Document ofThe World 13ank

Report No. 16f076 POI,

STAFF APPRAISAI, RFPORT

Poland

Municipal Finance Project

June 19, 1997

Countrv Operations DivisionCountry Department 11Europe and Central Asia

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CURRENCY EQUIVALENTS(as of April 30, 1997)

Currency Unit=New Polish Zloty (Pl,N)US$ = PLN 3.1 5

AVERAGE EXCHANGE RATES

1992 1993 1994 1995 1996US$ =PLN 1.36 1.81 2.27 2.42 2.70

WEIGHTS AND MEASURES

Metric System

ABBREVIATIONS AND ACRONYMS

BBs Borrowing BanksBISE Bank Inicjatyw Spoleczno-Ekonomicznych SA(Bank for Socio-

Economic Initiatives)CEM Country Economic MemorandumETP Economic Transformation ProgramEU European UnionFSU Former Soviet UnionGDP Gross Domestic ProductGFOS Municipal Funds for Environmental ProtectionIDF Institutional Development FundJCLGC Joint Central-Local Government CommitteeLSGA Local Self Government ActMDA Municipal Development AgencyMoF Ministry of FinanceNBP National Bank of PolandNFOS National Fund for Environmental Protection and Water ResourcesPBK Powszechny Bank Kredytowy SA w Warszawie (General Credit Bank)PHRD Policy and Human Resources DevelopmentPPL Public Procurement LawRIO Regional Audit ChambersUSAID United States - Agency for International DevelopmentWFOS Voivodship Funds for Environmental Protection

FISCAL YEARJanuary 1 - December 31

Vice President Johannes F. LinnActing Director Hans ApitzDivision Chief: Michel NoelTask Manager Daniel Oks

Poland

Municipal Finance ProjectTable of Contents

Loan and Project Sunmarx ........................ ..................... . ...........

CHAPTER I T1HE SECTOR ................................ ..... . ... . ......................................... .................. IA l)ecentralization of Public Services .......... .. . . . .. ..... IB Agency Rcsponsibilities i Central Govenument ........ . ...... 2C Municipal Finance and Management. ...... ........................ ......- 2J) MMuicipa] Inves tment ................ ... . ............ . ... ............. 41. Environmental Finance ....... 4.................................... . ........................... ........ 41;. Status of the Financial Sector, Municipal Credit 5G. Issues of Municipal Creditworthiness - Government Strategy . 6

CHAPTER Il: TITE PROJEC .. ........ . . ..... . ........ .. ........ ...... .......... 9A. Project O rig in . ........... .. .... . ........ . 9B. CAS and Rationale for Bank Involvement ..... 9. .. .............. .... ........................................ 9C'. IProject Objectives ........ .. ............ . 9D. IProject Descriptioii 9T. Project Costs and Finianicing Plan ....................... .................................... 1............. 12F O(n-lending Termis .................... .. ........... ........ .. ..... . 13

. I'articipatioii ......................... ........................... 14If Financial Analysis .... .. ..................... ....................... ....... 141. Economic Analysis .1........... ................................................... ....... .... 14J Sources of Risk lor the Project .1........ .. . ............... ...... . .. ...... 16

CHAPTER Im: PROJECT IMPLEMENTAlION 19.. ................... . ........ .. . . 19A. Institutional Responsibilities ..... ..................... .1.......................................... ............ 19B Contractual Arrangements .................. .. 1........ .... ....................... ........ 9 ............................... 19C. Implementation Arrangements ..... 1. .........................................................- 19D. Environmental Aspects ..... 2..1... .... .. .. .................................................... ... 21F Procurement Arrangemenits .. 2. ... . ............. 1. .............................................. 21F. I)isbursements and Special Account ............................... 22G. Reporting and Audits 2.. . ........ 2. .... ........ ....... I........ ........ ....... 2211. Project Supervision .. 2....3. ....... -..... .. ... ................................... ..I...... 23

CHAPTER IV A(GREM I MENTS RIFACIhED DURING NFGOTIATIONS ........... ............... 25......... . ........ ........ . 25

ANNEXES.Annex I. Municipal Finance and Investment in PolandAnnex 2a Project Implementation PlanAnnex 2b Project Inplementation Plan - Key Performance IndicatorsAnnex 3: Sample Appraisal Report with Financial Analysis: PulawyAnnex 4: Disbursement ScheduleAnnex 5: Eligibility criteria for banksAnnex 6. Review of the borrowing banksAnnex 7 List of Selected Documents in Project File

This report was prepared on the basis of an appraisal mission between March 25 and April 5, 1996, and a post-appraisal mission from May 21-29,1996. The project was prepared by Daniel Oks (Task Manager, EC2CO), Rochelle Hilton (EC2CO); Vincent Gouarne (TWUWS); Jan Drozdz(EMTIE); Oscar Alvarado (I.A3EU); Juliana Pigey (Consultant); Robert Weeks (Consultant). EC2 Country Operations is the responsible division(Michel Noel, Division Chief, Wei Ding, Principal Economist), in the Central Europe Department (Hans Apitz, Acting Director). William Dillinger(LAI PS) and Brian Smith (EC2AR) acted as Peer Reviewers.

POLAND

Municipal Finance Project

Loan and Project Summary

Borrowers: Bank for Socio-Economic Initiatives SA (BISE) and Powszechny BankKredytowy SA w Warszawie (General Credit Bank - PBK)

Guarantor: Republic of Poland

Beneficiaries: Municipalities and municipal enterprises

Poverty: Not applicable

Amount: US$4 million and DM 5.2 million to BISE, and US$8 million and DM 12million to PBK. Aggregating about US$22.0 million equivalent

Terms: 17 years, including 5 years of grace for level repayment, at the Bank'sstandard interest rate for LIBOR-based DM and US$ single currency loans

Commitment Fee: 0.75 percent on undisbursed loan balances, beginning 60 days aftersigning, less any waiver

Onlending Terms: The commercial banks will on-lend the proceeds of the IBRD loans tomunicipal sub-borrowers. The cost to the banks of IBRD loans will becomposed of: the IBRD interest rate and commitment fees; and the 2percent sovereign guarantee fee collected by the MoF (paid upfront).Loans to final beneficiaries will be made either in (a) foreign currency at arate reflecting the above costs, plus a spread to cover the commercialbank's administrative costs and its risk premium; or (b) in local currencyon the same terms as (a) but also reflecting the foreign exchange riskpremium. Sub-loans will be made for terms of between 5-15 years,including a grace period of up to 3 years, depending on the type ofinvestment financed

Financing Plan: The proposed Bank loans, totaling US$22.0 million, could finance up to75 percent of total investment cost of individual subloans. This amountcould vary depending on the availability of funds from other sources.Sub-borrowers are expected to contribute about 20 percent of the totalcost. Support is expected from national and regional grant programs, andpossibly from commercial banks own sources

Net Present Value: N/A

Project Identification No: 35082

POLAND

MUNICIPAL FINANCE PROJECT

CHAPTER I: THE SECTOR

A. Decentralization of Public Services

1. The Economic Transformation Program (ETP) launched by Poland in 1990 has been successful inengaging the restructuring of the Polish economy, reducing inflation and initiating from 1992, a path ofeconomic recovery. Output growth averaged 6.1 percent in 1994-96. However, despite the great need tomodernize Poland's infrastructure and public services, public investment declined from, on average, 5.5percent of GDP in 1986-88 to 3.9 percent in 1990 and 2.9 percent in 1996.

2. Under the Local Self-Government Act (LSGA) of 1990, Poland transferred to over 2,400municipalities (gminy) the provision of a broad range of local infrastructure and services including waterand sanitation, drainage, land development, urban streets, mass transit, and district heating. Furtherdecentralization reforms are underway or being considered, such as the creation of a second, county-leveltier of local government (the powiats), and the devolution of new functions in the social, educational andcultural sectors. Decentralization is seen as a means to deepen democratic processes at the local level andbring decisions on local services closer to the beneficiaries.

3. By and large, Polish gminy have risen to the challenge of their expanded role under the LSGA andtaken charge for the services devolved. A number of cities and towns have engaged in restructuring theirmunicipal services bodies into corporate utilities, and have adopted responsible service pricing policies thatrequired politically painful increases in user charges. Gminy have also played a key role in small-scaleprivatization by divesting property and commercial assets. Local budgets have generated sizeable currentsavings, and the municipal sector now accounts for over one half of total public investment. Improving theefficiency, coverage, management and pricing of municipal services is a long-term effort, however, andprogress varies sharply across gminy. Many towns have a long way to go in restructuring municipalenterprises, adopting modem financial management and planning tools, spinning off non-core businesses(such as construction and engineering departments), and bringing user charges to a level that makes localutilities financially self-reliant. And the present level of municipal investment still falls short of the needs.

4. Poland's decentralization is not complete, and further transfers of tasks are placing new burdens onlocal resources. The devolution of primary schools, started in 1992 on a voluntary basis, was extended toall gminy in 1996. Additional tasks in health care, secondary education, road maintenance, culturalinstitutions were transferred to 47 large cities and towns in 2 metropolitan agglomerations in 1994, under apilot program. Since 1996, this change has been made permanent for 46 large cities and the localauthorities of the City of Warsaw, according to the provisions of the "Big City Law" of November 1995.From 1995, gminy became responsible for the allocation of housing subsidies to low-income households, acharge which absorbs up to 10 percent of local revenues. These new expenditure mandates have notnecessarily been matched with a commensurate devolution of revenues (particularly in the case of the BigCity Law), and they could be placing increased stress on municipal budgets.

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B. Agency Responsibilities in Central Government

5. Poland does not have a ministry specifically in charge of municipal affairs, and gminy deal withdifferent departments or agencies of the central government depending on the activity concerned. TheMinistry of Finance (MoF)--which created a separate Municipal Finance Department in 1996--calculatesand distributes the general subsidy, collects and transfers to gminy their proceeds of shared taxes (throughits regional tax offices), and monitors municipal budgets and compliance with debt limits. SeventeenRegional Audit Chambers (RIO) are responsible for compliance auditing of municipal budgets. They alsoissue opinions on municipal borrowings at the request of lenders, and have been a source of information andtraining for municipalities, in particular for changes in administrative law.

6. A number of sectoral ministries (e.g., Construction, Education, Environment) have separateprograms, with minimal coordination among them, to support municipal development in each of theirsectors. Likewise, responsibilities to formulate new policies on municipal affairs have been diffuse. During1992-94 the Council of Ministers' Office of Public Administration Reform led decentralization efforts, suchas the powiat program, but its role has been more limited recently. In 1993, the Government created a JointCentral-Local Government Committee composed in equal numbers of central government officials andmunicipal representatives, as a forum for discussion of decentralization issues. The Committee promotedthe creation of a Municipal Development Agency (MDA), which was legally established as a foundationand started operating in 1995. The MDA's objectives are to provide advice, information and technicalsupport to help grniny strengthen their management capacities, prepare viable projects, and mobilizeinvestment finance.

7. At the regional level, the 49 voivodships (deconcentrated branches of the central government)channel central support and guidance to their constituent gminy. The voivodships have significantdiscretion, within their resource limits, in allocating matching grants to municipal projects. Eachvoivodship has an assembly composed of gminy representatives, which provides feedback to the (centrallyappointed) voivod on municipal priorities and has an important consultative input on, inter alia, grantallocation.

C. Municipal Finance and Management

8. Annex I gives details of recent trends in local revenues and expenditures. As of 1996, municipalexpenditures in Poland represented 8.3 percent of GDP, equivalent to 14 percent of total publicexpenditures. Municipal investment was a much higher share (55 percent) of total government investment.This ratio of municipal to total government capital expenditures is relatively high by middle-income

country standards, but reflects the low overall level of public investment in recent years and the capital-intensive nature of the main services devolved to gminy.

9. On average, own-source revenues account for about 40 percent of the municipal budgets. Theseinclude local taxes (real estate, agriculture, transport, business license, etc.) and duties, income from the saleand lease of municipal property, interest income, and transfers of profits from municipal enterprises. Themain source of own revenues is the property tax (11 percent of the municipal budgets in 1996). Gminy havepartial discretion in setting property tax rates, up to a national cap. The property tax is levied on a flat persquare meter rate regardless of location values, which limits its potential. Moving to an ad-valoremproperty tax is a medium-term objective, requiring considerable work in preparing property cadasters andvaluation methods. Only a few cities, such as Krakow, have made significant progress towards thisobjective, which also requires new legislation. The balance of municipal revenues consists of shared taxes(municipalities accrue 15 percent of the personal and 5 percent of the corporate income tax), a block

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equalization grant, transfers for delegated tasks such as education and cost-sharing (matching) grants forinvestments in selected sectors, as well as an additional share of 6-8 percent of the personal income tax forcities covered by the Big City Law.

10. The financial position of Polish gminy varies across regions, by city size (with smaller and medium-sized cities doing better overall than the largest cities or small towns--see Annex 1), and also according tothe capacities and reform orientation of local officials. It has also varied from year to year, mainly as theresult of changes in the inter-governmental allocation of revenues and expenditure. The important point is,however, that in a period of considerable uncertainty, the sector as a whole has maintained a positive andsteady flow of current savings, equivalent to about 22-25 percent of revenues, and has been able to maintaina significant pace of investment, largely on a self-financing basis. Gminy need to generate still highersavings to support their large investment needs, take on new tasks, and replace the one-off revenue sourcethat they have been getting from asset sales. However, the change required is incremental rather than aqualitative jump. In this sense, Poland's municipal sector contrasts with those of many transitioneconomies, where local revenues cover only a small fraction of the needs (as in all FSU countries andsouthern Central Europe), or have been subjected to sharp annual swings reflecting central fiscal constraints(as in Hungary, for instance).

11. Gminy have made considerable progress in a few years in budget preparation, presentation andcompliance. Financial analysis tools and skills are still insufficiently developed, however, and multi-yearfinancial planning, beyond the annual budget cycle, is performed in few cities. The budgetary classificationsystem elaborated by the Ministry of Finance until now has been geared to the needs of central monitoringrather than local management, and disclosure standards have not been designed with the objective ofdocumenting creditworthiness. The Ministry is, however, aware of the need to revise this system and, as ofthe last quarter of 1997, intends to incorporate municipal debt indicators in the budgetary indicatorsrequested from gminy.

12. Even more than their municipal owners, local utilities and service enterprises vary considerably intheir organizational form and in the quality of their management. Few Polish towns so far have privatizedutility operations (Gdansk water), but private involvement is now being sought more actively, especially forsolid waste. Even without private involvement, many gminy have transformed their service enterprises intobusiness-like, corporate utilities (joint-stock or more frequently limited-liability companies), with cleardelineation of roles and accounts between the company and its municipal owner/regulator. Most utilitiesare able to recover their recurrent costs from user charges, and in some sectors such as water supply, theygenerate a sizeable cash flow which should enable sustained investment in service expansion andimprovement.

13. Still, the in-depth restructuring needed to raise efficiency in service provision has barely started inthe municipal utilities sector. Being sheltered from competitive pressures, many municipal enterpriseshave raised their rates or deferred service improvements rather than cut recurrent costs and reduce theirgenerally oversized work-forces. A large number of medium-sized or small cities have missed, with noapparent consequences, a succession of legal deadlines for defining the future status of their utilities, whichare still operated largely as departments of the municipal administration and without clear bottom lines.And in the absence of long-term credit, utilities cannot become fully self-reliant financially--they stilldepend largely on investment grants or equity contributions from the municipal budgets.

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D. Municipal Investment

14. In 1996, aggregate gmina investment reached 1.5 percent of Poland's GDP. Given its wide sectoralscope (which includes capital-intensive services), and in spite of the relatively high ratio of municipal tototal government capital expenditures, Poland's municipal sector needs to invest more--probably between 2-3 percent of GDP--with water and wastewater alone accounting for about 1.5 percent.

15. As do most transition countries of Central Europe, Poland has a high coverage of localinfrastructure in relation to its income level. Piped water and waste collection are almost universallyavailable in urban areas, with no widespread service disruptions, and street and transit networks are highlydeveloped. Nevertheless, major investments are needed, with potentially high economic returns, to: (a)clear a backlog of deferred maintenance and overdue asset renewal; (b) address a legacy of pastenvironmental neglect, and to comply with stringent EU environmental standards, by expanding andupgrading sewage treatment and solid waste disposal facilities, and retrofitting heat supply plants; (c)undertake optimization investment, especially to conserve energy and water in utilities networks; (d) in theurban transport sector, respond to the fast growth of car ownership and mitigate related congestion andenvironmental risks; and (e) address bottlenecks in the provision of infrastructure for new housing.

16. The sectoral distribution of municipal investment is not well documented, as national statisticsaggregate many sub-sectors into one big item called "municipal economy". Based on a survey of a smallsample of localities, the main sectors of investment in 1993 were sewage treatment (17 percent), watersupply (15 percent), sewage collection (8 percent), education (14 percent), and streets (8 percent). The highshare of environmental services (water and waste) reflects not only local priorities, but also a greateravailability of concessional finance for these sectors. By far the main source of funds for local governmentinvestment has been their current savings--as reflected in an aggregate self-financing ratio of 102 percent in1995. Other sources include grants from voivodships, central ministries, and grants or subsidized loansfrom the environmental funds (see below). Other than soft loans for environmental projects, the use ofcredit for municipal investment has been negligible. The absence of long-term municipal credit fromcommercial sources has been a hurdle to local investment, especially for "lumpy" infrastructure projectswith long asset life that cannot easily be funded from current savings on a pay-as-you-go basis. It reflectsweaknesses both in the municipal sector, which has difficulty proving its creditworthiness, and in thefinancial sector, which has been unable to appraise municipal risk or generate term finance with maturitiessuitable for infrastructure projects.

E. Environmental Finance

17. Poland has a highly developed system of national, regional and municipal environmental funds(NFOS, WFOS and GFOS), which has been established to accelerate the country's cleanup and protectioneffort by putting a price--positive or negative--on environmental externalities. The system, led by theMinistry of the Environment, is based on the collection of polluter charges and fees for the use of naturalresources such as water, and the recycling of these fees as matching grants or low-interest loan contributionsin support of environmental protection investments by industries, municipalities or utilities. The fees,equivalent to almost 0.4 percent of GDP, are collected at the voivodship level. The local voivodship andgmina (municipal) environmental funds retain, on aggregate, about 60 percent of the proceeds, which areused to support projects that have mainly local benefits. The remaining 40 percent is transferred to NFOS,which concentrates on larger investments, or projects that have an impact across voivodship boundaries.NFOS also receives support from extemal donors including the EU. NFOS provides most of itscontributions in the form of subsidized-rate loans, with typical maturities of 4-5 years, a I to 2 year graceperiod, and interest rates as low as 0.2 to 0.6 of the National Bank of Poland's refinance rate. In addition, up

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to 50 percent of principal repayment can be forgiven by NFOS if a project meets agreed conditions (such astimely project completion and debt service).

18. Together, the environmental funds have been by far the largest source of national and regionalsupport to municipal investment, and almost the only source of term credit to the municipal sector. Theyhave provided a major boost--unique among transition countries--to the pace of expansion and improvementof local services, especially for sewage treatment. The focus and effectiveness of this system could befurther improved, however. The management of NFOS has been strengthened in recent years, but theWFOS are weaker institutionally. The use of more explicit lending criteria, defined up-front, wouldimprove transparency and help beneficiaries design their financing plans at an earlier stage of projectpreparation. Overall, Poland's strong environmental finance system could leverage its resources further,having the environmental funds operate more as co-financiers alongside commercial sources, with theprovision of soft loans limited, in a transparent fashion, to the environmental externality they finance.

F. Status of the Financial Sector, Municipal Credit

19. Since 1990, Poland has transformed its banking system from a virtual appendix of the CentralPlanning Office into a free market-type banking system with an adequate regulatory framework and anincreasingly effective supervisory authority. The Treasury still owns over two-thirds of the banking sector(total assets as of December 1996 amounted to US$57 billion), but there has been a surge in the number ofprivate and foreign participants. Of the nine regionally-based commercial banks that were initially spun offfrom the Central Bank, four have been privatized, one more (PBK) is expected to be privatized in the next3-6 months, and another is expected to be privatized in 1998. The sector also includes about 1,500 smallcooperative banks (representing about 3 percent of banking assets) servicing mostly rural areas and towns,and four large specialized banks. One of these four, Bank Handlowy, has diversified itself beyond foreigntrade and become a profitable universal bank. Privatization of this bank is scheduled to take place during1997. Another one, PKO SA, was, in 1996, consolidated with the remaining three state-owned commercialbanks and will be privatized in 1998. The other specialized banks, the housing and savings bank (PKO BP)and the rural bank (BGZ), which inherited troubled loan portfolios in socially complicated sectors, havebeen heavily re-capitalized over the last few years, and the future viability of BGZ is still uncertain.

20. New lending by banks had been limited, until at least 1994, reflecting improved supervision andawareness of credit risk, lack of appraisal experience, inadequate collateral arrangements, large governmentborrowing needs, and the uncertain prospects of most candidate borrowers in the early contraction years ofthe transformation program. During that period, banks invested the bulk of their resources in TreasuryBills. However, with increased competition for deposits and falling yields on treasuries, the banks are nowfacing reduced spreads, and are seeking more active and profitable types of lending. After falling for fouryears in real terms, bank credit (excluding credit to central government) increased by 11 percent (in realterms) in 1995 and by a further 29 percent in 1996.

21. Over the past two years, Polish banks have started to take an active interest in the municipal sector,which they see as a potential market for relatively safe lending with higher spreads than central governmentfinancing. Municipal lending has increased considerably since 1994. Aggregate outstanding municipaldebt increased from PLN 83 million in the first quarter of 1994 to PLN 425 million in the first quarter of1996. By end-August 1996, this had risen to PLN 514 million. With this increase, the sources of financinghave started to change and the maturity of loans has been lengthening. In early 1995, over 90 percent ofcredits to gminy with maturities beyond one year were disbursed by the environmental funds. By end-August 1996, this percentage had fallen to about 70 percent with 20 percent originating from the 9 regionalbanks, and loans with maturities of more than one year exceeded shorter-term loans. The main constraint

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for commercial lending to municipalities, however, continues to be that, while municipal borrowers requirelong-term loans to match the life of their infrastructure assets, bank liabilities are strongly skewed towardsshort-dated instruments. Issuing longer-term loans would expose bank treasuries to refinance risks whichcould become serious in a liquidity crisis. And even though the use of floating-rate loans reduces theinterest rate risk for the banks, shifting this risk to the borrowers raises the risk of credit defaults. Otherconstraints for long-term commercial loans to municipalities are: poor collateral arrangements; lack ofexperience in assessing municipal credit risk; and competition from subsidized sources of municipalfinancing (primarily, environmental funds).

22. Non-bank sources of municipal credit are likely to acquire greater significance, as is increasinglythe case with non-bank financing of firms. Among the most significant developments in the fixed-incomemarket in Poland is the recent emergence of quasi-commercial paper of domestic firms, issued byinvestment banks. This constitutes a growing (albeit still small) source of competition to commercial bankloans. More recently, and in line with the passage of a new Bond Law (July 1995), some large cities havetaken steps towards the private placement of short-to-medium-term municipal bonds. Gdynia successfullyplaced its first bonds in January 1996, followed by Krakow, Lodz and Gdansk later in the year. However,the issuance of municipal bonds (particularly, in the case of more liquid public issues) entails significantfixed costs associated with: information disclosure, obtaining a credit rating, costly marketing and complexcollateral arrangements. As a result, bond issues are likely to be attractive mainly for larger gminy and theirrevenue-earning utilities, while bank lending may be more effective for smaller and medium-sizedborrowers.

23. With continued economic growth, gradually falling inflation and increased competition amongintermediaries and financial services firms (partly as a result of recent OECD membership and prospectiveEU accession and partly as a result of progressive--albeit slow--privatization of banks), Poland's financialsector has a favorable outlook over the medium term, and should be able within the next few years to extendaccess to credit, with gradually longer maturities, to well-managed borrowers--whether these aremunicipalities or businesses. Development of institutional investors, such as mutual and pension funds,could further boost the supply of long-term savings in the economy. However, the development ofmunicipal credit will require specific developments in municipal management, municipal collateral, andbanking skills.

G. Issues of Municipal Creditworthiness - Government Strategy

24. The main hurdles to establishing municipal creditworthiness relate to the ability of gmniny to prepareand document bankable projects; revenues with insufficient predictability to back multi-year debtcommitments; their lack of an established credit record; and their limited ability to provide viable securitypackages to lenders or bondholders:

* First, most gmniny and local utilities lack project experience, and they need technicalsupport in selecting and preparing projects supported by credible feasibility studies(addressing not just technical choices, but also documenting the sustainability of thearrangements proposed to operate project facilities and recover their costs). Astrengthening of utilities and their local govemment supervisors is also needed, e.g.,through adoption of corporate status, appointing non-political members to utility boards.

* Second, in view of continuing uncertainties on inter-govemmental fiscal relationships,credit backed by general municipal obligations should be approached prudently in thecoming years, with conservative financial assumptions and high debt coverage ratios.

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Credit backed by utility revenues should be more attractive in the near future. Gminy canhelp their own utilities become financially more predictable (and creditworthy), by givingthem a corporate status with substantial management autonomy, and by entering intoformal multi-year indexed price cap agreements with them, in order to reduce perceivedregulatory risk for lenders.'

And third, legal work and pilot experiments are needed to introduce the use of municipalrevenues as a secure form of loan or bond collateral -- experience from other countriesshows this to be a key driver in the emergence of municipal credit markets, and alternativessuch as the pledging of municipal property are less effective.

25. Through the proposed municipal project and complementary programs financed by EU-Phare,USAID, British Know-How Fund and other donors, the Government of Poland intends to act on the abovefronts. It has created the MDA and mobilized donor-funded technical assistance (EU, USAID) to helpmunicipalities prepare projects and develop their financial planning skills. Existing Polish legislation alsolimits the municipality's ratio of unsecured debt service to revenues to 15 percent. On a highly selectivebasis, it is providing guarantees for viable, well-prepared municipal investment projects that have ademonstration effect. A team of lawyers contracted through the MDA is working on municipal collateralissues. And the Government has requested Bank support to prepare and finance a time-bound, pilot-scalecredit program, with funds channeled through the banking sector, in order to establish an experience in termfinance for municipal investments.

I The rates for municipal utilities are not generally indexed for inflation--any adjustment, even nominal, stillrequires approval of the full City Council. The open-ended nature of this process is a deterrent for lenders. Multi-year indexed rate cap agreements are being introduced for utilities who borrow directly from IBRD, such as Aqua,the water company of Bielsko Biala.

CHAPTER II: THE PROJECT

A. Project Origin

26. Since 1991, the Government and the Bank have had a continuing dialogue on fiscaldecentralization, municipal development and local infrastructure. Bank inputs include a 1992 report onDecentralization and Reform of the State, sector work on urban transport, heat supply and water andsewerage, dedicated sections in the 1994 CEM, and support through an IDF grant for a survey of localinvestment and studies of further decentralization steps. The Bank's 1992 Decentralization Report flaggedthe need for an institution to coordinate training and technical assistance efforts in the municipal sector(along the lines of the MDA), and suggested pilot-scale investment lending to initiate a market for long-term municipal credit. The project was formally entered in the Bank's lending program in May 1994, afterthe Govemment decided to create the MDA and assign to it the tasks of developing a pipeline of viablemunicipal investment projects as well as supporting arrangements for financing these projects.

B. CAS and Rationale for Bank Involvement

27. The project supports two key, inter-related objectives of the country assistance strategy (CAS):promoting private sector financing of municipal infrastructure; and helping municipalities to raise thenecessary finance to carry out their environmental responsibilities. The project will contribute to thediversification and deepening of Poland's financial sector by facilitating private commercial bank entry inthe long-term municipal credit market. It directly supports Bank operations in the water sector by creating achannel for "retailing" Bank funds, which is the logical next step to a series of single water and wastewaterloans. This channel will play an essential role in mobilizing donor support for a wider range of cities andtowns than could be served through direct lending, and in improving the consistency of extemally fundedprograms in the sector.

28. Through its dialogue with the Government, liaison with donors, and interaction with Polish banksand cities, the Bank has played a significant role in supporting key steps of project development andfacilitating a consensus between the main participants. The Bank's experience, both in appraising individualinvestment projects and in designing municipal sector lending instruments including innovative securityarrangements, is perceived as an important factor in enhancing the project's quality. Continued Bankinvolvement is therefore essential for building confidence and maintaining the project's momentum.

C. Project Objectives

29. The main goal of the MFP is to promote the development of a credit market for municipalinvestment in Poland. To this end, the project pursues the following two inter-related objectives. First, itwill provide long-term financial resources to commercial banks for municipal lending in the infrastructuresector. And second, it will help the banks identify and prepare a sustained pipeline of viable investmentprojects, backed by creditworthy towns or local utilities.

D. Project Description

30. The proposed project, a US$22 million line of credit guaranteed by the Republic of Poland, consistsof a single-currency loan to each of two selected commercial banks. The loans will finance a program oflong term subloans issued by these banks (the borrowing banks) to municipalities and revenue-earningmunicipal service enterprises. The project is designed as a pilot operation to demonstrate how term-finance

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of municipal investments at commercial terms can work. All subloans will be at market terms and willfinance works, goods and services for eligible municipal infrastructure investment sub-projects for water,wastewater, solid waste, and urban transport (including street lighting and road improvement), as well as foreducation infrastructure investments. Banks will be responsible for all aspects of the management andimplementation of the loan including sub-project appraisal. The minimum size of a subloan will beUS$250,000; the maximum subloan by PBK or by a consortium of the two borrowing banks will be US$14million. The average cost of a sub-project is, however, expected to be about US$4 million equivalent andsubloans will finance up to 75 percent of individual sub-project costs. Subloans to single final borrowerwill not exceed US$14 million in the aggregate. The project will also promote the channeling of donor-provided technical assistance resources (through the Municipal Development Agency - MDA) to marketparticipants including: (a) municipalities, in the areas of project preparation and financial management; (b)banks, for appraising municipal credit and structuring robust loan security arrangements; and (c) the MDAto strengthen its continuing role as a facilitator of municipal investment.

31. Eligibility of borrowing banks. Borrowing banks are required to be, and to continue to be, in fullcompliance with NBP regulatory and supervision requirements including standard guidelines for capitaladequacy, asset concentration, foreign exchange risk and loan provisioning. The Bank's appraisal of thebanks also focused on overall managerial capacity, policies for assessing and managing credit risk,asset/liability risk management, training practices, profitability benchmarks, capacity to administer theproject, and consistency of their business plan with the project objectives. Private ownership, or (if not)clear determination to be privatized over the next year, was also one of the key eligibility criteria. A moredetailed description of the eligibility criteria for the borrowing banks is provided in Annex 5. Theborrowing banks, PBK (Powszechny Bank Kredytowy SA w Warszawie) and BISE (Bank for Socio-Economic Initiatives SA) meet all the above eligibility criteria. Several other banks were also considered aspotential borrowers under the project but were finally excluded either because they did not satisfy thecriteria--particularly with regard to privatization status--or because they were not ready to enter into aborrowing commitment at this time. A number of banks (which are likely to meet the above criteria) did,however, express a strong desire to participate in any later operation.

32. PBK Bank. PBK is one of the nine Treasury-owned commercial banks spun off from the centralbank; with assets of about US$3 billion, this is one of the largest commercial banks in Poland. PBKreceived extensive training and advisory assistance under a twinning arrangement with San Paolo Bank(Turin) financed from the Financial Institutions Development Loan (Loan 3341). Most of the current topmanagement was appointed in 1995 and the Head Office was extensively reorganized in February 1996.The present management of the bank is seen as more progressive than its predecessors and is activelyseeking strategic investors to participate in its privatization. This process is at an advanced stage and PBKis scheduled for privatization in the next three-six months, with the Government retaining only a 5 percentshare to cover restitution claims. The bank, which operated originally in the Warsaw and north-easternregions of Poland, has recently begun expansion into other regions both through the opening of newbranches and the purchase of existing banks or their branches (the bank had 47 branches at the end of 1996).

Its strategy is based on becoming a broadly based commercial bank providing a wide range of banking andfinancial services to companies, institutions (including municipalities) and individuals. While the bank'sexperience in municipal lending has so far been limited, staffing and organizational arrangements to handlethe Municipal Finance Project are adequate.

33. PBK is well capitalized (at 14.2 percent, its risk-adjusted capital-adequacy ratio is much higher thanthe NBP requirement) and has been highly profitable (over 27 percent return on average equity in 1996).About 55 percent of PBK's loans are to state-owned enterprises. Although the share is decreasing, asignificant part of this lending remains in the problematic heavy industry and coal mining sectors, a legacy

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of the 1989 NBP spin-off. However, as a result of effective work-out efforts and revised lendingprocedures, "irregular" loans continued to decline from 31.6 percent in 1994 to 15.6 percent in 1996; and allirregular loans are adequately provisioned according to NBP requirements. With regard to liquidity, thebank has a substantial share of Treasury Bills in its balance sheet; this provides a substantial cushion tocompensate for a substantial asset-liability maturity mismatch. To the extent that most assets carry afloating interest rate, the interest rate risk of the maturity mismatch is limited. The bank also has a balancedoverall foreign exchange position. A more detailed description of the bank and review of its activities isprovided in Annex 6.

34. BISE Bank BISE is a relatively small (assets of about US$49 million in 1996) and over-capitalizedbank (equity was about 40 percent of liabilities in 1996); it has specialized in lending to small businessesand, to a lesser degree, to municipalities. About 56 percent of BISE's equity is in private hands (CreditFoncier, Credit Industriel d'Alsace et de Lorraine and Caisse Centrale de Credit Cooperatif of France arethe three largest private shareholders). BISE's original purpose was to provide financial support to thedevelopment of small businesses and to stimulate development of small towns and rural communities.About 77 percent of BISE's loans are to private sector companies and individuals, 22 percent are togovernment entities (primarily municipal), and I percent to state-owned enterprises. The Frenchshareholders have provided, and continue to provide, significant technical assistance in the areas ofmunicipal lending, housing finance and small business. BISE is located in Warsaw and has a wellqualified/well trained staff. Its management team has a clear view of the bank's defined mission, and iscommitted to a policy of cautious growth, including the introduction of new products (such as factoring andleasing). From an early stage, the bank has been seriously committed to participation in the MFP and hastaken organizational steps to prepare for implementation of the project (including approaching potentialmunicipal borrowers); this is consistent with the bank's explicit strategy of strengthening its presence inPoland's municipal credit market.

35. Net income (after all expenses except income taxes) more than trebled in 1995 and increased by afurther 10 percent in 1996. However, the return to equity remains low, at 1.4 percent in both 1995 in 1996,in part reflecting its over-capitalized condition. "Irregular" loans have declined from 15.4 percent of theportfolio in 1994 to about 8 percent in 1996, a substantial improvement but still relatively high given thebusiness nature of much of its portfolio. BISE's business strategy is characterized by greater commercialorientation and, supported by its strong capital base, faster balance sheet growth in the future. Most of theloan portfolio is on a floating rate basis so, despite an asset-liability maturity mismatch (as in the case ofPBK), interest rate risk is minimized. The bank has a balanced net foreign exchange position. A moredetailed description of the bank and review of its activities is provided in Annex 6.

36. Eligible final borrowers will be creditworthy municipalities or enterprises operating municipalservices (either municipally owned enterprises or private firms operating municipal services in eligiblesectors under concessions awarded by local governments). Eligible sectors will be water, wastewater, solidwaste and urban transport (including street lighting and road improvement), as well as infrastructure foreducation. Additional sectors may be added during implementation, in agreement with the Bank. Eligibleinvestments will include rehabilitation, replacement, improvement or expansion of service assets in eligiblesectors, supported by adequate studies documenting their financial, economic, environmental and technicalfeasibility, with cost recovery and loan service based either on direct user charges (utilities and localtransport) or general municipal revenues (for services that are financed from local taxes, such as urbantraffic management) (see also Annex 2a, Box 2).

37. Initial batch of projects. A first batch of sub-projects, identified jointly by the Bank and/or MDA,includes the following: Sulejowek, Limanowa, Radom, Dabrowa-Gornicza (wastewater), Pulawy (solid

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waste), and Krakow (urban transport). The total loan size of these projects (at different stages ofpreparation) is expected to be in the region of US$30 million. Even allowing for a 50 percent slippage ordroppage, this pipeline should be sufficient to ensure satisfactorv commitments and disbursements duringthe first year of the project. Efforts by both the borrowing banks and the MDA are continuing to ensure thedevelopment of a healthy pipeline.

38. Project-related technical assistance. The project-related technical assistance is divided into twoseparate elements, feasibility studies and institutional development, both of which are financed primarilythrough grant resources provided by a variety of donors (e.g., principally EU-Phare, but also USAID), andwhich is being administered by the MDA. The MDA, in consultation with the respective municipalities ormunicipal enterprises, could assist in preparing TORs for feasibility studies of future investments.2 Inaddition, a PHRD grant is being used primarily to complement institutional development assistance. Thisfocuses on two areas of support: (a) the institutional development and strengthening of the MDA, includingthe carrying out of a collateral study; and (b) preparation of projects and financing requests for participatingmunicipalities (e.g., budgetary accounting, financial planning and project evaluation skills). In addition,borrowing banks could request support from MDA to develop their skills in municipal finance (e.g., projectappraisal, collateral arrangements). MDA's continued involvement as a provider of project-related technicalassistance to municipalities is important and could contribute to the achievement of the project's objectivesbut has not been incorporated as a project component for a number of reasons discussed in para 49.

E. Project Costs and Financing Plan

39. The total cost is estimated at about US$40 million equixalent, with an estimated 10 percent localtax content. This is considered to be a reasonable size for a pilot operation of this type. Given theprogrammatic nature of the project, price and physical contingencies do not apply; they will be embedded inthe individual sub-loans.

40. Table I shows the financing plan. The proposed Bank loans totalling US$22 million equivalentcould finance up to 75 percent of individual sub-projects. This share may vary (depending on theavailability of funds from other sources) and is expected to finance about 55 percent of total project costsoverall. Funds for sub-projects will come from: (a) cash contributions by beneficiary gminy, utilities or userassociations (at least 20 percent); (b) proceeds of the Bank loan channeled by the borrowing banks; as wellas (c) possible matching grants or concessional loans from the NFOS for environmental projects; and/or (d)financing by commercial banks from their own sources (either by the borrowing bank itself, or throughsyndication arrangements).

Table I - Indicative Financing Plan

Source Financing % of cost(lUSS million)

Sub-borrower equity 8.0 20National grant programs/commercial banks 10.0 25IBRD through banks 22.0 55

Total 40.0 100

2 Sample TORs have been prepared for each sector and are provided in the Project File, Annex 7).

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41. Cooperation with NFOS. For sub-projects that have environmental benefits, NFOS may providematching soft loans, in accordance with NFOS' lending guidelines, and as mentioned in the letter ofcooperation that it has signed with the Bank for this project.3 This will help municipal borrowers identifyupfront potential financing from both NFOS and commercial sources. NFOS will thus supplement, ratherthan substitute for, commercial lending, de facto leveraging its scarce financial resources to achieve nationalenvironmental objectives. NFOS will apply its own environmental criteria including approval from thevoivodship environmental authorities for sub-projects to be eligible for its soft-loan financing program.

F. On-lending Terms

42. The borrowing commercial banks (BBs) will on-lend the proceeds of the IBRD loans to localgovernment sub-borrowers. The cost to the banks of IBRD loans will be composed of: the IBRD interestrate and commitment fees; and the sovereign guarantee fee collected by the Ministry of Finance (a one-timepayment of 2 percent of the principal amount of the loan). Borrowing banks will on-lend the funds toeligible final borrowers (gminy or local utilities) for viable infrastructure projects. The banks will berequired to lend long-term, with maturities ranging from 5-15 years, including a grace period of up to 3years, depending on the type of investment financed. The banks will not be required however to offermaturities that are strictly "back-to-back" with the IBRD loans, as this might not match in all cases thespecific financing needs of the final borrower. These long-termn subloans to final beneficiaries will be madeeither in: (a) foreign currency at a rate reflecting the above costs, plus a spread to cover the commercialbank's administrative costs and risk premium; or (b) in local currency on the same terms as (a) but alsoreflecting the foreign exchange risk premium. These onlending terms were agreed with the BBs duringnegotiations and will be reflected in the lending agreements between them and the final beneficiaries.

43. The BB's spread negotiated with each final borrower will depend on the borrower's risk profile andcollateral, on the bank's administrative and fee costs and, for zloty sub-loans, on the exchange rate premiumapplied by the bank.4 To obtain the most competitive spread, municipal borrowers may wish to submit thesame loan application to both borrowing banks. The commercial banks have indicated that, depending onthe above factors, they are likely to apply spreads ranging from 1.5 to 4 percentage points on foreigncurrency sub-loans.

44. Risk allocation. The Government will be exposed to the risk of commercial bank failure. Theborrowing banks have therefore been required to meet strict qualification criteria. The credit risk of themunicipal borrowers will stay with the borrowing banks. These banks will remain liable to service the loanregardless of their own performance in collecting the municipal sub-loans. To mitigate the municipal risk,the banks will seek collateral arrangements and will carry out a financial appraisal of the sub-borrower.

45. Collateral arrangements. Loans to final borrowers are expected to include a variety of loanexisting security arrangements including: revenue-based collateral property (commercial property); banking

3 The letter of cooperation with NFOS, dated March 11, 1996, indicating the scope of cooperation with theMFP and NFOS eligibility guidelines for projects will be included among the selected documents in the project file(Annex 7).

4 The overall financing costs for each sub-project will depend on: (a) how much is financed from theborrower's equity; (b) whether it qualifies for grant or other concessional financing, e.g., from NFOS; and (c)whether the financing package offered by the bank includes only proceeds of the IBRD funding or also financing(likely with shorter maturities) by the bank itself, or by other banks, from their own resources.

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and financial instrument collateral (cession of debtor bank accounts, blocking of bank accounts). Work by alegal task force to examine other options, including an escrow on local tax revenues and/or pledge of theincome stream of municipal enterprises, intercept of the general subsidy to gminy, is being financed withresources from a Japanese PHRD grant and is expected to be concluded by July 1997.5

G. Participation

46. Participation of local communities in the various sub-projects is ensured as individual investmentsare proposed by local government bodies who are elected representatives of the people who will be mostdirectly impacted. Furthermore, sub-projects will require City Council approval which provides for publicfora to discuss municipal investment plans. The ability of a municipality to borrow long-term funds underthe MFP will require (based on the Local Self Government Act of 1990) an express authorization from thelocal City Council; Mayors and the Executive Boards can exercise discretion only for short- and medium-term borrowing levels (subject to agreed ceilings). Evidence that this approval has been obtained isincorporated in the appraisal criteria for sub-projects.

H. Financial Analysis

47. Two project features are aimed at enhancing the financial "integrity" of the project:

* At the sub-project level, bank's own credit analysis and sub-project appraisal criteria,including a 1.5 debt service coverage ratio. In those sectors where cost recoverymechanisms are feasible (water, wastewater, solid waste and urban transport), recovery ofoperation and maintenance costs and of debt service, at a level appropriate for the specificsector, are required.

- Banks absorb the municipal credit risk (i.e., commercial spreads and collateralarrangements cover for that risk); the risk to the budget, in turn, is minimized by theapplication of strict eligibility criteria for banks.

L. Economic Analysis

48. Public/private sector issues. The project focuses on investments in the local infrastructure sectorfor which little private sector interest has been demonstrated so far, beyond operational contracts which donot include investment finance. Lending to private concessionaires or joint ventures is possible under theproject, assuming the municipalities are ready to promote such schemes (including the regulatoryframework). The creation of autonomous water utilities in cities of more than 50,000 inhabitants, one of theappraisal criteria of the project, is a first step for the cities to increase private sector participation in thefuture. Even if there is no private sector participation in concessions as such, the facilitation of municipalinvestment plans by the MFP will create increasing opportunities for the private sector to participate in theconstruction, or in management contracts, of new municipal investment projects.

49. Project Design Alternatives. Several alternative project designs were considered, including theestablishment of a Municipal Credit Agency. The creation of such a specialized financial institution would,however, have been costly (due to staffing and capitalization), time-consuming (due to training needs and

5 A preliminary review of the possible use of the different security instrunents and the output of this reportwill be included in the project file (Annex 7).

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development of regulatory/supervisory framework), and counter to the objective of stimulating acompetitive market for municipal finance. It would also have presented risks of politicized or unsustainablelending as shown by Bank experience with similar agencies in other countries. As designed, the projectminimizes fiscal costs and potential liabilities for the national budget through the involvement of theexisting commercial banks, which will assume the full credit risk of the municipal borrowers, and throughMDA's access to external grant resources to fund technical assistance needed in the project. The maintechnical assistance grant donors (EU Phare and USAID) support the final project design. Incorporatingtechnical assistance as a project component by giving the MDA a more central role would have impliedboth an additional fiscal cost and monitoring effort for the Government. Furthermore, the Government wasnot willing to borrow for technical assistance and the banks were unwilling to pay a technical assistance feeto the MDA. The borrowing banks also feared that they would be penalized, by delays in both processingand implementation of the project and through additional commitment fees, if MDA did not performnsatisfactorily. Taking these factors into account, the design of this pilot project has been kept simple and anattempt made to minimize the above risks. While a more formal involvement of MDA could help theproject achieve its objectives (and could be even more important if there were to be a follow up operation),this is not essential, particularly since a sufficient number of potential sub-projects have been identified andthe project can be effectively implemented under the proposed arrangements.

50. Fiscal impact. At the local level, most of the sub-projects6 will be in revenue-earning utilities andwill have cost-recovery features which will make them self-financing, thus, having no net budgetary impactover the medium and long term. Over the short term, larger gminalutility deficits will reflect new financingopportunities, not reductions in saving. At the central level, budgetary savings may result from reducedpressure from local governments to obtain grants/subsidies from the central government (as better access tofinancial resources would provide a financing option virtually non-existent now). There is a contingentfiscal impact if excessive borrowing by municipalities leads to episodes of default and, in response, thecentral government ends up bailing out banks/municipal borrowers. The project is designed to minimizethis risk. The application of prudent technical and financial qualification criteria of the project and banks'own financial criteria aim at avoiding these situations. In addition, the risk of default resulting fromuncontrolled municipal borrowing is addressed by existing Polish legislation which limits the ratio ofunsecured debt service to 15 percent of revenues.

51. Benefits and costs. Benefits will accrue from: (a) strengthening of municipal management andfinances including improved access to financial markets; (b) diversification of commercial banks activitiesinto municipal lending through the lengthening of liability maturity, credit enhancement (collateralarrangements), municipal lending with their own resources, and acquisition of knowledge in the area ofproject appraisal; (c) improving of urban efficiency (e.g., reduced time of travel) and living standards (e.g.,reduced health problems resulting from better quality water) in beneficiary cities; and, (d) a more rationalallocation of municipal resources resulting from improved project selection and appraisal criteria. Since theproject pursues high rates of cost-recovery in most of the sub-projects, most of the costs are expected to bepaid by the final beneficiaries of the municipal services. In general, improved service is expected tofacilitate willingness to pay (higher tariffs, when there is cost recovery, taxes otherwise).

52. Economic analysis of sub-projects. All investments will be supported by appropriate feasibilitystudies, of a depth that is in line with the sub-project's size and complexity. These studies will demonstrate

6 Other investments, such as those to improve traffic management and drainage, would be covered throughgeneral municipal revenues rather than user charges.

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that each sub-project meets a prudently assessed demand in a least-cost way, and is economically viable(appraisal criteria are described in Annex 2a, Box 2).

53. Environmental benefits and costs of a typical sub-project. Environmental benefits quantified interms of improved quality of both surface and ground water resources, air quality, protection of naturalamenity, and improved management of the environmental resources will occur from: (a) wastewater andeffluent treatment; (b) improved resources utilization through metering and adjusted tariffs; (c) improvedcollection and utilization of municipal solid waste; (d) improved efficiency of urban transport systems.Environmental costs, namely costs of environmental pollution control, will be recovered through tariffs,user charges and prices of goods paid by the users. Investment costs of addressing negative environmentalexternalities might be, in part, covered by the National Environmental Fund. Environmental benefits ofinvestments undertaken by economic entities are generally not perceived by them as financial benefits. Butsince they do represent social and economic benefits, it is in society's interest and well being to supportinterventions by Environmental Funds to the level where costs of mitigation are equal to the value ofenvironmental externalities.

J. Sources of Risk for the Project

54. The main policy-related risks are: (a) further decentralization of public expenditures may beinadequately matched by revenue allocations, reducing the ability of gminy to service long-term debtobligations and creating risks of default; (b) excessive municipal borrowing could become a problem byraising aggregate public sector expenditures and effecting the stabilization program; (c) municipalities maybe unwilling to borrow at commercial rates, particularly in view of the presence of subsidized funds fromthe environmental funds/bank and other national/regional funds; (d) municipalities may lack the capacity toprepare quality projects meeting commercial bank and IBRD criteria, and the incipient MDA may notdevelop sufficient capacity to discharge its facilitation role; and (e) the city may not want to take the foreignexchange rate risk.

55. The project seeks to alleviate these risks in the following manner: (a) the uncertainty concerningfuture inter-government revenue allocation emphasizes the importance of careful selection of municipalitiesor municipal enterprises, prudent lending criteria, solid collateral arrangements, and focus of the project oninvestments recouped from direct user charges and backed by financially self-reliant utilities; (b) the risk ofuncontrolled municipal borrowing is addressed by regulations which limit the ratio of unsecured debtservice to revenues to 15 percent, and the debt carrying capacity of municipalities will be an importantfactor in sub-project selection; (c) with regard to the prospective competition from low-cost funds, thecooperation agreement with the NFOS reduces the risk of potential displacement of commercial financingof MFP sub-projects by soft loans by identifying up-front the amount of financing that will be availablethrough the NFOS and, thus, also the gap for commercial loans; (d) efforts are being made to designadequate loan security arrangements and to strengthen local level capacity (one objective of the technicalassistance to be provided by the MDA); and (e) regarding the foreign exchange rate risk, the banks areexpected to pass this on to the municipal borrowers. The municipal borrower's ability to mitigate this riskwill depend on its overall debt service carrying capacity, its foreign exchange-earning capacity (or capacityto link tariffs to the exchange rate) and other specific arrangements that it may be able to enter into (e.g.,creating a liquidity reserve to absorb unexpected changes in the exchange rate and lengthening theamortization of the loan if there is an unexpected devaluation). In addition, Poland's sound macroeconomicsituation does not suggest the presence of severe distortions in its exchange rate (although future volatilitycannot be ruled out).

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56. The project aims to mitigate the risk of slow commitments and disbursements that havecharacterized other lines of credit in Poland in several ways: (a) by considering the cities' commitments toborrow as a key condition for sub-project appraisal; (b) by keeping this first demonstration project to scalethat is a small fraction of current sector investment volumes, and that is tested against effective marketinterest; and (c) by simplifying and streamlining appraisal, procurement and disbursement procedures tohelp reduce transaction costs associated with Bank loans. Furtherrnore, in addition to a first batch of sub-projects for which evidence of borrower interest has been established, efforts have been made to expand thepipeline by adding sub-projects at different stages of preparation, to allow for an unavoidable slippage anddroppage factor. Having the banks as direct borrowers and having them pay the commitment fees to theWorld Bank will increase incentives for mobilizing the line of credit faster, plus the fact that supplementalfinancing from the NFOS will help make the total financial package more attractive to the municipalborrowers. In addition, if commitments by one of the banks is slower than anticipated, the Bank and theBorrowers have agreed to consider the possibility of onlending the uncommitted funds to the other bank, orto a third bank that meets the eligibility criteria for inclusion in the project.

57. The risk that banks may be interested in long-term financing of the sub-projects with their ownresources, rather than with the long-term funds provided under the MFP, is considered moderate, and isdiminished by providing for their participation in sub-project financing. Interested banks are aware of therisks (and possible future regulatory costs) of long-term financing with short-term liabilities (typically atfloating rates); this exposes excessively the final borrower (and indirectly the banks) to fluctuations inliquidity through high interest rate volatility. The proposed loan provides the banks with an importantsource of long-term financing and the SCL instrument offered under this project constitutes for them acompetitive source of funding at the margin (e.g., compared to what the banks will be able to obtain inforeign capital markets). At present, there is a rapidly evolving competition for medium-term financing ofmunicipal projects (up to 5 years); the finance instruments most likely to be used in this segment of themarket are floating-rate loans (from banks with substantial liquidity and/or with large retail networks) andmunicipal bonds (for the larger projects/cities).

CHAPTER III: PROJECT IMPLEMENTATION

A. Institutional Responsibilities

58. The borrowing banks (BBs) will be both the borrowers and the executing agencies of the proposedloans. The Ministry of Finance (MoF), as the representative of the Republic of Poland, will be theguarantor. The Municipal Development Agency (MDA) will be involved in development of the projectpipeline. These responsibilities are summarized below and described in more detail in Annex 2a.

59. A single currency IBRD loan will be made to each of the borrowing banks, which will use the fundsfor issuing long-term subloans in foreign exchange or domestic currency at market rates to localgovernments or municipal utilities for viable infrastructure sub-projects. The BBs will be responsible forassessing and bearing the credit risk of the borrowing entity, bearing the foreign exchange risk for localcurrency loans and for managing all aspects of the subloans to final borrowers. The gminy or local utilitieswill be responsible for implementing the approved sub-projects. The MDA will channel project-related,grant-financed technical assistance to local governments, municipal utilities and borrowing banks. MDAwill screen applications from local governments and municipal utilities to select beneficiaries for grant-financing of feasibility studies.

B. Contractual Arrangements

60. The above responsibilities will be formalized in a series of legal arrangements, as summarized inthe following table.

Table 2 - Contractual Arrangements

Parties to Agreement Type of Agreement

With the Bank Bank and MoF (Guarantor) Guarantee Agreement for each Loan

Bank and each BB Loan Agreement

With the BBs BB and Municipality/Utility, for each Subloan Agreementsubloan

C. Implementation Arrangements

61. Project administration. Implementation arrangements, described in more detail in Annex 2a,were discussed with the BBs during appraisal and confirmed during negotiations. Each BB will beresponsible for all tasks relating to the implementation and administration of the project and associatedloan. Each BB has appointed a project coordinator who will have overall responsibility for projectimplementation in the BB. Specific staff within the BB will be responsible for verifying thatprocurement under subloans is carried out in accordance with the agreed procedures and for handling theadministration of subloans, including: (a) sub-project appraisal and financial management of subloans;(b) preparation of documentation for withdrawals from the Bank loan; (c) supervision of sub-projects; (d)sub-project information management (such as seeking approvals from the World Bank for financingfrom the loan, providing implementation status reports, and sub-project auditing); and (e) liaison with the

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World Bank. The Bank will organize seminars, including a project launch workshop, to train therelevant staff in procurement and disbursement procedures.

62. Pipeline Development. The Bank and/or MDA has prescreened an initial batch of 6 sub-projects, for which BB financing is now being sought. Future sub-projects will initially be screened byMDA (if its technical assistance for feasibility studies is required) or will be directly assessed by theBBs, in accordance with the criteria, described in Annex 2a. For those sub-projects entering the pipelinethrougih MDA, MDA will also make a short pre-feasibility assessment of those projects to enable it toallocate the limited grant resources available for feasibility studies to the most promising sub-projects.

63. MDA will, as mentioned earlier (para. 38) be responsible for building up a project pipeline,supporting both participating municipalities and banks. It has on staff three technical experts, a financialspecialist and a lawyer to fulfill these functions and will be strengthened with support from projectmanagement/institutional development consultants, which MDA is in the process of appointing. Theconsultant/s will assist MDA staff and municipalities in preparing bank loan applications and inpreparing terms of reference for feasibility studies, as well as in training MDA in pre-feasibility studyproject evaluation. These experts will be financed from the ongoing PHRD Grant.

64. Sub-project Appraisal. In preparation for sub-project appraisal, the cities/utilities (withassistance from the MDA if appropriate) will ensure that the TORs for the feasibility studies areconsistent with sub-project appraisal criteria, which are described in Annex 2a (Box 2) and have beenagreed with the BBs. All sub-projects will be appraised by the BBs. The appraisal of any sub-projectbelow US$2.5 million will be carried out in accordance with the guidelines of the concerned borrowingbank. This appraisal will be based on a feasibility study of a scope commensurate with the complexityand size of the sub-project under consideration, giving appropriate attention to technical, financial,institutional and environmental considerations. The first subloan from each BB and all subloans ofUS$2.5 million or more will require the prior review by the Bank. Subloans below US$2.5 million,except the first subloan from each BB, will be reviewed expost.

65. Onlending Arrangements. Each BB will:

* be responsible for all financial aspects of sub-project implementation, including:completing its own appraisal to assess the credit/commercial risk and financial viabilityof sub-projects, in accordance with agreed criteria, including, for revenue-earninginvestments, cost recovery of O&M and debt service at a level appropriate for thespecific sector;

* ensure that its municipal borrowers carry out the investments and use the funds for thepurpose provided;

* ensure that environmental and legal (including planning and construction permit)requirements have been met;

* verify that procurement of inputs and maintenance of project records are in accordancewith IBRD guidelines;

* ensure that its project records and financial statements are audited at the end of eachfiscal year in accordance with international standards and provide copies of the auditreports to the Bank;

e make adequate arrangements to meet the World Bank administrative requirements(procurement, disbursements, accounting and reporting).

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66. Implementation of the investment sub-projects will be the responsibility of the beneficiary cities(gminy or local utility enterprise). The subloan agreements between the BBs and the final borrower, aswell as detailing the financial terms and conditions, will require that the final borrower: carries outprocurement in accordance with procurement procedures agreed between the Bank and the BB;disburses funds to contractors and suppliers; provides counterpart funding and mobilizes domesticfinancing where applicable; keeps accounts/records of sub-project expenditures; has these recordsaudited in accordance with Polish law; and reports to the BB on sub-project progress.

D. Environmental Aspects

67. The project has been rated "B" for the purpose of OD 4.01. Line of credit operations throughfinancial intermediaries require that each sub-project financed with these resources comply with nationalenvironmental standards and regulations, supported by an appropriate institutional framework. In thecase of Poland, this framework is in place. In accordance with existing regulations, an EnvironmentalImpact Analysis (EIA) must be carried out for green field operations. Where necessary, this analysis willalso be completed as part of feasibility studies, financed from grant resources managed by the MDA.

68. Investments including financing from the NFOS will be thoroughly screened by the Fund.' Inaddition, verification that sub-projects comply with environmental regulations will be the responsibilityof the BB, which will have to check that sub-projects submitted for its approval comply with all Polishlegal requirements, including environmental ones. The final beneficiary will have to submit theappropriate environmental permit before subloan approval. In all cases, the BBs will ensure in theirsubloan agreements that the final borrowers are in compliance with Polish environmental regulations andagree to rehabilitate/build/operate the planned sub-projects according to these regulations. Commercialbanks need to develop procedures to screen projects and to manage them for environmental risk as wellas environmental liability. The BB's compliance with these responsibilities will be reviewed by the Bankduring project supervision.

E. Procurement Arrangements

69. The loans will finance sub-projects for municipalities or municipal enterprises for themodernization, rehabilitation, construction or improvement of municipal infrastructure. To the extentpossible, it is expected that subloans will finance supply and installation contracts. If certain items cannotbe incorporated in such a contract, they will be procured separately, but efforts will be made to keep to suchprocurement to a minimum. All project components financed from the proposed Bank loans will beprocured in accordance with the Bank's Guidelines for Procurement (August 1996), including theapplication of the Polish Public Procurement Law (PPL), as explained below. Given the nature of thisproject, involving support to sub-projects, most of which have not been preappraised, detailed estimates forthe breakdown of the project expenditures by procurement method are not available. Details of theprocurement arrangements, including thresholds for the various methods and review requirements, areincluded in the Project Implementation Plan (Annex 2a).

7 Details of the selection and evaluation criteria used by NFOS have been reviewed by the Bank and areconsidered to be satisfactory.

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70. Procurement for each municipal investment sub-project will be carried out by the individualbeneficiary local government or municipal utility responsible for its implementation, under procurementmethods and procedures reviewed by and satisfactory to the Bank, including procurement through NCB,where applicable. A Country Procurement Assessment for Poland was undertaken in May-June 1995,during which time the PPL, approved in June 1994, was reviewed in detail. As a result of the discussion ofthis assessment with the Government, it has been agreed, for contracts for works, and for supply andinstallation contracts, estimated to cost less than US$5 million per package, that the unlimited tenderingprocedure, as provided for in the PPL,' is acceptable to the Bank subject to certain conditions (Annex 2a).This procedure is to be used in place of the National Competitive Bidding procedure described in theProcurement Guidelines. Similarly, it has been agreed that the procurement method called "request forproposals" in the PPL will be used in place of: (a) International Shopping for contracts for equipment andmaterials estimated to cost less than the equivalent of US$400,000 per package, based on a comparison ofprice quotations from at least three suppliers in two different countries; and (b) National Shopping forequipment and materials estimated to cost up to US$100,000 per package, and for small works of up toUS$300,000 per package.

F. Disbursements and Special Account

71. The loan will finance up to 100 percent of the amounts disbursed by borrowing banks tomunicipal borrowers for eligible subloans. These disbursements are expected to cover: (a) up to 75percent of the total cost of any sub-project financed; and (b) eligible expenditures, i.e., contracts forworks, equipment and services procured in accordance with arrangements agreed with the Bank.Disbursements for subloans of less than US$2.5 million equivalent will be on the basis of statements ofexpenditures. To facilitate disbursements, each BB will establish a Special Account with a qualifiedcommercial bank.

72. The detailed disbursement schedule is provided in Annex 4 and is summarized below (Table 3).It is anticipated that total loan proceeds will be committed against subloans within 3 years of loaneffectiveness and that disbursements will be spread over 4.5 years. Based on this schedule, the expectedcompletion date for the project is June 30, 2001 and the Closing Date is December 31, 2001.

Table 3: Disbursement Schedule

IBRD FY FY98 FY99 FY2000 FY2001 FY2002US$ million

Annual 3.5 8.0 7.5 2.2 0.8

Cumulative 3.5 11.5 19.0 21.2 22.0

Percentage 16% 52% 86% 96% 100%

G. Reporting and Audits

73. The project account, Special Account and Statements of Expenditure will be maintained by eachBB and will be audited at the end of each fiscal year in accordance with international standards, as partof the annual audit of the BB. Assurance were obtained during negotiations that each borrower will

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appoint independent auditors acceptable to the Bank and that it will present to the Bank, within sixmonths after the end of each fiscal year, audited financial statements. The financial statements of thefinal beneficiaries will be audited in accordance with Polish law. The audit reports for the finalbeneficiaries will be retained by the respective borrowing banks and made available to the Bank onrequest.

74. The borrowing banks will maintain financial records of the project and provide periodic progressreports to the Bank on the status of sub-project financing. These reports will also comment on projectexecution achievements and compare them with the key performance indicators listed in Annex 2b. Theformat for these reports was confirmed during negotiations. Assurances were also obtained that each BBwill be responsible for preparing an implementation completion report and will submit this to the Bankwithin six months after the closing date of the loan.

H. Project Supervision

75. It is anticipated that supervision of this project will require an above average effort, with aheavier concentration in the first two years of implementation and at least three supervision missionsannually, because ofthe support required to appraise sub-projects. By end-1999, the BBs and the Bankwill jointly undertake a mid-term review of implementation progress and compliance with loan. In yearsI and 2 of implementation, 18 staffweeks per fiscal year are anticipated, divided amongst the TaskManager, a municipal finance specialist, a banking expert and technical specialists (using local experts tothe extent possible) in the various sectors. In addition, limited support (totaling less than 1 week/year)from procurement and institutional development experts is envisaged. In later years the supervisioneffort should be reduced to 12-15 staffweeks per year. Ongoing support for day-to-day activities isanticipated from the Resident Mission (about 6 staffweeks) and is expected to increase over time as itwill assume the responsibility for sub-project review as its staff develops experience in this area.

CHAPTER IV: AGREEMENTS REACHED DURING NEGOTIATIONS

76. The following agreements were reached during negotiations:

a) Borrowing banks to remain in full compliance with NBP regulatory and supervisionrequirements (para 3 1)

b) Subloans not to exceed US$14 million (para 30)c) Eligible final borrowers will be creditworthy municipalities or enterprises operating

municipal services, and eligible sectors will be water, wastewater, solid waste, urbantransport (including street lighting and road improvement) and education (para 36)

d) Terms and conditions of the onlending agreements between the BBs and municipalborrowers, including the implementation responsibilities of the BBs (paras 42-43, 65)

e) Borrowing banks to assign a project coordinator with overall responsibility for all tasksrelating to project implementation and administration (para 61)

f) All investments to be supported by appropriate feasibility studies, which will inter aliaestablish their economic viability (paras 52 and 64)

g) Criteria for appraisal of sub-loans (para 64 and Annex 2a, Box 2)h) All subloans of US$2.5 million or more, and the first subloan from each BB, regardless of

size, to be subject to prior review by the Bank (para 64)i) Borrowing banks to provide to the Bank, within six months after the end of each fiscal year,

audited financial statements from independent auditors (para 73)j) Key performance indicators (para 74 and Annex 2b)k) Mid-term review to be carried out by end-1999 (para 75).

27ANNEX I

Page I of 9

MUNICIPAL FINANCE AND INVESTMENT IN POLAND

A. Decentralization of Public Infrastructure and Services

1. Under the Local Self-Government Act (LSGA) of 1990, Poland transferred to over 2,400municipalities (gminy) the provision of a broad range of local infrastructure and services including waterand sanitation, drainage, land development, urban streets, mass transit, and district heating. Furtherdecentralization reforms are underway or being considered, such as the creation of a second tier of localgovernment (powiats), and the devolution of new functions in the social sectors. Given their newownership of public service assets, local governments have assumed the responsibility to mobilize resourcesfor operation, maintenance and expansion of these services. Decentralization is seen as a means to deependemocratic processes at the local level, and bring the control of local services closer to the beneficiaries.

2. By and large, Polish gminy have, within their means, risen to the challenge of their expanded roleunder the LSGA and have taken charge for the services devolved. A number of large and medium-sizedcities have engaged in the restructuring of their municipal enterprises; this process can comprise thecreation of limited liability companies, joint-stock companies, sale to employees, full privatization orliquidation. Six years into decentralization, enterprise restructuring has not been completed everywhere. Insome small and medium-sized cities, municipal enterprises have been re-consolidated into one municipalcompany, partly to avoid payment of the corporate income tax and to reserve funds for investment. Thispractice can lead to prolonging inefficient structures and cross-subsidizing services. Most cities haveadopted responsible service pricing policies that required politically painful increases in user charges.Many gminy have also started work on strengthening their management and revenue administrationsystems, and defining investment priorities responsive to the needs of their constituents. In addition, gminybudgets generate sizeable current savings and account for a large part of total public investment.

3. Decentralization of tasks (and the associated financing) to local authorities accelerated between1994-96, with some of these tasks requiring important operating funds from municipal budgets. Effective1995, gminy became responsible for the allocation of housing subsidies to low income households. Gminyare now authorized to raise rents on municipal housing units, within a fixed ceiling (which varies byvoivodship), but housing allocations must be paid to low-income inhabitants of cooperative as well asmunicipal housing. This new charge has been estimated at up to 10 percent of municipal budgets, anddepends on the mix of municipal and cooperative housing in each gmina. Primary education was finallytransferred to all municipalities in 1996 (up to the end of 1995, 700 gminy had accepted this responsibility).Also in 1996, the "Big City Law" replaced the powiat pilot program which had been established in 1994.Under this law, voivodship and national tasks, including secondary and vocational education, art schools,social care and assistance centers, health care establishments, culture and art institutions, road maintenanceand protection, were transferred to 46 specific cities, as well as to the local authorities of Warsaw.

4. The recent and continuing transfer of these partially unfunded mandates in education, housingallocations and powiat tasks (for the largest cities) is placing increased stress on municipal budgets. Thisevolution may limit municipal financial capacity for investments; indeed, investment expendituresincreased much less rapidly between 1994-96, compared to previous years. The level of investment maytaper off in the next 2-3 years, despite continued major backlogs of deferred maintenance and replacement(such as urban transport) and the need to bring existing equipment in line with stricter environmentalstandards (sewage treatment facilities, solid waste landfills). Such an evolution only highlights the need for

28ANNEX I

Page 2 of 9

(sewage treatment facilities, solid waste landfills). Such an evolution only highlights the need for municipalaccess to long-term capital, enabling municipalities to meet investment needs and to leverage theirmun