Zambia - Small and Medium Scale Industry Development Project

Document of The World Bank FILE go FOR OFFICIAL USE ONLY Report No. 2328 PROGRAM PERFORMANCE AUDIT REPORT ZAMBIA - SECOND PROGRAM LOAN (LOAN 1322-ZA) December 29, 1978 Operations Evaluation Department This document has a restricted distribution and may be used by recipients only In the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.   FOR OFFICIAL USE ONLY PROGRAM PERFORMANCE AUDIT REPORT ZAMBIA - SECOND PROGRAM LOAN (LOAN 1322-ZA) TABLE'OF CONTENTS Page No. Preface i Basic Data Sheet ii Highlights iii PROGRAM PERFORMANCE AUDIT MEMORANDUM 1. Introduction 1 2. The short-term difficulties 1- 3 3. The loan's long-term objectives 3- 5 4. Evaluation of the fiscal and payments situation 5 - 6 5. Achievements under the Loan 6 - 10 6. Conclusions 10 - 11 Annexes: I. Economic Data 12 II. LME Copper Prices 13 III, Schedule of Disbursements - Actual 14 IV. Graphed Plotted Schedule of Disbursements - Actual 15 Attachment: Program 'C!rpletkonr Report Introduction 16 Economic Situation Preceding the Program Loan 16 - 17 Background to the Loan 18 - 19 Objectives 19 IMF 19 - 20 The Program Loan 20 - 21 Policy Understandings and Actions 22 Strengthening Agricultural Institutions 22 - 23 Agricultural Prices 23 - 24 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  - 2 - Page No. Stabilizing the Budget 24 Counterpart Funds 25 Conclusion 26 - 28  PROGRAM PERFORMANCE AUDIT REPORT ZAMBIA - SECOND PROGRAM LOAN (LOAN 1322-ZA) PREFACE This report presents an audit of performance under the Second Program Loan to Zambia (Loan 1322-ZA). The loan, in an amount of US$30 million, was approved in September 1976 and fully disbursed by February 1977. The audit memorandum is based on the attached Program Comple- tion Report (PCR) prepared by the Bank's East Africa Regional Office, file research and discussions with Bank staff. OED finds the PCR com- prehensive and accurate; the memorandum elaborates on the issue of tying the loan with negotiations between the Government of Zambia and the IMF, as well as on the usefulness of creating a special project account to receive counterpart funds generated by the loan. No comments were received from the Borrower.   - ii - PROGRAM PERFORMANCE AUDIT REPORT ZAMBIA - SECOND PROGRAM LOAN (LOAN 1322-ZA) BASIC DATA SHEET Amounts (in US$ mln) as of 10/31/78 Original Disbursed Cancelled Repaid Outstanding Loan 1322-ZA 30.0 30.0 - - 30.0 Project Data Original Plan Actual Conception in Bank Sept/Oct.1975 -- Board Approval February 1976 9/07/76 Loan Agreement -- 9/17/76 Effectiveness -- 10/06/76 Loan Closing -- 6/30/77 Mission Data Month, No.of No.of Year Weeks Persons Manweeks Date of Report Preparation & Oct/Nov Preappraisal 1975 4 5 11 ] Aug. 9, 1976 Appraisal March 1976 4 5 11   - iii - PROGRAM PERFORMANCE AUDIT REPORT ZAMBIA - SECOND PROGRAM LOAN (LOAN 1322-ZA) HIGHLIGHTS 1. This was the second of two program loans made by the Bank to the Republic of Zambia in 1973 and 1976 respectively, to help the country overcome difficulties originating in a drop in copper prices. 2. The approval of the program loan was tied to the conclusion of a standby agreement between the IMF and the Government of Zambia, and, as a result, was delayed. However, given the continuance of low copper prices, the loan served the objective of providing the country quick- disbursing funds to finance essential imports during a period of serious foreign exchange stringency. 3. The main policy objectives of the loan were not fully met. The Government did raise agricultural produce prices, which was one of the policy objectives of the loan and which is expected to have a long- term impact on the country's growth. In the short run, though, given the budgetary constraints and the related austerity measures agreed with the IMF, the objective of reorienting the emphasis and perspective of the government towards agriculture and rural development and strengthening agricultural services would have necessitated budgetary reallocations which proved impossible for the Government to implement (vide para. 5.10 of PPAM). 4. Other points of interest are: - creating a Project Account to receive counterpart funds generated by the sale of foreign exchange disbursed under the loan does not appear to have served any useful purpose (vide para. 5.04 of PPAM, paragraphs 32 and 33 of PCR); - impossibility of allocating counterpart funds to the sup- plementary categories of the recurrent and capital budgets of the Ministry of Rural Development because of the late timing of loan approval (vide para. 5.04 of PPAM, para. 36 of PCR); - doubt about the usefulness of linking the approval of the loan to an agreement between the Government and the IMF (PPAM para 5.05); and - lack of follow-up on the suggestion of creating a stabiliza- tion account (development equalization account) to receive excess public resources during periods of high copper prices (vide para. 5.06 of PPAM, paragraphs 29 to 31 of PCR).   PROGRAM PERFORMANCE AUDIT MEMORANDUM ZAMBIA - SECOND PROGRAM LOAN (LOAN 1322-ZA) I. INTRODUCTION 1.01 Loan 1322-ZA in an amount of US$30 million was the second program loan made by the Bank to the Republic of Zambia. It was approved in September 1976, committed in October 1976 and closed fully disbursed in June 1977; it followed a first program loan (Loan 911-ZA) in a like amount made in 1973. 1.02 At the request of the Government, the balance of the first loan (58%) was cancelled in June 1974, following a sharp upturn in copper prices whose previous decline had provided the rationale for Bank assistance. An Audit Report covering this first loan (SecM77-165) was distributed to the Board on March 8, 1977. Apart from the totally unexpected upturn in copper prices, this first loan was marked by procedural difficulties which led to slow disbursement, as well as by the fact that the Government did not open a special account to hold counterpart funds as required by the loan agree- ment. II. THE SHORT-TERM DIFFICULTIES 2.01 The second Program Loan (under review) was made in the context of a particularly severe economic crisis which has only deepened since then. The recovery in copper prices which had led to the cancellation of part of the first loan turned out to be short-lived. After having reached a peak of US$1.38 a lb in April 1974, the price of copper on the London Metal Exchange (LME) slumped even more rapidly than it had climbed before, oscillating since the beginning of 1975 around 60 cents a lb, except for April-September 1976 when it was around 70 cents a lb (see chart Annex I). Low copper prices have been particularly detrimental to the Zambian economy, owing to the latter's heavy reliance on copper mining which alone accounts for 95% of total export earnings and as much as 45% of public revenues during high copper price periods. This has made the economy highly vulnerable to fluctuations in copper prices on the international market upon which Zambia has little or no control even though it provides more than 15% of the world's total copper exports. The Government's mining  revenues have suffered most from such large swings in copper prices, being based almost entirely on mining companies' income taxes whose volatility is higher than that of export earnings themselves. 2.02 During 1975 Zambia's export earnings from copper dropped by 45% compared with 1974. Moreover, the value of imports continued to progress on the basis of past growth, exceeding exports for the first time in the country's history (PCR, para. 7). These developments led to a current account deficit of US$610 million which Zambia was unable to finance in its entirety, causing arrears in payments for imports and private transfers to accumulate. As a result of lower copper prices, the mining revenues of the Government dropped by 83% between 1974 and 1975, i.e., by the equivalent of 75% of the loss in the country's copper export earnings between these two years, indicat- ing that the Government Budget absorbed most of the impact of the lower copper prices. This was, however, attenuated to some extent by the contin- uous improvemant in the Government non-mineral tax performance, as suggested by the following table: Table 1 Central Government Revenue (Kwacha million)-/ Average 1971-1973 1974 1975 1976 1977 (P) Mining revenues 93.5 339.2 59.3 11.6 0.1 (% of copper export earnings) ( 17.1 ) (40.5 ) ( 12.6) ( 1.7 ) ( 0.0 ) Other revenue 293.3 311.8 403.0 449.2 510.6 (% of current expenditures) ( 69.6 ) (,77.1 ) ( 75.8 ) (79.9) (86.0) Total revenue 332.7 651.0 462.3 460.8 510.7 (% of total ( 68.1 ) ( 114.9 ) ( 59.6 ) (63.0) (66.3) expenditures ) 1/ Prior to February 1973, Kl US$1.40 February 1973 to July 1976, Kl US$1.554 July-December 1976, Kl US$1.2499 1977 - Kl US$1.2675 2.03 Considering the gravity of the foreign exchange situation (by the end of 1975 international [gross] reserves were down to slightly above one month's imports) and the apparent persistence of low copper prices, the Govern-  -3- ment requested the Bank in September 1975 to make a second program loan. Preappraisal and appraisal missions visited Zambia in November 1975 and February 1976, respectively. The Government was at the same time negotiating a standby agreement with the IMF to bridge part of the 1976 current account deficit on the balance of payments (US$300-400 million); this standby agre 7 ment.was to cover drawings from the second and part of the third tranches.- In this context. the Bank made it clear to the Government of Zambia that a satisfactory agreement had to be reached with the Fund before a program loan could be made.. 2.04 To meet the budgetary crisis, the Government announced in January 1976 a number of austerity measures, including in particular a 10% reduc- tion in recurrent expenditure (to be achieved mainly through a cut in subsidies on food items and fertilizers) and a 36% reduction in capital expenditures; the Government also raised the price of a number of important farming products (see paras. 10 and 11 of PCR). These measures, however, fell short of IMF requirements, and negotiations (in particular, regarding the need for devaluing the Kwacha) continued until July 1976 when agree- ment was reached in an amount equivalent to US$61 million on a standby. agreement for a period of one year. This standby became effective in August 1976; the Bank program loan was approved in September 1976 and became effective in October 1976. 2.05 The Bank loan was intended to finance the importation of essential goods, including intermediate and capital goods, required to maintain a reasonable level of economic activity. The loan was also meant to support an appropriate public investment program through the use of counterpart funds generated by the sale of the foreign exchange under the loan to private and parastatal entities; these funds were to be deposited in a special project account to be created with the Central Bank and transferred periodically to cover expenditures under specified categories of the 1976 capital budget as well as under a supplementary recurrent and capital,budget for the Ministry of Rural Development and provincial Cabinet offices. - III. THE LOAN'S LONG-TERM OBJECTIVES 3.01 When the loan was made, it appeared that the crisis which Zambia was passing through was essentially of a cyclical (short-term) nature and 1/ During 1975, Zambia had already drawn US$67 million ($22 million net) from the first credit tranche and the oil and compensatory financing facilities of the IMF. 2/ During negotiations, the Government had agreed to approve this supple- mentary budget which was to increase its 1976 budgetary allocations for rural development in amounts equivalent to 2.8% of the original alloca- tion on current account and 21% of that on capital account.  that therefore, its solution naturally fell within the jurisdiction of the Fund. However, a number of structural imbalances generated by the extreme dualism of the economy aggravated the impact of short-term difficulties and, in consideration of their impact on the development process, justified the Bank's assistance. A posteriori, copper prices have not recovered and the deterioration in Zambia's terms of trade now appears more persistent than was originally expected. 3.02 The Zambian economy has been characterized by a sharp dualism between an urban sector dominated by mining activities and a largely under- developed agricultural sector. Until the second program loan was made, most of the resources generated by copper mining were transferred to the urban sector (by way of either consumer subsidies or fixed investment), and the Government's action in improving the agricultural sector was con- sidered by the Bank as inadequate. The country's dependence on mining made the economy vulnerable to erratic fluctuations in copper prices, affecting most particularly public revenue. Since the beginning of the decade the Government has endeavoured to diversify its sources of revenue (vide Table 1, p. 3); in 1976, non-mineral Government revenues accounted for approximately 28% of GDP, compared to 16% in 1971. This increase, however, was neutralized by a commensurate growth in recurrent expendi- tures (of which consumer subsidies were an increasing item), leaving little resources available for development purposes. 1/ Moreover, imple- mentation of development programs was constantly hindered by the "stop-go" pattern dictated by copper price cycles. 3.03 These considerations pointed to the need to diversify the economy away from copper mining by developing the country's agricult- ural potential so as to create conditions for stable development as well as to bridge the urban-rural income gap which had been increasing. The performance of the Government with regard to the policies in the agricultural sector had been below potential. While the issue had been raised in general terms when the first program loan was made, the dialogue between the Bank and the Government which took place on the occasion of the second loan was more focused, emphasizing policy measures necessary to develop agriculture as well as ways to improve the the management of public financial resources. The understandings which had been reached during negotiations between the Government and the Bank on these two matters were recorded in supplemental letters from the Government, signed along with the Loan Agreement. 3.04 As regards agriculture, the discussions were conducted on the basis of conclusions of the Bank's 1975 Agricultural and Rural Sector Survey 1/ Government savings during the 1971-76 period averaged less than 2% of total revenues (i.e. less than 1/2% of GDP).  - 5 - (Report No. 841a-ZA) which had been discussed with the Zambian authorities. The Government concurred with the two-pronged strategy proposed in the report: In the short run increases in output were to be obtained through policy improvements - mostly price adjustments; agricultural prices, which are kept under Government control through (parastatal) monopoly marketing boards, had been allowed to drift substantially below border prices, thus discouraging domestic production and encouraging sale of higher-priced imports at subsidized prices. In a longer term per- spective, increased production was to stem from a transformation of the traditional (mainly subsistence) sector. This, in turn, was to require increased budgetary allocation of investment and recurrent resources, as well as a number of ancillary institutional changes. In this regard, the Agricultural and Rural Sector Survey had emphasized the need for strength- ening administrative services dealing with agriculture and rural develop- ment and promoting a greater decentralization of decision making and implementation responsibilities to the provinces. 3.05 The Government indicted during loan negotiations that it intended to strengthen the Ministry of Rural Development as well1las the provincial administrative structures related to rural development;- technical assistance for this was to be contracted under bilateral arrangement. The Government was also to set up an interministerial working group with the task of drawing up a program to reorganize these services; recoumenda- tions from this working group were expected within three to four months (i.e. early 1977). 3.06 As regards the management of public financial resources, the Bank's position was in line with that of the Fund. Apart from the imposi- tion of credit ceilings and the requirement that the Kwacha be devalued, the IMF had insisted that mining revenues be allocated entirely to develop- ment budget, recurrent expenditures being entirely covered by non-mineral revenues. On the basis of budgeted expenses and continued improvement in tax collection, this objective was attainable in 1976. In addition, the Government agreed to establish a special Development Equalization Account which was to finance development expenditures in years when mining revenue would be insufficient, and receive excess balances from mining revenue during periods of higher copper prices. By producing steady, reasonably equalized stream of development investments, this account was meant to foster a steady growth of the development budget, consistent with the long-term availabliity of resources. IV. EVOLUTION OF THE FISCAL AND PAYMENTS SITUATION '.01 During 1976, the Government was unable to curb recurrent expen- ditures as it had intended to; in sharp contrast with the 13% cut that was l/ In particular, the Government intended "to establish at all provincial headquarters planning units comprising inter alia, Farm Management Officers, Land Use Planning Officers, Economists, and Specialists in Agricultural Statistics" (Supplemental letter).  -6- budgeted, recurrent expenditures increased by almost 6%, which still corresponded to a reduction of about 6% in real terms. This however, was insufficient to enable the Government to adhere to the credit ceilings imposed under its standby agreement with the IMF (see para. 17 of PCR). 4.02 As regards the balance of payments, the Zambian Government's inability to finance its deficit through new medium-term credit persisted, possibly as a result of its failure to obtain IMF credit. As a consequence, the level of arrears on payments for imported goods and services continued to climb, reaching US$290 million by the end of 1976. Moreover, shortfalls in net capital inflows led to a drastic cut in imports, total imports being kept in 1976 more than 26% below the Bank's estimate of minimum requirements for the year. These difficulties persisted through 1977 as copper prices, contrary to expectations, did not recover and pro- duction declined as a result of the non-availability of medium-term credit, leading to shortages of essential imports (see paras. 21 and 22 of the PCR and Table 2 of Annex 2 of this Memorandum). V. ACHIEVEMENTS UNDER THE LOAN 5.01 Performance under the loan has to be reviewed with reference to its two objectives which were (i) to contribute to bridging the 1976 current account deficit (by financing the importation of essential intermediate and capital goods required to maintain a reasonable level of economic production) and support an appropriate public investment program through the use of counterpart funds generated by the sale of foreign exchange; (ii) to support the Government's effort to diversify the economy from copper mining and promote agricultural and rural development. 5.02 Disbursement under the Loan and Use of the Bank Funds. Quick dis- bursements were clearly essential if the objectives to support the balance of payments situation and enhance the Government's budget position during 1976 were to be achieved. To ensure quick disbursement, a special unit was created within the Bank of Zambia whose function was to process the necessary documentation (under the first loan, commerical banks had shown little interest in processing application for foreign exchange purchases). Moreover, the requirement that imports made by the public sector be obtained through international competitive bidding was eliminated, thus simplifying procurement procedures. These measures led to much quicker disbursement than under the first program loan. Although no forecast of disbursements had been made with the loan, it had been originally assumed that, given loan approval early 1976, the loan would be fully disbursed by 1976-end. However, with the loan approved in September 1976, 58% of the loan amount (US$17.4 million) was disbursei b- 1976-end (see Annexes 3 and 4) and the loan was fully disbursed within another five months (September 1976 - February).  5.03 Although the loan had not the catalytic effect which was expected in terms of promoting the mobilization of term credit from commercial sources, it did contribute to the financing of essential imports at a time when shortage of foreign exchange was particularly acute, accounting for 2% of total imports in 1976 and 3% in 1977, i.e. the equivalent of 8% and 14% of net capital inflow in 1976 and 1977, respectively. 5.04 It is more difficult to assess the impact of the loan on the allocation of public revenues. The Government opened a Project Account with the Bank of Zambia as was required under the Loan Agreement and the Kwacha equivalent of foreign exchange disbursed under the loan was credited to this account. These funds were then credited to the Government's main account to meet development expenditures under the categories specified in the Loan Agreement (Schedule 4) (see paras. 32 and 33 of PCR); however, funds started to reach the Project Account too late in 1976 to finance supplementary allocations to the recurrent and capital budgets of the Ministry of Rural Development as they were intended to (see para. 34 of PCR). In spite of specific reporting requirements in the loan agreements, information is available as regards the exact allocation of Bank funds among the eligible categories of the Government capital budget for less than half the amount of the loan. Furthermore, under the Loan Agreement, the Govenlment was requested to have the Project Account audited by a firm acceptable to the Bank; an audit report was prepared which does acknowledge the proper funding of the Project Account, but fails to examine the final utilization of funds (see para. 33 of PCR). The fungibility of public resources makes the allocation of Bank funds among budget categories an unimportant issue, the relevant question being the possible restructuring of budget expenditures during the period of the loan. The budgeted share of development expenditures channelled through the Ministry of Rural Development remained constant at 8.2% through 1976 and 1977; however, the lack of actual figures for 1977 prevents an assessment of the impact of cuts in total (development) expenses on actual allocations. In any case, the creation of a special account for counterpart funds does not appear to have served any useful purpose. 5.05 The fact that the loan was disbursed approximately six months later than was originally envisaged is entirely attributable to the delays, which took place following the original identification mission, in having the loan approved, pending the conclusion of a standby agreement with the IMF. In themselves, these delays were not detrimental to program perfor- mance as the balance of payments situation kept worsening during 1977 and the Bank funds were fully utilized by February of that year. However, had  - 8 - copper price projections (made in May 1976) proved correct,-/ the timing issue would have been crucial as it was under a number of other program loans such as the first program loan to Zambia (Loan 911-ZA) and the second one to Korea (Loan 1219-KO). Moreover, the fact that the loan was fully disbursed 2yen though the Government was not in a position to meet IMF requirements- casts some doubt on the usefulness of having the approval of the loan predicated on an agreement between the Government and the Fund. 5.06 Management of public revenues. The use of mining revenues for development purposes and their stabilization over time through the creation of a Development Equalization Account have remained academic issues because of the lack of such revenues since the loan was made. While agreeing with the concept of a stabilization fund as suggested by the Bank and the Fund, the Government has not yet established the account, arguing that the need for it was not yet actual (vide para. 31 of PCR). More importantly, dis- cussions on the subject have remained at a very general level and its technicalities have not so far been worked out (such as the trigger 1/ Price forecasts made on a vearlv basis have been Ps follows: (US c./lb 1fL current US dollars) 1974 1975 1976 1977 1978 1979 1980 1985 Actual price 93 56 64 59 59 Forecasts made May 1974 110 105 107 109 117 125 135 200 May 1975 68 81 98 109 117 126 196 May 1976 67 80 104 112 120 180 May 1977 70 80 95 120 180 May 1978 62 68 85 160 Average of first 8 months Forecast in the past few years have been regularly biased upwards while in fact there has been continuing recession in copper export markets. One cent per lb difference on the price of copper represents additional annual export earnings of approximately US$15 million for Zambia. This suggests that if price forecast made in May 1976 had materialized in 1977, additional foreign exchange earnings would have amounted to about US$450 million, i.e. fifteen times the amount of the loan. 2/ During 1976 Zambia was only able to draw SDR 19 million (i.e. 25% of its quota) to which it was eligible unconditionally under the compensatory financing facility (CFF), bringing its total drawing under this facility to 50% of its quota. Zambia did draw another SDR 19 million under CFF in 1977, which brought its total drawing under this facility to 75% of its quota, this last drawing being conditional (vide para. 18 of PCR).  - 9 - mechanism which would initiate/interrupt fund accumulation phases or the use of excess balance in the account), indicating a lack of follow-up on the Bank's part regarding this matter; the arguments for such lack of follow-up are that projections for copper prices still do not indicate a build-up in the account in the near future and there have been delays in the Third National Development Plan which would provide the fram- work for such an account. In particular, while the idea to create a stabilization account is good, the important exercise of linking future development expenditures with projections of the long-term trend increase in copper revenues has not been conducted, leaving the possibility of having the Government unprepared in case of a sudden rise in copper prices. 5.07 Agriculture. An essential, immediate measure which the Govern- ment agreed to consider in order to foster agricultural production was to review producer prices with a view toward improving incentives. Price in- creases announced in January 1976 (i.e. prior to the loan) were a step in the right direction but proved insufficient to close the gap between the two sets of prices. Moreover, prices announced in October 1976 (too late in any case to have any significant impact on the farmers" decisions re- garding their sowing operation for the 1976/77 season) were kept unchanged in spite of the devaluation of the Kwacha. Price increases were only announced a year later (August 1977), and again in 1978, reducing partially the gap with border prices. 5.08 The Government set up a working group to draw up a program for strengthening the Ministry of Rural Develppment. This working group sub- mitted its recommendations several months behind schedule; moreover, these recommendations do not appear to have been implemented, neither for that matter have they been transmitted to the Bank (vide para. 26 of PCR). In April 1977, the Government did however reinforce the Ministry of Rural Development by increasing its focus on project identification and prepara- tion, and adding to it a number of related services, the ministry being now called Ministry of Lands and Agriculture (vide para. 27 of PCR). 5.09 The Bank had proposed to finance technical assistance as part of the loan to strengthen the new Ministry of Lands and Agriculture, but the Government was not willing to accept Bank terms for such a purpose while bilateral grants were available. Recently the Government has been able to obtain technical assistance (from the Canadian Government) to strengthen the new Ministry. The Bank is in the process of preparing a technical assistance credit for Zambia on IDA terms. 5.10 Apart from the need for the Government to improve its efforts in agriculture, the main issue remains the feasibility of implementing far reaching administrative reorganization and reinforcement in the midst  - 10 - of economic difficulties. The improvements suggested in the Agricultural and Rural Sector Report necessitated above all increased budgetary alloca- tions on current account. A proper relationship between capital and recurrent expenditures needs to be maintained if the Ministry of Lands and Agriculture is to have the positive role which the Bank wanted to impart to it. Moreover, for the rural development program to be effective it was considered essential to decentralize the Government's decision-making and implementation services; apart from the problem of a general shortage of agricultural staff, decentralization would require increased allocation of funds to maintain staff in the field in the face of the strong attraction of higher-income urban areas. These considerations suggest a conflict between the IMF program and the Bank's objectives in the short run, given the acute shortage of funds which the Government was facing at the time, unless the Government was willing to make cutbacks elsewhere. Since then, the rise in copper prices and Government revenues which was expected has not taken place, making it impossible for the Government to increase its recurrent budgetary allocation to the agricultural sector. VI. CONCLUSIONS 6.01 Although small in comparison with Zambia's shortfall in foreign exchange, the progran loan played a useful purpose by financing essential imports at a time when further import restrictions would have affected very seriously the country's productive capacity. Administrative protedures related to disbursement were streamlined in connection with the loan and funds were disbursed with much greater efficiency than they had been under the first program loan three years before, thus reaching the first objective of the loan of assuring a prompt transfer of resources. 6.02 Persisting economic difficulties throughout 1977 made the late approval of the loan an unimportant issue; the delays which took place in having loan approval held up by IMF negotiations, however, could have forced the Bank to cancel part of the loan, had economic developments, particulatly copper prices,taken the course that was expected. This highlights the importance of the timing question in relation to program loans, an issue which has proved crucial in a number of other cases such as the first pro- gram loan to Zambia (Loan 911-ZA) and the second one to Korea (Loan 1219-KO). 6.03 As regards the Bank's long-term objectives in making this loan to Zambia, little progress could reasonably be expected from the Govern- ment during the short period of the loan towards solving the problem of reorienting the emphasis and perspective of its administration regarding agriculture and rural development. Apart from the subdued performance of the Government as regards policies suggested by the Bank and the difficulty  - 11 - of monitoring performance under most of the measures agreed during negotiations, the question arises as to the immediate feasibility of the loan's objectives in the particular context in which they were set. The Bank did achieve one policy objective which could have a long-term impact, i.e., raising agricultural producer's prices together with establishing a mechanism for a periodical review of these prices. On the other hand, it is apparent that the strengthening of agricultural services desired by the Bank was not fully compatible with short-term budgetary constraints and the related austerity measures imposed by the IMF, unless the Government was willing to make matching cutbacks else- where. While the Fund was trying to impose "across the board" budgetary cuts, the Bank clearly attempted to foster a reallocation of resources among the different budget categories. On the basis of preliminary figures, this does not seen to have been feasible and, in this context, there is no indication that the creation of a project account to receive counterpart funds generated by the sale of the loan proceeds played any useful purpose, in the sense that it did not succeed in influencing the allocation of internal resources. Operations Evaluation Department December 29, 1978  AN'NEX I - 12 - X 0~ ~~~~~~~ _  - 13 - PROCRAM PERFOMRtANCE AUDIT RPI'ORT ANNEX II ZAMBIA - SECOND PROCRAM LOAN (LOAN 1322-ZA) 1. Gross Domestic Prodtuct at corst;zint prices (in millions of 1965 K,jaclha) 1974 1975 1976 1977 Agriculture 119.9 128.5 135.9 137.0 Manufacturing 118.6 114.5 107.9 102.0 ;1ining 222.5 204.5 227.6 207.0 Other 539.4 550.4 548.0 532.8 GDP 1,000.4 997.9 ] Ol9.4 973.8 2. Balance of Payments Surnar (Kwacha millions) 1974 1975 1976 1977 (est.) Exports, f.o.b. 898.2 512.9 733.7 704.0 (of which copper) (838.5) (472.0) (688.6) (659.0) Imports, f.o.b. 508.5 595.4 496.0 565.7 Trade balance 389.6 - 82.5 237.7 138.3 Invisibles (net) - 341.1 - 341.9 - 367.8 - 357.4 Current Account Balance 48.5 - 424.4 - 130.1 - 219.1 Non-monetary capital net 43.6 223.6 67.6 94.3 Errors and omissions - 73.5 - 49.2 - 73.7 - 89.9 Overall balance 18.6 - 250.0 - 136.2 - 214.7 Change in foreign assets (- = increase) - 9.4 151.6 39.8 57.7 Payments arrears - 102.1 103.6 156.9 Currency realignment - 9.2 - 3.7 - 7.2 - 3. Central Government Budget (Kwacha millions) 1974 1975 1976 1977 1978 (budget) Tax revenue 596.6 390.4 382.8 439.7 471.6 (Mining revenues) (339.2) ( 59.3) ( 11.6) ( 0.1) ( - ) (Income Taxes) (110.5) (142.6) (159.1) (198.6) (199.7) (Excise taxes) ( 86.0 (125.2) (151.6) (179.5) (210.9) (Import duties) ( 60.9) ( 63.2) ( 60.5) ( 61.5) ( 61.0) Non-tax revenue 54.4 71.9 78.0 71.0 79.1 Total revenue 651.0 462.3 460.8 510.7 550.7 Compensation of employees 100.8 120.5 142.9 148.9 161.5 Subsidies 47.4 82.8 59.8 66.2 44.2 Other current expenses 256.1 328.5 359.6 378.5 375.1 Total current expenditure 404.3 531.8 562.3 593.6 580.8 Capital expenditure 112.8 143.6 122.8 92.3 92.1 Net lending 49.5 100.8 46.7 84.2 38.0 Total surplus ( - deficit) 84.4 - 313.9 - 271.0 - 259.4 - 160.2 Source: IM  - 14 - PROGRAM PERFORMANCE AUDIT REPORT ANNEX III ZAMBIA - SECOND PROGRAM LOAN (LOAN 1322-ZA) SCHEDULE OF DISBURSEMENTS -/ Cumulative Disbursement 1976 - September October 2.1 November 11.6 December 17.4 1977 January 26.8 February 30.0 1/ No estimated schedule of disbursement was prepared at appraisal  - 15 - PROGRAM PERFORMANCE AUDIT REPORT ANNEX IV ZAMBIA - SECOND PROGRAM LOAN (LOAN 1322-ZA) C; p CRAPHED PLOTTED SCHEDULE OF DISBUTRSEMENTS - ACTUAL -14 -'-4 Cl)~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~Q Ca  - 16 - ZAMBIA Completion Report Second Program Loan (Loan 3322-ZA) Introduction 1. The following report is based on the reports of the various pre- appraisal and appraisal missions, the President's Report, Loan Agreement and supplementary letters, and on the discussions and correspondence between the Bank and the Government during the supervision of the loan. A detailed analysis of Zambia's economy is contained in the Basic Economic Report on Zambia (No. 1586-ZA, dated October 3, 1977). Economic Situation Preceding the Program Loan 2. The extent of Zambia's dependence on copper mining is illustrated by the fact that, in 1975, a relatively unfavorable year for mining, the sector still accounted for about one quarter of GDP, more than 90 percent of merchandise export earnings, and 13 percent of government revenues. 1/ 3. Due largely to this reliance upon copper as the principal mover in the economy, Zambia neglected the agricultural and rural sector. With urban incomes on the average estimated at more than three times those in rural areas, migration to urban centers was rapid, and by 1974 more than 35 percent of the population was urban. The overall economic performance of agriculture, despite plentiful land resources for crops and livestock, was disappointing. During 1965-76 agricultural output grew less than 2 percent per annum so that the country came to rely more and more on imported food and agricultural raw materials. In 1974, for example, approximately 40 percent by value of Zambia's marketed food was imported. The major imports (e.g., beef and dairy products, wheat, edible oils and cotton) were all products for whtich the country had significant production potential. 4. For a long time, the Government's policies and development strategy failed to give sufficient priority to agriculture. Farmers were not given proper incentives to increase output, and public investment failed to set the stage for the longer term development of the rural areas. The prices of agricultural products, most of which are fixed by government marketing boards, were not allowed to rise as rapidly as those of manu- factured goods. This discouraged production and depressed farm incomes and, with rapid rises in modern sector wages, the gap between urban and rural areas widened. At the same time, investments in agriculture were insufficient in volume and, over a long period, whatever schemes were undertaken suffered from inadequate planning and implementation, largely because of the shortage of qualified personnel and weak organization. 1/ In 1974 the mining sector accounted for more than 50 percent of govern- ment revenues.  - 17 - 5. Just prior to the second program loan, the Government had begun to de- vote somewhat more attention to the rural areas and to stimulatine aericultural development. It started a number of programs (e.g., school production units, rural reconstruction program) aimed at reorienting attitudes, par- ticularly among youth, toward rural work and living. There also was a steady increase in output of a government-owned sugar plantation and factory, which had enabled Zambia to reach self-sufficiency, as well as rice and rainfed wheat projects and greater efforts to revive cotton and expand edible oilseed production. These, and new policy developments in pricing and strengthening agricultural institutions (see paras 10 and 11), were en- couraging beginnings in turning Zambia to agriculture and reducing its dependence on copper. 6. After reaching an all-time high of $1.52 per lb in April 1974, copper prices declined rapidly. The average price for 1975, $0.56 per lb, was the lowest since 1957. This difficulty was compounded by a series of developments adversely affecting landlocked Zambia. Until 1973, when the border with Rhodesia was closed, the bulk of Zambia's trade was transported through Rhodesia to and from the Mozambican ports of Beira and Nacala. After the border's closure, the Benguela Railway and the port of Lobito in Angola became a major route, carrying more than one half of Zambia's total exports and a slightly smaller percentage of imports. With the war in Angola and closure of Lobito, Zambian trade had to be diverted to other routes once again, a difficult and expensive undertaking. 7. Zambia's export earnings from copper in 1975 dropped by 45 percent compared with 1974. The balance of payments on current account turned from $75 million surplus in 1974 to a $610 million deficit in 1975. In that year, for the first time in the country's history, the value of goods imported exceeded exports. During the year, net foreign assets were reduced by $236 million while $159 million in arrears in payments for imports and private transfers were accumulated. At the end of the year, Zambia's international reserves (gross) stood at only $149 million, the equivalent of only slightly more than one month's imports. Net foreign assets were negative. 8. The impact on goverament revenues was equally devastating. Revenues in 1975 declined by 30 percent, reflecting in part a $425 million fall in revenue from mining (income tax, minerals tax, withholding tax on dividends to shareholders and dividends to the government). Meanwhile, recurrent expenditures climbed by more than 35 percent. The result was an unprecedented $514 million budget deficit as compared to a $127 million surplus in 1974. The government had to borrow heavily from the banking system to finance this deficit since foreign borrowing and domestic borrow- ing from the public were insufficient. Such year-to-year swings, due to vari- ations in mining revenues., has made implementing an investment program and managing the economy very difficult. Large cyclical fluctuations in invest- ment expenditures over the years have led to excessive strains on the country's physical and administrative capabilities at the peak of the cycle and to difficulties in meeting high priority needs at the trough when commitments to ongoing programs left little or no room for maneuvering in development planning.  - 18 - Background to the Loan 9. With Zambia passing through its most severe economic crisis since independence in 1964, and with little likelihood of improvement in the immediate future, the government in September 1975 requested the Bank to make a program loan. A mission, whose visit to Zambia coincided with that of the Regional Vice President, initially appraised the request in October-November 1975. Their discussions in Zambia focussed on the need to (i) diversify the economy away from its dependence on copper, (ii) bridge the urban-rural income gap by holding the line on urban wages and promoting agricultural and rural development, and (iii) improve the manage- ment of financial resources. Specific policy measures sought included: (a) reducing consumer subsidies, (b) restraining urban wages, (c) restrain- ing recurrent budget expenditures, (d) formulating a rural development strategy and initiating a plan of action, and (e) raising agricultural producer prices. The Finance Minister agreed at the mission's conclusion to (a) reduce consumer subsidies by 60 percent in the next budget (announced in January 1976), (b) announce higher agricultural prices in the budget speech, and (c) work out the broad outlines of an agricultural action program. 10. In January 1976, the Government's budget advanced a series of austerity measures, most important of which was a 10 percent reduction in recurrent budget expenditures, achieved mainly by reducing subsidies by 40 percent and gross capital expenditures by 36 percent, compared to 1975 (actual expenditures). Customs duties and sales, excise and income taxes were raised and other measures to reduce demand and encourage savings initiated. In mid-1975 the retail price of wheat flour had been in- dreased by 85 percent, of bread by 33 percent, sugar by 14 percent and edible oils and fats by 26 and 30 percent respectively. In February 1976, the retail prices of other basic commodities were also increased sub- stantially -- maize meal, the major item in the Zambian diet, by 25 per- cent for coarse and 120 percent for refined; and fresh milk by 18 percent (28 percent for reconstituted milk). Prices of fertilizers also increased by 56 percent. Further, in an effort to keep wages in line with prevailing economic conditions within the country, the Government agreed not to raise Government employees' salaries during 1976 and 1977 and to try to hold down wage increases in parastatal organizations. By cutting expenditures and increasing non-mineral revenues, the Government expected to reduce its 1976 deficit by about 25 percent as compared with 1975. 11. Reducing subsidies and raising consumer prices required con- siderable political courage on the part of the Government and reflected the extent of its concern about the financial crisis, as well as the need to provide adequate price incentives for agricultural production. 12. Following these developments, and a visit to Washington by Zambian officials, a Bank mission went to Zambia in March to explore with the GDvernment these measures and, particularly, its rural development strategy to determine whether or not there were sufficient achievements and plans to justify proceeding with a program loan. Zambian officials  - 19 - were also advised that the country would have to make full use of the Fund facilities available to it before the proposed program loan could be presented to the Executive Directors. The mission, upon its return, recommended that, depending upon the outcome of the Government's discussions with the Fund, the Bank proceed with negotiating a program loan of up to $35 million. The loan committee authorized negotiations in Lusaka for a loan of $30 million. Objectives 13. The major objectives of the program loan essentially were two- fold: First, over the short term, to provide foreign exchange to help finance a minimum level of imports to (i) maintain a reasonable level of output in agriculture, manufacturing and mining, and (ii) support an ap- propriate Government investment program. Second, over the longer term, the loan was to support the Government in its efforts to reduce the economy's heavy dependence upon copper and enhance its prospects for stable development. Negotiations for the program loan were part of a continuing dialogue between the Government and the Bank which centered upon diversification, particularly through promoting agricultural and rural development. Prior to the loan, the Government had begun taking appropriate measures, including negotiating a standby arrangement with the IMF (see below), to reduce the short-term impact of the economic crisis. In addition, the Government had announced its firm intention to emphasize economic diversification, agricultural and rural development and a better balance between the urban and rural sectors. The program loan was designed to support these policies and to encourage the Government to undertake specific measures in their support. IMF 14. In 1975, Zambia had purchased $67 million, $22 million net, from the IMF first credit tranche, oil and compensatory financing facilities. In April 1976, the Government and the Fund negotiated a standby arrangement which, due to difficulties the Government had in accepting some of the Fund con- ditions, was not approved by the Fund's Executive Board until July 21 and did not become effective until August 1976. On July 9, Zambia announced, "as part of a comprehensive financial program", a devaluation of the kwacha of 20 percent. 15. The one-year standby arrangement, covering the second and most of the third credit tranches,was for SDR 62.0 million ($71.3 million) to support a program designed to arrest the deteriorating balance of payments situation and to provide the basis for increasing economic growth and improving the balance of payments in the medium term. The measures which the Government already had taken were considered as constituting a new policy direction designed to gradually reduce the economy's overdependence on copper by stimulating agricultural output, diversifying exports and re- ducing food imports.  - 20 - 16. Under the standby arrangement, Zambia undertook (i) not to increase salaries of Government employees in 1976 and 1977 and to make every effort to prevent wage increases in parastatals, (ii) adjust agri- cultural producer prices to take account of the direct and indirect impact of the exchange rate adjustment, (iii) spend less on subsidies8 (iv) enlarge the non-mining tax base and reduce the reliance on mineral revenue to finance current expenditure, (v) limit the net domestic assets of the banking system (K 710.7 million in December'-1975) to no more than K 823.7 million up to September 30, 1976 and K 830.7 million up to December 31, 1976,(vi) limit net credit to Government (K 317.8 million in December 1975) to K 387.8 million and K 392.8 million respectively (for the same two periods as in(v)), and (vii) reduce the arrears on current international transactions (SDR 135.7 million in December 1975) to SDR 70.0 million by December 31, 1976 and SDR 30.0 million by March 31, 1977. 17. Over the remainder of 1976, the Government, however, was unable to meet the credit limits or to reduce the arrears in payments as specified in the IMF agreement. First, there was a shortfall in estimated Government receipts (due mainly to reduced disbursements of foreign loans, which, in turn was caused by a slowdown in the implementation of public sector capital projects). Second, this shortfall was coupled with a more rapid than anti- cipated increase in recurrent expenditures, largely for subsidies, defense and debt service, which led to supplemental budget Appropria- tions. As a consequence, the net domestic assets of the banking system by the end of September were some K 55 million over the ceiling, and net credit to Government K 93 million over the limit. By the end of 1976, the ceilings were exceeded by K 144 million and K 178 million respectively. The arrears in payments also continued to climb, reaching a level of SDR 222 million in December 1976. Part of the reason for the continued rise in arrears was the Zambian Government's inability to finance them through obtaining new medium- term credit, as had been anticipated by the IMF. 18. Despite these difficulties, Zambia's relationship with the IMF has continued to be good. During 1977, Zambia drew an additional SDR 19 million under the IMF's Compensatory Financing Facility, raising its total drawings under the Facility from 50 to 75 percent of its quota. Since such a drawing is conditional, the Zambian Government had to be actively co- operating with the Fund to find appropriate solutions to its balance of payments problems in order to make use of the Facility. Moreover, on the basis of the 1978 budget, the Fund and Zambia shortly will begin negotiat- ing a new standby arrangement. The Program Loan 19. The Bank's Executive Directors approved the second program loan of $30 million on September 7, 1976. The loan agreement was signed on September 17 and became effective on October 6; disbursements started later in the month. Compared with the difficulties experienced with disbursing the first program loan, the second loan was drawn down rapidly and without major  - 21 - problems. By the end of 1976, total disbursements amounted to $14.3 million. Disbursements continued at a rapid pace, and the loan was fully disbursed in early February 1977, five months after Board approval and four months after loan effectiveness (compared with an estimate Of six to nine months at Board presentation). The loan's rapid disburse- ment underlined the Government's pressing need for foreign exchange in 1976/77 to enable it to purchase essential imports. 20. A breakdown of the disbursements under the program loan shows that about $20 million was spent for imports of machinery and transport equipment, $4.5 million for raw materials, $3.5 million for manufactures and $2.0 million for chemicals. Had the loan not been made, Zambia would have had to restrict imports of such vital goods even further than was actually the case -- with further adverse effects upon the country's development effort and productive capacity. The Government, in the absence of the loan, might have postponed reducing imports for a time by increasing its short-term borrowing -- but only by adding to the grow- ing pressures on its balance of payments over the next few years. 21. In any case, the untinuation of low copper prices through the remainder of 1976 and 1977,- coupled with the shortfalls in anticipated net capital inflows, made further reduction in imports inevitable. At the time the loan was presented to the Board, it was estimated that a net capital inflow of $286 million,2/ in addition to the anticipated drawings under the IMF standby arrangement and other Fund facilities, was needed in 1976 to maintain a reasonable level of imports and allow a $76 million reduction in the arrears in payments. In contrast, Zambia was able to realize only $173 million during 1976, of which disbursements from the Bank's program loan accounted for $14.3 million. 22. As a consequence, 1976 imports were only $836 million -- more than 26 percent below the 1975 level -- compared with the Bank's estimate of 1976 requirements of $1,135 million. In 1977, although net capital inflows fell to an estimated $120 million (including $22 million from the IMF Compensatory Financing Facility), imports were about the same as in the previous year. Shortages of imported spare parts and other essential goods became increasingly serious. Output, particularly in manufacturing, transport and construction, declined sharply and unemployment, already uncomfortably high, rose further. GDP, according to preliminary estimates, fell by 4 percent in 1977; the decline would have been even more serious if agricultural production had not been at relatively favorable levels. On the international side, gross reserves slipped from about $149 million at the end of 1975 to about $50 million -- equivalent to only about 3 weeks of imports -- by the end of 1977. During the same time, arrears in payments on current account rose from SDR 135.7 million to SDR 350 million. 1/ The Bank's projected copper prices ("Price Prospects for Major Primary Commodities", June 1976) at the time of presentation to the Board were $0.67 per lb for 1976 and $0.80 for 1977. The actual average prices in the two years were $0.64 and $0.59 per lb respectively. 2/ $412 million gross capital inflow, less $126 million debt repayments (including $76 million for reducing the arrears in payments).  - 22 - Policy Understandings and Actions 23. In connection with the loan, the Bank obtained several important understandings: First, the Government indicated that it was taking a number of measures to strengthen key agricultural institutions. Second, the Government agreed to review the price structure of agricultural commodities and production inputs on a periodic basis -- at least annually -- and take whatever measures might be needed to maintain adequate price in- centives for production. Third, the Government stated its intention to curb recurrent budget expenditures and provide for greater stability in its budgeting by (i) funding recurrent expenditures from non-mineral revenues, while using all mineral revenues (and any recurrent budget surpluses) to finance capital expenditures; and (ii) establishing a special development equalization account in the Bank of Zambia into which mineral revenue surpluses relative to development requirements in any year would be deposited for use in subsequent years when there were shortfalls. Strengthening Agricultural Institutions 24. The need to strengthen key agricultural institutions was an important topic in the Bank-Zambian dialogue, both preceding and following the program loan. In a supplemental letter, the Government wrote that it recognized "the vital importance to the country of accelerated agricultural and rural development and as an expression of its total commitment to pro- vide such development" was taking a number of measures with a view to strengthening in particular the Ministry of Rural Development as well as provincial administrative structures. Specifically, the Government reported, first, that it was preparing an official request to the Canadian Government (following up on an earlier informal approach) for technical assistance in strengthening the Ministry of Rural Development's project planning capacity. Secondly, the Government had decided to establish at all provincial head- quarters, planning units comprising, inter alia, farm management officers, land use planning officers, economists and agricultural statisticians. Thirdly, the Government had set up a working group to draw up a program for strengthening the Ministry of Rural Development and expected its re- commendations in three or four months. After reviewing the working group's recommendations, and in consultation with the Bank, the Government would speedily implement all measures necessary to achieve the objectives outlined, and request assistance, should the need arise, from the Bank in carrying out the program. 25. The Government did follow up its informal approach to the Canadian Government with an official request for technical assistance in filling a number of specific positions; the Government also requested Sweden to help as well. The Canadian Government reportedly has approved technical assistance to the Ministry of Lands and Agriculture in the form of one senior agri- cultural economist who would advise the Under-Secretary for Planning and three agricultural economists, one of whom would devote himself to project planning and analysis, another to project management and implementation and the third to marketing. All would be assigned to the Ministry's planning unit.  - 23 - In addition, there would be a team coordinator who would work in the National Planning Commission. The Zambian Government currently is re- viewing the draft project agreement, which the Canadian Government expects to be signed in March 1978, with personnel starting to arrive in Zambia around June. In regard to the provincial planning units, the Government established the requisite posts. However, none have been filled, due largely to the scarcity of qualified Zambian manpower. 26. Turning to strengthening the Ministry of Rural Development, the working group in early 1977, several months behind schedule, submitted its report to the Cabinet Office. The report, however, was not considered as a satisfactory basis for taking any action. (The Government, in fact, has declined to make a copy available to the Bank because it considers the report unsatisfactory.) 27. Nevertheless, the Government in April 1977 transformed the Ministry of Rural Development into the Ministry of Lands and Agriculture, sharpened its terms of reference and appointed a new, dynamic minister as its head. However, there has to date been little improvement in the MLA's staffing. With this new leadership and the emphasis the top leadership now places on agriculture and rural development, the Ministry of Lands and Agriculture has intensified identification and preparation of agri- cultural projects. As part of this proces*, the Ministry is working closely with the Bank; two projects have been identified, and preparation of both is almost complete. Other external financiers, particularly the EEC, also are working with the Ministry in preparing and financing projects. As a result, the pipeline of agricultural projects should increase sig- nificantly over the next few--years. Agricultural Prices 28. In its dialogue with the Zambian Government, the Bank had con- sistently advocated the use of agricultural producer prices as an important instrument to stimulate agricultural production. During discussions lead- ing up to the program loan, and subsequently in the Loan Agreement, the Government committed itself to review prices of agricultural commodities and production inputs at regular intervals and announce new prices suf- ficiently in advance of the planting season for farmers to consider them as part of their crop planning for the coming season. While the Government had been reviewing agricultural prices periodically prior to the program loan, 't had failed to maintain levels that would provide sufficient in- centive for production. As a consequence, Zambian price levels had fallen further and further below border prices. In January 1976, however, the Government announced substantial rises in agricultural producer prices, ranging from 20-56 percent. These higher prices, coupled with favorable weather, brought 1976 agricultural crop production to record levels. Real value added in agriculture rose by 4.6 percent with maize output increasing by 33 percent to 8 million bags (a record level of production) and sub- stantial increases registered in the production of other important crops --  - 24 - rice (60 percent), groundnuts (25 percent), sunflower (50 percent) and cotton (19 percent). Preliminary estimates for 1977 show that on balance the level of agricultural production has been maintained: maize output declined slightly to 7.5 million.bags (still a near-record level) but cotton, wheat, rice, groundnuts, tea and coffee all increased. In August 1977, producer prices were again raised by 8-25 percent for mai2e, sunflower, groundnuts, soya beans, cotton and coffee, so that the prices of all major agricultural commodities now are close to prevailing border prices. Stabilizing the Budget 29. Planning Government expenditures in the face of widely fluctuating copper prices and revenues has been a major problem in Zambia (para. 8). In a second supplementary letter to the Loan Agreement, the Government agreed to take a new approach to budgeting recurrent and capital expenditures. In the future, mineral revenues would be treated as a windfall gain. The Government would finance current expenditures entirely from non-mining tax revenues, while development expenditures would be financed from recurrent budget surpluses, mineral revenues and domestic and foreign borrowings. Thus, when recurrent surpluses, mineral revenues and borrowings exceed the requisite development expenditures, Government balances would be built up. Conversely, when surpluses, mineral revenues and borrowings were lower than needed for development, these balances would be utilized. The Government agreed to establish a Develop- ment Equalization Account in the Bank of Zambia to handle the surplus balances and to commence accumulations as soon as the price of copper and mineral revenues exceeded certain levels to be agreed upon in consultation with the Bank. 30. Bank staff have discussed the establishment of the account in overall terms several times with the Government. In the absence of agreed- upon national development objectives, overall fiscal policies and projections of revenues and investment requirements for future years, however, it has not been possible to discuss the policies to be followed in administering the account nor the prices of copper and levels of mineral revenues which would determine accumulations and decumulations of funds. Zambia's Third National Development Plan originally was to be ready for initiation in January 1977, but delays in preparation and in the United National Independence Party's and the Government's deciding upon future develop- ment objectives and strategies have forced postponement. These questions are still under discussion, although their resolution, in the form of either a five-year development plan or possibly a three-year "emergency program", currently is expected around the middle of 1978. 31. Since mineral revenues at present are nil and are expected to remain insignificant for the immediate future, the Government has maintained that there is no need to establish the development equalization account. Nevertheless, the Bank has continued to urge its establishment, even though any accumulation likely would not commence for several more years.  - 25 - Counterpart Funds 32. Pursuant to the Loan Agreement (Section 3.02), the Government opened a Project Account with the Bank of Zambia into which the counter- part funds to the foreign exchange disbursed under the loan were paid. The Bank of Zambia regularly furnished the Bank with statements of the account whenever there were transactions. As stipulated in the Loan Agreement (Section 3.02 (d)), the Ministry of Finance supplied the Bank with certificates for the months of October, November and December 1976, showing expenditures actually made under each category of its capital budget and supplementary budget for 1976 specified in Schedule 4 of the Loan Agreement, and the amounts withdrawn from the Project Account in respect of such expenditure. These amounts totalled K 11.4 million. For the remaining K 12.5 million, which accumulated in January and February 1977, the Ministry of Finance requested the Bank's permission to use them for similar categories in the Government's 1977 capital budget. The Bank agreed to this request, but suggested that part of the remaining counterpart funds be used for an urban project for which the Bank had made a loan and which had received an insufficient allocation in the Government's budget. Subsequently, however, the Bank agreed that it was not necessary to allocate counterpart funds to the urban project in 1977, as other arrangements have been Trade to nrovide for the project's financial needs. 33. The Ministry of Finance informed the Bank that the K 12.5 million had been transferred from the Bank of Zambia to the Government's main account, but has not yet submitted certificates drawing funds from this account actually expended under each budget category, as stipulated in Section 3.02 (d) of the Loan Agreement. The Government also has not transmitted to the Bank certified copies of the financial statements in connection with the project account in the Ministry of Finance, nor a signed copy of the audit report prepared "by auditors acceptable to the Bank" (Section 3.02 (e) of the Loan Agreement). The financial state- ments and report were supposed to have been sent before September 30, 1977. The Government, however, did send to the Bank (in February 1978) a copy of an auditor's report dated September 26, 1977 and addressed to the Bank (but never received), which stated that the loan proceeds had been "properly brought to (the project) account" and had been "treated by the Bank of Zambia ... in compliance with the terms and conditions relating thereto as set out in the loan agreement". The report emphasized, though, that the auditors had not examined the application of the loan proceeds once they had been credited to the project account. 34. During loan negotiations, the Government had agreed to increase its budgetary allocations for rural development by K 2.7 million in 1976 in a supplementary budget. However, as the counterpart funds started to become available much later in the year (almost at the end) than had originally been anticipated, the additional allocation was not made. Moreover, the Ministry of Finance argued that in any case the Ministries concerned would be unable to spend the additional funds effectively in the short time remaining in the year.  - 26 - Conclusion 35. The objectives of the second program loan were: (a) over the short term to provide foreign exchange to help finance a minimum level of imports for maintaining a reasonable level of output and supporting the Government's investment program, and (b) over the longer term, to support the Government's efforts to diversify the economy and enhance its prospects for stable development. With the country suffering through the most severe economic crisis in its history, Zambia urgently needed such assistance: First, it had an immediate need for foreign exchange to help make up the shortfall in earnings from copper exports. Second, the Government had begun to pursue a policy of economic diver- sification, mainly by developing agriculture, which over the longer term would reduce Zambia's heavy dependence on copper and lessen the need for further special assistance in the future. The program loan was important to the latter since it gave support, at a particularly crucial time, to the Government in what it considered to be a difficult undertaking. As such, it was an essential link in Bank's policy dialogue with project lending to Zambia for reducing the country's vulnerability to the vagaries of copper production and exports. 36. The program loan, by financing critically needed imports, un- questionably helped Zambia maintain its economy and investment program. Unfortunately, the loan by itself was not sufficient to cover fully the shortfall in Zambia's requirements. As a consequence, 1976 imports were 26 percent below the 1975 level and oonsiderably less than the Bank's estimate of requirements. Shortages of essential imported goods reduced output, particularly in manufacturing, transport and construction, and raised unemployment. The Government's investment program also suffered badly. Public capital expenditures (in real terms) declined in 1976 by 38 percent, compared with 1975, and in 1977 by another 30 percent. New projects were deferred; many ongoing projects were delayed as budget allocations were cut. In the absence of the program loan, the deteriora- tion, of course, would have been even more serious. 37. The shortfall between estimated and actual external receipts was due to (i) smaller export earnings than had been projected at the time of the program loan, and (ii) Zambia's failure to obtain the amount of financing from the IMF and other external sources that had been anti- cipated. The appraisal report, for instance, projected 1976 exports at $1,050 million, while actual exports reached only $987 million.l/ The shortfall in capital inflows was also large. The Bank, assuming the above figure for exports, estimated that $286 million in net capital inflow, in addition to the anticipated drawings under the IMF stand-by 1/ Of the $1,050 million, copper exports, assuming a volume of 650,000 tons and an average price of $0.67 per lb, were projected to earn $867 million. Although prices averaged only $0.635 per lb, actual copper exports totaled $964 million since some 740,000 tons were exported.  - 27 - arrangement and other Fund facilities, was needed in 1976 to maintain a reasonable level of imports ($1,135 million) and a $76 million reduction in payments arrears. 38. In fact, the Government was able to realize net capital inflows of only $173 million, of which disbursements from the Bank's program loan accounted for $14.3 million. The projections made in appraising the pro- gram loan, of course, proved overly optimistic. Because of the shortfall in anticipated external assistance, however, it is equally obvious that the Bank's loan was even more crucial to helping Zambia maintain its economy than had been expected. Moreover, the additional kwacha which became available from the program loan as counterpart funds enabled the Government to sustain its investment program at a level wiiich otherwise would not have been possible -- without further increasing its already large budget deficit. As it was, the overall 1976 deficit came to K 300.9 million ($421.3 million), compared with the budget estimate of K 249.7 million. 39. One of the reasons for the shortfall in projected external capital was Zambia's inability to draw upon funds from the IMF stand-by because it could not meet the performance criteria. While it is true the Bank's pro- gram loan was premised upon Zambia's successfully carrying out the IMF-agreed stabilization program and using the higher credit tranches, it is difficult, even in retrospect, to argue that the Bank's loan should have been directly linked to drawings under the IMF stand-by. In the first place, while the IMF's stabilization program addressed short-run balance of payments and budgetary problems (and hence was important to Zambia's economic recovery and to the effectiveness of Bank assistance generally); the program loan was primarily concerned with the longer-term problems of economic diver- sification and structural change. 40. In the second place, the Bank and the IMF, of course, expected Zambia to satisfy these criteria, even though it was evident that they were difficult to meet. The Zambian Government had, after all, already taken a number of politically difficult decisions which demonstrated its will to deal with the crisis: it had devalued the kwacha and introduced a number of austerity measures including reductions in recurrent expendi- tures (mainly through subsidy cuts) and tax increases. However, the size of the 1976 btidgetary deficit and consequent need to borrow from the banking system were not correctly foreseen: recurrent expenditures were higher than predicted mainly due to rising prices of goods and services purchased by Government and increased debt service, and revenues were lower than forecast because import restrictions reduced receipts from customs, sales and excise taxes. 41. Even without any drawings from the IMF stand-by, the Bank's program loan has contributed materially to Zambia's efforts to diversify the economy and enhance its prospects for stable development. The country has steadily increased its commitment to these efforts and to agricultural development as a priority objective. Agricultural crop  - 28 - production reached record levels in 1976 following substantial in- creases in agricultural producer prices, which now are largely eliminat- ing the gap between domestic and world prices. The newly-created Ministry of Lands and Agriculture, with a new, dynamic minister, has intensified identification and preparation of agricultural projects, working closely with the Bank and other external financiers. With re- gard to fiscal management, the Government has continued to voice its intention to restrain recurrent expenditures and to implement progtams which would provide for greater stability in long-run development ex- penditures. The Government has restrained increases in recurrent ex- penditures in its 1977 and 1978 budgets mainly through cuts which have reduced subsidies to slightly over half their 1975 level. Nonetheless, the Government's performance in some areas has fallen short of expecta- tions, and some undertakings made in connection with the program loan have not yet been completed. There has been little or no progress in strengthening the Ministry of Lands and Agriculture or the provincial administrative structures. Both remain distressingly weak. The Government has yet to establish the special development equalization account, although both the Minister of Finance and the Governor of the Bank of Zambia have responded favorably to the proposal. The National Commission for Development Planning has conveyed its intention to in- clude a stabilization scheme in the next development plan. Finally, the certificate relating to the use of the counterpart funds in 1977 have not yet been received nor has the project account been fully audited. EA1DB May 8, 1978