Nepal - Country assistance strategy for the period 2004 - 2007

27783 COUTR ASITACENepal C O U N T R Y A S S I S T A N C E S T R A T E G Y -~~~~ 0 0' w AE THE WORLD BANK  Nepal C O U N T R Y A S S I S T A N C E S T R A T E G Y 2 0 0 4 - 2 0 0 7 THE WORLD BANK  The World Bank Nepal Office P.O. Box 798 Yak and Yeti Hotel Complex Durbar Marg Kathmandu, Nepal Tel.: 4226792,4226793 Fax: 4225112 www.worldbank.org.np www.bishwabank.org.np Head Office 1818 H. Street, N.W. Washington, D.C. 20443, USA Telephone: 1 202 477 1234 Facsimile: 1 202 477 6391 www.worldbank.org Vice President: Mr. Praful Patel, SARVP Country Director: Mr. Kenichi Ohashi, SACNP Task Team Leader: Ms. Deborah A. Bateman, SACNA DESIGN AND PROCESSED BY WordScape, Kathmandu  TAB L E O F C O N T E N TS EXECUTIVE SUMMARY V INTRODUCTION 1 i The CAS Context 5 A. Social Context 7 B. Political Context 8 C. Macroeconomic Performance and Medium Term Prospects 10 D. Progress Under the Last CAS and Lessons Learned 12 2 Nepal's Poverty Reduction Strategy 15 A. The Reform Process 17 B. The Poverty Reduction Strategy 20 C. Assessment of the PRS 24 3 The Country Assistance Strategy 27 A. The Context 29 B. The Bank's Strategy for FYo4-FYo7 31 C. Portfolio Management 40 4 Implementing the CAS 45 A. Partnerships 47 B. Monitoring Outcomes 50 C. Risks 51 ANNEXES 53 APPENDICES 97  A B B R E V I A T I O N S A N D A C R O N Y M S AAA Analytical and Advisory Activities MDGs Millennium Development Goals ADB Asian Development Bank MFA Multi-Fibre Arrangement AMUCFT Anti-Money Laundering/Combating Financing of Terrorism MIGA Multilateral Investment Guarantee Agency APP Agricultural Perspective Plan MOF Ministry of Finance BPEP Basic and Primary Education Project MoPE Ministry of Population and Environment CAE Country Assistance Evaluation MTEF Medium Term Expenditure Framework CAP Country Assistance Program NBL Nepal Bank Limited CAS (PR) Country Assistance Strategy (Progress Report) NC Nepali Congress (Party) CBO(s) Community Based Organization(s) NDC National Development Council CCF Community Carbon Fund NDF Nepal Development Forum CEA Country Environmental Analysis NEA Nepal Electricity Authority CFAA Country Financial Accountability Assessment NGO(s) Non-Governmental Organization(s) CIAA Commission for Investigation of Abuse of Authority NIDC Nepal Industrial Development Corporation CITES Convention on International Trade in Endangered Species NLSS Nepal Living Standards Survey of Wild Fauna and Flora NPC National Planning Commission CPAR Country Procurement Assessment Report NPPR(s) Nepal Portfolio Performance Review(s) pDC(s) District Development Committee(s) NTA Nepal Telecommunications Authority DfID UK Department for International Development NTC Nepal Telecommunications Corporation DPR Development Policy Review OED Operations Evaluations Department EU European Union PAF Poverty Alleviation Fund FAO Food and Agricultural Organization PCR Project Completion Report FAP Foreign Aid Policy PDF Power Development Fund FDI Foreign Direct Investment PER Public Expenditure Review FSS Financial Sector Strategy PERC Public Expenditure Reform Commission FY Fiscal Year PIC Public Information Center GDP Gross Domestic Product PIP Portfolio Implementation Plan GEF Global Environmental Facility PCF Prototype Carbon Fund GtZ Gesellschaft fur Technische Zusammenarheit (German PRGF Poverty Reduction and Growth Facility Agency for Technical Cooperation) PRS(C) Poverty Reduction Support (Credit) HMGN His Majesty's Government of Nepal RBB Rastriya Banijya Bank IAP Immediate Action Plan RPP Rastriya Prajatantra Party ICR Implementation Completion Report SEDF South Asia Enterprise Development Facility IDA International Development Association SMC(s) School Management Committee(s) IDF Institutional Development Fund SME(s) Small and Medium Enterprise(s) IF Integrated Framework SOE(s) State Owned Enterprise(s) IFC International Finance Corporation TA Technical Assistance ILO International Labor Organization UML United Marxist Leninist (Party) IMF International Monetary Fund UNDP United Nations Development Program INGO(s) International Non-Governmental Organization(s) UNEP United Nations Environmental Program ITTA International Tropical Timber Agreement UNFPA United Nations Population Fund IUCN The International Union for Conservation of Nature UNICEF United Nations Children's Fund JBIC Japan Bank for International Cooperation VDC(s) Village Development Committee(s) JICA Japan International Cooperation Agency WHO World Health Organization JSA Joint Staff Assessment WTO World Trade Organization WWF World Wildlife Fund Currency and Equivalents Currency Unit = Nepali Rupee (NRs.) US$1 = NRs. 74.5 (as of October 20, 2003) Fiscal Year Nepal: July 15-July 14 (fiscal year starting on July 15, 2003 is designated as FY03/04) The World Bank: July 1-June 30 (fiscal year starting on July 1, 2003 is designated as FY04)  EXECUTIVE SUMMARY i. Today, Nepal stands at the crossroads anti-corruption drive has been started by the between a brighter future that promises Commission for Investigation of Abuse of more sustained poverty reduction and the Authority (CIAA), thereby giving Nepali possibility of the country becoming mired in citizens a hope that the days of rampant a more protracted internal conflict. During corruption may be coming to an end. The the past few years, the insurgency has recently adopted Poverty Reduction Strategy escalated sharply, involving an open conflict (PRS)-based on the Tenth Plan (FYo2/03- with the army since November 2001. This, FYo6/o7)-builds on these successes, and combined with external developments, has gives the reform process much greater undermined the economy and weakened the strategic coherence and clarity. country's fiscal position. Despite the many positive changes Nepal has seen since the iii. Nepal's PRS breaks from the past, largely advent of multi-party democracy in 1990 ineffective plans in a number of significant and the first wave of economic liberalization ways. For the first time, it explicitly identi- measures in the early-1ggos, the recent fies social exclusion as one of the fundamen- developments have highlighted the stark tal development challenges. It also recog- and worsening inequities in Nepal, not only nizes HMGN's constrained fiscal situation in terms of incomes, but also of the funda- and weak implementation capacity, and mental ability of the Nepali citizen to places the PRS in a realistic framework of participate in social and political decision- implementation abilities, both fiscal and making processes. The deepening crisis, institutional. Thus, the MTEF gives it both a however, has also created the space for the medium term fiscal framework and annual reform-minded political and technocratic budgetary translation of the strategy, while leaders to begin a renewed drive to build an the IAP will be used as an annual implemen- economic and social foundation for sustained tation plan for high priority reform actions peace and poverty reduction. that would receive continual attention from the highest levels of HMGN. These two ii. Important reforms have emerged in instruments and the track record of signifi- o several areas over the past two years. First, cant early progress give the PRS considerable C to prevent a possible financial sector crisis, a credibility. With the aim of reducing H key initial step was taken by putting the two poverty and improving critical public 3 ailing commercial banks under external services, the PRS is built around four pillars: c management teams. Second, facing up (i) broad-based economic growth; (ii) social > squarely to the fiscal pressures, His Majesty's sector development; (iii) social inclusion; and w Government of Nepal (HMGN) introduced a (iv) good governance. In implementing it, Medium Term Expenditure Framework the PRS stresses decentralization, rationaliza- cn (MTEF) in FYo2/03 to rationalize the tion of central government functions and > development budget and instill the discipline transparency. z of a hard budget constraint. Third, respond- 0 ing to the urgent need to improve public iv. Despite the successes and a palpable service delivery, HMGN has started to change in the energy with which the reform transfer key services to community manage- leaders are pushing the agenda at the center, ment in primary education and primary the benefits of the reforms have not yet been > health care. Fourth, to ensure implementa- felt widely at the grassroots levels. There is q m tion of priority reforms, HMGN devised an clearly a need to accelerate the reform Co Immediate Action Plan (IAP) in 2002, which actions embodied in the PRS, including in c was effectively used to hold relevant Minis- particular greater decentralization. This tries and Departments accountable for would be essential not only for rebuilding the promised actions. Fifth, a highly visible people's confidence in the state, but also for  making meaningful progress toward poverty by increasing financial support to facilitate reduction and achieving the Millennium Nepal's own reform efforts. To align the Development Goals (MDGs). Bank's assistance program with the PRS, the CAS will be fully outcomes-focused, continu- v. Given the continuing political turmoil, ing the outcomes-based approach developed the Bank no doubt faces a risky environment by the Nepal Country Team over the last two in which to operate in Nepal. The Bank, years. however, should not lose sight of the most important risk the country faces, and hence vii. Given the risks of politics getting in the by extension the Bank also faces-i.e., the way of reforms, the Bank will continue to risk of Nepal spiraling into a widespread maintain sharply differentiated lending armed conflict and a breakdown of state levels linked to progress on reform imple- institutions. In comparison, many of the mentation. The base case envisions an other risks are modest if not trivial. The average annual lending of about US$19o current wave of reforms is a determined million (consistent with the current IDA effort by the reform leaders to mitigate this resource allocation for Nepal), including fundamental risk. Unlike in typical reform programmatic support to facilitate acceler- episodes, the leadership for change has come ated implementation of the core PRS priori- more from a growing number of reform- ties. If the reform process stalls (low case), minded technocrats and some enlightened the lending support will be curtailed sharply political leaders who stand apart in an to a range of US$o-5o million. In the high establishment that has provided largely case-which is associated with peace and passive support rather than explicit leader- accelerated reforms-lending could increase ship. Because of this, the reform efforts may to US$200-25o million annually. With the seem more tenuous and less spectacular. prevailing uncertainties, however, there Nevertheless, the basic contents of the could be a need to revisit the strategy. As reform program enjoys strong support from such, a CAS Progress Report (CAS PR) will be the population at large and at least tacit prepared in approximately eighteen to support from mainstream political parties. twenty-four months, or sooner should the Vi This is not to minimize the risks that the situation warrant. reform process could be stifled by myopic >_ political interests or the implementation viii. The Executive Directors may wish to '9 capacity is curtailed by hostilities. Imple- discuss: w mentation of the Bank's strategy will be * The appropriateness of the basic strategy <r cognizant of these risks. of providing strong support to Nepal's PRS m in the face of significant political uncer- vi. Through the lean years of slow reforms, tainty; the Bank worked consistently with reform- * The appropriateness of the outcomes-based c, minded leaders and facilitated the begin- approach outlined in the CAS; and z nings of the current reform process. The * The choice of instruments to deliver the < firm linking of lending levels to actual lending program. ,,, reform implementation has challenged and - inspired the reformers. And, an uncom- ix. In many respects, Nepal is truly at a monly strong partnership has developed critical juncture in its development process, between these leaders and the Bank, with a and it is difficult to predict which path the strongly shared vision for the reforms that country will follow. While the on-going ar Nepal needs. More importantly, the reform- reforms offer the best hope for laying the H ers have risen to the occasion and have foundation for sustained peace and develop- , begun implementing the far reaching ment, the insurgency makes their implemen- 0 program articulated in the PRS. Because of tation more difficult. Yet, one thing is clear. o the fiscal pressures, accelerating its imple- With strong support of the Bank as outlined in mentation will require increased external this CAS, the chances are much greater that resource flows, particularly of a program- the reform program will succeed, and hence, matic nature. The Bank's CAS for FY04- lead eventually to real improvements in the FY07 is designed to respond to this situation lives of Nepal's poor and most vulnerable.  uo.,onpoul uoi3lopoijulI   1 The last Country Assistance Strategy far-reaching reform program. Notable (CAS) for Nepal-considered by the Board on progress has been made in financial sector December 13, 1998-identified poor reform, public expenditures management, governance as the fundamental constraint changes in public service delivery restricting Nepal's development.' Since modalities, the fight against corruption and then, while there have been improvements, the infrastructure regulatory environment. governance-broadly defined to encompass To give the reform process greater public accountability, transparency and coherence, the country has recently social inclusion-remains the country's formulated a Poverty Reduction Strategy central challenge. In part reflecting the (PRS).3 Nonetheless, the impact of the 3 structure of poor governance, over the last reforms have not been felt widely enough to five years Nepal has gone through turbulent date and Nepal remains one of the world's times. Both growth and poverty reduction poorest countries, with an annual per capita have suffered from a number of factors, income of about US$230 and bleak social - including: (i) successive ineffective indicators. Nepal also needs to address Governments and a continuing unstable fundamental issues related to social political environment; (ii) an escalation of exclusion and redress the widespread the insurgency, interspersed with two failed perception that the state has been failing to attempts at peace talks (in 2001 and 2003); deliver basic public services. While the on- and (iii) harsh repercussions from the global going reforms offer the best hope for laying economic slowdown that have severely the foundation for sustained peace and affected Nepal. development, the insurgency makes their implementation more difficult. 2 As reported in the CAS Progress Report (CAS PR) of November 2002,2 despite this 3 Thus, Nepal is at a critical juncture in instability and uncertainty-or perhaps its development process today. Nepal may be because of it-over the last two years, Nepal turning toward a brighter future, but the risk has begun implementing an impressive and of the country becoming mired in a more  protracted internal conflict cannot be political turmoil and uncertainties, in the last discounted. Despite this unpredictable two years there has been much greater environment, there are several good reasons continuity and certainty in the reform for the Bank to formulate a new CAS at this process, backed by broad support from the time. Most fundamentally, a new CAS will general public. As such, there is a solid process allow the Bank to align its assistance program of change that Bank assistance can and closely to the current reform process should support. This is not to minimize the embodied in the PRS, hence providing more risks the reform process faces, but all the more effective support and encouragement to the reason the Bank should have a clear strategy reform efforts. Moreover, contrary to the to deal with the various possibilities. Report No. 18578-NEP, dated November 17,1998. 2 Report No. 241 70-NEP, dated November 18, 2002, and discussed by the Board on December 19, 2002. 3 The draft PRS received cabinet endorsement in May 2003. It was finalized and officially submitted to the Bank and IMF in late-June, at which time work was initiated on a Joint Staff Assessment (JSA).  1 p4 ~~~~~ ~~ ~.. .7 i ,. The CAS Context A. Social Context B. Political Context C. Macroeconomic Performance and Medium Term Prospects 0. Progress Under the Last CAS and Lessons Learned   A. Social Context 4 Despite improving economic which are controlled by the insurgents) performance during the 199os in which per where poverty is as high as 70%. While there capita income growth increased to about have been noticeable improvements in 2.5%, Nepal remains extremely human development indicators in recent impoverished. Although the most 'recent' years, they are still quite low and show poverty estimates are rather outdated4 and significant urban/rural and geographical comparability among different poverty variations. There has been some progress in estimates is questionable, it is possible to draw reducing gender disparities-e.g., life some broad conclusions regarding poverty expectancy, literacy levels, and school trends over the last few decades. Specifically: completion rates-but, great advances are * The absolute number of poor in Nepal has still required for Nepali woman to be increased since the mid-198os; considered truly empowered. * The distribution of income has become more unequal throughout the country; 6 As important, there are significant and ethnic and caste-based disparities in what is * Progress towards attaining the Millen- recognized as a largely pluralistic society nium Development Goals (MDGs) has been with diverse ethnic, caste, linguistic and slow. religious communities.6 Broad linkages have been identified between caste and poverty, The country will continue to face many and caste and human development levels, challenges towards achieving the MDGs in and there are some clear messages: (i) most the coming decade (see Box 1 and Appendix I). of the Dalit population is disadvantaged; and (ii) there are striking caste and ethnicity- 5 With approximately 85% of the total based disparities in education. A number of population living in rural areas, poverty is factors-including its limited natural resource largely a rural phenomenon in Nepal-a rural endowment, land-locked and rugged terrain, poverty incidence of 44% compared to about and series of ineffective and unstable 23% in urban areas.5 Of the country's Governments-have contributed to Nepal's ecological regions, poverty in the mountains, poverty problems. Adding to these, much of at about 55%, is significantly above the the economic growth has been in non- national average, as it is in the more remote agricultural sectors, leaving behind the mid- and far-western districts (many of majority of Nepalis living in rural areas.  IVI--ILLENNIUM DEVELOPMENT GOUAL NEPAL'S CURRENT POSITnION Halve, between 1990 and 2015, the As of 1995, it was estimated that about 40% of Nepal's proportion of people whose income is population lived on less than US$1 /day. There is little evidence less than US$1 /day. that poverty has declined since the 1980s and the absolute number of poor has likely increased. Enroll all children in primary education by There is evidence that the net enrolment rate of primary-aged 2015. children rose in the 1990s reportedly to over 70% and the youth literacy rate increased to 63%. Make progress towards gender equity There have been significant improvements in the relative and empowering women by eliminating access of girls to school education during the 1990s (a ratio gender disparities in primary/secondary of girls to boys in primary/secondary education of 82%); education by 2005 and all levels by 2015. however, the ratio of young literate females to males is still less than 60%, and Nepali women are still largely without voice and influence in the public domain. Reduce infant and child mortality rates by Within the last decade, there have been considerable two-thirds between 1990 and 2015. reductions in infant mortality (from 100 per 1,000 live births to 66) and child mortality (f rom 145 per 1,000 to 91); nevertheless, large regional variations persist. Reduce maternal mortality ratios by three- Maternal mortality remains high (estimated at 830 per 100,000 quarters between 1990 and 2015. live births in 1995) with only about 12% of births attended by skilled health staff. Have halted by 2015 and begin to reverse It is hard to obtain an accurate assessment of the HIV/AIDS the spread of HIV/AIDs, incidence of situation; however, evidence suggests that the HIV rate is 8 malaria and other major diseases rising rapidly-perhaps the early stages of a concentrated epidemic-in several vulnerable groups, notably Nepalis working abroad and sex workers. Integrate the principles of sustainable There are issues-e.g., deletion of soil nutrients and arsenic development into country policies and contamination in the Terai-that show environmental programs, and reverse the loss of sustainability remains a problem. However, other initiatives- environmental resources. in drinking water and forestry-indicate positive progress. A national sustainable development strategy is under preparation. Develop a global partnership for Nepal has an overall low level of telephone density and <. development. approximately two-thirds of telephones are in the Kathmandu valley. r Note: See Appendix I for the MDGs and related indicators for Nepal. Sources: Staff estimates. B. Political Context 7 Nepal has seen extraordinary political insurgency has claimed over 8,ooo lives and o instability in recent years-i.e., there have the remit of the state machinery shrunk been twelve changes in Prime Minister in the largely to urban and semi-urban areas in past eight years. Peace has also eluded Nepal many districts (see Box 2). An important for more than seven years while a violent breakthrough was made on January 29,  2003 when His Majesty's Government of levels-were allowed to expire in July 2002. Nepal (HMGN) and the insurgent leaders With an escalation of insurgency-related agreed to a cease-fire. After three rounds of violence-in part a campaign to prevent peace talks, however, the insurgents elections-Mr. Deuba recommended unilaterally called off the cease-fire on deferment of elections for over a year. This August 27, 2003. While all sides stress the led the King to dismiss the Government in need for a peaceful resolution of the conflict, September 2002, and has resulted in two the path to peace is not obvious. successive interim Governments. 8 On the political front, the Parliament 9 The first interim administration- was dissolved on May 22, 2002, and Mr. headed by Prime Minister Lokendra Bahadur Sher Bahadur Deuba remained as caretaker Chand of the Rastriya Prajatantra Party Prime Minister for about six months. During (RPP)-was appointed by the King on October this time, the terms of locally elected bodies- 11, 2002 with a mandate, among other both at the village/municipality and district things, to restore peace, hold the suspended THE INSURGENCY The exclusion-witnessing that have been taking insurgency-previously a little social and economic place with greater low intensity and mainly progress; and frequency and often rural campaign to form a lasting 2-3 days; and (iii) a 'people's republic'-has * Failure of governance, generally low level of claimed more than 8,000 including lack of delivery economic activity caused lives by official accounts of public services: by decreased business and has resulted in Nepal's specifically, weak confidence and low longest and bloodiest institutions have failed to tourism. Furthermore, conflict since the mid- meet the basic needs of there have been large 1700s. It is clearly a political the population and direct impacts on the movement with a firm continue to be linked livelihoods of millions of political philosophy, but has with corruption, political primarily rural-based gained strength because of infighting and instability. individuals, for which certain social-economic killing, extortion, confisca- conditions, including in The insurgency has tion, forced recruitment, particular: increasingly challenged the and infrastructure * Horizontal inequality and fragile economy-the costs destruction have created social exclusion: have been estimated at 8- fear and resulted in specifically, economic 10% of GDP, including: (i) migration, decreased growth has largely damage to infrastructure- agricultural production, benefited Kathmandu e.g., over 1/3 of the 3,900 and a decline in living valley residents, with Village Development standards-it is estimated the large impoverished Committee (VDC) buildings that approximately and deprived rural have been destroyed; (ii) 300,000 people have population-for decades lost economic activity due migrated to the Kathmandu a target of social to bandhs-i.e., strikes- valley in recent years.  elections, fight corruption and improve Nevertheless, the political situation remains service delivery. While public opinion was tense and a speedy return to functioning firmly behind the peace talks and supported democracy does not appear imminent. the administration, the main political parties-most notably, the split Nepali Congress (NC) Party and the United Marxist C. Macroeconomic Performance Leninist Party (UML)-continually and Medium Term Prospects challenged the administration's legitimacy. On the basis of the standoff that 11 Since the last CAS, the Nepali developed with the political parties agitating economy has fluctuated. After growing at a for the restoration of Parliament and rate of 5% per year during the 199os, real formation of an all-party Government, the GDP fell in FYol/02 primarily due to Chand administration resigned in late-May declines in manufacturing and tourism (see 2003, and the King appointed Mr. Surya Table 1). A number of factors-including Bahadur Thapa-also of the RPP-as the new sluggish worldwide growth, the insurgency, Prime Minister on June 4. market saturation, and inadequate quality control and standards-contributed to the 10 As head of the second interim decline, as did irregular rainfall that administration, Prime Minister Thapa has adversely affected agricultural production. been vested with full executive powers to More recently, there have been signs of a assemble an all-party Government, but the modest recovery underway, with GDP five main political parties have so far all growing by 2.3% in FYo2/o3. Economic declined to join, claiming that the current activity picked up noticeably after the administration is no different from its January cease-fire with some recovery in predecessor. As such, the cabinet contains tourism, transportation and other services, 10 only six additional members, all from the and certain manufactured exports- RPP. Mr. Thapa has outlined a ten-point especially garments. Nevertheless, the agenda that includes: (i) resolving the economy remains weak. insurgency problem and establishing lasting peace; (ii) creating an environment 12 As imports have also somewhat conducive to local and general elections; (iii) rebounded, the current account balance establishing the foundations of good recorded a slight deficit (about 1% of GDP) governance and strengthening the in FYo2/o3. Remittances from Nepalese administrative machinery; (iv) effectively working abroad have grown tremendously f implementing anti-corruption measures; (v) (estimated at around US$855 million in accelerating economic reforms and facilitating FYo2/03), with this item now larger than an enabling environment for investment; and the value of merchandise exports. Gross (vi) building consensus for political, economic official reserves remained high at about < and social reforms. In this context, securing a US$1.2 billion-about six 1/2 months of lasting peace with the insurgents, reaching a imports-at end-FYo2/03. The external political settlement with the parties and debt service ratio is low (about 7.5%) of building an environment conducive to holding exports of goods and services, because of the elections all remain high on HMGN's agenda. highly concessional nature of external Strongly related to this, HMGN's recent borrowing. replacement of public servants with political appointments in local bodies (see footnote 11) 13 In recent years fiscal management can be viewed as a precursor to local elections. has come under stress, as the worsening  insurgency situation and fragile economy strengthened during FYo3/o4 and into the contributed to weak revenue growth and second month of the fiscal year, budget security-related spending increased. In implementation is strong. In the past, the FYo1/02, revenues were below the budget deficit has largely been financed by target (despite serious collection efforts, concessional foreign financing, however, in including imposition of special security FYoo/oi and FYo1/02 domestic financing surtaxes) and security spending was about rose slightly. With successful 1% above the budgeted amount (although implementation of the reform program, in still well below the level of similar spending the future it is envisioned that foreign in other countries in the region). financing will increase. Anticipating further fiscal pressures, HMGN embarked on a bold fiscal consolidation 14 Led by a recovery of manufacturing exercise in FYo2/03 that has been and exports, stronger agricultural implemented with a considerable degree of performance and productivity, and higher success.7 Despite low levels of development investment, in the medium term growth in expenditures in FYo2/03, pro-poor spending Nepal is expected to increase to the 5% rates has been protected. Furthermore, with experienced during the 199os.8 There are, revenues increasing by 13% over the however, several key pre-conditions for these previous year, the deficit before grants to occur. First and foremost, renewed declined to 4% of GDP in FYo2/03 (compared economic growth will require political stability to the iggos average of 6%). Fiscal and peace. Second, Nepal will need to management will continue to be implement a range of growth-enhancing Table 1: Selected Economic Indicators: FY99/00-FY05/06 Fiscal Year 99/00 00/01 01/02 02/0311 03/0421 04/052' 05/0621 Real GDP (% change) 6.1 4.8 -0.5 2.3 3.5 4.6 5.4 Agricultural GDP 4.9 5.5 2.2 2.1 2.8 3.0 3.5 Non-agricultural GDP 6.8 4.3 -2.1 2.5 3.9 5.7 6.4 Manufacturing 7.2 3.8 -10.0 0.4 2.3 6.7 7.2 Other sectors 6.8 4.4 -0.6 2.9 4.2 5.5 6.4 Fiscal indicators (% of GDP) Total revenue 10.7 11.4 11.5 12.3 12.4 12.8 13.4 Total expenditure 15.7 17.6 17.2 16.3 18.7 18.5 18.2 Current expenditure 9.6 11.2 11.6 11.6 13.1 12.5 12.1 Capital expenditure and net lending 6.1 6.4 5.7 4.7 5.6 6.0 6.1 Overall deficit before grants 5.0 6.2 5.7 4.0 6.3 5.7 4.8 Overall deficit after grants 3.5 4.5 4.3 1.9 3.6 2.6 2.0 Domestic financing (net) 0.9 2.7 2.9 1.2 1.7 1.3 0.6 Current Account Balance (% of GDP) 0.5 1.2 2.6 -0.9 -1.7 -1.8 -2.3 Gross official reserves (US$ millions, end of perod) 1,385 1,020 1,048 1,177 1,237 1,292 1,347 In months of imports of goods & services 5.6 7.0 6.7 6.9 6.4 6.3 6.2 External debt/GDP (%)31 51.8 49.9 52.9 52.2 47.2 44.8 42.4 Debt service4' 4.7 6.1 7.5 7.4 7.9 8.1 8.1 Source: IMF (as of October 6, 2003) Estimate 2. Projected Includes estimated private sectordebtand short-term trade credits. In % of exports of goods, services, and private transfers, including debt service to the IMF  structural reforms to stimulate a more pro- progress in implementing the reform poor and inclusive growth process, including: program, for much of the last CAS period (i) enhancing the development impact of Nepal remained in a low case lending public expenditures and improving tax scenario. Given the fungibility of aid administration; (ii) improving power, resources, without substantial improvement transport, banking and telecommunications in the use of public resources, more financial services; (iii) boosting Nepal's export assistance from IDA would not have been a competitiveness by addressing some behind solution to Nepal's problems. HMGN clearly the border constraints; (iv) addressing sector began recognizing poor governance- specific reforms such as rationalizing irrigation reflected most acutely in weak subsidies in agriculture and improving labor implementation of reforms, poor service market flexibility for manufacturing and delivery and corruption-as a central services; and (v) undertaking governance obstacle to development. Growing reforms that enhance the impact of the recognition of the gravity of the financial structural measures. sector conditions and their direct link to the system of poor governance, led the Bank to 15 The macroeconomic framework attach special importance to financial sector recently agreed by HMGN with the Bank and reform (see Box 3). As the first major step in International Monetary Fund (IMF), as well as reforming the financial sector, the assistance from both institutions to implement introduction of external management teams the reform efforts-through Poverty Reduction in the two large ailing commercial banks Support Credits (PRSCs) and a Poverty became the 'litmus test' for moving into a Reduction and Growth Facility (PRGF)-will base case scenario. By the time of the support Nepal's attempts to achieve more December 2002 CAS PR significant progress sustainable growth. The key elements of the had been achieved toward implementing the 12 framework are consistent with the PRS and reform program, including in the financial include: (i) a fiscal strategy to improve sector, and hence the decision was made to revenue mobilization, prioritize spending- move Nepal to the base case. towards social and infrastructure sectors to help reduce poverty-and contain domestic 17 While in the low case (late-1998 to E1 borrowing over the medium term; (ii) a late-2002), the lending program focused monetary policy geared to supporting the peg primarily on infrastructure development, to the Indian rupee; (iii) continuation of the and four projects-in education, rural financial sector reforms; (iv) public sector infrastructure, road maintenance and reforms including civil service and public telecommunications-were approved for a enterprise; and (v) governance reforms to total of US$94.6 million. Strong emphasis strengthen the fight against corruption and was placed on helping to build the agenda accelerate decentralization to local levels to and needed consensus for reform. To a great improve accountability and service delivery. extent, the introduction of a Medium Term Expenditure Framework (MTEF) and Immediate Action Plan (IAP-see paragraphs D. Progress Under the Last 21-24) have been prompted by the Bank's CAS and Lessons Learned9 Analytical and Advisory Activities (AAA). In addition to key formal reports (see Table 2), CAS Implementation the Bank's follow up through technical 16 Because of the limited and slow assistance (TA) and intensive dialogue have  FiNANCIAL SECTOR Poor in problems of growing budget or 8.6% of GDP. In management of financial non-performing assets and late-2000, HMGN adopted resources at Rastriya capital adequacy, and an a strategy that commits to Banijya Bank (RBB) and increased scope for reducing the role of the Nepal Bank Limited (NBL) systemic risk within the public sector in the sector has been a way through sector. RBB and NBL- as a direct owner of which powerful elite have accounting for about 50% financial institutions, while abused public institutions. of total banking system strengthening its role as a Poor management and assets-are estimated to supervisor and regulator oversight of the financial have had losses (as of of banks and financial sector-in part, occasioned mid-1998) of as much as institutions (see paragraph by heavy-handed state US$450 million-equivalent 32). made significant contributions to the possible to simply 'negotiate' aid out of IDA. In foundations of many of the on-going and getting to this point, a number of valuable envisioned reforms. Internally, the Bank's lessons have been learned-both from our Nepal team has also moved to an outcomes- experiences in Nepal and world-wide, based work programming approach to including through instruments such as The sharpen its focus on facilitating reforms (see Global Poll (May 2003). The following have paragraph 49). Since the transition to the taken into account in developing this new CAS: base case in December 2002, three additional projects (in the financial sector, * In an environment of poor governance, 13 power development and education) have closely linking lending levels to progress been approved for a total of US$96.9 million. in implementing reforms and achieving results on the ground-not just promises- Lessons Learned can provide significant leverage. While 18 Today, there is a realization in Nepal such an approach by itself might not that the Bank is truly concerned with the prompt reforms, when spontaneous > well-being of the poor and that it is not reform initiatives emerge, it can provide Table 2: Key Formal Reports Since FY99 Poverty Report FY99 Public Expenditure Review FY00 Priorities & Strategy in Education Sector Reform FY01 , Power Sector Development Strategy FY01 Business Environment & Manufacturing Perform. FY01 Country Procurement Assessment Report FY01 Country Financial Accountability Assessment FY02 Financial Sector Study FY03 Trade & Competitiveness Study FY03 Towards a Sustainable Approach for Poverty Reduction and Decentralization: A Note on PAF FY03 Country Assistance Strategy Progress Report FY03  an important and constructive discipline reform implementation. These need to be to the process, and can even strengthen better understood for the Bank to be more the hands of reform leaders. In addition, effective in identifying and supporting this fosters peer pressure among senior emerging reform opportunities. When officials to look at development more reforms do happen, they are often sponta- holistically, as they realize that sectoral neous and episodic, and often fall outside funds could be blocked if the overall conventional frameworks that donors are progress is not made toward larger accustomed to. Moreover, Government country goals (i.e., governance); officials are not generally good at showcas- ing reform progress, nor are they prac- * A work program grounded in an outcomes ticed at communicating successes to the framework encourages a more holistic and public. These are important aspects to multi-sectoral approach for the Bank stress and take into account if the benefits team. Outcomes need to be realistic and of reforms are to be the best arbiter for focus on those areas where the Bank plays deeper reforms in the future; a significant role, with clear linkages to the country's stated objectives; * The linkages between peace and stability, and poverty reduction are strong- m To be most effective, consistent dialogue possibly forming a vicious circle. Develop- and investment in a solid relationship with ment/poverty reduction can not be key counterparts are essential. In addition delayed or postponed until there is peace to building consensus for change/reform, and stability, as many of the root causes of such an investment also builds and conflict-i.e., failure of governance, encourages ownership of and buy in for including lack of delivery of public reform programs. Proactive outreach services, and horizontal inequality and 14 helps build wider understanding of the social exclusion-are often also the major development challenges and opportunities; challenges of reducing poverty; and C. * It takes time for reform to catch on; hence, * Donor coordination is essential, but not there is a need to simultaneously develop always easy. Ultimately, the Govern- 'low case appropriate' interventions- ment must be encouraged to coordinate typically modest in size and often support- donor assistance by setting out its own ing community-based projects or small, development strategy and priorities. sector-specific reform efforts; Clearly, donors-including the Bank-need to respect Government efforts to 'regulate' * The interplay of diverse political economy and direct foreign assistance. realities have an important impact on fn 4 The most recent estimates are based on the 1995/96 Household Survey. A Nepal Living Standards Survey (NLSS) was launched in early-2003 to update household level information on consumption, poverty and their determinants. A full Poverty Report based on this survey will be finalized in FY05. For more details on the poverty situation in Nepal, see the Poverty Reduction Strategy. All poverty figures cited are based on the results of the 1995/96 Household Survey and can be compared to an overall poverty incidence 3" estimated at 42% of the population. c 6 Nepal has over 100 languages and dialects, and more than 60 recorded ethnic groups, some of which are further sub-divided into distinct o caste rankings. There are many indigenous ethnic ('Janajati') groups and 12-15% of the population are 'Dalits' or occupational caste groups who have been historically disadvantaged and continue to lag behind. 7 See paragraphs 21-23 for details on the implementation of the MTEF and fiscal adjustments. 8 Nevertheless, a key concern will be the removal of the Multi-Fibre Arrangement (MFA) based quota protected markets that had stimulated the growth of manufacturing and trading over the last decade. 9 For a more detailed discussion of the experience with implementing the last CAS, see Appendix II.  U5~~~~~~ 0 - *= C CD D cc E Iq ~~4 II ~ ~ ~ C I *L~~~~~~~~~~~~~~~~~~C r. ~ ~ c   A. The Reform Process March 2000, where HMGN announced a comprehensive reform program that focused The Context: Nepal at the Edge of Chaos o mrvn oenneadrdcn , on improving governance and reducing I? Nepal is struggling to emerge from a poverty. As the severity of the financial period of intense turmoil and its future problems of the two largest commercial hangs in balance. The acutest form of this banks became apparent in 2001, reformers turmoil is the insurgency that escalated into became alarmed by the prospect of a a serious armed conflict involving the army financial sector crisis and began to use it as a 17 in November 2001. In the backdrop, focal point of the reform process. Then, with however, had been growing disappointment the fiscal situation deteriorating rapidly in with the political and development processes 2002, HMGN started to use this as a driver that have failed to meet the aspirations of for public expenditure reform. At the same the people, which had been raised after the time, to respond to the serious challenges reinstatement of a multi-party democracy in caused by the insurgency, reformers began 1990. With the heightened level of to design radical ways to improve public hostilities, the economy slowed and fiscal service delivery even under severe fiscal pressures built. When this crisis did not constraints. By the beginning of FYo2/o3, seem to prompt political leaders into serious these somewhat disparate initiatives took corrective action, the frustration of many shape as a more cogent strategy, embodied in turned into a sense of alarm that the nation the IAP and the financial sector reform was heading for a catastrophe. From this program that would place the two ailing deep sense of crisis, a new wave of reforms banks under external management as the was born. It is being led by a growing first step. An integral part of the IAP has number of reform-minded technocrats and been the introduction of the MTEF to some enlightened political leaders. substantially rationalize the development budget. In parallel, after its legal framework 20 An important beginning was made was strengthened in 2002, the Commission at the Nepal Development Forum (NDF) in for Investigation of Abuse of Authority  conltains 24 refOrm actions infrastructure development, tance of the action, a directly linked to the four targeted programs and preliminary cost estimate PRS pillars. As such, it is decentralization. The and timeframe for imple- more ambitious than its Reform and Development mentation, and an outline of predecessor and covers Group-a joint HMGN/donor the proposed arrangements reforms in about a dozen task force-has worked to review implementation areas. In addition to areas diligently on developing the progress. Past experience previously covered-i.e., 2003 IAP and has identified has shown that sectoral public expenditure manage- 'lead Ministries' and 'lead ownership at the highest ment, civil service reform donor agencies' responsible levels has contributed to and anti-corruption-the for carrying out detailed achievements above and 2003 IAP covers actions in assessments of each of the beyond the original targets agriculture, private sector actions. These assess- established in the IAP (see development, public ments include an explana- Appendix 111). (CIAA) started to take some highly visible primary health facilities to community actions against senior civil servants and management; (iv) public posting of budget politicians on corruption charges."' This has information and tracking of expenditures; been met with enthusiastic support from the (v) implementing public procurement and 18 general public. As explained below, the PRS financial accountability reforms; and (vi) builds on these reform successes and expands developing and starting to implement an the scope of reforms, with a more integrated anti-corruption strategy. With all the approach within a medium term perspective. Ministries and Departments relevant to the IAP galvanized into action, nearly all of the The Immediate Action Plan 19 actions were completed by the end of 21 In June 2002, HMGN adopted the FYo2/03. Inspired by this achievement, IAP that was designed to expedite reforms in HMGN decided to turn the IAP into an three critical areas-prioritizing public annual process to define and monitor a set of expenditures, improving service delivery, critical actions necessary for the successful and strengthening anti-corruption and implementation of the PRS. After being accountability measures. Recognizing their endorsed by the cabinet, the 2003 IAP was weak implementation capacity, HMGN took announced in July 2003 and the measures pains to keep the plan selective. Main IAP are expected to be implemented by the first actions included: (i) setting a realistic budget quarter of 2004 (see Box 4 and Appendix III). ceiling and eliminating a number of low In this regard, reform leaders are keenly priority projects; (ii) assuring funding for aware that these early successes have not high priority projects, but tying funds translated into significant impacts on the release to performance; (iii) improving lives of average citizens at the grassroots service delivery modalities by initiating the levels, especially in rural areas. To make the transfer of public primary schools and reform process meaningful and sustainable,  there is an urgency to accelerate the understanding among line ministries of the implementation, especially of the reforms seriousness of this prioritization exercise. that bring quick impact to the community level. The 2003 IAP is designed with this 23 At the same time revenue growth objective in mind. Lengthy delays in local was slowing during the last two fiscal years, elections, however, present an obstacle, as security spending was increasing sharply as they have dampened the momentum for the level and scale of the insurgency decentralization. In many Districts, locally escalated. From a very modest level of Rs. 7 elected District Development Committee billion (1.9% of GDP) in FYoo/ol to support (DDC) and Village Development Committee the police and a small standing army, (VDC) chairs (who had executive power) security spending rose to about Rs. 15 billion tended to be strong promoters of change at in FYo2/03. While in principle this increase the grassroots level.,, was detrimental to the development efforts, NPC/MOF turned it to its advantage. As the Medium Term Expenditure increase in security spending was an absolute Framework and Fiscal Adjustments imperative, the resulting severe fiscal 22 Based on the recommendations of the pressure made it easier to impose a hard 2000 Public Expenditure Review (PER)12 and budget constraint on line ministries and the work of the Public Expenditure Review politicians who had been accustomed to much Commission (PERC) in 2001, and prompted softer budget constraints in the past. The by the worsening fiscal situation, HMGN majority of the cuts hit low priority, decided to introduce an MTEF starting in politically motivated projects. Total FYo2/03. Overcoming the entrenched development spending declined from Rs. 37 tendency to seek increased foreign aid to cope billion in FYoo/oi to Rs. 27 billion in FY02/ with fiscal stress, the reform-minded 03. The developmental impact of this National Planning Commission (NPC) and reduction appears to have been relatively 19 Ministry of Finance (MOF) used the fiscal modest, as most of the dropped and P3 projects pressures to motivate serious adjustments in had been ill conceived to begin with and budget allocations. This led to elimination of receiving only modest annual funding 16o low priority projects (out of 625 without any realistic hope of completion in projects) in the FYo2/03 budget. Further the foreseeable future. cuts in projects would have been desirable, 24 In the meantime, through reforms to but were politically impossible. Instead, HMGN chose to be pragmatic and opted for decentralize service delivery modalities-not an unorthodox solution in which remaining only in primary education and health care, projects were classified into three priorities- but also in agricultural services-the quality P1, P2, and P3. While funding for the top of recurrent spending has started to improve. priority (Pi) projects was assured, funding In FYo3/o4, further measures are for lower priority (P2 and P3) projects would anticipated in this regard, including: (i) the be contingent on actual availability of funds operationalization of an autonomous Roads after all P1 projects are adequately funded.13 Board that is expected to bring more While seemingly vulnerable to political rationality and transparency to the pressures, NPC and MOF nevertheless allocation of road maintenance budget; (ii) managed to use this system effectively to incentive grants to schools that improve concentrate funding to the P1 projects and enrolment of disadvantaged groups; (iii) within a year established a clear implementation of the essential health care  package approach to focus the limited 64 to 45 per 1,000 live births; (iii) raising resources on priority health issues; and (iv) life expectancy from 62 to 65 years; and (iv) greater participation of the private sector in increasing access to drinking water to 85% of infrastructure services-e.g., establishment of the population (from 72%), access to the Power Development Fund (PDF) to electricity to 55% (from 40%), and providing promote private investment, introduction of telephone facilities to every VDC. To meet a rural telecommunications operator and these objectives, the PRS is formulated opening the licensing system for private around four key pillars: cellular operators. In effect, HMGN has been u Achieving sustained high and broad-based able to turn the fiscal and service quality economic growth, focusing particularly on crises into an opportunity to establish a leaner the rural economy; and more efficient public spending program. * Accelerating human development through As Nepal begins to implement its PRS in full a renewed emphasis on effective delivery of scale and increase expenditures to support it, basic social services and economic infra- far greater impact from additional spending structure; can be expected than in the past. * Ensuring social and economic inclusion of the poor, marginalized groups and less developed regions; and B. The Poverty Reduction Strategy . Vigorously pursuing good governance both as a means of delivering better development Background results, and ensuring social and economic 25 Nepal's PRS is based on the reform justice. successes and limitations it has seen over the last two years, and gives the process a 27 In implementing these pillars, the broader, and longer-term vision and strategic strategy stresses four cross-cutting themes: 20 coherence. Early on, HMGN decided that the (i) re-defining the role of the State and Tenth Plan (FYo2/og-FYo6/o7) would form limiting public interventions; (ii) promoting the basis for its PRS. Many of the past plans, private sector development and enlisting the however, have suffered from a number of involvement of the private sector, Non- weaknesses, including in general an overly Governmental Organizations (NGOs), optimistic fiscal framework and limited focus International Non-Governmental on implementation, monitoring and Organizations (INGOs) and Community evaluation. Therefore, while relying on the Based Organizations (CBOs); (iii) supporting planning framework that was familiar to greater social diversity in the structure of HMGN, the NPC managed to build the recent governance at all levels, and more socially ,. reform experience (in particular lAP and and geographically inclusive access to social MTEF) into the PRS and make it a far more and economic services; and (iv) accelerating credible strategy than any recent five-year the decentralization process, including plans. community participation in and management of activities at the local levels. 26 The PRS identifies reducing the 8 overall poverty ratio from about 40% to 30% by the end of the Tenth Plan (FYo6/o7) as its pillars are closely inter-related and address key target. Other targets include: (i) raising different aspects of the same problem. the above 15 literacy rate from 49% to 63%; Nevertheless, each pillar is described (ii) reducing the infant mortality rate from separately both in the PRS and below.  Furthermore, as a foundation for broad- financial and social services are explicitly based economic growth, the PRS recognizes recognized as key sub-sectors-the emphasis is the need for an appropriate enabling on reducing the role of the State in economic environment and macroeconomic stability. activities and creating an environment more Thus, the PRS incorporates a sustainable conducive to private sector investment. The macroeconomic framework, whose objectives strategy includes: (i) removing the include: (i) maintaining fiscal discipline; (ii) impediments to private sector development; ensuring efficient use of public resources; (ii) accelerating privatization of state owned and (iii) sustaining monetary and external enterprises (SOEs)'4; (iii) streamlining stability. This is complemented by a regulatory processes and making them more structural reform agenda that aspires to transparent; (iv) amending labor laws to make the public sector more diverse, make them more flexible; and (v) introducing efficient and effective, remove constraints to important private-sector friendly legislation private sector competitiveness and improve and judicial reform. In parallel, reforms will the conditions of the poor. In this regard, key be implemented in corporate and financial reforms are envisioned in: (i) public finance, governance. including public expenditure management- i.e., implementation of the MTEF; (ii) 31 The PRS places importance on financial sector reform; (iii) improving the infrastructure development in facilitating competitiveness of private sector, including private sector development, and hence gives trade and labor market reform; (iv) priority to the strategic road network, governance, including civil service reform maintenance of major roads and highways, and decentralization; and (v) promoting and expansion of infrastructure in electricity private sector involvement in and communications. The intention is for the infrastructure. private sector to play a more prominent role in these sectors, as well as to clarify the roles and 21 Broad-Based Economic Growth responsibilities of private and public operators. 29 The PRS argues that higher growth Examples of reforms initiated and/or will be achieved through greater productivity envisioned in the near future include: (i) in in agriculture and non-agriculture, along with roads, improving road maintenance through recovery in manufacturing, tourisfm and establishment of an autonomous Road Fund exports. The agricultural growth strategy- Board and transferring to DDCs the the Agricultural Perspective Plan (APP)-aims responsibility for development and to modernize, diversify and commercialize maintenance of rural roads; (ii) in electricity, crop and livestock production by expanding internal unbundling of the Nepal Electricity the use of technology and increasing the access Authority (NEA), establishment of a PDF and of farmers to modern agricultural inputs and creation of an independent regulatory agency; credit. This strategy is closely linked to ground and (iii) in information and communications, water development (i.e., irrigation strategy), conversion of the Nepal Telecommunications increasing rural infrastructure (i.e., rural Corporation (NTC) into a public company electrification and rural roads) and under the Company Act, opening up general sustainable development of the forestry sector. and rural telecommunication services to the private sector and establishment of a legal 30 In the non-agriculture sector-for framework creating functional autonomy of which manufacturing, trade (see Box 5), the postal service. Infrastructure development tourism, transport, construction, and is also critical for agricultural growth and  TIVENESS ThetradetoGDP significant constraints- competitiveness and ratio in Nepal is about 50%. including delays in customs productivity, and facilitating With regard to exports, Nepal and transshipment, an trade. Nepal faces is dependent on a relatively extremely rigid formal labor significant challenges for small number of products- market, infrastructure, and realizing its export potential ready-made garments and ineffective and unpredict- in the medium term, carpets account for nearly able public sector policies including the forthcoming 60% of exports-with and institutions-that phasing out of the MFA, the exports to North America, constrain the country's accession of China into the Europe and India accounting trade prospects. A WTO and a more restrictive for 95% of the total. Despite recently completed study- trade treaty with India. As this narrow basis, trade was The Nepal Trade and improving competitiveness a key factor behind the Competitiveness Study led is an important component acceleration of Nepal's by the Bank under the of the growth agenda, the economic growth in the auspices of the Integrated Bank will continue to work 1990s. Framework (IF)-provides closely with Nepal's other recommendations on key development partners Along with Sri Lanka, Nepal issues, such as Nepal's supporting follow up of the has the most liberalized accession to the World key IF recommendations productivity improvements, and as such, the education, guided by the goal of 'education strategy emphasizes the infrastructure for all,' the strategy aims at improving the developments needed to meet these objectives. access to and quality of primary education. In doing so, a key objective is to expand 32 Finally, it is recognized that a strong literacy programs, with special emphasis on financial system is of critical importance for improving educational attainment and thus, private sector development. In this respect, the livelihood opportunities of historically the PRS envisions continuing implementation excluded groups, especially girls, Dalits and of Financial Sector Strategy (FSS), which disadvantaged ethnic groups. At higher includes among other things: (i) restructuring levels-i.e., secondary, vocational/technical and privatizing the two large ailing state and tertiary-the objectives are similar, banks; (ii) strengthening the monitoring and with emphasis on producing manpower with regulatory capacity of the Central Bank; and higher skill levels. To achieve this, the (iii) strengthening the legislative and strategy is to decentralize management of institutional framework for the sector. schools to local school management committees (SMCs) at the lower levels and to Social Sector Development the governing body of the individual 33 The PRS outlines the importance of institutions at the tertiary level. This improving service delivery through a process at the primary level-a fundamental gradual process of decentralization and shift from the currently centrally-managed greater empowerment of local communities system-has begun over the past year with in the management of social services. In over 250 schools transferred by end-  September 2003 and an additional 500 proposes targeted programs for women and applications pending approval. In addition, the most vulnerable poor ethnic minorities the strategy envisions implementing a living in remote areas. The PRS reviews the program of targeted scholarship programs weaknesses of past efforts and discusses using for girls and children from Dalit and new mechanisms (e.g., the Poverty disadvantaged ethnic minority families. Alleviation Fund-PAF) and analytical tools (e.g., poverty mapping data) to improve 34 In health, the objective is to increase effectiveness. The PRS also stresses the need and extend essential health care services to for 'quick results' in order to gain the all, with special emphasis on poor confidence of those who have thus far been populations living in rural areas. To this left behind by development efforts. end, the sector strategy focuses on implementing an essential health care 36 The PRS lists a number of areas- package that is based on preventative care, including agriculture, forestry, wage maternal and child health, and family employment and social sectors-where planning. Improvements in service delivery special efforts will be made to mainstream are also expected to occur through a process and empower women, Dalits and the of devolving health facilities-starting with disadvantaged through a variety of means, sub-health posts-to local communities and including targeted programs. Other reforms working increasingly with the private sector include: (i) revising existing laws to and NGOs. Related to this, the PRS eliminate legal discrimination against elaborates on the importance of access to safe women; and (ii) implementing affirmative water for health outcomes and aims to action programs to increase the social increase access in rural areas. Key actions diversity of public service. The approach to focus on rehabilitation and maintenance of mainstreaming deprived communities and existing projects, and developing new other vulnerable groups will be similar, in 23 projects using the demand-driven user group that emphasis will be placed on ensuring - participation and empowerment approaches social inclusion in all programs. supported by the Rural Water Supply and Sanitation Fund Development Board (i.e., 37 Recognizing the limited effectiveness 'Fund Board'). In urban areas, the focus will of targeted programs in the past, the PRS has be on improving delivery of utility services, adopted some new approaches, including, and water supply and sanitation among others: (i) merging programs similar management in some major towns is to be in nature; (ii) establishing PAF as an contracted out to the private sector over the umbrella organization for targeted next few years. programs; and (iii) adopting a population and poverty-based resource allocation Social Inclusion and Targeted Programs formula for fund transfer to the districts. To 35 At the core of this pillar is a specific achieve its goals the PRS proposes to commitment that in the implementation of implement an integrated infrastructure all PRS pillars, efforts to reduce gender and development program (drinking water, ethnic/caste-related disparities will be small irrigation, schools, health posts and mainstreamed, and in new programs trails) in remote areas through local emphasis will be placed on ensuring equity of government, CBOs and NGOs. access for all, with special attention to the Q most vulnerable. In addition, the PRS 38 In parallel, HMGN has shown serious commitment to addressing the inclusion  agenda at the political level. In the context financial management and accountability of the last round of peace talks, while through among other things, implementing adhering to constitutional monarchy and the recommendations of the recent Country multi-party democracy, HMGN also Financial Accountability Assessment; and proposed far-reaching reforms to the (iii) implementing the anti-corruption parliamentary system. The proposals strategy, in part through the enactment of included, among other things: (i) an Anti-Money Laundering Act15 and proportional representation in Parliament strengthening key institutions charged with (as opposed to the 'first-past-the-post' system fighting corruption, including the National copied from the Westminster model); (ii) Vigilance Center and the CIAA. reforms to ensure wider representation in the Upper House of Parliament; (iii) strengthening of the prime ministerial C. Assessment of the PRS system (with a provision to allow non-elected technocrats to be included in the cabinet); 40 The Tenth Plan/PRS has been (iv) constitutional reservations for under- developed in the context of the current political served and under-represented groups; (v) turmoil in Nepal in a relatively participatory consolidation of local government manner (see Box 6). Although it stands on the structures, and wider powers and tradition of the periodic plan process, the PRS responsibilities to the local level; and (vi) a has been able to break from the historical constitutional provision for referenda on baggage of the established process in a number issues of national significance. of important ways. While the implementation strategy of the PRS is not as sharply explained Good Governance as one might like, the PRS relies on several 39 The PRS recognizes that improving strategic and cross-cutting instruments to 24 governance is essential if the reforms are to achieve its basic objectives, including: (i) stimulate pro-poor growth, improve service decentralization; (ii) re-defining the role of the delivery and lay the foundation for lasting State and reinforcing market functions; (iii) F peace. HMGN's strategy to improve changing public service delivery modalities; governance covers: (i) civil service; (ii) (iv) strengthening accountability financial management and accountability; mechanisms; (v) maintaining macro/ and (iii) decentralization. While HMGN has financial discipline and improving public made some progress in improving human expenditure management; (vi) targeted resource management practices over the programs; and (vii) increasing investment in past few years-most notably through the infrastructure and agriculture. creation of a computerized personnel information system-the PRS recognizes that 41 Beyond the more thoughtful additional progress is needed to make the structure of the poverty-focused strategy, civil service more efficient, accountable and there are several things that give the Tenth transparent. Future actions include: (i) Plan/PRS considerable credibility, including: reforming public employment through * Acknowledging the difficulty of getting introduction of merit-based recruitment and away from the tradition of an 'all encom- C evaluation systems and a long-term pay passing plan' document, NPC condensed policy, as well as right-sizing, improving the the voluminous Tenth Plan in the tradi- capacity and skills mix, and introducing an tional mold into a lean summary-i.e., the affirmative action program; (ii) improving PRS. This shows HMGN's ability to be  PRS adopted a participatory June 2001 to discuss the process, broad consen- and relatively 'bottom up' draft Tenth Plan Approach sus and wide support approach. An extensive Paper, as well as linkages have been developed for consultation process was between district plans and the PRS/reforms. initiated at various levels to the national plan. The However, the conflict discuss and solicit Approach Paper was then likely constrained the feedback on the ideas and finalized and discussed in consultation process in recommendations pre- the National Development some parts of the country sented in various drafts. Council (NDC)-composed and HMGN intends to Consultations were initiated of all Ministers, Secretaries, address this once it is in August 2000 with and representatives of all feasible. With support numerous public meetings political parties, private from the development held-two exclusively with sector, academia, ethnic partners HMGN is women's groups-in minorities, labor unions, developing a comprehen- eastern, central and women, NGOs and CBOs- sive participatory western Nepal bringing in January 2002. These implementation, monitoring together representatives efforts were complemented and evaluation strategy. from all 75 DDCs and all by consultations organized The exercise will be facets of civil society (i.e., from time to time by various completed by end-2003, socially excluded, minori- agencies responsible for with civil society to play a ties, academics, private developing key sectoral prominent role in monitor- sector, NGOs/CBOs). programs, thematic ing efforts. 25 selective and strategic, indicating the basis .6 By recognizing its own implemen- seriousness attached to the PRS. tation capacity limitations and by devising z a practical instrument to manage this * The PRS is backed by the MTEF, giving problem, HMGN has shown a real serious- budget prioritization a serious framework. ness about implementing the PRS. > Also, the performance-based cash release Uf system for the high priority projects is v The reformers are far more serious about forcing a greater focus on implementation poverty reduction, with particular focus performance. on inclusion. One thing the insurgency has done is to force the Kathmandu-based * Through the IAP, HMGN has succeeded in power elite to think about Nepal as a being selective in reform actions and nation state that will survive only if building an internal consensus on the glaring disparities in living standards, absolute necessity for implementing the and access to political and economic relatively few commitments made under powers are rectified. This seriousness is the IAP. HMGN now intends to use the reflected in a frank admission in the PRS annual IAP process as the instrument to about past failures and exclusionary ensure implementation of a small set of key consequences of poor public policies and reforms to support the PRS on a priority commitment to addressing them; and  * The people are demanding the kind of * Identify the sources of growth, along with changes that the PRS envisions, thereby the key linkages to poverty reduction; giving the PRS the political impetus, legitimacy and sustainability. * Address gaps in costing and prioritization, and link these to the annual budget and 42 Thus, the PRS, combined with the MTEF; MTEF and IAP, form a sound basis on which to build the Bank's CAS."7 A Joint Staff * Implement a coherent monitoring and Assessment (JSA) of the PRS was carried out evaluation strategy, including building by staff of the Bank and the IMF in July capacity for poverty monitoring within a 2003.:' In addition to highlighting the clear institutional framework; and strengths of the PRSP-many of which are listed above-the JSA suggests a number of a Further elaborate pro-poor rural strate- shortcomings and challenges on which gies, especially to ensure social inclusion HMGN will have to focus on in the coming through changes in the way in which year, including the need to: public services are delivered in all sectors. 26 10 In FY02/03, the CIAA filed 154 cases in various courts. Of these, the Special Court for corruption has passed judgment on 55 cases, of z ~~~~which 43 have been in favor of the CIAA. The most prominent cases, however, are pending. <11 To fill the vacuum at the local level, recently the cabinet appointed numerous DDC and municipality officials, including some former DDC chairs, vice chairs and mayors. After experimenting with running local bodies through civil servants, HMGN concluded that local bodies were better govemed by political leaders; hence, the appointments. 12 Nepal: Public Expenditure Review, Report No. 20211 -NEP, April 11, 2000. )1 3 To deal with unexpected revenue shortfalls, the budget should include some lower priority projects. The FY01 /02 budget, however, < ~~~~contained more projects than the most optimistic revenue projection could fund. 14 While budgetary transfers to SOEs averaged 1.8% of GDP over the last three years, total contingent liabilitiea are unknown. To estimate privatization costs, HMGN has stepped up carrying out audits in public enterprises and Bank sector work in this area is planned for FY05 rc ~~~~(see Table 4). I-- 1 5 Related to this, last year HMGN expressed interest in receiving assistance to begin the process of establishing a regime to protect the z D ~~~~financial sector from money laundering and the financing of terrorism (AML/CFT). If legislation is enacted as envisioned, a number of ID ~~~~steps-including establishing an action plan for issuing regulations and guidelines, and creating the necessary institutional structures- u ~~~~will be required to implement and enforce the new law. The Bank stands ready to assist in these efforts. 16 In a sense, lAP is the equivalent of the MTEF with regard tohreform implementation resources. 17 These are also the basis for the IMF PRGF. For more details on the IMF program in Nepal, see footnote 41 and Appendix IV. 1 8 The complete PRS policy matrix is contained in Annex Bi 1. This matrix-in which the outcomes and milestones supported by this CAS are highlighted-also elaborates other donor support to realizing the PRS objectives and outcomes.  The Country Assistance Strategy A. The Context B. The Bank's Strategy for FY04-FY07 C. Portfolio Management  I  A. The Context Bank is relied on as a trusted advisor to the reformers, giving the Bank an impor- 43 The Bank finds itself in a tant role as a 'facilitator of change'; and particularly strong partnership with HMGN. More specifically: * The Bank is the only donor with signifi- * While many aid agencies maintained high cant headroom for increasing lending levels of aid to Nepal in recent years, the levels just when HMGN is in serious need 29 Bank took a firm position on governance of additional resources, especially pro- and sharply cut back new lending during grammatic support. This gives the Bank FY99-FYo2. Highlighting poor gover- not only strong influence, but also a nance as the central obstacle to develop- heavy responsibility as the fiscal ability to ment, the Bank's stance strongly reso- implement the PRS may depend to a large nated with the reform-minded in Nepal. extent on what the Bank decides to do. It has also convinced HMGN that the Bank > is not driven by any 'lending pressure' 44 Furthermore, in each of the PRS pillar and that it is truly concerned with areas, the Bank has already undertaken poverty reduction. The Bank can, there- considerable background work, and as such, fore, engage in policy dialogue from a has a strong base to build on. In broad-based position of considerable credibility; economic growth, the Bank's assistance over the last few years has focused heavily on the * The Bank has been closely supporting quality of public expenditures, the soundness several key reform measures taken over of the financial system and the investment the last few years, including the MTEF, climate (see Box 7). The Bank has also the IAP, financial sector and transfer of supported reforms and investments in key public schools to community manage- infrastructure sectors, like the main road < ment. This has established unusually network, inland container terminals and strong collaboration between the reform customs facilities, rural roads, power leaders and the Bank. In many areas, the generation, and telecommunications.'9 In  ENVIRONMENT INlr NEPAL policies are ofTIen perceived and unpredictablity and An investment climate as well-designed, they are inconsistencies in policies. survey-The Business often changed and The implementation of the Environment and Manufac- implemented so inconsis- tax regime, import regime turing Performance in tently that they contribute to and labor laws are Nepal-was finalized in an unpredictable and risky specific areas that FY01. Based on a survey business environment. In significantly affect firms of private manufacturing addition, firms suffer and need to be urgently enterprises, the report's considerably from addressed. Private sector key findings are that poor excessive bureaucratic red development-including implementation of reforms, tape, long delays in establishing a supportive bureaucratic burdens and provision of public services business environment- continued political/policy and having to deal with will be an important theme uncertainties are the corrupt public officials. in the Bank's work under greatest obstacles to doing These problems are often the broad-based economic business in Nepal. More facilitated by lack of clarity growth pillar. agriculture, the Bank has supported transfer of driven, community-based rural water and small irrigation schemes to farmer sanitation schemes. management, and improvement in research 30 and extension services. 46 In the area of inclusion, aided by a policy note-Towards a Sustainable Approach 45 In human development, the Bank for Poverty Reduction and Decentralization- has focused on improving the quality of the Bank has led the dialogue on the PAF and education and health care, through a encouraged HMGN to use this as the main HMGN-led, sector-wide approach. instrument to reach out to marginalized Supported by the analytical work completed groups that tend to be overlooked by existing in FYol (i.e., Priorities and Strategy in institutions. In specific community-based Education Sector Reform) there has been projects-e.g., Rural Water and Sanitation- considerable progress in basic and primary the Bank has begun to address social education, with a number of donors exclusion issues more vigorously. In participating in a basket funding approach promoting universal primary education, the to a common program. The Bank has also Bank has also been engaging HMGN to played a pivotal role in supporting the design ways to improve access by transfer of public schools to community disadvantaged groups. management. In health, the Bank is actively supporting an important shift to a 47 In governance, the Bank has taken a sector-wide approach, as well as the very clear and strong stance since the last devolution of sub-health posts to local CAS. The reforms in public expenditure communities. Furthermore, the Bank has management and banking are as much about been instrumental in expanding demand- governance as efficiency. Decentralization  has also been a key focus area, both through based approach that has been pursued in the specific projects that have tried to give local Bank's work program in Nepal for the last governments greater roles-e.g., Rural two years. Infrastructure LIL-and through analytical work-focusing especially on the fiscal 49 While it is easy to agree that the decentralization framework. The Bank, in focus should be on development outcomes, it close coordination with committed HMGN is not so easy to define the Bank's teams, has conducted a Country Procurement accountability for such outcomes, for in the Assessment Review (CPAR, FYo1) and Country end the Bank's role is only to facilitate or Financial Accountability Assessment (CFAA, support the changes in a country. Thus, FY02), and in each case is following up with there is a danger that an attempt to hold Institutional Development Fund (IDF) grants staff 'accountable' for outcomes will lead the to strengthen relevant institutions and Bank to select only outcomes that are nearly implement main policy recommendations certain. Clearly, failing to support riskier (see Appendix V). Finally, anti-corruption but more important outcomes would be a actions have been a continual theme in the mistake. To resolve this tension, a structure Bank's policy dialogue. has been developed over the last two years and the same approach is envisioned for the future. Specifically, B. The Bank's Strategy for . An 'outcome' is a significant change that FY04-FY07 would be highly desirable and possible within the four-year CAS horizon. For the The Strategy: PRS-Based and Outcomes-Focused immediate year ahead, a specific 'mile- 48 The Bank's strategy will build on the stone'-i.e., key step toward achieving the achievements under the 1998 CAS-which four-year outcome-is defined; in short were to facilitate the beginnings of * Each outcome is expected to have less than 31 determined reform efforts-and support the 1oo% probability of happening, even with Nepali-led reform process in a significant best efforts on the part of the Bank;20 span and depth. Thus, in operational terms, * The matrix of outcomes is seen as a it may seem to be simply supporting key 'portfolio' in its entirety-i.e., consisting of elements under each of the PRS pillars. It is, some high-probability, but relatively low- however, backed by a successful process of impact outcomes and some low-probabil- supporting the reform dynamics that have ity, but high-impact outcomes. To avoid been gaining strength. This strategy was extremes, the portfolio of outcomes is presaged in the CAS PR which articulated constructed with an expected overall continuation of focus on improving success rate of around 65-70%;' governance-by bringing resources to * The matrix and annual milestones are grassroots levels and improving updated each year, with some outcomes development effectiveness-but with replaced-either through achievement or increased emphasis on growth and inclusion. a change in strategic priorities-and new The seven broad strategic instruments milestones defined; associated with the PRS (see paragraph 40) * Rather than holding staff accountable for are equally important in the approach the achievement of specific outcomes, the Bank has emphasized. Furthermore, the Country Team is collectively held ac- spirit of focus on selective outcomes embodied countable for the overall outcome of the in the IAP is consistent with the outcomes- portfolio;12 and  Table 3: CAS Outcomes Development Results* CAS Outcome Broad-Based Economic Growth Improved public expenditure management *Outcome focused budgeting and monitoring in place . Magnitude of SOE financial problems recognized by HMGN and strategy/ action plan developed Expanded private investmenl Irade ancd m Reform labor 13-a 1r all,vv grealer iiexrluliy in employment opportunities i employment m Lowered costs of doing business by liberalizing business support services m Increased institutional capacity for trade policy S formulation/implementation St-rengthened financial sector ,* NRB performing regulatory and supervision functions effectively * RBB/NBL privatized or liquidated increased agricultural growth and broad *- Improved enabling environment for factor and output -based rural development i markets * Increased agricultural productivity and farm incomes Well-developed road network a. Percentage of main road network in poor condition reduced to 10% * Share of population with close access to roads I increased by 4% Improved telecommunication * Private operator introduced for rural telephone service in Eastern Region Expanded coverage and improved quality E Improved efficiency of NEA (as measured by a reduction of electricity in system losses to 20%), combined with greater private sector participation * 30,000 additional households in remote areas served by micro-hydropower Social Sector Development Improved quality of and access to primary, 1 * 25% of public schools under community management, 3 2 secondary and tertiary education I and providing socially inclusive and higher quality education * Efficient and timely textbook distribution system in place, as measured by all primary school children having books at the beginning of the school year * Progress towards financial sustainability of public I universities Improved basic health care services, with * Essential health care services implemented in 25 emphasis on poor/underserved populations| districts, at least half with low health indicators Improved quality of and access lo suslainable * Exiend rural waier supply lo an addilional 1 O o ol the rural drinking water and sanitati onpopulation I Extend coverage of sanitation services to an additional < _ . 5% of the rural population Social Inclusion and Targeted Programs Social inclusion promoted through equitabie| * Reduced out of school primary aged children (primarily education girls, Dalits and disadvantaged Janajati groups) by 50% Improved fiscal transfers to disadvantaged groups * Increased public funds used by disadvantaged rural groups for services A civil service that better reflects the gender, * Affirmative action policy and implementation system caste and ethnic diversity of Nepal for improving the diversity of the civil service in place and functioning Good Governance ,o Enhanced development through stronger * Decentralization (as designed in the Local Self X9 locally elected governments Governance Act) advanced substantially, with good monitoring systems in place Improved incentives and mechanisms to ensure a * Clear delineation of responsibilities between Ministers more performance oriented and accountable and civil service to ensure autonomy and accountability public serviceservice a of civil Improved accountability and transparency Items in BOLD are objectives associated with actions in the Immediate Action Plan (lAP); see Annex Bll and Appendix Il.  * The same approach is applied to a set of two parts. The 15 areas and 26 specific annual milestones as well, so that annual outcomes for the CAS period are displayed performance can be monitored against in Table 3. A more detailed matrix (see some expected overall achievement rate. Annex Bio) describes briefly, for each outcome, the Bank's strategy for achieving 50 Based on this framework for work it, annual milestones, Bank instruments and programming, this CAS has identified 15 PRS key partners. Specific annual milestones for areas-out of the 34 PRS areas-that are FY04 are provided for each outcome with central to poverty reduction and are some additional milestones for subsequent consistent with the Bank's relative strengths years. As noted, these annual milestones are vis-a-vis Nepal's other development updated each year, and as such, milestones partners. They spell out the broad for FYos, FYo6 and FY07 should be seen 'development results' or outcomes that the more as indicative. The more detailed CAS will focus on. While the importance of matrix also links the CAS outcomes to these results are obvious, the CAS timeframe specific country outcomes identified in the is too short to set direct and measureable PRS, showing the strong linkage between the targets for them. Therefore, these 15 higher Bank's contributions and the country's goals level outcomes are translated into 26 as established in the PRS.24 intermediate outcomes-corresponding to the base case scenario described in paragraph Cross Cutting Themes 64-that are specific and meaningful for the 52 Gender and Social Inclusion. For FYo4-FYo7 period. In a high case scenario- the successful implementation of this CAS, with acceleration of reforms-the matrix there are a number of cross cutting themes- would likely be updated to include more specifically, gender and social inclusion, outcomes. These outcomes were selected fiduciary and environmental policies, and based on four key criteria: capacity building-that deserve special 33 * In each priority area, the outcome is mention. In rural areas, the women's O representative of the broader change critical role as economic providers-either