Document o f The World Bank

FOR OFFICIAL USE ONLY

Report No. 26556-NEP

INTERNATIONAL DEVELOPMENT ASSOCIATION

PROGRAM DOCUMENT

FOR A

PROPOSED FIRST POVERTY REDUCTION SUPPORT CREDIT

IN THE AMOUNT OF SDR 51 MILLION

(EQUIVALENT TO US$70 MILLION)

TO

THE KINGDOM OF NEPAL

October 15,2003

Poverty Reduction and Economic Management South Asia Region

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

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ADB APP CIAA CFAA CPAR CWIQ DAP DFID DIDO DHS EHSP IAP ICD IDA IMF HMGN LSGA MDG MTEF NBL NEA NGO NOC NRB NTA PAF PIS PRSP PRSC RBB RTS SMC SHPS VDC WTO

CURRENCY EQUIVALENTS (Exchange Rate Effective October 15, 2003)

Currency Unit = Nepalese Rupees (NRp) US$1.0 = 74.50 NRp

FISCAL, YEAR July 15 - July 14

ABBREVIATIONS AND ACRONYMS

Asian Development Bank Agriculture Perspective Plan Commission for the Investigation of Abuse of Authority Country Financial Accountability Assessment Country Procurement Assessment Report Core Welfare Indicators Questionnaire Development Action Plan Department f or International Development District Infrastructure Development Office Demographic Health Survey Essential Health Service Package Immediate Action Plan Inland Container Depots International Development Association International Monetary Fund H i s Majesty's Government of Nepal Local Self Governance Act Millennium Development Goals Medium Term Expenditure Framework Nepal Bank Limited Nepal Electricity Authority Non-Governmental Organization Nepal O i l Corporation Nepal Rastra Bank Nepal Telecommnunications Authority Poverty Alleviation Fund Personnel Information System Poverty Reduction Strategy Paper Poverty Reduction Support Credit Rastriya Banijya Bank Rural Telecommunications Service School Management Committee Sub-Health Posts Village Development Committee World Trade Organization

Vice President: Praful Pate1 Country Director: Kenichi Ohashi

Sector Director / Manager: Task Team Leaders:

Sadiq Ahmed / Ijaz Nabi Hassan Zaman / Roshan Bajracharya

FOR OFFICIAL USE ONLY

TABLE OF CONTENTS

I . Overview ............................................................................................................................................................. 1 I1 . Country Context and Development Performance ........................................................................................... 3

Poverty and Social Context ............................................................................................................................... 3 Economic Context ............................................................................................................................................. 4 Political Context ................................................................................................................................................ 5

I11 . Nepal's Poverty Reduction Strategy ................................................................................................................ 7 I V . Reforms Supported by the Proposed Credit ................................................................................................... 9

Reforms to Restore Broad-based Growth ......................................................................................................... 9 Reforms to Improve Service Delivery ............................................................................................................ 18 Reforms to Promote Social Inclusion ............................................................................................................. 20 Reforms to Improve Governance .................................................................................................................... 21

V . The Proposed Credit ......................................................................................................................................... 24 The World Bank's Assistance Strategy .......................................................................................................... 24 Credit Design and Fiduciary Issues ................................................................................................................ 27 Poverty and Social Impact Monitoring ........................................................................................................... 29 Benefits and Risks ........................................................................................................................................... 31

LIST OF TABLES

Table 2: Selected Economic Indicators 1997/98-2002/03 ......................................................................................... 4 Table 3: Medium Term Fiscal Framework .............................................................................................................. 13 Table 4: PRSC Themes and Partnerships with Other Donors ................................................................................. 26

Table 1: Regional Disparities. Nepal. 1995/96 .......................................................................................................... 3

LIST OF BOXES Box 1: Potential Sources o f Growth .......................................................................................................................... 9 Box 2: Fiscal Sustainability Scenarios .................................................................................................................... 10 Box 3: Key Recommendations from the Country Financial Accountability Assessment (CFAA) ......................... 21 Box 4: Prior Actions for PRSC I and Indicative Prior Actions for PRSC I1 ........................................................... 29

LIST OF FIGURES Figure 1 : The PRSC Program and AAA Underpinnings

ATTACHMENT Attachment 1: Letter o f Development Policy

LIST OF ANNEXES Annex I: Annex 11: Annex 111: Poverty in Nepal Annex IV: Annex V: Annex VI: Social Indicators Annex VII: Key Economic Indicators Annex VIII: Key Exposure Indicators Annex IX:

Nepal Medium Term Policy Reform Matrix Analysis o f the Potential Impact o f Removing the Kerosene Subsidy

Public Financial Management and Accountability in Nepal Nepal At a Glance

IMF Public Information Notice

This document has a restricted distribution and may be used by recipients only in the performance of their official duties . I t s contents may not be otherwise disclosed without World Bank authorization .

Task Team

Hassan Zaman, Senior Economist and Task Leader; Roshan Bajrachaiya, Senior Economist and co-Task Leader; Rajib Upadhya, Senior External Affairs Oficer; Robert P. Beschel, Lead Public Sector Management Specialist; Bigyan Pradhan, Senior Financial Management Specialist; Ismail Radwan, Private Sector Development Specialist; Giovanna Prennushi, Lead Economist; Rajendra Dhoj Joshi, Senior Education Specialist; Lynn Bennett, Adviser; Surendra Govinda Joshi, Senior Transport Specialist; Shyam Sundar Ranjitkar, Senior Irrigation Engineer; Tashi Tenzing, Senior Sanitary Engineer; Asif Faiz, Operations Adviser; Masami Kojima, Lead Energy Specialist; Nawaf Al-Mahamel, Counsel; Tara Vishwanath, Lead Economist; Tirtha Rana, Senior Health Specialist; Jagmohan Kang, Senior PHN Specialist; Ahmad Ahsan, Lead Economist; Sabin Shrestha, Financial Sector Specialist; Donna Thompson, Senior Financial Management Specialist; Geeta Sethi, Senior Economist; Syed Mahmood, Senior Private Sector Development Specialist; Bala Bhaskar Naidu, Research Analyst; Narayan Sharma, Consultant; Ram Chandra Mishra, Consultant; Nuru Lama, Summer Intern, Shahnaz Sultana Ahmed, Program Assistant; Kiran Gautum, Program Assistant and Neena Shresta, Program Assistant.

Peer Reviewers: Sudhir Shetty, Sector Manager; Ritva Reinikka, Research Manager; Shantayanan Devarajan, Chief Economist.

KINGDOM OF NEPAL FIRST POVERTY REDUCTION SUPPORT CREDIT

Borrower:

Amount:

Terms:

Description:

0

0

0

Credit and Program Summary

The Kingdom o f Nepal

SDR 5 1 mill ion (US$70 mill ion equivalent)

Standard IDA terms; 40-year maturity with 10-year grace period

The proposed credit supports the implementation o f the Government’s Poverty Reduction Strategy Paper (PRSP), which focuses on:

Generating economic growth: The PRSP argues that higher growth wi l l require greater productivity o f the agricultural sector and a recovery in manufacturing, tourism and exports. In addition to describing the important exogenous factors that determine Nepal’s growth, the PRSP also identifies key barriers to growth that public policy can influence. Restoring peace w i l l clearly prove a boon to the overall investment climate and to the tourism industry in particular. Maintaining macro-economic stability, greater efforts at domestic resource mobilization, expenditure prioritization and better financial management w i l l create the fiscal space to spend on maintaining and creating public assets. Improving the investment climate w i l l require a reduction in transport costs, significant strengthening o f the financial system, more reliable power and telecom services and greater flexibility in labor markets.

Zmproving service delivery: The PRSP outlines the importance of improving service delivery through a gradual process o f decentralization, greater empowerment of local communities and greater involvement o f the private sector in the management o f social services. This shift away from a ‘Kathmandu controlled’ system to one where key decisions are made at the local level stems from a recognition by key decision-makers that in a diverse country like Nepal, devolving authority to the grassroots i s essential to improving the quality o f services and overcoming the prevailing disillusionment with Government services. This process has begun in a wide range o f sectors including education, health, water, agriculture and roads.

Promoting social inclusion: The PRSP recognizes that promoting social inclusion w i l l require fundamental policy and institutional changes - particularly in the way services are delivered and in the gender, ethnic and caste composition of the civi l service. In addition, in order to enhance the flow o f resources to excluded groups in the short run, the PRSP outlines the need to have targeted programs for the hard-core poor, ethnic minorities, people l iving in remote areas, female-headed households and women. The strategy discusses the importance o f using the new Poverty Alleviation Fund to target communities in conflict-affected areas as well as introduce scholarship programs for girls and ethnic minorities to improve access to schooling.

Zmproving governance. Recognizing that governance improvements are essential if reforms to stimulate pro-poor growth and improve service delivery are to have their desired impact, the PRSP develops both cross-cutting and sector-specific governance improvement strategies. Cross-cutting themes include: (i) improving the effectiveness o f the civi l service; (ii) strengthening anti-corruption institutions; (iii) improving the functioning o f key agencies and

Benefits:

(iv) improving financial management. These w i l l be complemented by tackling governance issues in key areas such as the financial sector, infrastructure, health and education.

The PRSC program supports selective key reforms that wi l l directly contribute to pro-poor growth by (i) creating fiscal space for, and improving the effectiveness of, growth enhancing public investments and (ii) improving the investment climate. The PRSC program also supports Nepal’ s track record o f meaningful reforms in improving service delivery by assisting HMGN in developing annual benchmarks consistent with the broad reform objectives and by providing the fiscal and technical resources necessary to accelerate the reform momentum. The PRSC process supports Nepal’s efforts to promote social inclusion by (i) improving the effectiveness o f targeted programs (ii) improving access to schooling for excluded groups and (iii) encouraging civi l service diversity. The PRSC program also supports HMGN’s strategy to improve governance by (i) improving the effectiveness o f the civi l service (ii) strengthening anti-corruption and accountability institutions (iii) improving the functioning of key agencies and (iv) improving financial management and procurement practices. The improvements in governance that are supported by the PRSC I are designed to bring about a more accountable, efficient and less corrupt government that w i l l create a more favorable investment climate and lead to better service delivery.

Risks and Mitigation Strategy:

There are several r isks associated with the PRSC: (i) a return to a prolonged period o f conflict would dampen growth prospects and the impact o f structural reforms on poverty; (ii) prior to and following national elections the efforts o f reform minded technocrats may be crowded out by political interference and threaten the sustainability of reforms; (iii) implementation capacity may not be sufficient to sustain a broad reform agenda; (iv) a further worsening o f global economic conditions may undermine the impact o f growth-enhancing reforms. These are real r i sks and there i s no guarantee that risk mitigation measures could overcome the joint effect o f these forces should they materialize. The risk mitigating measures partly l ie in an on-going process of bringing the delivery and management of resources closer to the people (by devolving authority from the center in education, health, water and extension services) and using targeted programs to provide opportunities and services for particularly marginalized groups and in the most deprived districts. Many of the reforms outlined in this document have a wide degree o f support across the political spectrum and from civi l society, as they have been based on consensus-building exercises and stakeholder consultations. Recognizing the risk o f capacity l i m i t s derailing the reform process, the reform program embedded in the PRSP and supported by the PRSC sets realistic implementation targets. The Immediate Action Plan (IAP) process plays an important role in this regard, in identifying an annual l i s t of high priority reform actions. While the above risk mitigation measures should provide adequate comfort that these r i sks are manageable, as an added risk-mitigation measure, the Bank w i l l provide a loan acceleration clause that would allow the Bank to demand immediate repayment o f the proposed loan by the Borrower in case reforms are reversed or materially changed.

Estimated Disbursement: SDR 51 mill ion ($70 mill ion equivalent) disbursed in a single tranche upon credit effectiveness.

Project ID Number: PO74685

IDA PROGRAM DOCUMENT FOR A PROPOSED PROGRAMMATIC STRUCTURAL ADJUSTMENT CREDIT

TO THE KINGDOM OF NEPAL

I. Overview

1. Thirteen years after the establishment of a multi-party democracy and the start of rapid economic liberalization, Nepal i s in the midst of a somewhat unnoticed but important “id- course correction.’ The aspirations o f the Nepali people for better and more inclusive governance and public services have become increasingly frustrated over the years. The armed rebel movement, which sharply escalated in 2001, was the starkest reflection of the rising tensions. Wide disenchantment with ineffective and corrupt government, however, has also created a strong internal pressure for reform. In parallel with the political process that i s focusing on restoring peace and a more effective democracy, a renewed drive has been underway to build the economic and social foundation for sustained peace and poverty reduction. Much o f the reform centers around creating a high-performance state that delivers public services efficiently and inclusively and supports broad-based economic growth.

2. Although some important progress was made in the 1990s, Nepal remains one of poorest countries in the world. Economic liberalization in the early 1990s spurred respectable growth, averaging 5% per annum in the 1990s. However, growth in the past two years has been more modest due largely to the insurgency and the effects of the global economic slowdown. Certain social indicators such as infant and child mortality, total fertility, and l i f e expectancy, have also improved significantly over the past decade. Nonetheless, widespread poverty has persisted, as the impact of growth has been dampened by high population growth and the Kathmandu centered growth pattem. Large inequities prevail across ethnic and gender lines, fueling the conflict.

3. The foundations for a lasting peace lie in improving service delivery, promoting social inclusion and reducing corruption: In late January 2003, a cease-fire was agreed upon by His Majesty’s Government o f Nepal (HMGN) and the rebels that lasted until August 2003. Conflict has since resumed following a breakdown o f talks. Key policymakers in Nepal are now acutely aware o f the need to make public services and economic growth more inclusive in order to arrive at a lasting peace, and such awareness i s reflected in the PRSP.

4. Important reforms that have taken place over the last eighteen months are restoring the credibility of the Government. These reforms focus on improving the delivery o f basic services complemented by far-reaching structural and governance reforms. Key reforms include: (i) revamping the expenditure management system to focus resources on priority development activities; (ii) handing over management of public schools and sub-health posts to local management committees; (iii) strengthening the legal power o f the anti-corruption authority (which used this authority to f i le charges in high profile corruption cases); (iv) bringing the two largest loss-making commercial banks under external management teams; (v) increasing private sector participation in power and telecom with provisions for rural services; (vi) setting up an independent Roads Board to improve road maintenance; (vii) passing legislation that improved women’s legal rights to parental property and (viii) significantly reducing the number of civi l service transfers.

5. These reforms are being championed largely by technocrats who have been given the space to carry out critical reforms. As the crisis in Nepal deepened over the past two years, an increasing number o f reform-minded individuals (mostly at the technocratic level but some at the political level) have begun to take determined actions to face up to the challenge. Strong reform

champions have emerged in a number o f central agencies as well as l ine ministries. The recent changes in administration has not hampered their efforts, for in most cases they are simply implementing the strategies and policies that had been adopted before and enjoy strong public support. If anything, the preoccupation o f politicians with power politics has given the reformers more space.

6. Nepal’s future reform agenda i s articulated in the PRSP. The poverty reduction strategy has been prepared through a highly consultative process. The PRSP rests on four key pillars: (i) generating economic growth; (ii) improving service delivery; (iii) promoting social inclusion and (iv) improving governance. Recognizing the constraints to implementation capacity, HMGN has prepared an ‘Immediate Action Plan 2003’ to ensure that a selective set o f key reforms under the PRSP are implemented.

7. HMGN has requested financial support f rom the Wor ld Bank and IMF to help implement the PRSP. In response, the IMF i s preparing a PRGF and we propose to support the PRSP through the PRSC process. A Joint Staff Assessment (JSA) of the PRSP i s being undertaken. The PRGF and the proposed PRSC I are being closely coordinated and a Board presentation o f mid November i s envisaged for both operations along with the PRSP and accompanying JSA.

8. Bank support to HMGN at this time i s critical to strengthen the reform process. Reformers have now reached a critical mass and have a higher profile than in the past. This presents an opportunity for the Bank to provide the fiscal and technical support that i s required to sustain the reform momentum. For several years the Bank restricted i t s financial support, thus strengthening its credibility and creating the incentives for reform in a fiscally constrained environment. B y recognizing a strong track record o f change, the Bank w i l l strengthen the reformers’ w i l l to move ahead with their agenda in the face o f opposition from the quarters that stand to gain from maintaining the status quo. It w i l l give a clear signal that future reforms w i l l also be duly supported and help protect the space required for reformers. Moreover, timely financial support would create fiscal space in the next budget to expand financing o f priority public services.

9. The risks underlying reform implementation can be mitigated and are balanced by the opportunity to strengthen the reform momentum. There are several key risks: (i) the breakdown of the peace process dampens the impact o f reforms (ii) prior to and following national elections the efforts o f reform minded technocrats may be crowded out by political interference; and (iii) implementation and monitoring capacity constrains progress. The basic risk mitigation measure i s in the design o f the reforms itself. The reformers are trying to use ‘quick-win’ reforms to deliver wide benefits and broaden the support for reforms. They are also using the Immediate Action Plan to set realistic implementation targets in line with capacity. Moreover, these r i sks are balanced by the benefits that can be brought about by continued progress on the reform agenda. I t would be no exaggeration to say the future o f Nepal depends on the success o f this process.

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11. Country Context and Development Performance

Poverty and Social Context

10. Nepal remains one of the poorest countries in the wor ld - per capita income i s about $250, around half the children under five are malnourished and progress towards Millennium Development Goal (MDG) targets remains slow. Growth in the 1990’s has been respectable, averaging 5% but its impact on poverty has been dampened by high population growth, by being concentrated in the Kathmandu valley and the escalation o f the conflict over the past two years.

1 1. The incidence o f consumption poverty stood at 42 percent in 1995/96; trends over the last few years w i l l be assessed in 2004 when the second round o f the Nepal Living Standards Survey, currently in the field, w i l l be completed. However, the main characteristics o f the poor are unlikely to have changed substantially since 1995/96. There are significant geographical differences, (see table 1) - in general the poor live in rural areas and engage in subsistence agriculture on small plots of land, often o f low quality; they have limited access to roads, markets, health and education services, often because o f remoteness; and rely on seasonal migration and remittances to cope with downturns. Indigenous ethnidcaste groups continue to lag behind in their income and asset levels, educational achievements, and human development indicators.

Table 1: Regional Disparities, Nepal, 1995/96

Poverty Poverty Gap Illiteracy Incidence (percent)

Nepal 42 0.121 64

Urban Rural

23 0.070 37 44 0.125 67

Urban Kathmandu Valley 4 0.004 24 Other Urban 34 0.109 45 Terai 42 0.099 69 Hills 41 0.136 58

Mountains 56 0.185 75

12. The evidence of changes in social indicators presents a mixed picture. Data from the 1996 and the 2001 Nepal Demographic and Health Survey indicate that the infant mortality rate has fallen from 79 per 1000 in 1996 to 64 in 2001 and child mortality from 43 to 29 per 1000. The improvement can be largely attributed to better immunization coverage -- the percentage o f children fully immunized has increased by 67 percent in the last five years. Total fertility has declined from 4.6 to 4.1 births per woman and l i f e expectancy has increased from 56 years to 59 years over these five years. On the other hand, there appears to have been little improvement in the nutritional status of children, with 50 percent of children under five years o f age stunted, 48 percent underweight, and 10 percent wasted (thin for their age). The gender gap in education has not narrowed, with a 13 percentage point difference at the primary level and an 8 percentage point difference at the secondary level (see Annex I11 for further details o f the poverty profile in Nepal).

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Economic Context 13. Export-led growth in Nepal averaged 5 percent per annum in the 1990's. Macroeconomic management strengthened during the mid 1990s, inflation was kept low and stable, and exchange rates-pegged to the Indian rupee-depreciated gradually to maintain stability and export competitiveness. Economic liberalization in the early 1990s' and successful stabilization o f the economy in the mid 1990s helped to create an enabling environment in the non-agriculture sector, which accounted for 75 percent o f growth during this period. The rapid manufacturing growth was primarily export-led; the value o f exports doubled between 1994/95 and 1999/00 (in U S dollar terms) with increased demand from the U S and Germany and even more rapid growth in the Indian market. Exports to India grew at a spectacular average rate o f 42 percent between 1998 and 2002, largely due to a five-year old bilateral trade treaty, whereby Nepali goods were allowed into India essentially duty and quota-free. The rapid growth of tourism was also a significant determinant o f non-agricultural growth - the number o f tourist arrivals grew by 51% between 1994 and 1999. Agricultural growth rose in 1999/00 and 2000/01 due to favorable weather and expanded fertilizer and irrigation use, though i t s overall contribution to growth in the 1990s has been modest (around one-fourth).

Table 2: Selected Economic Indicators 1997198-2002lO3

1997/98 1998/99 1999/00 2000/01 2001/02 2002/03 Prelim

GDP growth rates Real GDP at factor cost 2.9 4.5 6.1 4.8 -0.5 2.3

Non-agricultural GDP 5.0 5.6 6.8 4.3 -2.1 2.5 Manufacturing 3.4 5.3 7.2 3.8 -10 0.4 Other Sectors 5.3 5.7 6.8 4.4 -0.6 2.9

Agricultural GDP 0.9 2.8 4.9 5.5 2.2 2.1

Govemment budget (percent of GDP) Total revenue Total expenditure Current expenditure Capital expenditure and net lending

Overall deficit before grants Overall deficit after grants Domestic financing (net)

10.5 10.2 10.7 11.4 11.5 12.3 16.7 15.4 15.7 17.6 17.2 16.3 9.2 9.4 9.6 11.2 11.6 11.6 7.5 6.1 6.1 6.4 5.7 4.7 6.2 5.2 5.0 6.2 5.7 4.0 4.4 3.9 3.5 4.5 4.3 1.9 0.5 1.4 0.9 2.7 2.9 1.2

Inflation - CPI (average) 8.3 11.4 3.4 2.1 2.9 4.7 Current account balance (excluding grants) -2.8 0.5 0.5 1.2 2.6 -0.9 Gross official reserves (in months of imports of goods and services) 5.3 4.9 5.6 7.0 6.7 6.9 Extemal debt/GDP (in percent) 49.7 50.3 48.2 49.9 52.9 52.2 Debt service b r c e n t of exports of goods and services) 5.1 5.3 4.7 6.1 7.5 7.4

Source: IMF

' Liberalization measures included: (i) reform o f investment regulations, including easing o f entry barriers; (ii) trade and financial sector reforms that facilitated the supply of raw materials, intermediate and capital goods; and (iii) regulatory reforms that allowed private sector participation in infrastructure.

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14. Growth has slowed sharply in recent years: Due to a combination o f factors, growth in 2001/02 slumped to - 0.5%, though preliminary estimates for 2002/03 suggests that a modest recovery i s underway. The Insurgency (through increased insecurity, destruction of physical assets/infrastructure, strikes and loss of business confidence) and the global economic slowdown led to a contraction in manufacturing output by 10% in 2001/02 compared to the previous year. The value o f merchandise exports i s estimated to have declined by 15 percent in 2001/02 after growing by 21 percent on average during the previous three years. The impact o f September 11” and the deteriorating domestic security situation led to a 22% decline in the number of tourist arrivals in 2001. Excessive monsoon rains also caused agriculture growth to slow to 2.2% in 2001/02. However, growth in 2002/03 i s projected at 2.4%. The improved security situation in the second half o f the fiscal year appears to have led to an increase in tourist arrivals (25% increase between August 2002 and August 2003) restored normality in the transport and service sectors and contributed to a rebounding o f certain manufacturing exports, particularly garments.

15. Nepal has maintained a prudent fiscal stance. The fiscal deficit after grants has not exceeded 4.5% of GDP over the past decade and has been largely financed by concessional foreign financing. Concerns over a growing share of domestic borrowing in financing the deficit in recent years were allayed in 2002103 as domestic borrowing was lower than expected. Revenue collection fluctuated little between 1994/95 and 1999/00 averaging 10.5% o f GDP. Following the implementation o f tax reforms, revenues rose significantly to 12.3% o f GDP in 2002/03. Total expenditures declined in 2002/03 due largely to shortfalls in development expenditure in light o f the security situation.

16. Balance of payments developments have been broadly positive. Preliminary estimates for 2002/03 suggest that the overall balance o f payment i s expected to remain in surplus though a rebounding economy has raised the level o f imports to the point where the current account deficit i s approximately 1 percent o f GDP. Remittances have grown steadily over the past few years-and now exceed merchandise exports-reflecting a rapid increase in the number o f Nepali workers in Malaysia and the Middle East. Gross official reserves stood at over $1 billion, covering almost seven months o f imports. While reserves are comfortable, they are not at a level where HMGN can afford to draw down reserves to finance budgetary expenditures, given Nepal’s vulnerability to exogenous shocks. The external debt service ratio (debt service as a proportion o f exports o f goods services and private transfers) i s around 7.4% and interest payments on foreign debt has averaged around 0.5% o f GDP in recent years (see Box 2 on ‘Fiscal sustainability scenarios’).

Political Context

17. In 1990, the Jana Andolan (People’s Movement) restored multi-party democracy and in a mere six weeks, the party-less Panchayat system that ruled Nepal for thirty years was gone. The fal l o f the Nepali Congress majority government in 1994, pulled down by a faction of i t s own party in Parliament, marked the beginning o f intensely fractious politics. Between then and 2001, all three major political parties split (although two have come back together again). Two general elections were held and there were ten changes in government, with the average l i f e o f each government being 9.5 months. During these years, ideology increasingly took a back seat as coalitions were blatantly made and broken along vested political and personal interests. Political interference in the day to day running o f the administration became more o f the rule than the exception.

18. Capturing the disenchantment with democracy as i t was practiced since 1990, a rebel movement took up arms in 1996. After a failed attempt for peace talks in 2001, the insurgency escalated sharply and led to a growing climate o f fear and insecurity in rural areas. Considerable

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damage has been done to infrastructure-over one-third o f the country’s 3,900 Village Development Council buildings have been damaged or destroyed, thirteen out o f seventy five districts are without phones, five hydroelectric plants are out of action, 250 post offices have been destroyed and six airports have been closed. Security concerns led to the postponement of local and national elections creating further political uncertainty.

19. Despite the deepening national crisis, frequent changes in Government continued in 2002. Following the dissolution o f the Parliament in May 2002, Prime Minister Sher Bahadur Deuba continued as caretaker prime minister and announced general elections for November 2002. In late- September, however, concluding that the insurgency was too big a security threat to ensure free and fair elections, Mr. Deuba recommended deferment o f the election by over a year. Determining that Mr. Deuba’s recommendation amounted to incompetence, the King dismissed Mr. Deuba and temporarily took over all executive powers. King Gyanendra made it clear that the government should be headed by and composed o f individuals o f “clean image” who would not run for office in the forthcoming elections-the dates of which are s t i l l unannounced.

20. On October 4, 2002, veteran politician Mr. Lokendra Bahadur Chand was appointed by the King as the new Prime Minister and head o f a cabinet composed o f technocrats and leaders o f the smaller political parties. The Chand government was given a five-point mandate: (i) restoring peace; (ii) holding the suspended elections; (iii) fighting corruption; (iv) improving service delivery; and (v) maintaining good relations with neighbors. However, the larger political parties refused to recognize the Chand government, declaring i t unconstitutional, and instead chose to agitate for the revival o f Parliament or formation o f an all party government with full executive authority in order to limit the King’s powers. Eight months into office, Mr. Chand stepped down on May 30, 2003, in a bid to narrow the rift between the Palace and the political parties. In spite o f the political turmoil that marked his tenure, implementation o f reforms continued unabated.

21. On June 4, 2003, the King appointed Mr. Surya Bahadur Thapa as Prime Minister -- Nepal’s twelfth in seven years and f i f th since the 1999 elections. Thapa’s appointment was accompanied with an executive order, vesting full executive powers in him. Thapa, also a veteran from the erstwhile Panchayat era as well as founder president o f the Rastriya Prajatantra Party (RPP), currently heads a seven member ‘mini cabinet’ which he hopes to expand if and when the political parties agree to join. Thapa’s appointment with full executive powers i s widely seen as a signal o f King Gyanendra’s withdrawal from overt political activity which his critics describe as unbefitting for a constitutional monarch. The appointment o f Dr. Prakash Chandra Lohani as Finance Minister augurs well for reform implementation. Lohani has held the finance portfolio in the past and was the chief architect o f stabilization and structural reform policies in the mid-eighties. He enjoys an excellent rapport with the Prime Minister.

22. The rebel movement and HMGN declared a ceasefire on January 29” 2003, and signed a code o f conduct in March. Two rounds o f formal peace talks were held before the rebels called o f f the cease-fire on August 27&, 2003, ignoring a far-reaching agenda for political and socio-economic change proposed by the Government side during the negotiations. Key rebel demands include an all- party conference, an inclusive national government and elections to a constituent assembly to frame a new constitution. Prime Minister Thapa maintains that peaceful resolution o f the conflict and a return to a functional multi-party polity based on parliamentary elections at the earliest, remain h is top priority in line with the wishes of the general public who clearly want peace.

23. While there i s substantial political uncertainty, a key recent development in Nepal i s the emergence o f a broad coalition of like-minded reformers comprising o f technocrats, intellectuals,

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business leaders and civi l society representatives who are pushing forward with a change agenda that i s likely to stay i t s course even if the political process falters. There seems to be growing hope that the on-going reforms may raise the standards for public sector performance and set new norms at the level of the political leadership. In short, this period may turn out to be a positive mid-course correction in the evolution of Nepal as a modem state.

111. Nepal’s Poverty Reduction Strategy

24. Nepal’s reform agenda revolves around the PRSP’s four key pillars: (i) generating economic growth; (ii) improving service delivery; (iii) promoting social inclusion; and (iv) improving governance. There i s by now a broad social and political consensus in Nepal, supported by analytical work2, that progress in these areas w i l l be critical to building a lasting peace, speeding up development and catching up for the years lost to the conflict. The poverty reduction strategy, a product of wide national participation, captures this consensus. The following extract from the PRSP illustrates the importance given by the poverty reduction strategy’s four pillars in tackling many of the underlying causes o f the recent conflict:

“There is little doubt that persistent poverty and inequalities in the Mid and Far Western regions have provided a fertile breeding ground for the insurrection. The reasons for the disaffection are well known: ( i ) The Democracy movement of 1990 created new hopes for change among the ethnic communities who perceived themselves as marginalized; but the results of various development activities hardly reached these groups; ( i i ) The failure of governments to deliver adequate and quality basic social services outside urban areas; ( i i i ) Increasing corruption and leakages, and with them lack of accountability in the govemment; and, (iv) The slow pace of decentralization and the lack of community involvement probably added to the frustration” (pg 39).

25. Generating economic growth: The PRSP argues that higher growth w i l l require greater productivity of the agricultural sector and a recovery in manufacturing, tourism and exports. While the global economic slow-down and restrictive trade practices by trading partners are essentially exogenous growth-dampening factors, there are other impediments to growth that HMGN can influence. Conflict in rural areas, heavy dependence on rain-fed agriculture, high transport costs, unreliable power and telecom services, a weak financial sector, a rigid labor market and the limited effectiveness o f public investments currently constrain growth in Nepal. HMGN’s growth strategy focuses on relieving each o f these impediments. Restoring peace i s particularly critical as it w i l l prove a boon to the overall investment climate and to the tourism industry in particular. Maintaining macro- economic stability, greater efforts at domestic resource mobilization and expenditure prioritization w i l l create the fiscal space for growth enhancing public investments. Improving the effectiveness o f irrigation, rural transport and power sector investments through public-private partnerships are key components of the PRSP’s agricultural growth strategy. The PRSP also argues that improving the productivity o f domestic manufacturing to promote export-led growth wi l l require greater flexibility in labor markets, significant strengthening o f the financial system and more reliable telecom and power services.

26. Zmproving service delivery: The PRSP outlines the importance o f improving service delivery through a gradual process o f decentralization and greater empowerment o f local communities in the management o f social services. In education, the key objectives are to improve primary completion rates, increase access for girls and ethnic minorities and raise the access to post-primary education. HMGN has begun to implement the required reforms designed to achieve these objectives. A process

DFID (2002) ‘Economic Aspects of the Insurgency in Nepal’

7

of devolving primary school management to communities has begun and represents a fundamental shift in approach from the current centrally managed system. Targeted scholarship programs for girls and ethnic minorities wi l l also be implemented. In health, the Government has developed a sector strategy that w i l l focus on implementing an Essential Health Care package focused on a range of critical preventative care, maternal and child health and family planning interventions. Improvements in service delivery are also expected to occur through a process of devolving sub-health posts to local communities. The PRSP elaborates on the importance o f access to clean water for health outcomes and aims to increase access in rural areas from 71% to 85% of the rural population by 2006. The key actions needed to achieve this are to focus on rehabilitation and maintenance o f existing projects and to develop new projects using the demand driven user group approach supported by the Rural Water Supply and Sanitation Fund Development Board. Urban water supply management w i l l be contracted out to the private sector over the next few years.

27. Promoting social inclusion: The PRSP recognizes that promoting social inclusion w i l l require fundamental policy and institutional changes - particularly in the way services in critical sectors l ike education and health are delivered and in the gender, ethnic and caste composition o f the civi l service. In addition, in order to enhance the follow o f resources to excluded groups in the short term, the PRSP proposes targeted programs for the hard-core poor, ethnic minorities (Janjatis), occupation castes (Dalits), people l iving in remote areas, female-headed households and women. The strategy reviews the weaknesses o f such efforts in the past and discusses using the new Poverty Alleviation Fund as well as analytical tools, such as poverty mapping data, to improve the effectiveness o f the proposed initiatives. The PRSP also stresses the need for ‘quick results’ in order to gain the confidence o f those who have thus far been le f t behind by development efforts. As a result the PRSP proposes to implement an integrated infrastructure development program (drinking water, small irrigation, schools, health posts, and trails) in remote areas through local Government, community groups and NGOs in light of the capacity constraints of the central Government. The PRSP discusses how gender issues w i l l be mainstreamed in various sectors. Girls education w i l l be promoted through scholarship programs and greater hiring o f female teachers. The Essential Health Care package w i l l have a strong focus on maternal and reproductive health and the community user group approach to expand drinking water has explicit provisions for the involvement o f women. Similarly, programs to promote the inclusion of marginalized ethnic groups wi l l be developed within each sector’s main programs.

28. Zmproving governance: Recognizing that governance improvements are essential if reforms to stimulate pro-poor growth and improve service delivery are to have their desired impact, the PRSP develops both cross-cutting and sector-specific governance improvement strategies. Cross-cutting themes include: (i) improving the effectiveness o f the c iv i l service; (ii) strengthening anti-corruption and accountability institutions; and (iii) improving the functioning o f key agencies; and (iv) improving financial management and procurement practices. These economy-wide governance improvement efforts w i l l be complemented with measures in core sectors including the financial sector, infrastructure, health and education. The progress made in tackling governance concerns in the financial sector (see below for further details) i s a testimony to HMGN’s commitment to move steadily on this front.

29. As a strategic document, the PRSP i s far more credible than the past plan documents. Although i t stands on the extension o f the traditional five-year plan process, there are at least three things that distinguish th i s strategy from recent five-year plans. First, although the underlying Tenth Plan i s voluminous, HMGN was able to use the PRSP to extract only priority issues and programs. This sense o f priority reflects much stronger concerns about poverty reduction and social inclusion, no doubt sharpened by the experience of the insurgency. Second, the PRSP i s linked with the Medium- Term Expenditure Framework (MTEF) which was introduced in 2002/03. The MTEF i s now accepted

8

by l ine ministr ies as a serious prioritization framework with a strong focus on performance and wi l l thus help focus public resources on PRSP-driven priorities. Third, in 2002, HMGN adopted the “Immediate Action Plan” (IAP), to bolster i t s track record of reform implementation. HMGN’ s success in using the f i r s t IAP to focus on the implementation of a few key measures has set a precedent of developing realistic annual targets that are necessary for the implementation o f the PRSP in the years ahead.

IV. Reforms Supported by the Proposed Credit

Reforms to Restore Broad-based Growth

30. HMGN has embarked on a reform agenda that w i l l boost various possible sources o f pro-poor growth. The key reforms relate to: (i) maintaining macro-economic stability and increasing the fiscal space for growth enhancing and pro-poor expenditures and (ii) improving the investment climate for private-sector led growth. Increasing fiscal space w i l l generate greater public investment in key growth-enhancing sectors and improve the returns to private investment. Improving the investment climate w i l l lead to greater private investment in both the rural economy as well as in the manufacturing and services sector. Peace i s clearly critical for sustained growth. The implementation o f the reform agenda w i l l also contribute to gains in total factor productivity and boost long te rm growth prospects. The key drivers o f pro-poor growth are expected to be through improved agricultural productivity, investment in the non-farm rural sector, light manufacturing exports and tourism (see Box 1).

e peace process wi l l

. Remittances have

9

Creating Fiscal Space

3 1. Creating the necessary fiscal space to increase public investments in growth-enhancing sectors as well as improving the effectiveness of these investments i s a key government priority. In order to create th is fiscal space, HMGN has maintained a prudent macro-economic stance (see Economic Context section), increased domestic revenue mobilization efforts, pruned unnecessary expenditures, improved expenditure management (see Governance reform section on improving public financial management) and taken steps to limit the fiscal burden caused by public enterprises. A fiscal sustainability exercise, carried out by the IMF, suggests that public debt dynamics would remain manageable under various plausible macro-economic scenarios (see Box 2). In order to ensure that the composition o f external debt remains concessional, HMGN’s Foreign Aid Policy bans all new suppliers credits.

32. Domestic revenues have increased by 1.6% o f GDP between 1999/00 and 2002/03. This increase i s due to measures to improve domestic resource mobilization including (i) the implementation o f the 2000 Income Tax Act, (ii) broadening the income and VAT tax base, (iii) expansion o f ASYCUDA for customs and (iv) the creation o f an integrated Inland Revenue Department. A Fiscal Commission was established in late 2002 to devise measures to streamline taxation procedures, promote exports and reduce the personal income tax burden at lower income levels. Key reforms that were proposed by the Commission and implemented in the 2003/04 Budget include: (i) eliminating VAT exemptions for edible oils; (ii) reduction in import duty rates (consistent with WTO accession requirements) offset by increases in excises; (iii) elimination o f export service charges and reduction in export taxes; and (iv) an increase in the income tax exemption threshold together with a widening o f the lowest tax bracket.

33. Following on from the recommendations of the Public Expenditure Review Commission, Nepal has taken the f i rs t steps towards the development o f a credible Medium Term Expenditure Framework (MTEF). The main focus in 2002/03 was in the prioritization o f the development budget into three ‘priority categories’ - P1, P2 and P3 projects. The significance of the priority classification i s that high priority projects (60% of the development budget in FY03) w i l l now receive f i r s t priority in the allocation o f funds. HMGN intends to extend the expenditure prioritization process over the medium run by further cuts in low-priority projects. The MTEF process w i l l also be extended to prioritize recurrent expenditures, although th i s distinction i s somewhat blurred currently in Nepal, given that a sizeable share o f development projects include recurrent expenditures.

34. In order to create more room for pro-poor projects, HMGN dropped 160 low priority, HMGN- funded projects from the development budget in 2002/03. This redressed the sharp growth in the number o f projects in the development budget - from 423 in 1993/94 to 770 in 1998/99 - that resulted in too many projects chasing too little money. Overall, the share o f education, health and drinking

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water increased from 21% of public expenditures in 1998/99 to 24% in 2003/04. The prioritization exercise has also led to a shift towards greater pro-poor programs within sectors. For instance, within the education sector budget, the share o f primary education increased from 44% in 1999/00 to 55% in 2002/03. In the health sector, the share devoted to preventative health care increased from 26% in 2001/02 to 40% in 2002103. In a context where security spending has had to increase, by about 1% of GDP in the past two years, i t i s noteworthy both that pro-poor spending has been protected and that the share o f security spending in the Budget i s s t i l l far below most neighboring countries.

35. Budgetary transfers to Nepal’s parastatals have averaged 1.8 percent of GDP for the last three years. HMGN has moved to reduce the fiscal burden o f public enterprises by establishing a hiring freeze. HMGN intends to progressively reduce i t s level o f budgetary transfers over the next few years. In an effort to improve corporate governance, HMGN has removed many political appointees from public enterprise management and begun to replace them with professional managers recruited from the private sector. An arrears reconciliation exercise took place between Government and three parastatals (telecoms, electricity and water) in 2002/03 with a partial clearing o f arrears. The remaining stock o f arrears i s expected to be cleared by HMGN in 2003/04.

36. The privatization process has gained some momentum with the privatization o f Butwal Power Company in early 2003. HMGN has also slated a further eight parastatals for privatizatiodliquidation and has started the liquidations o f Hetauda Textiles, Nepal Coal and Cottage Handicrafts. The Birgunj Sugar Mill and the Agricultural Tool Factory have been dissolved under the Privatization Act and HMGN i s off-loading i t s shares in Himal Cement Factory. HMGN intends to build on t h i s momentum in the coming years and has announced the privatization o f the Bhaktapur Bricks Factory, the Nepal Foundry, and the Pokhara Milk Supply Scheme. Bidding documents have also been prepared for Hetauda Cement, Lumbini Sugar, and Nepal Rosin and Turpentine Factory and a decision on their privatization i s expected shortly.

37. The total costs o f adjustment in the f i r s t wave o f eight parastatals, i s estimated to be in the order o f US$47.4 million, composed o f severance related costs o f US$18.5 mill ion and other liabilities of US$28.9 million. Current uncertainty over these estimates w i l l be resolved through increased audits. HMGN intends to complete an annual audit in every parastatal and has gradually increased the number o f annual public enterprise audits from 16 in 1998 to 27 in 2002 out o f a total o f 43 parastatals. This measure would allow government to finally get an accurate estimate o f the contingent liabilities involved in adjustment. The ADB i s supporting this process of public enterprise reform through a budget support operation.

38. In March 2003, HMGN decided to brave the political consequences of raising fuel prices, to levels comparable to those in India, in order to stem the potential impact o f the Nepal Oil Corporation’s (NOC) losses on the Budget. At the time, the retail prices were not covering the import, transportation, distribution, and other supply costs o f the petroleum products. Further, because the retail prices in Nepal were lower than those in India,3 a significant amount of products was smuggled back to India, exacerbating NOC’s financial problem. As a result, NOC, which made a profit o f 2.9 bil l ion rupees in 2001/02, reportedly suffered a loss o f 4 bil l ion rupees (almost 1 percent of GDP) in the one year prior to the price increase. NOC used i t s reserves to fund these losses and took out commercial loans. The timely price hike prevented an imminent fiscal bail-out.

Prior to the March 2003 fuel price increase, kerosene was priced at the equivalent of 28 rupees per l i ter in India and only 17 in Nepal - diesel was priced at 26.5 rupees in Nepal and the equivalent of 33 Nepali rupees in India.

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39. Whi le the immediate fiscal concern may have been tackled, there remains an unfinished medium run reform agenda in the petroleum sector. HMGN introduced a dual price system for kerosene. Experience in other countries suggests that the dual price system i s most l ikely to lead to significant leakage, diverting rationed kerosene intended for household use to the automotive diesel sector and nominally inflating i t s demand. On the positive side, the price gap between market and rationed kerosene has been narrowed. Whi le there i s n o immediate fiscal concern in the petroleum sector at present, a medium term concern would be that, should the border prices rise to those observed in April 2003, NOC could again suffer a significant financial loss. Hence the dual kerosene price structure needs to be phased out over time. An analysis o f the poverty impact o f eliminating the kerosene subsidy (see Annex 11) shows that an increase o f Rs. 4 per l i ter (the price difference between subsidized and market kerosene in June 2003) i s anticipated to have a negligible impact (about 0.3 percent) on the household budget o f the bottom three deciles. In 2003/04, HMGN w i l l move to an automatic price adjustment mechanism using a transparent pricing formula, as in Pakistan and Sri Lanka. In the medium to long term, the government w i l l liberalize the sector and introduce competition b y issuing an Ac t for sector deregulation and establishing an independent regulatory agency4.

40. The medium term fiscal framework i s based on the discussion above and i s based on the understanding reached wi th a jo int IMF-Wor ld Bank mission in September 2003. Table 3 below i s premised o n the fol lowing assumptions:

0 Higher capital and current expenditures: Development spending i s projected to increase over the medium term in line w i th PRSP priorities. The Government may also initiate new development projects and expand or fully implement existing ones if relative peace returns quickly5. Hence, development spending i s projected to rise by 1.4% of GDP by 2005/06, compared to estimated levels for 2002/03. Current spending i s also projected to increase by 1.5% o f GDP in 2003/04 compared to the previous year in light of higher recurrent spending in health and education; higher wage allocation for security personnel; and allocations for the clearance o f utility arrears and contingent liabilities o f public enterprises.

0 Increased development spending combined with structural reforms can help in moving towards MDG goals: An initial attempt at costing the MDG goals i s underway and preliminary results, suggesting that there i s need for a significant increase in resource mobilization to meet these targets, are in l ine w i th recent cross-country estimates6. However, these estimates are also very sensitive to assumptions regarding the poverty elasticity o f growth, income distribution and the incremental capital output ratio, which in turn are affected b y structural reforms. The medium term fiscal framework presented in Table 3 envisages an increase in development spending commensurate wi th Nepal's implementation capacity and assumes that structural reforms to improve the investment climate and reduce exclusion w i l l improve the efficiency by which this additional spending i s translated into development outcomes.

4A number o f issues would need to be carefully considered in preparing the bil l and accompanying regulations: competitive procurement o f petroleum products, the future o f the infrastructure facilities currently belonging to NOC, requirements for market entry, and anti-trust regulations, to mention a few.

explosives during the conflict.

Bank, Policy Research Working Paper.

For instance implementation o f road construction projects was slow due to the concerns o f storing and using

See Devarajan, Mil ler and Swanson (2002) "Goals for Development: History, Prospects and Costs." World

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Reduced domestic borrowing and higher foreign financing: The medium term framework envisages a reduction in domestic borrowing to 0.6% o f GDP in 2005/06, compensated by a larger share of foreign financing.

0 Higher domestic revenue effort: The medium term framework envisages a 1.1% increase in domestic revenue, as a share o f GDP, by 2005/06 (from 12.3% in 2002/03 to 13.4% in 2005106). This target i s based on revenue administration reforms and rationalization o f VAT and customs exemptions, described earlier.

Table 3: Medium Term Fiscal Framework

2002/03 2003/04 2004/05 200306 Budget Estimate Staff Projection

Total revenue Tax revenue Nontax revenue

Grants

Total expenditure Current

Capital and net lending Ofwhich: Interest payment

Overall balance before grants Overall balance after grants

Financing Net foreign loans

Gross disbursements

Net domestic financing Ofwhich: IDA budget support

11.9 9.8 2.1 3.1

18.4 13.0 1.7 5.4

-6.5 -3.4

3.4 1.4 2.6

2.1

(In percent of GDP)

12.3 12.4 12.8 13.4 9.4 9.9 10.7 11.3 2.8 2.5 2.0 2.1 2.2 2.7 3.1 2.8

16.3 18.7 18.5 18.2 11.6 13.1 12.5 12.1

1.5 1.6 1.6 1.6 4.7 5.6 6.0 6.1

-4.0 -6.3 -5.7 -4.8 -1.9 -3.6 -2.6 -2.0

1.9 3.1 2.6 2.0 0.7 1.4 1.3 1.4 1.9 2.6 2.7 2.7

1.2 1.7 1.3 0.6 1.1

Sources: IMF

Improving the Investment Climate

41. A lasting peace w i l l help attract investment as all sectors have been disrupted due to the conflict. In addition to insecurity, a recent Investment Climate Assessment7 also pointed to: (i) high transport costs; (ii) deficiencies in access to power and telecom services; (iii) a weak financial sector; (iv) rigid labor laws and (v) excessive government bureaucracy and corruption as impediments to increasing investment. Below, we review the issues that constrain the investment climate for both agricultural and non-agricultural growth (transport costs, power, the financial sector and telecommunications), discuss proposed reforms in the delivery o f agricultural services and finally move onto one specific constraint on the manufacturing and service sector - labor regulations. The section on governance discusses measures to reduce corruption and improve the effectiveness o f key public agencies that w i l l also contribute to improving the investment climate.

Biggs et al(2000) ‘The Business Environment and Manufacturing Perfoimance in Nepal’ World Bank 1 Federation of Nepalese Chambers o f Commerce and Industry.

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42. Broad-based growth wil l require raising the productivity of agriculture and stimulating off- farm employment. The three-pronged strategy to do so, articulated in the PRSP, aims at removing the bottlenecks that constrain the investment climate in the rural sector (e.g. poor physical infrastructure, limited access to credit, unreliable power supply), improving the effectiveness o f agricultural services (extension, research and irrigation) and strengthening public expenditure management in the agricultural sector (see sections on ‘creating fiscal space’ and ‘governance’). This follows a series of f i r s t generation reforms that have liberalized input and output markets and greatly reduced policy distortions. On the agriculture input side, the subsidy on urea was completely phased out in 1999 while subsidies on other fertilizer types were removed earlier in 1997. More importantly, the relinquishment o f the government monopoly on fertilizer transport and distribution to the private sector has led to greater fertilizer use8. However, fertilizer use i s sharply correlated with distance to markets as are crop sales, crop diversification and the use o f modern technology. The level of commercialization and the productivity o f Nepal’s agro-processing industry i s also low by regional standardsg. Hence improving access to physical infrastructure, improved power supply and greater access to telecom services i s an essential part o f a pro-poor rural growth strategy.

43. Improving the effectiveness of agricultural services: There i s also a clear need to improve the effectiveness of extension, research and irrigation services. Extension services are being decentralized to the district level and contracting-out pilots are in place for both extension and research services. HMGN expects to expand the contracting out o f these services to the private sector and NGO’s, with greater involvement o f farmer’s groups, in line with i t s Agriculture Perspective Plan (APP). HMGN wi l l also scale up i t s programs that promote crop diversification and more intensive farming practices through appropriate water management and extension activities - for instance the ‘On Farm Water Management’ program wi l l be expanded from the current nine districts to twenty districts. Agriculture research i s being administered by a newly created National Agricultural Development Fund which wi l l be given autonomy in 2003104 and made more demand-driven. Only 15 percent o f Nepal’s cultivable land i s under year-round irrigation partly due to poor recovery o f operations and maintenance costs in surface irrigation systems. HMGN i s in the process o f revising the current Irrigation Regulations in order for water users to impose sanctions on irrigation water charge defaulters. A process of contracting out the management o f mediudlarge scale irrigation projects to the private sector w i l l be initiated by mid 2004. Moreover the subsidy for shallow tubewells was eliminated in 2000 but they remain for deep and medium sized tubewells. In order to ensure rational investment decisions HMGN wi l l review the existing incentive structure for irrigation.

44. Nepal has taken important steps to increase trade and competitiveness. Nepal has one o f the most liberal trade regimes in the region - the average tariff, after a decade o f reductions, stands at only 14% (and a top rate o f 30%) compared to 40% in 1990 and 32%, currently, in India. Along with trade liberalization, important steps to promote domestic competitiveness has contributed to the respectable export-led growth rates witnessed in the 1990s (see Economic Context section). The industrial sector has been largely deregulated, reductions in corporate and trade taxes have taken place and private sector participation in infrastructure provision i s encouraged. The Government has taken impressive steps over the past year to accelerate the procedures for market entry”. A new Bankruptcy Bill i s being drafted to facilitate exit. In September 2003, Nepal completed negotiations to jo in the World Trade Organization (WTO).

Fertilizer use increased from an average of 28kghectare for a four year period prior to 1997 to an average o f 43 kghectare between 1998-2000.

See F. Shilpi (2003) ‘Nepal’s Accession to WTO: Constraints and Options for Improving Agricultural Competitiveness’ World Bank (draft) lo Discussions with the private sector confirm that the registration process i s no longer a major obstacle to doing business in Nepal -most businesses are registered within ten days.

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45. However, despite these reforms, productivity remains low in Nepal and the external environment i s becoming increasingly challenging. Nepal w i l l have to improve i t s competitiveness to cope with the imminent withdrawal of the Multi-Fibre Arrangement quotas and cope with WTO accession issues. Recent analytical work on trade and competitiveness" point to constraints found by the Investment Climate Assessment (transports costs, access to power and telecommunications, the financial sector and labour rigidities) that are discussed below. In addition, there are certain trade- specific constraints; a key one being the need to addressing delays in customs and transshipment to Kolkata port. I t i s clear that piecemeal reform in Customs w i l l not be effective given the nexus between governance, infrastructure and customs procedures in reducing these delays. Hence, HMGN i s embarking on a multi-faceted program o f customs reform by: (i) introducing more selectivity in customs inspections; (ii) harmonizing its trade classification with the Indian EDIFACT system to facilitate transshipment; (iii) re-drafting the Customs provisions to make them consistent with WTO provisions; (iv) developing a code o f conduct specific to Customs employees; and (iv) creating a post- entry valuation section.

46. Lowering transport costs: Nepal's landlocked and mountainous terrain mean that high transport costs are a key constraint to agricultural productivity and manufacturing exports". While the density o f the road network i s s t i l l very low (0.1 km per square km), significant rehabilitation work, has resulted in a strategic road network that has been brought up to a maintainable condition. Hence the establishment o f the National Roads Board in late 2002 i s a critical and timely reform as cross- country experience shows that the quality of the road maintenance expenditures improves with this form o f institutional arrangement. This i s particularly important in the case o f Nepal, as the PER highlighted the significant under-funding o f operations and maintenance in the road sector. In order to carry this process forward it i s important that the fuel levy receipts are channeled to the Roads Board in a timely manner. However, while improving road maintenance i s critical, increasing the road network i s equally important for both rural farm and off-farm activities and further development of tourism. In this context, HMGN has developed a sequenced plan to connect all district headquarters and responsibilities for local road and trail development are being devolved to the district level. In addition to a more extensive, better maintained road network, a recent study13 highlighted the importance of Inland Container Depots (ICDs) in reducing the cost of transport for Nepali exports. Two inland container depots are now managed and operated by private terminal operators and by mid 2004 it i s expected that the Sirsiya ICD, with a direct link to the Indian railway system, w i l l also begin operations contributing to lowering the cost o f international transit.

47. Improving access and reliability of power: In view o f Nepal's physical characteristics and abundance o f water resources, hydropower i s a key potential source o f growth for Nepal. However, less than 2% of Nepal's hydropower generation capacity has thus far been de~eloped'~. Around 25% of the population have access to electricity but disparities are stark with over 90% of urban households connected in contrast to an estimated 14% in rural areas. Another key issue in the power sector i s the relatively high cost o f electricity in Nepal compared to i t s South Asian neighbors - this i s due both to technical factors, notably the capital intensive nature o f hydropower development involving high upfront costs15 and to inefficiencies within the Nepal Electricity Authority (NEA). I t i s clear that the

'Nepal: Integrated Framework Study' (HMGN I World Bank 2003). l2 The share o f transports costs in exports are around 50% more than other competitor countries - see 'Nepal Trade and Competitiveness Study' (World Bank 2003) for more details. l3 Subramanian and h o l d (2001) 'Forging Subregional Links in Transportation and Logistics in South Asia' l4 Out of a hydropower generation capacity estimated at 43,000 MW, only about 522 MW have been developed with around 119 MW under construction. l5 About 80% of power generation i s hydro-based which i s significantly more expensive than thermal generation; small size of generation units and the lack o f inter-connections all contribute to high costs.

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investment requirements to significantly expand access to power i s beyond the capacity o f HMGN or the NEA. Hence, Cabinet approval of the Hydropower Development Policy in 2001 was an important step as i t paved the way for private sector operators in electricity generation and distribution - there are now three Independent Power Producers operating in Nepal. In order to promote micro hydropower projects in isolated rural communities, HMGN provides a one-off subsidy to private entrepreneurs. Actions expected to take place in 2004 include the establishment o f the Power Development Fund to promote greater private sector investment, and the development of guidelines for rural electrification schemes through cooperatives. B y 2005 an independent regulatory body i s expected to be in place and around ten community based micro-hydro schemes operational. The internal unbundling o f NEA through signing o f performance contracts between the NEA management and generation, transmission and distribution centers - to improve the independence, authority and accountability of managers at all levels o f NEA - i s in process and i s expected to be completed in the short term. Improved efficiency o f NEA combined with the implementation of the Electricity Theft Control Act ought to reduce the current system loss o f 23.4% to roughly 21% by the end o f 2005, contributing to the reduction in the cost o f power.

48. Improving the effectiveness of the financial sector: The two largest commercial banks, Rastriya Banijya Bank (RBB) and Nepal Bank Limited (NBL), accounting for close to 50% of banking sector assets, have an estimated negative net worth amounting to 7-9 percent of GDP because o f large non-performing assets. HMGN has made it clear in i t s Financial Sector Strategy Statement (2001) that the State w i l l withdraw its ownership stake (100% in RBB and 40% in NBL) from these two banks by seeking to fully privatize them. The road-map to achieving this ‘end-game’ w i l l require HMGN deciding whether these Banks w i l l be merged or whether they w i l l seek private sector participation as two separate institutions. IDA i s providing technical advice on this issue through i t s Financial Sector Technical Assistance Project.

49. A key reform that overcame fierce resistance was the appointment o f external management teams at NBL in mid-200216 and in RBB from January 2003. Lending by these banks was often politically-motivated or involved insider dealing and hence reform initiatives were resisted not only by the banks’ boards (and employee unions) but also by many well-connected borrowers. The management teams have signed performance contracts with HMGN. Key performance benchmarks that are being implemented are (i) improved accounting systems and compliance with disclosure requirements (ii) implementation o f a retrenchment program and a revised remuneration package and (iii) an aggressive policy, including legal action, against loan defaulters. As a s i g n o f the continuity of the reform process, one o f the f i r s t significant steps taken by the new Government was the formation o f a Loan Recovery Tribunal effective from July 16, 2003. The Tribunal i s expected to speed up the loan recovery from the identified major defaulters in the banking sector. The current process o f cost restructuring, being implemented by the new management, i s an important step towards the next phase o f balance sheet restructuring which w i l l be done at the point o f sale. The exact fiscal cost o f bringing these two banks to an internationally acceptable level o f capital adequacy cannot be determined precisely yet, as the balance sheet position i s being determined. However, it i s clear from the very approximate negative net worth estimates that HMGN wi l l not be able to carry the full burden o f re- capitalization and external assistance, including from IDA, w i l l be needed.

50. Strengthening the ability o f the Central Bank to carry out i t s core functions i s also critical. The new Nepal Rastra Bank (Central Bank) Act increases the independence and authority o f the central bank and gives NRB greater authority to supervise commercial banks, including severely punishing

l6 To take over management of the majority privately-owned NBL, the Central Bank invoked provisions of the new NRB Act and suspended the NBL board.

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irregularities by bank officials. The Central Bank i s being restructured and a process o f shedding excess labor i s currently being implemented. Further improvements in the legislative framework are required and the Banking and Financial Institutions Ordinance, which w i l l tighten regulatory rules governing all deposit-taking bodies, i s expected to be enacted shortly.

51. Access to micro-finance and agricultural credit i s an important element o f rural farm and off- farm growth. HMGN has introduced a number o f important legislative changes recently to facilitate the growth o f the micro-finance sector (e.g. the Development Banking Act and the revisions to the Financial Intermediaries Society Act). However, important reforms remain in t h i s sector. I t i s expected that Government representation w i l l be withdrawn from the Boards o f the Grameen Bikas Banks and professionals appointed in their place. In the medium run, the Cooperatives Act w i l l be amended to address i t s shortcomings”.

52. Improving access to telecom services: The development of a competitive telecom sector, with wide outreach, i s important to reduce the costs of doing business and improving access to relevant market information. The telecom sector reform program has made significant progress over the past year with the establishment o f a regulatory body, the Nepal Telecommunications Authority (NTA), and the undertaking o f various initiatives to introduce competition such as the licensing o f over 70 VSAT, radio paging, and internet service providers. It i s also expected that in the next few months, a new board o f directors w i l l be appointed in order to convert the Nepal Telecommunications Corporation into a Company under the Company Act. In January 2003, HMG and NTA made the decision to re-launch the licensing of the Rural Telecommunications Service (RTS) to a private operator for 534 rural VDCs - i.e. roughly one-fourth o f all communities currently without access to telephones. A private operator was selected in September 2003 and it i s expected that operations w i l l commence in the next few months.

53. Relieving the labor law bottleneck: A flexible labor market i s important for Nepal’s export and tourism led growth prospects. Industries such as garments, hotels and restaurants need to adjust to fluctuations in demand and require high service standards which in turn requires the ability to lay of f workers without excessive red tape and the ability to set performance based pay. The Nepalese labor market i s currently defined by some o f the most rigid laws in the region that are a key impediment to investment, diluting the progress made in reducing the barriers to starting a new business.

54. The 1992 Labor Act grants “permanent” status to workers who have completed more than 240 days in a business with over ten employees. Dismissing permanent workers and/or closing failing ventures requires the consent o f the Department o f Labor, a costly, lengthy and often arbitrary process. The Act discourages informal businesses from becoming formal and/or growing beyond ten workers. I t also encourages employers to hire and fEe workers before they can become permanent and/or recruit Indian workers who are unable to enforce their rights. The labor law also mandates the payment o f wages based on hours worked, and specific job descriptions as well as annual increments which l i m i t s transfer o f employees and reduces the incentives for increased productivity. Moreover, having five different minimum wages for different occupational categories also l i m i t s labor mobility including from one enterprise to another within the same holding company.

l7 Amendment to the Cooperatives Act need to include: (i) the formation o f more than one savings and credit cooperative per district; (ii) permission for R M D C to lend to sound cooperatives that meet RMDC’s lending criteria; (iii) permission for the formation o f women-only cooperatives and (iv) permit cooperatives to work in more than three VDC’s.

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55. HMGN has committed itself to increase labor market flexibility by amending the relevant legislation.** However, these are sensitive issues in Nepal and w i l l require a consensus building exercise between government, the employers and the unions. Although there was an earlier move to amend the labor laws by ordinance, all parties agree on the need for constructive dialogue and the need for parliamentary approval o f any proposed amendments. Tripartite discussions are ongoing brokered by the L O . As part o f the process, an appropriate safety-net wi l l have to be developed; hence the earliest feasible time-frame for an amendment o f the relevant laws i s mid 2004.

Reforms to Improve Service Delivery

56. Improvements in service delivery are taking place through a gradual process of decentralization, greater empowerment o f local communities in the management of social services and increased private provision o f social services. Greater control o f resources and an improved ‘voice’ in local service delivery issues are important in improving the quality o f local services and eventually development outcomes. In Nepal’s context, greater control o f resources by communities has the added benefit of partly addressing the disenchantment in rural areas that fueled the insurgency.

57. Strengthening the decentralization framework: During the past decade Nepal has taken significant steps towards decentralization. In 1992, through separate Local Government acts for villages, municipalities and district bodies, Village Development Committees (VDCs), District Development Committees (DDCs), and Municipalities were created. The Local Self-Governance Act (LSGA) came into effect in 1999 and two years later a Fiscal Commission was created to design and implement an intergovernmental fiscal system. The key concern with the current state o f affairs i s that the terms o f Local Governments have expired and elections have not been held because o f security issues. Civi l servants are currently carrying out the administrative functions in the DDCs and VDCs. In September 2003, HMGN decided to bolster implementation capacity at the local level by filling mayor and DDC chairmen posts on an interim basis until local elections are held.

58. However, even during this interim period the reform agenda to strengthen decentralized service delivery i s likely to move ahead. First, the government has identified 23 sectoral acts conflicting with the LSGA. O f these, 14 acts have been redrafted and i t i s important that this exercise be given priority since service delivery functions have already begun to be channeled through local entities. Second, local governments in Nepal currently have limited capacity in financial management, auditing, budgeting, and disclosure o f information. Hence, a capacity building program needs to be in place along with measures to improve transparency. Third, current block grants do not address inter- jurisdictional inequalities, compromising the potential role o f fiscal transfers in reducing regional disparities and inequality. Hence by mid 2004, i t i s expected that HMGN wi l l prepare a fiscal framework in accordance with the LSGA and that piloting o f th i s fiscal framework i s likely to take place in 2-3 districts by mid 2005.

59. Improving the quality of education services: There has been modest progress in primary enrollment rates and literacy over the past decade, but the quality o f education remains poor. Drop-out and repetition rates are high in primary and pass rates in public schools are significantly lower than in private schools. In an effort to improve the quality o f education, the 7* Amendment o f Education Act 2001 provided for the devolution o f school management to communities, represented by School Management Committees (SMCs). Experience in other countries suggests that decentralization to school management committees i s an effective mechanism to improve education quality particularly

Relevant legislation includes: Labor Act 1992, Labor Rules 1993, Labor Court Laws 1997, Trade Union Act 1995, Bonus Act 1971, Industrial Training Act 1982, Foreign Employment Act 1985 and the Companies Act.

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when there are cohesive communities and motivated teachers”. The guidelines for schools transfer to communities or VDCs/municipalities were adopted by the Cabinet in September 2002 and thus far over 270 schools have been transferred. These committees w i l l oversee teacher recruitment, monitor attendance as well as make decisions on resource utilization, all measures that are likely to improve the quality o f education, reduce drop-out rates and improve test scores. While these transfers are small in relation to the total number o f schools in Nepal (around 26000 primary schools), the importance o f these initial transfers l ies in the shift in mindset that they symbolize. This ‘shift’ away from a ‘Kathmandu controlled’ system to one where key decisions are made at the local level stems from a recognition by key decision-makers that in a diverse country l ike Nepal, devolving authority to the grassroots i s essential to improving the quality of services and overcoming the prevailing disillusionment with Government services. The process o f school transfers i s expected to pick up pace over the next two years2’. The Bank and HMGN are in the process of launching an assessment o f the impact o f school decentralization on educational quality and outcomes which wi l l provide feed-back into the design o f the transfer process.

60. However, i t i s clear that transferring schools to communities i s only part o f a wider effort to improve education quality and redress gender, caste and ethnic disparities. Measures are being developed to: (i) increase the primary scholarship amount for the f i r s t child of households from which no member has completed primary school and none are currently attending primary school; (ii) provide free education for f i rst girl and f i r s t Dalit child of households from which none have completed lower secondaryhecondary schools and none are attending lower secondary/secondary school; and (iii) provide an incentive grant for schools recruiting female teachers and bilingual teachers.

61. Improving the quality of health services: Nepal has significantly improved child survival rates, reduced fertility and achieved gains in communicable disease control in the nineties”. However critical challenges remain, including a high maternal mortality rate o f 539 per 100,000 live births, widespread malnutrition and wide disparities in health outcomes across regions22. Weak institutional capacity, inadequate public financing and inefficient spending, limited coverage and poor service quality, poor value from private health spending and a difficult topography, all impact health services and outcomes. HMGN has developed a Health Sector Strategy in 2002 to address these issues. Key elements include ( i ) decentralizing service delivery; (ii) introducing an Essential Health Care Package that focuses on reproductive health, child health, communicable disease control and improved outpatient services; (iii) public-private partnerships.

62. HMGN has already initiated action on decentralizing service delivery by handing over the management o f some 460 Sub-Health Posts ( S H p s ) to the S H p Management Committees in eight districts. Implementation o f the Essential Health Care Package (EHSP) in twelve pilot districts in

l9 See for example the experiences o f Nicaragua and Pakistan (Rawlings, Laura B., 2000. “Evaluating Nicaragua‘s School- Based Management Reform.” and Sedlacek, Gui lheme and Pamela Hunte, 2000, “Evaluating the Impacts of Decentralization and Community Participation on Educational Quality and the Participation of Girls in Pakistan“. In Michael Bamberger, ed., “lntegrating Quantitative and Qualitative Methods in Development Research” Wor ld Bank, Poverty Reduction and Economic Management Network, Gender Division, Washngton, D.C.) 2o B y mid 2004, i t i s expected that there w i l l be an additional 1,000 primary schools, 200 lower secondary schools and 100 secondary schools transferred to community management. B y the end o f FY 2005, the transfer o f an additional 2000 primary schools, 400 lower secondary schools and 200 secondary schools to community management i s expected to take place. 21 Between 1990 and 2000, infant mortality declined from 107 to 64 per 1000 live births and fertility rate by over a child f rom 5.6 to 4.1 children per woman. Effective TB treatment i s available in about 90% o f the country, and polio i s almost eradicated. 22 For example, l i f e expectancy at birth ranges from 74 years in Kathmandu to only 37 years in the mountainous Mugu district.

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2003/04 w i l l precede a wider roll-out in subsequent years. HMGN intends to improve the management of hospitals by contracting out two district hospitals to the private sector by 2004 and another four by 2005.

63. Improving the effectiveness of drinking water services: The PRSP estimates the national water supply coverage at about 71% and sanitation at 25% with considerable regional variations. One o f the key constraints facing the sector i s a multitude of service delivery actors23 and HMGN i s in the process o f revising the Rural Water Supply and Sanitation Policy to clarify the various roles and responsibilities in line with the emphasis on decentralized service delivery. A draft Act i s also being prepared to make the Rural Water Supply and Sanitation Fund Development Board an autonomous agency. In order to redress the poor management o f urban water supply in Katmandu, the Government has revised the Nepal Water Supply Corporation Act which paves the way for a private operator to manage water supply and sanitation operations in the valley. Once a private operator i s in place in Kathmandu, HMGN wi l l take the necessary steps to introduce private sector participation in towns outside the valley. The formulation of a new Municipal Service Act to establish a National Regulatory Board and a Kathmandu Valley Water Authority i s also in progress.

Reforms to Promote Social Inclusion

64. The reforms needed to improve social inclusion in Nepal and promote greater equity in access to resources, opportunity and voice, are structural in nature. They reflect a shift in deep seated gender, ethnic and caste-based social hierarchies and they cannot be expected to occur with the stroke o f a pen. But since the reinstatement of democracy in 1990 there i s greater openness to a diverse array of civi l society voices - including those o f historically marginalized groups. Moreover, the steady critique o f the old “feudal” system coming from the armed rebels has created considerable public momentum for change. Evidence for this i s in recent (September 2002) amendment to the ‘Mulk i Ain’ (national code) inheritance laws which, though s t i l l not fully equitable to women, did widen the conditions under which they can inherit parental or spousal property. There was a fierce battle in Parliament over this, but compromises were made and some important changes have materialized in women’s access to productive resources.

65. This momentum for change i s strongly reflected in the PRSP and the range o f strategies i t proposes for overcoming the culturally embedded barriers to equity o f access which are increasingly seen by reformers in government as perpetuating the basis for violent conflict. Among the specific measures outlined are targeted programs that w i l l be implemented to improve access to education for girls and children from minority households (see section on ‘improving education quality’ for further details). Women and ethnic minorities are also under-represented in the civi l service. HMGN, with the support o f donors such as UNDP, and ADB are in the process of developing an Affirmative Action Plan to improve the gender diversity in the civi l service.

66. A key element in the overall approach to social inclusion i s the Poverty Alleviation Fund (PAF). The PAF can be seen as a direct targeted effort to reverse the vicious cycle o f social exclusion poverty and conflict. HMGN envisages the PAF to: (i) fund community projects with an emphasis on

23 The principal public sector institutions are the Department o f Water Supply and Sewerage (DWSS), the Nepal Water Supply Corporation (NWSC) and the Rural Water Supply and Sanitation Fund Development Board (the Board) reporting to the Ministry of Physical Planning and Works (MPPW). A recent addition to the institutional framework i s the District Infrastructure Development Offices (DIDO) in the Ministry of Local Development set up to assist District Development Committees (DDCs) in providing community based water supply and sanitation services. Thus, with DIDO offices in 75 districts there are now 150 Central Govemment offices in the sector. Moreover, there are many non-govemmental agencies (VNGOs) programs providing rural water supply and sanitation services and the sector has over twenty donors.

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conflict-affected areas; (ii) create a single instrument where different development partners can come together in a coordinated manner; and (iii) demonstrate to the numerous stakeholders innovative and effective ways o f reaching poor and excluded groups. To achieve the above objectives, the PAF wi l l target some o f the poorest villages in Nepal and w i l l be implemented by communities themselves with the support o f NGOs. The PAF ought to contribute to the harmonization agenda as donors can come together in a coordinated fashion to support targeted anti-poverty programs in Nepal.

67. International experience has shown that social fund type institutions operate effectively with an autonomous board, with limited government representation and the draft PAF ordinance provides for such an arrangement. The PAF would operate through a lean structure with limited staff on competitive salaries. HMGN has approved the draft ordinance and appointed the Executive Vice- Chairman o f the new autonomous board recently.

Reforms to Improve Governance

68. There i s a wide consensus that improving governance i s a crucial requirement for improvements in pro-poor growth and in service delivery. HMGN’s strategy to improve governance includes: (i) improving financial management and procurement practices; (ii) strengthening anti- corruption and accountability institutions; (iii) improving the effectiveness of the civi l service; and (iv) improving the functioning o f key agencies. These components are clearly inter-linked; for instance technical measures to improve the financial management system need to be reinforced with incentives and sanctions that ensure compliance by strengthening the civi l service and enhancing the credibility of anti-corruption bodies.

69. Public financial management: A joint HMGN-IDA Country Financial Accountability Assessment (CFAA) was carried out in 2001/02 and HMGN has begun implementing its key recommendations (see Box 3), monitored regularly by a high-level committee chaired by the Financial Comptroller General. The CFAA indicates that although there are significant weaknesses in Nepal’s public financial accountability system, the foundations for reform are in place. Nepal has an impressive legal and regulatory fiduciary framework but fiduciary risk in Nepal remains high primarily due to the lack o f compliance with existing regulations. The reforms discussed below, and elaborated in Annex IV, are part o f an integrated strategy to strengthen the financial management system as well as the incentives for compliance.

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70. Tying budgets with perj4omzance: A far-reaching reform that started in 2002/03, stemming from the CFAA, i s the development o f detailed work-programs and physical performance targets for each project in the development budget. The extent o f physical progress, the amount o f money spent and the priority level o f the project i s now used as the basis for the subsequent trimester’s fund release. This has instituted a clear rule for fund release, replacing the ad-hoc politically influenced fund release system that the 2000 PER describes as ‘)perhaps the most significant procedural factor affecting project implement~t ion”~~. Moreover, this form o f monitoring w i l l facilitate the preparation of reimbursement claims to donor agencies and help improve aid disbursements.

71. Improving financial transparency: HMGN i s committed to publicly sharing budgetary data in the public domain and in this spirit discussed the 2002/03 mid-year Budget review with the media. At the local level, District Development Offices have started publishing their annual work programs, budgets and amount spent. An expenditure tracking survey was piloted by HMGN for the education sector in 2002/03 and the results have recently been discussed with the education sector. HMGN plans to expand the number o f sectors covered under future expenditure tracking surveys and w i l l make them an integral part o f the PRSP monitoring process.

72. Improving accounting and auditing practices: HMGN i s in the process of creating an autonomous Financial Accounting Standards Board and Board of Auditing Standards that w i l l formulate appropriate accounting standards in order for the public and private sectors to move towards internationally recognized accounting standards. A new Chart o f Accounts i s being designed in line with the I M F ’ s General Financial Statistics classification and i s expected to be piloted from the 2004/05 Budget. The Auditor General’s accounts w i l l be audited by a reputable external auditor and an external audit o f the Central Bank w i l l be carried out in 2003/04, in line with the recommendations o f the IMF Safeguards Assessment.

73. Procurement reform: Greater transparency in public procurement i s also an essential part of improving financial management. A recent Country Procurement Assessment Report (CPAR) was conducted and while waiting for the new Procurement Law to be drafted and approved, the Financial Administrative Regulations were amended in September 2003 in order to: (i) include sufficient time for bid advertisement and preparation; (ii) prohibit post bid negotiations with any bidder and (iii) ensure that the lowest evaluated bidder be awarded a contract based on criteria that includes not only price, but also experience, capacity etc. Medium run measures are expected to include: (i) enactment o f a new Procurement Law based on the UNICTRAL, model law for procurement; (ii) the creation o f an independent procurement agency with functions to be defined by the new Procurement Law; and (iii) more widespread procurement related training in the civi l service.

74. Anti-corruption measures: HMGN has taken significant preventive measures to stem corruption. New legislation, particularly the Prevention o f Corruption Act, has given the Commission for the Investigation o f Abuse o f Authority (CIAA) the power to initiate cases against all top officials, including the Prime Minister and his Cabinet, without the need to secure permission. The C IAA i s enjoying increased status and prestige and, empowered by the recent legislation, has recently initiated a number o f high-profile anticorruption cases.25 Over the last two years, the number o f complaints coming to the CIAA has increased by 194 percent, and the disposal o f cases has increased by over 300 percent. The number o f new court cases filed on corruption related charges has increased by over 12 times (albeit from a very low base) and i s set to double again t h i s year. In order to enhance i t s

24 World Bank (2000) ‘Nepal Public Expenditure Review’, Volume 1 page 18. 25 The CIAA has filed charges against three former ministers, 22 M o F civ i l servants, the Executive Director o f the national airline and the Joint Secretary o f the Ministry o f Physical Planning.

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effectiveness, the CIAA i s developing an electronic database to track complaints and monitor action; improving training for i t s officers (mostly on deputation from other Ministries) in interrogation and prosecution techniques; and trying to secure better facilities by mid-2004. The CIAA has recently produced a five year strategy to guide the agency’s expansion. Future priorities w i l l include strengthening the CIAA’s presence at the district level and addressing the backlog of earlier cases currently pending within the justice system.

75. HMGN has also recently established a National Vigilance Center (NVC) located within the Prime Minister’s Office, which i s tasked with advancing the anticorruption agenda within HMGN. The N V C has broad responsibilities, ranging from strengthening prevention and raising public awareness to monitoring the performance of corruption prone departments. A newly-constituted inquiry commission, headed by a supreme court judge, has been given sweeping powers to investigate the property of political leaders and bureaucrats. I t has ordered about 500 public office holders- including the Prime Minister and other Ministers-to disclose details o f properties they own.

76. Civil service reform: The core civil service in Nepal comprises 106,000 positions, or roughly 0.4 civi l servants per hundred population, which in per capita terms i s one o f the smallest in both South Asia and the developing world. The actual numbers are even lower, as the estimated vacancy rate i s around 16 percent. The composition of Nepal’s civi l service i s particularly skewed towards the lower tiers, with a much smaller number o f senior administrative staff than in India and relatively more civi l servants at the lowest Classless level (e.g. peon, driver, guard, etc). 26 Accountability mechanisms have historically been weak, performance and productivity low, and political interference in daily operations a chronic problem often translating into frequent transfers o f staff.

77. In order to improve the efficiency and accountability o f the civi l service, the government has taken several important actions. A complete Personnel Information System (PIS) has been developed with support from the ADB. In spite of resistance from various ministries, Cabinet ordered the elimination o f approximately 7,500 vacant positions in late 2002 out of a total of 17,000 (as of September 2003, over 6000 o f these positions had actually been eliminated.) A partial decompression o f salaries took place in mid 2000, though the salary structure remains very compressed. There have also been significant steps towards reducing politically-motivated transfers in government and as a result the number o f transfers has almost halved in the last three years2’.

78. Further actions planned include connecting the PIS to the payroll system to create a comprehensive human resource database (essential for tracking posts, vacancies, transfers, and forecasting future salary and pension liabilities). The PIS w i l l shortly be expanded to cover the approximately 106,000 teachers and eventually extended to cover the police and armed forces. HMGN i s currently considering an ordinance that w i l l delineate more clearly the roles o f civi l servants and politicians in administration, thereby reducing the scope for political interference. I t i s also taking measures to make the “advisor” function more transparent. Outsourcing o f selected support activities; a position reclassification exercise to permit greater decompression o f salaries; and selective elimination o f remaining vacant positions are planned by mid-2004. Transfer data wi l l be publicly reported in order to promote greater transparency in 2004. Various measures to enhance the ethnic and gender balance of the civi l service are also under consideration (see section on ‘Promoting social inclusion’).

26 Source: IMF (2002) ‘The Civil Service Sector : Key Issues and Reform Plans’ Nepa l Selected Issues Paper. 27 The number of transfers has been substantially reduced in the last three f iscal years: from 4.497 in FYOO to 2967 in FYOl and 2553 in FY02 (Source: ADB Governance Reform Program).

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79. Agency reform: The government has also taken action to improve the functioning o f key agencies. Govemance Reform Units (GRUs) have been established in three ministr ies to advance reforms in individual l ine departments, and they wi l l be expanded to other ministr ies over the course o f the next year. In the Income Tax Department, for example, the assessment, collection, and audit functions have been separated to prevent all three tasks from being concentrated in the hands of a single officer, as was the case earlier. The Income Tax Department has introduced a citizens’ charter but this needs to be revised based on stakeholder consultation to reduce the time-limits for receiving refunds, tax-payer identity cards, and to clarify grievance redressal procedures2*. Other agencies with large public interface where service delivery gains could be made by mid 2004 are in land and property registration as well as passports. Improvements in other functions o f district administration are expected by mid 2005.

80. Access to information: Major measures introduced to promote transparency include the passage o f a Political Party Law in 2002 requiring the Auditor-General to audit the accounts o f all parties; a decision to open up FM radio programming to both private and community participation; and the establishment of a National Vigilance Center in the Prime Minister’s Office. These steps w i l l be furthered by public reporting o f audit findings relating to political parties; creating a web-portal for HMGN (initially with links to other departments, forms, information on schemes and programs, and an official directory) by end 2003; drafting Freedom of Information (FOI) legislation, based on wide public consultation, by mid 2004; and institutional strengthening o f the National Vigilance Center also by mid 2004.

V. The Proposed Credit

The World Bank’s Assistance Strategy

81. A Country Assistance Strategy Progress Report (CAS-PR) for Nepal was discussed at the Board in December 2002. The CAS-PR outlined the rationale for remaining in the low case o f IDA lending since the time of the previous full CAS in 1998 and proceeded to argue the case for moving Nepal to a base case lending scenario. This shift to the base case was endorsed by the Board in light o f the significant reform initiatives taken by HMGN over the past twelve months (see previous section for details) and the consequent achievement o f the majority o f base case triggers.

82. The CAS-PR confirmed that the key elements o f the earlier full CAS remain valid with the Bank continuing to act as a change agent to: (i) catalyze the necessary policy reforms required to generate growth and improve service delivery through greater emphasis on programmatic lending and relevant analytical work; (ii) strengthen the focus on creating an improved governance framework both through policy dialogue and as conditions for accessing IDA resources; and (iii) build human and physical capital through an appropriate mix o f technical assistance and investment projects in selective sectors where IDA has a comparative advantage.

83. A full CAS i s currently under preparation and w i l l be discussed at the Board at the same time as the proposed PRSC. The full CAS articulates the importance o f moving towards a more “programmatic” approach in response to HMGN’ s request for budgetary assistance to help implement its reform program. In addition, the strategy envisions the continued use o f traditional investment lending for community-based projects and for piloting/testing new instruments--e.g., a Second Rural Water Supply and Sanitation Project using a community-demand driven approach in poor rural areas, a Nepal Community School Support Project to support the devolution o f schools, a Health Sector

28 There i s a weekly public hearing to resolve issues but the current charter makes no reference to it.

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Program Project to support the implementation of the Essential Health Care package and a Poverty Alleviation Fund Project to channel resources to the poorest o f communities. Moreover, through a number o f on-going operations - such as the Rural Infrastructure Project, Rural Water Supply and Sanitation, and Irrigation Sector Development - community-driven approaches have been tested, local capacity strengthened and valuable lessons learnt towards improving service delivery at the local level.

84. Analytical work: The reforms underway draw on a wide variety o f formal and informal analytical sources. World Bank involvement in analytical work includes an Investment Climate Assessment (2000) and a Trade and Competitiveness Study (2003) that contribute to the understanding o f the growth agenda. A 2000 Public Expenditure Review, a 2002 Country Financial Accountability Assessment (CFAA), a 2002 Country Procurement Assessment Report (CPAR) and on-going support to the MTEF process form the basis of reforms in public expenditure management and improved accountability. A 1999 Poverty Assessment and a 2001 Demographic and Health Survey report form the basis of the knowledge on poverty and changes in living standards. A full household survey (NLSS 11) i s currently in the field (data collection has been delayed due to the civi l conflict) and a full Poverty Assessment i s planned once the clean data set i s available. As part of t h i s work, the Bank w i l l provide technical support and capacity building in poverty analysis and more broadly, monitoring and evaluation issues. Preliminary work has also been done for a Country Social and Gender Analysis that w i l l examine the causes and consequences o f gender, caste and ethnic social exclusion in Nepal and develop strategies to support government, civi l society and donor efforts to overcome these barriers. With support from the ADB, a civi l service census was carried out in 2000-01 that provides data on civi l service size and composition. Analytical work i s being initiated by the Bank (Nepal country team and DECRG) in collaboration with local analysts to better understand the political economy o f reform in Nepal and provide guidance to the Bank’s operational engagement in policy reform. Moreover, an assessment o f the impact o f decentralization of school management to school committees w i l l also be launched. A policy note on agriculture that w i l l provide further guidance on the future policy reform agenda in the sector i s also underway in collaboration with FAO. This note w i l l also lay out the type of support the Bank can provide through a combination o f investment lending, budgetary support and technical assistance. Finally, a Development Policy Review i s planned for 2003/04 and w i l l help to refine the policy agenda for 2004/05 and beyond. Figure 1 in Annex 1 illustrates the link between analytical work and the proposed PRSC lending program.

85. Coordination with ZMF and other donors. The Bank i s working closely with the IMF on macro-economic and structural issues and the PRSC and PRGF processing schedules have been tightly coordinated. A Joint Staff Assessment (JSA) o f the PRSP i s also in progress. The ADB has recently approved a budget support operation that focuses on privatization and c iv i l service reforms issues - there has been close coordination on these issues between the preparation teams o f both the IDA and ADB credits. IDA and DFID are jointly supporting the MTEF work and reforms in governance, health and privatization, supported by the PRSC, benefit from DFID’ s long-standing dialogue and technical assistance. Finally, a coordinated donor effort in Kathmandu--including the Bank, IMF, ADB, DfID, Denmark, Japan and Norway --has been supporting the implementation o f HMGN’s Immediate Action Program (IAP). Table 4 summarizes the key policy themes being supported by the PRSC and the key donors involved in each sector.

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Table 4: PRSC Themes and Partnerships with Other Donors

Poverty Alleviation Fund ImDroving access to schooling

I Broad-Based Economic Growth

UK Denmark, Finland, Japan, ADB, EU, UN

Macroeconomic stability Fiscal reforms . _ _ _ _ ~ _ _ _ . _ _ _ - ~

I I

Improving civi l service diversity

. . Financial sector SOE restructuring Agriculture I irrigation

_.

Agencies Norway, Netherlands: UK ADB, UN Agencies Canada, UK

Trade

IMF IMF, ADB IMF, ADB ADB ADB, FAO, IFAD, OPEC Fund, EU

__ __

IMF, UN Agencies, WTO

UK, Denmark, Germany UK, Germany . .

UK Australia, Canada, Denmark, Finland, Germany, Kuwait Fund, India, Japan, Norway, Saudi Fund, Switzerland, UK, US Norway, UK

_--________

I I ____ __ ~- ____ ____ -

. .

- Labor Roads Germany, India, Japan.

Switzerland, UK, US Power Canada, Denmark, Finland,

Agencies Germany, Japan, Norway, I Sweden, US

Improving Service Delivery

__ Education

ADB, UN Agencies ADB, EU, UN Agencies

_ _ _ _ _ _ ~ ~

. ..

EU, UN Agencies

I Drinking water and sanitation 1 ADB, UN Agencies

Denmark, Norway, UK, US Canada, China, Denmark, Finland, Germany, India, Japan, Norway, Switzerland, UK Auitralia, China, Germany, India, Japan, Norway, Germany, Switzerland, UK,

________ - ~ _ _ _

__ __ - - - __ . . -

us Finland, Japan, Norway, UK

I I

Good Governance

_ _ _ _ _ ~ ADB, UN Agencies UK k-1 Canada, Denmark, Norway, Civ i l service reform t Anti-corruption

. - I - - Financial management Switzerland UK, US Germany, Denmark,

- -

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Credit Design and Fiduciary Issues

86. The proposed Poverty Reduction Strategy Credit (PRSC) program i s based on the PRSP, linked to the CAS objectives and built on appropriate structural, social and fiduciary analysis. The PRSC I aims to: (i) support Nepal’s reform champions in implementing far-reaching reforms that revive growth, improve service delivery, promote social inclusion and improve governance; and (ii) contribute to maintaining a sound macro framework and in protecting high priority programs by fi l l ing part o f Nepal’s financing gap.

87. Credit design: We propose to support Nepal’s reform program with a $70 mill ion PRSC I, that w i l l be the f i r s t slice o f a multi-year program o f support for the PRSP. Upon approval by the Bank Board, the PRSC I wi l l be disbursed in the second quarter o f FY04 based on the significant reforms undertaken over the past eighteen months including the implementation o f all prior actions agreed during the PRSC I preparation process. Box 4 as well as Annex I summarize the completed prior actions for the PRSC I as well as indicative prior actions for PRSC 11. The amount of the credit i s related to the intensity o f the reform effort and the medium term macro-economic framework discussed earlier.

88. The PRSC I actions form the f i r s t part of a larger medium-run reform agenda laid out above and in Annex I. The program supported by future PRSCs wi l l retain sufficient flexibility to support a reduced core part o f the overall program with a smaller loan amount should the full set of proposed reforms not take place. Moving forward with the proposed PRSC I in Nepal i s important in order to: (i) support meaningful reforms that w i l l assist in reviving growth, reduce poverty and provide the foundations for sustained peace; (ii) maintain the credibility of the Bank and o f ‘change-agents’ within Government; and (iii) provide the fiscal resources to protect pro-poor expenditures in formerly conflict-affected areas, l imit domestic borrowing and maintain macro-economic stability.

89. The medium term program’s objectives, described above, w i l l be monitored using specific outcome and intermediate indicators. The implementation of the growth strategy i s expected to gradually revive growth to 5.5% by 2005/06. This w i l l be achieved by creating fiscal space for growth-enhancing public investments and through an improvement in the investment climate. Hence the intermediate indicators that w i l l be monitored include (i) the share o f high priority projects in the Budget; (ii) greater access to basic infrastructure (roads, power, telecoms) services and (iii) reduced costs o f doing business. The medium term strategy also aims to improve social indicators. Access to, and the quality of, education, health and drinking water services w i l l be improved through a process o f community involvement and private sector participation in social services. Access to these services w i l l also be made more inclusive and the proportion o f women and minority households that benefit w i l l rise significantly. User surveys w i l l also be used to measure improvements in governance and the quality o f public services and w i l l reflect the extent that the foundations for sustained peace have been laid (see Annex I for details on the medium term outcomes and monitoring indicators).

90. Fiduciary issues: The disbursements under the proposed PRSC program wi l l be closely aligned with HMGN’s budget cycle, in order to improve resource predictability. The PRSC I wi l l follow the Bank’s simplified disbursement procedures for adjustment operations. An important mitigating factor for the high fiduciary r isks i s the government’s commitment and demonstrated progress in the implementation o f i t s public financial management reform agenda. The Government w i l l open and maintain a Deposit Account with the Nepal Rastra Bank (NRB) into which the proceeds of the Credit wi l l be disbursed. Disbursement w i l l not be linked to any specific purchases and procurement wi l l follow normal Government policies and procedures. I f any portion o f the Credit i s used for ineligible purposes as defined by the Development Credit Agreement, IDA wi l l require the

27

government either to return that amount to the Deposit Account for use for eligible expenditures or to refund the amount to IDA.

91. The NRB wi l l provide the required information on the receipt and use o f the Credit funds and w i l l prepare annual financial statements, up to and including the fiscal year in which the balance in the Deposit Account i s zero. The financial statements o f the Deposit Account w i l l be audited by independent auditors acceptable to IDA under terms o f reference in accordance with acceptable international standards o f auditing.

92. Environmental issues: The main environmental challenges in Nepal pertain to the sustainable use o f natural resources and adequate integration o f environmental planning in development programs and their implementation. HMGN has responded to the environmental challenges by incorporating conservation activities in sectoral plans and programs. Furthermore, environment-related provisions have been incorporated in various actsz9. Despite these efforts to address environmental management, weak institutional capacity and poor coordination has constrained the implementation o f various environmental policies and programs. There i s also a significant gap between the content o f the international environmental conventions and their implementation at the national level. With a large donor and NGO presence in this area, the CAS proposes that Bank involvement in the environmental agenda be highly selective, focusing on helping HMGN articulate an effective strategy for environmental conservation, management and capacity building.

93. There are three types o f policy reforms supported by the PRSC that may potentially have an environmental impact: (i) SOE reform; (ii) phasing out o f the kerosene subsidy and (iii) expanding access to electricity. In cases where SOE’s are leased or sold to the private sector, HMGN would retain liability for any past irreversible impacts (stemming from land use changes and air pollution emissions). Assets that are sold would be operated under existing environmental regulations pertaining to soil excavation and control of industrial emissions. The phasing out o f the kerosene subsidy i s also unlikely to lead to any significant increase in firewood consumption as it i s mainly used for cooking in urban areas and among the relatively well-off. Hence the environmental impact i s expected to be negligible. Finally, the reforms to increase access to electricity in rural areas center around the promotion o f small and medium scale hydropower projects that w i l l replace the need for fossil fuel based power generation plants. Moreover, the expansion of grid connected electricity w i l l reduce the demand for kerosene used for lighting thereby reducing the impact of kerosene subsidy elimination on poor households.

29 Environmental provisions feature in the Local Self-Governance Act (1998), the Forest Act (1992), the National Parks and Wildl i fe Conservation Act (1973 and amended in 1993), the Environment Protection Act (1996).

28

Objectives

Pro-poor growth

Service delivery

Social in c 1 us i o n

Governance

DX 4: Prior Actions for PRSC I and Indicatii

PRSC Z

2002/03 development budget scaled down and prioritized [Done - 160 projects dropped and remaining project classified into high, medium and

Adjust retail petroleum prices to cover the cost o f purchase, transport and distribution in order to reverse large petroleum-related losses [Done]

Establish new autonomous Road Board and take necessary steps to begin operations o f Road Board. [Done]

Dissolve Boards, introduce new professional management teams at the two main commercial banks, Rastriya Banijya Bank and Nepal Bank Limited [Done]

low priority]

1 Transfer 150 public primary schools to School Management Committees to demonstrate effective commencement o f HMGN’s school decentralization strategy. [Done]

Hand over 400 Sub-Health Posts (SHP) to district level Management Committees (MCs) [Done]

m

. Enact PAF Act through an ordinance and take necessary steps to establish new independent P A F board. [Done]

Prosecute high-profile corruption cases [Done - corruption charges filed against three former ministers, 22 tax officials and a senior c iv i l servant] Revise Financial Administrative regulations in line with Country Procurement Assessment Report recommendations [Done]

Halve the number o f c iv i l service transfers f rom the levels prevailing in 2000. [Done]

.

.

Poverty and Social Impact Monitoring

PRSC ZZ (Indicative actions expected by Sevtember 2004)

Draft relevant legislation to make labor employment and retrenchment laws more flexible.

Rationalize incentives for imgation to promote greater private sector investment in imgation.

Transfer fuel levy receipts to Roads Board in a timely manner to ensure regular resources for road maintenance.

Make the Birgunj I C D operational through finalizing the (Nepal-India) rail agreement and appointing a terminal management operating company through competitive tender.

Implement scheme to rationalize excess staff at NRB, NBL and RBB. Transfer 600 primary schools, 100 secondary schools and 200 lower secondary schools to community management.

Make Rural Water Board autonomous to improve effectiveness o f community based drinking water services

Implement Essential Health Care services in 14 districts, prioritizing those with poor health indicators.

package for girls and Dalit children in secondary schools.

Ensure adequate tenure at senior c iv i l service level, strengthen capacity o f Public Service Commission to oversee transfers and publicly report transfer data. Prepare and enact a new Procurement law and begin implementation.

. 1

.

. Begin implementation o f scholarship

=

.

94. The reform program supported under the PRSC i s part o f the proposed actions under Nepal’s PRSP. The PRSP outlines the institutional arrangements that w i l l be implemented to monitor Nepal’s poverty reduction strategy. The proposed framework w i l l seek to coordinate and unify the efforts o f a range o f actors to ensure that a more systematic assessment of Nepal’s progress towards the MDG’s i s produced.

29

95. Strengthening the monitoring o f public expenditures i s a key priority. Fiscal reports on overall aggregates and on high priority expenditures wi l l be produced and disseminated widely every trimester. Annual work-plans and physical performance targets for development projects have been introduced; these w i l l be monitored and publicized to improve accountability. The extent and use of funds that have been channeled to VDC’s and DDC’s wi l l also be posted outside their offices to improve transparency. Expenditure tracking surveys w i l l be periodically carried out by an independent third party and the results made publicly available. HMGN has already carried out a pilot survey and w i l l be working towards scaling up and institutionalizing this process.

96. Monitoring the impact o f investment climate reforms i s also important. Preliminary discussions have been held with HMGN on the type o f indicators that could be monitored, the data sources required and relevant agencies. The type o f indicators could include the time taken to obtain investment approvals, clear customs, obtain tax refunds and close an enterprise. The Ministry o f Industry and Commerce in conjunction with the National Planning Commission are likely to take the lead role in monitoring. The private sector have also expressed a willingness to be an integral part of this monitoring system. Further discussions on this topic i s envisaged as part of the PRSC I1 preparation.

97. The monitoring of long-term outcome/impact indicators that relate directly to MDG’s, and those that can be used to assess the poverty impact o f reform, w i l l to a large extent be achieved through the Nepal Living Standards Survey (the next round, N L S S 11, i s scheduled to be completed in 2004). The N L S S I1 wi l l be comparable to the 1995/96 N L S S which was the basis for the ex-ante impact analysis o f a petroleum price increase (see Annex 11). Demographic and Health Survey’s (DHS) w i l l also play an important role in monitoring outcomes/impacts; the most recent Nepal DHS was carried out in 2001. HMGN also proposes, in the PRSP, to use the 2001 Census data for a poverty mapping exercise to facilitate the targeting o f anti-poverty programs and improve the allocation of public resources3o. The above-mentioned surveys need to be complemented by information on changes in ‘intermediate’ variables that affect outcomes such as teacher absenteeism, availability of drugs etc. In the coming year, HMGN wi l l identify the key set o f intermediate indicators, assess existing data bases in relation to these indicators, and finalize the data needs, including modifying existing surveys to address the lacunae, including the areas for capacity building to support the implementation o f an integrated monitoring framework.

98. The monitoring o f the PRSP wi l l be coordinated by two sets o f committees - the National Development Action Committee (NDAC), chaired by the Prime Minister, w i l l review progress every four months while the Ministerial Development Action Committee (MDAC) w i l l assess progress in their respective sectors every two months. A new section for coordinating poverty and social indicators monitoring and analysis w i l l be formed in the National Planning Commission. The new Poverty Monitoring Unit w i l l work closely with the Central Bureau o f Statistics, that w i l l continue to be responsible for carrying out household surveys and assembling national account statistics. The PRSP stresses that significant capacity building assistance w i l l be sought from development partners to enhance monitoring and evaluation capacity at the central, line ministry and local levels.

30 T h i s work i s being supported by the Statistical Capacity Building Trust Fund from the World Bank.

30

Benefits and R i s k s

Benefits

99. The reform process supported by the proposed PRSC program i s expected to reduce poverty by stimulating pro-poor growth. Sustained peace w i l l arguably be the single most important factor in reviving growth given i t s importance in attracting tourists and the boon it w i l l provide to development activity in the conflict-affected rural areas where the majority o f the poor reside. The PRSC supports selective key reforms that w i l l directly contribute to improving pro-poor growth by: (i) creating fiscal space for, and improving the effectiveness of, growth enhancing public investments and (ii) improving the investment climate.

100. Efforts to improve service delivery and implement targeted programs are critical to reduce the social exclusion and sharp disparities in access to basic services that have been key causes o f recent conflict. Improvements in service delivery are taking place through a gradual process o f decentralization, greater empowerment o f local communities in the management o f social services and through the private provision o f social services. Targeted programs such as the Poverty Alleviation Fund are critical in targeting conflict affected areas with basic community built projects. The PRSC program supports Nepal’s track record o f meaningful reforms in improving service delivery by assisting HMGN in developing annual benchmarks consistent with the broad reform objectives and by providing the fiscal and technical resources necessary to accelerate the reform momentum.

101. The proposed PRSC program supports HMGN’s strategy to improve governance by: (i) improving the effectiveness o f the civi l service; (ii) strengthening anti-corruption and accountability institutions; (iii) improving the functioning o f key agencies; and (iv) improving financial management and procurement practices. The improvements in governance that are supported by the PRSC program are designed to bring about a more accountable, efficient and less corrupt government that w i l l create a more favorable investment climate and improved service delivery.

Risks

102. There are several r isks associated with the PRSC program: (i) the recent break down in the peace process leads to a sustained period of violence that dampens growth prospects and the effects of reforms in service delivery on poverty and social exclusion; (ii) prior to and following national elections the efforts of reform minded technocrats may be crowded out by political interference and the sustainability o f reforms may be threatened; (iii) implementation capacity may not be sufficient to sustain a broad reform agenda; and (iv) a further worsening o f global economic conditions may undermine the impact o f growth-enhancing structural reforms. These are real r isks and there i s no guarantee that risk mitigation measures could overcome the joint effect o f these forces should they materialize. The reformers in Nepal, however, are well aware o f these risks and are designing the reforms in such a way to counter the r isks. The purposefulness of t h i s reform process has been uncommon. As an external development partner that has consistently encouraged a home-grown reform initiative, the Bank needs to be prepared to take these r isks and to fulfill i t s part o f the bargain by rewarding a strong track record o f meaningful change and giving a clear signal that future reforms w i l l also be duly supported.

103. Risks and mitigation measures associated with the peace process: In a scenario where hostilities resume for a sustained period, there i s risk that the government loses credibility and the level o f distrust between the two sides as well as between political parties w i l l rise. Elements o f the

31

Government’s program designed to address the underlying causes o f the conflict could be constrained in a sharply polarized political environment and hindered by poor security and low morale. On the other hand, the reformers’ resolve may stiffen and they may be given even more space to implement reform, at least in the roughly two thirds o f the country that HMGN controls. The risk mitigating measures partly l i e in an on-going process o f bringing the delivery and management o f resources closer to the people (by devolving authority from the center o f education, health, water and extension services) and using targeted programs to provide opportunities and services for particularly marginalized groups (e.g. scholarships for Dalit children) and in the most deprived districts (e.g. targeting resources using the Poverty Alleviation Fund).

104. Risks and mitigating measures associated with crowding out of reformers and opposition from vested interests: Implementation o f some o f the more politically contentious ‘prior actions’ (e.g., regular adjustment o f petroleum prices) could face delays in the run-up to elections. The continuity and sustainability o f reforms could be threatened if national elections result in bringing to power a critical mass o f politicians who want to slow down, or reverse, the reform process. Moreover, there could be significant opposition to the reforms from powerful vested interests. For instance improving the performance o f the banking sector entails taking action against wealthy private sector individuals who have powerful patrons in Government. Taking action to stem fuel adulteration and reduce corruption are also clearly likely to be met with resistance.

105. The broad-based support for the reforms i s the best counter weight to these pressures. Many o f the reforms outlined in this document have a wide degree o f support across the political spectrum and from civi l society, for they have been based on consensus-building exercises and stakeholder consultations. The legislation creating the Road Fund i s an example of how popular support for the reform drawn from an extensive consultative process helped overcome the political forces that wanted to water down the legislation. Measures to fight corruption, too, enjoys very strong popular support. Moreover, certain actions are, by nature or because o f legislative change, difficult to reverse, e.g., introduction of foreign management teams at RBB and NBL, and legal amendment to strengthen CIAA.

106. Certain reforms have a built-in mechanism to expand the support base for the change rapidly, thereby reducing the risk o f a reversal. For instance, transfer of public primary schools and sub-health posts to community management w i l l quickly turn those communities into strong constituencies to defend the reform, as they tend to feel the benefits immediately. Similarly, the Poverty Alleviation Fund and scholarships for disadvantaged children can be expected to develop a momentum o f their own as they get underway. The benefits that the liberalization o f telecom services has brought in terms o f improved cellular services and greater internet access w i l l also be difficult to reverse.

107. Risks and mitigating measures associated with implementation and monitoring capacity. The reform agenda i s comprehensive and w i l l stretch the capacity o f both central and district level officials. The challenge w i l l be significant for the few senior officials in central ministries who are responsible for the overall coordination and monitoring o f the reform program. L ine ministries w i l l also be stretched. For example the pace at which schools are devolved may be constrained by capacity constraints at the central ministry level in processing the school devolution applications. At the district level, the capacity of DDC’s and VDC’s to cope with increased responsibilities w i l l be put to the test. Moreover, the monitoring functions set up as part o f the PRSP process w i l l need significant support. Recognizing the risk o f these capacity l i m i t s derailing the reform process, the reform program embedded in the PRSP and supported by the PRSC sets realistic implementation targets. The IAP process plays an important role in this regard, in identifying an annual l i s t o f high priority reform actions. Further, significant technical assistance i s provided by donors in support o f these reforms. For

32

instance the ADB has focused on building the institutional capacity to implement civi l service reform measures and DFID and IDA are jointly providing support to the MTEF process. Finally, efforts at greater donor coordination are also helping to reduce the demands on Government officials.

108. Risks and mitigating measures associated with exogenous shocks. Nepal i s vulnerable to erratic weather patterns and fluctuating world demand for i t s key exports. These factors, along with a depressed investment climate due to the conflict, have contributed to poor growth over the past two years. The growth-enhancing reforms supported by the PRSC aim to create a more favorable investment climate that should lead to diversification in the economy and reduce vulnerability to these shocks. Nevertheless, in the short run, sharp exogenous shocks do have the potential to depress growth.

109. While the above risk-mitigation measures should provide adequate comfort that these risks are manageable, as an added risk-mitigation measure and to strengthen the hands of the reformers, the Bank w i l l provide a loan acceleration clause that would allow the Bank to demand immediate repayment o f the proposed loan by the Borrower in case reforms are reversed or materially changed.31

31 Article VI1 ‘Acceleration of Maturity’ in the General Conditions Applicable to Development Credit Agreements Dated January 1, 1985 (as amended through October 6, 1999)

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ATTACHMENT

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KINGDOM OF NEPAL LETTER OF DEVELOPMENT POLICY

Date,-

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Poverty Rerlectioilrs Strategy

r Oar?: Broad Based Growth

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Sincerely,

ANNEXES

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Annex I1 Page 1 of I

Analysis of the Potential Impact of Removing the Kerosene Subsidy

What impact would the removal o f the subsidy on kerosene have on the poor? I t i s claimed that kerosene i s a “fuel o f the poor” and i s used predominantly for cooking. Data from the 1995/96 Nepal Living Standards Survey (NLSS) and the 2000/01 Rural Consumption Survey (RCS) can be used to check whether these claims are true (both surveys were conducted by the CBS and the data are available).

The 1995/96 shows that in fact most households did not use kerosene for cooking, but rather firewood. Only 4.6 percent o f the households used kerosene as their main source of cooking fuel (two thirds o f these were in urban and one third in rural areas). Some households used i t as a secondary cooking fuel, so in total 7 percent used this fuel. Of these, 4.3 were in urban areas and 2.8 in rural areas (60 percent of urban households and 3 percent of rural households).

The households that used kerosene for cooking were not among the poor. Seventy-two percent o f those using kerosene fe l l in the fifth consumption quintile (that is, those who had consumption levels among the top twenty percent), and another 16 percent were in the fourth quintile. So kerosene i s by no means a “fuel o f the poor.”

However, most households did use kerosene for other uses, primarily lighting, so that 90 percent o f households reported some expenditures on kerosene. But lighting does not require much kerosene. Households who purchased kerosene for uses other than cooking consumed on average almost five times less than those who used i t for cooking-29 liters a year compared to 133 liters (quantities estimated based on prices reported in the N L S S community survey). As a result, expenditures on kerosene were on average a small, though non-negligible share o f total consumption: about one percent.

The above observations are based on the data from the 1995/96 survey, which i s now 7-8 years old. More recent data can be found in the 2000/01 Rural Consumption Survey, although the survey i s confined to rural areas. I t shows a slight increase in kerosene use for cooking, from 3 to 6.4 percent. On the other hand, the number o f households reporting use o f oil, electricity, and kerosene (unfortunately they are all lumped together in the question) declined slightly from 84 percent to 8 1 percent.

How would an increase of, say, NRs 4 per liter (going from the subsidized price o f Rs. 20 per liter to the market kerosene price o f Rs. 24, prices effective in June 2003) affect the budgets o f those in the bottom decile? Since household consumption data are available only for 1995/96, to obtain an estimate for 2002/2003 we assume that it grew at the same rate as private consumption from the national accounts (10.3 percent per year in nominal terms). In the absence o f more recent data, the quantities o f kerosene consumed (which in turn depend on consumption by individual households and the percentage o f households using kerosene, especially for cooking) are assumed to be the same as those observed in 1995/96. A price increase o f NRs 4 per l i ter would amount on average to an increase o f 0.3 percentage point of total household consumption in the bottom decile and o f 0.2 percent in the top decile.

Annex I11 Page 1 of 4

Poverty in Nepal

Poverty Remains Widespread

A few indicators give a sense of the depth o f poverty in Nepal, ranked 142 among 173 countries in the 2002 Human Development Index. Forty-two percent o f i t s people were considered poor in 1995/96 in terms of a national poverty l ine based on minimum food and non-food consumption. Forty percent of adult males and 65 percent o f females are illiterate; infant and child mortality are around 64 and 95 percent respectively.

Women and girls suffer even more. Female l i fe expectancy continues to be slightly lower than men's -- a rare occurrence since women tend to live longer -- because of high maternal mortality. One adult woman in three and one young woman in two i s illiterate double the rate for men. Fewer girls than boys attend school. Women and girls are also less likely to seek or receive health care when ill. Women carry a greater burden from onerous household activities such as collecting water and wood. They are not well represented in political and social l i f e and are disadvantaged in front o f the law.

The Poor are Predominantly in Rural Areas and Engage in Subsistence Agriculture

The last poverty assessment for Nepal was completed in 1998 and was based primarily on data from the 1995/96 Nepal Living Standards Survey I (NLSS I).32 While these data are now several years old, i t i s unlikely that the geographical, occupational, and social profile o f the poor has changed dramatically.

The 1998 poverty assessment found that the incidence of consumption poverty was much higher in rural than in urban areas (44 versus 23 percent) and that the urban Kathmandu Valley was significantly better o f f than the rest of the country (with an incidence of poverty o f 4 percent compared to a national average o f 42 percent). Poverty rates were higher in the more remote areas -- in the mountains (56 percent), and in the Mid- and Far-Western Development Regions (53 percent in the Terai and 72 percent in the hills and mountains). Table 1 reports figures on the incidence o f poverty, poverty gap, and illiteracy by region, from the 199996 survey.

The vast majority o f the Nepali people draw their livelihood from agriculture, and the poor are no different (See table 2 on sources o f income by consumption quartile). But the poor farm land o f poorer quality, do not have access to irrigation, credit, marketing, and agricultural services, and make limited use of fertilizers. Thus, they end up growing "poorer" crops -- potato, maize, barley -- mostly for their own consumption, and achieve lower yields. Wage work in agriculture provides a way to supplement income from cultivation, but the poorest of the poor have limited access to wage-earning opportunities, partly because o f remoteness and isolation. Off-farm employment opportunities are limited in rural areas, and migration to the Terai plains represents a coping strategy for many poor households. Illiteracy hinders progress in agricultural production and represents a formidable barrier to getting better employment opportunities outside agriculture.

A poverty update, based on information from various other surveys, i s underway and a full poverty assessment wil l be 32

conducted when the data from the NLSS I1 become available in mid-2004.

Annex I11 Page 2 of 4

Table 1: Regional Disparities, Nepal, 1995/96

Nepal 42 0.121 64

Urban Rural

23 0.070 37 44 0.125 61

Urban Kathmandu Valley 4 Other Urban 34 Rural Eastem Terai 42 Rural Central Terai 38 Rural Westem Terai 40 Rural Mid- and Far-West. Terai 53 Rural Eastem Hills/Mtns 28 Rural Central HillsMtns 61 Rural Westem Hills/Mtns 40 Rural Mid- and Far-West. Hills/Mtn 12

0.004 0.109 0.095 0.082 0.092 0.132 0.068 0.108 0.128 0.281

24 45 62 I1 69 12 59 66 54 13

Terai 42 0.099 69 Hills 41 0.136 58 Mountains 56 0.185 15

Source: Nepal Living Standards Survey 1995/96.

Table 2: Sources of Income by Consumption Quartile

Bottom 25 percent 50 5 35 10 25-50 percent 48 7 30 15 50-75 percent 49 8 27 16 Top 25 percent 43 11 22 23 Average 47 8 28 16 Source: Nepal Living Standards Survey 1995/96.

The reach o f infrastructure i s very l imited in rural areas, despite significant efforts made since the 1950s, when there was n o road outside the Kathmandu Valley, and n o road link to the rest o f the world. In 1995/96, the average rural household l ived more than f ive hours away by foot f rom a paved road and more than three hours f rom a vehicle-passable dirt road. Virtually n o one outside o f urban areas had a private telephone, and only nine percent o f rural households had access to electricity. Needless to say, access b y the poorest was even lower (for instance, only three percent o f a l l households in the bottom 25 percent, including those in urban areas, had access to electricity) (see Table 3).

Annex I11 Page 3 of 4

Table 3: Access to Infrastructure by Consumption Quartile

Bottom 25 percent 3 10 3 15 25-50 percent 50-75 percent Top 25 percent

3 12 6 14 5 15 11 23 19 43 32 37

Average 8 22 14 23 Source: Nepal Living Standards Survey 199996.

Indigenous ethnidcaste groups lagged behind in their income and asset levels, educational achievements, and human development indicators. People belonging to occupational castes and to marginalized and minority ethnic groups, such as the Tharu in the Terai and the Tamang in the hills, had higher poverty rates and lower social indicators in 1995/96.

Recent Progress has been Mixed

Some progress has been made in recent years on social indicators. Net primary school enrollment rose from 69 to 73 percent between 1996 and 2001, according to the Nepal Demographic and Health Survey (NDHS), primary completion rates have increased and average school going years has doubled for females. Literacy rates are rising, though the gender gap remains unacceptably high (table 4).

Table 4: Gender Disparities in Key Human Development Indicators, 1996 and 2000

Source: Nepal Human Development Reports, 1996 and 2001

Data from the same surveys indicate that the infant mortality rate has fallen from 79 to 64 per 1000 between 1996 and 2001, and under five mortality from 107 to 91 per 1000. This i s partly the result of successful immunization campaigns - the percentage o f children fully immunized has increased by 67 percent in the last five years. Total fertility has declined from 4.6 to 4.1 births per woman. But malnutrition rates remain high, with 50 percent of children under five years o f age stunted (short for their age), 48 percent underweight, and 10 percent wasted (thin for their age).

As mentioned, new data to assess trends in consumption poverty w i l l be available only in a year’s time, but some data are available for rural areas. Published data point to an increase in rural consumption with respect to 1995/96, but these need to be revised to take into account differences in data collection and analysis methodology. While good rains and substantial inflows o f remittances in the second half o f the 1990s may explain an improvement in rural consumption levels, the lack o f progress in reducing malnutrition calls this into question.

Annex I11 Page 4 of 4

A simple exercise o f projecting the incidence of poverty forward f rom 1995196 to 2001/02 using actual GDP growth rates as a proxy for private consumption growth and population growth rates based on the 2001 Census shows that the projections done in the 1998 poverty assessment, which showed a decline in poverty incidence, were broadly on track. But inequality may have changed during t h i s period, (for example if growth has been faster in urban than in rural areas), so the projections need to be taken with great caution.

Annex I V Page 1 of 3

Public Financial Management and Accountability in Nepal

1. The 2002 Country Financial Accountability Assessment (CFAA) indicates that although there are significant weaknesses in Nepal’s public financial accountability system, the foundations for reform are in place. Fiduciary risk in Nepal i s considered high - the level similar to that found in many developing countries - primarily due to the lack o f compliance with existing regulations.

2. The strengths o f Nepal’s public financial accountability system, as identified in the CFAA, include an impressive legal and regulatory fiduciary framework, comprised in part by these four elements:

+ The Financial Procedures Ac t (1999) and Financial Administration Regulations (1999) specify very detailed provisions for budget preparation, accounting and reporting on budget implementation, internal control procedures, and annual consolidated financial statements for the entire government. T o increase accountability, the Ministry o f Finance submits a detailed annual report to Parliament just prior to budget presentation comparing achievements wi th targets for each line ministry.

+ The Local Self-Governance Ac t (1999) clearly specifies roles and responsibilities, including those for financial management, for local government committees and councils.

+ The Office o f the Auditor General has complete legal and professional independence.

+ The Public Accounts Committee (PAC) discusses the annual Auditor General’s report and recommendations and forwards them to the Government wi th an implementation directive. PAC meetings, which are open to the public and the press, are held year round to address most aspects o f public sector financial management. However, in light o f the current interim administration, P A C has been disbanded until the new Parliament i s elected.

3. However, despite this impressive legal and regulatory fiduciary framework in Nepal, the CFAA indicated that the lack o f compliance and poor implementation o f regulations i s the single most important problem that affects public sector accountability.

Core Issues

4. The C F A A identified eight public financial accountability areas which are in need o f reforms: i) complying wi th constitutional, statutory, and regulatory framework b y tying budgets and case releases to results and outputs, ii) improving Nepalese public sector accounting and auditing standards and practices, iii) strengthening local level financial accountability, iv) strengthening the independence and capacity o f the Office of the Auditor General, v) strengthening the Public Accounts Committee and the Commission for the Investigation o f Abuse o f Authority, vi) reducing fiduciary risk on projects, vii) strengthening private sector accounting and auditing standards, and vi i i ) strengthening the regulation and monitoring o f NGOs.

5. The proposed PRSC w i l l support financial management reforms and capacity building measures under the “improving governance pillar”. Four priority areas were identified to address some of these financial management deficiencies:

+ Budgeting: The diagnostic work indicates that budget releases are not t ied to demonstrated results. Moreover, the budget classification i s not sufficiently detailed to isolate key

Annex IV Page 2 of 3

expenditures and the presentation i s not consistent wi th IMF’ s General Financial Statistics (GFS) format.

+ Accounting and Financial Reporting: The chart o f accounts does not meet financial and management reporting needs. Revenue and expenditure figures are not accurately tracked and reported to identify gaps between financial progress and physical outputs. Compliance w i th internal controls i s also weak.

+ Auditing: There i s not sufficient guidance to the Auditor General’s office regarding audit scope and selection o f agencies; risk-based auditing i s not in place. Moreover, the performance o f the Auditor General’s office i s not reviewed by an independent entity.

+ Transparency and Oversight:: Fiscal transparency i s currently l imited as accurate information related to revenues, expenditures, and physical performance o f projects i s not publicly disseminated.

Reform Strategy and Expected Results

6. Promoting a culture o f accountability requires strong political w i l l and an enforceable incentive and disincentive structure. Hence, improvements in financial management are closely related to c iv i l service reform and anti-comption efforts. These issues are elaborated in the main text and the rest o f this annex describes HMGN’ s efforts to implementing the CFAA recommendations.

Actions Taken and Underway

7. HMGN i s in the process of reforming i t s budget processes based on recommendations in the CFAA. The government has formally constituted a Reform Monitoring Committee chaired b y the Financial Comptroller General w i th members representing appropriate public and private sector agencies. Actions underway include:

+ Releasing budget resources in FY03 based on: i) priority for P1 projects and ii) new performance based criteria using the f i r s t two trimester fiscal reports

Reconciling Government arrears to public utilities

Piloting an expenditure tracking survey for education by the Financial Comptroller General’s office Designing a new Chart o f Accounts to align w i th I M F ’ s General Financial Statistics classification

Creating an autonomous Financial Accounting Standards Board and Board o f Auditing Standards

Submitting FY03 Auditor General’s accounts to a reputable external auditor.

+ +

+ +

Proposed Actions

9. B y the end of the three-year PRSC period, HMGN expects to:

+ Publish FY04 and FY05 revenue and expenditure figures each trimester and physical performance o f a l l P1 projects. Fiscal transparency w i l l be extended to the local level wi th revenue and expenditures o f DDC’s and VDC’s published in front o f their offices.

Annex I V Page 3 of 3

+ Adopt accounting and auditing standards in line wi th international standards

+ Implement expenditure tracking surveys and publicly disseminate results.

+ Pilot new Chart o f Accounts in line wi th I M F ’ s General Financial Statistics classification.

+ Adopt a risk-based audit approach and increase selectivity. Expand audit scope based on materiality considerations and risk-based assessments.

Submit FY04 and FY05 Auditor General’s accounts to an external auditor

Conduct an external audit o f the Nepal Rastra Bank and implement key recommendations o f the I M F ’ s Safeguards Assessment.

+ +

Annex V Page I of 2

At A Glance 10/7/03

POVERTY and SOCIAL

2003 I

Population, mid-year (million) GNI per capita (Atlas method, US$) ‘GDP per capita (US$) GNI (Atlas method, US$ billion)

Average annual growth, 1997-03

Population (%) Labor force PA)

Most recent estimate (latest year available, 1997-03) Poverty (% of population below national poverty line, 7996) Urban population (“A of totalpopulation) Life expectancy at birth (years) Infant mortality (per 7,000 live births) Child malnutrition (“A of children under 5) Access to an improved water source (% ofpopulation) Illiteracy (“A ofpopulation age 75t) Gross primary enrollment (% of school-age population)

Male Female

KEY ECONOMIC RATIOS and LONG-TERM TRENDS

GDP (US$ billions) (in percent) Gross domestic investmenffGDP Exports of goods and services/GDP Gross domestic savingdGDP Gross national savings/GDP

Current account balance/GDP Interest payments on external debVGDP Total external debt/GDP Total debt service/exports Present value of debffGDP (2001) Present value of debffexports (2001)

(average annual growth) GDP GDP per capita

1983

2.4

19.6 10.2 8.5

10.7

-7.4 0.2

18.5 6.5

1983-93 1993-03

5.1 4.3 2.7 2.0

Nepal

24.2 240 238 5.7

2.2 2.6

42 13 60 66 48 88 55

118 128 108

1993

3.7

22.6 18.4 12.2 14.5

-8.1 0.8

54.9 8.8

2002

-0.5 -2.7

South Asia

1,401 460

640

1.8 2.3

28 63 71

84 44 97

108 89

2002

5.5

24.6 16.1 11.8 25.7

2.6 0.4

52.9 4.6

28.1 74.0

2003

2.3 0.1

LOW- income

2,495 430

1,072

1.9 2.3

30 59 81

76 37 95

103 87

2003

5.7

26.1 14.6 11.3 25.6

-0.9 0.4

51.8 5.2

2003-07

4.8 2.2

1 Development dlamond’

Life expectancy

T Gross

primary nrollment

I Access to improved water source

-Nepal - - - - - - Low-income group

Economic ratlos’

Trade

T

Investment Domestic savings

I

Indebtedness

-Nepal - - - Low-income group

STRUCTURE of the ECONOMY

(“A of GDP) Agriculture Industry

Services

Private consumption General government consumption Imports of goods and services

Manufacturing

(average annual growth) Agriculture Industry

Services Manufacturing

1983

60.3 12.8 4.6

26.9

81.3 10.1 21.3

1983-93

3.4 9.2

10.1 4.7

1993 2002 2003

41.3 39.6 39.6 20.2 20.9 20.7 8.6 8.1 7.9

38.4 39.5 39.7

79.3 78.1 78.2 8.5 10.0 10.5

28.8 28.8 29.3

1993-03 2002 2003

3.3 2.2 2.1 4.9 -3.3 2.3 4.2 -10.0 0.4 5.5 -1.4 2.7

Growth of GDP (%) I L T

I -GDP

Note: 2003=2002/03.

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

Annex V Page 2 of 2

PRICES and GOVERNMENT FINANCE

Domestic prices (% change) Consumer prices Implicit GDP deflator

Government finance (% of GDP, includes current grants) Current revenue Current budget balance Overall surplus/deficit

TRADE

(US$ millionsj Total exports (fob)

Food Pulses Manufactures

Total imports (cif) Food Fuel and energy Capital goods

BALANCE of PAYMENTS

[US$ millions) Exports of goods and services Imports of goods and services Resource balance

Net income Net current transfers

Current account balance Official transfers

Financing items (net) Changes in net reserves (-=increase)

Memo: Reserves including gold [US$ millions) Conversion rate (DEC, local/US$j

EXTERNAL DEBT and RESOURCE FLOWS

[US$ millions) Total debt outstanding and disbursed

IBRD IDA

Total debt service IBRD IDA

Official grants Official creditors Private creditors Foreign direct investment Porlfolio equity

World Bank program Commitments Disbursements Principal repayments Net flows Interest payments Net transfers

Composition of net resource flows

1983

14.0 12.3

1983

82

457

1983

249 483

-233

12 36

-1 85 4

137 44

13.8

1983

453 0

172

20 0 2

94 68

1 -1 0

45 31 0

31 1

29

1993

9.9 11.2

1993

379

860 101 84

169

1993

675 1,053 -378

8 75

-295 77

380 -1 62

571 48.0

1993

2,010 0

832

69 0

10

77 156 -1 0

6 0

0 69 4

66 6

60

2002

2.9 3.2

11.5 -0.1 -5.7

2001

942 65 56

256 1,773

81 338 31 2

2002

1,060 1,687 -626

-7 777

143 143

-323 36

1,055 75.9

2002

2,933 0

1,156

88 0

26

143 4 0

-4 0

23 38 18 20 8

12

2003

4.7 3.5

12.3 -4.0 -4.0

2003

782

1,707

2003

949 1,821 -872

-6 a25

-53 161

-1 43 -1 23

1,184 77.8

2003

2,975 0

1,185

96 0

30

161

0 -2 0

97 27 21

6 9

-3

Inflation (%)

15 T

I -I 98 99 A 01 I d: -GDP deflator ' 0 - C P I

Export and Import levels (US$ mill.) ~2.000 T

97 98 99 00 01 02 03

E Exports E Imports

Current account balance to GDP (%)

110 T

5

0 99 00 01 02

Composition of 2002 debt (USS mill.)

~5 G 3 6

A - IBRD 6 . IDA D. Other multilateral F - Pnvate C . IMF

E - Bilateral

G. Short-term

~~

Development Economics 10/7/03

Social Indicators

Annex V I Page 1 of 1

~~ ~~~

Latest single year Same regiodincome group

1970-75

13.1 2.0 5.0 6.2

120 17

1980-85

16.2 2.1 7.8 5.9

170 35 33

1995-2001

23.6 2.4

12.2 4.2

42.0 23.0 44.0

250 141 143

36.7 7.6

44.8

South Asia

1,377.8 1.8

27.8 3.2

450

Low- income

2,505.9 1.9

30.8 3.5

430

POPULATION Total population, mid-year (millions)

Urban population (Yo of population) Total fertility rate (births per woman)

POVERTY (“7 of population) National headcount index

Urban headcount index Rural headcount index

Growth rate (“h annual average for period)

INCOME GNI per capita (US$) Consumer price index (1995=100) Food price index (1995=100)

INCOMEKONSUMPTION DISTRIBUTION Gini index Lowest quintile (% of income or consumption) Highest quintile (% of income or consumption)

SOCIAL INDICATORS Public expenditure

Health (“h of GDP) 0.9 1 .o 1.1 Education (“% of GDP) 1.5 2.7 3.7 2.5 2.8 Social security and welfare (“h of GDP) 0.1 0.1 0.4

Net primary school enrollment rate (“7 of age group)

Total 72 Male 77 Female 67

Access to an improved water source (“7 of population)

Total 88 84 76 Urban 94 94 90 Rural 87 80 70

Immunization rate (“7 under 12 months)

Measles 34 71 58 60 DPT 32 72 65 61

Child malnutrition (“h under 5 years) 69 48 Life expectancy at birth (years)

Total 45 51 59 63 59 Male 46 52 60 62 58 Female 44 50 59 63 60

Infant (per 1,000 live births) 149 117 66 71 80

Adult (15-59)

Mortality

Under 5 (per 1,000 live births) 223 170 91 99 121

Male (per 1,000 population) 482 376 314 252 312 Female (per 1,000 population) 476 395 314 202 256

Maternal (modeled, per 100,000 live births) 830 Births attended by skilled health staff (“h) 10 12 42

Notes: 0 or 0.0 means zero or less than half the unit shown. Net enrollment rate: break in series between 1997 and 1998 due to change from ISCED76 to ISCED97; ratios exceeding 100 indicate discrepancies between the estimates of school-age population and reported enrolment data.

2003 World Development Indicators CD-ROM, World Bank

Annex VI1 Page 1 of 2

Key Economic Indicators As of 10/8/2003

Actual Estimate Projected Indicator 98/99 99/00 00101 01/02 02/03 03/04 04/05 05/06

National accounts (as % of GDP) Gross domestic producta

Aaculture Industry Services

Total consumption Gross domestic fixed investment

Government investment Private investment

Exports (GNFSY Imports (GNFS)

Gross domestic savings Gross national savings

Memorandum items Gross domestic product (USS million at current prices) GNI per capita (US$, Atlas method) GDP per capita (US$)

100 40.1 21.2 38.7

86.4 19.1 7.0

12.1

22.8 29.7

13.6 20.6

5034

230 228

Real annual growth rates (%, calculated from 1985 prices)

Real annual per capita growth rates (%, calculated from 1985 prices)

Gross domestic product at market prices

Gross domestic product at market prices

4.5

2.2

Balance of Payments (US$ millions) Exports (GNFSf

Merchandise FOB Imports (GNFS~

Merchandise FOB Resource balance Net private transfers Current account balance Official transfers

Long-term loans (net) Official Private

Other capital (net, incl. errors &omissions) Change in reserves

1270 763

1595 1390

338 25

137 157 89 68 -7

-183

-325

Memorandum items

Annual growth rates (in US$ terms) Resource balance (% of GDP) -6.5

18.0 Merchandise imports (CIF) -10.4 Merchandise exports (FOB) (excluding re-exports)

100 39.6 21.5 38.9

84.8 19.3 7.0

12.4

23.3 32.4

15.2 24.6

5494

240 243

6.1

3.8

1433 97 1

1922 1713 -489 497

28 133 148 97 52 61

-240

-8.9

37.3 23.3

100 100 38.4 39.6 21.3 20.9 40.3 39.5

85.1 88.2 19.0 19.3 7.6 7.6

11.4 11.7

22.4 16.1 31.5 28.8

14.9 11.8 27.2 25.7

5582 5549

240 230 242 235

4.8 -0.5

2.4 -2.7

1359 1060 942 754

1984 1687 1773 1496

680 777 64 143

108 143 96 38 60 58

-625 -626

36 -20 -86 -213 -80 36

-11.2 -11.3

4.6 -18.1 3.5 -15.6

100 39.6 20.7 39.7

88.7 19.2 7.0

12.1

14.6 29.3

11.3 25.6

5739

240 238

2.3

0.1

949 633

1821 1630 -872 825 -53 161 45 74

-29 133

-123

-15.2

2.4 9.0

100 38.7 22.7 38.6

88.4 20.0 7.5

12.5

16.0 30.9

11.6 24.9

6408

250 259

3.5

1.2

1022 680

1982 1777

867

243 13 47

-34 166 -77

-960

-107

-15.0

7.4 9.0

100 100 38.1 37.4 23.0 23.3 38.9 39.3

87.6 87.1 20.5 21.5

7.9 8.1 12.6 13.4

18.3 18.1 32.9 32.7

12.4 12.9 25.2 25.2

6812 7311

260 280 270 283

4.6 5.4

2.3 3.0

1246 1322 883 935

2243 2389 2024 2155

891 912

252 248 16 27

-997 -1067

-121 -169

37 -41 -22 68 166 193 -70 -65

-14.6 -14.6

5.9 6.0 13.9 6.5

Annex VI1 Page 2 of 2

Key Economic Indicators (Continued)

Actual Estimate Proiected Indicator 98/99 99/00 00101 01/02 02/03 03/04 04/05 05/06

Public finance (as % of GDP at market price$ Total revenues Total expenditure Current expenditures Capital expenditure and net lending

Overall deficit before grants Overall deficit after grants Domestic financing (net) Foreign financing (net)

10.2 10.7 11.4 11.5 12.3 12.4 12.8 13.4 15.4 15.7 17.6 17.2 16.3 18.7 18.5 18.2 9.4 9.6 11.2 11.6 11.6 13.1 12.5 12.1 6.1 6.1 6.4 5.7 4.7 5.6 6.0 6.1 5.2 5.0 6.2 5.7 4.0 6.3 5.7 4.8 3.9 3.5 4.5 4.3 1.9 3.6 2.6 2.0 1.4 0.9 2.7 2.9 1.2 1.7 1.3 0.6 2.5 2.6 1.8 1.4 0.7 1.4 1.3 1.4

Monetary indicators M21GDP 44.7 49.0 52.3 53.2 55.3 55.6 Growth of M 2 (%) 20.8 21.8 15.2 4.4 8.3 11.1 Private sector credit growthltotal credit growth (%) 90.9 109.6 88.0 59.2 132.1 107.4

Price indices Real exchange rate (eop; percentage change -= depreciation) 1.3 -2.2 3.8 -9.2 -1.3 Consumer price index (% change) (FY85=100) 11.4 3.4 2.4 2.9 4.7 5.4 4.6 4.2 GDP deflator (% change) (FY85=100) 8.8 4.6 3.2 3.2 3.5 4.9 4.6 4.6

a. GDP at factor cost. b. "GNFS" denotes "goods and nonfactor services." c. Includes net unrequited transfers excluding official capital grants. d. Includes use of IMF resources. e. Consolidated central government.

Annex VI11 Page I of I

Key Exposure Indicators As of 10/6/2003

Actual Estimate Projected Indicator 98/99 99/00 00/01 01/02 02/03 03/04 04/05 05/06

Total debt outstanding and disbursed (TDO) (US$mIa

Net disbursements (US$mla

Total debt service (TDS) (US$m)a

Debt and debt service indicators (%) TDOKGS~ TDO/GDP TDSKGS Concessional/TDO

IBRD exposure indicators (%) IBRD DS/public DS Preferred creditor DS/public DS (%)' IBRD DSKGS IBRD TDO (us$mId

IDA TDO (us$mld Share of IBRD portfolio (%)

IFC Loans (US$m) Equity and quasi-equity (US$m)e

MIGA MIGA guarantees (US$m)

2,702.0

141.0

84.0

162.6 53.7

5.1 97.5

0.0 61.5 0.0 0.0 0.0

1,107.0

56.8 3.4

2,848.0 2,786.0 2,933.0 2,993.0

146.0 -62.0 147.0 60.0

83.0 84.0 88.0 96.0

141.8 131.5 152.9 160.9 51.8 49.9 52.9 52.2 4.1 4.0 4.6 5.2

98.4 97.7

0.0 0.0 0.0 0.0 64.9 72.3 73.1 74.1 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

1,123.0 1,102.0 1,156.0 1,185.0

57.3 56.0 54.0 3.4 3.7 3.2

3,022.0

29.0

114.0

152.5 47.2

5.8

0.0 74.8 0.0 0.0 0.0

1,193.0

3,054.0 3,097.0

32.0 43.0

120.0 125.0

136.7 132.6 44.8 42.4

5.4 5.4

0.0 0.0 75.9 75.9 0.0 0.0 0.0 0.0 0.0 0.0

1,204.0 1,217.0

33.0 33.0 19.1 30.1

a. Includes public and publicly guaranteed debt, private non-guaranteed, use of IMF credits and net short-term capital. b. "XGS" denotes exports of goods and services, including workers' remittances. c. Preferred creditors are defined as IBRD, IDA, the regional multilateral development banks, the IMF, and the Bank for

International Settlements. d. Includes present value of guarantees. e. Includes equity and quasi-equity types of both loan and equity instruments.

Annex IX Page 1 of 4

Public In format ion N o t i c e EXTERNAL RELATIONS DEPARTMENT

Public Information Notice (PIN) No. 03/110

September 5,2003

International Monetary Fund 700 19' Street, NW Washington, D. C. 20431 USA

IMF Concludes 2003 Article I V Consultation with Nepal

On August 22,2003, the Executive Board of the International Monetary Fund (IMF) concluded the Article lV consultation with

Background

Nepal remains among the poorest countries in the world with almost 40 percent o f the population l iving in poverty due to insufficient growth and inadequate targeting of the poor. During the 1990s, macroeconomic conditions remained broadly stable and the fiscal position was manageable, but growth was constrained by financial sector weaknesses, weak public sector management, and poor governance. In the financial sector, Nepal Rastra Bank (NRE3) oversight i s s t i l l weak, and intermediation i s inadequate largely due to a banking environment in which loan default i s endemic, especially by well-connected borrowers. Partly as a result o f this, the two largest commercial banks now have large nonperforming assets. Similar problems exist at two large development banks. In the public sector, investment has been spread thinly over projects and enterprises suffer from weak management and accountability. More recently, intensified security problems and adverse external developments contributed to lower growth and the fiscal position has deteriorated since 2000/01.

The ceasefire agreed in January 2003 with the insurgents has renewed hopes for peace and efforts have been made to sustain the reform momentum. Progress in achieving lasting peace would facilitate poverty reduction and implementation o f policies contained in the government's Poverty Reduction Strategy Paper (PRSP). However, political uncertainties persist as major political parties continue to maintain that the appointment of governments by the King since the dissolution of parliament i s unconstitutional. The parties have also refused to jo in the peace talks.

GDP growth i s estimated to be 2 percent in 2002103. The ceasefire has helped restore some normality in the transport and service sectors and the decline in tourism may have halted. There are also signs that some

33 Under Article IV o f the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. O n retum to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. A t the conclusion of the discussion, the Managing Director, as Chairman o f the Board, summarizes the views o f Executive Directors, and this summary i s transmitted to the country's authorities.

Washington, D.C. 20431 Telephone 202-623-7100 Fax 202-623-6772 www,imf,org

Annex IX Page 2 of 4

exports and manufacturing production are rebounding. Inflation, which rose to about 7% percent in mid-May (12-month basis) reflecting price developments in India, administrative price changes, and supply factors, i s expected to moderate by early 2003/04.

The 2002/03 budget met revised targets set in a mid-term review. Based on weak revenue performance due to lower activity during the first half of the year and external aid shortfalls relative to the initial budget targets, the authorities revised the budget at mid-year. Specifically, the tax revenue target and external financing were revised down. To compensate for these shortfalls, total expenditure was also revised down and the revised budget set a net domestic financing target of 2 percent o f GDP. Following the announcement o f the ceasefire, economic activity picked up and revenue performance improved. However, capital spending was below the revised budget, reflecting continued implementation constraints at the local level. As a result, domestic financing was around 1% percent o f GDP.

Monetary policy has been accommodative and the real effective exchange rate has depreciated. To help economic recovery, the NRB lowered cash reserve requirements by 1 percentage point in August 2002 and maintained a refinancing facility for lending to “sick” industries. Aided by the recovery in activity and monetary easing, private credit appears to have revived and higher remittances contributed to a rise in banking system foreign assets. However, reserve money growth has been curtailed, due largely to lower net credit to the government. Lending and deposit rates have declined somewhat. The Nepalese rupee has depreciated in real effective terms since early 2002, reflecting the peg to the Indian currency which has appreciated only somewhat against the weakening U S dollar.

Balance of payments developments turned favorable in mid-2002/03 and external reserves are adequate. Large and increasing remittances helped buoy the current account. Garment exports began recovering in late 2002, while recorded exports to India declined, carpets and pashmina exports continued to stagnate, and imports increased with the recovery. The current account (excluding official transfers) i s expected to move into a deficit o f about % percent o f GDP, but with higher aid and other inflows official foreign exchange reserves are expected to r ise to US$1 bil l ion (6% months of imports of goods and services).

In 2002/03, significant progress was made in financial sector reform implementation. The NRl3 took steps to reduce staffing through a voluntary retirement scheme (VRS). Progress was made in restructuring the two largest commercial banks, which had external management teams installed. The teams have prepared management plans, made progress in assessing the banks’ financial status, and proposed VRSs to reduce overstaffing. Some improvements have already taken place with success in loan recovery and branch rationalization, although loan recovery from well-connected borrowers continues to be difficult. Prioritization o f budgetary spending improved, anti-corruption efforts were boosted, and public enterprise reform implementation and governance reforms progressed. To improve prioritization, a Medium Term Expenditure Framework was introduced with World Bank assistance to help align development spending with national and sectoral priorities. Administered price increases for petroleum products were announced in March 2003, although some price increases were rolled back under public pressure. Liquidation procedures were initiated for four public enterprises; preparations for the privatization o f one enterprise were brought to an advanced stage.

Governance reforms progressed and anti-corruption efforts were boosted. The cabinet approved in September 2002 the elimination o f 7,500 vacant civi l service positions. To tackle corruption in public life, the Commission for Investigation o f Abuse o f Authority and a newly established Judicial Commission

Annex IX Page 3 of 4

initiated investigations against politicians and revenue officials perceived to have accumulated unaccountable assets. The Anti-Corruption Strategy was adopted.

Executive Board Assessment

Executive Directors stressed that to address the pervasive level o f poverty in Nepal, growth needs to be raised significantly over the medium term through vigorous implementation o f structural reforms, particularly in the financial and public sectors. In this regard, Directors welcomed the authorities’ Poverty Reduction Strategy Paper (PRSP), which i s founded on broad-based growth, social sector development, targeted programs for the poor and deprived groups, and improved governance. Directors looked forward to considering a Joint Staff Assessment o f the PRSP in the near future. They encouraged the authorities to reach early agreement on a program that could be supported by the Poverty Reduction and Growth Facility to help achieve PRSP goals.

Directors welcomed the ceasefire agreement with the insurgents reached in January 2003. They underlined that continued peace was essential to help sustain the economic recovery currently under way. Directors also noted that progress in the peace talks and the build up of confidence should help relieve budgetary pressures for security spending.

Directors commended the authorities’ for maintaining broad fiscal stability to create conditions to support economic growth. Looking forward, Directors endorsed the authorities’ fiscal strategy based on revenue mobilization, expenditure prioritization, and a reduction in domestic borrowing. They welcomed the 2003/04 budget as the f i rst step in implementing this strategy. However, Directors called for a determined effort to meet the revenue targets and to resist spending pressures. To raise revenue over the medium term, Directors suggested cuts in exemptions, improvements in tax and customs administration, and increases in the VAT rate. Directors welcomed the steps taken to prioritize development spending to help achieve poverty reduction goals, including the introduction of a medium-term expenditure framework, and encouraged the extension of such efforts to all expenditures. Directors noted that the envisaged reductions in domestic borrowing would help maintain fiscal sustainability over the medium term, especially in view o f potentially large contingent liabilities from financial sector and public enterprise reforms. Continued technical assistance in the fiscal area w i l l help address capacity constraints.

Directors agreed that monetary and exchange rate policies should remain geared to supporting the exchange rate peg to the Indian rupee, stressing that the peg had served Nepal well given i t s close links with India. Looking forward, they noted that prospective external developments, such as the phasing out o f the Multi- Fibre Agreement, would likely have implications for external competitiveness and the appropriate choice and level of the peg. Directors pointed to the need for policy measures to ensure that remittances are sustained, as well as for efforts to diversify Nepal’s export base. They also noted that external competitiveness could be enhanced by measures to raise labor productivity and lower transport costs.

Directors commended the authorities for progress in financial sector reforms, but noted that much remained to be done. They stressed the need for strengthening Nepal Rastra Bank (NIB) supervision o f the financial sector. The NRB should also improve performance incentives for skilled personnel, while encouraging separations at lower levels. Directors welcomed the appointment o f external managers at the two largest insolvent commercial banks, and noted recent steps taken by the new managers to improve the financial condition o f the banks. To help support these efforts and, more generally, to create a sound banking

Annex IX Page 4 of 4

environment, Directors noted the authorities’ intention to phase out priority sector lending requirements, and emphasized the effective implementation o f recently adopted debt recovery mechanisms, including the Debt Recovery Tribunal and blacklisting o f loan defaulters.

Directors welcomed ongoing public sector reforms, including the elimination o f vacant positions, the introduction o f merit-based promotions, the decompression o f the wage scale, as well as improvements in the public procurement process. Looking forward, Directors recommended the adoption o f civi l service accountability in order to improve policy implementation. They welcomed the public enterprise reform efforts that would lower government ownership in the economy and increase the enterprises’ net budgetary contribution-through privatization and restructuring o f viable enterprises and liquidation o f unviable ones. Several Directors stressed that due regard should be paid to the pace and sequencing o f these reforms. Also, an appropriate compensation scheme could help smooth implementation o f workforce reductions. Directors welcomed recent efforts to combat corruption, but emphasized the need to pursue forcefully those responsible for the misuse o f public funds. Directors supported the authorities’ plans to increase decentralization to enhance service delivery. However, they noted that the implementation o f these measures should be accompanied by improved public sector governance and capacity building at the local level.

Directors supported measures to improve the business climate for private sector development through legal reforms and streamlining o f administrative procedures to facilitate trade. They recommended revisions to labor legislation to make labor hiring more flexible and modifications to the Company and Insolvency Acts to allow more orderly and timely exit of unviable f m s .

Directors commended Nepal for i t s open trade regime, and welcomed the authorities’ efforts to gain early World Trade Organization (WTO) accession. Directors welcomed the elimination o f the exchange restriction arising from quantitative limits on payments for personal travel. Directors encouraged the authorities to further improve statistics to enhance policy formulation and monitoring. They urged full implementation o f Fund technical assistance recommendations.

Public Information Notices (PINS) are issued, (i) at the request o f a member country, following the conclusion o f the Article IV consultation for countries seeking to make known the views o f the IMF to the public. This action i s intended to strengthen IMF surveillance over the economic policies o f member countries by increasing the transparency o f the I M F ’ s assessment o f these policies; and (ii) following policy discussions in the Executive Board at the decision o f the Board. The Staff Report for the 2003 Article I V Consultation with Nepal i s also available.

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