Nepal - Second Structural Adjustment Credit Project

Docent of The World Bank FOR OFmaCIAL USE ONLY Reort No. 12871 PROJECT COMPLETION REPORT NEPAL SECOND STRUCTURAL ADJUSTMENT CREDIT (CREDIT 2046-NEP) MARCH 21, 1994 Country Operations, Industry and Finance Division Country Departsent I South Asia Regional Office This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  Currency Equivalents 1 Rupee - 100 Paise 1 Rupee - US$ 0.0392 NRs.25.50 - US$ 1.00 Abbreviations and Acronyms AIC Agriculture Imports Corporation CBPASS Commercial Bank Problem Analyses and Strategy Study DOI Department of Irrigation ESAF Enhanced Structural Adjustment Facility HMG His Majesty's Government of Nepal ICB International Competitive Bidding NBL Nepal Bank Ltd. OGL Open General Licenses 3&M Operations and Maintenance PBPM Program Budgeting and Project Monitoring PFP Policy Framework Paper QRO Quantitative Restriction (on Imports) RBB Rastriya Banijya Bank SAF Structural Adjustment Facility SAL Structural Adjustment Loan (Credit) T&T Trade & Transit Impasse UNDP United Nations Development Program Fiscal Year (FY) of Borrower July 15 - July 14  FOR OFFICIAL USE ONLY THE WORLD BANK Washington, D.C. 20433 U.S.A. Office of Director-General Operations Evaluation March 21, 1994 MEMORANDUM TO THE EXECUTIVE DIRECTORS AND THE PRESIDENT SUBJECT: Project Completion Report on Nepal - Second Structural Adjustment Credit (Credit 2046-NEP) Attached is the Project Completion Report on Nepal - Second Structural Adjustment Credit (Credit 2046-NEP) prepared by the South Asia Regional Office, with Part II contributed by the Borrower. This project aimed at continuing to support the Govemment's structural adjustment program initiated under the First Structural Adjustment Credit (Credit 1769-NEP). To this end, it encompassed conditionality over a broad front, including tax reform, public expenditures restructuring, foreign trade liberalization, agricultural sector improvements (distribution of fertilizers, management of irrigation), and commercial banks strengthening. Since these reforms would require major institutional improvements and thorough preparation, the credit relied on the future undertaking of various studies to firm up specific action plans in key areas. The required technical assistance to conduct and help implement these studies, however, was financed and managed by other donors, an arrangement that led to serious problems. Implementation of the project faced several difficult challenges. In addition to the design problems just described, there were major political changes in the country and severe trade and transit disruptions with Nepal's principal trading partner. It is remarkable, then, that in spite of such problems most of the actions contemplated in the program were satisfactorily completed, albeit with some delays. Macro-economic stability was maintained, some tax and trade policy improvements were attained, and a start was made towards strengthening fertilizer and irrigation management. On the other hand, progress in the areas of banking reform, public expenditure controls and tax- system elasticity was much less than anticipated. In spite of the shortfalls, the overall outcome of the project is rated as satisfactory, its institutional development impact as substantial and its sustainability as likely. The PCR is comprehensive and informative. It presents a full picture and assessment of the project's implementation experience and outcome. Part II highlights the role of fiscal policy and stresses the importance of ownership in carrying out a broad based reform program. Some of the weaknesses of this project (too broad coverage, inclusion of issues which had not been sufficiently clarified or ironed out) had been identified by OED as shortcomings of the first Structural Adjustment Credit (OED Report #9681). Unfortunately, those lessons of experience were not learned early enough. An audit is planned. Attachment This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.   FOR OFFICIAL USE ONLY PROJECT CtIPLEflONI REPORT IEPAL SECOND STRUCTURAL ADJUSTHMET CREDIT (CREDIT 2046-REP) TABLE OF COIITERTS Page No. Preface ................................................................ Evaluation Summary .................................................... ii Part I: PROJECT REVIEW FROM BANK'S PERSPECTIVE ........................1 1. Project Identity ......................................... 1 2. Background ............................................... 1 3. Program Objectives and Scope ............................. 3 4. Program Design and Organization ......................... 4 S. Program Implementation ................................... 6 - Macroeconomic Management .............................. 7 - Revenue Enhancement/Rationalizing the Revenue System .................................... 9 - Improving Public Expenditure Management ............... 10 - Improving Trade Policies .............................. 13 - Strengthening Financial Sector Institutions ........... 15 - Agricultural Reforms .................................. 17 6. Program Sustainability ................................... 20 7. Social Impact ............................................ 22 8. IDA's Performance ........................................ 23 9. Procurement and Auditing ................................. 24 10. Consulting Services ...................................... 25 Part II: PROJECT REVIEW FROM THE BORROWER'S PERSPECTIVE ............... 26 PART III: STATISTICAL INFORMATION ...................................... 28 - Program-Related Information ................................ 28 - Economic Data .............................................. 29 Annexes: - Annex I : Tranche Release Conditions .................. 47 - Annex II: Policy Matrix and Implementation Summary ......... 49 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.l   PROJECT COMPLETION REPORT NEPAL SECOND STRUCTURAL ADJUSTMENT CREDIT (CREDIT 2046-UEP) PREFACE This is the Project Completion Report (PCR) for the Second Structural Adjustment Credit for which Credit 2046-NEP in the sum of US$60.0 million (SDR46.2 million) was approved by the Executive Directors on June 27, 1989 and became effective on August 10. 1989. The Credit Closing date was originally set on December 31, 1991 but was extended to July 31, 1992. The Credit was fully disbursed on closure. The PCR was prepared by the Country Operations, Industry and Finance Division. Country Department 1, South Asia Region (Preface, Evaluation Summary, Parts I and III). The Borrower prepared Part II of the PCR and contributed data for the tables included in Part III. Preparation of the PCR was started during the Bank's final supervision mission in August 1992 and is based on the Memorandum of the President, the Development Credit Agreement, related Working Papers, supervision reports and correspondence between the Borrower and the Association. Comments were also obtained from the Bank staff who originally identified, prepared, appraised and subsequently supervised the implementation of the adjustment program The PCR has been reviewed by His Majesty's Government of Nepal. The Government's comments on Part I and III of earlier drafts have been incorporated into the PCR as appropriate.   - iii - PROJECT COMPLETION REPORT NEPAL SECOND STRUCTURAL ADJUSTMENT CREDIT (CREDIT 2046-NEP) EVALUATION SUMMARY (a) Proiect Obiectives (Para 3.1). The main objectives of the Credit were to accelerate economic growth with macroeconomic stability on a sustain- able basis by improving the allocation of public and financial resources and increased reliance on the private sector. To this end, the reform program supported by the Credit aimed at consolidating the policies already adopted under SAL I and reinforcing the adjustment process through additional mea- sures, particularly by (i) maintaining sound macroeconomic management; (ii) enhancing government revenues; (iii) improving public expenditure management; (iv) encouraging further trade liberalization and expanding Nepal's trade relations with third countries; (v) strengthening financial institutions; and (vi) enhancing the role of the private sector in fertilizer distribution and irrigation management. (b) Implementation Experience (Section 5). Against this background of a severe disruption in prevailing trade and transit arrangements with Nepal's principal trading partner - India - and major domestic political changes and uncertainties, three successive governments remained committed to the reform program. However, slippages in implementation arose because of: (i) the inability of the "caretaker" coalition government which was comprised of different political parties to reach a consensus on policy reforms and take timely actions; (ii) lack of sufficient commitment to certain aspects of the reform program; (iii) delays in completing key technical assistance studies which provided the analytical basis of further reforms to be implemented in the latter part of the period (e.g., in the financial sector); and (iv) shortcomings in program design/specification itself. Despite these problems, however, most of the actions contemplated in the program were satisfactorily completed, though about 14 months behind schedule. (c) Results (paras 5.6. 5.7. 5.8. 5.12. 5.15. 5.16. 5.19. 5.20, 5.24, 5.25. 5.28 and 5.29). The Credit was a qualified success. The most notable achievements of the adjustment program were: (i) maintenance of macroeconomic stability in the face of severe external and domestic disruptions, and (ii) improvements in trade policy (and exchange rate) reforms which surpassed program expectations. Exports and the foreign exchange reserve position improved significantly. A good start was also made in improving fertilizer distribution and irrigation management, and preventing a potential collapse of the two large government-owned banks (which comprised 95% of banking assets at the time). However, the more fundamental reforms to restructure the two banks to ensure their long term viability, increasing the elasticity of the tax system, and improving public expenditure management were not realized as anticipated.  - iv - (d) Sustainabilitv (Section 6). The SAL II program helped the Government to maintain macroeconomic stability and make important gains in a number of areas in a volatile and uncertain environment. It (as well as SAL I which preceded it) reinforced the belief among key decision-makers that Nepal can indeed make significant progress with improved economic policies and management, and helped to create a strong constituency for policy reforms. Thus, even though there was some concern and debate about the pace and some of the aspects of the reform program, there was still reasonably strong commit- ment to the reform program as a whole. The new Government subsequently entered into a new ESAF arrangement with the IMF and a fourth year PFP, and has recently undertaken a number of further important policy reforms, which have in some areas exceeded the reforms far beyond SAL II expectations. In addition, the sustainability of the reform process has received a strong boost from economic liberalization in neighboring India, since Nepal needs to at least keep in step in many areas. However, Nepal so far has shown willingness to go even further in a number of areas. On the other hand, effective implementation of reforms, especially where major institutional changes are involved, has been a persistent problem. A stronger commitment to address the implementation/institutional aspects is essential to ensure effectiveness and sustainability of the reforms. (e) FindinRs and Lessons Learned. (i) By and large, the SAL II program was satisfactorily implemented though somewhat behind schedule. Formulated and implemented in an extremely volatile external and domestic environment, it achieved and even exceeded its goals in some areas, while falling short of expectations in others. It also helped to consolidate earlier reforms, and build a strong constituency for sustaining and accelerating the reform process. (ii) The delays in implementation were due to a large extent to unanticipated political developments and the perceived inability of the transitional government to take necessary decisions to implement the agreed reforms. In addition, delays in completing the technical studies which provided the analytical basis for the recommended reforms (as in the case of the financial sector) contributed to implementation slippages. (iii) The degree of government ownership of and commitment to the reform program, with a changing cast of decision-makers at various levels, was an important factor contributing to the varying degrees of success of the differ- ent parts of the program. For example, in the financial sector where the vision of the reform program was not fully shared by the Government, the reform program was less effective. Similarly, in public expenditure manage- ment, little enthusiasm at the highest political levels existed for expendi- ture rationalization; and a strong constituency at the technical level for some of the proposed institutional changes was also missing. This was also the case with the irrigation sector where, initially, there was insufficient commitment for reform. On the other hand, where such commitment or institu- tional changes were not at issue, progress was much more rapid - e.g., in trade and exchange rate policy.  -v- (iv) Implementing reforms where institutional changes were required were particularly difficult. This was the case with changing AIC's role in fertilizer management and in operationalizing the new program budgeting and monitoring mechanisms. Apart from the program ownership issue noted above, this also reflects the fundamental difficulties of institution-building in Nepal, which is nothing new. To that extent, the SAL II program itself was overly optimistic in this regard. In retrospect, it underestimated the delays and difficulties involved in institution-building and evolving new processes and procedures in Nepal; in fairness to the authors of the program, they could not have anticipated the changed political environment and technical assis- tance problems which occurred. (v) In addition, other weaknesses in the design of the program also contributed to the implementation problems. In particular, since further reform measures for shaping the future of the banking system were to be identified on the basis of the outcome of studies to be undertaken during the program period, it left room for considerable debate and disagreement, and slippages, especially in a situation where the Government itself was unclear about the future role of the government-owned banks. Similarly, in the irrigation sector, the proposed actions were not clearly defined in the program, and created considerable ambiguities about what a "satisfactory" level of implementation meant. These problems could and should have been avoided, if necessary, by leaving out such components of the reform program which lacked sufficient clarity and specificity. (vi) In conclusion, the SAL II program was a qualified success. As noted, it helped Nepal to cope with the Trade and Transit treaty (T&T) impasse and a series of domestic political changes; and to initiate important reforms during the program period. Equally important, it built a strong constituency for future reforms. Among the lessons to be learned from the operation are that, given the complexities of institution-building in Nepal, it is desirable to: (i) set realistic objectives about how rapidly institutions can be improved; (ii) limit the interventions to essential key requirements and (iii) undertake thorough preparation and follow-up.   PROJECT COMPLETION REPORT NEPAL SECOND STRUCTURAL ADJUSTMENT CREDIT (CREDIT 2046-NEP) PART I: Protram Review From the Bank's Perswective 1. Project Identity Name : Second Structural Adjustment Credit Credit Number : 2046-NEP RVP Unit : South Asia Region Country : Nepal Sector : Economic 2. Background 2.1 With a per capita income of about US$170, Nepal remains one of the poorest countries in the world. Social indicators remain well below the average for the South Asia region. Life expectancy at birth is 52 years, and infant mortality is 128 per 1,000 (1989), and adult literacy stands at only 39 percent. With the population growing rapidly at 2.1-2.6 percent per annum , population density with respect to arable land (around 600 persons per square kilometer) is one of the highest in the world. In a predominantly rural economy with limited natural resources, population pressure has contributed to fragmentation of land holdings, declining productivity, widespread poverty and growing environmental problems. Presently, about 7-8 million of its popula- tion of 19 million remain below the poverty line. A poor resource endowment, highly underdeveloped infrastructure even by South Asian standards and a difficult physical environment (a rugged terrain and land-locked location) remain serious obstacles to rapid economic development. In addition, a long and open border with India (which, while conferring significant benefits in terms of market access and inflows of investment and technology), has in the past limited Nepal's flexibility in designing and implementing independent economic policies in such key areas as trade, exchange rates, interest rates and pricing. (More recently, however, with India moving rapidly to liberalize its economy and implement structural reforms, this factor has become an important catalyst, rather than an impediment, for economic reform in Nepal.) These constraints have been exacerbated by a poor public administration and weak institutions and a history of ineffective economic management and inappropriate development policies. Consequently, the economy remains structurally weak, national savings as well as Government revenues as a proportion of GDP remain quite low, exports finance only about 40% of imports, and the country continues to depend heavily on external assistance. 2.2 Emerging from self-imposed isolation in the early 1950s, Nepal endeavored to construct a modern physical and administrative infrastructure to 1 2.1% according to Government estimates.  promote economic development. However, these efforts were insufficient to create the basis for rapid development and alleviating poverty. Even though Nepal did not experience severe macroeconomic imbalances during this period, the economy continued to operate in a low level equilibrium; and economic growth barely kept up with population growth. In the early 1980., the Government resorted to increased public spending (financed to a considerable degree by domestic bank borrowing) to accelerate the pace of economic growth. This strategy proved to be unsustainable as fiscal and external deficits reached 10-12 percent of GDP, and the domestic inflation rate accelerated to 15 percent. Faced with this situation, in the mid-1980s, the Government adopted a Fund-supported stabilization program beginning in December 1985; and subsequently undertook a comprehensive structural adjustment program, which was supported by a three-year SAF arrangement with the IMF and by a structural adjustment credit (SAL I) by IDA covering the FY87-89 period. 2.3 SAL I sought to provide the transition from economic stabilization to more rapid development on a sustainable basis by laying the foundations for structural reform of the economy, while curbing inflation and strengthen- ing the balance of payments. A GDP growth rate of 4-5% p.a. was targeted. To this end, SAL I focussed on improving macro-economic management (by enhancing government revenues and public savings, restraining the growth of less essential expenditures, and increasing investment levels); promoting agricul- tural development (by liberalizing input distribution, streamlining the role of public sector institutions and increasing private sector involvement in such activities); liberalizing industrial, trade and exchange rate policies (aimed in promoting export development, gradually freeing up imports and facilitating private investment and activities); improving management of public enterprises and initiating a longer term program for privatization; and strengthening development administration through a series of measures aimed at improving budgeting, planning and expenditure monitoring. Despite some implementation delays and shortfalls in some areas (for example, agricultural reforms and privatization of PEs), the reform program was broadly carried out. Economic growth and investment levels increased, the inflation rate decelerat- ed, macroeconomic management improved, and considerable progress was made in reducing trade restrictions, liberalizing imports and providing incentives to exports. The project performance audit report for SAL I2 (which provides a detailed account of the reform program and its accomplishments) concluded that "the SAL stimulated major improvements in economic policymaking, ...the structural adjustment program was sustained even after the economic difficul- ties occasioned by the March 1989 disruption in the trade and transit treaty with India" and that "the primary value of the first SAL probably lay in its demonstration effects: it showed the Government that the Nepalese economy can indeed be brought out of stagnation if appropriate policy changes are intro- duced." 2 Project Performance Audit Report, Nepal: First Structural Adjustment Credit (Credit 1769-NEP), SecM91-964 dated July 25, 1991.  - 3 - 2.4 The Trade and Transit treaty' (T&T) impasse with India in early 1989 interrupted Nepal's progress and again threatened to undermine macroeco- nomic stability. The T&T impasse severely disrupted the flow of Nepal's exports and imports through India, created shortages of essential inputs and commodities, adversely affected economic activity, investment and growth prospects, and sharply increased the rate of domestic inflation in the early part of 1989. Staff projections at the time indicated that GDP growth would decline from a pre-crisis estimate of 5% to less than 2% in FY89 and to virtually zero in FY90, while inflation was expected to accelerate from (a pre-crisis) 9% to 10% in PY89 and to 14% in FY90. Both the budget and the balance of payments came under severe pressure. Government revenues were expected to fall from an estimated (pre-crisis) 11.3% of GDP to 10.0% in FY89 and to 9.8% in FY90. As a result the overall fiscal deficit was projected to rise from 9.4% of GDP to 10.5% in FY89 and domestic financing of this deficit to rise from 1.1% of GDP to 2.2%. In regard to the balance of payments, both exports and imports were expected to decline sharply; and even through the external deficit was projected to remain at the pre-crisis level of 10% of GDP, the reduction in trade flows was expected to create severe dislocations in the economy. The T&T impasse, if anything, demonstrated the vulnerability of Nepal's weak economic structure to external vicissitudes; and underlined the need for further structural reforms to cope with the consequences of the crisis in the short term, as well as to steer the economy on to a sustainable growth path over the medium term. 3. Proaram Obiectives and Sc2pe 3.1 Against this background, the Second Structural Adjustment Credit (SAL II) was intended to support the second phase of the Government's adjust- ment program over the FY89-FY91 period. The main objective of the program was to accelerate economic growth on a sustainable basis with macroeconomic stability by improving the allocation of public and financial resources and increased reliance on the private sector. To this end, the reform program supported by the Credit aimed at consolidating the policies already adopted under SAL I and reinforcing the adjustment process through additional mea- sures, particularly by (a) maintaining sound macroeconomic management; (b) improving government revenues and development expenditures management; (c) encouraging further trade liberalization and expanding Nepal's trade relations with third countries; (d) strengthening financial institutions; and (e) enhancing the role of the private sector in fertilizer distribution and irrigation management. 3.2 SAL II was designed to be disbursed in three equal tranches of $20 million each. The Credit amount of $60 million equivalent was expected to constitute approximately 11% of the required gross capital inflows during the 3 These treaties had provided duty-free transit over Indian territo- ry for goods traded between land-locked Nepal and third countries and between western parts of Nepal itself, in addition to favorable trading arrangements for Nepal's exports to and imports from India. Moreover, in recent years (before the T&T impasse) about 40% of Nepal's trade had been with India.  -4- FY89-91 period, and to finance approximately 5.1% of anticipated imports during this period. 4. Program Design and Oraanization 4.1 In terms of design and comprehensiveness, by and large, the focus of SAL II was appropriate. In light of disruptions caused by T&T impasse, it focussed on the key areas where strong actions were deemed necessary to restore macroeconomic stability and accelerate economic growth; i.e., improv- ing macroeconomic management, fiscal and trade policies, fertilizer policy and irrigation sector reforms, and ensuring solvency of the banking system. These were indeed critical areas at the time. However, in retrospect, there were a number of shortcomings in the program's design and timing: (a) The reforms envisaged in many of these areas required major institutional improvements, and considerable ad- vanced preparation to both agree on the specific content of the reforms and action plans for implementation. As against this need for more comprehensive preparation, the Credit had to carefully balance the need to provide assis- tance quickly to help the Government cope with the disrup- tions caused by the impasse. Since the latter option was chosen, the Credit took the approach of relying on various T/A studies to firm up the recommendations and action plans for reforms which were to be implemented later in key areas, such as the financial sector and the irrigation sector. This led to considerable vagueness in the condi- tionality, disagreements about the required reforms and implementation delays (para 5.25) in these areas. (b) In light of these weaknesses, it would seem that the pro- gram tried to do too much; and should have been probably more narrowly focussed. The reforms in the financial sector, for example, should have been left until the TIA studies were completed and the objectives of reform and specific actions were clearly understood and agreed upon, to be supported by a separate financial sector operation. (c) Given the institutional changes envisaged, the Credit underestimated the time required for these changes. The Credit envisaged that the action program which commenced in mid 1989 would be completed by late 1990. In effect, implementation took considerably (15 months) longer; and even then, the objectives in regard to institutional chang- es fell considerably short of expectations (para 5.16). 4.2 The Credit's design with regard to trade Policv reforms was appropriate. The commitments to gradually shift from QRs and licensing controls to an OGL/passbook/auction mechanism provided an excellent vehicle for the transition to a more liberal import regime. The auction mechanism in particular helped to address the Government's need to liberalize  banned/restricted imports while preventing their diversion to India and to channel a part of the high economic rents from such imports to the Treasury. In regard to exports, permitting duty-free access to imports for production of carpets was achieved satisfactorily by requiring the abolition of import duties on raw wool. However, establishing a duty draw-back system for other exports proved to be administratively cumbersome. Fortunately, the Govern- ment's strong commitment to improved exchange rate management and rapid progress towards a liberal import regime helped to overcome these deficiencies (para 5.20). 4.3 In regard to revenue enhancement, the action proposed in the program were designed to address some of the obvious shortcomings of the tax system (excessive exemptions from direct taxes and a weak tax administration), without changing the structura of the tax system itself. This was a proper approach at that time, given the fact that the preparatory work which is necessary for changing the tax system had not been undertaken; and the Government itself was not ready for a more fundamental tax reform. However, given the rapid pace of implementation of trade policy reform, the significant loss of revenues associated with tariff reductions and the consequent need to rapidly develop alternative sources of fiscal revenues were not anticipated. As a result, the program actions were not sufficient to enhance revenues as expected (para 5.12). 4.4 In regard to expenditure management, the program focussed on the key problem areas - poor budget preparation and monitoring and lack of accountability. However, given the fact that the reforms involved major institutional and procedural changes with regard to budgeting, accounting and monitoring, the pace of implementation assumed was too optimistic. The slippages in implementation were also due to the fact that an effective Planning Commission did not exist at the time; the technical assistance studies undertaken for this purpose were not well coordinated and managed (para 5.16); there was insufficient ownership of the proposed institutional changes; and the implementation capacity in the country itself was limited. Greater caution was necessary in setting a time-frame for institutional changes. 4.5 On the government side, the main organization responsible for the Credit - the lead agency - was the Finance Ministry. It took the lead in formulating the Credit, managing key parts of it and supervising implementa- tion by other concerned government agencies. Major aspects of the program - revenue mobilization and expenditure management - were direct responsibilities of the Finance Ministry itself. Nevertheless, some parts of the program in these areas involved other government agencies and required close collabo- ration and co-ordination. For example, in regard to revenue reforms, removal of tax exemptions involved the concurrence of the Ministry of Industries. Similarly, a number of expenditure reforms, especially those designed to improve budget planning and monitoring, involved the National Planning Commission, as well as key line ministries where planning units were to be strengthened to facilitate preparation of sector expenditure programs and their monitoring. In the financial sector, the key government institutions involved were the Nepal Rastra Bank which was the principal interlocutor on the government side, the two commercial banks which were the targets of the  -6- reform (RBB and NBL), and the Finance Ministry in a coordinating/supervisory role. In agriculture, the key organizations involved were: in fertilizer pricing and management, the Ministry of Agriculture and the Agricultural Inputs Corporation (AIC); and in the case of irrigation sector, the Ministry of Water and Power and the Department of Irrigation under it; with Finance Ministry playing a supervisory/coordinating role in both cases. 4.6 This lead agency arrangement with Finance Ministry in overall charge worked reasonably well. It enabled the Bank to deal with one institu- tion - the Finance Ministry - as the focal point in case of implementation delays. However, it did not prevent implementation delays from occurring even in areas which were the direct responsibility of the Finance Ministry (e.g., expenditure management), as well as in areas handled by other agen- cies/ministries (e.g., financial sector, irrigation). The reasons for these shortfalls, however, were not the organizational arrangements for the Credit outlined above, but other problems identified below. 5. Program Implementation 5.1 The Credit became effective on August 10, 1989 shortly after the Credit Agreement was signed; and the first tranche was released on effective- ness. The release of the second tranche (which was originally scheduled for October 1989) took place on March 08, 1990. The fulfillment of the second tranche conditions was deemed satisfactory, although the tranche release, as noted, was delayed by six months. The review mission initially (in October 1989) found that even though the specific conditionality for the release of the second tranche were fulfilled, (this required that the Government (a) establish a satisfactory medium-term policy framework and (b) adopt a flexible fertilizer pricing policy which would at least ensure parity of domestic prices with those at the Indian border), the regulations aimed at liberalizing fertilizer dealership policy were not being implemented effectively. Correc- tive action, however, was taken subsequently. The release of the third tranche (originally scheduled for November 1990) was also delayed, due to the late completion of technical assistance which underpinned the formulation of key recommendations for reform of the financial sector and slippages in the implementation of key irrigation sector actions. These were however satisfac- torily completed subsequently; and the third tranche was released on March 1992 and was fully disbursed by August 17, 1992. 5.2 SAL II was complemented by a Policy Framework Paper (PFP) and an IMF Structural Adjustment Facility (SAF) arrangement which covered the same period. The final disbursement under the SAF program was made in the late 1990; and in early 1991, the Fund Board reviewed the Government's overall performance under the SAF program and found it to be satisfactory. Subse- quently, in late 1992 the Government negotiated a new Enhanced Structural Adjustment Facility (ESAF) arrangement with the Fund and a fourth year PFP with the Fund and the Bank; these provide a framework for continued economic reform and adjustment, and are currently under implementation. 5.3 The following sub-sections outline the key macroeconomic targets (macro framework) of SAL II and, for the major program areas, the specific  actions that were to be taken (intent), together with details of their subsequent implementation before and after the tranche release (performance), and IDA's assessment of their impact (results) and sustainability. 5.4 Macroeconomic Management. Macroeconomic policy reforms in SAL II were aimed at maintaining macroeconomic stability (to provide an environment conducive to increased private and public investment and economic activity) and strengthening the fiscal and balance of payments positions through reforms in three key areas: (a) enhancing government revenues, (b) improving public expenditure management, and (c) improving trade policies. Given the uncer- tainties at the time of program formulation, SAL II required that an appropri- ate policy framework paper (PFP) covering the program period be finalized as a condition of second tranche release. This PFP subsequently set out specific targets for key macro variables (including the external and fiscal deficits, government's domestic borrowing and inflation) against which performance was to be broadly measured (see Table 1). 5.5 During the SAL II implementation period (FY90-92), macroeconomic management has been satisfactory, despite the fact the Nepal was beset by severe external and domestic shocks. Apart from the T&T impasse in 1989 noted earlier, Nepal also went through an extended period of domestic political uncertainty during its successful struggle to establish a parliamentary democracy during FY90 and FY91. Notwithstanding these disruptions and uncertainties, three successive governments, including the interim coalition government, remained committed to maintaining macroeconomic stability. And, although the progress was uneven in the key areas of reform (for example, the Government was able to make rapid progress in trade policy reforms, but less so in fiscal reforms - see below), macroeconomic stability was maintained. The new Government which took over power in May 1991 demonstrated a strong and renewed commitment to improving macroeconomic management and implementing structural reforms. As noted, it agreed on a new ESAF arrangement and PFP with the IMF and IDA covering the FY93-95 period; and has begun to implement further far-reaching reforms in a number of key areas, such as industrial and trade policies, exchange rate reforms, public enterprise and public adminis- tration reforms, etc. (Section 6). 5.6 In regard to the balance of payments, Nepal's exports, which were expected to decline by about 20% in US dollars terms, actually increased modestly by 10% in FY90, and accelerated sharply by 30Z in FY91 and by a further 33% in FY92, far more rapidly than anticipated in the SAL II program. The reform measures implemented during the program clearly contributed to this rapid growth. On the other hand, import growth, though more uneven, was also higher than projected in the SAL II program. The external current account deficit remained below the levels anticipated in the program in FY89 and FY90, and rose slightly above the target level in FY91 and FY92; this was, however, fully financed by inflows of external aid and other capital. Nepal's gross foreign exchange reserves continued to grow steadily, (in part reflecting unanticipated capital inflows, including cross-border trade) from US$316 million in FY89 to about US$550 million in FY92, i.e., the equivalent of about 7 months imports, significantly exceeding the program target of 5 months' import equivalent.  -8- 5.7 In regard to fiscal management, the implementation performance produced mixed results. Although, specific measures to augment government revenues were satisfactorily implemented, the revenue/GDP ratio did not improve as envisaged (para 5.12). At the same time, popular demands for wage increases, continued subsidization/price controls and rising debt service payments contributed to higher recurrent expenditures and fiscal pressures. The Government, therefore, resorted to restraints on overall expenditures, particularly development spending, in order to limit the fiscal deficit. Notwithstanding these efforts, the overall fiscal deficit initially increased substantially over the program target of 9-10% of GDP to approximately 11-13Z range in FY89 and FY90; and net domestic financing (averaging around 3.0% of GDP per annum in these two years) also exceeded program targets. In the ensuing two years - FY91 and FY92 - the government brought the overall budget deficit to around 8Z of GDP (below the program targets) and reduced domestic borrowing to a range of 0.5Z-1.8% of GDP. This was, however, accomplished largely by slowing down development spending; and as a result, both project implementation and aid utilization deteriorated, contrary to the expectations of the SAL II program. 5.8 Economic growth performance significantly exceeded' the program targets of -2.2% for FY90 and 3.0% for FY91, respectively. Favorable weather conditions for agricultural crops and the easing of transit restrictions by India after the early months of the trade and transit impasse (enabling continued availability of essential inputs) contributed to this improved economic performance. Increased agricultural production, together with higher than expected imports (facilitated by the improvements in trade policy) also helped to contain domestic inflation to the targeted levels -- around 12% in FY90 and 10% in FY91. In FY92, however, poor crops due to bad weather contributed to slower GDP growth (of only 2.52); and along with the impact of a series of key price adjustments and a major devaluation of the exchange rate in Nepal (as well as in neighboring India), to a one-time increase in the inflation to an annual rate of 20%. As these price adjustments worked themselves out, and with continued tight macroeconomic management in Nepal and the abatement of price pressures in neighboring Indian border states, the inflation rate has again come down to around 8-9% in FY93. 5.9 In summary, overall macromanagement has been reasonably satisfac- tory. The balance of payments position, in particular exports and foreign exchange reserves, have continued to strengthen, as the SAL II program helped Nepal to overcome the adverse effects of the T&T impasse and subsequent turmoil. Domestic investment and savings levels, after falling in the wake of the T&T impasse, had recovered to nearly pre-crisis levels by FY92. Macroeco- nomic stability continued to be maintained, indicating strong government 4 Original Government estimates of GDP growth for FY90 and FY91 - 3.6% and 4.0% respectively - have been recently revised upwards to 6.1% and 5.5% (see Table 1). However, ongoing studies by the Government indicate that these recent estimates are subject to methodological errors; and substantially overstate actual growth. Consequently, these estimates are now being reviewed by the Government; and it is likely that both agricultural and overall GDP growth for FY90 and FY91 would come down closer to original estimates.  - 9 - commitment to this objective. The major disappointment in this area has been, however, with fiscal management, where program achievements fell significantly below expectations in many respects (see below). 5.10 Revenue Enhancement/Rationalizinf the Revenue System. Reforms in this area were aimed at increasing revenue elasticity and efficiency of the tax system by widening the tax base and improving tax administration. To this end, the SAL II program sought to: (a) mobilize additional government revenues of Rs300 million - equivalent to 0.4 of GDP - in the FY90 budget, of which at least Rs200 million was to be from new revenue measures;5 (b) formulate a time-bound action plan to reduce tax holidays in three years and to implement the first year action in FY90; (c) establish a closed and unified revenue service and to take the initial steps in this regard in order to improve tax administration; and (d) take initial steps to improve the indirect tax system and to convert specific excise taxes in certain identified products into ad-valorem taxes. 5.11 These and other policy commitments were documented in the policy matrix and in the Implementation Program which comprised Schedule III of the Development Credit Agreement (DCA). These commitments were largely completed satisfactorily, though with some delays. In regard to revenue reforms, the Government implemented new revenue measures totalling NRs.500 million a year in each of the program years (FY90, 91 and 92) which far exceeded the NRs.300 million commitment for FY90. To improve indirect tax base, excise taxes on a number of identified products were converted from a specific to ad-valorem basis along with rationalization of import taxes. A separate sales tax department was created to improve the collection from this tax. Legal and administrative arrangements to create a unified revenue service were made quite early in the program period, but its actual implementation was delayed until FY92, because of delays in obtaining Parliamentary approval. An action plan to gradually eliminate tax holidays over a three year period was approved and the first two years of the plan were satisfactorily implemented during the program period. For example, in early March 1990, tax holidays for a number of industries (rice, oil and flour mills, jewelry, tobacco products, alcoholic beverages, saw mills, brick-making, tanning, wooden furniture and packing, and cottage industries requiring foreign exchange for more than 1OZ of their raw materials) were removed. The FY91 budget terminated the exemptions for a number of additional industries. However, there was a reversal of this 5 Since the Government's revenue receipts, in absolute terms, was expected to decline as a result of the T&T impasse, it was felt that a requirement that the revenue/GDP ratio be raised above the preceding (FY89) year's level by a specified percentage would not be appropriate.  - 10 - progress subsequently; the new Government,in order to encourage private investment and activities, carried out a major re-evaluation of its trade, industrial and investment policies in 1992; and as part of its new industrial policy, announced new income tax exemptions (for example, for exports, tourism and air transport) in 1992. 5.12 Notwithstanding their satisfactory implementation, the impact of these measures fell short of program expectations. As noted, Government revenue/GDP ratio did not improve during the program period. This was due to a number of factors: first, during the T&T impasse government revenues (and the revenue/GDP ratio) actually declined, due to reduced trade flows and domestic activity levels. Second, the Government subsequently embarked on a major tariff reform program (see below); and this reduced the growth of collections from import taxes which are still the primary source of revenues (about 40X) in Nepal. Third, and more important, the SAL II reforms, though desirable in themselves, did little to change the underlying weaknesses of the tax system, i.e., low elasticity and low coverage, as well as the need to develop more domestic sources of revenues to compensate for the reduction in import-based taxes associated with tariff reforms. It is now realized that a fundamental overhaul of the tax system is needed to resolve these problems; and the SAL II program in this regard fell short of these needs. Recognizing the need for structural reform of the tax system, the Government in late 1992 initiated technical assistance from the Fund for this purpose; and an IMF staff report was finalized in early 1993. The Government is now examining these recommendations as well as conducting its own independent review, with a view to formulating specific recommendations for tax reform in the next year's and subsequent budgets. 5.13 Improvina Public Exbenditure MHanaremnt. In this area, the main objectives of the SAL II program were to ensure prudent public expenditure management consistent with resource availability and macroeconomic stability, and to improve the effectiveness of the public expenditure program. A number of measures were to be implemented to achieve these goals: (a) agreed ceilings were set on the overall fiscal deficit and domestic borrowing in order to limit expenditure growth; (b) institutional changes were to be made to improve the plan- ning and budgeting process (for example, by improving the working of the Resource Committee, extending and institu- tionalizing the Program Budgeting approach for budget preparation and management, improving accounting and moni- toring capacity, etc.); and (c) changing budget allocation and release procedures for facilitating project implementation and maintenance (e.g., providing sufficient budget allocations for operation and maintenance needs in selected sectors and for a list of 35 core projects, delinking fund releases from procedures to control financial irregularities in order to improve the flow of budgeted funds to projects, etc.).  - 11 - 5.14 In regard to implementation, as noted in above, the Government broadly adhered to the agreed ceilings on the overall budget deficit and domestic borrowing. While there were some deviations over the program period, these were relatively minor. (For example, SAL II program set a domestic financing target of NRs.1400 million - equivalent to 1.5% of GDP - for FY90 as part of the third tranche conditionality; actual domestic financing, however, was NRs.2150 million or 2.4X of GDP in FY90. The Government, however, sharply reduced the domestic financing the following year (FY91) to only NRs.560 million or 0.5% of GDP, so that the average for the two years was below the envisaged budget.) Given the commitment to restrain the fiscal deficit, the ratio of total expenditures declined over the program period from 23% of GDP in FY89 to about 19% reflecting the reduced availability of resources and the need for maintaining macroeconomic stability. Many of the institutional reforms and budget allocation changes were also carried out as envisioned. For example, the third phase of the PBPM project was carried out, efforts were made to improve the functioning of the Resource Committee; and strengthen the planning and monitoring capacity at the line ministry level. Budget alloca- tions for O&M in four specified sectors and for 35 core projects were in- creased, as agreed, and fund release procedures were initially relaxed. 5.15 Although specific measures proposed under the program were implemented, for a variety of reasons the impact of these measures on improv- ing public expenditure management was quite limited. For example, it was not possible to continue liberal fund release mechanisms on a sustainable basis to ensure smoother project implementation; While SAL II tried to develop new institutional mechanisms and processes, the hoped for changed did not occur as speedily as anticipated. The hoped for prioritization of the expenditure program, as well as the initiation of a three year rolling budget did not materialize within the program period. Similarly, even though the PBPM project did achieve some improvements in the data base for financial monitor- ing of the budget, it did not basically alter the way in which the budgeting process was being planned and managed. The effectiveness of the Resource Committee in terms of bringing greater discipline to the budget formulation process and providing the basis for a systematic mid year review did not improve significantly. 5.16 The limited impact of the SAL II program on public expenditure management can be attributed to a number of factors, both political and program-related: First, the environment in which the program was implemented was an exceedingly difficult one. A "caretaker" coalition government of different political shades and opinions was in power during most of the program period. This government saw its role purely as a "caretaker" and shied away from undertaking any major economic reforms. Moreover, given its composition, reaching agreement on reform issues was indeed difficult. Not unexpectedly, the political consensus for prioritizing the expenditure program, dropping marginal projects and establishing budgetary discipline through a rolling budget process was lacking in this environment. Thus, although efforts were made at the technical level to review the expenditure program and prioritize it, political support at the highest levels was missing to carry these initiatives to their conclusion. Second, it would appear in retrospect that a strong constituency which was necessary to carry through the proposed institutional reforms was also missing at the technical level also.  - 12 - An effective Planning Commission which could take the leadership in develop- ment budget preparation and management did not exist at that time. This put a disproportionate burden on the Finance Ministry, which was ill-equipped for this task. while the proposed reforms tried to alleviate this problem by developing the capacity of line ministries to formulate appropriate expendi- ture programs and monitor their implementation, this approach was not fully shared by the Finance Ministry in practice. To some extent, this could be attributed to the fact that the reforms envisioned in the program were too sophisticated in relation to Nepal's environment. For example, the Program Budgeting approach of delegating greater responsibility to the line ministries for program prioritization and management required both a willingness to undertake greater decentralization of the budget process as well as greater accountability and discipline at the line ministry and project level. But, in an environment where expenditure monitoring capacity and accountability were very weak at both the ministry and project levels, the Finance Ministry was reluctant to relinquish its traditional control-oriented approach. This was indeed at the root of the fund release problem which the program tried to resolve. Third, the resource situation became progressively tighter during the program period, as the revenue ratio stagnated and regular/current expenditures rose due to rising wage claims, subsidies and debt-serve pay- ments. Against such a background, the Finance Ministry became even less willing to relinquish controls over budget programming and fund release process. Fourth, even though the PBPM project was implemented, there was not sufficient ownership of it within the Government; the PBPM project was largely carried out by external and domestic consultants, and did not sufficiently involve personnel of government ministries and agencies in its work, so that the necessary "institutional building" did not really take place. Conse- quently, despite the reforms introduced in the SAL II program, there was little tangible improvement in expenditure management; and project implementa- tion and aid utilization performance did not improve. 5.17 Given the limited progress achieved under SAL II, expenditure management continues to be a critical area where major improvements are needed. This need is now recognized by the Government. Moreover, there have been a number of new positive developments which hold considerable promise for the future. Over the past year the Government has initiated a major review of externally aided projects (which comprise 60Z of the development budget) and of the regular budget with a view to rationalizing the expenditure program. This work is being managed in collaboration with the Finance Ministry by the National Planning Commission, which has emerged as a key player in economic management over the past year. This critical new development (which was lacking at the time of SAL II formulation and implementation) has helped to significantly strengthen the institutional base for carrying out expenditure reform. Moreover, the implementation of the proposed Arun Hydropower project has provided another important motivation for change; the Government, needs to ensure that the Arun project can be implemented without crowding out other necessary high priority investments which are needed to achieve its develop- ment (including poverty alleviation) goals. This now provides a better basis and stronger political commitment which have been lacking so far to undertake expenditure reform.  - 13 - 5.18 Improvint Trade Policies. Until'the mid-eighties, Nepal had a highly restrictive trade and payments regime characterized by excessive import licensing, high tariffs (up to 450%), r$ig4# quantitative restrictions and preferential trade arrangements with India (under which imports from third countries were levied additional duties up tq 55%). Under the SAL I program, the Government tried to move away from this to a more outward-oriented system by progressively liberalizing the trade and industrial licensing system, removing quantitative restrictions, rationalizing and simplifying the tariff structure on imports from third countries, and increasing incentives for the export sector. The Government accordingly introduced a passbook system for industrial imports, placed several important raw materials under OGL, and established an auction system for commercial imports. (In FY88, roughly 10% of third-country imports were under the passbook/OGL system, 14% under auctioning and a further 37Z under direct import licensing, while the balance was essential public imports, such as fertilizer and petroleum). During the T&T impasse with India, Nepal tried to further liberalize trade arrangements with third countries in FY89 and diversify exports into third countries. In this context, trade reforms proposed under SAL II aimed at extending the coverage of previously introduced trade reform measures and improving their implementation. The specific measures proposed were to: (a) expand coverage of items under the OGL/passbook system to 35% of third country non-aid imports in FY89 and to 50% in FY90; (b) streamline the import license auction procedure (by replac- ing the existing product-specific system by a marginal bidding system for broad categories of imports), and in- crease the auction amount by at least 50% to NRs.1.5 bil- lion in FY89 and by a further 50% in FY90; and (c) provide duty-free imports of raw wool for the production of carpets and extend the prevailing duty drawback system for garments to all exports. 5.19 These measures were fully implemented. The OGL/Passbook system was substantially widened during the Trade and Transit treaty impasse to encourage imports from third countries. The list of eligible imports was further expanded by an additional 12 items (including tea, cement, cotton fabrics, clinical equipment etc.) in February 1990'. During FY90 and FY91, satisfactory procedures were adopted to improve the efficiency of the import license auction system. The frequency of auctions was increased from 4 to 6 times a year; the scope of the auction scheme was also widened by shifting to the scheme a number of items which had been previously subject to quantitative 6 During the T&T impasse, the additional duties on third country imports were temporarily removed by some 73 essential items; with the normal- ization in trade relations in mid 1990 these were reintroduced. However, as a part of the government's latest reforms, these additional duties were lowered to a range of 3-12% (from 5-20%) earlier), along with the exchange rate unification and trade liberalization.  - 14 - restrictions. Foreign exchange allocations for the auction system were increased to NRs.1.5 billion in FY90 as agreed, to NRs.1.9 billion in FY91 and to NRs.3.5 billion in FY92. To improve the efficiency of the auction system, the Government streamlined the auction procedures by combining the numerous separate allocation categories into two broad commodity groupings; and adopted a marginal building system. With the expansion of these (OGL/Passbook/- Auction) schemes, the share of non-aided third country imports financed through the schemes rose to about 83% in FY91. In regard to exports, (a) import duties on raw wool imports for production of carpets were eliminated in FY90 and (b) the duty drawback system for ready made garments was further streamlined; a decision was also made to refund duty drawbacks once export documentation formalities have been completed, without waiting for the foreign exchange receipts from exports. These two items comprised nearly 75% of exports during FY92. During the T&T impasse with India, cash subsidies were provided to other exports to encourage exports to third countries. With the normalization of trade with India, however, cash subsidies for agricultural exports were removed in early FY91. The other export subsidies were also eliminated later on following a large (22%) nominal devaluation of the Nepalese currency in early FY92. 5.20 During the program period and subsequently the Government adopted a number of new measures which went far beyond commitments envisaged under SAL II. In addition to above measures, significant progress was made in reducing tariffs7, with maximum tariff rates being reduced to 100% and the median rates remaining in a 20-50% range. The exchange rate was gradually depreciat- ed by nearly 70% in nominal terms between FY89 and FY92 providing a strong boost for exports. Subsequently, in mid 1992 the Government eliminated its industrial licensing policy (except for a specified list of industries which continue to be regulated for security, health and environment reasons); and simultaneously eliminated import permit/passbook system for industrial imports. More recently in February 1993, the Government unified the prevail- ing dual exchange rate (effectively the devaluing the Nepalese Rupee by a further 17-20% for those goods such as petroleum, fertilizer and industrial machinery which were imported earlier at the official rate and about 5% for other imports) and removing all restrictions on imports, except for a group of 6 items (with potential for smuggling) which are channeled through the auction mechanism. Consequently, the Nepalese Rupee is now fully convertible for all current account transactions, including both goods and services. 5.21 The measures adopted under the SAL II program represented a significant step forward in improving the efficiency of the trade system and rationalizing incentives especially for exports. They had a tremendous impact on increasing exports (particularly carpets and garments) which rose dramati- cally from the equivalent of $165 million in FY89 to $311 million in FY92. Moreover, they have had a catalytic effect on and solidified the basis for 7 The SAL II program recognized that given the proximity to India, Nepal's progress in reducing tariffs and pursuing an independent exchange rate policy would be limited. While India's recent moves to liberalize its economy created opportunities for further trade and exchange rate reforms for Nepal. Nepal's actions in this area even exceeded India's.  - 15 - further trade and industrial policy reforms; coming at an opportune time and, given the Government's desire to diversify its trade pattern, they helped to demonstrate that with appropriate policies Nepal can make considerable progress in rationalizing the trade and industrial system and strengthening the balance of payments. 5.22 StrenRtheninf Financial Sector Institutions. Recognizing that a healthy financial sector is a prerequisite for sustained economic growth, SAL II aimed at correcting the serious portfolio problems of the two government- owned commercial banks,' initiating measures to strengthen their financial and operational performance; and improving the legal and institutional environment in the financial sector by enhancing the capacity of Nepal Rastra Bank (NRB) - the central bank - to supervise the banking system and implement improved regulations and practices with regard to capital adequacy, loan classification and accounting policies. The key reforms, which formed the centerpiece of the third tranche of the Credit, were the following: (a) Take satisfactory action to strengthen and improve the financial and economic performance of the Rastriya Banijya Bank (RBB) and the Nepal Bank Limited (NBL), including provisions for bad debts, recapitalization and debt recov- ery targets; (b) Prepare an action plan to make current all government-guar- anteed loans to public enterprises (PEs) within three years, and make the necessary payments for FY90; (c) Enact a modified Income Tax Act to allow financial institu- tions to take income tax deductions for provisions for bad debts and suspended interest; and (d) Enact a modified Commercial Bank Act, NRB Act and NIDC Act to enable NRB to exercise necessary supervisory control over financial institutions. (e) A number of other conditions were also stipulated regarding debt recovery targets, setting up of an effective Credit Information Bureau, and implementing technical assistance studies to provide the basis for further improvement of the banking system. 5.23 These conditions were implemented with some delays. A Credit Information Bureau was set up in 1989, 100 large defaulters were blacklisted and denied further access to credit and debt recovery targets were set for the two banks. To assess the portfolio problems of the banks and identify corrective measures, the Government initiated a Commercial Bank Problem Analysis and Strategy study (CBPASS) in January 1990. In the mean time, the a The government-owned commercial banks-Nepal Bank Limited (NBL) and the Rastriya Banijya Bank (RBB)-controlled nearly 95% of the country's commercial banking assets in 1989.  - 16 - Government and IDA agreed on a three-year action plan to make all government- guaranteed bank loans to public enterprises current by FY92; and a payment of NRs.400 million was effected during FY90, followed by a second payment of NRs.260 million in FY91. Following the completion of the CBPASS study, the Government decided to go beyond the agreed plan to make the government guaranteed debts current and instead actually repay the full amount of outstanding loans made by the two banks under government guarantees to public enterprises. Additionally, the Government adopted the main recommendations of CBPASS on strengthening the banks, including recapitalizing the banks and enabling them to provision adequately for non-guaranteed bad debt. Conse- quently, in March 1991 the Government introduced a Supplementary Budget to provide NRs.443 million for recapitalization (equivalent to 6% of risk assets) of the two banks and another NRs.3.12 billion for provisioning/repayment of bad debt, including NRs.1.2 billion for private and NRs.1.9 billion for public enterprise debt. The Government also vested the Nepal Rastra Bank with the responsibility of implementing specific measures to strengthen the two state- owned commercial banks; and announced that it would no longer provide loan guarantees to public enterprises. NRB has subsequently proceeded to carry out this mandate. Thus (a) provisioning and recapitalization of the two banks was completed by July 1991; (b) separate loan recovery departments were set up in RBB in March 1991 and in NBL in May 1991; and (c) guidelines to all commercial banks on a new system of loan classification and accounting policies for interest suspension and provisioning (based on CBPASS methodology) were issued in May 1991. In addition, technical assistance (with UNDP funding) for institutional development and restructuring of the two banks and assessing the viability of their branch network were also initiated. Technical assistance was also sought and obtained from the IMF to etrengthen the banking supervi- sion and inspection functions of the Nepal Rastra Bank. To encourage banks to take adequate provisioning and suspension of interest by making them tax deductible, the Income Tax Act was duly amended in September 1989. Legisla- tive changes were enacted to permit the Rastra Bank to supervise NIDC. Accordingly, the fourth amendment of the Commercial Banks Act (CBA) and the eighth amendment of the NRB Act were both gazetted in October 1989; while the amendment of the NIDC Act was enacted in January 1990. 5.24 In regard to impact, the actions taken under SAL II represented a good beginning in introducing much needed reforms in the financial sector. In the short term, the reform program had some significant benefits: (a) It helped to avert a potential crisis in the banking system by recapitalizing and propping up the two banks; (b) The new institutions that were created (e.g., Credit Bureau), the new accounting and loan classification procedures and the strengthening of regulatory/supervisory powers of the Nepal Rastra Bank led to some useful institution-building; (c) It helped to modify the traditional government attitudes of viewing the banking system as a means of financing public enterprises; and probably stiffened the new Government's resolve to make PEs more self reliant and commercially oriented; (d) Interest rate liberalization and the program's stress on market orientation also probably encouraged the Government to take more supportive view towards the evolution of new joint venture banks and other new financial institutions (such as finance companies) which have begun to increase and flourish recently.  - 17 - 5.25 Despite these benefits, the reforms however were not successful in their primary objective of bringing about fundamental changes which are needed to transform the two banks into viable commercially-oriented institutions. The hoped for restructuring of the two banks and changes in the culture of their management, operational standards, and portfolio quality have still not taken place. While the NBL, which is 49% privately owned, has shown some improvement, RBB still remains poorly managed. Although follow-up technical studies on evaluating the viability of the branch network of the two banks and developing possible approaches to bank restructuring were completed, no consensus was reached on what should be done with regard to the branches or how the banks themselves should be restructured. In part, this was due to the lack of a clear vision on the part of the Government about what the roles of these two government-owned banks should be. There is still considerable ambivalence within the Government whether these banks should continue to undertake a multiplicity of functions (including broader development and social objectives), or whether they should be more commercially-oriented, whether they should remain in the public sector or be eventually privatized. Until these broader questions are resolved, however, it is difficult to see how a clear strategy for restructuring the banks could be evolved. In part, the design of the SAL II program itself probably contributed to this inconclu- siveness. There was no clear agreement at the time of the formulation of the SAL II program on how, when and what form the restructuring of banks would take place. This was expected to fall out of the recommendations of the study and to be agreed upon later on. This however did not prove to be possible, particularly since the study was not completed until the concluding stages of the program; and there were significant differences between the Government and the Bank staff about what the appropriate approach to further reform/re- structuring should be, and what specific commitments the program entailed for the Government in this regard. 5.26 Agricultural Reforms. These reforms were intended to stimulate production in the dominant agriculture sector (which accounts for roughly 55% of GDP and an even larger share of employment) and thereby help accelerate overall output, income and employment growth. It was recognized that the major constraints to agricultural growth have been problems in the supply and delivery of fertilizer, inefficient and unreliable irrigation, slow progress in developing appropriate production technology and weak extension. Some improvements were made under SAL I in this regard by ensuring parity of fertilizer prices in Nepal with those in India (to prevent smuggling of fertilizer to India), and by permitting private dealers to enter into retail distribution of fertilizer. SAL II aimed at building on this progress by: (a) Substantially increasing fertilizer imports; and improving the capacity of the Agricultural Inputs Corporation (which has a monopoly of fertilizer imports) to forecast and moni- tor domestic fertilizer demand and to plan and procure imports on a timely basis; (b) Improve the retail distribution system by removing prevail- ing restrictions on private dealers (for example, by allow- ing them to open dealerships in any location, to compete with cooperatives, and to appoint sub-dealers);  - 18 - (c) Maintain parity between retail prices (net of transport costs) in Nepal with those in India; and to delegate au- thority to AIC management in order to make any needed price adjustments automatically; and (d) Studies were also to be undertaken to develop a medium term strategy for improving fertilizer management and distribu- tion. 5.27 In irrigation, while public expenditures have focussed on large scale surface irrigation projects, their performance (in terms of timely completion and water delivery) has been poor, in part due to the absence of an effective tertiary distribution network and adequate farm-level water manage- ment; inadequate resources devoted to O&M and lack of agricultural support services. The Government's new irrigation sector strategy, formulated in 1988, sought to redress these problems by emphasizing ground water development and promoting greater collaboration between the Government and farmers in irrigation development and maintenance. To this end, SAL II reforms sought to support the Government's new strategy through a number of actions which formed part of the conditionality for the third tranche: (a) The adoption of a satisfactory action plan and time-table for the establishment of an Irrigation Management Division in the Department of Irrigation (DOI), (b) Increased emphasis on operation and maintenance (O&M) of government irrigation schemes through adequate budgetary allocations and farmer participation, (c) Turnover of small and medium government schemes to farmer management and ownership, and (d) Establishment of mechanisms for cost recovery for O&M and adoption of a satisfactory implementation plan. 5.28 Most of the proposed actions in fertilizer area were either prior actions or second tranche conditions; and were accordingly implemented quite early in the program period, with some minor hiccups. For example, domestic fertilizer prices were adjusted in November 1989, and have been generally maintained above Indian prices up to now9. The Government has continued to follow this posture consistently, tracking and matching any upward changes in Indian prices more or less routinely. AIC was also empowered to make small adjustments (less than 10%) in fertilizer prices as needed; but the anticipat- ed automaticity in adjusting fertilizer prices was not realized, because (i) given the political sensitivity of fertilizer pricing, the AIC management shied away from this task; (ii) significant adjustments in the exchange rate over the past 2-3 years necessitated large increases in fertilizer prices 9 Except for DAP and Complex, the prices of which were held somewhat below Indian prices, in order to popularize their use domestically; however, these prices were increased in line with Indian prices recently.  - 19 - (which required cabinet approval) periodically. The restrictions on private dealerships were also removed; however, their smooth implementation remained a problem, requiring government interventions form time to time as political parties and local interest groups resisted this move. By and large, however, these initial difficulties have been overcome. Nevertheless, the effective- ness of the private sector in fertilizer retail distribution is still limited, because the AIC has had a total monopoly over fertilizer imports, and supply availability has been unreliable (see below). The Government also increased foreign allocations for fertilizer imports as envisaged. In light of the much improved foreign exchange position of the country, foreign exchange availabil- ity for fertilizer is no longer an issue. The major problem in this regard has been the inefficiency of the monopoly public sector importer - AIC - itself. While technical assistance for improving fertilizer demand forecast- ing and monitoring was provided to AIC, the latter has been particularly ineffective in managing the external procurement and import of fertilizer on a timely basis. In two out of the past three years, AIC has not been able to manage imports in time, leading to unnecessary disruptions in domestic fertilizer availability. This has prompted the Government to change its import policy in late 1992 (in line with the recommendations made in the T/A financed study on medium term reforms for improving fertilizer management) to allow private sector imports. However, since the major types of fertilizers used in Nepal have continued to be heavily subsidized'