Nepal - Power Sector Efficiency Project

Document of The World Bank ]FOR OMCAL USE ONLY MICROFICHE COPY Report No. P- 5404-NEP Type: (PM) O'LEARY, D/ X80408 / / ASIIE Report No. P-5404-NEP MEMORANDUM AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEV',LOPMENT ASSOCIATION TO ';'HE EXECUTIVE 'DIRECTORS ON A PROPOSED CREDIT OF SDR 48.1 MILLION TO THE KINGDOM OF NEPAL FOR A POWER SECTOR EFFICIENCY PROJECT FEBRUARY 27, 1992 This document has a restricted distribution and may be used b- recipients only in the performance of tbeir ofricial dudies. Its contents may not otherwise be disclosed writhout World Bank authorization.  CURRENCY EQUIVALENTS 1 Nepalese Rupee (NR) US$ 0.023 1 Nepalese Rupee (NR) 100 Nepalese Paise 42.7 Nepalese Rupees US$ 1.00 MEASURES 1 Kilovolt (kV) 1,000 volts (V) 1 Kilowatt (kW) 1,000 watts (W) 1 Megawatt (MW) = 1,000 kilowatts (kW) 1 Kilowatt - hour (kWh) = 1,000 watt - hours (Wh) 1 Megawatt - hour (MWh) 1,000 kilowatt - hours (kWh) 1 Gigawatt - hour (GWh) = 1,000,000 kilowatt - hours (kWh) ABBREVIATIONS AND ACRONYMS ADB - Asian Development Bank EA - Environmental Assessment HIMG/N - His Majesty's Government of Nepal HV - High Voltage IEE - Initial Environmental Examination IMF - International Monetary Fund MHPP - Marsyaagdi Hydroelectric Power Plant MOF - Ministry of Finance MOI - Ministry of Industry MOWR - Ministry of Water Resources NDF - Nordic Development Fund NEA - Nepal Electricity Authority PE - Public Enterprise SAC - Structural Adjustment Credit SAP - Structural Adjustment Facility SLA - Subsidiary Loan Agreement UNDP - United Nations Development Programme FISCAL YEAR July 16 - July 15  FOR OFFICIAL USE ONLY _ ii - NEPAL POWER SECTOR EFFICIENCY PROJECT CREDIT AND PROJECT SUMMARY Borrower: Kingdom of Nepal Beneficiary: Nepal Electricity Authority (NEA) Amount: SDR 48.1 million (US$ 65.0 million equivalent) Terms: Standard, with 40 years maturity. Onlending Terms: Out of US$65 million, the Government would onlend US$ 60.8 million to NEA at a rate of 10.25Z for a period of 20 years, including a grace period of 5 years; the remaining US$4.2 million covering energy conservation and catchment management would be passed on as grants to the Ministries of Industry and Works and Transport. HMG/N would bear the foreign exchange risk. Financing Plan: Government US$ 1.6 million NEA US$ 18.8 million France US$ 5.1 million Germany (GTZ) US$ 4.2 million Nordic Development Fund US$ 5.4 million IDA US$ 65.0 million Total US$100.1 million Economic Rate of Return: 18Z. Staff Appraisal Report: Report No. 9077-NEP Maps: IBRD 22331 IBRD 22780 This document has a restricted distribution and may be iuee E X recipients only in the performance of their official duties Its cokitents may not otherwise be ussuosed without World Bank authorization.  MEMORANDUM AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED CREDIT TO NLPAL FOR A POWER SECTOR EFFICIENCY PROJECT The following memorandum and recommendation on a proposed development credit to Nepal for SDR 48.1 million (US$ 65.0 million equivalent) is submitted for approval. The proposed credit would be on standard IDA termis with 40 years maturity and would help finance a power sector efficiency project. The Government would onlend US$60.8 million to NEA at an interest rate of 10.252 per annum for a period of 25 years, including a grace period of 5 years; the remaining US$4.2 million would be passed on as grants to the Ministries of Industry and Works and Transport respectively. The project will be cofinanced by the Governments of France and the Federal Republic of Germany and by the Nordic Development Fund. PART I COUNTRY POLICIES AND BANK GROUP ASSISTANCE STRATEGY A. Background 1. Nepal--one of the poorest countries in the world--faces a uniquely difficult development challenge. Its development efforts in recent decades have been hindered by a number of fundamental and persistent constraints: (a) the country's rugged terrain and land-locked location together with the country's poor resource endowment and inappropriate policies have undermined the potential for economic growth. (b) Nepal's long and open border with India, while conferring significant benefits in terms of market access for agricultural goods and inflows of investment and technology, has limited its flexibility in designing and implementing independent economic policies in such key area, as trade, interest rates, exchange rates and pricing. (c) Continued high population growth has increased pressure on limited arable area and contributed to widespread poverty (especially in the hills), deforestation and environmental degradation. (d) The structure of the administrative and political system has limited the country's capacity to utilize available resources, implement development projects and programs, and deliver public services effectively.  2. W4hile some of these factors are beyond its control, Nepal still has substantial scope for improving its domestic economic management, policies and institutions to enhance the effectiveness of its development effort. Economic policies pursued in the first half of the last decade were, by and large, inappropriate. Although the Government subsequently made a sustained effort to improve its economic policies, the positive impact of these changes was blunted by two developments over the last three years. First, the Trade and Transit treaty (T&T) dispute with India disrupted trade, transport, and economic activity in the FY89-90 period. Second, political developments interrupted economic reform during FY90-91. The democratically elected Government wlhich took office in May 1991 has just embarked on the difficult course of resuming economic restructuring in an effort to achieve sustainable poverty alleviation. 3. Overall, the rate of economic growth and development has been slow. Per capita income is currently estimated at only $170. The basic transport and communications network in the country is rudimentary, commercial energy consumption (19 kg of oil equivalent per head in 1988) is one of the lowest in the world, adult literacy is only 19Z, and population growth rate (2.7Z per annum over the past two decades) remains high despite low life expectancy (51 years at birth) and high infant mortality rates. Agriculture accounts for over half of GDP and nearly 902 of employment. Structural weaknesses in the economy help to perpetuate the conditions of poverty: the domestic savings rate, averaging about 1OZ of GDP in the eighties, has been low; and the extremely limited export base finances only 25-30% of imports. Nepal thus relies heavily on external assistance for financing much of its development activity and imports. B. Recent Economic Developments 4. Following centuries of self-imposed isolation, Nepal's efforts to develop a modern economy began in the 1950s with a series of development plans. The early development plans concentrated on building infrastructure to provide a basis for future economic growth. Although progress was made in this regard, economic growth during the 1970s barely kept up with population growth. Frustrated by this slow economic growth, the government expanded public expenditures in the early 1980s in an attempt to accelerate development. Investment increased from 18Z of GDP in FY81 to 23% in FY85, and annual GDP growth averaged almost 52 over this period. But, in the absence of comparable efforts to mobilize domestic savings, the government resorted to excessive bank borrowing. This resulted in sharp increases in the fiscal and current account deficits, as .ell as a rise in inflation. Government controls over pricing and preferential access of public enterprises to bank credit tended to undermine their efficiency and stifle private initiatives; while a generally permissive attitude to using the banking system to promote various government objectives significantly weakened the (largely state-owned) financial system. 5. Faced with this unsustainable macroeconomic situation, in the mid- eighties, the Government implemented a stabilization program supported by an IMF Standby arrangement approved in December 1985. Recognizing that  -3- macroeconomic stability by itself would not lead to accelerated growth, the Government subsequently undertook a structural adjustment program (SAP) which was supported by IMF stand-by and SAP arrangements and IDA structural adjustment credits to address some of the longer-term constraints to economic growth. The adjustment program included measures to increase domestic resource mobilization, reduce the growth of government expenditures and borrowing from the banking system, improve project implementation, strengthen the financial position of public enterprises, reform the financial sector in order to improve monetary management and resource allocation and strengthen the weak commercial banking sector, and liberalize industrial and trade policies to expand the traded goods sector--all areas where significant progress in alleviating structural constraints could be made within a medium- term framework. These measures were complemented by sectoral reforms in agriculture, forestry, and energy. 6. The economy's initial response to the adjustment program was good. Strong growth was achieved in FY88, while tighter monetary policies, increased revenues, and restrained recurrent expenditures helped contain the budget and balance of payments deficits. Some progress was also made in implementing structural reforms by reducing tariffs, easing trade restrictions, and improving the fertilizer and distribution system. Slippage, occurred, however, in implementing financial sector reforms and in privatizing selected public enterprises. Efforts to expand rapidly access to education and health care led to inefficiencies. 7. These generally favorable developments were sustained during FY89, despite the disruption caused by the lapse of the trade and transit (T&T) treaties with India in March 1989 which had pro-rided duty-free transit through India for goods from third countries and between eastern and western parts of Nepal itself, in addition to favorable trading arrangements for Nepal's exports to and imports from India. After a few months of shortages, the supply situation for key imports improved and economic activity picked up, both because informal trade with India was allowed to continue and because continued good weather in Nepal led to good agricultural crops in FY89 and FY90. As a result, overall GDP growth reached 3.92 in FY89 and 3.6% in FY90. Revised information also suggests that inflation, at 10X in FY90, was less affected by the T&T dispute than was thought at the time. Despite political disruptions (see below) the resolution of the T&T dispute and another good year for agriculture spurred GDP growth of 4.02 for FY91. External reserves rose to the equivalent of nearly six months of imports at the end of FY91 in part due to large capital inflows from India.1' 8. A series of dramatic political changes starting in early 1990 culminated in April 1990 in a sharply reduced role for the monarchy and form.tion of an interim coalition government to prepare for parliamentary democracy. The interim Government resolved the T&T dispute with India, revised the constitution, and held democratic elections in May 1991. The Nepali 1/ Nepal has traditionally aimed at maintaining a reserve cover of at least six months of imports in view of the country's relative isolation and exposure to wide fluctuations in export earnings.  -4- Congress Party secured a majority and a coalition of Couz.unist parties won a strong minority of seats in the parliament. While the political changes hold considerable promise for social and economic development. over the longer term, the democratic transition has also created high popular expectations for rapid improvements in economic conditions. Table 1: NEPAL-KEY INDICATORS, FY87-91 FY87 FY88 FY89 FY90 FY91!' Real GDP Growth 3.9 7.3 3.9 3.6 4.0 Government Revenues/GDP 10.1 10.6 9.9 10.5 10.7 Government Expenditures/GDP 19.4 20.3 23.2 21.6 20.4 Overall Budgetary Deficit/C-DP -9.3 -9.7 -13.3 -11.1 -9.7 Gross Investment/&ZP 21.8 21.4 22.0 18.2 18.0 National Savings/GDP 14.7 12.8 12.3 8.0 7.1 Exports/GDP 5.1 6.0 5.4 5.8 7.6 Imports/GDP 18.4 20.2 20.8 20.8 24.1 Current Account Deficit/GDP -7.1 -8.6 -9.7 -10.2 -10.9 Gross Official Reserves (months of imports) 3.8 5.4 5.0 6.3 6.0 Domestic Inflation Rate 13.3 11.0 6.3 11.5 9.8 aI Provisional Source: Ministry of Finance and staff estimates. 9. The new elected Government which took office in May 1991 inherited a situation in which current public expenditures (including higher subsidies and large wage increases) had increased significantly and the finances of many public enterprises were extremely weak. Moreover, since the interim government maintained fiscal and external control in part by restricting development expenditures, project implementation problems were widespread. 10. During its nine months in office, the new Government has made an effort to come to grips with the immediate fiscal problems and address the longer-term problems of poverty and development. Both tasks have been complicated by recent economic reforms in India. Nepal wisely matched India's adjustments in the exchange rate and fertilizer and petroleum prices. The Government also implemented a long overdue increase in electricity tariffs of around 60Z. While such reforms are badly needed to control Nepal's rising budget deficit, these price increases, and the secondary effects of Indian inflation and exchange rate changes, have caused Nepal's annual inflation rate to rise to about 152. Over time, greater liberalization of the Indian economy would provide an opportunity for Nepal to both open up its own economy and exploit Indian markets for its exports. The new Government is studying these  possibilities and in the draft Approach Paper for the Eighth Plan the Government has made clear that it is committed to an outward-oriented growth strategy and a lead role for the private sector in a market-directed and competitive economy. While the new Government has set poverty reduction as its primary goal, the magnitude of the problem and high popular expectations will make the job exceedingly difficult. C. The Policy Framework 11. The new Government has begun discussions with the IMF and the Bank to formulate a comprehensive reform program. Many of the policy reforms would be embodied in the Eighth Plan and the FY93 budget to be issued in July 1992. In the face of the fundamental constraints noted earlier, the attainment of growth rates in excess of 3-42 per annum on average over a sustained period is a major challenge. Nepal cannot rely solely on a high growth-led strategy to solve its poverty and employment problems. A more balanced and integrated approach, combining efforts to stimulate near-term economic growth along with revitalized human resource development, (emphasizing restraints on population growth, as well as training and upgrading human capital through improved provision of education, health facilities and other services) is therefore essential to ensure sustainable development in the longer term. Concurrently, attention needs to be given to better management of Nepal's fragile ecological base and to improving the institutional capacity. 12. It is also recognized that there is no easy solution to Nepal's development challenge. Despite the overriding importance of agriculture as a source of income and employment today, it has limited potential, given the scarcity of arable land. While there is some scope for irrigation and productivity improvements in non-irrigated areas in the Terai area bordering Northern India, agriculture alone cannot be expected to generate sufficient incomes and productive employment for the incremental labor force. The industrial sector (which is presently quite small, contributing about 62 of GDP) also is unlikely to be a catalyst for growth in the near to medium term. Thus, a large proportion of the new entrants to the labor force is likely to be thrown into services and self employment activities, with probable declining productivity and marginal incomes. Nepal, therefore, will need to explore and exploit all possible opportunities for income and employment. generation in every sector. For example, there is potential to expand labor- intensive exports to third-country markets (building on the recent success of ready-made garments and carpets); there is also scope to better capitalize on Nepal's proximity to India by identifying and developing particular niches in the latter's vast market for exports of selected Nepalese small-scale industrial as well as agricultural products. Nepal also needs to explore the possibilities for cost-effective and environmentally sound exploitation of her main natural resources--hydropower (for which India is likely to be a large market) and tourism. 13. The new Government has indicated that it shares this perception of the country's problems and potential. It also agrees that sound macroeconomic policies and improved management of public resources are critical prerequisites for poverty alleviation. It appreciates the fact the  -6- government's weak institutional capacity has thwarted previous development efforts; and it is determined to redress this situation. Moreover, it has moved swiftly to strengthen relations with India with the objective of expanding cooperation through trade, investment, and water resource development. Nevertheless, it will take considerable fortitude for the newly elected government to maintain fiscal restraint and implement the necessary longer-term reforms in the face of short-term political pressures. Macroeconomic Management and Policies 14. The establishment of macroeconomic stability and revitalization of the economic reform process is a necessary prerequisite for accelerating growth and development. Prudent fiscal and monetary policies need to be pursued to protect the balance of payments. Achievement of macroeconomic stability should permit the Government to focus its attention on improving public resource management in order to mobilize and reallocate resources more efficiently. Concurrently, bearing in mind economic relationships with India, efforts need to be made to strengthen financial, trade, and industrial policies to improve resource allocation and competitiveness and encourage private initiative. An important step was made under SAC II to improve banking supervision, recapitalize the two government-owned commercial banks (which dominate the banking system), and improve collections of overdue debt service. To ensure that these institutions remain viable, the initial efforts need to be followed up with moves to restructure the two state-owned banks, as well as to improve their management and operational procedures. More determined efforts are also needed to foster greater competition in, and efficiency of, the financial system by freeing up interest rate determination and developing new monetary instruments. 15. To invigorate the export sector and to achieve higher growth, greater liberalization and rationalization of the trade regime within the limits posed by India's evolving system is also essential. Incentives are still high for smuggling and import substituting activities, and export profitability remains low, in large part due to price distortions created by the trade regime; the number of tariff rates is still large, and the relatively large dispersion of tariffs within similar categories of goods provides scope for progress towards unifying effective tariff and protection rates. There is general agreement within the Government on the need for trade reform aimed at import liberalization and improved export competitiveness taking into consideration the pace and direction of reforms in India, as well as the revenue impact of tariff liberalization. Public Resource Management 16. Improved development performance will require significant reform in the management of public financial resources and in public administration. While Nepal needs to increase public investment levels, since resources will inevitably be scarce, it is even more important to increase the efficiency of resource use. Moreover, to enable Nepal to make better use of foreign resources, it must mobilize more domestic resources and develop better mechanisms for planning, allocation and utilization of available (domestic and external) resources.  -7- 17. On the revenue side, tax reforms are needed to broaden the tax base, simplify the tax structure, and increase tax elasticity. There is also considerable room for increased cost recovery from users of publicly provided goods and services through appropriate adjustments in prices and tariffs. On the expenditure side, there is a need for greater realism in planning, allocating, and implementing the expenditure program. A more balanced strategy to manage human and natural resources for development would require higher recurrent, as well as O&M, expenditures in many areas than has been provided up to now. To release resources for these purposes, as well as for development projects, other current expenditures need to be cut back. Towards this end, the Government needs to restrain public sector wages, benefits, and employment--all of which have increased significantly in recent years; and it will need to reduce domestic borrowing in order to restrain the growth of debt service. Equally important is the need to reexamine the development budget and reallocate resources to higher priority projects. The development program is heavily over-committed in relation to the Government's financial, administrative, and managerial capacity; and many projects, although largely externally funded, are starved of funds, in part due to bureaucratic procedures and because most of the limited local currency resources are earmarked for purely locally funded projects, many of which have not been properly appraised. This rationalization of expenditures would be facilitated by establishment of a realistic resource envelope, and definition and implementation of a core program. In an encouraging first step, the National Planning Commission (NPC) has been revitalized and has been given a mandate to work with the Ministry of Finance (MOF) and line ministries in a proiect by project review of the public investment portfolio. Public Administration 18. A continuing impediment to Nepal's development effort to date has been weak project implementation and the poor quality of government services at all levels. These public sector institutional problems have been well documented: they include a poorly motivated civil service; excessive centralization and overstaffing at the central level, combined with inadequately trained and supervised local staff; and archaic administrative procedures. The recommended reforms in public administration are not new. These include restructuring of civil service pay and incentives, retrenchment of superfluous staff (in government service, as well as in public enterprises); procedural simplification; increased local revenue mobilization; and redefinition of the role of government in service delivery to improve cost recovery and take into account the comparative advantage of the private sector and NGOs. The new Government believes that it needs a high calibre and responsive civil service to fulfill its election promises to redirect development programs to reduce poverty and improve the quality of government- provided services. Toward this end, it has established an Administrative Reform Commission chaired by the Prime Minister, which is scheduled to present a comprehensive program of phased reforms by March 1992. Public Enterprise (PE) Reform 19. Poor performance of PEs remains a serious problem, draining budgetary resources and undermining potential for efficient industrial growth and  sustainable employment generation by discouraging new entrants and wasting resources. Pestrictive pricing and labor policies and poor investment choices and decision-making further contribute to PE inefficiency. In addition, interventionist policies affecting PE output, pricing, and access to inputs, as well as controls on employment and compensation, prevent PEs from operating on commercial principles. The financial condition of the PEs has deteriorated further in recent years as a res. t of excess hiring and a rapid growth in compensation. 20. The previous Government's efforts to improve PE performance and privatize a few firms were largely unsuccessful. The new Government has stated that it wishes to institute PE reforms; and it has asked the Bank (with UNDP financing) to assist it in an initial demonstration effort to t..ivatize three firms. Consultants are now working with Grvernment to help wi'-I valuation and preparation of bids. In addition, a more comprehensive program of PE reforms is needed for those firms which remain in the public sector. Role of the Private Sector 21. As noted earlier, the new Government has stated that it wishes to harness the energies of the private sector in the task of development. Modest efforts were made under the SAC/SAF programs to expand the role of the private sector in the distribution of fertilizer; and explicit measures were undertaken to involve user groups in public irrigation schemes and in the forestry subsector. However, progress to date has been slow, in part due to the perceived absence of a strong indigenous industrial and business community and, more importantly, the continuation of prevailing interventionist attitudes and policies. 22. Although prospects for foreign investment, aside from India, are limited given Nepal's resource base and landlocked position, initiatives need to be taken over a broad front to encourage greater private participation. The creation of a more attractive economic policy framework is an important requirement for encouraging more efficient, and hence sustainable, private investment. Deregulation of industrial licensing, relaxation of government controls over pricing, and a reduced role for public enterprises in the economy are important steps in this regard. There is also scope and need for involvinC the beneficiaries in the design and implementation of a broad range of local development activities--for example, in irrigation, forestry, rural infrastructure, and especially in mobilizing participation and resources for operation and maintenance of publicly created assets. From the start, the new Government has expressed its intention to move in this direction. It is now working to back up its initial pronouncements with specific policy statements and programs--including proposed amendments to the legislation governing industrial investments and foreign investment. D. Sectoral Policies and Programs 23. Any attempt to come to grips with Nepal's formidable obstacles to development (para. 1' must take account of sectoral issues. More than in most countries, sectoral problems--including rapid population growth, low  -9- agricultural productivity, environmental degradation, and inadequate human resource development--have contributed to Nepal's disappointing development performance. While sound macroeconomic management is a prerequisite in Nepal as it is in all countries, major sectoral reforms will be needed to interrupt the cycle of poverty and achieve self-sustaining development. 24. Population, Poverty, and the Environment. Nepal's population growth averaging 2.7Z per annum has eroded the limited gains that have been made in GDP and agricultural output. Population pressure has caused cultivation of increasingly marginal lands, resulting in stagnating average foodgrain yields. It has also increased the demand for forest resources for fuel, fodder, and timber, leading to a rapid loss of forest cover and soil erosion. Moreover, by straining the institutional and financial capacity of the government to deliver public services, high population growth has impeded efforts to increase access to education and other social services. As a result, Nepal's indicators for literacy (estimated at 35Z), infant mortality (124 per 1000), and incidence of disease although improving are still amongst the worst in the world. And the condition of women is well below that of men as reflected in primary school enrolment ratios of only one-third for girls compared to one half for boys. 25. The inextricable link between population growth, poverty, and environmental degradation in Nepal suggests that efforts to reduce poverty and preserve natural resources must include a more effective attack on population growth. In contrast to most other Asian countries, Nepal has never had a strong population campaign backed by the highest levels of Government. The current population program is extremely weak, and relies too heavily on sterilization. There is a need for a massive effort to reach couples of reproductive age with information and services and to offer them a variety of temporary contraceptive methods, supported by follow-up services and motivational efforts. The Government is also beginning to provide extra resources to give higher priority to expanded education for girls and rural health services. 26. A concerted effort to limit population growth is a necessary but not sufficient condition for the reduction of poverty. Nearly half of Nepal's inhabitants live in absolute poverty. Since there is little scope for income redistribution, solutions to the poverty problem must be found in sustainable growth which creates employment for the poor without damaging the country's natural resources. While Nepal does not operate the large-scale subsidy and transfer programs found in many developing countries, there are a number of poverty alleviation programs, most of which have had very little success. Subsidies on food distribution, fertilizer, and interest rates account for the bulk of the expenditures under these programs; but these are not well targeted and place an increasing burden on the government budget. Although isolated small development and credit projects--often managed by NGOs--have had some success in reaching the poor, they are generally costly, require heavy supervision, and would not be replicable on a large scale. While there is scope for improving the focus of these programs, the major impact on alleviating poverty is likely to stem from country-wide policy reforms to promote broad-based growth and more effective population programs as well as strengthened education services. In particular, measures such as promotion of  - 10 - user groups in forestry and minor irrigation, development and dissemination of appropriate technical packages for hill agriculture, and investments in health, primary education, and--on a selective basis--in rural physical infrastructure are likely to have a especially beneficial effect on the poor. If properly designed, these efforts are also likely to be the most cost effective approaches to preservation of the environment. 27. Agriculture. Although the Government and foreign donors have given priority to agriculture in recent years, their results in raising incomes and productivity have been disappointing. Reasons for the pnor performance of agriculture include lack of reliable water supply even on irrigated land; unreliable fertilizer supplies and poor management of the state-owned distribution agency; and weak agricultural research and extension. The new Government has indicated that it intends to give new vigor to the measures begun under the SAC to liberalize the distribution of agricultural inputs and involve farmer user groups in the management of irrigation facilities. It needs to strengthen the community forestry program, which is of prime importante not only for raising incomes in the hills, but also for preserving Nepal's environment. In addition, agricultural research should be made more responsive to farmer needs and should make greater use of more successful applications in India and elsewhere. 28. Manufacturing, Trade, and Water Resources. While manufacturing grew rapidly in the eighties, its share in GDP remains about 62 and its share of employment is even lower. The industrial sector is characterized by high import protection and extensive regulation which inhibit productive economic activity and encourage rent-seeking and trading. The changing policy environment in India could provide an opportunity for Nepal to shift to a more .outward looking trade and industrial regime as exemplified in recent successes in garments and carpets as well as in transport cost related commodities and cottage industries for the domestic market and India. To benefit from such reforms, Nepal must also maintain competitive wage rates through appropriate fiscal, monetary, and exchange rate policies; and it must improve the skills level of its labor force. 29. Nepal's proximity to India also offers longer-term opportunities for export of hydropower. However, given the relatively large capital costs of hydropower projects, the Government needs to review its resource constraints and investment priorities to determine a manageable and financeable energy program (see para. 36). Over the longer-term, revenue from power exports could help alleviate Nepal's chronic balance of payments deficit and generate resources for the budget. The new Government appears to appreciate the mutual benefits which could be derived from cooperation with India on water resources, and has given serious and high level attention to bilateral negotiations. E. IDA's Assistance to Nepal 30. Bank Group Operations. The Bank fielded its first economic mission to Nepal in 1963 and the first IDA credit was approved in 1969. The relationship of more than 25 years has grown increasingly close. The Bank's  - 11 - role in preparing periodic economic reports and in organizing and chairing the Aid Group for Nepal has provided the basis for a regular dialogue. This advisory role became particularly close when the Government sought the assistance of the IMF and the Bank in FY86 in support of a structural adjustment program--which was subsequently supported with two IDA adjustment credits approved in FY87 and FY89. Since taking office in May 1991, the new Government has maintained a close working relationship with the Bank and has sought frequent advice from the Bank on economic and developn t issues. 31. IDA has approved a total of 57 credits for Nepal. totalling (net of cancellations) US$1,084.2 million (Table 2). In recent years, disbursements have averaged $50-100 million annually. Five sectors account for about 76X of IDA credits by amount: agriculture and irrigation; water supply and sewerage; power and energy; telecommunications; and highways. Agriculture and irrigation have accounted for 372 of the amount and 42? of the number of credits. Since most of the aid from bilateral donors is on grant terms, IDA's share of Nepal's total external debt is about 452 as compared to about 28Z for the Asian Development Bank and 3? for the IMF. However, IDA's share of Nepal's debt service (which includes payments on a commercial purchase of an aircraft and IMF charges) is only about 12Z. IFC has made two investments in Nepal, the first in FY75 (US$3.2 million) for the expansion of the Soaltee Hotel project in Kathmandu and the second in FY82 (DM 14.5 million) to the Nepal Orind Magnesite Company for mining and production of dead burnt magnesite. No IBRD loans have been made to Nepal and MIGA has not conducted any operations in Nepal. Table 2: IDA ASSISTANCE TO NEPAL, FY70-92 a/ (In US $ Million) Commitments Operations Amount Sector Number Sector $ Million Share 2 Share ? Agriculture 162.90 14.57 13 22.81 Irrigation 247.50 22.13 11 19.30 Industry 28.00 2.50 4 7.02 Power/Energy 200.80 17.95 5 8.77 Education 66.98 5.99 5 8.77 Telecommunications 43.78 3.91 4 7.02 Transport 82.51 7.38 4 7.02 Urban/Water 148.30 13.26 5 8.77 SACs 110.00 9.84 2 3.51 TA & Other 27.60 2.47 4 7.02 Total 1,118-37k1 100.00 57 100.00 a! As of January 1992. b/ US $1084.15 million net of cancellations.  - 12 - 32. Project Implementation. Utilization of IDA assistance has been constrained historically by Nepal's limited absorptive capacity. The overriding constraint is the institutional one. Weaknesses in public administration both contribute to and are affected by shortfalls in counterpart funding, protracted procurement, delays in release of funds, inadequate cost recovery for public services, and unreliable supplies of raw materials. These perennial problems were exacerbated by the trade and transit dispute which caused shortages and delays in obtaining fuel and other essential commodities. In addition, the political transition caused delays in decision making on procurement and release of funds, while the fiscal problems noted above have caused the Government to reduce funding for a number of IDA projects. The result has been a marked deterioration of the portfolio and decline in the ratio of disbursements to outstanding commitments in comparison to earlier years. There is also concern about the need to improve cost recovery and provide adequate operations and maintenance. In its dialogue with the new Government, the Bank has made it clear that implementation performance is the major criterion for increased IDA assistance. The Government shares this concern about the need to improve implementation. It has commenced a portfolio review and has indicated that it wishes to work closely with IDA to either restructure or terminate projects with serious problems. Meanwhile IDA has strengthened supervision and taken actions to simplify projects and restructure the portfolio. While this should help, these efforts will need to be reinforced by systemic reforms to deal with the underlying public sector management problems describAd above. 33. Economic/Sector Work and Investment Priorities. Historically, the Bank's assistance strategy focused on infrastructure development (primarily hydropower, highways, and irrigation), agriculture, and forestry, with some involvement in industry and education. This strategy reflected the need for basic economic infrastructure in a country virtually unexposed to modern development until the mid-1950s, the dependence of the economy on agriculture, and the scarcity of human resources at all levels. These priorities continue, but particular emphasis is now being given to strengthening social services as well as overcoming the institutional impediments to development as part of a broader strategy to ensure sustainable natural resource management. 34. Almost all IDA operations, as well as economic and sector work (ESW), are designed to address, either directly or indirectly, the primary goal of poverty alleviation which in Nepal is predicated on more rapid growth. A two volume FY91 Bank report "Nepal: Relieving Poverty in a Resource-Scarce Economy11' recommended a strategy to expand employment and income generating activities and alleviate poverty through: (a) a more effective population and health program; (b) improved minor irrigation and better technical support for agriculture; (c) cost-effective road and trail building to improve rural access; (d) expanded basic education; and (e) rationalization of transfer programs to reach the target beneficiaries. IDA's lending and ESW is intended to assist in implementation of this strategy. 3/Report No. 8635-NEP  - 13 - 35. Of the 13 operations currently being prepared for possible approval in FY92-94, three will be in human resource development, one in basic education and two in population and health. These projects, as well as a planned rural water supply project, will improve the quality and expand the availability of services and facilities for the poor and women in particular. Such projects are very difficult to do in Nepal because of the weak institutional capacity, especially in the rural areas. Extra time and resources are being devoted to preparation and appraisal in an attempt to (a) learn from previous donor- funded projects and (b) foster full government commitment. In both cases, IDA is working closely with other donors and NGOs; and in each case the objective will be to channel multi-donor support to a single government program rather than continue to finance diverse projects. The effectiveness of two proposed projects in the agriculture sector and one in forestry are being enhanced by involving farmers more in all stages of implementation. Participation of local groups in project planning and management is viewed as essential to improve the quality of operations and maintenance and, ultimately, to achieve sustainable development. In addition, it is seen as the key to preservation of the environment. 36. IDA expects to continue to support the development of the Nepal's considerable hydropower resources, both to meet domestic energy requirements and in the longer run as a potential source of export earnings. Under IDA's leadership, a dozen donors have for a number of years supported the Government's efforts to prepare the Arun hydropower project. During this time, design changes and delays caused by the T&T dispute and political changes have caused the costs to rise. Given the scale and current costs of the proposed Arun project (402 MW, for which the first phase of 268 MW would cost about US$1 billion) in comparison to Nepal's economy, IDA is currently reviewing its affordability and the operational sequencing of Arun and alternative hydropower and thermal investments in an effort to arrive at a balanced investment program on which both the Government and the donors can agree. In the meantime, the proposed Power Efficiency Improvement project would reduce system and financial losses and would, inter alia, help to strengthen the capacity of the electricity authority to carry out the power investment program and operate and maintain the system. 37. In contrast to more developed countries where environmental problems are caused by too much development, in Nepal environmental degradation is a consequence of poverty caused by population pressures on limited natural resources. Consequently, efforts to preserve the environment must involve limits on population growth and the more efficient use of the country's resources. In particular, recently approved and planned projects in population and health, education, agriculture, irrigation, forestry, and hydropower are all designed to realign this fundamental relationship between the Nepalese people and their environment. This broad strategy will be supplemented by a number of specific environmental project components including watershed management, industrial pollution standards, and drinking water purity. The Government, with the assistance of UNDP, ADB, IDA and ODA, has undertaken a number of studies addressing environmental issues and is in the midst of preparing an action program which would meet the needs of the forthcoming UNCED conference as well as establish future lending and technical assistance priorities for donors including IDA.  - 14 - 38. More efficient use of public expenditures is a prerequisite for more rapid development in l.epal. The budget must be streamlined to ensure that scarce government resources support activities which enable the private sector to make a maximum contribution to growth and employment generation. In addition, budget priorities must be reoriented to serve the poverty alleviation strategy described above. As noted earlier, the new Government shares this view, and it has cooperated with the Bank on ongoing economic work focused on these issues. The Government has also sought IDA's advice and possible support in its administrative reform efforts. If further progress is made on these public resource management issues, they are likely to be the focus of the next IDA policy-based operation for Nepal. 39. Since government involvement in the economy in Nepal often inhibits rather than fosters development, IDA's strategy emphasizes greater reliance on the private sector. Efforts to shift from public to private sector the distribution and management of fertilizer and irrigation water were central to the SAC reforms. Further progress in such reforms is being reinforced through projects in irrigation and forestry. Sector work and IDA assistance will also support follow-up to the financial sector reforms initiated under the SAC with the objective of promoting efficiency and competition among the public and private sector banks and increasing the availability of credit for private investment. In addition, planned ESW underway is exploring the possibility for greater reliance on the private sector for delivery of services at the local level. IDA is also assisting the Government in its preliminary efforts to privatize a few PEs; and Government has expressed interest in IDA assistance in undertaking a more comprehensive program to rationalize the PE sector and reduce the growing burden inefficient state-owned corporations place on the government budget. As appropriate, IFC/FIAS will assist the Government in privatizing selected PEs, as well as in attracting foreign investment. With the recent expansion of the IFC Regional Office in New Delhi, IFC is actively pursuing possible new investment projects in tourism and agro-industries in collaboration with other private foreign partners. 40. Planned Lending Level and Composition of Assistance. During FY92-95 IDA expects to commit US$400-500 million for about 12 operations in Nepal, including one or two adjustment credits. The actual amount of new lending each year will depend on (a) progress in improving performance under ongoing projects and in processing new operations, and (b) maintenance of sound macroeconomic policies and a focus on poverty alleviation through human resource development. If the Government demonstrates a commitment to further reforms under SAP, IDA would consider a policy-based credit to support reforms in public resource management. Investment credits will give added attention to the social sectors, in addition to the traditional emphasis on agriculture and infrastructure. 41. Coordination with the IMF. The Bank and the IMF have worked closely in Nepal since the commencement of adjustment efforts in 1985. A third Policy Framework Paper prepared by the Government, with the joint assistance of the Fund and the Bank, was discussed by the Committee of the Whole on November 7, 1989. The Bank has also worked closely with the Fund on financial sector issues and on related studies of public enterprises. Most recently, Bank and  - 15 - Fund staff have collaborated in discussions with the new Government with a view toward a possible PFP/ESAF program. 42. Aid Coordination. The aid community has given generous support to Nepal for many years. The donors have, however, expressed concern in recent years about weak project implementation and the lack of sustainable development results. At the October 1990 Aid Group meeting in Paris, a number of donors expressed hope that the recent political developments and emerging democratic framework might provide an opportunity for more broad-based development. With this situation in mind, the donors pledged a total of US$1 billion equivalent for the two-year period, FY91-92. The donors represent a large segment of the international community, led by IDA, the ADB, and Japan. Coordination among the donors has improved in recent years, assisted by regular meetings of the Local Aid Group--co-chaired by the Bank's Resident Representative and the UNDP Resident Representative. The next Paris meeting is scheduled for April 1992. F. External Financing Requirements 43. Nepal should be able to achieve an economic growth rate on the order of around 42 per annum over the medium term, provided that the government remains committed to the task of accelerating growth and development. To support such growth and particularly to finance the necessary investment levels, Nepal will need to rely on substantial increases in external assistance. Even with an improvement in the government revenue/GDP ratio and domestic savings, Nepal will still face a savingslinvestment gap on the order of 9-10% of GDP, and an overall fiscal deficit of about the same magnitude without taking into account possible additional financing requirements for one or more large hydropower investments over the next few years. Thus far, these deficits have been largely financed by external aid. Even though Nepal's merchandise exports in nominal dollar terms are expected to rise by about 13? per annum, and imports of goods are expected to rise by only 6? in nominal dollar terms, the external current account deficit is also expected to remain around 9-102 of GDP over the next few years. This will mean that, allowing for maintenance of foreign exchange reserves at 6-7 months of imports coverage, gross external financing requirements will average $300-350 million a year over the next few years. 44. Nepal has a substantial accumulated project aid pipeline of about $1.4 billion; and a significant part (over half) of the required disbursements are expected to come from the existing pipeline. Improved public resource management, as envisaged in the development strategy, could help improve project implementation and facilitate increased disbursements from the existing aid pipeline. The balance of the required disbursements would need to come from new commitments, including modest amounts of quick-disbursing assistance, mainly from the Asian Development bank (ADB), IDA, and to a lesser extent, bilateral donors. The IMF presently does not have a program with Nepal; however, the possibility of an Enhanced Structural Adjustment Facility (ESAE) currently under discussion could provide significant balance of payments support over the next three years.  - 16 - 45. Nepal's outstanding medium- and long-term external debt is expected to increase from an estimated $1.6 billion at the end of FY91 to about $2.0 billion by end FY93. Given the substantial (23Z) devaluation of the Nepali Rupee last July, external debt in local currency terms is expected to rise to 66% of GDP in FY92. This ratio is expected to remain around 70Z over the medium term. Nevertheless, since most loans carry highly concessional terms, the debt service ratio is projected to remain modest at about 13-142 of current export receipts. G. Summary Assessment and Performance Criteria 46. Nepal, with her meager resource endowment and topographical and locational constraints, faces a uniquely difficult development challenge. Reform efforts in recent years, although successful in achieving a measure of macroeconomic stability and improving domestic policies in key areas, have had little impact in stimulating economic growth, or ameliorating the structural weaknesses of the economy. Alleviation of widespread poverty and interruption of the cycle of population pressure, denudation of the limited resource base, and environmental degradation remain pressing development goals. For this purpose accelerated economic growth must be accompanied by a broad-based and comprehensive development strategy emphasizing greater attention to human resource development and better management of natural and financial resources. 47. The establishment of macroeconomic stability and revitalizing the economic reform process, particularly in the areas of sound public resource management, improving and strengthening institutions and policies in the financial sector, increasing the efficiency of public enterprises and involving the private sector more actively in the task of development are vital to sustain economic growth and generate employment opportunities. Nepal also needs to take advantage of the reforms in India to liberalize its own trade and industrial policies to improve resource allocation and growth potential (especially for exports) and to monitor its wage rate policies in order to maintain its external competitiveness. As important as these macroeconomic policies are, improvwnents in major sectoral policies are equally critical to improving development performance in Nepal. Given the complex interlinkages between rapid population growth, declining agricultural productivity in the hills, inadequate human resource development and environmental degradation, a frontal attack on Nepal's development problem must begin with a much greater government cormitment to curbing population growth. There is also need for increasing access of the poor (who account for virtually half of the population) to education, other social services and basic infrastructure. In agriculture, industry, irrigation, as well as forestry, there is a critical need to involve the beneficiaries in the design and implementation of projects, in the delivery of inputs and services and especially in mobilizing and in managing resources for the operation and maintenance of assets. Nepal also needs to explore possible exports to third countries and to India, especially hydroelectric power, and the potential for tourism. Above all, there is a pressing need to improve institutional and absorptive capacity, which has frustrated Nepal's development efforts all along, by improving the quality and motivation of the public administration. While the advent of a democratic political system and the initial economic  - 17 - policy thrust of the new Government offer considerable promise for improvements in these difficult areas, it will take determination to follow through with the necessary reforms to accelerate and sustain development. 48. IDA's country assistance strategy is designed to support the Government's development effort mainly through a series of investment operations particularly in the areas of population, health and education, water resource development, and financial development, and through economic work and technical assistance aimed at improving public financial and natural resource management. In judging the country's progress towards more sustainable development, as outlined above, IDA would focus on: - continued maintenance of macroeconomic stability through prudent fiscal/monetary policies, further trade liberalization measures and flexible exchange rate policies; - effective actions to improve public resource management, including prioritizing recurrent and capital expenditures, increasing allocations for social sectors, reductions in inefficient subsidies and strengthened resource mobilization measures including improved cost recovery from users; - reform of the administrative system as evidence by a more streamlined and motivated civil service and revitalized institutions; - privatization and/or commercialization of selected public enterprises and liberalizing the regulatory framework; -financial sector reforms, including less reliance on subsidized directed credit, more flexible interest rate policies, and restructuring the state banks; and - efforts to reduce population growth, enhance the effectiveness of social sector programs, particularly for the rural poor and women, and improve natural resource management. Performance will be monitored through future PFPs, economic reports for the regular Paris aid group meetings and on-going as well as planned adjustment and investment operations. PART II: THE PROPOSED CREDIT 49. Background. Since 1981 Nepal has more than quadrupled its hydropower capacity to 241 MW. However, the scarcity of spare parts and inadequate maintenance of its older plants have resulted in a progressive decline in generating plant efficiency and availability which may be seriously aggravated unless action is taken to rehabilitate these plants. At the same time, delays in the expansion and reinforcement of the transmission and distribution system have led to increased system losses, interruption of supply and deterioration of service. The creation of the Nepal Electricity Authority (NEA) in August 1985 by amalgamating a number of entities has improved systems planning and  - 18 - subsectoral coordination; however, NEA's overall performance has been weak. The joint IDA/ADB Power Subsector Review (Report No. 6879a-NEP dated January 15, 1988) established a strategy which was endorsed at a Donors' Meeting in Paris in May 1988 for the efficient development of Nepal's power system, including a least cost investment program and a Performance Improvement Plan. NEA's financial position has become very weak due to stagnant tariffs and financial management deficiencies. The proposed project is part of NEA's investment program, and it includes measures to restore NEA's financial viability over a four-year period. 50. Rationale for IDA Involvement. IDA has provided six credits to support power subsector development in Nepal; two of these supported the preparation of hydroelectric projects while four financed investments. While progress on the preparatory studies has generally been satisfactory, experience with two completed hydroelectric projects (Kulekhani and Marsyangdi) has been mixed. Physical implementation of projects has improved markedly but weaknesses in institutional and financial performance still exist. The proposed Project would be the first IDA credit for which NSA would be the principal beneficiary and would involve IDA in the development of priority areas of NEA's investment program including rehabilitation of existing generation and transmission facilities. It is consistent with the agreed framework set out in the Power Subsector Review for the development of Nepal's power subsector and would facilitate IDA's support for NEA's Performance Improvement Plan. It would also enable NEA to strengthen its financial performance and finance an increasing share of the local costs of its investment program 51. Proiect Objectives. The project's primary objective would be to: (a) increase NEA's effective supply capacity by improving technical and operational efficiency, upgrading existing generation capacity and improving the system load factor; (b) restore NEA's financial viability and strengthen its institutional performance; and (c) enhance energy conservation measures. In addition, the project would address remaining environmental concerns arising from the Marsyangdi Hydroelectric Power Project (NHPP) (Cr. 1478-NEP) by supporting an innovative approach to catchment management on a pilot basis. 52. Project Description. The project would include: (a) rehabilitation of the 35 MW Trisuli and Devighat hydroelectric plants; (b) reinforcementl upgrading of the existing transmission and distribution system in the Katbmandu valley including provisions for spares, equipment and tools, and construction of a 132 kV interconnection with India to upgrade power exchange capabilities; (c) provision of equipment for NEA's headquarters offices, a training centre and centrally located workshops; (d) provision of technical assistance to the Ministry of Industry to assist local industries in identifying energy conservation measures; and (e) implementation of the Marsyangdi Catchment Management Pilot Plan, includings (i) soil conservation and sediment control; (ii) upgrading of the Dumre-Besisahar road; and (iii) rural electrification in the Marsyangdi valley. Technical assistance in the form of consulting services to assist HMG/N and NEA in implementation and training of Nepalese technical staff would be provided with each project component as well as to improve the effectiveness of NEA's management, train higher level and support staff and improve billing.  - 19 - 53. The total project cost is estimated at US$88.6 million equivalent, with a foreign exchange component of US$72.1 million (81Z). A breakdown of costs and the financing plan are shown in Schedule A. Amounts and methods of procurement and of disbursements, and the disbursement schedule are shown in Schedule B. A timetable of key project processing events and the status of Bank Group operations in Nepal are given in Schedules C and D, respectively. Two maps highlighting the project areas, IBRD Nos. 22331 and 22780, are attached. The Staff Appraisal Report No. 9077-NEP dated February 27, 1992 is being distributed separately. 54. Agreed Actions. HMGtN has already completed the following agreed actions: (a) implementation of a tariff increase of 61? effective November 17, 1991 in accord with the financial covenants described below; and (b) prepared a draft three year rolling Performance Contract (PC) with NEA to provide the framework for implementing NEA's Performance Improvement Plan which was discussed and agreed with IDA during negotiations (signature of the PC will be a condition of effectiveness). Also NEA has: (c) employed a new, well qualified Director of Finance on contract; (d) set up a Human Resources Department reporting directly to the Managing Director; (e) developed and is implementing a dated monitorable action program for reducing its consumer receivables to the equivalent of three months sales by July 15, 1993 and maintaining them at that level thereafter; and (f) initiated a number of steps to improve the accuracy of its financial accounts (including revaluation of assets, completion of subsidiary loan agreements since its incorporation, and the transfer of the Marsyangdi Project) as well as bring its audits up to date. The financial covenants agreed for the project provide that NEA will adjust its tariffs and undertake other measures to: (a) self finance increasing proportions of the local costs of its investment program (including interest during construction) rising from 45X (FY92) to 702 (FY97); and (b) achieve rates of return on revalued assets of 5? in FY96 and 62 thereafter. In addition NEA has agreed: (a) to submit to IDA by March 31 each year: (i) details of its proposed investments for the three following years with a related financing plan; and (ii) annual forecast financial stateuents, together with the proposed measures (including tariff adjustments) to meet the requirements of the financial covenants; (b) during the execution of its investment program, not to undertake any further investments estimated to cost more than US$5 million outside the program without the approval of IDA; and (c) to set up a separate Directorate to manage its rural electrification program. 55. Environmental Impact. The proposed Project is not expected to generate appreciable adverse ecological effects. An environmental assessment (EA) has been conducted of the Trisuli-Devighat component as well as an initial environmental examination (IEE) of the RV component. The EA includes an environmental action plan that was discussed and agreed between NEA and IDA to ameliorate the Trisuli-Devighat's component's environmental impacts relating to reclamation of the borrow pit and use of commercial energy sources (kerosene, electricity) and firewood acquired from legal sources by the civil works contractor. The EA established that no landholdings would be affected by the Trisuli-Devighat component. The IRE (prepared according to the Bank's environmental guidelines for transmission lines) established that 42 households would need to be resettled including those affected by the  - 20 - substations. NEA and IDA have agreed on an acquisition/compensation/ resettlement action plan under generic guidelines that NEA has developed for transmission projects in accord with the norms developed under the Arun-III Access Road Project (Cr. 2029-NEP). The Project includes funding to implement the action plans. The Marsyangdi catchment management component will address environmental concerns such as soil conservation and sediment reduction through changing land use patterns in degraded land and improving local inhabitants' income. 56. Poverty Alleviation. During the construction and civil works stages, the proposed Project would provide direct employment to the local labor force. Local employment would also be increased by the economic activities stimulated by the backward and forward linkages to improved electricity supply. The Marsyangdi catchment management component could have a special impact because It is directed towards the most intensive users of the project area's marginal lands, who are the poorest people and are expected to benefit from improved land use productivity and jobs induced by the component. They are also most likely to benefit from job opportunities created by micro enterprises resulting from rural electrification. 57. Women in Development. In addition to the project benefits identified above, the project's Marsyangdi catchment management component would directly benefit women (who are largely responsible for both herding livestock and collecting fuelwood) through land management changes that would increase the availability of fuelwood and fodder on communal lands and encourage movement away irom free grazing towards the stall feeding of cattle and through the promotion of horticulture as an income earning opportunity. 58. Benefits. Benefits would include meeting forecast electricity demand at least cost, resource savings from increased operating efficiencies, restoration/enhancement of lost capacity and reduced system losses, deferral of investments due to extension of power plant life and reinforcement of existing substations, improved reliability and quality of electricity supply, and NEA's institutional strengthening, particularly in finance, manpower planning and training. In addition, the Marsyangdi catchment management component would extend the useful life of the hydroelectric project investment through developing sustainable approaches to catchment soil conservation and sediment erosion which could eventually be expanded to other catchments upstream of other existing and planned hydropower projects. The estimated economic rate of return for the overall project is 18Z, and 272 for the rehabilitation of the Trisuli-Devighat plants. 59. Risks. No unusual technical risks are foreseen for the project's power components. The main risks concern project implementation delays and NEA's continued weak financial performance. These risks have been mitigated by requiring appointment of supervisory consultants and signature of the Performance Contract between HKG/N and NEA prior to credit effectiveness; providing for effective project management by NEA and consultants, and continued close attention to implementing measures to enhance NEA's cost recovery. With respect to the remaining components, the major issue concerns the Marsyangdi-catchnent management soil conservation and sediment reduction program. The approach used depends on the willingness of farmers to adopt new  - 21 - land management systems for marginal forest grazing land. Given the pilot nature of the project, its very modest scale and the fact that other approaches to soil conservation in Nepal have proved ineffective, the risk is acceptable. 60. Recommendation: I am satisfied that the proposed credit would comply with the Articles of Agreement of the Association and recommend that the Executive Directors approve the proposed credit. Lewis T. Preston President Attachments Washington, D.C. February 27, 1992  Schedule A NEPAL POWER SECTOR EFFICIENCY PROJECT Estimated Costs and Financing Plan Estimated Costss Local Foreign Total - - -(USS million)------ A. Generation Rehabilitation 3.4 20.2 23.6 B. HV Reinforcement 2.2 12.9 15.1 C. NEA Infrastructure/Buildings 2.1 5.5 7.6 D. Marsyangdi Catchment Management Plan 2.4 6.6 9.0 E. Industrial Energy Audits 0.2 2.4 2.6 F. Consultant Services 0.7 11.8 12.5 Base Cost 11.0 59.4 70.4 Physical Contingencies 2.1 6.8 8.9 Price Contingencies 3.4 5. 9.3 Total Project Cost a/ 16.5 7'.1 88.6 Interest during Construction 11.5 11.- Total Financing Required 28.0 72.1 100.1 a/ The total cost net of taxes and duties (US$ 4.0 million) is US$ 84.6 million. Financing Plant Local Foreign Total ---(US$ million)- IDA 6.3 58.7 65.0 Cofinancing 1.3 13.4 14.7 HMG/N 1.6 1.6 NEA 18.8 18.8 Total 28.0 72.1 100.1  Schedule B Page 1 of 2 NEPAL POWER SECTOR EFFICIENCY PROJECT PROCUREMENT METHODS AND DISBURSEMENTS -Procurement Method - Total Project Component ICB LCB Other NA Cost --------USS Million-------- Generation Rehabilitation , ' . ; - Civil Works 14.2 3.0 17.2 (12.7) (2.6) (15.3) - Equipment 13.3 13.3 (12.0) (12.0) HV Reinforcement - 132 and 66 kV lines and 16.4 16.4 substation (Turnkey) (14.8) (14.8) - Spares, Tools, Vehicles 3.5 3.5 and Equipment NEA Infrastructure/Buildings - Civil Works 2.2 ^.o 3.2 (1.9) (1.9) - Equipment, Vehicles, 3.6 3.0 6.6 Tools (3.2) (3.2) Marsyangdi Catchment Plan - Soil Conservation ) - Institutional Support ) 4.9 4.9 - Rural Electrification 3.0 3.0 - Dumre-Besisahar Road 3.6 3.6 (3.3) (3.3) Industrial Energy Audits 3.3 3.3 (2.9) (2.9) Technical Assistance 13.6 13.6 (11.6) (11.6) 47.5 8.8 32.3 88.6 a/ (42.7) (7.8) (14.5) (65.0) NOTE: Figures in parenthesis indicate amounts to be financed by IDA. a/ Includes duties and taxes estimated at US$4.0 million  Schedule B Page 2 of 2 DISBURSEMENT Categ& Amount Z (US$ million) (a) Civil works 16.0 lOC% of foreign expenditures and 65 of local expenditures. (b) Materials, and selected 29.2 1002 of foreign expendi.:ures installation works (cif). 100% of local expenditures (ex-factory cost) and 70? of local expenditures for items procured locally. (c) Consultant Services and 7.6 100z. institution building (d) Studies and Works 5.0 1OOX Unallocated 7.2 65.0 Estimated IDA Disbursements: IDA Fiscal Year 92 93 94 95 96 97 Annual 7.8 20.7 17.0 14.3 3.2 2.0 Cumulative 7.8 28.5 45.5 59.8 63.0 65.0  Schedule C NEPAL POWER SECTOR EFFICIENCY PROJECT Timetable of Key Project Processing Events (a) Time taken to prepare: Two Years (b) Prepared by: Government with IDA assistance (c) First IDA Mission: November 1989 (d) Appraisal Mission Departure: June 1990 (e) Negotiations: April/May 1991 (f) Planned Date of Effectiveness: July 1992 (g) List of Relevant PCRs and PPARs: Kulekhani Hydroelectric Project (Crs. 600-NEP and 600-1-NEP), PPAR No. 6177 dated March 8, 1986.  - 26 - Schedule D Pge. 1 of 2 THE STATUS OF BAK GROUP OPERATIONS IN NEPAL A. STATEMENT OF BANK LOANS AND IDA CREDITS > (As of Decembr 81, 1991) Amount In US8 miIlion (lose cancell ltions) Fiseca Undlo- Credit No. Year Borrower Purpose Bank IDA bursd S5 credits have been fully disbursd 377.96 Of which SECAL, SALs and Progrsa Loans b) Cr. 1769-NEP 1987 Nepol Structural Adjustment 0.00 60.00 Sub-Total 0.00 60.00 Cr. 1198-NEP 1982 Nopal Education 1I 14.10 4.11 Cr. 1400-NEP 1984 Nepal Forestry TT (Tersi) 7.38 6.52 Cr. 1483-NEP 1984 Nepal Educotion III (Primary) 9.61 5.21 Cr. 1476-NE? 1984 Nepl Power II (Marsyangdi) 107.00 51.11 Cr. 1S15-NEP 198S Nepal Highways III 47.50 30.20 Cr. 1534-NEP 196S Nbpal Agricultural Manpower 8.40 6.78 Ce. 135-NEP 1985 Nepal Industrial Development 7.50 3.80 Cr. 1570-NEP 1985 Ncepl Agriculturol Extension II 7.20 7.16 Cr. 1688-NEP 1985 Nepal T,lecomunications IV 22.00 17.31 Cr. 1696-NEP 1968 Nepal Cottage A Small Industries 10.00 6.41 Cr. 1715-NEP 1986 Nepal Narayani Irrigation III 24.50 22.44 Cr. 1727-NE? 1987 Nepol Rural Development III 19.10 19.67 Cr. 1814-NEP 1987 Nepal Sunsory-morang II 40.00 26.96 Cr. 1902-NEP 1986 Nepal Third T.A. (Panchoewar) 14.40 3.32 Cr. 1922-NEP 19*8 Nepal Road Flood Rehabilitation 16.50 13.02 Cr. 1924-NE? 1966 Nep"l Mahakal Irrigation II 41.30 27.10 Cr. 198-NEP 198 Nepal Municipal Dov Ii Earthquake 41.50 22.30 Cr. 2026-NE? 1989 Nepal Hill Coamunity Foroestry 80.50 29.87 Cr. 2029-NE? 1989 Nepal Arun III Access Road 82.80 34.6 Cr. 2044-NE? 1989 Nepal Engineoring Education 11.40 11.90 oCr. 2040-NE? 1969 Nepal Structural Adjustment II 60.00 22.17 Cr. 2047-NEP 1989 Nepel Earthquake School Rehab 22.60 21.20 Cr. 2144-NEP 1990 Nepal Shairaws Lumbini III 47.20 49.70 Cr. 2239-NE? c) 1991 Nepal Urban Water and Sanitation Rehab. 60.00 05.06 Total 0.00 1079.64 d> 507.18 d> of which has been repaid 11.42 Total now held by lank and IDA 0.00 1068.42 Amount sold of which repaid Total undisbursed 507.21 a) No Bank loans have been made to Nepal. b> Approved during or after FY60. c> Not yet effective. d> The prinetpal amounts of MDA credits are shown in US Dollar equivalent at date of negotstions, as shoen in the Preoident's Report. Undisbured amounts shown In US Dollar equivalent are valued at th, exchange rate applicable on the date of this statement. In se"o casew, therefore, the undisbursed bo.'nc. indicates a dollar aount greater than the original principal credit amout *xpressd In dollars. * SAL, SECAL or Program Loan.  - 27 - Schedu l. D Pag 2 o1 2 STATEMENT OF IFC INVESTMENTS (Ac of Decmber 81, 1991) Investmet Fiscal Type of Loan Equity Total Nuber Year Obligor Business (USe Mill1on) si2 1975 Soelte. Hotel (Private) Ltd. Hotel 2.70 0.48 3.13 824 1962 Nepal Orind Magnesita Mine and Proc... (Privato) Ltd. Magnes;to Ore 4.97 - 4.0t Total Cross Com.itmento 7.67 0.43 6.10 Less Cancel lations, tOrQinations, repoyoent and sales 8.38 - 3.86 Total Commitments now hold by IFC a) 4.29 0.43 4.72 Total Undisbursed ftncluding ParICIpanCs1 DOrtson; G> Exchange adjustment. account for variation in total gross commitments, loes cancellations, atc., and total comitmente now held by IFC.  - 28 - Schedule E Page 1 of 1 Table 1: NEPAL - KEY INDICATORS, 1987/88-1993/94 _--ACIIAL--- ------PROJECTED-- 1987/68 1986/89 1989/90 1990/91 1991/92 1992/93 1993/94 REAL GROWTH RATES: | GOP GROWTH RATE I 7.3 a.9 3.6 4.0 3.0 4.0 4.1 PER CAPITA GDP CROWTH RATE I 4.7 1.8 1.0 1.4 0.4 1.4 1.6 DEBT A DEBT SERVICE TOTAL DOD */ (IN USS MN.) I 1109 1281 1480 1662 1844 2047 2278.0 QCD/GDP I 33.1 44.6 46.6 50.9 80.6 62.7 67.2 DEBT SERVICE/XOS I 7.3 9.1 17.8 18.9 14.9 14.1 13.7 DEBT SERVICE/GDP | 1.2 1.4 2.0 2.7 3.0 2.9 2.6 GROSS INVESTMENT/CDP I 21.4 22.0 20.2 20.9 21.2 21.3 21.4 RESOURCE QAP/GOP I -9.6 -9.9 -10.3 -11.7 -11.1 -10.9 -10.6 GROSS NATIONAL SAVINGS/GDP 12.8 12.3 10.0 6.7 9.9 10.6 11.0 PUBLIC INVESTMENT/CGP 8.0 8.C 7.2 7.4 7.6 7.7 7.7 PRIVATE INVESTMENT/GOP I 13.4 13.4 13.0 18.4 13.0 13.6 18.7 GOVERNMiENT REVENUES/CDP I 10.6 9.9 10.5 10.6 10.9 11.2 11.6 GOVERNMENT EXPENDITURES/GDP I 20.3 28.2 22.2 21.1 21.7 22.8 22.7 DEFICIT(-) OR SURP$S(+)/CDP I -9.7 -18.8 -11.7 -10.4 -10.8 -11.1 -11.2 CPI (1980=100) 236 246.0 273.0 298.7 342.9 377.0 408.6 IMPLICIT GOP DEFLATOR (X CHANGE) 6.9 9.6 9.4 9.1 14.6 10.0 7.0 EXPORT GROWTH RATE (USS NOMINAL) 36.2 -12.1 8.6 83.0 31.0 9.3 10.8 EXPORTS/CDP ! 6-o 6.4 6.8 7.6 11.8 11.6 11.6 IMPORT GROWTH RATE MUSS NOMINAL) 26.0 1.1 1.7 16.9 0.4 7.1 7.0 IwPORTS/GDP 20.2 20.6 20.8 24.1 273 27.2 27.2 TERMS OF INDEX (PERCENT CHANGE) 10.8 4.4 -2.2 0.0 0.8 1.9 1.3 CURRENT ACCOUNT (USS MN.) I (BEFORE OFFICIAL CAPITAL GRANTS) 1 -207.6 -296.0 -816.0 -380.0 -316.0 -320.0 -386.0 CURRENT ACCOUNT/GOP I -8.6 -9.7 -10.2 -12.1 -11.3 -10.7 -10.4 GROSS OFFICSAL RESERYES (IN I UMONTHS OF IMPORTS) 6.3 6.0 6.3 6.0 6.1 6.5 6.6 _ _ _ _ _ _ _ _ _ _ _ _ _~~~~~~~~~I________________________________ _ a/ Medium and long term debt outetending and disbursed. Soursc: Miniotry of Financo and Staff Estimates.  r 18RD 22331 NEPAL kf<s _ - ' \ POWER SECTOR EFFICIENCY PROJECT PROOSED Of UNDER UNDER CONSTRUCTIO,N INVESTIGATION EXISTING 3X I-s \ {; * 9 EZ I E21 Lorgn Hydro PlcmtS SS7 EKOT . *E Small Hydro Plants KEAITARI. -A - - - ;> Dsiewl Power StStitors IW DARCODA 45 t jIsANO; . "- E x t Solar Power Stations trt%IAR JR..C Wind Power Stotions PANCREDWAR BAJUXA I R-N AL CE 0 Power TrEaT:fnr Points~~~~~~~~~~~~~~~~~~~~~~~~~~-e,Trrd. Pnt | h *< >11/v 2 ~~~~~~~~~~~~~~~~~K A R N AiL|>kZ Vsololn sm' ~ ~ ~ K A~-~220 kV Troosmissiat Ln.s PAS%nEEWAo. 66. - . 32 kV Transmission Lines E -M)U.tA 66 kV TrcmsmUESEA i _,_Li_s ' 1HADHELDW S T E R N ArHH^ X I D .................................. W E S T E R N ' y .....................------ ------ 33 kV Transmission Lines .000 ~~~~~~~7~?JjM ID W-E SWfT E RN EnergyTrsfn 5o00rt T.1A ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~~ ~ ~~ ~~ ~~~~~~~~~~~~~~~~~~~~~~~~~Ds Import t \ Jm >t 2 twJOM30M~~~~~~~~~~~ - RirWErs ~~~~~~~~~~~~~~~~~TADUJA ' i Or a < NL%f"' Zon --,_oondoe H E R I ~ ~ ARUl'~ Region Bmnosdaies ~~~AANEfl A n la~~~~~~~~~~~~~~~~~~~~~iternatiorsa Ba,ndonins ~~~~~~~f A--E R A P T E V E R N Now T w G 3 N D A K I WO&SoUko nIEsnnl.s C IwO EV-i. 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