Cambodia - Structural Adjustment Credit

Document of The World Bank FOR OFFICIAL USE ONLY Report No. P-7359-KH REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED STRUCTURAL ADJUSTMENT CREDIT OF SDR 21.9 MILLION TO THE KINGDOM OF CAMBODIA February 7, 2000 Poverty Reduction and Economic Management Unit East Asia and Pacific Region This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EVALUATIONS Currency Unit = Cambodian Riel AVERAGE VALUE OF USS1.00 IN 1997 1998 1999 Februarv 2000 2,946 3,744 3,785 3,800 WEIGHTS AND MEASURES Metric System GOVERNMENT'S FISCAL YEAR January I - December 31 ABBREVIATIONS AND ACRONYMS ADB - Asian Development Bank ADD - Accelerated District Development AFTA - Asian Free Trade Area ASEAN - Association of South-East Asian Nations BOP - Balance of Payments CAS - Country Assistance Strategy CDC - Council for the Development of Cambodia CG - Consultative Group CPIA - Country Policy and Institutional Assessments CPP - Cambodia People's Party CVAP - Cambodia Veterans Assistance Program DFW - Department of Forestry and Wildlife EU - European Union FAO - Food and Agricultural Organization of the United Nations FDI - Foreign Direct Investment FIAS - Foreign Investment Advisory Services FUNCINPEC - National Unity Front GDP - Gross Domestic Product ID - Identification IDA - International Development Association IFC - International Finance Corporation IMF - International Monetary Fund LDP - Letter of Development Policy LOI - Law on Investment MEF - Ministry of Economy and Finance METR - Marginal Effective Tax Rate MTEF Medium Term Expenditure Framework NBC - National Bank of Cambodia NGO - Non-Govemmental Organization ODA - Official Development Assistance PAP - Priority Action Program PER - Public Expenditure Review PFP - Policy Framework Paper PIMS - Public Investment Management System PIP - Public Investment Program PRGF - Poverty Reduction and Growth Facility PSI - Pre-shipment Inspections SAC - Structural Adjustment Credit SEDP - Socioeconomic Development Plan SDR - Special Drawing Rights SWAP - Sector-Wide Approach TA - Technical Assistance UNDP - United Nations Development Program UNTAC - United Nations Transitional Authority in Cambodia VAT - Value Added Tax WHO - World Health Organization WTO - World Trade Organization Vice President: Jean-Michel Severino, EAPVP Country Director: Ngozi Okonjo-Iweala, EACSM Sector Director: Horni Kharas, EASPR Task Manager: Su-Yong Song, EASPR  KINGDOM OF CAMBODIA STRUCTURAL ADJUSTMENT CREDIT FOR OFFICIAL USE ONLY TABLE OF CONTENTS I. BACKGROUND .........................................................1 IX. RECENT REFORM PROGRESS AND ECONOMIC PEFORMANCE ....................2 III. GOVERNMENT'S MEDILJM-TERM REFORM PROGRAM ....................................4 IV. THIE SAC PROGRAiM ........................................................5 A. Public Resource Management: Revenue Mobilization ...........................................6 B. Public Resource Management: Forestry Management ......................................... 11 C. Public Sector Management: Expenditure Rationalization ................................... 14 D. Public Sector Management: Preparatory Steps for Military Demobilization and Administrative Reform ....................................................... 20 E. Enhancing Governance and Fighting Corruption .................................................. 23 V. THE SAC OPERATION ........................................................ 24 A. Rationale for the Credit ....................................................... 24 B. Credit Amount, Disbursement, and Audit ....................................................... 25 C. Conditionality and Monitoring ....................................................... 26 D. Benefits and Risks ....................................................... 28 E. Government Ownership and Donor/Civil Society Collaboration ......................... 30 VI. RECOMMENDATION ....................................................... 30 ANNEXES ANNEX I: Letter of Development Policy ...............................3................................... 31 ANNEX II: Matrix of Policy Actions ...... 45 ANNEX III: Performance Indicators ........ 52 ANNEX IV: TA Matrix .............................................................................................. 55 ANNEX V: Law on Investment and Marginal Effective Tax Rates .56 ANNEX VI: Statistical Tables ............................... . ....... 67 The task team includes Su-Yong Song (Task Manager, EASPR); Bill Magrath (EASES); Andrew Stone (PSDBE), Chris Redfem (EASRD); Chris Thomas, Vincent Turbat (EASHD); James Crittle (CFAAP); Markus Kostner (SDVPC); Raj Soopramanien (LEGEA); Mohammed Bekhechi (LEGEN); Omowunmi Lapido (LOAAS); Varga Azad (EASPR); Tom Hart, Bill McCleary, Geoff Dixon, Young Lee, David Steedman (Consultants). Anne Green provided editorial assistance and Nancy Mensah provided administrative support. The report has been prepared under the guidance of Homi Kharas (Sector Director, EASPR); Ngozi Okonjo-Iweala (Country Director, EACSM); and Richard Newfarmer (Lead Specialist, EASPR). Peer reviewers were Luca Barbone (ECCI 1); Kyle Peters (ECSPE); and Vinaya Swaroop (DECRG). This document has a restricted distribution and may be used by recipients only in the performance of their t official duties. Its contents may not otherwise be disclosed without World Bank authorization.  I  The Kingdom of Cambodia Structural Adjustment Credit Credit and Program Summary Borrower: The Kingdom of Cambodia Amount: SDR 21.9 million (US$30 million equivalent) on standard IDA terms, with a maturity of 40 years, including a grace period of 10 years. Description: Since 1996, the Government's reform efforts weakened due partly to internal political developments, and fundamental fiscal and governance problems surfaced. The new Government, which took office in late November 1998, renewed reform efforts and has recently taken some notable policy actions. The Government's recent policy actions have created new momentum for reform. Cambodia is now at a critical juncture in making a transition to sustainable development. To make a successful transition, the Government must tackle its underlying governance problems in economic management. The SAC program aims to help push forward the Government reform program in the following three areas, in close collaboration with IMF's PRGF program. First, the SAC program aims to assist in improving public resource management which includes resource mobilization and forestry management. Second, it would assist in enhancing public sector management which comprises expenditure rationalization and preparatory steps for military demobilization and administrative reform. Third, it would assist in formulating a strategy on enhancing governance and fighting corruption in economic management and implementing it. Benefits: The proposed SAC would assist the Government in making a successful transition toward sustainable development with significant poverty reduction and broad-based economic growth. Under the CAS base case scenario which assumes full implementation of the SAC program, Cambodia would move from the current bottom quintile based on the country policy and institutional assessments on Bank member countries to the next quintile so that aid effectiveness would be enhanced. Furthermore, Cambodia would improve enabling environment for private sector development through tackling governance problems. While the SAC program dose not include programs directly targeting the poor, it would contribute to improving the access of poor households to basic social and economic services such as basic education, health facilities, piped water, rural roads through reorientation of expenditures toward basic  ii health, education, and rural development. According to the CAS base case scenario, per capita income could increase from US$290 in 1999 to US$360 in 2002. In parallel, the level of poverty could fall from 36 percent in 1999 to 27 percent by 2002. Although these potential outcomes would not just stem from the SAC program implementation, the benefit of implementing the SAC program would be significant. Risks: There are four main risks concerning SAC implementation: (a)deterioration in political stability; (b) insufficient political will; (c) weak institutional capacity; and (d) given the weak governance environment, funds not being used for the purposes intended. First, although armed conflict has ended, and peace has prevailed for more than a year since the last elections, there is lingering friction between the Government and opposition party particularly on issues of governance and accountability. Our ability to mitigate these political risks is limited, except through promotion of activities that foster greater participation and transparency. Second, the reform program could slacken if the reforms encroach on powerful vested interests such as the military and businesses. These risks could be mitigated through concerted donor/NGO efforts in monitoring the progress of the reforms. Third, even with the Government's full commitment, implementation of a reform program could be delayed because of weak capacity of public institutions. We aim to mitigate this risk by: formulating a clear phased strategy in policy actions; focusing on preparatory steps rather than the implementation of institutional reforms per se (e.g., administrative and military reform); focusing on a pilot ministry (e.g., expenditure management); increasing flexibility in the timing of reform with a floating tranche (e.g., military demobilization); and assuring that in all the key areas of SAC implementation, institutional capacity is being built up through well targeted technical assistance. Fourth, while tracking the usage of funds will be impracticable, several steps will be taken to mitigate the risk: performance indicators, which have been developed to effectively measure progress towards achieving development objectives under the SAC program, will be monitored rigorously; the Government will be required to submit several reports on a regular basis; information on the SAC will be widely disseminated to the public, leading to closer participation in and monitoring by civil society; and an audit of the Deposit Account will be required on an annual basis to be carried out by independent auditors, using acceptable international auditing standards. These risks are not minor. But they are acceptable when viewed relative to the potential benefits. The next three years constitutes the first serious opportunity in a generation for Cambodia to launch its development. Poverty Category: The SAC program supports a reorientation of public expenditure toward basic social and economic services to the poor.  iii Disbursements: The credit would be disbursed in three tranches. The first tranche of SDR 7.3 million (US$10 million equivalent) would become available immediately upon effectiveness; the second tranche of SDR 11.0 million (US$15 million equivalent) after a satisfactory review of the implementation of the agreed actions and achievement of the second tranche release conditions; and the floating tranche of SDR 3.6 million (US$5 million equivalent) after the satisfactory review of the implementation of the agreed actions and achievement of the floating tranche release conditions.   REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED STRUCTURAL ADJUSTMENT CREDIT TO THE KINGDOM OF CAMBODIA 1. I submit for your approval the proposed Structural Adjustment Credit (SAC) to the Kingdom of Cambodia for SDR 21.9 million (US$30 million equivalent). The credit would be on standard IDA terms with 40 years maturity and a 10-year grace period. The proposed operation, the first SAC, is central to the Bank's Country Assistance Strategy, and is an integral part of the Government's reform program articulated in the attached Letter of Development Policy and in the Policy Framework Paper for 1999-2002. The program is also supported by the IME through a Poverty Reduction and Growth Facility (PRGF) approved in October 1999. I. BACKGROUND 2. After almost three decades of armed conflict, Cambodia remains one of the poorest countries in Asia. Its 11 million citizens have an average per capita income of US$290, and 36 percent of them live below the poverty line. Poverty is concentrated in the rural areas, and rural poverty is four times higher than the 11 percent poverty incidence in Phnom Penh. 3. Low levels of capital in infrastructure--agriculture and industry--and inadequate human resources severely constrain Cambodia's development. Most people lack access to potable water (Table 1). Schools and health clinics destroyed in the war have yet to be rebuilt. Rural areas lack serviceable roads, irrigation systems, and agricultural extension facilities. High transport costs, erratic power supply, and poor telecommunications facilities hamper industry and trade. Years of war have had even more devastating human consequences. More than one-third of Cambodians are illiterate. One-third of the population over five have had no education, only 20 percent have had schooling beyond the primary level, and only 4 percent have completed lower secondary education. The infant mortality rate, at 103 per 1,000 live births, is one of the highest among the countries in the region. 38 percent of children suffer from malnutrition. 4. Unsettled politics still shapes policy and economic performance. The formation of the Royal Government in 1993--a coalition government with two co-Prime Ministers from two main parties, the CPP (Cambodian People's Party) and the FUNCINPEC (National Unity Front), and another smaller party--allowed the country to stabilize the economy, restore economic growth, and begin reforms to transform the economy into a market-oriented one. Since 1996, however, tensions between the two main coalition partners over power sharing escalated, and culminated in July 1997 when the First Prime Minister was ousted by force. The Government's reform efforts weakened, serious fiscal and governance problems again surfaced, and the economy deteriorated. Many donors suspended all but humanitarian assistance. After a long political stalemate, the elections were held in July 1998 for the National Assembly. A new coalition Government comprising the CPP and the FUNCINPEC and led by Prime Minister Hun Sen emerged in November 1998 and politics has become more stable. The security situation has also improved significantly following the mass defection of the former Khmer Rouge soldiers (see CAS, February 29, 2000). As demonstrated in the Royal Government of Cambodia's Platform on Second Term, 1998-2003, the new Government is keenly aware of the need to improve  2 macroeconomic policies, mobilize resources for investment, rationalize expenditures, and address governance problems as a way of starting the country down a path to sustainable growth. 5. At the third CG meeting held in February 1999, Prime Minister Hun Sen reiterated the Government's commitment to such a program. The Public Expenditure Review (18791-KH), January 8, 1999, presented specific recommendations on revenue mobilization, expenditure rationalization, and forestry management. Many have been incorporated into the Government's reform program. Donors were encouraged with the Government's recent actions and have signaled a willingness to be partners in Cambodia's new development efforts. Table 1: Economic and Social Indicators: International Comparison a/ Average of Sub- East Asia & Cambodia Lao PDR Vietnam Saharan Africa Pacific GDP per Capita USS 290 330 330 480 990 Infant Mortality per thou.live births 103 98 29 91 37 Life Expectancy Years 54 52 66 49 69 Access to safe water % of population 13 36 41 47 77 Illiteracy Rates %pop.age 15- 35 43 8 42 15 Gross Primary School Enrollment % gross 110 109 111 76 117 Agriculture/GDP Ratio % 51 52 26 18 18 Gross Domestic Savings/GDP Ratio % 5 1 i 21 17 38 Aid/GDP RaOo % 9 23 4 n.a. n.a. Aid peT Capita uss 29 57 l 5 n.a. n.a. Notes: a/ Most recent data available. Source: Statistical Information Management and Analysis, World Bank. 6. The current economic situation is still precarious. Nonetheless, the Government's recent policy actions have created new momentum for reformn, and Cambodia is now at a critical juncture. If it can fully implement its program and capitalize on a supportive international environment, it may be able to unleash a virtuous circle of reforms, rising incomes, and new opportunities for further reforrms and growth. II. RECENT REFORM PROGRESS AND ECONOMIC PERFORMANCE 7. As the political turmoil of the 1 980s subsided, the Royal Government began a comprehensive reform program in 1993 with substantial support from the donor community. Fiscal management has been the key factor in reducing the rate of inflation. A doubling of budgetary revenues as a share of GDP between 1991 and 1994, restraint on the growth of current expenditures combined with inflows of foreign resources all but eliminated monetary financing of the budget deficit. Substantial progress has also been made toward a market economy: prices were freed up; a two-tiered banking system has been introduced; most non-tariff barriers were eliminated and tariffs were reduced and streamlined; a liberal foreign investment law was put in place; dollars were allowed to circulate freely, and account for more than 80 percent of transactions; and the exchange rate was allowed to float with progressively less intervention. 8. A combination of market reforms, liberalization and stabilization combined with external assistance has led to economic recovery and a more stable macroeconomic environment. GDP  3 expanded at an average annual rate of about 6 percent during 1991-1996 and inflation, which had averaged about 140 percent per annum in 1990-1992, was reduced to single digit by 1995 (Table 2). Inflows of foreign direct investment, larger aid flows and improved export performance have all contributed to an improved balance of payments position and an increase in official reserves. 9. In 1997-1998, progress on structural reforms stalled. In mid-1996, the ruling coalition began disintegrating and rival factions checkmated policy reforn. While macroeconomic stability was largely maintained, little progress was made in addressing fundamental fiscal and governance problems. Although the Government did improve banking supervision and privatize some state-owned enterprises, it granted a plethora of tax exemptions and created tax handles to compensate. Inadequate budgetary expenditures for social and economic infrastructure, owing to weak revenue mobilization and overTuns in defense expenditures, hampered rapid and broad- based economic growth. Economic management also suffered from insufficient accountability and transparency. In particular, the lack of action in implementing a sound forestry management policy and in channeling forestry revenues into the budget posed serious concerns for sustainable development. Illegal logging was estimated at least three times higher than a sustainable level. If this anarchic situation continued, the commercial potential of Cambodia's forest resources would be exhausted in less than five years. Table 2: Macroeconomic Indicators, 1991-99 1991 1992 1993 1994 1995 1996 1997 1998 1999 Est. Real GDP Growth (%/6) 7.6 7.0 4.1 4.0 7.6 7.0 1.0 1.0 4.5 Inflation(finalquarterbasis,%) 150.4 112.5 41.0 17.9 3.5 9.0 9.1 12.6 5.0 M2 Growth (%) 28.6 209.0 40.0 35.6 43.6 40.4 16.6 15.7 18.4 Budget Revenue (% of GDP) 4.4 6.2 5.4 9.6 8.9 9.1 9.7 8.7 11.2 Budget Expenditure (% ofGDP) 7.8 9.8 11.2 16.5 16.7 16.3 13.9 14.8 14.5 CurrentBudgetDeficit(%/oofGDP) -1.2 -4.3 -1.4 -1.4 -0.7 -0.8 0.7 -0.3 1.7 Export of Goods (US$ Mn., excluding re-export) 81 101 168 234 268 295 534 579.0 548.0 ImportofGoods (US$ Mn., retained import) 113 160 361 509 714 771 799 802.0 898.0 External CurrentAccount Deficit (% of GDP) -1.5 -2.5 -9.4 -13.1 -16.8 -14.6 -6.8 -8.3 -12.8 Official Exchange Rate (annual avg., Riels/US$) 703 1,253 2,470 2,543 2,451 2,624 2,946 3,744 3,785 Source: Data provided by the Cambodian authorities, and staff estimates. 10. To make matters worse, in mid-1997, two shocks hit the economy: the political events of July 1997 and the ensuing suspension of a substantial part of donor assistance, and the regional financial crisis. Political uncertainty remained through the runup to the elections in July 1998 and stalemate in forming a new coalition government. GDP growth decelerated to 1 percent both in 1997 and 1998. Capital outflows increased. Inflation doubled to 9 percent in 1997 from the 1995 level and further increased to 13 percent in 1998. The highly dollarized nature of the economy disciplined monetary policy but also complicated it by magnifying the effects of monetary expansion on the price level and exchange rate. Budgetary developments in 1998 were worrisome in that the Government borrowed substantial amounts from the National Bank of Cambodia (NBC) after having avoided bank financing of the budget deficit since 1994. ODA and FDI inflows dropped significantly. 11. The elections of 1998 gave Cambodians a new opportunity for reforn and growth. Taking office in late November 1998, the new Government has taken some notable policy actions: implementing the value-added tax (VAT) beginning January 1, 1999, which generated 2.8 percent of GDP in 1999; curtailing illegal logging and canceling concession contracts in  4 violation of the terms of contracts; eliminating ghost soldiers and initiating military demobilization with registration of soldiers; and amending the Implementing Regulations for the Law on Investment to further tighten exemptions. Cambodia became a member of ASEAN in April 1999. 12. With returning confidence and signs of renewed policy reforms, economic outcomes for 1999 were favorable. GDP growth was estimated at 4.5 percent, reflecting buoyant garment exports and rising tourism as the East Asian recovery took hold. The exchange rate was stable and inflation low. Budgetary performance was broadly favorable. VAT collections exceeded expectations and customs duty collections have increased with the effective elimination of ad hoc exemptions. Nonetheless, non-tax revenue has fallen well short of budget targets owing to a sharp drop in logging activity and slow recovery of arrears from post and telecommunications. Defense and security expenditures exceeded the budgetary target. III. GOVERNMENT'S MEDIUM-TERM REFORM PROGRAM 13. The Government's medium-term program focuses on achieving lasting improvements in the structure of the public finances and in public resource management, in particular forestry. The program also aims at rebuilding basic institutions, and undertaking related structural reforms, to create a secure environment for the private sector. (For further background, please refer to the PFP issued in October 1999). 14. The medium-term macroeconomic framework for 2000-2002 aims at: raising economic growth to 6 percent; lowering annual inflation to 4 percent; maintaining robust export growth of 8 percent per annum in real terms, led by the garment sector; containing the external current account deficit to 12-13 percent of GDP; and increasing gross official reserves to about four months of import coverage. The projected increases in output growth are premised on rising investment and savings. These will require a fiscal reform that increases revenues significantly, and redirects spending priorities toward social and economic reconstruction. 15. Cambodia's main fiscal problems are threefold: revenues are too low relative to the demand for public goods because of a exemption-riddled, distorted tax system; expenditures are distorted by the military and security purpose; and the accountability of the public sector to the public is limited. The fiscal agenda aims at generating the resources needed to fund increased spending in priority areas, eliminating tax loopholes and reducing distortions, and strengthening the role of the budget for economic management. (The Government's fiscal policies are described in detail in the Sections A and C of the SAC program.) To achieve the targeted increase in revenues from 11.2 percent of GDP in 1999 to 13.2 percent by 2002, the Government will: fully implement the remaining provisions in the Law on Taxation; strengthen the administrative capacity to collect taxes; and further broaden the revenue base. The main focus will be on a strengthening of tax and customs administration, and on ensuring full collection of non-tax revenues, including arrears. The Government aims to achieve a substantial shift in public expenditure toward priority social areas and economic infrastructure. Budget expenditures for social and economic sectors are targeted to increase from 3.8 percent of GDP in 1999 to 5.1 percent by 2002. With recent improvements in the security situation, the Government aims at a significant rationalization in defense and security spending, in line with the removal of ghost soldiers and the demobilization program. The civilian wage bill will be contained and any further increases in wages will be tied to progress in implementing civil service reform.  5 16. Banks have not yet become an effective channel of intermediation of savings and investment. Under the new Commercial Banking Law, banks will be subject to re-licensing, and those banks that are in violation of the law will be closed. The Foreign Trade Bank will be restructured and privatized by end-2001. On-site inspections of banks through internationally recognized audit firmns will be continued and their frequency increased. Issuance of treasury bills at market determined interest rates will be initiated to promote intermediation and provide the NBC with a monetary policy instrument, thereby contributing to dedollarization. 17. The Government will maintain its market-based exchange rate policy consistent with its monetary policy. With an outward-oriented growth strategy, the Government will expand international trade. Preparation is well advanced for Cambodia's participation in the ASEAN Free Trade Area (AFTA) and for accession to the World Trade Organization (WTO). The Government aims to further rationalize and reduce import tariffs. The Government intends to limit its foreign borrowing to concessional assistance. The Government will also make its best effort to conclude the one remaining bilateral agreement under the 1995 Paris Club agreement (the United States), and the agreement with Russia within the framework of the Paris Club, as well as seeking comparable treatment by other bilateral creditors. 18. Over 2000-2002, export growth is projected to accelerate to an average annual rate of 11 percent in dollar terms, while import growth is projected to rise to about 10 percent annually, reflecting increases in project aid and private long-term capital flows as confidence returns. Accordingly, the current account deficit (excluding official transfers) would be contained to 12-13 percent of GDP, and official reserves would rise moderately to about four months of import coverage. On this basis, the total external financing requirement for the period 2000-2002 is projected at $2.0 billion.' Total disbursements from official grants and loans are projected at $1.0 billion and foreign direct investment at $0.4 billion. The residual financing gap, estimated at $0.3 billion, could be covered by prospective disbursements of the SAC, other bilateral loans, and the IMF's PRGF. Given the projected level and average terms of financing envisaged, Cambodia's external debt would amount to $1.1 billion (about 25 percent of GDP) at end-2002. Since new debt would be contracted on highly concessional terms, the debt service ratio is projected at 5 percent in 2002. 19. Three important structural policies--forestry management, administrative reform and military demobilization, and enhancing governance and fighting corruption--are described at length in the Sections B, D, and E of the SAC program. IV. THE SAC PROGRAM 20. IDA has provided fast-disbursing support in the form of an Emergency Rehabilitation Credit in 1993 and an Economic Rehabilitation Credit in 1995, but without specific conditionality attached. The SAC program has been formulated under the overarching framework of the Country Assistance Strategy (CAS) for FYOO-03. Among various policy reform areas, it focuses on fiscal and governance issues, critical impediments to development. IDA has been closely collaborating with IMF so that the SAC program and the PRGF program complement and reinforce each other's efforts. The PRGF program aims at accelerating 1 It was assumed that debt relief would be granted during 2000. (For details, please refer to Annex D: Debt Sustainability Analysis of the CAS.)  6 economic reconstruction and improving governance primarily through fundamental reforms in the structure of public finances and in public resource management and also through trade policy reform and the development of the banking sector. 21. The SAC program aims to help push forward the Government reform agenda in the following three areas, with an emphasis on institutional underpinning. First, the SAC program would assist in improving public resource management which includes resource mobilization (Section A) and forestry management (Section B). Second, it would assist in enhancing public sector management which comprises expenditure rationalization (Section C) and preparatory steps for military demobilization and administrative reform (Section D). Third, it would assist in formulating a strategy on enhancing governance and fighting corruption in economic management and implementing it (Section E). A. Public Resource Management: Revenue Mobilization 22. In Cambodia, prospects for accelerating growth and reducing poverty is severely constrained by weak domestic revenue efforts. While domestic revenue as a share of GDP doubled between 1991 and 1994, it has been flat at about 9 percent during 1995-1998, amounting to about half the average for low income countries.2 The main reasons for the country's poor revenue performance are related to weak governance: inadequate enforcement of the Law on Taxation; generous tax exemptions granted under the Law on Investment; ad hoc tax and customs duty exemptions, often associated with unwarranted political interference; weak capture of forestry revenues; and limited capacity in tax, customs, and non-tax administration. To compensate, the Government has had to rely on high import duty rates and adopt tax handles, such as the minimum tax on turnover, that limit economic activity and inhibit private investment. 23. There exists substantial revenue enhancing potential. Foregone revenues in 1996 and 1997 estimated by the PER were large, amounting to 5-6 percent of GDP each year. The new Government has taken some initial actions to realize the revenue potential by: introducing a VAT, with special emphasis on about 1,500 large tax payers; reducing the scope for ad hoc exemptions by amending the Implementing Regulations for the Law on Investment to eliminate tax incentives for domestic consumption goods and resource and resource processing activities; increasing timber royalty; and beginning to put in place the procedures to grant duty exemptions under the Law on Investment only if investment enterprises are in compliance with domestic taxes. The main challenges for the Government are: (a) protecting the integrity of taxation, particularly the VAT; (b) rationalizing tax incentives under the Law on Investment; (c) strengthening tax and non-tax administration; and (d) capturing adequate forestry revenue (for this issue, see the next section on forestry management). Taxation 24. The Government has made considerable progress in strengthening the revenue system since the adoption of the Law on Taxation in 1997. The major new measures were: broadening the coverage of the excise tax and levying the turnover tax on the first sale after import; for income taxes, introducing withholding taxes and a tax on dividends and interest while 2 In 1999, revenue increased to 11 percent of GDP thank to the implementation of the VAT and also to the windfall revenue from garment quota auctions.  7 substantially reducing the exemption level of the tax on salaries; strengthening various tax rules and procedures; and introducing a VAT. 25. Trade taxes account for over a half of revenue and the combination of trade taxes and indirect taxes (excise tax and VAT) account for roughly 90 percent. Because all indirect taxes are dependent on the level of economic activity, any slippage in the Asian recovery would have a detrimental effect on revenues. There is also the issue of the Cambodian membership in ASEAN and the reduction in customs tariffs under AFTA. Over the next ten years, without any move to a more broad-based tax system, Cambodia would have to place increasing reliance on domestic consumption taxes such as the VAT. Technical Assistance is expected from the IMF to develop alternative tax schemes to compensate for the revenue loss from tariff reduction. 26. Value-added Tax. The VAT was introduced on January 1, 1999 for about 1,500 large taxpayers registered with the Large Taxpayer Unit of the Tax Department. Implementation of the VAT would add 1.7 percent of GDP to revenue collection (i.e., revenue enhancement of 0.8 percent of GDP over those collected under the old turnover tax system). Implementation of the VAT has been largely effective. The VAT will be the major contributor to domestic revenue as long as the integrity of the VAT is protected. IMF is expected to provide technical assistance in VAT implementation. 27. It is essential to ensure the integrity of the VAT building on the recent policy actions. First, the VAT was to be implemented through a combination of ministerial regulations (prakas) and a Sub- Decree. The Sub-Decree for the VAT was only approved in December 1999. Thus, until very recently, the Tax Department operated under this temporary prakas but any actions taken under these rules and procedures would lack full legal standing under the Law on Taxation and could be subject to dispute thereby weakening the revenue potential for this tax. Second, in response to strong protest from the garnent manufacturers, the Government granted the exemption for the garment sector. Moreover, some interest groups have asked that the Law on Investment (LOI) be extended to cover VAT, contrary to the Government's decision in the Implementing Regulations for the LOI. This should not be the case as the VAT falls on the domestic consumer. Third, a major problem with implementation of the VAT has been the refund procedure. Until very recently, once VAT refunds were processed by the VAT unit, it took two months or longer before the refunds were actually issued . The main problem was the excessive number of approvals that must be obtained after the VAT unit has validated the refund request. This approval procedure was contrary to a sound VAT policy and put the Government in a position of having an excessive backlog of refunds to pay. 28. As a Board presentation condition, the Government has: (a) passed the Sub-Decree on VAT, satisfactory to IDA; (b) continued its policy disallowing exemptions to the VAT other than those specified in the Law on Taxation, and (c) reduced the backlog of refunds to those no more than 15 days old following the approval of refund request and maintained a refund policy that will ensure that all future refunds are made available to the VAT taxpayer within 15 days of approval by the Tax Department. 29. The Tax Department is expanding the coverage of the real regime system of taxation which is administered by the Large Taxpayer Unit in Phnom Penh to certain targeted provinces. This effort will strengthen overall compliance and improve revenue collections across all taxes. Of particular importance is the expanded VAT tax base. Such an expansion must be carefully managed so that it will not dilute the effectiveness of the real regime system of taxation. In the Letter of Development Policy (LDP), the Government commits itself to extending the coverage of  8 the large taxpayer office to target provinces that will be managed by the Tax Department in a phased manner commensurate with ability to implement effectively. 30. Tax on Profits. Estimated revenues from the Tax on Profits for 1999 show little gain over 1998. This is due partly to the slow implementation of new withholding tax rules that were part of the Tax on Profits. The major problem is the absence of the regulations. The private sector has expressed concern on the lack of such regulations, causing arbitrary intervention of tax officials. In the LDP, the Government commits itself to finalizing draft Prakas on Tax on Profits and issuing to the public in thefirst quarter of year 2000. 31. Tax Policy Framework. Over the medium term, the overall tax system will need to be reformed. As stated in the LDP, the Government is committed to reviewing the tax policy framework with assistance from the IMF and IDA with the objectives of raising revenues, enhancing tax buoyancy and equity, and removing distortions that discourage private investment. Based on the outcome of the review, the Government intends to introduce a new tax system during the period 2000-2002. Law on Investment 32. The provisions of the Article 14 in the Law on Investment (LOI) are detrimental to improved revenue mobilization and cause distortion to the overall tax policy framework. In the PER, forgone revenue for 1997 associated with the LOI was estimated at 1.6% of GDP. The Law provides incentives that are too generous: tax holidays of up to eight years; a special 9 percent corporate tax rate after the end of the holiday period; duty free importation of capital goods and other fixed and movable assets; duty free importation of raw materials for export enterprises; and restrictions on the taxation of remissions abroad. The experience of other countries indicates that tax incentives rank low on the list of the major determinants of investment flows as compared to political and economic stability, a sound legal environment, and an adequate quality of physical infrastructure. Furthermore, the exemption of certain earnings, dividends, and interest, paid abroad, is hard to justify, because they represent a subsidy to foreign governments, as most of the payments exempted in Cambodia are taxable in the home country of the investor. 33. Implementing Regulations for the LOI were amended in June 1999 to remove domestic consumption goods and the production activities related to natural resources from the scope of the LOI. Exploration activities, however, remain as activities under the LOI. Natural resources represent a major revenue potential for Cambodia. Cambodia has yet to effectively utilize this revenue source. To improve the Government's ability to negotiate fair and equitable natural resource contracts, in the LDP, the Government commits itself to developing a modern tax framework and transparent procedures for managing natural resource concessions, including mining, petroleum and forestry with the objectives of improving their sustainable, efficient utilization and enhancing revenues to the Government. 34. There is little justification for the tax incentives provided under the LOI. The Law on Taxation contains very liberal tax-based incentives including: a 20 percent profit tax rate (10-15 percentage points lower than those of other ASEAN countries); accelerated depreciation; and a 5-year operating loss carry forward. Another important issue is that the current mechanism in determining the length of tax holidays is largely arbitrary in practice, despite a complex matrix system due to weak administrative capacity, leaving it open to manipulation and corruption. Cambodia could look at such countries as Indonesia (1983) and Estonia (1993) that tied significant tax reforms to the elimination of the laws similar to the LOI. In both cases, the  9 rationalizing tax incentives, lessening administrative burden, and removing the uncertainties associated with those incentives was the major motivation behind increased levels of foreign direct investment. 35. While the statutory profit tax rate at 20 percent in Cambodia is much lower than those in ASEAN countries, the marginal effective tax rate (METR) is much higher without the incentives currently provided under the LOI. (See Annex V which has been prepared in collaboration with FIAS). This is because of high level of import duties imposed on capital goods and the imposition of the minimum tax. Under the Law on Taxation, major burden on investment firms is the minimum tax. Because of the poor tax compliance, the Government imposes the minimum tax that is levied on all real regime enterprises including those covered by the LOI, is collected through a monthly prepayment of the tax on profit equal to 1 percent of turnover, and is reduced by the amount of the Tax on Profits paid. Even if a firm incurs a loss, it is required to pay this tax. Such a tax is an inefficient instrument that has little justification in a modem tax system with good compliance and administration. 36. As the LOI grants an exemption from customs duty on capital imports, the METR is reduced for firms under the LOI. However, profit tax incentives do not make the METR any lower as they are overridden by the necessity to pay the minimum tax. The current system is seriously flawed in that it sacrifices substantial revenue without accruing proportional increase in investment. In sum, the current investment incentive system suffers from the following weaknesses: * sacrificing substantial revenue without significantly attracting investment * bringing about a bias toward "footloose" companies and against long-lived investments * putting serious pressure on administrative capacity in approving and monitoring the incentives, and bringing about opportunities for corruption * resulting in a very narrow corporate tax base which is detrimental to tax buoyancy over the longer term 37. Thus, reform of the current investment incentives in the context of a more general reform of the tax system is necessary for the Government to achieve its growth objective, as stated in para 31. As a first step, the SAC program proposes the following: As a second tranche release condition, the Government will have submitted for adoption by the National Assembly an amendment to Article 14 of the Law on Investment, and introduced related measures, acceptable to IDA and in form and substance consistent with paragraph 8 of the Letter of Development Policy, with a view to rationalizing the incentive regime inherent in the Law on Investment and eliminating distortions thereunder. Technical assistance is expected from FIAS for the revision of the LOI. 38. To promote a less distortionary tax environment and to enhance the Government's efforts to promote private investment, the Government will need to phase out the minimum tax in the context of a broader reforn that would put revenues on a sounder footing. Another area for reform is customs duty reduction on capital goods. In the LDP, the Government commits itself to subjecting all imports under the Law on Investment which are currently exempted from customs duty to a reduced rate, to be determined with assistance from FIAS and the IMF.  10 39. By incorporating the recommendations above, along with the revision of the LOI, METR could be reduced to a rate which is very competitive when compared with most ASEAN competitors and would be available to all taxpayers automatically via the Law on Taxation, without evaluation or approval. By capturing more investment firms under the tax net and by attracting more investors, revenues would be enhanced. Tax and Customs Administration 40. A major part of the Law on Taxation was the strengthening of administrative law. The administrative law provisions include improved collections and enforcement procedures supported by new administrative and criminal penalties. As stated in the LDP, the Government is committed to continuing to use all means available under the provisions of the Law on Taxation to improve compliance and enforcement, including establishing targeted working group with the participation of the private sector, to ensure proper implementation of rules and procedures of tax laws and regulations. 41. The rules and procedures under the Implementing Regulations of the LOI have significantly improved the ability of the Council for the Development of Cambodia (CDC) to monitor the activities of investment enterprises particularly with regard to customs duty exemptions. As indicated in the LDP, the Government is committed to strengthening the system of information exchange between the Tax Department, Customs Office, State Property Department, and CDC to monitor effectively the activities offirms approved under the LOI (e.g., firms that are not current on payment of tax obligations should not be granted duty exemptions under the LOI). 42. Tax Audit and Arrears Collection. There are two interrelated problems in tax collection. First, the current audit strategy for the tax on profits focuses on one tax year at a time. The current year under audit is 1996. The strategy of auditing all tax returns for one year creates a major problem in the implementation of the Law on Taxation. It will be one to two years before there are any active audits of the tax returns filed for the current tax year. Such a strategy will put the Tax Department and taxpayers in an awkward position when audits are actually done on the current tax year. In the LDP, the Government commits itself to developing a new audit strategy that will allow for the selective audit of tax returns in all years open to investigation, with an emphasis on the current tax year. Second, collection of arrears continues to be a problem. The main problem in analyzing arrears is the lack of any statistics other than the gross amount of arrears. Without maintaining any data on the age of the tax arrears, the Tax Department does not have an active strategy that would allow them to establish priorities for collection of arrears according to the age of the arrears. The basic premise of the Law on Taxation is that the longer the arrears remain outstanding the more severe the penalty. As stated in the LDP, the Government is committed to developing a methodology for measuring the maturity of the outstanding arrears and for each year maintaining the data on the total amount of assessments issued, the total amount of assessments paid, the outstanding assessments which are less than six months old, and the total amount of outstanding assessments that are more than six months old, with monthly update. 43. Pre-shipment Inspection. The pre-shipment inspection (PSI) system was introduced in 1995 with a view to: enhancing customs revenue by reducing the scope for under-invoicing; helping to strengthen custom administration in valuation of imports; and facilitating port clearance procedures. Since the inception of the program, there have been numerous problems. First, the Government extended the exemption from the PSI to imports for the projects approved  11 under the LOI, garments, and cigarettes. As a result, only one third of the original coverage was recently under the PSI. Second, initially the importers were required to pay the inspection fee but since then the Government assumed the fee payment and accumulated in arrears in fee payment. Third, the PSI system has not eliminated port delays because there have been no real reforms in port clearance procedures. The Government and the PSI agency have agreed to terminate the contract, and tendering for a new PSI provider is well underway. 44. While verification, valuation, and timely clearance of shipments should be one major benefit of the PSI, there is another area that PSI could provide significant benefits to the Government. The LOI allows for the duty free import of the capital assets and raw materials. Since the inception of this program the major problem has been monitoring of the importation and use of these goods. CDC lacks the ability to maintain a complete accounting of the tax free assets, goods, and materials circulating in the country that are supposedly used by investment enterprises. Pre-shipment inspection and valuation of duty exempt assets and goods could provide an accurate view of one side of the monitoring process. 45. There are at a minimum three separate Government organizations operating within the major port. The delay of shipments which is closely tied to the governance issue is costly to legitimate importers and investors. Pre-shipment inspection has done little to reduce the port delays or the explicit and implicit costs related to the clearance of goods. Such an environment is a major disincentive to use pre-shipment inspection and is understood to be at the root of most major complaints about the program. 46. The Government needs to enhance the effectiveness of the PSI system by incorporating the concerns raised above. The IMF is providing TA on the improvement of the PSI system. 47. As a Board presentation conidition, the Government has: (a) initiated a tendering process in a transparent and competitive manner for a pre-shipment inspection (PSI) agency, with provisions for achieving the elements and objectives set out in the second tranche release condition; and (b) used the already established PSI database as a basis for determining customs valuation during the interim period. 48. As a second tranche release condition, the Government will have re-established a system of pre-shipment inspection of imports, on terms and conditions acceptable to IDA, and in accordance with the policies and principles laid down in paragraph 11 of the Letter of Development Policy. In tandem, as stated in the LDP, the Government is committed to simplifying port clearance procedures at port by establishing guidelines, enabling the Customs Department to manage the overall clearance process and specifying the procedures through which other government agencies will be involved in that process. B. Public Resource Management: Forestry Management 49. Forests are Cambodia's most developmentally important natural resource and could bring in significant revenues. Conditions in forestry, however, have deteriorated seriously throughout the mid-1990s, posing serious governance problems and showing evidence of pervasive corruption. Illegal logging reached alarming levels: in the 1997-1998 logging season: illegal logging was estimated at 3-4 million cubic meters, as compared with sustainable levels of 0.5-1 million cubic meters. The revenue loss arising from illegal logging to the Government in 1997 was estimated well in excess of US$60 million, or 2 percent of GDP. Furthermore, a system of uncoordinated and uncontrolled issuance of log collection quotas outside the concession  12 contracts came to dominate harvesting, local people were being negatively affected by forestry operations, the Department of Forestry and Wildlife (DFW) was severely restricted in its capacity to control and protect the resource, and forest industries were being negatively affected by low wood product prices resulting from the regional financial cnrsis. Political circumstances, including campaign-related interference in forest resource allocations and limited control and discipline among anned groups, have hampered progress in forestry. The recent forestry situation clearly demonstrated the urgent need for fundamental reforms toward establishing an environmentally sustainable, socially responsible, and economically viable sector. 50. Based on the recommendations of the four studies undertaken with technical assistance from the Bank, UNDP, and FAO, the Government recently has taken some important initial actions: (a) crackdown on illegal logging (with the support of military, police and provincial authorities); (b) the cancellation of 12 concessions in violation of terms of contracts or Cambodian law and conversion of the cancelled areas to national parks; (c) termination of the log collection quota system; and (d) the unilateral announcement of a concession royalty increase to US$54 per cubic meter from the previous US$14. Building on these initial actions, the Government is proceeding on wide-ranging efforts with substantial technical assistance from IDA, ADB, UNDP, FAO, and other bilateral donors. The main elements of the policy actions are in the areas of forest crnme monitoring, concession management, and forest law. Forest Crime Monitoring 51. As stated in the LDP, the Government is committed to continuing its efforts in cracking down on illegal logging with the support of military, police, provincial authorities, civil society, and neighboring countries. International practice suggests that an effective assault on illegal logging and other forest cnrmes should involve elements of prevention, detection and suppression. The Govermnent, with IDA's technical assistance, has prepared a comprehensive program for a forest crime monitonrng system to support this approach and to feed into well targeted suppression actions, and began implementing it. The program involves the DFW in the detection and reporting of incidents on commercial forest areas and the Ministry of Environment on the parks and protected areas system. In addition, it involves an independent intemational monitor (Global Witness, an NGO) in investigating autonomously and reporting forest crimes. A multilateral trust fund administered by UNDP for financing this arrangement has been established with donor contributions (from the United Kingdom, Australia, etc.). 52. As a Board presentation condition, the Government has. (a) developed and implemented a work program for establishing forestry crime monitoring capacity of the Department of Forestry and Wildlife, the Ministry of Environment, and the Council of Ministers, including procurement, staffing, training, and budgeting, satisfactory to IDA; and (b) reported quarterly on the forest crime monitoring to the public, including the first full report made available in early February, 2000. 53. As a second tranche release condition, the Government will have satisfied IDA that it has maintained its quarterly publication on forestry crime monitoring and that such publication has been made regularly available to the public, in accordance with the provisions in paragraph 13 of the Letter of Development Policy.  13 Concession Management 54. Concession Management Regulatory Framework. Concession operations approvals are currently based on outdated technical regulations. The current system does not adequately address critical considerations such as area to be harvested, the length of the cutting cycle, social demands on the forest, and biodiversity considerations. Recommendations on these, and other technical aspects of concession management have been made under the IDA assisted TA program. The Government needs to establish the legal and regulatory framework to enforce these requirements on concessionaires. A sub-decree on concession management makes reference to an associated set of Codes of Practice which has been adopted in June 1999. These cover inventory, planning, biodiversity, social responsibility, theft prevention, logging, and road construction. IDA has been providing assistance in this area. 55. As a Board presentation condition, the Government has adopted the Sub-Decree on forestry concession management, satisfactory to IDA, by encompassing the main provisions from a set of Codes of Practice and providing the Department of Forestry and Wildlife with an appropriate level of independence from political interference in enforcement, after consultations with concessionaires and NGOs. 56. Concession Contract Review. Under a study assisted by IDA assisted TA, legal advisers hired by the Government have concluded that the contracts which define the concession system, although seriously biased against the Government and subject to many defects and limitations, should be considered as binding obligations. Nevertheless, specific performance obligations have been identified and these provide a basis on which the Government might assess the specific perforrnance of concessionaires and seek relief in the case of default. The Government should pursue a consistent and rigorous case-by-case concession performance review leading, insofar as possible, to an overall restructuring of the concession management system, within the framework of Cambodian law and existing contracts. Terms of reference for this review have been produced under the IDA-assisted TA. These recommend a triage approach which would identify cases of clear default and set the basis for detailed review of concessions with reasonable claim to contract compliance. Among the principles which should guide the review and re-negotiation process are: transparency (including full public disclosure of revised terms and conditions and basis for terrninations and other actions); fairness (in particular, revenue provisions need to be linked to the realistic commercial potential of specific tracts); predictability (including prior notification); and defined provisions for appeal. The Government has initiated the performance review process for the 21 concessionaires with ADB's technical assistance since July 1999 and aims to complete the review by early 2000. 57. As a second tranche release condition, the Government will have completed a forestry concession review and taken actions based on the outcome of the review, in accordance with the provisions ofparagraph 14 of the Letter of Development Policy. 58. The Government unilaterally increased the forestry royalty level from US$14 per cubic meter to US$54 starting from January 1999. While most concessionaires are complying with this new royalty level after some delay, one large concessionaire has yet to comply and suspended its operations. Apart from the contractual dimension, the economic viability of Government's US$54 per cubic meter royalty is uncertain. There are reasons to presume that an entirely different revenue structure would be more appropriate over the medium-term. The reasons include risks from corruption, administrative feasibility, and various efficiency concerns. As stated in the LDP, the Government is committed to reviewing alternative mechanisms for  14 timber royalties with a view to moving toward more transparent and market-based pricing principles and establishing and applying such a mechanism to renegotiation of the contracts based on the concession contract review process. 59. Community Forestry. With poverty in Cambodia concentrated in rural areas, it is essential to fully utilize forest resources in the support of agriculture and rural development. In addition to requiring concessionaires and parks and protected areas managers to adhere to strict standards of social responsibility, the Government needs to support community forestry as part of an approach to rural development and forest concession management. Under community forestry, Government needs to ensure mechanisms for the award of long-term tenure rights to forest resources to local communities, indigenous peoples, and to other targeted groups. The Government is currently developing a Community Forestry Sub-Decree, with technical assistance from ADB. In the LDP, the Government commits itself to adopting a sub-decree defining a community forestry policy, after proper consultation with all stakeholders. Forest Law 60. The legislative framework for forestry development has been reviewed by the Government's legal advisers. This review noted serious weakness in the assignment of responsibility for forest land management and administration, the provision of enforcement authority, intersectoral oversight and public accountability. Several efforts have been made to prepare comprehensive forest legislation. These have suffered from a number of technical weakness, but more importantly have been compromised by the absence of a process for stakeholder engagement, consensus building and participation. Technical assistance is being provided by ADB. 61. As a second tranche release condition, followingfull consultations with stakeholders, and in accordance with the provisions of paragraph 15 of the Letter of Development Policy, the Government will have submitted for adoption by the National Assembly a draft law revising the Forest Law, acceptable to IDA, and establishing clear responsibility for forest management and administration, and providing for enforcement authority, inter-sectoral oversight and public accountability. C. Public Sector Management: Expenditure Rationalization 62. Despite its critical role in reconstructing infrastructure, developing human resources, and improving the accessibility of public services to the poor, the effectiveness of public expenditures in Cambodia is constrained not only by weak revenue efforts but also by low efficiency and equity associated with the allocation of public expenditure. Furthernore, while the Government has managed to overall deficits under control, its budget institutions and processes have not produced a spending composition that would have maximum development impact, nor is delivering spending very efficiently. Thus, to enhance the effectiveness of public expenditures to deliver better program and service delivery, the Government must reorient spending and manage it more efficiently. Expenditure Reorientation 63. Current expenditures have stabilized at about 9-10 percent of GDP in recent years. Given weak revenue mobilization, high levels of defense and security outlays, and the need to maintain macroeconomic stability, allocations for essential social and economic sector spending are  15 severely squeezed, especially those for non-wage operating expenditures. Moreover, shortfalls from budgeted amounts for the social and economic sectors are frequent as these sectors are the balancing residual in the event of revenue shortfalls or defense/security overruns. As a result, development expenditures are much less effective than planned. 64. Public capital spending is critical to Cambodia's rehabilitation and recovery. Because domestic revenues are barely sufficient to cover current expenditures, almost all of public capital expenditures are financed by external grants and concessional loans (including NGO) sources.3 Local cost financing provides small amounts of counterpart funding for externally financed projects or for small local projects. Both of these items are vulnerable to cutbacks due to revenue shortfalls or defense/security overruns. 65. In Cambodia, investment in human resources is a critical policy component of the development strategy to accelerate growth and reduce poverty. The development experiences of successful countries in the region underline the importance of investment in education and health in improving labor productivity and increasing the shared basis of economic growth. However, the outlay for human resource development from the government's own resources has been extremely low. In 1998, for example, expenditures on education and health from the government's resources constituted only about 1 percent and 0.5 percent of GDP, respectively. Even when total expenditures on public services (i.e., financed from government, donors, and NGOs) are considered, the education and health sectors together secured only 5 percent of GDP, which is inadequate in view of the massive human resource development needs. Similarly, total expenditure on public services available for physical infrastructure was limited. In particular, in a country where 85 percent of the population and 88 percent of the poor are concentrated in rural areas, the agriculture and rural development sectors received only 22 percent of the total expenditure on public services. 66. Defense expenditures have crowded out outlays for key social and economic services. During 1994-1998, defense expenditures varied between 3.3 and 5 percent of GDP, compared with the averages of 2.3 percent for East Asian countries and 2 percent for developing countries generally. The Government needs to rationalize defense expenditures to make way for increased allocations for key social and economic sectors. (See the subsequent Section on Preparatory Steps for Military Demobilization.) 67. The Government aims to channel resources obtained from improved revenue efforts and from rationalization of the military service and public administration to key social and economic sectors (health, education, agriculture, and rural development). Toward this objective, the Government should make increased allocations for these key sectors and monitor the implementation of the budget carefully to provide greater assurance that these objectives would be reached. 68. Furthermore, within these key sectors the Governmnent should ensure increased allocations for priority programs/sub-sectors. In health, spending on primary health care and 3In Cambodia, various donors and NGOs provide assistance of a public expenditure nature. The PER established the consolidated database: expenditures financed from the government's own revenues formed only 8.4 percent of GDP in 1996; expenditure estimates included in the official budget (which partially captures donor assistance were 17.2 percent of GDP; and aggregate expenditures on public services from all sources constituted 24.8 percent of GDP.  16 disease control programs (preventive spending) needs to be increased substantially relative to hospitals and drugs. In education, the Government needs to ensure appropriate outlays for primary and lower secondary education, in particular non-wage operations and maintenance such as textbooks and teaching materials., while putting in place policies which encourage private sector involvement in upper secondary, tertiary, and technical education. In agriculture and rural development, the Government needs to allocate more expenditures to irrigation, rural roads, and agricultural extension services to help extend a market economy to rural areas and enhance income earning opportunities for the poor. 69. The Government has initiated the process toward expenditure reorientation with the 2000 budget. In particular, the Government: (a) introduced a Priority Action Program (PAP) which is meant to constitute protection of critical expenditures such as programs for primary education, basic health, rural roads regardless of whether revenues reached projected levels or not; and (b) extended the Accelerated District Development (ADD) program for district health centers which is a cash advance system designed to give program managers greater certainty in regard to the level of budget funds available to them and greater flexibility in the use of those funds. 70. As a Board presentation condition, the Government has presented to IDA a plan for increasing expenditures for the key social and economic sectors (i.e., health, education, agriculture, rural development) over the next three years, satisfactory to IDA. As an initial phase of the plan, the Government has presented to IDA the 2000 budget for health (9% of total current expenditure), education (14% of total current expenditure), and agriculture and rural development (3% of total current expenditure), showing improvement over the 1999 budget in terms of share in total current expenditure, as agreed with IDA. In addition, the Government has presented to IDA the budget allocations and the contents of the Priority Action Program (PAP) for health and education and also for the Accelerated District Development (ADD) program, as agreed with IDA. 71. As a second tranche release condition, the Government will have submitted to IDA satisfactory evidence in terms of the formula specified in paragraph 19 of the Letter of Development Policy, to show that: (a) the ratio of actual disbursements of non-wage operating expenditures for the health, education, agriculture and rural development sectors combined during the year 2000 have been not less than the corresponding ratio for the remaining sectors combined; and (b) actual disbursements for the Accelerated District Development (ADD) program during the same period have been not less than the corresponding budget allocation. 72. As a second tranche release condition, the Government will have presented to IDA a draft year 2001 budget, acceptable to IDA, including budget allocations for, and contents of the Priority Action Program (PAP) and the ADD, and showing enhanced allocations for health, education, agriculture and rural development sectors in terms of share of total current expenditures as compared with the year 2000 budget. 73. As stated in the LDP, the Government is committed to implementing the envisaged budgetary framework during 2000-2002. To facilitate this, the Government is committed to disburse expenditures more evenly over the year. It should be emphasized, however, that increased expenditure allocations to key social and economic sectors alone will not automatically bring about improved quality of services in these sectors. In order to ensure improved quality of service in these priority sectors, the Government must enhance the effectiveness of expenditure management as described in the following section. In tandem, the Government needs to carry out administrative reform with a view to achieving a better paid and motivated civil service. In  17 addition, sector specific policy and institutional issues need to be addressed. As indicated in the LDP, the Government is committed to addressing policy and institutional issues in the health and education sectors, as recommended in the Public Expenditure Review. Expenditure Management 74. Budget processes in Cambodia have delivered significantly improved fiscal management since the early 1990s. The Budget Law of 1993 lays out the presentation, timetable and procedures for the preparation of the annual budget. It calls for a single unified national budget consolidating the receipts and expenditures of national and provincial governments in local and foreign currency. It also calls for revenue collection to be centered in the Treasury Department of the Ministry of Economy and Finance (MEF). Subsequently, under the framework of the Budget Law a number of measures have been introduced aimed at strengthening central control and improving the transparency of governnent operations. 75. These reforms have resulted in considerable improvements in budgetary procedures and controls relating to aggregate fiscal discipline. The gains in aggregate fiscal discipline from a very centralized system, however, have been at the expense of losses in allocative and technical (operational) efficiency. First, budget processes are extraordinarily centralized, with the approval at ministerial level being required for routine budget disbursements by line ministries. Second, there is frequently a failure to honor budgeted allocations to the social and economic sectors. Third, there is limited transparency of the uses made of budget funds, particularly at the provincial and district levels, and evidence of leakages/diversions of funds from the purposes for which they were appropriated. 76. Achieving close links between planning, policy, and budgeting is an integral factor contributing to desirable budgetary outcomes. Over the last few years, some progress has been made to link the Five-Year Socio-economic Development Plan (SEDP) with the annual budget through three-year rolling Public Investment Programs (PIPs); nevertheless, the linkage between the medium-term plan and the annual budget remains tenuous. A critical institutional weakness is the absence of a proper system of monitoring. The Government has recognized this problem and a system for monitoring of the PIP is to be established under the Public Investment Management System (PIMS). ADB is providing technical assistance on PIP. 77. Thus, PER recommended three changes in the Cambodian budget process: * ensuring the integrity of the budgetary process * strengthening the public investment management system * improving the performance of spending units These reforms are inter-related, and should proceed in parallel. The implementation of the recommendations for budget reform across the board, however, would present a daunting challenge in view of capacity constraint. To resolve this, a pilot approach to budget reform needs to be adopted. A single ministry could be identified as the focus of an integrated and in-depth program of improved budget management. The pilot ministry should be a ministry in which there already exists an intemal reform orientation, and good access to external technical assistance. The most likely candidate meeting these criteria would be the Ministry of Health. Based on the experience in the Ministry of Health, budget reform would be gradually extended to other ministries in the next phases.  18 78. Ensuring the Integrity of the Budgetary Process. Budget processes in Cambodia frequently fails to honor budget allocations to the social and economic sectors. This reflects ad hoc remaking of the budget during the budget year. Key reasons for low levels of spending on the social and economic sectors are revenue shortfalls and overrun in outlays for defense, security, and the Prime Minister's Office. These result in actual spending falling short of budgeted amounts in key development sectors, and allocative and operational inefficiency. The problem is most serious in the health sector. 79. Two main factors contribute to this failure to allocate amounts budgeted for the social and economic sectors. The first reflects lack of political will to enforce the prioritization decisions previously made during budget preparation. In effect, the budget is continuously re- made at the political level during the course of the budget year at the Ministry of Economy and Finance (MEF)'s monthly budget allocation meeting. The second reason is leakages/diversions of the budget allotted to social and economic programs to other purposes. Particularly damaging is the diversion of funds at the level of the provincial governor. A contributing factor here is the failure of the MEF to copy the Prakas informning each province of its monthly allocation to the central office of the line ministries in Phnom Penh and their provincial departments. In the LDP, the Government commits itself to providing the monthly spending plans (Prakas) to each line ministry and its provincial departments on a timely basis prior to thefirst day of each quarter. 80. The Government initiated procedures for ensuring the integrity of the budgetary process in the context of the 2000 budget law. In particular, the MEF created a Budget Strategy and Execution Center whose function is to facilitate the implementation of programs and ensure the shift in allocations from defense and security toward social and economic reconstruction. IDA is expected to provide technical assistance. 81. As a Board presentation condition, the Government has established a budget strategy and enforcement center at MEF, with adequate mandate, staffing, and procedures, satisfactory to IDA, as a one-stop shop to streamline the procedures to screen the bids for funding and facilitate cash disbursements to key social and economic sectors (health, education, agriculture, and rural development), both at the central level and provincial departments. The Government has also requested provincial treasuries to provide monthly reports to MEF on the variance between the monthly allocations and actual disbursements to key social and economic sectors, the reasons for the variance, and measures to be taken to compensate for the variance, and provide the monthly reports to IDA. 82. Over the medium term, strengthening the capacity of core budgetary institutions is key to enhancing the integrity of the budget. As indicated in the LDP, the Government is committed to developing a program for strengthening the capacity of core budget institutions (MEF, Ministry of Planning, budget departments of line ministries, budget departments of provinces, Controller's Office, Audit Office) for budget preparation, implementation, and monitoring and reporting, in particular (a) clarifying and coordinating their respective roles; (b) developing cost center-based budgeting; (c) preparing for fiscal decentralization, and (d) strengthening accounting and internal and external auditing. 83. Strengthening the Public Investment Management System. The PIP in Cambodia is, to a large extent, an amalgamation of fragmented donor-driven projects that may not necessarily result in a coherent sectoral policy agenda, and whose cumulative recurrent costs may be unsustainable in the medium-term. While some progress has been made in recent years with assistance from IDA and ADB, there exist three types of weaknesses in the linkage between the  19 PIP and the annual budget. First, the capital budget is largely developed by the Ministry of Planning in isolation from the recurrent budget prepared by the MEF. It appears that project costings are not rigorously reviewed. Second, monitoring of existing projects is inadequate. The amounts budgeted for ongoing projects should reflect progress with implementation of each project. Third, there is no systematic provision for the operation and maintenance costs of projects that have been completed. 84. These issues could be resolved by moving toward a development of a medium tern expenditure framework (MTEF). This framework would eventually incorporate out-year estimates for both capital and recurrent spending by each agency. This would provide a stable planning environment both for the MEF and the program ministry. Provided the pilot ministry has introduced robust accounting, financial control and project costing systems, the MTEF could provide that ministry with baseline budget estimates of capital and current allocations over the subsequent two annual budgets. While these would be subject to new policy decisions in the course of preparing the subsequent budgets, the baseline estimates would provide a more certain planning environment for both the MEF and the pilot ministry. In parallel, the Government needs to move toward better aid coordination. A promising way would be the Sector Wide Approach (SWAP). Under SWAPs, the responsibility for sector development is led by the Government and supported by donors. While SWAPs will involve considerable efforts on the part of the Government and donors, this approach would link donor funded capital spending more closely with the priorities of the Government as identified in the SEDP. WHO is proving technical assistance to the Ministry of Health in moving toward a SWAP. In the LDP, the Government commits itself to initiating a MTEF in the health sector as a pilot, and as part of that process, preparing a SWAP for coordinating donors. 85. Improving the Performance of Spending Units. Spending agencies continue to operate in a difficult environment in Cambodia because of: lack of funds; inability to plan their operations due to uncertainty about the future level of funding; overly restrictive budget line items which limit the flexibility with which managers can use funds; delays associated with pre-audit of spending actions; and leakages/diversions of funds. Devolution of greater freedom to spending agencies is seen in many countries as the key to more effective funds management by spending agencies. The Government introduced in 1996 the ADD system which provides more efficient and flexible funding directly to hospitals and health centers in a small number of districts as a pilot approach toward program-based budget allocation. An evaluation of the effectiveness of the ADD program needs to be undertaken and a trial of a similar program-based approach needs to be planned. In the LDP, the Government commits itself to preparing a review of the experience with the ADD program with a set of recommendations about how performance could be improved and take steps to resolve the impediments (accounting system in particular). Building on the findings, the Government is committed to making necessary adjustments and alterations with a view to extending the coverage of the ADD within the Ministry of Health and piloting at the Ministry of Education. 86. However, while financial devolution offers major benefits, it also incurs significant risks. Since the devolution of financial control from central agency to spending agency under a transition from pre-audit to post audit of budget execution by spending ministries will weaken this budgetary control, it is vital that substitute financial control procedures be established. The installation of government accounting software would play a key role in this regard, particularly by ensuring increased transparency of funds flows within spending agencies. Australia is providing technical assistance in this area. In the LDP, the Government commits itself to  20 introducing a simple integrated computer-based accounting and management system (low end, off-the-shelf software using double entry accounting and pre-determined financial management and control modules) at the central and provincial levels of the Ministry of Health. The Government is also committed to extending the scope for advance payment arrangement in the context of the PAP in parallel with the improvedfinancial management systems. D. Public Sector Management: Preparatory Steps for Military Demobilization and Administrative Reform Military Demobilization 87. Recognizing the critical importance of military demobilization and reintegration, in 1995- 1996 the Government prepared a comprehensive Cambodian Veterans Assistance Program (CVAP) which envisaged a substantial reduction in the regular armed forces plus several thousand Khmer Rouge defectors, but it was not implemented due partly to the political turbulence during and following July 1997. Following successful elections and the defections of the remainder of the Khmer Rouge combatants, the security situation has improved considerably and the Government intends to move to effect a significant reduction in the armed forces on a phased basis during 2000-2003. 88. To guide the downsizing, the Government has established a National Council for Demobilization of the Armed Forces with cross ministerial representation. The General Secretariat has been set up for the program preparation and implementation. This Secretariat, with assistance from the IDA and Australia, has conducted several studies profiling the characteristics and needs of soldiers; examined the possibilities for alternative employment; assessing the institutional capacity of Government to implement a downsizing and reintegration program; and assembled the lessons learned from previous demobilization and refugee integration attempts during the UNTAC period. The studies are currently being updated. 89. The CVAP has four stages--registration, demobilization, reinsertion, and reintegration. Registration involves verification of identity, the creation of a personnel database and data processing, the issuance of an ID card, and the production of personnel record and payroll system. Demobilization involves assembly and disarmament, health screening, orientation and discharge, transport to the community of choice and arrival counseling. Reinsertion involves the provision of a transitional safety net for veterans and their families to ease the transition to civilian life. The final stage consists of reintegration assistance in the form of counseling and information, skills enhancement, micro projects, community welfare projects, job referrals and access to land. The CVAP also provides for special target groups such as the disabled and chronically ill, and female veterans. 90. The Government initially targeted 55,000 soldiers for demobilization. With IDA's assistance through a post-conflict grant, the process of registering all legitimate military personnel has been completed. As a result, the demobilization has in fact already begun as the Government has identified 15,551 "ghost soldiers" and more than 160,000 "ghost children", and removed them from the payroll. In addition, 8,148 widows of dead soldiers are in the process of transferring to the Ministry of Women and Veterans' Affairs. Thus, about 31,500 soldiers would be demobilized during 2000-02. Based on the preliminary results and experience with a pilot phase of 1,500 soldiers to be demobilized in four provinces in 2000 and using the lessons learned, the overall program would be designed on the following schedule: 10,000 in late 2000;  21 10,000 in 2001; and 10,000 in 2002. Targeted reintegration would be offered until the end of 2003. 91. With technical assistance from IDA and Germany, the preparation for the pilot program is well underway, addressing the issues such as the level and modality of the transitional safety net, updating the profile of the beneficiaries, land availability, and the linkage of the reintegration component to existing community development programs. Germany, Sweden, and the Netherlands are providing financial assistance for the preparation and implementation of the pilot phase of demobilization. In parallel, with assistance from Australia the Governrment is preparing a White Paper on the long-term national defense policy focusing on improving efficiency of the military force. The SAC program aims to help the Government in carrying out preparatory steps toward military demobilization and reintegration in the next stage. 92. As a proposed Board presentation condition, in full consultation with donors, NGOs, and civil society, the Government has: (a) completed the identification and registration of soldiers; and (b) formulated a pilot demobilization and reintegration program, satisfactory to IDA, including provisions for independentfinancial and technical audits of the program. 93. Progress in the implementation of the demobilization program may be subject to unplanned delays in view of the nature of the program and the political sensitivity of military reform, of which the CVAP is an integral part. The CVAP, thus, faces a number of risks and implementation difficulties that justify a flexible approach to tranche release. For instance, given the current state of infrastructure, demobilization logistics may require more time than envisaged. The verification of soldiers identified for demobilization on the basis of transparent criteria may be more time consuming. A consensus acceptable to all participating donors and NGOs would need to be found before donors would commit resources to the CVAP. The SAC program, therefore, proposes the following as a floating tranche release condition, i.e., its timing is not pre-specified. 94. As a proposed floating tranche condition, in accordance with the provisions of paragraph 28 of the Letter of Development Policy, the Government will have: (a) achieved progress satisfactory to IDA in the implementation of the pilot phase of the demobilization and reintegration program; (b) in full consultation with stakeholders, conducted an interim review of the progress of the program; and (c) based on the results thereof, developed a proposal, acceptable to IDA, for the demobilization and reintegrationz program. Administrative Reform 95. The Government's capacity to formulate and implement economic management and development programs has been severely constrained by the quality of the civil service. The Government inherited a civil service which was badly decimated, lacking the knowledge and skills to manage a technical bureaucracy in a market economy, badly remunerated and suffering from a distorted age profile. Absenteeism is prevalent because wages--at an average of US$20 per month--are well below the poverty line. 96. Since 1993, the Government has been working on a wide ranging administrative reform program for which UNDP was the lead donor, with other donors contributing. While there has been some progress, political uncertainty, particularly following the events of July 1997, and the lack of clear vision have caused delays in implementation. While administrative reform is unlikely to save much money due to the need for the rationalization of the pay structure and the  22 payment of reasonable salaries, the scope for rationalizing expenditures to make them effective, efficient, and productive is immense (i.e., significantly improving the efficiency and effectiveness of programs and service delivery). 97. Recognizing this critical importance, the Government has recently renewed its efforts on administrative reform and taken a number of concrete steps. First, in March 1999, a decree was adopted creating the Supreme Council of State Reform, chaired by the Prime Minister, which in turn oversees five Councils of Reform in key areas: administration, demobilization, arrny, justice, and fiscal reform. Second, the Council of Administrative Reforn has been specified as the body in charge of all aspects of administrative reform. Third, a sub-decree enforcing the mandatory retirement age for civil servants at 55 years has been adopted. Fourth, basic salaries in the public sector were raised by 30 percent as of May 1, 1999 although it was not linked to any merit or incentive system. 98. The Government has put a computerized payroll system in place in five ministries under EU's technical assistance and extension to other ministries is planned in a phased manner to establish a control mechanism for payroll management and personnel transactions. With TA from IDA, a small-scale, limited-scope, decentralized census of the civil service is well underway and a functional review of ministries is to be carried out to determine the services each is to provide, the appropriate organization, and the required numbers and skills of personnel. The Government has eliminated 18,000 ghost and irregular workers from the payroll and is committed to continuing to eliminate ghost and irregular workers as the census proceeds. 99. The Government has announced a Public Administration Reform Program covering 1999-2003 which has two key objectives: to rationalize the size of the civil service to a reasonable level similar to that of other countries in the region; and to transform the public administration into a more operational, productive, and responsive organization with acceptable levels of remuneration. Work would proceed in three phases. Phase I, which covers up to mid- 2000, would involve the completion of key prerequisite activities such as a computerized payroll system, a small scale census of civil servants, and a functional review of ministries. Phase II, covering mid-2000 to mid-2001, involves the reorganization of public institutions and staff redeployment. And Phase III, covering mid-2001 to end- 2003 involves activities which rationalize workforce size, develop institutional structures and procedures, and improve the capacity of the civil service. Technical assistance is ongoing/expected from UNDP (establishment of a remuneration system, decentralization, etc.), ADB (safety nets for retrenched civil servants), IDA (functional review and census), EU, Canada, and Japan. 100. The SAC program aims to help the Government in carrying out preparatory steps toward implementing administrative reform in the next phase. As indicated in the LDP, the Government is committed to preparing a comprehensive action plan for rationalizing the size and function of the civil service, satisfactory to IDA, based on the findings of the extension of the computerized payroll system to all ministries, the carrying out of a census of civil servants covering their personnel data, education, skills, and experience, and a functional review of all ministries. 101. The Government's medium term vision, which should guide the preparation of the comprehensive action plan, is to achieve a lean state whose role is to deliver basic social and economic services for its citizens in areas where the private sector cannot be expected to intervene and to ensure sound macroeconomic management and implement policies which encourage private sector development. The Government also realizes that to achieve this goal it must strengthen the capacity of the core ministries and regulatory agencies to root out corruption  23 within Government operations and to hold the line ministries accountable for the use of public resources. Over the medium term, the Government will need to: (a) strengthen the technical team charged with planning and managing the reforms under the political guidance of the Council of Administrative Reform; (b) establish a computerized management system and database for controlling the payroll and personnel movements; (c) identify priority sectors for public sector intervention and a clear vision of the role of the state; and (d) reorganize the overall structure and individual ministries to reflect the new role and priorities. In order to provide improved economic management and service provision, the gradual implementation of more appropriate ministerial structures and organizations, professional personnel management and a new remuneration system will need to be accompanied by a sustained effort at professional renewal, including: voluntary departure and recruitment aimed at re-equipping the public sector with the human resources which will be needed to undertake its priority tasks; a major training effort for civil servants identified as trainable and therefore to remain in the service; and sound policies on the use of donor resources and technical assistance so that on-the-job learning and capacity building slowly enhance the ability of the civil servants to provide necessary policy advice and professional expertise. E. Enhancing Governance and Fighting Corruption 102. Enhancing governance in economic management is critical not only to public sector performance but also to providing an enabling environment to the development of the private sector, which must play the leading role in Cambodia's economic growth. Good governance is key to economic development and poverty alleviation through better managing public resources, underpinning markets, and stimulating investment. The 1997 World Development Report demonstrates a strong correlation between private investors' evaluation of a government's credibility and its record of growth and investment. It shows that corruption fundamentally undermines state credibility. 103. As described in the preceding sections, the SAC program aims to help the Government to improve governance in public resource management and public sector management by strengthening the tax system, forestry management, and expenditure management. In addition, SAC program aims to assist the Government in formulating a strategy to address the issues of governance and corruption in economic management and implementing it. It is perceived that corruption is widespread in Cambodia and is undermining development efforts. IDA's survey of Cambodian private enterprises which was conducted in September 1998 in the context of the PER and subsequent interviews demonstrate that corruption reduces the quality of state services, diminishes the fairness of the application of laws and regulations, reduces the value of state contracts with private providers, and encourages evasion of the law. Unofficial payments are often demanded and given both to have Government officials carry out their assigned duties and to grant special consideration or privileges to the payers. Key contexts for payments include the granting of business licenses and registration, the evaluation and payment of tax and customs obligations, connection to public utilities, and the granting, supervision and payment of government contracts. While recognizing the pervasive problem of low public sector salaries, reported corruption extends beyond petty gifts requested by low-level officials to carry out their appointed jobs: it weakens government's ability to mobilize and allocate resources, manage public expenditure, implement laws and regulations, distribute social services, and underpin competitive markets. 104. The new Government stated its commitment to combating corruption and strengthening governance, as evidenced by the Prime Minister's statement at the CG meeting of donors and the  24 Government's letter to IDA. This commitment needs to be translated into a clear strategic framework and follow-up actions. With assistance from IDA, the Government would formulate a good governance/anti-corruption strategy and implement it, in full consultation with donors, the private sector and civil society. The Government designated the Supreme Council for the Reform of the State, chaired by the Prime Minister as the coordinating body to execute this task. Three analytical surveys have been conducted in November/December 1999: one of a representative sample of 1000 households, one of 300 private enterprises, and one of 600 public officials. The enterprise and household survey focus on evaluation of quality and integrity of various public organizations/services. These two surveys also collected experience-based information on the circumstances, frequency and costs of corruption. The public officials survey provides the basis to relate agency performnance and integrity to specific institutional arrangements, practices and incentives in agency's management of personnel, budget, service delivery, procurement and information. Technical assistance is also ongoing from ADB, Australia, and Canada on various aspects of enhancing governance in public sector. Based on the diagnostic studies of the surveys and also findings of other initiatives, a national action plan is to be prepared in full consultation with donors, NGOs, and civil society. 105. As a second tranche release condition, followingfull consultations with stakeholders, and in accordance with the provisions of paragraph 34 of the Letter of Development Policy, the Government will have: (a) conducted surveys on governance and corruption, and, on the basis thereof, prepared a diagnosis and formulated a national action plan acceptable to IDA; (b) disseminated the findings of the surveys and details of the national action plan; and (c) begun implementation of the national action plan. 106. Establishing the rule of law is central to creating clarity in economic transactions and a level playing field between economic agents. The Government has been reforming the legal framework with a view to establishing greater certainty and clarity in laws and procedures. As yet, there are a number of gaps and inconsistencies, and areas where laws and implementing regulations do not yet exist. In particular, the Government has been preparing a commercial code since 1995 but it has been delayed in part related to the redrafting the previous drafting from the French system to the Anglo-Saxon system in accordance with the ASEAN practices. As stated in the LDP, the Government is committed to establishing a complete and modern commercial code, including Business Organizations, Trademark, Commercial Arbitration, Commercial Agency, Bankruptcy, Commercial Contract, Product Liability, and Product Liability and adopting implementing regulations and required sub-decrees in full consultation with the relevant business and professional community. In order to improve the enabling environment for foreign direct investment in Cambodia, a transparent dispute resolution mechanism for commercial matters and contracts is essential. In 1960, Cambodia filed an instrument of accession to the Convention on the Recognition and Enforcement of Foreign Arbitral Awards but it has not been ratified. In the LDP, the Government commits itself to submitting to the National Assembly the required ratification act related to the Convention and adopting appropriate implementing regulations in a timely manner. V. The SAC Operation A. Rationale for the Credit 107. Rationale. Cambodia is at a crossroads in making a transition to sustainable development. In order to make a successful transition, the Government must decisively  25 implement policy actions to resolve the fiscal and governance problems. The political and security situation improved significantly and the new Government renewed its reform efforts and is committed to deepening its efforts. The SAC aims to help the Government in its endeavors in implementing policy actions to address the fiscal and governance problems. The proposed SAC program is a logical follow-up to our efforts initiated with the PER. With the IMF's PRGF program for 1999-2002 in place, the SAC program would bring about synergy in assisting the Government in implementing the necessary reforms more effectively. 108. The SAC program has been prepared in a broad framework of the CAS for FYOO-03. The proposed SAC is a core element of the CAS. Under the base lending scenario which assumes satisfactory progress in maintaining macroeconomic stability and in implementing fiscal and structural reforms, the SAC is envisaged as the first in a series of measures to build a sound macroeconomic framework and the foundations for good governance in public resource and public sector management. Building on the implementation of the SAC program, a Public Sector Reform Credit (FY02) would continue and deepen reforms in public sector management. B. Credit Amount, Disbursement, and Audit 109. Credit Amount. The proposed credit amount is SDR 21.9 million (US$30 million equivalent). The borrower will be the Kingdom of Cambodia. The credit will be disbursed in three tranches, subject to the conditions detailed in the Matrix of Policy Actions (Annex II). The first tranche of SDR 7.3 million (US$10 million equivalent) would become available upon effectiveness; the second tranche of SDR 11.0 million (US$15 million equivalent), after a satisfactory review of the implementation of the agreed actions and achievement of the second tranche release conditions; and the floating tranche of SDR 3.6 million (US$5 million equivalent), after the satisfactory review of the implementation of the agreed actions and achievement of the floating tranche release conditions. Unlike standard tranche release, the timing of the floating tranche release is not pre-specified. Counterpart funds generated by the SAC will be used to finance part of the Government's budgetary expenditures for economic development. 110. Disbursement, Accounting, and Audit. The Government will open and maintain a Deposit Account with the National Bank of Cambodia into which proceeds of the Credit will be disbursed. The proceeds of the Credit will not be used to finance expenditures excluded under Schedule 1 of the Development Credit Agreement. If any portion of the Credit is used for ineligible purposes as defined by the Credit Agreement, IDA will require the Government either to return that amount to the Deposit Account for use for eligible purposes or to refund the amount directly to IDA, in which case IDA will cancel an equivalent undisbursed amount of the Credit. Disbursements under this Credit will not be linked to specific purchases, and therefore evidence to support disbursements will not be required. To secure the release of each tranche, the Government will submit a simplified Withdrawal Application against which IDA will disburse the Credit proceeds into the Deposit Account for the Government's use. The National Bank of Cambodia, on behalf of the Government, will maintain an appropriate accounting system, in accordance with generally acceptable accounting principles, providing all necessary information on the receipt and use of funds channeled through the Deposit Account and will prepare annual Financial Statements in a format to be agreed at negotiations. The Financial Statements will be audited annually by independent auditors acceptable to IDA under terms of reference agreed with IDA and in accordance with acceptable international auditing standards. The first audited Financial Statements will be submitted to IDA within three months of the Government's fiscal year ended December 31, 2000 and annually thereafter.  26 C. Conditionality and Monitoring 111. The Government's reform program to be supported by the SAC is set out in the Letter of Development Policy (Annex I) and summarized in the Matrix of Policy Actions (Annex II). Throughout the duration of the SAC, the Government will maintain a sound macroecononic framework, as outlined in the Policy Framework Paper. 112. Board Presentation Conditions. The Government has completed the following actions: * The Government has: (a) passed the Sub-Decree on VAT, satisfactory to IDA; (b) continued its policy disallowing exemptions to the VAT other than those specified in the Law on Taxation; and (c) reduced the backlog of refunds to those no more than 15 days old following the approval of refund request and maintained a refund policy that will ensure that all future refunds are made available within 15 days of approval by the Tax Department. * The Government has: (a) initiated a tendering process in a transparent and competitive manner for a pre-shipment inspection agency, with provisions for achieving the elements and objectives set out in the second tranche release condition; and (b) used the already established PSI database as a basis for determining customs valuation during the interim period. * The Government has developed and implemented a work program for establishing forestry crime monitoring capacity of the Department of Forestry and Wildlife, the Ministry of Environment, and the Council of Ministers, including procurement, staffing, training, and budgeting, satisfactory to IDA; and (b) reported quarterly on the forest crime monitoring to the public, including the first full report made available in early February, 2000. * The Government has adopted the Sub-Decree on forestry concession management, satisfactory to IDA, by encompassing the main provisions from a set of Codes of Practice and providing the Department of Forestry and Wildlife with an appropriate level of independence from political interference in enforcement, after consultations with concessionaires and NGOs. * The Government has presented to IDA a plan for increasing expenditures for the key social and economic sectors (i.e., health, education, agriculture, rural development) over the next three years, satisfactory to IDA. As an initial phase of the plan, the Government has presented to IDA the 2000 budget for health (9% of total current expenditure), education (14% of total current expenditure), and agriculture and rural development (3% of total current expenditure), showing improvement over the 1999 budget in terms of share in total current expenditure, as agreed with IDA. In addition, the Governnent has presented to IDA the budget allocations and the contents of the Priority Action Program (PAP) for health and education and also for the Accelerated District Development (ADD) program, as agreed with IDA. * The Government has established a budget strategy and enforcement center at MEF, with adequate mandate, staffing, and procedures, satisfactory to IDA, as a one-stop shop to streamline the procedures to screen the bids for funding and facilitate cash disbursements to key social and economic sectors (health, education, agriculture, and rural development), both at the central level and provincial departments. The Government has also requested  27 provincial treasuries to provide monthly reports to MEF on the variance between the monthly allocations and actual disbursements to key social and economic sectors, the reasons for the variance, and measures to be taken to compensate for the variance, and provide the monthly reports to IDA. * In full consultation with donors, NGOs, and civil society, the Government has: (a) completed the identification and registration of soldiers; and (b) formulated a pilot demobilization and reintegration program, satisfactory to IDA, including provisions for independent financial and technical audits of the program. 113. Second Tranche Release Conditions. In addition to maintaining a sound macroeconomic policy, the Government will have fulfilled the following conditions before the release of the second tranche: * The Government will have submitted for adoption by the National Assembly an amendment to Article 14 of the Law on Investment, and introduced related measures, acceptable to IDA and in form and substance consistent with paragraph 8 of the Letter of Development Policy, with a view to rationalizing the incentive regime inherent in the Law on Investment and eliminating distortions thereunder. * The Government will have re-established a system of pre-shipment inspection of imports, on terms and conditions acceptable to IDA, and in accordance with the policies and principles laid down in paragraph 11 of the Letter of Development Policy. e The Government will have satisfied IDA that it has maintained its quarterly publication on forestry crime monitoring and that such publication has been made regularly available to the public, in accordance with the provisions in paragraph 13 of the Letter of Development Policy. * The Government will have completed a forestry concession review and taken actions based on the outcome of the review, in accordance with the provisions of paragraph 14 of the Letter of Development Policy. * Following full consultation with stakeholders, the Government will have submitted for adoption by the National Assembly a draft law revising the Forest Law, acceptable to IDA, and establishing clear responsibility for forest management and administration, and providing for enforcement authority, inter-sectoral oversight and public accountability. * The Government will have submitted to IDA satisfactory evidence in terms of the formula specified in paragraph 19 of the Letter of Development Policy, to show that: (a) the ratio of actual disbursements of non-wage operating expenditures for the health, education, agriculture and rural development sectors combined during the year 2000 have been not less than the corresponding ratio for the remaining sectors combined; and (b) actual disbursements for the Accelerated District Development (ADD) program during the same period have been not less than the corresponding budget allocation. * The Govermnent will have presented to IDA a draft year 2001 budget, acceptable to IDA, including budget allocations for, and contents of, the Priority Action Program (PAP) and the ADD, and showing enhanced allocations for health, education, agriculture and rural  28 development sectors in terms of share of total current expenditures as compared with the year 2000 budget. * Following full consultations with stakeholders, and in accordance with the provisions of paragraph 34 of the Letter of Development Policy, the Government will have: (a) conducted surveys on governance and corruption, and, on the basis thereof, prepared a diagnosis and formulated a national action plan acceptable to IDA; (b) disseminated the findings of the surveys and details of the national action plan; and (c) begun implementation of the national action plan. 114. Floating Tranche Release Condition. This tranche will be released upon the Government's fulfillment of the following condition. It is expected that this tranche would be released, at the latest, in the course of the implementation of the year 2001 budget. * In accordance with the provisions of paragraph 28 of the Letter of Development Policy, the Government will have: (a) achieved progress satisfactory to IDA in the implementation of the pilot phase of the demobilization and reintegration program; (b) in full consultation with stakeholders, conducted an interim review of the progress of the program; and (c) based on the results thereof, developed a proposal, acceptable to IDA, for the demobilization and reintegration program. 115. Performance Indicators. To effectively measure progress toward development objectives under the SAC program, performance indicators have been prepared in close collaboration with the Government and donors and NGOs, in particular thematic donor sub- groups (fiscal, forestry, demobilization, administrative reform, and social sectors) (Annex III). Performance indicators do not constitute conditionality per se but rather provide monitorable indicators to assess the impact of the SAC program.4 Performance indicators will be monitored jointly with the Government and donor/NGO community. D. Benefits and Risks 116. Benefits. The proposed SAC would assist the Government in making a successful transition toward sustainable development with significant poverty reduction and broad-based economic growth through enhancing the effectiveness of public resource management and public sector management, the core of which lies with improving governance. Under the CAS base case scenario (or full reform scenario) which assumes full implementation of the SAC program, Cambodia would move from the current bottom quintile based on the country policy and institutional assessments (CPIA) on Bank member countries to the next quintile so that aid effectiveness would be enhanced, as evidenced in the Bank's recent study on the correlation between economic management and aid effectiveness.5 Furthermore, Cambodia would improve enabling environment for private sector development through tackling governance problems. While the SAC program does not include programs directly targeting the poor, it would 4 It should be emphasized, however, that it would be difficult to isolate the impact of the SAC program on the outcome indicators. 5 The recent Bank research provided empirical evidence on the positive correlation between the CPIA and economnic growth based on the cross country regressions. Assessing Aid, World Bank Policy Research Report, 1998, provided empirical evidence on the positive correlation between the country's policy environment and effectiveness of aid.  29 contribute to improving the access of poor households to basic social and economic services such as basic education, health facilities, piped water, and rural roads through reorientation of expenditures toward these sectors. In addition, while the SAC program does not include programs directly targeting environmental protection, it would contribute to establishing environmentally sustainable forestry management through enhancement in forest crime monitoring, concession management, and legal and regulatory framework. According to the CAS base case scenario, per capita income could increase steadily from US$290 in 1999 to US$360 in 2002 and further to US$440 in 2005. In parallel, the level of poverty could fall from 36 percent in 1999 to 27 percent by 2002 and further to 19 percent by 2005.6 Although these potential outcomes would not just stem from the SAC program implementation, the benefit of implementing the SAC program would be significant. 117. Risks. There are four main risks concerning SAC implementation: deterioration in political stability; insufficient political will; weak institutional capacity; and given the weak governance environment, funds not being used for the purposes intended. * Although armed conflict has ended, and peace has prevailed for more than a year since the last elections, there is lingering friction between the Government and opposition party particularly on issues of governance and accountability. The upcoming commune elections may aggravate this. The eventual trial of former Khmer Rouge leaders could be highly sensitive. Our ability to mitigate these political risks is limited, except through promotion of activities that foster greater participation and transparency. * The reform program could slacken if the reforms encroach on powerful vested interests such as the military and businesses. Potential areas include military demobilization, canceling/renegotiating non-performing forestry concession contracts, re-establishing pre- shipment inspection on imports, and rationalizing investment incentives. These risks could be mitigated through concerted donor/NGO efforts in monitoring the progress of the reforms in the context of quarterly joint government/donor consultation mechanism and its monthly donor sub-group meetings. e Even with the Government's full commitment, implementation of a reform program could be delayed because of weak capacity of public institutions. We aim to mitigate this risk by: (a) formulating a clear phased strategy in policy actions; (b) focusing on preparatory steps rather than the implementation of institutional reforms per se (e.g., administrative and military reform); (c) focusing on a pilot ministry (e.g., expenditure management); (d) increasing flexibility in the timing of reform with a floating tranche (e.g., military demobilization); and (e) assuring that in all the key areas of SAC implementation, institutional capacity is being built up through well targeted technical assistance (see Annex IV for TA matrix). * As the funds available through the SAC are to be used for general budget support purpose, tracking the usage of funds will be impracticable. Nevertheless, several steps will be taken to mitigate the risk that credit is misused. First, performance indicators will be monitored rigorously. Second, the Government will be required to submit several reports on a regular 6 It should be emphasized that these poverty projections are based on the assumption of no change in income distribution. The recent increase in inequality-- the Gini coefficient rose from 0.38 in 1993-94 to 0.42 in 1997-- suggests that the projections may be too optimistic as widening inequality would offset the growth impact on poverty reduction. For example, a 10 percent deterioration in inequality would increase the poverty level by 18 percent.  30 basis. Third, information on the SAC will be widely disseminated to the public, leading to closer participation in and monitoring by civil society. Fourth, an audit of the Deposit Account will be required on an annual basis to be carried out by independent auditors, using acceptable international auditing standards. 118. These risks are not minor. But they are acceptable when viewed relative to the potential benefits. The next three years constitutes the first serious opportunity in a generation for Cambodia to launch its development. E. Government Ownership and Donor/Civil Society Collaboration 119. Government Ownership. Government's ownership is key to the success of the reform program. Throughout the SAC preparation, the task team has collaborated very closely with the Government, in particular the Interministerial High Level Committee for Economic and Financial Policies chaired by the Minister of Economy and Finance and composed of various ministers and vice ministers and also its Working Level Committee composed of department directors, to ensure the Government's commitment/ownership. The Interministerial High Level Committee for Economic and Financial Policies will be the focal point for the implementation and monitoring of the SAC program. 120. Collaboration with Bank Group. The SAC has been prepared in close collaboration with IFC and FIAS, in particular issues on governance and private sector development with IFC and issues related to investment incentives with FIAS. 121. Collaboration with Donors and Civil Society. To strengthen the country's commitment, enhance sustainability of reforms, and mitigate any adverse impact on would-be losers, IDA has been closely coordinating with other donors, NGOs, and the private sector. Strong partnerships with other donors in helping the implementation of the SAC program are highlighted in the TA matrix. In particular, under the PFP/PRSP framework, the SAC program has been closely coordinated with the IMF's PRGF program. VI. RECOMMENDATION 122. I am satisfied that the proposed credit would comply with the Articles of Agreement of the Association and I recommend that the Executive Directors approve it. James D. Wolfensohn President by Sven Sandstrom Washington, D.C. February 29, 2000  31 Annex I Mr. James D. Wolfensohn President International Development Association Washington D.C., USA LETTER OF DEVELOPMENT POLICY Dear Mr. President: 1. The Royal Government of Cambodia has been implementing a wide-ranging reform program since its formation in 1993 and has achieved initial success in stabilizing the economy, restoring economic growth, and undertaking policy reforms to transform the economy into a market-oriented one. Since 1996, however, our reform efforts have weakened, due partly to internal political and external developments, and the progress has been slow in implementing measures to address key fiscal and governance issues. As a result, the economic situation became precanrous. 2. Taking office in late November 1998, the second term Royal Governnent is keenly aware of the critical need to address the fiscal and governance problems, as demonstrated in the Royal Government of Cambodia's Platforn on Second Term, 1998- 2003, and has recently taken concrete actions such as implementing the value-added tax (VAT), curtailing illegal logging and concession contracts in violation of the terns of contracts, and eliminating ghost soldiers and initiating military demobilization with registration of soldiers. Our renewed reform efforts were recognized, among others, by the successful Consultative Group (CG) meeting in February 1999 and the resumption of IMF assistance under the new Poverty Reduction and Growth Facility (PRGF) in October 1999. 3. Cambodia remains one of the poorest countries in Asia: 36 percent of the population lives below the poverty line and rural poverty is four times higher than the poverty incidence in Phnom Penh. To make a transition toward sustainable development with significant poverty reduction and broad-based economic growth, Cambodia must substantially upgrade its physical infrastructure and human resources. Toward this end, the Royal Government, declared as "economic government', is fully aware that it has to implement a coherent economic program that will produce rapid and broad-based economic growth over the long term. As its centerpiece, the Royal Government is committed to tackling its underlying governance problems. In particular, building on the recent actions taken, the Royal Government will continue and deepen its actions in addressing weak domestic revenue mobilization, inadequate and inefficient public expenditure management, and environmentally unsustainable forestry management.  32 REFORM AGENDA 4. Our reform agenda, which is summarized in the attached matrix of policy actions, focuses on tackling interrelated fundamental fiscal governance problems which is key to making a successful transition toward sustainable development. As such, our reform agenda comprises the following main elements: * Public Resource Management (i) Revenue Mobilization (ii) Forestry Management * Public Sector Management (i) Expenditure Rationalization - Expenditure Reorientation - Expenditure Management (ii) Preparatory Steps for Military Demobilization and Administrative Reform - Military Demobilization - Administrative Reform