

E. Summary Project Analysis

1. Economic 132. Financial 133. Technical 134. Institutional 135. Environmental 146. Social 157. Safeguard Policies 16

F. Sustainability and Risks

1. Sustainability 162. Critical risks 163. Possible controversial aspects 17

G. Main Conditions

1. Effectiveness Condition 182. Other 18

H. Readiness for Implementation 18

I. Compliance with Bank Policies 18

Annexes

Annex 1: Project Design Summary 20Annex 2: Detailed Project Description 24Annex 3: Estimated Project Costs 27Annex 4: Cost Benefit Analysis Summary 28Annex 5: Financial Summary 29Annex 6: Procurement and Disbursement Arrangements 30Annex 7: Project Processing Schedule 37Annex 8: Documents in the Project File 38Annex 9: Statement of Loans and Credits 39Annex 10: Country at a Glance 41

MAP(S)

AZERBAIJAN

Financial Sector Technical Assistance

Project Appraisal Document

Europe and Central Asia RegionECSPF

Date: May 15,2001 Team Leader: Rochelle HiltonCountry Director: Judy O'Connor Sector Director: Paul SiegelbaumProject ID: P070973 Sector(s): FS - Financial Sector DevelopmentLending Instrument: Technical Assistance Loan (TAL) Theme(s): Financial Sector

Poverty Targeted Intervention: NProgram Financing Data[ I Loan [Xi Credit [ I Grant [ I Guarantee [ ] Other:

For Loans/CreditslOthers:Amount (US$m): 5.4 million equivalent (SDR 4.3 million)

Proposed Terms (IDA): Standard CreditGrace period (years): 10 Years to maturity: 35Commitment fee: 0.50 Service charge: 0.75%Financing Plan: Source Local Foreign TotalBORROWER 0.25 0.00 0.25IDA 0.00 5.40 5.40OTHER SOURCES OF BORROWING COUNTRY 0.60 0.00 0.60

Total: 0.85 5.40 6.25

Borrower: AZERBAIJANResponsible agency: MINISTRY OF FINANCE AND AZERBAIJAN NATIONAL BANKAZERBAIJAN NATIONAL BANK, Project Management UnitAddress: Baku - 370070, 32 R. Behbudov Street, AzerbaijanContact Person: Rustam TahirovTel: 994 12 973 970 Fax: 994 12 973 970 Email: [email protected]

Other Agency(ies):MINISTRY OF FINANCEAddress: Baku, AzerbaijanContact Person: Yashar Mamedov, Director of Internal Debt DepartmentTel: 994 12 93 93 44 Fax: 994 12 98 79 69 Email:Estimated disbursements Bank FYiUSSM):

FY 2002 2003 2004 2005 2006Annual 0.50 1.20 1.70 1.60 0.40

Cumulative 0.50 1.70 3.40 5.00 5.40

Project implementation period: 4 yearsExpected effectiveness date: 10/15/2001 Expected closing date: 02/28/2006

A. Project Development Objective

1. Project development objective: (see Annex 1)

Since 1996, the Government of Azerbaijan has been trying to implement a strategy which includes therestructuring and divestiture of the state-owned banks, as well as the development of financial sectorinfrastructure and strengthening of the regulatory and supervisory framework. Progress has been made insome areas of banking sector reform since the two-tier banking system was created in 1992. TheAzerbaijan National Bank (ANB) has been proactive in the area of reforr, has undertaken its ownrestructuring, has strengthened its banking supervision skills and is in the process of looking at thevulnerability of private banks. An effort was made, with support from the IDA-financed StructuralAdjustment Credit (SAC) and Institution Building Technical Assistance Project (IBTA I), to restructureand turn around three state-owned banks (Agroprom, Prominvest and Savings Bank). However, despitethese efforts Agroprom (AIB) and Prominvest (PIB) continued to run operating losses and had littlefranchise value. They continued to suffer from poor management, internal controls and governance andremained deeply insolvent with bad loan portfolios. These problems were also endemic to many of theprivate banks. Furthermore, significant weaknesses remained in the financial sector infrastructure, legalframework supporting banking activity and banking supervision. As a result, progress in the developmentand improvement of financial services and financial intermediation has been slow.

By late 1999, the banking sector was showing signs of significant stress, as revealed by widespreadoperational losses, lack of liquidity and insufficiency of capital. The resulting low level of confidence inbanks was restricting their ability to attract the savings of individuals and enterprises, as well as theprovision of lending, payment and other banking services to support economic growth. The Governmentrecognized that more drastic actions than previously initiated were needed to turn around the financialsector. As a consequence, since late 1999, the Government has intensified its efforts to address theproblems and has requested further support from the World Bank and the IMF in this regard. In support ofthe Government's intensified efforts, the Bank and the IMF jointly drafted a financial sector strategy anddiscussed it with the Government.

The Government has already initiated actions to implement this strategy, including moving ahead with avery difficult and politically sensitive decision to close down AIB, PIB and the Savings Bank (SvB). TheUnited Universal Joint Stock Bank (BUSbank) was created from the good assets of the three entities,primarily those of the SvB, and AIB has been transformed into Agrarcredit (a non-bank credit institution)which will deal with the collection of bad loans and handle, on an agency basis, some limnited lendingactivities (see Section 2 for a discussion of the Government's strategy).

The main objective of the project is to provide technical assistance to the Government of Azerbaijan tosupport further implementation of its financial sector development strategy. This technical assistance willfocus on: (i) bank restructuring and divestiture; and (ii) enhancement of banking infrastructure and bankingsupervision.

2. Key performance indicators: (see Annex 1)

The proposed project will support the Government's program to reform the banking sector. Keyperformance indicators are ambitious and may not all need to be met for the project to be successful andachieve its objectives. The key performance indicators for the sector would be:* Strengthened financial sector infrastructure* Reduction in the number of state-owned banks and consolidation of commercial banks to strengthen

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their capital base and operational effectiveness

Performance indicators relating to the achievement of the project objectives would include:* Finalization of the closure of the three state-owned banks - ALB, PJIB and SvB (already accomplished)* Enhancement of the operational structure of BUSbank, leading to its eventual privatization* Enhancement of ANB's supervisory capacity, particularly on-site inspection* Implementation of an efficient payments system* Introduction of LAS-based national accounting standards for commercial banks

Performance indicators relating to component outputs would include:* Withdrawal of the banking license for AIB, in addition to PIB and SvB (already accomplished)* Completion of the transfer of selected assets and liabilities to BUSbank and to the loan recovery unit,

based on a portfolio review to assess the collectibility of the bad loans* Implementation of an agreed business strategy for BUSbank to strengthen its operational structure, in

accordance with the Memorandum of Understanding agreed with the Ministry of Finance, ANB3 andBUSbank

* Initiation of the privatization process for BUSbank* Establishment of the legal framework to support a card-based small value payment system* Implementation of a small value payments system* Establishment of Azeri National Accounting Standards compatible with LAS* Passage of the required laws and regulations to enable the administration of the above accounting

standards* Financial reporting by commercial banks based on the standards prescribed by ANB* Completion by ANB of the manual of procedures and guidelines for accounting practices* Completion of study assessing the need for and design of a collateral registry system* Development and strengthening of banking supervision on-site inspection procedures and guidelinese Review and revision of the laws and supporting regulations to enhance ANB's supervisory capacity

B. Strategic Context1. Sector-related Country Assistance Strategy (CAS) goal supported by the project: (see Annex 1)Document number: IDA/R99-157/1 (IFC-145/1) Date of latest CAS discussion: 9/14/99

The IDA assistance strategy supports the Government's development agenda of restoring sustained growthand alleviating poverty. The project is consistent with the Govermnent's strategy and will support one ofthe three priorities stated in the Country Assistance Strategy, namely promoting sustainable private sectorgrowth as a means to reducing unemployment and poverty in a sustainable manner. A well-functioningfinancial sector is essential for private sector-led growth. The project would help establish a bankingsystem that can efficiently mobilize resources and provide financial services, especially to the more remoteand rural areas of the country. To support this goal, the project will provide technical assistance to:

* reduce state ownership of the banling system, with a view to preventing the accrual of additionallosses, restoring confidence in the banking sector and addressing moral hazard issues;

* enhance financial infrastructure, with particular focus on the development of an efficient paymentssystem and the introduction of IAS-based national accounting standards;

* enhance the supervision capacity of the ANB;* strengthen the legal and regulatory framework necessary for the development and diversification of

private banking activities and services; and* promote a competitive environment, encouraging the entry of private foreign investors or joint venture

financial institutions, and raise the level of skills of the overall financial sector.

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2. Main sector issues and Government strategy:

The banking sector of Azerbaijan is continuing to develop. The sector is relatively small, with total assetsof about US$880 million (26 percent of GDP) in September 2000. Until early in 2000, four state-ownedbanks, AIB, PIB, SvB and the International Bank of Azerbaijan (IBA), dominated the market. Thenon-performing loans accounted for well over 90 percent of portfolios of AIB and PIB and, in spite ofconsecutive recapitalizations, they continued to run operating losses. In addition, the banking sector hasthe following characteristics:

* until earlier this year, the payment and settlement systems were rudimentary, with interbank paymentscarried out primarily on a physical basis. The inefficiency of the payments system did not provide thedegree of confidence required to support the development of the financial sector and constitutes anadditional cost of financing for the private sector. A Real Time Gross Settlement system startedoperating in February 2001, with encouraging initial results. This system handles large payments andaction now needs to be focused on the settlement of small value (retail) payments;

* the private commercial banking network consists of about 60 banks, most of which are seriouslyunder-capitalized and play a limited role (less than ten percent of the total sector);

* although the ANB and the Government intend to encourage the opening of foreign banks, this presenceis currently limited;

* with assistance from the IMF, banking supervision and banking regulation have been strengthened butmore needs to be done, particularly to improve the clarity and transparency of rules and strengthenenforcement;

_ although an International Accounting Standards (IAS)-based chart of accounts for banks was preparedand introduced in early 2000, lAS-based national accounting standards have not yet been completed.

The Government's strategy

The Government and the ANB, in close cooperation with both the Bank and the IMF, adopted, in late 1999,a comprehensive strategy for systemic banking sector reform. The strategy (summarized in theGovernnent's letter to the Bank dated April 20, 2001) is aimed at three broad areas: (a) a more effectiveapproach to restructuring and divestiture of the state-owned banks, (b) a more systematic focus onproblems in the private banking sector, and (c) actions to identify more clearly and address weaknesses inthe broad infrastructure supporting banking activity. The main elements of this strategy include: (a)effective closure of AIB and PIB through a limited merger of the viable parts of ATB, SvB and PIB into anew bank; (b) strengthening and development of the operational structure of the new bank with a view to itseventual privatization; (c) work-out of the loan portfolios of AIB, SvB and PIB, through the establishmentof a loan recovery mechanism, if deemed necessary; (d) restructuring, consolidation and strengthening ofthe private commercial banks; (e) broadening of the role of foreign investors as a source of capital,technology and know-how transfer; (f) enhancing of the legal and regulatory framework, resources andcapacity for bank supervision and regulation; (g) strengthening of the financial infrastructure (accounting,auditing, payments system) necessary for supporting a sound, efficient banking system. The Government'slong-term goal is to have a sound, efficient private banking system, which would support the needs of afunctioning market economy.

Recognizing that past efforts to improve the performance of the state-owned banks did not produce thedesired results and, even if additional recapitalization and operational restructuring of AMB and PIB weremade, their long-term viability was doubtful, the Government recently accelerated implementation of the

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above strategy and has achieved significant results. The BUSbank was created in February 2000 from themerger of the viable parts of AIB, SvB and PIB. As part of this process and consistent with the strategy,the banking licenses of PIB and SvB were withdrawn in July 2000. The banking license of AIB wasinitially limited and was subsequently withdrawn, effective April 1, 2001. A new limited license was issuedto BUSbank according to which the bank is allowed only to collect deposits, perform limited foreignexchange activities, invest in government securities and perforn cash payment services for the SocialProtection and Pension Funds and other budgetary entities. The terms of the license firther prohibitBUSbank from engaging in lending activities for two years, so that it will, in effect, operate as a narrowbank. Meanwhile, the Minister of Finance (MoF), as the sole owner of the BUSbank, has issued bonds, fora total of AZM 52 billion, to meet BUSbank's minimum capital requirement according to the existinglegislation, although a further contribution may be needed to bring the bank into full compliance withANB's capital requirements. Over the next two years, the operational structure of the BUSbank will bedeveloped and an effective lending capacity established to help strengthen the bank and improve itsefficiency, introduce competition into the banking sector, and create the conditions for the eventualprivatization of the bank through the sale of a controlling share to a strategic investor. A Memorandum ofUnderstanding defining the activities of BUSbank, prepared in cooperation with the World Bank and theIMF, was signed in April 2001 by the Minister of Finance, the Governor of the ANB and the managementof BUSbank. Efforts to strengthen the BUSbank are expected to include the upgrading of its internalmanagement and operational systems, and further rationalization to strengthen its operational structure.The eventual privatization of the BUSbank will require additional planning and effort with emphasis onavoiding a negative impact on depositors' confidence and the Government's macroeconomic managementpolicies and practices. The proposed project will support the Government and BUSbank's management incarrying out this program.

Actions will also need to be initiated to carry out the disposition and liquidation of the remaining financialand physical assets of the merged banks. In this regard, the former AIB has been transformed into anon-bank credit institution (Agrarcredit). Legal actions are in process to complete the establishment ofAgrarcredit, which will have two functions: (i) the collection of bad loans from the former Agroprom,Prominvest and Savings Banks; and (ii) the carrying out of the agency function for specific agriculturallending projects of international financial institutions. The Government will establish a loan recovery unitwithin Agrarcredit to undertake the aggressive collection of the bad loans, with a view to maximizing netrecoveries. However, at end-October 2000, the Government passed legislation on debt relief, under theterns of which state enterprise debt incurred prior to October 1, 2000, could be forgiven. This legislationcould substantially reduce the magnitude of the non-performing loans to be transferred to this unit althoughthe full impact of its provisions has not yet been assessed. To this end, the Government intends to carryout a study to assess the collectibility of the non-performing loan portfolios of AIB, PIB and SvB and,based on the findings of the study and taking into account the impact of the new legislation, will decide onthe operational structure of this unit. The proposed project will provide the institutional, legal andoperational support for the creation and start up of this unit, which would have a limited life.

The Government's strategy also encompasses strengthening banking supervision and regulations,improving the legal framework, and providing the financial infrastructure, necessary for the development ofprivate banking. Some progress has been made in each of these areas. The IMF has been providingextensive support to the ANB for off- and on-site supervision, but further assistance is needed, particularlyto improve ANB's on-site inspection capacity. The proposed project would support the strengthening ofbanking supervision. With regard to strengthening financial infrastructure, including the payments systemand accounting and audits, a new chart of accounts that conforms with International Accounting Standardshas been developed for the banking sector. In addition, implementation (with support from the ongoingIDA-financed Institution Building Technical Assistance Project - IBTA I) of a modern payments system

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(Real Time Gross Settlement - RTGS) system and a core general ledger system are underway. Substantialwork remains to be done to develop and introduce national accounting standards and procedures inconformity with IAS so that the new chart of accounts can be effectively implemented and transparency ofthe banking system improved, to complete the payment system reform and to expand ANB's general ledgersystem. The Government is also envisioning the development of a collateral registry system to helpimprove effectiveness and cost efficiency in delivering secured lending services to the private sector. Theproposed project will provide support for these activities.

3. Sector issues to be addressed by the project and strategic choices:

The proposed project will support the Government in its effort to implement the above agenda of reforms.The technical assistance is designed to ensure that adequate resources are in place in a timely manner tofacilitate the continued implementation of the Government's financial sector reform program.

The political decision has been made to establish the loan recovery mechanism within Agrarcredit. Theoperations and scope of the activities of this unit will depend on the findings of a portfolio review to becarried out by outside experts, and taking into account the impact of the recent legislation on Debt ReliefThe technical assistance needed for this unit could be limited, depending on the findings of this assessment.In the event that the funding allocated for this purpose is not needed, it could be used for otherproject-related activities. Furthermore, the eventual privatization of this unit could be considered duringproject implementation.

The authorities are concerned that appropriate arrangements should be put in place to provide rural credit,particularly in view of the liquidation of AIB. However, as AIB had not been servicing the rural populationin the past (since its basic focus was on funding large cooperatives and state farms), its closure will haveno adverse impact. Furthermore, the issue of the availability of credit to the rural sector is being addressedunder other IDA-financed operations: (i) the recently approved Agricultural Development and CreditProject, which is about to start up, would help create sustainable funding structures, such as creditcooperatives and village banks; and (ii) arrangements are underway to ensure that the agency function forlines of rural credit that a.e being provided under the Farm Privatization Project remains with Agrarcredit.In this regard, a study has recently been completed which indicates that this institution could recoversufficient operating costs to make retaining this function sustainable. Specific activities for rural credit are,therefore, not included in the proposed operation.

The privatization of the International Bank of Azerbaijan (IBA) has been part of the Government'sfinancial sector strategy for some time, since IBA's timely and proper privatization is essential for thefuture development of the Azeri banking sector. Currently around 49 percent of IBA's shares are held byprivate entities. The authorities have indicated their intention to privatize the 51 percent that remain inGovernment hands and have issued a Presidential Decree outlining the plan for this privatization.According to this plan, 20 percent of the shares would be sold to a fit and proper foreign strategicinvestor(s), including IFis, a little over 25 percent would be sold to the public at cash auctions, and 5percent would be kept by the Government The European Bank for Reconstruction and Development(EBRD) has been providing support for the IBA and had indicated its interest in taking an equity share inthis bank. Discussions between the Government and EBRD are continuing, including, inter alia, questionsrelating to the privatization formula and the percentage interests that would be sold to the strategic investorand to the public. The final decision of EBRD on its involvement in the transaction has not yet been taken.The privatization of IBA, which entails the transfer of majority ownership and/or control to a fit and properinvestor(s), is an important issue for the future of the banking sector. This issue is being actively pursuedby the IMF under its program. In view of the IMF's and EBRD's involvement, and as a technical

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assistance project is not an appropriate vehicle for dealing with policy conditionalities, issues relating toIBA and its privatization have not been included in this operation.

As the design of the collateral registry system is not yet defined, implementation of this component will berealized in phases, the first of which will be supported by the project. This would comprise an initialassessment to: (i) verify that there is sufficient demand from all interested parties for credit using movableproperty as security; (ii) verify that an appropriate legal framework is in place; and (iii) establish that theGovernment is willing to provide its commitment for implementation, with a clear ownership structure.Subsequent phases provide for revisions to the legal framework and preparations for the operation of acollateral registry systern, followed by implementation of the system. If sufficient funding becomesavailable under the Credit, consideration could be given to supporting further work in this area.

C. Project Description Summary

1. Project components (see Annex 2 for a detailed description and Annex 3 for a detailed costbreakdown):

The proposed project is divided into two main parts: (i) support to the Ministry of Finance to implement itsprogram for bank restructuring and divestiture, including assistance to strengthen and prepare theBUSbank for its eventual privatization, and to establish a loan recovery mechanism within Agrarcredit, thenon-bank credit institution which has been created out of the former AIB; and (ii) support to the ANB,particularly to strengthen banking supervision and banking sector infrastructure. It also includes assistanceto support project management and administration.

Indicative Bank- % of-- . - - ; Coiponert Sector Costs % of financing Bank-

(US$M) Total (US$M) financingMinistry of Finance: 1.96 31.4 1.70 31.5- Advisor to Ministry of Finance- Assistance to BUSbank- Assistance to Agrarcredit

Azerbaijan National Bank: 3.97 63.5 3.40 63.0- Advisory services for seniormanagement and IT- Banking supervision- Financial sector infrastructure

Project Management 0.32 5.1 0.30 5.6

Total Project Costs 6.25 100.0 5.40 100.0

Front-end fee 0.00 0.0 0.00 0.0Total Financing Required 6.25 100.0 5.40 100.0

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2. Key policy and institutional reforms supported by the project:

The proposed project will support the Government's program to reform the banking sector in order toencourage improvement of financial intermediation and diversification of services. It will focus specificallyon the rationalization and strengthening of commercial banks, strengthening of financial sectorinfrastructure, and strengthening bank supervision. Although this is not a policy-based operation, it isdesigned to complement the program of financial sector reform that the IMF is discussing with theGovernment.

3. Benefits and target population:

The project aims to minimize the fiscal cost of the banking sector reform program by curtailing theloss-making operations of the state-owned banks and by taking actions leading to divestiture, includinginitiating a privatization program. Strengthening banking sector infrastructure, prudential bankingprocedures and practices, legal and judicial environment, accounting practices and encouraging thedevelopment of sound private banks will, in the medium-term, help increase financial intermediation, and,ultimately, place the banking sector on a sounder footing. A well-functioning, transparent andcost-efficient financial environment is an essential element for private sector development, and provides thepoor with access to credit and other financial services. The benefits from this project will help contributeto the authorities' objectives to achieve this long-term goal.

4. Institutional and implementation arrangements:

The project would be implemented over about 4 years. A mid-term review will be carried out by October31, 2003.

Details of the implementation arrangements were agreed during appraisal and are described in the ProjectImplementation Plan. It has been agreed that the ANB will be responsible for overall project coordinationand administration. In this regard, the deputy governor responsible for banking supervision has beenassigned responsibility for general oversight of the project. To handle the day-to-day project management,a Project Management Unit (PMU) has been established in the ANB, to take care of administration andimplementation activities. The PMU will report to and be under the general supervision of the Director ofthe Foreign Relations Department of ANB. The PMU is staffed by two procurement officers, one of whomwill head the Unit, a financial management specialist, from the Accounting Department of the ANB, and anadministrative assistant/office manager. The financial management specialist will also be supported, on apart-time basis, by another officer from the Accounting Department who will handle disbursements of theproject funds. Additional support will be provided under the project for procurement advisory services.

Technical responsibility for the project components will rest with the Ministry of Finance and the ANB, asappropriate. The PMU will liaise closely with the various beneficiaries, including BUSbank andAgrarcredit, to ensure that project activities are handled effectively, in a timely fashion and in accordancewith World Bank requirements, as well as that adequate information is provided for reporting purposes.The proposed project will provide funding, during the frst year of implementation, to cover limnitedincremental operating costs required for the establishment of the financial management system on theexisting hardware of the PMU and training for PMU staff in procurement, project and financialmanagement under World Bank financed projects. All other operating costs, including staff salaries, officespace, utilities, office supplies, and communication costs will be covered by the ANB.

The Ministry of Finance will be responsible, from a technical point of view, for overseeing the componentsrelated to the BUSbank and Agrarcredit. The management of these two entities will be responsible for the

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day-to-day irnplementation of the assistance for which they are the primary beneficiaries. The MoF hasdesignated the Director of the Internal Debt Department as the main counterpart for the project withresponsibility for implementation of issues relating to these components, in close coordination withBUSbank and Agrarcredit. This official will report directly to the Minister on project-related issues andwill liaise closely with the PMU to facilitate effective project implementation and management.

ANB will be responsible for the financial and banking infrastructure component, including the developmentand implementation of LAS compatible accounting standards for banks, improving the payments system,augmenting the general ledger system and assessing the needs for a collateral registry system, as well as forthe banking supervision component. Project managernent would also be the overall responsibility of theANB.

Retroactive fnancing may be required to ensure the early establishment of the financial managementsystem, as well as the timely appointment of the advisory services for BUSbank and to review the optionsfor the small value payments system.

Project Financial Management: A project specific financial management system, similar to one that isbeing used for other IDA-financed projects in Azerbaijan, has been established in the PMU. TOR for thisassignment were agreed with the PMU and can be found in the PIP. The accounting system will bemaintained in accordance with intemational standards, based on principles of double-entry bookkeeping.The Bank infomied the PMU of Bank requirements on maintaining accounts and records in accordancewith Intemational Accounting Standards (IAS). This system that has been acquired is capable of providingaccurate and timely information regarding project resources and expenditures, including planning, internalcontrols, accounting and financial reporting and audit arrangements relating to the project. The projectaccounts will be based on a Chart of Accounts drawn-up by the appraisal mission with the assistance of thePMU. The Chart of Accounts will accommodate the proposed project to capture sources and uses offunds, assets and liabilities in sufficient detail to satisfy PMR-based reporting requirements. Cash basisaccounting will be applied. The proposed system will, in addition to producing periodic and cumulativebudgeted and actual expenditures, link the financial data to measures of output and procurement activitiesof the project.

Disbursement arrangements under the project will commence on the basis of traditional disbursementmethods (e.g., direct payments, replenishments of the Special Account on the basis of SOEs and fulldocunentation). Once the PMU's capacity and experience has improved with regard to internal controls,implementation, budgeting and forecasting, the ANB/PMU, in consultation with the Bank, will decide onthe timing and transition to the use of the quarterly PMRs for disbursement purposes. It is expected thatPMU will have the capacity to prepare the first full set of PMRs by March 31, 2002. The PMU willmaintain the Special Account in the International Bank of Azerbaijan (IBA) for the disbursement of Creditfunds. An independent accredited auditing firm will audit the accounts annually.

Internal Controls: Operational procedures and guidelines for project financial management are beingdocumented in an Operational Manual, which is being prepared by the PMU and which encompasses alllevels of project management and administration. The Bank will review the drft Manual and give itscomments. The PMU will incorporate these comments, as well as comments from the Ministry of Finance,and finalize the manual prior to Credit Effectiveness. The Manual will include financial managementprocedures and staffing, identification of accounting and auditing standards and procedures used for theproject, project reporting and monitoring, procurement procedures, procedures for cash management andformats of project management reports. Further actions to strengthen project financial management areshown in Annex 6.

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The PMU will prepare project information for all components and prepare quarterly Project ManagementReports (PMRs) including a financial report, project progress report and procurement management report,for project monitoring and reporting for submission to the Bank. An outline of reports contained in thesystem and the format for the PMRs, which were provided to the PMU during appraisal, have beendiscussed and agreed

Auditing Arrangements: The PMU will appoint independent auditors under terms of reference (TOR)acceptable to the Bank. The auditors selected for the Project are required to be members of theIntemational Federation of Accountants (IFAC). Audited Project Financial Statements will be submitted tothe Bank with the audit report six months after end of each year audited. The ANB has already appointedauditors to carry out the 2001 audit of ANB's financial statements. During negotiations, it was agreed thatthe same auditors, who were selected on a competitive basis, will be retained to audit the project accountsfor the Year 2001. The cost of the annual project audit will be financed from the proposed IDA Credit.

An Implementation Completion Report and plan for the future operation of the project will be prepared bythe Borrower within six months after the completion of the Project. Agreement was reached dunngnegotiations on the above reporting requirements, submission schedule and procedures.

D. Project Rationale

1. Project alternatives considered and reasons for rejection:

Preparation of the proposed Financial Sector Technical Assistance (FSTA) Project started as a financialsector component of the proposed Second Institutional Building Technical Assistance Project (IBTA II),which focuses on public administration reform and institution building. Given the multiple objectives andcomplexity of the proposed IBTA II, as well as the need to link the IBTA II to overall progress in theimplementation of the Govemrnment's public sector reform agenda, it was decided that it would be moreappropriate to separate the financial sector work from that project. The FSTA Project will provide crucialtechnical assistance to the banking sector and also complements the IMF's financial sector program. Afree-standing financial sector operation will enable this essential program to move ahead even if there aredelays in irnplementing the politically sensitive public sector reform programL

Financing through either a Leaming and Innovation Loan (LIL) or an Adaptable Program Loan (APL) wasnot considered to be an appropriate instrument for this operation. The operation does not meet the criteriafor a LIL since the objective of the project is not to build institutional capacity in preparation for alarge-scale operation, it is not of a pilot nature and the proposed Credit exceeds the current limit for LlLs.The APL was also not considered a suitable instrument. Although a comprehensive approach in providingassistance for the implementation of banking sector reform is needed, it is not considered appropriate tophase the technical assistance. This is true in spite of the fact that, given the ambitious nature of theprogram, the degree of success achieved in all areas included in the project is likely to be uneven.

The possibility of using donor financing for selected components was also explored but the availability ofalternative sources of financing is limited. Flexibility is being built into this project to allow funds to betargeted to alternative project-related activities, particularly if donor funding subsequently becomesavailable for any component in a timely manner.

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2. Major related projects financed by the Bank and/or other development agencies (completed,ongoing and planned).

Latest SupervisionSector Issue Project (PSR) Ratings

(Bank-financed projects only)Implementation Development

Bank-financed Progress IP) Objective (DO)Policy-based operation Structural Adjustment Credit S S

(SAC)Public and financial sector TA Institutional Building Technical S S

Assistance Project (IBTA I)Public sector TA IBTA II (under preparation)

Other development agenciesIMF PRGF

Payments SystemBanking SupervisionAccounting Reform

UNDP Preparation of the Chart ofAccounts

EU - TACIS Bankers Training Center

IP/DO Ratings: HS (Highly Satisfactory), S (Satisfactory), U (Unsatisfactory), HU (Highly Unsatisfactory)

3. Lessons learned and reflected in the project design:

Technical assistance projects have a mixed performance record both within the Bank Group and in theECA Region. Experience, including that gained from the implementation of the IBTA Project, has beentaken into account in the design of the proposed project. The main lessons learned and actions taken aresummarized below:

(i) The main element of success in technical assistance is the commitment and ownership of the relevantstakeholder, at both the design and implementation stage. Experience gained from the IBTA Project alsosuggests that slow implementation of reform affects the development of the institutions supporting thereform program. Preparation of the FSTA Project has proceeded only after the strong commitment of boththe highest levels of Government and the ANB was clearly demonstrated and the actions required toimplement the financial sector reform strategy initiated. To reinforce this commitment, the Government haswritten a letter to the Bank outlining its plans and vision for the development of the banking sector (seeSection 4). This letter will provide the basis for exiting from the project, if needed, in the event that theGovernment does not follow through with the implementation of the reform program.

(ii) Earlier lessons point to the desirability of retaining a degree of flexibility in the project to allowadjustments to respond to changing priorities within the overall framework of the operation. If theimplementation period is lengthy, there is a risk that individual priorities become less relevant. Tomaintain the desired flexibility, activities for the first year of the project will be agreed in detail, otheractivities will be refined as part of project supervision. To avoid a lengthy implementation period, the

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project is designed to allow the program to be completed in about three years, with a little more than oneadditional year to provide for implementation delays. This contingency is realistic given the ambitiousnessof the refonn program supported by the project and taking into account experience from other operationswhich indicate that technical assistance programs rarely proceed as quickly as expected.

(iii) The IBTA Project supported the implementation of a very broad agenda, across many institutions.Performance of one institution could impact the overall project. The proposed project, althoughambitious, is limited to the financial sector. Progress in other areas of public sector reform could benefitthis operation but the project does not depend on this and could, therefore, proceed independently of thisagenda. Experience with other projects shows that restructuring of banks alone is not sufficient to supportthe development of a well-functioning financial sector. Therefore, the scope of the project focuses ondifferent elements of the financial sector which are interlinked. In addition, sound regulations andsupervision, a good supporting legal framework, adequate rules and practices on auditing and accounting,as well as other elements of financial infrastructure, such as a payments system, are also necessaryrequirement and are supported by this project.

(iv) Finally, the existence of adequate implementation capacity and management continuity are alsonecessary conditions. Implementation will be closely monitored and performance measured againstconcrete and specific indicators. Procurement and financial management capacity are weak but resourcesare provided under the project to train PMU staff and for procurement experts to provide guidance and totransfer the needed knowledge and expertise to their Azeri counterparts.

4. Indications of borrower commitment and ownership:

The Government and the Azerbaijan National Bank have consistently reiterated their commitment tofinancial sector reforr, banking sector restructuring and bank privatization. The authorities have agreedon a comprehensive banking reform strategy with the IMF and the Bank and have demonstrated theircommitment by achieving progress in a number of sensitive areas, including the effective closure of thethree state-owned banks, the establishment of a new bank (the BUSbank) from the good assets of thesebanks, the ongoing implementation of a modem payments system, development of an lAS-based chart ofaccounts for the banking sector and the ANB's ongoing efforts to improve banking supervision.Furthermore, the ANB has recently completed an extensive reorganization to help modernize and increasethe efficiency of the institution and has asked for support from the project, particularly for the newlycreated internal audit department, accounting and IT departments as well as for a policy adviser to helpwith strategic planning. There is clear recognition and high-level support from the Government and theANB that prompt action to support reform of the banking sector is a prerequisite for the resumption ofeconomic growth and private sector development. The project will provide the needed technical assistanceto help the authorities continue in the implementation of the agreed reform program. As further evidence ofthe Government's commitment to carry out this reform program, during negotiations, the Prime Ministersent a letter to the Bank outlining the Government's intentions for banking sector reform and the steps itplans to take to realize this.

5. Value added of Bank support in this project:

The proposed project continues and expands the technical assistance already provided to the Governmentthrough the IBTA project. The Government, the ANB and other international donors look to the IDA andthe IMF to provide continued support to the Government to help sustain banking sector development.

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E. Summary Project Analysis (Detailed assessments are in the project file, see Annex 8)

1. Economic (see Annex 4):O Cost benefit NPV=US$ million; ERR = % (see Annex 4)O Cost effectiveness* Other (specify)Not applicable

2. Financial (see Annex 4 and Annex 5):NPV=US$ million; FRR = % (see Annex 4)Not applicable

Fiscal Impact:

The losses incurred by the state-owned banks have a substantial cost to the Government's budget.Furthermore, poor financial controls and accountability, and limited lending capacity have prevented thedevelopment of a sound banking sector. The proposed project will support the Government's efforts to: (a)resolve issues relating to the state-owned banks; (b) strengthen the financial sector and encourage privatebanking; (c) promote financial intermediation; and (d) build on the foundation for increased private sectordevelopment. It is, therefore, expected to assist the Government in reducing the insolvency in the financialsector and curtailing the losses of state-owned banks, thereby minimizing exposure to potential furtherfiscal costs. The budgetary implications of the liquidation of the three banks and the establishment ofBUSbank will be limited to the interest payments due on Government contributions made to BUSbank andto ANB to cover previous losses accrued on the lending portfolios of the three banks and to satisfymninimum capital requirements. To date, the Government has issued bonds to the BUSbank with a value ofManat 52 billion (about US$12 million equivalent), for this purpose. A further govenmment contributionmay be needed so that the bank is in full compliance with the capital requirements of ANB.

3. Technical:Successful financial sector reforms require high-quality advice and expertise in a number of areas. Thesetechnical skills are weak in the banking sector. The project will ensure that the Government of Azerbaijanhas access to the necessary expertise, through top level advisors and consultants, to facilitate theachievement of its reform objective in a timely manner. An important element of the project will be for theexperts hired to train and transfer these skills to counterparts, for example in banking supervision andaccounting, particularly in the area of on-site examinations.

4. Institutional:

4.1 Executing agencies:

The implementation responsibility for the proposed project will be shared by the Ministry of Finance andthe National Bank of Azerbaijan. However, the institutional capacity of the both of these executingagencies is weak. Due to their lack of expertise, the proposed project includes consulting services toprovide guidance and advice in procurement matters, as well as experts to assist both the MoF and ANB inquestions relating to overall policy formulation, management and strategic planning.

The MoF will be responsible, on a technical level, for the restructuring, strengthening and eventualprivatization of BUSbank and the establishment of the loan recovery unit. The project will provideresources to build the necessary capacity within the MoF, to ensure effectiveness of implementation.

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The ANB will be responsible for banking supervision and infrastructure components. Banking supervisionwill be managed from a technical point of view by the Supervision department Support for accountingreform, implementation of the small value payment system and expansion of the general ledger will beunder the technical responsibility of the Accounting and Settlement Department These departments havesufficient capacity to manage these components, with the help of the PMU and with consultants' assistance,as appropriate, particularly in the preparation of technical specifications for IT systems.

4.2 Project management:

The PMU in the ANB, in close liaison with the Ministry of Finance, will be responsible for overall projectcoordination, financial management, procurement, accounting and disbursement. The ANB has somelimited capacity to manage project implementation from experience gained through its involvement in otherBank-financed projects, but will require substantial support under the project to supplement this, to buildon the existing experience. To address this weakness, the proposed project will provide the necessaryoutside expertise to improve capacity within the ANB to ensure effectiveness and timeliness inimplementation. Furthermore, it is anticipated that an intensive supervision effort will be required.

4.3 Procurement issues:

Procurement will be centralized within the ANB, which has limited procurement experience to date. Tomitigate this problem, training will be provided to the two staff responsible for procurement and aninternationally recruited procurement adviser will provide additional assistance.

4.4 Financial management issues:

From a financial management perspective, the risks associated with the Financial Sector TechnicalAssistance Project are limited. The Credit amount is relatively small, with a few large contracts expected.Financial flows in the majority of the cases would be from the Special Account directly to the consultantsor suppliers. To mitigate any unforeseen problems, an Operational Manual has been prepared, whichclearly specifies all the fiduciary responsibilities of the PMU, including the responsibilities of the individualstaff, procedures and guidelines for approving and authorization of payments. The project financialmanagement system will have the relevant safeguards to protect data entry and data integrity. Procurementprocedures will be closely monitored by the Bank. Qualified staff has been selected for the PMU but theyhave no prior experience with Bank-financed projects. To mitigate this problem, funding is being providedunder the project to enable both financial management and procurement staff to participate in relevanttraining courses to enhance their understanding of Bank procedures. The project will be audited byauditors acceptable to the Bank.

5. Environmental: Environmental Category: C (Not Required)5.1 Summarize the steps undertaken for environmental assessment and EMP preparation (includingconsultation and disclosure) and the significant issues and their treatment emerging from this analysis.

No significant environmental issues

5.2 What are the main features of the EMP and are they adequate?

not applicable

5.3 For Category A and B projects, timeline and status of EA:Date of receipt of final draft: not applicable

5.4 How have stakeholders been consulted at the stage of (a) environmental screening and (b) draft EAreport on the environmental impacts and proposed environment management plan? Describe mechanisms

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of consultation that were used and which groups were consulted?

not applicable

5.5 What mechanisms have been established to monitor and evaluate the impact of the project on theenvironment? Do the indicators reflect the objectives and results of the EMP?

not applicable

6. Social:6.1 Sunmmarize key social issues relevant to the project objectives, and specify the project's socialdevelopment outcomes.

The proposed project could have a limited social impact, as the initial merger of the three banks which tookplace last year has already resulted in some downsizing and displacement of management and personnel ofthe three merging banks. According to information from BUSbank, about 1,500 staff were affectedcountry-wide. These staff received compensation in accordance with provisions of the Labor Code. Theseprovisions provide for affected staff to be given two months' notice, allowed the opportunity to seekaltemative employment without loss of pay and to receive up to three months' salary, unless they findalternative employment within this three month period. Within the framework of a personnel and branchrationalization program to be developed under the project with the help of consultants, there may be someadditional downsizing, particularly in the Baku area, but this process will take place only over time, due tothe current labor-intensive nature of BUSbank's operations, and is not expected to have any measurableimpact. Furthermore, as part of the rationalization program, MoF and ANB are expected to provide for there-training and redeployment of bank staff with a view to minimizing the social costs of their phase-out. Inaddition, affected staff, who have comparatively good skills, are expected to find alternative employmentrelatively easily. They will also receive severance payments, in accordance with the provisions of the locallaw. Such payments will not be funded from the project. Given the shortage of experienced bankers inAzerbaijan, qualified individuals are already finding better positions in the private sector and this trend isexpected to continue, fiurther reducing the negative social impact. In the long-run, the project will bringabout beneficial social effects by building capacity in the banking sector, which would help to stimulate theprivate sector, and eventually lead to the creation of new job opportunities.

6.2 Participatory Approach: How are key stakeholders participating in the project?

The Bank has pursued an ongoing dialogue with key players in the financial sector, including the PrimeMinister, the Ministry of Finance, the National Bank of Azerbaijan, the management of the state-ownedbanks. Consultations have also taken place with the Securities Exchange Commission and the otherrelevant agencies and institutional bodies involved. The proposed project is tailored to address the needs ofthe Government and of these institutions. Meetings have also been held with private bankers and actionsproposed under the project endeavor to address some of their concerns about shortcomings with thebanking system and its infrastructure.

6.3 How does the project involveconsultations or collaboration with NGOs or other civil societyorganizations?

Not applicable

6.4 What institutional arrangements have been provided to ensure the project achieves its socialdevelopment outcomes?

Not applicable

6.5 How will the project monitor performance in terms of social development outcomes?

Not applicable

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7. Safeguard Policies:7.1 Do an of the followin safe licies awl to the project?

Po-mio o ApplicabilityEnvironmental Assessment (OP 4.01, BP 4.01, GP 4.01) 0 Yes 0 NoNatural habitats (OP 4.04, BP 4.04, GP 4.04) 0 Yes * NoForestry (OP 4.36, GP 4.36) 0 Yes * NoPest Management (OP 4.09) 0 Yes 0 NoCultural Property (OPN 11.03) 0 Yes * NoIndigenous Peoples (OD 4.20) 0 Yes * NoInvoluntary Resettlement (OD 4.30) 0 Yes * NoSafety of Dams (OP 4.37, BP 4.37) 0 Yes 0 NoProjects in International Waters (OP 7.50, BP 7.50, GP 7.50) 0 Yes 0 NoProjects in Disputed Areas (OP 7.60, BP 7.60, GP 7.60) 0 Yes 0 No

7.2 Describe provisions made by the project to ensure compliance with applicable safeguard policies.

Not applicable

F. Sustainability and Risks

1. Sustainability:

The objective of the financial sector reform is to establish a sound, well-fimctioning and competitivebanking system that can mobilize a rising level of financial resources, efficiently service the credit needs ofa growing economy, and provide broadly accessible, efficient and secure payments services at both thewholesale and retail level. To achieve this objective, the Government and the Azerbaijan National Bankhave begun the implementation of a reform program to realize their comprehensive strategy for systemicbank restructuring and reform. These reforms are critical for the long-term health and sustainability of thefmancial sector. In addition, the IMF, in cooperation with the Bank, is also addressing financial sectorissues in its program, which would help achieve the sustainability of the reforms supported by the project.

2. Critical Risks (reflecting the failure of critical assumptions found in the fourth column of Annex 1):

Risk Risk Rating Risk Mitigation MeasureFrom Outputs to ObjectiveThe main risk is that the Government will H The Government has already taken tangiblewaver in its commitment to implement the steps and imnportant political steps infinancial sector reform program due to implementing the financial sector reformninsufficient high-level political support for program, with the effective closure of AIB, PIBand possible unpopularity of the actions and SvB and the establishment of the BUSbank.which could lead to the further The project-related support and the continuedrationalization of personnel and branches assistance from the IMF will help mitigate thisand the liquidation state-owned assets risk. The Government letter setting out its plans

for the sector will also help in this respectContinued dialogue with the Government andother opinion-leaders in the country on thebenefits of banking sector reform andmodernization.

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From Components to Outputs(i) The Government will not follow N The Government has already taken the difficultthrough on its agreement with the Bank step of withdrawing the licenses of SvB andand the IMF to withdraw AIB's banking PIB. In spite of political opposition tolicense withdrawing AIB's banking license, this license

was withdrawn prior to negotiations (on April1), a further strong indication of theGovernment's seriousness to follow through onthe reform program

(ii) The BUSbank will start performing M BUSbank may perform limited lending activitieslending activities on an agency basis under ongoing IDA-financed

projects. The risk that it will initiate additionallending activities is mitigated by the applicationby ANB's supervision departmnent of existingprudential regulations, and the provisions in theMemorandum of Understanding which establishthe framework BUSbank's operations.

(iii) Resistance by the BUSbank H The early appointment of advisers, collaborationmanagement to technical assistance to of BUSbank's management in the selectionchangeover and accept changes in process, and close oversight by the MoF will bemanagement procedures and policies, critical.accounting and administration, and failureof the Government to finance from thestate budget privatization advisers neededto handle the privatization of BUSbank.(iv) Geneml delays in providing technical S Early agreement on terms of reference andassistance in a timely manner subsequent appointment of foreign experts can

help maintain momentum in the Governrnent'sagenda and reduce the risk of delays.

(v) Delays in revising and introducing the S samenecessary legal framework supportingbanking sector development andprivatization, as well as private sectordevelopment.(vi) Commercial banks fail to work with M The large value payments (RTGS) system hasthe ANB to establish a small value recently become operational with very tangiblepayments system results. Early initiation of work to establish a

small value payment system will benefit fromthe positive momentum of the RTGS system.

Overall Risk Rating HRisk Rating - H (High Risk), S (Substantial Risk), M (Modest Risk), N(Negligible or Low Risk)

3. Possible Controversial Aspects:

Hiring of high-priced foreign consultants

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G. Main Loan Conditions

1. Effectiveness Condition

The Operational Manual, satisfactory to the Association, has been adopted by the PMU (DCA - 6.01).

2. Other [classify according to covenant types used in the Legal Agreements.]

Project Implementation/Management:Continued commitment to the reform program as outlined in the letter of intent for banking sector reform(DCA - B and 5.01).Standard auditing covenants will apply (DCA -4.01).

Qualified personnel will be designated to support project implementation (DCA Schedule 4, para 1).

Monitoring, review and reporting:Standard reporting covenants will apply.A mid-term review will be undertaken no later than October 31, 2003 (DCA Schedule 4, para 3(c)).

Disbursements:Retroactive financing: of up to $100,000 for expenditures incurred after April 15, 2001, including up toUS$40,000 to establish the financial management system and US$60,000 to start up urgent consultingassignments (DCA Schedule 1, para 3).The PMU will start to prepare PMRs from the third quarter of 2001. It is expected that the PMU will beable to produce full PMRs by the quarter ending March 31, 2002 (DCA -4.02(a)).

H. Readiness for Implementation

O 1. a) The engineering design documents for the first year's activities are complete and ready for the startof project implerrLentation.

1 1. b) Not applicable.

LI 2. The procurement documents for the first year's activities are complete and ready for the start ofproject implementation.

12 3. The Project Implementation Plan has been appraised and found to be realistic and of satisfactoryquality.

[ 4. The following items are lacking and are discussed under loan conditions (Section G):

An Operational Manual is under preparation and will be completed by effectiveness.

1. Compliance with Bank Policies

12 1. This project complies with all applicable Bank policies.L] 2. The following exceptions to Bank policies are recommended for approval. The project complies with

all other applicable Bank policies.

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Rochelle Hilton Paul Siege JudyO'&onnorTeam Leader Sector Director Country Director

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Annex 1: Project Design Sunmnary

AZERBAIJAN: Financial Sector Technical AssistanceKey Performance

: Hierarch iy<SZp o~Obj.Indicators Monitoring & Evaluation Critical AssumptionsSector-related CAS Goal: Sector Indicators: Sector/ country reports: (from Goal to Bank Mission)Promote sustainable private Strengthened financial sector Performance against Financial Government's commitment tosector growth through infrastructure, including the Sector Development the reforms is sustained. Indevelopment and legal environment, accounting benchmarks in Country the long run, interventions inenhancement of financial practices, regulation and Assistance Strategy the areas of payment systems,sector. supervision, reduced number (November 1999). banking laws and regulations,

of state-owned banks and ANB reports. banking supervision,consolidation of commercial accounting reform andbanks to strengthen their divestiture of state-ownedcapital base and operational banks will help create aeffectiveness. competitive environment to

stimulate private sectorgrowth through theliberalization of resources andmore effective provision ofcredit.

Finalization of the closure of AIB's license will beAIB, SvB and PIB. withdrawn prior to

negotiations (actual)

Project Development Outcome / Impact Project reports: (from Objective to Goal)Objective: Indicators:Provide support to the * Withdrawal of the Consultanfts reports. Withdrawal of AIB's licenseGovernment for further banking license of AIB, Project monitoring, (actual).implementation of its financial in addition to PIB, and supervision and evaluation Government and ANBsector development strategy. SvB. reports. maintain their policy for and

Progress and project commitment to the financialmanagement reports. sector reform program.

* Enhancement of the BUSbank operates in a soundoperational structure of financial and operationalBUSbank leading to its situation to ensure successfuleventual privatization. privatization.

* Enhancement of ANB'ssupervisory capacity,particularly on-siteinspection.

* Implementation of anefficient paymentssystem.

* Introduction oflAS-based nationalaccounting standards forcommercial banks.

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ra~che d'Objectv_-t- ..........;-lcIt#. Monitoring & Evaluation Critical AssumptionsOutput from each Output Indicators: Project reports: (from Outputs to Objective)Component:Strengthen the financial * Completion of the Consultants' reports Continued strong support forsituation and operational transfer of selected Quarterly progress and and commitment to thestructure of BUSbank. assets and liabilities to supervision reports program from the Government

BUSbank (and to the Annual audit of BUSbank in and the BUSbankloan recovery unit) accordance with IAS managementbased on a portfolio Business plan for BUSbankreview to assess the Creation and maintenance of acollectibility of the bad political environment and willloans to privatize BUSbank

* Implementation of anagreed business strategyfor BUSbank tostrengthen itsoperational structure inaccordance with theagreed Memorandum ofUnderstanding

* Initiation of the Ministry of Finance financesprivatization process for from the state budget theBUSbank services of a privatization

advisorEnhancement of the efficiency * Establishment of legal Progress and implementation Actions to maintainand quality of financial framework to support a reports by consultants momentum and coordinateservices through improved small value payment Project monitoring, interventions are not delayedbanking sector infrastructure: system supervision and evaluation No impediments exist to

reports prevent the establishment ofthe appropriate legalenvironment

* Implementation of a Commercial banks and ANBsmall value payments are willing to work together tosystem implement and operate the

small value payments system* Implementation of

accounting and generaladministration modulesof ANBs general ledger

* Establishment of theNational AccountingStandards compatiblewith IAS

* Passage of the required The IMF continues to providelaws and regulations to support for accounting reformenable theadministration of theabove accountingstandards

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* Financial reporting bycommercial banks basedon the standardsprescribed by the ANB

* Completion by ANB of Manual of accountingthe manual of practicesprocedures andguidelines foraccounting practices

* Completion of study Assessment Review Clear agreement on ownershipassessing the need for by relevant parties for theand design of a implementation of a collateralcollateral registry system registry system

Improved banking supervision * Development and Consultants' reports. Effectiveness and timing ofand regulatory capacity. strengthening of on-site Annual Audit of ANB. assistance is not derailed by

inspection procedures Project monitoring, political pressures orand guidelines supervision and evaluation entrenched interests

reports* Review and revision of

laws and supportingregulations to enhanceANB's supervisory andregulatory capacity

Project Components Inputs: (budget for each Project reports: (from Components toSub-components: component) Outputs)MINISTRY OF FINANCE

* MoF US$0.11 million Project status reports, Timely appointment ofsupervision and disbursement advisers and consultantsreports

* BUSbank US$1.71 million Strong commitment of MoFand BUSbank management.

* Agrarcredit US$ 0.14 million Government proceeds with thetransformation of AIB intoAgrarcredit (a non-bank creditinstitution) and creates a loanrecovery unit

AZERBAIJAN NATIONALBANK

* ANB Management US$0.12 million Project status reports, Timely appointment ofsupervision and disbursement advisers and consultants.reports Strong commitment of ANB's

management* Supervision US$0.22 million* Banking infrastructure US$3.63million

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PROJECT MANAGEMENT* Procurement, Financial US$0.32 million Progress reports, disbursement Good coordination between

Management and Audit reports and project audit MoF and ANB onreports. project-related activities.

Timely selection andappointmnent of consultants to:

(i) assist and train ANB andMoF staff;(ii) set-up the fmiancialmanagement system;(iii) prepare internal

procedures and standardizedreporting.

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Annex 2: Detailed Project DescriptionAZERBAIJAN: Financial Sector Technical Assistance

By Component:

Project Component I - US$1.96 million

1. Ministry of Finance for Bank Restructuring and Divestiture

Advisory services to the BUSbank, to strengthen the bank, improve its organization and operations. Thiswould include:

(a) a foreign advisor for the MoF, who would be in charge of diverse issues, including provision ofassistance related to the issues regarding the transformation of the Agroprom Bank into Agrarcredit (anon-bank credit institution) and oversight and privatization of the BUSbank;

(b) a resident advisor to the Chief Executive Officer (CEO) of the BUSbank, for about 15 months. Theadvisor would assist the CEO in guiding, directing, controlling and supervising the activities of the bank'sline managers, ensuring that the bank operates in an efficient and prudent manner, generates positiveearnings while adequately controlling risk and expenditures, and maintains a strong capital base. Theadvisor would also help the CEO in designing and implementing a business strategy and an action plan, inline with the Memorandum of Understanding that has been signed by bank management, the Ministry ofFinance and the ANB. In addition, the advisor will also perform the final valuation and reconciliation ofthe accounts of the BUSbank. It is envisaged that the advisor will be a member of the ManagementCommittee of the BUSbank;

(c) a short-tern advisor to the Chief Accountant of the BUSbank for about three months. The advisor willassist the management of the BUSbank in the imnplementation of the new lAS-based chart of accounts,develop basic accounting policies and procedures to ensure that the bank's accounts are maintained inaccordance with international standards;

(d) short-term consultants services, based on the recommendations of the resident advisor, in such areas asinformation technology and Management Information Systems, the intra-bank fund transfer system, thegeneral ledger and internal control procedures, which need to be improved or strengthened to introduceefficient standards procedures and strengthen existing operational units. Assistance will include training ofpersonnel, as well as the design, development and provision of essential software;

(e) annual IAS based financial audits by an acceptable reputable auditing company to cover at least twoyears following the establishment of BUSbank;

The pnvatization advisory services (an investrnent bank) eventually needed to assist in BUSbank's eventualprivatization including performance of due diligence, preparation of an information memorandum and legaldocumentation, and assistance to the MoF in identifying and selecting fit and proper strategic investors, etc.will be covered from the Government's budget allocation for privatization.

Advisory Services for the Establishment and Operations ofAgrarcredit

This includes technical assistance to assess the design and legal structure for transforming Agroprom into anon-bank credit institution (Agrarcredit) to enable it to carry out its mandated objectives and functions. It

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includes the provision of legal and technical advisors to support the establishment and operations of thenew institution, which will include loan recovery and, on an agency basis, provision of rural credit for sixpilot farms that is being provided under the IDA-financed Farm Privatization Project. A success feestructure will be designed to cover any loan recovery activities that are carried out to pernit Agrarcredit tofinance its operations and naximize collection.

Project Component 2- US$3.97 million

2. Azerbaijan National Bank

The proposed project will provide assistance to the Government in its effort to strengthen the capacity ofthe Azerbaijan National Bank to effectively exercise its regulatory and supervisory roles; and to improvebanking infrastructure. With this in mind, the project will provide support in the following areas:

(a) an advisor to the top management to provide high level support in the implementation of its strategy tostrengthen the ANB;

(b) Banking Supervision: advisors to assist ANB for about twelve months to improve its bankingsupervision capacity. This would supplement assistance that is being provided by the IMF and wouldfocus on on-site inspection by helping with the evaluation of commercial banks in order to effectivelyassess their solvency and liquidity condition, management quality, intemal systems and compliance withprudential regulations. The objective of this assistance will be to contribute to improving bankperformance and developing a more detailed strategy for addressing systemic weaknesses.

(c) Banking Infrastructure: the existing state of banking infrastructure in Azerbaijan is not conducive tothe development of modem and efficiently functioning banking activity. The proposed project will providethe following support:

* funding for additional hardware and software needs to finalize the implementation of the paymentsystem reform. The ANB has developed a strategy for payment system reform based on theestablishment of a Real Time Gross Settlements (RTGS) system for large value payments and a batchand card-based low-value, retail payments system. An IME Resident Adviser has been assisting theANB in the development of this strategy and the RTGS system, supported with fimding from theongoing IBTA I project, started operating in February 2001. The initial results of the RTGS areencouraging as the system now enables settlements to be made within seconds rather than days. Thenext phase of the strategy is to implement a small value payments system. The project provides forconsultants' services to examine the options and assist in the development and implementation of thissystem, as well as the acquisition of the approved systems, which must be capable of smoothlyinterfacing with the newly operational RTGS system. The project also provides for an informationtechnology (IT) specialist to help the ANB IT department develop and implement its extensivemodernization program;

* funding for the expansion of the ANB's general ledger system. Implementation of the core systemunderway with financing from the ongoing IBTA I project. It is important for the ANB to expand thissystem by adding additional modules, such as for the management information system, accounting andreporting and administration. An essential element of this expansion will be that the supplementarymodules are completely compatible with the core general ledger. Project-related assistance will includeconsultants' services to prepare and evaluate bidding documents, as well as the procurement of therelevant modules.

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* short-term assistance to develop detailed procedures and an implementation plan for theintroduction and implementation of the new IAS-based national accounting standards for bankingsector. Funding is available under the IBTA I project to finance the introduction of IAS basedaccounting standards and uniform chart of accounts for the enterpnse sector. To supplement this, theANB has already begun work to develop uniform accounting standards but substantial additional workis needed. As part of this activity, the proposed project would provide additional assistance to theAccounting Department of ANB, including a substantial training effort for bankers, bank supervisorsand tax examiners of the MoF in the implementation of the new accounting standards. This supportwould complement the training that is being provided through the new Azerbaijan Bank TrainingCenter (ABTC) which, has recently been established with TACIS funding.

* short-term consultants' services to carry out an initial assessment of the need for, and alternativedesigns to implement, a collateral registry system to facilitate financial intermediation. The systemwould help itemize assets utilized by banks, financial entities, enterprises and individuals as collateralfor loans. The assessment would analyze the feasibility of establishing such a system, either as acombined registry for movable and immovable property or a separate registry for movable property.Based on the findings and recommendations of this assessment, a decision would be made on thedesign, establishment and location for the registry. Consideration could be given to financingadditional activities relating to the establishment of the registry system if sufficient funding becomesavailable during project implementation.

Project Component 3 - US$ 0.32 million

3. ProjectManagementandAdministration

(a) Project audits: provision is included in the project to finance the annual audits of the project andspecial accounts.

(b) Procurement advisers: a long-term contract will be concluded with a reputable consulting firm toprovide procurement guidance periodically during the project period. It is anticipated that the adviserwould be resident for the early months of project implementation that be hired on a retainer-basis to provideadvice and guidance as needed over the subsequent two years.

(c) Incremental operating costs: Most of the operating costs for the project, including staff salaries, officespace, utilities, office supplies, communications and postage costs, will be covered by the ANB.Furthermore, for project start-up the ANB has acquired and implemented a suitable financial managementsystem (FMS) for the project. The system selected has been used in other IDA-financed projects in theregion and could be financed retroactively from the proposed IDA Credit for this project. The system hasbeen installed on the PMUYs hardware. In addition, staff assigned to the PMU will require some specializedtraining in procurement, financial management and project management under World Bank-financedprojects. These incremental operating costs for the FMS and training for the PMU staff, estimated at about$60,000, will be financed from the proposed IDA Credit.

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Annex 3: Estimated Project Costs

AZERBAIJAN: Financial Sector Technical Assistance

Project Cost by Component Local Foreign ToWlI US$ ndUilon US$ millioni US$ million

Ministry of Finance (MoF)

Advisory Services to the MoF 0.01 0.10 0.11

United Universal Joint Stock Bank (BUSbank)

Management and Operational Strengthening 0.08 0.80 0.88Infrastructure development (General Ledger, MIS, Intrabank fundsransfer) 0.12 0.60 0.72IAS Financial Audits 0.01 0.10 0.11

Subtotal 0.21 1.50 1.71

grarcreditOperational Start-up, Management and Operational strengthening 0.01 0.10 0.11Annual Audits 0.00 0.04 0.04

Subtotal 0.01 0.13 0.14Subtotal MoF 0.23 1.73 1.96

Azerbaijan National Bank (ANB)

Management/SupervisionAdvisory Services for Senior Management 0.02 0.10 0.12Institutional Development for Banking Supervision 0.02 0.20 0.22

Subtotal 0.04 0.30 0.34

Banking InfrastructureSmall Value Payments System 0.32 2.03 2.35Expansion of general ledger system 0.11 0.57 0.67Institutional strengthening for IT and Accounting Reform 0.10 0.45 0.55Assessment of needs for a Collateral Registry System 0.01 0.05 0.06

Subtotal 0.53 3.11 3.64

Subtotal ANB 0.57 3.40 3.97Project ManagementProcurement Services 0.02 0.15 0.17Annual Audits 0.00 0.04 0.04Incremental Operating Costs 0.05 0.06 0.11

Subtotal Project Management 0.07 0.25 0.32Total Projects Costs 0.87 5.38 6.25

Project Cost by Category Local Foreign Total US$US$ million US$ million million

Goods 0.51 2.87 3.38Services 0.31 2.45 2.76Incremental Operating Costs 0.05 0.06 0.11

Total Project Costs 0.87 5.38 6.25Total Financing Required 0.87 5.38 6.25

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Annex 4AZERBAIJAN: Financial Sector Technical Assistance

Not applicabie

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Annex 5: Financial SummaryAZERBAIJAN: Financial Sector Technical Assistance

Years EndingDecember 31

I Year1 I Year2 I Year 3 1 Year 4 Year 5 I Year 6 I Year 7Total Financing RequiredProject CostslnvestmentCosts 0.1 1.5 1.7 1.7 1.2 0.1 0.0Recurrent Costs 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Total Project Costs 0.1 1.5 1.7 1.7 1.2 0.1 0.0

Total Financing 0.1 1.5 1.7 1.7 1.2 0.1 0.0

FinancingIBRDSIDA 0.1 1.1 1.4 1.6 1.1 0.1 0.0Govemment 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Central 0.0 0.0 0.0 0.0 0.0 0.0 0.0Provincial 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Co-financiers 0.0 0.0 0.0 0.0 0.0 0.0 0.0ANB 0.0 0.2 0.2 0.1 0.1 0.0 0.0Others 0.0 0.2 0.1 0.0 0.0 0.0 0.0

Total Project Financing 0.1 1.5 1.7 1.7 1.2 0.1 0.0Main assumptions:Amounts shown are in US$ millions.Others: Contributions from BUSbank will be about $80,000 in Yr 2, $60,000 annually in Yrs 3-4 and$10,000 in Yr I and 20,000 in Yr. 5

Contributions from commercial banks Yrs 3-5: $10,000.Central Government (Ministry of Finance) contribution will be about $1,000 in Yr 1, $3,500 annually in Yrs.2-5 and $2,000 in Yr. 6. In addition, privatization advisers to prepare and manage the privatizationtransaction for BUSbank will be funded from the central budget fund for privatization.

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Annex 6: Procurement and Disbursement ArrangementsAZERBAIJAN: Financial Sector Technical Assistance

Procurement

The procurement of goods and services will be carried out in accordance with the World Bank's Guidelineson Procurement under IBRD Loans and IDA Credits (January 1995, Revised January and August 1996,September 1997, and January 1999) and the Guidelines on Selection and Employment of Consultants bythe World Bank Borrowers (January 1997, Revised September 1997 and January 1999). The WorldBank's standard bidding documents for IT procurement, and the standard forms of contract and request forproposals for Consultant Services will be used for the project. Any goods or services not financed by theWorld Bank will be procured in accordance with the regulations of the country. A General ProcurementNotice was published in the United Nations' Development Business issue dated April 30, 2001.

Procurement will be managed by the Project Management Unit (PMU) established at the AzerbaijanNational Bank (ANB), for all components of the Project. Two procurement officers have been appointed tohandle the separate requirements of the Ministry of Finance (MOF) and ANB comnponents. Given theirlimited experience with procurement procedures, a procurement consultant will be hired to augment anddevelop capacity at the ANB. In addition, Credit funds have also been earmarked for training, when suchtraining is available at the Bank or at ILO, Turin.

The cost of installation of software for the FMS would be eligible for retroactive financing.

There has been no Country Procurement Assessment Report prepared for Azerbaijan. However, a capacityassessment of the PMU has been done, taking into account the experience of the ANB with implementationof a component under the ongoing IBTA project as well as the procurement environment in the country.

A project launch workshop will be conducted immediately after the effectiveness of the Development CreditAgreement, expected in mid-October 2001.

Summary of Procurement Activities, Methods and Schedule

Procurement methods (Table A)

Goods:All contracts for goods (technical services), which are estimated to cost US$100,000 equivalent or

more each, will be subject to International Competitive Bidding (ICB).

Consulting Services:

(i) Services for the BUSbank such as resident advisor, advisor to the Chief Accountant, short termadvisors to operational units, and Services for Accounting reform for the ANB will be procured throughQuality and Cost-Based Selection (QCBS).

(ii) Short term assignments for the BUSbank to develop software specifications for the GeneralLedger, Management Information System, and intra bank funds transfer as well as for the ANB to reviewoptions and prepare bid documents for the small value payments systems (aggregate amount US$0.1mnillion) would be selected based on Consultant Qualifications (CQ) criteria. Each contract shall not exceed

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US$0.1 million equivalent.

(iii) Services for bank and project financial audits (aggregate amount US$0.2 mnillion) which arestandardized and have well established practices will be procured through the least cost (LC) method ofselection.

(iv) Services for the review, revision and development of the legal framework for the small valuepayment system (aggregate amount US$0.1 million) will be procured through fixed budget method ofselection.

(v) Services for the first year's Project financial audit may be procured through the single-sourceselection method.

(vi) Services to strengthen the capacity of the PMU as well as advisory services for MOF andANB management, banking supervision, and ANB IT strategy, and additional short term assignments forthe transformation of the AIB into a non-bank financial institution (aggregate amount US$1.1 million),would be done through selection of individual consultant (IC) method. The selection of individualconsultants will be in accordance with the provisions of paragraph 5.1 through 5.3 of the Guidelines onSelection and Employment of Consultants by World Bank Borrowers.

Incremental Operating Costs:

The credit will finance the incremental operating costs of about US$60,000 to cover the expensesfor the installation of the FMS and training of PMU staff, during the first year. All other expenses,estimated at US$50,000 over 4 years, would be covered by the ANB, to meet the needs of the PMU projectadministration, including staff salaries, communications, maintenance and operation costs for officeequipment, office supplies etc. Items under incremental operating costs will be procured in accordancewith the administrative procedures of the ANB.

Table A: Project Costs by Procurement Arrangements(US$ million equivalent)

Procurement Method'2Expenditure Category ICB NCB Other N.B.F. Total Cost

1. Works 0.00 0.00 0.00 0.00 0.00(0.00) (0.00) (0.00) (0.00) (0.00)

2. Goods 3.38 0.00 0.00 0.00 3.38(2.87) (0.00) (0.00) (0.00) (2.87)

3. Services 0.00 2.76 0.00 2.76

() (0.00) (2.45) ( (2.45)4. Incremental Operating 0.00 0.00 0.06 0.05 0.11Expenses

(0.00) (0.00 (0.06) _(00) 0.6

Total 3.38 0.00 2.82 0.05 6.25(2.87) (0.00) (2.51) (0.00) (5.38)

Figures in parenthesis are the amounts to be financed by the IDA Credit. All costs include contingencies.

2' Includes consultants' services and incremental operating costs related to managing the project.

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Table Al: Consultant Selection Arrangements (optional)(US$ million equivalent)

Selection Method

Expenditure Category QCBS QBS SFB LCS CQ Other N.B.F. Total Cost'A. Firms 1.20 000 0.11 0.18 0.20 0.00 0.00 1.69

___________ (1 4) (0.00) (0.11) (0.17)_ (0.18) (0.00) (0.00) _(I.50)

B. Individuals 0.00 1 .00 0.00 0.00 1.07 0.00 1.07

_______ __ __ (0.00) (0.00) (0.00) (0.00) (0.00) (0.95) (0.00) (0.95)Total~ 1.20 0.00 0.11 0.18 0.20 1.07 0.00 2.76

_____________ ~(.04)(0.0) 0.1) 10.1) (0.18) (0.95) -(.0 245LL I ~~~~~~(1.04) Lo 7o t )m (a ( s (0.00) (2.451' Including contingencies

Note: QCBS = Quality- and Cost-Based SelectionQBS Quality-based SelectionSFB = Selection under a Fixed BudgetLCS = Least-Cost SelectionCQ = Seiection Based on Consultants' QualificationsOther = Selection of individual consultants (per Section V of Consultants Guidelines),Single-source selection, Commercial Practices, etc.

N.B.F. = Not Bank-financedFigures in parenthesis are the amounts to be financed by the Bank Credit.

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Pnor review thresholds (Table B)All ICB contracts will be subject to prior review by IDA. Consultants' contracts estimated to cost overUS$100,000 for firms and US$50,000 for individuals, single-source selection contracts, as well as allTORs and methods for selection of consultant contracts, irrespective of value, shall be subject to priorreview by IDA. All other contracts shall be subject to ex-post review by IDA's supervision missions, or byfocused procurement review or audit missions. IDA rnissions will review at least 2 out of 5 contractswhich are subject to post review.

Table B: Thresholds for Procurement Methods and Prior Review

Contract Value Contracts Subject toThreshold Procurement Prior Review

-Expenditure Category (US$ thousands) Method (US$ millions)1. Works 0

2. Goods 0 ICB 3.38

3. Services (Indiv) more than 50 SIC 0.85(Firms) more than 200 QCBS 1.22(Firms) more than 100 LCS 0.10(Firns) more than 100 CQ 0.20(Finns) more than 1 00 SFB 0.10

Total value of contracts subject to prior review: $5.85 m

Overall Procurement Risk Assessment

High

Frequency of procurement supervision missions proposed: One every 6 months (includes specialprocurement supervision for post-review/audits)

Thresholds generally differ by country and project. Consult OD 11.04 "Review of ProcurementDocumentation" and contact the Regional Procurement Adviser for guidance.

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Disbursement

Allocation of credit proceeds (Table C)Disbursement of the proceeds of the Credit will be administered by the Project Management Unit (PMU) ofthe ANB, under the overall responsibility of the Project Coordinator. The Credit is expected to be fullydisbursed over 4.5 years. IDA will finance: (i) 100 percent of expenditures for consultant services; (ii) 100percent of foreign expenditures for direct imports of goods, 100 percent of local ex-factory costs for locallymanufactured goods and 80 percent of local expenditures for other goods procured locally, and (iii) 100percent of incremental operating costs for the first 12 months of the project, to establish the financialmanagement system and provide training to PMU staff, in accordance with the budget agreed with theBank. Retroactive financing of up to US$100,000 will be provided for contracts entered into after April15, 2001, for establishing the financial management system, as well as for advisory services for BUSbankand for reviewing options for the small value payments system.

Table C: Allocation of Credit Proceeds

Expenditure Category Amount in US$mIllIon Financing PecentageGoods 2.65 100% of foreign expenditures, 100% of

local expenditures (ex-factory cost) and80% of local expenditures for other items

_rocurd plocallyConsultants Services and Training 2.19 100%Including AuditIncremental Operating Costs 0.06 100% until June 30, 2002, and 0%

thereafterUnallocated 0.50

Total Project Costs 5.40

Total 5.40

Use of statements of expenditures (SOEs):

(a) Goods: expenditures under contracts costing less than US$100,000 equivalent(b) Consulting firms: contracts estimated at less than US$100,000 equivalent(c) Individual consultants: contracts less than US$50,000 equivalent(d) Incremental operating costs and training: all contracts

Documentation supporting the SOEs will be retained by the PMU and made available for review by IDAsupervision missions and auditors.

Special account:To facilitate timely Project implementation, the Borrower will establish, maintain and operate, underconditions acceptable to IDA, a Special Account (SA) in US dollars in a commercial bank. The authorizedallocation of the Special Account will be US$200,000, representing approximately four months of eligibleexpenditures. Upon effectiveness of the Development Credit Agreement, the Borrower may withdrawUS$100,000, representing 50 percent of the authorized allocation. When the funds withdrawn from theCredit Account and any outstanding Special Commitments amount to SDR 1,500,000, the Borrower maywithdraw the remaining amount of US$100,000 by submitting the relevant Application for Withdrawal.

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Replenishment applications are to be submitted at least every three months, and must include reconciledbank statements as well as other appropriate supporting documents.

The Special Account will be established in the International Bank of Azerbaijan (IBA) IBA holds theSpecial Accounts for other IDA Credits and was, at that time, selected on a cornpetitive basis. IBA meetsthe Bank's requirements in this regard in that it:

(a) is financially sound as demonstrated by its latest accounts, audited by an intemationally recognizedaudit firm;

(b) has significant foreign correspondence banking in all major currencies;(c) has some experience, or at least the capacity to acquire experience, in issuing letters of credit and

transacting direct foreign payments;(d) is a member of SWIFT;(e) has issued a Comfort Letter to assure that amounts deposited in the SA will not be set, seized or

otherwise attached to satisfy amnounts due to the commercial bank by the Borrower,(f) is willing and able to adequately maintain accounts as required by IDA, including regular statements,

and any other information that may be considered necessary; and(g) charges competitive rates for services and other transactions fees.

Fmancial Management:

Project Financial Management. A project specific financial management system has been established atthe PMU. The TOR for this assignment were agreed with the PMU and can be found in the PIP. Theaccounting system will be maintained in accordance with international standards, based on principles ofdouble-entry bookkeeping. The Bank informed the PMU of Bank requirements on maintaining accountsand records in accordance with International Accounting Standards (IAS). This system is capable ofproviding accurate and timely information regarding project resources and expenditures, includingplanning, internal controls, accounting and financial reporting and audit arrangements relating to theproject. The project accounts will be based on a Chart of Accounts drawn-up by the appraisal missionwith the assistance of the PMU. The Chart of Accounts will accommodate the proposed project to capturesources and uses of funds, assets and liabilities in sufficient detail to satisfy PMR-based reportingrequirements. Cash basis of accounting will be applied. The proposed system will, in addition toproducing periodic and cumulative budgeted and actual expenditures, link the financial data to measures ofoutput and procurement activities of the project. The Project Management Reporting (PMRs) formats andsubmission schedule have been discussed and agreed with the ANB and the PMU.

Disbursement arrangements under the project will commence on the basis of traditional disbursementmethods (e.g., direct payments, replenishments of the Special Account on the basis of SOEs and fulldocumentation). Once the PMU's capacity and experience has improved with regard to internal controls,implementation, budgeting and forecasting, the ANB/PMU, in consultation with the Bank, will decide onthe timing and transition for the use of the quarterly PMRs for disbursement purposes. It is expected thatPMU will have the capacity to prepare the first full set of PMRs by March 31, 2002. The PMU willmaintain the Special Account in IBA for the disbursement of Credit funds. An Independent accreditedauditing firm will audit these accounts annually.

Internal Controls. Operational procedures and guidelines for project financial management will bedocumented in an Operational Manual, encompassing all levels of project management and administration.A draf has been prepared by the PMU. The Bank and the Ministry of Finance will review the manual andgive their comments. The PMU will incorporate these comments and finalize the manual prior to Credit

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Effectiveness. The Manual will include financial management procedures and staffing, identification ofaccounting and auditing standards and procedures used for the project, project reporting and monitoring,procurement procedures, procedures for cash management and formats of project management reports.Further actions to strengthen project financial mnanagement are shown below.

The PMU will prepare project information for all components and prepare quarterly Project ManagementReports (PMRs) including a financial report, project progress report and procurement management report,for project monitoring and reporting for submission to the Bank. An outline of reports contained in thesystem and the format for the PMRs were provided to the PMU and were agreed during Negotiations.Training will be provided for project management, financial management and procurement. Funding forthese training activities will be provided from the Credit

Auditing Arrangements. The PMU will recruit independent auditors under terms of reference acceptable tothe Bank. The TOR for this assignment have been agreed with the PMU and can be found in the PIP. Theauditors selected for the Project are required to be members of the International Federation of Accountants(IFAC). The audit report of the project will include a separate opinion on the project financial statements,the special account, and the SOE. Audited Project Financial Statements will be submitted to the Bank withthe audit report six months after the end of each year audited. Auditors for to audit the 2001 Projectaccounts have already been selected. The cost of the audit will be financed through the IDA Credit.

Financial Management Action Plan:

An assessment of the financial management system of the PMU was carried out during project appraisal.The PMU will be responsible for project accounting, administration of the Special Account, loandisbursements, procurement and project supervision. The PMU is developing a financial managementsystem, using software that has been successfully used in other IDA-financed projects in Azerbaijan andthat meets Bank requirements. The PMU's accountant has several years of accounting experience, butwould require training in meeting Bank's procedures and reporting requirements.

PMU and the Bank have agreed on the following timebound action plan regarding the strengthening ofProject Financial Management to meet Bank accounting and fnancial reporting requirements under OP/BP10.02:

By May 3. 2001: Install the FMS software on the PMU's hardware.By May 7. 2001: Make the FMS operational.By June 15. 2001: Fine tune the systern and train PMU staff in its operation.By December 2001: Procurement and financial management staff to have received training to

be funded from the Credit.

Project Management Reports: The PMU will start to prepare PMRs (Reports 1,2 and 3), starting fromthe third quarter of 2001. It is expected that, the PMU will be able toproduce full PMRs, by the first quarter ending March 31, 2002.

Disbursements: The Borrower will utilize the Bank's traditional disbursement method atthe start of the Project and have the option to move to a PMR baseddisbursement method after the Bank has issued a 4A certification.

An Implementation Completion Report and plan for the future operation of the Project will be prepared bythe Borrower within six months after the completion of the Project.

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Annex 7: Project Processing SchedLieAZERBAIJAN: Financial Sector Technical Assistance

BPrQIe4tS #i ; a |Planned ActualTime taken to prepare the project (month9 9First Bank mission (identification) 09/08/2000 09/24/2000Appraisal mission departure 03/04/2001 03/03/2001Negotiations 04/18/2001 04/20/2001Planned Date of Effectiveness 10/15/2001

Prepared by:

The World Bank in collaboration with the Ministry of Finance and the Azerbaijan National Bank.

Preparation assistance:

Bank staff who worked on the project included:

Name SpecialityRochelle Hilton Task team leader/Project implementationTunc Uyanik Banking sector specialistEmin Huseynov Project officer, implementation/coordinationCarlo Segni Banking sectorRama Chandran ProcurementHiran Herat Financial management/AccountingLynn Gross Task Team AssistantDilek Barlas LawyerHannah Koilpillai Disbursements

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Annex 8: Documents in the Project File*

AZERBAIJAN: Financial Sector Technical Assistance

A. Project Implementation Plan

Procurement Plan

B. Bank Staff Assessments

Aide memoireslBTORs: IdentificationPreparationAppraisal

Procurement Capacity and Risk AssessmentFinancial Management Capacity Assessment

C. Other

ABN Strategy for Payment System ReformTechnical specifications for ANB's core general ledger

*Including electronic files

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Annex 9: Statement of Loans and Credits

AZERBAIJAN: Financial Sector Technical AssistanceMay-2001

Difference between expectedand actual

Original Amount in US$ Millions disbursenents'Project ID FY Purpose IBRD IDA Cancel. Undisb. Orig Frrn Rev'd

P008284 2000 IRRIGIDRAINAGE REHAB 0.00 42.00 0.00 37.70 -0.09 0.00P057959 1999 EDUC REF 0.00 5.00 0.00 3.11 2.69 0.00P058969 1999 CLLT HERIrAGE PRSV 000 7.50 0.00 6.81 2.70 0.00P085504 1999 RECNSTR PILOT (IDP) 0.00 10.00 0.00 9.17 -0.25 0.00P035813 1999 AGRIC DEVT& CREDIT 0.00 30.00 0.00 26.53 4.87 0.00P035770 1999 PILOT RECON 0.00 20.00 0.00 1058 8.50 0.00P055156 1998 URG ENV INVST 0.00 20.00 0.00 17A2 1Z45 0.00P008287 1997 GAS REHAB 0.00 20.20 0.00 9.47 10.37 10.33P040544 1997 FARM PRIV 0.00 14.70 0.00 2.80 2.94 0.00P008283 1996 IBTA 0.00 18.00 0.22 2.55 5.25 0.00P008288 1995 BAKU WS 0.00 61.00 0.00 9.42 15.62 0.00

Total: 0.00 248.40 0.22 135.55 68.04 10.33

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AZERBAUJANSTATEMENT OF IFC's

Held and Disbursed PortfolioMay-2001

In Millions US Dollars

Committed DisbursedIFC IFC

FY Approval Company Loan Equity Quasi Partic Loan Equity Quasi Partic1999 Amoco Caspian 30.20 0.00 0.00 9.47 30.20 0.00 0.00 9.471998 Azerb. JV Bank 0.00 1.00 0.00 0.00 0.00 1.00 0.00 0.001997198 Baku Coca Cola 5.25 0.00 0.00 0.00 5.25 0.00 0.00 0.001999 Baku Hotel 17.50 0.00 0.00 0.00 17.50 0.00 0.00 0.001999 Early Oil Fin 14.20 0.00 0.00 4.46 14.20 0.00 0.00 4.461999 Lukoil Overseas 17.76 0.00 0.00 5.57 17.76 0.00 0.00 5.571998 SEF Azdemiryol 0.04 0.00 0.00 0.00 0.04 0.00 0.00 0.001998 SEF Azerigaz 0.24 0.00 0.00 0.00 0.24 0.00 0.00 0.001998 SEF Rabitabank 0.25 0.00 0.00 0.00 0.25 0.00 0.00 0.001999 Turkish Petrol 11.99 0.00 0.00 3.76 11.99 0.00 0.00 3.761999 Unocal Chirag 17.85 0.00 0.00 5.60 17.85 0.00 0.00 5.60

Total Portfolio: 115.28 1.00 0.00 28.86 115.28 1.00 0.00 28.86

Approvals Pending Conunitment

FY Approval Company Loan Equity Quasi Partic2001 Azer JV Increase 0.00 0.00 60.00 0.00

Total Pending Comnitment: 0.00 0.00 60.00 0.00

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Annex 10: Country at a Glance

AZERBAIJANt Financial Sector Technical AssistanceEurope &

POVERTY and SOCIAL Central Low-Azerbaijan Asia Income Development dlamond'

1999Population, mid-year (millions) 8.0 475 2,417 Life expectancyGNP per capita (Atlas method, USS) 460 2,150 410GNP (Atlas method, US$ billions) 3.7 1 022 988

Average annual growth, 1993-99 TPopulation (%) 1.0 0.1 1.9Labor force t%) 1.2 0.6 2.3 GNP Gross

per . , primaryMost recent estimate (latest year available, 1993-99) capita enrollment

Poverty (% of population below national poverty line) 68Urban population (% of total population) 51 67 31Life expectancy at birth (years) 72 69 60Infant mortality (per 1,000 live births) 17 22 77Child malnutrition (% of children under 5) 10 8 43 Access to safe waterAccess to improved water source (% ofpopulation) .. . 64Illiteracy (% of population age 15+) 0 3 39Gross primary enrollment (% of school-age population) 106 100 96 -Azerbaijan

Male 108 101 102 Low-income groupFemale 105 99 86

KEY ECONOMIC RATIOS and LONG-TERM TRENDS

1979 1989 1998 1999Economic ratlos'

GDP (USS billions) .. .. 4.2 4.0Gross domestic investmenVGDP 45.8 39.6 TradeExports of goods and services/GDP 24.1 33.8 TGross domestic savings/GDP 12.0 22.8Gross national savingslGDP 8.1 10.3

Current account balancelGDP -37.7 -27.6 DomesticInterest paymentslGDP 0.2 0.2 InvestmentTotal debtGDP 12.6 14.7 SavingsTotal debt servicelexports 8.8 3.9Present value of debtlGDP 13.0Present value of debVexports - 51.8

Indebtedness1979-89 1989-99 1998 1999 1999-03

(average annual growth)GDP 3.2 10.0 7.4 -AzerbaijanGNP per capita -0.4 6.7 -3.6 - Low-income groupExports of goods and services 11.1 -11.2 67.1

STRUCTURE of the ECONOMY1979 1989 1998 1999 Growth of Investment and GDP (%)

(% of GDP) 7sAgriculture 21.4 23.3Industry 42.6 35.4 s\

Manufacturing 10.4 8.5 25

Services 36.0 41.3

Private consumption 77.2 65.5 -25 94 SC 9

Generalgovernmentconsumption 10.9 11.7 GO GDPImports of goods and services 58.0 50.6

1979-89 1989-99 1998 1999 Growth of exports and Imports (%)(average annual growth)Agriculture 2.3 6.2 24.0 BIndustry 3.9 14.8 3.1

Manufacturing -30.2 -20.7 -34.5 40

Services .. 3.1 7.9 3.3

Private consumption -0.7 21.0 -14.4 0 97General government consumption 4.9 0.4 8.4Gross domestic investment 26.0 20.4 -11.9 .40

Imports ot goods and services 16.3 21.4 -17.3 Exports .. ImportsGross national product 0.5 7.7 -2.8

Note: 1999 data are preliminary estimates.

The diamonds show four key indicators in the country (in bold) compared with its income-group average. If data are missing, the diamond willbe incomplete.

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Azerbaijan

PRICES and GOVERNMENT FINANCE1979 1989 1998 1999 Inflation (%)

Domestic pricesro(% change) .Consumer prices -0.8 -8.9 400

Implicit GDP deflator -6.9 -5.1 200

Government finance(% of GOP, includes current grants) 94 95 96 97 go 99

Current revenue . 17.0 19.8 -200

Current budget balance -2.8 -2.1 - GDP deflator CPIOverall surplus/deficit -4.8 -7.0

TRADE

(US$ millions) 1979 1989 1998 1999 Export and Import levels (USS mill.)

Total exports (fob) 678 1,025 2,000Crude oil from new fields 133 383Petroleum products 393 321 ,.0 sooManufactures 56 239

Total imports (cif) 1,793 1,476 1.* **Food 175 208 500Fuel and energy 28 21Capital goods 791 627 0

93 94 99 96 97 9g o 9Export price index (1995=100) .. .. 120 79Import price index (1995=100) .. .. 100 96 U E:pOrts U ImportsTerms of trade (1995=100) 120 83

BALANCE of PAYMENTS

(US$ millions) 1979 1989 1998 1999 Current account balance to GDP (%)

Exportsotgoodsandservices a1,010 1,282 oImports of goods and services 2,425 1,919 93 -Resource balance -1,415 -636 tra

Net income -203 -526Net current transfers 40 56 20 " ICurrent account balance -1,578 -1.106 -30

Financing items (net) 1.505 1,246Changes in net reserves 74 -139 40

Memo:Reserves including gold (USS millions) .. .. 623 546Conversion rate (DEC, localUSS) .. .. 3,869.0 4,118.0

EXTERNAL DEBT and RESOURCE FLOWS1979 1989 1998 1999

(US$ millions) Composition of 1999 debt (USS mill.)Total debt outstanding and disbursed 526 587

IBAD .. .. 0 0 F10 G4IDA 160 199 E:27

Total debt service 92 51 0:96BAD 0 0 .199IDA . .1 1

Composition of net resource flowsOfficiai grants 29Official creditors -17 54Private creditors 5 -4Foreign direct investment 1.083 373Portfolio equity 0 0 C 251

World Bank programCommitments 40 60 A - IBRD E - BilateralDisbursements 45 61 B - IDA D - Other mulblateral F - PrivatePrincipal repayments 0 0 C - IMF G - Short-termNet flows 45 61Interest payments 1 1Net transfers 44 60

Development Economics 9112/00

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