Document ofThe World Bank

FOR OFFICIAL USE ONLY

Report No. P- 7257 - BH

REPORT AND RECOMMENDATION

OF THE

PRESIDENT OF THE

INTERNATIONAL DEVELOPMENT ASSOCIATION

TO THE

EXECUTIVE DIRECTORS

ON A

PROPOSED CREDIT

IN AN AMOUNT EQUIVALENT TO SDR 37.6 MILLION

TO

BOSNIA AND HERZEGOVINA

FOR AN

ENTERPRISE AND BANK PRIVATIZATIONADJUSTMENT CREDIT

June 1, 1999

This document has a restricted distribution and may be used by recipients only in theperformance of their official duties. Its contents may not otherwise be disclosed without WorldBank authorization.

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CURRENCY EQUIVALENTS/EXCHANGE RATES(as of May 28, 1999)

Unit of currency

Convertible Mark (KM), equivalent 1:1 to Deutsche Mark

1KM=US$0.533

WEIG]HTS AND MEASURES

Metric System

FISCAL YEAR

January 1 to December 31

Vice President: Johannes F. LinnCountry Director: Christiaan J. PoortmanSector Director: Lajos BokrosTask Team Leader: Saumya Mitra

FOR OFFICIAL USE ONLY

ABBREVIATIONS AND ACRONYMS

BH Bosnia and HerzegovinaBPU Bank Privatization UnitCAS Country Assistance StrategyCPA Cantonal Privatization AgencyEBPAC Enterprise and Bank Privatization Adjustment CreditEBRD European Bank for Reconstruction and DevelopmentEU European UnionFBA Federation Banking AgencyFIB Federation Investment BankFPA Federation Privatization AgencyGDP Gross Domestic ProductIDA International Development AssociationIGA Investment Guarantee AgencyIMF International Monetary FundKfW Kreditanstalt fur WiederaufbauKM Convertible MarkMFTER Ministry for Foreign Trade and Economic RelationsMoF Ministry of Finance (of each Bosnian Entity)OHR Office of the High RepresentativePFSAC Public Finance Structural Adjustment CreditPHRD Policy and Human Resources Development FundPIC Peace Implementation ConferencePIF Private Investment FundsRS Republika SrpskaSBA Stand-by ArrangementTAC Transition Assistance CreditUSAID United States Agency for International Development

This document has a restricted distribution and may be used by recipients only in the performance of theirofficial duties. Its contenits may not otherwise be disclosed without World Bank authorization.

BOSNIA AND HERZEGOVINAENTERPRISE AND BANK PRIVATIZATION

ADJUSTMENT CREDIT

Loan Summary ...................................................................... i

I. INTRODUCTION ............. I.........................................................III. MACROECONOMIC SETTING AND FINANCING REQUIREMENTS ...................................... 2

A. MACROECONOMIC PERFORMANCE AND POLICY FRAMEWORK ............................... 2B. MACROECONOMIC PROSPECTS ...................................................................... C. EXTERNAL FINANCING REQUIREMENTS ...................................................................... 4

111. STRENGTHENING THE FRAMEWORK FOR PRIVATE MARKET DEVELOPMENT ...........6A. BACKGROUND ............................................. 6B. REFORM STRATEGY AND PROGRESS ...................................................................... 7

IV. STRENGTHENING THE BANKING SECTOR ...................................................................... 9A. BACKGROUND . ..................................................................... 9B. REFORM STRATEGY ..................................................................... 10

Actions to be SupportedhY EBPAC' ............................................................................................ 14V. KEY POLICY QUESTIONS IN PRIVATIZATION ............................................ 16

Actions to be Supported bY EBPAC ................................................................ 17VI. PRIVATIZATION OF ENTERPRISES ............................................................... 20

A. BACKGROUND ............................................................... 20B. PRIVATIZING ENTERPRISES IN THE FEDERATION . ...................................................... 20

Actions to he supported bY EBPAC ................................................................ 24C. PRIVATIZING ENTERPRISES IN REPUBLIKA SRPSKA . .................................................. 24

Actions to he supported hy EBPAC .............................................................. 28D. LARGE-SCALE ENTERPRISES AND UTILITIES: FEDERATION AND RS ..................... 28

Actions to he su pporied hY the EBPA4( .................. ........ . ........................................................... 29VIl. PRIVATIZATION OF BANKS ...................................... 31

A,ctions to he supported hb the EBPA(' ...................................... 35VIII. THE PROPOSED CREDIT ...................................... 37

A. RATIONALE FOR BANK INVOLVEMENT ...................................... 37B. CREDIT AMOUNT, BORROWER AND COFINANCING .................................................... 37C. CREDIT DESIGN .................................................................. 37D. ADMINISTRATIVE ARRANGEMENTS .................................................................. 38E. DISBURSEMENT ................................................................... 38F. MONITORING ARRANGEMENTS AND TRANCHE RELEASE CONDITIONS ............... 38G. ENVIRONMENTAL ASSESSMENT REQUIREMENTS ........... .................................... 41H. BENEFITS AND RISKS .................................................................. 41

IX. RECOMMENDATION .................................................................. 42

ANNEX I Letter of Development Policy

ANNEX 11 Policy Matrix

ANNEX III Issues Relating to the Success of Privatization

ANNEX IV Key Economic Indicators

BOSNIA AND HERZEGOVINA

ENTERPRISE AND BANK PRIVATIZATIONADJUSTMENT CREDIT

Credit and Operation Summary

Borrower: Bosnia and Herzegovina

Beneficiaries: Federation of Bosnia and Herzegovina.

Republika Srpska

Amount: SDR37.6 million (US$50 million equivalent)

Terms: 35 years, including a 1 0-year grace period

Credit Objectives: To support the privatization of enterprises and banks and implementationof policy reforms at the Entity level. Specifically, the Credit will support:

(i) development of the design, legal framework and regulations, andbuilding up of institutional capacity and implementation of the programfor the privatization of solvent publicly-owned commercial banks andliquidation of insolvent ones: (ii) financial sector reforms to improve banksupervision, strengthen banking laws, establish deposit insurance systems,and limit public intervention in credit markets; and (iii) completion of theinstitutional and legal framework for enterprise privatization, to includerapid initiation of small enterprise privatization, and preparation forprivatization of larger enterprises, holding companies and utilities. Inaddition, the Credit will provide support to reforms of the legal andinstitutional framework necessary for private sector development.

Credit Description: The Credit will be extended to the State of Bosnia and Herzegovina,which will in turn onlenid it in the amounit of SDR22.56 million to theFederation and SDR 15.04 millioni to Republika Srpska, at the same termsof the IDA Credit. Thle Credit will be disbursed in two tranches forbudgetary and balance of paymenits support to the two Entities of Bosniaand Herzegovina. Releasc of tranches will be linked to policyconditionality as agreed during the negotiation of the Credit.

Benefits: The proposed operation will support measures that are crucial to furtheringthe development of a market-based and internationally competitiveeconomy in both Bosnian Entities. A pre-condition for private sector-ledeconomic growth in post-war Bosnia is the rapid transfer of publicownership in enterprises and banks into private hands. By assisting in theimplementation of the privatization agenda, the project will expedite thisprocess and help resolve the issue of pre-war debt and war-related citizenclaims. By pursuing essential reforms in the financial sector, the operationwill help restore confidence in the banking system and mobilize domesticsavings resources that are urgently required to finance investments in theeconomy. By supporting the development of a suitable framework for

i

private business activity, the operation will also contribute to attractingadditional domestic and foreign investment, creating employment andreducing poverty.

Risks: There may be a legal risk associated with the process of privatization. Eventhough a first tranche condition for both Entities is deemed to have been metby the promulgation of the State Privatization Law, it poses a certain riskbecause this Law has been promulgated by the High Representative usinghis powers under Annex X of the Dayton Agreement and powers given tohim by the Bonn Peace Implementation Council. The exercise of thispower may be viewed as an imposition and hence could be challenged.This risk is mitigated by the fact that the Government has represented in itsletter of development policy that the State Parliament is expected to enactthe State Privatization Law under normal legislative procedures in 1999.There is at present a challenge pending in the Constitutional Court of BHagainst the ongoing process of privatization. However, we do not expectthat this challenge will materially or adversely affect the implementation ofthis project in any substantive way.

Quite apart from the general risks of operating in a post-conflict economysuch as that of Bosnia and Herzegovina, the potential risks faced by theproposed Credit are political unwillingness or lack of capacity on the part ofthe authorities to undertake agreed policies and reversal of reform measures.To mitigate the risk of non-implementation of agreed policies and reversalof reform measures, the Bank has been conducting an intensive dialogue,and has mobilised the support of other donor partners to jointly promote theimplementation of the reform agenda. There has been steady progress onthe part of the political authorities to agree on solutions to implementationdifficulties. Moreover, the strong support for privatization among thegeneral public is an important factor mitigating risk.

Poverty Category: Not Applicable

Rate of Return: Not Applicable

Map: IBRD 27708-R

Project ID Number: BA-PE-48461

ii

REPORT AND RECOMMENDATION OF THE PRESIDENT OF THEINTERNATIONAL DEVELOPMENT ASSOCIATION

TO THE EXECUTIVE DIRECTORSON A PROPOSED

ENTERPRISE AND BANK PRIVATIZATIONADJUSTMENT CREDIT

IN THE AMOUNT EQUIVALENT TOSDR 37.6 MILLION

TO BOSNIA AND HERZEGOVINA

1. I submit for your approval the following report and recommendationi on a proposedCredit to Bosnia and Herzegovina (BH), Enterprise and Bank Privatization AdjustmentCredit (EBPAC). in the amount of SDR 37.6 million (US$50 million equivalent) to helpfinance a privatisation operation. The proposed Credit would be on InternationalDevelopment Association (IDA) terms, with a 35-year maturity, including a 10-year graceperiod. This operation follows a structural adjustment operation in 1996 and a PublicFinance Structural Adjustment Credit (PFSAC) in 1998, and it is the first of two plannedoperations that focus on privatization. The Country Assistance Strategy (CAS) wasdiscussed by the Board of Executive Directors in August 1997, and a CAS Progress Reportwas discussed in August 1998. The most recent economic report on BH (Bosnia andHerzegovina: From Recovery 1o Sustainable Groitih) was published in May 1997.

1. INTRODUCTION

2. The proposed Credit builds on BH's achievements to date in establishing therequired legal and institutional framework for privatization of enterprises and banks, andsupports further progress in institution-building and policy reforms in private sectordevelopment. It aims to achieve this objective by focusing on the following areas: (i)development of the design, legal framework and regulations, and building up ofinstitutional capacity and implementation of the program for the privatization of solventpublicly-owned commercial banks and liquidation of insolvent ones; (ii) financial sectorreforms to improve bank supervision, strengthen banking laws, establish depositinsurance systems, and limit public intervention in credit markets; and (iii) completion ofthe institutional and legal framework for enterprise privatization, to include rapidinitiation of small enterprise privatization, and preparation for privatization of largerenterprises, holding companies and utilities. In addition, the Credit provides support toreforms of the legal and institutional framework necessary for private sectordevelopment.

I

II. ECONOMIC OUTLOOK AND FINANCING REQUIREMENTS

A. Macroeconomic Performance and Policy Framework

3. Macroeconomic Performance. The combination of prudent economic policies andlarge-scale donor assistance has yielded impressive results in Bosnia and Herzegovina.Economic growth has averaged about 40 percent in real terms each year since 1995.Inflation has fallen progressively, and is currently running at single digit rates on a country-wide basis. There has been a significant increase in real per capita consumption for mosthouseholds. Many schools and health clinics have reopened. and the main infrastructurenetworks have been largely rehabilitated. Commerce and production are picking up withthe help of donor-financed lines of credit. External debt rescheduling has been successfullycompleted with both London Club and Paris Club creditors, significantly reducing the debtinherited from the formner SFRY. The London Club agreement provided for a 73 percentreduction in the net present value of outstanidinig debt, including arrears: and the Paris Clubagreement provides for debt rescheduling on Naples temis or a 67 percent reduction in thepresent value of the debt. Regularization of relations with remaining creditors, includingthe resolution of issues related to outstanding foreign claims on non-government creditors.is expected to be completed by the end of this year.

4. Despite the rapid economic recovery, reflecting the extremely depressed level ofpost-war economic activity. GDP is still only at about 40 percent of its prewar level andliving standards for many Bosnian families remain low. Measured unemployment, whichfell sharply during the initial years of economic recovery, appears to have stagnated ataround 35 percent--very high even by the standards of transition economies. Due to thelater start to donor assistance and economic recovery, and limited integration with theinternational economy, incomes are lower in Republika Srpska than in the Federation.Although aid flows to Republika Srpska accelerated following the election of a moderategovernment in January 1998, its close economic integration with the Federal Republic ofYugoslavia makes it particularly vulnerable to the ongoing conflict there (see para. 8below).

5. The Macroeconomic Policy Framework. Maintaining the macroeconomicstability that has been achieved to date requires sustained prudent fiscal management by theauthorities, further progress in institution building and transition reforms, and continuedinternational financial and technical assistance. The basic underpinnings for this policyframework are provided by an IMF Stand-by Arrangement (SBA) that was approved inJune 1998.

6. The principal elements of the SBA program are: (i) use of a fixed exchange rateas a nominal anchor through the currency board arrangement; (ii) limiting the fiscaldeficit of the consolidated public sector to levels compatible with available sources offoreign financing and avoiding borrowing by all levels of government from the domesticbanking system and non-bank public; (iii) avoiding any significant accumulation of newdomestic arrears, especially in wage and social security payments; and (iv) continuationof large scale external assistance on concessional terms. Structural elements of theprogram include customs tariff reform and trade liberalization, consolidation of the fiscal

2

institutions of the State and the Entities, and reform of the payments system. Theprogram also contains important elements of the agenda for banking reform andenterprise privatization and restructuring. The first review of the SBA has been delayedbut is now expected to be successfully concluded shortly. The authorities have recentlyrequested that the SBA be converted later this year into an Enhanced StructuralAdjustment Facility (ESAF) arrangement, which would provide a medium-termframework for macroeconomic policies and continued IMF assistance.

7. The govemment's reform efforts have also been supported through adjustmentlending by the World Bank. The Bank's first non-emergency adjustment operation, thePFSAC (SDR 46.2 million, approved in June 1998) assisted the Bosnian authorities inimplementing key public finance reforms in 1998. These reforms were instrumental inimproving the consistency betweeni State and Entity budgets. establishing a transparent andpredictable funding meclhanismii for the State budget. setting the legislative framework forbudget management. establishing a legal and institutional framework for debt management,initiating the harmonization and reform of Entity tax systems, and initiating reform and re-organization of Entity pension systems. The PFSAC was fully implemented and disbursedin less than a year providing a sound basis for the proposed follow-up operation to broadenpublic finance reforms. The EBPAC would support the government's efforts in initiatingbank and enterprise privatization through privatization of small and medium-sizedenterprises, bank restructuring and support for a deposit insurance scheme.

B. Macroeconomic Prospects

8. Prospects for Growthi. Continued stabilization, institution-building and reformefforts are essential in the coming years to ensure sustainable recovery and growth.However, the fluid political environment adds a certain degree of unpredictability, and risk,to Bosnia's future economic performance. The ongoing conflict in the Federal Republic ofYugoslavia (FRY) is having an important impact on economic developments in Bosnia andHerzegovina. notably Republika Srpska. The main channels for this impact includereduced trade, investment and economic activity, and higher unemployment. The fiscalpositioni of both Entities has come under pressure from lower tax revenues and higherpublic spending to deal with increased domestic social needs and new refugees.

9. Despite the disruptions from the crisis in FRY, the Bosnian authorities havepledged themselves to press forward with their economic reform programs. Under ascenario of continued policy reform, and assuming that the crisis in FRY stops in thecoming months, simulations indicate that after 1999 GDP growth would return to itsgradual path of deceleration from the very high postwar rates to rates more normallyassociated with open and dynamic economies (see Table 1). As in the recent past, growthand employment generation in the next few years would be stimulated, to a large extent, bydonor-financed activities. Subsequently, however, consistent with anticipated declines indonor assistance for the reconstruction program, achieving balance of payments viabilityand creditworthiness will require a sizable reduction in domestic absorption. Thisreduction will have to come from public sector investment in light of the current veryconsiderable reconstruction-driven levels of public investment. At the same time, an effortwill be required to offset this reduction in public investment by completing structural

3

reforms, in particular, to attract private capital and increase investment efficiency.Recurrent public expenditures would actually be expected to increase modestly, in line withthe need to strengthen social safety nets and to make appropriate provision for the operationand maintenance of new investments. Consequently, enhanced revenue performancewould be critical to ensure medium-term fiscal sustainability. With these assumptions,Bosnia and Herzegovina's GDP should reach about two-thirds of its prewar level by themid-2000s, bringing living standards in Bosnia much closer to the average of transitioncountries in Central and Eastern Europe.

Table 1: Selected Key Economic Indicators'. 1996-2005

hAIm,oaled P'rolecied

1996 1997 1998 1999 2(1N) 2001 2002 2N1O5(Cross Domestic Pro(luct

(DI' hISS nmillion) 2741 3423 4(082 45 33 533 6262 709(10 9(8(Real (11)'growxth (') 69 .3 18 8 14 14 ()sIn esimnt i° ,of GIP) 41 42 * K8 3. 28 2 5

Public 24 24 2O 16 13 11 7 2P'riv ale 17 1 18 17 2) 21 2 1 23

Consumption )O. of6I)IO) 118 I1) 99 92 87 84 82 78

Public Sector Balances

Expenditures (0, of(dl)P) 78 56 52 48 48 47 44 4(0

Recenucs ( oOl'ofGD) SI 31 32 31 35 36 37 38

Dclicit 1-) ( of' GiP) -27 -"2 .2( -1 7 -13 -I t -7 -2

External Financing (00 ofG(11)1') 27 23 2)1 17 13 11 7 2

Balance of Pavmcnts

'manting Rlequirenrnm.s (I '" ,nillion; 2333 20((6 1683 1423 1289 1247 1022 587

o %Current Account Deficit 1528 17101 1397 1079 1035 990 743 361

o w D)eht Service (scheduled) 575 386 227 195 204 207 229 175

ow%k Increase in Foreign lExchange Reserxes 230 -9(1 59 150 50 5(1 50 50

Inalin - v,gSorr,e (i 5Ss illihon) 2333 2()06 1683 1362 1188 1196 972 587

o V Unlrequited Current Official 'I'ransltrs 558 422 19() 94 45 45 20 7

o. w l)onor Financing 1707 750 983 968 711 700 500 200

o P:1D and Other Private l owvs 1) 0 101) 60 162 185 230 280

o.(v Arrears Clearance and l)ebt Relief -125 306 172 63 47 38 25 11

o.%% Others 194 528 238 178 224 228 197 88

Remain,imng hlnncinLg( G (i NSs ,illw) 0) () 0 61 101 50 50 0

External Debt

Total ExternalDebt' (in 0o ofGDP) 137 127 71 72 68 64 60 55

)ebt scrrice (in '. of'total exports) 66 35 9 8 8 7 6 5

1/ Data refers to estimates for all Bosnia attd Hcrzcgovinia unless otherwise stated.

2/ Excludintg itttercst atnd oft'icial transfers.

3/ litcludittg use of IMF resources, other budgetary/balance of payments support. and financing for reconstruction.

4 Reduction ot'debt stock in 1998 reflects debt rescheduling wNith London Club and Paris Club creditors.

SSource: Otficial data. Bank and IMF staff estiiates.

C. External Financing Requirements

10. Exceptional external financial assistance has made a major contribution to Bosniaand Herzegovina's balance of payments. In addition to generous humanitarianassistance, the international community made commitments during 1996-98 ofUS$4.2 billion, mainly on a grant basis, for Bosnia's reconstruction and peaceimplementation activities. As of end-1998, total disbursements of grants and loan aidwere estimated at about US$2.8 billion. The Donor Conference held in May 1999, whichwas the last to be held in support of the Priority Reconstruction Program, produced total

4

pledges of US$1.05 billion. With the commitment of these pledges, the external financingrequirement of the US$5.1 million Priority Reconstruction Program would be met. Overthe next several years. disbursements of donor funds committed for the PriorityReconstruction Program will provide a substantial share ,f Bosnia's external financing.

11. Allowing for the impact of the crisis in FRY. Bosnia and Herzegovina's totalexternal financing requirement in 1999 is estimated at US$1.4 billion. As in recent years,this financing requirement consists mostly of reconstruction costs and debt serviceobligations. After taking into account anticipated reconstruction assistance and otheridentified official and private flows (including planned disbursements from the proposedPFSAC 11 and EBPAC). there would be a residual financing gap of about US$60 million in1999 which is expected to be closed within the next few months.

5

III. STRENGTHENING THE FRAMEWORK FOR PRIVATE MARKETDEVELOPMENT

A. Background

12. The challenge faced by BH in the economic field after the Dayton Accords was notconfined to reconstruction alone. To lay the foundations for high rates of self-sustaininggrowth, it was necessary to begin the transition to a private sector-based economy. Theeconomy consisted of socially owned or state-owned enterprises and banks. Socialownership meant control of enterprises by management. workers and other enterprises; andbanks were owned by major enterprises. With no clear set of incentives for corporate ormanagement behaviour, and, indeed, with severe conflicts of interests, both enterprises andbanks suffered from serious weaknesses. Management and workers had few incentives topreserve capital or to ensure healthy profits; rather, incentives worked towards maximisingwages and company indebtedness. As banks were founded by enterprises and as laws oninsider lending and lending to connected parties were weak, banks typically lent heavily totheir owners. Banks were insufficiently motivated by maximising returns to capital andwere poor channels for the optimal allocation of investible funds.

13. Corporate and banking behaviour of the above-mentioned kind were facilitated by anabsence of laws enforcing adequate corporate governance and shielding enterprises andbanks from political interference. The accountancy standards fell short of those in mostindustrial countries; entry and exit from economic activities was heavily regulated;investment was directed by non-market considerations and credits were subsidised byadministrative decisions; and state trading played a significant role. All thesecharacteristics were inconsistent with the development of a market economy.

14. Enterprise Sector. A relatively small number of large- and medium-scale publicly-owned enterprises have long dominated the economy of BH, complemented by a largenumber of small-scale private businesses that were allowed to operate in the formerYugoslav economic system. In the Federation, less than 9 percent of the nearly 26,000registered enterprises are in public ownership. but more than half of these 2,300 publicly-owned enterprises are classified as large-scale businesses. In the RS, only about 700 of the11.000 enterprises registered as of 1996 are publicly owned, yet they accounted for 80percent of pre-war enterprise output. Publicly owned enterprises dominated the energy,metal fabrication, wood products, food processing, construction and engineering, lightmanufacturing, trade, services and utility sectors.

15. There is broad consensus within BH that a market-based economy and a vibrantprivate sector are preconditions to lasting growth and for preparing the country forparticipation in Europe's economic and political institutions. There is also growingawareness that private business activity requires an appropriate legal and institutionalframework to operate and grow. While BH has made some considerable progress since theend of the conflict in late 1995 to establish such a framework, the country is still behindsome other former Yugoslav republics that were not paralyzed by war after they gainedindependence and started their economic reforms. Private businesses in BH today face acomplex legal and regulatory framework, a heavy public administrative system (includingthe high-cost, public monopoly represented by the payments bureau), and a weak judicial

6

structure that does not sufficiently ensure enforceability of contracts. These issues arebeing addressed in the context of comprehensive reforms.

B. Reform Strategy And Progress

16. Establishing the architecture for a private, market-based economy is essential notonly for the long-term future of the BH economy, but also in order to maximise theprospects for successful sales of publicly owned enterprises and banks. Since the end ofthe war, several key legal and institutional reforms conducive to private business activityhave been implemented, notably the introduction of a common currency, passage of a StateLaw on foreign investment, and introduction of uniform trade and customs policies acrossthe Entities. The major items in the agenda now being addressed are: clarification ofproperty rights, strengthening of corporate governance, enforcement of commercialcontracts, adherence to fair market practices, introduction of capital market instruments,institution of a privately owned competitive payments and clearing system. enforcementand simplification of taxes, improvements to accounting and auditing standards, and reformof regulations on dependent labor and social welfare. While the establishment of the policy,legislative and institutional framework for supporting private sector growth is theresponsibility of each Entity, Entity governments seek to harmonize policy reforms andnew legislation to the extent possible. In all the areas outlined above where policy andinstitutional development is needed, the Entities are cooperating closely with specialistassistance teams from international donors (notably USAID and the UK Know-How Fund)to put in place solutions that will facilitate private sector development and the success ofthe privatization programs.

17. Commercial Law. The existing legal basis for commercial business activity in theEntities is actively being strengthened. Laws have been passed by the Federation and RSparliaments that secure the rights of shareholders; standardize the reporting activities ofenterprises; specify the duties and obligations of officers of a company; and provide forbetter enterprise registration and streamlined regulation of business activity. In addition toimproved corporate behavior, investors require certainty about their rights and obligationswhen entering into contracts. Existing laws on obligations at the Entity level requireharnonization and streamlining. Further reforms are needed to allow for securedtransactions and collateral-based lending. These include the establishment of an officialregistry of collateral security interests as well as procedures and mechanisms for the rapiddisposal of pledged items. Each Entity has made good progress in these reform areas,aided by international technical assistance, and the remaining aspects of the commerciallaw framework are expected to be in place this year.

18. A new Bankruptcy Law was passed in the Federation, allowing investors in theFederation to enter into agreements and alliances with Bosnian businesses by ensuringadequate procedures for dealing with failed companies and limiting risk to the size of theinvestment. Regarding real and personal property rights, efforts are under way to clarifythe ownership of all forms of property, including "internal shares" in state-ownedenterprises prior to privatization. There is also donor-supported activity to develop anadequate registration system covering all types of property, including shares and realproperty.

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19. Accounting and Auditing. Supported by considerable technical assistance, theFederation has passed a law requiring that Federation enterprises adopt certain keyinternational accounting standards beginning January 1, 1998. By adhering to suchstandards, domestic enterprises will generate auditable, accurate and timely financialstatements that are of use to both foreign and local investors, to local banks and thegovernment. Enterprises will also be better equipped to understand and manage their ownfinancial position and operations. Simnilar reforms in the RS laws are expected in mid-1999.

20. Capital Market Development. With the issuance of privatization claims in theFederation and vouchers' in the RS and the divestiture of publicly owned enterprises,mechanisms are required to allow citizens to transfer and trade their claims and vouchersthrough an organized capital market. With donor assistance, a comprehensive set of capitalmarket laws has been passed by parliaments in both Entities, to address this requirement.These include the Law on Securities, the Law on Security Commissions; the Law onRegistrar of Securities; and the Law on Management Companies and Investment Funds.

21. The Law on Foreign Investment was passed at the State level in mid-1998. With itshighly liberal provisions and a clear level playing field for potential foreign investors itoffers an attractive environment for investment in all sectors.

22. A suitable set of laws is a necessary pre-condition of success in building a privatemarket, but ultimate success will depend on light, but effective, regulation, vigilantprotection of shareholder and investor rights, and clean corporate governance ensured bysurveillance bodies. Much donor effort centers on assisting the institutions that will beresponsible for the enforcement of these laws. Progress in setting up the appropriatearchitecture for fostering private markets has greatly outpaced developments in othertransition economies, and Bosnia. having suffered the severe retrogression brought aboutby the war, is now poised to advance rapidly.

For the definition of claims and vouchers, see Boxes 1 and 2.

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IV. STRENGTHENING THE BANKING SECTOR

A. Background

23. There are 55 banks operating in the Federation, 13 of which are majority owned bythe public sector. These publicly owned banks hold over DM5 billion in assets (at currentbook value, unadjusted for potential losses) or about 77 percent of total banking assets inthe Federation. In the RS, there are 15 banks, II of which are majority owned by publicenterprises. The four largest of these control two-thirds of all RS bank assets. Privatebanks in both Entities were generally created during or after the war and are generally verysmall in capital or asset size. While BH is over-banked in terms of the number of banksregistered, the level of banking and, in particular, lending services available is highlyinadequate to support the recovery of the economy after the war.

24. Prior to the war, BH banks, as in the rest of Yugoslavia, served as captive financecompanies, lending to their publicly owned enterprise owners and providing depositservices, pension payment services, and other basic safe-keeping functions. Banksfollowed a non-commercial orientation characterized by connected lending, excessconcentration, distorted loan classification, and a passive administrative role in disbursingcredits to their owners. On the asset and revenue side, little to no financial analysis wasinvolved in assessing risk. Principal when due was frequently rolled over without evidenceof debtors' ability to repay. Interest was often capitalized. When enterprises neededfurther funds, they were often able to obtain them from those banks that they commonlyowned. Banks took out mortgages and liens on borrowers, but collateral values were ofdubious quality due to problems of collateral perfection and inability to controlcollateralized properties. The judicial structure was not set up to enforce contracts orresolve disputes in favor of creditors. These factors led to a passive banking system inwhich banks neither lent according to commercial criteria, nor monitored for risk onceloans were made.

25. On the liability side, as elsewhere in former Yugoslavia, foreign currency depositswere subject to nearly 100 percent reserve requirements at the National Bank of Yugoslaviain Belgrade. With the breakup of Yugoslavia, these liabilities were not honored byBelgrade; in turn, Bosnian banks were compelled to freeze foreign exchange depositsplaced within them. Liabilities with respect to foreign creditors are being substantiallyreduced through the London and Paris Clubs.

26. The result of bank behaviour on both the asset and liability side described above ledto a significant incidence of insolvency amongst public banks. In BH, the poor quality oflending eroded asset values massively and the effects of the war led to further non-performance of loans. On the liability side, deposits could not be honoured as the reserverequirements were not released by the central bank in Belgrade.

27. Hyperinflation from the late 1980s into the 1990s erased local currency values, andwith it the savings and confidence of the public. The subsequent conflict led to acurtailment of international lending flows that had been routinely passed through thedomestic banking system to finance large enterprise projects. By the end of the war in late1995, these general trends, combined with the imposition of sanctions, led to a loss of

9

liquidity, evaporation of confidence, and a virtual halt to banking operations in the country.Today, banks are illiquid and generally unable to perform significant lending services,other than those refinanced through donor-provided credit lines. There are no activeinterbank or domestic capital markets. Market interest rates of up to 3 percent per monthon DM-based short-term loans from banks reflect this shortage of credit. Meanwhile, highcost structures of socially owned banks relative to volume of banking activity impose verysubstantial operational inefficiencies.

B. Reform Strategy

28. The reform strategy being pursued by both Entities of BH is intended to enhancepublic confidence in the privatised banking system through (i) strengthened bankingsupervision. aided by the powers of a modem commercial bank law, (ii) the liquidation ofall insolvent banks, (iii) institutioni of a deposit insurance scheme; (iv) promoting the entryof foreign banks: and (v) securing long tern funding for commercial banks. It is the policyof both Entities that all solvent publicly-owned banks would be rapidly privatised.

29. Banking Supervisiont. After the war, each Entity proceeded to establish its ownbanking supervision agency. In the Federation, the Federation Banking Agency (FBA) wascreated in mid-I 996 to assume the mandate of carrying out the Entity's bank licensing andsupervision function: it has made an impressive start, assisted by foreign technicalassistance. The agency has begun to actively examine and monitor banks, and implementthe system of supervision. Resident advisors and agency staff have participated jointly in aseries of enhanced supervisory reviews of the Federation's publicly-owned and private-owned banks. Recent amendments to the FBA Law have further strengthened the mandateand independence of the agency. In the RS. the corresponding banking supervision agencywas established by Law in early 1993 and has made progress since then, assisted byconsiderable technical assistance provided by USAID (United States Agency forInternational Development), and using qualified local staff from the former National Bankof RS.

30. To date, the majority of technical assistance to both banking supervision agencieshas focused on the on-site supervision function. The agencies have begun to conduct risk-focused safety and soundness examinations as opposed to the more compliance-basedreviews. New examination report formats have been adopted, and the overall examinationprocess has been strengthened. A system for monitoring the banking sector on an offsitebasis has also been introduced.

31. The Federation agency is now well established and is steadily raising itsprofessional standards but will continue to require technical assistance. In the RS, the taskahead is much greater. The most significant needed enhancement in the RS includes theresolution of the agency's funding structure and implementation of a plan that provides forfinancial independence. In both Entities, a clarification of conservatorship powers andproblem bank enforcement authority remains to be done, particularly in the context of theexpected institution of deposit insurance agencies later this year (see below). The depositinsurance legislation currently under discussion would embody this required clarification.Other areas warranting attention in both Entities include offsite supervision capabilities,bank accounting standards, establishment of an integrated supervisory approach, licensing

10

procedures, and agency enforcement authority. These issues are being addressed in thecontext of continuing technical assistance to the Entity banking agencies. notably byUSAID.

32. Commercial Bank Law. Assisted by the donors, both Entities have prepared theirnew commercial bank laws. These new laws define the authority of the Entities bankingsupervision agencies to supervise, rehabilitate and liquidate banks. The laws establishgeneral operational requirements for banks, defining permissible activities, prohibitedtransactions, prudential standards and insider relationships. They include insolvencydefinitions, the conditions under which a provisional administrator may be appointed by thebanking supervision agencies, the powers and duties of that administrator, and a definedreceivership role, but, as noted above, certain clarifications are required. Liquidationpowers by the banking supervision agency include receivership appointment and oversight,and institutional resolution. The law also permnits deposit and investment banking andestablishes a priority of claims in the liquidation process. Finally, the laws establishgeneral criteria for the disposition of assets and liabilities of banks, and for bank sales ormergers. The law in the Federation was passed at end- 1 998, and the RS law is expected tobe adopted in mid-1999.

33. Liquidating Insolvent Banks. The liquidation of insolvent banks is particularlyvital if confidence in the banking system is to be restored and if appropriate incentives areto be felt by banks as to prudent banking behavior. Existing and proposed legislationclearly requires this and gives appropriate powers to the banking agencies. It would beinadvisable to attempt to rehabilitate or recapitalize insolvent banks as such a course ofaction would not constitute a prudent use of scarce fiscal resources. The Entitygovernments have committed themselves to avoiding such a measure. As a first step,insolvent banks will be closed immediately upon determination of insolvency by thebanking agency. Thereafter, they will be liquidated in an orderly manner.

34. The Federation authorities had set a deadline of March 8, 1999 for thedetermination of the solvency position of all publicly-owned banks. This deadline wasrespected with regard to three public banks, and the authorities are providing further timefor the remaining banks. In 1998, the Federation Banking Agency had established that thelargest publicly owned bank in the Federation was insolvent by a large margin and hadrecommended its closure to be followed by liquidation to the Federation government. As aresult of recent legal proceedings involving this bank and several other publicly-ownedbanks as to the allocation of certain liabilities of these banks and ongoing negotiationsbetween these banks and certain of their foreign commercial creditors, the final solvencyposition of these banks would not be determnined for several more weeks or, possibly,months. If, as expected, the largest publicly-owned bank in the Federation is confirmed asbeing insolvent, the Federation government is expected to close this bank and instituteliquidation proceedings.

35. Careful audits and examinations of banks based on new legislation has beeninitiated in Republika Srpska. Insolvent banks will be treated in the same fashion.

36. Deposit Insurance. As of end-i 997, Federation banks attracted only a very modestvolume of demand deposits of about DM350 million, with practically no savings and term

11

deposits (less than DM60 million) and virtually no deposits held by individual households.As a result, banks have very limited resources for new lending. The same situation appliesin the RS. The war and a reduced level of economic activity have undoubtedly contributedto dissavings by many households. In addition, savings were wiped out as a result ofinflation and the freezing of foreign currency deposits. The latter involves nominal claimsof about DM3 billion from depositors in Federation banks and about DMI.2 billion fromdepositors in RS banks.

37. There are additional reasons for public reluctance to place deposits in banks. Whilemany publicly-owned banks are tainted by their inability to honour frozen foreignexchange deposits, many of the (new) private banks offer limited financial information.depriving prospective depositors of a sound basis for evaluating their financial strength.The enforcement of the strengthened Commercial Bank Law will raise inforrnation anddisclosure standards and help generate new confidence. Another factor is the lack ofservices provided by most banks. Apart from exchanging currency, handling remittancesfrom abroad and providing other minimal services -- all at high fees -- banks offer fewuseful banking services to households or enterprises. Lending transactions as well assophisticated payment services (credit cards. ATMs) are largely unavailable. A broaderrange of services is expected to emerge with privatization and, particularly, entry of foreignbanks. The existence of the payments bureaux that enjoy monopoly in making paymentsand clearing payments is an important factor stultifying the development of a healthybanking industry. The comprehensive reform of the payments bureaux that is planned forimplementation by the Entity governments from mid-1999 onwards will eradicate thismarket-inhibiting barrier.

38. An appropriately structured deposit insurance system would contribute importantlytoward restoring depositor confidence in Bosnia and bringing depositors back to banks inboth Entities. The purpose of establishing deposit insurance systems would be to: (i)protect small depositors from loss in the event of failure of an insured bank; (ii) discouragebank runs that might lead to system-wide financial problems that are associated withmonetary contraction; and (iii) provide an efficient mechanism for disposing of insolventbanks, including a system for disposing of failed bank assets and distributing collectionproceeds to creditors. All European Union (EU) countries are by now required to havedeposit insurance systems.

39. There are two potential problems frequently ascribed to deposit insurance: (i) itmay discourage or eliminate depositor discipline, thereby encouraging banks to takeadditional, and possibly excessive, risk (moral hazard problem); and (ii) it can prove to beexpensive and place a substantial financial burden on healthy banks or taxpayers. Themarket discipline issue can best be addressed by providing a modest level of insurancecoverage for each depositor. At the outset coverage would be set at DM5,000 perdepositor, or over five times the current GDP per head of BH.

40. A modest level of insurance coverage would also reduce the cost of the depositinsurance system. So, too, would several other features of the proposed system: (i) depositinsurance would be restricted to deposits in private banks that meet capital requirements;publicly-owned banks would be excluded; participation of foreign banks operating in thecountry would be compulsory; (ii) insured banks that subsequently fail to meet capital

12

requirements would be subject to restrictions on their expansion of insured deposits; and(iii) insured depositor preference in the event of bank failure would allow the depositinsurer to recover most or all of its outlay to insured depositors in most instances.

41. The deposit insurance scheme to be established under Bosnia's financial sectorreform program would be funded by an initial seed capital contribution which is estimatedat DM14 million for the Federation and DM6 million for RS. In addition, there would be alevy on deposits in insured banks of some 0.25 percent per year. Financial projectionsdemonstrate the viability of a scheme run along these lines. As the credibility of thedepositor insurer (both domestically and internationally) is a prerequisite if depositors areto retumn to banks, the deposit insurer would enjoy substantial independence. Under theprogram, a small. permanent Deposit Insurance Agency would be established in eachEntity as an autonomous agency accountable directly to parliament to administer thescheme. The institution would be appointed receiver for closed insured banks and wouldhave responsibility for collecting on failed bank assets and distributing the proceeds tocreditors.

42. Entry of Foreign Banks. Attracting foreign banks will be a necessary complementto strengthen competition and revitalize the banking sector in both Entities. Since the endof the war, two foreign banks have set up green-field operations in the Federation. Furtherforeign bank entries are hoped for in the form of strategic investments during the bankprivatization process. A number of international banks have begun to explore the prospectsof entry into BH and one bank has carried out a detailed feasibility study. The privatizationof the Federation Investment Bank (FIB), (see paragraph below), offers one prospect forforeign entry. The European Bank for Reconstruction and Development (EBRD) has takenan equity position in two banks in the Federation and has encouraged twinning programs.

43. Finance for Investment - the Federation Investment Bank. Investment capitalhas been scarce in Bosnia since the end of the conflict. Limited short- and medium-termcapital needs have been met by donor lines of credit and local businesses, but there remainsa complete absence of longer-term investment capital. This is despite the fact that capitaldemand is strong and potential profitable projects are numerous. In response to this issue,the Federation government created, in late 1997, the Federation Investment Bank (FIB).Using reflows of donor lines of credit and other donor funds, FIB is expected to support thelong-term investment finance needs of the Federation economy.

44. In preparation for the proposed IDA Credit, the Bank has been in discussions withthe Federation government on the structure and operations of the FIB. These discussionsproduced an agreement in June 1998, intended to bring FIB's charter and businessorientation into line with the objectives of the government's bank privatization program.This agreement sets out the types of assets and liabilities the bank can hold and eliminatesthe role of the government in determining final beneficiaries of credit. FIB will extendcredits only indirectly, as a second-tier bank, to final beneficiaries through the commercialbanking sector. While FIB may require local banks to allocate a limited amount of creditsfor specific purposes (i.e. projects that will support exports), FIB will make no evaluationof individual loan decisions which will be taken by the participating first-tier banks. First-tier banks will extend credits financed from FIB resources only for long-term investmentprojects.

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45. The agreement also specifies that FIB will have the right to accept deposits fromthe Federation Govemment (but only until end-1999), and not from any other source. FIBwill have to pay competitive fees for the advantage of holding government deposits.Finally, FIB will pursue majority private owvnership and management in the near fiuture.

46. The Federation government has announced its policy of privatising the FIB rapidlyand has invited the assistance of the World Bank Group and the German Kreditanstalt furWiederaufbau (KfW) to this end. Private investors could be other banks. foreign and local,and multilateral banks. Work is underway to structure the balance sheet of the FIB in away that would be of interest to potential buyers. The shareholding of the Federationgovernment would be limited to 10-15 percent of the total share capital of FIB.

47. Finance for Investment - Otlier Activities. With the assistance of internationaldonors, a number of other initiatives have been taken in both Entities to provide finance forinvestment. Under an IDA project - the Industrial Restart Project - an InvestmentGuarantee Agency (IGA) has been established to provide guarantees against political risk(war or civil disturbance, cancellation of licenses or restrictions on trade, expropriation,foreign exchange inconvertibility, and certain other risks) to commercial lenders forworking capital. The International Finance Corporation (IFC) has participated in three keyactivities to encourage finance for investment: a venture capital fund, a microenterprisebank, and a credit line for medium-sized wood sector manufacturers. The EBRD is alsoparticipating in the venture capital and the microcredit activities. Credit lines have beenextended by IDA to both Entities and also by USAID. IDA is assisting the Entityauthorities to prepare a line for the financing of inputs for exports that will leverage inprivate sources of finance. This project is likely to include support for the issuance ofperformance bonds by BH companies; the lack of such bonds is considered to be a majorimpediment to exports by BH.

Actions to be Supported by the EBPAC

48. The financial sector reform program, supported by the proposed operation, willseek to further strengthen banking supervision capabilities in the Federation and their rapiddevelopment in the RS. Given extensive technical assistance provided by USAID to bothEntities on a long-term basis, progress in all areas of banking supervision is expected toremain quick and substantial. The RS will also pass a new Commercial Bank Law. Inorder to create deposit insurance systems, first tranche release for the Federation would beconditioned on the Government 's submission to Parliament of a Deposit Insurance Lawthat is satisfactory to IDA. For second tranche release, the Deposit Insurance Agency is tohave started finctioning in the Federation. Second tranche release for the RS isconditioned upon the passage of a Deposit Insurance Law and the setting up of the DepositInsurance Agency, (the functioning of which is expected to require a few months beyondsecond tranche r elease).

49. First and second tranche release conditions of the proposed Credit for theFederation are that it shall not establish or extend any credit lines using budget resourcesoutside the FIB, similarly for the RS that it shall not establish or extend any credit linesusing budget resources. Also, neither Entity shall establish any new bank or increasecapital subscription in any existing bank.

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50. Further first tranche release conditions for the Federation are that (i) theoperations of the FIB are to be based solely on market principles, and (ii) the Federationshall initiate efforts to privatize the FIB. By second tranche release, the Federation is tohave taken actions satisfactory to IDA on reaching agreement with private investors on theprivatization of the FIB. (As the RS has not established a specialised development banklike the FIB, there are no similar conditions for the RS. The RS has a development bankingunit within its payments bureau, and this unit will be privatised in line with its bankprivatization program.)

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V. KEY POLICY QUESTIONS IN PRIVATIZATION

51. Competence to Privatize Resides with thze Entities. The Dayton Accords providethe framework for building the governance structure in BH. Under the Accords, BH is asovereign state consisting of two multi-ethnic Entities, the Federation of Bosnia andHerzegovina and Republika Srpska, with a State government responsible for internationalrelations and certain other specific functions identified in the Dayton Accords. Keyeconomic institutions and policies envisaged at the State level include a central bank(organized as a currency board for a period of at least six years) and a new currency,customs and trade policies (but not administration -- an Entity responsibility), internationalfinancial relations (including servicing of international debts and debt management) andinternational and common aspects of telecommunication and transport.

52. The Entity governments, in contrast, have exclusive responsibility in theirrespective territories over defense, internal affairs and police, justice, environmentalpolicies, economic and social sector policies (such as agriculture, industry, education andhealth), refugees and displaced persons, public investment and reconstruction programs andtax and customs administration. They are responsible for the administration andimplementation of all economic policies (even those assigned to the state at the policylevel, e.g., customs, trade). with the central bank being responsible for the currency boardfunction. To carry out their responsibilities, each Entity has ownership of the taxescollected in its territory.

53. However, the constitution of Bosnia and Herzegovina does not deal explicitly withthe ownership of public property in post-war Bosnia and Herzegovina. Public property inthe former Yugoslavia was not generally state owned, but was owned by enterprises andworker-management councils. After considerable debate among the State and Entitygovernments and in close consultation with the international community, the principle wasestablished that the competence to privatise will reside with the Entities, and the Entitieswill have the sole right of enjoying the proceeds. Each Entity will be responsible forprivatising assets located only in its territory and will also acquire corresponding liabilities.Cross-Entity claims will be settled by arlbitration.

54. Through a State-level Privatization Law -- that was promulgated by the HighRepresentative in August 1998 using hiis powers under the Dayton Agreement and PeaceImplementation Conference (PIC) decisions -- the State recognizes and reaffirms the rightof the Entities to carry out privatization of publicly-owned assets and to dispose of theresulting proceeds. The Law requires Entities to ensure that privatization recognises therights of all citizens, including displaced persons and refugees. The Law furthermoreprovides for an audit of the balance sheet and the ownership of companies that have beenirregularly privatised since the onset of the war. The responsibility for carrying out theseprovisions of the State Law rests with the Entity governments and privatization institutions.In order to monitor Entity performance in these regards, the High Representative hasestablished a monitoring commission reporting to him. It is expected that the Stateparliament will pass this Law through normal legislative process in 1999.

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Action to be Supported by the EBPAC

55. The first tranche release of any portion of the credit is conditioned upon thepromulgation of the State Privatization Law. (This condition is deemed to have been met.)

56. Privatization Methlod. As in other countries. BH had a choice of approaches tocarry out enterprise and bank privatization. In light of the vast amount of some DM15billion that is owed to the citizens of the Federation by the Federation Government and afurther estimated DM2 billion in similar obligations of the RS Government towards itscitizens, it was decided to permit room for a voucher-based approach (called claims in theFederation, and claims or vouchers or coupons in the RS) in parallel with cash and otherapproaches in order to compensate as many claims as possible through the enterprise (andapartment) privatization process. Bank privatization is allowed through cash purchasesonly.

57. In the Federation, claims will be issued in exchange for certain liabilities owed tocitizens by the Entity. The four categories of such specific claims relate to frozen foreigncurrency deposits in Federation banks, unpaid wages of soldiers, unpaid pensions, andrestitution. In addition, a general claim for all citizens based on number of years ofworking life will be issued. In the RS, the specific obligations of the Entity towards itscitizens that will be honored relate to frozen foreign currency deposits in RS banks andveterans and families of fallen soldiers. In addition, a general voucher for all citizens willbe issued in a uniform amount per citizen. In the RS, vouchers related to veterans andsoldiers and the general voucher will be identical in character and usage; frozen foreigncurrency deposits will be compensated for by the issuance of coupons that will be eligibleto be used in cash sale privatization. For this reason, coupons are also called "cashequivalents"'.

58. As the Entities lack the fiscal resources -- either cash or capacity to contract debt --to satisfy such claims, vouchers or coupons, the exchange of Entity assets offers theoptimal solution. Claims are being carefully checked, and a number of implementationdifficulties are being addressed at present. It is expected that claims will be issued in theFederation in the third quarter of 1999 and in the RS coupons will be issued by autumn1999 and vouchers some months thereafter. A final category of specific claims in theFederation is planned to compensate holders of restitution claims on the Federationgovernment. Such claims related to restitution are expected to be issued in late 1999. TheRS plans to provide for restitution not through the issuance of vouchers but by establishinga special Restitution Fund late in 1999.

59. In the Federation, claims will be used by holders (who may trade them freely) topurchase shares in enterprises being privatised (especially small scale privatizations) or ininvestment funds, and, importantly, they will also be used to buy apartments. TheFederation has passed a law on privatization of apartments. It is estimated that a significantshare of claims will be absorbed via purchases of property; this will help to buoy up thevalue of claims, whilst making greater room for cash privatization under the programs. Inthe RS, vouchers will be used in privatizations of medium and large enterprises, where atleast 55 percent of the value of the company has to be put up for purchase through claims.A further 10 percent of shares in large enterprises will be allocated to the RS Pension Fund

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and a further 5 percent to the Restitution Fund. Cash or coupons will be used for smallenterprise privatizations and for the purchase of apartments.

60. Mass privatization using claims or vouchers has shown mixed results in othercountries and the privatization prograims in the Entities has been designed with theselessons in mind. In order to address the weaknesses of corporate governance, the lack offresh capital injection, and insufficient development of capital markets that have beenassociated with voucher programs in other countries, the schemes in both Entities havebeen tailored to providing scope for cash and strategic invesment by limiting voucherprivatization of small firms to 65 percent in the Federation, with the outstanding balance tobe paid in cash. In the RS. only cash or cash equivalents are allowed to be used in small-scale privatization. For large enterprise privatization. the Federation will make room on acase by case basis for the use of claims; in the RS the main use of vouchers is expected tobe in the context of large enterprise privatization. but a strategic stake of up to 30 percent ofthe company could be provided for. In each Entity, large enterprises will prepareprivatization plans with due attention being given to need for increased capitalization of theenterprise and for foreign strategic investment. The establishment of a trading system thatmakes possible transparent and low cost trading of both claims and shares bought throughthem and other measures to promote capital market development, such as the institution ofinvestment funds, are vital features of the programs. The trading systems are beingdeveloped with donor technical assistance in both Entities.

61. As experience in other countries has shown, investment funds could be easily proneto abuses. The laws of the Entities provide for strict regulation on the conduct andgovernance of such funds, for dealing with potential conflict of interests and for appropriatedisclosure in the interests of stringent shareholder protection. By these means, it will bepossible to cancel the claims against Entities through vouchers without suffering theweaknesses associated with voucher privatizations of the past.

62. Eligibility to Participate in General Claims Privatization. Participation inpriva.ization needs to be broad to ensure public acceptance of the program and to providecompensation of all eligible citizen claims in the process. While all citizens of BH areconsidered eligible to participate in all privatization transactions, a specific question ofeligibility relates to the entitlement to obtain the Entity-issued general claims for use inenterprise privatization in both Entities and also for apartment privatization in theFederation. The State Privatization Law requires that all BH citizens resident in theterritory of an Entity as of end-March 1991 (the date of the final pre-war census) be entitledto receive general claims from that Entity, regardless of their current residency. Legislationof each Entity (together with supporting regulation) is consistent with the State Law andprovides for the equal treatment of all citizens and, in particular, safeguards the rights ofdisplaced persons and refugees in the issuance of general claims. General claims may beissued by each Entity to other groups of BH citizens. Thus, Entity Laws and regulationshave given clear importance to the principles of non-discrimination, transparency in theprivatization process, and to accountability.

63. Assets Covered by Privatization. The privatization laws of the Entities relate to thepublicly-owned assets of enterprises and banks, including public corporations and utilities,that are located within the territory of the Entity. Assets of enterprises and banks located in

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the other Entity or abroad and which are not under the control of the Entity in question willnot be subject to privatization by that Entity. These claims and cross-claims are eitherincluded within an inter-Entity arbitration procedure as set out under Annex 5 of theDayton Accords, or they will need to be dealt with by other bodies charged with resolutionof ownership claims among the former Yugoslav republics. The majority of publicly-owned BH enterprise and bank assets are located within the territory of BH and areincluded in the privatization program of each Entity. The remaining assets under disputewill be resolved and, if applicable, privatized at a later stage.

64. Speed of Privatization. A broad consensus has been reached among both Entitiesand the international community that speedy privatization is of utmost importance in thespecific Bosnian context. Privatization must be rapid to prevent further deterioration ofwar-damaged assets, to minimize illegal or spontaneous privatizations in areas notadequately under the control of the Entity authorities, and, above all, to rapidly create theconditions for sustained, private sector-led growth while foreign-financed officialreconstruction assistance is being gradually phased out. Continued public ownership ofproductive assets adds little value in light of the complete lack of budgetary resources tofinance public investments, and in view of the general inability of the Entity governmentsto effectively control enterprise management prior to privatization. Removal of ownershipuncertainty through privatization is a pre-condition for attracting much needed directforeign investment. While rapid privatization bears risks of underestimating the value ofsome assets, the benefits of speedy divestiture outweigh these risks in the BH context.

65. Sequencing of Privatization. The privatization strategy provides for rapidprivatization of small enterprises (during 1999-2000) with a flexible set of possibilities ofusing a mix of cash and claims in the Federation and a mix of cash and cash equivalents inthe RS. Privatization of banks will be exclusively through cash sales and requirement bythe purchaser to inject further capital in banks, with the first major transactions expected totake place by end 1999. Larger enterprises, holding companies, and utilities will follow.Prior to privatization, holding companies need to be disaggregated into privatizablebusiness units that are under the control of one Entity. Utilities require the priorestablishment of adequate regulatory frameworks, to be harmonized between the Entities soas to ensure BH-wide freedom of communication, transport and other services. In the areasof telecommunications and electric power generation and distribution, work is proceedingon developing the regulatory framework. The framework will provide for increased privateparticipation in these sectors. Progress is likely to be more rapid in telecommunicationsthan in electricity and privatization of existing telecom operators is envisaged for 2001.Work on the regulatory framework for other sectors is being initiated with donor assistance.

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VI. PRIVATIZ,ATION OF ENTERPRISES

A. Background

66. The two Entities have adopted a comprehensive set of laws for the privatization ofenterprises and have, furthermore, established agencies to undertake the task. In theFederation, Laws on Enterprise Privatization and on Opening Balance Sheets (that definesthe balance sheet of the enterprise to be privatised) have been adopted. Privatizationagencies at the Federation level and in cantons have been established and their division ofresponsibilites clarified. However, not all cantonal agencies are adequately staffed orfunctioning; it is expected that full functioning of these agencies may yet take severalweeks. Republika Srpska legislation on enterprise privatization and opening balance sheetswas passed in July 1998, thereby annulling the earlier highly defective Privatization Law of1996, and the privatization agency is functioning.

67. The book value of privatizable assets in state-owned enterprises remains unknownuntil opening balance sheets and privatization plans are established for all enterprisesconcerned. Book values will provide guidance. but the market value of enterprises (andshares in them) will be known only through the auctions or the tendering process orthrough negotiated sales.

B. Privatizing Enterprises In The Federation

68. Establishing Claisa. As early as in December 1995, the Federation adopted anapproach to enterprise privatization whereby publicly- or socially-owned assets (e.g., smallbusinesses, business assets, enterprise shares, and apartments) would be exchanged insettlement of various citizen claims. The approach also provided for restitution ofnationalized property -- which would create financial restitution claims in cases whereactual assets could not be returned -- and for general privatization claims, with the latterbased on years of prior employment.

69. In adopting this approach, the intent was to compensate citizens claims and wartimesacrifices without resorting to cash payments that could not be financed from the budget. Itis expected that many of the claims would be absorbed by citizens buying apartments. Theresulting full extinguishing of citizen claims was deemed the only practicable alternative tocash payments.

70. The approach chosen by the Federation relies on the Federation PrivatizationAgency (FPA) being responsible for enterprises that are located in more than one cantonand the 10 canton-based privatization agencies for enterprises located within one canton.The agencies will assess the privatization plan prepared by each enterprise, establish thevalue of privatizable assets in their jurisdiction and carry out the matching of citizen claimsand enterprise assets. The FPA oversees the entire process and ensures compliance withthe applicable Laws. The FPA issues regulations and directives applicable for all canton-based agencies, covering the methodology of preparing opening balance sheets ofenterprises and of carrying out auctions.

71. The first step in the process is the creation of unique citizen claim accounts. Thesewill cover the following types of claims:

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- General claims. All citizens of BH and residents on the territory of theFederation as of March 31st, 1991, who are 18 years or older, are eligible toreceive these claims. The amount of this claim will be based upon the numberof years of work according to data submitted by the pensions bureau andMinister of the Interior to the payments bureau. The juvenile children ofdeceased parents who are elegible for the general claim will inherit that claim.

- Frozen foreign currency claims. All citizens of BH and residents on the territoryof the Federation as of March 31 st, 1991, with foreign currency accounts with

Box 1: OVERVIEW OF MASS PRIVATIZATION IN THE FEDERATION

Liability Term Can be used in Can be used in Can be used toSmall-scale Large-scale buyPrivatization* Privatization apartments

General: (Provided to all Claim Yes Yes Yescitizens based on workingyears)Specific: (provided to certaincitizens)

Frozen Foreign Currency Claim Yes Yes YesMilitary Back Pay Claim Yes Yes YesPension Arrears Claim Yes Yes YesRestitution Claim Yes Yes Yes

In the Federation Privatization system, each eligible participant will be provided an individual claim account at thepayment bureau. The Claim account represents the sum of five categories (general, foreign exchange, militarywages, pension arrears, and restitution) that are given value based on the liabilities the Federation has towards thecitizen in each of these areas. In the Federation, claims have a nominal face value and may be sold or traded.

* For Small-scale Privatization, assets may be purchased for a minimum of 35% cash with the balance to bemade up in any combination of cash and claims.

* For Large-scale Privatization, assets may be purchased for any combination of cash and claims.

* In the Federation, small-scale privatization is defined as enterprises with less than 15 employees or under500,000 DM in assets, any non-core business unit of an enterprise undergoing mass-privatization, or any catering,service, trade, or transport business as defined by the Ministry of Industry.

more than DM100 on the territory of the Federation as of March 31, 1992 areeligible to receive claims. The information on frozen foreign currency accountsis to be verified by account holders and then submitted by banks to thepayments bureau.

- Armed forces members's claims. All members of the armies of BH and policeduring the war are eligible to receive claims. These data will be submitted bythe Minstry of Defense to the payments bureau.

- Pension arrears. Arrears in pension payments are to be eliminated through theissuance of claims.

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- Restitution. All persons who have a court decision on determined right torestitution will be compensated through claims. A Law on restitution has notyet been passed; no procedures for creating these claims have been established.(This will, however, not hold up privatization as restitution claims will beissued at a later stage and used for enterprises being privatised in the secondphase.)

- Once the data has been submitted to the payments bureau, it will assemble anaccount for all eligible individuals. The information on the account will then bemailed to the recipients of the claim for verification. The claims will bedematerialized and tradeable claims held in accounts at the payments bureau.

Enterprise Privatization Timeline in the FederationActions 1999 2000

_UIMA MA I | J JAI S 10 N D JI F MIAIMA J I J Al S JOIN I)Law on Enterprises adopted* rT TTrr TTTTX r r rNaming of Security Commissionr_

Citizen claims statement mailed

Claims correction period

Enterprises prepare and submit OBS &Privatization Plan

All Cantonal Agencies functioning

Securities Commission operational

OBS and Privatization Plan reviewed

Small-scale privatization

Share registry operational

Claims related to rcstitution issued

Management companies licensed

Private Investment Funds (PF _)registeredSubscriptions to I'lI s

Large-scale l'rivatization

Prospectus for sale of'Felecom andElectrical Power

72. Implementation Timetable. All enterprises which are candidates for privatization,except for a small number of strategic enterprises, were responsible for preparing openingbalance sheets by April 1999. Enterprises will also submit a proposed privatization planthat will include its preferred method of sale (auction or tender). It will then be up to theappropriate privatization agency (Federation or cantonal) to accept or reject the openingbalance sheet and adjust the privatization program as necessary. Publicity of firms to besold will take place in two stages, first the appropriate privatization agency will publish alist of all privatizable assets, and then specific announcements for auctions and other saleswill be made in the media. For small scale privatization, the Law on Privatization ofEnterprises in the Federation requires at least 35 percent cash payment and the balance tobe made up in cash or claims. Any combination of cash and claims can be used to purchaseassets sold under mass privatization.

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73. Institutional Aspects. The enterprise privatization program, as designed in theFederation, requires the processing of a vast amount of information so as to assign claimsfor liabilities. Data on citizen claims are difficult and time-consuming to collect in theirentirety and requires the establishment of specialized departments within the FPA. Generalclaims data is compiled by combining information from the pensions bureau and theMinistry of Interior; frozen foreign currency data from banks, and army back pay datafrom the Ministry of Defense.

74. In addition to the legislation, the institutional structure has been built up over thepast year and a half. While the FPA in Sarajevo has been functioning since May 1997,only in early 1999 has the tenth and final Cantonal Privatization Agency (CPA) beenestablished. Not all cantonal agencies have been fully staffed or are as yet operational. It isexpected that all would be fully operational by end-spring or early summer. The role of thecantonal agencies is critical given the decentralized approach to privatization in theFederation. According to the Federation Law on Privatization Agencies, each canton isresponsible for passing a separate cantonal Law to create its CPA, name a director anddeputy director, select the CPA management board and supervisory board, and finance itsCPA. Various political and implementation difficulties have been responsible for slowprogress in this work, mainly the two ethnic groups have not cooperated successfullv inthose cantons with mixed populations and enterprises in those cantons have also notcooperated in providing data.

75. Two major immediate operational tasks are required to be completed beforeenterprise privatization can start in eamest in the Federation. First, eligible citizen claimsneed to be identified, which requires gathering information on army back-pay, on frozenforeign exchange deposits, and the determination of general claims based on years of priorwork. The FPA has made considerable progress in cooperation with banks and the nationalpayments bureau to identify citizen claims and establish citizen accounts, except forrestitution claims which will wait for a later stage of privatization. The two armies in theFederation have reached agreement on army back pay. Second, CPAs need to carry out anassessment of enterprises' opening balance sheets and privatizable asset values. Recentprogress in collecting and assembling these data indicate that these tasks would requireseveral more weeks for completion. A third, less immediate, task is the issuance of claimsrelated to restitution.

76. All enterprises are required to draw up their opening balance sheets according to theLaw within tight deadlines and then to prepare a plan for privatization that wins theapproval of the privatization agency. Under the Law, enterprises are divested of theirforeign loan liabilities that have been subject to Paris and London Club deals. In preparingtheir privatization plans, enterprises have considerable freedom, but protection is beingbuilt in against insider transactions. The Laws of both Entities provide for a great deal offlexibility in determing the shape of the individual sale, in particular the relationshipbetween cash and claims, subject to the approval of the final plan by the relevantprivatization agency.

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Actions to be supported by the EBPAC

77. Prior to first tranche release of the proposed Credit, the Federation would initiatesmall enterprise privatization by conducting auctions or issuing tenders for at least 45small companies. Payment may be for cash or claims. If not all citizen claims have beenformalized in the payment bureau accounts, the privatization authorities will allowadditional time for citizens to settle the claims portion of the puirchase pirice. A lso, allcantonal privatization agencies would need to be filly staffed and operating. One area ofprivate sector development, the establishment of a capital market and particularly thedevelopment of privatization investment funds, is considered crucial to the success of theprogram. First tranche release of the proposed Credit will, therefore, he condilioned onthe passage of Lawo on Management Companies and Privatization Investmnent Fundsallowing citizens to invest their claims in enterprises through funds as well ais individually.Finally, in light of the new State-level Privatization Law ancd its requiirements, as acondition for first tranche release, the Federation is required to amend its EnterprisePrivatization Law, to ensure consistency wvith the non-discrinminairy principle of the statleprivatization Law.

78. Before the second tranche release, the Federation will have conclulded and settledprivatization transactions for at least 500 small enterprises, excluding candidales fornatural restitution. Also by that time, the Federation will begin subscription fio shares inat least 100 medium to large-scale enterprises. In the medium term, the FPA will need totackle the particular challenge of restructuring and privatizing the complex holdingcompanies that dominated the Bosnian economy prior to the war. Prior to second trancherelease, the prospectus for the sale of at least one holding company by its constituent partswill have to be issued

C. Privatizing Enterprises in Republika Srpska

79. Legislative Framwork. The legal framework for enterprise privatization in the RShas changed considerably over the period since the end of conflict. The RS initiallydecided to follow a very different approach than the Federation towards privatization thatrelied heavily on a lottery system for the allocation of shares to its residents. Moreoever, alarge percentage of total shares were to be allocated to seven privatization funds whichwould remain under public control.

80. This initial approach to privatization in the RS raised a number of serious concerns.Among other issues, it would not have been transparent nor equitable as citizens wouldhave had no choice in the composition of their initial share portfolio. Also, the opportunityto compensate specific citizen claims through transfer of privatized assets would have beenlost. The incentives arising from private ownership would be highly blunted as thepublicly-owned privatization funds would exert heavy influence. Moreover, no reform ofcorporate governance under these conditions could be expected to take place.

81. Upon advice by the Bank, the RS government that took office in early 1998,assisted by the British Know-How Fund and USAID, have rapidly put in place a set ofLaws and have strengthened institutions. In the summer 1998, the parliament passed:

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* the Law on the Privatization of State Capital in Enterprises;

* the Law on Opening Balance sheets in the Course of Privatization of State Capital inEnterprises; and

* the Laws on Securities, on Privatization Investment Funds, on ManagementCompanies, and on the Central Registry of shares.

82. In the same package, the RS Parliament passed the Banking Laws (on Privatizationof State Capital in Banks and on Opening Balance Sheets in the Course of Privatization ofState Capital in Banks) as well as the Law on Enterprises. The latter ties in very closelywith the development of capital markets and addresses key areas such as the rights ofshareholders, the delineation of duties and obligations of corporate officers and directors,the contents of founding documents (corporate charter) and the requirements for generalassemblies.

83. With all required Laws in place. the RS now faces the same challenge as theFederation to move quickly into implementation of enterprise privatization. The RSprivatization agency staff needs to be strengthened and equipped with technical skills - thistask is being undertaken by foreign technical assistance. The process of defining claimsand establishing enterprise opening balance sheets is expected to be completed in Summer1999. Finally, a number of rules and regulations need to be drafted and adopted toimplement privatization.

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Box 2: OVERVIEW OF MASS PRIVATIZATION IN THE RS

Liability Term Can be used in Can be used in Can be UsedSmall-scale Mass to BuyPrivatization Privatization Apartments

General (all eligible Voucher No Yes Nocitizens)Specific: (providedto certain citizens)Frozen foreign Coupon Yes Yes Yes*currencyFamilies of killed Voucher No Yes NosoldiersVeterans Voucher No Yes No

* Current Law states that apartments. when sold. mav be purchased using frozen foreign currency. I lo cvcer.it does not specifically allow coupons to he used. When the l,awk is drafted, the use ol coupons w ill be regulated.

In the RS Privatization system. public capital in a single enterprise valued at less than 300,000 DM isprivatized for cash and coupons only. At the request of the citizen, a percentage of the value of frozencurrency on his/her account is transferred to the payment bureau where is it converted into coupons. This is aone-way process - unused coupons cannot be converted back into a foreign currency liability.

Coupons have a nominal value and are tradable among local legal and physical Entities. PrivateInvestment Funds (PlFs) may not engage in the trade of coupons.

Interested eligible citizens register at the payment bureau for a voucher account. All eligible citizens mayreceive vouchers in the categories indicated. While vouchers have no nominal value, they may be tradedthrough an exchange and by PIFs.

* Where state capital is valued at less than 300,000 DM, assets maybe purchased by eligible citizenswith only cash or coupons, in any combination.

* Where state capital is valued at 300,000 DM or greater, 10% of the sale of shares are transferred to theRS pension fund and 5% to a restitution fund. A minimum of 55% of the capital must be offered by salein the vouchers program. The remaining balance 30% may be offered for sale by tender of the assetsmay be purchased by strategic investors and with any combination of vouchers, cash, or coupons.

84. Institutional Aspects. The nature and use of vouchers in the RS is quite differentthan the analogous use of claims in the Federation. While they are similar in that they willbe dematerialized and tradeable, they vvill not be bid alongside cash in sales. Vouchers willhave no face value, unlike in the Federation, and therefore cannot be used against cash insales. There will be an equal distribution of general vouchers per holder and an additionaldistribution going to veterans and families of fallen soldiers. Frozen foreign currencydeposits will be compensated by the issuance of coupons. These coupons will have a facevalue but can only be used in small-scale privatization and for purchase of apartments. Theprivatization process will therefore follow two distinct tracks.

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$ Small-scale enterprises (firms with less than DM300,000 in capital) will beprivatized through a combination of cash and coupon sales.

* Assets of large-scale enterprises privatizated will be sold as follows: at least 55percent for vouchers, 15 percent for restitution and pension funds, and the remaining 30percent to strategic investors for cash or investment tenders or through remaining vouchers.cash, or coupons. The purpose behind this is that, in larger firms, vouchers will be used forwide ownership, and cash will be associated with strategic investors who will recapitalizeenterprises.

85. The RS Law is consistent with the requirements of the State Privatization Law.General vouchers will be issued to the core group of the population (see Chapter V) and toother groups, of which the most significant is individuals who have taken up RS residencysince 1991. This implies that the Federation-based approach of the government notifyingits citizens on the value of vouchers credited to their account will not be feasible in the RS.Rather, individuals will be invited publicly to register for vouchers. Unlike in theFederation, the RS would need to start an intensive public infornation campaign andprovide means of registration of citizen claims. The majority of citizens who have alreadyregistered under the previous privatization attempt will not need to do so again.

86. Other specific challenges to implement enterprise privatization in the RS relate tothe weak commercial court system, which promises to create a bottleneck for enterpriseregistrations and re-registrations. There is also uncertainty as to the capacity of the RSClearing and Payments Office (SPP) to manage the xoucher privatization process with itsgiven staffing and technology. Substantial technical and financial assistance has beensecured from the British Know How Fund and USAID to address these issues.

87. Implementation Timetable. It is currently envisaged that the RS privatizationagency will staff itself adequately in the first months of 1999. The submission of enterprisedata regarding audited financial statements, opening balance sheets and ownership will takeplace in mid-1999; with the review by the privatization agency of this informationfollowing shortly thereafter. Cash sales for small privatization will begin in mid-1999.The distribution of vouchers is expected to be completed in autumn 1999, therebypermitting mass voucher privatization transactions thereafter.

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Enterprise Privatization Timeline in the RSActions 1999 2000

M__M A M JJA S O NID J FMIA M J J A S| N Don Directorate professionallv staffed

Nomination of Security CommissionManagers-Enterprises prepare and submit OBS

Citizen registration for vouchers

Pilot cash auctions

Securities Commission Operational

Coupons issued

Small-scale privatization*

Review of validity of'the 013S by PrivatizationDirectorate

Finalize technical issues concerning voucherdistribution (IT)

Private Investment Funds registered

Vouchers issued

Share Registry Established

'I'rade of vouchers commences

Large-Scale Privatization

P'rospectus for sale ofTFelecom and IllectricalPower

Actions to be Supported by the EBPAC

88. C(onditions ffor first tranche release are that the RS Parliament adopt Laws onenterprise privatization which will insure transparency of the process and equlilabletreatment of the residents as well as provide a rapid and rigid timelinec/or privatization tofbllowi. Prior to second tr anche release, the RS will have begun privatization of small-scaleenterprises and have privatized at least 30 percent of small-scale enterprises. For mediuimand larger enterprises, by the time of second tranche release, the RS will have preparedand execuled international tenders of the majority capital stake in at least three large-scaleenterprises. Prior to second tranche release, a prospectus for sale will be issued for partsof the holding company by its constituent parts which will be tendered

D. Large-scale Enterprises and Utilities: Federation and RS

89. The small-scale privatizations are expected to be completed within one year in eachEntity. Preparations have already begun, albeit in a preliminary way, for the sale of largeenterprises and conglomerates. These enterprises are outdated, with markets lost, and skillsdispersed. The strategy is to identify the centers of profitability that exist within someenterprises of these conglomerates and to sell those to strategic investors under publictender offerings. To implement the strategy, conglomerates will have to develop businessplans for the promising enterprises and a privatization plan with the opening balance sheet.

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Parts of conglomerates that could not be privatizated will be closed. The task of completingmass privatization will take up to two years.

90. The enterprise privatization program in both Entities provides for utilities as well.Public corporations such as utilities are covered by Annexes 4 and 9 of the Dayton accordsin relation to the respective rights of the State and the Entities and as to the organisation,regulation, and operation of the utilities. The rights of the State are confined tointernational and common aspects of communications and transport. The Entities havebegun to cooperate fruitfully with each other to reorganize these sectors and will also workwith the State and with the Commission on Public Corporations (a Dayton body) to ensurethat constitutional requirements are fully implemented. It is equally vital to ensure thatthese sectors are reorganised and regulated in such a way as to maximize the prospects ofprivatization or concessioning in each of these sectors.

91. The privatizations of two major utilities, telecommunications and electric powergeneration and distribution, will be the forerunnlers in utility privatizations. The Statepassed the Telecommunications Law in late 1998 so the regulatory regime is expected to beestablished in 1999 in line with World Bank and EBRD technical assistance. The strategyrelies on introduction of privately provided services with the privatization of existingoperators occurring at a later stage. in 2001. The telecommunication privatization wouldbring in significant cash for Entity budgets and much new investment to the benefit ofservice standards.

92. The electric power generation sector is considerably decentralized in the country,which is an advantage for privatization. The same is true for distribution. There is acommon grid between the Entities and trade takes place, but is over-regulated at present.Moreover, BH is expected to join the Union for the Coordination of Production andTransmission of Electricity and to become a significant trader of electricity. The Entitieswill reach a common understanding on policies and regulation in this sector in the nearfuture. This understanding, together with supporting Entity legislation, will create theconditions for establishment of regulation. Privatization is expected in both Entitiessometime in 2001.

93. In privatizations in the utility sectors, the Entity governments will follow thestrategy of maximising prospects for investment commitments and new technology, whilstattempting to provide for claims. Thus, the typical pattern will be to find one or aconsortium of strategic investors. Future program of private participation in utilities willinclude sales or concessioning in railways, road transport, water, gas and all other sectors.This will necessarily take a period of two to three years into the new century.

Action to be supported by the EBPAC

94. Work has begun to examine the structure of the utility sectors. Significant progresshas been made in the telecom and power generation and distribution sectors/areas. Thesetwo sectors are the closest to being ready for enhanced private sector participation andeventual privatization and now need an appropriate regulatory structure designed andimplemented. A condition for second tranche release in the Federation is theestablishment of the regulatory framework necessary for privatization of telecom and

29

electric power generation and distribution. There is no similar condition for the RS in viewof the RS program being behind by several months with respect to that of the Federation.

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VII. PRIVATIZATION OF BANKS

95. Without relief from their pre-war international debts and from their liabilitiestowards domestic citizens for frozen pre-war foreign currency deposits. Bosnia's publicly-owned banks have no possibility of becoming solvent and, subsequently, privately-owned.Pre-war loans to domestic enterprises have to be largely written off due to heavy wardamage and loss of markets for the borrowing enterprises. Also, banks' claims on theforner National Bank of Yugoslavia for foreign exchange deposits are doubtful at best. Inorder to resolve these issues of liabilities with foreign creditors and frozen foreignexchange deposits-which combined account on average for some 90 percent of today'sbank assets-and to pave the way for subsequent bank privatization, a strategy for bankrestructuring and privatization has been developed with assistance from thle Bank and otherforeign donors. This strategy consists of two pieces of legislation: a Law on OpeningBalance Sheets, and a Law on the Privatization of Banks. Both Entities have passed theseLaws and started with their implementation.

96. Opening Balance Slheets. The Law on Opening Balance Sheet determines whichof the end-1997 assets and liabilities will be removed from State-owned banks' balancesheets at the time of privatization. Removable items are classified into: (i) ''neutral" assets.consisting of apartments and other assets subject to restitution; and (ii) 'passive" assets andliabilities that are not under the control of banks. The latter include: (a) pre-war, frozenforeign currency deposits redeposited with the former National Bank of Yugoslavia, alongwith banks' corresponding liabilities towards domestic households; (b) pre-war externaldebt, including guarantees (covered by soverign guarantees). with corresponding and non-performing loans to public enterprises, and (c) war-damaged physical bank assets, non-performing assets and other assets and liabilities out of the banks' control, such as brancloffices located in other former Yugoslav republics or in the other Bosnian Entity.

97. The Entity Ministries of Finance (MoF) will take over these carved-out neutral andpassive assets and liabilities, after write-offs, while the opening balance sheets of the state-owned banks will only show the remaining "active" items. Claims by the London Clubcreditors were rescheduled in late 1997 and an agreement with the Paris Club was reaclhedin June 1998. Claims of other foreign creditors will be dealt with througlh debtrescheduling at the State level and subsequent debt service by the Entity concenied.Claims by households for lost foreign exchange savings will be compensated through aprovision to their individual claim accounts that may be used in the enterprise privatizationprocess.

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Solvenr Banksntpo Timva o pn p raion and RSrions 1999 2000

Mn MMFIH111111_ J IJ A s o N D J IFI M IA IM J J AS 0 N DSovency test for majority state-owned ________ _ _ _

Liquidation of Insolvent Banks _ -------

Solvent Banks' privatization plans prepared

Bank Privatization Unit provides comments___ ____r- ______ IIIIDeposit insurance scheme introduced

MoF decision on P. Plan. Banks wvith Plansnot approved begin liquidation processExecution of P. Plan and sale of'solventbanksFIB fully privatized

1 W _MA M1 .1 JA S O N I) JI 1 M A M J .1 A S IN 1)

RS Ministry of Finance issues instructions

Adtobanks performed

Banks submit OBS to Bank P'rivatization

Adoption of Commercial Bank Law

Bank Plriv. Lnit/Min. of Finance approves0135RS Banking Agency conducts solvency test

lDeposit insurance scheme introduced

Liquidation of'Insolvent Banks

Solvent banks Suibmit privatization programi

Governmienit decides on appropriatenessand applicability ot'privatization programSale of'privatized banks

If no sale of'bank. Gov. must make decisionlon liquidation of'solvent banks

98. Bank Privatization. Subsequent to these carve-outs, the Law on Privatization ofBanks sets criteria by which publicly-owned banks will be selected for privatization orliquidation, and it defines the roles of the Entity's banking supervision agency and the MoFin that process. Through the enactment of the Laws on Bank Privatization in both Entities,ownership of publicly-owned banks has been passed over to the MoF. The MoF and thebanking agency are now jointly monitoring and supervising the privatization procedure.

99. In the Federation, the Bank Privatization Unit is preparing opening balance sheetsfor the majority-publicly owned banks that have not submitted audited opening balancesheets of the required quality. The opening balance sheets for three banks weresubmitted to the Federation Banking Agency for a solvency test in March 1999. For

32

other banks, the authorities have provided additional time, possibly until late summer1999. At this time, banks considered insolvent will have their license revoked and willbe assigned a conservator. Banks determined to be solvent will proceed with theprivatization process and must be privatized by June 2000.

100. In the RS, banks are in the process of preparing their opening balance sheets forsubmission to .he RS Bank Privatization Agency. The RS Bank Privatization Agencywill review the Opening Balance Sheets and if accepted forward them to the RS BankingAgency for a solvency test. As in the Federation. RS banks that are considered insolventwill have their license revoked and those that are solvent will proceed with theprivatization process. Entity Bank Privatization Laws charges the MoF to carry out theprivatization of solvent banks but remains silent on the specific method of privatization.There is broad consensus that finding strategic international investors from within thebanking industry will be the preferred solutioni. followed by sales to non-bank torei .ninvestors or other domestic bank or non-bank investors. The intention is for the MoF tolaunch international tender offers for these banks, to be complemented by directnegotiated transactions. Interested investors will undergo a qualification process by thebanking supervision agency.

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Proposed Organizational Relationships Between Deposit Insurance Agency, Asset and LiabilityWorkout Unit and Bank Privatization Group

Superivsory Role

Cooperative Role

Entity Parliament l

Ministry of Finance

Deposit Insurance Agency * Banking Agency Bank Privatization Unit (temporary)- Eligibility of Insurance Cooperation - On-site supervision Carved Out Insolvent Bank:- Management of insurance fund on - Off-site supervision - Bank Marketing and Sales- Paying depositor claims insolvent - Licensing - Advising FBA on various resolution transactions- May act as a receiver for insured insured - Enforcementprivate banks private - Conservatorship Asset and Liability Workout Sub-unit*

banks - Appoints receiver for Solvent Banks:insolvent banks - Closing/taking possession of banks

- Identification of all assets and liabilities- Disposal of assets and settlement of liabilities- Preparing regulatory reports- H-landling requests from interested parties- Investigating causes of bank failures

Foreign Banks Insured Private Uninsured Private lEntitv Banks Entity Banks * Sub-unit to be Folded into the Deposit Insurance

Agency

113. The legal framework for bank privatization was put in place in early 1998 by theFederation and in mid-1998 by the RS, and its timely implementation is now the challenge facedby each Entity. As long as the government owns certain banks that it also regulates, there will bea perceived and real conflict that will discourage private bank development. Most publicly-owned banks can be expected to seek the maximum time possible to be privatized. They willlikely request more time, if only because they cannot identify acceptable investors, at least onterms that best serve their own interests. Of concern is that the operation of publicly-ownedbanks throughout the privatization period is left largely to the bank managers. The lack of activeownership interest raises a moral hazard problem. It cannot be assumed that the best interest ofthe managers matches that of its Entity owners.

114. To facilitate the bank privatization process. a dedicated Bank Privatization Unit (BPU), incharge also of the worki-out of carved-out assets and liabilities, has been set up in each Entity MoFand given a clear mandate to implement privatization of solvent banks and liquidation of insolventbanks. Substantial. long-term expatriate technical assistance has been secured by the Bank forthese units through financing by the Govemments of the Netherlands (for Federation MoF) andSweden (for RS MoF). The BPU will determine and carry out privatization actions for eachsolvent publicly-owned bank, and will be charged with asset collection activities for either carved-out balance sheets items or for insolvent public banks undergoing liquidation. Asset collection willbe complicated by inter-Entity and inter-former Yugoslav Republic claims. The tasks ofreceivership and bank liquidation should both be vested in this unit. Upon the abolition of the unit,after some two years. receivership and bank liquidation will be subsequently devolved upon anewly created Deposit Insurance Agency. (See chart for the relationships of responsibilitiesbetween the various public bodies in this field.)

115. Getting strategic and qualified investors commited to invest in Bosnia's public banks is anuncertain proposition. Legal uncertainty, a large bank labor force of mixed quality, excess fixedassets, exposure risk to called letters of credit and guarantees and other contingent liabilities arelikely to pose obstacles to attracting foreign banks as investors. De novo entry could be theapproach an interested foreign bank would select in BH. However, if there is real interest, itshould take no more than several months to identify it and reach agreement on a privatization sale.The legislation offers the MoF the latitude to initiate a bank privatization program for a specificbanlk at any time, even prior to obtaining the proposed privatization plan from a specific bank.

116. It may be advantageous to organize a consolidation or merger of public banks, involving thelargest public, solvent banks in each Entity and several of the smaller public banks, as a pre-condition for successful privatization. Under all circumstances, rehabilitating banks by injectingfresh capital or incurring any other form of cash, debt or contingent fiscal costs needs to beavoided. No forms of assisted transactions should be contemplated at all. Strategies forconsideration for resolving insolvent and non-saleable banks should include purchase andassumption transactions where deposits are transferred to another institution along with selectedassets. Essential to the use of such efficient, less disruptive resolution techniques is the passage ofa proposed depositor preference provision in the Commercial Bank Law (as discussed in the earliersection on deposit insurance agencies).

Actions to be Supported by the EBPAC

117. The proposed operation will support the launching of the implementation of the bankprivatization process in each Entity. To ensure an expedient start, prior to first tranche release, the

35

Federation Government will close the largest insolvent bank as a first step toiward liquicdation. TheRS first tranche release condition is the adoption of the Law1 on Bank Privatization and thepassage of the Law on Opening Balance Sheets for Banks that provide for a secure basis for r apidprivatization of banks and enterprises. For both Entities, the M1oF is r equiired to establish a fillystaffed and functioning bank privatization unit by first tranche release.

I I 8. Before the second tIranche release, in the Fedeerction, the liquidation o 'the previously closedlargest insolvent bank in the Federation will he conmpleted. The solvency position of Central ProfitBank and Union Bank wiill have been determined and each will have been closed, wt'ith theliquidation process hegun (i/ insolvent) or wvill hacve issuted a prospectus for sale (ifsolvent). In theRS prior- to second tranche release, the BPU] will have established the solvency f oJstate ownedbanks and taken control and closed the largest insolvent bank plus one other insolvent hank.Furthermore, the BPU wi'ill have issued the sales prospectae for the three largest solvent statehanks in the RS

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VIII. THE PROPOSED CREDIT

A. Rationale for Bank Involvement

119. The Bank Group's assistance strategy during FY98/99--as outlined in the CountryAssistance Strategy dated July 31. 1997. and a Progress Report of July 5, 1998 (discussed by theBoard on August 6, 1998)--aims at assisting BH in moving from immediate postwarreconstruction towards sustainable recovery and growth. The key objectives of this strategy are:(i) strengthening the institutions of macroeconomic management: (ii) initiating structural reformmeasures, particularly in privatization and banking reforms. and (iii) carrying forward physicalreconstruction of the country.

120. Particular emphasis will be placed on support for structural reform measures aimed at puttingthe economic system on a private-based, competitive footing. Key among these efforts are reformsto transfer ownership of enterprises and banks into the private sector, strengthen the financialsector, and improve the framework for private sector development. The proposed Enterprise andBank Privatization Credit is the main IDA instrument in the FY98/99 program to achieve theseobjectives. It is complemented by ongoing economic sector work, including for post-privatizationassistance, payment system reforn, and enterprise finance assistance, as well as ongoinginvestment lending for commercial credit lines in both Bosnian Entities. A second possibleenterprise and bank privatization credit focusing on large-scale enterprise and utility privatizationsand on reform of the payments system is being considered for FY2000 so as to assist the Entitygovernments complete the privatization process.

B. Credit Amount, Borrower and Cofinancing

121. The proposed IDA Credit, in an amount equivalent to US$50 million (SDR 37.6 million).will be lent to Bosnia and Herzegovina (the State) for a period of 35 years, including a 10-yeargrace period, on standard IDA terms. The State will onlend, through subsidiary agreements.SDR22.56 million equivalent of the Credit proceeds to the Federation and SDR 15.04 millionequivalent of the Credit proceeds to Republika Srpska, on the same terms of the IDA Credit.FIunding for technical assistance required for the preparation of this operation was providedthrough a Japanese PHRD grant. Technical assistance for the implementation of the project hasbeen secured from a number of donors, including the governments of the Netherlands, Sweden, theUnited Kingdomii and the United States.

C. Credit Design

122. The proposed Credit would provide quick-disbursing funds for fiscal and balance ofpayments assistance in support of the government's efforts to privatize enterprise and banks andfurther develop the private and financial sectors. It will support the first phase of the authorities'multi-year overall privatization program. The main elements of the program supported by thisoperation include: (i) development of the institutional capacity and implementation of theprogram for restructuring and privatization of state-owned commercial banks; (ii) financialsector reforms to improve bank supervision, strengthen banking Laws, establish depositinsurance systems, and limit public intervention in credit markets; and (iii) completion of theinstitutional and legal framework for enterprise privatization, rapid initiation of small enterpriseprivatization, and preparation for privatization of larger enterprises and holding companies andutilities. In addition, the Credit provides support to reforms of the legal and institutional

37

framework necessary for private sector development. Conditionality (as specified in section F) islinked to institutional and legal reforms required to allow privatization to take place quickly andefficiently. Other substantive reforms discussed in the previous sections are important for anefficient and competitive private sector in the longer term. The Bank may decide to support thesereforms in the context of support for the next phase of the privatization program with a possiblefollow-up operation.

D. Administrative Arrangements

123. The State Ministry for Foreign Trade and Economic Relations (MFTER) is responsible foroverall administration of the Credit on behalf of Bosnia and Herzegovina. the borrower. EachEntity's Ministries of Finance is responsible for administering the pre-allocated amount of funds ofthe Credit. Based on the discussions with govemment authorities. it is understood that thecounterpart funds of the proposed Credit would be used to support fiscal expenditures of the Entitygovernments, in particular. contributions of the Entities to the 1998/1999 State budget for debtservice obligations, essential social expenditures such as pension payments and minimum incomesupport, and costs related to institution-building efforts in the areas of privatization, debtmanagement, budget management and tax administration. Credit proceeds will allow the RS tosupport wider use of the national currency. the convertible mark, within the Entity and toencourage a move away from the use of the Yugoslav dinar.

E. Disbursement

124. The Credit will be disbursed in two tranches to the deposit account of the State at the CentralBank of Bosnia and Herzegovina. The first tranche amounts to US$25 million equivalent andconsists of a Federation share of US$15 million and a Republika Srpska share of US$10 million.Each Entity would be eligible to obtain its share of the first tranche upon (i) Credit effectiveness;and (ii) satisfaction by the Entity in question of its first tranche release conditions. The secondtranche amount and Entity-specific allocation is identical to that of the first tranche, and eachEntity would be able to obtain disbursement of its share of the second tranche upon: (i) review bythe IDA of the satisfactory implementation of the adjustment program as a whole; and (ii) thefulfillment of the specific second tranche conditions by the Entity in question. Details of first andsecond tranche release conditions are provided in the following section.

F. Monitoring Arrangements and Tranche Release Conditions

125. Implementation of the policy program will be monitored by a Committee composed of therepresentatives of the State MFTER and t]he Entity Ministries of Finance. The Committee willhave responsibility for monitoring and evaluating progress under the various components of theprogram with input from participating ministries and institutions. IDA will monitorimplementation with the help of the Committee's reports, and through supervision missions.

126. Specific conditions for first tranche release of the proposed Credit are as follows:

For the State of Bosnia and Herzegovina:

(a) Promulgation of the State Privaitization Law;

For the Federation of Bosnia and Herzegovina:

38

(a) Government closes the largest insolvent bank as a first step toward liquidation.

(b) The Entity shall not establish or extend any credit lines using budget resourcesoutside the Federation Investment Bank (FIB). The operations of the FIB to be basedsolely on market principles. Government initiates efforts to privatize FIB. Nor shall theEntity establish any new bank or increase capital subscription in any existing bank.

(c) The Government shall establish a fully staffed and functioning Bank PrivatizationUnit (BPU).

(d) The Governmenit shall submit a Law on Deposit Insurance to Parliament that issatisfactory to the World Bank.

(e) The Law on Managemiienit Companies and privatization investment funds allowingcitizens to invest their claims/vouchers in enterprises through funds as well asindividually shall be adopted.

(f) The Entity will amend the Enterprise Privatization Law to ensure consistency with thenon-discrimination principle of the State Privatization Law.

(g) The Government will initiate privatization, by conducting auctions or issuing tendersfor at least 45 small privatization objects. Payment may be for cash or claims. If not allcitizens claims have been formalized in Payment Bureau accounts, the privatizationauthorities will allow additional time for citizens to settle claims portion of the purchaseprice.

(h) Cantonal privatization agencies will be fully staffed and operating.

For the Republika Srpska:

(a) The Entity will pass a Law on Opening Balance Sheet that provides for a secure basisfor rapid privatization of banks and enterprises.

(b) The Entity shall not establish or extend any credit lines using budget resources. Norshall the Entity establish any new bank or increase capital subscription in any existingbank.

(c) The Entity shall adopt a Law on Bank Privatization.

(d) The Government shall establish a fully staffed and functioning Bank PrivatizationUnit (BPU).

(e) The Entity shall adopt Laws on Enterprise Privatization which will ensuretransparency of the process and equitable treatment of the residents, and which willinclude a rapid and rigid timeline for privatization to follow.

127. Specific conditions for the second tranche release are as follows:

For the Federation of Bosnia and Herzegovina:

39

(a) The Entity will complete liquidation of largest insolvent bank.

(b) The Government will determine the solvency position of Union Bank. If Union hasbeen found solvent, the Government will issue a prospectus for sale for Union Bank. IfUnion has been found insolvent. the Government will close Union and begin the processof liquidation.

(c) The Government will determine the solvency positioin of Central Profit Bank. IfCentral Profit Bank has been found solvent. the Government will issue a prospectus forsale for it. If Central Profit Bank hlas been found insolvenit, the Government will close itand begin process of liquidation.

(d) The Entity shall not establish or extend any credit lines usinlg budget resourcesoutside the FIB. Nor shall the Entity establish any new bank or increase capitalsubscription in any existing bank.

(e) The Government will take actions satisfactory to IDA on reaching agreement withprivate investors on privatization of FIB.

(f) The Deposit Insurance Agency will have started functioning.

(g) The Government will conclude and settle privatization transactions for at least 500small enterprises. excluding candidlates for natural restitution.

(h) The Governmenit will begin public subscription for shares in at least 100 medium/large enterprises.

(i) The Government will issue prospectus for sale for at least one holding company by itsconstituent parts.

() The Entity will establish regulatory framework necessary for privatization of telecomand electric power generation and distribution.

For the Republika Srpska:

(a) The Government will establish the solvency of state owned banks, take control ofand close the largest insolvent bank plus one other insolvent bank.

(b) The Entity shall not establish or extend any credit lines using budget resources. Norshall the Entity establish any new bank or increase capital subscription in any existingbank.

(c) The Government shall issue sales prospectae for the three largest solvent state-owned banks.

(d) The Entity shall pass a Law on Deposit Insurance.

(e) The Government shall set up a Deposit Insurance Agency.

40

(f) The Government shall begin privatization of small scale enterprises and privatize atleast 30 percent of small scale enterprises.

(g) The Government shall prepare and execute international tenders of majority stake inat least three large scale enterprises.

(h) The Government shall issue prospectae for sale for parts of the holding company byits constituent parts which will be tendered.

128. Progress witlh Respect to First-Tranchle Release Coniditionts As noted in this report, bothEntities have made substantial accomplishmenits in the design and implementation of theenterprise and bank privatization programs. A State Privatization Law has been promulgated thatsets out the fundamental criteria in privatization that have to be respected. The Federation hasfulfilled a number of its first tranche release conditions. The conditions outstanding are: (i) theclosure of the largest insolvent bank; (ii) submission of a Draft Law on Deposit Insurancesatisfactory to the Bank; (iii) initiation of small enterprise privatization, and (iv) the fullestablishment and functioning of all cantoiial privatization agencies. Work is underway toensure the satisfaction of these conditions within a few weeks after approval of this Credit by theBoard. There has been steady progress in most of the areas mentioned above. Republika Srpskahas fulfilled all its first tranche release conditions.

G. Environmental Assessment Requirements

129. In accordance with the Bank's Operational Directive on Environmental Assessment(OD 4.01, Annex E). the proposed operation has been placed in Category "C" and does not requirean environmental assessment.

H. Benefits and Risks

130. Benefits. The proposed operation will support measures that are crucial to furthering thedevelopment of a market-based and intemationally competitive economy in both Bosnian Entities.Private sector-led economic growth cannot gain momentum in post-war Bosnia without the rapidtransfer of public ownership in enterprises and banks into private hands. By assisting in theimplementation of the privatization agenda, the project will expedite this process and contribute tothe resolution of the issue of pre-war debt and war-related citizen claims. By pursuing essentialrefonns in the financial sector, the operation will help restore confidence in the banking system andmobilize domestic savings resources which are urgently required to finance investments in theeconomv. By supporting the development of a suitable framework for private business activity,the operation will also contribute to attracting additional domestic and foreign investment, creatingemployment and reducing poverty.

131. Risks. There will be general project risks associated with BH's process of peace andreconciliation in the framework of the Dayton Accords in December 1995. The continuedstrengthening of the common institutions of the country, steady progress in cooperation betweenthe different national groups within state institutions, and greater inter-Entity cooperation arehighly encouraging factors. However, there may be a legal risk associated with the process ofprivatization. Even though the first tranche condition for both Entities is deemed to have been metby the promulgation of the State Privatization Law, it poses a certain risk because this Law hasbeen promulgated by the High Representative using his powers under Annex X of the Dayton

41

Agreement and powers given to him by the Bonn Peace Implementation Council (see para 48). Theexercise of this power may be viewed as an imposition and hence could be challenged. There is atpresent a separate challenge pending in the Constitutional Court of BH against the ongoing processof privatization, the outcome of which is unpredictable. This risk is mitigated bv the fact that theGovernment has represented in its Letter of Development Policy that the State Parliament isexpected to enact the State Privatization Law under normal legislative procedures in 1999.

132. Quite apart from general political and implementation risks of operating in the BH economy,the potential risks faced by the proposed Credit are unwillingness or inability of the authorities toundertake agreed policies and reversal of refonr measures. This may arise from political costs(e.g.. of liquidating banks or selling companies to foreigners) or from lack of capacity to undertakethe ambitious program within agreed deadlines. There has been less thani satisfactory cooperationbetween the two major national peoples in the Federation and delays have resulted. To mitigatethe risk of non-implementation of agreed policies and reversal of reform measures, the Bank hasbeen conducting an unusuallv intensive dialogue with donor partners and has mobilized theassistance of the High Representative. other multilaterals and certain bilaterals with a view tojointly promoting the implementation of the reform agenda. Technical assistance on a large scalefor banking and enterprise privatization provided in parallel to this Credit is expected to helpreduce any domestic tension over the reform program that may arise and remove potentialbottlenecks to program implementation. The strong support enjoyed by privatization among thegeneral public in BH and growing cooperation at the implementation level between national groupsare further mitigating factors to these risks.

IX. RECOMMENDATION

133. 1 am satisfied that the proposed Credit complies with the Articles of Agreement of theAssociation. and I recommend that the Executive Directors approve it.

James D. WolfensohnPresident

by Sven Sandstrom

June 1, 1999

42

SCHEDULE A

BOSNIA AND HERZEGOVINA

PROPOSED ENTERPRISE AND BANK PRIVATIZATION ADJUSTMENT CREDIT

TIMETABLE OF KEI PROJECT PROCESSING EVENTS

1. Time taken to prepare: sixteen months

2. Project prepared by: Entity Governments with IDA assistance

3. Identification Mission: November 1996

4. Preparation Mission October 1997

5. Appraisal Mission: March 1998

6. Negotiations: August 1998

7. Planned Board Presentation: June 1999

8. Planned Effectiveness: July 1999

9. Expected Project Completion: June 2000

10. Relevant SAR: Not applicable

43

SCHEDULE B

BOSNIA AND HERZEGOVINAPROPOSED ENTERPRISE AND BANK PRIVATIZATION

ADJUSTMENT CREDIT

STATUS OF BANK GROUP OPERATIONS IN BOSNIA AND HERZEGOVINA

A. STATEMENT OF BANK LOANS a

(As of May 24. 1999)US$ Millioni

Loan Fiscal (Less Cancellations)No. Year Borrower Project Loan Undisbursed

Loans/Credits/Grants

IBRD "4038-BOS 1996 Bosnia and Herzegovina Consolidation Loan A 28.6 0.04039-BOS 1996 Bosnia and Herzegovina Consolidation Loan B 284.9 0.04040-BOS 1996 Bosnia and Herzegovina Consolidation Loan C 307.1 0.0

Total 620.6 0.0

Of Which: Repaid 24.9Total Now Held by the Bank: 595.7

TFBHc" (Under Disbursement)TF-024030 1996 Bosnia and Herzegovina Emergenicy Recovery Credit 45.0 0.0TF-024031 1996 Bosnia and Herzegovina Emergency Farm Reconstruction 20.0 0.0TF-024032 1996 Bosnia and Herzegovina Emergency Water Supply 20.0 0.0TF-024033 1996 Bosnia and Herzegovina Emergency Transport 35.0 1.8TF-024034 1996 Bosnia and Herzegovina Emergency District Heating 20.0 0.0TF-024035 1996 Bosnia and Herzegovina Emergency War Victims Rehabilitation 5.0 0.0TF-024040 1996 Bosnia and Herzegovina Emergency Education Reconstruction 5.0 0.0

Total 150.0 1.8

IDA2897-BOS 1996 Bosnia and Herzegovina Emergency Education Reconstruction 5.0 0.02896-BOS 1996 Bosnia and Herzegovina Emergency War Victims Rehabilitation 5.0 2.62902-BOS 1997 Bosnia and Herzegovina Emergency Housing Repair 15.0 0.02903-BOS 1997 Bosnia and Herzegovina Emergency Power Reconstruction 35.6 0.22904-BOS 1997 Bosnia and Herzegovina Emergency Public Works and Employment 10.0 0.82905-BOS 1997 Bosnia and Herzegovina Emergency Landmines Clearance 7.5 0.02906-BOS 1997 Bosnia and Herzegovina Emergency Demobilization and Reintegration 7.5 0.52914-BOS 1997 Bosnia and Herzegovina Transition Assistance Credit 90.0 0.0NOOI-BOS 1997 Bosnia and Herzegovina Emergency Industry Re-Start Guarantee 10.0 0.0N002-BOS 1997 Bosnia and Herzegovina Emergency Microenterprise/Local Initiatives 7.0 0.4N003-BOS 1997 Bosnia and Herzegovina Essential Hospital Services 15.0 3.7

The status of these proiects is described in a separate repon on all Bank/lDA financed projects in execution, which is updated twice yearly andcirculated to the Executive Directors on April 30 and October 31.

Consolidation Loans A. B. and C were approved on June 13. 1996 and became effective on June 14. 1996.

Trust Fund fbr Bosnia and Herzegovina.

44

N032-BOS 1998 Bosnia and Herzegovina Transport Reconstruction 11 39.0 6.7N035-BOS 1998 Bosnia and Herzegovina Education Reconstruction 11 11.0 2.73028-BOS 1998 Bosnia and Herzegovina Reconstruction Assistance Project 17.0 4.83029-BOS 1998 Bosnia and Herzegovina Etnergencv Natural Gas 10.0 0.43070-BOS 1998 Bosnia and Herzegovina Emergency Pilot Credit (RS) 5.0 2.73071-BOS 1998 Bosnia and Herzegovina Power 11 25.0 25.0N040-BOS 1998 Bosnia and Herzegovina Forestry 7.0 6.23090-BOS 1998 Bosnia and Herze,ovina Public Finance I (Structural Adjustment) 63.0 0.03191-BOS 1999 Bosnia and Herzegovina Local Development 15.0 15.03020-BOS 1999 Bosnia and Herzegovina Basic Health 10.0 10.0

Total 409.6 81.7

45

B. STATEMENT OF IFC INVESTMENTS(As of March 31. 1999)

Gross CommitmentsUS$ Million

FiscalYear Obligor Type of Business Loan Equity Total

1977 Tvornica Kartona i Ambalaze Cazin Timber. Pulp and Paper 3.65 0.00 3.651985 Sour Energoinvest Industrial Equipment and Machinery 8.53 0.00 8.531997 Horizonte BiH Enterprise Fund SME Investment 0.00 1.93 1.931997 Microenterprise Bank Microcredit 0.00 0.57 0.571997 Sarajevska Pivara Beverage Manufacturing 3.89 0.00 3.891998 SEF Akova Abbatoir. Meat Packing and Processing 2.08 0.00 2.081998 Wood Agency Credit Line Furniture and Other Wood Products 13.69 0.00 13.691998 SEF Lignosper Furniture Manufacturing 2.27 0.00 2.271999 SEF Kopex Industrial and Consumer Services 2.46 0.00 2.46

Total Gross Investments 36.57 2.50 36.57Participations. Cancellations, Terminationis. Exchange Adjustments.Repayments, and Arrears (Principal Only) 13.01 0.00 13.01

Total Commitments Now Held by IFC 36.57 2.50 36.57

Total Undisbursed 14.20 1.54 14.20

Total Outstanding 22.37 0.96 22.37

46

SCHEDULE CBOSNIA AND HERZEGOVINA

PROPOSED ENTERPRISE AND BANK PRIVATIZATION ADJUSTMENT CREDITCOUNTRY AT A GLANCE

Bosnia and Herzegovina at a glance 3/4/99

Bosnia Europe &POVERTY and SOCIAL and Central Low-

Herzegovina Asia income Development diamond'1998Population. mid-year Iminl/ons) 4 2 476 2,048 Life expectancyGNP per capita (Atlas method. USS) 2,320 350GNP (Atlas method US$ b,ll,ons) 1.106 722

Average annual growth, 1991-97

Population 1%) 0.1 0 2 2 1Labor force (%) 0D3 0 5 2 3 GNP Gross

per primaryMost recent estimate (latest year available, 1991-97) capita enrollment

Poverty (% of population below national poverty tine;Urban population 1% of total population) 42 67 28Life expectancy at birth `years) 69 59Infant mortality (per 1.000 live births) 19 25 78Child malnutrition 1/% of children under 5) Access to safe waterAccess to safe water 1% of populationr 71Illiteracy (% of population age 15-) 47Gross primary enrollment (% of school-age population) 92 91 - Bosnia and Herzegovina

Male 100 Low-income groupFemale 81

KEY ECONOMIC RATIOS and LONG-TERM TRENDS

1976 1986 1997 1998Economic ratios'

GDP /US$ billions) 3 4 4 1Gross domestic investment/GDP 41 9 38.3 TrdExports of goods and serviceslGDP 29 3 33.5 radeGross domestic savings/GDP -6 3 4.8Gross national savings/GDP 9 6 13.9

Current account balance/GDP -32 3 -24.5 Domestc L IInterest payments/GDP 6 7 2 7 . InvestmentTotal debt/GDP 128.3 70.6 SavingsTotal debt service/exports 38 9Present value of debt/GDPPresent value of debUexports

Indebtedness1976-86 1987-97 1996 1997 1998

(average annual growth)GDP , 40 7 20 8 156 - Bosnia and HerzegovinaGNP per capita . Low-income groupExports of goods and services 67 7 47 8 32 4

STRUCTURE of the ECONOMY1976 1986 1997 1998 Growth rates of output and investment I%)

(% of GDP) 250Agriculture 200Industry ,50

Manufacturing iccServices 50

Private consumption 92 93 94 95 96 97 98General government consumption 0 GDl - GDPImports of goods and services 77 4 67 1

1976-86 1987-97 1997 1998 Growth rates of exports and imports I%)(average annual growth)Agriculture 140Industry 1n0

Manufacturing a\Services .s

40Private consumption . 20General government consumption , o 0Gross domestic investment 24.6 5 9 92 93 94 95 s9 97 o8Imports of goods and services 12 9 0 2 - Exports 0-importsGross national product

Note: 1997 data are preliminary estimates.

The diamonds show four key indicators in the country 1in bold) compared with its income-grouP average If data are missing, the diamond willbe incomplete.

47

PRICES and GOVERNMENT FINANCE

Domestic prices 1976 1986 1997 1998 Inflation (%)

(% change) 2

Consumer pricesImplicit GDP deflator .

Government finance(% of GDP, includes current grants) oCurrent revenue 92 93 94 95 96 97

Current budget balance - GDP deflator -OCPI

Overall surplus/deficit

TRADE

(US$ millions) 1976 1986 1997 1998 Export and import levels (USS millions)

Total exports (fob) 575 817 3000

Commodity 1 2 500

Commodity 2 2000

ManufacturesTotal imports (cif) 2,371 2,460 .500

Food 1¶000 I

Fuel and energy ' °°° 9 ]92 3 9

Capital goods -

Export price index (1995=100) . |

Import price index (1995=100) Expons I Imports

Terms of trade (1995=100)

BALANCE of PAYMENTS

(US$ millions) 1976 1986 1997 1998 Current account balance to GDP ratio I%)

Exports of goods and services 1.002 1,367 0Imports of goods and services 2.650 2.735 5 91 92 93 54 95 96 97 Ss

Resource balance -1.648 -1.368 10

Net income -228 -109 .15

Net current transfers 772 480 20

Current account balance -1104 -997 .25

Financing items (net) 1,061 1,021 30

Changes in net reserves 43 -24 -35

Memo:Reserves including gold (US$ millions)Conversion rate (DEC. local/US$)

EXTERNAL DEBT and RESOURCE FLOWS1976 1986 1997 1998

(US$ millions) Composition of total debt, 1998 (US$ mililons)

Total debt outstanding and disbursed . . 4,392 2,879

IBRD . . 596 581

IDA 291 433 A 581

Total debt service 385 123 E 822

IBRD 35 35

IDA 2 3

Composition of net resource flowsOfficial grants 612 612 B 433

Official creditors 443 328

Private creditors -107 -75

Foreign direct investment 0 100 C77

Portfolio equity 0 0 0968

World Bank programCommitments 77 100 A - IBRD E - Bilaterai

Disbursements 100 142 B - IDA D - Other multilateral F - PrivatePrincipal repayments o . C - IMF G - Shon-term

Net flows 100 142

Interest payments 37 38

Net transfers 63 104

Development Economics 3/4/99

48

ANNEX I

Bosnia and Herzegovina

Enterprise and Bank Privatization

February 25. 1999

Mr. James WolfensohnPresidentThe World Bank

LETTER OIF PRIVATE SECTORDEVELOPMENT POLICIES

Dear Mr. Wolfensohn,

Infroduclion

The economic strategy of the governments of the state and the Entities of Bosnia and Herzegovinais being increasingly focussed towards the development of policies and institutions that will ensurecontinued high rates of economic growth in the post emergency reconstruction period. Theauthorities are aware that the extraordinary external donor effort will be gradually wound downfrom 1999-2000 and that much greater reliance will have to be made on domestic savings andforeign private capital to finance the investment needs of a fast-growing economy. It is equallyapparent to us that the capacity and the financial resources of the public sector is dwarfed by theinvestment requirements of the economy. These factors illustrate the urgent importance ofdeveloping the private sector of our economy in transition and of creating conditions that giveconfidence to savers and investors -- domestic and foreign alike.

For nearly two years now, the authorities of the Entities have been putting in place a series ofpolicy actions, with parallel development of institutions, that are intended to foster a privatemarket economy. The essential legislation for establishing a competitive market economy andpermitting privatization has been adopted, and agencies responsible for implementation arefunctioning. It should be recalled that our economy, unlike that of the former Soviet Unioncountries or some in eastern and central Europe, was never a command economy, but enjoyedfeatures of decentralization with self-management of enterprises. We believe that we are better

50

placed to achieve the transition to a market economy. but we recognize that many old institutionsand Laws will have to be changed to conform to the modern standards of European nations.

This letter is organized as follows. We first describe the commitments of the authorities to themacro-economic program that is being supported by IDA adjustment credits and by a standbyarrangement with the Fund. The overall framework for private sector development policies andthe measures being taken to strengthen our banking system follow - these are essential pre-conditions for the success of privatization and of the newly-privatized companies. The section thatfollows outlines the overall privatization program phased over a period of about three years. Thetwo succeeding sections explain in detail the program covering enterprises and bantks and thespecific strategy being followed as well as the key policy or action commitments of the authorities.These policies and actions will constitute the conditions underlying our request for an IDAadjustment credit.

Kei, e/emenis en. Ohe L7O-L'CrflOmt setting

The authorities of the state and the Entities recognize fully the importance of a stable macro-economic framework for the orderly and rapid development of private markets. Low inflation, astable currency, clear and efficiency-promoting rules are of the utmost importance in this context.The introduction of the new currency -- the convertible mark -- and the operation of the centralbank as a currency board offers firm assurances of low inflation and a stable external value of thecurrency. The budget of the state will be balanced and hence no recourse to deficit financing ofany kind will be necessary. The state budget relies on transfers from the Entities to meet all itsexpenditures -- relating to administration and debt servicing obligations, and the Entities reaffirmtheir commitment to making these transfers in adequate amounts and in a timely fashion andautomatically.

The budgets of the Entities will be in deficits strictly only to the amount that will be madeavailable through external financiig, thus, no domestic borrowing or accumulation of arrears inbudgetary payments will be made. Considerable fiscal relief to the budgets of the Entities hasbeen provided by the London Club agreement of 1997 covering commercial bank debt, whichreduced our extemal debt to these creditors by over two-thirds in net present value terms. Asimilarly beneficial agreement with the Paris Club of bilateral creditors was reached in autumn1998. The monetary. fiscal and external debt policies described above will provide soundunderpinning for the currency board arrangement and ensure a stable macroeconomic framework.

The Entity authorities intend to pursue structural reforms so as to increase the supply capacity ofthe economy and to provide incentives for domestic savings and investment. The program ofreform of public finances centers on changes in Entity tax structures and administrations andgreater harmonization betweeni the Entities as well as on pension reforms. Other important goalsin this regard are the establishment of secure means to fund the state budget, in particular, theexternal debt servicing mechanism, a clarification of inter-governmental finance and strengtheningof budget systems. These programs are being supported by a standby arrangement with the Fundand adjustment lending from IDA.

Given the absence of a lender of last resort facility in our currency board arrangement,macroeconomic stability and associated growth in confidence can be assured only with a profoundstrengthening of our banking system. Measures to strengthen our banks with a view to

51

privatization and to improve the system of bank regulation and supervision are outlined later inthis letter.

The framework for private sector development

In the architecture of supporting private markets, major changes will be made in each Entity in theareas of corporate governance. contracts, competitive market practices. and property riglhts.Moreover, standards in accounting and auditing will be raised. We summarize below the chiefelements of the policy, and legislative and institutional framework of our reform program.

To strengthen corporate governance, a Law on enterprises has been passed in one house of theFederation parliament and is expected to be adopted by the full parliament in coming weeks. Webelieve this Law will provide a corporate framework that is modern and consistent with the higistandards of similar legislation in western European countries. A Law on enterprises has alreadybeen adopted in the RS. These Entity Laws clearly establish the rights of shareholders as in otherEuropean economies, place clear responsibilities on corporate governance on boards of companies.and set up a system of company register and overall regulation system. Supporting legislation oncontracts, secured transactions and collaterized lending will provide the legal basis for suchtransactions by establishing a register on liens, and procedures and mechanisms for enforcement.The Law on bankruptcy will provide clear policies and mechanisms for exit to the benefit ofinvestors and lenders in companies.

Clarification of ownership rights to property will take place through proper recognition of"internal shares" (i.e., shares to the private sector issued in the past) and the setting up of an assetsregister that will also record land and real estate titles. Accounting and auditing reform will focuson introducing internationally accepted standards (IAS/ISA). By adhering to such standards, ourenterprises will produce accurate and timely financial statements, useful for domestic and foreigninvestors and to potential creditors.

In addition to the comprehensive framework of legislative and institutional changes describedabove, the time is right for the orderly development of post-privatization capital markets. Suchmarkets are necessary initially for the trading of' claims, coupons and vouchers that are beingissued for privatization, and then for the secondary trading of shares and of investment funds, andat a later stage as the mechanism for raising fresh capital for companies. An appropriate packageof legislation has been developed on securities, investment funds and mutual funds andmanagement companies and, on the regulation side. for a Securities Commission and Registrar.

This package of legislation was passed by the Republika Srpska parliament in July 1998 and bythe Federation parliament in October 1998. Work is now under way to identify appropriatemanagement for the new institutions and establish operational guidelines and by Laws that willestablish, govern, and strengthen these new institutions. Extensive donor technical support hasbeen made available to both the Entities to assist in these efforts.

The Law on foreign investment at the state level entered into force in July 1998 and with its highlyliberal provisions and a clear level playing field for potential foreign investors offers an attractiveenvironment for investment in all sectors.

52

The authorities of the Entities, who bear the burden of implementing legislation in these areas, arefully conscious that a suitable set of Laws (as outlined above) is a necessary pre-condition ofsuccess in building a private market. but ultimate success will depend on light, but effective,regulation, vigilant protection of shareholder and investor rights, and clean corporate governanceensured by surveillance bodies. These are now being carefully developed. Nominations for themanagement team of the Share Registry and Securities Commission in the Federation are expectedto be finalized by April 1999. Once constituted, the Securities Commission could begin to workimmediately. Investment fund management companies. whose development is dependent onregulations and guidelines established by the Securities Commission, will be .reated soon after. Inthe RS, the process is similar to that in the Federation. but nominations for management of theShare Registry and Securities Commission will take place only after the powers of the governmentto make these nominations are legislated.

Our progress in setting up the appropriate architecture for fostering private markets has greatlyoutpaced developments in other transition economies and we believe that, havinig suffered thesevere retrogression brought about by the war, we are now poised to catch up with our competitorsin eastern and central Europe.

Measures to strengthen the hanking system

The banking system within both the Entities is exceptionally weak. On the asset side, banks areburdened with a large proportion of non-performing loans arising from poor, past lendingdecisions during the period of self-management of enterprises and banks and ov-nership of banksby enterprises that led to imprudent insider lending. Non-performing assets also arise from thedestruction caused by war. On the liability side, the volume of deposits in the system is extremelylow for reasons of lack of confidence. The effective confiscation of past foreign-currencydenominated deposits through the imposition of 100 per cent reserve requirements by the centralbank in Belgrade that were not honored to banks when due and the hyperinflation of the earlyperiod of the war that all but eliminated local currency deposits are the principal factors behind thedistrust of banks by the general public.

Given the importance of a well functioning banking system as a mobilizer of savings andintermediator of funds, the authorities of the Entities intend to take action in four areas in order tobolster confidence: (i) strengthen banking supervision and liquidating insolvent banks; (ii)institute a deposit insurance scheme; (iii) encourage the entry of foreign banks; and (iv) ensuremedium and long term funding for commercial banks on market criteria are in place.

Strengthening banking supervision cnd liquidating insolvent banks. In both Entities, measureshave been taken to create a framework for banking supervision in line with international standardsand implementation is at an advanced stage. A comprehensive Law on commercial banking waspassed in the Federation in October 1998 and is expected to be passed by the RS parliament incoming weeks. This Law covers licensing, supervision, liquidation of banks and prescribes thestandards that banks must follow. It will help to eradicate the past abuses in the banking systemarising from lending to insiders, lending to connected parties, and ensure that fit and properpersons are owners and managers of banks.

53

Laws on banking agencies were passed in both Entities in the spring 1998 and, with considerableinternational technical assistance, strengthened standards of regulation and supervision. bettertrained staff, and greater authority and respect of the banking agencies are already evident.

The licensing standards required for banks is much stricter than in the past and a gradual rise in theminimum capital requirement is planned so as to rationalize the banking system. Much emphasishas been placed so far on on-site supervision. with the institution of risk-focussed safety andsoundness examinations in contrast to compliance-based reviews of the past. Attention will nowshift towards reinforcing off-site capabilities, not least with a view to developing an early warningsystem for detecting risk.

We consider as particularly vital the liquidation of insolvent banks. Existing and proposedlegislation clearly requires this and gives appropriate powers to the banking agenicies. It is not thepolicy of the Entity governments to attempt to rehabilitate or recapitalize such banks as such acourse of action would not constitute a prudent use of our highly scarce fiscal resources. As a firststep, insolvent banks will be closed immediately upon determination of insolvency by the bankingagency. Thereafter, they will be liquidated in an orderly manner. It is clear that the largestpublicly owned bank in the Federation is insolvent by a large margin. The Federation governmentwill close this bank and institute liquidation proceedings.

Careful audits and examinations of banks based on new legislation have been initiated inRepublika Srpska. Insolvent banks will be treated in the same fashion.

Deposit insurance. Whilst strengthened licensing and supervision standards will help to restorepublic confidence in banks, we believe that a system of insuring deposits is essential if thisrecovery in confidence is to be rapid and forceful. The Entity authorities are firmly committed tointroducing a scheme to insure deposits from mid-1999 in each Entity directed at protecting smalldepositors from loss in the event of bank failure, discouraging runs on banks, and providing anefficient mechanism for disposing of insolvent banks. The scheme will be in line with thoserequired to be instituted in all European IJnion countries. To minimize the fiscal burden and toencourage prudent bank behavior, the scheme will cover deposits only up to a proposed DM5,000and would be open only to private banks that met all regulatory standards. Moreover, depositorpreference under banking legislation will also help to minimize costs of the scheme.

We hope that the seed capital for the fund -- estimated at DM20 million for both Entities -- wouldbe subscribed by donors. This is the initial reserve capital base corresponding to the stock ofdeposits at the beginning of the scheme. As deposits grow, this fund will have to rise. Theviability of the fund would be ensured by appropriate levies (insurance premia) on banks related tothe volume of their deposits. The Deposit Insurance Agency responsible for the scheme would beautonomous, reporting directly to Entity parliaments.

Entry of foreign hanks. We are anxious to see foreign banks enter the country. We see their entryas being essential to the development of the barking system along efficient lines. Foreign bankswould do much to generate confidence for domestic savers and foreign investors and help raisestandards in the industry. The existing legislation creates an attractive environment for foreignbanks and we have requested the assistance of the World Bank Group ant other multilaterals inpromoting our country to foreign banks.

54

Finance Jor investment. The acute shortage of medium and long-term funds faced by banksgreatly limits the resources available for investment. Thus far. donors (chiefly World Bank andUSAID) have provided longer term funding. To ensure that these funds continue to revolve in themost efficient way, the Federation government has established a purely second-tier bank, theFederation Investment Bank (FIB), that would run exclusivelv on market principles as anintermediator of funds to commercial banks. It will not take deposits. except Federationgovernment deposits, and will not be able to lend to the government. The FIB will also channellimited credit lines from the budget for certain priority sectors for a temporary period, i.e.. only upto end-1999. The Federation government will not channel any lines of credit to the economyoutside the agreed framework of the FIB.

The Federation government wishes to privatize the FIB rapidly and has invited the assistance ofthe World Bank Group. the EBRD and the German KfW to this end. Private investors could beother banks, foreign and local. and multilateral banks. The shareholding of the Federationgovernment would be limited to 10-15 per cent of the total share capital of FIB and would bedisposed off completely to private investors by end-2000.

As the volume of credit lines to Republika Srpska grow. the authorities will develop a privatesector based solution to the management of these revolving funds conducted on pure marketprinciples. In particular, no lines of credit financed by the RS budget will be established, exceptthose funded through specific donor resources. Discussions with the World Bank will be held tothis end.

The final item on the unfinished agenda of financial sector reforms relates to the paymenIs .systemnsin the Entities. Our payments systems are complex. highly costly and inefficient arrangementsthat enjoy a monopoly position and they constitute a significant barrier to the development of amodern banking system. The Entity governments are committed to the establishment of aprivately-based payments and clearing systems and to a transfer of other functions currentlyundertaken by the payments bureau to other institutions, such as the transfer of the treasuryfunctions to the Entity ministries of finance. in accordance with a plan that is being developed bythe Entity governments and international donors. Implementation of the reforms will begin in acomprehensive and well planned manner from mid- 1999.

StSafe 17rivrtivationl lai!

A Law at the level of the state has come into effect clarifying the responsibilities of the Entities inprivatization of enterprises and banks and ensuring that equal rights of all citizens are upheld inthe process. The Law recognizes the sole competence of the Entities to privatize enterprises andbanks located in the territory of the Entity. In doing so. it removes certain uncertainties as toownership and authority and this will be entirely to the benefit of confidence on the part ofpotential investors, domestic and foreign. The Law also requires Entities to ensure thatprivatization recognizes the rights of all citizens, including displaced persons and refugees.

The privatization program

The Entity authorities believe that an immediate start has to be made on a comprehensiveprivatization program covering all publicly owned enterprises and banks. The groundwork for

55

such a program has been laid over the past eighteen months with the establishment of a clearstrategy and with Laws and agencies to implement the strategy. Considerable extemal technicalassistance, notably from the Bank. has been used in this process. We believe that the program willspan about three years, i.e., until late 2001.

Phase 1. In both the Federation and Republika Srpska. we expect to initiate the first phase ofprivatization with small-scale enterprises. generally executed at the cantonal level (in the case ofthe Federation) and by the central privatization agency (in the case of Republika Srpska). At thesame time, the large enterprises will be required to prepare business plans in support of eventualprivatization that will identify competitive and promising parts of enterprises that could be spuInoff for sales. During this phase. the groundwork will be laid for setting up the regulatoryframework for privatization or concessioning in public utilities.

In the first phase, all banks will be asked to prepare their opening balance sheets with a view todetermining their net capital and sales prospects. In the Federation, focus will be placed on thelargest three banks, one of which will be liquidated and the other two prepared for sale if found tobe solvent and adequately capitalized. In Republika Srpska. sales prospectus for the three largestbanks will be issued if these banks are found solvent.

Phase 2. The second phase of the privatization program. spanninig the period to the second hall of2000, will see the completion of the small-scale enterprise privatization in both Entities. Duringthis phase the privatization of larger companies will begin. Telecommunications and electricpower will begin to be privatized at this stage as we believe that rapid progress can be made inpreparing the sales plans for telecommunications and electric power. Preparatory work for theregulatory regimes for other public utilities will be carried out.

This phase will also see the sales executed for all solvent public banks in both Entities, ifnecessary by the implementation of merger or consolidation plans for some of the solvent banks,and liquidation proceedings taking place for all insolvent banks. During this period, we shallcomplete the radical reform of the payments systems in both Entities with the aim of establishing acompetitive, private clearing system for payments and a modern Treasury management system forpublic finances.

Phase 3. In the final phase of the program (to late 2001). all enterprises in both Entities will besold or liquidated. At the same time, the public utilities will be fully privatized or concessionsawarded for private sector participation, with road transport in non-arterial areas being anexception.

Bank support. Our current request for an adjustment credit in support of enterprise and bankprivatization covers the first phase of this tlhree-year program. We expect to qualify for a furtherone or two adjustment credits or IBRD loans in this area, spaced twelve months apart, to supporteach successive phase of this program.

Enterprise prilvatization

The two Entities have adopted a comprehensive set of Laws for the privatization of enterprises andhave. furthermore, established agencies to undertake the task. In the Federation, Laws on

56

enterprise privatization and on opening balance sheets (that defines the balance sheet of theenterprise to be privatized) were adopted several months ago, together with other supportinglegislation. Privatization agencies at the Federation and cantonal levels have been established andtheir division of responsibilities clarified. Republika Srpska legislation was passed in July 1998.thereby annulling the earlier highly defective privatization Law of 1996. and the privatizationagency is functioning.

Legislation of each Entity (together with supporting regulation) is consistent with the stateumbrella Law and provides for the equal treatment of all citizens and, in particular, safeguards therights of displaced persons and refugees. Cash sales will be open to all -- citizens of either Entityand to foreigners. General vouchers (RS) or claims (Federation) will be issued by each Entity, inaccordance with its Law to those declared to be eligible by the state Law, and provided suchcitizens wish to participate in voucher privatization of that Entity.

(a) The Federation

The Federation Law has been amended to make it consistent with the state Law. It will giverecognition to the core groups of the population Entitled to receive general claims, the amount ofthese claims issued per individual will depend on number of years of working life. In theFederation, additional claim accounts are being established for certain specific liabilities held bycitizens against Entity organizations. The three major category of such specific claims relate tofrozen foreign currency deposits in Federation banks. unpaid wages of soldiers, and restitutionclaims that cannot be satisfied by physical restitution. As we lack the fiscal resources -- eithercash or capacity to contract debt -- to satisfy such claims, we believe that the exchange of Entityassets for such claims offers the optimal solution. It is expected that claims will be issued in early1999.

Claims related to restitution are expected to be issued in late 1999. as the task of drawing up theregister of all eligible claims and then determining those that cannot be satisfied through physicalrestitution is necessarily a highly time--consuming onle.

Claims will be used by holders (who may trade them freely) to inter alia purchase shares inenterprises being privatized or in investment or mutual funds and, importantly, they will also beused to buy apartments.. The Federation has passed a Law on privatization of flats. It is estimatedthat a significant share of claimis will be absorbed via purchases of property; this will help to buoyup the value of claims.

(b) Republika Srpska

The Republika Srpska Law has the clear provision that the class of eligibles will include allcitizens or residents on the Entity in question as well as those who were resident in the Entity inthe immediate pre-war period, provided such citizens wish to participate in the voucherprivatization of that Entity. The Republika Srpska has given the highest importance to theprinciples of non-discrimination, transparency in the privatization process, and to accountability aswe are enjoined to do under state legislation.

57

In the Republika Srpska. as noted general vouchers will be issued to all citizens. The majorspecific obligations of the Entity towards its citizens relate to frozen foreign currency deposits inRS banks and remuneration to veterans and to families of soldiers killed. With respect to frozenforeign currency deposits, coupons will be issued to such deposit-holders and these coupons willbe treated as cash-equivalents in the privatization process; with respect to soldiers' relatedremuneration, claims identical in form and usage to the general claim will be issued. Restitutionclaims will not be satisfied through issuance of vouchers, but through a restitution fund that isbeing established. The list of vouchers and coupons are being carefully checked; coupons will beissued in coming weeks as they will be eligible to be used in cash sales for small privatizations.but vouchers (both general and those related to soldiers') will be issued later in the year.

(c) Both Entities.

Voucher privatization has shown mixed results in other countries and we have learned from thelessons of others. In order to address the weaknesses of corporate governance, the lack of freshcapital injection, and insufficient development of capital markets that have been associated withvoucher programs in other countries, the voucher schemes in both Entities have been tailored toproviding scope for cash and strategic investment. In the Federation, a ceiling of 65 per cent ofvoucher participation in the sale of any one enterprise has been established for small-scaleprivatization. In the Republika Srpska, only cash or cash equivalents are allowed to be used insmall-scale privatizations; and there will be appropriate role for strategic investors in largeprivatizations.

Furthermore, the establishment of a trading system that makes possible transparent and low costtrading of both vouchers and shares bouglht througlh them and other measures to promote capitalmarket development, such as the institution of investment funds, are vital features of ourprograms. Notably, there is no floor for voucher participation in individual enterprise sales in theFederation: thus, enterprises in the Federation could be sold wholly for cash.

As experience in other countries has shown, investment or mutual funds could be easily prone toabuses. Our Laws provide for strict regulation on the conduct and governance of such funds, fordealing with potential conflict of interests and for appropriate disclosure in the interests ofstringent shareholder protection. Investment funds will be established as closed-end funds; mutualfunds as open-end funds. The capital requirements of these funds is high; strict diversification ofshare holdings is required, funds are limited to a 20 percent stake in any one enterprise; and alltrading is electronic and highly transparent. Price determination is through auctions and all fundsare fully tradable. By these means, we are confident that we shall attain our important objective ofcanceling claims against Entities through vouchers and claims and ensuring that the weaknessesassociated with voucher privatization are firmly dealt with.

All enterprises are required to draw up their opening balance sheets according to the Law withintight deadlines and then to prepare a plan for privatization that wins the approval of theprivatization agency. Thus, enterprises have considerable freedom, which is appropriate, as theyknow their business conditions best. But it is important to be mindful of the temptations forinsider transactions and the privatization agencies will be vigilant in this respect. The requirementof approval of the privatization plan of each enterprise by the Entity privatization agency offersprotection against abuse.

58

In the Federation, certain enterprises have opened themselves to participation by privateshareholders over the past six years. This has usually taken place through fresh injection of capitalby private companies, domestic or foreign. Where such transactions have taken place on marketterms with transparent capital infusion, recognition will be given to the shareholders: in cases ofpurely paper or ill-priced transactions. such sales will be considered null and void. The extent ofsuch transactions is still to be established in both Entities and will be done through the drawing upof the register of all public companies. but is believed to be much smaller in the RS.

The privatization agencies have been building up their capability to undertake their challengingtasks and have received much useful technical assistance from donors. We firmly believe that, inthe interests of building up our own capacities and skills and in order to secure firm ownershipover our own programs as well as maintain the high degree of public support for privatization,authorized agencies should be allowed to perform tasks of sales. monitoring, investigation andcorrection of alleged abuses. The commercial aspects of privatization will be a matter for Entityprivatization agencies to monitor. We welcome the privatization commission that has been set upby the Office of the High Representative to monitor the process as it relates to aspects of non-discrimination.

In both Entities, enterprise privatization will begin with sales of small-scale enterprises for claimsand cash in the Federation and or for cash and cash equivalents (coupons) in the RS. Small-scaleprivatization is expected to begin in both Entities in mid-1999. The sale methods will encompasspublic auctions (if the selling price is the primary consideration), public tender (if investment,expertise or technology infusion are important), direct sales or a management contract/lease (ifpublic auctions or tender fail). Large-scale enterprises will be sold via public offering of shares ortenders. In the preparation of privatization, the register of enterprises to be privatized with theirownership structures has to be drawn up -- this is a major task. Federation and cantonal agenciesand the Privatization Directorate in the RS are now engaged in this work.

We believe that the small scale privatizations can be completed in a period of about one year, i.e.,early 2000 for the Federation and mid-2000 for the RS. Preparations have already begun, albeit ina preliminary way. for the sale of large enterprises and conglomerates. These enterprises were thepride of Bosnia in the pre-war period as they embodied technological and managerial excellenceand were the major exporters. Our strategy is to identify the centers of profitability that existwithin some enterprises of these conglomerates and to sell those to strategic investors under publictender offerings. Some portion could be reserved for cash or even voucher sales. To implementthe strategy, conglomerates will have to develop business plans for the promising enterprises and aprivatization plan with the opening balance sheet. Those parts of conglomerates that cannot besuccessfully sold would be liquidated. We expect that the task of completing sales of these largeenterprises will taken up to two years.

The enterprise privatization program in both Entities provides for utilities as well. The respectiverights of the state and the Entities and the organization, regulation, and operation of the utilities arecovered by Annexes 4 and 9 of the Dayton accords. The rights of the state are confined tointernational and common aspects of communications and transport. The Entities have begun tocooperate fruitfully with each other to reorganize these sectors and will also work with the stateand with the Commission on Public Corporations (a Dayton body) to ensure that constitutionalrequirements are fully implemented. It is equally vital to ensure that these sectors are reorganizedand regulated in such a way as to maximize the prospects of privatization or concessioning in eachof these sectors. The state will play a constructive role to this end.

59

We believe that the privatization of two major utilities. telecommuniicationis and electric powergeneration and distribution. can be accomplished rapidly. The state passed the telecommunicationsLaw in late 1998 and now the regulatory regimes at the state and Entity levels will be establishedin line with World Bank and EBRD technical assistance. This will permit us to prepare this sectorfor privatization-- it is our hope that the prospectus for sale could be drawn up in later in 1999 or2000 and the sale conducted in the following y ear.

We believe that telecommunications privatization will provide a highly visible signal to theoutside investors that Bosnia and I-lerzegovina is open foI business. It wvill bring in significantcash for Entity budgets and much new investment to the benetit of service standards. We hope toexceed the standards of the highly successful privatization of telecommunuLications in many othercountries.

The electric power generation sector is considerably decentralized in the country. which is anadvantage for privatization. The same is true for distribution. We have a common grid betweenthe Entities and trade takes place. but under very circumscribed conditiolls. Moreover, we expectto rejoin the Union for the Coordination of Production and Transmission of Electricity (UCPTE)and the country can expect to become a significant trader of electricity. The Entities will reach acommon understanding on policies and regulation in this sector in the near future. Thisunderstanding, together with supporting Entity legislation, will create the conditions forestablishment of regulation, in which task we invite the assistance of the World Bank.Privatization could follow in 2001 in both Entities.

In privatization in the utility sectors, the Entity governments, through the terms for tendercontracts, will attempt to maximize prospects for investment commitments and new technology,whilst attempting to raise cash to the extent possible for Entity budgets. Thus, the typical patternwill be to find one or a consortium of strategic investors. Minority shares in the utility could besold for cash in an atomized way or even for vouchers (particularly for late issue of vouchersrelating to restitution), but recourse to such methods will take second place to the primaryconsiderations of fresh investment.

Future program of private participation in utilities will include sales or concessioning in railways,road transport, water, gas and all other sectors. This will necessarily take a period of two yearsinto the new century.

Bank privatization

For reasons given earlier in this letter, we consider it vital to move in parallel with theprivatization of our banks. Only with private ownership, whether domestic or foreign, could theconditions be created for a restoration of confidence in our banking system.

Public banks in the Federation are in the process of presenting their opening balance sheets to theFederation bank privatization unit in accordance with the Law. Public banks in the RS are poisedto present their opening balance sheets but await instructions from the RS government. Theseinstructions are expected to be issued by April 1999. Banks are currently burdened by non-performing assets and carry illiquid foreign currency deposits. Under the Law, non-performingassets that were funded through foreign borrowing from commercial banks or bilaterals (i.e.,associated with London and Paris Clubs) will be removed from the balance sheets of banks. In

60

parallel the foreign liabilities of banks from London or Paris Club-sourced borrowings will bewritten off. Frozen foreign currency deposits will be transformed into privatization vouchers asexplained above. Thus, banks will be left with a clean, but vastly shrunk, balance sheet.

Banks that find themselves with negative capital or with inadequate capital will be closedpromptly and, thereafter, liquidated. The remaining banks will be sold individually or merged andconsolidated to improve sale prospects. A period of about one-year will be permitted for sale totake place. Banks unsold within this period will be put under voluntary dissolution.

Both Entities have adopted legislation enabling the above strategy to be implemented and haveestablished bank privatization units under Entity ministries of finance that will undertake this task.Generous external technical and financial support is being provided to these units by the Dutchand the Swedish governments under World Bank supervision.

The results of recent bank examinations and audits for the Federation show clearly the largenegative equity position of the largest publicly-owned bank in the Federation. The net capitalposition of other public banks will be known only after certain legal decisions. Some of thesmaller banks are expected to be candidates for liquidation, whereas others could be merged orconsolidated and then sale attempts made. In the RS. the opening balance sheet exercise has notyet started and the final judgement is still out.

The bank privatization units in the ministries of finance face a major challenge in attempting tosell our banks. Many investors, especially foreign. may prefer to enter our market through agreenfield operation. It is clear that vouchers will play no part in bank privatization. The searchwill begin for strategic investor or investors of high repute and banking experience. The primaryconsideration will be fresh capital injection and know-how into banks rather than cash for theEntity budgets. The strengthening of bank supervision, raising of minimum capital requirements.institution of a deposit insurance scheme. and the financing being made available from the FIB inthe Federation are factors that will help attract potential investors into our banks.

61

Conclusion

In this letter, we have laid out a comprehensive strategy and set of measures that will be pursuedand implemented by the authorities of the state and the Entities of Bosnia and Herzegovina topromote a market economy. Privatization is an essential element of this strategy for without achange of ownership and the incentives that go with it no lasting reforms can be made. But thetransformations required in building an efficient market economy -- Laws, institutions, individualand corporate behavior, even attitudes and mindsets -- are profoundly complex and challengingand, despite the experiences built up in the post-cold war period, still not fully understood. Bosniaand Herzegovina's programs are ambitious and rapid and they deserve international assistance.We fully expect the World Bank to continue to undertake its lead responsibility in the provision oftechnical knowledge and finance in this area.

Yours sincerely,

Edhem Bicakcic Milorad DodikPrime Minister Prime Minster

Federation of Bosnia and Herzegovina Republika Srpska

Dragan Covic Novak KondicDeputy Prime Minister and Finance Minister

Minister of Finance Republika SrpskaFederation of Bosnia and Herzegovina

Mirsad KurtovicMinister of Foreign Trade and Economic Relations

Bosnia and Herzegovina

62

ANNEX II

BOSNIA AND HERZEGOVINA\E:NTERPRISE AND BANK PRIVATIZATION CREDIT -- POLICVNSIATRIX

(Items in itblic hand bold are conditions for tranche release)

POLICY AREAS AND |ACHiEi'VEMENTrSIM1.ASURI.S |SUPPORI'INGMESRS|MEASURES PRIOR TO FiRST |MEASllRES PRIOR TO TIIE SECOND |AGENDA FOR FOLLOW UPOBJECTIVES Al.Rl:ADY INTRODUCI:D tJNDERWAY ( 1998 -MARCH 1999 TRNH 1ISBURSEMI:,NT TRANCHE DISBURSEMENT PRIVATIZAI'ION CREDIT

1. BANK RESTRt:CTt'RING AND PRIVATIZATION

The Federatlion 4 Passed La. on Opening Balance o (ilfi etnmeni clo,e rthe largevt Ins l/1ent * C {*-pleteliqlridatlon vsflurgevt inst)lh enr henb Sale of Centtal and Union(ifA Action./ 1'W1hwle Sheet. 1 his L ar. compels bank as tt Isixtep l.,avrd liquidatim. # Derermine .- b-Ieng- ps irion osf Jnion 11unk. If solvent) completed

enterpriscs and banks which have tUnhsn harhbeen fimad solve¢nt issue a prospectus Othcrwise. voluntaryassets and liabdiiies either not f,,r.,alef,r Vtnion Bank. IfUnion hats eenfiund, dissolution and liquidationperfonming or out of the insolient. close Union and begin process of completcenterprise's Ibank's control to liquidation.remove these items from their * Determine. solen:i pos.ition of' entrel Profibalance sheets This ptocess moves Baunk, 1f1Centrel P,fut Rank has been foundmarty state owned banks and .ah-ent. issue a prospetu.s for saler it IfCentralenterprise ftotn insolency/ PreJit Rank has been band insolrent. chose it andbankrupicy to solkency begin prcexvs of liquidation.

# Passed Law on Btank Privatization 'TCepatc opcning balance sheets and praistiafiAonplans for remaining state banks

* Bank Privatization usttt to review and approve or * Take control of. close and* rhe Entity shall not establish or extend reject ptivatizatton plans for small banks liquidate all state banks which

ant credit lines using budget resaurce.s * Small banks to issue prospeciae for sale have not been successful atout.side ;he 1ederai-n investment Bank * The Enritr shall nt establish or extend aunt credit privatizatiotff718). The operations of the FIB tub be lines using budget resources outside the Filt Norbusedsirletr on market principle, *hall the Entity establish any new hunk or increasefioernment initiates eff,,ris tr, pri,atize capital subscription in antr existing hank/I. Nor suall the Entilt establish anr * Gir,ernment takes actions suatifator r to II)DA onnew bank or increase capital subscription reaching agreement with prli-ute iniswranrsoin unY exrising bank. priatization of Fllt

1, lnsfiintumn,al Isevcpierucnt

IBank lPrivili Uirt * Establishfut(e staffed and/untrioiagOrt'l/I 1iank Priatttirtion Unit fBIPU).IHlao XSurpc-ision Estuhablishmeit of Fl'A hired staff * Pass amendments to FBA las to establish 4 Improve off-site capabilities * Step by step rise tn minimum

(ommrrchdl lMink Isis and drafted regtilalions on pertoanence and independence of FBA * Itpiv-me licensing practices capital requiremcntssuiperisory functions * Clarify powers of conservatorship.

Regnicriuwi,s s,n * Successful motiutoring and receivership and liquidation Define role of-nrmecsdloihd A examination of banking industry FBA as supervisor ofthese activities.

* Completed draft of loas on Batiks rather than implementer. Includcwhich defines FHA authority to provisions for Dl role in handlingsupeesise. rehabilitate and liquidate insolvent or undercapitalized insuredbanks. and regulatiotns on bank banksactivity. * All existing banks to hase permanent

licenscs. increase minimum capitalrequirenients

* Establish specific actions to deal withinsolsent banks

* Establish specific actions to deal withcapital of inadequate banks

I-epjsvl /lls rmn lr (i) a Cabinet submils Ia., on dep,,sit * Deposit Insurane Ageny 1t ha,re started * P'repare DI Agency to assumeinsurance to Parliament that is fJunaci-ning. all liquidation activities aftersatisfacrtori to the World Bank. closure of BPUJ

l/stsnirrris Ss.sii-m * Linked the tno separate payments l Pass legislation that puts intosystems in the Federation. but not effect the plan to separateunified P'ayments system from tax

o Established a clearing mechanisnl collection and financial onltrolbel.cen tile Entities' payrnems systemsbste nts Pass legislation that puts into

effect the plan for a modenmprivate, competitive payment

_________ _________ _________ _________ __ ______ _________ _________ ________ _________ _________ _________ _________ _________ _________ __ssyste

BOSNIA AND HERZEGOVINAENTERPRISE AND BANK PRIVATIZATION CREDIT -- POLICY NIATRIX

(Items in italic and bold are conditions for tranche release)

POLICY AREAS AND ACHIEVEMENTS / MEASURES SUPPORTING MEASURES I MEASURES PRIOR TO FIRST MEASURES I'RIOR 10 I'lI SECOND I A(-ENDA I-OR FOILIOW UPOBJECTIVES ALREADY INTRODUCED UNDERWAY (1998 - MARCH 1999) TRANCHE DISBURSEMENT T'RANCHI. DISBUtRSlMlN'I PRIVA'I'AlION CREIDIT

1. BANK RESTRUCTURING AND PRIVATIZATION

Republiks SrpskaA. A,ctins * Issue terms of reference for external audits * Pass Lau tin Opening Balance Sheet * Extablish .sot-en,- t.lateoti,nned bun.s, take

of state banks that prtridesfar a secure buaisJct and, /is. e the largc'st in.soDNent bank piu.,* Appoint external auditors and prepare rapid priatization qf banks and one wther inliebank.

opening balance sheets enterprises. * The Anrit shall nit eslablish -r c.stendt. ' creditlines uasng, budge resources '-r shall the E.nti

* The Entit .shall not establish or tstend etablish a nt ne bank tr incce.ase capitalant credit lines using hudget res-ure., subscriptitn in any existing bank.Na, s.hall the Entitt- establish uny ne,hank Ir increa.se apital subscriprinn inant exi.sting hank.

* Banks to prepare pri%atization ! ltank ttrisati7anttt r,vt t-i. e-ics asd i 1 l......t I pt -apl l-tc slit tlehicc lkrgconsolidation plans fipriati-ali ll .ittsiiltd;ttio phavt htsks it takc cattl, ofatd

* tegit elEfits at p,tiatiatlic, eo tsitlidlwo Is close t banks. ieginSoNlseiv state havvks liplvidlawnotitt cl-sed hauks

* Complete draft l.as on Bank Pri.atizatioo * .dIdpt la.w tn Bank Priraization. * I.s.ue sale. prvt.spe-t ae for three largest sivlvtnr sta(include legislation for Bank Prisatization bank.sI it)

B. InsNttivttl IDeeluehipmevtIivtavk Iiiisaii:tititt ibiji * F .stablihb/ullc staffedt andJunctvtining

Bank PrBeiatizati:n tnit (IIPL).

Icooik Ro,erv iitslon * Pass law that establishes and * E:stablish agency, with ke- staff hired. office .C l ( tvpiclet litg it stallC ' .1-r estaliltsli lit taviindependent RS Banking Agency space rented and equipped. rcstviurce futciuit

* Draft and initiate bank examination plan

Cotnt*ercial llvtik *stalli,ht cic co-itt :siad a vf....itsc titk sit B istott C I iitttit al stei hty step raisiitgLttvv actis11c tresi vinittivivvt caviital

* Istablislsp-citic eguvlatiitvs ltfo havdtlinp il si.. cNt reqtilenve iltBegutlitition, tn banks avtd uuid,i,a;lvthtv/d vatiks

cotmmercial hattks bPass a ctivrvncicial thvk lts L ha i ShclMl-it

possCes of -vvestv sltt.eceioc I bilt aIdliquidation. a, ell a, auth itv 1i-t tic latcate ;ivvlupers-ice banks

Dtevposit Insurtince * Complete draft Las on Deposit Insuravce Pass tI a. onn Dteprs1it Inuane P el e IN1 Agea;iy tov assurneSecueni finvaociig tv capl,atv. D)1 ivstvv l liq1uidlatiton actisifies after

* Net up DI)eptpit In-urance Agen"t. clois,r vvfltIPUt* 1cgin insvvrivv all fmrcigVv haviks avid all app.p.ecd

prisate duvmetic hatlks

Paymenis Syslem * Established a clearing mechanvism C I'ass legislation that puts intobetween the Entilies' payments effect the plan to separatesystems. ttaymentts system from tax

collection and financialcontrol system,' ass legislation that putt into

effect the plan for a modern,private. compaetitive paymentsystem.

BOSNIA AND HERZEGOVINAENr;ERPRISE AND BANK PRIVA'AIZATI0N ('REDIT -- POLKA NIA'ARIX

(hems in hialic and bold are condilions for iranche rclease)

POLICY AREAS AND ACHEVEMENTSIMEASURES SUPPORTING MEASURES I MEASURES 'RIOR TO FIRS Ml:ASlURIS P'RIOR DK I('II Si.(')ON AGiLND)A FOR FOLL,OW UPOBJECTIVES ALREAD)YINTRODUC'ED) UNDER WAY(1A998 MARCH 1999) | TRANCHED8ISBCURSEMI:N-I T ''RANCIB:L DIS31RSI-MSINI I PRIVATI'AHlONCREIDI'

13. ENTERPRISE ?SkMXvILkTI1ON

The Federation

A ,Aciir,n i'miltA icsprec-andifrat,s fi,rpri-'zalusicaa,r

L egal * Passagc of l-ass on Prisaozation of * Sel nethlod.log5 tor preparing opening Pa.s Ian on Mn,agvr'mnt (mpani-eEnterprises. Settlemeint of Citizen balance sheels aod pass re-ulaition fie andpri-atizalin in i',tc'nt fulndsClaims sales methodolog- atof-ing citizens Is, in s-t their

E Establish valuationo of oiche points claim'iol,ucher. in nterprisic thr oghfund., as, .,ell as imli,ijdualls

* A'mend enterrri.ePri,ati:ctti-n tn- ts,

eni,l c.nutfI.tCe vi ith t11e n,n-di.scrimitation principl-f th-state

Lnterprises * ('reate a ditectoislist of all prViatizabcl 4 tllitiiii ins' ;ii,.ta li.i..l. liucstate cotterprise, Separating eniterprises liy cocipl i..small. largy a-ii straegi, (.NtI I

* list of stiatcgLic eiteriprise apitoved b.Parliament

Voucliers/ Claims * Gos emment issues instioctioos. diaited bsthe FVPA to Mlit, of' IWtlose. baitks antdpeiision fund to

. proside cai,-e,i access to recirds thatdetermine the amitountt of their claitit tobe exchanged for soahlies.

. provide these sante records to thePavtnents Bureau and give insinhctircisto the Paxtoents Bureau to providefinal accounts to the public

Infontiation carilpaign Fminalfie ouicher accounts at ZPI'

* Embatk on ai exltensivc public educationcamnpaign

truss's-s if l'riisitizitiiiiti

Small enterprise rltivali,atiotl 4 Develocp regulations for small n / nitiate small pi,iati:itiiotn hy a-tind g * (ttneludearndna'tilepriiateaissnp.it atization aucrions it issuing tender, f/r at lea.,t 4r tranusaat,in - r1- at lat sgo,all

small pri,atiz:alion tubjeult. Paun-it nimai enlprieitea, cx hludig antdid/awt fi'rbelttr cash or claims. Ij nit all citiens naturul rsltit1tiomnclaims hate heen formalized in PainntentBureau accounts, the pri,atizatihnuuth,,,itie trill afloat additional tmiJe,aecitizens tisettle claims portion of thepurhave price.

BOSNIA AND HERZEGOVINAE.NTERPRISE AND BANK PRIVATIZATION CREDIT -- POLICY.NIA1TRIX

(Items in itlaic and bold are conditions for tranche release)

POLICY AREAS AND |ACHIEVEMENTS /MEASURES |SUPPORI-ING MEASURES |MEASURES PRIOR TO FIRS-1 I MASIURES PRIORT10 1HESl:(C(NI)D AGENDA 17OR l:Ol.LOW lJPOBJECTIVES |ALREADYINTRODUCED |UNDERWAY (1998 -MARCHi1999) |TRANCHE DlSBURSEMEN1 | TMRANIIE DISBURSEMENI F I'RIVAII/ATION CRI.D11-

11. ENTERPRISE PRIVATIZATIONS

Large enterprise Privazatiton * Begin to identify likely candidates for * Re,iecs and scrif% Prisati-ation prlgramsforeign investment. from all largc errterpr sCs o Žplete large scale

* Strategy! policy declaration and * legin publi- sub-ription fi srhare,'.s in t prisatzatiotmethodologies (with time table) for le-ast 100 mediumn large ent rpripes * P, i-u all holdingpri-atizing large enterprises * I.se ervpectu u/e Jl r at leasa r,ns' ceorpatnics All sctarable

h.lding -mptanr h4 its --ntitn-nt parts. tins t Itolditty costnpantics,1hould Ire pInivoreied,eparatelY

Strategic Sector I Utilities * Privatization plans and methodologies for E wstablish -egulal. ramentrr n-ce-urt * lkploc 1rsOti,ati'mil ofthe strategic sector approved by fur priratizatin -rr teeomand electri tiei-t atid electric ,oscParliament p-,re genceaai- oa anahstihutifnifi- yc,ne-io n ad distilmbutio

* IFstablish regolations t; , othce utilitics

B I-nstimtl-r,nl ltelehptenlt * Establishment of Federation * 1998 budget of FPA re,iewed! approved * Cantnaalpri-aizati-t agenciesfidrliPrivatization Agency, with several wtafed uandte rpatingof the Cantonal agenciesestablished, but not yet fullyfunctional

Republika Srpska

A. Actionsl Poli,ie.s

P-ecunditirtsfiJr pi-rization

Citizen registry * Registration of large portion ofcitizens for privatization program

Enterprises * Valuation of many state owned * Create and publish a directory of allenterprises privatizable state enterprises

* Identify and publish a list of all likelycandidates for each wave of privatization.foreign investment or special privatizationprojects, or sale by auction.

Public lnformoation * Embark on an extensive public educationcampaign

Legal nd ittstitutional * Passage of Law on Privatization of * Develop corporatization gauidelines with a * Adopt Later tin enterprise pei-atiutiatnrequirements for Enterprises. (June 1996) and standard set of articles of incorporation nhich nill ensace transparencr f theprivutibation to he amendments thereto (June 1997) inventory of asuets and enterprise pene-s and equitable treatment ufthesuccessful registration. residen en. Include u rapid and rigid

* Draft and adopt Securities Las and stock timelinefar peieaiian tfilonnmarket regulation

* Develop licensing procedures and trainingfor stock brokers/ dealers,

* Establish and train a securities andexchange commission

BOSNIA AND HERZEGOVINAENSTERPRISE AND BANK PRIVATIZATION CREDIT -- POLICY IATRIN.

(Items in italic and botd are conditions for tranche release)

POLICY AREAS AND ACHIEVEMENTS / MEASURES SUPPORTING MEASURES MEASURES PRIOR TO FIRST MEASURLS PRIOR 'O I'lil. SECOND A(NiNDA F(R UOLLOW UPOBJECTIVES ALREADY INTRODUCED UNDERWAY (1998 - MARCH 1999) TRANCHE DISBURSEMENT TRANCIIE D)ISBURSI MFNlI I'RIVA'I VA l'ION CRED)IT

Proce.- fllr,Jri,arirnt * Design and implement a share tradingsystem

Small scale privatizatton *.............. 0 Begin pirariwaioan fs .mta// saleCnferplpre.s. ltrraiat N a.tedleu.d/tpcr,rsenm -mafl rcae enterp,ALe.

Privatition projects * Develop a plan for the privatizatton of * flepare and e.-eNle intrena,hnatl tender.s I lahIrli reerIattotrs totutilities and other special enterprises not of mnajrrin -taAe in at h/ast rhree larg. eludCcovered in the Law. wale caentcrpie'.

* Develop plans for the prtvatization of * Prepale at least rtte hrrldrtar npttn; tttholding companies. by their constituent pris attattt bts Osl ts,sttlctst patts ltpars ts tettde.r .t tstttssst

* Establish an auction process and * Ar prorpea - sa/e f,rs p.,ers o] theinfrastructure for preparing and esecotinty holding- prsna ht its -nsritaentr paer.international tenders for sclectcd nhih n.ill be tendered.enterprses.

B Inrsttirtur,issi/ Id a tpmc'metl Establishment of RS PrivatizationAgency

ANNEX III

ISSUES RELATING TO THE SUCCESS OF PRIVATIZATION

I. MACRO ECONOMIC STABILITY

1. Maistlaininas a StableMacrocwonomic Framework

The State of Bostis andHeanegoina

AIrkl'ts/k x un we I'lkstr. ROt,

* Establishing institutional * Approsed Central Bank I a * Continued implementation of the Central Bank Law * Continued implcienctuation of the Central Bank las

framework for morneita * t raencs Board Fanetboorthemanagement

* Issued the ncs curenc'

* Adoptim of plan for hqurdat.on of * Complete liquidation on Narodna BankNarodna Banka i the old central bank o

* Liquidation of Narodna Banka

* Maintaining policies conducise * las restored and maintained moneltr and * Continued satisfactorx implementation of the nonetarx policies. * Continued saisfactory itnpleritettatiio of the * Continued satisfactory

to monelars and exchange rate exchangc rate stabilit, since late It99 and maintenance of the estenral pee for the cotrvenible mark monetoam policics aitd rttaimctrance of K\ peg implementation of the monetary

stability consistent with the Currenc%. 13oard anangement policie s atid tmtaittenance ofKMP''Y

The Federatirn

* Fiscal statce that aoids * Maintained budgets thnt hose abstained * Balance budgets lshtch abstain from botrosin, frota the norm- * Balance budgets oHIclr abstait, lrorrr borrowing 1roa * Balanrce budgets sslhich abstain

recourse to domestic borrowing from borroming from the hkmestic bank and barkina sector Present accumulatiotl of arrears. tIre nrrn-bark attd branking sectior Prcsent frrm borro.mg4 fronm Itre non-

and thus supports monetary banking sector accumulatirr ol arrears hatik and batrking sector. lPresent

policy * Ialanced budgets which abstainr from accrmt ionatort *sf arrears

borrowing from tlte nmo.haik and bankingsetor Prevent accumulation of arears

The Republika Srpska

Ii.iscrl l'rr/hr

* Fiscal stance that aoids * Mairtainred budgets that hawe ahbatined B Balance budgets rshich abstain from horeorg from the non- * lalance budgcis which arstains friror bon-owirrgr * Balarcte budgets whiich abstain

recourse to domestic bonrowing from boreowirr from the domcstic bank and banking sector Present accumulation of anears. the non-bank anrd batiking secto. Present frrrm brorss itrg filrm the non-

and thus supports nornetary balrking sector accunmulation of arrcars bank and baorking sector. Prevent

policy * Balancc budgets nhich abstairn front acconwhition of ncars

borrosing frotn the norr-bank and bankingseCtor Irrseat uccumulatiorr of anears.

ISSUES RELATING TO THE SUCCESS OF PRIVATIZATION

II.THE ENABLING ENVIRONMENT FOR PRIVATE SECTOR DEVELOPMENT

ll. Ensuning the l egal anid.Institutional Framewsork for PrivatcSeem,r Di veluoment

The Federation

f immevr-el lL,o * Pass Las on Business C(ompanics so that it giVes * m1e11nrent Lass on Business C(omparnes * Refonn the regulatory framework

* greater emphasis to shareholder rights. to stimulate effciency-la r -n rtrerprir tar vii Itusin-ss (tioripanies drafted . more precise delneation of corporate governance, p .ik trce Payments systems

* better definition of artiles for inclusion in fiunding betiseen and within tilc Entitiesdocuments lIe corporate charlers).

* a registration system and oserall regulation of enterpi-ecs

Inn cchi Uhlgoriiirn * 'otking srlh CITY to drafi amendments to las on Obligations * Andopt arirer-dments to l.as ott Obligatiorrs

ALninrini .S..rrcl.. I sarrrrnrig s ay, to develop a legal * Rvising draft Lawliirswiisinmni iiiirvlliiPriiil iegistfl * Establih an official registry of collateral

1), VI) I.aw Wrsuloc" * Implement procedures and mechanisms for enforccirricil

lhrnikrrrpiis Cciv * ltarrktptcy lan passed * Adopt amendmcnts to bankruptcy Lao once lIax on ericiipisesis adopted

i.iiir WI uRni *? # Adopt amendtnents to clearly delire o- ncrship of all forirs ofleeriurird 1'ep,rnra propcirt. including irriernal sharcs' in siatc-oss-ied erittv1rr cc

* Implemert an adequate registration systemn fir sharcs ii p,ogen,1Nartd rcal propcny

.4Z'X'}tia ig noezl . lscliiintg * lirnetmatiosal accunltng anid adidting * Adopt crlier necscsar, irternatiiral auditing principles arid * ( Corfinuc training program to lring pIcicinces in lincfe/scm stantdardsid lASt legislated stailirds and beginetxc-sise training s,ith intennatiroral standards

* Collected of rufoimatron oni gaps rctieencrulrrl stalidards arid pracices arid IAS

* Andopted iitenlaiional accountinglanidards to he eiifisrceable Jan I. 1999

' crpiirl ,rciteil * Passed las, oil Secin-iies Securities * Pass necessars amendments to * Create prirf,ssionalls staffed and operatirnal apitalComrnissiori. Registrar of Securifiec. aid Lna on SCcuTities narkel instilutions ori accordance siih capital marketI'riate lirsestincilI iinds and ILa.sMtariageitiei ( Conipanires * Lass oa Registrar of Securities

Iore,gn rgi hira eni t Pass Iais, and adopt regulations oniF Iorirgn investment, including regulations on indemnificationfor crpiopi(ation and profit repuITiation

. The fonmationi. taxation and operation of foreign owned legalEntities

I TeciI crrtinrkd I 'hiinins * Draft Lan to deal v ith extratenutorial claims (of the fourier * Adopt lass to deal ,rth extra temitorial claimsYugoslavai).

ISSUES RELATING TO THE SUCCESS OF PRIVATIZATION

II.THE ENABLING ENVIRONMENT FOR PRIVATE SECTOR DEVELOPMENT

Republika Srpska

(rwminrsis Rl/a/.ir * Adopt ne, lIaw or significantly rcvise old l.aw on enterprise so * Reforn tire retilone fiarntewrk

thiat it gives~ tor stimulate efficieney.

/.na,, hntr*sy I rpri s e s . adeqsuate emphasis to shareholder righs . productivity and profitabilityof cnrporate * ~~~~~~~~~~~~~~~~~~~~~~~~~~~~l.ittk the PamnsSysteatis

.tCC~5C piccisc delilleafi of g goserrtnttvv. between and within the lntities.

. proper definition nf arlicles fon inclusiom in fioundingdocrirrients li c corporatr charters).

. a reyitration sysem, atid -rverall tegulario.i of enterprises

L.a s,, ()tligs,ri,rrs * I)raft amenrrdmnents to stitplifr ls Obt I thligatiotns

I..,, .esl wed tamining ways to develop a legal * (tor plete draft regtlations foe the establisltrent of

Iri,n.socliv,i registry att oflicial registry of collateral

C (complete draft prTocedics atid mechalnisris lonenfortcemneni

* tstablis ian official registry of collateral

* plenienent procedurcs antd nrcitaiiisms fo,erlofic'enit

ls k-ptur Lsai *M arli of arntiedirents to existing lvrkRniprs Laoss

* Adopt amentesnts to halikruptcv I.as

/.0(is }sir llsiil a{ri * liriliaft al-crdrerst, reiidltior,s to clear Is delfic (iss tciship ol all l Adopt amenodmrents. implemnent reg,dalfioins definnitg

1'eroi,n/ I'Ir-prsrs fr nsrf ot propel , i-scIlnding initerinal sOarts ir satec--osstted ms ne1rship

CtCl1l 5ev *I miplemenert tIre registrationi system fir shates si

* Iiralie a Ilaot, sr dcevlopme an adequate registliho sssrerrl for propenr and real propertyshRarcr h it r 1 ert> atsd real properlt

.s ss rrrlinrg fr.! Irritrirsy I assed lass osr, Audits * Adopt ness I.ass on accouirntrog

/le/sorrsr * Adirpt iitenaiotiial acco-u,ting staidraids

* Adopt international atiditing principles anidstandards.

( oirmi:rkrrs * Ilassed la. orr Scenritics arid Secunifies * P1ss riceessays amendmtenits iosColmimnission. Iaw on Registrar of .I as o S-sitiesSecuritics. and l.ass or, Privatc Ilnrestmn.enrFuaids and Slanagercmnt Companies . Ias Registrar of Securities

l,ass orr Private Investment [minds and Mlanagemient

/ii'reaigar aIrme.r,it * New Law air l irecigi Investment passed

/ vlrd I erriltsi.il #t. * DIraft lass to deal withl ctratenitorial clainis so the firyrmer o Adopt lass to deal with extra territomial clairis

Y'ugoslaIial

ANNEX IV

Table 1: Bosnia and Herzegovina - Key Economic indicators

Estimate ProjectedIndicator 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

National accounts(as % GDP at currentmarket prices)

Grossdomesticproduct 100 100 too too too too too too too too tooAgricultureIndustryServices

Exports (GNFS)a 20 24 29 33 34 34 35 35 36 36 36Imports (GNFS) 71 83 76 70 59 54 50 46 43 41 40

Memoranduim items

Gross domestic product 1867 2741 3423 4082 4533 5333 6262 7090 7731 8386 9081)(US$ million at currentprices)

Real annual growth rates%. calculated from 1995prices)Gross domestic product at 69 30 18 8 144 14 10 6 5 5market prices

Real annual per capitagrovth rates (%, calculatedfrom 1995 pTices

Gross domestic product at 28 17 7 13 13 9 5 4 4market prices

Balance of Payments(UlSSm)

Exports(GNFS)Y 381 658 1002 1367 1541 1816 2162 2498 2796 3044 3293Merchandise FOB 152 336 575 817 955 1131 1387 1628 1843 2008 2169

Imports (GNFS)' 1334 2278 2606 2864 2659 2863 3124 3234 3358 3460 3596Merchandise FOB 1082 1882 2333 2573 2397 2586 2826 2935 3051 3152 3278

Resource balance -953 -1620 -1604 -1498 -1118 -1047 -962 -736 -562 -416 -303Netcurrenttransfers 1002 10)94 772 510 311 281 245 210 170 104 37(including official currenttransfers)Current account balance -193 -748 -1060 -1127 -896 -879 -831 -640 -504 -424 -350(after official capital grants)

Net private foreign direct 0 0 0 100 60 162 185 200 200 200 200investmentLong-termloans(net) -271 439 12 43 24 117 190 146 144 96 39Othercapital (net, including 578 542 959 1015 944 648 528 390 242 182 161errors and omissions)

Change in reserves5 -1 14 -232 89 -31 -132 -48 -72 -96 -82 -54 -50(continued)

Table 1: Bosnia and Herzegovina - Key Economic indicators(Continued)

ProjectedIndicator 1099 1996 1997 1498 1999 2000 2001 2002 2003 2004 2005

Memorandun ilenisResource balance (%/o ot' -5I -59 -47 -37 -25 -2( -15 -10 -7 -5 -3(iDP at current marketprices)Real annual growth rates1995 prices)Merchandiseexports 155 71 40 14 15 19 14 10 6 5(FOB)Merchandise imports 8( 40 11 -10 5 h 1 0(CIF)

Public Sector Balances(as % of GDP at currentmarket prices)Expenditures 36 78 56 52 48 48 47 44 43 42 40Revenues 29 51 31 32 31 35 36 37 38 38 38Deticit (-) -7 -27 -25 -20 -17 -13 -11 -7 -5 -4 -2External Financing 7 27 23 20 17 13 11 7 5 4 2Others, incl. Arrears 0 0 -2 0 ( 0 0 0 0 0 0

Monetary indicatorsM2/GDP (at current market 21 28 34prices)Growth of M2 (%) 9 96 52

Price indices(1995=100)Implicit GDP dellators(% change)Federation -40.4 9.1 13.7 2.0Republika Sirpska 53.1 -35 7 -04 9 8

a. "GNFS" denotes "goods and nonfactor services."b. Includes use of IMF resources.

Source: Otlicial data and staffestimates.