Nepal - Structural Adjustment Project

Docutent of The World Bank FOR OFFICIAL USE ONLY CR /70-e Report No. P-4473-NEP REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED FIRST STRUCTURAL ADJUSTMENT CREDIT IN AN AMOUNT EQUIVALENT TO $50 MILLION TO THE KINGDOM OF NEPAL March 3, 1987 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 OMCL41 USE ONLY KINGDOM OF NEPAL FIRST STRUCTURAL ADJUSTMNDT CREDIT Table of Contents Page No. Loan Summary ................................................... (i PART I - THE ECONOMY 1s5*a*a*. .. .....ew.e.*.......... I 'J A. An Overview. *......... . . . * * * * *........... . ... 1 B. Recent Economic Developments ........................ 2 PART II - PROBLEMS OF ECONOMIC STRUCTURE ..... 4 PART III - THE GOVERNMENT'S ECONOMIC REFORM PROGRAM .... 5 A. Macroeconomic M sagement ........................ ... 5 B. Agriculture and Forestry . ........*.*...... 9 C. Industry and Trade ... * ...... . . .... . ............. 15 D. Public Enterprises .................................. 16 E. Development Implementation .......................... s18 F. Social Impact ............... ........................ 21 PART IV - THE STRUCTURAL ADJUSTMT CREDIT.. ...... 22 A. Background...: ........... , ,. 22 B. Objectives and Description.......... . 22 C. Coordination with the IMF and Other Donors .......... 23 D. Credit Administration and Management ..... 24 E. Procurement, Disbursements and Retroactive Financing 24 P. Tranching ..............................,,. 25 G. Benefits and Risks ... ..................... 25 PART V - BANK GROUP OPERATIONS IN NEPAL ................ 26 PART VI - RECOMMENDATION .., 28 Text Tables Table 1: Selected Economic Indicators ................. 7 ANNEXES Annex I : Economic Indicators Annex II : Status of Bank Group Operations in Nepal Annex III: Supplementary Data Sheet Annex IV : Macro-economic Projections Annex V : Letter of Development Policy Annex VI : Policy Matrix 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.  (i, KINGDOM OF NEPAL FIRST STRUCTURAL ADJUSTMENT CREDIT CREDIT SUMMARY Borrower: The Kingdom of Nepal Amount: SDR 40.9 million (US$50 million equivalent) Terms: Standard IDA terms Credit Description: The proposed credit would support the Government's program of structural adjustment and stabilization. The program aims at increasing investment and economic growth by reducing controls. accelerating efficient use of domestic and foreign resources. and promoting exports. The principal elements of the program include: (i) macro-economic policies to strengthen the countxy's budgetary and external finances and maintain a realistic exchange rate; (ii) liberalizing foreign trade and industrial policies; (iii) reducing and improving the focus of government interventions in the agricultural sector; (iv) conmencing the restructuring of public sector enterprises and improving their administration; and (v) improving the administration of development expenditures. Estimated Disbursements: The credit would be disbursed in two tranches. a first tranche of SDR 20.45 million upon effectiveness and the second tranche of SDR 20.45 million after a performance review to be held in October 1987.  FOR OFmFCLIL USE ONLY INTERNATIONAL DEVELOPMENT ASSOCIATION REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED DEVELOPMENT CREDIT OF SDR 40.9 MILLION (US$50 MILLION EQUIVALENT) TO THE KINGDOM OF NEPAL FOR A STRUCTURAL ADJUSTMENT PROGRAM 1. I submit the following report and recommendation on a proposed Development Credit for SDR 40.9 million (US$50 million equivalent) on stand- ard IDA terms to the Kingdom of Nepal to support the 1986/87 and 1987/88 Structural Adjustment Program of His Majesty's Government (HMC). PART I - THE ECONOMY 2. An economic memorandum (Report No. 5867-REP) was distributed to the Executive Directors in December 1985. Economic data appear in Annex I. A. An Overview 3. Nepal is one of the poorest countries in the world with a per capita income of about US$160; life expectancy, infant mortality, and adult literacy rates are well below the South Asian norm and much of the country remains in abject poverty. Over the past two decades, real GDP growth has barely kept up with that of the population, which is now growing by 2.7 percent per annum, and more recently per capita food production has been falling. 4. The economy of Nepal comprises two geographically distinct regions -- the hills and the lowland terai which borders India. Historically the terai was the source of cereal surpluses which were exported to India and the hills. In recent years, however, a vicious circle has emerged as the poor performance of the hills economy, exacerbated by population pressure, has led to deforestation of slopes, loss of arable land, increasing food deficits and further pressure on marginal lands and migration to the terai. The conse- quent acceleration of soil erosion in the hills has contributed to down- stream flooding and silting of rivers, which has contributed to the loss of agricultural production, both actual and potential, in the terai; combined with immigration the terai's exportable surplus has dwindled. 5. Much of Nepal's poor record in respect of growth and development derives from its meagre natural resource base and its landlocked position. Agriculture dominates the economy, accounting for 60 percent of GDP, 75 per cent of exports, and 90 per cent of employment. Moreover, much of the small- industrial sector is agro-based. With irrigation facilities (which are largely rudimentary) covering only about one eighth of arable land, agricul- turaL output is highly vulnerable to the weather. I Ths document has a restricted distribution and may be used by recipients only in the perfornnce of their official duties. Its contents may not otherwise be disclsed without World Bank authorization.  -2- 6. Nepal shares a long and open border with India, is cut off and far separated from sea routes and is influenced in many respects by the Indian economy. Laws and regulations provide for a relatively free exchange between the two economies; geography and private traders make it inevitable. The implication of this is that economic conditions in India, and economic policies adopted by India, set the framework for the Nepalese economy. Nepal can have little or no influence over these factors which, conversely, influence Nepal significantly. In practical terms this means that Nepal's economic policies must, to a certain extent, accommodate this interrelated- ness in a number of ways. For example, Nepal's prices are significantly affected by demand and supply conditions in India and by India's economic and financial policies. Since India is the largest market for Nepal's goods as well as the source of many Nepalese imports, conditions in India will inevitably influence Nepal's economic prospects. This integration is likely to grow once Nepal exploits its enormous potential to generate and market hydroelectricity to India and to provide dams that can more efficiently regulate the flow of rivers to the Cangetic Plain, improving the potential for irrigation while reducing the incidence of flooding. ClearLy, Nepal's supply of goods and services to India will substantially increase its demands for goods and services produced there, given the limited convertibility of the Indian Rupee. 7. While geography and meager resource endowment have contributed to faltering economic performance, another important factor has been the limited capacity for managing the economy and administering the development program (see para 57). The system of production incentives has been inadequate and budgetary management has had many shortcomings. Weaknesses in public administration are reflected in a combination of low public sector investment as a percentage of CDP and the slow implementation of development projects. B. Recent Economic Developments 8. The period 1981/82-1984/85 (Nepal's fiscal year runs from July 15 to July 14) witnessed a significantly higher rate of real CDP growth than that of the previous five years-3.4 percent per annum compared with only 2.1 percent per Annum. However, annual growth fluctuated widely an account of drought. The overall level of investment averaged about 19 percent of CDP financed in approximately equal shares by domestic and foreign sources. Poor domestic budgetary revenue mobilization performance (with tax collection averaging 9 per cent of CDP), was reflected in an overall fiscal deficit averaging about 10 per cent of CDP. Domestic bank financing of the budget averaged about four per cent of CDP. Credit to the private sector and to public sector corporations to offset continuing losses also expanded substan- tially so that domestic credit expansion averaged more than 25 percent per annum in the latter years of this period. 9. The counterpart of this rapid domestic credit expansion emerged in a balance of payments deficit as Nepal's external position deteriorated substantially While Nepal, historically, has had sizable current account  -3- deficits, until recently these were covered by highly concessional foreign inflows. However, during 1982/83-1984/85, the cumulative balance of payments deficit of US$120 milLion was financed principally by a draw-down of interna- tional reserves; gross reserves fell from about B months of imports at the end of 1981182.to about 3 months at the end of 1984/85. 10. Most of Nepal's external debt has been contracted on highly conces- sional terms. While the ratio of external debt to CDP and the ratio of debt service payments to exports of goods, non-factor services and private remit- tances remain low, both have increased steadily in recent years. During the five-year period ending June 1985, the former rose from 10.1 percent of GDP to 14.2 percent and the latter from 1.9 percent to 6.2 percent of exports and remittances. 11. In the face of the continuing deterioration in both internal and external finances, the Government adopted a stabilization program in December 1985 and entered into a 14 month stand-by arrangement with the INM. Principal elements of the program are: a devaluation of the rupee by 14.6 percent, with the exchange rate to be managed flexibly thereafter; tighter budgetary policies with the initial focus on expenditure restraint, then on revenue in 1986/87 fiscal year; reduced expansion of credit to Government and public enterprises; adjustments in administered prices; restraints on exter- nal borrowing; and import liberalization. 12. Economic and financial performance improved in 1985/86. As a result of good weather, agrisulture rebounded. The introduction of a more liberal industrial licensing policy, as well as improved supplies of electricity, contributed to an expansion in the industrial sector and tourism receipts rose significantly. Real economic growth was 4.2 per cent. As anticipated, the impact of the devaluation and administered price adjustments was immediate and strong. Inflation accelerated from 17 percent in November 1985 to 34 percent in February 1986 on a twelve-month point-to-point basis. However, by late 1986 inflation had decelerated to below 10 percent, reflect- ing the tighter demand management policies and an improved supply situation. There were no wage adjustments in the Government sector, and private sector wage increases have been significantly less than the rate of inflation. As was intended, the overall budget deficit was reduced, and the share of domes- tic bank financing of the deficit was almost halved to 2 percent of GDP. The overall balance of payments showed dramatic improvement, recording a surplus of about US$15 million compared to the approximately US$53 million deficit of the previous year. In summary, the stabilization program has been effective in contribiting to the correction of the external and internal financial imbalances in the economy.  -4- PART II -- PROBLEMS OF ECONOMIC STRUCTURE 13. In the.attached Letter of Development Policy (LODP) HHG identifies a number of areas of structural weakness in the economy. First, serious environmental degradation (especially in the ecologically fragile hills and mountains), a burgeoning population and pronounced dependency on the vagaries of monsoon agriculture which have worsened living conditions in rural areas. Second, macroeconomic management, although much improved since the inception of the stabilization program, will require continued remedial efforts in the areas of domestic resource mobilization and control of recurrent expenditures and inflationary financing. Third, structural weaknesses have also con- tributed to disappointing agricultural performance, exacerbated by excessive and poorly-directed public sector interventions. Financially weak agricul- tural institutions have not only been a drain on public sector finances but have failed to provide the services for which they were constituted; and excessive regulatory controls have also prevented more private sector initia- tive from taking place in agriculture. Fourth, inappropriate industrial and trade policies have been directed at encouraging manufacturing on the basis of low-cost imported inputs. The higher prices of these inputs in India and the long, virtually open border with that counrry have given rise to strong incentives for smuggling; however, the panoply of industrial and trade con- trols enacted to deter smuggling have paralyzed industrial development without stemming the incentive to smuggle. Fifth, structural weaknesses have also given rise to the poor performance of public enterprises, most of which are financially weak, and some of which are heavily indebted, proving to be a drain on the budget and the banking system. Sixth, weak public administra- tion is a constraint to effective economic management. Seventh, management of development spending has slackened giving rise to a declining share of annual disbursements relative to the pipeline of aid commitments. 14. Nepal has been actively implementing a development program to deal with these problems for many years, but these efforts have not been successful. During the past year, HMG intensified its efforts to place the economy on a firmer path toward growth and development. In addition to policy actions undertaken with respect to the stand-by arrangement with the IMP, a number of other measures, described below, have been initiated. If growth and deveLopment are to be ensured, however, the basic structure of the economy will have to change; to accomplish this, it is necessary to set in. motion a process that will simultaneously stimulate growth and the required structural change. Critical to the process will be improving the effective- ness of public sector management-by reducing interventions that are ineffec- tive or counterproductive, and by doing more effectively those things the Government needs to do.  PART III -- THE GOVERNMENT'S ECONOMIC REFORM PROGRAM This section discusses the Government's stabilization and structural adjustment program. IDA's role in supporting the reform program is discussed in the next section. 15. HNG's macroeconomic objectives over the medium term are to sustain a CDP growth rate in the range of f-5 percent per annum while curbing inflation and strengthening the balance of payments. The growth objective is con- sidered the minimum required to absorb new entrants into the labor force. Inflation is to be reduced from the current annual rate of around 10 percent to 5 percent by 1989/90. Cross international reserves will be maintained at 3.5 months of imports and the external current account deficit will average about 10 percent of CDP throughout the period to 1990/91. To achieve these medium-term objectives, demand management policies will be complemented by growth-oriented structural measures. The priorities are: (a) to increase resource mobilization to support a sizable increase in public sector investment; (b) to continue the financial reforms aimed at improving monetary control and resource allocation; (c) to promote agricultural production and preserve forests; (d) to stimulate non-agricultural growth through a more liberal industrial and trade regime; (e) to adjust the size of the public enterprise sector in line with a more selective role for state involvement while strengthening the finances of the remaining public enterprises; and (f) to improve the implementation of development projects. Consequently, EM6's structural adjustment program is focused on five main areas: macro- economic policy; agricultural policy; industrial and trade policy; public enterprise policy; and development implementation. The structural adjustment policies are outlined in detail in the Letter of Development Policy (Annex V) and are summarized below (paras 17-66). 16. Consistent with greater emphasis on the private sector, the authorities have not defined a precise set of growth targets for individual sectors and subsectors toward which their policies will be directed. Instead, tbey have decided to follow policies that accommodate more efficient decentralized decision-making by fostering clearer market signals, and to recognize explicitly the major external constraints over which they have little or no control. A. Macroeconomic Management 17. The measures agreed with the IMF, reflected in large part in the FYBS/86 and FY86187 Budgets - devaluation with flexible exchange rate management; tighter fiscal policies; controlled credit expansion; adjustments in administered prices; restraints on external borrowing and import liberalization - are designed to place the economy on a more sustainable growth path. The continuation of these policies is key to the success of the structural adjustment program (see para 8 of the LODP). The authorities envision continued close cooperation with the IMF in the form of Structural  -6- Adjustment Facility (SAF) programs comencing in 1986187. Within the policy framework, it is expected that the main economic aggregates will evolve along the lines set out in Table 1; Annex IV presents details on the projected evolution of the budget, the balance of payments and the national accounts over the period to 1990191. These medium-term targets will be continuously monitored by the Government, IDA, and the IMF as a basis for determining the need for subsequent policy action and adjustments. Measures to achieve these targets by strengthening the performance of the agricultural, industrial and trade and public enterprise sectors and development implementation are dis- cussed below. 18. By fiscal year 1990/91, HKG expects its economic and financial policies to: increase the rate of growth of real output to a sustainable average of about 4-5 percent per annum--compared to the fluctuating perfor- mance of recent years which averaged 3.4 percent; increase the level of investment to about 24 percent of GDP compared to 19.0 percent, and reduce the annual rate of inflation to about 5 percent compared to 10 percent. The agricultural sector growth rate is projected to be about 3 percent (which is slightly above the growth of population), and the non-agricultural sector, about 6 percent. This projected growth is expected to come from industry, tourism and exports. Under the foreseen scenario, the real growth rate of consumption per capita would increase steadily to about 1.5 percent compared to the 0.7 percent average during 1981/82 - 1985/86 (Table 1).  -7- Table 1: NEPAL: SELECTED ECONOMIC INDICATORS 1981/82-1985186 PROJECTED ESTIMATED PROJECTED AVERAGE AVERAGE 1986/87 1990/91 (19B6687-1990191) Growth Rate (Z p.a.) GDP 3.1 4.2 1.5 4.7 CDP/capita 0.7 1.7 -- 2.2 Consumption/capita 0.7 1.0 1.5 Inflation 9.8 6.6 12.0 5.0 Exports (G,NFS) 4.2 5.1 1.6 6.9 Imports (G,NFS) 4.6 8.2 12.5 7.6 Share of GDP (Z) National Accounts: -Cross Investment 18.6 22.9 20.5 23.6 -Public Investment 7.1 8.1 8.1 8.5 -Domestic Savings 9.8 11.3 9.9 12.5 -National Savings 11.8 12.9 12.0 13.1 Budget: -Government Revenues 8.8 10.9 9.5 12.0 -Government Expenditures 20.0 21.5 19.4 22.9 -Development Expenditure 13.3 15.0 13.1 16.0 -Deficit 10.3 10.6 9.9 10.9 -External Finance 6.4 9.3 B.2 9.6 External Accounts: -Exports (a, NFS) 11.8 13.5 14.1 14.5 -Imports (G, NFS) 21.6 24.2 24.7 25.6 -Current Account - 8.0 - 10.1 - 8.5 - 9.9 Debt Service (Public and Public Guaranteed) Percent of: Exports of Goods & Services 5.1 9.8 6.2 12.2 CDP 0.6 1.4 0.9 1.8 Memorandum Items U.S.$ Killions Amount Current Account -200.0 -321.5 - 219.3 - 376.5 Debt Service (Public and (Public Guaranteed) 5.0 35.0 16.5 50.0  -8k- 19, A major objective of macroeconomic policy will be to improve domestic resource mobilization, especially in the public sector. The government intends to increase Government revenue as a share of CDP from 9.0 percent in 1985/86 to more than 12 percent by 1990/91 through new revenue measures combined with actions to improve the elasticity and buoyancy of the tax system. Nepal has received substantial technical assistance from the IMF in this area in recent yearo, and a revenue mobilization program will be prepared in the spring of 1987, prior to the 1987/88 budget, as part of the first year's financial program under the SAF. At the same time, the govern- ment intends to limit the rate of growth of regular expenditure to about the growth rate of the economy. To achieve this target, an effort will be made to limit the growth of the wage bill taking into account the contribution to be made by natural attrition in certain areas, while paying due regard to the need to develop a more competent civil service. A further major target of policy is to increase the country's capacity to absorb long-term concessional assistance which should permit an increase in development spending to 16 percent of GDP (an increase of about four percentage points over 1985/86 -- see paras. 57-66 below for a detailed description of measures to improve development implementation). Although the overall fiscal deficit is expected to average about ten and one half percent of CDP over 1986/87-199D/91 (which is about the same as in the previous five years), it will be financed by large public sector surpluses and increased absorption of foreign assistance. These two sources of financing will rise to about 5 percent and 10 percent of GDP, respectively, compared to 2 percent and 6 percent during the earlier period. This will reduce domestic financing to about 1.5 percent of CDP, thus increasing the availability of domestic bank credit to the productive sectors. 20. Strengthening the balance of payments is a another major goal of policy. A continuation of the present policy of managing the exchange rate flexibly, paying due regard to movements in relative prices and overall indicators that reflect the strength of the external account, is an important element of HKG's policies--as are efforts to increase exports and provide incentives for efficient import substitution. Export growth is projected to increase by an average of about 5 percent a year in real terms. Particularly important to this outcome will be the expansion of two major exports: car- pets and garments. These two exports, which provide major employment opportunities, have shown rapid growth in recent years, rising from US$6 million in 1981/82 to US$46 million in 1985/86. The continued growth of carpet exports, which face a rising demand, will be encouraged as raw wool has been placed under open general license. Four garment items have been placed under quota by the United States. However, the provisions for an annual increase in the quota, combined with the scope for upgrading quality and the production of additional items and the emerging markets in the EEC, will permit healthy growth in this sector. The recently-approved IDA-supported cottage and small industry project (Cr. 1696-NEP) is expected to provide additional stimulus to the export of carpets and garments as well as to the development of other small-scale industrial activities.  -9- Additionally, expanding hotel accommodation and supporting services for tourim are expected to lead to a healthy growth in service earnings. Imports are expected to show a substantial rise as the result of improvements in the utilization of foreign aid and import liberalization. Reflecting Government's efforts to increase development expenditure and the absorption of long-term concessional assistance, the external current account deficit is projected to rise from its 1985/86 level of 8.2 percent to about 9.9 percent of GDP in 1990/91. 21. The projected current account deficits are sustainable in view of the large pipeline of concessional assistance and the expected continuation of comfitments from the donor community in support oi the program as well as accelerated disbursements. Implementation of a program of adjustment along the lines outlined above would imply that over the period 1986/87 through 1990/91, the cumulative external current account deficit would amount to US$1.6 billion or an average of US$320 million annually. Additionally, the authorities will need to allow foreign exchange reserves to build up by about US$100 million over the period, for the country to maintain a reserve level equal to about three and one-half months of imports. After taking into account amortization of external debt, the external financing requirement amounts to about US$1.8 billion. This requirement is expected to be financed by project-related aid disbursements of US$900 million from the existing aid pipeline of about US$1.1 billion, additional project and program related aid disbursements of US$550 million from expected new commitments of about US$1.8 billion over the period, and financing for aircraft. After these sources of financing are taken into account, a financing gap of aboutl US$250 million remains, of which US$80 million will be over the next two years. It is proposed that IDA and the IMF provide financing to cover it through the proposed SAL of US$50 million and US$17 million of a three-year SAP of US$22 million. The ADB and other bilateral donors have expressed strong interest in supporting the adjustment program. Current indications are that from US$10-15 million of quick disbursing assistance from these sources will be available in the first two years of the program. B. Agriculture and Forestry 22. Despite major investments in agricultural support services and inputs, crop production has continued to lag behind population growth. AgricuLtural production increased only by about 2.2 percent per annum between 1974/75 and 1985/86 while population grew by about 2.7 percent, thus leading to a progressively deteriorating food balance. Forest resources have also continued to decline rapidly with serious consequences for the country's environment and economy. Agricultural production needs to be raised on a sustained basis, at least in line with population growrl (see para 25) and the trend L deforestation needs to be reversed. In agriculture, reform measures are needed to improve resource utilization and productivity. Measures will focus on (i) improving production incentives; (ii) enhancing the availability and reliability of services and inputs; and (iii) strengthening key public sector support agencies. At the same time,  -10- measures are needed to provide incentives for the private sector to assume a greater role in Nepal's agricultural development. Comunities and individuals also need to become actively involved in managing the country's forests. 23. Although the importance of assigning high priority to agriculture was recognized in previous five-year plans in which quantitative targets were established for the sector, the government's agr