Nepal - Country assistance strategy

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 15508-NEP MEMORANDUM OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A COUNTRY ASSISTANCE STRATEGY OF THE WORLD BANK GROUP FOR NEPAL April 30, 1996 Country Department II South Asia Region 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.  The last Country Assistance Strategy for Nepal was reviewed by the Executive Directors on April 12, 1994 CURRENCY EQUIVALENTS (as of mid-March 1996) Currency Unit Nepali Rupees (NRs.) US$1 = NRs. 57.30 FISCAL YEAR July 16 - July 15 ABBREVIATIONS AND ACRONYMS ADB - Asian Development Bank APP - Agriculture Perspective Plan CAS - Country Assistance Strategy CEM - Country Economic Memorandum CPPR - Country Portfolio Performance Review FIAS - Foreign Investment Advisory Services EDI - Economic Development Institute ESAF - Enhanced Structural Adjustment Facility ESW - Economic and Sector Work FY - Fiscal Year GDP - Gross Domestic Product IDA - International Development Association 1DF - Institutional Development Facility EFC - International Finance Corporation IMF - International Monetary Fund MIGA - Multilateral Investment Guarantee Agency MW - Megawatt NEA - Nepal Electricity Authority NEPAP - Nepal Environmental Policy and Action Plan NGO - Non-Governmental Organization O&M - Operations and Maintenance PFP - Policy Framework Paper RPP - Rastriya Prajatantra Party SAC - Structural Adjustment Credit UML - United Marxist-Leninist (Party) USAID - United States Agency for International Development VAT - Value Added Tax  FOR OFFICIAL USE ONLY NEPAL: COUNTRY ASSISTANCE STRATEGY Table of Contents Page No. A. The Economy ........................................................1 I. Recent Economic and Social Performance ....................................,.,.,,,,,.,.1 B. Nepal's Development Strategy ....................................4 I. A Poverty Alleviation Strategy for Nepal ................................. , , , . 4 II. Priorities for the Next Three Years ................................ , , , . 7 Using Public Resources More Effectively ........................... , , . , . 7 Building Capacity ...........................9 Encouraging Private Sector. NGO, and Beneficiary Participation .............................................. 10 III. Macroeconomic Scenario .12 C. The Bank Group Assistance Strategy .12 Policy Dialogue, Economic and Sector Work, and Technical Assistance .13 Lending Program .14 Portfolio Management ..20 Coordination with Other Institutions .21 D. Agenda for Board Consideration .23 Attachments and Annexes Attachment 1: Nepal Strategy Matrix Annex 1: Selected Indicators of Portfolio Performance and Management Annex 2: Bank Group Fact Sheet, FY93-99 Annex 3: Summary of Economic and Sector Work Annex 4: Social Indicators Annex 5: Key Economic Indicators Annex 6: Key Exposure Indicators Annex 7: Status of Bank Group Operations in Nepal Technical Annexes This document has a restricted distribution and may be used by the recipients only in the performance of their official duties. Its contents may not be otherwise disclosed without World Bank authorization.  I  MEMORANDUM OF THE PRESIDENT OF THE IDA TO THE EXECUTIVE DIRECTORS ON A COUNTRY ASSISTANCE STRATEGY OF THE WORLD BANK GROUP FOR NEPAL A. The Economy I. Recent Economic and Social Performance I. Since the last CAS was presented to the Board in April 1994, Nepal has witnessed a period of serious political instability. The Nepali Congress government, which had been in power since 1991, resigned in June 1994. Subsequent mid-term elections failed to yield a clear winner, and a minority United Marxist-Leninist (UML) government was formed. After ten months in power, this was in turn replaced by a coalition government led by the Nepali Congress. The current government is rather fragile, depending as it does on the support of the minority partner in the coalition, the Rastriya Prajatantra Party (RPP), to remain in power. 2. Political instability has had a negative impact on economic performance over the last two years: good results were achieved in FY94, but several indicators have deteriorated since then.' Severe weaknesses have since reemerged on the fiscal and external fronts, and little progress has been made in civil service reform, financial sector reform, and public enterprise reform, all of which were identified by the last CAS as areas where changes were necessary. 3. Performance was satisfactory in FY94. GDP grew at 5.5 percent and the investment rate was sustained at 20.5 percent (seven percent public, 13.5 percent private). On the fiscal side, the Government implemented revenue and expenditure reforms agreed to with IDA and the IMF in the 1993-95 Policy Framework Paper and discussed in the last CAS. Revenues were raised by expanding the income and sales tax net and increasing the number of taxpayers; expenditures were rationalized by applying some of the results of a Public Expenditure Review supported by IDA -- identification of a core program of priority projects, cancellation of several low-priority activities, reduction in subsidies on fertilizer and electricity, and further privatization of five public enterprises. As a result, the fiscal deficit declined to seven percent of GDP, and domestic borrowing was contained to one percent of GDP. On the external front, the current account deficit declined to six percent of GDP, and the overall balance of payments registered a significant surplus, thanks to foreign aid and other capital inflows (mostly related to unrecorded exports to India). The fiscal year starts in mid-July. Economic and social statistics are reported on a fiscal-year basis only.  - 2 - 4. Progress stalled in FY95. Political uncertainty had a negative impact on both public and private investment. Total investment declined slightly to 20 percent of GDP, with public investment dropping from seven to 5.5 percent of GDP, while private consumption increased. GDP growth declined to 2.8 percent due to poor agricultural performance, which remains largely determined by weather fluctuations. On the fiscal front, the FY95 budget passed in December 1994 contained a significant increase in expenditures, as wages were increased and new domestically-funded expenditure programs were introduced. Over the course of the fiscal year, no adjustments were made in the prices of goods and services provided by public enterprises, and subsidies increased substantially. The PFP target for domestic borrowing of one percent of GDP was met, but this occurred largely at the expense of development activities: projects came to a virtual halt during the first part of the fiscal year. Therefore, actual development expenditures turned out to be substantially lower than initially budgeted, thus compensating for the increase in regular expenditures; public investment was reduced in favor of public consumption. No progress was made in either civil service reform, pnrvatization, or the restructuring of the two inefficient public banks, which continued to accumulate bad loans and suffer high operating losses, posing a potential threat to fiscal stability. Nepal: Fiscal Indicators (percent of GDP) X___________X _______________ FY91 FY94 FY95 Revenues 8.9 9.8 11.1 Expenditures 19.5 16.8 17.5 Regular Expenditures 6.3 6.2 8.8 Development Expenditures 13.2 10.6 8.7 Fiscal Deficit - 10.6 - 7.0 -6.5 Foreign Financing 7.0 5.8 5.4 Grants 1.8 1.2 1.3 Loans 5.2 4.6 4.1 Domestic Financing 3.6 1.2 1.1 5. The external position also weakened. Following a few buoyant years, overall export growth leveled off in FY94 and exports actually declined 12 percent in constant dollar terms in FY95. Weak demand, quality problems, and concerns in the importing countries over employment of child labor in some factories adversely affected Nepal's main export, carpets. Exports of ready-made garments, Nepal's other major export item, which had benefited from preferential treatment under the Multi-Fiber Agreement, suffered as international trade regulations changed. This crisis highlighted the fundamental weakness of Nepali exports, namely their lack of diversification in terms of both products and markets. Reserves came under increasing pressure in the first few months of FY96, as no policy measures were taken to counteract either the trade imbalance or the widening interest rate differentials with India.  - 3 - Nepal: External Indicators (US$ million) _FY91 FY94 FY95 Exports of GNFS a 437 965 1068 Merchandise Exports 228 392 359 Non Factor Services 210 573 709 Imports of GNFS 854 1278 1556 Merchandise Imports 715 1048 1313 Current Account Balance 344 - 275 - 375 Official Grants and Loans 246 234 283 Other Net Capital Flows 225 176 100 Change in Reserves (+ = Surplus) 127 135 8 a Goods and Non-Factor Services. 6. The coalition government which came to power in September 1995 was faced with the difficult tasks of addressing the external imbalance, re-focusing public expenditures, and restarting the liberalization progress. In its most comprehensive pronouncement to date, the FY96 Budget Speech presented in October 1995, the Government expressed its commitment to a stable macroeconomic framework, better targeting of public resources to the sectors with the highest impact on growth, and further liberalization of the economy to encourage private initiative and foreign investment. Following up on the Budget Speech, actions were taken in several areas. Work resumed on a Three-Year Rolling Expenditure Plan reflecting development priorities and an annual 'bore program" of projects to be protected in case of budget shortfalls; legislation was passed to introduce a Value Added Tax; the Foreign Investment Act was amended to remove a provision limiting foreign investment in small companies; the privatization process was restarted, with three companies to be offered for sale in FY96,2 and awareness is growing on the negative impact of inefficiencies in the financial sector on private investment. 7. The dialogue with the IMF and IDA on macroeconomic issues was resumed on the basis of the renewed commitment to reforms, and agreement in principle was reached recently on a Policy Framework Paper (PFP) to be supported by an Enhanced Structural Adjustment Facility (ESAF) with the IMF. The PFP includes reforms on taxation (primarily introduction of the VAT) and expenditures (preparation of the Three-Year Rolling Plan and annual core programs as well as gradual phase-out of subsidies) with a view to further reducing domestic borrowing as a percentage of GDP, tight monetary policy, privatization of 14 enterprises over the next three years, reform of the two state banks with a view to complete divestiture by 1998, and further measures to improve the efficiency of the financial system and strengthen Central Bank supervision. Agreement was also reached in March 1996 on a set of prior actions to be implemented before presentation of the PFP to the Boards of IMF and IDA. These include: completion of a mid-term budget review and implementation of measures to control expenditures if needed; offer for sale of shares of Nepal Bank Limited (one of the two public banks) to reduce government ownership below 50 percent; formation of a committee for the 2 As of end-March 1996, the sale of one of the three companies has been completed.  - 4 - recovery of non-performing loans of the Rastriya Banijya Bank (the other public bank); and increases in the administered prices for fertilizers and petroleum products. 8. However, despite the agreement reached on the Policy Framework Paper, macroeconomic imbalances remain a very serious concern. On the fiscal side, the revenue and foreign financing projections of the FY96 budget are likely to prove overly optimistic, and spending will likely have to be contained to maintain domestic borrowing around the agreed target. On the external side, import growth has slowed, but exports have not picked up, and pressure on reserves is continuing. Several of the prior actions envisaged in the Policy Framework have not yet been taken,3 and political instability continues to distract the Government from the task at hand. An improved macroeconomic framework, careful management of public resources, and the establishment of an environment conducive to private investment are crucial to achieving the faster GDP growth rates which are desperately needed to improve the living conditions of the Nepali people. Poor macroeconomic performance and the unsatisfactory implementation of the development program are harming the efforts to improve Nepal's very low social indicators. Thus, the current situation calls for decisive action to redress the fiscal and external imbalances and to give new momentum to the reform process. Nepal: Social Indicators Nepal India South Asia most recent most recent most recent Population Growth Rate 2.5 2.0 1.9 Per Capita Income 200 300 310 Adult Literacy, Female 13 % 34 % 31 % Life Expectancy, Female 54 61 60 Infant Mortality (per 1000 1. b.) 96 79 85 Total Fertility Rate 5.8 3.7 4.0 Access to Safe Water, Urban 58 % 79 % 74 % Access to Safe Water, Rural 49 % 57 % 67 % Road Densitv (km per th. sq. km) 21 41.3 n.a. Access to Electricity (% househ.) 9 % 54 % n.a. B. Nepal's Development Strategy I. A Povertv Alleviation Strategy for Nepal 9. Broad-Based Growth. The striking beauty of the Nepali landscape stands in stark contrast with the country's widespread poverty. With a per capita income of about US$200, Nepal remains one of the poorest countries in the world. GDP has been growing at an average rate of 4.6 percent over the last decade, but population has grown at 2.7 percent a year and income per capita has increased slowly. Moderate growth of output is 3 In early April, petroleum and fertilizer prices were increased, thus completing two of the prior actions.  - 5 - due to a combination of factors: limited natural resources combined with a landlocked location and difficult topography, poor infrastructure, a weak human capital base with extremely poor levels of education and health, and weak administrative capacity. The poverty alleviation strategy outlined in the last CAS remains appropriate for Nepal. With a low per capita income fairly evenly distributed and almost no surplus to redistribute, there is little scope for targeted poverty-alleviating efforts on any scale large enough to make a difference at the national level; therefore, poverty alleviation will require faster per capita income growth. This, in turn, will require faster output growth and slower population growth. 10. Sustainability. Faster output and income growth will only be sustainable if it follows a development path consistent with the preservation of Nepal's natural resources. In Nepal, the link between growth, poverty, and natural resources is particularly close, as the vast majority of the population earns its livelihood from agriculture and tourism, both of which depend on the sustainable use of natural resources. Nepal cannot afford to 'grow now and clean up later", environmental sustainability has to be integrated in the design of policies and programs at both the macro and the sectoral level. 11. Sources of Growth. Nepal's economy is characterized by a large rural sector based on subsistence agriculture and a small modern sector centered around a few manufacturing activities and tourism. In the short-to-medium run (three to five years), agriculture presents the highest potential for growth and poverty alleviation, as it accounts for almost 50 percent of GDP and 80 percent of employment: any increase in production would have a direct impact on a large segment of Nepal's population and help reduce unemployment and underemployment. The potential of agriculture has not been fully tapped: Green Revolution-type yields have not yet been achieved in Nepal, because the productive Terai plain remains largely unirrigated, and the hills have not yet made the transformation from subsistence rice-growing to higher-valued fruits and vegetables, to which they are potentially better suited. Such transformation would have positive environmental effects, as higher productivity in the Terai would reduce the pressure to cultivate marginal lands, and the fragile hill ecosystem would benefit from a shift to tree-based production. The Agriculture Perspective Plan completed in 1995 concluded that the agricultural growth rate, which has been stagnant in per capita terms, could be raised by about two percentage points, adding about one percent per annum to GDP growth.4 12. Other sources of growth -- hydropower, tourism, specialized exports to the growing Indian market -- have potential, but will take time to develop. Nepal's hydropower potential is vast and could be developed for exports, thus generating revenues to fund development programs and substantial foreign exchange. But development costs are high because of the difficult terrain and the risks posed by the young hydro-geology of the Himalayas; the capacity to develop the large projects which are needed for exports is not yet present; and existing agreements with India will not by themselves be sufficient to overcome the risks that have to be dealt with in order to obtain the substantial funding needed for significant growth in power 4 Agriculture grew by an average 2.7 percent per annum over the FY85 - FY95 period, at about the same rate as population.  - 6 - exports. Thus, it is unlikely that hydropower will make a significant contribution to exports and growth in the near future. 13. Similarly, Nepal's tourism potential is high, thanks to its scenery and rich cultural heritage. But tourism development is hampered by poor infrastructure -- limited airport capacity, poor roads, unreliable power supply, poor water quality and sanitary conditions -- and by growing environmental problems, especially in the Kathmandu valley and in the most heavily visited national parks. Building up the stock of infrastructure to provide quality services to high-end tourists and access to trekkers, as well as cleaning up air, water, and waste in Kathmandu and reversing the environmental degradation in the national parks will take time. 14. Nepal's potential for exports of manufactures and services to India is also significant. Nepal's position at the periphery of India -- an economy 80 times larger -- poses constraints and at the same time offers opportunities. On the one hand, Nepal's international competitiveness is severely hampered by high transportation costs. All imports and exports must travel 500 miles on road and rail and through a border to reach the port of Calcutta, Nepal's main access to international markets, and the country is highly vulnerable to disruptions in traffic along this route.5 On the other hand, the recent liberalization of the Indian economy facilitated a similar process in Nepal, and Nepal's growth prospects are positively influenced by growth in India, as markets open up and trade and tourism flows increase.6 Exploiting these opportunities will require better policies, better infrastructure and a more educated labor force. 15. In summary, in the next few years Nepal needs to focus on agricultural and on laying the infrastructure and human resource base for sustainable growth in the future, while at the same time slowing population growth and protecting its natural resources. The success of this strategy depends on progress in three key areas: (a) using public resources more effectively; (c) building capacity; and (b) encouraging private sector, NGO, and beneficiary participation. The following paragraphs detail the priorities in these areas for the next three years. 5 In addition, Nepal's ability to implement autonomous macroeconomic and sectoral policies is constrained by the free flow of goods and people through its long open border with India. Also, its currency is pegged to the Indian Rupee, which facilitates cross-border trade but subjects the economy to increases in the price of imports (most notably, fertilizer, oil, and foodgrains) whenever the Indian Rupee depreciates. 6 Cooperation between the Nepali and Indian governments is crucial, and the progress made in February towards expanding existing trade arrangements is a welcome step.  I. Priorities for the Next Three Years Using Public Resources More Effectively 16. Prioritization of Public Expenditures. Faster growth in agriculture and faster accumulation of human and physical capital will require carefully prioritizing the use of scarce resources for productive investments and for the maintenance of existing assets. New investments should be designed keeping in mind the difficulties of the Nepali environment -- soil erosion, high sedimentation, flooding risks, deforestation -- to ensure that natural resources are not further depleted in the process of growth. In addition, allocations for O&M should be adequate to maintain the productivity of existing capital, human, and natural resources, so as to reap the full benefits of past investments. 17. Steps have been made in the direction of formulating sectoral strategies in the priority sectors to guide new investments and the provision of recurrent costs. In agriculture, the Government endorsed the Agriculture Perspective Plan, which provides a growth strategy for the sector based on developing sustainable foodgrain production in the Terai and fruit and vegetable production in the hills. Implementing this strategy requires a package of investments appropriate for each area and focused on irrigation, roads, power, and technology, and policy reforms to encourage private investment, provide the right price incentives, and ensure that users have control over natural resources (primarily tenure over land, forests, and water rights). Since the requirements outlined by the Plan are vast and the policy changes significant, the task ahead is to prioritize them and identify investment needs and policy actions for the next couple of years. 18. In road transport, there is broad agreement between the Government and the donors that the priorities are completing the East-West highway, rehabilitating and maintaining the strategic network, and building farm-to-market roads in the Terai. However, the Government currently attaches a higher priority than does IDA to the construction of North-South roads linking remote district headquarters to the strategic network. This issue will be discussed in the context of the Prioritized Investment Plan for the Road Sector under preparation, which will provide the basis for future investments. For all levels of roads, much remains to be done to adopt cost-effective and environmentally sound construction and maintenance standards; community participation should be considered wherever possible. 19. In the power sector, the Government's strategy is two-fold: to seek donor financing for large hydropower projects while encouraging private financing for medium and small projects. At the recent Nepal Aid Group Meeting in Paris, the Asian Development Bank (ADB) and the Government of Japan advised that they are appraising the Kali Gandaki A project (140 MW) and indicated their plans to commit a total of US$320 million to cover the foreign cost component of the project. In addition, the German Government indicated that about US$120 million would be available to finance the development of Middle Marsyangdi (42 MW), possibly in conjunction with private financiers. On the private front, the agreement reached in February 1996 between the Government and a public/private consortium (which includes the ADB, the IFC, and the  - 8 - Norwegian Agency for Development Cooperation) to develop Khimti Khola (60 MW) indicates that, if the Government provides appropriate guarantees, there is interest on the part of the private sector. 20. After withdrawing its support for the Arun III Hydropower Project, IDA is assisting the Government in encouraging private investment. IDA is helping the Government in screening potential sites and ranking them on the basis of technical, economic, social and environmental criteria. The Government plans to present the projects at the top of the ranking to potential private investors, and a Power Development Fund, to be established with an IDA credit, would provide financing. Recognizing that private investment in generation is unlikely to materialize in a significant manner without Government guarantees unless the distribution entities are viable and creditworthy, IDA is assisting the Government in improving the efficiency and financial viability of the Nepal Electricity Authority (NEA). In the future, the option of selling part of NEA's shares to the public, which is foreseen under the Privatization Act, should be explored. The Government is also promoting the development of micro-hydro and bio-gas plants to provide a source of energy alternative to fuelwood in rural areas and reduce the pressure on forests. 21. In education, the Government's first priority is to provide access to primary education to all, including girls, and improve its quality. To this effect, the Government is implementing, with donor support, the Basic and Primary Education Program, a comprehensive effort to construct schools, train teachers, and improve teaching materials. Efforts are also underway to reform the curricula for secondary education, and a plan to transfer grades 10-12 from the university to the secondary education system is under preparation. In health and population, the Government is committed to strengthening the primary health care system, making health care accessible to the rural population, and reducing the total fertility rate. To this effect, the Government is setting up health posts in each of Nepal's 4,000 villages, training female community health workers and birth assistants, and moving from vertical programs to the integrated delivery of family planning, maternal and child health services, and other preventive services. But results on the ground remain unsatisfactory. 22. The Government recognizes the need to prioritize expenditures and direct investment to: (a) the priority investments in agriculture identified as a result of the Agriculture Perspective Plan -- groundwater irrigation, farm-to-market roads, development of quality inputs; (b) investments in the basic transport, water supply, and power systems which promise the highest returns in terms of growth and which cannot be undertaken by the private sector; (c) investments in basic and primary education, family planning, and basic health to build up human capital and improve living standards. In the Eight Plan and the FY96 budget, agriculture, basic infrastructure, and primary education figure as priority sectors. However, little has been done to move forward with the implementation of the Agriculture Perspective Plan; family planning and primary health have received inadequate attention while sizable allocations have been made for tertiary health; and the budget still does not contain sufficient allocations for O&M of existing assets. IDA recommends that the  - 9 - Three-Year Rolling Expenditure Plan under preparation and the FY97 and FY98 budgets and annual core programs: (a) reflect more fully a prioritization of expenditures and investments; and (b) provide adequate allocations for O&M. If necessary, the number of new project starts should be limited so as to ensure adequate funding to implement priority projects and O&M, while remaining within the PFP macroeconomic targets. 23. The Government's policy on environment is contained in the Nepal Environmental Program and Action Plan (NEPAP), completed in 1993. The NEPAP identified five policy objectives: manage natural resources sustainably; address the problems of population growth, poor health, and poverty; safeguard the country's cultural heritage and biodiversity; mitigate adverse environmental impacts of urban, industrial, and infrastructure development; and develop appropriate laws and institutions. Currently, work is underway to prepare an Environmental Protection Bill and sectoral NEPAPs in water resources, industry, and forestry. Environmental Assessment Guidelines have been issued, and training for administration officials and project staff on environmental assessment procedures and methods is underway. The Government recognizes that much remains to be done in virtually all the areas identified by the NEPAP. Building Capacity 24. Civil Service Reform. Efforts at improving the utilization of public resources must be complemented by a build-up of capacity at the central and local government level. The civil service lacks the skills, tools, and frequently also the motivation for efficient administration, and weak capacity continues to hamper good management and project implementation. Little has happened on civil service reform since the last CAS, and there is even less government commitment than at that time to undertake sweeping reforms. Nevertheless, a concerted effort should be made to devise reforms which improve skills, pay, and performance, are politically implementable, and respect the expenditure targets set forth in the PFP. As first steps, the Government intends to establish a computerized central payroll system, update the Census of civil servants completed in 1993, and link salary increases and promotions more closely to performance evaluations, as agreed in the PFP. 25. Economic Management Capacity. Despite efforts made in recent years, the capacity to manage the budget remains rather limited and needs further strengthening, particularly in the areas of project screening, implementation monitoring, and evaluation. The Government has requested support from IDA and other donors, and these initiatives should receive high priority. Regular staff, rather than short-term consultants, ought to acquire the necessary skills, and trained staff ought to remain in place for some time after the training, so as to ensure adequate institutional sustainability. 26. Environmental Management Capacity. One area where capacity is particularly weak is environmental management. A Ministry of Environment and Population has been created under the FY96 budget, but its role and responsibilities have not yet been defined and it remains unclear whether it will replace or complement existing institutions, in  - 10 - particular the Environmental Protection Council. Responsibilities for urban environmental planning, monitoring, and enforcement in the Kathmandu Valley are particularly ill- defined, and the confused institutional setup hampers work to improve environmental conditions in the area. Despite the attention devoted to institutional aspects in the NEPAP, very little progress has been made since its completion. IDA expects the Government to quickly pass the Environmental Protection Bill, define responsibilities clearly, and seek support to strengthen capacity based on assigned responsibilities. 27. Local Capacity Building. The capacity of agencies at the district level and of local governing bodies is especially weak. Rural development through local initiative has been emphasized by successive governments, and transfers to villages for local development projects have been increased. However, decentralization will not be successful unless it is accompanied by a strengthening of the capacity to make and implement technical and financial decisions at the village level. District-level agencies will need to provide technical support and coordination where needed. The Government intends to monitor the implementation of local development programs closely, and evaluate what the capacity-building requirements of local institutions are and how they can be met. Encouraging Private Sector. NGO. and Beneficiary Participation 28. Private Sector Initiative. While efforts at prioritizing public investment and building capacity will help, public resources and the capacity of the pubfic administration remain limited. Private resources and competence, whether from the private sector, NGOs, or beneficiaries, must be mobilized to increase the level and efficiency of investment and service delivery. Commercial private sector provision of infrastructure and services is not a panacea in Nepal: costs are high because of the difficult terrain; income levels are in some cases too low to allow full cost recovery; the number and expertise of local entrepreneurs is limited; and foreign interest is still not very strong. However, competent private sector operators are active in some important areas, such as telecommunications, power, air and land transport, and tourism. Where costs can be recovered, there is scope for further private initiative in both new investment and the operation of existing facilities. 29. The Government recognizes the importance of encouraging private domestic and foreign investment, and has intensified its dialogue on these issues with IDA and IFC. To signal commitment, the Government intends to move decisively to: (a) privatize public enterprises, including the national airline and the telecommunications corporation; (b) restructure the two state-owned banks for eventual privatization; (c) improve the performance of enterprises and utilities remaining in the public domain, beginning with more timely submission of audited accounts; (d) issue licenses for private provision of wireless phone services; and (e) amend the Foreign Exchange Act to facilitate repatriation of earnings. All of these actions were agreed to in the PFP. 30. NGOs. There are many qualified domestic and intemational NGOs active in Nepal, especially in the social sectors and in the environment. NGOs may represent the only way to reach the many areas and communities which government agencies will not be able to serve in  - I1 - the near future. In addition, they often work with disadvantaged beneficiary groups, such as low occupational castes and ethnic minorities, which are generally difficult to reach through public agencies. To date, most government agencies have been ambivalent toward NGOs, giving positive general statements but resisting any significant expansion of NGO-based service delivery. Over the next three years, IDA will continue to encourage the Government to expand service delivery through NGO channels, including Social Fund- type mechanisms to provide social services to underserved areas, and support donor initiatives aimed at strengthening the capacity of local NGOs. In environmental management, the Government will be encouraged to work with qualified NGOs to strengthen management of existing national parks and conservation areas and to seek donor support for the establishment of an Environmental Trust Fund. 31. Beneficiary Participation. Even where full cost recovery is not possible, there is scope for beneficiary participation in investment and maintenance costs, as well as project design, implementation, and monitoring. Cost-sharing by beneficiaries strengthens 'bwnership" of assets, and reduces the need for public coverage of investment and O&M costs, thus stretching what can be achieved with a given government budget. Part of the failure to achieve tangible results, especially in rural areas, is due to the centralized, top-down approach which the Government and the donors have followed for years in implementing programs and projects. There is a long tradition of self-reliance in Nepal, partly a result of the remoteness of many areas, and experience suggests that communities do not hesitate to get involved. For instance, school reconstruction under the Earthquake Schools Rehabilitation Project was facilitated greatly and costs were reduced thanks to villagers who helped transport materials and construct classrooms. Similarly, communities have welcomed receiving formal rights and the responsibility to manage forests they had traditionally been using. 32. In the last few years, the Government has taken some significant steps towards greater beneficiary involvement. Progress has been made on water and land rights through the issuance of policies and guidelines which enable user groups to take full control of small/medium irrigation schemes, rural drinking water supply schemes, and communal forests. All these initiatives are in the right direction, but they are only first steps: the guidelines need to be fully implemented, and local capacity has to be strengthened. IDA recommends that, over the next few years, the Government: (a) continue to transfer responsibility for O&M of irrigation schemes to Water User Associations; (b) continue to transfer forest rights to Forest User groups; (c) address the issue of land tenure; and (d) implement legislation devolving part of tourist fees to communities living in or near protected areas, and support NGO initiatives to involve local communities in the protection and restoration of natural resources, building on the experience of successful 7 programs. 7 The programs in the Annapurna Conservation Area, Sagarmatha National Park and the Makalu- Barun Conservation Area, and under the Parks and People Project provide good examples of community involvement in the management of natural resources.  - 12 - III. Macroeconomic Scenario 33. The base-case scenario for the macroeconomic projections used in the CAS assumes that the Government will implement the policy reforms and adhere to the macroeconomic targets for revenues, expenditures, domestic borrowing, money growth, and reserves agreed to in the PFP. Recognizing that it will take time before more efficient investment raises the rate of growth of GDP, the growth assumptions used in the scenario are conservative: agriculture is assumed to grow at about three percent a year on average, and industry and services at about 5.4 percent, yielding overall GDP growth of about 4.5 percent a year over the next three years. Revenues are projected to grow from 12.1 to 13.2 percent of GDP over FY97-99, recurrent expenditures to remain stable at about 10.6 percent of GDP, and development expenditures to grow from 8.5 to 10 percent of GDP, mainly reflecting the increase in investment related to the Kali Gandaki power project. Assuming foreign financing for the budget of the order of 6.5 percent of GDP over the period, domestic borrowing would be contained to the sustainable level of half a percent of GDP. 34. Slippage from this scenario in terms of lower revenues and/or higher regular expenditures would affect development expenditures directly, as lack of counterpart funds would slow or halt project implementation, and with it aid utilization. Slippage in terms of higher domestic borrowing or faster money growth would lead to higher interest rates and a crowding-out of private investment. Such developments would have a negative impact on GDP growth, which could slow to 3.5-4 percent. Conversely, particularly good revenue performance might allow for an expansion of public investment, if regular expenditures are contained, and sound credit management policies could lead to higher private investment, thus accelerating growth to around five percent. 35. Under the base-case scenario, Nepal's development needs and economic growth require imports at a level which is likely to continue to grow faster than that of exports. In the longer run, foreign private capital may help bridge the gap (even though payments for dividends and debt service would also increase), but in the short and medium term substantial levels of concessional aid will be required. Concessional aid of the order of eight to nine percent of GDP during the FY97-FY99 period, or disbursements of roughly US$400 million per year on average will be required to implement the agreed policy framework. Such a level of aid -- about US$17 per capita on a disbursement basis -- is high and most likely unsustainable. In the short to medium term, such aid flows can be achieved only if they are supported by: (a) adherence to a high-quality policy framework and budget management; (b) accelerated preparation of high-quality projects; (c) decisive efforts at building implementation capacity; (d) effective aid coordination; and (e) mobilization of private sector support wherever suitable and available. C. The Bank Group Assistance Strategy 36. In designing an appropriate strategy to assist Nepal, IDA reviewed progress since the last CAS and took into account two major lessons of past experience. First, even well-designed projects have little impact if macroeconomic and sectoral policies create the  - 13 - wrong incentives; therefore, operations must be accompanied by appropriate policy reforms. Second, it takes a long time to overcome capacity constraints; therefore, such constraints have to be taken as given in the medium term, and operations must be designed so as to be effective given existing capacity. Therefore, this CAS proposes that: a) highest priority be given to the establishment and maintenance of an acceptable macroeconomic, sectoral, and environmental policy framework; b) IDA's lending operations be selectively concentrated in a small number of priority sectors where the policy framework is (or can be expected to become) satisfactory; c) IDA's operations be simple in design, include strong capacity building components, and involve as much as possible the private sector, NGOs, and beneficiary/user groups for service delivery and maintenance; In support of this strategy, IDA's policy dialogue would be aimed at assisting the Government in its efforts to follow sound macroeconomic and sectoral policies, improve public resource management, and encourage private initiative. IDA's economic and sector work would be used to help forge a consensus around programs and policies in the priority sectors, providing the right context for IDA lending and other external assistance. Technical assistance would be aimed at strengthening capacity of public agencies and of other institutions able to deliver services. In all of its activities, IDA will put special emphasis on environmental sustainability and improved management of Nepal's fragile natural resources. 'olicy Dialogue. Economic and Sector Work, and Technical Assistance 37. Policy Dialogue and Economic Work. IDA's macroeconomic policy dialogue -- supported by IDA's economic work (the 1994 Country Economic Memorandum, the 1996 CEM Update, and the recently completed Policy Framework Paper) has focused on the themes of macroeconomic stability, public resource management, financial sector and public enterprise reform, and capacity building. These themes will remain central, as much work remains to be done. Issues of poverty, environmental sustainability, access to various forms of capital, and beneficiary participation will be brought to the forefront through a Poverty Assessment (FY97) based on the data collected by the Nepal Living Standards Survey now underway,8 a study on Financial Sector and Rural Banking (FY98), and an analysis of the nexus between decentralization, rural development, and poverty alleviation (Country Economic Memorandum, FY98). 38. Sector Work. In order to guide our sectoral dialogue and provide the policy context for lending operations, IDA's future sector studies will maintain the methodological approach followed in recent studies on infrastructure and education: they 8 The last Poverty Assessment (Nepal: Poverty and Incomes, completed in 1991) was based on 1984/85 data.  - 14 - will contain sectoral expenditure reviews and outline sector programs and policy actions.9 Thematically, the studies will focus on issues related to sustainable development. The Agriculture Strategy Paper (FY97) will help define IDA's role in support of the policy reforms and prioritized investment plan now under preparation based on the 1995 Agricultural Perspective Plan. 39. Two studies will assist the Government in formulating a comprehensive natural resources management strategy, which will provide the policy and incentive framework for environmentally sustainable investment operations. The analysis in the Water Resources Strategy (FY97) will address the complex issues of water allocation among competing uses (hydropower, agriculture, industry, urban and rural areas), pricing policies, cost- sharing of investment and O&M, environmental impacts, and institutional reform. The Land Resources Management Study (FY98) will look at the nexus between agricultural practices, use of forests, watershed management, and biodiversity conservation. IDA will work with the newly-created Ministry for the Environment, the Environmental Protection Council, and various Ministries, such as Water Resources and Forestry and Soil Conservation in preparing, discussing, and disseminating these studies. 40. Sector work on Operational Issues in Health (FY97) will take a comprehensive look at health expenditures, quality and efficiency in the delivery of services, pricing policies, and the respective roles of the public and private sectors. The launch workshop for this study has brought together experts from the Govemment, the private sector, the donor community and NGOs. This model will also be followed at the finalization and dissemination stages. 41. Technical Assistance. IDF grants will be used to support capacity building in the management of public resources. An IDF grant of about US$200,000 has recently been approved to strengthen expenditure planning and monitoring through a twinning arrangement between the Economic Planning Unit in the Government of Malaysia and the National Planning Commission and Ministry of Finance in Nepal. An additional IDF grant to improve auditing capabilities is being considered. Technical assistance is also being provided to support the establishment of a regulatory agency and legal framework for licensing of private service providers in telecommunications. Lending Program 42. Selectivity. This CAS proposes a lending program of about two-three IDA operations a year, concentrated on agriculture (irrigation, research and extension), natural resource management (forestry and biodiversity), basic infrastructure (transport, power, 9 The study on Selected Issues in Infrastructure Development (Report No. 11800, February 1994) discussed the spatial allocation of resources and recommended directing infrastructure investments to areas with high growth potential. The study on Critical Issues in Secondary Education (Report No. 12243, August 1994) recommended reallocating expenditures from providing free secondary education to improving the quality of and access to public schools while providing incentives for increased private provision of secondary education.  - 15 - rural water supply and sanitation), social services (basic and primary education, family planning and basic health). These priority sectors for IDA involvement were selected on the basis of their importance for poverty alleviation, growth, and natural resource management. Other considerations were the Government's willingness to undertake sectoral policy reforms, and IDA's comparative advantage relative to other donors. This selection implies that in some important sectors, such as urban infrastructure, telecommunications, tourism, and urban environment, IDA would not seek to develop new lending operations. In some of these areas, other donors are supporting the Government's objectives; in others, the private sector has shown willingness to take the initiative. The selective focus of the proposed strategy will not be easy to uphold, as there are strong pressures, internally and externally, to be involved more broadly. However, this selective focus has the potential to achieve more lasting results, as resources, both human and financial, both at IDA and in the Government, will be focused more effectively on the most important capacity-building interventions. 43. The proposed operations will cover the following sectors: * Agriculture. Building on the Agriculture Perspective Plan endorsed by the Government, IDA will support irrigation, research and extension. In the context of the Water Resources Strategy under preparation (FY97), the Irrigation Sector Project (FY98) will provide support for private, farmer- managed surface and groundwater schemes and the transfer of systems to farmer organizations for operations and maintenance. Learning from the experience of past projects, investments in irrigation will pay attention to design, implementation, and sustainability issues (with particular emphasis on water rights and water charges), promote cost-sharing in O&M and investment, and emphasize beneficiary participation to the maximum extent possible. To reap the full benefits of expanded irrigation, IDA will support the complementary provision of a package of integrated services, including research and extension, fertilizer, and farm-to-market roads in the areas of highest potential. The Agricultural Technology and Dissemination Project (FY97) will assist with the development and dissemination of appropriate techniques and varieties of crops by supporting the strengthening of public research and extension capacity as well as the expansion of private extension and veterinary services. The project will explore mechanisms to improve the link between extension agents and farmers groups. * Natural Resource Management. Drawing on the lessons learned from previous IDA activities, the experience of other donors, the 1992 report on Natural Resource Management,'