Document ofThe World Bank

ReportNo: 18643 BH

PROJECT APPRAISAL DOCUMENT

ONA

PROPOSED CREDIT

IN THE AMOUNT OF SDR 1 1.1 MILLION

TO

BOSNIA AND HERZEGOVINA

FOR A

LOCAL DEVELOPMENT PILOT PROJECT

March 12, 1999

Urban GroupInfrastructure Sector UnitEurope and Central Asia Regional Office

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CURRENCY EQUIVALENTS

Currency Unit = Convertibile Mark (KM); equivalent 1:1 to Deutsche Mark1 KM= 1 DM=US$0.55

FISCAL YEARJanuarv 1 - December 31

ABBREVIATIONS AND ACRONYMS

BiH Bosnia and HerzegovinaCAS Country Assistance StrategyEC European CommissionFBA Federation Banking AgencyFIB Federation Investment BankFY Fiscal YearIAS International Accounting StandardsICB Intemational Competitive BiddingICMA International City/County Management AssociationIDA International Development AssociationiS International ShoppingKM Convertibile MarkLDF Local Development FundLGU Local Government UnitMW Minor WorksNCB National Competitive BiddingNS National ShoppingOSCE Organization for Security and Cooperation in EuropeNGO Non-Governmental OrganizationPCB Private Conmmercial BankPFSAC Public Finance Structural Adjustment CreditPIU Project Implementation UnitPMR Project Management ReportPWEP Public Works and Employment ProjectRETF RS Employment and Training FoundationRS Republika SrpskaSOE Statement of ExpensesUNDP United Nations Development ProgramUSAID U.S. Agency for International Development

Vice President: Johannes Linn, ECAVPCountry Director: Christiaan Poortmann, ECCO4

Sector Director: Ricardo Halperin, ECSINSector Leader: Margret Thalwitz, ECSIN

Task Team Leader: Sarah Forster, ECCBA

Bosnia and HerzegovinaLocal Development Pilot Project

CONTENTS

A: PROJECT DEVELOPMENT OBJECTIVE ......................................................................... .

1. PROJECT DEVELOPMENT OBJECTIVE AND KEY PERFORMANCE INDICATORS ............................................ 2

B: STRATEGIC CONTEXT ..........................................................................

1. SECTOR-RELATED COUNTRY ASSISTANCE SrRATEGY (CAS) GOAL SUPPORTED BY THE PROJECT ..........22. MAIN SECTOR ISSUES AND GOVERNMENT STRATEGY ....................................................................... 33. SECTOR ISSUES TO BE ADDRESSED BY THE PROJECT AND STRATEGIC CHOICES ....................................... 6

C: PROJECT DESCRIPTION SUMMARY ..........................................................................

1. PROJECT COMPONENTS ....................................................................... 7...2. KEY POLICY AND INSTITUTIONAL REFORMS SUPPORTED BY THE PROJECT ............................................. 93. BENEFITS AND TARGET POPULATION ....................................................................... 9...4. INSTITUTIONAL AND IMPLEMENTATION ARRANGEMENTS: .................................................................... 10

D: PROJECT RATIONALE ........................................................................ 1.

1. PROJECT ALTERNATIVES CONSIDERED AND REASONS FOR REJECTION ...................... ............................ 132. MAJOR RELATED PROJECTS FINANCED BY THE BANK AND/OR OTHER DEVELOPMENT AGENCIES .......... 143. LESSONS LEARNED AND REFLECTED IN THE PROJECT DESIGN ................................................................ 144. INDICATIONS OF BORROWER COMMITMENT AND OWNERSHIP ................................................................ 155. VALUE ADDED OF BANK SUPPORT IN THIS PROJECT ....................................................................... L5

E: SUMMARY PROJECT ANALYSIS .........................................................................

1. ECONOMIC ......................................................................... L5..2. FINANCIAL ............................................................................ L3. TEcHNICAL ..............................

4. INSTITUTIONAL .......... 16..5. SOCAL .1....... 166. ENVIRONMENTAL ASSESSMENT ................................. 1.7.7. PARTICIPATORY APPROACH ................................. 17.

F: SUSTAJNABILITY AND RISKS ................................... 1.7.

1. SUSTAINABILITY ................................. 17..2. CRITICAL RISKS ................................... 183. POSSIBLE CONTROVERSIAL ASPECTS ................................. L8

G: MAIN LOAN CONDITIONS ................................. 18.

1. EFFECTIVENESS CONDITIONS ................................. 18.2. OTHER ....................................

H. READ I NESS FOR IMPLEMENTATION .................................. 19

I. COMPLIANCE WITH BANK POLICIIES ................................. 19

ANNEXES

ANNEx 1: PROJECT DESIGN S UMMARY ........................................................... 2.ANNEX 2: PROJECT DESCRIPTION ........................................................... 21.ANNEX 2.1: ELIGIBILITY CRITERIA FORPARTICIPATING MUNICIPALITIES/UTILITIES ............................... 24ANNEX 2.2: ELIGIBILITY CRITERIA FORPARTICIPATING BANKS .......................................................... 2.6ANNEx 3: ESTIMATED PROJECT COSTS ........................................................... 2 7.ANNEx 4: INSTITUTIONAL ARRANGEMENTS .......................................................... 29ANNEX 5: APPRAISAL OF FINANCIAL INTERMEDIARIES ......................................... o.............. 30ANNEx 6: PROCUREMENT AND DISBURSEMENT ARRANGEMENTS .......................................................... 32ANNEX 7: PUBLIC INFORMATION AND CONSULTATION STRATEGY .......................................................... 42ANNEX 8: PROJECT PROCESSING BUDGET AND SCHEDULE .......................................................... 44ANNEx 9: DOCUMENTS IN THE PROJECT FILE .......................................................... 45.ANNEX 10: STATEMENT OF LOANS AND CREDITS .......................................................... 46ANNEx 11: COUNTRY AT A GLANCE ........................................................... 48.

Bosnia and HerzegovinaLocal Development Pilot Project

Project Appraisal Document

Europe and Central Asia Regional OfficeBosnia and Herzegovina Country Unit

Date: March 12, 1999 Task Team Leader/Task Manager: Sarah ForsterCountry Manager/Director: Christiaan Poortman Sector Manager/Director: Ricardo HalperinProject ID: BA-PE-56192 Sector: Urban Development/ Program Objective Category: Economic Management/

Municipal Finance Private Sector DevelopmentLending Instrument: Specific Investment Loan Program of Targeted Intervention: [ I Yes [X] No

Project Financing Data [I Loan [XI Credit [I Guarantee [J Other[Specify]

For Loans/Credits/Others:

Amount (US$m/SDRm): SDR 11.1 million (US$15 million equivalent)Proposed tenns: [1 Multicurrency f Single currency, specifyGrace period (years): 10 [I Standard Variable [ Fixed [ LIBOR-basedYears to maturity: 35Commitment fee: Standard IDAService charge: Standard IDA

Financing plan (US$m):Source Local Foreign TotalGovernment "' 1.5 0.0 1.5Cofinanciers2' 0.0 2.0 2.0IDA 11.1 3.9 15.0Total 12.6 5.9 18.51/ Govermment contribution comprises 10 percent sub-project cofinancing by sub-borrowers and contribution to LDF operating costs.2/ Donor cofinancing in an amount of at least US$2 million is expected to be mobilized.

Borrower: State of Bosnia and Herzegovina, with on-lending to the Federation of BiH and Republika Srpska.Guarantor: N/AResponsible agencies: Federation and Republika Srpska Local Development Funds

Estimated disbursements (Bank FY/US$M): 1999 2000 2001 2002 2003Annual 0.2 1.0 5.1 5.4 3.3Cumulative 0.2 1.2 6.3 11.7 15.0

For Guarantees: [ Partial credit [ Partial risk

Project implementation period: 4 years Expected effectiveness date: May 1999 Expected closing date: May 2003

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A: Project Development Objective1. Project development objective and key performance indicators (see Annex 1):

The project has two main development objectives:* to strengthen the institutional and financial capacity of local governments in Bosnia and

Herzegovina (BiH) so as to enable them to provide improved municipal infrastructure andservices in response to citizen demand and to help stimulate local economic growth.

* to initiate, on a pilot basis, the development of a municipal credit market to provide a long-termsource of financing for creditworthy municipalities for infrastructure investment.

Key performance indicators include:* Participating municipalities demonstrate improved financial management capabilities.* Pilot PCBs demonstrate improved municipal credit on-lending abilities.* Measurable improvements in the quantity and quality of municipal infrastructure.* High loan repayment rate reflected in high quality loan portfolio -- no more than 10 percent of

LDF portfolio at risk (60 days past due).

B: Strategic Context

1. Sector-related Country Assistance Strategy (CAS) goal supported by the project (see Annex 1):

CAS document number: 16866-BIH Date of latest CAS discussion: August 6, 1998

Local governments (cantons, cities and municipalities) are important economic players inBiH, the locusof reconstruction activity and refugee return, with responsibility for provision of basic services andinfrastructure at the municipal level. As such, they face huge demands as they try to meet the needs ofexisting and returning communities. Yet, BiH local governments and their utility companies areinstitutionally and financially weak. Post-conflict reconstruction has focused on emergency infrastructurerehabilitation with little attention to building local institutional capacity and the institutional and financialsystems to support long-term economic growth and development.

Tlhis project will support the shift from emergency, post-conflict reconstruction to sustainable economicgrowth and development, which is the main strategic goal of the Country Assistance Strategy. Theproject contributes to all three development themes of the CAS - strengthening public financemanagement, private sector development in support of the transition to a market economy, and deepeningthe sustainability of reconstruction:

* strengthening public finance management - technical assistance will be provided to municipalgovernments to improve their financial management skills, particularly in the areas of capitalplanning and budgeting, accounting and financial management. The project will provide an incentivefor local governments to implement new government accounting standards and improve theirfinancial management practices by making LDF loan eligibility conditional on reaching agreedstandards of financial management and creditworthiness.

* private sector development - under the project, selected local commercial banks will be provided withtechnical assistance in municipal credit analysis and project appraisal, so building their capacity toprovide long-term financing for municipal investment projects. By channeling loan funds throughlocal banks, the project aims to lay the foundation for the development of a local, private sectormunicipal credit market.

* deepening the sustainability of reconstruction - the project will improve the financial sustainability ofreconstruction by assisting municipal governments and their utilities improve their financial planningand tariff setting practices so as to increase cost recovery levels. Participation of local citizens ininvestment decision-making will further improve sustainability by building local ownership of capitalinvestment decisions and increased willingness to pay for improved services.

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2 Main sector issues and Government strategy:

Local Government Structure and Fiscal Relations

The Washington Agreement of March 1994 and the Dayton Peace Agreement of December 1995describes the governmental framework for Bosnia-Herzegovina. Under this framework, the centralgovernment of Bosnia and Herzegovina has limited powers, related to foreign policy, foreign trade, debtservice administration and inter-Entity matters. The central government has minimal centralizedspending power (10 percent of total government revenue in FY98) and no central taxes or redistributiverole. The majority of government functions are assigned to the two Entities, the Bosniak-CroatFederation of Bosnia and Herzegovina and the Republika Srpska. All taxes are collected at the Entitylevel and the Entities are responsible for almost all spending, including defense, education, health,pensions, social assistance, and infrastructure.

Local government structures differ within the two Entities. In the Federation, governmental functions aredivided between three levels: Entity, Canton and Municipality. The Cantons have been created as a newregional level of government with considerable revenue and expenditure power and autonomy indecision-making. There are also two city governments in the Federation - Sarajevo and Mostar. InRepublika Srpska (RS), govermmental functions are divided between two levels: Entity and Municipality.The RS Government is considering the establishment of 8 "counties". However, if established, these arelikely to have a more limited role and revenue-raising power than the Cantons of the Federation.

In the Federation, Cantons are assigned revenues from sales tax, income tax and corporate profit tax'.Municipal revenues are subject to determination by the cantons. Most cantons have followed theFederation recommendation and allocated 20 percent of the sales and income taxes to the municipalitieswhere they are collected. Some cantons have stabilized this practice by passing cantonal legislation,while others make the distribution as part of the annual budget process. In RepublikaSrpska, a number oflaws govern revenue assignments to the municipalities. For example, municipalities are assigned 26percent of personal income tax and 30 percent of sales tax. However, overall municipal revenues have asimilar level in both Entities.

The Federation Cantons are assigned responsibility for cantonal institutions, health care, education,culture, social needs, and "other needs as determined by the canton authority." Municipal responsibilitiesare similar in both Entities. Generally speaking, municipalities are responsible for maintaining andoperating municipal infrastructure and services (water, sewage, street cleaning etc.) through municipalutility companies2. In smaller municipalities, one company provides multiple services. In largermunicipalities, separate utility companies provide individual services, e.g. water supply, treatment anddistribution, solid waste removal, street cleaning and park and cemetery maintenance. Currently, theseutility companies are municipally-owned and have varying degrees of local government control anddependence on government budget subsidies. However, the strategy of both Entity governments is toencourage increasing cost recovery and develop municipal utility companies as autonomous, self-financing commercially-oriented enterprises that may eventually be privatized. Municipal governmentsare also responsible for social assistance, pre-school and child care, as well as urban planning andregulation of commercial activities.

1 In the Federation, revenue and expenditures assignments are governed by the "Law Regarding The Allocation OfPublic Revenue in the Federation of Bosnia and Herzegovina" approved in late 1996.2 If a municipality has a majority population different from that of the Canton as a whole, the Cantonal governmentis obliged to delegate to that municipality all functions concerning education, culture, local business and media aswell.

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Local Government Creditworthiness

As part of project appraisal, a study was carried out to assess the degree of creditworthiness and demandfor credit by local govemments. The study assessed the financial, economic and management capacity ofall ten cantons in the Federation, seven municipalities in the Federation and seven municipalities inRepublika Srpska3. The main findings of this study are as follows:

* The economic and financial conditions for local government are gradually improving and appear tobe stabilizing. A number of jurisdictions show strong increases in revenue flows since 1996. Thisreflects not only growth in underlying economic activity but further strengthening of tax compliance.Based on this initial assessment, about one-third of the sample jurisdictions appeared to be potentiallycreditworthy, although more in-depth analysis is required to confirm this.

* The financial and management capabilities of local governments within BiH are weak. Mostmunicipalities have limited internal ability to assess financial conditions and local borrowingcapacity. Furthermore, an understanding of the realities of commercial borrowing has not yet beeninculcated into government perspectives and practices.

* Existing government accounting, budgeting and financial reporting requirements are insufficient toallow an in-depth analysis of creditworthiness. Fiscal imbalances are obfuscated by cash (non-accrual) accounting practices. However, both Entity governments are putting in place new modifiedaccrual accounting and reporting standards, as well as a budget classification scheme, that will helpaddress these issues.

- Municipal utilities still need legal and institutional restructuring and improvements in cost recovery.Many municipal utilities have deferred service improvements and investments in long overduemaintenance. Currently, municipal utility companies are considered to be poor credit risks on theirown given the relatively low levels of cost recovery. Hence, loans to utilities will likely need to besecured by general obligation pledges from the municipal budget.

Municipal Credit Market and Lending Risks

There is at present no long-termn lending available to local governments. Even short-to-intermediatelending (two years or longer) is virtually non-existent. The only lending BiH banks provide tomunicipalities are cash management loans (month-to-month loans to cover cash flow shortfalls) and eventhese are rare.

Yet the capital needs of local governments in post-war Bosnia and Herzegovina are enormous. Directwar damage combined with years of inadequate maintenance and lack of new capital investment has ledto a substantial backlog of investment requirements. Emergency assistance provided by donors hascontributed to significant infrastructure repairs throughout the country. However, such donor financingwill diminish over the coming years and will far from meet the needs for local infrastructure investment.Hence, local governments will increasingly need to generate their own resources for infrastructureinvestment or secure access to long-term financing.

The Entity Governments have provided local governments with the legal power to borrow for capitalinvestment purposes provided it does not exceed a certain level of debt servicing capacity. In theFederation, this power is provided for under the "The Law of the Budgets in the Federation of Bosnia andHerzegovina" adopted in April 1998, Article 39 of which states that "Cantons, cities and municipalitiesmay borrow from domestic and foreign sources for the purpose of financing a capital investmentexpenditure....". The law sets a limit that annual debt service of principal and interest may not exceed 20percent of annual revenues. A similar budget law with the authorization for municipalities to borrow forcapital investment purposes is currently under parliamentary review inRepublika Srpska and is expected

3See "Local Government Creditworthiness in BIH Study", October 1998 by Larry Seale for further detail, availablein the project files.

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to be adopted shortly. The World Bank will not approve any lending to municipalities in RS under theProject until this law is passed.

Other Donor-Financed Municipal Development Programs

Several other donors have programs which are complementary to the Local Development Project. Underits Municipal Infrastructure and Services (MIS) Project, in 1999, the U.S. Agency for InternationalDevelopment (USAID) will focus on institutional strengthening and restructuring of municipal utilitycompanies through a series of workshops and direct technical assistance to a selected number of pilotmunicipal utility companies. Assistance will help the utilities restructure to a more corporate structureand improve management and technical skills and cost recovery capacity.

The European Commission (EC)-Phare is supporting a "Water Sector Institution Building Program" thatsupports legal and institutional reform of the water sector at the State and Entity level. The program hasfive components: legal, institutional, water quality, financing and cost recovery, and human resourcesdevelopment. In the area of financing and cost recovery, EC-Phare is financing a number of pilot projectsto improve the commercial operation and financial management of water utility companies including thegradual introduction of total metering and charging of cost-related tariffs.

The Organization for Security and Cooperation in Europe (OSCE), as part of its governance program, issponsoring a "Municipal Infrastructure Finance and Implementation Training" which links training onmunicipal finance with providing municipal actors with tools to assist them overcome local politicalconflicts and build public support and consensus for municipal decisions. The municipal finance trainingis being provided by the International City/County Management Association (ICMA) through a series ofworkshops scheduled from Dec 1998 - May 1999.

All these agencies are supportive of the project and see it as providing a source of financing for thosemunicipalities and utilities that demonstrate their creditworthiness, which will help provide leverage totheir own TA efforts. Technical assistance provided under the Local Development Project (LDP) will notreplicate TA provided by other donors, but rather fill the gaps. For example, the LDP will focus primarilyon technical assistance to municipalities and local banks, rather than to utilities which is largely coveredby the USAID and EC-Phare programs.

Capacity of the Local Banking Sectors to Intermediate Local Government Lending

The banking sector in both the Federation and the RS is weak. The majority of banks areundercapitalized and there is little long-term lending in any sector. The ratio of bank deposits to GDP inBiH is less than 10 percent as compared to approximately 50 percent in most other Eastern Europeaneconomies. Most banks suffer from liquidity problems and currently rely on credit lines from donors astheir main source of lending.

BiH is over-banked in terms of the number of banks registered, yet the level of banking and, in particular,lending services are inadequate to support the recovery of the economy. There are currently 55 licensedbanks operating in the Federation, 13 of which are majority owned by state-owned enterprises. Thesestate-owned banks hold over 77 per cent of total banking assets in the Federation. In the RS, there are 15banks, 11 of which are majority-owned by state enterprises. The four largest of these control two-thirdsof all RS bank assets. Private banks in both Entities were generally created during or after the war andcurrently have limited nominal amounts of assets and capital.

Hence, today, commercial banks do not satisfy the demand for longer-term municipal infrastructure loans.This is because: i) deposits are small and an unreliable source of financing, ii) medium and long-termdebt cannot be financed with the current modest levels of domestic savings; and iii) commercial banksare generally short of equity capital which inevitably imposes constraints on their business volumes. As

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the funding sources to which the Federation and RS have access are short-term only, extending long-termcredit would expose the banks to high liquidity and interest rate risks. These funding constraints arereflected in the term structures of the banks loan portfolios. The vast majority of bank loans have termsof up to one year maximum. Loans with terms of more than one-year are extremely rare. Federation andRS banks also lack the expertise required to analyze municipal and utility credit risk.

Since 1995, a financial sector reform program has been underway in BiH in which the World Bank hasbeen actively involved. This includes financial sector reforms to improve banking laws and regulations,strengthen bank supervision, establish deposit insurance systems, and limit public intervention in creditmarkets, as well as the restructuring and privatization of state-owned commercial banks. All majoritystate-owned banks will undergo a solvency test by the Entity Banking Agencies. Those banks determinedto be solvent must be privatized by June 2000. This privatization process is likely to lead to theconsolidation and strengthening of the banking sector. The development of fewer, larger, stronger banksis a positive factor for the LDP. Although, the state of flux of the banking sector underlines the need toselect participating banks extremely carefully.

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

There are two sets of sector issues that will be addressed by the project:

(i) Municipal CreditworthinessThe primary impediments to establishing municipal creditworthiness are the low levels of municipalrevenues, local governments' inability to identify and prepare bankable projects, the lack of an establishedcredit record, and underdeveloped legislation regarding a municipality's ability to borrow and secureloans for capital investment purposes.

Ongoing work under the Public Finance Structural Adjustment Credit (PFSAC) operations is of directrelevance to the LDP in the area of local government revenues. One of the objectives of the proposedPFSAC II, currently under preparation, is to rationalize local government revenue and expenditureassignments among different levels of government and to enhance municipal own source revenues e.g.through development of a property tax system. This work should support greater rationalization of fiscaldecentralization in BiH and provide for higher levels and greater stability of municipal revenues.

As regards preparing bankable projects, the LDP will provide technical assistance to help municipalitiesanalyze their financial position and prepare bankable projects that are in-line with their debt servicingcapacity.

In regards to credit risk, a principal objective of the pilot project is to reduce municipal credit risk soencouraging private banks to lend for municipal investment. The credit risk involved in lending toutilities and/or municipalities will be reduced by: (i) requiring full disclosure of a municipality's currentand projected financial condition; (ii) careful financial appraisal by the lender of the municipality's abilityto repay the loan under different revenue assumptions; (iii) identifying secure forms of municipalguarantees (land, property, municipal and/or utility revenue); (iv) requiring ageneral obligation pledgefrom the borrowing municipality; and (v) introducing liens on intergovernmental revenues as a form ofguarantee. Overall, the LDP aims to provide the banks the necessary risk management tools to moveaway from real property as the only source of collateral.4 Under the project, liens on inter-governmentalrevenues will be introduced as a form of credit enhancement. Under this system, a local government thatborrows capital funds must enter into a contractual agreement with the bank allowing it to divertmunicipal revenue transfers from the canton or Entity in the event the municipality does not repay its loan

4 There is a natural inclination to secure loans with tangible property--such as land or buildings. This is appropriatefor commercially-oriented development projects, but less appropriate for government entities. Further, the legalprocedures for foreclosing on municipally-owned property are unclear.

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on a timely basis. This system can minimize some of the credit risk for the lender. It also minimizescredit risk for the Entity or Cantonal government, which may (legally or practically) have residualresponsibility for local government loan repayment. A lien (in the event of municipal non-payment) ontransfers from the Cantonal government is a guarantee (or, credit enhancement) only. Local authoritiesare expected to budget debt repayments, and to adjust local fees and charges or other expenditure itemsunder local control to ensure that they make debt payments in full and on time.

The LDP will also finance research on the legal and regulatory framework for municipal lending. Thisresearch will lead to policy recommendations to the government as to how to improve laws andregulations in this area.

(ii) Developing a Private Sector Municipal Credit MarketThe project also aims to help overcome the structural and institutional deficiencies which are currentlypreventing local commercial banks from satisfying the demand for long-term infrastructure loans. Byproviding access to long-term credit funds, the LDF will enable the banks to reduce the liquidity andinterest rate risk incurred on longer-term loans. Technical assistance will be provided to the participatingbanks focusing on municipal credit analysis and monitoring to ensure successful repayment of LDF loans.

In addition, suitable incentive structures will be designed which ensure that the banks have an economicinterest in carrying out long-term municipal lending. Under the LDP, the banks will receive an interestrate margin of about 5 percent. This must be regarded as modest, especially bearing in mind the smallnumber of loans projected to be disbursed during the pilot phase (15-205 and therefore the relatively highadministrative costs relative to the total volume of funds disbursed. For this reason, consideration will begiven to allowing the banks, at some later date, to charge a processing fee. This mechanism would allowthe LDF to adjust the effective interest margin in line with the banks' actually observed cost structureswithout increasing the absolute size of the sub-borrowers' monthly debt service burden.

C: Project Description Summary

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

The project has four components:

1. Local Government Capacity Building (US$1.28 million). Technical assistance and training willbe provided to municipal governments to strengthen their financial management skills and publicparticipation in the capital budgeting process. In the first year, technical assistance will be targetedtowards 15-30 pilot municipalities that have demonstrated their potential creditworthiness in accordancewith criteria described in Annex 2.16 Selection of these municipalities will be carried out during projectimplementation with the assistance of the international municipal consultants in accordance with thepolicies and procedures described in the LDF Operational Manual. Final selection of the municipalitieswill be subject to the non-objection of the LDF Board of Directors and the World Bank. The technicalassistance program will be designed with the participation of municipal representatives to ensure that it isresponsive to their needs. The TA program will likely comprise seminars, study tours and individualconsulting in the following areas: capital planning and budgeting, accounting, financial management,project design, preparation and appraisal, procurement, environmental assessment and public consultationand participation in the capital budgeting process. In addition, a non-core program of technical assistancewill be offered on a demand-driven basis in areas such as urban and spatial planning, and the role of localgovernment in private sector development. TA and training services will be planned and managed by an

5It is expected that about 80% of the 15-30 participating municipalities will have sub-loans approved.6 Selection of the pilot municipalities will also take into account where USAID, EC-Phare and OSCE are providingtechnical assistance to municipal governments and their utility companies.

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international consulting firm selected through international bidding. The international consultants areexpected to work with a team of local consultants and utilize the capacity of local institutions in TAprovision to the extent possible. The project will coordinate extensively with USAID, EC-Phare andOSCE with respect to the provision of technical assistance. This component provides financing for thecosts of the international and local consultants.

2. Banking Sector Capacity Building (US$ 1.01 million). Technical assistance and training will beprovided to 3-5 local private commercial banks (PCBs) to improve their municipal credit analysis andproject appraisal skills. TA and training services will be provided by an international bank orinternational bank consulting group working with local consultants. Final selection of the participatingPCBs will be based on a competitive tendering process that will take place during project implementationin accordance with procedures described in the LDF's Operational Manual. The international bankconsultants will also provide technical assistance to LDF management in LDF financial management,and their internal control, monitoring and auditing procedures. It is also expected, that the internationalconsultant will assist in facilitating an exit strategy for theLDF. This component provides financing forthe costs of the international and local consultants.

3. Local Development Fund (US$ 11.8 million). A loan fund will be established under thiscomponent that will be administered by Local Development Funds (LDF) in each Entity. TheLDFs willon-lend funds to PCBs for on-lending to municipalities and/or their utilities for eligible investments.Eligible investments will be municipal infrastructure and services sub-projects that are supported byadequate project design and feasibility studies and that meet the project's eligibility criteria (see Annex2.1). The most likely investments will be in water supply, sewage, district heating and transportation. Anestimated 15-20 first cycle sub-loans will be disbursed during the project implementation period.

The maximum individual loan amount will be KM 2 million (about US$1.2 million equivalent), with theexpected average loan size for first cycle loans expected to be around KM 700,000 (about US$450,000equivalent). LDF loans will finance a maximum of 90 percent of the sub-project cost, with municipalitiesexpected to contribute a minimum of 10 percent. The maximum loan term will be 10 years. Localcommercial banks will not be encouraged to grant grace periods to municipalities, unless required by thestructure of the project, in which case a maximum of one year grace period on principal may be granted.The LDF will on-lend funds to the PCBs at an annual effective interest rate of Euro-based LIBOR plus 1percent, but not to exceed a maximum of 4 percent per annum. The PCBs will propose the maximumfinal on-lending rate to the municipalities in their tenders. Final agreement on this ceiling rate will bemade as part of the PCB selection process although it is expected that it will not exceed 9 percent perannum.7

4. LDF Management Support (USS 0.9 million). This component will cover the local costs of LDFmanagement, including: (i) remuneration of local LDF staff on a declining basis; (ii) equipment andvehicles; (iii) operating expenses; (iv) international external audits. It will also cover the costs of impactand evaluation studies. The Entity Governments will provide office space as counterpart funding, as wellas some furniture and equipment. The project will cover operational costs on a declining basis. Fromyear 3 (FY2002) onwards, it is expected that LDF operational costs will be fully covered from the interestrate spread.

7 This is significantly lower than the going rate of interest for short-term loans (16-24 percent p.a.) and is in line withthe relatively inexpensive interest rates payable on longer-term corporate loans that are currently being subsidizedby the international donor/lender community.

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Table 1: Project Components (see Annex 3 for detailed Project Costs by Entity)Component Category Cost Incl. % of Bank- % of

Contingencies Total financing Bank-(US$M)__________________ _ (US$M) financing

1. Local Government Institution Building 2.6 15% 1.3 9%Capacity Building

2.Banking Sector Capacity Institution Building 1.0 6% 1.0 6%Building3.Local Development Fund Credit 12.5 74% 11.8 79%4. Project Management Project 0.9 5% 0.9 6%

Management I I _ITotal 17.0 100% 15.0 100%

Note. The total project cost of US$17 million includes estimates of donor cofinancing in an amount of US$2 million.The Govemments of the Netherlands and Italy have expressed serious interest in cofinancing the LDP. Firm commitnents areexpected to be made at the next donors conference.

2. Key policy and institutional reforms supported by the project (see Section B.3for details):

The project will support the following key policy and institutional reforms:

* Institutional strengthening of municipal governments and their utilities.* Improvements in municipal government financial management.* Improvements in local government transparency and public accountability.* Improved tariff-setting policies by municipal utilities and increasing cost recovery levels.* Improvements in the legal and regulatory framework for municipal borrowing.* Introduction of private banks to municipal lending and facilitating the development of a private sector

municipal credit market in which risk is clearly identified, clarified and limited.

3. Benefits and target population:

For citizens in the municipalities where LDF loans are made, the primary benefits of the project will beimprovements in the quality of municipal infrastructure, such as better access and increased quality andreliability of water supply and heating systems. Citizens will also benefit from a more fiscallyresponsible, transparent and accountable local government and a greater stake in local governmentdecision-making.

For the pilot municipalities, the main benefits will be: (i) strengthening of financial management andplanning capacity; (ii) direct access to long-term financing for municipal infrastructure investments; (iii)increased creditworthiness providing improved opportunities to access financing from the private sector;(iv) more rational and efficient allocation of budgetary resources due to improved budgeting and capitalinvestment planning.

For the participating local banks, the main benefits will be: (i) acquisition of new skills in municipalcredit analysis and management; and (ii) early entry into a new lending market with potential for growthand profits in the future.

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4. Institutional and implementation arrangements:

The project will be implemented over a four year period (May 1999-May 2003).

The IDA Credit will be lent to Bosnia and Herzegovina which will on-lend the proceeds of the credit tothe Federation and Republika Srpska. Project management and on-lending of the funds will be theresponsibility of a Local Development Fund (LDF) to be established as an autonomous, legal institutionin each Entity (see Annex 4 for diagram). Legal establishment of the LDF by at least one EntityGovernment is a condition of project effectiveness.

Each LDF will have a Board of Directors to oversee LDF management and set policy. The Board willcomprise representatives from the Ministry of Finance, Ministry of Local Self-Governance (applicable inthe RS), the Association of Cantonal finance managers in the Federation and the Association ofMunicipalities in the RS8, the Bankers Association, the Banking Agency and the LDF Executive Director.The international consultants and a World Bank representative will participate in the Board meetings asexternal observers with no voting rights. The Board of Directors is expected to meet a minimum of fourtimes a year or as required.

The LDFs will have a small staff with a full-time Executive Director and an Administrative Assistant andwill be housed in existing Entity institutions - the Federation Investment Bank (FIB) in the Federationand the RS Employment and Training Foundation in RS. These institutions have the in-house capacity toprovide the LDF with financial management and other support services on a contractual basis.Management and technical advice will be provided to the LDFs by the international consultants.

In principle, the LDFs are designed to be transitional institutions that will disappear once their mission ofhelping to establish a municipal credit market has been accomplished. A sunset (exit) clause will beincorporated into the LDFs' statutes providing the possibility for closure of the LDFs and transfer of theirassets and loan monitoring responsibilities to another institution (in the Federation, the FederationInvestment Bank (FIB) which is a second tier lending institution might prove an appropriate institution totake over the LDF portfolio, once the FIB is privatized).

The roles and responsibilities of the key players in project implementation are as follows:

Individual citizens, local community councils, non-governmental organizations (NGOs) and otherstakeholder groups, through participation procedures built into the project design (see Annex 7) will helpformulate local priorities for investment to be submitted by their local governments for LDF funding.

15-30 potentially creditworthy municipalities will be selected to participate in the project. These localgovernments and their respective utility companies (LGUs) - through their mayors and electedrepresentatives - will apply to the participating local banks for LDF financing of priority capitalinvestment projects. Prior to sub-loan application, LGUs will benefit from training and technicalassistance in financial management, capital planning and budgeting and project preparation to ensure thatthey submit sound loan applications.

About 3-5 local PCBs will be selected to on-lend LDF funds to creditworthy LGUs. PCBs will beselected through a competitive bidding process based on a tendering process among a short-list ofselected banks that meet basic eligibility criteria (see Annex 2.2). The international consultants will carryout the final appraisal of the banks and will recommend 3-5 PCBs to the LDF for approval. Finalselection will be subject to the non-objection of the World Bank. Such a bidding process, as well as beingcompetitive and transparent, will allow a more in-depth inspection of the potential partner banks'financial statements at a time that is closer to actual loan disbursement and after financial statements have

8 The Federation LDF will facilitate the formation of a similar association of municipal finance managers in theFederation, which once formed would have Board representation.

I1

been prepared that include carve-outs of non-performing assets and re-adjustment of fixed assets in linewith Banking Agency regulations. The PCBs will have the following responsibilities: (i) assess thecreditworthiness of LGUs; (ii) review LGUs sub-loan applications for sub-project financing; (iii) ifeligible, carry out a technical, financial and environmental appraisal of sub-projects; (iv) approve/rejectsuch applications; (v) submit approved sub-loan applications to LDF for final approval; (vi) if approved,make loans to LGUs; (vii) monitor performance of LDF financed sub-loans; and (viii) take fullresponsibility for the credit and other risks of sub-loans to LGUs.

The Local Development Fund (LDF) will have the following responsibilities: (i) select the pilotLGUswith the assistance of international municipal consultants; (ii) appraise and select the PCBs, with theassistance of the international bank consultants; (iii) support the international consultants in the planning,management and implementation of technical assistance to the PCBs and the LGUs; (iv) review andapprove/reject sub-loan applications by PCBs; (v) disburse sub-loans to PCBs; (vi) collect sub-loanrepayments from PCBs; (vii) monitor PCB and LGU performance; (viii) report regularly to the State andEntity Governments and the World Bank on LDF performance and (ix) support policy work in the areasof inter-governmental fiscal reform and improvements of the legal and regulatory framework formunicipal lending.

An international municipal consulting firm will be contracted by the LDFs to provide technicalassistance to the LGUs. The consultants will provide technical assistance and training in the followingfields: (i) government accounting and improved financial management practices; (ii) capital planning andbudgeting; (iii) review and rationalization of LGU expenditures; (iv) project prioritization and planning;(v) project procurement; (vi) project technical, economic, financial, environmental and social appraisal;and (vii) public consultation and citizen participation in the capital budgeting process. The consultantsmay also provide other types of technical assistance based on demand e.g. in urban and spatial planning.The consultants will also do work on the legal and regulatory framework for municipal lending, as well asmaintain contacts with those involved in inter-governmental fiscal reform efforts.

An international financial institution or consulting firm will be contracted through internationalbidding to be responsible for assisting the LDF in financial management and providing TA and training tothe PCBs. The international bank will: (i) assist in the selection of eligible PCBs; (ii) provide technicaladvice to the LDF staff on establishing internal policies and procedures in the areas of financialmanagement and portfolio management; (iii) review and approve/reject loan requests by PCBs; (iv) co-authorize LDF sub-loans to PCBs; (v) monitor LDF performan6e;-and (vi) advise on strategies for the exitof the LDF from the municipal credit market and facilitating PCBs' access to long-term commercialsources of financing for municipal lending.

The international bank will also be responsible for providing high caliber technical assistance and trainingto PCBs in the following areas: (i) establishment of lending policies, procedures and standard loandocumentation for LDF loans; (ii) creditworthiness assessment of LGUs; (iii) credit analysis of sub-loanapplications; (iv) management of a long-term credit portfolio of loans to LGUs; (iv) monitoring LGUborrowers performance with respect to outstanding loans; (vi) methods of transparent reporting of LGUloan portfolio performance; and (vii) technical, financial and environmental appraisal of proposed sub-projects.

Financial Management and Auditing Arrangements

The LDFs will be responsible for the financial management of the IDA credit and the LDF loan portfolioin accordance with International Accounting Standards as issued by the International AccountingStandards Committee. Prior to effectiveness, an assessment of the financial management systems of theLDFs will be carried out. This assessment will result in a time-bound action plan agreed between theBank and the LDFs which will describe the steps to be taken to ensure that the LDFs have an acceptablefinancial management system in place by effectiveness and prepare Project Management Reports (PMR)

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by December 31, 1999. The establishment of a financial management system satisfactory to the Bank, asassessed by a certified Financial Management Specialist, will be a condition of effectiveness.

Technical advice and training in the areas of financial management and procurement to all project players- the LDF, the PCBs and the LGUs - will be an integral part of the assistance to be provided by theinternational consultants. These consultants will also play a role in the oversight and monitoring offinancial management and procurement practices and ensure that they meet Bank standards.

The LDF will provide quarterly financial statements to the LDF Board of Directors and the World Bank.PCBs will be required to provide monthly financial statements to the LDF on their LDF loan portfoliostatus.

International audits will be conducted on an annual basis by international auditors acceptable to the Bankin accordance with International Accounting Standards as issued by the International Federation ofAccountants. The State Ministry of Foreign Trade and Economic Relations is currently in the process ofhiring international auditors to audit all ongoing World Bank-financed projects. The contract will be atwo year contract with the option to renew for up to two additional years, based on performance. Theseauditors are expected to be employed by April, 1999. The LDP accounts will be audited by this auditingfirm in FY2000 provided their performance this FY proves satisfactory to the Bank. Employment ofthese auditors is a condition of effectiveness. The external audit will include audits of all LDF accounts.Furthermore, all PCBs will be required to submit to the LDFs their annual external audits. In addition,borrowing municipalities will be required to carry out a financial management review and an audit relatedto LDF sub-project expenditures. External audits at all levels will help support the signal that allocationcriteria - especially creditworthiness - must be strictly adhered to and will be audited thoroughly for allLDP project participants.

Procurement Arrangements (see Annex 6)

Procurement of the consultant services contracts will be carried out by the LDFs. The World Bankprocurement specialist will provide guidance on World Bank procedures for international biddingprocedures for consultants and supervise this procurement process. Procurement of civil works/goodswill be carried out by the municipal government borrowers. As part of the technical assistance andtraining to municipalities under the Local Government Capacity Building component, training inprocurement methods will be provided. In addition, the LDF, with the support of internationalconsultants, will be responsible for overseeing procurement and ensuring that it complies with the WorldBank guidelines.

Disbursement Mechanisms (see Annex 6)

The proposed IDA credit is expected to be disbursed over a four year period. The disbursement profile isconservative taking into account the project's primary focus during FY2000 on institution-building withsub-loan disbursements commencing in FY2001.

For the first year of project implementation, disbursements will be made using the Bank's traditionaltransaction-based disbursement method based on Statements of Expenditures (SOEs). The LDFs'financial management capacity will be reviewed after one year and if it is considered that they havegained sufficient experience with the FMS and reporting using PMRs, they may switch to PMR-baseddisbursement.

Disbursements from the IDA credit will be for consultant services, LDF operating costs and sub-loans.Disbursements for consultant services will be against consultant services contracts based on standardconsultant contracts acceptable to the World Bank. Disbursements for sub-loans will be made againstSubsidiary Loan Agreements between the LDF and the PCBs, key terms and conditions of which are

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described in the Project Agreement. Details on disbursement methods and documentation requirementsare provided in Annex 6.

D: Project Rationale

1 Project alternatives considered and reasons for rejection:

Direct on-lending by a Government Agency. An alternative project design would have been to channelproject funds through a government agency for direct lending to local governments. This is a model usedby many World Bank-financed municipal development projects around the world, including in the easternand central Europe region. However, this approach was rejected in the Bosnian context for severalreasons. First, the creation of such a specialized government institution would have been counter toobjective of stimulating competitive, private sector commercially-based municipal lending. In Bosnia,the government and the Bank are encouraging all lending to be done through the private sector. Theproject approach is in line with this policy. Second, such a model presents high risks of politicizedlending decisions. This risks credit decisions being made not on the municipalities' ability to repay and,hence, poor repayment performance. Such a risk was considered very high in BiH which is a highlypoliticized environment. Third, such a model tends to "crowd out" private sector lending rather thanstimulate the creation of private municipal credit markets. Finally,, municipalities expressed theirpreference to borrow from commercial banks rather than a government institution. Local banks have alsoexpressed keen interest in municipal lending.

Inclusion of a Social Fund or Grant Component During project preparation, consideration was givento including a grant fund to provide grant financing for low-income municipalities, where revenue-generation capacity is insufficient to enable borrowing. The possibility of targeting such assistance torefugee return areas was also considered. This option was discussed extensively by the Bank and theGovernment counterpart teams and eventually rejected on the following grounds. First, considerableamounts (estimated as at least US$50 million during the period 1999-2000) of grant financing are alreadybeing channeled by the EC and bilateral donors to municipal infrastructure and community projects on agrant basis, primarily through NGOs for refugee return-related projects. Under this project, only US$2-3million could have been allocated to this fund which would have been insignificant in this context.Second, it was agreed that it would be best to keep the design of this project simple and focused on theprimary objective of developing a municipal credit market, rather than mixing grant and loan programswith differing objectives under one project. Third, it was agreed that the Bank has a comparativeadvantage in focusing on the development of long-term sustainable systems, such as municipal credit, andthat providing credit to those who can afford to borrow will in itself lead to a better allocation of transfersand grants to non-creditworthy municipalities.

Delay the Project. During project preparation, some argued that the project should be delayed given thestate of flux of intergovernmental fiscal relations, relative lack of creditworthiness of municipalities andthe weakness and under-capitalization of the local banking sector. However, the Government and theproject team believes that it is important to start working with local governments, and banks, now to startbuilding their creditworthiness and to put in place a financing mechanism that will ease the transitionfrom emergency reconstruction to long-term development, when donor resources will be scarce andaccessing capital markets will be necessary to meet investment needs. This institution building processwill go on in parallel with the inter-governmental fiscal reforms. A further reason for not delaying theproject is to preempt the creation of inefficient mechanisms of resource allocation that would be likely toarise to fill the present void in local government financing in BiH.

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

Sector issue Project Latest Supervision (PSR) Ratings(Bank-financed projects only)Implementation DevelopmentProgress (IP) Objective (DO)

Bank-financedMunicipal demand for investment Public Works and Employment S S

Project (FY96)Cost recovery in the water sector Emergency Water Supply and S S

Sanitation (FY96)Capacity of banking sector - Fed Emergency Recovery Project HS HS

(credit line component) (FY96)Capacity of banking sector - RS Emergency Pilot Credit Project S S

(FY97)Public finance reforn; inter- Public Finance Structural S Sgovernmental fiscal issues Adjustment Credit (FY98)Financial sector and private sector Proposed Enterprise and Bankreform Privatization Adj. Credit (FY99)Other development agenciesStrengthening of cantonal capital ICMA technical assistancebudget planning and financial program financed by USAIDmanagement capacity. (1996-98).Institutional strengthening of water USAID Municipal Infrastructureutilities. Services (MIS) ProjectPolicy and institutional reform in EC-Phare Water Sector Institutionwater sector. Building ProgramLocal government capacity- OSCE, Canadian Urban Institutebuilding/urban planning. (Tuzla); various NGOsIntegrated local development; UNDP PROGRESS Projectstakeholder participation. I_I

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

3. Lessons learned and reflected in the project design:

The institutional capacity of local government needs considerable strengthening - experience inBiH,including direct experience with municipalities under the Public Works and Employment Project (PWEP)and several other emergency reconstruction projects, shows that the institutional capacity and financialskills of municipalities varies widely, but is generally weak. Hence, this project's emphasis onstrengthening the institutional and financial capacity of local governments. In addition, some localgovernments still suffer from ethnic division and conflict between resident and returning populationshighlighting the need to focus on good governance and public participation as an integral part of capacitybuilding efforts.

Municipal development projects need to build in incentives for local governments to pursueinstitutional development, which is a lower priority for them than physical investments - experiencefrom municipal development projects elsewhere attest to this. Hence, the linkage made between loaneligibility and the adoption of basic institutional and financial management improvement measures.

Measures need to be taken to minimize the weakness of the banking sector - experience from ongoingcredit lines financed by the Bank and other donors offer the following lessons: (i) select only a few banksto on-lend project funds with intensive training and supervision during project start-up; (ii) make thebanks take the full credit risk - this enhances repayment performance; (iii) introduce standard loandocumentation, loan analysis and reporting formats; and (iv) introduce penalties for past-due payments bythe participating banks to the LDF.

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4. Indications of borrower commitment and ownership:

Municipal and cantonal officials have expressed keen interest in the project. This interest is demonstratedby the high rate of responsiveness to an initial survey of creditworthiness and the large number of projectproposals put forward for financing (see Section E). Entity and State level officials have also expressedstrong support for the project which is regarded as timely and supportive of a more decentralized localgovernment system as well as being a project that will assist BiH move towards a more market-based,sustainable economy and financial sector. Both Entities showed their commitment by appointingcounterpart teams which worked closely with the Bank team during project preparation.

5. Value added of Bank support in this project:

This project is in line with the Bank's overall approach of shifting BiH from post-war reconstruction tonormalization of the economy, and long-term sustainable development and growth. The Bank'sinvolvement brings with it over 20 years experience in municipal development throughout the world. Theproject can also provide leverage to others' institutional reform efforts by providing the "carrot" (accessto financing) at the end of technical assistance efforts being supported by other agencies.

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

1. Economic:

[ ] Cost-Benefit Analysis: NPV=US$ million; ERR= % []Cost Effectiveness Analysis:[x] Other: individual sub-projects to be financed by the LDF will be identified during projectimplementation. Economic analysis will be carried out as part of sub-project feasibility studies.

LDF financing will be used to support municipal infrastructure and services projects, mainly in the areasof water, sewage, transport, heating and electricity distribution. As part of the creditworthiness study,sample jurisdictions were requested to submit data on projects that met the parameters of the LocalDevelopment Project and which would be ready to implement in 1999 if financing was available. A totalof 95 project briefs were submitted for a total value of DM 60 million with an average cost of DM693,000. The highest demand for project financing is in the areas of water supply (43%), sewage (15 %)and transportation (12%).

No detailed economic or financial analyses of individual projects were carried out during preparationgiven that the pilot municipalities have not been selected and it is too early to develop a project pipeline(sub-loan applications are not expected to be submitted until early 2000). However, it is clear that there isa large supply of viable projects. All sub-projects submitted to the PCBs forLDF financing will have tobe supported by appropriate feasibility studies, of a depth in line with the sub-project's size andcomplexity. These studies will have to demonstrate that each sub-project has employed a least costsolution and is economically viable with respect to cost recovery (see Annex 2.1 for eligibility criteria).

2. Financial:

During preparation, a creditworthiness assessment was carried out to assess the financial condition of asample of cantons and municipalities. Based on this study, criteria were developed that will be used toselect local governments as eligible for project participation. These include that revenues are increasing,and that the local government is free from any arrears, e.g. for salaries (see Annex 2.1). All sub-borrowers will be required to carry out a financial assessment of the sub-projects submitted for financing.Priority will be given to sub-projects that demonstrate a positive financial rate of return of at least 10percent, although in some instances an economic rate of return might be considered sufficient justificationfor sub-loan approval, particularly for sub-projects with limited cost recovery but with high social,environmental or economic benefits. Such sub-loans would require a general obligation pledge by thesub-borrower.

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Fiscal impact:The project design minimizes the fiscal costs and budget liabilities at the State and Entity level by on-lending the credit funds via the LDF to PCBs which will take the full credit risk and repay the LDF torepay IDA on behalf of the State. Donor grant funds will be sought for the technical assistancecomponents. Overall, the fiscal benefits to the Entity are expected to outweigh any potential costs, as theproject will encourage increased revenue generation at the local government level, so reducing demandson Entity governments for grants or subsidies.

The project is expected to have a positive fiscal impact at the local government level. Financial benefitsinclude improvements in the creditworthiness of participating municipalities and the financial position ofutilities. There is a risk of excessive borrowing by local governments leading to fiscal deficits. This riskwill be minimized by applying a debt service limit that annual debt service must not exceed 15 percent ofannual revenue.

3. Technical:

Feasibility studies will be carried out for all sub-projects. The majority of sub-projects will be technicallysimple and well within the capacity of local engineering firms to design and implement. Technicalassistance will be available in the case that municipalities or their utilities need additional support inproject preparation and appraisal.

4. Institutional:

The institutional capacity of local government varies but is generally weak. The main institutionalweaknesses lie in the areas of financial management and public participation, transparency andaccountability. Local PCBs' capacity is also weak particularly in the areas of municipal credit analysisand portfolio management. Hence, the project's primary focus on providing technical assistance andtraining both to municipal governments and to banks to strengthen their institutional capacity asborrowers and lenders respectively.

5. Social:

The social assessment undertaken for the project confirmed the high demand for improved municipalinfrastructure. There is widespread dissatisfaction with the quality and consistency of existing serviceswhich have suffered from war damage, lack of maintenance and under-investment. Many placeinfrastructure investment, particularly in water, sewerage systems and roads, as a top local developmentpriority. Overall, 42 percent of the sample expressed willingness to pay more for improved services while32 percent said they could not afford to pay more.

In some municipalities, a key social issue will be to build trust and reconciliation between residentpopulations and returnees, particularly those from a minority ethnic group. Hence, the project's focus onpublic participation and government accountability in its capacity-building efforts. Conflict resolutiontechniques may also be considered as part of the technical assistance program.

According to the social assessment, the vast majority of municipal citizens want increased participation inlocal government decision-making. In response to the question of how decisions regarding municipalinvestments should be made, only 20 percent of respondents were willing to leave this entirely tomunicipal leaders. Another 19 percent recommended that local community councils be involved. Anoverwhelming 57 percent felt that citizens and citizen's associations should be involved in decision-making about municipal investments. Focus group discussions supported these findings. Focus groupswere insistent that citizens and external technical experts be consulted on investment decision-makingsince group members believe that, on their own, most municipal leaders lack the skills to make technicaldecisions and are likely to be swayed by political or personal considerations. A Public Information andConsultation Strategy has been devised for the project based on the findings of the social assessment (seeAnnex 7).

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6. Environmental assessment:

Environmental Category [ ] A [x] B [ ] C

The environmental impact of the sub-projects will vary depending on their nature. Guidelines forenvironmental assessment of sub-projects will be incorporated into the LDF Operational Manual whichwill be subject to World Bank review and non-objection prior to project effectiveness. Sub-projectfeasibility studies done by the borrowing municipalities will be required to include an environmentalassessment and propose appropriate mitigation actions to avoid any negative environmental impact, ifnecessary. PCBs will be trained in environmental assessment as part of the TA program. Suchassessment work may be sub-contracted to a local environmental firm if such capacity exists by the timeof sub-loan disbursement. The LDF will check that the sub-project meets environmental assessmentrequirements as part of their review of the sub-project applications to ensure that the investment fulfillslocal environmental standards and policies and the LDF Operational Manual guidelines. Sub-projectswith serious negative environmental impacts would not be eligible for financing.

7. Participatory approach [key stakeholders, how involved, and what they have influenced; ifparticipatory approach not used, describe why not applicable]:

a. Primary beneficiaries and other affected groups: The social assessment consisting of focus groupdiscussions, in-depth qualitative case studies, and a survey of 2,400 households has ensured consultationwith domiciled residents, displaced persons and returnees from all three ethnic nationalities. The resultsof the survey confirmed the widespread dissatisfaction with municipal infrastructure and services and thewillingness to pay for improved services. It has also led to the development of a Public Information andConsultation Strategy to ensure citizen participation in the decision-making process. A local governmentstudy was also carried out to hear the local government's perspective and ensure that their views wereintegrated in the project design.b. Other key stakeholders: Preparation also involved consultation and collaboration with otherinternational organizations, particularly USAID, EC and OSCE and with NGOs, particularly thoseinvolved in local development. Input from other organizations helped develop the project concept anddesign and resulted in a project that is designed as part of an overall municipal development program withdifferent donors supporting various elements.

F: Sustainability and Risks

1. Sustainability:

The project design aims to achieve financial and institutional sustainability in the following ways: (i)placing a central focus on institution building of local government so providing them with the tools tofinance and manage investments on a sustainable basis; (ii) institutionalizing participatory processes thatbuild public support for the investments and increase citizens' willingness to pay for the servicesprovided; (iii) providing PCBs for the first time with hands-on experience in assessing municipal creditrisks and managing a municipal loan portfolio; (iv) exposing local governments - also for the first time -to credit financing with the incentive to adopt sound management practices to build creditworthiness; and(v) laying the foundation for a private sector municipal lending market at the level of both the banks andthe borrowers.

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2. Critical Risks (reflecting assumptions in the fourth column ofAnnex 1):

Risk Risk Risk Minimization Measureg_ __

Annex 1, cell 'from Outputs to Objective"Municipalities do not have sufficient revenues to S Carefiul selection of participating municipalitiessupport long-term borrowing. which takes into account the level, stability and

trends in revenues. Close collaboration with inter-governmental fiscal reform work to encouragepolicies to increase municipal revenues.

Annex 1, cell 'from Components to Outputs"Municipalities are not willing to adopt better M Municipalities will provide input into technicalfinancial management practices. assistance program design. Sub-loan eligibility is

conditioned on achievement of acceptablefinancial management standards.

Insufficient supply of well-defined projects with M Technical advice will be provided for projectadequate feasibility studies. feasibility studies during the municipal

institutional capacity building phase, as required.PCBs lack the financial capacity and skills to S Strict capital adequacy ratios are a key selectionmanage municipal credit risk adequately. criteria for PCBs. The Project will provide

training for PCBs in municipal risk analysis andlending.

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

3. Possible Controversial Aspects:

None.

G: Main Loan Conditions

1. Effectiveness Conditions:

(a) A Project Agreement has been executed on behalf of the Association and an Entity on terms andconditions satisfactory to the Association.

(b) For the Entity referred to in paragraph (a) above:(i) The respective LDF has been established in form and substance satisfactory to the Association and

its Operational Guidelines have been adopted satisfactory to the Association;(ii) A Subsidiary Financing and Project Implementation Agreement has been executed on behalf of the

Borrower, said Entity and the respective LDF on terms and conditions satisfactory to theAssociation;

(iii) A financial management system satisfactory to the Association is operational.

(c) The external auditors have been employed.

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

None.

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H. Readiness for Implementation[ ] The engineering design documents for the first year's activities are complete and ready for the start ofproject implementation. [x] Not applicable.[ ] The procurement documents for the first year's activities are complete and ready for the start ofproject implementation. [x] Not applicable, although draft Terms of Reference for consultant servicescontracts have been prepared.[x] The Project Implementation Plan has been appraised and found to be realistic and of satisfactoryquality.

[x] The following items are lacking and are discussed under loan conditions (Section G):Completion of the Operational Manual is a condition of effectiveness.The establishment of an operational financial management system, satisfactory to the Bank, is a conditionof effectiveness.

I. Compliance with Bank Policies[x] The Project complies with all applicable Bank policies.[ ] [The following exceptions to Bank policies are recommended for approval: The project complieswith all other applicable Bank policies.]

Task Team Leader/Task Manager: Sarah Forster (ECCBA)

Acting Sector Manager/Direc t Thalwitz (ECSIN)

Country Manager/Director: Christia

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Annex 1Bosnia and Herzegovina: Local Development Pilot Project

Project Design Summary

Narrative Summary Key Performance Indicators Monitoring and Critical AssumptionsEvaluation

CAS Goal: 1. Implementation progress on Adjustment credit (Goal to Bank Mission)Support the shift from public finance reforms under supervision reports. 1. Continued politicalemergency reconstruction to PFSAC. Bank ESW. stability.sustainable economic growth 2. Implementation of privatization Donor reports e.g. 2. Gov't commitment toand development. and financial sector reforms. USAID. implement economic reforms.

3. GDP growth.Project Development (Objective to Goal)Objective: LDF and international 1. Timely and increasing rate1. Strengthen the capacity of 1. Participating municipalities consultant reports. of collection of affordablelocal governments to provide demonstrate improved financial Bank supervision reports. tariffs.improved infrastructure and management capabilities. Quarterly PCB and LDF 2. Increasing capitalization ofservices (including 2. Pilot PCBs demonstrate improved reports. banking sector.improving the legal and municipal credit lending ability. Impact assessments.regulatory framework for 3. Measurable improvements in themunicipal borrowing). quantity and quality of municipal2. Initiate the development infrastructure.of a municipal credit market. 4. High quality portfolio - no more

than 10 percent of LDF portfolio atrisk (60 days past due).

Project Outputs (Outputs to Objective)1. 15-30 LGUs trained in 1. No. of LGUs that meet the LDF Quarterly project progress LGUs have predictable andimproved financial financial management standards. reports by municipal well-defined revenue flows.management and public 2. No. of LGUs that meet the LDF consultants. LGUs implement costparticipation in the capital public participation standards. WB supervision reports. recovery based on sound tariffbudgeting process. Reports from related policies.

projects - USAID, EC. Clear legal and regulatoryframework for municipal

l_____________________ ______borrowing.

2. 3-5 PCBs trained in 1. No. of PCBs trained in municipal Quarterly project progress PCBs increase capital andmunicipal lending and credit analysis and portfolio reports by PCB liquidity.municipal loan portfolio management. consultants. PCBs committed to municipalmanagement.. 2. No. of PCBs implementing sound WB supervision reports. lending.

municipal lending policies andprocedures.

3. 10-20 LDF loans 1. No. and value of loans disbursed. PCB quarterly portfolio LGUs able to service long-disbursed to LGUs for 2. Loan to values increase and/or reports to LDF. term debt.investment in municipal negative covenants decrease. Quarterly project progressinfrastructure and services. reports by PCB

consultants.WB supervision reports.

Project Components: Project Inputs: Regular project progress (Components to Outputs)1. Local Government Technical Assistance and Training reports. LGUs willingness to adoptCapacity Building. Support to local governments: Reports by municipal better financial managementto 15-30 potentially US$ 1.3 million consultants. practices.creditworthy municipalities.2. Local Bank Capacity Technical Assistance and training to Progress reports. PCBs willingness to engage inBuilding: capacity building PCBs. Reports by PCB municipal lending.support to 3-5 selected US $1.0 million consultants.PCBs.3. Local Development Credit fund: Portfolio and financial Pipeline of well-definedFund: on-lending through US $11.8 million management reports. projects.PCBs to .LGUs4. Project management: Staff salaries, equipment, operating Quarterly project progress Qualified staff appointed byincluding monitoring and costs: reports. Entity governments to manageevaluation US $0.9 million project.

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Annex 2

Local Development Pilot Project

Project Description

The project is designed as a pilot operation that aims to build the institutional and financial capacity of15-30 local governments and demonstrate their creditworthiness. The project also aims to demonstratethe ability of local banks to make long-term loans to local governments and secure repayment so layingthe foundations for the development of a private sector municipal credit market.

Component 1: Local Government Capacity Building. Technical assistance and training will beprovided to 15-30 municipal governments (two thirds in the Federation and one third in RS). These pilotmunicipalities will be selected according to the eligibility criteria described in Annex 2.1 and theprocedures described in the Operational Manual. The World Bank will provide a non-objection to thefinal selection of pilot municipalities.

The first phase of the project will focus on providing technical assistance to build the institutional andfinancial capacity of the selected pilot local governments and preparing for commercial borrowing.Technical assistance will comprise seminars, study tours, and individual consultants in the followingareas: accounting, financial management, capital planning and budgeting, project design, preparation andappraisal, procurement, environmental assessment and public consultation and participation in the capitalbudgeting process. In addition, a non-core program of technical assistance would be offered on a demand-driven basis in areas such as urban and spatial planning, modernization and streamlining of administrationand procedures, management information systems and the role of local government in private sectordevelopment. The technical assistance program will be designed in a participatory manner with the inputof municipal representatives from the pilot municipalities so that it is responsive to their needs.

The list below describes the types of topics to be covered by the technical assistance as identified duringthe local government creditworthiness study:

A. The Role of the Public and Private Sector in Economic Planning and Development* Development of a long term economic development strategy.* Understanding that the primary role of local government is to provide adequate infrastructure and

public services.* Establishing links with the private sector for most capital investment for economic development.

B. Capital Planning and Budgeting* Understanding the need to segregate capital (investment) decisions from operating decisions

because the benefits accrue over a different time frame.* Development of a multi-year capital plan founded on the economic strategies determined above

with a clear view of local government priorities.* Assisting municipalities to construct efficient operating and capital budgets, analyze expenditures

in terms of core and non-core local municipal activities, and determine a local municipal debtservice capacity. Assistance in multi-year financial planning, beyond the annual budget cycle, willalso be provided.

* Techniques for estimating the direct financial benefits (enhancing local own-source revenuesand/or costs savings) from proposed projects.

* Basics of cost benefit analysis to determine the optimal project implementation strategy.

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C. Basics of Debt Management* Why the use of debt may be desirable for capital purposes; spreading the costs over the life of the

benefits.* Determining debt capacity.* Different debt structures and their appropriate use.* Accounting for debt (loan proceeds are not revenue).

D. Accounting* Developing the use of fund accounting so various enterprises can be brought into a consolidated

and transparent local government budget.* Accounting for balance sheet items; showing changes in fund balances; displaying transactions in

"below the line" financing items.

E. Utility Management* Concepts of full cost recovery, including provision for capital investment.* Eliminating (or making transparent) social assistance objectives, which should be handled outside of

the utility budget.* Consideration of different legal structures, e.g. corporatization and eventual privatization.

Component 2: Banking Sector Capacity Building. Technical assistance and training will be provided to3-5 local PCBs to improve their municipal credit analysis and project appraisal skills. Participating PCBsmust meet the eligibility criteria described in Annex 2.2. Final appraisal and selection of the PCBs willtake place in accordance with the procedures described in the Operational Manual and with the non-objection of the World Bank.

TA and training services will be provided by an international bank or international bank consulting groupwith a good reputation and proven experience in municipal lending. The international bank consultantswill also provide technical assistance in LDF management, disbursement of LDF credit funds, and theinternal control, monitoring and auditing procedures of the LDF.

Component 3: Local Development Fund (LDF). This component will comprise a loan fund fromwhich loans will be made to selected local PCBs to on-lend to pilot LGUs for eligible investmentprojects. The fund will be managed by Local Development Funds to be established by the Government ineach Entity as autonomous legal institutions.

Sub-loan Terms and Conditions. Sub-loans will be made up to a maximum individual amount of KM 2million (about US$1.2 million equivalent) with a maximum loan term of 10 years. The LDF will on-lendthe funds to the PCBs at an effective interest rate of Euro Libor plus I percent per annum, but not toexceed 4 percent per annum. The final on-lending rate from the PCBs to the LGUs will be determined bythe PCBs as they will bid on the final price as part of their tender. However, an interest rate ceiling of 9percent per annum to the final borrower will likely be applied given the lack of market-based interest ratesetting in BiH. Grace periods will be avoided unless required by the structure of the project (for example,a utility project that will not produce revenue until completed). Projects funded from the existing tax baseor revenue streams should normally begin amortizing immediately so the local government does notcommit the revenue stream to other uses. In the case a grace period is given by the local bank to themunicipality, it would be for a maximum of one year on principal only. There will be no grace periodprovided between the LDF and the local commercial bank.

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The table below summarizes the on-lending terms and conditions between the different levels:

I Level of LendingConditions: IDA to BiH(LDF) LDF to PCBs PCBs to LGUsTerm 35 years 5-10 years Same as LDF/PCBGrace Period 10 years TBD Same as LDFIPCBCommitment Fee p.a. 0.50% (typically waived) Not applicable Not applicableInterest rate p.a. 0.75% Euro Libor + I %, Up to 9.0 % p.a.

but not to exceed4%p.a.

Size of loans:-maximum Not applicable KM 2.0 million KM 2.0 million- expected average Not applicable KM 0.7 million KM 0.7 million-minimum Not applicable KM 100,000 KM 100,000

Eligible Investments. Eligible investments will include municipal infrastructure and services sub-projectsthat are supported by adequate design and feasibility studies and meet the LDF eligibility criteria (seeAnnex 2.1). The most typical investments are likely to be water supply, sewage, electricity distribution,transportation, gas heating systems, flood protection, solid waste, and markets. Cost recovery and debtservicing of the loans will be derived either from direct user charges (for utilities) or indirectly fromgeneral local government revenues. Local governments borrowers will be expected to contribute at least10 percent to the sub-project cost.

Component 4: LDF Management Support. This component will cover the local costs of LDFmanagement, including: (i) remuneration of local LDF staff on a declining basis; (ii) equipment andvehicles; (iii) operating expenses; (iv) international external audits. It will also cover the costs of impactand evaluation studies. The Entity Governments will provide office space as counterpart funding, as wellas some furniture and equipment. The project will cover LDF operational costs on a declining basis.From year 3 (FY2002) onwards, LDF operational costs will be fully covered from the interest rate spread.

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Annex 2.1

Eligibility Criteria for

Participating Municipalities/Utilities and Eligible Sub-Projects

Participating municipalities will be selected on the basis of their ability to demonstrate that they arepotentially creditworthy. Selected nmnicipalities will have to demonstrate that they meet a largenumber of these criteria or are committed to meeting them9. More detailed eligibility criteria and theselection process are described in the Operational Manual:

A. Financial Condition

i) Revenues are at least stable and preferably increasing. There should be at least two years ofrevenue growth (adjusting for any tax policy changes).

ii) The local government should have a stable source of revenue. That means nmnicipalitiesoperating in cantons where no law has been passed to allocate revenues to municipalities willnot be eligible unless such a law is passed or acantonal guarantee is provided for the nunicipalloan.

iii) The local government should be free of any "arrears" (e.g. for municipal employee salaries) orhave clear plans as to how to cover arrears.

iv) The municipality has control over the operation of the utility and the revenues it generates.v) The utility generates a surplus of operating revenue over operating expenditures in the case that

the LDF sub-loan is to a utility.

B. Economic Environment

i) Levels of employment in the municipality are growing.ii) The wage levels are higher than the national average.

iii) There exists a diverse economic base, with emnployment spread among a number of differentcompanies and industries, rather than concentrated in one or two.

C. Management Capacity

i) The key local government employees (esp. financial managers) have significant experience infinancial management, preferably governmental financial management.

ii) There is limited turnover in the local government staff, and there is not a pattern of abruptpolicy changes among the political leadership.

iii) The b