Nepal - Country assistance strategy

Document of The World Bank Report No. 26509-NEP MEMORANDUM OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A COUNTRY ASSISTANCE STRATEGY FOR THE KINGDOM OF NEPAL November 24,2003  The last Country Assistance Strategy for Nepal (Report No. 18578-NEP) was discussed on December 13, 1998 and a Country Assistance Strategy Progress Report (Report No. 24170-NEP) was discussed on December 19,2002. I I Currency and Equivalents CurrencyUnit =Nepali Rupee (NRs.) US$1 NRs. 74.5 (as of October 20,2003) = Fiscal Year Nepal: July 15-July 14(fiscalyear startingon July 15,2003is designatedas FY03/04) The World Bank: July 1-June 30 (fiscal year startingon July 1,2003is designatedas FY04) Abbreviations and Acronyms A M Analytical and Advisory Activities MDGs Millennium Development Goals ADB Asian Development Bank MFA Multi-Fibre Arrangement AMLICFT Anti-Money LaunderingKombating Financing of MIGA Multilateral Investment Guarantee Agency Terrorism MOP Ministry of Finance APP Agricultural Perspective Plan MOPE Ministry of Population and Environment BPEP Basic and Primary Education Project MTEF Medium Term Expenditure Framework CAE Country Assistance Evaluation NBL Nepal Bank Limited CAP Country Assistance Program NC Nepali Congress (Party) CAS (PR) CountryAssistance Strategy (Progress Report) NDC National DevelopmentCouncil CBO(s) CommunityBased Organization(s) NDF Nepal Development Forum CCF Community Carbon Fund NEA Nepal Electricity Authority CEA Country Environmental Analysis NGO(s) Non-Governmental Organization(s) CFAA Country Financial Accountability Assessment NIDC Nepal Industrial Development Corporation CIAA Commission for Investigation of Abuse of Authority NLSS Nepal Living Standards Survey CITES Convention on International Trade in Endangered NPC National PlanningCommission Species of Wild Fauna and Flora NPPR(s) Nepal Portfolio Performance Review(s) CPAR Country ProcurementAssessment Report NTA Nepal Telecommunications Authority DDC(s) District Development Committee(s) NTC Nepal Telecommunications Corporation DfID UK Department for International Development OED OperationsEvaluations Department DPR DevelopmentPolicy Review PAP Poverty AlleviationFund EU European Union PCR Project Completion Report FA0 Food and Agricultural Organization PDF Power DevelopmentFund PAP Foreign Aid Policy PER Public Expenditure Review FDI Foreign Direct Investment PERC Public Expenditure Reform Commission FSS Financial Sector Strategy PIC Public Information Center FY Fiscal Year PIP Portfolio ImplementationPlan GDP Gross Domestic Product PCF Prototype Carbon Fund GEF Global Environmental Facility PRGF Poverty Reduction and Growth Facility GtZ Gesellschaft fur Technische Zusammenarheit (German PRw-3 Poverty Reduction Strategy(Credit) Agency for Technical Cooperation) RBB Rastriya Banijya Bank HMGN His Majesty's Government of Nepal RPP Rastriya Prajastantra Party IAP Immediate Action Plan SEDF South Asia Enterprise Development Facility ICR Implementation Completion Report SMC(s) School Management Committee(s) IDA International Development Association SME(s) Small and Medium Enterprise@) IDF Institutional Development Fund SOE(s) State Owned Enterprise(s) IF Integrated Framework TA Technical Assistance IFC International Finance Corporation UML United Marxist Leninist (Party) ILO International Labor Organization UNDP United Nations DevelopmentProgram IMP International Monetary Fund UNEP United Nations EnvironmentalProgram INGO(s) International Non-Governmental Organization(s) UNFPA United Nations Population Fund ITTA International Tropical Timber Agreement UNICEF United Nations Children's Fund IUCN The International Union for Conservation of Nature VDC(s) Village Development Committee@) JBIC Japan Bank for International Cooperation WHO World Health Organization JICA Japan International Cooperation Agency WTO World Trade Organization JSA Joint StaffAssessment WWF World Wildlife Fund Vice President: Mr. Prafkl Patel, SARVP CountryDirector: Mr. Kenichi Ohashi, SACNP Task Team Leader: Ms. Deborah A. Bateman, SACNA  NEPAL: Country Assistance Strategy TABLE OF CONTENTS Executive Summary.......................................................................................................................... 1 Introduction.................................................................................................................................... 1 I. The CAS Context ............................................................................................................... 2 A. Social Context ........................................................................................................ 2 B. 3 C. Political Context..................................................................................................... Macroeconomic Performanceand Medium Term Prospects ................................. 4 D. ProgressUnder the Last CAS and Lessons Learned.............................................. 6 CAS Implementation.................................................................................... 6 Lessons Learned........................................................................................... 7 I1. Nepal's Poverty Reduction Strategy ................................................................................ 8 A. The Reform Program.............................................................................................. The Context:Nepal at the Edge of Chaos .................................................... 8 8 The ImmediateAction Plan.......................................................................... 9 MediumTerm ExpenditureFramework and Fiscal Adjustments...............10 B. The Poverty Reduction Strategy........................................................................... 11 11 Broad-BasedEconomic Growth................................................................. Background................................................................................................. 12 Social Sector Development........................................................................ 13 Social Inclusionand Targeted Programs.................................................... 13 14 C. Good Governance....................................................................................... Assessmentofthe PRS......................................................................................... 15 I11. The Country Assistance Strategy ................................................................................... 16 A. 16 B . The Context.......................................................................................................... The Bank's Strategyfor FY04-FY07 ................................................................... The Strategy: PRS-Basedand Outcomes-Focused..................................... 18 18 19 Instrumentsto Achieve the CAS Outcomes .............................................. Cross CuttingThemes ................................................................................ 23 Bank Group Scenarios ............................................................................... 24 C. PortfolioManagement.,........................................................................................ 27 IFC.............................................................................................................. IDA............................................................................................................. 27 29 MIGA ........................................................................................................ -29 IV. Implementing the CAS .................................................................................................... 30 A. .......................................................................................................... 30 B. Partnerships ........................................................................................... C. MonitoringOutcomes Risks..................................................................................................................... 33 32  BOXES Box 1 Nepal's Progress TowardsAchieving the MillenniumDevelopmentGoals..........2 Box 2 4 Governanceand the Financial Sector..................................................................... The Insurgency....................................................................................................... Box 3 6 Box 4 9 Box 5 ImprovingNepal's Trade and Competitiveness................................................... The 2003 L4P......................................................................................................... 12 Box 6 The PRS ConsultationProcess............................................................................ .15 Box 7 The BusinessEnvironment in Nepal ................................................................... .17 Box 8 The Responseto Environmental Challenges....................................................... .21 Box 9 FinancialManagementBroadly De~ned .............................................................. 27 Box 10 The CAS ConsultationProcess ........................................................................... .30 TABLES Table 1 SelectedEconomic Indicators: FY99/00-FY05/06 ............................................... 5 Table 2 Key Formal Reports SinceFY99 ........................................................................... 7 Table 3 CAS Outcomes.................................................................................................... -20 Table4 Formal AAA, FY04-FY07................................................................................... 23 Table 5 Key Triggers for CAS Scenarios.......................................................................... 25 Table 6 IDA Base Case LendingProgram: FY04-FY07.................................................. 26 Table 7 Project Performanceat Exit.................................................................................. 28 Table 8 IDA Portfolio Trends and Performance: FY99-FY04......................................... 28 Table 9 Partnerships in Implementingthe Poverty Reduction Strategy............................ 31 ANNEXES Annex A2 At A Glance Annex B2 SelectedIndicators of Bank PortfolioPerformanceand Management Annex B3 Bank Group Program Summary Annex B4 Summaryof Non-Lending Services Annex B5 SocialIndicators Annex B6 Key EconomicIndicators Annex B7 Key Exposure Indicators Annex B8 Status of Bank Group Operations Annex B9 Summaryof DevelopmentPriorities Annex B10 CAS OutcomesMatrix Annex B11 HMGN's Policy Matrix for the PRS Reform Agenda and World BanWPartnerPrograms and Support APPENDICES Appendix I The MillenniumDevelopmentGoals and Related Indicators AppendixI1 Implementingthe Previous CAS and Lessons Learned AppendixI11 The 2003 IntermediateAction Plan Appendix IV Fund RelationsNote Appendix V The Main Findings of Two Key FiduciaryAssessments: CFAA and CPAR Map (IBRD26085)  NEPAL COUNTRYASSISTANCE STRATEGY EXECUTIVESUMMARY 1. Today, Nepal stands at the crossroads between a brighter future that promises more sustained poverty reduction and the possibilityof the countrybecomingmired in a more protracted internal conflict. During the past few years, the insurgency has escalated sharply, involvingan open conflict with the army since November 2001. This, combined with external developments, has undermined the economy and weakened the country's fiscal position. Despite the many positive changes Nepal has seen since the advent of multi-party democracy in 1990 and the first wave of economic liberalization measures in the early-l99Os, the recent developments have highlighted the stark and worsening inequities in Nepal, not only in terms of incomes,but also of the fundamental ability of the Nepali citizen to participate in social and political decision-makingprocesses. The deepening crisis, however, has also created the space for the reform-minded political and technocraticleaders to begin a renewed drive to build an economic and social foundationfor sustainedpeace and povertyreduction. ii. Important reforms have emerged in several areas over the past two years. First, to prevent a possible financial sector crisis, a key initial step was taken by putting the two ailing commercial banks under external management teams. Second, facing up squarely to the fiscal pressures, His Majesty's Governmentof Nepal (HMGN) introduced a Medium Term ExpenditureFramework (MTEF) in FY02/03 to rationalize the development budget and instill the discipline of a hard budget constraint. Third, responding to the urgent need to improve public service delivery, HMGN has started to transfer key services to community management in primary education and primary health care. Fourth, to ensure implementationof priorityreforms, HMGN devised an Immediate Action Plan (IAP) in 2002, which was effectively used to hold relevant Ministries and Departments accountable for promised actions. Fifth, a highly visible anti-corruption drive has been started by the Commission for Investigation of Abuse of Authority (CIAA), thereby giving Nepali citizens a hope that the days of rampant corruption may be coming to an end. The recently adopted Poverty Reduction Strategy (PRS)-based on the Tenth Plan coherenceand clarity. (FY02/03-FYO6/07)-builds on these successes, and gives the reform process much greater strategic ... 111. Nepal's PRS breaks from the past, largely ineffectiveplans in a number of significantways. For the first time, it explicitly identifies social exclusion as one of the fundamental development challenges. It also recognizes HMGN'sconstrainedfiscal situation and weak implementationcapacity, and places the PRS in a realistic framework of implementationabilities, both fiscal and institutional. Thus, the MTEF gives it both a medium term fiscal fi-ameworkand annual budgetary translation of the strategy, while the IAP will be used as an annual implementationplan for high priority reform actions that would receive continual attention from the highest levels of HMGN. These two instruments and the track record of significant early progress give the PRS considerable credibility. With the aim of reducing poverty and improving critical public services,the PRS is built around four pillars: (i) broad-based economic growth; (ii) social sector development; (iii) social inclusion; and (iv) good governance. In implementing it, the PRS stressesdecentralization,rationalizationof central governmentfunctions and transparency. iv. Despite the successes and a palpable change in the energy with which the reform leaders are pushing the agenda at the center,the benefits of the reforms have not yet been felt widely at the grassroots levels. There is clearly a need to accelerate the reform actions embodied in the PRS, including in particular greater decentralization. This would be essential not only for rebuilding the people's confidence in the state, but also for making meaningful progress toward poverty reduction and achieving the MillenniumDevelopmentGoals (MDGs).  - 11 - .. V. Given the continuing political turmoil, the Bank no doubt faces a risky environment in which to operate in Nepal. The Bank, however, should not lose sight of the most important risk the country faces, and hence by extension the Bank also faces-Le., the risk of Nepal spiraling into a widespread armed conflict and a breakdown of state institutions. In comparison, many of the other risks are modest if not trivial. The current wave of reforms is a determined effort by the reform leaders to mitigate this fundamental risk. Unlike in typical reform episodes, the leadership for change has come more from a growing number of reform-minded technocrats and some enlightened political leaders who stand apart in an establishment that has provided largely passive support rather than explicit leadership. Because of this, the reform efforts may seem more tenuous and less spectacular. Nevertheless, the basic contents of the reform program enjoys strong support from the population at large and at least tacit support from mainstream political parties. This is not to minimize the risks that the reform process could be stifled by myopic political interests or the implementation capacity is curtailed by hostilities. Implementation of the Bank's strategywill be cognizant of these risks. vi. Through the lean years of slow reforms, the Bank worked consistently with reform-minded leaders and facilitated the beginnings of the current reform process. The firm linking of lending levels to actual reform implementation has challenged and inspired the reformers. And, an uncommonly strong partnership has developed between these leaders and the Bank, with a strongly shared vision for the reforms that Nepal needs. More importantly, the reformers have risen to the occasion and have begun implementing the far reaching program articulated in the PRS. Because of the fiscal pressures, accelerating its implementation will require increased external resource flows, particularly of a programmatic nature. The Bank's CAS for FY04-FY07 is designed to respond to this situation by increasing financial support to facilitate Nepal's own reform efforts. To align the Bank's assistance program with the PRS, the CAS will be fully outcomes-focused, continuing the outcomes-based approach developed by the Nepal Country Team over the last two years. vii. Given the risks of politics getting in the way of reforms, the Bank will continue to maintain sharply differentiated lending levels linked to progress on reform implementation. The base case envisions an average annual lending of about US$190 million (consistent with the current IDA resource allocation for Nepal), including programmatic supportto facilitate accelerated implementation of the core PRS priorities. If the reform process stalls (low case), the lending support will be curtailed sharply to a range of US$O-50 million. In the high case-which is associated with peace and accelerated reforms- lending could increase to US$200-250 million annually. With the prevailing uncertainties, however, there could be a need to revisit the strategy. As such, a CAS Progress Report (CAS PR) will be prepared in approximately eighteen to twenty-four months, or sooner should the situation warrant. viii. The Executive Directors may wish to discuss: 0 The appropriateness of the basic strategy of providing strong support to Nepal's PRS in the face of significantpolitical uncertainty; 0 The appropriateness of the outcomes-based approach outlined in the CAS; and 0 The choice of instruments to deliver the lendingprogram. ix. to predict which path the country will follow. While the on-going reforms offer the best hope for laying Inmany respects, Nepal is truly at a criticaljuncture in its development process, and it is difficult the foundation for sustained peace and development, the insurgency makes their implementation more difficult. Yet, one thing is clear. With strong support of the Bank as outlined in this CAS, the chances are much greater that the reform program will succeed, and hence, lead eventually to real improvements in the lives of Nepal's poor and most vulnerable.  NEPAL COUNTRY ASSISTANCE STRATEGY INTRODUCTION 1. The last Country Assistance Strategy (CAS) for Nepal-considered by the Board on December 13, 1998-identified poor governance as the fundamental constraint restricting Nepal's development.' Since then, while there have been improvements, governance-broadly defined to encompass public accountability, transparency and social inclusion-remains the country's central challenge. In part reflecting the structure of poor governance, over the last five years Nepal has gone through turbulent times. Both growth and poverty reduction have suffered from a number of factors, including: (i) successiveineffective Governmentsand a continuingunstable political environment;(ii) an escalation of the insurgency, interspersed with two failed attempts at peace talks (in 2001 and 2003); and (iii) harsh repercussionsfrom the global economic slowdownthat have severelyaffectedNepal. 2. As reported in the CAS Progress Report (CAS PR) of November 2002,' despite this instability and uncertainty-a perhaps because of it-ver the last two years, Nepal has begun implementing an impressive and far-reachingreform program. Notable progress has been made in financial sector reform, public expenditures management, changes in public service delivery modalities, the fight against corruption and the infrastructureregulatory environment. To give the reform process greater coherence, the country has recently formulateda Poverty Reduction Strategy (PRS).3 Nonetheless, the impact of the reforms have not been felt widely enoughto date and Nepal remains one of the world's poorest countries, with an annual per capita income of about US$230 and bleak social indicators. Nepal also needs to address fundamentalissues related to social exclusionand redress the widespreadperception that the state has been failing to deliver basic public services. While the on-going reforms offer the best hope for laying the foundation for sustained peace and development, the insurgency makes their implementation more difficult. 3. Thus, Nepal is at a critical juncture in its development process today. Nepal may tie turning toward a brighter future,but the risk of the country becoming mired in a more protracted internal conflict cannot be discounted. Despite this unpredictable environment, there are several good reasons for the Bank to formulate a new CAS at this time. Most fundamentally,a new CAS will allow the Bank to align its assistanceprogram closely to the current reform process embodied in the PRS, hence providing more effective support and encouragement to the reform efforts. Moreover, contrary to the political turmoil and uncertainties,in the last two years there has been much greater continuity and certainty in the reform process,backed by broad support from the general public. As such, there is a solid process of changethat Bank assistancecan and should support. This is not to minimize the risks the reform process faces,but all the more reason the Bank should have a clear strategyto deal with the various possibilities. 1 Report No. 18578-NEP,datedNovember 17, 1998. 2 Report No. 24170-NEP, datedNovember 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).  Nepal CountryAssistance Strategy Page 2 of 34 I. THE CAS CONTEXT A. Social Context 4. Despite improving economic performance during the 1990s in which per capita income growth increased to about 2.5%, Nepal remains extremely impoverished. Although the most `recent' poverty estimates are rather outdated4and comparability among different poverty estimates is questionable, it is possible to draw some broad conclusions regarding poverty trends over the last few decades. Specifically: The absolute number of poor in Nepal has increased since the mid-1980s; The distribution of income has become more unequal throughout the country; and Progress towards attaining the Millennium Development Goals (MDGs) has been slow. The country will continue to face many challenges towards achieving the MDGs in the coming decade (seeBox 1and Appendix I). Millennium Development Goal Nepal's Current Position Halve, between 1990and 2015, the As of 1995,it was estimatedthat about 40% of Nepal's population lived on less proportion of people whose income is less than US$l/day. There is little evidence that poverty has declined since the than US$l/day. 1980sand the absolute number of poor has llkely increased. Enroll all children in primary education There is evidence that the net enrolment rate of primary-aged children rose in by 2015. the 1990sreportedly to over 70% and the youth literacy rate increased to 63%. Make progress towards gender equity and There have been significant improvements in the relative access of girls to empowering women by eliminating school education during the 1990s(a ratio of girls to boys in primary/secondary gender disparities in primary/secondary education of 82%); however, the ratio of young literate females to males is still education by 2005 and all levels by 2015. 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 reductions in infant two-thirds between 1990 and 2015. mortality (from 100per 1,000live births to 66) and child mortality (from 145 per 1,000to 91); nevertheless, large regional variations persist. Reduce maternal mortality ratios by Maternal mortality remains hgh (estimated at 830 per 100,000live births in three-quarters between 1990 and 2015. 1995)with only about 12%ofbiAhs 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 situation; however, the spread of HIV/AIDs, incidence of evidence suggests that the HIV rate is rising rapidly-perhaps the early stages malaria and other major diseases of a concentrated epidemic-in several vulnerable groups, notably Nepalis worlung abroad and sex workers. Integrate the principles of sustainable There are issues-e.g., deletion of soil nutrients and arsenic contamination in development into countrypolicies and the Terai-that show environmental sustainability remains a problem. programs, and reverse the loss of However, other initiatives-in drinking water and forestry-indicate positive environmental resources. progress. A national sustainable development strategy is under preparation. Develop a global partnership for Nepal has an overall low level of telephone density and approximately two- development. thirds of telephones are in the Kathmandu valley. Note: SeeAppendix I for the MDGs and re ted indicators for Nepal. Sources: Staff estimates. I 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.  Nepal Country Assistance Strategy Page 3 of 34 5. With approximately 85% of the total population living in rural areas, poverty is largely a rural phenomenon in Nepal-a rural poverty incidence of 44% compared to about 23% in urban areas.' Of the country's ecological regions, poverty in the mountains, at about 55%, is significantly above the national average, as it is in the more remote mid- and far-westerndistricts (many of which are controlled by the insurgents)where poverty is as high as 70%. While there have been noticeable improvementsin human development indicators in recent years, they are still quite low and show significant urbadrural and geographical variations. There has been some progress in reducing gender disparities-e.g., life expectancy,literacy levels, and school completionrates-but, great advances are still required for Nepali woman to be consideredtruly empowered. 6. As important, there are significant ethnic and caste-based disparities in what is recognized as a largely pluralistic society with diverse ethnic, caste, linguistic and religious communities.6 Broad linkages have been identified between caste and poverty, and caste and human development levels, and there are some clear messages: (i) most of the Dalit population is disadvantaged;and (ii) there are striking caste and ethnicity-based disparities in education. A number of factors-including its limited natural resource endowment, land-locked and rugged terrain, and series of ineffective and unstable Governments-have contributed to Nepal's poverty problems. Adding to these, much of the economic growthhas been in non-agriculturalsectors,leaving behind the majority of Nepalis living in rural areas. B. Political Context 7. Nepal has seen extraordinary political instability in recent years-Le., there have been twelve changes in Prime Minister in the past eight years. Peace has also eluded Nepal for more than sevenyears while a violent insurgency has claimed over 8,000 lives and the remit of the state machinery shrunk largely to urban and semi-urban areas in many districts (see Box 2). An important breakthrough was made on January 29,2003 when His Majesty's Government of Nepal (HMGN) and the insurgent leaders agreed to a cease-fire. After three rounds of peace talks, however, the insurgents unilaterally called off the cease-fireon August 27,2003, While all sides stress the need for a peaceful resolution of the conflict, the path to peace is not obvious. 8. On the political front, the Parliament was dissolved on May 22, 2002, and Mi-. Sher Bahadur Deuba remained as caretaker Prime Minister for about six months. During this time, the terms of locally electedbodies-both at the village/municipalityand district levels-were allowed to expire in July 2002. With an escalation of insurgency-relatedviolence-in part a campaign to prevent elections-Mr. Deuba recommended deferment of elections for over a year. This led the King to dismiss the Government in September2002, and has resulted in two successiveinterim Governments. 9. The first interim administration-headed by Prime Minister Lokendra Bahadur Chand of the Rastriya Prajatantra Party (UP)-was appointed by the King on October 11, 2002 with a mandate, among other things, to restore peace, hold the suspended elections, fight corruption and improve service delivery. While public opinion was firmly behind the peace talks and supported the administration,the main political parties-most notably, the split Nepali Congress (NC) Party and the United Marxist Leninist Party (UML)-continually challenged the administration's legitimacy. On the basis of the 5 All poverty figures cited are based on the results of the 1995196Household Survey and can be compared to an overall poverty incidence estimated at 42% of the population. 6 Nepal has over 100 languages and dialects, and more than 60 recorded ethnic groups, some of which are further sub-divided into distinct 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.  Nepal CountryAssistanceStrategy Page 4 of 34 standoff that developed with the political parties Box 2: The Insurgency agitating for the restoration of Parliament and The insurgency-previously a low intensity and formation of an all-party Government, the mainly rural campaignto form a `people'srepublic'-has Chand administration resigned in late-May claimed more than 8,000 lives by officialaccounts and has 2003, and the King appointed Mr. Surya resulted in Nepal's longest and bloodiest conflict sincethe Bahadur Thapa-also of the RPP-as the new mid-1700s. It is clearly a political movement with a fm Prime Minister on June 4. political philosophy, but has gained strength because of certain social-economicconditions,includingin particular: 10. As head of the second interim 0 Horizontal inequality and social exclusion: administration, Prime Minister Thapa has been specifically, economic growth has largely benefited vested with full executive powers to assemble an Kathmandu valley residents, with the large impoverished and deprived rural population-for decades a target of all-party Government, but the five main political social exclusion-witnessing little social and economic parties have so far all declined to join, claiming progress;and that the current administration is no different 0 Failure of governance, including lack of delivery of from its predecessor. As such, the cabinet public services: specifically,weak institutionshave failed contains only six additional members, all from to meet the basic needs of the population and continue to the RPP. Mr. Thapa has outlined a ten-point be linked with corruption, political infighting and agenda that includes: (i) resolving the instability. insurgency problem and establishing lasting The insurgency has increasingly challenged the peace; (ii) creating an environment conducive to fragile economy-the costs have been estimated at 8-10% local and general elections; (iii) establishing the of GDP, including:(i)damage to infrastructure-e.g., over foundations of good governance and 1/3 of the 3,900 Village Development Committee (VDC) buildings have been destroyed; (ii) lost economic activity strengthening the administrative machinery; (iv) due to bandhs-i.e., strikes-that have been taking place effectively implementing anti-corruption with greater frequency and often lasting2-3 days; and (iii) measures; (v) accelerating economic reforms a generally low level of economic activity caused by and facilitating an enabling environment for decreased business confidence and low tourism. investment; and (vi) building consensus for Furthermore, there have been large direct impacts on the political, economic and social reforms. In this livelihoods of millions of primarily rural-based context, securing a lasting peace with the individuals, for which killing, extortion, confiscation, insurgents, reaching a political settlement with forced recruitment, and infrastructure destruction have the parties and building an environment created fear and resulted in migration, decreased conducive to holding elections all remain high agriculturalproduction,and a declinein living standards- it is estimated that approximately 300,000 people have on HMGN's agenda. Strongly related to this, migrated to the Kathmanduvalleyin recent years. HMGN's recent replacement of public servants with political appointments in local bodies (see footnote 11) can be viewed as a precursor to local elections. Nevertheless, the political situation remains tense and a speedy return to functioning democracy does not appear imminent. C. MacroeconomicPerformanceand Medium Term Prospects 11. Since the last CAS, the Nepali economy has fluctuated. After growing at a rate of 5% per year during the 1990s, real GDP fell in FYO1/02 primarily due to declines in manufacturing and tourism (see Table 1). A number of factors-including sluggish worldwide growth, the insurgency, market saturation, and inadequate quality control and standards-contributed to the decline, as did irregular rainfall that adversely affected agricultural production. More recently, there have been signs of a modest recovery underway, with GDP growing by 2.3%in FY02/03. Economic activity picked up noticeably after the January cease-fire with some recovery in tourism, transportation and other services, and certain manufactured exports-especiallygarments. Nevertheless, the economy remains weak. 12. As imports have also somewhat rebounded, the current account balance recorded a slight deficit (about 1% of GDP) in FY02/03. Remittances from Nepalese working abroad have grown tremendously  Nepal Country Assistance Strategy Page 5 of 34 (estimated at around USS855 million in FY02/03), with this item now larger than the value of merchandiseexports. Gross officialreservesremained high at about US$1.2 billion-about six % months of import-at end-FY02/03. The external debt serviceratio is low (about 7.5%) of exports of goods and services,because of the highly concessionalnature of external borrowing. Table 1: Selected Economic Indicators: FY99/00-FY05/06 Fiscal Year 99/00 00/01 01/02 02/031' 03/04'' 04/05'' 05/062 Real GDP (% change) 6.1 4.8 -0.5 2.3 3.5 4.6 5.4 Agricultural GDP 4.9 5.5 2.2 2.1 2.8 3.0 3.5 Non-agricultural GDP 6.8 4.3 -2.1 2.5 3.9 5.7 6.4 Manufacturing 7.2 3.8 -10.0 0.4 2.3 6.7 7.2 Other sectors 6.8 4.4 -0.6 2.9 4.2 5.5 6.4 Fiscal indicators (% of GDP) Total revenue 10.7 11.4 11.5 12.3 12.4 12.8 13.4 Total expenditure 15.7 17.6 17.2 16.3 18.7 18.5 18.2 Current expenditure 9.6 11.2 11.6 11.6 13.1 12.5 12.1 Capital expenditure and net lending 6.1 6.4 5.7 4.7 5.6 6.0 6.1 Overall deficit before grants 5.0 6.2 5.7 4.0 6.3 5.7 4.8 Overall deficit after grants 3.5 4.5 4.3 1.9 3.6 2.6 2.c Domestic financing (net) 0.9 2.7 2.9 1.2 1.7 1.3 0.6 Current Account Balance (% of GDP) 0.5 1.2 2.6 -0.9 -1.7 -1.8 -2.3 Gross official reserves (US$ millions, end of 1,385 1,020 1,048 1,177 1,237 1,292 1,347 period) In months of imports of goods & services 5.6 7.0 6.7 6.9 6.4 6.3 6.2 External debt/GDP (%)3' 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) 'IEstimate "Projected "Includes estimated private sector debt and short-term trade credits. "In % of exports of goods, services, and private transfers, includingdebt service to the IMF. 13. In recent years fiscal management has come under stress, as the worsening insurgency situation and fragile economy contributed to weak revenue growth and security-related spending increased. In FYO1/02,revenues were below the budget target (despite serious collection efforts, including imposition of special security surtaxes) and security spending was about 1% above the budgeted amount (although still well below the level of similar spending in other countries in the region). Anticipating further fiscal pressures, HMGN embarked on a bold fiscal consolidation exercise in FY02/03 that has been implementedwith a considerabledegree of success.' Despite low levels of development expenditures in FY02/03, pro-poor spending has been protected. Furthermore,with revenues increasing by 13%over the previous year, the deficit before grants declined to 4% of GDP in FY02/03 (compared to the 1990s average of 6%). Fiscal managementwill continueto be strengthenedduring FY03/04 and into the second month of the fiscal year, budget implementation is strong. In the past, the deficit has largely been financed by concessional foreign financing, however, in FYOO/Ol and FYO1/02 domestic financing rose slightly. With successfulimplementationof the reform program, in the future it is envisioned that foreign financingwill increase. 7 See paragraphs 21-23 for details on the implementation of the MTEF and fiscal adjustments.  Nepal CountryAssistance Strategy Page 6 of 34 14. Led by a recovery of manufacturing and exports, stronger agricultural performance and productivity, and higher investment, in the medium term growth in Nepal is expected to increase to the 5% rates experienced during the 1990s.* There are, however, several key pre-conditions for these to occur. First and foremost, renewed economic growth will require political stability and peace. Second, Nepal will need to implement a range of growth-enhancing structural reforms to stimulate a more pro- poor and inclusive growth process, including: (i) enhancing the development impact of public expenditures and improving tax administration; (ii) improving power, transport, banlung and telecommunications services; (iii) boosting Nepal's export competitiveness by addressing some behind the border constraints; (iv) addressing sector specific reforms such as rationalizing irrigation subsidies in agriculture and improving labor market flexibility for manufacturing and services; and (v) undertaking governance reforms that enhance the impact of the structural measures. 15. The macroeconomic framework recently agreed by HMGN with the Bank and International Monetary Fund (IMF), as well as assistance from both institutions to implement the reform efforts- through Poverty Reduction Support Credits (PRSCs) and a Poverty Reduction and Growth Facility (PRGF)-will support Nepal's attempts to achieve more sustainable growth. The key elements of the framework are consistent with the PRS and include: (i) a fiscal strategy to improve revenue mobilization, prioritize spending-towards social and infrastructure sectors to help reduce poverty-and contain domestic borrowing over the medium term; (ii) a monetary policy geared to supporting the peg to the Indian rupee; (iii) continuation of the financial sector reforms; (iv) public sector reforms including civil service and public enterprise; and (v) governance reforms to strengthen the fight against corruption and accelerate decentralization to local levels to improve accountability and service delivery. D. Progress Under the Last CAS and Lessons Learnedg CASImplementation 16. Because of the limited and slow progress in implementing the reform program, for much of the last Box 3: Governance and the Financial Sector Poor management of financial resources at Rastriya CAS period Nepal remained in a low case lending Banijya Bank (RBB) and Nepal Bank Limited scenario. Given the fungibility of aid resources, (NBL) has been a way through which powerful elite without substantial improvement in the use of public have abused public institutions. Poor management resources, more financial assistance from IDA would and oversight of the financial sector-in part, not have been a solution to Nepal's problems. HMGN occasioned by heavy-handed state involvement- clearly began recognizing poor governance-reflected has resulted in problems of growing non- most acutely in weak implementation of reforms, poor performing assets and capital adequacy, and an service delivery and corruption-as a central obstacle increased scope for systemic risk within the sector. to development. Growing recognition of the gravity of RBB and NBL-accounting for about 50% of total the financial sector conditions and their direct link to banking system assets-are estimated to have had losses (as of mid-1998) of as much as US$450 the system of poor governance, led the Bank to attach million-equivalent to about 46% of the budget or special importance to financial sector reform (see Box 8.6% of GDP. In late-2000, HMGN adopted a 3). As the first major step in reforming the financial strategy that commits to reducing the role of the sector, the introduction of external management teams public sector in the sector as a direct owner of in the two large ailing commercial banks became the financial institutions, while strengthening its role as `litmus test' for moving into a base case scenario. By a supervisor and regulator of banks and financial the time of the December 2002 CAS PR significant institutions (see paragraph 32). 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 11.  Nepal CountryAssistance Strategy Page 7of 34 progress had been achieved toward implementing the reform program, including in the financial sector, and hence the decisionwas made to move Nepal to the base case. 17. While in the low case (late-1998 to late-2002), the lending program focused primarily on infrastructure development, and four projects-in education, rural infrastructure,road maintenance and telecommunications-were approved for a total of US$94.6 million. Strong emphasis was placed on helping to build the agenda and needed consensus for reform. To a great extent, the introduction of a Medium Term Expenditure Framework (MTEF) and Immediate Action Plan (IAP-see paragraphs 21- 24) have been prompted by the Bank's Analytical and Advisory Activities (AAA). In addition to key formal reports (see Table 2), the Bank's follow up through technical assistance (TA) and intensive dialogue have made significant contributions to the foundations of many of the on-going and envisioned reforms. Internally, the Bank's Nepal team has also moved to an outcomes- based work programming approach to sharpen its focus on facilitatingreforms (see paragraph 49). Since the transition to the base case in December 2002, three additional projects (in the financial sector, power development and education) have been approvedfor a total of US$96.9million. Lessons Learned 18. Today, there is a realization in Nepal that the Bank is truly concerned with the well-being of the poor and that it is not possible to simply `negotiate'aid out of IDA. In getting to this point, a number of valuable lessons have been learned-both from our experiences in Nepal and world-wide, including through instruments such as The Global Poll (May 2003). The following have taken into account in developingthis new CAS: In an environmentof poor governance,closelylinking lendinglevels to progress in implementing reforms and achieving results on the ground-not just promises+an provide significant leverage. While such an approach by itself might not prompt reforms, when spontaneous reform initiatives emerge, it can provide an important and constructive discipline to the process, and can even strengthen the hands of reform leaders. In addition, this fosters peer pressure among senior officials to look at development more holistically, as they realize that sectoral hnds could be blocked if the overallprogress is not made toward larger country goals (Le., governance); A work program grounded in an outcomes framework encourages a more holistic and multi- sectoral approach for the Bank team. Outcomes need to be realistic and focus on those areas where the Bank plays a significantrole, with clear linkagesto the country's stated objectives; To be most effective, consistent dialogue and investment in a solid relationship with key counterparts are essential. In addition to building consensus for change/reform, such an investment also builds and encourages ownership of and buy in for reform programs. Proactive outreach helps build wider understandingof the developmentchallengesand opportunities;  Nepal CountryAssistance Strategy Page 8 of 34 0 It takes time for reform to catch on; hence, there is a need to simultaneously develop `low case appropriate'interventions-typically modest in size and often supporting community-basedprojects or small,sector-specificreform efforts; 0 The interplay of diverse political economy realities have an important impact on reform implementation. These need to be better understood for the Bank to be more effective in identifying and supportingemergingreform opportunities. When reforms do happen, they are often spontaneous and episodic, and often fall outside conventional frameworks that donors are accustomed to. Moreover, Government officials are not generally good at showcasingreform progress, nor are they practiced at communicating successes to the public. These are important aspects to stress and take into accountif the benefits of reforms are to be the best arbiter for deeperreforms in the future; 0 The linkages between peace and stability, and poverty reduction are strong-possibly forming a vicious circle. Development/povertyreduction can not be delayed or postponed until there is peace and stability, as many of the root causes of conflict-i.e., failure of governance, including lack of delivery of public services, and horizontal inequality and social exclusion-are often also the major challengesof reducing poverty; and 0 Donor coordination is essential, but not always easy. Ultimately, the Government must be encouraged to coordinate donor assistanceby setting out its own development strategy and priorities. Clearly, donors-including the Bank-need to respect Government efforts to `regulate' and direct foreign assistance. 11. NEPAL'SPOVERTYREDUCTIONSTRATEGY A. The Reform Process The Context: Nepal at the Edge of Chaos 19. Nepal is struggling to emerge from a period of intense turmoil and its future hangs in balance. The acutest form of this turmoil is the insurgency that escalated into a serious armed conflict involving the army in November 2001. In the backdrop, however, had been growing disappointment with the political and developmentprocesses that have failed to meet the aspirations of the people, which had been raised after the reinstatementof a multi-party democracy in 1990. With the heightened level of hostilities, the economy slowed and fiscal pressures built. When this crisis did not seem to prompt political leaders into serious corrective action, the frustration of many turned into a sense of alarm that the nation was heading for a catastrophe. From this deep sense of crisis, a new wave of reforms was born. It is being led by a growing number of reform-mindedtechnocratsand some enlightenedpolitical leaders. 20. An important beginning was made at the Nepal Development Forum (NDF) in March 2000, where HMGN announced a comprehensive reform program that focused on improving governance and reducingpoverty. As the severity of the financial problems of the two largest commercial banks became apparentin 2001, reformersbecame alarmedby the prospect of a financial sector crisis and began to use it as a focal point of the reform process. Then, with the fiscal situation deteriorating rapidly in 2002, HMGN started to use this as a driver for public expenditurereform. At the same time, to respond to the serious challenges caused by the insurgency, reformers began to design radical ways to improve public service delivery even under severe fiscal constraints. By the beginning of FY02/03, these somewhat disparate initiatives took shape as a more cogent strategy, embodied in the IAP and the financial sector reform program that would place the two ailing banks under external management as the first step. An integral part of the IAP has been the introduction of the MTEF to substantially rationalize the development budget. In parallel, after its legal frameworkwas strengthened in 2002, the Commissionfor  Nepal Country Assistance Strategy Page 9 of 34 Investigation of Abuse of Authority (CIAA) started to take some highly visible actions against senior civil servants and politicians on corruption charges." This has been met with enthusiastic support from the general public. As explained below, the PRS builds on these reform successes and expands the scope of reforms, with a more integrated approach within a medium term perspective. TheImmediate Action Plan 21. areas-prioritizing In June 2002, HMGN adopted the IAP that was designed to expedite reforms in three critical public expenditures, improving service delivery, and strengthening anti-conuption and accountability measures. Recognizing their weak implementation capacity, HMGN took pains to keep the plan selective. Main IAP actions included: (i) tting a realistic budget ceiling and eliminating a number of low priority projects; (ii) assuring funding for high priority projects, but tying funds 4: The 2003 IAP release to performance; (iii) improving service The 2003 IAPBox contains 24 reform actions directly delivery modalities by initiating the transfer of linked to the four PRS pillars. As such, it is more ambitious than its predecessor and covers reforms in public primary schools and primary health facilities about a dozen areas. In addition to areas previously to community management; (iv) public posting of covered-Le., public expenditure management, civil budget information and tracking of expenditures; (v) service reform and anti-corruption-the 2003 IAP implementing public procurement and financial covers actions in agriculture, private sector accountability reforms; and (vi) developing and development, public enterprise rationalization, starting to implement an anti-corruption strategy. infrastructure development, targeted programs and With all the Ministries and Departments relevant to decentralization. The Reform and Development the IAP galvanized into action, nearly all of the 19 Groupa joint HMGN/donortask force-has worked actions were completed by the end of FY02/03. diligently on developing the 2003 IAP and has Inspired by this achievement, HMGN decided to identified 'lead Ministries' and 'lead donor agencies' responsible for carrying out detailed assessments of turn the IAP into an annual process to define and each of the actions. These assessments include an monitor a set of critical actions necessary for the explanation of the impacthmportanceof the action, a successful implementation of the PRS. After being preliminary cost estimate and timeframe for endorsed by the cabinet, the 2003 IAP was implementation, and an outline of the proposed announced in July 2003 and the measures are arrangements to review implementation progress. expected to be implemented by the first quarter of Past experiencehas shown that sectoral ownership at 2004 (see Box 4 and Appendix 111). In this regard, the highest levels has contributed to achievements reform leaders are keenly aware that these early above and beyond the original targets established in successes have not translated into significant the IAP (seeAppendix111). impacts on the lives of average citizens at the grassroots levels, especially in rural areas. To make the reform process meaningful and sustainable, there is an urgency to accelerate the implementation, especially of the reforms that bring quick impact to the community level. The 2003 IAP is designed with this objective in mind. Lengthy delays in local elections, however, present an obstacle, as they have dampened the momentum for decentralization. In many Districts, locally elected District Development Committee (DDC) and Village Development Committee (VDC) chairs (who had executive power) tended to be strong promoters of change at the grassroots level." 10 In FY02l03, the CIAA filed 154 cases in various courts. Of these, the Special Court for corruption has passed judgment on 55 cases, of 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 experimentingwith running local bodies through civil servants,HMGN concluded that local bodies were better governed by political leaders;hence, the appointments.  Nepal CountryAssistance Strategy Page IO of 34 Medium TermExpenditure Framework and Fiscal Adjustments 22. Based on the recommendationsof the 2000 Public Expenditure Review (PER)I2and the work of the Public Expenditure Review Commission (PERC) in 2001, and prompted by the worsening fiscal situation, HMGN decided to introduce an MTEF starting in FY02/03. Overcoming the entrenched tendency to seek increased foreign aid to cope with fiscal stress, the reform-minded National Planning Commission (NPC) and Ministry of Finance (MOF) used the fiscal pressures to motivate serious adjustments in budget allocations. This led to elimination of 160 low priority projects (out of 625 projects) in the FY02/03 budget. Further cuts in projects would have been desirable, but were politically impossible. Instead, HMGN chose to be pragmatic and opted for an unorthodox solution in which remaining projects were classified into three priorities-P1, P2, and P3. While funding for the top priority (Pl) projects was assured,funding for lower priority (P2 and P3) projects would be contingenton actual availability of funds after all P1 projects are adequately funded.13 While seemingly vulnerable to political pressures, NPC and MOF nevertheless managed to use this system effectively to concentrate fundingto the P1 projects and within a year establisheda clear understandingamong line ministries of the seriousnessof this prioritizationexercise. 23. At the same time revenue growth was slowing during the last two fiscal years, security spending was increasing sharply as the level and scale of the insurgencyescalated. From a very modest level of Rs. 7 billion (1.9% of GDP) in FYOO/O1 to support the police and a small standing army, security spending rose to about Rs. 15 billion in FY02/03. While in principle this increase was detrimental to the development efforts, NPCMOF turned it to its advantage. As the increase in security spending was an absolute imperative,the resulting severe fiscal pressure made it easier to impose a hard budget constraint on line ministries and politicians who had been accustomedto much softerbudget constraintsin the past. The majority of the cuts hit low priority, politically motivated projects. Total development spending declined from Rs. 37 billion in FYOO/Ol to Rs. 27 billion in FY02/03. The developmentalimpact of this reduction appears to have been relatively modest, as most of the dropped and P3 projects had been ill conceived to begin with and receiving only modest annual funding without any realistic hope of completionin the foreseeablefuture. 24. In the meantime, through reforms to decentralize service delivery modalities-not only in primary educationand health care,but also in agricultural services-the quality of recurrent spending has started to improve. In FY03/04, further measures are anticipated in this regard, including: (i) the operationalization of an autonomous Roads Board that is expected to bring more rationality and transparency to the allocation of road maintenance budget; (ii) incentive grants to schools that improve enrolment of disadvantagedgroups; (iii) implementationof the essential health care package approach to focus the limited resources on priority health issues; and (iv) greater participation of the private sector in infrastructure services--e.g., establishment of the Power Development Fund (PDF) to promote private investment, introduction of a rural telecommunications operator and opening the licensing system for private cellular operators. In effect,HMGN has been able to turn the fiscal and service quality crises into an opportunity to establish a leaner and more efficient public spending program. As Nepal begins to implement its PRS in full scale and increase expendituresto support it, far greater impact from additional spendingcan be expectedthan in the past. 12 Nepal: Public Expenditure Review, Report No. 20211-NEP,April 11,2000. 13 To deal with unexpected revenue shortfalls, the budget should include some lower priority projects. The FYO1/02budget, however, contained more projects than the most optimistic revenue projection could fund.  Nepal Country Assistance Strategy Page 11of 34 B. The PovertyReductionStrategy Background 25. Nepal's PRS is based on the reform successes and limitations it has seen over the last two years, and gives the process a broader, and longer-term vision and strategic coherence. Early on, HMGN decided that the Tenth Plan (FY02/03-FYO6/07) would form the basis for its PRS. Many of the past plans, however, have suffered from a number of weaknesses, including in general an overly optimistic fiscal framework and limited focus on implementation, monitoring and evaluation. Therefore, while relying on the planning framework that was familiar to HMGN, the NPC managed to build the recent reform experience (in particular IAP and MTEF) into the PRS and make it a far more credible strategy than any recent five-year plans. 26. The PRS identifies reducing the overall poverty ratio from about 40% to 30% by the end of the Tenth Plan (FY06/07) as its key target. Other targets include: (i) raising the above 15 literacy rate from 49% to 63%; (ii) reducing the infant mortality rate from 64 to 45 per 1,000 live births; (iii) raising life expectancy from 62 to 65 years; and (iv) increasing access to drinking water to 85% of the population (from 72%), access to electricity to 55% (from 40%), and providing telephone facilities to every VDC. To meet these objectives, the PRS is formulatedaround four key pillars: 0 Achieving sustained high and broad-based economic growth, focusing particularly on the rural economy; 0 Accelerating human development through a renewed emphasis on effective delivery of basic social services and economic infrastructure; 0 Ensuring social and economic inclusion of the poor, marginalized groups and less developed regions; and 0 Vigorously pursuing good governance both as a means of delivering better development results, and ensuring social and economicjustice. 27. In implementing these pillars, the strategy stresses four cross-cutting themes: (i) re-defining the role of the State and limiting public interventions; (ii) promoting private sector development and enlisting the involvement of the private sector, Non-Governmental Organizations (NGOs), International Non- Governmental Organizations (INGOs) and Community Based Organizations (CBOs); (iii) supporting greater social diversity in the structure of governance at all levels, and more socially and geographically inclusive access to social and economic services; and (iv) accelerating the decentralization process, including communityparticipation in and management of activities at the local levels. 28. The PRS recognizes that the four pillars are closely inter-related and address different aspects of the same problem. Nevertheless, each pillar is described separately both in the PRS and below. Furthermore, as a foundation for broad-based economic growth, the PRS recognizes the need for an appropriate enabling environment and macroeconomic stability. Thus, the PRS incorporates a sustainable macroeconomic framework, whose objectives include: (i) maintaining fiscal discipline; (ii) ensuring efficient use of public resources; and (iii) sustaining monetary and external stability. This is complementedby a structural reform agenda that aspires to make the public sector more diverse, efficient and effective, remove constraints to private sector competitiveness and improve the conditions of the poor. In this regard, key reforms are envisioned in: (i) public finance, including public expenditure management-i.e., implementation of the MTEF; (ii) financial sector reform; (iii) improving the competitiveness of private sector, including trade and labor market reform; (iv) governance, including civil service reform and decentralization; and (v) promoting private sector involvement in infrastructure.  Neual CountwAssistance Stratem Paae 12 of 34 Broad-Based Economic Growth 29. The PRS argues that higher growth will be achieved through greater productivity in agriculture and non-agriculture, along with recovery in manufacturing, tourism and exports. The agricultural growth strategy-the Agricultural Perspective Plan (APP)-aims to modernize, diversify and commercialize crop and livestock production by expanding the use of technology and increasing the access of farmers to modem agricultural inputs and credit. This strategy is closely linked to ground water development (Le,, irrigation strategy), increasing rural infrastructure (i.e., rural electrification and rural roads) and sustainable development of the forestry sector. 30. In the non-agriculture sector- for which manufacturing, trade (see Box Box 5: Improving Nepal's Trade and Competitiveness 5), tourism, transport, construction, and The trade to GDP ratio in Nepal is about 50%. With financial and social services are regard to exports, Nepal is dependent on a relatively small explicitly recognized as key sub- number of products-ready-made garments and carpets account sectors-the emphasis is on reducing for nearly 60% of exports-with exports to North America, the role of the State in economic Europe and India accounting for 95% of the total. Despite this activities and creating an environment narrow basis, trade was a key factor behind the acceleration of Nepal'seconomic growth in the 1990s. more conducive to private sector Along with Sri Lanka, Nepal has the most liberalized investment. The strategy includes: (i) trade policy in South Asia. However, there are significant removing the impediments to private constraints-including delays in customs and transshipment, an sector development; (ii) accelerating extremely rigid formal labor market, infrastructure, and privatization of state owned enterprises ineffective and unpredictable public sector policies and (SOEs)I4; (iii) streamlining regulatory institutions-that constrain the country's trade prospects. A processes and making them more recentlycompletedstudy-The Nepal Trade and Competitiveness transparent; (iv) amending labor laws to Study led by the Bank under the auspices of the Integrated make them more flexible; and (v) Framework(IF)-provides recommendationson key issues, such introducing important private-sector as Nepal's accession to the World Trade Organization (WTO), improving competitiveness and productivity, and facilitating friendly legislation and judicial reform. trade. Nepal faces significant challenges for realizing its export In parallel, reforms will be implemented potential in the medium term, including the forthcomingphasing in corporate and financial governance. out of the MFA, the accessionof China into the WTO and amore restrictivetrade treaty with India. As improving competitiveness 31. The PRS places importance on is an important component of the growth agenda, the Bank will infrastructure development in continue to work closely with Nepal's other development facilitating private sector development, partners supportingfollowup of the key IF recommendations. and hence gives priority to the strategic road network, maintenance of major roads and highways, and expansion of infrastructure in electricity and communications. The intention is for the private sector to play a more prominent role in these sectors, as well as to clarify the roles and responsibilities of private and public operators. Examples of reforms initiated andor envisioned in the near future include: (i) in roads, improving road maintenance through establishment of an autonomous Road Fund Board and transferring to DDCs the responsibility for development and maintenance of rural roads; (ii) in electricity, internal unbundling of the Nepal Electricity Authority (NEA), establishment of a PDF and creation of an independent regulatory agency; and (iii) in information and communications, conversion of the Nepal Telecommunications Corporation (NTC) into a public company under the Company Act, opening up general and rural telecommunication services to the private sector and establishment of a legal framework creating functional autonomy of the postal service. Infrastructure development is also critical for agricultural growth and productivity 14 While budgetary transfers to SOEs averaged 1.8% of GDP over the last three years, total contingent liabilities are unknown. To estimate privatization costs, HMGN has stepped up carrying out audits in public enterprisesand Bank sectorwork in this area is plannedfor FY05 (see Table4).  Nepal Country Assistance Strategy Page 13 of 34 improvements, and as such, the strategy emphasizes the infrastructure developments needed to meet these objectives. 32. Finally, it is recognized that a strong financial system is of critical importance for private sector development. In this respect, the PRS envisions continuing implementation of Financial Sector Strategy (FSS), which includes among other things: (i) restructuring and privatizing the two large ailing state banks; (ii) strengthening the monitoring and regulatory capacity of the Central Bank; and (iii) strengtheningthe legislative and institutional frameworkfor the sector. Social Sector Development 33. The PRS outlines the importance of improving service delivery through a gradual process of decentralization and greater empowerment of local communities in the management of social services. In education, guided by the goal of `education for all,' the strategy aims at improving the access to and quality of primary education. In doing so, a key objective is to expand literacy programs, with special emphasis on improving educational attainment and thus, the livelihood opportunities of historically excluded groups, especially girls, Dalits and disadvantaged ethnic groups. At higher levels-i.e., secondary, vocational/technical and tertiary-the objectives are similar, with emphasis on producing manpower with higher skill levels. To achieve this, the strategy is to decentralize management of schools to local school management committees (SMCs) at the lower levels and to the governing body of the individual institutions at the tertiary level, This process at the primary level-a fundamental shift from the currently centrally-managed system-has begun over the past year with over 250 schools transferred by end-September 2003 and an additional 500 applications pending approval. In addition, the strategy envisions implementing a program of targeted scholarshipprograms for girls and children from Dalit and disadvantaged ethnic minority families. 34. In health, the objective is to increase and extend essential health care services to all, with special emphasis on poor populations living in rural areas. To this end, the sector strategy focuses on implementing an essential health care package that is based on preventative care, maternal and child health, and family planning. Improvements in service delivery are also expected to occur through a process of devolving health facilities-starting with sub-health posts-to local communities and working increasingly with the private sector and NGOs. Related to this, the PRS elaborates on the importance of access to safe water for health outcomes and aims to increase access in rural areas. Key actions focus on rehabilitation and maintenance of existing projects, and developing new projects using the demand-driven user group participation and empowerment approaches supported by the Rural Water Supply and Sanitation Fund Development Board (Le., `Fund Board'). In urban areas, the focus will be on improving delivery of utility services, and water supply and sanitation management in some major towns is to be contracted out to the private sector over the next few years. Social Inclusion and TargetedPrograms 35. At the core of this pillar is a specific commitment that in the implementation of all PRS pillars, efforts to reduce gender and ethnidcaste-related disparities will be mainstreamed, and in new programs emphasis will be placed on ensuring equity of access for all, with special attention to the most vulnerable. In addition, the PRS proposes targeted programs for women and the most vulnerable poor ethnic minorities living in remote areas. The PRS reviews the weaknesses of past efforts and discusses using new mechanisms (e.g., the Poverty Alleviation Fund-PAF) and analytical tools (e.g., poverty mapping data) to improve effectiveness. The PRS also stresses the need for `quick results' in order to gain the confidence of those who have thus far been left behind by development efforts.  Nepal CountryAssistance Strategy Page 14of 34 36. The PRS lists a number of areas-including agriculture, forestry, wage employment and social sectors-where special efforts will be made to mainstream and empower women, Dalits and the disadvantaged through a variety of means, including targeted programs. Other reforms include: (i) revising existing laws to eliminate legal discriminationagainst women; and (ii) implementing affirmative action programs to increase the social diversity of public service. The approach to mainstreaming deprived communities and other vulnerable groups will be similar, in that emphasis will be placed on ensuring social inclusion in all programs. 37. Recognizing the limited effectivenessof targeted programs in the past, the PRS has adopted some new approaches, including, among others: (i) merging programs similar in nature; (ii) establishing PAF as an umbrella organization for targeted programs; and (iii) adopting a population and poverty-based resource allocation formula for fund transfer to the districts. To achieve its goals the PRS proposes to implement an integrated infrastructure development program (drinking water, small irrigation, schools, health posts and trails) in remote areas through local government, CBOs and NGOs. 38. In parallel, HMGN has shown serious commitment to addressing the inclusion agenda at the political level. In the context of the last round of peace talks, while adhering to constitutional monarchy and multi-party democracy, HMGN also proposed far-reaching reforms to the parliamentary system. The proposals included, among other things: (i) proportional representation in Parliament (as opposed to the `first-past-the-post' system copied from the Westminster model); (ii) reforms to ensure wider representation in the Upper House of Parliament; (iii) strengthening of the prime ministerial system (with a provision to allow non-elected technocrats to be included in the cabinet); (iv) constitutional reservations for under-served and under-represented groups; (v) consolidation of local government structures, and wider powers and responsibilities to the local level; and (vi) a constitutional provision for referenda on issues of national significance. Good Governance 39. The PRS recognizes that improving governance is essential if the reforms are to stimulate pro- poor growth, improve service delivery and lay the foundation for lasting peace. HMGN's strategy to improve governance covers: (i) civil service; (ii) financial management and accountability; and (iii) decentralization. While HMGN has made some`progress in improving human resource management practices over the past few years-most notably through the creation of a computerized personnel information system-the PRS recognizes that additionalprogress is needed to make the civil service more efficient, accountable and transparent. Future actions include: (i) reforming public employment through introduction of merit-based recruitment and evaluation systems and a long-term pay policy, as well as right-sizing, improving the capacity and skills mix, and introducing an affirmative action program; (ii) improving financial management and accountability through among other thmgs, implementing the recommendations of the recent Country Financial Accountability Assessment; and (iii) implementing the anti-corruption strategy, in part through the enactment of an Anti-Money Laundering Act" and strengthening key institutions charged with fighting corruption, including the National Vigilance Center and the CIAA. 15 Related to this, last year HMGN expressed interest in receiving assistance to begin the process of establishing a regime to protect the financial sector from money laundering and the financing of terrorism (AML/CFT). If legislation is enacted as envisioned, a number of steps-including establishing an action plan for issuing regulations and guidelines, and creating the necessary institutional structures-will be required to implement and enforce the new law. The Bank stands ready to assist in these efforts.  Nepal Country Assistance Strategy Page 15 of 34 C. Assessment of the PRS 40. The Tenth Plan/PRS has been developed in the context of the current Box 6: The PRS Consultation Process political turmoil in Nepal in a relatively The Tenth Plan/PRS adopted a participatory and relatively `bottom up' approach. An extensive consultation process participatory manner (see Box 6). Although it was initiated at various levels to discuss and solicitfeedback stands on the tradition of the periodic plan on the ideas and recommendations presented in various process, the PRS has been able to break from drafts. Consultations were initiated in August 2000 with the historical baggage of the established numerous public meetings held-two exclusively with process in a number of important ways. While women's groups-in eastern, central and western Nepal the implementation strategy of the PRS is not bringing together representativesfrom all 75 DDCs and all as sharply explained as one might like, the facets of civil society (Le., socially excluded, minorities, PRS relies on several strategic and cross- academics,private sector,NGOs/CBOs).Additionalregional cutting instruments to achieve its basic consultations were held in June 2001 to discuss the draft Tenth Plan Approach Paper, as well as linkages between objectives, including: (i) decentralization; (ii) districtplans and the nationalplan. The ApproachPaper was re-defining the role of the State and then finalized and discussed in the National Development reinforcing market functions; (iii) changing Committee (NDC)-composed of all Ministers, Secretaries, public service delivery modalities; (iv) and representatives of all political parties, private sector, strengthening accountability mechanisms; (v) academia, ethnic minorities, labor unions, women, NGOs maintaining macro/financial discipline and and CBOs-in January 2002. These efforts were improving public expenditure management; complementedby consultationsorganized fkom time to time (vi) targeted programs; and (vii) increasing by various agencies responsible for developing key sectoral investment in infrastructure and agriculture. programs, thematic chapters and background papers. Throughout this process, broad consensus and wide support 41. Beyond the more thoughtful structure have been developed for the PRSheforms. However, the conflict likely constrained the consultationprocess in some of the poverty-focused strategy, there are parts of the country and HMGN intends to address this once several things that give the Tenth Plan/PRS it is feasible. With support from the development partners considerable credibility, including: HMGN is developing a comprehensive participatory implementation, monitoring and evaluation strategy. The exercisewill be completedby end-2003,with civil societyto 0 Acknowledging the difficulty of getting away from the tradition of an `all play a prominentrole in monitoringefforts. encompassing plan' document, NPC condensed the voluminous Tenth Plan in the traditional mold into a lean summary-Le., the PRS. PRS. This shows HMGN's ability to be selective and strategic, indicating the seriousness attached to the 0 The PRS is backed by the MTEF, giving budget prioritization a serious framework. Also, the performance-based cash release system for the high priority projects is forcing a greater focus on implementation performance. 0 Through the IAP, HMGN has succeeded in being selective in reform actions and building an internal consensus on the absolute necessity for implementing the relatively few commitments made implementation of a small set of key reforms to support the PRS on a priority basis.I6 By recognizing under the IAP. HMGN now intends to use the annual IAP process as the instrument to ensure its own implementation capacity limitations and by devising a practical instrument to manage this problem, HMGN has shown a real seriousness about implementing the PRS. 0 The reformers are far more serious about poverty reduction, with particular focus on inclusion. One thing the insurgency has done is to force the Kathmandu-based power elite to think about Nepal as a nation state that will survive only if glaring disparities in living standards, and access to political 16 In a sense,IAP is the equivalentof the MTEF with regard to `reformimplementationresources.  Nepal CountryAssistance Strategy Page 16 of 34 and economic powers are rectified. This seriousness is reflected in a frank admission in the PRS about past failures and exclusionary consequences of poor public policies and commitment to addressingthem; and 0 The people are demandingthe kind of changesthat the PRS envisions,thereby giving the PRS the political impetus,legitimacyand sustainability. 42. Thus, the PRS, combined with the MTEF and IAP, form a sound basis on which to build the Bank's CAS.17 A Joint Staff Assessment (JSA) of the PRS was carried out by staff of the Bank and the IMF in July 2003.18 In addition to highlighting the strengths of the PRSP-many of which are listed above-the JSA suggests a number of shortcomings and challenges on which HMGN will have to focus on in the comingyear, includingthe need to: 0 Identifythe sources of growth, along with the key linkages to poverty reduction; Address gaps in costing and prioritization,and link these to the annualbudget and MTEF; 0 Implement a coherent monitoringand evaluation strategy,including building capacity for poverty monitoringwithin a clear institutionalframework;and 0 Further elaborate pro-poor rural strategies,especially to ensure social inclusion through changes in the way in which public servicesare deliveredin all sectors. 111. THE COUNTRY ASSISTANCE STRATEGY A. The Context 43. The Bank finds itself in a particularly strongpartnershipwith HMGN. More specifically: 0 While many aid agencies maintained high levels of aid to Nepal in recent years, the Bank took a firm position on governance and sharply cut back new lending during FY99-FY02. Highlighting poor governance as the centralobstacleto development,the Bank's stance stronglyresonatedwith the reform-mindedin Nepal. It has also convinced HMGN that the Bank is not driven by any `lending pressure' and that it is truly concerned with poverty reduction. The Bank can, therefore, engage in policy dialogue from a position of considerablecredibility; 0 The Bank has been closely supporting several key reform measures taken over the last few years, including the MTEF, the IAP, financial sector and transfer of public schools to community management. This has establishedunusually strong collaborationbetween the reform leaders and the Bank. In many areas, the Bank is relied on as a trusted advisor to the reformers, giving the Bank an importantrole as a `facilitatorof change'; and 0 The Bank is the only donor with significant headroom for increasing lending levels just when HMGN is in serious need of additional resources, especially programmatic support. This gives the Bank not only strong influence, but also a heavy responsibility as the fiscal ability to implement the PRS may depend to a large extent on what the Bank decidesto do. 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. 18 The complete PRS policy matrix is contained in Annex B11. Ths 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.  Nepal CountryAssistance Strategy Page 17of 34 44. Furthermore, in each of the PRS pillar areas, the Bank has already undertaken considerable background work, and as such, has a strong base to build on. In broad-based economic growth, the Bank's assistance over the last few years has focused heavily on the quality of public expenditures, the soundness of the financial system and the investment climate (see Box 7). The Bank has also supported reforms and investments in key infrastructure sectors, like the main road network, inland container terminals and customs facilities, rural roads, power generation, and telecommunications.'9 In agriculture, the Bank has supported transfer of small irrigation schemes to farmer management, and improvement in research and extension services. 45. In human development,the Bank has focused on improving the quality of education Box 7: The Business Environment in Nepal and health care, through a HMGN-led, sector- An investmentclimate survey-The Business Environment wide approach. Supported by the analytical and Manufacturing Performance in Nepal-was finalized in FYO1. Based on a survey of private manufacturing work completed in FYOl (i.e., Priorities and enterprises, the report's key findings are that poor Strategy in Education Sector Reform) there implementation of reforms, bureaucratic burdens and has been considerable progress in basic and continued politicaVpolicy uncertainties are the greatest primary education, with a number of donors obstacles to doing business in Nepal. More specifically, participating in a basket funding approach to a although policies are often perceived as well-designed, common program. The Bank has also played they are often changed and implemented so inconsistently a pivotal role in supporting the transfer of that they contributeto an unpredictableand risky business public schools to community management. In environment. In addition, firms suffer considerably from health, the Bank is actively supporting an excessive bureaucratic red tape, long delays in provision important shift to a sector-wide approach, as of public services and having to deal with corrupt public officials. These problems are often facilitated by lack of well as the devolution of sub-health posts to clarity in laws and regulations, and unpredictability and local communities. Furthermore, the Bank has inconsistenciesin policies. The implementationof the tax been instrumental in expanding demand- regime, import regime and labor laws are specific areas driven, community-based rural water and that significantly affect fms and need to be urgently sanitation schemes. addressed. Private sector development-including establishg a supportive business environment-will be 46. In the area of inclusion, aided by a an important theme in the Bank's work under the broad- policy note-Towards a Sustainable based economicgrowthpillar. Approach for Poverty Reduction and d&entralization-the Bank has led the dialogue on the PAF and encouraged HMGN to use this as the main instrument to reach out to marginalized groups that tend to be overlooked by existing institutions. In specific community-based projects-e.g., Rural Water and Sanitation-the Bank has begun to address social exclusion issues more vigorously. In promoting universal primary education, the Bank has also been engaging HMGN to design ways to improve access by disadvantaged groups. 47. In governance, the Bank has taken a very clear and strong stance since the last CAS. The reforms in public expenditure management and banking are as much about governance as efficiency. Decentralization has also been a key focus area, both through specific projects that have tried to give local governments greater roles--e.g., Rural Infrastructure LL-and through analytical work-focusing especially on the fiscal decentralization framework. The Bank, in close coordination with committed HMGN teams, has conducted a Country Procurement Assessment Review (CPAR, FYO1) and County Financial Accountability Assessment (CFAA, FY02), and in each case is following up with Institutional Development Fund (IDF) grants to strengthen relevant institutions and implement main policy 19 Formal reports include The Public Expenditure Review (FYOO), Power Sector Development Strategy (FYOl), The Business Environment and Manufacturing Performance (FYO1)) The Financial Sector Study (FY03),and The Trade and Competitiveness Study (FY03).  Nepal Country Assistance Strategy Page 18 of 34 recommendations (see Appendix V). Finally, anti-corruption actions have been a continual theme in the Bank'spolicy dialogue. B. The Bank's Strategyfor FY04-FY07 The Strategy: PRS-Based and Outcomes-Focused 48. The Bank's strategywill build on the achievementsunder the 1998 CAS-which in short were to facilitate the beginnings of determined reform efforts-and support the Nepali-led reform process in a significantspan and depth. Thus, in operationalterms, it may seem to be simply supportingkey elements under each of the PRS pillars. It is, however, backed by a successful process of supporting the reform dynamics that have been gaining strength. This strategy was presaged in the CAS PR which articulated continuation of focus on improving governance-by bringing resources to grassroots levels and improving developmenteffectiveness-but with increased emphasis on growth and inclusion. The seven broad strategic instruments associated with the PRS (see paragraph 40) are equally important in the approach the Bank has emphasized. Furthermore,the spirit of focus on selective outcomes embodied in the IAP is consistent with the outcomes-based approach that has been pursued in the Bank's work program in Nepal for the last two years. 49. While it is easy to agree that the focus should be on development outcomes, it is not so easy to define the Bank's accountabilityfor such outcomes, for in the end the Bank's role is only to facilitateor support the changes in a country. Thus, there is a danger that an attempt to hold staff `accountable'for outcomes will lead the Bank to select only outcomes that are nearly certain. Clearly, failing to support riskier but more important outcomes would be a mistake. To resolve this tension, a structure has been developedover the last two years and the same approachis envisionedfor the future. Specifically, 0 An `outcome'is a significantchangethat would be highly desirable and possible within the four- year CAS horizon. For the immediate year ahead, a specific `milestone'-Le., key step toward achieving the four-yearoutcome-is defined; 0 Each outcome is expectedto have less than 100%probability of happening, even with best efforts on the part of the Bank2' The matrix of outcomes is seen as a `portfolio' in its entirety-i.e., consisting of some high- probability,but relatively low-impactoutcomes and some low-probability,but high-impact outcomes. To avoid extremes, the portfolio of outcomes is constructed with an expected overall success rate of around 65-70%;21 The matrix and annual milestones are updated each year, with some outcomes replaced-ither through achievement or a change in strategicpriorities-and new milestones defined; Rather than holding staff accountablefor achievementof specific outcomes, the Country Team is collectivelyheld accountablefor the overall outcome of the portfolio;22and 20 In practice, the probabilities of 20, 40, 60 or 80% are assigned, recognizing the relatively crude nature of the probability assessments. 21 This does not imply that for outcomes that are not fully achieved, there will be no progress. In many cases, it is likely that some progress toward the ultimate outcome will have been made. 22 Unless an entirely unforeseen event changes the country setting profoundly, a significant shortfall in reaching the expected rate of achievement would mean either: (i) the initial assessment or strategy was unrealistic; or (ii) the Bank's efforts were inadequate.  Nepal Country Assistance Strategy Page 19 of 34 The same approach is applied to a set of annual milestones as well, so that annual performance can be monitored against some expected overall achievementrate. 50. Based on this framework for work programming, this CAS has identified 15 PRS areas-out of the 34 PRS areas-that are central to poverty reduction and are consistent with the Bank's relative strengths vis-a-vis Nepal's other developmentpartners. They spell out the broad `developmentresults' or outcomes that the CAS will focus on. While the importance of these results are obvious, the CAS timefi-ame is too short to set direct and measureable targets for them. Therefore, these 15 higher level outcomes are translated into 26 intermediate outcomes--corresponding to the base case scenario described in paragraph 64-that are specific and meaningful for the FY04-FY07 period. In a high case scenaric-with acceleration of reforms-the matrix would likely be updated to include more outcomes. These outcomes were selected based on four key criteria: In each priority area, the outcome is representative of the broader change envisioned by the PRS. Thus, it is not the only change expected. If this particular change is happening, many associated changes are likely happening, thereby contributingto the larger PRS goals; 0 As much as possible, the outcomes should be linked to an action in the IAP to ensure high priority accorded by HMGN; In general, the outcome is clearly defined,measurable and feasible;23and 0 In applying the selectivity principle, the Bank has a comparative advantage in facilitating the outcome and has a well-developed strategyto contributematerially to its realization. 51. The outcomes matrix is organized around the four PRS pillars and presented in two parts. The 15 areas and 26 specific outcomes for the CAS period are displayed in Table 3. A more detailed matrix (see Annex BlO) describes briefly, for each outcome, the Bank's strategy for achieving it, annual milestones, Bank instruments and key partners. Specific annual milestones for FY04 are provided for each outcome with some additional milestones for subsequent years. As noted, these annual milestones are updated each year, and as such, milestones for FY05, FY06 and FY07 should be seen more as indicative. The more detailed matrix also links the CAS outcomes to specific country outcomes identified in the PRS, showing the strong linkage between the Bank's contributions and the country's goals as established in the PRS.24 Cross Cutting Themes 52. Gender and Social Inclusion. For the successful implementation of this CAS, there are a number of cross cutting themes-specifically, gender and social inclusion, fiduciary and environmental policies, and capacity building-that deserve special mention. In rural areas, the women's critical role as economic providers-either through unpaid labor on the family farm or as wage workers for others-is widely recognized. Indeed, the poorer the family, the greater its reliance on the skills and labor of female family members for economic survival. While there is great variation in the gender systems of different ethnic and caste groups in Nepal, all of them to some extent discriminate against women in terms of access to property, investments in health and especially education, and in the degree to which women's voices are heard in community decision-making or national governance. 23 Certain outcomes are stated rather generally for lack of a better definition. In such cases, however, annual milestones tend to be quite specific to help clarify the kind of change the CAS hopes to support. 24 In the PRS matrix in Annex B11, in addition to linking the CAS outcomes to the PRS outcomes, the specificintermediate indicators/activities corresponding to each of the milestones are also highlighted.  Nepal CountryAssistance Strategy Page 20 of 34 service I Improved accountability and transparency *Itemsin BOLD are objectives associated with actions in the Immediate Action Plan (IAP); see Annex B11 and Appendix 111. 53. Gender is clearly one important dimension of social exclusion in Nepal, however, more recently-especially in the years following the reinstitution of democracy-other dimensions of social exclusion-namely caste and ethnicity-have come into greater prominence as indigenous groups (Janajati) and formerly `low caste' (Dalit) groups have been able to organize and speak out. In response to this-and to the insurgents criticism that the Nepali state has largely been in the hands of males from the dominant caste and ethnic groups-the PRS has recognized the disparities resulting from gender, ethnicityand caste. To better understand the institutionalunderpinningsof caste, ethnic and gender-based social and economic exclusion in Nepal and how these affect poverty outcomes-as well as the options for policy and institutionalreforms-a Social and Gender Analysis is currentlybeing carried out and will be completed in FY04. Furthermore,in all interventions-cspecially in the sector-wide approachesto be employed in education, rural water supply and health-efforts will be made to ensure that social and gender inclusion issues are explicitly recognized and receive close attention. To ensure that gender and  Nepal CountryAssistance Strategy Page 21 of 34 social aspects are fully integrated at both the project and policy level work of the Nepal program, in the last year a Lead Social Scientist was posted in Kathmandu." 54. Fiduciary and Environmental Policies. Similarly, in implementing the CAS, ensuring adherence to sound fiduciary and environmental policies will be crucial. As mentioned, a CPAR was finalized in FYOl and a CFAA was completed in FY02 (see Appendix V), with IDF grants supporting implementation of the key recommendations.26 While the legal and regulatory framework for ensuring public sector financial accountability is impressive, implementation-including compliance with the framework-is generally weak. In the area of procurement, very few countries today still follow the system used by Nepal-under which public procurement is governed by a set of financial rules issued by the Government-and hence, the major need is to enact a modern, transparent, and competitive publi procurement law. ~ ~ ~ ~~ Box 8: The Response to Environmental Challenges 55. Despite a rather comprehensive HMGN has responded to the environmental framework for environmental protection, in challenges by incorporating conservation activities in addition to weak capacity and poor sectoral plans and programs. Furthermore, environment- coordination, the main environmental related provisions have been incorporated in various acts challenges in Nepal pertain to the such as: (i) the Local Self-Governance Act (1998) that sustainable use of natural resources and specifies the role of DDCs and VDCs in environmental adequate integration of environmental planning, forest and biodiversity conservation, land-use management, and public sanitation; (ii) the Forest Act planning in development programs and their (1992), and the National Parks and Wildlife Conservation implementation. In response, HMGN has Act (1973 and amended in 1993)that provide for community incorporated conservation activities in involvement in forest management and species conservation; selected sectoral plans and programs, while and (iii) the Environment Protection Act (1996) and the environment-related provisions have been Environment Protection Rules (1997) that contain provisions incorporated in various acts (see Box 8). for institutionalizing environmental impact assessment and Among the accomplishments: (i) the donor- expanding pollution control activities. In addition, a National supported Community Forest Program has Environmental Policy and Action Plan was prepared (1993) been successful in helping to reverse to help implement Agenda 21 of the Rio Earth Summit; an deforestation in the hill regions; (ii) Environment Protection Council was constituted as a policy endangered mammal species have been advisory body (1992); and a Ministry of Population and recovered in the Terai; and (iii) careful Environment (MoPE) was established (1995). Nepal is a attention to designated conservation areas party to 16 environment-related international Conventions supported by eco-tourism have had and Agreements, including CITES and ITTA. important impacts on poor and remote rural Despite these efforts to address environmental communities. Beyond the five key management, weak institutional capacity and poor environmental issues-forest depletion, soil coordination between MoPE and sectoral agencies has degradation, solid waste management, water constrained the implementation of environmental policies and programs. There is also a significant gap between the quality and air pollution-a number of new content of the international environmental conventions and challenges have emerged, such as rapid but their implementation at the national level. There are many uncontrolled and haphazard urbanization donors (eg, Denmark, Germany, UNDP, UNEP) and (resulting partially from insecurity and international (e.g., WWF, IUCN) and national (e.g., King violence in rural areas), glacial lake outburst Mahendra Trust for Conservation of Nature) NGOs active in floods, arsenic contamination of the environmental arena and funding is not a constraint. groundwater, indoor air pollution from 25 This has been made possible in part through the generous support of the United Kingdom's Department for International Development (DffD). 26 It is important to note, however, that the team looks at fiduciary issues in a much broader context than that covered by the CFAA. See Box 9 for details.  Nepal CountryAssistance Strategy Page 22 of 34 biomass burning and food contamination. With the large donor and NGO presence, Bank involvement in the environmental agenda will be selective and focus on helping HMGN articulate an effective strategy for environmental conservation and management and capacity building. Accordingly, a Country Environmental Analysis (CEA) is planned for FY05. Using this as a basis, we would focus on possible outcomes for Bank support and then determine appropriate instruments. Given Nepal's biological diversity, however, there are possibilities for use of funds from the Global Environmental Facility (GEF)-e.g., support to sustainable gathering, processing and marketing of high value plants and herbs, micro-hydropower, or remediation of glacial lake outburst floods. There are also good prospects for implementationof programs supported by the Prototype Carbon Fund (PCF) and the Community Carbon Fund (CCF) 56. Capacity Building. As institutional weaknesses and lack of capacity are well-recognized constraints, an important cross cutting theme of the CAS is capacity building. According to some estimates, over US$lOO million per year is spent by donor agencies and INGOs in Nepal on what can be broadly termed `capacity building' activities. The outcome is clearly very disappointing, and both HMGN and donors agree that a serious rethinking is in order. There is, however, an entrenchedthinking to equate provision of consultants and training with capacity building, which in part explains the continuedattemptto `throwmoney' at the capacitybuilding challenge. 57. A strong public sector institution requires: (i) sound institutional set-up; (ii) `enabling environment' for the institution-especially a system that shields the institution from undue political interference and rewards professional performance; (iii) good people-which requires a performance- oriented and financially decent incentive system as well as training; and (iv) experience. In Nepal, development partners have tended mainly to focus on institutional set-up and training people, without paying sufficient attention to the other aspects or finding effective ways to get at them. Improving the `enabling environment' and creating a performance-oriented incentive system are inherently political processes, and donors can only encourageindigenousefforts. Thus, donor support needs to be somewhat opportunistic. An important dimension that has tended to be neglected by donors is helping the institutions to build experience. If anything, by substituting for HMGN's own work, development partners may have tended to hamper the ability of Nepali institutions to strengthen through experience. The Bank's knowledge in supporting key reform initiatives indicates that capacity building is more about creatingspace for the Nepalis to think for themselves and act on their own, and providingknowledgeonly where it is specifically demanded.27Money is seldom the real constraint to capacity building in Nepal. Based on this perspective,the Bank's effortswill focus on: 0 Facilitating country-led changes, as in the end this is what capacity building is about. The primary concentration will be on helping HMGN build its own policy formulation and implementationcapacity at the central level through experience. This effort depends criticallyon the ability of the country-based staff--especially Nepali staff-to engage and motivate HMGN counterparts in reform thinking, backed by the ability to bring in global knowledge from the rest of the Bank and/or internationallyas needed. While this concept of decentralizationis already working well, further efforts will be made, especiallyto strengthenthe capacity of the country-basedstaff;and 0 Where there are legitimateneeds for more traditional TA and training that arise from the Nepal- led and Bank-supported reform efforts, the Bank will continue to be prepared to provide such assistance through a variety of means. Since all IDA-funded projects involve important reform elements, almost all include TA and/or training components. To maximize their impact, however,the Bank relies heavily on identificationof needs by the reform leaders themselves. In some areas-such 21 Good examples of this are the experience with the introduction of MTEF and development of IAP as noted in noted in paragraph 43.  Nepal Country Assistance Strategy Page 23 of 34 as public expenditure management, monitoring and evaluation in conjunction with PRS implementation, and improving financial accountability systems-TA and training of central importancewill be supportedby IDF grantsand direct TA. Instruments to Achieve the CAS Outcomes 58. A critical element for achieving the CAS outcomes is an internal alignment of the work program with the outcomes. The formulation of the annual work program is used as an important process to develop a consensus on the annual milestones toward achieving the longer term CAS outcomes, and the broad strategy and specific instruments to reach those milestones. This has helped to develop organic integration of a range of AAA instruments (e.g., formal reports, informal policy notes, TA, seminars, policy dialogue, strategic communication) and lending instruments. It has also enabled much more effective cross-sectoralefforts directedtoward the shared outcomes. This process, combinedwith regular monitoring of progress from the outcomes perspective, is the cornerstone of the outcomes-based approach. 59. In relation to many outcomes,AAA will continueto play an importantrole and will be used more consciously to overcome specific obstacles to reforms. During the past four years, while the lending program remained in the low case and the work program focused on motivatingreforms, the Bank learned to use AAA more strategically for engaging Nepali authorities in policy dialogue and has been effective in evoking change. The shiftby the Bank toward an outcomes-focused approach also changed the nature of AAA. From the outset, each AAA piece is conceived as part of a strategy to help facilitate some specific development outcome. This has led to two important changes: (i) unlike in the past, dissemination of AAA outputs is no longer an afterthought,but is an integral part of the motivation for the AAA task itself; and (ii) there is much greater use of small, informal, and targeted reports that are designed to help the reform leaders in Nepal themselves rather than bulky reports whose target Table 4: Formal AAA, FY04-FY07 audience is often unclear. Under this CAS, these FY04 Develonment Policv Review trends will continue. In additionto supportingthe MTEF, IAP and overall structural reform efforts, I Note on Rural Sector Issues ISocial II and Gender Assessment dialogue and TA will continue to be used widely II Studyon Labor Remittances to help achieve the CAS outcomes, including in FY05 power, higher education, fiscal decentralization, Poverty Report 4 civil service reform and special interest issues Public Expenditure Analysis-Evaluating the MTEF such as child labor and traffichng. Public Expenditure Analysis-The SOE Sector Country Environmental Analysis 60. Going forward, formal AAA will continue Rural Factor Market Study to help lay a foundation for building the agenda FY06 and needed consensus for reform (see Table 4). Countrv Economic ReDort Contributing to the completion of all core I Financial Sector Reform: Lessons and Next Stem I I diagnostic pieces2*and helping to prioritize future Update on Chld Labor policy reform areas, a Development Policy Review FY07 (DPR) is envisioned for FY04, along with key An Evaluation of Community Managed Schools studies on apculture, labor remittances, and a Re-evaluating Social and Gender Issues social and gender assessment. Also during the Update on Fiduciary Assessments 28 As mentioned (see paragraph 47), the CPAR and CFAA have been completed. With regard to other core diagnostic AAA: (i) a PER was completed in FY02 and a number of follow up pieces-evaluating the MTEF and analyzing SOEs-are envisioned for FY05;(ii) a Poverty Assessment was completed in FY99, with an update planned for FY05;and (iii) a CEA is planned for FY05.  Nepal Country Assistance Strategy Page 24 of 34 CAS period, important work will be undertaken analyzing the impacts of the financial sector reforms and providing an update of the child labor ~ituation,~'as well as continuouspublic expenditureanalysis. 61. The International Finance Corporation (IFC) and Multilateral Investment Guarantee Agency (MIGA) will both play important-albeit relatively limited-roles in the implementation of the strategy. IFC will continue to support export-oriented manufacturing, private investment in telecommunicationsand power generationand distribution,financialmarket development,and the growth of small and medium enterprises (SMEs). Due to the still weak security situation and political uncertainties,currently there are few investment opportunities in Nepal large enough for direct financing, so IFC doesnot expect to make many new investments duringthe CAS period. Instead, IFC will focus on technical assistance for SMEs through the South Asia Enterprise Development Facility (SEDF) based in Dhaka. This facility-funded by IFC in partnership with Canada, Netherlands, Norway, the UK, Asian Development Bank (ADB) and the European Union (EU)-will deliver programs in Nepal to increase access for SMEs to financing and business development services, improve the business environment for SMEs and develop linkages with larger enterprises. SEDFwill closely coordinate with the Bank's efforts in the financial sector to provide TA and training to banks, including introducing best practices and new products for SME lending. SEDF will also work with selectedbusiness associations in the agribusiness and tourism sectors. SEDFintends to locate a staffmember within the Kathmandu office to manage these programs. Over the upcoming CAS period, MIGA will continue to support suitable foreign direct investmentsinto Nepal as they present themselves. Bank Group Scenarios 62. Given the current rather significant political uncertainties, the CAS must be able to respond constructively to a wide range of possible eventualities. Without a doubt, the greatest source of uncertaintyis the insurgency. If a peace settlement is reached,there will likely be a need for a large scale `nation re-building' program and the Bank would be expected to be part of ita3' On the other hand, renewed hostilities could turn more intense and severely curtail the ability of HMGN to implement the PRS. In either of these extremes or in between, the nature of the reforms envisioned in the PRS will remain relevant. Therefore, it is useful to think of the following three scenarios that naturally correspond to the standard CAS scenarios: 0 Base (`central') case-in which the hostilities are limited or not severe enough to interfere seriouslywith developmentwork and the currentreforms continue to move forward; 0 Low c a s e i n which renewed hostilitieshamper implementation of the PRS-thus, reducing the external fundingneeds-or the reform efforts themselves become stalled-thus, making it difficultto justify high levels of IDA funding; and 0 High case-in which it is assumed that a peace agreement is reached and/or the reforms accelerate,thereby creatingboth a need and environmentfor larger aid flows. 29 This will follow up on Understanding Children's Work in Nepal (March 2003). This study-carried out jointly with ILO and UNICEF-includes a set of recommendations and proposed policy actions that will help formulate a more comprehensive framework for handling issues associated with child labor. 30 Purposely, the word `reconstruction' is avoided, as the reconstruction needs are llkely to be modest given that conflict-affected areas tend to suffer from under-investment. Instead, what is required is a major effort to upgrade mfrastructure and social services in these regions that have long been under-served.  Nepal Country Assistance Strategy Page 25 of 34 Low Case Implementation of annual IAP falls significantly short of targets (less than half attained). (US$O-50 Decentralization of basic service delivery-especially in education and health-stalls. million) 0 Banking reform stalls-i.e., restructuring by FY05 not in sight. Management of public expenditures weakens-i.e., weakened application of MTEF/project prioritization systerdsimilar mechanisms. 0 Anti-corruption drive loses momentum. Base Case (US$120-200 million) High Case Annual IAP implementationis complete and the process is deepened. (US$200-250 0 Decentralizationof basic services accelerates. million) 0 Fiscal decentralizationaccelerate, with full decentralization implemented in some districts. Strongmeasures implemented to improve access to basic education for disadvantaged children. 0 NBL/RBB restructuring plans agreed and implementation initiated. 0 Continued satisfactoryportfolio performance to confm absorptive capacity. 64. A notional base case lending scenario is presented in Table 6 in which the IDA lendingprogram would average about US$190 million per year, consistentwith Nepal's current IDA all~cation.~' In each year, the lending program would be anchored in a PRSC providing programmatic support to the implementation of the PRS/IAP (see Box 9). The first PRSC aims to: (i) support Nepal's reform champions in implementing far-reachingreforms that revive growth, improve service delivery, promote social inclusion and improve governance; and (ii) contribute to maintaining a sound macro framework and in protecting high priority anti-poverty programs by filling part of Nepal's financing gap. Future PRSCs will focus on key elements that are critical to achieve the CAS outcomes. In the broad-based growthpillar, these include: (i) public expendituremanagement; (ii) labor market; (iii) infrastructure(e.g., the main road network andrural roads); and (iv) financial sector reform. In social sector developmentand inclusion, the focus will be on improving service delivery-in education, health and waterhanitation-in additionto implementingtargeted programs for excluded groups. Finally, in governancethe focus will be on public/civil servicereform as well as re-activatingand strengtheningthe decentralizationprocess. 31 As indicated, the outcomes in Table 3 are those explicitly lmked to the base case scenario and in a high case scenario there would likely be more outcomes. 32 While the base case envisages an average annual lending program of about US$l90 million, there is some uncertainty associated with the ability of HMGN to implement projects under different security and political situations. As such, a realistic range-US$l20-200 million-has been established.  Nepal CountiyAssistance Strategy Page 26 of 34 65. In each year, the PRSC would be Table 6: IDA Base Case Lending Program: FY04-FY07 complemented by three or four investment (values in US$ millions) or sectoral operations to support key FY04 I 235.0 I programs in the focus areas. With Pove Reduction Su ort Credit I increasing emphasis on growth, the lending Basic and Primar Education Pro'ect,Phase I1 program will continue to focus on infrastructure investment. Since the existing Rural Water Su 1 and Sanitation I1 portfolio already has a strong tilt toward Financial Sector Restructurin ,Phase I1 70.0 infrastructure, the base case lending FY05 185.0 program does not show large new Health Sector Operation 50.0 infrastructure projects. In part, this also Poverty Reduction Support Credit I1 70.0 recognizes the difficulty of implementing Rural Access Improvement 30.0 large-scale projects during a conflict. Reform Techmcal Assistance1CapacityBuilding 10.0 Nevertheless, if the opportunities arise, Higher Education 25.0 financial support for infrastructure can be readily increased through both the PRSC and, in case of peace, additional investment operations. The necessary technical work has been built into the base case program. 66. Given its low income level, it is assumed that Nepal will continue to receive a portion of its IDA allocation in the form of grants at least for a part of the CAS period.33 HMGN has expressed a preference to use IDA grant financing for: (i) key priorities in the social sectors (including for PAF), and (ii) for technical a~sistance.~~ Although the base case lending program represents a significant increase in the level of IDA lending to Nepal (the base case was US$70-120 million under the 1998 CAS), this should not pose any debt service difficulties. With a highly concessional debt structure, the public debt service to GDP ratio stands at a modest 1.6%and external debt servicing is only about 7.5% of exports of goods and non-factor services.35 67. In a low case scenario, the lending volume would be significantly less than in a base case-Le., averaging US$O-50 million per year. The nature of IDA assistance in the low case would depend on its circumstance. If the cause is renewed hostilities-and the consequent narrowing of the reach of HMGN-then it would be appropriate to cut back on investment operations to account for the reduced physical scope of reform implementation. On the other hand, if the cause is slow implementation of the reforms, then the focus of lending activities would revert back to supporting decentralization and community-based projects (which would likely lay the foundation for better governance dynamics in the future) and whatever specific reforms that nonetheless managed to proceed at the central level. 33 Availability of IDA grants in FY06-FY07 will depend on the outcome of the IDA14 replenishment deliberations. 34 This is consistent with HMGN's Foreign Aid Policy (FAP) that states "technical assistance for project design, institutional and capacity building, technical backstopping, and project monitoring and review are more suitable for grant financing than for concessional loans." 35 Nepal is a `less indebted low-income' country with a ratio of external debt to GDP of 53% and a total public debt to GDP ratio of 70% (end FY01/02). IMF simulations suggest that if key variables remained at their average value of the last ten years, the total debt to GDP ratio would decline to 53% in FY06107.  Nepal CountryAssistance Strategy Page 27 of 34 68. A high case scenario- Box 9: Financial Management Broadly Defined associated with peace and/or an When evaluating whether a country is considered `ready' for acceleration of the reform program- programmatic support, it is common to evaluate its financial envisions annual lending levels management capacity. Financial management, however, should averaging US$200-250 million. Related not be equated with narrow matters of financial rules and to reform acceleration, the high case regulations. But, it is fundamentallyconcernedwith effectiveuse would be triggered by stepping up fiscal of fmancial resources. First, therefore, fmancial management is decentralization efforts, as well as about good resource allocation. Through the MTEF, HMGN's accelerating decentralization of basic resource allocations have improved considerably over the last services, initiating the restructuring of two years, eliminatingmuch of the fat, imposing a fm budget the two large commercial banks, and ceiling and prioritizing development expenditures. Second, financial management is about improving service delivery deepening implementation of the IAP modalities.Through many programs initiated during the last two (see Table 5). The nature of the years-e.g., transferring management of schools and sub-health additional support in a high case would posts to local communities-HMGN has demonstrated likely include some additional commitment to improving service delivery. Finally, at the next interventions related to `nation re- level, financial management is about providing decision-makers building' activities, but it is difficult to with sufficient, accurate and timely financial information to be very specific about such evaluate: (i) overall public sector financial management interventions at this time, as they must performance; (ii) stewardship of resources placed under public emerge Erom the peace process itself. sector control;and (iii) the extent to which resources are used in With the prevailing uncertainties, there accordance with prescribed budgets and mandates. Although admittedly further strengthening is required, there are serious may be a need to revisit the assistance programs under way-e.g., implementing the CFAA strategy in eighteen to twenty-four recommendations,capacity building for accounting and auditing months or even sooner. As such, a CAS staff, and increased monitoring of financial and physical PR will be prepared at least by early- progress. Therefore, when looking more broadly at financial FY06 or as the situation warrants. management, Nepal has come a long way and has fully demonstratedits seriousnessto tackle the right issues. C. PortfolioManagement IDA 69. The operating environment in Nepal has been characterized by weak public management, a low skills base, political instability and the aftermath of an armed insurgency that has affected a majority of the country's 75 districts. Despite these heavy odds, project implementation performance and outcomes have improved in the last five years. On many accounts-satisfactory outcomes, project sustainability and institutional development-performance of the Nepal portfolio substantially improved and compares favorably to both the region and Bank (see Table 7). As such, overall the Bank's contribution to development in Nepal in the last five years can no longer be considered as "unsatisfactory in outcomes, modest with respect to institutional development impact and highly uncertain in terms of sustainability" as summarized in the Country Assistance Evaluation (CAE) by the Operations Evaluation Department (OED).36Furthermore, more recently there has been greater borrower commitment as shown by adequate levels of counterpart funding and efforts to improve project staffing and management. While in the past project implementation has suffered from political interference-in part seen through frequent staff transfers-the dedication and commitment of reform-minded senior civil servants and project staff have helped to achieve the improved outcomes. Perceived or real corruption and lack of accountability in public institutions remain a drag on project performance, but recent actions by the public sector to rectify these ills should help to improve accountability and strengthen governance. 36 ReportNo. 19850-NEP,dated November 1, 1999.  Nepal CountryAssistance Strategy Page 28 of 34 Table 7: Project Performance at Exit Nepal Regional Bank FY77-89 FY90-97 FY98-02 Average Average Number of projects 27 26 11 140 1,236 Satisfactory outcome 63% 64% 81% 77% 74% Likely sustainable 44% 16% 64% 64% 64% Sustainable institutional development 23% 28% 45% 42% 44% Bank performance (supervision) . * 83% 83% 81% Borrower performance (implementation) 75% 66% 67% Note: Regional and Bank averages are for the period FY98-02. Source: OED audits of Implementation CompletionReports (ICRs) and Project Completion Reports (PCRs). 70. Following the implementation of Portfolio Implementation Plans (PIPS) in FY99 and FYO037- which included actions to improve the performance of individual projects, as well as specific measures to address generic issues-there was a remarkable improvement in the status of the Nepal portfolio, with projects at risk dropping to 13% of the portfolio. This was not to last, however, as the declaration of a national emergency in November 2001 resulted in an escalation of violence and impaired security. This affected much of the portfolie-especially in the remote and less developed mid- and far-western regions-with IDA unable to carry out adequate supervision and project activities slowing or even coming to a halt in some instances under force majeure. By January 2003, 43% of the projects and over 70% of IDA commitments were considered at risk, but following the cessation of hostilities, there had been a steady improvement and by end-FY03, the portfolio risks have been reduced to more manageable levels (see Annex B2). The Bank shares the experience with other donors that truly community-owned projects tend to be largely unaffected by the insurgency. 71. The current IDA portfolio in Nepal consists of nine active projects, of which five are due to close in the next eighteen months (see Table 8). Active operations as of September 15,2003 represented an Table 8: IDA Portfolio Trends and Performance: FY99-FY04 (As of September 15,2003) FY99 FYOO FYOl FY02 FY03 FY04 Number of projects under implementation" 10 9 8 8 10 9 Average implementationperiod (years)2' 3.6 3.1 3.7 3.7 3.2 3.3 Commitments (US$ million) 17.5 54.5 0.0 22.6 96.6 0.0 Disbursements (US$ million) 59.9 46.1 47.3 38.0 27.2 6.2 Number (%) actualproblem rojects3' 2 (20.0) 2 (22.2) 1 (12.5) 1 (12.5) 2 (20.0) 2 (22.2) Number (%) projects at risk4 P 6 (60.0) 5 (55.6) 1 (12.5) 2 (25.0) 2 (20.0) 2 (22.2) Proactivity index 100 100 100 100 100 100 Realism index 33 40 100 100 100 100 *`Average As shown in the Annual Report on Portfolio Performance, including GEF. age of projects in the portfolio as of the end of each FY. 3/Projects rated U or HU (unsatisfactory or hghly unsatisfactory) on Development Objective (DO) or ImplementationProgress (IP). 4/Number of actual and potential problem projects. 37 The FY98 Annual Report on Portfolio Performance identified Nepal as a priority PIP country-i.e., a country with more than 50% of the portfolio andior more than 33% of commitments at risk, with more than eight active projects andor US$250 million in commitments.  Nepal CountyAssistance Strategy Page 29 of 34 aggregate IDA commitment of about US$298 million (net of cancellations), of which US$167 million remains undisbursed. The portfolio declined from fourteen projects in FY98 to eight projects in FYOUFY02 as a result of the low lending levels since FY99, closing of aging projects and a deliberate policy to ensure adequate quality at entry. With the move to the base case in December 2002, the portfolio has increased slightly. 72. Despite the noted improvements, the portfolio remains at risk and could be adversely affected by a resumption of insurgent activities or a period of protracted political instability. To mitigate the risks, the Bank-primarily through the staff in the country office-has been proactively supporting and monitoring project implementation. In this effort, the Bank, together with HMGN, ADB and the Japan Bank for International Cooperation (JBIC) have been carrying out joint Nepal Portfolio Performance Reviews (NPPRs) since 2000. The main objective of these reviews is to discuss generic issues affecting portfolio management-such as security, passage of laws and regulations, procurement, financial management and safeguards-and agree on time-bound action plans to resolve the identified issues. A memorandum of understanding is signed by all parties and the actions are closely monitored and reviewed semi-annually. The most recent review was conducted in October 2002, with a mid-term review taking place in May 2003.38These joint reviews are complemented by quarterly reviews of the implementation progress of IDA projects, along with close supervision and monitoring with frequent site visits. In addition to placing emphasis on quality at entry and quality of supervision, Bank staff are active in identifying and resolving potential issues before they become problems. 73. A number of initiatives-i.e., the preparation of the CPAR, the CFAA and Public Works Directives with ADB assistance-have provided a sound framework for addressing generic implementation issues and improving the general operating environment. Special committees have been established to implement the CPAR and CFAA recommendations, and are expected to modernize, as well as simplify and streamline, the public procurement and financial accountability regimes, resulting in a higher level of transparency in public procurement and enhanced accountability in financial transactions. Portfolio Performance is expected to improve further with the implementation of performance-based budget allocations and fund releases under the MTEF, and systematic project and program monitoring by sector agencies and the NF'C. There is an increasing awareness to strengthen environmental and social safeguards in all public investments, but as indicated, implementation remains weak and will require continued support. IFC 74. IFC's current held exposure in Nepal is US$79.9 million-US$53.0 million from IFC's own account and US$26.9 million in B loans-in four projects, of which two are in private power generation, one in tourism and one in leasing. The investment in the tourism sector was restructured as the performance of the company suffered due to the political instability and insurgency. The remaining portfolio is in good condition, with a loss reserve ratio of only 4% of total exposure. MIGA 75. To date, MIGA has facilitated estimated foreign direct investment into Nepal in the amount of US$122.4 million. MIGA's outstanding portfolio in the country consists of four contracts of guarantee 38 The mid-term review acknowledged progress and achievements since the NPPR, noting that the reforms have had a positive impact on portfolio performance. However, a number of generic issues-including effectivenessdelays, poor quality of civil works, financial management, and cost and time over-runs-were noted as requiring priority action. The 2003 NPPR will be carried out in November.  Nepal CountryAssistance Strategy Page 30 of 34 for the Himal Power Limited project-a 60 MW run-of-the river project located on a tributary of the Tama Khosi River-which was the first foreign direct investment in the energy sector in Nepal. IV. IMPLEMENTINGTHE CAS A. Partnerships Box 10: The CAS Consultation Process 76. As strengthened through the consultation As noted (see Box 6), Nepal's PRS was prepared process (see Box lo), effective partnerships with through a very consultative process. As such, the Nepal's other development partners will be overwhelming focus of the CAS consultations has essential in CAS implementation. Partnerships been on aligning donor support around the PRS with emphasis on: (i) discussing the Bank's proposed will be maintaineddeveloped in the context of strategy and its relationship to the PRS to ensure that HMGN's leadership of donor coordination in the aggregate, donor support is adequate to cover efforts3', respecting the Foreign Aid Policy implementation of key PRS programs; and (ii) (FAP).40There are three types of partnerships that identifying specific areas of collaboration. The Bank will be important: (i) official partnerships; (ii) has worked closely with DfID-which is preparing an partnerships with the private sector; and (iii) outcomes-focused Country Assistance Plan (CAP)- partnerships with civil society. The Bank will including holding a one-day joint workshop in continue to work closely with key multi-lateral Kathmandu to discuss ways to support PRS and bi-lateral partners with whom there are many implementation effectively. Taking the collaboration with DfID to a new level of closeness, DfID and the examples of strong, effective coordination efforts, Bank have agreed on a set of PRS-based outcomes as including: the common goals for DfID's new CAP and the Bank's new CAS. In addition, small focus groups- 0 The Reform and Development Group- with representatives of HMGN, NGOs and civil HMGN and seven donors that are prepared in society-have been convened along the way to principle to consider programmatic-type discuss various CAS drafts. To be most effective in assistance to Nepal (ADB, Denmark, IMF, assisting HMGN implement the PRS, consultation Japan, Norway, UK and the Bank)-has been with Nepal's other development partners will be a supporting development, implementation and continuous process throughout the CAS lifetime. monitoring of the IAF'. 0 Significant sectoral collaborations have taken place in: (i) the financial sector reform efforts with coordination between the Bank, IMF4' and DfID; (ii) the power sector where the Bank, UNDP, Germany, US and Norway are collaborating in several areas, including the PDF and development of micro-hydro systems in rural areas; and (iii) the education sector in which a number of donors- 39 In May 2003, the local donor coordination group agreed to break from the tradition of having the United Nations Development Programme (UNDP) and the Bank as co-chairs and invited HMGN to chair the group. 40 HMGN has made impressive efforts in the preparation and initial implementation of the FAP that outlines objectives, guidelines, strategies and policies aimed at guiding the flow and composition of foreign aid to ensure better aid utilization. 41 Board presentation of the IMF PRGF is anticipated for mid-November. Overall, IMF-Bank collaboration has been excellent. The proposed PRSC I has been prepared in parallel with the PRGF and the two institutions are working closely to ensure that the programs relnforce each other. For more information on the IMF program in Nepal, see Appendix IV.  Nepal CountvyAssistance Strategy Page 31 of 34 including IDA, Denmark, the EU, Finland and Norway-are providing joint support to a well- formulatedten-year primary educationreformprogram4'; and As mentioned (see paragraph 72), for a few years the Bank together with HMGN, ADB and JBIC have been carryingoutjoint implementationperformancereviews. 77. In line with the PRS philosophy, various sectoral ministries-e.g., education and health-are talung a proactive leadership role in the coordination of programs supported by development partners. While a shift of this nature takes time, Bank assistance and the deployment of programmatic support instruments in particular will provide leverage to Nepali reformers to expand and accelerate this process. Where cross-cutting interventions are critical (e.g., in HIV/AIDS) the Bank will work with other development partners to improve the framework for inter-agency collaboration and coordination. An important part of the coordination effort revolves around selectivity in implementing the PRS and ensuringthat the key PRS programs can be implemented. The multi-lateraland bi-lateral partnershipsfor implementingthe PRS are summarizedin Table 9. Social Sector Development Education J ADB, EU, UN Agencies Canada, Denmark, Finland, Germany, Japan, Norway, Switzerland, UK Health EU, UN Agencies Australia, Canada, China, Germany, India, Japan, Norway, Switzerland, UK, US Drinking waterhanitation J ADB, UN Agencies Canada, Germany, Japan, Norway, Sweden,UK Social Inclusion J ADB, EU, UN Agencies Canada, Denmark, Germany, Netherlands, Norway, Switzerland, UK Good Governance Civil servicereform J ADB, UN Agencies UK, Switzerland Anti-corruption ADB Denmark, Norway, Switzerland, UK Decentralization J ADB, UN Agencies Canada, Denmark, Germany, Netherlands, Norway, Switzerland, UK, US Human rights Canada, Denmark, Norway, Switzerland,UK Integrated security developmentplan us 42 Similar joint support is being developed to assist implementation of the Health Sector Strategy. The Ministry of Health has established a Health Sector Reform Committee to lead the reform process, including key donors (Germany, IDA, Japan, UNFPA, UNICEF, UK, US and WHO), NGOs, and the private sector.  Nepal Country Assistance Strategy Page 32 of 34 78. Through two participatoryNDFs (2000 and 2002) and the PRS, HMGN has come to engage civil society and the private sector more effectively in policy dialogue. Also, in Bank-financed projects, HMGN has shown greater willingness to benefit from partnerships with NGOs and CBOs, in particular those that involve community mobilization, service delivery and monitoring in remote rural areas. The Bank will continue to encouraged these efforts. In addition to policy dialogue, partnerships among HMGN, the private sector and the Bank will remain central to the efficient provision and expansion of basic infrastructure services,particularly in power and telecommunications. The Bank Group's capacity to work with the private sector will be enhanced with the introduction of the SEDF (see paragraph 61). Partnerships in capacity building will also be strengthened with institutions key to development effectiveness, such as local bodies and media. As with official partnerships, the Bank's dialogue and coordination with the private sector and civil societywill be guided by principles establishedin the PRS with a view towards strengtheningnational ownershipof the developmentagenda. 79. Helping to reinforce these partnerships,the Bank will continue to communicate its development support to Nepal through outreach mechanisms already in place-e.g., the Nepal website, and regular consultative and dissemination events-as well as partnerships with the media. A Public Information Center (PIC)---cun-ently located in the country office-will be built up and moved to a publicly accessible location and managed in collaboration with an external partner. The Bank will also work closely with other donors to support HMGN in the delivery of a strategic communicationprogram built aroundthe Tenth PladPRS. B. Monitoring Outcomes 80. Given that the CAS supports implementation of the PRS and CAS outcomes are closely aligned with PRS outcomes, effective monitoring will only be possible if HMGN's monitoring and evaluation capacity is enhanced. Therefore, much of the Bank's efforts will be through capacity building to help establish an in-country monitoring and evaluation capacity. HMGN's past efforts have been limited largely to expenditure monitoring, with few linkages to outputs and service delivery. Although reviews were held every two months within the Ministerial Development Action Committee and quarterly at the National Development Committee (NDC-chaired by the Prime Minister), a fundamental focus on achieving development outcomes was lacking. To redress these weaknesses, since the beginning of FY02/03 several initiatives have been started by HMGN to monitor both financial and physical progress, including:(i) publishing on the internet detailed work programs with monitorable output indicators for all P1 projects; (ii) releasing hnds based on satisfactoryimplementationperformance, as certifiedby the line mini~tries;~~and (iii) regular reporting-through the mid-term budget review and other means-of expenditureperformance of P1 projects to the NPC and MOF. Though there have been some delays, the systemhas proven effective,especiallyin the scarce cash budget management environment. Another new initiative has been the monitoring of IAP activities that has led to satisfactory completion of the IAP activities and has embeddeda culture ofjoint monitoring/partnershipamong core ministries. 81. Cognizant of the need to align and strengthenHMGN's integrated financial management system with public sector monitoring and evaluation to effectively implement and assess the country's progress in achieving the annual PRS targets towards the MDGs: (i) a Central Monitoring Division has been established within the Poverty Monitoring Unit at the NPC; and (ii) the Central Bureau of Statisticshas been entrusted with gathering survey data for poverty monitoring. HMGN has prepared a poverty- monitoring framework, initiated streamliningof the existing surveys to be linked to PRS monitoring and identified preliminary indicators under each of the four PRS pillars. Though these indicators are by no means complete, efforts are under way to: (i) develop intermediate indicators; (ii) identify appropriate 43 Performance is assessed every three months. Upon announcement of the cease-fire, this rule was relaxed to expedite resource flow to insurgency-affected areas where project activities had been severely affected.  Nepal Country Assistance Strategy Page 33 of 34 surveysand frequenciesto monitor these indicators; (iii) institutionalizeIAP reporting; (iv) strengthenthe link between the fund release mechanism and measurable outcomes; (v) initiate a poverty mapping exercise to direct basic social sector infrastructureto the poor and marginalized groups; and (vi) extend expenditure tracking and client surveys through participatory monitoring exercises on specific areas and sectors. Under the direction of the Vice Chairman of the NPC, the Poverty Monitoring Unit will prepare annual poverty reports-the country report on progress towards the MDGs-to be reviewed by NDC.44 The Bank is working closely with HMGN to develop this capacity and at the same time, will take advantageof these effortsto ensure that all CAS outcomes can be measured and regularly evaluated. C. Risks 82. The most importantrisk that Nepal faces today is one of the country spiraling into a widespread armed conflict and a breakdown of state institutions. By extension, this is the gravest risk the Bank should be concernedwith. The current reform process has in fact emerged as an antidote againstthe risk of widespread internal conflictand the breakdown of the developmentprocess. Hence, supportingit must be at the core of the Bank's own risk management strategy. Nevertheless, at the next tier of the risk structure, it is useful to consider various risks to the reform process itself, so that the Bank is well- prepared to support the reform process under different circumstances. The fragile security situation and political turmoil present obvious uncertainties. At a deeper level, however, there are two types of blockages that may arise: (i) the possibility that the reform process itself is stymied or reversed; and (ii) the possibility that capacity to implement the reforms-even if commitment is sustained-becomes seriouslycurtailed. 83. While the major political parties and political leaders have tacitly supported the current reform process, the risk of their underminingthe reform efforts out of short term political considerations cannot be discounted and would be consistent with the politics of Nepal in the past. If the peace process advances, there is also a risk that some of the more control-oriented economic policy agenda and unrealistic elements of welfare state agenda of the insurgents (e.g., restrictive trade policies, stopping privatization of SOEs, ban on private schools, free social services) may influence the reform program. When the more technocraticinterim Governmentsmake way for an elected Government,there is a risk of old-style patronage politics returning and with it tendencies for rent-seeking, slowing of reforms and crowdingout of the reform-mindedsenior civil serviceleaders. 84. The reform leaders are acutely aware of these risks and believe that the best safeguard is the broad popular supportfor the reforms. By givingthe people and communitiesmore power and immediate benefits, they can expand the political constituency for reforms. This thinking is clearly reflected in the 2003 IAP which places a strong emphasison service delivery. In the medium term, as the broader PRS is implemented, the Nepali people at large should begin to expect good public service delivery and public policies, rather than more personal gains, from the political process. Such a change could eventually transform the patronage-based politics of the past into a democracy that focuses on public interests. In this regard, the basic strategy of the Bank is to support the reformers to accelerate the reform process. Close coordination among the developmentpartners to send consistent messages is a key element of the Bank's strategy. An added risk mitigation measure is the starkly differential lending scenarios-Le., the difference between the low and the high case is potentially US$250 million per year-that continue to send a strongmessage that the Bank's financial supportis linked to continuedreform implementation. 85. The second risk is mainly associated with renewed and escalated hostilities that would sharply reduce HMGN's ability to implement the programs envisioned by the PRS. While it would make the reform process more difficult in the conflict-affectedareas, it may well stiffen the resolve of the reform 44 Utilizing available information, the first such report has already been issued.  Nepal CountryAssistance Strategy Page 34 of 34 leaders to accelerate reform implementation in the rest of the country. In such a situation, continued support by the Bank would no doubt give considerable encouragement to HMGN to carry forward the reform process. Renewed and severe hostilities would also pose a fiscal challenge. Security spending would rise and revenues would suffer fkom further slowing in economic activities. Although the rise in security spending would be in part offset by slowing development activities, the net impact on HMGN's fiscal position would likely be significantly negative. HMGN has already positioned itself to cope with such a situation in an orderly manner based on its prioritized development program. Aware that this is the only way to counter the fiscal problems, the reformers-as in the last two years or so--may also use the fiscal pressure and the need to obtain budget support from the Bank and other development partners as a tool to further rationalize spending and acceleratereforms. 86. A political impasse has developed between the major political parties and the interim Governments (and by association, the King who appointed them). Although the increasingly belligerent attitude of the major political parties has dismayed many Nepalis, there is a risk that this will lead to wide-spread civil disorder and distract the administration. In such a situation, even the reform-minded technocrats would find it difficult to get cabinet decisions on further reforms and to keep the civil service focused on improving public services. The Bank can do little to mitigate such a risk, but it will monitor the situation closely. 87. Lastly, an additional risk is that the economic situation will continue to deteriorate and Nepal will be even more vulnerable to the external environment. Given Nepal's dependence on tourism and exports, unless there is a recovery in the global and domestic economic situations, Nepal's medium term prospects remain bleak. Again, implementing the reform agenda-specifically maintaining fiscal and macroeconomic stability, and increasing economic productivity and competitiveness-provides the best chances for mitigating this risk. 88. The challenges Nepal faces in taking the reform process forward are formidable. The cost of a failure, however, is nothing short of widespread internal conflict, likely resulting in the breakdown of the development process. The current reform leaders are very conscious of the risks and the high stakes. In essence, implementing reforms with more speed and vigor is their strategy to reduce the risk of reversal, and ultimately achieve peace and poverty reduction. Supporting this process is the core of the Bank's own strategy and risk mitigation. This is consistent with the basic strategy that the Bank has followed over the last several years-support reform actions consistently and forcefully. James D. Wolfensohn President By: ShengrnanZhang  Annex A2 Page 1 of 2 At A Glance lor7103 POVERTYand SOCIAL South Low- Nepal Asia income , Developmentdiamond' 2003 Population,mid-year (million) 24.2 1,401 2,495 GNI per capita (Atlas method, US$) 240 I 460 430 Life expectancy GDP per capita (US$) 238 - GNI (Atlasmethod, US$ billion) 5.7 640 1,072 Average annual growth, 1997-03 Population(%) 2.2 1.8 1.9 Gross Laborforce (%) 2.6 2.3 2.3 I 2 primary Most recent estimate (latest year available, 1997.03) capita enrollment Poverty(% ofpopulation belownationalpovertyline, 1996) 42 , I Urbanpopulation(% of totalpopulation) 13 28 30 Life expectancyat birth (years) 60 63 59 infant mortality (per 1,000live births) 66 71 81 Child malnutrition(% of children under 5) 48 1 Access to improvedwater source Access to an improvedwater source (% of population) 88 84 76 Illiteracy(% ofpopulation age 15+) 55 44 37 Gross primary enrollment (% of school-agepopulation) 118 97 95 Male 1 128 108 103 -Nepal Low-incomegroup ~ Female 108 89 87 KEY ECONOMICRATIOS and LONG-TERMTRENDS 1983 1993 2002 2003 Economic ratios' GDP (US$ billions) 2.4 3.7 5.5 5.7 (in percent) Gross domestic investrnenffGDP 19.6 22.6 24.6 26.1 I Trade Exportsof goods and servicesiGDP 10.2 18.4 16.1 14.6 Gross domestic savings/GDP 8.5 12.2 11.8 11.3 Gross nationalsavings/GDP 10.7 14.5 25.7 25.6 Current account balance/GDP -7.4 -8.1 2.6 -0.9 interest paymentson external debffGDP 0.2 0.8 0.4 0.4 Total externaldebffGDP 18.5 54.9 52.9 51.8 Total debt servicelexports 6.5 8.8 4.6 5.2 I I Presentvalue of debffGDP (2001) 28.1 Presentvalue of debffexports (2001) 74.0 I indebtedness 1983-93 1993-03 2002 2003 2003-07 (average annual growth) GDP 5.1 4.3 -0.5 2.3 4.8 -Nepal __ Low-incomegroup GDP per capita 2.7 2.0 -2.7 0.1 2.2 STRUCTURE of the ECONOMY 1983 'Igg32o02 (% of GDP) Growthof GDP(%) Agriculture 60.3 41 3 39 6 396 Industry 12.8 20 2 20 9 Manufacturing 4.6 8 6 8 1 Services 26.9 38 4 39 5 Privateconsumption 81.3 79 3 78 1 78 2 I -2 Generalgovernment consumption 10.1 8.5 10.0 10.5 Importsof goods and services 21.3 28.8 28.8 29.3 *GDP 1983-93 1993-03 2002 2003 (average annual growth) Agriculture 3.4 3.3 2.2 2.1 Industry 9.2 4.9 -3.3 2.3 Manufacturing 10.1 4.2 -10.0 0.4 Services 4.7 5.5 -1.4 2.7 Note: 2003=2002/03. 'Thediamondsshowfourkeyindicatorsinthecountry(inbold)comparedwithitsIncome-groupaverage.Ifdataaremissing,thediamondwill be incomplete.  Annex A2 Page 2 of 2 PRICES and GOVERNMENT FINANCE Domesticprices 1983 1993 2002 2003 Inflation (%) (% change) l5T Consumer prices ImplicitGDP deflator 14.0 12.3 11.2 9.9 3.2 2.9 4.7 3.5 Government finance (% of GDP, includes current grants) I Current revenue 98 99 00 01 02 03 Current budget balance 11.5 12.3 Overall surplusldeficit -0.1 -5.7 -4.0 -4.0 -GDP deflator -CPI I TRADE (US$ millions) 1983 1993 2001 2003 Export and import levels (US$ mill.) Total exports (fob) 2.000 T Food 82 379 942 782 1,500 Pulses 65 1,000 Manufactures I 1,773 256 56 Total imports (cif) 500 0 Food 457 860 1,707 97 98 99 00 01 02 03 Fueland energy 101 338 81 Capital goods 169 84 312 EZ Exports rn Imports BALANCE of PAYMENTS (US$ miliions) 1983 1993 2002 2003 Current account balance to GDP (%) Exportsof goods and services Imports of goods and services . 483 249 1,053 675 1,060 1,821 949 lo T Resource balance -233 -378 1,687 -626 -872 Net income Net current transfers 36 12 75 8 777 -7 825 -6 Current account balance Official transfers -185 4 -295 77 143 143 161 -53 Financing items (net) Changes in net reserves (-=increase) 137 44 -162 380 -323 36 -123 -143 1 - 5 1 Memo: Reserves including gold (US$ miiiions) Conversion rate (DEC, local/US$) 13.8 48.0 571 1,055 75.9 1,184 77.8 EXTERNAL DEBT and RESOURCE FLOWS (US$miiiions) 1983 1993 2002 2003 Composition of 2002 debt (US$ mill.) Total debt outstanding and disbursed IBRD 453 2,010 2,933 2,975 1,185 0 F:5 G:36 IDA 172 0 8320 1,156 0 Total debt service IBRD 20 69 260 88 96 IDA 2 0 10 0 300 Composition of net resource flows Official grants Official creditors 94 156 77 143 161 Private creditors 68 4 Foreign direct investment -10 1 -16 0 -4 0 -2 0 Portfolio equity 0 0 0 World Bank program Commitments A - IBRD E -Bilateral Disbursements 45 690 23 97 - ~ E - IDA D - Other multilateral F -Private Principal repayments 38 216 27 C IMF G -Short-term Netflows 31 310 66 4 20 18 Interest payments Net transfers 29 1 60 6 12 8 -3 9 Development Economics 10/7/03   Annex B3 Page 1of 2 Bank Group Program Summary a/ As of 10/15/2003 Fiscal US$ Implementation Year Project Name (millions) R;wardy H/M/L Risksb/ (H/M/L) 2004 Poverty ReductionSupport Credit I 70.0 H H Basic & Primary Education II (2nd Phase) 50.0 H L Poverty Alleviation Fund LIL 15.0 H H Rural Water Supply and Sanitation II 30.0 M L Financial Sector Restructuring,Phase II 70.0 H H Subtotal 235.0 2005 Health Sector Operation 50.0 M M Poverty ReductionSupport Credit II 70.0 H H Rural Access Improvement 30.0 H M Reform TechnicalAssistance/Capacity Building 10.0 H M Higher Education 25.0 H M Subtotal 185.0 2006 Agriculture Sector Operation 30.0 H M Poverty ReductionSupport Credit Ill 70.0 H H Poverty Allevation Fund II 30.0 H M Financial Sector Restructuring, Phase Ill 75.0 H H Subtotal 205.0 2007 Poverty Reduction Support Credit IV 70.0 H H Infrastructure Development 40.0 H M DecentralizationSupport 30.0 H H Subtotal 140.0 Total FY04 FY07 - 765.0 a/ This table presents a notional Base Case lending program for the next four fiscal years. bl Foreach project, indicatedwhether the strategic rewards and the implementation risks are expected to be High (H). Moderate (M), or Low (L)  Annex B3 Page 2 of 2 IFC and MIGA Programs, FY 1999-2004 As of 9/15/2003 1999 2000 2001 2002 2003 2004 IFC Approvals (US$ millions) 0.0 0.0 0.3 0.0 0.0 0.0 Sector (%) Finance and insurance 100.0 Total 0.0 0.0 100.0 0.0 0.0 0.0 Investment instrument (99) Loans Equity 100.0 Quasi-Equity Other Total 0.0 0.0 100.0 0.0 0.0 0.0 MIGA Guarantees (US$ millions)a' 32.8 32.8 19.1 30.1 30.1 30.1 a. MIGA gross exposure at end of FY  Annex B4 Page 1 of 1 Summary of Non-Lending Services As of 1011512003 FYof Cost (US$ Product Comdetion Thousand) Audience Objectiveb/ Recent Completions Terai Options Study FYOI 275 GIDIBIPD KGIPS Priority and Strategy in Education Sector Reform FYOI 145 GIDIB KGIPDIPS Propowed Power Sector Development Strategy FYOI 260 GID KGIPD Business Environment and Manufacturing Performanct FYOI 140 GIDIB KGIPDIPS Country Procurement Assessment Report (CPAR) FYOI 56 GIDIB PS Country Financial Accountability Assessment (CFAA) FY02 130 GIDIB KGIPDIPS Economic Update FY02 30 GIDIB KGIPDIPS Financial Sector Study FY03 65 GID KGIPS Trade and Competitiveness Study FY03 100 GIBIPD KGIPS A Note on the Poverty Alleviation Fund FY03 a5 GIDIB KGIPS Country Assistance Strategy Progress Report FY03 95 GIBIPD PDIPS On-goinglplanned Study on Labor Remittances FY03I04 50 GIDIBIPD PDIPS Reform Episodes FY03I04 50 GIDIBIPD KGIPS Social and Gender Assessment FY04 230 GIDIBIPD KGIPDIPS Development Policy Review FY04 150 GIDIBIPD KG/PS/PD Rural Sector Issues Note FY04 75 GIDIBIPD KGIPSIPD Poverty Report FY05 200 GIDIBIPD KGIPDIPS Public Expenditure Analysis-Evaluating the MTEF FY05 100 GIBIPD KGIPDIPS Public Expenditure Analysis-The SOE Sector FY05 100 GIDIBIPD KGIPDIPS Rural Factor Market Study FY05 150 GIDIBIPD KGIPDIPS Country Environmental Analysis FY05 125 GIDIBIPD KGIPDIPS Country Economic Update FY06 75 GID KGIPD Financial Sector Reform: Lessons and Next Steps FY06 100 GIDIBIPD KGIPDIPS Update on Child Labor FY06 100 GIDIBIPD KGIPDIPS Evaluation of Community Managed Schools FY07 150 GIDIB KGIPDIPS Re-evaluating Social and Gender Issues FY07 100 GIDIBIPD KGIPDIPS Update on Fiduciary Assessments FY07 100 GIDIB KGIPD Technical AssistancelOther Medium-Term Expenditure Framework FY03I05 100 GIBID KGIPDIPS Decentralized Organizations FY03104 130 GIDIBIPD KGIPD Fiscal Decentralization FY03I05 60 GIBIPD PDIPS Living Standards Survey FY03I04 200 GIB KGIPS Joint IDA-IMF Staff Assessment of the PRSP FY03I04 150 GIBIPD KGIPDIPS Country Assistance Strategy FY04 125 GIBIPD PDIPS Country Assistance Strategy Progress Report FY06 75 GIBIPD PDIPS a/ Government (G), Donor (D), Bank (B), Public Disseminiation (PD). b/ Knowledge Generation (KG), Public Debate (PD), Problem Solving (PS).  Annex B5 Page 1 of 1 Social Indicators As of 10/6/2003 Latest single year Same regionlincome group South Low- 1970-75 1980-85 1995-2001 Asia income POPULATION Total population, mid-year (millions) 13.1 16.2 23.6 1,377.8 2,505.9 Growth rate (% annual average for period) 2.0 2.1 2.4 1.8 1.9 Urban population (% of population) 5.0 7.8 12.2 27.8 30.8 Total fertility rate (births per woman) 6.2 5.9 4.2 3.2 3.5 POVERTY (% ofpopulation) National headcount index 42.0 Urban headcount index 23.0 Rural headcount index 44.0 INCOME GNI per capita (US$) 120 170 250 450 430 Consumer price index (1995=100) 17 35 141 Food price index (1995=100) 33 143 INCOMElCONSUMPTlON DISTRIBUTION Gini index 36.7 Lowest quintile (% of income or consumption) 7.6 Highest quintile (% of income or consumption) 44.8 SOCIAL INDICATORS Public expenditure Health (% of GDP) 0.9 1.o 1.1 Education (% of GDP) 1.5 2.7 3.7 2.5 2.8 Social security and welfare (% of GDP) 0.1 0.1 0.4 Net primary school enrollment rate (55of age group) Total 72 Male 77 Female 67 Access to an improvedwater source (% ofpopulation) Total 88 84 76 Urban 94 94 90 Rural 87 80 70 Immunization rate (75under 12months) Measles 34 71 58 60 DPT 32 72 65 61 Child malnutrition (% under 5 years) 69 48 Life expectancy at birth (years) Total 45 51 59 63 59 Male 46 52 60 62 58 Female 44 50 59 63 60 Mortality Infant (per 1,000 live births) 149 117 66 71 80 Under 5 (per 1,000 live births) 223 170 91 99 121 Adult (15-59) Male (per 1,000 population) 482 376 314 252 312 Female (per 1,000 population) 476 395 314 202 256 Maternal (modeled, per 100,000 live births) 830 Births attended by skilled health staff (%) 10 12 42 Notes: 0 or 0.0 means zero or less than half the unit shown. Net enrollment rate: break in series between 1997 and 1998 due to change from ISCED76 to ISCED97; ratios exceeding 100 indicate discrepancies between the estimates of school-age population and reported enrolment data. 2003 World Development Indicators CD-ROM, World Bank  Page 1 of 2 Annex E6 Key Economic Indicators As of 10/8/2003 Actual Estimate Projected Indicator 98/99 99/00 OO/Ol 01/02 02/03 03/04 04/05 05/06 National accounts (as % of GDP) Gross domestic producta 100 100 100 100 100 100 100 100 Agriculture 40.1 39.6 38.4 39.6 39.6 38.7 38.1 37.4 Industry 21.2 21.5 21.3 20.9 20.7 22.7 23.0 23.3 Services 38.7 38.9 40.3 39.5 39.7 38.6 38.9 39.3 Total consumption 86.4 84.8 85.1 88.2 88.7 88.4 87.6 87.1 Gross domestic fixed investment 19.1 19.3 19.0 19.3 19.2 20.0 20.5 21.5 Government investment 7.0 7.0 7.6 7.6 7.0 7.5 7.9 8.1 Private investment 12.1 12.4 11.4 11.7 12.1 12.5 12.6 13.4 EXPOITS (GNFS~' 22.8 23.3 22.4 16.1 14.6 16.0 18.3 18.1 Imports (GNFS) 29.7 32.4 31.5 28.8 29.3 30.9 32.9 32.7 Gross domestic savings 13.6 15.2 14.9 11.8 11.3 11.6 12.4 12.9 Gross national saving8 20.6 24.6 27.2 25.7 25.6 24.9 25.2 25.2 Memorandum items Gross domestic product 5034 5494 5582 5549 5739 6408 6812 7311 (US$ million at current prices) GNI per capita (US$, Atlas method) 230 240 240 230 240 250 260 280 GDP per capita (US$) 228 243 242 235 238 259 270 283 Real annual growthrates ("hicalculated from 1985prices) Gross domesticproduct at market prices 4.5 6.1 4.8 -0.5 2.3 3.5 4.6 5.4 Real annual per capita growth rates ("h,calculated from 1985prices) Gross domestic product at marketprices 2.2 3.8 2.4 -2.7 0.1 1.2 2.3 3.0 Balance of Payments (US$ millions) E X P O ~ ~(GNFS)~ S 1270 1433 1359 1060 949 1022 1246 1322 Merchandise FOB 763 971 942 754 633 680 883 935 Imports (GNFS)~ 1595 1922 1984 1687 1821 1982 2243 2389 Merchandise FOB 1390 1713 1773 1496 1630 1777 2024 2155 Resource balance -325 -489 -625 -626 -872 -960 -997 -1067 Net private transfers 338 497 680 777 825 867 891 912 Current accountbalance 25 28 64 143 -53 -107 -121 -169 Official transfers 137 133 108 143 161 243 252 248 Long-term loans (net) 157 148 96 38 45 13 16 27 Official 89 97 60 58 74 47 37 -41 Private 68 52 36 -20 -29 -34 -22 68 Other capital (net, incl. errors & ommissions) -7 61 -86 -213 133 166 166 193 Change in reserve# -183 -240 -80 36 -123 -77 -70 -65 Memorandum items Resource balance ("?of GDP) -6.5 -8.9 -11.2 -11.3 -15.2 -15.0 -14.6 -14.6 Annual growth rates (in US$ terms) Merchandise exports (FOB) (excluding re-exports) 18.0 37.3 4.6 -18.1 2.4 7.4 5.9 6.0 Merchandise imports (CIF) -10.4 23.3 3.5 -15.6 9.0 9.0 13.9 6.5 (Continued)  Annex B6 Page 2 of 2 Key Economic Indicators (Continued) Actual Estimate Projected Indicator 98/99 99/00 OO/Ol 01/02 02/03 03/04 04/05 05/06 Public finance (as % of GDP at market prices)e Total revenues 10.2 10.7 11.4 11.5 12.3 12.4 12.8 13.4 Total expenditure 15.4 15.7 17.6 17.2 16.3 18.7 18.5 18.2 Current expenditures 9.4 9.6 11.2 11.6 11.6 13.1 12.5 12.1 Capital expenditure and net lending 6.1 6.1 6.4 5.7 4.7 5.6 6.0 6.1 Overall deficit before grants 5.2 5.0 6.2 5.7 4.0 6.3 5.7 4.8 Overall deficit after grants 3.9 3.5 4.5 4.3 1.9 3.6 2.6 2.0 Domestic financing (net) 1.4 0.9 2.7 2.9 1.2 1.7 1.3 0.6 Foreign financing (net) 2.5 2.6 1.8 1.4 0.7 1.4 1.3 1.4 Monetary indicators M2IGDP 44.7 49.0 52.3 53.2 55.3 55.6 Growth ofM2 ("h) 20.8 21.8 15.2 4.4 8.3 11.1 Private sector credit growtldtotal credit growth (%) 90.9 109.6 88.0 59.2 132.1 107.4 Price indices Real exchange rate (eop; percentage change -= depreciation) 7.3 -2.2 3.8 -9.2 -7.3 Consumer arice index (% change) (FY85=100) 11.4 3.4 2.4 2.9 4.7 5.4 4.6 4.2 GDP deflaior ("hchange) (FYb?=iOO) 8.8 4.6 3.2 3.2 3.5 4.9 4.6 4.6 a. GDP at factor cost. b. "GNFS"denotes "goods and nonfactor services." c. Includes net unrequited transfers excluding official capital grants. d. Includes use ofIMFresources. e. Consolidated central government.  Annex 37 Page 1of 1 Key Exposure Indicators As of 101612003 Actual Estimate Projected Indicator 98/99 99/00 OO/Ol 01/02 02103 03/04 04105 05106 Total debt outstanding and 2,702.0 2,848.0 2,786.0 2,933.0 2,993.0 3,022.0 3,054.0 3,097.0 disbursed (TDO) (US$m)" Net disbursements (US$m)" 141.0 146.0 -62.0 147.0 60.0 29.0 32.0 43.0 Total debt service (TDS) (US$m)" 84.0 83.0 84.0 88.0 96.0 114.0 120.0 125.0 Debt and debt service indicators (%) TDO~XGS~ 162.6 141.8 131.5 152.9 160.9 152.5 136.7 132.6 TDOiGDP 5'3.7 51.8 49.9 52.9 52.2 47.2 44.8 42.4 TDSIXGS 5.1 4.1 4.0 4.6 5.2 5.8 5.4 5.4 ConcessionaliTDO 97.5 98.4 97.7 IBRD exposure indicators (%) IBRD DSipublic DS 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Preferred creditor DSipublic DS (%)' 61.5 64.9 72.3 73.1 74.1 74.8 75.9 75.9 IBRD DSiXGS 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 IBRD TDO (US$mld 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Share of IBRD portfolio (%) 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 IDA TDO (US$mId 1,107.0 1,123.0 1,102.0 1,156.0 1,185.0 1,193.0 1,204.0 1,217.0 IFC Loans (US$m) 56.8 57.3 56.0 54.0 Equity and quasi-equity (US$m)" 3.4 3.4 3.7 3.2 MIGA MIGA guarantees (US$m) 33.0 33.0 19.1 30.1 a. Includes public and publicly guaranteed debt, private non-guaranteed, use of IMF credits and net short-term capital. b. "XGS" denotes exports of goods and services, including workers' remittances. c. Preferred creditors are defined as IBRD, IDA, the regional multilateral development banks, the IMF, and the Bank for International Settlements. d. Includes present value of guarantees. e. Includes equity and quasi-equitytypes of both loan and equity instruments.  N z 2 CO 2 (CI 7 2 8 2m 0 9 0 - d0 F - .-m v) eQ 1 '0 mmQ .-0a, B & E 0 0 N W- N c 1 v) Ummv) a, 3 (D 9 v) 3m (D 1 C C a, 0 E2 .-a, 10 .-VI n E -m 'D 'D c S m m 4- 0 0 m 0 N .-3 v) 0- m E S B 7S a, 1 ; 'D m C 9 0 g '0 a, m z E n .-*e mn C n. .-e  Annex B8 Page 2 of 2 Statement of IFC's Held and Disbursed Portfolio As of 813112003 (In US$ Millions) Held Disbursed FY Approval Company Loan Equity Quasi Partic Loan Equity Quasi Partic 1994 Himal Power 23.4 0.0 3.4 0.0 23.4 0.0 3.4 0.0 1996 Bhote Koshi 18.0 3.O 0.0 26.9 18.0 3.O 0.0 26.9 1998 Jomsom Resort 4.0 0.0 0.0 0.0 4.0 0.0 0.0 0.0 2001 ILFC - Nepal 0.0 0.3 0.0 0.0 0.0 0.3 0.0 0.0 Total Portfolio 45.4 3.2 3.4 26.9 45.4 3.3 3.4 26.9  Z .P .P.P.P I,, I 111   n m 0 W g 3 E! (d  r Y 3 e,  a Y 3m e  W E n vi E  3  5 8 a C g .3Li  N   e  I * a,  6* B8  6* B8 s  8*8 B  I.   1 . . . E 0 9  I 3a       x   I .-c v)   Appendix I The Millennium Development Goals and Related Indicators Forest area (% of total land area) 32.7 27.3 Nationally protected areas (% of total land area) 7.8 7.8 8.9 GDP per unit of energy use (PPP $ per kg oil equivalent) 2.6 3.3 3.8 C02 emissions (metric tons per capita) 0 0.1 0.1 Access to an improved water source (% of population) 67 88 Access to improved sanitation (% of population) 20 28 Access to secure tenure (% of population)  Appendix I TheMillennium DeveloDment Goals and Related Indicators Page 2 of 2 Life expectancy at birth (years) 53.6 56.3 59.4 59.9 Aid (% of GNI) 11.5 9.6 6.7 Externaldebt (% of GNI) 44.4 53.7 46.7 Investment (% of GDP) 18.4 25.2 24.3 24.1 Trade (% of GDP) 31.6 58.8 54.4 47.8 Source: World Development Indicators database, April 2002 Note: Insome cases the data are for earlier or later years than those stated. Goal 1targets: Halve, between 1990and 2015, the proportion of people whose income is less than one dollar a day. Halve, between 1990 and 2015, the proportion of peoplewho suffer from hunger. Goal 2 target: Ensurethat, by 2015, children everywhere, boys and girls alike, will be able to complete a full course of primaryschooling. Goal 3 target: Eliminate gender disparity in primary and secondary education preferablyby 2005 and to all levels of education no later than 2015. Goal 4 target: Reduceby two-thirds, between 1990and 2015, the under-fivemortality rate. Goal 5 target: Reduceby threequarters, between 1990and 2015, the maternal mortality ratio. Goal 6 targets: Have halted by 2015, and begun to reverse,the spread of HIWAIDS. Have halted by 2015, and begun to reverse,the incidence of malaria and other major diseases. Goal 7 targets: Integrate the principles of sustainable development into country policies and programs and reverse the loss of environmental resources. Halve, by 2015, the proportion of people without sustainableaccess to safe drinking water. By 2020, to have achieved a sianificant imorovement in the lives of at least 100 million slum dwellers. Goal 8 targets: Developfurther an open, rule-based, predictable, non-discriminatory trading and financial system. Address the Special Needs of the Least DevelopedCountries. Address the Special Needs of landlockedcountries and small island developing states. Deal comprehensively with the debt problems of developing countries through national and international measures in order to make debt sustainable inthe long term. In cooperation with developing countries, develop and implement strategies for decent and productive work for youth. In cooperationwith pharmaceuticalcompanies, provide access to affordable, essential drugs in developing countries. In cooperation with the private sector, make available the benefits of new technologies, especially information and communications. Source: DEC (as of10/14/2003)  Appendix I1 Implementingthe Previous CAS and Lessons Learned A. Background As indicated, the last CAS for Nepal was discussed by the Board of Directors on December 13, 1998. Although outcomes to be achieved during the CAS period were not explicitly elaborated, the triggers for the base case scenario provide useful insights on the main outcomes the Bank intended to influence through the CAS interventions, specifically: (i) at the lower end-of the base case scenario-stabilization of the situation and no further deterioration in economic and administrative management, characterizedby: (a) Domestic revenues as a share of GDP remaining at or above 11%, domestic borrowing below 2% of GDP, and satisfactoryimplementation of VAT; and (b) Improved management of public expenditures, with no further increase in the number of projects in the public investment program, and adequate funding for donor-assisted and other priority projects. (ii) beyond stabilization-Le., within a more solid base case scenariewith a modest, but clear reform effort, as reflected in the followingtypes of steps: (a) Tangible progress in decentralization and local self-government, with greater local involvement in the management of developmentprograms; (b) Action on improving central government administrative performance, such as stricter enforcement of rotation rules; (c) Privatization of three public enterprises, and improvement of the efficiency and transparency of privatization procedures and decision-makingprocesses; (d) Introduction of a three-year rolling investment program, and full funding of core programs and projects; (e) Progress in restructuring RBB and preparing its divestiture, completing the privatization of NBL, improving banking regulations and improving NRB's supervisory and regulatory capacity; (f) Progress in telecommunications reform, including introduction of competition; and (8) Introduction of new measures to reduce corruption. An appropriate mix of Bank interventions-both lending and non-lending-were proposed to assist Nepal in achieving these outcomes. B. Achievements during the CAS period Background For four years-until December 2002-given the limited and slow progress in implementing reforms, Nepal remained in a low case scenario. Given the fungibility of aid resources, without substantial improvements in public expenditure management and public service delivery, more financial assistance from IDA would not have been a solution to Nepal's problems. HMGN clearly began recognizing poor governance-reflected most acutely in weak implementation of reforms, poor service delivery and corruption-as a central obstacle to development (see Box 1). Growing recognition of the gravity of the financial sector conditions and the direct link to the system of poor governance-  Appendix II Implementing the Previous CAS and Lessons Learned Page 2 of 9 specifically, the possible risk of a financial sector crisis, the huge drain on public resources and an indication of HMGN's willingness to do away with the `old way' of doing business-also led the Bank publicly discussed in its entirety in Nepal and also The 1998 CAS was the first such document to be Box I: Publicizing the CAS to attach special importance to financial sector reform. As the first major step towards implementing the financial sector reforms, the widely disseminated,including in Nepali. As a result, introduction of external management teams in the not only did the strategy and the various lending two large ailing commercial banks became the scenarios quickly enter the development lexicon, the `litmus test' for moving into a base case scenario. benchmarkshriggers helped broaden people's The Bank's position in this regard was well-known understanding of governance, that previously had been narrowly understood as corruption. Since this and other donors-most notablythe IMF andDiD- also selected this important reform measure as a key to was the first CAS that explicitlylinked Bank support overall progress against governance-related milestone for providing additional support to Nepal. benchmarks, it took a while for Government officials to understand the implications of this shift with regard outputs to the funding of specific sectors. However, gaining this understandinghas forced some senior officials to Lending. The low case lending program think more holistically about development. They focused on community-based projects-to mobilize realized that "good performance" in their particular and leverage social capital at the grassroots level- sector was not sufficient to warrant Bank support,but and on supportingspecificbut modest reform efforts. that such support can only be forthcoming with improvements in overall governance;hence, resulting Implicitly assuming a quick transition to the base in the development of a healthy peer pressure for case, the Bank continued to prepare a number of has been put "the 1998 CAS eventually shook the accountability and governance improvements. As it larger, `reform-heavy'projects and in retrospect may have missed an opportunity to develop and deliver a whole tree to the point that the branches were few more `lowcase appropriate'projects. . sufficientlythreatened." While in the low case scenari+i.e., between December 1998 and December 2002-four projects were approved for a total of US$94.6million; specifically: The Second Basic and Primary Education Project (BPEP, Cr. 3185-NEP) was approved in March 1999 (US$12.5 million). Conceived as an Adaptable Program Loan (APL), the objectives of the first phase are to develop institutional capacity for qualitative and quantitative improvements in primary education. Through the project, a number of donors-including IDA, Denmark, the European Union, Finland, Norway, Japan, UNICEF and the ADB-are providingjoint support to a well-formulated ten- year sectoralprogram; The Rural InfrastructureProject (Cr. 3215-NEP) was approved in May 1999(US$5 million) to strengthen the institutional capacity of a decentralized governance system in its planning and managing capabilitiesto improve the quality, efficiency and sustainabilityof rural roads with active participation of project beneficiaries, Given limited Bank experience implementing community-based road projects in Nepal, a Learning and Innovation Loan (LIL) was selected as the appropriate vehicle to test this fundamental shift in approach. Through this project a number of decentralization options are being tested, including working: (i) directly with the DDCs; (ii) with DDCs through contractors; (iii) with CBOs; and (iv) through NGOs. The many implementation challenges associated with this project have made it a learning experience for all involved. Nevertheless, recent results are promising as confidence and experienceare being accumulatedto work more effectivelyat grassroots levels; The objective of the Road Maintenance and DevelopmentProject (Cr. 3293-NEP)-approved in November 1999 (US$54.5 million)-is to help achieve sustainable maintenance, rehabilitation and construction of an economicallyjustifiable strategicroad network, while also promoting more sustainable funding and efficient public sector management of road maintenance. The project supports key sectoral  Appendix 11 Implementing the Previous CAS and Lessons Learned Page 3 of 9 policy reforms by establishing a Roads Board and Road Fund to assure a stable source of funding for maintenance expenditures, while at the same time providing motorable access to isolated districts in the mid- and far-westregions of the country (the heart of the insurgencyarea); and The Telecommunications Sector Reform Project (Cr. 3581-NEP) was approved in December 2001 (US$22.6 million) and supports on-going sectoral reforms and increasing rural access to telecommunicationsservices through the licensing of a private operator (selected on a competitive basis) and establishingpublic telecommunicationscenters. Following the move to the base case scenario in December 2002, three additionalprojects have been approved for a total of US$96.9million, specifically: The Financial Sector TechnicalAssistance Project (Cr. 3227-NEP) was approved in December 2002 (US$16.0 million) and supports the efforts of HMGN to improve the financial sector in order to bring macroeconomic stability and promote private sector-led economic growth. The project focuses on three major objectives: (i) helping to restructure and re-engineer the Central Bank (Nepal Rastra Bank, NRB) so that it can effectively perform its key central banking functions; (ii) initiating commercial banlung reform in the two large ailing commercial banks that dominate the sector-Rastriya Banijya Bank (RBB) and Nepal Bank Limited (NIL)-by introducing stronger bank management that protects their financial integrity; and (iii) supporting a better environment for financial sector reforms in areas such as enhanced credit information, better financial news reporting, and better training for staff in financialinstitutions; The Power Development Project (Cr. 3293-NEP) was approved in May 2003 (US$50.4 million IDA Credit and US$25.2 million IDA Grant) to help: (i) develop Nepal's hydropower potential in an environmentally and socially sustainable manner so as to help meet electricity demand; (ii) improve access of rural areas to electricity services and (iii) promote private sector participation in the power sector as a way to improve sector efficiency and to mobilize financing for the sector's investment requirements. In early-FY04, the potential for a parallel Global Environmental Facility (GEF) operation-to possibly include contingency financing for pipeline development of small and micro hydro projects, and support for institutional developmentto facilitateprivate sector delivery of energyefficiency services-will be assessed,with a possibleoperationcoming later on; and Another LE-the CommunitySchool Support Project (Cr. 3808-NEP)-was approved in June 2003 (US$5 million) to support the devolution of the responsibility for management of schools to communities. The project provides support for school grants, scholarships, capacity building, and monitoring and evaluation. The lessons learned from this project will help IDA (together with HMGN and the other education developmentpartners) design furtherphases of BPEP. Analytical and Advisory Activities (AAA). Consistent with the low case scenario, strong emphasiswas placed on helping to build the agenda and needed consensus for reform. To a large extent, the introduction of the Medium Term Expenditure Framework (MTEF) and the Immediate Action Plan April 2000) was very influential in this regard. The PER helped to shape the framework for many of the (IAP)have been prompted by the Bank's dialoguewith HMGN. The Public Expenditure Review (PER, public expenditure reforms that are currently under implementation or envisioned. This has been followed up with intensive technical assistance and dialogue-in collaboration with the UK Department for International Development (DfID)-which have helped (and will continue to help) HMGN develop and implement the MTEF. As important,the Bank's continuing dialogue with the authorities on the topic of the financial sector reforms-including financing the RBB/NBL diagnostic studies and the Nepal: Financial Sector Study (October 2002)-have kept the process on track, although admittedlyprogress has  Appendix11 Implementing thePrevious CAS and Lessons Learned Page 4 of 9 at times been slow'. Otherkey pieces have also focused on reform agenda items, including: (i) Priorities and Strategiesfor Education Sector Reform (July 2001) which helps to identify and build consensuson a comprehensive reform agenda at all levels in this fundamental sector2; (ii) Proposed Power Sector Development Strategy (March 2001) which identifiesthe key constraints and makes recommendationsto expand Nepal's hydropower resource potential to service the electricity needs of the people and to generate export potential; (iii) The Business Environment and Manufacturing Performance in Nepal (December 2000), the first investment climate survey carried out in the South Asia Region; and (iv) more recently, the Nepal: Trade and Competitiveness Study (July 2003), carried out under the Integrated Framework (IF). Another AAA focus area has been governance,including decentralizationand improving service delivery. The study Poverty at the Turn of the Twenty-First Century (May 1999)analyzedpoverty trends and projections, the poverty profile and key elementsfor a poverty alleviationstrategy. Related to service delivery, the Terai Options Study (October 2000) examined experience with various institutional arrangements for delivery of rural services in the Terai and makes recommendations for future developmentof cost-effectiveservicedelivery in the context of decentralization. A CountryProcurement Assessment Report (CPAR) was finalized in FYOl and many of its recommendations are being implemented. A Country Financial Accountability Assessment (CFAA)--carried out with an extremely committed HMGN partner and other donors-was completed in FY02, also with an agreed action plan currently under implementation3, In the area of decentralization, three areas-the proposed Poverty Alleviation Fund (PAF), fiscal decentralization,and local institutions in the delivery of services in rural areas-have been selected as focal areas for the coming years. The PAF policy note Towards a Sustainable Approach for Poverty Reduction and Decentralization in Nepal was finalized in November 2002. The majority of the formal reports have been-and continue to be-followed up by policy dialogues,consensusbuilding, and technical assistance,which have resulted in a remarkablyhigh level of achievement on many of the original CAS outcomes, especially in the areas of public expenditure management,decentralization,financial sector reform, telecommunications,and educationreform. Among the informal studies, the Bank facilitated and OECDDAC led a Review of Development Partnerships. The review-a highly consultative exercise+overed the whole gamut of donor-recipient relationships that have impacted development partnerships in Nepal. The findings complemented HMGN's own formulationof a Foreign Aid Policy (FAP) that was endorsedby the developmentpartners during the 2002 Nepal Development Forum. Outcomes Over the last few years, the South Asia Region has emphasized a results-focused work programming. The Nepal Country Team has been in the forefront of these efforts, and has set the 1 DfID and the IMF have been important partners in these efforts. In addition, IMF has been providing technical assistance to the central bank. 2 The intense sectoral dialogue that followed this work and has continued through the implementation of BPEP has in large part been responsible for triggering the current efforts to transfer school management to community-based groups. 3 Financing was obtained under two different Institutional Development Fund (IDF) Grants to assist in the efforts to implement certain recommendations/action plans of the CPAR (related to public procurement reform) and CFAA (related to public audit reform).  Appendix 11 Implementing the Previous CAS and Lessons Learned Page 5 of 9 standard for the countries in the region. Over the last two years, the team has adopted a `portfolio approach' to outcomes, in which the entire team-not an individual-is held accountable for achieving a high proportion of outcomes that have been selected using specific criteria. The approach employed- discussed below-ensures that risluer, but high importance outcomes will also be attempted. The structure used over the last two years is as follows: 0 Each `outcome' is a significant change that would be highly desirable and possible within the four-year CAS horizon. For the immediate year ahead, a specific `milestone'-i.e., key step toward achieving the three-year outcome-is defined; 0 Such a milestone is expected to have less than 100%probability of happening-for practical purposes probabilities of 20, 40, 60 and 80% are assigned-even with best efforts on the part of the Bank; 0 The set of outcomes is seen as a `portfolio' in its entirety-i.e., consisting of some high- probability, but relatively low-impact outcomes, and some low-probability, but high-impact outcomes. To avoid extremes, the set of outcomes is normally constructed with an expected overall annual success rate of around 65 - 70%4. 0 The matrix and annual milestones are updated each year, with some outcomes replaced- either through achievement or a change in strategicpriorities-and new milestones defined; 0 Rather than holding staff accountable for achievement of specific outcomes, the Country Team is collectivelyheld accountable for the overall outcome of the portfolio5;and 0 The same approach is applied to a set of annual milestones as well, so that annual performance can be monitored against some expected overall achievement rate. Near the end of each FY, the country team evaluates the achievement of the milestones during the year. Reflecting on the lessons learned and the experiencein general, the team then updates the outcomes matrix and annual milestones for the following FY. Such a process has led to a situation in which there is real team ownership and awareness of the milestones and outcomes. This has also resulted in a more holistic approach to the Bank's efforts in Nepal, in which sectors and instruments are initially `ignored' as the team focuses wholly on outcomes, with the discussion on instruments to achieve those outcomes becoming secondary. The results of the review exercise for FY03 are presented in Table 1. Of the 15 milestones established for FY03, 11 were substantially achieved, resulting in an overall `success rate' of slightly higher than 70%, as compared to the original expectation of 60%. It is interesting to note that a number of milestones assessed as having a relatively high probability (Le., 80%) of being achieved in the beginning of the FY-such as developing the design of the decentralization fiscal fkamework, and launching a joint review of the experience of community-based rural development programs-were not achieved. However, a number of milestones assessed as having a relatively low probability (Le., 20 or 4 This does not imply that for outcomes that are not fully achieved, there will be no progress. In many cases, it is likely that some progress toward the ultimate outcome will have been made. 5 Unless an entirely unforeseen event changes the country setting profoundly, a significant shortfall in reachg the expected rate of achievement would mean either: (i) the initial assessment or strategy was unrealistic; or (ii) the Bank's efforts were inadequate.  Appendix 11 Implementing the Previous CAS and Lessons Learned Page 6 of 9 40%) of being achieved in the beginning of the FY-such as piloting the transfer of management of primary schools to communities, and establishing a realistic resource ceiling for development expenditures-were achieved. Many of the outcomes adopted by the country team for the FY03-FY05 period are closely linked to the outcomes implicit in the 1998 CAS. These links, as well as an assessment of the CAS outcomes and the instruments employedto achieve these outcomes,are provided in Table2. C. Lessons Learned Today, there is a realization within Nepal that the Bank is truly concernedwith the well-being of the poor and that it is not possibleto simply `negotiate'aid out of IDA. However, this realizationwas not necessarily quick or easy in coming, and along the way, a number of important lessons have been learned-both fi-om our experiencesin Nepal and world-wide, including through initiatives such as The Global Poll (May 2003). While many of these lessons have been alluded to above, they can be summarized as follows: 0 In an environment of poor governance, closelylinking lending levels to progress in implementing reforms and achieving results on the ground-not just promises-can be tremendously effective in a country such as Nepal. In doing so, it is important to send a firm and consistent message-and most importantly, stick with it-that unless the important issues are seriously tackled-improving governance and service delivery-additional fundingwill not be forthcoming(at least fi-omthe World Bank). While such an approach by itself would not prompt reforms, when spontaneousreform initiatives emerge, it can provide an important and constructivediscipline to the process and can even strengthen the hands of the reform leaders. Such a stance can foster peer pressure among senior officials to look at development more holistically, as they realize that sectoral funds are held hostage to improvements in larger country goals (i.e., governance); 0 A work program grounded in an outcomes approach-in which all team members share responsibility for achievement of a portfolio of outcomes-acourages a more holistic and multi-sectoral approach. Outcomes should be realistic, focused on those areas where the Bank plays a significantrole, and clearly linked to stated country objectives (such as PRS objectives or MDGs). In addition, it is importantto be able to measure milestoneshntermediateindicators and periodically monitor and evaluate whether these milestones are being achieved; 0 The introduction of a number of important reforms-such as the MTEF, the financial sector reforms, the IAF', and the transfer of primary schools to community management-have resulted from a long Bank associationand consistent dialoguewith HMGN. To be most effective, it is essentialto invest in a solid relationshipbuilt on a strong dialogue with key counterparts. In addition to building consensus for changeheform, such an investmentalso builds and encourages ownership of and buy in for the reform programs, while proactive outreach contributesto a wider understanding of development challenges and opportunities; 0 Implicitly assuming a quick transition to the base case, the Bank continued to prepare a number of larger, `reform-heavy'projects during the CAS period. In retrospect, opportunitieswere likely missed to develop and deliver a few more `low case appropriate' projects-typically modest in size, and often supporting community-based projects or small, sector specific reform efforts (e.g., telecommunications sector); 0 The interplay of diverse political economy realities has an important impact on reform implementation and hence, needs to be understood better for the Bank to be more opportunistic in its  Appendix 11 Implementing the Previous CAS and Lessons Learned Page 7of 9 support. When reforms do happen, they often appear to be spontaneous and episodic, and tend to fall outside the conventional frameworks that donors prefer to work in. Finally, Government officials are not necessarily good at showcasing reform progress, nor are they practiced at communicating successes to the public at large. These are important aspects to stress if the benefits of reforms are to be the best arbiter for deeper reforms in the future; The linkages between peace and stability, and reducing poverty are strong-i.e., a potential vicious circle. Developmentlpoverty reduction can not delayedpostponed until there is peace and stability, as the root causes of conflict-Le., failure of governance, including lack of delivery of public services, and horizontal inequality and social exclusion-are often the major challenges of reducing poverty; and 0 Donor coordination is important, but is not always easy as donors often send different and mixed messages to the Government--e.g., the Nepali reform efforts of the late-1990s/early-200Os warrant low case lending levels vs. these reform efforts warrant base case lending levels. Ultimately, the Government must be encouraged to coordinate donor assistance by setting out its own development strategies and priorities. Clearly, donors-including the Bank-need to respect Government efforts to `regulate' foreign assistance through vehicles such as a Foreign Aid Policy (FAP). Such an effort, along with a firm foundation for donor assistance-such as that contained in a Poverty Reduction Strategy-will encourage more holistic and coordinated development.  Appendix 11 Implementing the Previous CAS and Lessons Learned Page 8 of 9 Table I: Neual Stratepic Outcomes for FY03-FY05 and Evaluation ofFYO. Milestones Assessed Evaluation of Outcomes FY03 Milestone Likelihood FY03 Milestones 1 An effective and transparent fiscal 0 Develop the design of the 80% No, DDCs were dissolved in decentralization mechanism decentralization fiscal framework. September 2002 and never established. reconstituted. 2 A Poverty Alleviation Fund (PAF) 0 Establish a good PAF 60% Yes, the ordinance is established and operationalized. framework. awaiting approved by cabinet. 3 At least 10%of primary schools have 0 Establishment of a 20% Yes, transfer of 150 schools community based management decentralized funding framework started. supported by Government grants. and initiation of piloting. 4 A coherent health reformprogram is in 0 Broad consensus on the sector- Yes, preparation of place supported by HMGN and donors. 40% wide program among comprehensive program is HMGNidonors. underway. 5 A system established to support 0 Joint HMGN/Bank review of 80% No, couldn't find a suitable community-based rural development experience launched. person to do the work. urograms. 6 Priority funding of the Agriculture 0 Significant matching of budget 60% No, Focus on Pls has held, Perspective Plan (APP). allocation to APP priorities. but not enough. - 7 Private operators introduced in 0 PDF created. 80% Yes for PDF. Kathmandu, rural telecom, and d a n d 0 Rural telecom operator 80% No for introduction of rural container terminals; Power introduced. telecom operator. - Development Fund (PDF)established. 8 Roads Board established and 0 Roads Board established and its 80% Yes, the Board has been operationalized. operations started. created and expected to start working in next year. 9 RBB and NBO restructured. 0 Management teams installed in 80% Yes, NBL and RBB under RBB and NBL, and effectively external management teams. supervised by NRB. 10 Regulatory functions and organizations Agreed plan for NRB 60% Yes, re-engineering support of NRB strengthened. strengthening. team is in place. 11 MTEF (with realistic resource ceiling) 0 Establish realistic resource 40% Yes, FY02 ceiling is soft, cstablished and made operational; ceiling for MTEF. but priority funding for P1s mechanisms in place to monitor and has served as a reasonable :valuate outcomes and cost- ceiling. - :ffectiveness of public expenditures. 12 Public debate on development agenda 0 Regular appearances of think 60% Yes, significant stablished. pieces by donors and political improvement in the quality leaders in Nepal & English media. of debate. - 13 HMGN/donoracceptance of common 0 Acceptance of common Yes, the Foreign Aid Policy irinciples of behavior. principles of behavior. 40% paper is being respected. - 14 3ther fiduciary work and some 0 CPAWCFAA follow up. Yes, recommendations of ireparatory work. CPAR and CFAA accepted and being implemented.  Appendix 11 Implementing the Previous CAS and Lessons Learned Page 9 of 9 Table 2: Evaluation of CAS Outcomes Evaluation Instruments Historical revenue to GDP ratios: FY99/00: 10.7%;FYOO/Ol: Dialogue [traditionally more in 11.4%;FYO1/02: 11.5%;FY02103: 12.3% the realm of IMF] Real progress in implementation of VAT ,although domestic borrowing has risen Number of development projects reduced from 785 (mid-1990s) Dialogue, PER, MTEF/IAP to 470 (FY02/03); MTEF adopted and all development projects support/TA prioritized (P1,P2, P3); Funding ensured for P1s Progress in decentralization legislation and in devolving Dialogue/IAP; Education schools, health facilities, agricultural extension and postal Reform Strategy AAA; BPEP, services to local levels; some (although limited) progress Community School Support towards establishing Poverty Alleviation Fund (PAF) Project; PAF policy note A hring freeze has been maintained and a number of successful Dialogue/IAP voluntary retirement schemes implemented; civil service roster and payroll computerized; Office of the Controller General producing/circulating periodic expenditure reports * - Butwal Power Company privatized; two SOEs closed; Dialogue/IAP privatization of five additional SOEs initiated [see (i) (b) above] [see (i) (b) above] External managers in place in NBL in July 2002; external Dialogue/IAP, Financial Sector managers in RBB in February 2003; re-engineering support Study, Financial Sector team in place in Central Bank in February 2003 Techmcal Assistance Project National telecommunications policy focused on sector Dialogue, Telecommunications liberalization adopted in 1999; 65 new private operators provide Sector Reform value added services; second private mobile operator selected in March 2001; license granted to second private national operator for basic services in May 2001; delays in introduction of rural operator (in part due to security situation) CIAA strengthened; CIAA arresting of 5 former ministers and Dialogue/IAP, CFAA, CPAR, other senior officials; independent commission review of IDA Grants property disclosure statements of political leaders and senior I civil servants; citizen's charter in place Notes: CAS outcome as identified in the first paragraph of this appendix. " "Nepal strategic outcome as identified in Table 1.   Appendix I11 The 2003 Immediate Action Plan continuing efforts to bolster the country's track record for implementing reforms. In June 2002, the The development of the 2003 Immediate Action Plan (IAP)marks the second year of HMGN's Council of Ministers adopted the first Immediate Action Plan (IAP)to establish a track record for implementingwhat it promises. The 2002 IAP focused on expeditingreforms in three areas-prioritizing public expenditures, improving service delivery and fighting corruption, as well as improving accountability. The successful implementation of the first IAP established a common understanding on helped to establish credibility for HMGN for undertaking reforms. Building on the success of the 2002 the essential need to carry out all the actions included in the IAP.Moreover, their implementation has key reforms. IAP,HMGN has subsequentlydecided to formulate an annual IAP to bridge capacity gaps and expedite Poverty Reduction Strategy (PRS). This second IAP consists of 24 reform actions-an increase from the The 2003 IAPcontains a set of measures that are critical for the successfulimplementationof the set of 19 containedin the 2002 version. Not only are the measures directly linked to the four PRS pillars, most programs are tied to the Medium Term Expenditure Framework (MTEF). The Cabinet approvedthe IAP in July 2003 and implementation of most actions is expected to begin by September 2003. In private sector development, rationalization of SOEs, infrastructure development, targeted programs, addition to the three areas covered under the 2002 IAP,the current IAP includes reforms in agriculture, decentralization,as well as measures to address human rights. The Reform and Development Group-a joint government-donortask force responsible for developing the IAP- identified lead Ministries and donor agencies (`Lead Agencies') responsible for carrying out detailed assessments of the respective actions. The assessments include an explanation of the impact or importance of the actions, monitoring indicators, specific outcomes, preliminary cost estimates, timeframe for implementation and the key implementing agencies on both HMGN and donor sides. The 2003 IAP actions and assessments are presented in the followingmatrix.  3 h 3 3h m c, 1 2h R0 a I - N  10 N B0 B0 B0 d 0 N d d i2ri N x 0 i2 2 0 0 0 3 N N 0 2 8 8 rj rj N ri 3 h I h h 222 0 N N h E .C cC 4 'c ca EE cE . c c - c2E .I Y Y  9 Z .-rCct c 5 ce .C 2+CE LC cE 4 c1E f c E E .I 0 4 CI  .I a2 m 2 4 NY uB z c, z 24 .I Y2 8a C b Fz Y 0 z sauE m E 0 .I 4c c, 0 5 a2 c, 0 L Y3 \ Yu ed E Y c, Ea2A rn 5 I .I a ,Lz E .P 4 kw Y   4 o m x 2 3  .-+c E -3 L C a + E . E i c c c E 2  NU dl --r 2 d m i U GE 30 H  I . . --. n m 8 N %8 8 +  Y d 0 0 CI Y m M $ 4 a .s  E 3 t i.: E Y cEc .C 5r; cE  Appendix IV' Fund RelationsNote InternationalMonetaryFund Public InformationNotice (PIN)No. 03/110 700 19thStreet,NW EMBARGOED Washington,D. C. 20431 USA NOT FOR NEWSWIRE TRANSMISSION UNTIL 11:30AM WASHINGTON TIME (1530 GMT) September5,2003 IMF Concludes 2003 Article IV Consultationwith Nepal consultationwith Nepal.2 On August 22,2003, the ExecutiveBoard of the International MonetaryFund (IMF) concludedthe Article IV Background Nepal remains among the poorest countries in the world with almost 40 percent of the population living in poverty due to insufficient growth and inadequate targeting of the poor. During the 1990s, macroeconomic conditions remained broadly stable and the fiscal position was manageable, but growth was constrained by financial sector weahesses, weak public sector management, and poor governance. In the financial sector, Nepal Rastra Bank (NRB) oversight is still weak, and intermediationis inadequate largely due to a banking environment in which loan default is endemic, especially by well-connected borrowers. Partly as a result of this, the two largest commercial banks now have large nonperforming assets. Similar problems exist at two large developmentbanks. In the public sector, investmenthas been spread.thinly over projects and enterprises suffer from weak management and accountability. More recently, intensified security problems and adverse external developmentscontributedto lower growth and the fiscal positionhas deteriorated since 2000/01. The ceasefire agreed in January 2003 with the insurgents has renewed hopes for peace and efforts have been made to sustain the reform momentum. Progress in achieving lasting peace would facilitate poverty reduction and implementation of policies contained in the government's Poverty Reduction Strategy Paper (PRSP). However, political uncertaintiespersist as major political parties continue to maintain that the appointment of governmentsby the King since the dissolution of parliament is unconstitutional.The parties have also refused tojoin the peace talks. 1 Note: This Appendix is as of July 25, 2003 and as such, the indicators deviate from the more updated indicators provided elsewhere in the document. 2 Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, whch fonns the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.  Appendix IV Page 2 of 5 GDP growth is estimated to be 2 percent in 2002/03. The ceasefire has helped restore some normality in the transport and service sectors and the decline in tourism may have halted. There are also signs that some exports and manufacturing production are rebounding. Inflation, which rose to about 7%percent in mid-May (12-month basis) reflecting price developments in India, administrative price changes, and supply factors, is expectedto moderate by early 2003/04. The 2002/03 budget met revised targets set in a mid-term review. Based on weak revenue performance due to lower activity during the first half of the year and external aid shortfalls relative to the initial budget targets, the authorities revised the budget at mid-year. Specifically,the tax revenue target and external financingwere revised down. To compensate for these shortfalls, total expenditure was also revised down and the revised budget set a net domestic financing target of 2 percent of GDP. Following the announcement of the ceasefire, economic activity picked up and revenue performance improved. However, capital spending was below the revised budget, reflecting continued implementation constraints at the local level. As a result, domestic financingwas around 1%percent of GDP. Monetary policy has been accommodative and the real effective exchange rate has depreciated. To help economic recovery, the NRB lowered cash reserve requirements by 1 percentage point in August 2002 and maintained a refinancing facility for lending to "sick" industries. Aided by the recovery in activity and monetary easing, private credit appears to have revived and higher remittances contributed to a rise in banking system foreign assets. However, reserve money growth has been curtailed, due largely to lower net credit to the government. Lending and deposit rates have declined somewhat. The Nepalese rupee has depreciated in real effective terms since early 2002, reflecting the peg to the Indian currency which has appreciated only somewhat against the weakening US dollar. Balance of payments developments turned favorable in mid-2002/03 and external reserves are adequate.Large and increasing remittances helped buoy the current account. Garment exports began recovering in late 2002, while recorded exports to India declined, carpets and pashmina exports continued to stagnate, and imports increased with the recovery. The current account (excluding official transfers) is expected to move into a deficit of about K percent of GDP, but with higher aid and other inflows official foreign exchange reserves are expected to rise to US$1 billion (6%months of imports of goods and services). In 2002/03, significant progress was made in financial sector reform implementation. The NRB took steps to reduce staffing through a voluntary retirement scheme (VRS). Progress was made in restructuring the two largest commercial banks, which had external management teams installed. The teams have prepared management plans, made progress in assessing the banks' financial status, and proposed VRSs to reduce overstaffing. Some improvements have already taken place with success in loan recovery and branch rationalization, although loan recovery from well-connected borrowers continues to be difficult. Prioritization of budgetary spending improved, anti-corruption efforts were boosted, and public enterprise reform implementation and governance reforms progressed. To improve prioritization, a Medium Term Expenditure Framework was introduced with World Bank assistance to help align development spending with national and sectoral priorities. Administered price increases for petroleum products were announced in March 2003, although some price increases were rolled back under public pressure. Liquidation procedures were initiated for four public enterprises; preparations for the privatization of one enterprise were brought to an advanced stage. Governance reforms progressed and anti-corruption efforts were boosted. The cabinet approved in September 2002 the elimination of 7,500 vacant civil service positions. To tackle corruption in public life, the  Appendix IV Page 3 of 5 Commission for Investigation of Abuse of Authority and a newly established Judicial Commission initiated investigations against politicians and revenue officials perceived to have accumulated unaccountable assets. The Anti-CorruptionStrategywas adopted. Executive Board Assessment Executive Directors stressed that to address the pervasive level of poverty in Nepal, growthneeds to be raised significantly over the medium term through vigorous implementationof structuralreforms, particularly in the financial and public sectors. In this regard, Directors welcomed the authorities' Poverty Reduction Strategy Paper (PRSP), which is founded on broad-based growth, social sector development,targeted programs for the poor and deprived groups, and improved governance. Directors looked forward to considering a Joint Staff Assessment of the PRSP in the near future. They encouraged the authorities to reach early agreement on a program that couldbe supportedby the Poverty Reduction and GrowthFacility to help achieve PRSP goals. Directors welcomed the ceasefire agreement with the insurgents reached in January 2003. They underlined that continuedpeace was essential to help sustain the economicrecovery currently under way. Directors also noted that progress in the peace talks and the build up of confidence should help relieve budgetary pressures for security spending. Directors commended the authorities' for maintaining broad fiscal stability to create conditions to support economic growth. Looking forward, Directors endorsed the authorities' fiscal strategy based on revenue mobilization, expenditureprioritization, and a reduction in domestic borrowing. They welcomed the 2003/04 budget as the first step in implementing this strategy. However, Directors called for a determined effort to meet the revenue targets and to resist spending pressures. To raise revenue over the medium term, Directors suggestedcuts in exemptions,improvementsin tax and customs administration,and increases in the VAT rate. Directors welcomed the steps taken to prioritize development spending to help achieve poverty reduction goals, including the introductionof a medium-term expenditure framework, and encouraged the extension of such efforts to all expenditures.Directors noted that the envisaged reductions in domestic borrowing would help maintain fiscal sustainability over the medium term, especially in view of potentially large contingent liabilities from financial sector and public enterprisereforms. Continued technical assistance in the fiscal area will help address capacityconstraints. Directors agreed that monetary and exchange rate policies should remain geared to supporting the exchange rate peg to the Indian rupee, stressing that the peg had served Nepal well given its close links with India. Looking forward, they noted that prospective external developments, such as the phasing out of the Multi- Fiber Agreement, would likely have implications for external competitivenessand the appropriate choice and level of the peg. Directors pointed to the need for policy measures to ensure that remittances are sustained, as well as for efforts to diversify Nepal's export base. They also noted that external competitiveness could be enhancedby measures to raise laborproductivityand lower transport costs. Directors commendedthe authoritiesfor progress in financial sector reforms, but noted that much remained to be done. They stressed the need for strengthening Nepal Rastra Bank (NRB) supervision of the financial sector. The NRJ3 should also improve performance incentives for skilled personnel, while encouraging separations at lower levels. Directors welcomed the appointment of external managers at the two largest insolvent commercial banks, and noted recent steps taken by the new managers to improve the financial condition of the banks. To help support these efforts and, more generally, to create a sound banking environment, Directors noted the authorities' intention to phase out priority sector lending requirements, and  Appendix IV Page 4 of 5 emphasized the effective implementation of recently adopted debt recovery mechanisms, including the Debt Recovery Tribunaland blacklistingof loan defaulters. Directors welcomed ongoing public sector reforms, including the elimination of vacant positions, the introductionof merit-basedpromotions, the decompression of the wage scale, as well as improvements in the public procurement process. Looking forward, Directors recommended the adoption of civil service accountabilityin order to improve policy implementation.They welcomed the public enterprisereform efforts that would lower government ownership in the economy and increase the enterprises' net budgetary contribution-through privatization and restructuring of viable enterprises and liquidation of unviable ones. SeveralDirectors stressedthat due regard shouldbe paid to the pace and sequencingof these reforms.Also, an appropriatecompensationscheme couldhelp smoothimplementation of workforcereductions. Directors welcomed recent efforts to combat corruption, but emphasized the need to pursue forcefully those responsible for the misuse of public funds. Directors supported the authorities' plans to increase decentralizationto enhance service delivery. However, they noted that the implementation of these measures should be accompanied by improvedpublic sector governance and capacitybuilding at the local level. Directors supported measures to improve the business climate for private sector development through legal reforms and streamliningof administrativeproceduresto facilitatetrade. They recommendedrevisionsto labor legislation to make labor hiring more flexible and modificationsto the Company and InsolvencyActs to allow more orderly and timely exit of unviable firms. Directors commended Nepal for its open trade regime, and welcomed the authorities' efforts to gain early World Trade Organization (WTO) accession. Directors welcomed the elimination of the exchange restriction arising from quantitativelimits on payments for personal travel. Directors encouragedthe authoritiesto further improve statistics to enhance policy formulation and monitoring. They urged full implementation of Fund technical assistancerecommendations. Public Information Notices (PINS)are issued (i) at the request of a member country, following the conclusion of the Article IV consultation for countries seelung to make known the views of the IMF to the public. This action is intended to strengthen IMF surveillance over the economic policies of member countries by increasing the transparency of the IMF's assessment of these policies; and (ii) following policy discussions in the Executive Board at the decision of the Board. The Staff Report for the 2003 Article IV Consultation with Nepal is also available.  Appendix IV Page 5 of 5 Nepal: Selected Economic Indicators, 1998199-2002103 l' 1998199 1999100 2000101 2001102 2002103 Est. '' -, (Percent change) Output and prices Change in real GDP 4.5 6.1 4.8 -0.5 2.0 Change in CPI (end-period) 9.0 0.6 3.4 3.5 7.5 31 (Percent of GDP) Budgetary operations Total revenue 10.2 10.7 11.4 11.5 12.0 Total expenditure 15.4 15.7 17.6 17.2 16.7 Current expenditure 9.3 9.6 11.2 11.6 12.4 Capital expenditure and net lending 6.1 6.1 6.4 5.7 4.2 Overall deficit 4' 3.9 3.5 4.5 4.3 2.4 (Percent change) Money and credit Domestic credit 16.1 17.8 18.8 9.2 12.4 Broad money 20.8 21.8 15.2 4.4 8.1 (In millions of US. dollars, unless otherwise indicated) External sector Exports, f.0.b. 763 971 942 754 670 Imports, c.i.f. 1,390 1,713 1,773 1,496 1,623 Current account " 24 28 65 144 -32 (In percent of GDP) 61 0.5 0.5 1.2 2.6 -0.6 Overall balance 136 192 38 -31 27 Gross foreign assets 795 946 1,020 1,048 1,088 Rupees per U.S. dollar (end-period) 68.5 70.8 74.7 78.0 75.1 Sources: Nepalese authorities; and IMF staff estimates. " Fiscal year ending July 15. 2`Asof July 25,2003. 31Mid-May. 4`After grants. " Includes re-exports. 61Before grants.   Appendix V The Main Findings of Two Key Fiduciary Assessments: The Country Financial Accountability Assessment (CFAA) and the Country Procurement Assessment Report (CPAR) A. The Country Financial Accountability Assessment' Context Nepal's legal and regulatory framework for ensuring public sector financial accountability is impressive for a country at its level of economic development. The 1990 Constitution requires the Ministry of Finance to submit a detailed comparison of the financialresults and budgets of all ministries to Parliament at the end of each fiscal year. The Constitution also accords the Auditor General (AG) completelegal and professionalindependence,exempting his emolumentsand the budget of the Office of the Auditor General (OAG) from parliamentaryvote. The Constitutionalso created a Commission for the Investigation of Abuse of Authority (CIAA) to investigate and recommend actions against errant and corruptofficialsand prosecutethem, if necessary. Furthermore, when the Public Accounts Committee (PAC)-headed by a member of the main opposition party in Parliament-was in session, it was proactive in its undertahngs. It is schedule to meet year round discussingpublic accounts and the AG's annual report and recommendations,as well as all aspects of public sector financial management. All meetings are open to, and receive full coverage in, the press, and it intervenes in on-going procurement processes when impropriety is suspected. Its collaboration with the AG is exemplary. It sends the AG's recommendations to the HMGN with a directive for the implementationof suchrecommendations. The 1999 Financial Procedures Act and 1999 Financial Administration Regulations (FAR) contain detailed and comprehensive provisions for: (i) budget preparation and approval; (ii) accounting and reporting on budget implementation every four months; (iii) a detailed report (Schedule 2 of the FAR) that includes a statement,not only of expenditures,but also of physical results and goals achieved; (iv) elaborate procurement and internal control procedures; (v) annual financial statements at all levels, with a consolidated financial statement for the whole public sector at the end of each fiscal year; (vi) internal and external audits; (vii) ministerial review of project implementation at regular intervals throughout the year, with rewards for good performersand explanationsfor poor performance. The 1999 Local Self-Governance Act (LSGA) presents the structure of local government. The roles, responsibilitiesand relationships of District DevelopmentCommittees (DDCs), Municipalities,and Village Development Committees (VDCs), and the Councils which govern them are explained in the LSGA. The regulations for financial accountabilityat the local level are even more impressivethan those at the center. They contain provisions and instructions for: (i) budget preparation; (ii) proper accounting 1 The CFAA was jointly carried out by HMGN and the Bank beginning in December 2001, with the establishment of a high level National Steering Committee (NSC). The NSC played a pivotal and strong leadership role which demonstrated the high level of HMGN ownership, and also was extremely useful in guaranteeing a high quality product. Throughout the process, a number of stakeholders meetings were held, including with representatives of donors, government agencies, oversight agencies and private sector agencies. Following a stakeholder's workshop in which over 200 people participated, formal discussions of the final CFAA report were carried out in June 2002. Subsequently, HMGN adopted the Development Action Plan of the CFAA.  Appendix V CFAA/CPAR Page 2 of 7 and reporting; (iii) creation of an Accounts Committee in every local body to oversee financial management; (iv) internal and external audits; (v) project monitoring; and (vi) an elaborate system for "ex-post" evaluation of projectswhich assesses,not only the direct costs and benefits of each project, but also the impact on employment creationand on the environment. Key Findings The followingare the CFAA'skey findings. While the legal framework appears comprehensive, Nepal has been less successful with compliance and implementation of the regulations, but commitment to upgrade the public sector's financialmanagement is strong. Compliance with the provisions of the FAR either has not been accorded the priority implied by the regulations. Schedule 2 of the FAR which requires reporting on physical and goal achievements is inadequately monitored. With adequatemonitoring, the linkages between financial progress and physical outputs/outcomes could be measured in ways that would fully meet the Bank's financial management requirements for Bank-financed projects. The imposition of penalties and fines prescribed by the FAR for non-compliance with reporting or other requirements is not strictly enforced. Until recently, 95% of the legal cases brought by the CIAA against errant officials have been unsuccessful but the successrate is reported to have improved to as much as 50%. At the local level, monitoring has been weak with the lack of adherence to M&E by most institutions as required by the LSGA. While accounting staff possess minimum technical qualifications required for the job, they have little or no experience in project accounting and financial management. Technical staff are known to give low priority to resource allocation and to establishing good financial management systems in their respective agencies/projects. Compliancewith internal controls and internal audits have to be strengthened. While the proactive involvement of the PAC during project implementationprocess has helped to check any malpractices or misdeeds, it can at times cause delays in decision-malungwith negative implicationsfor development. Several explanations have been given for the dichotomy between precept and practice: (i) insufficient political commitment or demand for compliance with financial accountability rules and regulations; (ii) reluctance to punish or impose sanctions on anyone; (iii) reported corruption in civil service appointments, promotions and transfers; (iv) politicization of the civil service and its decision- making processes; and (v) some donors and foreign development partners bypassing the requirement for establishing financial systems and requirements for the projects they support, thereby contributing to the lack of compliancewith the country'slaws and regulations. Ultimately, the problem with compliance can be attributed to two basic factors. First, Nepal is still in the process of fully developing a solid financial management framework for implementing the laws and regulations on public accountability. For example, tying expendituresto outputs and outcomes requires a budgetary system that specifies outputs or results expected from expenditures as well as funds; accounting and reporting systems that recordreport quantitative and qualitative achievementsin addition to financial data/financial statements; and an auditing system which enables an independent auditor to trace expenditures and their results. Second, political instability including frequent government changes andmore urgent priorities have diminishedthe attention on financial managementneeds. The present challenge for Nepal is supportinginstitutional changes to shift away from inadequate compliance to earnest and consistent implementation of the country's existing impressive legal and regulatory framework. The CFAA's Development Action Plan (DAP) contains a host of recommendations towards improving financial accountability of the public sector and a summary is providedbelow.  Appendix V CFAAEPAR Page 3 of 7 Budgeting and Accounting Transparent criteria must be developed for selectingofficials to handle state funds, whether in the form of revenue or as spending budget. A key requirement would be the ability of the individual to properly account for the funds as stipulated by existing regulations, including reports on physical results or measurable goals achieved from previous expenditures and to be achieved from the proposed prograddevelopment expenditure. No budget should be accepted or approved for any public office, whether at the village, municipal, district, department or ministry level, nor should Parliament approve the national budget unless the relevant budget contains: (i) a retrospective account of physical or other measurable achievements or goals resulting from previous expenditures; and (ii) a prospective forecast of the physical results or other measurable goals expected from proposed expenditures. A suitable simplified framework should be developed that can be realistically implemented at the local (village, municipal and district) level. Each disbursement to any office (whether at local or at central level) should be made against a report from that office showing: (i) expenditures for the immediately preceding period and their physical or other measurable achievements; and (ii) the proposed expenditures and their anticipated physical or other measurable achievements. Independent Auditing and Parliamentary Oversight The following measures would go a long way to improving the chances that the recommendations of the OAG and the PAC are implemented. The Monitoring Section of the National Planning Commission (NPC) should be strengthened to ensure full ownership by NPC for instituting a realistic system of monitoring all development projects, in addition to the core projects, in close collaboration with concerned line ministries, and to report their progress three times a year. The Financial Comptroller General Office (FCGO) and the internal audit services at central and local levels ought to be strengthened to be able to: (i) certify offices qualified to receive and properly account for funds; (ii) monitor compliance with the new regulations (that is, the above recommendations) all through the year; and (iii) take proactive actions to rectify any violations of rules and regulations before they are raised by external auditors. The OAG should improve its capacity to confirm annually whether or not the new rules are being complied with and to provide services in financial auditing and outcomes-based performance auditing. Capacities of the line ministries have to be built to effectively monitor their programs and prepare time-bound action plans to rectify issues or implement recommendations in the OAG's report. MOF must monitor the implementation of the action plans of all ministries. MOF should establish an effective monitoring system to follow up on reported irregularities and periodically report on the actions taken. Such monitoring should include the status of the following: (i) audit backlogs and action plan to keep all audits up-to-date; (ii) revenue realization; (iii) clearing reimbursable grants and loans; (iv) tax deduction at source; (v) repayment of principal and interest made by HMGN on guaranteed loans but not recovered from concerned institutions; (vi) dividends receivable, and other receivables, from corporate bodies and boards; (vii) amounts to be paid by HMGN to various entities; and (viii) follow-up on the recommendations of the PAC.  Appendix V CFAA/CPAR Page 4 of 7 The PAC must be given an unambiguous and enforceablemandate to insist on political demand for accountabilityand transparencyand compliancewith the new regulations. Fiduciary Risk and Programmatic Lending For fiduciary risk on programmatic lending to approximate the fiduciary risk now accepted for project lending, accountabilityand internal control standards in the whole civil servicemust approximate those currently existing in Bank-financedprojects. The existing legalh-egulatoryfiamework meets these standards but compliance must be enhanced. The objective for HMGN should be to harmonize the reporting system that is acceptable to all donors. There is no reason to not consider some budgetary support/programmatic lending, but it should be accompanied by: (i) a pragmatic program of targeted assessment and strengtheningof sectors and institutions scheduledto benefit from such lending; and (ii) implementation of the recommendationsmade in the DAP for the public sector over the medium term. Sectors, ministries and institutions envisaged for budgetary support should be the first to be assessed and certifiedby a panel of independent experts representingthe accountabilityinstitutionswhich include MOF, FCGO, NPC and OAG (or may also include experts designated by donor partners participatingin budgetary support) as complyingwith the accountabilitystandardsrecommended above. Followingthe full implementationof the proposed integrated financial managementimprovement program,a quickreview would be desirable to confirm the effectivenessof the compliancesystem,before generalized programmatic lending benefiting all sectors, ministries, and institutions is launched. All levels of governmentwould need to be reviewed for adequate compliancebefore moving forward. A Task Force or a Reform MonitoringCommittee should continueto monitor the implementation of the recommendations of the CFAA. Implementation status should be periodically reported to the Finance Committeeof the Parliament,the Finance Secretary, and Nepal'sdevelopmentpartners. Capacity Building and Implementation of CFAARecommendations Implementation of the CFAA recommendations in the form of the DAP by the entire public sector has been underway since mid-2002. A progress report of the Plan is regularly updated and posted on the MOF's external website. In addition, the Government requested the Bank's assistance in two areas: capacity building of the accounting and auditing staff and upgrading the quality of audits. Specifically, the request entailed enhancing the capacity of the OAG towards improving public sector financial accountability. In March 2003, the Bank provided an Institutional Development Fund (IDF) grant of US$0.5 million. On the basis of the CFAA recommendations and agreement reached with the OAG, the grant will finance: (i) the revision of the audit guidelines and reporting methodology to be compatible with international standards or best practice; and (ii) the establishment of institutionalized trainingarrangementswithin OAG to implement the guidelines.  Appendix V CFAA/CPAR Page 5 of 7 B. The CountryProcurementAssessmentReport' Context Like most countries,Nepal's constitutiondoesnot addressthe issue of public procurement,but in contrast to most countries, there is no law (in the sense of a generally applicable set of rules enacted by the legislature) about public procurement. In this respect, Nepal (like its neighboring countries Pakistan and India, and a few others) is different from most other countries in the world. Most countries have introduced a public procurement law, enacted by parliament which alone can change it, which law deals exclusively with the public procurement of goods, works and services by governmental entities at all levels, and most often both for the centralauthoritiesas well as those on a provincial and communal level. The system used in Nepal is represented by the Financial Administration (Related) Rules of 1999" (FAR99) was originally introduced by the British but is no longer practiced in the U.K. This approach consists of the issuanceby government (rather than by the legislature) of a set of financial rules which essentially describe the financial powers of various governmental authorities, and in particular the procedures they should follow in securing and disbursing the public funds required to discharge their functions, including the rules governing the procurement of public contracts. Having been issued by government,these rules-i.e., FAR99--can also be changedby government,without any approval by the legislature, which it is felt in most countries is not in the public interest. Rules of this nature, which govern the use of huge amounts of public funds, should be difficult rather than easy to change, and they should be changed only in a public and transparentmanner. Key Findings Procedures and Practices FAR99 represents an improvement over its predecessor but the enactment of a Public Procurement Law is a necessity. The Bank revised the rules for National Competitive Bidding (NCB) under Bank-financedcontracts, in order to properly reflect the interests of the public purchaser. In fact, the list (notedbelow) indicatesthe areas of the public procurement systemrequiring attention. Provision of sufficienttime for bid preparation. Bidders access to bidding documentsby mail or in person. Evaluation of bids accordingto pre-disclosed criteria. Bid opening in only oneplace and immediatelyafter deadlinefor bid submission. No preference to local bidders competingwith foreignbidders. Contractawardedto lowest evaluatedbidder. No post-biddingnegotiationswith the lowest or any other bidder. No bid rejection on the basis merely of price estimates. No rebidding without IDA'Sprior concurrence. Requirementfor all bidders to provide bid and performance securities. 2 The CPAR was carried out as jointly between the Bank and HMGN. The work was initiated in November 1999and finalized in April 2002.  Appendix V CFAA/CPAR Page 6of 7 No awards b y lottery. 0 Extension o f bid validity only according to Bank's InternationalCompetitive Bidding (ICB) rules. 0 No bidding on the basis of a percentage premium over estimated cost. BiddingDocuments There following includes further recommendations to strengthen the National Competitive Bidding (NCB) provisions in the procurement schedulesof credit agreements. 0 Bidders must be allowed, prior to the deadline for bid submission,to amend or withdraw their bids. 0 Larger civil works contractors must not be prohibited fkom competing against smaller contractors; a two-envelope system must not be used for the procurement of goods and works. Issues Related to Expertise, Audit, Anti-corruption In addition to the problems related to the legal and procedural framework in which procurement is conducted in Nepal, there are other problems mentioned below: 0 Like in almost all borrowing countries of the Bank, there is a tremendous need to train public officials in the principles and practices of public procurement. 0 The Auditor General's staff has been found, in the case of donor-financed contracts, to insist upon the application of local procurement rules instead of the donor's procurement rules (although the applicableNepalese rules make it clear that the latter should apply). 0 Nepalese laws and rules dealing with corruption seem to penalize only passive corruption (i-e,,the soliciting or accepting of bribes by public officials), but not acts (just as dangerous) of active corruption (Le., the offering or giving of bribes to public officials by private parties). 0 There is a perception amongst the bidders and business community that corruption is a problem in public procurement in Nepal. Summary of Major Recommendations The 2002 CPAR contains the followingprincipal recommendations: 0 Enacting a modem, transparent and competitive public procurement law, based on the UNCITRAL Model Law for Procurement, to apply to public procurement by all public entities in Nepal at all levels, as well as to parastatals. 0 Creating a small, independent procurement agency, with functions defined by the Public Procurement Law (essentiallypolicy, and not oversight or line clearances of procurement decisions). 0 Pending the enactment of such a Public Procurement Law, amend FAR'99 in the sense of changing the anti-competitive rules and practices listed in this Executive Summary. Review and develop as needed standard bidding documents to be used for procurement financed by HM own government. Develop and accelerate procurement training at all levels of government, including the Auditor General's staff.  0 Instructing the Auditor General's staff, in the case of donor-financed procurement, to insist on the application of the donor's procurement rules and not of local procurement rules. 0 Amending the anti-corruption legislation in such a way as to (i) impose harsh penalties (including blacklisting) on the acts of active fraud and corruption, particularly the offering/giving of bribes to public officials, and (ii) specifically allowing/inviting bidders to report acts of corruption by other bidders, as well as solicitation of bribes by public officials. Capacity Building and Implementation of CPARRecommendations The Government is strongly committed to implementing the CPAR recommendations. The Government revised provisions of the FAR99 soon after the publication of the CPAR. They include ensuring sufficient time for bid preparation, evaluation of bids according to pre-disclosed criteria, awarding of bids and prohibiting post-bidding negotiations with bidders. The Bank is currently providing technical assistance through a three-year IDF grant of about US$0.3 million to implement three areas of the above-mentioned CPAR recommendations. The grant- launched in March 2003-will finance: (i) the development of a draft modem transparent and competitive Public Procurement Law in line with international standards and related rules and procedures; (ii) the creation of a comprehensive framework for public procurement training and building a pilot training program particularly for trainers and officials responsible for the management of public procurement.