Nicaragua - Second Economic Recovery Credit

Document of The World Bank FOR OFFICIAL USE ONLY Report No. P-6340-NI REVORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCTATION TO THE ECUTIVR DIRECTORS ON A PROPOSED SIZCOND ECONOMIC RECOVERV CREDIT IN AN ANoUNT EQuIVALEN To SDR 42.5 MILLION AND AN llA REFLOWS SUPPLEMENTAL CREDIT IN AN AMoUNT EQUIVALENT TO SDR 5.36 MILLION TO THE REPUBLiC OF NICARAGUA MAY 27, 1994 MlCROGRAPHICS R{eport No: P- 6340 Ni This document has a restnicted distribution sac Type: PR their offici4 dudies Its contents may not oth  CURRENCY EQUIVALENTS US$1 = 6.4 Nicaragua C6rdobas (March 1994) FISCAL YEAR January 1 - December 31 ABBREVIATIONS AND ACRONYMS ATP Temporary Protection Tariff (Arancel Temporal para la Protecci6n) BANADES National Development Bank (Banco Nacional de Desarrollo) BANIC State Bank for Industry and Trade (Banco Nicaraguense de Industria y Comercio) CACM Central American Common Marlzet CEM Country Economic Memorandum CET Common External Tariff CG Coni4tative Group CORNAP State Holding Corporation (Junta General de Corporaciones Nacionales del Sector Pablico) ESAP Enhanced Structural Adjustment Facility ESW Economic and Sector Work ENIGAS State Gas Company (Empresa Nicaragaense de Gas) FISE Emergency Social Investment Fund (Fondo de Inversi6n Social de Emergencia) FNI National Investment Fund (Fondi' Nacional de Inversi6n) GATT General Agreement on Tariffs and Trade lCB International Competitive Bidding IDC Institutional Development Credit IDB Inter-American Development Bank IDF Institutional Development Fund IEC Special Consumption Tax ampuesto Especial al Consumo) INISER State Insurance Company (Instituto M zragaense de Seguros) ISC Selective Consumption Tax (Impuesto Selectivo al Conswwo) LUBNICA State Oil Products Company (Lubricantes de Nicaragua) MOH Ministry of Health MCT Ministry of Construction and Trade NAFTA North American Free Trade Agreement NEAP National Environmental Action Plan NTB Non-Tariff Barrier PETRONIC State Petroleum Company (Empresa Nicaragtlense del Petr6leo) PFP Policy Framework Paper PMU Reform of the State Program Management Unit SILAIS Departmental Health Units (Sistema Local de Asistencia Integrada para la Salud) TAC Technical Assistance Credit TELCOR State Telecommunications Company (Insetuo Nicaraglense de Telecomwnicaciones y Correos) UNDP United Nations Development Programme UNO United National Opposition (Unidad Nacional Opositora) USAID United States Agency for International Development  FOR OFFICIAL USE ONLY NICARAGUA SECOND ECONOMIC RECOVERY CREDIT- Table of Contents CREDIT AND PROGRAM SUMMARY .. ...... ................ - . i Part I. COUNTRY ASSISTANCE STRATEGY ............................... 1 A. Historical Perspective and Recent Developments ......................... 1 B. The External Environment . * . .................................... 4 C. Government Development Policies and IDA Assistance Strategy. 6 Government Strategy and Growth Prospects .......... .................. 6 IDA's Objectives and the Development Agenda .......7I .................. 7 Reviving Growth. 7 Public Seaor Reform and Capacity Building ....... ........... .... 10 Alleviating Poverty and Invessing in Hwnan Capital . 11 Environmental and Natural Resource Management .13 Lending Levels and Composition .14 ESW Program ....................... .................... 14 Portfolio Implementation .................. 15 IFC and MIGTA Activities .................. 15 Cooperation with Other Institutions .................. 16 External Financing Needs .................. 16 D. Agenda for Board Consideration .................. 17 Part II. THE GOVERNMENT'S ADJUSTMENT PROGRAM ................ .. 17 A. Macroeconomic Framework .................. 18 B. Reform of the State .................. 18 C. Financial Sector Reform .................. 20 D. Private Sector Development .................. 22 E. Social Inpact .................. 24 Part m. THE PROPOSED CREDIT .................. 24 A. Background .................. 24 B. Conditions for Tranche Release .................. 25 C. Procurement, Disbursement and Auditing .................. 27 D. Relations with Other Financial Organizations and Donors .................. 28 E. Cofinancing ............................................... 28 F. Technical Assistance ............................. 28 G. Program Benefits and Risks .................................. ... 29 Part IV. RECOMMENDATION ............................. 29 TEXT TABLES Table 1: Projects under Implementation ............ ................ 15 Table 2: External Financing Requirements and Sources, 1993-97 .16 This document has a restricted distribution and may be used by recipients only in the pefom of their afflcial dutes Its contents may not otherwise be disclosed without World Bank athorization.  TEXT BOXES Box I: The Economic Challenge ....................... 3 Box 2: The Property Rights Problem ........................ 9 Box 3: Decentralizing Health ....................... 12 ANNEXES A. St-tistical Appendix B. Objectives and Instruments of the Country Assistance Strategy, FY95-99 C. Matrix of Policy Actions D. Action Plan to Improve Prudential Supervision E. Government Letter of Development Policy F. Government Letter of Labor Policy (. Supplementary Credit Data Sheet  NICARAGUA: SECOND ECONOMIC RECOVERY CREDIT CREDIT AND PROGRAM SUMMARY Borrower: Republic of Nicaragua Amount: IDA SDR 42.5 million (equivalent to US$60 million) IDA Reflows SDR 5.36 million (equivalent to US$7.6 million) The proposed Supplemental Credit for Nicaragua was contained in t;ie President's Memorandum of January 4, 1994 entitled 'Distribution of FY94 Annual Allocations from IDA Reflows-Proposed Supplemental Credits for Bolivia, Ethiopia, Ghana, Guyana, Honduras, Kenya, Malawi, Mauritania, Senegal, Sierra Leone, Uganda and Zambia' (IDA/R94-1), approved by the Board on January 14, 1994. Terms: Standard IDA terms, with an amortization period of 40 years, including a grace period of 10 years. Program Objectives: The proposed second EconomIc Recovery Credit (ERC II) would support the Government's structural adjustment program, which alms to: (i) carry out a major reform of the State; (ii) increase the efficiency of financial intermediation; and (iii) improve conditions for private sector develop.nent. Credit Description: To help achieve the program's objectives, the proposed ERC I would support measures to: (i) maintain a stable macroeconomic framework; (ii) reform the State, including: (a) reducing public sector employment, (b) privatizing state-owned enterprises, and (c) implementing a comprehensive public sector reform program; (iii) improve the efficiency of state-owned banks and strengthen prudential supervision of the financial system; and (iv) improve incentives for private sector activity by: (a) strengthening the property rights resolution process, (b) increasing transparency and reducing discretionality in incentives and policies, (c) implementing a phased program to reduce protection, and (d) improving labor policies. A policy matrix spelling out the objectives of the proposed credit, measures already taken, measures to be taken under the credit, and proposed timing is provided as Annex C. Benefits: Implementation of the reform program would allow the Government to carry out an orderly adjustment in response to the prospective 4ecline in foreign aid and establish the conditions for a revival of private sector-led growth. Approval of ERC U would enable the Government to mobilize additional balance of payments support, which would permit a more gradual and predictable economic adjustment path to reduced aid flows. Moreover, to the extent that the program succeeds in reviving growth within a stable macroeconomic environment, there would be modest but importat improvements in living standards and the Government would be in a better position to address the country's complex, longer-term development challenges. Risks: The proposed credit will involve two major types of risks. First, a breakdown of the consensus-building process and strong opposition to some of the reforms could lead to a political impasse as occurred in 1993. Although the political situadon remains uncertain, there is also greater awareness in Nicaragua that the country has no option but to adjust to the decline in external aid, and that this will necsarily involve a  - ii - reduction in the public sector. Second, the Government's weak institutional capacity could delay implementation of several components of the program. To address this risk, the proposed credit has been designed with considerable flexibility, relying on implementation of action plans, which allow for the monitoring of overall program execution while leaving sufficient room for variability in implementation of different components. Implementation of the structural adjustment program would also be supported by a proposed Technical Assistance Credit and other capacity-building elements of IDA's country assistance strategy. Poverty Category: Not applicable. Estimated Disbursement: The credit would be disbursed in three tranches. The first tranche of US$30 million, supplemented by the IDA Reflows Credit of SDR 5.36 million (US$7.6 million equivalent), would be eligible for disbursement upon effectiveness, planned for July i994. Two tranches of US$15 million each would be available for disbursement upon fi'.lfillment of second and third tranche conditionality, expected by December 1994 and August 1995, respectively. Retroactive financing will be permitted for those eligible imports made before the date of the credit agreement and after February 1, 1994, up to an amount not to exceed one third of the credit (SDR 14.17 million equivalent). Schedule of US$ million Disbursements: FY95 FY96 Annual 52.6 15.0 Cumulative 52.6 67.6 Financing Plan: The Governments of Germany, Sweden and Switerland are considering cofinancing equivalent to US$12 million, US$9 mill. a and US$6 million, respectively. In addition, the Government of Nicaragua has requested cofinancing of US$60 million from the Government of Japan. Appraisal Report: Ihis is a combined staff appraisal and President's Report. This report was prepared by Ian Bannon (LA2C2). Contributors to the report were: Ulrich L&Cbler (Residt Representaive, Nicargua), Nancy Cooke and Harold Bedoya (LA2C2). The Task Manager for ERC It ie UWich lAchler who led a team composed of: Ian Bannon, Douglas Tinsler (LA2C2); Richard Clifford (LA2ME); Luis Guasch (LATAD); Ligia Carvajal, Juan Luis Daly, Caola Peasmo and Rafael Ravetmo (consultas). The Division Chief is Robert Lacey, the Departmet Project Advisor is Pul Knotter and the Countty Deatment Director is Edilbewto Segura.  REPORT AND RECOMMENDATION OF THE PRESIDENT OF IDA TO THE EXECUTIVE DIRECTORS ON A PROPOSED SECOND ECONOMIC RECOVERY CREDfT AND AN IDA REFLOWS SUPPLEMENTAL CREDIT TO THE REPUBLIC OF NICARAGUA 1. I submit for your approval the following report and recommendation on a proposed Second Economic Recovery Credit (ERC I) for SDR 42.5 million (US$60 niillian equivalent), and an IDA Reflows Credit for SDR 5.36 million (US$7.6 million equivalent) to the Republic of Nicaragua in support of the Government's structural adjustment program. The credits would be on standard IDA terms, with an amortization period of 43 years, including a grace period of 10 years. Cofinancing possibilities are being explored with Germany, Sweden and Switzerland. In addition, the Govermnent of Nicaragua has requested cofinancing of US$60 million from the Government of Japan. Part I. C3UNTRY ASSISTANCE STRATEGY' A. HISTORICAL PERSPECTIVE AND RECENT PEVELOPMENTS 2. When the Government of President Chamorro assumed office in April 1990, following 11 years of civil war, it faced a highly polarized society. The United National Opposition (UNO), which Mrs. Chamorro led into the elections, was a loosely knit coalition, united only in its antagonism to the then Sandinista Government. The Sandinistas, by contrast, represented (even after their electoral defeat) a consolidated, coherent front, and controlled the security apparatus, including the Armed Forces. Under these circumstances, the Government attempted to govern through consensus, leaving largely intact both Sandinisu control of the security forcee and other key institutions (including the Judiciary), as well as many of the, property transfers that took place during the Sandinista adminisxration. Initially, this strategy was successful. Relying on the high popularity of the President and massive support by the international donor community, the Government embarked on an ambitious stabilization and reform program. The economy was devastated and characterized by a cumbersome, centralized public sector, a small, overregulated private sector and atrophied market institutions. Exports and GDP per capita had declined to 40 percent of the levels attained in the mid 1970s, and major macroeconomic imbalances inherited from the previous Administration had resulted in hyperinflation and a massive external debt of more than five times the size of GDP. In 1991-92, the Government implemented a strong stabilization program, supported by an IW Stand-by arrangement. At the same time, it began to implement a structural adjustment program aimed at transforming Nicaragua into a market economy capable of achieving sustained growth. IDA supported the Government's reforms through an Economic Recovery Credit (ERC 1), approved in September 1991. Program implementation was satisfactory, and the second and last tranche of ERC I was released on schedule in June 1992. 3. The stabilization measures introduced in March 1991 were remarkably successful. Inflation was reduced from hyperinflationary levels in 1988-90 to single digit annual rates from April 1991 through December 1992, and in 1992, the economy recorded a very modest output growth for the first time since 1983. The key factors responsible for this success were a major reduction of the fiscal deficit, the maintenance of credit discipline and the adoption of a fixed exchange rate system facilitated by large inflows of foreign aid. With strong donor support, the Government succeeded in clearing its arrears with the Bank/IDA and 1DB in September 1991, and reached a Paris Club Agreement on enhanced terms in December 1991, as a first step toward normalizing relations with external creditors. 1. lhis will be the first Board discussion of Nicaragua's Country Assistance Strategy.  .2 4. Ihe Government also succeeed In implementing the first phase of its structural adjustment program supported by ERC 1. In addition to underpinning the stabilization effort, the main achievements of the structural reform program by early-1993 were: (i) Public Sector Adjustment: a major downsizing of the public sector through reductions in current expenditres, the reduction of military personnel by over 80 percent and of govemrnent employees by 12 percent, and the divestiture of 233 out of an initial 351 state-owned enterprises; (ii) Foreign Trade: liberalization of foreign trade through unification of exchange rates, the adjustment of most inport tariffs to a range of 10-40 percent, the elimination of most non-tariff import and export barriers, and the abolition of state-trading monopolies; (iii) Domestic Trade Uberalization: liberalization of domestic commerce through the elimination of official price controls, especialy for agricultural goods, and privatization of state trading activities; (iv) Financial Sector: creation of an autonomous Superintendency of Banks; and financial sector liberalization through the elimination of interest controls, the restructuring of state-owned conmmercial banks (including the liquidation of one state bank and a 50 percent reduction in staff and branch offices of the remaining ones), and the opening of the financial system to private banks (7 private banks are now in operation); and (v) Social Inpact: creation of systematically targeted social safety nets, including an IDA- supported emergency social investment fund (FISE) and an employment generation program, coupled with an expanded public investment program designed to rehabilitate the deteriorated infrastructure. 5. Despite this progress, the political situation began to deteriorate in the second half of 1992. The continued influence over certain key state powers by the Sandinistas, combined with the slow resolution of property rights disputes, led to disaffection with the Government among certain groups within UNO. This was exacerbated by the extension of the debate over property rights and the role of the Sandinistas to the floor of the US Senate and the consequent suspension of USAID disbursements of balance of payments support. The National Assembly ceased to functien effectively and by the end of 1992, the Government had established a fragile working majority in the Assembly by relying on the Sandinistas and a small group of former- UNO members. Ihe majority of UNO continued to boycott tne Assembly and to challenge its legitimacy. 6. Developments in 1993. The political impasse deepened in 1993. The crisis in the Assembly, weak law enforcement, continued rural violence which disrupted agriculure, and a malfunctioningjudicial system, deepened polarization and splits began to emerge, not only within UNO, but also among the Sandinistas. Guerrilla warfare re-emerged in the countside and at times spread to urban areas. Under these circumstances, it became very difficult for the Government to achieve and sustain the necessary consensus to carry forward its stabilization and reform programs. Attempted fiscal adjustment measures were met with violent strikes and dtmonstrations leading to their withdrawal. The turbulent political environment was accompanied by economic deterioration. GDP decreased by 0.9 percent, inflation increased to 19.5 percent and net inenational reserves declined by US$100 million. Output growth also fell victim to a marked drop in commodity prices and adverse weather. Moreover, the interruption of important bilateral aid flows led to an abrupt tightening of credit that added uncertainty to the business climate. As a result of these developments, the overall fiscal performance was below target during 1993 and contributed to delays in preparation of the IMF's ESAF program and IDA's proposed ERC II, with the result that balance of payments support declined significantly compared to 1992 levels. Despite these adverse conditions, the Goverment succeeded in maintaining macroeconomic stability by postponing investment expenditures and tight monetary control.  Box 1: TIE ECONOMIC CHALLENGE A remarkable stabilization effort .. ... with strong fiscal adjustment.. (inflation Rat.) (Public Savi,go, % of GDP) 10090% - . . .- --** 0500 ... ... ---1 %---.- tOWS,, ....~.. .... .. _ , ...... t ._ ........ ,_ ., .. ,._, .,, ... . , ../ 10_% ..... . _ - I , -30% - 199O I99t 1992 S3 190 S91 192 ...but no economic growth... ... and conthugin external imbalance. (GDP Growt Rate) (Cuznt Account Deficit, % of GDP) 1"I 4992 - 4M% 0950 10- 1 I t 92 Oa 7. Recent Progress. During the April 1993 Consultative Group meeting, the donor commuity expressed grave concerns over Nicaragua's political impasse and growing polarization. At the same tme, donors sent a clear signal that while bilateral aid would certainly decrease (para. 10), futute prospects would depend on the Government's ability to continue economic reforms and forge a political consensus to support the effort. During 1993, donor agencies, including IDA, continued to impress on the Government the need to develop a national consensus and offered to help in the process. Pary as a result of these efforts, but also a growing national realization that the confrontational politics of 1993, if continued, would lead to chaos, the political situation stabilized In the closing weeks of 1993 and then began to improve. This process benefitted from the increasing influence of moderate elements on the left and right, and greater awareness throughout the body politic of the depth of the economic crisis and the paucit- of available options. In recent months, rural violence has diminished, a negodated setlement was reached on a simmering insurgency in t-a North, changes have been made or agreed tu in the leadership of the armed forces, the Assembly is functioning again, a new Controller General has been appointed by the Assembly, political negotiations are underway to modify several key aspects of the Constitution, and changes have been made in the Supreme Court. These developments provide Nicargua with an important oppoMnity to reach the political consensus required to implement the strog stabilizton and adjustment measures that would maintain stability and revive growth. While political prospects have improved, to reinforce this emerging consensus the Government must move quicldy to implement is refbrm program and mobilize the support of the donor community.  -4 - 8. Poverty and Sodal Developments. Although reliable trend data are not available, economic and social indicators show mixed results over the past three years. GDP per capita fell by 8 percent durng 199093 and official estimates indicate unemployment may currently approach 20 percent. On the other hand, private consumption per capita grew by 12 percen: - er 1990-93, made possible by the large inflow of foreign aid that began in early 1991. At the same time, real wages expanded by 23 percent per annum during 1991-92 and fell slightly in 1993. In any case, poverty .s widespread and basic social services are inadequate. The Government has made considerable effovl to protect the poor during adjustment, through the establishment of targeted safety net mechanisms, and by attempting to protect allocations to the social sectors from fiscal stringency. Social conditions and IDA's strategy are discussed in greater detail in Section C below. B. THE EXTERNAL ENVIRONMENT 9. Nicaragua's small and weak economy is highly vulnerable to external conditions. Three areas are particularly important: (i) ex.ernal aid; (ii) export prospects for its primary commodities; and (iii) external debt. In addition, Nicaragua's trade reform effort is framed within the context of the ongoing regional integration process in Central America. 1). Aid Prospects. Since the mid 1970s, Nicaragua has become increasingly dependent on foreign aid. This dependence became especially pronounced during 1990-92, when exceptional volumes of foreign assistance became available to support the Government's stabilization and structural adjustment program. During 1990-92, gross disbursements of grants and loans averaged about US$600 million annually, equivalent to about US$150 per capita. This placed Nicaragua among the three top aid per capita recipients in the world. Recent indications suggest that Nicaragua can no longer count on such large aid inflows, as key donors continue to face increasingly tight aid budgets and rearrange priorities in response to the emergence of new aid claimants. In addition, as a result of cutbacks in assistance from some key donors, total aid to Nicaragua will decline even more abruptly than would oe expected on account of global trends. In 1993, gross disbursements of grants and loans fell to US$390 million, 35 percent below the average for 1990-92, and a drop equivalent to about 12 percent of GDP. Ihe extent to which international fimancial institutions can make up for these lower flows will remain limited by the country's creditworthiness and the availability of concessional funds. This poses two types of problems for Nicaragua. First, the economy has no option but to adjust to this decline in aid, but given Nicaragua's small economy even relatively small aid shortfalls require considerable domestic adjustments. for this reason and the country's heavy foreign debt burden, external financing needs remain large. (External financing requirements and sources are discussed in para. 54.) Second, the problem is exacerbated by the unpredictability of the pace of decline. The urgent task now facing the Government is to adopt domestic policies which can offset the prospective decline in foreign savings and, over the medium term, reduce the economy's aid dependence. This will necessarily involve increasing domestic savings and reducing consumption. 11. The Government's stabilization and adjustment program, supported by the IMF and IDA, aims to gradually render the economy less dependent on aid by increasing domestic savings and exports. The adjustment program supported by ERC II, especially the public sector reform component, is a critical element in the Government's strategy to raise public savings through a structural transformation of the State and to improve conditions for private sector development. In addition, through the Consultative Group (CG) process and its donor coordination activities, IDA will continue efforts to mobilize donor support for Nicaragua's development programs, especially by encouraging donors to make the decline in aid smoother and more predictable. 12. Export Prospects. Two factors have contributed to Nicaragua's high dependance on aid-the lack of supply response in the export sector, especially agriculture, and a decline in commodity prices for its main exports. Except for a brief surge during 1989-90, total exports have followed a declining trend since the late 1970s. Six commodities (coffee, cotton, sugar, beef, banaas, and shrimp) account  for about 70 percent of total merchandise exports. All but shrimp suffered international price decline between 1990 and 1992, with those of coffee and cotton particularly severe. These adverse price movements account for about 40 percent of the US$107 million fall in total exports observed over the period, while the rest was due to lower output and yields. The performance of merchandise exports improved somewhat in 1993, but at US$267 million, they were still only 60 percent of the nominal level achieved in 1980. 13. Nicaragua's weak export base and a1ck of supply response are symptomatic of the constraints affecting private sector development, especially in agriculture, The Government's efforts have focused on liberalizing markets, improving incentives, removing the State from production and tt&ding activities, and improving property rights and security in rural areas. These efforts need to be continued and deepened, especially in the agriculture sector, where there is considerable potential for a quick supply response without substantial additional investments. In addition to supporting the next phase of the Government's adjustment program through ERC II, IDA's recently approved Agricultural Technology and Land Management project aims to increase agricultural productivity and improve land property rights. 14. External Debt. Nicaragua's total external debt of US$11.8 billion at end-1993 makes it one of the most severely indebted countries in the world. Total external debt is more than six mes its Gi)P and the ratio of total debt to exports is more than 3,000 percent. Abo-ut 80 percent of the total is long- term debt, of which about 37 percent was contracted with the Russian Federaticn, former Eastern Block countries and the former German Democratic Republic, about 19 percent is owed to Latin American countries, about 16 percent to commercial banks, about 12 percent to international financial institutions and 9 percent to Pars Club members. This enormous debt overhang contributes to an acute and unsustainable external situation, which Nicaragua has only been able to manage by incurring substntal arrears on debt servicing. 15. The Government has made considerable eftbrts to regularize its situation with external creditors. In December 1991, Nicaragua was the first country to be granted "enhanced Toronto tern:s" by the Paris Club. The Govermnent and the Paris Club reached an agreement that effectively cut debt service in half over tne period 1992-94 and left open the possibility of reducing the stock of debt at the end of this period. The Government also renegotiated its debt with Mexico, Colombia and Argentina on highly favorable terms. The treatment of debt to the Russian Federation, the former German Democratic Republic and the terms of debt forgiveness from Germany remain to be addressed. In August 1992, the Board approved an allocation of up to US$25 million from the Debt Reduction Facility for IDA-only Countries for a proposed commercial bank debt reduction operation, and a grant from the Facility of up to US$750,000 to engage financial and legal advisors to assist in preparing the debt reducion operation. It was expected that IDA's allocation would act as a catalyst to mobilize additional cofinancing from bilateral donors. So far only a small number of dor. -s have expressed interest in cofinancing the proposed debt reduction operation and although efforts are continuing the prospects for mobilizing sufficient cofinancing appear extremely limited. 16. Nicaragua's longer-term prospects will depend critt-,lly on reaching a comprehensive solution to its debt overhang. Given the magnitude of the problem and the country's limited prospects for a rapid reactivation of growth, tis will necessarily entail substantial debt forgiveness. Untl the debt problem can be comprehensively resolved, Nicaragua's fragile extesa position wfll critically constrain Government efforts to promote private investment, especially foreign. Over the medium term, Nicaragua will continue to face very high exceptional financing needs. 17. Regional Integration. Nicaragua is a member of the Central American Common Market (CACM), together with Costa Rica, El Salvador, Guatemala and Honduras. In recent years the CACM has transformed itself into an outward-oriented institution, reinforcing national policies to liberalize trade and encourage exports to third markets. In 1993, the CACM was expanded and deepened into a General Treaty of Central American Economic Integration, covering not only trade but coordination of  -6 - macroeconomic policies, financial and other services and, eventually, free factor mobility. Under the Treaty, there is free trade between members and a Common External Tariff (CEI). The CET has been gradually reduced-by December 1993, except for Nicaragua it was within a range of 5-20 percent with a few relatively minor exceptions. However, in accordance With the 'Guatemala Protocol', signed in September 1993 by the Economic Cabinets of all CACM members, Nicaragua was granted preferential treatment reflecting its special eircumstances. In particular, a more gradual reduction in protection from imports originating outside CACM is allowed, arid Nicaragua has the ability to impose selective consumption taxes on goods originating in Central America. Under the trade reform program supported by ERC 11, Nicaragua would reduce its tariff structure graduaily to reach a ceiling of 20 percent by 1999. Although given the structure and level of Nicaragua's exports, the CACM would have little immediate impact or -e economy, its membership does provide an important source of support and encouragement to maintautl outwardly oriented policies. The country's special treatment does not mean it is deprived of the wider benefits of CACM membership, including the interchange of policy experience, support in developing a national consensus on reform, and -a common frint in facing external developments, such as the European Union's banana policy and the impact of NAFTA. Both IDA and IDB are involved in strengthening CACM and Treaty institutions. Among ongoing IDA initiatives is a study examining the impact of NAFIA on Central America, especially possible trade and investment diversion effects. C. GOVERNMENT DEVELOPMENT POLICES AND IDA ASSISTANCE STRATEGY Government Strategy and Growth Prospects 1l. The basic aims of the Governmenqt's development strategy have been to: (i) maintain a stable economy; (ii) achieve a massive economic transformation-away from a centralized command economy to a market and private sector-driven system; (iii) revive growth in a sustainable and equitable manner; aad (iv) render the economy less dependent on foreign aid. Although these aims have been clear and the Government has not wavered in its commitment, there has been less clarity and consensus on specifics of the strategy. This reflects, iirst and foremost, Nicaragua's deep political divisions, which maket k difficult to build a national consensus on detailed elements of the strategy. With a volatile political environment, coupled with difficult economic and social problems, the Government's attention is frequently focused on extinguishing short-term political and economic fires. These difficult circumstances are compounded by the Government's weak institutional capacity and by acute impatience in the country with the lack of growth and pervasive social problems. As a result, the Government is often on the defensive, taking a reactive stance instead of proactively articulating a iorger-term development agenda. 19. Nicaragua can achieve sustained growth in the second half of the 1990s. In the short run, however, a rapid reactivation of growth appears difficult due to tight macroeconomic constraints. The best that can be hoped for is annual growth averaging about 3.2 percent over the next three years, until the economy's structural transformation is further advanced and the private sector has acquired enough confidence to step up its investment activities. Such a structura transformation and renewed private sector confidence are contingent on: (i) consolidation of the stabilization process and deepening of the structural adjustment program; (ii) a major reduction of the extea debt burden; (di) a strengthened institutional capacity of the State; and (iv) significant progress in resolving property rights disputes and improving law and order conditions. Ihe main sources of growth over the medium term are expected to be: (i) a recovery of production and exports in the agriculture, fishing and mining sectors toward levels reached in the late 1970s; and (ii) productivity improvements stemming from a more efficient utitization of existing capacity. The recovery of agriculture and the natural resource sectors will be driven mainly by the removal of policy distortions and price controls, while commodity prices improve modestly over the projection horizon. Productivity improvements would result from more efficient financial intermediation, the elimination of price distortions, improved security in rural areas, more efficient management of privatized enterprises and public utilities, and the rehabilitation of ecoomic inrastructure. Over the longer term, growth is expected to arise primarly from increased private investment, especially in agriculture-based export actvities. Gross domestic savings are expected to  -7- increase substantially during 1994-97, through reductions in public and private consumption, which would contribute to growth by releasing more resources for investment. IDA's Objectives and the Development Agenda 20. MAs Strategy. The central aim of IDA's assistance stategy is to support the Government in its efforts to complete the transformation toward a market economy capable of sustaining growth and -reducing poverty. An overriding priority is to revive economic growth. Although the other aspects of the development agenda (described below) are also important and clearly complement the aim of sustainable development, without a revival of growth there would be little chance that progress could be made in meeting these other challenges, especially in terms of reducing poverty, or that Nicaragua could successfully complete the transition to a democratic and more equitable society. 21. Limited resources require that IDA's strategy be highly selective. In this light, our assistance strategy over the FY95-99 period will adopt a two-track approach. On the one hand, we will maintain a sharp focus on stabilization and structural adjustment, in order to lay the foundations for a sustained and private sector-led economic recovery. Adjustment lending, through the proposed ERC II and a subsequent ERC III, would be the centerpiece of this effort but would also be reinforced by an intensive policy dialogue, analytical work and donor coordination, including resource mobilization. The second track would concentrate on equity and sustainable development, focusing on: (i) capacity building; (ii) poverty alleviation and human resource development; (iii) restoration of physical and social infrastructure; and (iv) improved environmental management. An overarching objective of the assistance strategy will be to build up the Government's capacity to manage, not only the structural reform program, but also the country's longer-term development agenda. 22. The Development Agenda. IDA's assistance strategy then seeks to address four key aspects of Nicaragua's development challenge: (i) reviving growth; (ii) reforming the public sector and strengthening institutional capacity; fiii) alleviating poverty and investing in human capital; and (iv) improving environmental and natural resource management. The objectives and instruments of IDA's assistance strategy, and their relationship to Nicaragua's development agenda are discussed below. Annex B summarizes the objectives and instruments of IDA's country assistance strategy over FY95-99. ReWving Growth 23. Reviving growth is critical. Within this overall framework, four interrelated issues need to be addressed: (i) maintaining a stable economy and deepening the structural adjustment process; (ii) developing a broad-based political consensus to underpin the reform effort; (i1i) removing constraints to private sector development; and (iv) rebuilding the country's social and physical infrastructure base to increase productivity and living standards. 24. The Need to Maintain Stabilzation and Deepen Adjustment. When the second tranche of ERC I was disbursed in June 1992, Nicaraguaes economy appeared to have stabilized and to be on the way to recovery. Instead, output growth became negative again in 1993 and the subsequent loss of reserves has left the economy in a precarious position. ITe need for a continuing stabilization effort is also rendered urgent by the anticipated decline in foreign aid inflows (discussed in Section B above). While these developments have once again placed stabilization at the forefront of the economic agenda, they have also underscored the need to deepen structural reforms so that they reinforce and complement the stabilization effort. 25. Over the short run, strong macroeconomic measures need to be taken to restore an adequate foreign reserve cushion and reduce the danger of renewed instability. Credit availability was very tight in 1993, so the stabilizadon effort needs to focus on firiher fiscal compression In order to increse public savings. The fiscal adjustment, however, needs to be sustained and focus on a structura improvement  -8 - in the public sector's savings performance. Since capital expenditures and the public investment program are almost entirely donor financed, the key fiscal stability indicator is public savings. A sustained improvement in public savings over 1994-97, will be required to both permit private sector expansion and to ensure an orderly economic adjustment to the expected decline in foreign savings. 26. Although stabilization issues are critical, the need to restore growth is also urgent-especially in view of Nicaragua's high population growth (an estimated 3.2 percent, among the highest in Latin America). In the absence of faster growth, the country's already dismal poverty conditions and fragile social peace will rapidly deteriorate. On the other hand, restoring growth will be extremely difficult under the currently weak economic conditions. In order to improve conditions for private sector-led growth, attention needs to be placed on: (i) reorienting the role of the State, to increase its efficiency and allow more room for private sector expansion, while contributing to longer-term fiscal stability; (ii) improving the efficiency of financial intermediation; and (iii) reducing key barriers to private sector confidence. The Government's reform program, to be described in Part I, seeks to address these issues. 27. IDA is supporting the Government's stabilization and adjustnent effort in two major ways. First, the need to ensure a stable macroeconomic framework, especially through tight fiscal policies, has underpinned our policy dialogue with the Government. IDA has made a major effort, in coordination with the IMP, to analyze the critical macroeconomic situation and explore with Government possible adjustment options. This has been done through the recently-completed CEM, a background document for the last CG meeting, and through a broad-based policy dialogue in the country. Second, the proposed ERC II, especially its public sector reform component, is designed to underpin the Government's fiscal adjustment effort, and to establish conditions for the revival of private sector-led growth. 28. PoliticaI Consemus. Nicaragua's economic and political situation remains difficult. The stabilization gains are fragile and the lack of growth, combined with a serious poverty and unemployment problem, exacerbate political and social tensions. The continuation of the stabilization and adjustment policies, essential to revive growth, will be difficult unless the Government is able to forge a sustained political consensus to underpin the reform effort. In order to contribute to the process of building such a consensus, IDA has widened its policy dialogue on stabilization and adjustment to include non- government representatives. As well as extensive informal discussions, IDA has also supported a process of constructive economic debate through, for instance, seminars reviewing economic options to deal with declining foreign aid prospects, attended by Government representatives and selected academic and opposition economists. As discussed above (para. 7), there are now indications that consensusbuilding efforts are beginning to yield fruit. Recent political developments have created a propitious moment for a series of imporant actions on the economic front which the Government is anxious to seize. Bilater donors are also looking to IDA and the IMF to provide the overall stabilization and adjustment framework that would enable them to continue supporting Nicaragua and to permit a more gradual reduction in overall bilateral aid flows. 29. Private Sector Development. The private sector, which is the key to sustained growth, especially in the agriculture sector, has been slow to respond to recent reforms due to the high risk of doing business in Nicaragua. One important source of risk is the possibility of future policy reversals created by an unstable political climate and fragile macroeconomic situation. The restoration of stronger macroeconomic control while deepening the structural reform effort, therefore, will be essential to strengthen investor confidence. Other important sources of risk are the ongoing property rights disputes, severe uncertaities created by the absence of adequate property rights guarantees, sudden and unpredictable changes in tax and economic policies, the uneven application of selected incentives, and unclear labor market and sector policies. To reduce these uncertainties and provide a more attractive environment for private investment, clear rules of doing business need to be established and transparently applied, and property disputes need to be settled as quickly as possible.  -9- 30. n addition to the market . ....--*-- .. :.v.** liberalization measures taken during the B a r1E P fU Y1IGIfr .;.Eg first phase of its structural adjustment program, the Government is making wiA ttieaproep r4riwfJiTaciftir efforts to improve the security situation in rih -4u Pvi rural areas and has set up a number of dutg te dinist Adm tf, 40n urban nd- rural rp'ia utlteosh%4. e institutional mechanisms to adjudicate u a n 1 ,rman na.ili tt t property rights disputes (Box 2). shortly. befnre lavsi le, theSadi4eg Improving the private sector environment possession of wse propmies by thfeir 1oc0pats iQ whabin remains a key priority of IDA's assistance `know as tpilt (a-h.of t hi strategy. The theme of the recent CEM : l a This son t Q and CG background- document was the ' *' - revival of private sector activity, and a U7 -- Vm e ofn w recent report on the public utilities and : proble ig of trulyd Go 4 styds m natural resource sectors analyzed and ue iboii 5,400 n B recommended a set of measures to rope.ckf eka. th ; encourage private sector participation and - over iO_ . the adoption of market-based regulatory A 3 e of r mechanisms.' The Agricultural Technology and Land Management Agig io92 the project is supporting a major land titling, a adt i _ registration and cadastre effort, as well as r .f.t .s a program to privatize extension services. . Y * E Under the project, it is expected that -= dw. about 50,000 land titles will be issued