Nicaragua - Second Economic Recovery Credit II

Report No. PIC896 Project Name Nicaragua-Second Economic Recovery Credit-II Region Latin America and the Caribbean Sector Non-Sectoral Project ID NIPA7784 Implementing Agency Ministry of Finance Date Prepared March 11, 1994 Appraisal Date March 28, 1994 Projected Board date June 21, 1994 Country Background 1. Upon assuming office in April 1990, after 11 years of civil war, the Government faced a highly polarized society and a devastated economy, characterized by an extensive and centralized public 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 hyper-inflation and a massive external debt of more than five times GDP. In 1991-92, the Government implemented a strong stabilization and adjustment program supported by the IMF, IDA and a number of donors. 2. The stabilization measures introduced in early 1991 were very successful. Inflation was reduced from hyper-inflationary levels in 1988-90 to single digit rates by end 1992 and the economy recorded positive, although modest, growth for the first time since 1983. The Government also advanced significantly in the implementation of its structural adjustment program, supported by IDA through the First Economic Recovery Credit (ERC I). The main achievements of the adjustment program were: (i) a major downsizing of the public sector, including reductions in military personnel; (ii) liberalization of external and domestic trade; (iii) liberalization of the financial system and creation of a Superintendency of Banks; and (iv) creation of social safety nets, including an employment generation program and an IDA-supported Emergency Social Investment Fund (FISE). 3. The Need for Adjustment. When the second tranche of ERC I was disbursed in June 1992, the economy appeared to have stabilized and on the way to recovery. Instead, GDP growth became negative again in 1993 (-0.7 percent) and foreign reserves declined markedly, leaving the economy in a precarious position. Continued stabilization and adjustment is essential to re-establish macroeconomic control and revive growth, but also to deal with an expected decline in external assistance. The decline in aid is the result of generally tighter external aid budgets and a shift in priorities by bilateral donors. Nicaragua's Adjustment Program 4. The second phase of the Government's structural adjustment program  seeks to address Nicaragua's main challengearesuming growth while maintaining macroeconomic stability in the face of declining external assistance. The Government's immediate priority is to restore and maintain macroeconomic stability. To do this, it will need to downsize the public sector sufficiently to increase public savings, restore a safe level of foreign reserves and permit expansion of private credit to stimulate growth. The main elements of the Government's adjustment program are: (i) development and implementation of a comprehensive public sector reform program, designed to refocus the role of the state, improve its efficiency and contribute to sounder fiscal policies; (ii) deepening of reforms in the financial system; and (iii) improvements in the private sector business environment. The Proposed Credit 5. Objectives. ERC II aims to support the Government's structural adjustment program, with particular emphasis on the longer-term effort to reform the public sector. ERC II is also designed to complement the stabilization program, to be supported by the IMF through a proposed three-year Enhanced Structural Adjustment Facility, and to assist the Government mobilize balance of payments support for its stabilization and adjustment program. ERC II would be accompanied by a parallel Technical Assistance Credit, currently under preparation, designed to assist the Government implement the reforms included in its structural adjustment program and provide continuity in the public sector reform program beyond the ERC II implementation period. 6. Description. ERC II would have four major support objectives: (i) an appropriate macroeconomic framework; (ii) reform of the state; (iii) financial sector reform; and (iv) improvements in the private sector business environment. Macroeconomic Framework. Maintenance of an appropriate macroeconomic framework would be monitored jointly with the IMF as part of the Policy Framework Paper process. Reform of the State. This component would have three parts: (i) implementation of a public sector labor mobility program, including a reduction in the number of employees in the public sector over the period 1994-96; (ii) divestiture of state-owned enterprises, including most of the 72 remaining CORNAP enterprises, shares of the telecommunications company, and enterprises in the Ministry of Construction and Transport and the state-owned petroleum company; and (iii) design and initial implementation of a comprehensive and longer-term public sector reform program, including institutional restructuring, budgetary and expenditure management, tax and customs administration, and decentralization. Financial Sector Reform. In order to improve the efficiency of financial intermediation, the Government will take steps to improve the operational performance of the two largest state banks and strengthen prudential supervision carried out by the Superintendency of Banks. The Private Sector Business Environment. The Government would - 2 -  reduce discretion and increase transparency in the application of economic incentives and policies, implement a phased tariff reduction program, prepare a duty drawback system to replace the current export promotion system by 1996, and prepare a Letter of Labor Policy to guide any future labor market reforms. 7. Financing. The Government's structural adjustment program would be supported by a $60 million equivalent IDA credit and additional bilateral cofinancing of, at least, a similar amount. 8. Environmental Aspects. The Government has completed a National Environmental Action Plan, which was presented to IDA in December 1993 as the Government's official program to address Nicaragua's environmental problems. The proposed measures supported by ERC II are not expected to generate negative environmental effects. The environmental assessment category for ERC II is C. 9. Implementation Arrangements. The Ministry of Finance would be responsible for implementing the reforms supported by ERC II. 10. Consulting Services. Consulting services will be required under the program. Contact Point: Public Information Center The World Bank 1818 H Street, N.W. Washington, D.C. 20433 Telephone: (202)458-5454 Fax No.: (202)522-1500 Note: This is information based on an evolving project. Certain components may not necessarily be included in the final project. -3-