Sri Lanka - Municipal Management Project

Damnist eof The World Bn FaR OMCIAL USE ONLY Report No. P-4224-CE REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED CREDIT OF SDR 11.3 MILLION TO THE DEMOCRATIC SOCIALIST REPUBLIC OF SRI LANKA FOR A MUNICIPAL MANAGEMENT PROJECT April 24, 1986 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed withouL World Bank authorization.  CURRENCY EQUIVALENTS Currency Unit Sri Lanka Rupee US$ 1.00 = SL Re 28.0 SL Re 1.00 US$ 0.036 ABBREVIATIONS AND ACRONYMS CEB - Ceylon Electricity Board CHBP - Center for Housing, Building and Planning CITP - Construction Industry Tra'ning Project CM - Colomibo Mhnicipal Council ICTAD - Institute for Construction Industry Training and Development LGTRI - Local Government Training and Research Institute LLDF - Local Loan Development Fund ILGHC - Ministry of Local Government, Housing and Construction NEDA - National Housing Development Authority NIBM - National Institute of Business Nanagenent SLIDA - Sri Lanka Institute of Development Administration UDA - Urban Development Authority ULAs - Urban Local Authorities UPU - Urban Program Unit WDB - National Water Supply and Drainage Board FISCAL YEAR January 1 - December 31  FOR OMCLAL USE ONLY SRI LANKA NUNIr-PAL MANAGEMENT PROJECT Credit and Proiect SumsarY Borrower: Democratic Socialist Republic of Sri Lanka Amount: SDR 11.3 millicn (US$13.0 million equivalent) Terms: Standard Project Description: The objectives of the project are to support the Government of Sri Lanka's sector policy adjustment process and strengthen the capacity of the Ministry of Local Government, Housing and Construction (MLGUC) for improving the managerial, financial and service delivery performance of urban local authorities (ULAs). The project supports the Goverment's strategy of further decentralization of authority by developing greater accountability in ULAs, introducing an incentive-based system of budgetary transfers, improving local resource mobilization, and implementing a concerted municipal management training effort. The project ccmprises: (a) technical assistance and studies in the areas of urban management and policy, financial management, local resource mobilization, urban service delivery, mapping and human resource development; (b) demonstration municipal civil works; (c) aerial photography, surveys and map production for urban areas; and (d) equipment, vehicles and supplies required for the efficient provision of the proposed technical assistance and training. By providing more efficient and cost-effective urban infrastructure and services, the urban population would benefit from an improved standard of living and the enterprises from increased productivity. The foreseeable risks are three, none of which is unduly serious: (a) lack of political support to reforms; (b) limited coordination capacity at the national level; and (c) insufficient availability of qualified local manpower at the national and ULA levels. This document has a restricted distribution and may be used by recipients only in the performance of their ofAicial duties Its contents may not otherwise be disclosed without World Bank authorization.  -ii- Estimated Coat: jJ Local EQKeign Total - -(US$ Million)-- Urban MNeagen ent and Policy 0.71 2.21 2.92 Financial Managenent and Resource Mobilization 0.81 2.16 2.97 Service Delivery 2.84 2.92 5.76 Napping 0.85 2.65 3.50 Human Resource Development 0.43 2.00 2.43 Project Administration 0D- 0,08 Total Base Cost 5.72 11.94 17.66 Physical Contingencies 0.02 0.25 0.27 Price Contingencies 0.84 1.2 -2,46 Total Project Cost 6.58 13.81 20.39 Financing Plan: Local FoEig Tota - (Us$ Million)--- Goverzent 6.58 0.81 7.39 IDA QMOQ 13.00 13.00 Total 6.58 13.81 20.39 Est&mated Disbursements: IDA FY MflL FY11 1m 9 I 1I0F9 FY92 1711 lxii (US$ Million) Annual 1.04 3.41 3.50 2.14 1.42 0.98 0.31 0.20 Cumulative 1.04 4.45 7.95 10.09 11.51 12.49 12.80 13.00 Economic Rate of Return-:, Not applicable StAffi ADraisi- lleport: Not applicable Nap: IBRD 19519 &J Includes taxes and duties of US$0.41 million.  INTERNATIONAL DEVELOPMENT ASSOCIATION REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED CREDIT TO THE DEKOCRATIC SOCIALIST REPUBLIC OF SRI LANKA FOR A MUNICIPAL MANAGEMENT PROJECT 1. I submit the following report and recommendation on a proposed credit to the Democratic Socialist Republic of Sri Lanka for SDR 11.3 million (US$13.0 million equivalent) on standard IDA terms to help finance a municipal management project. PART I - THE ECONOMY 1/ 2. A country economic memorandum, "Sri Lanka: Recent Economic Developments and Policies for Growth" (Report No. 5628-CE, dated May 14, 1985) was distributed to the Ezecutive Directors on May 28, 1985. Country data are provided in Annex I. 3. After almost ten years of low growth at 2.9 percent per annum, Sri Lanka, in 1977, initiated a new development strategy. It entailed a package of policy measures to liberalize the economy and allow a greater role for the private sector. These policies, supported by the IMF, were designed to: (a) reduce government intervention in comodity markets; (b) reduce government consumption subsidies and restore producer incentives and public savings; and Cc) create a favorable environment for private (foreign and domestic) invest- ment through tax concessions, the creation of an Investment Promotion Zone, and the unification and depreciation of the exchange rate. Two important characteristics of this policy reform package were: (a) periodic increases in the domestic support price for paddy (to bring it into line with world prices) that spurred a highly positive response from paddy producers; and (b) a decline in the cost of selected subsidies and transfers from about 10 percent of GDP in 1977 to about 3 percent by 1981. 4. At the sAme time, the Covernment began to implement an ambitious public investment program centered on three major initiatives: (a) accelerated implementation of the Mahaweli Ganga Development Program, the 1/ This part is substantially unchanged from Part I of the President's Report for the Second Industrial Development Project (Report No. 4284-CE), which was approved by the Executive Directors on May 8, 1986.  -2- largest multipurpose river basin development program ever undertaken in Sri Lanka; (b) establishment of a 200-square mile free trade zone to attract foreign investors located north of Colombo near the international airport; and (c) institution of a massive housing and urban renewal program focusing mainly on the Colombo metropolitan region, including the construction of a new capital complex at Kotte, a suburb of Colombo. As the public investment program gained momentum, its share in GDP jumped from 6 percent in 1977 to an average of 13 percent in 1978/79 and a peak of 19 percent in 1980. The public investment was financed in part by domestic resources (generated, in turn, by a reduction in subsidies and transfers) and, in part, by high levels of foreign aid. 5. The initial result of both the policy reforms and increased level of investment was an impressive jump in the GDP growth rate during 1977-80 to an annual average of 6.8 percent. The growth rate subsequently declined to a more sustainable 5.3 percent in 1980-83 and 5 percent in 1984-85. Underlying the increased growth of output was the expansion of paddy production, garment exports, construction, and tourist services. The growth rate of paddy production averaged 5.7 percent a year during 1978-85 with the result that rice imports declined sharply and averaged only 10 percent of total rice consumption during that period compared to 33 percent during 1970-77. Manufactured garment exports increased from US$12 million in 1977 to an estimated US$300 million in 1985 and now account for 80 percent of non-petroleum manufactured exports. Tourist arrivals increased from 150,000 in 1977 to 400,000 in 1982. However, due to ethnic disturbances, arrivals have declined since to 320,000 in 1983/84 and an estimated 260,000 in 1985. 6. The rapid expansion in aggregate demand, led by high levels of public investment, resulted in serious financial imbalances affecting the budget and the balance of payments. The massive public investment initiated in 1977 led to increases in budgetary spending from 23 percent of GDP in 1977, to a record 43 percent in 1980. These high levels of spending, however, were not accompanied by corresponding increases in fiscal revenues. When the economy began to show serious signs of "overheating" in the early 1980s, the Government squeezed current spending by reducing subsidies and by placing limits on already inadequate public sector salaries and operation and main- tenance expenditures. But with severe limits on the extent to which these expenditures could be curtailed, the Government was impelled to borrow heavily to finance the deficits which varied between 10 and 17 percent of GDP during 1981-85. During that period, 45 percent of the deficits were financed by foreign aid, 10 percent were financed by foreign commercial borrowings and 45 percent by domestic borrowing. 7. The high levels of of investment also spilled over into the balance of payments. Between 1977 and 1980, import volumes grew at an average annual rate of 19 percent, while imported investment goods increased from US$83 million to US$493 million, and intermediate goods and petroleum imports tripled in current prices. As a result of this fairly broad-based expansion, merchandise imports as a share of GDP increased from 23 percent in 1977 to 51  -3- percent in 1980. Export volumes, however, expanded at a much lower rate (an average annual growth rate of 5 percent between 1977 and 1980) as the decline in tree crop export volumes offset the strong growth in garment exports from firms established in the Investment Promotion Zone. Consequently, merchan- dise exports as a share of GDP increased from 21 percent in 1977 to only 26 percent in 1980. These diverse trends in the volume of trade were accom- panied by a 26 percent deterioration in the terms of trade over the same period. Rapid growth in tourism receipts and private remittances from abroad failed to offset this deterioration in the trade account, and the current account balance deteriorated from a surplus equivalent to 2.4 percent of GDP in 1977 to a record deficit equivalent to 19.8 percent of GDP in 1980. Deficits in 1978 and 1979 were more than offset by increased net aid disbursements, and Sri Lanka continued to add to international reserves. But, in 1980 the situation changed, when the current account deficit rose to $800 million. It was financed by concessional flows, use of reserves (which declined by $220 million) and recourse to commercial borrowing. 8. ReaLizing that a continuation of the 1980 trends would result in serious financial instability, the Government initiated an adjustment program in 1981. The measures agreed upon initially, in consultation with the IMF, includev tighter overall monetary policy, a substantial reduction in govern- ment spending, and a gradual realignment of the exchange rate. The economy began to respond positively by the end of 1981 (when the current account deficit in the balance of payments declined to 13.7 percent of GDP and the budgetary deficit to 15.5 percent), but in 1982 - a year in which there were presidential elections and a referendum to extend the life of Parliament - the political resolve to continue to apply the needed policy mix weakened. As a result, both the external and internal deficits increased in 1982 (to 15.3 percent and 17.3 percent, respectively) and the GDP growth rate declined to 5.1 percent. Although policy measures did contribute to the decline in the current account deficit of the balance of payments in 1983 and 1984 (12.4 percent of GDP in 1983 and 3.7 percent in 1984), the primary factor was the improvement in the terms of trade as a result of higher tea prices. With the subsequent decline in the price of tea, the terms of trade deteriorated in 1985 and the current account deficit of the balance of payments increased to 8 percent of CDP. Furthermore, on account of lower receipts from taxes on exported tea and higher defense expenditures, the overall budget deficit increased from 10 percent of GDP in 1984 to 11 percent in 1985. Because the price of tea declined in the second half of 1985, however, its effects on the budget will mostly be felt in 1986 when the fiscal deficit may turn out to be much higher. 9. Achieving a more viable internal and external financial position are now two prime policy objectives for Sri Lanka. To improve the external position, one of the foremost requirements of government policy will be to restructure the economy towards exports rather than producing for the very limited domestic market. With the exception of garments, for which Sri Lanka has a particularly strong comparative advantage, exports have performed poorly. A major focal point for improvinig export performance is the tree  -4- crop sector, which, as a result of more than a decade of neglect, has experienced a stagnant level of production. This trend must be reversed. To promote export activities, a more neutral incentive framework is needed, including a foreign exchange policy that would permit the full diversity of Sri Lanka's comparative advantage to develop. 10. The Government has recently indicated its determination to pursue reforms in this sector. In 1985, it reduced the overall tax burden on tree crops. This reduction, in combination with the management/incentive reform package for state-owned plantations implemented in early 1984, has improved incentives for producers throughout this traditionally overtaxed subsector. The Government has also introduced tariff changes, based on recommendations made in the final report of the Presidential Tariff Commission on trade taxes, aimed at reducing the overall tariff level and the variance of effec- tive protection among sectors. 11. The comparatively high levels of social welfare expenditures which the population has long enjoyed and which cannot easily be reduced, together with sharply increased defense expenditures, means that the Government must renew its efforts to improve domestic resource mobilization -- especially in the public sector - to pay for these outlays. Improving the domestic finan- cial situation will require broadening the tax base thus increasing tax revenues and reducing unproductive government expenditures. A focal point of these measures will have to be the public sector enterprises, which account for 40 percent of the value added in the non-petroleum manufacturing sector, but are a heavy burden on the budget because of high protection from external competition, administered prices for their products, their monopolistic or quasi-monopolistic position, and the inefficient use of resources. They will have to improve their management and reduce the support they obtain from the budget. 12. Throughout the entire 1978-85 period, the response of the interna- tional aid community to the Government's development efforts has been enthusiastic. Project aid was stepped up, particularly for the Accelerated Mahaweli Program. The overall level of aid commitments per year increased from US$250 million in 1977 to a record US$800 million in 1981, equivalent to US$55 per capita. Disbursements grew much more slowly so that the aid pipeline rapidly expanded to around US$1.63 billion by the end of 1981. Because implementation and domestic financial constraints required cuts in public capital spending after 1981, aid commitments declined to US$500 mil- lion in 1982, US$350 million in 1983, and US$460 million in 1984, halting further increases in the pipeline. Aid disbursements have increased steadily, from US$200 million in 1977 to US$550 million in 1984. Continued high levels of aid will depend upon donors' willingness to finance a sizeable portion of local costs, provide supplementary financing for ongoing projects, where needed, and to increase non-project aid. Local cost financing in support of Sri Lanka's resource mobilization efforts will not only provide valuable relief from budgetary pressures, but will also supplement foreign exchange resources needed to support the balance of payments.  -5- 13. At the end of 1985, the external public debt outstanding and dis- bursed stood at an estimated US$2.7 billion, about 40 percent of GDP. Although over 70 percent of this debt is on concessional terms, the increased commercial financing resorted to in 1981 and 1982 contributed to the increase in the debt service payments (excluding IMF charges and repurchases) between 1982 and 1985, at which time the debt service ratio had risen to 15 percent. Assuming that the Government's efforts to contain the budget deficit and to implement policy measures designed to stimulate exports and efficient import substitution activities are successful, the current account deficit in the balance of payments should decline to approximately 7 percent of GDP toward the end of the decade, and the debt service ratio, after temporarily rising to almost 19 percent because of existing debt repayment commitments, should drop to 15 percent in 1990. Nonetheless, the Government will need to monitor carefully the level and terms of external borrowing to ensure that the country maintains a satisfactory external payments position. PART II - WORLD BANK GROUP OPERATIONS 14. Since the beginning of its operations in Sri Lanka in 1954, the World Bank has approved 12 loans totaling US$183.7 million (net of cancellations) and 38 credits totaling US$753.2 million (net of cancellations) in support of 47 projects. About 53 percent of World Bank assistance has been for agricul- ture (irrigation, tree crops, and rural and dairy development), 17 percent for power, 10 percent for transportation, and the remainder of 20 percent among development finance company operations, a program credit (involving the import of raw materials for industry), water supply, construction industry training, and telecommunications. Eight loans and 16 credits have been fully disbursed. Annex II contains a summary statement of World Bank Group opera- tions as of March 31, 1986. 15. In Sri Lanka, the IFC has a total investment of US$2.13 million equivalent in equity and US$18.69 million equivalent in loans as of March 31, 1986. Investments have been made so far in two textiles industries, one polypropylene bag industry, one equipment-leasing company, one hotel, and two IFC lines of credit, one of which has been extended to the government-owned Bank of Ceylon for term loans to medium-sized industries. 16. A central element of the World Bank Group's current strategy in Sri Lanka is the achievement of a more sustainable balance-of-payments posi- tion in the medium term through export promotion and import substitution in viable economic activities. The Bank Group's macroeconomic and sectoral analyses of the Sri Lankan economy indicate that achieving and maintaining external equilibrium in the context of a growing economy require major policy changes in several areas: investment priorities should be assessed more carefully than in the 'past; the system of economic incentives should become more consistent; the role of the public sector in manufacturing activities  -6- should be limited to clearly established priority areas; and cost recovery should be seen as complementary to, rather than conflicting with, greater equity in distribution. 17. Within the above framework, the Bank's lending program has been concentrating resources on directly productive sectors, such as agriculture and industry, and in support of energy and transport infrastructure. Within agriculture, Bank Group strategy had given until recently the highest priority to the expansion of paddy production and to rehabilitation of the vital tree crops subsector. Regarding tree crops, the objective has been to channel resources into an activity in wihich Sri Lanka has a comparative advantage. While this objective will retain its importance, the probable attainment of self-sufficiency in rice wiLl allow the lending program to support in the future programs aimed at expanding the production of other important agricultural products for local consumption and, possibly, local processing for exports. 18. The World Bank has also provided financing for a broad range of large-, medium- and small-scale industrial enterprises, primarily in the private sector, through support of industrial development finance institutions. Future lending in the sector would continue this support, focusing on firms with export potential. It would also capitalize on the conclusions of technical assistance financed through past operations to provide support for improvement in trade and incentive policies, and for increasing the efficiency of public enterprises. 19. The Government's priority to rehabilitate rundown infrastructure and expand the capacity of existing capital stock by high priority new invest- ments is well placed and necessary in order to support expanded economic activity, particularly in the private sector. Major elements of the lending program would be directed at helping to meet the energy needs of the economy and at easing transport bottlenecks. The World Bank has provided financing to a number of power projects for generation, transmission and distribution. The thrust of future operations would be decided on the basis of a comprehen- sive assessment of investment needs in all three areas. However, given that the majority of high yielding sources of energy in Sri Lanka have been util- ized already, it is envisaged that the future program would accord relative priority to energy conservation rather than generation, through both required investments and policy measures. The old and inefficient power distribution system would be rehabilitated to reduce system losses; small but significant improvements in energy conservation would be undertaken in large energy consuming industrial/commercial units; and a study is underway to recommend measures to improve energy efficiency in the transport sector, a large con- sumer of commercial energy in Sri Lanka. Support to the transport sector would continue with rehabilitation and upgrading of the road network, institutionalizing proper maintenance methods and improving sectoral planning of policies and programs.  -7- 20. Institutional capabilities, at both the planrking and implementation levels, have been strained by the recent rapid expansion of public investment. Continuing emphasis would be placed on project components sup- porting institution building, human resource development, business and industrial management, and public administration. 21. The World Bank's development of a coherent lending program for Sri Lanka, and its continuous dialog'e regarding the specific elements of the program and policies necessary for increasing the program's effectiveness, have been accompanied by firm support for a substantial transfer of resources to Sri Lanka. The main grounds for this support have been the need to offset the deterioration in the world trade environment; the achievement of a high and sustained growth rate; and the tightness of the Government's budgetary situation as increased operational and maintenance requirements make demands on domestic resources. 22. The World Bank Group, as of the end of 1984, accounted for 15.2 percent (IBRD, 2.3 percent; IDA, 12.9 percent) of Sri Lanka's total debt outstanding and disbursed, and 5.0 percent of debt service on medium- and long-term debt. The projected World Bank Group's share in total existing external debt outstanding and disbursed will increase to 18.3 percent (with IBRD's share declining to 1.9 percent) and its share in debt service will increase to about 5.4 percent, by the end of 1986. PART III - THE URBAN SECTOR Development Context 23. Sri Lanka's urban population is currently about 3.4 million or 21.5 percent of the total population. The urban population's growth rate is low by regional standards. Government projections estimate urban population growth of about 2.4 percent per year for the period 1981-1991, increasing the share of urban population to 23.2 percent. The relatively slow growth of urban areas is related to achievements of social policies: birth and death rates are lower in Sri Lanka than in any other country of its income class; welfare, edacation and health standards, although under pressure in recent years, are relatively high and are widely spread over the island. 24. Several factors will keep Sri Lanka's urban population from growing rapidly in the near future. Conscious policy efforts at decentralization have resulted in geographically dispersed social services and nearly equal social welfare indicators in urban and rural areas. Transportation networks allow easy commuting from farms and villages to smaller urban centers for employment, commerce, social services and amenities, helping decrease rural to urban migration. However, non-agricultural production currently con- tributes about 70 percent of GNP, and typically urban economic activities such as manufacturing (14.3 percent of GNP), construction (8.8 percent of  -8- GNP), commercial services (17.6 percent of GNP), financial services (3.8 percent of CUP) and utilities, transport and other services (26 percent of GNP) are expected to slightly increase their contribution to national economic development. Therefore, improved urban efficiency is critical for sustained economic growth. Sector Organization 25. An adequate national framework for urban administration is in place in Sri Lanka under the guidance of the Ministry of Local Government, Housing and Construction (MLGHC). The 51 urban local authorities (ULAs) and 7 statutory bodies, including the Urban Development Authority (UDA), the Natioral Housing Development Authority (NHDA), the National Water Supply and Drainage Board (WDB) and 7 departments are supervised by MLGHC (see Chart). The single-tiered local government structure consists of popularly elected ULA councils, each with an independent corporate status, whose powers and duties are conferred by statute. 26. Administration in the ULAs generally follows the British model of local government and is, in principle, capable of handling the full range of local government duties. The ULAs have been granted independent raxing and charging authority (property, entertainment, business and trade taxes, and various user charges and fees for services) and borrowing power. Local expenditures, on the other hand, are determined by the type of services prescribed by law. UIAs are responsible for the regulation and administra- tion of all matters relating to public health, public utility services and local roads, and generally for promoting the welfare and amenities of their respective urban areas. Except for shelter and, in some cases, water produc- tion and distribution and electricity distribution, all basic urban services are delivered through local governments, including streets, drainage, street lighting, sanitation, solid waste collection and disposal, and community facilities such as bus depots, markets, slaughter houses, playgrounds and libraries. In addition, the decentralization of some urban planning and shelter implementation functions from UDA and NHDA to the ULAs was initiated in 1985. However, until recently, the MLGHC was neither adequately organized nor staffed to develop and implement policies and support programs for ULAs (para. 39). Sector Issues 27. The principal issues facing the urbar sector are that: (a) locally mobilized resources and direct cost recovery are inadequate for providing needed services; (b) financial management by the ULAs is weak; (c) ULAs have become excessively dependent on government transfers for providing a minimum acceptable range of municipal services; (d) provision of municipal services is deteriorating; and (e) recruitment, training and retention of qualified staff by ULAs are unsatisfactory.  -9- 28. Local Resource Mobilization. Locally mobilized resources and direct cost recovery are inadequate. As a result, many ULAs are not in a position to cover the cost of their administration and the operations and maintenance of their assets. In addition, ULAs have been defaulting on payments to WDB and to the Ceylon Electricity Board (CEB) for water and power retailed through the local authorities. For all urban services except electricity (i.e., administration, planning, water supply and sanitation where applicable, refuse collection, roads, street lighting, health and welfare services), ULAs spent a total of about Rs 179 (about US$8.60) per capita in 1982, a relatively small amount even for essential maintenance of existing municipal services. 29. ULAs are financing a decreasing proportion of their expenditures from local taxes, with the balance being financed by service charges and govern- ment transfers. In 1977, 44 percent of local expenditures were financed from local taxes; in 1979, 29 percent; in 1982, 26 percent; and they are projected to decline further to about 18 percent by 1987 if the proposed policy adjust- ments are not implemented (para. 38). Because real per capita expenditures generally remained stable over the period, the ULAs' financial deterioration has resulted from decreasing local resource mobilization rather than spending acceieration. ULAs do not need additional taxing authority but would need to improve the administration of existing revenue sources, such as improved valuation, rating and revenue records. 30. Financial Management. Although ULAs have the potential to be strong local organizations, the trend has been one of deterioration. Not until recently has a sense of responsibility in financial management been supported by government policies, and by administrative and financial reforms. A valuation unit with sufficient capacity to revalue all urban property on a five-year cycle has been largely unused, while obsolete and incomplete assessments significantly reduce yields from the local tax with the greatest potential for increasing locally generated revenues, the property tax. A lack of sound fiscal management on the part of the ULAs for financing urgently needed urban services has resulted in increasing government sub- sidies on recurrent account (para. 33). The Government's willingness in the past to provide subsidies was a further disincentive for the ULAs to adopt sound financial practices. 31. All ULAs are required to prepare an annual budget consisting of estimates of revenues and expenditures on both recurrent and capital accounts. By law, the budget should be balanced by raising sufficient local revenues through the property tax system to meet the difference between proposed expenditures and income from sources other than property taxes. In practice, this has not been done in many ULAs, leading to shortfalls in both required capitaL investments and operating expenditures. 32. The MunicipaL and Urban Councils Ordinance also requires councils to use a standard system of program budgeting. However, prescribed financial systems and practices, for the most part, are not being observed and the  -10- standard of local financial management is weak. This has been attributable in part to a lack of experienced staff, inadequate financial information systems, and laxity in monitoring at the central level. Nearly all ULAs are behind in meeting the legal requirements for closing their books and conduct- ing audits. The Auditor General is resFronsible for the audit of urban local authority accounts; however, an urban local authority is not required to publish its accounts, nor does the audit procedure provide for public examination or objection to the accounts -- a serious weakness in public accountability. A system of auditing is in operation, but the preparation of annual accounts for many ULAs is considerably in arrears. In September 1985, 20 ULAs had not submitted their 1984 accounts, and several were more than one year in arrears. 33. Government Transfers to ULAs. To sustain minimum levels of urban services, ULAs depend on the national treasury and receive subsidies to meet shortfalls in their operating budgets. A large proportion of the recurrent grant is allocated according to increases in employee costs statutorily imposed on ULAs by Government to ensure that local government staff salaries and conditions are equivalent to those of central government employees. Total transfers from Government to the ULAs have increased steadily from about Rs 79 million in 1977, to Rs 318 million in 1983, and 580 million in 1984. These transfers absorbed about 1.2 percent of Government's recurrent expenditure budget in 1984. The importance of government transfers is even greater when seen from the point of view of the ULAs' operating budgets. For example, in 1977 transfers covered 43 percent of ULAs' operating expenditures; in 1983, 44 percent; and in 1984, 80 percent. The large increase in 1984 was due to the Government's greater statutory salary support requirements and payment of debts accumulated by the ULAs with CEB and WDB over several years, and was in addition to revenue sharing and coverage of operating deficits. Unless a strategy for strengthening local resource mobilization and improving financial management is implemented, these trends could have more serious fiscal implications for the treasury and further diminish the capacity of urban areas to provide infrastructure for and serv- ices to households and businesses. 34. In contrast to transfers for recurrent expenditures, total capital grants are very small (Rs 12.3 million in 1984). Until 1986, there was no formal strategy for the allocation of capital grants to ULAs. The assistance distributed was based on a small (Rs 0.2 million) allocation per electorate. ULAs are expected to generate internal resources or to borrow to cover the cost of capital projects. Nevertheless, the ULAs cannot effectively exercise their borrowing authority because their creditworthiness is perceived as limited. As a result, the ULAs' borrowing instrument, the Local Loans Development Fund (LLDF), depends on government sources of finance, amounting to approximately Rs 5 million a year, which is insignificant compared to the ULAs capital needs. In addition, LLDF is not organized effectively and an expansion of its operations should be reviewed.  -11- 35. Urban Service Delivery. Although, in general, conditions of cities in Sri Lanka are better than in neighboring countries, ULAs suffer from many deficiencies. Municipal services for developing land have not kept pace with population growth. Shanties are estimated to house 15,000 families in Colombo. The 1981 Housing Census estimated that piped water supply was available to less than half of all urban households; of which only one quarter have it on the premises. Sanitation was underdeveloped: only a few parts of Colombo have waterborne sewerage systems and those are in poor repair. Although 18 percent of households had f'.ush toilets and 65 percent had other forms of latrines, 18 percent had no facilities. The planning, construction, operations and maintenance of other urban services, such as roads and storm drains, is severely inadequate. Even the necessary correc- tive maintenance often is not carried out, allowing assets to fall into disrepair and premature deterioration. A water supply and sanitation rehabilitation project, being processed in parallel with this project, would provide financing to help ease some of these constraints. 36. Human Resource Development. In some larger cities, the numbers of ULA staff seems adequate. This is not the case, however, in the smaller towns which are at a disadvantage in recruitment of qualified staff and where positions often remain unfilled for months or even years. Moreover, the appearance of adequate staffing may be the result of towns not performing many of their development functions because of shortage of funds. Where there have been attempts to increase significantly the developmental activities of cities or to collect reasonable levels of taxes and charges, inadequate staffing has emerged as a serious problem. 37. The Local Government Department of the MLGHC is responsible for assisting local authorities to recruit, place and train staff. There is no overall humn resource development strategy, however, and the existing train- ing resources in municipal management have been inadequate in the areas of administration, finance, resource mobilization and even in operations and maintenance of municipal services. Little systematic training is available to new recruits in the ULAs, forcing on-the-job training on ill-prepared local officers. The Sri Lanka Institute of Development Administration (SLIDA) offers only one short course in budgeting and financial control and one diploma course in public financial management. These courses, however, are broadly focused and not aimed specifically at municipal finance. The National Institute of Business Management (NIBM) also offers finance and management courses for businesses and industries, but those courses do not meet ULA needs. Finally, the training approach of the Local Government Training and Research Institute (LGTRI) of the MLGHC has relied mostly upon a small lecture program to the exclusion of "hands on" exercises and work experience and on outside lecturers with less relevant training and experience in municipal financial management. LGTRI now focuses on training of rural leaders. A vocational training project being processed in paralleL with this project would provide financing to help ease some of the con- straints in the construction industry.  -12- Sector Policy Adjustments 38. Emerging Sector Strategy. Recognizing the magnitude of the issues facing the ULAs, the growing importance of urban areas in the Sri Lankan economy, and the risk of social unrest, the Government carried out in 1983, under the leadership of the MLGHC, a joint sector review with IDA to develop a sector strategy (paras. 42-43) to implement the required policy adjustments. The strategy aims at developing, testing and adopting new approaches to improve local government administration, focusing on the managerial, financial and service delivery capacity of ULAs before consider- ing significant increases in capital investments. The emerging strategy looks for long-term, sustainable improvements in sector management by decentralizing authority, developing greater self-reliance and accountability, reducing financial dependence on the central Government through increasing local resource mobilization, developing incentives for better resource use and proper operations and maintenance of municipal services, and initiating a national effort of technical assistance and training. To reduce the financial dependence on the central Government, the strategy aims at eliminating open-ended transfers to cover ULA operating deficits in the next eight years, limiting transfers only to statutory salary increases imposed by the Government on ULAs, and to sharing locally generated revenues collected by Government. The actions detailed below have been taken by MLGHC to initiate implementation of the sector policy adjustments in preparation for the municipal management project. 39. Urban Program Unit. In April 1985, the MLGHC took the first steps to establish an Urban Program Unit (UPU) for developing, implementing and monitoring a municipal development program. Six staff members were appointed to the UPU in August 1985. Its mandate is to: (a) initiate basic financial and operational improvements in the ULAs principally within the existing legal, institutional and financial framework; (b) develop a detailed policy framework and strategy for long-term, sustainable improvements in ULA performance; (c) introduce and develop an incentive-based system of grants and an improved capital loan fund instrument; (d) assist each ULA in prepar- ing and implementing management and finance plans; and (e) monitor actual performance and assess the impact of the national strategy and municipal program. 40. In an effort to support the UPU in fulfilling its mandate, the MLGHC initiated in August 1985 a 12-month UNDP-financed, IDA-executed technical assistance project. The project provides for four full-time specialists Ceach working closely with their counterparts in the UPU in the areas of urban management, local government finance, municipal engineering, and resource mobilization), and a part-time urban training specialist. The UNDP project also aims at testing and implementing short-term improvements par- ticularly in the areas of budgeting, resource mobilization, financial manage- ment and operations and maintenance of pilot municipal services. With UPU assistance, the ULAs have taken immediate steps to improve property tax administration (records, billing and collection measures); introduce a finan-  -13- cial appraisal process for capital investments; and establish (in the 12 larger ULAs) a Budget and Finance Committee, a General Management Committee and an Operations and Maintenance Committee to exercise better control of financial management. The ULAs are now paying all current bills for water and electricity, and a schedule has been established to repay all arrears owed to CEB and WDB in the next three years. 41. Government Transfers to ULAs. In 1985, the Government reformed the inter-governmental transfer system by introducing performance criteria for allocating grants. These criteria include: timely financial reporting (monthly and annual accounts); improved revenue performance (especially, property tax administration and reevaluation); efficiency of service delivery with emphasis on operations and maintenance; settlement of arrears with CEB and 1DB; preparation of an annual investment plan and a four-year development plan, introduction of quarterly and yearly coordinating meetings; etc. The number of criteria and the relative weight assigned to each in deciding specific allocations to each ULA need further rationalization in order to make the new system more effective. Recognizing this, the Government is proceeding cautiously with the introduction of the system. In 1986, about Rs 32.4 million of recurrent and capital grants, or about 5 percent of total transfers to ULAs, have been withheld because of actual performance. Notwithstanding the limited portion of grants allocated on the basis of performance criteria, preliminary information suggests that ULAs are already responding positively to this reform. In -he first three months of 1986, five ULAs have introduced tax rate revisions, two have undertaken property revaluations, two have improved billings and collections, three have increased water user charges and three have introduced new accounting systems. IDA Role and Sector Assistance Strategy 42. IDA's support for urban development in Sri Lanka has been con- centrated over the past decade in the water supply and sanitation subsector. Two lending operations have been undertaken and a third is under consideration. Lessons from the first two water supply operations (Credit 709-CE) suggest that greater emphasis should be given to strengthen- ing of management and that institutional development efforts should be tar- geted at the sector as a whole. In addition, IDA completed a Water Supply and Sanitation Sector Study (No. 4190-CE) and an Urban Sector Report (No. 4640-CE) (para. 38) in 1984, both with significant participation of Sri Lankan sector agencies. These reports have been the basis for developing sectoral policies, broadening discussions with donor agencies, understanding more fully sector institutions and issues, and identifying the proposed project. 43. IDA's sector assistance strategy supports the Covernment's policy adjustments (paras. 38-41) and emphasizes three objectives: (a) the strengthening of policy formulation and public sector management capacity through, inter alia, more systematic technical assistance and training (espe-  -14- cially in the area of financial and municipal management); (b) improvement of local resource mobilization, through better administration of the property tax and, more importantly, the introduction of a performance-based system of government transfers to ULAs; and (c) more efficient and effective use of resources in delivering and maintaining urban services. The Association can assist the Government in achieving these objectives by supporting its policy adjustment process to improve municipal management. PART IV - THE PROJECT Project Formulation 44. The project was identified during the preparation of the Urban Sector Report (paras. 38 and 42), which included a broad review of the country's urban policies and programs. The project's objectives, scope and preparation schedule were agreed with Government in August 1984. Following this agreement, MLGHC decided to establish the UPU (para. 39) as the focus of sector policy development and for preparing a municipal management program, and mobilized consultants in August 1985 to support project preparation under the UNDP-financed, IDA-executed technical assistance project (para. 40). The proposed project was appraised in November 1985. Negotiations were held in Washington, D.C. from March 24-25, 1986. The Sri Lankan delegation was led by Mr. R. Paskaralingam, Secretary, MLGHC. No appraisal report has been prepared given the technical assistance nature of the project. A supplemen- tary project data sheet is attached as Annex III. Project Objectives 45. The proposed project would support the Government's sector policy adjustment process as set out in para. 38, strengthening the MLGHC's organization and developing and refining approaches for improving the managerial, financial and service delivery performance of all ULAs. It is an explicit objective of the project to support all ULAs, including the less stronger ones, so they can benefit from technical assistance and training in management improvements. The objectives of the proposed project have a high probability of being achieved for two reasons. First, the Government at its highest levels, and also MLGHC's leadership, are determined to bring about necessary reforms in all ULAs. Second, the Government possesses an effective means of inducing ULAs ro introduce the required reforms through the provi- sion of grants, which finance more than 50 percent of ULA's operating expenditures. The Government has already introduced a performar;ce-based system of grant allocations among the ULAs, covering 5 percent of total grant alLocations (para. 41), and has explicitly stated that the allocation of progressively greater portions of grants to ULAs would become subject to performance criteria. The proportion allocated on the basis of the perfor- mance criteria would be decided on the basis of annual reviews of ULA response to this incentive system.  -15- Project Description 46. The project supports improvements in five areas: (a) urban manage- ment and policy, (b) financial management and resource mobilization, (c) service delivery, (d) mapping, and (e) human resource development. Inputs for technical assistance and studies would provide an annual average of 0.13 staff years of foreign expertise and about 0.55 staff years of local expertise for each ULA during the 7-year period. These provisions are based on minimum requirements for developing, testing and adopting the proposed management improvements. 1. Urban Management and Policy (US$2.92 Million) (a) Urban Program Unit: Technical assistance and studies for strengthening the management of the UPU, and developing further its capacity for policy formulation, investment programming, monitoring performance of ULAs and preparing a feasibility study for a follow-up municipal program. MLGHC would maintain the UPU and would staff it with appropriately qualified staff. (b) General Management: Technical assistance for strengthening the ULAs' administrative organization, developing management informa- tion systems and administrative procedures, improving organiza- tional structures, assisting manpower planning and development, and preparing management and financial plans. (c) CMC Organization and Management: A study for the improvement of the organizational structure, information systems, staffing, financial and technical management of the Colombo Municipal Council (CMC), and assistance for implementation of reforms recommended by the study, by July 31, 1989. (d) Ministerial Organization: Technical assistance and studies for reviewing the structure of the KLGHC and its sectoral departments and agencies, and developing a strategy for organizing a more efficient structure, and assistance in the implementation of reforms. It is expected that reforms would be introduced by July 31, 1989. 2. Financial Management and Resource Mobilization (US$2.97 Million) (a) Capital and Recurrent Transfers: Technical assistance for fur- ther developing and rationalizing the grant system, monitoring the new performance system for allocating funds (para. 41), and a feasibility study to review the LLDF and its potential develop- ment into a municipal loan fund. MLGHC would maintain the performance-based grant system, would conduct an annual review of the system, and starting in June 30, 1988, in consultation with  -16- the Association would institute appropriate changes to the system, including allocating an increasing proportion of grants based on performance. (b) Financial Management: Technical assistance, equipment and studies for streamlining, improving and updating the municipal financial reporting system, including: introduction of new budgeting formats which relate revenues from and expenditures on services provided; introduction of a capital assets register and a supplies inventory; a streamlined accounting system and a study to review the long-term auditing requirements; capital expendi- ture programming and financial information systems for decision making, including a CMC computerization study (which would lead to computerization of CMC's operations in 1989); and (c) Resource Mobilization: Technical assistance and studies for improved organization and management of local resource mobi- lization in ULAs, with special emphasis on the local property tax and business fees, including new systems of property valuation, rating and revenue records, improved appeals and tax exemption p ocedures, including a study to set up a central rating/valuation unit. Revised property tax valuation and rebate systems are to be instituted in 1988. 3. Service Delivery (US$5.76 Million) (a) Infrastructure and Municipal Services: Technical assistance, pilot civil works, vehicles and equipment for demonstrating on an annual basis in selected ULAs more cost-effective approaches to: (i) planning and design, construction and rehabilitation, opera- tion and maintenance of infrastructure (e.g., water supply and sanitation facilities, streets, storm drainage, electricity supply and street lighting); and municipal services and facilities (e.g., markets, libraries, and public administration buildings); and (ii) preparation of standards, guidelines and procedural manuals for implementing similar improvements in all ULAs; and a first phase of priority improvements in solid waste management for CHC. Criteria for selecting ULAs for pilot schemes include: coverage of service areas, diversity in popula- tion size, geographical location, institutional capability, past service performance and magnitude of needs. Pilot schemes would be selected annually from existing ULA investment programs. (b) Studies for: (i) defining ULAs' role in shelter programs and developing a 5-year shelter program for ULAs; (ii) municipal drainage systems and the development of guidelines for the preparation of local drainage plans; and Ciii) traffic management for greater Colombo and guidelines for traffic management, including management of public transport systems in Larger ULAs.  -17- 4. Base Mapping (US$3.50 Million) Technical assistance and training for building up the capacity of the Survey Department, aerial photography, equipment, materials and vehicles for the production and updating of urban base maps for an area of about 530 km2, including links to the plot registration system in ULAs and in the Valuation Department, in a phased program for the ULAs, to be completed in 1991. 5. Human Resource Development (US$2.43 Million) (a) Technical assistance, equipment and books for setting up a Local Government Training Unit within the UPU and for implementing a 5-year training program for ULAs in the managerial, financial and technical areas, including staffing, program content and institu- tional arrangements with existing training organizations, to prepare and deliver about 105 course weeks per year. (b) Training fellowships and overseas training and study tours. (c) A study to formulate a long-term human resource development strategy for ULAs, including staffing needs, recruitment policies and salary structures (included in the urban management and policy component). Operational Action Plan 47. The implementation of the technical assistance studies, physical and managerial improvements and policy measures would follow a number of bench- mark dates by which actions should be taken. These have been grouped into an agreed Operational Action Plan, which would facilitate the monitoring of progress of the project and the achievement of its objectives. The Action Plan would be reviewed annually by MLCHC and updated in consultation with the Association. Project Costs and Financing 48. The estimated total cost of the project, including contingencies is US$20.4 million, with taxes and duties of US$0.41 million (Annex IV, Table 1, Summary Project Cost). Base costs are expressed in prices projected as of JuLy 1986. The estimated foreign exchange component is US$13.8 million, representing approximately 68 percent of total project costs. Physical contingencies of 10 percent have been allowed on equipment, supplies, vehicles, and books, but excluding the pilot civil works component. Price contingencies have been based on the following rates: for foreign costs, 7.0 percent for 1986 and 1987; 7.5 percent for 1988; 7.7 percent for 1989; 7.6 percent for 1990; and 4.5 percent for 1991 onwards; for local costs, 10.0 percent for 1986 and 1987; 9.0 percent for 1988; 8.0 percent for 1989; 7.6  -18- percent for 1990; and 4.5 percent for 1991 onwards. The project includes about 195 staffyears of local and 45 staffyears of foreign consultant and advisory services to MLCHC, the UPU, the Survey Department and the 51 ULAs, including CMC. The project would be financed by an IDA credit of US$13.0 million covering 64 percent of total project costs (65 percent net of taxes), and the Government's contribution of US$7.4 million (36 percent of total project cost, 35 percent net of taxes). Credit proceeds and Government counterpart funds would be passed on as budgetary allocations to the MLGHC and as grants to the various ULAs. Project Implementation 49. Status of Project Preparation. Project preparation was initiated by an MLGHC Steering Committee and several Task Forces which emerged from the preparation of the joint Association/Government Urban Sector Report. Responsibility for project preparation was assumed by the UPU in May 1985. The unit became fully operational in August 1985, with the appointment of six staff in urban finance, resource mobilization, service delivery, urban management and training, and with consultants supported by the UNDP-funded/IDA-executed Technical Assistance Project (para. 40). The project's broad objectives, institutional design and components were presented in a proposal in late 1985. UNDP supported technical assistance would be continued to July 1986 to complete preparation and to initiate pilot testing of the proposed improvements in financial reporting, revenue administration and service delivery standards and maintenance procedures, and to initiate key training courses. 50. Recruitment of additional staff needed for the UPU has begun. Final terms of reference have been prepared for the major technical assistance components requiring consultants' services. Shortlisting of qualified firms began in April 1986. Selected firms and consultants would be in the field starting September 1986. An overall procurement plan has been prepared (para. 52). All critical preparation work should be compLeted in time for the scheduled project start-up in September 1986. 51. Implementing Agencies. The MLCHC, through the UPU, would have over- all responsibility for coordination and management of the project. The implementation strategy is one of testing, refining, learning and adapting methods in municipal management. The ministry would also be responsible for contracting consultant services for the UPU. The phasing of the principal activities is illustrated in the implementation schedule (Annex V) and in the Operational Action Plan (para. 47). The agencies involved in the project are: (a) the MLGHC would be responsible for the institutionalization and strengthening of the UPU and training of its staff, the reforms of the grant and loan system including the monitoring of ULA performance, the ministry's organizational strengthening, and the human resource development study;  -19- (b) the MLGHC, through the UPU, would be responsible for overall policy direction, monitoring of project implementation, including prepara- tion of a follow-up urban program, and the technical assistance and studies components; tc) the NLGHC, through the LGTU, to be established as part of the UPU, and with assistance from SLIDA, NIBM and CITP/ICTAD, the universities, and CHBP, would execute the training components; (d) the ULAs, with UPU assistance and as appropriate the sectoral agen- cies (namely WDB and CEB), would implement the municipal service delivery component; Ce) the ULAs, with UPU assistance, would implenent the financial manage- ment and resource mobilization components; (f) the CNC, in liaison with the MLGHC, would implement the organization and management and computerization studies for that city, the ini- tial phase of the solid vaste management improvements and the traf- fic management study; and Cg) the Survey Department, in liaison vith the MfLGKC, would execute the base mapping component. Procurement 52. Procurement arrangements are snmmarized in the Table below. Consultants services for technical assistance and studies would be obtained through short listing in accordance with IDA guidelines on selection of consultants (US$10.6 million). Technical assistance for training would be awarded to the consultants currently engaged for this purpose (US$0.85 million). Fellowships would be avarded following'approval by the Association (US$1.1 million). The equipment, supplies and vehicles that could be grouped into contracts vplued at US$50,000 or more would be procured through International Competitive Bidding (ICB) (US$2.5 million). Goods manufactured locally would be given a preference margin of up to 15 percent or the applicable customs duty, whichever is lower, on ICB procurement. All civil works contracts (US$2.8 million) and equipment and supplies contracts (US$0.7 million) with a value less than US$50,000 would be procured through LCB. Minor equipment and supplies (US$0.2 million) in packages of US$10,000 or less would be procured through local shopping based on at least 3 quotations. Minor civil work' for maintenance and rehabilitation of municipal services and infrastructure (US$1.0 million) and mapping (US$0.5 million) would be carried out by force account in the ULAs and the Survey Department, respectively. It is not likely that any of the individual civil works con- tracts would be large enough to attract foreign bidders. Moreover, the local construction industry is well developed and capable of executing small municipal works at costs competitive with international bidders. Local competitive bidding (LCB) policies and procedures followed by Government are generally compatible with Association requirements.  -20- I ________Procurgent Methods I I Short I I I I Total I ICB I List &/I LCB I Other I N/A -I Costs 1. Technical Assistance I I 10.60 1 I 0.85 b/l I 11.45 and Studies I I (7.67) I (0.62) I 1 (8.29) 2. Civil Works l l 1 2.80