Nepal - Maintaining structural reforms and managing public resources

RIpod No. 8352 NEP Nepal Maintaining Structural Reforms and Managing Public Resources March 30, 1990 Asia Country Department I FOR OFFICIAL USE ONLY N~~ .' X, N 'N~~~~~~~~' .N N ,~~~~~~~~ \~~~~~~~~~~~~~~~~~~~~~~~~~~~ . Docaumut of dte Woeo Bank this documert has a restricted distribution and may be used by recipients only in the perfofmance of their official duties. Its contents may not odterwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS Year US $1 Equivalent (Avg.) 1982183 Rs. 13.9 1983184 Rs. 15.3 1984/85 Rs. 17.8 1985/86 Rs. 19.8 1986/87 Rs. 21.6 1987/88 Rs. 22.1 1988/89 Rs. 25.6 Since November 30, 1985, the Nepali rupee has been floating with respect to a basket of currencies in which the Indian rupee has high weight. Fiscal Year (FY) July 16 - July 15 All years refer to the Gregorian calendar. !  FOR OFFICIAL USE ONLY List of Abbreviations and AcronYms Used ADB - Asian Development Bank ADBN - Agricultural Development Bank of Nepal AIC - Agricultural Inputs Corporation BNP - Basic Needs Program CBPASS - Commercial Bank Problem Analysis and Strategy Study CCD - Corporations Coordination Division CPI - Consuuer Price Index DOI - Department of Irrigation DTO - District Treasury Office FCGO - Financial Controller General's Office FMIS - Farmer Managed Irrigation Schemes GATT - General Agreement on Tariffs and Trade GDP - Gross Domestic Product HMG - HiL Majesty's Government IC - Indian Currency IFC - International Finance Corporation iMF - International Monetary Fund iOC - Indian Oil Corporation MFN - Most Favored Nation MIS - Management Information System MOF - Ministry of Finance MTEP - Medium Term Expenditure Plan NEA - Nepal Electricity Authority NFC - Nepal Food Corporation NGO - Non-Governmental Organization NIDC . Nepal Industrial Development Corporation NPC - National Planning Commission NOC - Nepal Oil Corporation NRB - Nepal Rastra Bank (Central Bank) NTC - Nepal Transport Corporation NWSC - Nepal Water Supply Corporation OGL - Open General License O&M - Operations and Maintenance PDLT - Panchayat Development and Land Tax PE - Public Enterprise POL - Petroleum, Oils and Lubricants QR - Quantitative Restriction This documtnt has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents ma r not otherwise be disclosed without World Bank authorization.  RHAC - Royal Nepal Airways Corporation SAF - Structural Adjustment Facility SAL - Structural Adjustment Credit SAP - Structural Adjustment Program SAARC - South Asian Association for Regional Cooperation T&T - Trade and Transit  NEPAL STRUCTURAL ADJUSTMENT. TRADE POLICIES AND PUBLIC RESOURCE MANAGEMENT TABLE OF CONTENTS PaRe Swnmry and Conclusions . . . . . . . . . . . . . . PART I a RECENT ECONOMIC DEVELOPMENTS Chapter 1 DEVRLOPMENTS PRIOR TO THE T&T IMPASSE A. Economic Structure and Constraints . . . . . . . 2 Constraints to Development . . . . . . . . . 2 The Structure of Output and Macroeconomic Balances .... . . . . . ....... . 4 Trade Regime and Structure. . . . . . . 7 B. Review of Recent Policies and Performance . . . 13 Overview of the SAP and Basic Needs Program 13 Performance and Policies prior to the Impasse . 14 Chapter 2 TRADE AND TRANSIT PROBLEMS. MACROECONOMIC IMPLICATIONS. AND ISSUES FOR THE FUTURE A. The Post-March 23 Trade and Transit Regime . 23 B. Economic Performance since the Impasse . . . . 25 Impact on Fuel Availability and Cost . . . . 25 Impact on Trade . . . . . . . . . . . . . . 26 Impact on O'itput . . . . . . . . . . . . . . 28 Impact on Macroeconomic Balances . . . . . . 30 C. Policy Issues for the Future . . . . . . . . . . 33 Interim Short-Run Macroeconomic and Trade Measures ... . . .. . . . 33 Medium Term Policy Heasures . . . . . . . . 35 P?RT II : PUBLIC RESOURCE MANAGEMENT Chapter 3 THE FINANCING OF PUBLIC EXPENDITURES A. Overview of the Revenue System . . . . . . . . . 40 B. Key Tax Issues and Recommendations . . . . . . . 42 C. Pricing Policies . . . . . . . . . . t. . 46 D. Government Subsidies to Public Enterprises . . . 51 Profile of PE Performance . . . . . . . . . 51 Sources of Demand for Subsidies . . . . . . 54 Reducing Subsidy Allocations From the Central Government . . . . . . . . . . 56  Chapter 4 THE UPPICIUCY OF PUBLIC IXPENDITU S A. Improving Project Planning and Implementation 59 Planning . . . . . . . . ..60 Program Budgeting. 62 Release of Funds . . . . . . . . . . . . . . 65 Accounting, Auditing, and Project Monitoring 66 Civil Service Reform and Decentralization 67 B. Improving the Productivity of Public Investments 69 Operations & Maintenance (O&M) Expenditures 69 The Private Sector Role in Economic Development . . . . . . . . . . . . . . . 72 PART III : MEDIUl TERM PFRAMEORK Chapter 5 MEDIUM-TERM SCENARIO AND IMPLICATIONS A. The Macroeconomic Framework . . . . . . . . . . 77 Economic Prospects . . . . . . . . . . . . . 78 B. Development Planning and External Aid Implications 83 The Role of Foreign Aid in Development . . . 83 Financing Requirements . . . . . . . . . . . 85 STATISTICAL APPENDIX . . . . . . . . . . . . . . . . 90 MAP  List of Text Tables Table No. Pase No. Chapter 1 1.1 Structure of GDP . . . . . . . . . . . . . . . . . . 4 I.2 Balance of Payments Structure . . . . . . . . . . . 5 1.3 Central Government Budgetary Performance . . . . . . 6 1.4 Macroeconomic Balances . . . . . . . . . . . . . . 8 1.5 Import Tariff Structure . . . . . . . . . . . . . . 10 I.6 Structure of Trade . . . . . . . . . . . . . . . . . 12 1.7 Structural Adjustment Program - Key Performance Indicators . . . . . . . . . . . . . . . . . . . 15 Chapter 2 I.8 Revised Additional Duty Schedule . . . . . . . . . . 24 1.9 Effect of the Impasse on Key Performance Indicators 31 Chapter 3 7I.1 Contribution o.- Various Taxes to Total Tax Revenue 41 II.2 Contribution of Property Taxes to Total Tax Revenue 42 II.3 Public Enterprise Pricing Policy . . . . . . . . . . 48 II.4 Nepal: Financial Performance of Non-Financial Public Enterprises, 1985/86 - 1988/89 . . . . . 53 II.5 PE Subsidy Allocation (1988/89) . . . . . . . . . . 55 Chapter 5 III.1 Key Economic Indicators and Projections . . . . . . 79 III.2 Balance of Payments Summary . . . . . . . . . . . . 81 III.3 Aid Contribution to Development Expenditures . . . . 84 III.4 Foreign Financing Requirements and Sources . . . . . 86 III.5 Aid Pipeline ............. ...... 88  Foreword The report Is based on the results of a aission that visited Nepal in September and October of 1989. The mission vas led by Mateen thobani and consisted of Albert Agbonyitor (public enterprises), Jean-Francois Bence (consultant - trade), Eric Crulkshank (industry and power), Anad Rajaram (consultaut - fiscal), Murray Smith (consultant - trade), Michael Stevens (Planniwg and Budgeting) *and Phai Van Thuyet (trade). Contributions to the report were also made by Inal Bradfield (transportation), Ana Jeria (education), Kali Kondury (consultant - statistical appendiz), Patrick McCarthy (water supply), Richard Reidinger (irrigation), W. James Smith (health and education), and Berman van Wersch (agriculture).  Pagp I of 2 CO.INTRY DATA - NEPAL AREA POPULATION (1918) DENST (1911) 140.800 hm2 18.05 millieon 12S per km2 Rate of gowth: 2.6% POPULATION CHARAC RI1CS (197) HEALTH (1917) Crude birlh nte (poe 1,000): 41.3 Infat tortlity (per 1000 live biul): 128 Cude deAth rate (per 1,000): 15.3 Population per pbysIcian: 30,230 Population per bospital bed: 5,721 INCOME DISTRUTION DISIRIBUTION OF LAND OWNERSHIP % of nlI income, higheu quintile: - X owned by top 10% of owners: S of national income, lowest quintile: - S owned by smafea 10%: ACCESS TD SAFE WATER (1983) ACCESS TO ELECTIRCrfY % of population - urban 71 % of populadon - ube -- X of populatioa - uraL 1 I5 of pepulation - Mnal -- NUTRTON (1916) EDUCATION (1915) Calorie itke per persn: 2,052 Iliteracy rate (% of population): 74.4 Per capita protein Intake (g/day): 52 Primasy school enrollment - (% of relevant age gp): 79 ONp PER CAPITA IN 1988: US$170 /I GROSS NATIONAL PRODUCr (1967/88) US$ min % ONP at Maket Prices 2,711 100.0 ros Dometic Investment 52: 19.3 Gross Nadowd Saving 378 13.9 Canet Account Balance 26S 9.9 xport ofGoods, NPS 381 14.1 baportofOoodsNPS 739 27.3 OUTPUT (1989) Value Added USsMln % Agriculture 1,611 55 3 bdsty 411 14.x Services 891 30.6 Totl/AVAge 2,913 100.0 GOVERNI FINANCE Central Government Rs Mln % of GDP 1987/88 1917/S8 198283 Current Receipts 7,350 10.8 8.4 Cuet Expenditure 8,560 12.6 11.8 Curent BDae (1,210) -1.8 -3.4 Capital Expendi 5.657 7.9 8.7 a Calcuabted in acordane with Atlas methodology. - = Not avinb.  Page of 2 COUNTRY DATA - NEPAL MONEY, CREDrr & PRCE 1913" 1985 1961116 21916 1917/P 191189 Millns of Na outsding eod of pedod) Money Supply 10,45S 12,297 15.159 17,498 21,423 26,605 Bank Credit to Public Sector 5,904 7,654 9.144 10,200 10,781 14.513 Bank Credit to Private Sector 3,142 4,895 6,10 7,23S 9.244 12,071 (Pretae or Index Nmnbern) Money as % of GDP 26.5 27.7 30.0 30.2 3..6 35.7 Consumer Price o ndx (1972/73=100) 269.8 210.9 325.S 368.7 409.3 442.4 Annual percentage changs in: Consumer Price Index 6.2 4.1 15.9 13.3 11.0 8.1 BankCredittoPublicSeetor 12.9 29.6 19.5 11.5 5.7 34.6 Bank Credit to Prvate Scator 17.7 27.4 24.6 18.6 27.8 30.6 BALANCE OP PAYMNiTS 1984t85 1985/86 19W8617 1987188 MERCHANDISE EXPORTS (AVERAGJ 1984/85-86/87) (millios of USS) USS Mln Percent Exoits of Goods, NFS 301.4 329.3 349.8 395.2 Jute goods 9.7 9.4 imports of Goods. NFS 523.2 559.0 559.1 728.9 Compmt 29.4 28.3 (of which Petroleum a) 51.6 53.3 43.0 47.6 Gatmenta 34.2 28.3 Resowuce Balne -221.8 -229.7 -249.3 -333.7 Hides & skn 84 8 1 Other 22.2 26.1 Net Factor Income 0.6 -S.7 -9.8 -8.8 Net CurentTransfe 42.7 44.8 64.3 74.9 Total 103.9 100.0 Balance on Cumrt Acc.at -178.5 -193.7 -194.8 -267.6 Official Gants 74.8 68.6 60.4 58.0 EXTERNAL DEBT, June 30, 1988 USS MIn NetMLT8eoumwing 71.3 91.7 87.4 198.1 Disbusemes 76.5 101.5 97.1 212.0 Public Debt. inel. Guaraned 978 Amoitization S.; 9.8 9.7 13.9 Nbe-Guivmtced Ptivate Debt - Other Capitd (net) and CApital ne.i. -16.1 61.8 64.5 114.7 DEBr SERVICE RATIO FOR 19S7/88 /b Oveall Balace -48.6 28.4 17.4 103.1 Public Debt inci. Guaranteed 7.3 Gros Reves (end yea) 142.0 164.6 205.0 310.7 Noa-Guarenteed Pdvate Debt - RATE OF EXCHANGB Amu-l Average 3MRD/IDA LENDING (06/30/89) (MIIUONS OF USS): 1986t87 1987/88 1988/89 mRD IDA USS1.0O=NPs 21.60 22.06 25.60 NRsI.00=USS 0.046 0.045 0.039 Out_tanding&Disbured - 43.8 Undidbumed - 370.4 Outang incl. Undisbud - 806.2 ls Crde nad derivatves.  SUM)ARY AND CONCLUSIONS RECENT ECONOMIC DEYELOPIENTS 1. Nepal, with its 18 million inhabitants, had a per capita income of only $170 in 1987/88.1/ It has been unable to raise its standard of living substantially despite over three decades of development efforts supported by external &csistance. During the early eighties, growing frustration with low rates of economic growth led the Government to abandon its earlier conservative fiscal policies and embark upon an expansionary fiscal path financed mainly by bank borrowing. Although this resulted in a substantial increase in the growth of output, it also contributed to a decline in internatinnal reserves as the excess demand led to increased imports from India. When it became apparent that the fiscal-led growth could not be sustained, the Government implemented a stabilization program in 1985/86 which was supported by an IMF Standby Arrangement. 2. Realizing that macroeconomic stability by itself would not lead to increased growth, the Government embarked on a structural adjustment program (SAP) to address longer-term constraints to growth. The program was supported by World Bank Structural Adjustment Credits in 1987 and 1989 and by an IMF Structural Adjustment Facility covering the fiscal years 1987/88-1989/90. Until March 1989, the program was successful in increasing the rate of growth and correcting macroeconomic imbalances, thereby setting the stage for sustainable growth. In addition, a beginning was made in addressing some of the longer-term and inctitutional constraints to growth. 3. The economy's growth momentum was interrupted abruptly on March 23, 1989 with the lapse of the trade and transit treaties between India and Nepal. Because of the close links between the Nepalese and Indian economies, the resulting disruption of tra'e has had widespread and serious repercussions on Nepal's economy. This report focusses on macroeconomic and incentive framework issues in light of the trade and transit impasse and on issues relating to public resource management, ie. raising public resources, improving planning and project implementation, and increasing the productivity of public investments. Economic Structure and Constraints 4. Various factors explain why Nepal's development has been cr!ns.rained: some reflect its rugged terrain, land-locked position, and resource endowment; some emanate from institutional weaknesses and poor infrastructure; and others are a consequence of inappropriate policies. The rugged terrain has restricted Nepal's arable area and created microclimates that impede the widespread application of standard cultivation techniques. At the same time, with the virtual eradication of diseases such as malaria, the population has continued to increase at an average rate of about 2.7 percent annually over the last two decades. The resulting high population density per unit of arable land, when combined with rapid human and livestock population growth, has forced farmers to cultivate increasingly marginal lands and forests. Forests have also been denuded to meet the growing household demand for fuelwood. This man-made depletion of forests exacerbates natural soil erosion 1/ The Nepalese fiscal year ends on or about July 15.  -ii- and further limits the magnitude and productivity of arable land. As a result, yields of virtually all crops have stagnated or declined over the last 15 years . The low productivity of land, especially in the Hill areas, coupled with small fragmented land holdings, has limited en-farm employment opportunities and caused many Hill and lountain people to seek off-farm employment and to migrate to the Terail& or to India. 5. Nepal's development is also constrained by limited infrastructure, weak institutions and a largely illiterate population. An all-weather road link from the far-westera part of Nepal te the central and eastern regions is still under construction; much of Nepal's irrigation system is unable to deliver a usable supply of water due to lack of funds for operating or maintaining the system; only about 10 percent of the population have access to safe water; and although literacy rates have increased substantially, female literacy rates, at about 18 percent, are less than half those of males. The low female literacy rates limit the ability to improve primary health care and control the population growth rates. 6. The structure of output and macroeconomic balances, as well as the fiscal and trade regimes, limit the speed with which policy measures can lead to imprcvements in the standard of living. Over half of GDP stems from agriculture. Given the constraints to increasing agricultural productivity, agriculture is unlikely to be the vehicle for substantial and sustained growth. The balance of payments is also structurally weak in that merchandise imports are three times exports. This results in a large current account deficit and a heavy reliance on foreign capital flows. Similarly, the fiscal accounts show that government revenues only finance about half of government expenditures, with the bulk of the deficit being financed by foreign aid. Thus a shortfall in domestic revenues or foreign financing leads to increased government borrowing from the Central Bank and contributes to macroeconomic instability. 7. Nepal's land-locked location, its close links with the Indian market, and its dependence on India for transit routes has led to a special trading relationship between Nepal and India. Prior to March 23, the special relationship was governed by two treaties signed in March 1978. A transit treaty allowed Nepalese imports entering Calcutta by 3ea ta pass through to Nepal at any one of 15 points along the Nepalese-Indian border free from Indian taxes or import duties. A trade treaty allowed bilateral trade to occur at 21 points along the common border. Other factors involved in the special relationship included the free movement of labor between the two countries, full convertibility of the Indian rupee in Nepal, no quantitative or other restrictions on either current account or capital market transactions, preferential tariffs between the two countries, and special commodity agreements between state corporations under which Indian corporations sold petroleum products, coal, sugar and salt to Nepalese state corporations at mutually advantageous prices. 8. Combined with India's transport cost advantage, the above factors have led to India being Nepal's dominant partner in trade and have also had 21 Nepal can be divid into three ecological zones: the mountains of the Himalaya, bordering Tibet to the north, the middle Hills, and the Terai plains to the south, bordering India.  -iii- ramifications on third country trade. Since Nepal and India, while having low tariffs between themselves, did not have a common tariff with respect to the rest of the world, it created incentives for smuggling. Given India's high tariff structure and Nepal's wish to keep a lower tariff structure, there was an incentive to smuggle third country goods from Nepal to India. To mitigate smugglir;, Nepal developed an elaborate structure of quantitative restrictions (QRs), import licenses and administrative controls on third country imports and kept its tariffs on many such goods at a higher level than desirable under normal circumstances. Although Nepal has recently taken a number of measures to simplify and liberalize trade, the open border with India and India's protectiie trade regime limits Nepal's ability to liberalize. Review of Recent Policies and Performance 9. There are two key initiatives that were launched by the Government in the mid 1980s: the Basic Needs Program (BNP) and the Structural Adjustment Program (SAP). The objective of the BNP is to improve the standard of living by the year 2000 through increased production of goods and services in food, clothing, shelter, health, education and security. The BNP was first announced in December 1985 but so far its efforts have been limited to planning and attempting to expand the civil service to prepare for the high investments foreseen during the 1990s. The theme of the SAP is to promote growth that is sustainable by strengthening macroeconomic and sectoral development policies and improving the efficiency of public sector investments and institutions. Key features of the SAP are measures to increase domestic resource mobilization, reduce domestic bank boLzowing, improve development administration and project implementation, strengthen the financial position of public enterprises, and reform the financial sector. These measures were complemented by sectoral policies to promote agricultural production through more efficient fertilizer distribution and irrigation water delivery; and to promote industrial production by liberalizing industrial and trade policies. 10. The last World Bank Country Economic Memorandum (CEM)31 focussed on an analysis and evaluation of both the SAP and BNP. It concluded that many of the objectives of the two initiatives were complementary and that a successful SAP was essential to meeting the worthy objectives of the BNP. The report found many positive features in the implementation strategy of the BNP. These included its focus on increasing incomes in agriculture and its reliance on the private sector. However, the report cautioned against an emphasis on self-sufficiency and on crash programs to meet supply-driven targets that could divert human and financial resources from efforts under the SAP that are also aimed at the poor. It therefore recommended greater flexibility in interpreting targets, a heavier focus on getting the institutional and policy framework right, and a consolidation of past investments before embarking on an ambitious investment program. 11. Prior to March 23, 1989, performance under the SAP was encouraging. Except for low growth during 1986/87 as a result of unfavorable weather, the rate of growth continued to be high In fact, most performance indicators for 1987/88 and the first eight months of 1988/89 were better than programmed. Real GDP grew substantially. It was expected to grow by a further 5.3 percent 3/ Nepal: Policies for Improving Growth and Alleviating Poverty, World Bank, Report No. 7418-NEP, October 14, 1988.  -iv- in 1988/89, higher than the programmed 4.4 percent. As a result of revenue measures to broaden the tax base and improve tax administration, revenues increased to 10.8 percent of GDP in 1987/88, exceeding the program target of 10.5 percent. Revenues were projected to increase further to 11.3 percent of GDP in 1988/89. On the expenditure side, regular expenditures were controlled while development expenditures were allowed to increase. Although the budget deficit increased slightly, external financing increased by even more, resulting in a substantial decline in domestic borrowing in 1987/88. This continued on into the first eight months of 1988/89. 12. Perhaps the most important aspect of the adjustment program has been to take fiscal and monetary measures to restore macroeconomic stability and reverse the outflow of international reserves, thereby ensuring that the growth could be sustained. Following a decline in exports during 1986/87 due to reduced agricultural and garment exports, exports grew rapidly in 1987/88 mainly because of a sharp increase in carpet exports as a result of the liberalization of raw wool imports and some recovery in garment exports. In addition, tourism receipts also increased rapidly, and the current account deficit was $239 million as compared to the programmed $289 million. International reserves thus grew from $147 million in July 1985 to $311 million in July 1988, exceeding the program target of $221 million. This ~rend continued for the first eight months of 1988/89. 13. In order to ensure that the growth is sustained over the longer-term, the Govertment also initiated a series of structural reforms to improve the efficiency of the economy. In the financial area, the Government initiated measures to strengthen financial institutions, improve the allocation of resources, improve bank regulation and supervision, and coordinate government domestic debt management and monetary programming. To improve the management of public expenditures, the Government took measures towards better planning and project implementation through the establishment of a program budgeting and project monitoring unit within the Ministry of Finance. In addition, the Government took measures to improve budget release procedures and has set up a Resources Committee to guide the budget preparation process. It also improved its irrigation strategy by completing a comprehensive sector masterplan and introducing a number of reforms which would rely more on private sector initiatives. Finally, under the SAP, efforts to improve the performance of public enterprises were intensified. 14. As yet there are no data to measure the impact of the SAP on the poor. The SAP is expected to have a positive social impact since it is oriented towards growth rather than fiscal austerity. Development expenditures, including those on social sectors, have grown substantially in real terms. GDP per capita has also grown significantly over this period. Measures under the SAP to liberalize fertilizer distribution, encourage irrigation and forestry user groups, and rationalize the Nepal Food Corporation's food distribution activities, in particular, are more directly expected to have a beneficial effect on incomes of the poor. However, because many of the poor subsist on small and marginal farms, often in remote areas without links to the rest of the economy, they are less likely to be directly affected by efforts to improve economic efficiency. At the same time most Government programs to target the poor more directly -- through subsidies and transfers, food supplements, employment and income generation, credit, and intensive rural development projects -- have had limited success.  The Post-March 23 Trade and Transit ReRime 15. Differences in views on a number of issues led to a breakdown in discussions to renew the trade and transit treaties. With the expiration of treaties on March 23, 1989, all trade over surface routes with India was restricted to two border points. The loss of the trade and transit points applied to trade with India, third country trade crossing India, and intra- Nepal trade lbetween Central and Western Nepal. Because trade between the westernmost development regions of Nepal and the rest of Nepal traditionally ;ok place through India and this was no longer possible. it led to severe aiortages of some essential goods in the west and an unmarketable surplus of some agricultural products. A second significant change in the trade and transit situation came as a result of the expiration of the special commodity arrangements on fuel and coal. Given the logistical difficulties in arranging for fuel from third countries, Nepal was unable to import the same volume of fuel for many months. The Government therefore introduced a stringent system of fuel rationing, which continued for about eight months. 16. Another important aspect of the new trade regime was that both India and Nepal now applied MFN tariffs to bilateral trade. Thus Nepalese exports, which had been exempt from Indian tariffs, became subject to Indian MFN customs duties that were typically in the 100-150 percent range, effectively halting Nepal's exports to India. Nepal's imposition of MFN tariffs on Indian imports resulted in a 25 to 45 percent increase in tariffs. Initially, in an attempt to mitigate the price increase caused by the new tariff structure, the Government lowered all import duties. However, it later reversed this measure for fiscal reasons, and instead lowered tariffs on a number of essential imports. The Government also added a number of items to its Open General License (OGL) list, revised some specific tariff rates, and announced selective export cash subsidies. However, balance of payments transactions between India and Nepal continued to be conducted in Indian currency and the exchange rate between the two rupees continued to remain fixed. Moreover, IC was still convertible into the Nepalese rupee. In an attempt to control capital flight, Nepal placed restrictions on the purchase of Indian currency. Economic Performance since the ImDasse 17. Under the new arrangements for importing fuel described above, both the volume and the cost of imported fuel were significantly affected. The cost of fuel was estimated to have increased by about 40 percent on average and the volume of fuel to have fallen by about 40 percent between March and October, before recovering. There have been even more difficulties in importing coal from third countries because of its bulky nature, and the landed cost is estimated to have been about 50 percent higher than that of Indian coal. After a few weeks of a virtual halt in imports from India immediately following the impasse, other imports from India have almost completely recovered as traders became familiar with Indian MFN procedures. However, it is estimated that the costs to importers have been raised by as much as 25 to 30 percent on average and that the price to the consumer is likely to have increased by even more than this amount. Imports from third countries also declined slightly following the impasse but this was due to a slowdown in economic activity rather than to difficulties in obtaining supplies or to an increase in costs.  -vi- 18. The effect of the impasse on exports to India has been dramatic. With the removal of the duty-free status of Nepalese exports to India and the application of Indian MFN tariff that were typically in the 100-150 percent range, Nepal's exports to India virtually disappeared. Of the two major exports to third countries, carpet exports continued to grow despite the impasse, but garment exports initially fell dramatically largely because of difficultias in procuring imported cloth from India. However, they have since picked up and are likely to reach record levels this year. Similarly, whereas Indian tourist earnings fell significantly last summer. third country tourism continued to grow to record levels as the Government gave tour operators and hotels priority for fuel and other essentials. 19. The effect of the impasse has varied considerably across regions and sectors. The western-most two development regions have been severely affected while the eastern and central terai regions have been the least affected given their proximity to the remaining two border points. Agricultural output, which accounts for over half of GDP and directly or indirectly provides employment to over 90 percent of the population, was not seriously affected since most crops had already been harvested prior to the impasse and because there has been favorable weather both in 1988/89 and 1989/90. However, industrial output, especially manufacturing and construction, which account for about 15 percent of GDP, was severely affected as a result of fuel, coal and power shortages, higher costs of imports, and the loss of the Indian market. Among the service sectors, retail and wholesale trade, transport, and financial services were seriously affected. Overall, it has been estimated that GDP during 1988/89 was about 3.5 percent less than it would have been in the absence of the impasse and that GDP growth during 1989/90 would be negligible, at best, instead of a previously forecast 4.5 percent. Thus the cumulative fall in GDP over the two years would be about 8 percent below what was expected in the absence of the impasse. 20. The impasse also contributed to a severe deterioration in central government public finances. During 1988/89, domestic revenues were 10.4 percent of GDP as compared to the 11.3 percent targeted under the SAP and are expected to remain at roughly the same level in 1989/90. Because of austerity measures taken by the Government following the impasse, regular expenditures were only slightly higher than programmed. On the other hand, development expenditures were much higher than programmed because the slowdown in project implementation following the impasse was offset by price increases in energy and construction materials, and by increases in advance payments to contractors. Thus the budget deficit reached 13.9 percent of GDP as compared to the programmed 10 percent. Although foreign resources for the budget were slightly higher than expected, it was not enough to make up for the overshooting of the deficit. Consequently, domestic financing of the budget increased to 4.5 percent of GDP in 1988/89, about three times the programmed level, but is programmed to fall to only 0.5 percent of GDP in 1989/90. 21. Given the difficulties in borrowing from the non-bank sector in the current circumstanceb, the higL domestic borrowing in 1988/89 led to a severe overshooting in central bank credit to the government. The resulting monetary expansion, coupled with the supply shock of the impasse, has led to a projected increase in the official rate of inflation to 10-12 percent for 1989/90. The monetary expansion, by contributing to increased imports and capital flight, also contributed to a decline in international reserves by one-third between March and October. With tightened fiscal and monetary  -vii- policy and a recovery in aid receipts, international reserves recovered to over 5 months equivalent of imports by February 1990. Policy Issues for the !uture 22. Prompt settlement of the impasse needs to be given the highest priority in view of its high costs resulting from the loss of trade and transit points as well as the uncertainties and costs associated with the new trade regime. In the interim, it is vital to ensure that macroeconomic balances are sustainable while continuing with structural reforms aimed at removing impediments to sustained growth. 23. To protect the viability of the balance of payments and restore faith in the Nepalese economy, the Government needs to continue with its program to tighten both fiscal and monetary policy, and to take additional external sector policies. On the revenue side, the Government has correctly taken measures in the last budget to raise taxes on some price inelastic goods. It is now important to resist pressures to increase tax exemptions. In addition, the Government should take measures to adjust or free-up the prices of many public enterprise goods and services, especially for power, water supply and fuelwood, in order to reduce central government contributions to public enterprises, increase efficiency, and improve the ability of public enterprises to fund operations and maintenance (O&M) expenditures. On the expenditure side, recent Government measures to reduce regular expenditures in 1989/90 are appropriate. Development expenditures were to have been cut by cancellation or deferment of low priority projects rather than by across-the- board cuts. While this has occured to some extent, in some cases the Government has cut back projects to a level where only salaries are paid and hence there is no implementation progress. If the project is clearly of low priority, the Government should consider shutting down the project and reassigning staff. Also, much of the cuts have occured in contingencies, which does not address the issue of prioritization of expenditures. 24. Monetary policy has been tightened by raising the commercial bank reserve ratio requirement from 9 to 12 percent. In addition, by sharply curtailing the contribution of the budget to monetary expansion, the growth of broad money is expected to decline sharply. The tight fiscal and monetary policies coupled with a continued gradual real depreciation of the Nepalese rupee against third countries should strengthen external competitiveness. These policies have so far been adequate to stop the outflow of international reserves. However, the Government needs to keep the exchange rate under close review and, in addition, may consider reversing the measure introduced in July which limited the convertibility of the Nepalese rupee into IC. This measure has proven to be unenforceable and has unforeseen negative consequences on Nepalese importers. 25. In addition to the interim policies described above, the Government needs to continue with the reforms initiated under the structural adjustment program so as not to lose the momentum of the reforms or send mixed signals to the economy. Key policies in this regard are in the areas of public resource management and financial sector reform. Given the large public investments in Nepal and, until recently, low GDP growth rates, there is widespread perception that the management of public resources is in need of improvement. Issues in this area relate to raising more public revenues through efficient tax reform and pricing policies, reducing budgetary subsidies to public  -viii- enterprises, improving the system of project planning and implementation, and improving the productivity of public investments through better O&M expenditures and increased private sector participation. The major recommendations in this area are described below (see Public Resource Management Issues). 26. There is an urgent need to improve the delivery of services in rural areas, particularly in family planning, health and education. Limited progress has been made in decentralization; and service delivery remains inadequate in all development sectors. Nowhere is this problem more apparent than in family planning. The high annual population growth rate limits the ability to improve the coverage or quality of services. There is thus an urgent need for more emphasis backed by a quantum increase in funding for family planning delivery, combined with greater devolution of responsibility and accountability to the local level. Increased funding for population programs must be accompanied by efforts to ensure access to education for girls and by further analysis into the factors which influence decisions on family size among the poor. Without a more frontal attack on population control, other efforts to alleviate poverty and preserve the resource base will be undermined over the longer term. 27. Measures are recuired to strengthen financial institutions and improve bank supervision and regulation. The banking system suffers from financial indiscipline with many borrowers being unable or unwilling to repay loans, while banks continue to accrue interest, show profits and pay out dividends. The situation has been exacerbated by poor supervision by the NRB and inadequate or non-existent prudential regulations in areas such as capital adequacy, single borrower lending limits, and loan provisioning. In addition, certain directives from NRB have further weakened the banking system. The most serious of these are directed credits, interest rate ceilings, and requiring commercial banks to open branches in rural areas. Recently, in principle, at least, most of these issues have been addressed. Banks are now legally free to set both deposit and lending rates, including those on priority sector credits; banks are no longer required to open rural branches; new directives on capital adequacy and lending limits have been issued; guidelines with respect to making adequate provisions for non-performing loans have been established; and appropriate legal amendments to extend the supervisory ambit of the NRB have been approved by the National Assembly. 28. However, some of these measures have not been implemented as envisaged. For example, the NRB has pressured commercial banks to make them agree on an interest rate structure. While most of the interest rates are in line with market forces, the principle of freedom to set interest rates and the flexibility to alter them as needed have been violated. In particular, the interest rate on priority sector credits has remained at 15 percent, 2 or 3 percentage points below administratively less costly industrial and commercial loans. This results in an implicit subsidy in excess of 5 percent, which ultimately erodes the capital of the banks. Similarly, the NRB is coercing the joint venture banks to open rural branches as a quid pro quo for permission to open branches in commercially-profitable areas. In addition, the Government is proceeding with a plan to require commercial banks to direct increasing amounts of credit to certain priority sector and income groups. Such measures will further weaken the banking system since experience in Nepal and elsewhere, especially in countries at low levels of development, has shown that directed credits in general are ineffective instruments of development  -is- and impair the financial condition of the banking system, which is an important pillar of economic growth.4/ It is imperative that the Government not require oanks to meet such lend_ng targets: instead, that measures be taken to liberalize explicit and implicit controls on bank behavior. PUBLIC R$SOURCE NhGDIENT ISSUES 29. Improving the management of public resources will require raising more resources and improving the efficiency with which they are spent. It is necessary to increase public revenues both to achieve a better balance between domestic savings and investment as well to finance more O&M expenditures and to leverage donor assistance for the public investment program. Here the focus is on increasing revenues through tax reforms as well as through adjustments in user charges and public enterprise prices. Ways to reduce public enterprise subsidies are also discussed. Until a more comprehensive sectoral review of expenditures can be undertaken, specific suggestions to improve the efficiency with which public resources are spent are divided into two categoriest (a) improvements in institutional aspects of government planning and project implementation, and (b) improvements in the productivity of public investments through better O&H, improved pricing policies, and greater reliance on private sector participation. Overview of the Revenue System 30. Although Nepal's revenue mobilization is among the lowest in the world (but comparable to that of other very low income countries), revenue efforts have improved substantially over the years. During 1965/66, Nepal only collected 3.6 percent of GDP in central government revenues; by 1984/85, this had increased to 7.1 percent of GDP. Following measures under the SAP to raise revenues and improve the efficiency and elasticity of public revenue, the ratio of revenues to GDP increased to 10.8 percent. The measures included tax reform, price adjustments, streamlining processes, improving tax administration, and transferring economic rents from the private sector to the Government. Key Tax Issues and Recunmendations 31. The last CEM suggested a number of measures to further improve the efficiency aspects of the tax system and its contribution to public revenues. These suggestions included reducing the use of exemptions on income, sales and excise taxes as incentives for investment, upgrading the tax on agricultural land which has been eroded due to exemptions and inflation, revaluing urban property, expanding the coverage of the personal income tax, including more services in the sales tax base, reforming the excise tax, and improving tax administration. Very few of these key reforms have been implemented to date. Since these tax reforms are crucial to increasing revenues by an estimated 2 percent of GDP over the medium-term, they need to be implemented at the first available opportunity. 4/ See, for example, Report of the Task Force on Financial Sector Operations, World Bank, July 1989.  32. In this report, particular attention is given to reforms in the area of property and land revenue taxes because their structure creates significant distortions in the economy while yielding little revenue. In addition, if the revenues from such taxes could be raised, they would contribute to local government revenues, an issue that has become more relevant in light of decentralization efforts and the crisis in local revenue collections as a rest:it of thi impasse. The report concludes that the overall system of property taxation needs to be streamlined. The major recommendations are to reduce property tax exemptions and to increase certain tax rates, particularly the tax rate on agricultural land. In addition, the value base needs to be kept current and the property taxes need to be developed as the main revenue source of local governments, thereby increasing the scope of fiscal decentralization. This would allow reduced reliance on more distortionary taxes &. on central government grants. Pricint Policies 33. There are many administered prices in Nepal. In addition to the user fees charged by different Government agencies (such as rural water, education and health services), there are a large number of goods and services provided by public enterprises (PEs) whose prices are fixed or regulated by the Government. PE pricing policy distinguishes between goods that are considered either non-essential or produced by the private sector, whose prices are to be determined by the market; those goods or services being produced by monop,ly enterprises, whose prices are to be regulated and set so as to recover full costs; and goods and services whose production is considered sensitive or critical for fulfilling basic needs, whose prices are decided by Cabinet. In such cases, the Government is to provide subsidies to cover the losses arising from the price controls; in addition, prices are to be adjusted gradually with the aim of reducing the size of the subsidies. 34. The above pricing policy has not been implemented as envisaged. Even when an agency has been given the authority to set prices, the Government, through its representation on the Board, exerts pressure on managers to set prices in line with politically dictated needs. For example, following the trade and transit impasse, the Timber Corporation was asked to lower the prices of fuelwood from Rs 90/kg to Rs 70/kg even though the open market price for fuelwood was over Rs 200/kg. In the case of monopolies, while the policy of regulation based on full price recovery is sound, the Government has often been reluctant to adjust prices. This has sometimes led to a deterioration of the service and an inability to expand its coverage (eg. urban water supply). In cases where the Government wishes to provide an explicit subsidy in order to promote its use or make it more accessible to the poor, the subsidy is often not able to be targeted effectively and/or provided to everyone. The consequent rationing usually results in the relatively well-off obtaining the subsidy. For example, the policy of subsidizing fertilizer in order to promote its use and make it more affordable to poor farmers resulted in the relatively better-off farmers or traders obtaining the subsidized fertilizer and selling it in India. In other cases, the subsidy has not been explicitly provided for in the budget, which threatens the financial viability of the PE and its ability to carry out its operations effectively. This has happened most dramatically in the Nepal Water Supply Corporation. 35. Recognizing many of the problems described above, the Government has recently taken a number of sensible policy measures. Fertilizer prices are  -si- now set at the levels prevailing at the Indian border and the AIC has been given the authority to adjust prices as frequently as necessary, without the need for Cabinet approval. As a result, Nepalese fertilizer prices are now roughly the same as in the Indian border towns. Similarly, petroleum product prices were raised by between 18 and 45 percent in July 1989 to reflect the increased cost of importing from third countries following the trade and transit impasse. International telephone and telex rates were raised in 1989 and Cabinet has approved increases in urban water tariffs of 100 percent. However, both the fuelwood price and lifeline electricity rates need to be raised significantly, and other power tariffs, telephone rates, irrigation water charges, urban water supply charges and diesel prices also need further upward adjustments. In addition, further reforms are needed in many areas in order to promote the flsxibility of the pricing system. Fixity of prices over long periods needs to be replaced by periodic review and adjustment as warranted by production conditions. Government Subsidies to Public Enterprises MPEs) 36. There are over 50 nonfinancial PEs in Nepal. PEs dominate major sectors of the economy with virtual monopolies in commercial energy and basic utilities, including electricity, oil, telecommunication and water. The manufacturing sector is dominated by PEs in the production of cement, jute goods, tobacco and sugar. Apart from a few PEs that generate persistent large losses, official statistics do not reveal a serious problem with respect to operational losses. Moreover, the main reason for the large losses is that these PEs undertake a welfare function for the Government. For example, the losses of the Agricultural Inputs Corporation and the Nepal Food Corporation, which account for 60 percent of total PE losses, arose mainly because critical agricultural supplies, especially chemical fertilizers, were sold below cost in response to national development objectives, and because food purchases by NFC were sold below cost to certain poor segments of the population. 37. Although Nepal's PEs appear to impose less of a fiscal burden than in other countries (2.5 percent of GDP rather than an Asian average of 4.5 percent), this is partly due to weak reporting, which understates the true contribution, and the fact that some implicit subsidies, such as loan guarantees, are off-budget. A more worrisome statistic is that the return on government equity is close to zero. 38. In order to control and rationalize subsidies, the Government needs to review various aspects of the subsidized programs and establish transparency and clear priorities. As a first step, the full subsidy cost needs to be identified by eliminating transfers provided implicitly through cross-subsidies and retention of revenues from commodity aid as well as through government-guaranteed loans. This would enable Government to establish clear guidelines concerning activities which should get priority in subsidy allocations and to develop options to limit the size of the subsidy budget. One option is to retain subsidies only in cases where Government insists on maintaining administered prices below the cost of delivery. Another option is to adjust prices gradually to reduce the needs for subsidy support as called for in the Government's official pricing policy for PEs (para 33). An alternative option is to link the provision of subsidies to monitorable improvement in performance (e.g. reduction in system losses, cost control, etc.). In addition, subsidy allocations to the commercially-oriented enterprises could be phased out gradually through a combination of price  -iit- adjustments and, where feasible, divestiture. If such PEs are still unable to operate in the market without subsidies. the Government should consider shutting them down. 39. Price adjustments are often an attractive way to reduce subsidies. In the public sector, however, where there are already severe problems of arrears to other public enterprises, the price incri 'i will not increase collections significantly. The arrears problem relates m, nly to the continued operation of loss-making enterprises and the inability of Government to phase them out or to provide adequate budgetary allocations to cover the persistent losses. To resolve this, the Government needs to budget adequately and explicitly for PE subsidies and, except in severe hardship cases, PEs need to enforce collection by cutting off service to agencies that are in arrears to them. Planning, Budgeting and Project Implementation 40. While Nepal has been highly successful in attracting large aid commitments and in introducing many important programs and policy initiatives, there is concern that returns on public expenditures have been much lower than envisaged, partly due to slow project implementation. The public expenditure program has been criticized for having too many low return projects, mainly as a result of poor planning, and for being overcommitted, both in its institutional and staffing capacity to implement the expenditure program and in the counterpart funds needed for speedy and effective implementation. This helps explain why there are insufficient expenditures on O&H and why realized returns on projects are much lower than expected returns. Nowhere is this more true than in the irrigation sector, where poor plannin; and insufficient O&M expenditures have led to a usable supply of water in only about half the command area. Improvements in the planning and budgeting system would create a better appreciation of the issues and bring out some of the trade-offs more explicitly. 41. While urrent reforms to improve the planning and program budgeting are on the right track, certain aspects need to be stressed in the manner in which the planning and budgeting system should evolve. Changes are needed in the planning system, shifting the emphasis away from target-setting towards helping create a medium term expenditure plan (MTEP) based on availabilities rather than needs, within which alternative uses of domestic and external resources can be analyzed, economic trade-offs considered and priorities established. For example, Eighth Plan growth targets have remained at the high levels consistent with BNP targets despite the difficulties caused by the impasse. Targeting indirectly encourages ministries to overload their programs and perpetuates the present situation of low project returns arising from agencies trying to operate beyond their absorption capacity and beyond the capacity of the Government to finance local costs. Finally, efforts underway to strengthen the planning capacity of the National Planning Commission (NPC) and to introduce program budgeting in line ministries should be complemented by efforts to strengthen planning units in major line ministries and to improve the recording of data, particularly national income data and the recording of aid in both the balance of payments and fiscal accounts. 42. Efforts to reintroduce program budgeting in the Ministry of Finance (MOF) have been successful in developing screening criteria for projects that  -xiii- have been used to identify a core program of high return projects in a number of sectors. In the process, budget preparation was systematized, the presentation of the Development Budget improved, and detailed knowledge on projects was built up in the MOF. The core program accounts for about three- quarters of development expenditures. Given the shortage of government counterpart funds and fluctuations in the availability of domestic revenues, it is now desirable to create a smaller set of "supercore& projects, which are crucial for economic growth and whose funding would be protected in the face of budgetary cutbacks. This became particularly apparent following the impasse which led to large shortfalls in domestic revenue collections. To be effective, the supercore program should be limited in size, no more, say, than 40 percent of the Development Budget. Program budgeting would also benefit by requiring agencies to routinely submit with their budget proposals up to date information on the total cost of projects, the utilization of funds to date and indicative estimates of future expenditures. In addition, in order to facilitate the proper provision of O&M expenditures, the budget process must more explicitly distinguish between capital, or other once-and-for-all costs and recurrent costs. Currently, the accounting system does not allow for a meaningful way to identify the capital and recurrent cost components of the budget. 43. Donors and project staff have frequently cited the budget release mechanism as a major factor behind Nepal's slow project implementation and have suggested a relaxation of release procedures. In fact, this mechanism is an instrument of expenditure control, enabling the Financial Controller General's Office to withhold money if expenditure statements are delayed or there are irregularities in the statements. In addition, it is the main instrument at MOF's disposal to control the budget deficit in the face of a shortfall in revenues. Thus the problems associated with the release of budgetary funds in Nepal are a symptom of fiscal stress, not a cause. More fundamental problems are the oveicommitment of the government budget, a lack of prioritization of expenditures, the incentive structure facing project managers, and an accounting system in need of reform. Thus, although there is a case for relaxing project release procedures for a few key projects, there is no point in unilaterally relaxing the release system for all projects at this juncture. Rather, the answer lies in working to reduce the overcommitment of the Government budget over the medium term and addressing civil service incentives, and delegation and accountability issues through improved legal procedures so that people rather than projects are penalized for irregularities. 44. Many observers believe that weak public administration is one of the root causes of Nepal's disappointing performance in project implementation. The Government has thus commissioned several studies to address the problem. Notwithstanding the extensive analysis and policy prescription by government commissions and other agencies, the administrative reforms have been slow in coming and the incentive structure of the Nepal civil service remaius weak. The tight resource situation precludes a significant increase in real pay. Retrenchment, which would be a complex undertaking, is considered politically unviable. While this has prevented some of the central issues of civil service reform from being directly addressed, the Government has proceeded with a number of other civil service reforms. The size of the civil service establishment has been frozen in budget terms and there has been some expansion in recent years in the number of grades. In support of decentralization, scales have been extended and specialist cadres have been  -xiv- created. It is now important to continue present job classification efforts and contain the overall size of the Civil Service, and to redeploy existing staff and tackle overstaffing and retrenchment. Improving the Productivity of Public Espenditures 45. In addition to macroeconomic and institutional reforms, there are two broad inter-related issues that need to be addressed in order to improve the productivity of public expenditures: (i) O&M issues, and (ii) private sector participation in development: (i) Operations and Maintenance Expenditures 46. Many public projects and programs in Nepal have not been able to achieve their full potential because of problems with O&M. For a variety of reasons, low priority has been given to O&M and insufficient funds have been allocated and spent on O&M. O&M institutions and management tend to be weak and there is a lack of staff incentives for O&M activities. The situation is exacerbated by the inadequate design of projects and by donors that are typically willing to finance new projects or to rehabilitate projects (that have deteriorated due to inadequate O&M) rather than to finance routine O&M. In addition, the Government and donors have undertaken more projects than can be sustained with the available amount of resources. Since there is both political pressure and pressure from donors to complete the projects, it is the O&M expenditures on completed projects that get squeezed. 47. The inadequate attention give- to O&M results in a deterioration of the good or service, lowering returns on existing projects and making it difficult to replicate the project or expand the coverage of the service. For example, the lack of maintenance on roads has deteriorated the roads to the extent that vehicle operating costs have increased by 30 percent or more and average speeds have fallen by 25 to 40 percent as compared to when the road was new. Thus there is no alternative but to carry out expensive road rehabilitation which could have been avoided if small amounts of routine maintenance had been carried out on a timely basis. For example, the Kathmandu-Hetauda road travel time is expected to be reduced from ten hours to six following a rehabilitation and proper maintenance. In urban water supply and sewerage, the lack of O&M funds to buy necessary chemicals endangers the quality of the water and poses a health hazard. In some areas, the Government has taken steps to address these issues. For example, the allocation to water supply has been doubled during the Eighth Plan and Cabinet has approved a doubling of water tariffs. At the same time, the Government approved in July, i989, a Comprehensive Development Plan for the urban water and sewerage sector, which addresses, inter alia, institutional weaknesses as well as problems of O&M and service coverage. With the assistance of donors, some of the most serious road deterioration problems are being handled through rehabilitation projects. 48. While the above measures are in the right direction, much more needs to be done to address this important problem. The most crucial is to budget increasing amounts for O&M. Because expenditures on O&M have not kept pace with the growth in infrastructure, returns on most O&M activities are now higher than in most new projects. Even if future O&M expenditures on new projects can be protected through careful project conditionality, their O&M requirements will crowd out O&M expenditures on other projects. Thus the Government and donors need to consolidate past investments and donors should  -xv- consider opportunities for funding O&M on past projects. In addition, where donors do not already finance 80-90 percent of project costs, donors should consider increasing their share of foreign financing in new projects. This needs to be accompanied by measures to improve management practices, develop O&M institutions, and find ways of relating O&M expenditures to project revenues or user charges. Management practices could also be improved by conducting annual sectoral surveys and assessments of O&M, by considering strategies for improving the efficiency and economy of O&M, and by issuing manuals for the maintenance of selective works (eg. irrigation, highways). Another important recommendation is to create an O&M division or unit within select line ministries such as within the Department of Irrigation. Finally, ways to earmark revenues from projects to expenditures on O&M is desirable in a number of areas such as irrigation, curative health services and higher education. (ii) The private sector role in economic development 49. There is a growing realization within the Government that while it needs to provide the necessary economic infrastructure and policy framework, the impetus for development must come from the private sector. This change in attitude has been brought about by the low or negative returns experienced in many public investments, which failed, in part, because they did not involve the private sector in the design and impleuientation stages. They were supply- driven rather that demand-driven investments. For example, one of the important causes for the poor water delivery in public irrigation schemes is the lack of farmer involvement in the critical design phase. Consequently, there is a lack of commitment by farmers and subsequent problems with maintenance, with a slow degeneration of the scheme to the point where farmers are unable to maintain the scheme. Often in such cases, it is necessary to carry out an expensive rehabilitation when relatively small amounts of routine O&M expenditures could have averted this situation. 50. The Government's new philosophy has manifested itself in both the BNP, which calls for increased private sector investment in helping fulfil basic needs, and the SAP, which makes the economic policy framework more attractive in order to encourage more efficient, and hence sustainable, private sector investment. Under the SAP, the Government has allowed an enhanced role for the private sectnr in the distribution of fertilizer and has reaffirmed a commitment to privatize select public enterprises. In addition, it has taken explicit measures to involve user groups in public irrigation schemes and in the forestry subsector. The Government is also: (a) identifying appropriate roles for the public and private sector in the importation and distribution of fertilizer and considering alternate ways of administering fertilizer subsidies; (b) considering the feasibility of contracting out the responsibility of urban water meter reading and repair, billing and collection; (c) planning the privatization of the National Transport Corporation's trucking and ropeway operations and encouraging the greater use of local contractors in public construction projects; and (d) considering an increased role for private consultants to supplement DOI's limited capacity to implement the irrigation sector program. 51. While these initiatives are in the right direction, they may be undermined by the top-down planning approach used both in the Basic Needs Program and in the Eighth Plan. Under this approach, inviolate, politically- mandated consumption or output targets are set and input requirements derived,  -xvi- regardless of the feasibility or costs of meeting either the output or input targets. Where the private sector cannot be induced to produce the good it is to be produced by the public sector, with foreign assistance making up the residual financing. This approach to planning fails to make important tradeoffs for resources between competing activities. There is little thought given to the question of how the production of the good is made accessible to the poor, who may not be able to afford the good. It is therefore suggested that targets be interpreted flexibly and that tradeoffs be explicitly considered through a realistic three-year rolling budget exercise. 52. Another way to increase private sector participation is through divestiture of select public enterprises. Although privatization has often been endorsed by successive governments in Nepal, there has been very 'Little progress in privatization. This is mainly due to the hesitation and unwillingness to adopt substantive measures that would result in significant changes in managerial control. Under the SAP, the Government reinitiated efforts to privatize, this time allowing the sale of block shares or whole enterprises (e.g. Balaju Textile, Tea Estates, Himal Cement) on a selected basis. However, these efforts were also unsuccessful for a variety of reasons. More recently, the Government is making efforts to revive the flagging privatization program with technical support from International Finance Corporation. The Government is now proposing to adopt a broader approach to privatization. It plans to retain strategic industries, such as utilities, in the public sector and to address the concerns that have frustrated previous reform efforts by broadening the range of instruments for pr"vatization. Accordingly, the Government is exploring a mix of options including (i) sale of shares to the public through the Securities Exchange, UiV sale of block shares or even the entire HMC share to groups or individuals, (iii) sale of shares to employees and managers, (iv) sale of assets of the enterprise, (v) use of leases or management contracts and (vi) restructuring or reorganizing as a prelude to divestiture. ItEDIN TEEM FPhMERR The Macroeconomic Framework 53. While _.ent efforts between the Governments of Nepal and India ta resolve the .,apasse are encouraging, it is still too early to speculate on when the impasse will be resolved or what trade regimv. will ultimately emerge. For purposes of economic forecasting under these circumstances, it has simply been assumed that the cur':ent trade and transit regime would prevail. On the policy side, it has been assumed that the Government continues to follow its structural adju.stment program. 54. Under these assumptions, and on the basis of policies outlined above, it was envisaged under the program that following two years of negative per capita GDP growth, positive growth would resume in 1990/91. Then, after an additional two or three years of low growth, Nepal would be back to the long- term growth path that would have occured in the absence of the impasse, although with a level of GDP that is about 13 percent lower. As a result of the higher import prices and transport costs, inflation is expected to rise in 1989/90, but to decelerate gradually to 7 percent by 1993194. The lower inflation rate is in line with expected Indian inflation and is supported by a restrained financial policy which envisages an increased tax effort and tight  -xvii- expenditure policies in order to avert an outflow of international re3erves. Thus following measures to broaden the tax base and to improve tax administration, Government revenues after 1989/90 are anticipated to increase by 0.5 percent of GDP annually. Development expenditures as a proportion of GDP are projected to grow somewhat in order to expand the infrastructure needed for the new regime while regular expenditures as a ratio of GDP are projected to decline. 55. Because of the effective loss of the Indian market and difficulties with garment exports to the United States, the dollar value of exports fell by 13 percent in 1988/89 and was expected to fall by an additional 20 percent in 1989190 under the program. Subsequently, exports were forecast to increase at 12-14 percent annually in dollar terms, although from a lower base. After an initial decline in 1989/90, imports were projected to grow at only about 5 percent annually, reflecting mainly the projected slow growth in domestic demand and some import substitution. The current account balance was envisaged to fall gradually from 10.4 percent of GDP in 1989/90 to 7.4 percent in 1993194. This is consistent with Government efforts to increase public savings which were assumed to increase from -1.9 percent of GDP in 1988/89 to 0.2 percent of GDP in 1993/94. 56. The current account deficit was expected to be financed mainly by grants and loans on highly concessional terms. Nevertheless, under the program international reserves are projected to continue to fall slightly to 1991/92. Although reserves are expected to improve subsequently, they would represent about 4 months imports coverage in 1993/94 as compared to 5.5 months in 1988/89. To maintain this level of reserves, Nepal would continue to need disbursements from program loans averaging $82 million annually. Since virtually all of Nepal's external debt has been contracted on highly concessional terms, its debt-service ratio, including repayments to the IMF, is projected to be only about 13 percent in 1989/90. This ratio is projected to fall after 1990/91 and should not pose a large burden. However, in view of Nepal's persistently large current account balance, it is necessary for the Government to continue with its policy to limit its external borrowing to concessional loans. Development Planning and External Aid Implications 57. External assistance, almost entirely in the form of grants and concessional loans, has played a major role in the design and finance of Nepal's development plans and expenditures. The share of foreign financing in development expenditures is likely to be much higher than the officially recorded figure of 49 percent during 1975/76 to 1987/88. This is because a significant proportion of direct payments and technical assistance disbursements are not recorded. The balance of payments only records foreign disbursements that are brought into the country. Thus salaries of expatriate staff that are not spent in Nepal and overheads of foreign contractors are not recorded. These payments typically also fail to get recorded in the development budget. Sometimes they are included in the budget but not recorded unuer expenditures, which may partially explain why actual expenditures appear to be only about 852 of budgeted expenditures. It is estimated that perhaps 20-25 percent of project aid disbursements fail to get recorded and that the proportion of unrecorded technical assistance is even higher-  -xviii- 58. Thus, the true levels of the current account balance and budget deficit are under-estimated. This undermines the whole planning exercise of the Government as well as Government attempts to obtain indications of donor support for their programs. If Nepal is to make its planning and budgeting system more relevant, it is critical to improve the recording system of aid flows and expenditures. Over the medium-term, the Government needs to improve its system of iecordation of aid flows. It may wish to consider technical assistance toward this end. In the short-run, such recording could be improved by reconciling donor disbursement data with that of the Government as best as possible and to adjust balance of payments and development expenditure data accordingly. 59. Although the under-recording of foreign assistance makes projections on aid requirements less meaningful, it is still instructive to compare how Nepal's aid disbursemer.t needs over the next three years compare with past levels, recognizing that both are probably underestimated. The current account deficit is projected to remain just below $300 million, thereby falling as a proportion of GDP. Taking into account loan amortization needs, the total disbursement requirement would be over $300 million annually, which is lower than what Nepal would require if the impasse was resolved. The bulk of this is expected to come from disbursements on already committed loans and grants, while new aid commitments for 1990/91, excluding the 268MW Arun-3 hydropower project, are projected to be about $370 million. Aid commitments for Arun-3 would be about $650-700 million, which would be committed over the four years 1990/91-1993/94. 60. If, as is likely, the impasse is resolved soon, both the economic prospects and implications for additional aid will need to be revised. As a result of stronger import growth, the current account deficit and foreign exchange requirements will be greater. More new development projects could be undertaken and domestic revenues could improve commensurately to provide the counterpart resources without straining the fiscal system. Aid commitments for 1990/91 would then need to rise to about $450-500 million, excluding Arun-3. Under this scenario, GDP growth could increase substantially, partly making up for the reduced economic activity for 1988/89 and 1989/90, and the Government could move ahead more forcefully on its structural reforms.  PART It RECENT ECONOMIC DEVELOPHENTS CHAPTER 1: DEVLOPMENTS PRIOR TO THE TRADE AND TRANSIT IMPASSE 1.01 Nepal, wit1h its 18 million inhabitants, had a per capita income of only $170 in 1987/88.11 It has been unable to raise its standard of living substantially despite over three decades of development efforts supported by external assistance. Other statistics confirm the existence of widespread poverty and deprivation. Life expectancy at birth (54 years for males and 51 years for females) and infant mortality rates (111 per 1000) are comparable with the world's least developed countries as a whole. 1.02 Nepal's first five development plans (1954155-1979/80) did not result in an appreciable increase in per capita income. During the Sixth Plan (1980/81-1984/85), growing frustration with low rates of economic growth led the Government to abandon their earlier conservative fiscal policies and embark upon an expansionary fiscal path financed largely by bank borrowing. Although this resulted in a substantial increase in the growth of output, it also contributed to a decline in international reserves as the excess demand led to increased imports from India. When it became apparent that the fiscal-led growth could not be sustained, the Government implemented a stabilization program in 1985/86 which was supported by an IMF Standby Arrangement. 1.03 Realizing that macroeconomic stability by itself would not lead to increased growth, the Government embarked on a structural adjustment program (SAP) to address longer-term constraints to growth. The program was supported by World Bank Structural Adjustment Credits (SALs) in 1987 and 1989 and by an IMF Structural Adjustment Facility (SAF) covering the fiscal years 1987188-1988/89. Until March 1989, the program was very successful in increasing the rate of growth and correcting macroeconomic imbalances, thereby setting the stage for sustainable growth. In addition, a beginning was made in addressing some of the longer-term and institutional constraints to growth. 1.04 The economy's growth momentum was interrupted abruptly on March 23, 1989 with the lapse of the trade and transit treaties with India. Because of the close links between the Nepalese and Indian economies, the resulting disruption of Nepal's trade has had widespread and serious repercussions on the economy and has implications for the Government's structural adjustment program. 1.05 This report focusses on two sets of issues: (i) macroeconomic and incentive framework issues in light of the trade and transit impasse and (ii) issues relating to public resource management. Both are key for sustained growth. The report is divided into three parts. Part I, which consists of Chapters 1 and 2, deals with recent economic developments. Chapter 1, which is limited to developments prior to the trade and transit 1/ The Nepalese fiscal year ends on or about July 15.  - 2 - impasse, describes the structure of the Nepalese economy, reviews progress under the SAP, and suggests medium-term policies for sustained growth. Chapter 2 describes economic developments since the impasse. It points out the changes in the trade and transit arrangements, describes policies and performance under the new regime, and discusses policy issues for the future. Part II, which consists of Chapters 3 and 4, focuses on public resource management. It addresses issues related to raising public resources and improving planning and project implementation, and suggests some ways to increase public investment productivity. Part III, consisting of Chapter 5, presents a medium term framework, discussing economic prospects and external financing issues. A. Economic Structure and Constraints Constraints to Development 1.06 Various factors explain why Nepal's development has been constrained: some reflect its rugged terrain, land-locked position, and resource endowment; some emanate from institutional weaknesses and poor infrastructure; and others are a consequence of inappropriate policies. The rugged terrain has restricted Nepal's arable area and created microclimates that impede the widespread application of standard cultivation techniques. At the same time, with the virtual eradication of diseases such as malaria, the population has continued to increase at an average rate of about 2.7 percent annually over the last two decades. The resulting high population density per unit of arable land, wher. combined with rapid human and livestock population growth, has forced farmers to cultivate increasingly marginal lands and forests. Thus, despite the introduction of high-yielding varieties of many crops, yields of virtually all crops have stagnated or declined over the last 15 years as a result of overcultivation, soil depletion, and use of more marginal lands. The low productivity of land, especially in the Hill areas, coupled with small fragmented land holdings, has limited on-farm employment opportunities and caused many Hill and Mountain people to seek off-farm employment and to migrate to the Teraill or to India. 1.07 In addition to the depletion of forests in order to cultivate crops or for use as fodder, forests have been denuded to meet the growing household demand for fuelvood. Over 90 percent of energy consumption in Nepal comes from traditional sources such as fuelwood and dung, of which two-thirds is from fuelwood alone. The man-made depletion of forests exacerbates natural soil erosion and further limits the magnitude and productivity of arable land. Thus, even though Nepal may make progress in its efforts to permit the economy to function more efficiently, this alone will not interrupt the vicious cycle of population growth, poverty, and depletion of natural resources. To do 21 Nepal can be divided into three ecological zones: the mountains of the Himalaya, bordering Tibet to the north, the middle Hills, and the Terai plains to the south, bordering India.  - 3 - this, Nepal must also make greater strides to limit population growth and build environmental considerations into its basic development decisions. 1.08 Besides the meagre endowment of physical resources, Nepal development is constrained by limited infrastructure, weak institutions and a relatively tiny literate or skilled population. Emerging from self-imposed isolation in the early 1950s, Nepal had practically no infrastructure or educational system at the time. Less than one percent of school-age children attended school in the early 1950s. Although Nepal has made much progress in expanding the infrastructure and schooling system, the expansion has been constrained by the rugged terrain, institutional capacity to implement projects, and ability to raise domestic revenues to operate and maintain the systems. An all-weather road link from the far-western part of Nepal to the central and eastern regions is still under construction; less than one half of one percent of Nepal's theoretic hydropower potential of 83,000 Mw has been tapped; much of Nepal's irrigation system is unable to deliver a usable supply of water due to lack of funds for operating or maintaininig the system; only about 10 percent of the population have access to safe water, and sanitation - facilities, to all intents and purposes, de not exist in the smaller towns and rural areas; and although literacy rates have increased to about 34 percent, female literacy rates, at about 18 percent, are less than half those of males. The low female literacy rates limit the ability to improve primary health care and control the population growth rate. In turn, a 2.6 percent annual population growth rate, implies that Nepal needs to increase services by 2.6 percent in real terms just to maintain the current population coverage. 1.09 Nepal's land-locked position and long border with India have increased transportation costs and limited its flexibility in designing economic policies, thereby restricting economic growth. For example, to stop the deflection of third country imports to India, which has high protection, the public sector has issued industrial and import licenses. These restrictions have tended to suffocate private sector productive activities and have led to unproductive rent-seeking activities. The problems have been compounded by inappropriate pricing policies and poorly designed or implemented public investments. For example, a policy of keeping fertilizer prices low in order to stimulate fertilizer consumption resulted in widespread smuggling of fertilizer to India. Similarly, a large number of donors, undertaking more projects than can be supported by existing domestic financial and institutional resources, has resulted in many low-return projects. For example, the bulk of Nepal's public irrigation schemes have failed to provide adequate water delivery while delays in project implementation and/or insufficient maintenance on completed projects have resulted in much lower returns in many projects. While measures under the SAP are designed to improve the efficiency of the economy by correcting such policies or strenghthening the institutional structure, such efforts are constrained by many of the factors discussed above.  - 4 - The Structure of Output and Macroeconomic Balances 1.10 The structure of output and macroeconomic balances, as well as of the fiscal and trade regimes, limit the speed or extent to which policy measures can lead to improvements in the standard of living. Although the share of agriculture in GDP has declined over the years. it still accounts for over half of GDP (Table I.1). Given the constraints to improving productivity I in crop or livestock production, agriculture is unlikely to be the vehicle for - substantial and sustained economic growth. However, since over 90 percent of Nepal's population and virtua'ly all of Nepal's absolute poor live in rural areas, it is important to intensify efforts to raise productivity and incomes in agriculture. This is even more true because of the limited ability to generate employment in other sectors. Although the manufacturing sector has grown fairly rapidly in recent years and has the most scope for further expansion and employment creation, it is constrained by the industrial and import licensing regime which is needed to prevent smuggling of third country goods to the protected Indian economy. In addition, Nepal's land-locked position increases import costs and its low wage advantage is mitigated by competition from the neighboring low wage Indian states of Bihar and Bengal. Similarly, whereas there is significant potential for hydropower development, this is dependent on the ability to reach understandings with India, which have thus far been elusive. In addition, while hydropower exports to India could bring in much revenues, they will not lead to significant increases in employment. Construction has been a booming sector but this has be n due largely to public construction activity, which is dependent on aid flows. Table I.1: STRUCTURE OF GDP 1975/76 1981/82 1984/85 1987/88 Agriculture, Fisheries, and Forests 66.1 57.2 53.9 52.1 Mining and Quarrying 0.1 0.2 0.3 0.2 Manufacturing 4.0 4.0 4.5 6.0 Electricity, Gas & Water 0.2 0.3 0.4 0.6 Construction 4.1 7.6 8.1 8.7 Trade, Restaurants & Hotels 3.5 3.4 4.1 4.5 Transport & Communications 4.6 6.4 6.2 5.5 Financial and Real Estate 6.7 7.6 7.7 7.3 Community & Social Services 6.0 7.0 8.3 8.0 Of which: Public 4.7 5.6 6.8 6.6 GDP at Factor Cost 95.4 93.7 93.6 92.9 Net Indirect Taxes 4.6 6.3 6.4 7.1 Of vhich: Agriculture 0.7 0.6 0.5 0.5 GDP at Market Price 100.0 100.0 100.0 100.0 Source: Statistical Appcndix Table 2.2.  - 5 - 1.11 Nepal's macroeconomic balances exhibit structural deficiencies that point to a heavy reliance on external assistance. The balance of payments shows that merchandise imports are three times merchandise exports and the resource balance grew to 11 percent of GDP by 1987/88 (Table I.2). Net factor service income and net current transfers, mainly from interest earnings and worker's remittances respectively, have helped reduce Nepal's needs for foreign financing. However, there is still a large and growing current account deficit. Because the deficit has been financed by foreign grants and concessional loans, it has not led to debt-servicing problems. However, the precarious nature of the balance of payments limits Nepal's ability to borrow funds on commercial terms. For example, Nepal's financing of two commercial aircraft on commercial terms along with their purchases under the IMF Standby Arrangement have resulted in a doubling of Nepal's debt- service ratio in three years. 1.12 The fiscal structure also shows a large and growing dependence on foreign financing. Following an attempt to stimulate aggregate demand, Table I.2: BALANCE OF PAYMENTS STRUCTURE (Percent of GDP; 1975/76 1981/82 1984/85 1987/88 Exports (GNFS) 10.8 11.6 12.1 12.8 Merchandise f.o.b. 6.9 4.8 6.2 6.1 Non-factor Services 3.8 6.8 5.9 6.8 Imports (GNFS) 14.2 18.8 21.0 23.9 Merchandise c.i.f. 11.6 16.0 17.5 20.5 Non-factor Services 2.6 2.8 3.5 3.4 Resource Gap 3.4 7.2 8.9 11.0 Net Factor Income 0.4 0.5 0.0 *0.1 Net Current Transfers 1.9 1.7 1.7 2.4 Current Account Balance -1.1 -5.0 -7.2 -8.7 Official Grant Aid 1.5 3.7 3.0 1.9 Net M&LT Loans 0.8 2.5 2.9 6.4 Capital Flows N.E.I. /a 0.9 0.4 -0.6 3.7 Overall Balance 2.1 1.6 -1.9 3.4 /a Includes errors and omissions. Source: Statistical Appendix Tables 3.1 and 1.2.  Central Government expenditures, which account for the bulk of public expenditures, grew tremendously during 1981/82-1987/88. Although such expenditures averaged only 12.9 percent of GDP during 1974/75-1980/81, they since have averaged 19.4 percent of GDP (Table 1.3). Most of the increase is accour"-ed for by an increase in development expenditures3/, which increased from 8.5 percent of GDP to 13.0 percent of GDP over this period. Over the same period, domestic revenues have averaged only 9.3 percent of GDP, less than half the level of expenditure. The gap has been financed either by foreign loans (41 percent), foreign grants (26 percent), or domestic borrowing (34 percent). Domestic borrowing has been treated as a residual and has shown great volatility. Because virtually all the domestic borrowing has been from the Central Bank at zero or concessional interest rates, it has contributed to macroeconomic instability and limited the ability of the Central Bank to carry out independent monetary policy. Table I.3: CENTRAL GOVERNMENT BUDGETARY PERFORMANCE (As percent of GDP) Average Average 1974/75- 1981/82- 1980/81 1981/82 1984/85 1987/88 1987/88 Revenue 7.6 8.6 8.8 10.8 9.3 Tax Revenue 6.2 7.1 7.1 8.5 7.4 Non-Tax Revenue 1.4 1.5 1.7 2.4 1.9 Expenditure & Net Lending 12.9 17.3 18.9 20.8 19.4 Regular 4.4 5.3 6.5 6.9 6.4 Development 8.5 12.0 12.4 13.9 13.0 Overall Deficit 5.3 8.7 10.1 10.0 10.1 Financed by: Foreign Grants 2.5 3.2 2.1 3.1 2.6 Gross Foreign Borrowing 1.6 2.4 4.0 5.6 4.1 Gross Domestic Borrowing 1.2 3.1 4.1 1.3 3.4 Source: Economic Survey, 1988/89 and Ministry of Finance. 3/ Development expenditures generally include all expenditures on foreign- funded projects or programs and a few select government-funded projects. Roughly half the development expenditures were recurrent during 1987/88. Regular expenditures comprise mainly salaries and interest payments, but also include capital and recurrent expenditures on most government-funded projects or programs.  - 7 - 1.13 Nepal's increasing dependence on foreign financing can also be seen by noting that the share of gross domestic investment financed by foreign savings has increased to over 40 percen.. of GDP by 1987/88 (Table I.4). The foreign savings are devoted entirely to financing public investment. In fact, the private sector investment/savings balance has been continuously negative suggesting that private savings, in the form of net domestic borrowing of the Government, have been used to finance public investment. Under the SAP, both the private investment balance and net domestic borrowing fell from their high levels in 1984/85. Another significant point is that despite Nepal's low per capita income, private national savings are relatively high at between 13 and 19 percent of GDP. This partially reflects sizeable net current transfers and factor service income from Nepalese nationals working abroad (mainly India) or receiving pensions from prior service in foreign armies. Trade Regime and Structure 1.14 Nepal's land-locked location -- its only access to the sea being through India -- and its long and relatively open border with India have been the main determinant of its trade regime. Its close links with the Indian market and dependence on Ind,a for transit routes has resulted in Nepal and India having a special trading relationship. This relationship has resulted in many advantages for Nepal but has constrained Nepal's ability to conduct an independent trade policy. 1.15 Prior to March 23, Nepal and India had a special trading relationship that was governed by two treaties signed in March 1978. A transit treaty allowed Nepalese imports entering Calcutta by sea to pass through to Nepal at any one of 15 points along the Nepalese-Indian border free from Indian taxes or import duties. It also specified provisions for storage, use of harbor facilities and transhipment. A trade treaty (along with a protocol to the treaty) allowed bilateral trade to occur at 21 points along the common border with primary commodity imports being duty-free in both directions. Manufactured exports from Nepal were duty-free as long as they met stringent criteria on rules of origin while Indian manufactured exports were typically charged a low preferential tariff but did not need to meet rules of origin criteria. An agreement of cooperation to control unauthorized trade was signed at the same time. 1.16 In addition to these treaties, there were several other factors involved in the special relationship. First, reciprocal privileged treatment was given for nationals of the two countries regarding residence and participation in commerce based on the 1950 Treaty of Peace and Friendship. This has led to an estimated 3 million Nepalese living in India and about 1 million Indians living in Nepal. Second, there is full convertibility of the Indian rupee in Nepal, with all balance of payments transactions between the two countries being conducted in Indian currency (IC). In addition, there are no quantitative or other restrictions on either current account or capital  Table 1.4: MACROECONOMIC BALANCES (Percent of GDP) 1975176 1981/82 1984/85 1987/88 Foreign Savings Current Account Balance /a -1.7 -4.5 -6.2 -8.5 Private Sector Gross Domestic Investment 11.5 9.1 14.8 11.8 Fixed Investment 10.4 9.6 13.0 9.9 Change in Stocks /b 1.1 -0.5 1.8 1.9 National Savings /c 13.7 14.1 19.4 13.0 Investment minus Savings -2.2 -5.0 -4.6 -1.2 Public Sector Jd Gross Domestic Investment 3.6 8.0 8.2 7.9 National Savings -0.3 -1.4 -2.7 -1.8 Current Revenues 6.4 8.6 8.8 10.8 Current Expenditures Ie 6.7 10.1 11.5 12.6 Investment minus Savings 3.9 9.5 10.8 9.7 Public and Private Investment minus Savings 1.7 4.5 6.2 8.5 Memorandum Item: Share of GDI financed by Foreign Savings 11.4 26.1 27.2 43.2 /a Due to discrepancies between national income and balance of payments acccmnts, figures may differ from those in Table I.2. /b Includes both private and public. Ic Excludes grants. /d Central Government only. /e Assumed to include all regular expenditures and 40-50 percent of development expenditures. ma?et transactions between the countries. The combination of these factors co?1bit.ed with India's size, proximity and transport cost advantage has led to India being Nepal's dominant partner for both exports and imports. In 1974/75, India accounted for 78 percent of Nepal's non-oil imports and 86 percent of its exports. However, with the recent increase in aid-related imports and carpet and garment exports to third-countries, the percentages dropped to 35 and 38 respectively in 1987188. Finally, there were special commodity agreements between state corporations under which Indian corporations sold petroleum products, coal, sugar and salt to Nepalese state  - 9 - corporations. The most significant of these was a product exchange arrangement whereby the Nepal Oil Corporation (NOC) purchased either refined petroleum products or crude oil internationally and delivered them to Indian ports such as Madras or Bombay, where they essentially became part of the Indian Oil Corporation's (IOC's) inventory. In exchange, IOC released to NOC Nepal's required mix of petroleum products from IOC's border refineries. The price was determined by IOC and reflected the delivered cost of the products at the entry port plus the costs of transportation, storage and handling. 1.17 The special features of the economic relationship with India had ramifications on both bilateral and third country trade. Since Nepal and India, while having low tariffs between themselves, did not have a common tariff with respect to the rest of the world, it created incentives for smuggling. Given India's high tariff structure and Nepal's wish to keep a lower tariff structure, there was an incentive to smuggle third country goods from Nepal to India. To mitigate smuggling, Nepal developed an elaborate structure of quantitative restrictions (QRs), import licenses and administrative controls on third country imports and kept tariffs on many such goods at a higher level than desirable under normal circumstances. Despite recent reforms, the system of foreign exchange allocation remains complicated. QRs are implemented through a licensing system linked to a foreign exchange budget that is allocated among each of the line ministries. The largest allocations are to the Ministry of Industry for industrial inputs and the Ministry of Commerce for commercial imports. 1.18 On bilateral trade, because of the relatively open border and low tariffs, India did not exempt the Indian exporter from paying domestic excise taxes on exports to Nepal as is customary. This is because the Indian Government feared that the Nepalese importer, having avoided the domestic Indian taxes, could find it profitable to re-export the good back into India. Instead, when a Nepalese importer ordered a good directly from the Indian manufacturer, the Indian Government gave the equivalent central excise duty refund to the Nepalese Government as long as the Nepalese tariff exceeded the Indian excise duty. Because of cumbersome administrative procedures and the convenience (including the possibility of credit) of importing through an Indian trader, only about 25 percent of non-oil imports from India received this refund. Similarly, to ensure that Nepalese manufactured exports to India did not have a high third country import component, India required the Nepalese exporter to demonstrate that at least 80 percent of the value-added was of either of Nepalese or Indian origin. These procedures were also very cumbersome -- each product of each company had to carry out the procedures and to repeat them every two years. Partly as a result, despite Nepal's "free" access to the enormous protected market next door, only about 20 percent of Nepal's exports to India were composed of manufactured goods. 1.19 Nepal has recently made a number of reforms in its trade regime co simplify and liberalize trade with a view to promote efficient industrial activity and to transfer economic rents from importers to the Government. A simplification of tariffs was implemented in July 1987. Prior to this, the tariff structure had 87 rates ranging from zero to 450 percent and a plethora of license fees and sales tax markups. This structure was collapsed to a  - 10 - system with 10 "basic duty* rates with a maximum rate of 100 percent and four additional duty rates ranging from 25 to 55 percent (Table 1.5). The rate were low to moderate on raw materials, machinery and intermediate goods and were high on consumer and luxury goods, reflecting Government desire to stimulate industry, obtain tax revenues, and minimize incentives to smuggle third country goods to India. As an exception, synthetic fabrics, which have a high potential for smuggling to India, were subject to a 100 percent additional duty rate and a few luxury goods, such as wines and liquors, were subject to 150-200 percent tariffs. License fees and other markups were abolished and a new simplified four-slab sales tax with rates in the 5 to 20 percent range was introduced. Finally, an export duty drawback system was introduced. 1.20 It was necessary to make the overall tariff structure high in order to reduce incentives for smuggling third country goods to India. U However, the Government also realized that if this structure would apply to trade between India and Nepal, importers would simply bypass formal chs'.-nels to avoid paying the high duties. Therefore, Indian imports were exempted from additional duties as long as the basic rate was below 50 percent. In addition, 7 other commodities were exempt from additional duties regardless of origin. Furthermore, goods imported from India did not need an import license and were not subject to quantitative restrictions. Recognizing the open border with Tibetan region of China and the historical trading ties, goods from the Tibet were given similar preferential treatment. Tariffs on libetan goods were in the zero to 10 percent range for 80 commonly imported items such as some raw materials, processed foods, qugar and precious stones. Finally, South Asian countries as members of the regional trade association, SAARC, were given a 10 percent rebate on the value of additional duty while 13 Most Favored Nation (MFN) countries received a 5 percent rebate. Table 1.5: IMPORT TARIFF STRUCTURE Basic duty (Percent) Commodities 5 Raw materials,machinery 10 Semi-processed 15 Fully processed 20, 25, 30 Consumer goods 50, 70, 100 Luxury goods Basic duty (Percent) Additional duty (Percent) 5-10 25 15-20 35 25-30 45 More than 30 55  - 11 - 1.21 Another significant development in the trade policy area was the introduction in 1986 of an auction system for import licenses for commercial imports from third countries. Approximately four times a year, the Ministry of Commerce conducted an auction for a positive list of commercial imports. By March 1989, the list grew to include virtually all commercial goods and also some industrial and raw material goods, though most industrial and capital goods continued to be outside the auction system. A few items that are both intermediate and final goods are included in the list. The premium for each good or category of goods was determined by taking a weighted average of the bid prices above a threshold (to discourage spurious bids to bring down the premia) and all bidders above this average were given a license. AP such, the bid prices reflected a combination of foreign exchange premium, quantitative restrictions, and potential profitability for smuggling to India. The average premium has fallen from 61 percent during 1986187 to 18 percent during 1988/89, reflecting an increased availability of foreign exchange and changes in the manner in which the auctions were conducted. Although there have been frequent shortfalls of the utilization of foreign exchange allocations, revenues from such auctions comprised 13.6 percent of total revenues in 1986/87 but only 6.4 percent in 1988/89. 1.22 A third development was the introduction of an Open General System (OGL) system for industrial inputs. Introduced initially to ease the import of raw wool and steel billets, the list was rapidly expanded to 91 items by March 1989. While there are no quantitative restrictions or monitoring for raw wool and billet, the other inputs importable under OGL are subject to annual limits based on the capacity of the firm. The output of the firm is then monitored to ensure that the goods were indeed used in production and not deflected to India or sold in the domestic market. To discourage deflection, the Government introduced premia ranging from 10 to 25 percent on many of these Inputs. By March 1989, about half the items under industrial OGL carried premia. 1.23 Nepal's composition of trade has changed remarkably over the years. Food and live animals accounted for over two-thirds of exports in 1975/76 but less than one-fifth of exports in 1987188 (Table 1.6). This reflects both a decline in the agricultural surplus and a rapid increase in garment exports to the United States and carpet exports to Europe. These two exports now account for over 50 percent of all merchandise exports. Imports, especially those from third countries, have grown more rapidly than exports. This is partly the result of increased aid-related imports. Although Indian imports have grown in real terms, their share of total imports has fallen substantially. However, they still account for over one-third of non-oil imports.41 4/ Under the special commodity arrangement, petroleum imports from the Indian Oil Corporation were recorded in both the Indian and third country trade statistics depending on whether they were paid for in Indian rupees or hard currencies. In general, transportation and handling charges of the Indian Oil Corporation were subtracted from the total cost of petroleum and paid for in Indian rupees, while the balance was paid for in hard currencies.  - 12 - Table 1.6: STRUCTURE OF TRADE Share of India Average All Countries in Total Real (Percent of Total) (Percent) Growth la 1975/76 1987/88 1975/76 1987/88 World India Exports, f.o.b. 100.0 100.0 75.4 38.1 3.0 -2.7 Food and live animals 67.8 19.5 89.8 96.1 -7.1 -6.6 Tobacco and beverages 0.3 0.2 87.5 17.8 0.3 -12.1 Crude materials, inedibles, except fuels 19.1 12.5 60.1 75.9 -0.6 1.4 Mineral fuels and lubricants 0.1 0.0 58.8 100.0 -12.8 -8.8 Animal and vegetable oils and fats 0.2 4.2 77.8 84.1 35.8 36.7 Chemicals and drugs 0.8 0.3 62.4 88.1 -4.8 -2.0 Manufactured goods, chiefly classified by materials 8.8 38.9 13.8 14.3 16.6 16.9 Machinery and transportation equipment 0.3 0.0 37.8 20.0 -21.4 -25.5 Other manufactured products 1.9 24.2 13.5 1.6 27.1 6.3 Other 0.6 0.1 72.6 100.0 -15.1 -12.8 Imports, c.i.f. 100.0 100.0 61.9 33.1 9.2 3.7 Food and live animals 14.7 11.0 88.7 76.3 6.6 5.3 Tobacco and beverages 2.1 1.2 75.2 94.7 4.4 6.4 Crude materials, inedibles, except fuels 4.5 7.5 35.1 12.4 14.0 4.5 Mineral fuels and lubricants 10.7 7.6 45.0 14.0 6.1 -3.7 Animal and vegetable oils and fats 0.4 2.5 74.3 1.8 28.1 -6.0 Chemicals and drugs 9.6 10.8 60.4 54.8 10.3 9.4 Manufactured goods, chiefly classified by materials 27.5 24.2 75.0 32.7 8.1 0.8 Machinery and transportation equipment 20.9 29.9 38.2 19.9 12.5 6.6 Other manufactured products 8.5 5.3 62.6 33.3 4.9 -0.4 Other 1.1 0.1 76.2 35.7 -15.8 -21.0 /a Average annual growth in current rupees deflated by GDP deflator. Source: Statistical Appendix Tables 3.2 and 3.3.  - 13 - B. Review of Recent Policies and Performance Overview of the SAP and Basic Needs Program 1.24 The theme of the structural adjustment program is to promote growth that is sustainable by strengthening macroeconomic and sectoral development policies and improving the efficiency of public sector investments and institutions. The adjustment program includes measures to increase domestic resource mobilization; reduce domestic bank borrowing; improve development administration and project implementation; strengthen the financial position of public tnterprises; reform the financial sector to strengthen the weak commercial banking sector and to improve monetary management and resource allocation; and liberalize industrial and trade policies to expand the traded goods sector and stimulate industrial production. These measures were complemented by sectoral policies to promote agricultural production through more efficient fertilizer distribution and irrigation water delivery; to promote tourism by purchasing two aircraft, liberalizing charter flights, developing new areas for mountaineering and trekking and restoring historical sites; and to conserve forests by enacting legislation to permit community-level forest user groups to manage and retain their earnings from certain forests. 1.25 Simultaneously with the SAP, the Government lar.ched an ambitious Basic Needs Program (BNP) to achieve by the year 2000 a standard of living which is commensurate to lead a life with human dignity by Asian standards." Aimed at reducing the proportion of population living in absolute poverty from 43 percent in 1985 to zero by the year 2000, BNP seeks to provide goods and services in six areas: food, clothing, shelter, health, education, and security. The program assumes that self-sufficiency is necessary to provide these services. Based on accepted national and social norms, production targets were calculated down to the district level and input and financing levels identified using fixed input-output coefficients. Realizing that the key to meeting basic needs in a poor country is through increasing incomes and employment rather than through redistribution and targeted expenditures and subsidies, the program emphasizes increased production, especially in agriculture, which directly or indirectly accounts for over 90 percent of employment. First announced in December 1985, the BNP has thus far been limited to planning and attempting to expand the civil service to prepare for the high investments foreseen in the 1990s. 1.26 The last World Bank Country Economic Memorandum (CEM)5/ focussed on an analysis and evaluation of both the SAP and BNP. It commended the BNP for dramatizing the urgency of the need to improve the living conditions of the poor. It concluded that many of the objectives of the two initiatives were complementary and that a successful SAP was essential to meeting the objectives of the BNP. The report praised the objectives of the BNP and its 5/ Nepal: Policies for Improving Growth and Alleviating Poverty, World Bank, Report No. 7418-NEP, October 14, 1988.  - 14 - found many positive features in its implementation strategy. These included BNP's focus on increasing incomes in agriculture and its reliance on the private sector, with appropriate roles for local government, community user groups and non-governmental organizations (NGOs). However, the report cautioned against an overemphasis on self-sufficiency and unrealistic output targets that could result in physical and financial input targets that bear little relation to demand or the ability to implement or finance the proposed investment targets. There is a danger that the emphasis on crash programs to meet demand driven targets will divert human and financial resources from efforts planned or underway to address the complexity of poverty and resource management problems. It therefore recommended greater flexibility in interpreting targets, a heavier focus on getting the institutional and policy framework right, and a consolidation of past investments before embarking on an ambitious investment program. Many of these recommendations are an integral part of the ongoing SAP. 1.27 The last report also found that efforts to reorient policies and meet basic needs represented a more coordinated and intensive approach than past programs and thus the opportunities for achieving structural reforms were much greater. It urged the pace of reforms to be maintained and pointed to early indications of a sustainable increase in the growth rate. Data on economic activity, public finances and the balance of payments through March 1989 support the thesis that economic growth in Nepal had indeed accelerated and that because of an improvement in macroeconomic balances and some progress in structural reforms, the growth was likely to be sustainable. The key features of the SAP and its performance relative to program targets are discussed in the next section. Performance and Policies Prior to the Impasse 1.28 Prior to March 23, performance under the structural adjustment program was encouraging. Except for low growth during 1986/87 as a result of harsh weather, the rate of growth appeared to have continued. In fact, the revised figures for 1987/88 indicate a real GDP growth of 9.7 percent for 1987/88, higher than prcviously estimated, and significantly higher than programmed (Table I.7). Agriculture was projected to have grown by 8.6 percent, following a year when production stagnated. Industrial activity, especially construction, is estimated to have increased rapidly. Capacity utilization for many manufacturing firms increased significantly. While evidence suggests that growth did indeed pick up sharply in 1987/88, these numbers probably overstate the magnitude (see para 1.43). The encouraging performance of GDP led the Government to target a growth rate of 4.4 percent for 1988/89 under the SAP. In fact, the rapid growth continued on into 1988/89; eight months into the year, it was projected that annual GDP growth would be 5.3 percent. Much of this was due to an exceptionally good harvest due to favorable weather. Moreover, because the growth rates occurred while the macroeconomic balances were improving, it was felt that the growth was sustaLnable. i  - 15 - Table I.77 STRUCTURAL ADJUSTMENT PROGRAM - KEY PERFORMANCE INDICATORS Program Actual 1984/85 1985/86 1986/87 1987/88 1987/88 .~~~~~~~~~~ GROWTH PERFORMANCE (Annual Z Change) Real GDP Growth 6.1 4.3 2.7 7.1 9.7 Of which, Agriculture 2.4 5.1 0.6 n.a 8.6 BUDGETARY PERFORMANCE (Percent of GDP) (Central Govt) Revenue 8.8 9.2 10.3 10.5 10.8 Expenditure 18.9 19.4 19.9 19.5 20.8 Regular 6.5 7.1 7.2 6.6 6.9 Development 12.4 12.3 12.8 13.1 13.9 Overall Deficit 10.1 10.2 9.6 9.0 10.0 Financed by: Foreign Grants 2.1 2.3 2.2 2.5 3.1 Gross Foreign Borrowing 4.0 5.0 4.7 4.8 5.6 Gross Domestic Borrowing 4.1 2.9 2.7 1.7 1.3 BALANCE OF PAYMENTS PERFORMANCE (USS Million) Exports of Goods 154 156 139 186 187 Imports of Goods 436 474 506 667 630 Current Account Balance -179 -194 -195 -289 -268 Foreign Grants 75 69 60 82 58 Foreign Loans 77 102 97 217 212 Intl. Reserves (period end" 142 165 205 221 311 MONETARY PERFORMANCE (Annual Percentage Change) Money and Credit Domestic Credit 28.8 21.5 14.4 12.6 15.3 Credit to Government 29.1 15.5 19.6 8.4 6.6 Credit to Nonfinancial PEs 22.0 48.4 7.5 7.8 5.9 Credit to Private Sector 27.4 24.6 18.6 18.7 27.8 Broad Money 17.6 23.3 15.4 16.6 22.4 Consumer Prices 4.1 15.9 13.3 8.0 11.0 Source: Statistical Appendix Tables 2.1, 3.1, 5.1, 6.1 and 9.1 for historical figures and Government targets under the SAP for 1987/88.  - 16 - 1.29 Perhaps the most important aspect of the adjustment program has been to take fiscal and monetary measures to restore macroeconomic stability and reverse the outflow of international reserves.6/ This involved controlling the growth of regular expenditures through a moderation of salary increases, a near freeze in hiring, and containing interest payments by slowing the growth of domestic and non-concessional borrowing. At the same time, efforts were made to raise revenues through implementing tariff reforms, introducing an auction system for import licenses, broadening the sales tax base, introducing a flat corporate tax, reducing tax exemptions, increasing the use of ad valorem taxes, and improving tax administration. The financing of development expenditures was strengthened through measures to improve aid absorption and through increases in user charges. 1.30 The revenue measures under the SAP were successful in raising revenues through new revenue measures and some broadening of the tax base. Revenues increased from an average of 8.6 percent of GDP during 1981/82- 1984/85 to 10.8 percent of GDP in 1987/88, exceeding the program target of 10.5 percent. Initially, the increase was due primarily to the introduction of an auctioning system for commercial import licensing, which shifted economic rents from traders to the Government. As license premia from each successive auction fell, revenues from the tariff reforms and discretionary changes in income and sales taxes accounted for a larger share of the increase. Because of new tax measures introduced in 1988/89, the share of revenues was projected to reach 11.3 percent of GDP. Following the first eight months of the year, tax revenues were expected to be even higher than programmed; however, because of a drop in non-tax revenues, mainly due to the declining import license premia, total revenues were running slightly lower than programmed. 1.31 While regular expenditures remained at about 7 percent of GDP due to tight wage and employment policies, development expenditures continued to increase. Despite the increase in total expenditures, net domestic borrowing fell markedly from an average of 4.3 percent of GDP during 1981/82-1984/85 to 1.3 percent of GDP in 1987/88. This was due both to an increase in domestic revenues and to an increase in external financing resulting both from donors' willingness to make concessional loans to support the Government's program and from an improvement in budget release procedures which speeded up disbursements in ongoing projects. These efforts led to a decline in domestic government borrowing from 4.1 percent of GDP in 1984/85 to 1.3 percent in 1987/88, lower even than the program target of 1.7 percent of GDP. It also resulted in a slowdown in credit to the Government from 19.6 percent in 1986/87 to 6.6 percent in 1987/88, below the target of 6.6 percent. This limited public credit expansion, thereby allowing credit to the private sector to grow very rapidly at 27.8 percent that year. During 1988/89, the rate of 9,rowth of government credit was projected to stay low. 6/ Because of an open border with India and the free convertibility of the Nepalese and Indian rupees at a fixed exchange rate, excessive monetary expansion spills over into increased imports from India and outflows of Indian currency reserves rather than in higher inflation, as in most countries.  - 17 - 1.32 Inflation, however, increased significaatly immediately following the November 1985 devaluation. While inflation in Nepal normally tends to follow that in India given the open border and fixed exchange rate, the devaluation resulted in a sharp divergence of inflation rates during the next several months until the effect of the devaluation was fully dissipated through higher prices.7/ Inflation was further exacerbated by the droughts and floods in 1986/87 that led to increased transportation costs and shortages of essential goods. During the first eight months of 1988/89, however, inflation was running at an annual rate of only 7 percent as compared to 9 percent programmed under the SAP. 1.33 Another area where structural reforms led to a rapid response in economic activity was in trade and industry. In particular, the introduction of an Open General License (OGL) for raw wool, when accompanied with measures to streamline export procedures, produced a rapid expansion in carpet exports. Several other measures were taken to stimulate industrial production by raising incentives for tradable goods and reducing the bias against exports. Aside from a devaluation at the start of the stabilization program, a system of export duty drawbacks, bonded warehouses and selective sales tax rebates were introduced. The tariff system was simplified, many quantitative restrictions were removed, and an auction system for import licenses was introduced to more efficiently allocate licenses and transfer rents from traders to the fiscal budget. A new lndustrial Enterprises Act was introduced and many regulatory procedures were simplified with the number of items being subject to industrial and import licensing being reduced significantly. Although some of the reforms need to be more effectively implemented while others need to be extended or fine-tuned, the measures have been at least partially responsible for the recent rapid growth in industry. 1.34 The SAP was very successful in turning around the rapid depletion of international reserves. International reserves grew from $147 million in July 1985 to $311 million in July 1988. This trend continued for the first eight months of 1988/89. Following a decline in exports during 1986/87 due to reduced agricultural and garment exports, exports grew rapidly in 1987/88 mainly because of a sharp increase in carpet exports as a result of the liberalization of raw wool imports and a recovery in garment exports. In addition, tourism receipts also increased rapidly. However, the current account deficit worsened over this period as imports of goods and services increased by a larger absolute amount due to import liberalization and purchase of a commercial aircraft in both 1987/88 and 1988/89. Despite the larger current account deficit, international reserves grew rapidly since the increase in the current account deficit was more than compensated for by an 7/ It is difficult to achieve a real devaluation against the Indian rupee given the free movement of labor across the border and the free convertibility between the Indian and Nepalese rupees. Although the real exchange rate vis- a-vis the Indian rupee had reverted to its pre-devaluation level, the competitive gains of the November 1985 devaluation were largely maintaired as the Nepalese (and Indian) rupee continued to depreciate against third countries in real terms.  - 18 - increase in capital flows resulting from increased foreign financing and large unexplained inflows of Indian rupees. 1.35 In the agricultural area, the most significant reforms have focussed on increasing the availability of chemical fertilizers and irrigation. This has been done both by improving the effectiveness and efficiency of public sector institutions in supplying these inputs and by improving the pricing and legislative framework. For fertilizer, this initially involved strengthening the financial position and management of the Agricultural Inputs Corporation, which is the sole importer of fertilizer.8 This was followed by adjustments in domestic fertilizer prices to approximate those in India to prevent the re-export of fertilizer to India. Simultaneously, the import of fertilizer was increased and its supply management improved. Moreover, the retail distribution of fertilizer was improved through regulations which encouraged private dealers to participate in distribution. This process is now continuing through additional measures permitting private dealers to appoint sub-dealers, granting advance purchase and bulk purchase discounts, increasing retail margins in the hills, decontrolling the number of dealers per zone, eliminating dealer trading zone restrictions while allowing full transport cost recovery by dealers and allowing private dealers in areas where cooperatives are active. These measures may have been partly responsible for the high yields observed during the last two years (Statistical Appendix Tables 7.1 and 7.2). 1.36 The adjustment policies above, aided by favorable weather and increased capital flows, have resulted in quick increases in output and turned around the decline in international reserves. In order to ensure that the growth is sustained over the longer-term, the Government has also initiated a series of structural reforms to improve the efficiency of the economy. These include mainly financial and institutional reforms relating to public resource management. 1.37 In the financial area, the Government has taken several measures to strengthen financial institutions, improve the allocation of resources, improve bank regulation and supervision, and coordinate government domestic debt management and monetary programming. Key actions to strengthen the financial system include carrying out independent audits of the two large commercial banks, improving loan recovery, increasing capitalization, clearing public enterprise arrears by the Government, and restructuring two development banks. The Government announced in July 1989 that interest rates on both depoaits and loans were freed and that the ceiling of 15 percent on selected 8I Given the high transportation costs and the low use of fertilizer in Nepal, the Government has a policy of subsidizing fertilizer to increase crop yields and farm incomes. As a result, the domestic price of fertilizer is substantially below world prices plus transportation and so there is little incentive for the private sector to import fertilizer.  - 19 - priority sectors lending was abolished.9/ Government debt management has benefitted from a broadening of the maturity range of government securities while the auction of treasury bills and securities is now a part of the a comprehensive monetary program in which the Government's domestic borrowing is guided by monetary policy rather than fiscal needs. Although there have been delays in several areas and some reforms were not implemented as announced, the financial sectors reforms are essentially on track. However, much more needs to be done (Section 2.C). 1.38 To improve the management of public expenditures, the Government has also taken a number of measures towards better planning and project implementation. Through technical assistance, the Government has set up a unit within the Ministry of Finance to conduct program budgeting and project monitoring. A good start has been made in this area -- "core" or high return projects have been identified in nine sectors accounting for over 80 percent of development expenditures and the project has raised awareness throughout the Government of the need for a more orderly and rational process of allocating resources and monitoring their actual usage. The next step is to establish an institutional base within each of the line ministries. This is being accompanied by two complementary technical assistance projects: one to strengthen the planning capacity of the National Planning Commission and line ministries and another to strengthen accounting and auditing in the public sector. The project monitoring component has been expanded to include all core projects and a management information system is now being installed in each of the major line agencies with a link to the District Treasury Offices and central decision makers to achieve accurate project monitoring and evaluation and an expeditious release of funds. To expedite the release of funds for priority projects, the Government has identified 35 high-priority projects that are to be provided funds even if there is an unexpected shortfall of revenues. In addition, the Government has decided to delink the release of funds from the clearing-up of irregularities in the use of funds, which are to be handled separately through a committee set up to look into such matters. 1.39 Finally, the Government has set up a Resources Committee representing the Ministry of Finance, the National Planning Commission and the Nepal Rastra Bank which would guide the budget preparation process by : (i) providing the Government with resource mobilization recommendations; (ii) establishing spending guidelines by sector; and (iii) revising the macroeconomic projections and resource estimates and reviewing budget execution during the fiscal year as a basis for mid-year budget revisions. The Committee plans to move towards expanding its analytical framework to permit multi-year revenue and expenditure estimates (rolling budget). While there has been progress in implementing measures to improve project planning 9/ Although the announcements were made, the Central Bank subsequently induced commercial banks to agree on a set of deposit and lending rates with only minor modifications from the prior regulated ones. In particular, interest rates on the administrative costly priority sector credits remained at 15Z, below those in other sectors.  - 20 - and implementation, much more needs to be done before the new institutions and processes will work as intended. Key issues to be addressed in this area are discussed in Section 4.A. 1.40 Among its efforts to improve the management of public resources are reforms in the area of irrigation. Given the low returns on public investments in agriculture, the Government is rethinking its past strategy of reliance on expensive gravity-based irrigation schemes. Such schemes are often maintained poorly, partly because of inefficient management and inadequate water charge collections. A comprehensive masterplan for the irrigation sector is under preparation and a number of reforms have already been introduced. There is an increasing emphasis on ground water irrigation and on the role of farmer associations in managing and maintaining irrigation schemes. Farmer user associations have now been provided legal status. Smaller public irrigation schemes are already being turned over to farmer's associations while larger schemes art being managed jointly by farmers and tne Government. Coordination between irrigation and other agricultural service agencies is being improved and the irrigation department has been reorganized to better handle their new role. While most of these measures are in the right direction, there are still several issues outstanding regarding the collection and level of user charges and the adequacy of expenditures on operations and maintenance. These are discussed in Section 4.B. 1.41 A related aspect of the emphasis on managing public expenditures is reform of the public enterprise sector. According to off:;iai statistics, Central Government expenditures on the 60 odd public enterp ses account for only 2.5 percent of GDP. However, such expenditures are grossly understated since many foreign-funded expenditures channelled through the Central Government fail to get recorded. In particular, the practice of giving government guarantees on public enterprise loans have resulted in arrears on such loans to equal 1.6 percent of GDP by July 1989. Moreover, the enterprises generate less than 1 percent of GDP in Government revenues through dividends, user fees and interest payments and the average rate of return on Government equity in public enterprises is close to zero. 1.42 With the disruptions caused by the trade and transit impasse, the situation has worsened considerably. As a whole, their performance has been poor, with high technical and economic inefficiencies resulting from a variety of factors. Under the SAP, efforts to improve the performance of public enterprises has been intensified. Initially, these efforts focussed on divestiture. The Government drew up an action plan classifying public enterprises into three categories: those which will be remain fully under government control, those which will be partly government owned, and those which will be fully privatized. Mainly because of political and technical difficulties, the divestiture program proved too ambitious to undertake. The focus now is to obtain technical assistance from the International Finance Corporation (IFC) to design and implement the divestiture of appropriate public enterprises, and to seek assistance from the IMF, World Bank and Asian Development Bank to improve the performance of public enterprises through (i) fostering financial self-sufficiency by promoting internal revenue generation through better pricing and efficient delivery of NPE services;  - 21 - (ii) establishing clear goals, priorities and limits for Government subsidies; and (iii) improving the management of enterprises retained in the public sector by developing an effective system for performance monitoring and evaluation and introducing mechanisms for prJvate sector management through management contracts and leases. 1.43 While there is little doubt that results under the SAP have been encouraging, there is a need to be cautious both because serious structural problems remain and because the magnitude of the gains may be overstated due to data measurement problems. The high profile Basic Needs targets may have biased GDP growth estimates toward the targets; the substantial upward revisions in GDP accounts going back three and four years, in some cases with little technical justification, may be indicative of these pressures. Despite recent good export performance and growth in international reserves, exports remain one-third of imports and much of the growth in reserves came from external capital inflows, a large part of it which was unexplainable. Similarly, despite good revenue performance, government revenues only finance just over half of government expenditures. The current account and fiscal deficits, which in 1987/88 were high at 8.7 and 10 percent of GDP respectively, would in fact have been substantially higher if all technical assistance services and direct payments on foreign-funded projects had been correctly recorded in the balance of payments and fiscal accounts (see Section 5.B). Thus one cannot get too complacent about the recent successes in obtaining high rates of growth while maintaining macroeconomic balances. In any case, the severe disruptions brought about by the trade and transit impasse described in the next chapter illustrate the fragility of the situation. 1.44 As yet there are no data to measure the impact of the SAP on the poor. The SAP is expected to have a positive social impact since it is orier.ned towards economic liberalization and growth rather than fiscal austerity. Development expenditures increased by 27 percent in real terms between 1985/86 and 1987/88 with social sector expenditures increasing by 20 percent. Similarly, while official statistics may overstate the increases in output, it is clear that GDP has grown substantially over this period. Measures under the SAP to liberalize fertilizer distribution, encourage irrigation and forestry user groups through legislative change, and rationalize the Nepal Food Corporation's food distribution activities, in particular, are expected to have a beneficial effect on incomes of the poor. However, because the many of the poor subsist on small and marginal farms, often in remote areas without links to the rest of the economy, they are less likely to be directly affected by efforts to improve economic efficiency. 1.45 To more directly address the poverty problem, the Government has implemented several programs to target the poor. A World Bank study10V is currently evaluating existing donor and Government financed programs and policies to assist the poor. Preliminary findings suggest that many agricultural programs are relatively ineffective in reaching the 101 Nepal: Income and Poverty Study, World Bank, forthcoming, 1990.  -22- poor -- mostly because the poor live in remote areas on land which does not lend itself to expensive inputs and risk taking. There are some 40 Government programs which attempt to target the poor directly through, inter alia, subsidies and transfers, food supplements, employment and income generation, credit, and intensive rural development projects. The results have been disappointing. Transfer and subsidy programs tend not to reach the poor. The other programs have had only occasional isolated success. The common characteristic of the few successful ones appears to have been strong leadership and an emphasis on group and local responsibility. Widespread replication of such experiments is likely to be difficult since it would require substantial changes in the incentive system in the Government bureaucracy. Moreover, such programs do little to address many of the most intractable problems of the poor which include inadequate resources to support the growing population and lack of access to markets, employment, and education, especially for women. However, a recent initiative to target the poor through a greatly expand the hill community forestry program has strong potential for poverty-alleviation, particularly in light of recent legislation to promote user groups.  - 23 - CHAPTER 2s TRADE AND TRANSIT PROBLMS. MACROECONOMIC IMPLICATIONS, AND ISSUES FOR THE FUTURE A. The Post-March 23 Trade and Transit Retime 2.01 As part of the renewal process, a draft trade treaty which was very similar to the 1978 treaty was negotiated aud initial:ed by the Secretaries of India and Nepal in October 1988. It was intended that this treaty would be ratified by the Foreign Ministers at a mutually agreeable time prior to March 23, 1989 and that simultaneously the 1978 transit treat. .uld be extended. However, differences in views on a number of issues led to a breakdown in discussions. The issues included, inter alia, whether there should be only one or two treaties covering trade and transit, tax preferences, the treatment of foreign labor, as well as political considerations. Following the expiration of the treaties on March 23, 1989, the trade and transit situation changed dramatically. While many of the changes were directly due to the expiration of the treaties, others were ae a result of coping measures taken by the Government. 2.02 Immediately following the impasse on trade and transit matters, all trade ovez surface routes with India was restricted to two border points, Raxaul and Jogbani on the Indian side and Birgunj and Biratnagar on the, eastern part of Nepal.111 The loss of the trade and transit points applied to trade with India, third country trade crossing India, and intra-Nepal trade between Central and Western Nepal. Thus transit facilities on third country imports continued to be provided, but at only two rather than the 15 points previously provided. Because of the lack of rail or all-weather road links between the western-most two development regions of Nepal and the rest of Nepal, trade between these areas traditionally took place through India. Following the expiration of the treaties, this was no longer possible and resulted in severe shortages of some essential goods in the west and an unmarketable surplus of come agricultural products. 2.03 A second significant change in the trade and transit situation came as a result of the expiration of the special commodity arrangements on fuel and coal. Because the trade treaty was considered the umbrella under which the special commodity arrangements had existed, these were not renewed and Nepal had to import fuel directly from third countries through Calcutta. Given the logistical difficulties in arranging for fuel from third countries, shipping it to Calcutta, clearing Indian customs, finding storage at Calcutta, and hiring small tanker trucks to transport it to Nepal, it took about two months from the expiration of the treaties before the first shipment of fuel arrived in Nepal. Since Nepal did not have a two month supply of stocks of petroleum it had to introduce a stringent system of rationing. Even after the fuel from Singapore began to arrive in Calcutta, Nepal continued with the 1ll In addition, Nepal has one infrequently used transit point each for bilateral trade with Bangladesh and Bhutan.  - 24 - rationing system for several months because the logistics of the operation did not allow the same volume of import. In July 1989, prices of petroleum products were raised by between 18 and 45 percent to reflect the higher cost of importing through India as compared to importing under the previous product exchange agreement. Although, on average, prices of petroleum products prices now cover costs, there is a cross-subsidy from gasoline to diesel consumers. 2.04 An important aspect of the new trade regime was that both India and Nepal now applied MFN tariffs to bilateral trade. This meant that Nepalese exports became subject to Indian MFN tariffs that were typically in the 100-150 percent range, thus effectively halting N-pal's exports to India. In addition, by unifying the tariff system, Nepal would now charge both basic and additional duties to all imports from India, whicn meant that tariffs on Indian goods would increase by between 25 and 45 percent. In early April, in an attempt to mitigate the price increase caused by the new tariff structure, the Government lowered all additional duties (Table I.8), thereby making the tariff structure more uniform. For the same reason, it added to the list of 91 items under industrial OGL, an additional 21 essential items, including petroleum products, under Ocommercial" OGL. Of these, nine items (petroleum products, coal, cotton yarn, raw wool, medicine and raw materials and chemicals for the manufacture of medicine, veterinary medicine and salt) were without premium. Other items such as sugar, clothing, milk, buses, trucks and - bicycles carried premia ranging from 1 to 21 percent. As a result, the value of items under OGL rose to 43 percent of non-aid imports as compared to 20 percent in 1987/88 and a target of 35 percent under the structural adjustment program. At the same time, the number of items exempt from additional duties was increased from 7 to 42. 2.05 In July 1989, the Government took a number of additional measures affecting the trading regime. In an effort to raise public revenues, the Government returned to the high additional duty structure prevailing prior to pre-March 23 (Table 1.5). At the same time, to minimize the effect the higher duties on increasing the price level, the Government increased from 42 to 72 Table I.8: REVISED ADDITIONAL DUTY SCHEDULE General or Basic Duty Additional Duty (Percent) (Percent) 5 to 20 10 25 20 30 25 More than 30 30 Synthetic Fabrics and Garments made of Synthetic Fabric 40 Select luxury goods unchanged  - 25 - the number of items that were exempt from additional duty. The 72 items, comprising broad categories of consumer and industrial goods, accounted for about 40 percent of all imports from India. The basic tariff in a few categories of goods was also raised, typically by between 10 and 20 percent, usually for the same goods on which the additional duty was exempt. In order to encourage exports, the Government announced cash subsidies of 10 to 25 percent for ten items, mainly agriculture-based products that had formerly been exported largely to India. 2.06 Balance of payments transactions between India and Nepal continued to be conducted in Indian currency and the exchange rate between the two rupees continued to remain fixed. Moreover, IC was still convertible into the Nepalese rupee. However, in an attemipt to control capital flight, Nepal no longer allowed the free convertibility of the rupee into IC. While trade with India continued to be free of quantitative restrictions and licenses, importers now had to register their imports and show invoices for their imports from India in order to obtain IC. In addition, limits were placed on the amount of IC that could be obtained for travel and other service payments to India. Procedures for trade and payments with third countries, however, remained unchanged. Imports from third countries continued to require licenses. Import licenses for third country goods are either auctioned (these mainly apply to consumer goods), subject to strict quantitative restrictions (mainly capital goods), or granted more liberally under the OGL/passbook scheme (raw materials, intermediate and some capital goods). Cottage industries continue to be able to import raw materials without licenses. Finally, while some changes to the import license auctioning procedures were made, they were unrelated to the trade and transit situation. B. Economic Performance since the Impasse 2.07 The trade an'd transit impasse has had widespread negative consequences on the Nepalese economy. Before arriving at an estimate of its impact on output and macroeconomic balances, it is helpful to trace through how the trade and transit impasse has affected fuel availability, imports and exports in the months immediately following the impasse. Impact on Fuel Availability and Cost 2.08 Under the new arrangements for importing fuel described above, both the volume and the cost of imported fuel have been significantly affected. This is due to a combination of reasons. Because of depth limitations at the Calcutta port, it is only possible to use small tankers of no more than 6000 metric tons, which raises the per unit cost of transportation. In addition, once the fuel is off-loaded, tanker and storage availabilities limit the quantities that can be transported to Nepal. Since the IOC is no longer involved in the port clearance process, such formalities take more time. At the same time, port and storage facilities at Calcutta are more expensive than in Bombay or Madras. But probably the single largest  - 26 - reason for the higher cost is land transportation. Although Calcutta is the nearest transshipment port, it is separated from the border by about over 500 miles of poorly maintained roads. Nepal has had to rely on small, privately- owned, tanker trucks to transport the fuel across to the border. Such transport is significantly more expensive than IOC transportation charges that are based on rail or pipeline costs. 2.09 The net efiect of the new arrangements has been to raise the cost of the delivered fuel by about 40 percent on average. The volume of imports between May and August fell to about 60 percent of its level a year earlier. The situation was particularly critical in western Nepal because of its distance from the two transit points and the lack of road links with the rest of Nepal, especially during the summer monsoon months. Although there was some evidence of smuggling from India during the early weeks following the impasse, this essentially stopped when the Indian Government introduced petroleum product rationing within 25 miles of the Nepalese border and forbade Indian trucks entering Nepal to carry any more than the minimum necessary to return to India. However, the volume of oil imports continued to increase as import procedures became more efficient. Thus fuel rationing was lifted in December. 2.10 As coal is a restricted item in India and trade in coal was conducted by the respective state corporations, such trade was discontinued with the expiration of the trade treaty. Although coal is not a very significant import, it is essential for the operation of some industries such as brick and cement. There were great difficulties in obtaining coal from third countries given its low value, high bulk nature. As much as eight months into the impasse, initial purchases from Indonesia had still not arrived in Nepal. The landed cost is estimated to be about 50 percent higher than from India; however, in so far as the Indonesian coal is of a higher quality than Indian coal, the cost difference is smaller. Impact on Trade 2.11 After a few weeks of a virtual halt in imports from India immediately following the impasse, imports from India began to pick up gradually as traders became familiar with new Indian MFN procedures. By the first month of 1989/90, the level of imports from India had completely recovered, despite the loss of preferential treatment for such imports. This is probably more a reflection of both the dependency of the Nepalese economy on Indian inputs and the existence of established trade and credit links rather thar. evidence that imports from India are internationally competitive. While some imports are flowing in smoothly, others such as live animals, garments, coal, petroleum products, and LPG gas are well below their earlier levels. Moreover, although supplies are generally available, it is estimated that the costs to importers have been raised by as much as 25 to 30 percent on i  - 27 - average.121 The increase in costs is due to a combination of the higher MFN tariffs applied by Nepal to imports from India, the loss of the cen:tral excise duty from India that was passed on to importers through lowered ta;.=ffs, and the higher customs clearance costs. As a result of higher transportation costs, the price to the consumer is likely to have increased by even more than this amount. 2.12 In aggregate, imports from third countries were not significantly affected as a result of the impasse. There is a small decline in third country imports in the first few months following the impasse but it was due to a slowdown in economic activity rather than difficulties in obtaining supplies. Supplies from third countries have continued to enter relatively smoothly. Because of a reduction in additional duty rates between April and July and the removal of additional daiAes on the additional 65 items, the landed cost of some imports actually fell. However, there were additional transportation costs in importing to the western regions as a result of the loss of 13 transit points and some cost increases caused by additional delays as a result of more intense scrutiny by Indian customs officials. Overall, the volume of imports from third countries have now totally recovered. 2.13 The effect of the impasse on exports has been even more dramatic. With the removal of the duty-free status of Nepalese exports to India and the application of In4ian MFN tariff that typically ranged in the 100-150 percent range, Nepal's official exports to India fell to about 2 percent of their level a year earlier in the first months following the impasse. Evidence on informal exports is mixed. While there is evidence of improved policing of the border by the Indian police, the incentives to circumvent official channels is also greater. Overall, it is probably true that the informal export of small shipments, mainly agricultural products, via headloads or bicycles, has increased, whereas the informal export of third country goods or manufactured goods via trucks has fallen. 2.14 More than 80 percent of exports to third countries consist of two items, carpets, which are exported exclusively by air and go mainly to Germany and Switzerland, and garments, which are exported by both air and sea and go mainly to the United States. While carpet exports continued to grow despite the impasse, garment exports initially fell dramatically largely because of difficulties in procuring imported cloth from India and the acute sensitivity of the highly seasonal US market to the reliability of supply. In addition, the industry is dominated by Indian workers, many of whom returned to India. More recently, garment exports have picked up substantially, and appear to be headed towards a record year. 12/ Although the data here refers to formal or authorized imports, there is anecdotal evidence to suggest that the costs of smuggling have also increased. Indeed, in a competitive market, since both activities occurred in parallel, the cost increase in the informal or mauthorized market should be similar to that in the formal one. In any case, data on the value of smuggled goods apprehended since the impasse suggests that policing of the border has improved significantly.  - 28 - 2.15 Tourism receipts accounted for about 20 percent of exports of goods and services during 1987/88. A little over half of these earnings are from Indian tourists, many of whom came to obtain third country goods that are more expensive in India. As compared to a year earlier, tourist arrivals from India declined significantly during the peak monsoon months following the impasse. The decline in Indian tourists affected both the tourist industry and retailers, many of whom catered mainly to Indian clientele. Third country tourism, on the other hand, was barely affected. Although the number of third country tourists declined slightly during the summer monsoon months, this is traditionally a slow season for third country tourists in any case. More importantly, during the important autumn months, the number of third country tourists was significantly higher than a year earlier. This was partly due to Government policy of giving priority for fuel and other essentials to tour operators and hotels. Tourism is also projected to have a record year during 1989/90. Impact on Output 2.16 The effect of the trade and transit impasse has varied considerably across regions and sectors. The westernmost two development regions have been severely affected while the eastern and central terai regions have been the least affected given their proximity to the remaining two border points. In addit'on, much of the subsistence subsector, especially in the hills and mountains, has not been greatly affected. Agricultural output, which accounts for over half of GDP and directly or indirectly provides employment to over 90 percent of the population, was not seriously affected while industrial output, especially manufacturing and construction which account for about 15 percent of GDP, has been severely affected (Statistical Appendix Table 2.2.A). However, because of a terms of trade loss, agricultural incomes have probably fallen. Among the service sectors, retail and wholesale trade, transport, and financial services have been seriously affected. Overall, it is estimated that GDP during 1988/89 is over 3 percent lower than it would have been in the absence of the impasse (1.5 percent growth as compared to over 5 percent expected prior to the impasse). Although production is rapidly recovering from its sharply declined level immediately following the impasse, the average level of production during during 1989/90 was initially estimated to be 2.2 percent lower than the average level the previous year. Since GDP growth in 1989190 was programmed to be 4.5 percent under the SAP, the cumulative reduction in GDP attrioutable to the impasse over the two years was initially estimated to be over 10 percent. However, with a resumption of normal fuel and power supplies, recent evidence suggests that GDP growth during 1989/90 may be positive. 2.17 There are several reasnns as to why agricultural output was not severely affected despite fuel shortages affecting land preparation, fertilizer distribution, threshing, irrigation, and transportation, and despite price increases in inputs from India and the loss of Indian agricultural markets. For 1988189, the main reason is that crops, which account for the bulk of agricultural output, were harvested prior to the impasse. In addition, much of tne crop output is grown on subsistence farms  - 29 - which do not rely on mechanical means of production or marketing. Although marketing was affected because of the loss of the Indian market and higher transport costs, this was mitigated by increased protection from Indian agricultural products (Nepal is only a marginal net exporter of agricultural products) and higher domestic consumer prices. Except in the western region, farmers and traders were able to pass on their higher production and marketing costs to consumers and avert an otherwise steep fall in their real incomes. In the western region, however, real incomes did fall significantly as the lack of marketing opportunities led to significantly lower output prices while prices of both agricultural inputs and essential consumer goods increased substantially. Although the Nepal Food Corporation doubled their purchases in these areas and the Agricultural Inputs Corporation airlifted fertilizer at controlled prices, the volumes involved were too small to make a significant difference to most farmers. 2.18 While livestock production was affected as a result of shortages of feed and veterinary medicines that come mainly from India, the impact on production was mitigated by strong growth during the first eight months of the year (Statistical Appendix Table 7.3). Poultry production, however, was more severely affected from the power cutbacks that were necessitated because of a lack of fuel to run thermal power plants or private back-up generators. As a result, hundreds of thousands of chicks are estimated to have died, and this will affect poultry production next year. In addition, there were difficulties in obtaining feed ingredients from India. 2.19 For the reasons alluded to above, agricultural production during 1989/90 will be more seriously affected than during 1988189. Nevertheless, agricultural production is expected to increase, although at a lower rate. This is because the weather, which is the main determinant of crop production, has once again been good. Moreover, the fuel situation has improved significantly. While Indian agricultural markets remain essentially closed because of the high Indian MFN tariffs, farmers are already adapting to the new conditions by planting additional pulses, which have export potential to third countries, and vegetables, which now have a more protected marketed in Kathmandu, while growing less wheat, which requires more fertilizer and land preparation. Also, the border has proven to be more porous than initially foreseen. 2.20 The impact of the trade and transit situation has been especially dramatic in the industrial sector. According to a survey, average monthly industrial output in the manufacturing sector was about 25 percent lower during the last four months of the year than in the first eight months of the year. Firms most affected are those that relied most heavily on either exporting their output to India or on importing their inputs, especially coal and diesel, from India. In addition, power cutbacks caused by a lack of diesel to run the thermal power plants, which supplement the hydropower plants before the monsoon months, caused many industrial firms to run at low capacity. For example, because of a lack of coal, cement and brick factories have either closed down or are operating at very low capacity. As mentioned earlier, the garment industry has also had to reduce its output; however, this industry has now recovered. A significant exception to the trauma suffered is  - 30 - the carpet industry, which, because it does not require much in the way of fuel or other inputs from India, has been insulated from the impasse. 2.21 As a whole, the service sectors have been less affected by the impasse. However, certain services have suffered significantly. Wholesale and retail services are down because of transport difficulties, lowered real incomes and the loss of income from Indian tourist purchases. Transport services have been severely curtailed as a result of fuel shortages. Financial service earnings are lower due to the reduced real income and profits in the real sector and the inability of some borrowers to repay loans. The Agricultural Development Bank and Nepal Industrial Development Corporation have already suffered from decreased collections. The poor financial condition of the two major commercial banks pre-dates the impasse and has masked the impact of the impasse; however, there is evidence of distress lending. Impact on Macroeconomic Balances 2.22 The trade and transit impasse contributed to a severe deterioration in central government public finances. Domestic revenues fell sharply during the last four months of the fiscal year, owing in part to the reduction in additional duties in April 1989 intended to help moderate the price impact of goods imported from India. However, significant shortfalls in other tax and non-tax categories were also experienced in response to a lower volume of imports and lower income tax collections resulting from the lower level of economic activity. For the year as a whole, domestic revenues were 10.4 percent of GDP as compared to the 11.3 percent programmed under the SAP (Table I.9). Although additional duties were increased to their old levels in July and a number of other new revenue measures were introduced at the time, domestic revenues are programmed to remain essentially unchanged in 1989/90 at 10.3 percent of GDP. 2.23 Because of austerity measures taken by the Government following the impasse, regular expenditures were only slightly higher than targetted under the SAP. On the other hand, development expenditures were much higher than programmed because the slowdown in project implementation following the impasse was more than offset by price increases in energy and construction materials, and by increased advance payments to contractors during the closing days of the year. The latter were due to line agencies efforts to use up their appropriations in anticipation of 1989/90 expenditure cuts. Thus the budget deficit reached 13.9 percent of GDP as compared to the programmed 10 percent.13, Although foreign budgetary resources were somewhat higher than expected, the difference was not sufficent to compensate for the overshooting 13/ These figures are not strictly comparable. Because the Ministry of Finance and IMF treat amortization payments and repayment of arrears on government-guaranteed loans differently, the Ministry of Finance estimate given here is about 0.8 percent of GDP higher than from using the IMF methodology upon which the program targets are based.  - 31 - Table I.9: EFFECT OF THE IMPASSE ON KEY PERFORMANCE INDICATORS New Program Estimate Program 1987/88 1988189 1988/89 1989/90 GROWTH PERFORMANCE (Annual Z Change) Real GDP Growth 9.7 4.4 1.5 -2.2 Of which, Agriculture 8.6 3.5 7.0 3.0 BUDGETARY PERFORMANCE (Central Govt) (Percent of GDP) Revenue 10.8 11.3 10.4 10.3 Expenditure 20.8 21.3 24.3 19.8 Regular 6.9 7.0 7.6 6.9 Development 13.9 14.3 16.7 12.8 Overall Deficit 10.0 10.0 13.9 9.5 Financed by: Foreign Grants 3.1 2.9 2.3 2.6 Gross Foreign Borrowing 5.6 5.6 7.1 6.4 Gross Domestic Borrowing 1.3 1.5 4.5 0.5 a/ BALANCE OF PAYMENTS PERFORMANCE (US$ M1illion) Exports of Goods 187 217 162 130 Imports of Goods 630 704 634 570 Current Account Balance -268 -301 -298 -290 Foreign Grants 58 95 47 48 Foreign Loans 212 229 190 182 Intl. Reserves (end of period) 311 356 313 300 MONETARY PERFORMANCE (Annual Percent Change) Money and Credit Domestic Credit 15.3 17.0 32.8 7.4 Credit to Government 6.6 8.0 40.0 -4.3 Credit to Nonfinancial PEs 5.9 12.0 10.3 8.0 Credit to Private Sector 27.8 26.7 27.8 18.8 Broad Money 22.4 16.0 22.4 6.0 Consumer Prices 11.0 9.0 8.1 12.0 IL Including repayment of public enterprises' arrears to the banking system by the Government. Source: Statistical Appendix Tables 2.1, 3.1, 5.1, 6.1 and 9.1 for 1987/88, government provisional estimates for 1988/89, and Government targets under the SAP for 1988/89 and 1989/90.  - 32 - of the deficit. Consequently, domestic financing of the budget increased to 4.5 percent of GDP, about three times the programmed level (Table I.9). Given the limitations of the Goverrnent to borrow from the non-banking system, the bulk of this was financed through borrowing from the Central Bank. During 1989/90, however, as result of a lower budget deficit and higher foreign financing141, net domestic borrowing is programmed to fall to only 0.5 percent of GDP, including repayment of arrears on government-guaranteed loans to the banking system. 2.24 The high domestic borrowing in 1988/89, in conjunction with difficulties in selling government securities outside the banking system, led to a severe overshooting in central bank credit to the government credit from a programmed 8 percent to 40 percent (Table 1.4). This, in turn, contributed to an acceleration in the growth of broad money from a programmed 16 percent to about 22 percent. The monetary expansion, coupled with the supply shock of the trade and transit impasse, led to an annualized increase in the urban consumer prWce index (point-to-point inflation) of 26 percent between March and July