Madagascar - Country Assistance Strategy

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 16249-NAG MEMORANDUM AND RECOMMENDATION OF THE INTERiNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A COUNTRY ASSISTANCE STRATEGY OF THE WORLD BANK GROUP FOR THE REPUBLIC OF MADAGASCAR January 17, 1997 Country Department 8 Africa 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.  MADAGASCAR COUNTRY ASSISTANCE STRATEGY CURRENCY EQUIVALENTS Currency Unit Malagasy Franc (FMG) US$ 1.00 FMG 4,352 (1/10/97) SDR I US$ 1.4292 (1/13/97) WEIGHTS AND MEASURES Metric system MALAGASY FISCAL YEAR January I - December 31 LIST OF ACRONYMS AGETIP(A) Agence d'Execution des Travaux d'lnteret Public (dA'ntananarivo) / Agency for the Execution of Public Works (in Antananarivo) CBI Cross Border Initiative for Eastern and Southern Africa COMESA Common Market for Eastern and Southern Africa CPPR Country Portfolio Performance Review CRC Committee for Reflection on Competitiveness EPI, EP2 Environment Program Phase 1, Phase 11 EPZ Export Processing Zone ESAF Enhanced Structural Adjustment Facility EU European Union FAC French Assistance Cooperation FID Fonds d'Intervention pour le Dc;veloppement (Social Fund) FDI Foreign Direct Investment GEF Global Environmental Fund IOC Indian Ocean Commission LPG Liquefied Petroleum Gas NEAP National Environmental Action Program PAIGEP Projet d'Assistance Institutionnel pour la Gestion Publique / Public Management Capacity Building project PE Public Enterprise PER Public Expenditure Review SAC Structural Adjustment Credit SECALINE Food Security and Nutrition project TSD Transport Sector Development project UNDP United Nations Development Program UNICEF United Nations Children's Education Fund USAID United States Agency for International Development Vice President: Mr. Callisto Madavo Country Director: Mr. Michael Sarris Staff Member: Ms. Manorama Gotur  FOR OFFICIAL USE ONLY MADAGASCAR COUNTRY ASSISTANCE STRATEGY TABLE OF CONTENTS Introduction and Summary 1 A. Recent Economic and Social Performance 3 B. The External Environment 4 C. Government Development Objectives and Policies 6 D. The Bank Group's Country Assistance Strategy 10 Partnership with Madagascar 10 CAS Objectives 10 Current Portfolio 11 Assistance in FY97-99 14 Alternative Economic and Lending Scenarios 18 Partnership and Aid Coordination 19 Risks 20 E. Agenda for Board Consideration 21 Boxes Box 1 Social Indicators in Madagascar 3 Box 2 Summary Poverty Profile 4 Box 3 Scorecard on Economic and Financial Reforms 5 Box 4 Dialogue and Participation 10 Box 5 CAS Plan for Agriculture and Rural Development 12 Box 6 Results on the Ground: Portfolio Highlights 13 Box 7 EP2's Mini-Projects: Close-up 16 Box 8 Summary of CAS Plan for Poverty Reduction 17 Attachments Appendix A CAS Matrix Appendix B Madagascar: Comparison of Macroeconomic Scenarios Appendix C Summary of Lending Program under Alternative Scenarios Appendix D Debt Sustainability Analysis Annexes 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.   MEMORANDUM OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A COUNTRY ASSISTANCE STRATEGY OF THE WORLD BANK GROUP FOR MADAGASCAR Introduction and Summary 1. Once in the same league as Indonesia and Thailand, Madagascar is today a country where 70% of the population lives in povertv. Ill- advised economic policies have been largely to blame. Economic performance has been Ral especially hurt by extensive controls, xenophobia and unproductive public investments. Govern- rrtrsa ment attempts at reform since the mid-1980s -- ---_ - 740 supported by the Bank -- had achieved good 0 results but lost their momentum in 1991, when a Ealy1M Tcx4y transition to pluralistic democracy got under way. The ensuing period was marked by partial reform and hesitant economic management by a leadership unsteady in its partnership with the Bank and IMF. In April 1996, the Progress Report of the Country Assistance Strategy (CAS) pointed to political factionalism and ambiguous commitment to economic reform, and to uncertainty as to when, and in which direction, the country would move next. The period since then, however, has seen substantial improvement in commitment amongst policymakers and an emerging nationwide consensus on the need for reform. While it remains to be seen whether the winner of the ongoing presidential elections will muster a coalition to sustain the reform momentum, the present CAS argues that these developments warrant a more active engagement on the Bank's part to help build on this progress. 2. The government aims to reduce poverty to roughly a third of the population within a generation. This will not be possible without high rates of economic growth underpinned by quantum leaps in investment levels; the country's rich potential provides a solid basis for such results, but only in the medium term, and only with sustained government commitment to overcoming formidable constraints impeding development. The timing and magnitude of poverty reduction will depend on the speed with which the government opens the economy, the timing of investor response, and progress in raising agricultural productivity and ensuring that growth is pro-poor. The most immediate challenge is to turn around investor confidence, seriously undermined by a long history of negative policy performance. Progress on that front would make a start in unleashing investment potential that appears already quite impressive. Concrete evidence exists that investors based in Japan, Thailand, Korea, Indonesia, Malaysia, Mauritius, Reunion, South Africa and France are drawn to the country's potential in export manufacturing, tourism, mining and agriculture; investor interest is also confirmed by strong growth in Madagascar's Export Processing Zone, created in 1990. 3. The Bank has helped develop, and aims to support, the government's objective of high growth and meaningful poverty reduction within a generation. The implied increase in foreign direct investment will require a first-rate policy environment superior to any Madagascar has ever known and better than that seen in most developing countries. The CAS supports this approach through structural adjustment that emphasizes concrete evidence of economic opening  2 rather than declarations of intent or passage of laws. Successful implementation of this strategy would eventually transform the country and lead to rapid economic growth, but would not yield early benefits to poverty reduction. The challenge for the Bank and the donor community is thus to help Madagascar rapidly put in place and sustain the policies to gain investor confidence and at the same time to remain engaged during the difficult transition to high growth, to ensure effective interventions aimed at direct poverty alleviation. 4. To ensure that the poor will indeed be better off, the CAS proposes activities that would improve rural transport, education and health, including nutrition and access to clean water. Efforts to raise agricultural productivity, mobilize foreign investment in agriculture, better manage natural resources at village levels, and find labor-intensive solutions for rural development constraints would also help raise rural incomes. The limited scope for increasing or reallocating public expenditures in the near term makes these efforts particularly important. A key focus of the CAS will be to assist in the empowerment of local communities to tackle their development challenges. An important role is also assigned to monitoring interim outcomes (e.g., enrollment rates, supply of medicines, number of jobs created) that would indicate progress towards poverty reduction, until the high performance targets come within reach. 5. Bank assistance will support: (i) broad-based growth, based on sound policies and led by foreign investment; (ii) human capital development, focused on primary education, basic health care and rural infrastructure; (iii) strengthening of the public sector's ability to deliver quality services and create a business-friendly climate; and (iv) natural resource management to reduce environmental degradation and develop eco-tourism potential. Improved use of funds in the existing portfolio will be an important instrument of the CAS. Total new lending over FY97-99 could range from US$135-450 million. Base case lending (US$330 million) is predicated on the achievement of IMF macroeconomic targets and implementation of up-front measures required under the proposed single-tranche SAC. Such lending would include support for: structural adjustment; capacity building; environmental needs; and investments in the social and infrastructure sectors. The Bank would shift to a core lending program in the event of lax macroeconomic policies and failure to deliver on agreed SAC measures. Core lending would be limited to capacity building, rural-focused social sector interventions and poverty alleviation activities; some projects would be scaled down to reflect likely weaker policies and implementation capacity. On the other hand, vigorous efforts to attract investors would trigger high case lending, signaling additional support for structural adjustment, financial intermediation and rural development. 6. The Bank's strategy is subject to significant risk. While the poor have much to gain from the economic reform program, rent-seeking bureaucrats and entrepreneurs spoiled by protection stand to lose, and could slow or reverse reform momentum. Present circumstances suggest, however, that the strategy has a reasonable chance to succeed. Pro-reform forces have put through significant measures under the SAC, with no evidence of backtracking; public opinion is demanding change; and the presidential candidates are supporting reform. The adjustment scenario is thus seen to be the most likely. At the same time, donor support and debt relief are key to the country's ability to implement reforms; the Bank will thus continue to emphasize donor coordination and financing, as an extension of shared objectives within the international community. The payoff for success is high: revival of investor confidence and economic activity could indeed achieve dramatic progress in poverty reduction. The risks of the CAS are thus seen to be worth assuming. Should the reform agenda be abandoned, the Bank would withhold future adjustment lending and major sector investment operations, limiting its lending -- and exposure.  3 A. Recent Economic and Social Performance 7. The majority of Madagascar's 13.5 million people live in a state of significant deprivation (see Boxes 1 and 2): this is the key finding of the Poverty Assessment (June 1996) and guides this CAS. The country is one among few experiencing declines in education, nutrition and life expectancy, with health and education indicators at or below highly unsatisfactory averages for sub-Saharan Africa (SSA). Disease bred by poor sanitation, low nutritional standards and lack of access to safe water is the leading cause of illness and death. Few seek health care: public facilities are ill-equipped, and private health care too costly. Schools are poorly managed and stocked, with under-paid, ill-trained teachers. Public spending on health and education has been falling in real terrns and does not benefit the poorest layers of the population. Also eroding living standards are problems of security in rural areas and isolation, combined with the lack of physical access to social services, financial services and agricultural markets. Finally, slash-and-burn agriculture continues to cause extensive deforestation and loss of topsoil, threatening biological diversity and the agrarian economy. BOX 1. SOCIAL INDICATORS IN MADAGASCAR Poverty incidence 70% Infant mortality rate 93/1000 Urban 47% Maternal mortality rate 600/100,000 Rural 77% % rural population without access to Primary enrollment ratio 83% potable water 68% Poorest 20% 48% % population without access to latrines 65% % of household heads % population without access to electricity 91% with secondary schooling 4% Household size 4.9 Severe stunting % households in one-room dwellings 53% (% of children 3-60 months) 30% Life expectancy at birth 50 Population growth rate 3% 8. Poverty became entrenched in Madagascar's social fabric over two decades through 1994. Inward-looking policies emphasized state control of the economy; resulting unproductive public investments quadrupled external debt and slowed real GDP growth through the early 1980s. Rural poverty also increased due to policies that favored urban consumers and shrinking public revenues that seriously hampered provision of public services. In the late 1980s, the government adjusted the exchange rate to realistic levels and set up an Export Processing Zone. In response, foreign investment rose sharply, as did non-traditional and manufacturing exports; per capita GDP growth turned positive, and inflation fell sharply. Progress was interrupted in 1991, however; with the transition to democracy, political factionalism and policy differences on economic reform blocked economic recovery. In 1990-93, GDP fell 4% a year on average, inflation peaked at 61% (end- 1994) due to lax monetary management and large subsidies that increased the overall budget deficit (excluding grants) to 11% of GDP; and foreign investment collapsed, from US$22 million to US$6 million (1994). 9. Economic management has haltingly improved since 1995. Stabilization measures contributed to growth in real GDP of 2%, a drop in the budget deficit to 9% of GDP, and lower inflation at end-1995, of 37%. In parallel, the government developed a package of structural reforms, in collaboration with the private sector. Early adjustment measures (exchange rate devaluation, increases in food and export crop prices, elimination of food subsidies, lower import tariffs) considerably changed the terms of trade in favor of the rural sector. Liberalization has also helped expand non-traditional agricultural exports (shrimp, litchis, sisal), offsetting somewhat the decline in traditional exports (see para. 11). Although sustained growth has remained elusive, progress on adjustment has been gaining momentum, and other elements of an  4 improved business climate have begun falling into place. Areas of progress have included: macroeconomic stability; financial sector reforms; and actions to encourage competition and open the country to foreign investment and tourism (Box 3, para. 19). BOX 2. SUMMARY POVERTY PROFILE Seven out of 10 Malagasy are poor (cannot purchase a minimum 21 00-calorie food basket and essential non-food items; six out of 10 are extremely poor (cannot purchase even the food basket). Over 85%/o of the poor live in rural areas, where poverty is also deeper; the remaining poor are urban, accounting for nearly half that population. Regionally, poverty incidence is highest in Toliara (80%). Farmers are the poorest: 80% of poor households are headed by farmers, herders and fishermen. In contrast, wage-earners fare best (only 14% of poor households). Poor households (compared to non-poor) have around 5 members (4) and are more likely to: be illiterate (60% vs 40%); not send children to school (56% vs 44%); have malnourished children; use wood as main source of fuel (85% vs 66%); and rely on lakes/ponds/rivers for drinking water (58% vs 41%). About 18% of poor households are headed by women, engaged mostly in farming (para. 50) Additional schooling, salaried employment, participation in the informal sector, and more land per cta available to the household were negatively correlated with poverty. 10. Notwithstanding the positive scorecard: per capita consumption continues to fall; low- productivity agriculture dominates the economy (about a third of GDP); the public sector accounts for two-thirds of investment and a quarter of GDP; private investment remains under 4% of GDP; debt is unsustainable and will stay at stressed levels even after assumed debt relief; and weak fiscal revenues (8% of GDP) continue inadequate to support provision of basic public services. Madagascar thus remains steeped in poverty, a country with clear potential but unable, yet, to draw investors and generate the growth needed to reverse the decline in living standards. B. The External Environment 11. Overall context. External financing is critical to Madagascar's economic prospects. Falling prices of traditional exports (coffee, vanilla and cloves) have cut total export receipts by 40% over the last decade and heightened dependence on foreign financing. Export coverage of imports has fallen to 70% in recent years from three-quarters ten years ago. Prospects for reversing this trend will be limited, as imports grow to support a recovery in per capita consumption while investment more than doubles to achieve and sustain high growth rates. To realize growth rates close to its potential within a decade, Madagascar would require net financing reaching about US$400 million per year, comprising debt relief and significantly higher levels of donor support and annual foreign direct investment. Assumed gross aid inflows over 1997-2000 are consistent with those of the last adjustment phase but well above current levels. If donor financing falls short, exceptional debt relief -- beyond Naples -- may be required, to avoid an increase in poverty, particularly in the early years of recovery. 12. Debt. Madagascar has a heavy debt burden of US$4.4 billion and will require considerable debt relief to meet its macroeconomic program targets. Of the total, US$2.1 billion is in arrears. In 1996, the net present value of debt is 450% of exports and 990% of government revenue. At 45% of exports in 1996, debt service has been declining, reflecting reduced capacity to borrow in recent years due to external arrears accumulation. These arrears are expected to be paid off in 1997 (US$2.1 billion of expected debt relief through Paris Club rescheduling on Naples terms and rescheduling of other debt on similar terms). The assumed rescheduling would  5 BOX 3. SCORE CARD ON ECONOMIC AND FINANCIAL REFORMS Actions taken Key elements of Remaining (Near to Medium-Term) Agenda Exchange 'Floating of Franc Malgache *Maintain flexible exchange rate rate and *Liberalized access to foreign exchange *Improve competition through exchange bureaus Trade *Lowered top tariff from 80% to 30% *Further reduce tariffs (under CBI) *Removed export, import licensing *Eliminate controls on current account *Agreed to abolish remaining export taxes (vanilla) in 1997 *Relax and gradually open capital account *Cut taxes on inputs for export production Interest rates *Liberalized lending and deposit rates *Maintain positive real interest rates and *Linked Central Bank reference rate to an indicator of *Develop inter-bank market in support of market- Monetary anticipated inflation determination of cost of money Policy *Introduced indirect instruments for monetary control; Lifted eComplete transition to indirect monetary control bank-by-bank credit ceilings, introduced reserve requirements instruments *Develop and improve T-bill market Financial *Appointed administrators at both state commercial banks; *Complete divestiture of state banks institutions selected (experienced) sales agents for pfivatization of the two *Strengthen regulatory framework 'Passed new banking law *Establish effective intermediation for small 'Strengthened supervision entrepreneurs *Enhance financial deepening (leasing, insurance) Public *Improved public expenditure management. reoriented funds *Strengthen tax and customs administration finance from defense to social sectors; strengthened PIP monitoring 'Broaden tax base *Raised energy prices significantly *Increase expenditures for basic health, primary :Ended petroleum, flour, retail rice subsidies education, basic infrastructure and public security *Passed law on public enterprise divestiture *Divest State from most public enterprises, beginning with strategically important ones *Define distribution of authority/resources between central govt. and local governments Private *Passed privatization law; revised laws I regulations on land *Actively promote competition in air transport, Sector ownership, property rights, commercial activities telecoms, tourism, petroleum distribution Develop- *Removed ex-ante investment approvals and fiscal incentives WMaintain simple tourist, investor regulations ment from Investment Code, and integrated incentives into tax code *Complete agreed divestiture from vanilla parastatal; 'Eliminated state monopoly anu liberalized legal/regulatory eliminate other monopolies (incl. sugar, cotton, framework in petroleum, electricity sectors ports, water supply, insurance) *Amended law to allow new entrants into telecoms 'Reform judicial system; establish legal / 'Abolished exit visas, relaxing visa/work/residence institutional framework favoring competition regulations for foreign investors and tourists 'Privatize public enterprises per agreed schedule *Liberalized air access policy and abolished monopoly of 4ir Madagascar on air traffic rights reduce debt service in 1997; thereafter, scheduled debt service (after Naples terms rescheduling and before adding debt service on future borrowing) would rise by about 4% a year through 2010. The debt service ratio will be under 20% in 1997-2000 and would remain below that level, provided exports grow by at least 4%. However, the present value of debt would remain above 200% of exports until 2002 (see Appendix D). Moreover, debt service would amount to 81 % of tax revenue in 1997, declining to 20% only after 2006. Thus, Madagascar is likely to continue to experience difficulties in meeting debt service payments for a number of years to come. 13. Private investment and regional integration. Madagascar needs to attract about US$300 million in annual foreign investment. Sufficient investor interest exists within the region, East Asia and Europe, to achieve and maintain such inflows at a level close to 2% of GDP. However, given Madagascar's past ambivalence over foreign involvement, investors will require consistent evidence of economic opening. Madagascar could gain further credibility by linking such opening to commitments under regional agreements. Under the Cross Border Initiative for Eastern and Southern Africa (CBI), Madagascar should facilitate movement of labor and capital, reduce external tariffs to an average of 15% by 1998 (from 18% in 1996) and achieve  6 free trade by 1998 with its partners in the Common Market for Eastern and Southern Africa (COMESA) and the Indian Ocean Commission (IOC). Implementing agreed policies could spur investment -- including in agriculture -- from Mauritius, South Africa, Zimbabwe and Kenya, and help Madagascar share tourists with these markets. Foreign investment must be channeled to diversify the economy and lower dependence on traditional exports with dim price prospects. 14. Export and import performance. The trade balance is expected to worsen from US$213 million in 1996 to over US$400 million in 2006. Export performance is projected to improve by over 25% to US$620 million over 1996-2000, led by growth in non-traditional exports. Over the medium term -- and assuming a competitive exchange rate is maintained and the measures to achieve the government's ambitious growth targets are in place -- non-traditional exports are forecast to grow at near double digit rates, doubling exports over the next decade. Growth in tourism (assuming a tenfold increase to 700,000 tourists over ten years) is also expected to boost services, estimated to rise from under US$250 million in 1996 to over US$600 million. Imports of goods have risen steadily from US$518 million in 1991 to US$720 million in 1996, and are projected to grow at 6-7% over the next decade. C. Government Development Objectives and Policies 15. The government's central objective is to steadily reduce the incidence of poverty from 72% in 1996 to 35% in 2015. These targets can only be realized by gradually achieving very ambitious economic growth rates of 9.5% from 2005 onwards, while reversing environmental degradation and improving the assets of the poor. Such high growth will require opening up to foreign investment and tourism and convincing investors that opening will be sustained. Pro- poor growth will call for: improved environmental and sector policies promoting rural development; more efficient public investment, and restructuring of public expenditure; and encouragement of local initiative and private investment. Government efforts will thus focus on (a) macroeconomic stability; (b) incentives for private investment; (c) refocusing the public sector on its core functions; and (d) managing Madagascar's natural resources. Macroeconomic Management 16. Given the importance of macroeconomic stability for attracting private investment, the government seeks to lower the rate of inflation from 37% at end-1995 to 4% by end-1999 and reduce the balance of payments current account deficit (including official transfers) from 7.2% of GDP in 1995 to 2.9% in 1999. An improved current account will need support from higher public savings through a reduction in the budget deficit, from 6.1% of GDP in 1995 to 2.1% in 1999. The deficit objectives will be underpinned by expenditure restraint and a gradual increase, in line with a recovery of per capita income, in the tax to GDP ratio from 8% in 1995 to 11% in 1999. As current expenditure levels will remain depressed (6% of GDP excluding interest on public debt), restructuring will be essential to improve basic public services for the poor. The wage bill (3% of GDP) will increasingly be geared to support civil service reform aimed at improving efficiency, supporting decentralization and relating pay to performance. 17. The government plans to support fiscal discipline through an active monetary policy. The Central Bank will continue to link its lending reference rate to an indicator of anticipated inflation, in line with its targeted reduction of inflation. The government intends to continue to float the Malagasy franc and will improve competition in foreign exchange markets by encouraging the opening of exchange bureaus. Sound policies are expected to support requests  7 for debt relief at the Paris Club and from other creditors; an active debt management strategy will aim to ensure that future debt service obligations rise at a slower pace than export growth. Incentives for investment 18. The government seeks to reestablish credibility, increase the efficiency of existing firms, and steer private investment towards exports and labor-intensive activities. It has therefore embarked on financial system reform and revised the investment code to equalize incentives across sectors and reduce subsidies to capital. It has also set up institutions to promote contacts between domestic entrepreneurs and foreign investors. By the end of the next decade, manufacturing and services are each expected to almost double and agriculture to increase by half. As these sectors expand, employment- and income-generating opportunities will help raise living standards and roll back poverty. The experience of 1986-1991 suggests that new jobs in the formal sector would total 60,000 by 2000, rising to 1 million by 2015. 19. A joint private/public sector group (the Committee for Reflection on Competitiveness, CRC) was created in 1995 to develop recommendations for mobilizing private investment. Reforms already implemented address the regulatory and tax constraints impeding entry, particularly by small and medium-sized local enterprises and foreign investors. Measures include: facilitating the movement of tourists and businessmen; freeing up land tenure to foreign investors; enacting tax reforms to promote exports; effectively lifting legal monopolies; abolishing required pre-investment approvals while integrating fiscal incentives into the general tax code; abolishing the 20% limit on foreign ownership of a firm's authorized capital; facilitating company registration; and simplifying leases in the fishery and forestry sectors. 20. Efforts over 1997-1999 will aim to increase competition by attracting new entrants to the financial, transport, water and energy, telecommunications and agriculture sectors. A legal framework has been established to combat anti-competitive practices. The government is also launching a program to divest public enterprises (PEs), supported by a privatization law adopted in August 1996, which would promote foreign investment, transparency and local private sector participation while benefiting the poorest sections of the population. The two inefficient state- owned commercial banks will be divested by end- 1997; other priority candidates include firms in sectors being exposed to competition and a few medium-sized profitable PEs. The government will also explore mechanisms to provide post-privatization investment finance to mobilize donor and private funds without the moral hazard of Government guarantees. Also planned are efforts to: reform export and tax policies; upgrade private sector capabilities; and improve public/private sector dialogue on means to increase competitiveness and foreign investment. Refocusing the public sector 21. The government aims to do fewer things better. The public sector will focus on facilitating economic activity and supporting local initiative while improving its efficiency and transparency. A stronger judiciary is envisaged, to ensure application of the "rule of law" and improved security for business transactions. Public expenditure will be made less regressive (currently, 41%/27% of education/health spending benefits the top 20% of households, compared to only 8%/15%, respectively, for the bottom 20%). Intra-sectoral reallocations will aim to increase outlays on basic health, primary education, key rural infrastructure and public security. As part of the decentralization process, responsibility for primary education and public health will be transferred to local governments beginning in 1997. Defining responsibilities and  8 distributing resources between central and lower levels of government will take priority. The central government will set standards and improve delivery capacity of weaker local authorities, while seeking greater collaboration with the private sector. Also planned are efforts to privatize commercially viable activities, along with expansion of AGETIP-type operations (which rely on small and medium-sized local enterprises to rehabilitate and maintain urban roads). 22. Health. A national strategy is soon to be enshrined in a Policy Framework and Master Plan being finalized with stakeholder and donor involvement. The strategy envisages increased investment in basic, district-level health facilities and services (access to safe drinking water, hygiene and sanitation; housing; nutrition from early child feeding and school feeding programs; education of girls and women; prevention and treatment of malaria and other leading killers; and family planning services). A growing priority is AIDS prevention, Madagascar being a high-risk country. While medical supplies will cost less following introduction of the non-profit, privately-operated central procurement office, cost-sharing for drugs will be extended nationwide through community-managed "village pharmacies". Capacity building will be pursued, to improve resource management by local communities and newly elected local governments. 23. Education. The government aims to restore the sector's former strengths -- near universal primary education, expanding secondary education and recognized university programs -- by improving the quality, internal efficiency and relevance of the education system. To benefit the poor, more public resources will be devoted to primary schools. Efforts in primary education will focus on: enabling local communities to plan and implement school-based programs; rehabilitating primary schools in far-flung and insecure areas; upgrading teacher skills as well as incentives; and providing basic educational materials, especially in poor communities. Upgrading of secondary and tertiary education will rely on higher beneficiary contributions and private sector involvement. Vocational training will be demand-driven and jointly managed with employers and providers of the training. A comprehensive program will be launched to: reform university management; establish new approaches to post-secondary education (distance learning, training based on labor market needs); reallocate expenditure towards pedagogical inputs; and encourage establishment of private institutions. 24. Public security and rural infrastructure. Physical security in rural areas is a top priority, to increase agricultural productivity, improve education and provide a link between the rural and urban economy. The government will increase appropriations to the police and national constabulary and is exploring additional protection from the army. Improved security also requires better roads and communications. While the liberalization of telecommunications and air transport should facilitate links within the country, rural roads need urgent attention. The rehabilitation of road and track networks will be a key focus of the decentralization effort. In parallel, and in coordination with the National Environmental Action Program (NEAP), communities and individuals will be offered reimbursable assistance to improve rural infrastructure, including irrigation-related works. 25. Agricultural productivity. The government aims to increase rural incomes by raising agricultural productivity, through (i) improved agricultural techniques; (ii) new employment opportunities tied to eco-tourism and natural resource management; (iii) labor-intensive public infrastructure projects; and (iv) development of mutual credit unions and promotion of micro- enterprises. A key role is expected for local governments and the private sector. The government also plans a comprehensive participatory effort to reassess land use rights policies  9 and develop consensus towards a revised land law (code foncier) on the necessary evolution of public land management (particularly in relation to decentralization). 26. Energy. Woodfuels supply most energy needs in Madagascar, with high associated environmental and health costs. Modern energy sources are important to the economy but state- run power and petroleum services are inefficient and reach few rural areas. The government intends to ensure more efficient production and utilization of wood fuels and reduce the environmental impact of their use. It is also liberalizing the modern energy subsectors and strengthening their physical and institutional capacities; steps have been taken to eliminate monopolies and encourage private participation. Other interventions will support village management of forests being exploited for fuel (a pilot program) and increased access to electricity in rural and lower-income urban areas. 27. Financial sector. To improve savings and support economic expansion, the government aims to raise Madagascar's low level of financial services. Access to these services outside key urban centers is especially limited. Sector reform began last year, when both state banks, whose politically-motivated lending had contributed to excessive monetary expansion, were placed under conservatorship. Government efforts will next focus on new financial instruments benefiting the poor, including support for the embryonic rural savings and credit cooperatives. Also envisaged are: adoption of market-determined interest rates; completion of sector divestiture and reform of the social security system; strengthening of financial infrastructure; and creation of a sound legal and regulatory framework to ensure entry of qualified institutions. Environmental management 28. The root causes of environmental degradation in Madagascar are poverty, population growth, the low level of agricultural technology and the absence of land management and agricultural production policies. A National Environmental Action Program was prepared in 1987 (the first of its kind in Africa), and will continue to be implemented through the second phase of the Environmental Program (EP2). The Program aims to reduce depletion of Mada- gascar's natural resource base by changing the enabling policies and institutions to give resource users the authority, responsibility and incentives to manage their own resources. Emphasis is on rural development and small-holder management of farmland, especially in areas of high population pressure. EP2 will focus on regional programming and local management of natural resources, and address important land titling issues, by enabling transfer of management rights of public land to village communities and redefining land management policies for the longer term. From a Government Agenda To a Bank Strategy 29. The government has set ambitious investment and growth objectives because unless those targets are achieved there can be no significant reduction in poverty. The underlying philosophy is that nothing short of turning the country into a business-friendly Mauritius or Singapore will be good enough. While Madagascar's natural endowments and expressed investor interest in- waiting augur well for gradual achievement of these targets in about a decade, the task promises to be extremely difficult because of enormous physical constraints rooted in twenty-five years of neglect and decline. An equally formidable obstacle is lack of credibility: after repeated policy reversals, doubts persist as to the government's ability to sustain good policies. Thus, tough times lie ahead particularly for the country's poor, before their situation gets better. The double challenge for the Bank and the donor community, with due attention to political risks, is to help  10 Madagascar rapidly put in place the policies to gain investor confidence while dealing with poverty during the difficult transition to high growth. The Bank strategy outlined below focuses on activities that would help achieve investment and growth targets while facilitating provision of services and opportunities for the rural poor. Even with this effort, the poverty situation will improve significantly only in a number of years. To help the government make tough choices amongst competing priorities, the Bank and the donor community would need to remain engaged in the long haul, even as the relative share of private capital inflow increases. D. The Bank Group's Country Assistance Strategy BOX 4. DIALOGUE AND PARTICIPATION Partnership with Madagascar Bank activities in Madagascar have 30. The Bank's assistance strategy has its increasingly sought to intensify and widen country dialogue, involving policymakers, beneficiaries, roots in intensive country dialogue carried out donors, NGOs, the private sector and other concerned in close collaboration with the IMF and other ,parties. Noteworthy examples of such efforts are: donors over the past two years. The dialogue * The participatory Poverty Assessment covering four has helped build consensus for reform and regions of Madagascar, with Malagasy teams develop commitment to a comprehensive anti- interviewing about 2500 households and 100 poverty strategy at the core of the Malagasy community leaders and others. leadership (Box 4). Anchoring all such part- * Extensive dialogue with four successive govern- nership has been the Resident Mission through ments over two years on economic reform, resulting in a breakthrough on adjustment and solid advances a strong, expanded presence. Recent Mission towards economic opening. initiatives include a Public Information Center * Steadfast consultation on financial reform resulting and a widely distributed quarterly economic in positive real interest rates, lower inflation, more report (both already much in demand). The modem banking laws, and progress on bank Mission took the lead in organizing two rounds divestiture -- all paving the way for IMF support. * A Borrower Feedback Survey aimed at better of town meetings with diverse groups to identifying client needs. discuss the Country Assistance Strategy. * Inclusion of private sector in policy discussions, begun in 1993 with joint Bank/IFC preparation of CAS Objectives Private Sector Assessment and continuing with periodic seminars organized by EDI. * Preparation of the Phase II Environment Program The CAS aims to reduce poverty by under Malagasy leadership in close partnership with helping alleviate the wide-ranging constraints the Bank, donors and NGOs. that stand between Madagascar and its * Greater local participation in the Country Portfolio potential. The strategy is built on the Poverty Performnance Review since FY95, involving NGOs, and Private Sector assessments, which donosi mayors and beneficiaries. conclude that poverty is so widespread that it * Extensive dialogue and participation resulting in ca bescsfulatckdoythug adoption of a National Health Policy in April 1996. can be successfully attacked only through broad-based economic growth, and that only the private sector can generate the growth needed to dent poverty. The Bank will focus on strengthening investor confidence, ensuring the pro-poor orientation of growth, and building human and institutional capacity. These outcomes will be pursued under four strategic objectives: (i) broad-based growth led by foreign investment; (ii) human capital development, focused on basic education, health care and rural infrastructure; (iii) a strengthening of the public sector's ability to deliver quality services and create an enabling business environment; and (iv) natural resource management to reduce degradation and develop eco-tourism potential. Reflecting a donor-coordinated approach, Bank assistance will be directed at unlocking bottlenecks or meeting needs unmet through alternative sources.  I1 32. The key challenge for the Bank is to ensure that the poor will indeed be better off. While the government's targets for high growth and poverty reduction are realizable in the medium term, several uncertainties exist: the government must regain investor confidence; investors must respond; resulting growth must be broad-based, while benefiting agriculture; and growth must be pro-poor. Recognizing these uncertainties, the CAS combines support for the government's ambitious growth strategy with interventions that aim to directly, and in a nearer timeframe, improve living conditions in rural areas and raise rural incomes. Such interventions will be especially important given the expected rise in poverty in the next few years, and will emphasize, in particular, empowerment of local communities. 33. Box 8 sums up the Bank's approach to poverty reduction in Madagascar. Assuming strong government efforts to attract foreign investment, private sector development should result in robust growth in salaried jobs in the medium term. Pending that result, multiple efforts are envisaged. Sustained (IMF/Bank) emphasis on macroeconomic stabilization and financial reform should help lower inflation and protect the poor's purchasing power. Expanding the Export Processing Zone will not only widen Madagascar's export base but also increase off-farm employment; these investments (garments, handicrafts) have typically relied heavily on unskilled as well as female labor. Wide-ranging support for agriculture is also planned, particularly to raise productivity. Interventions to improve land and forest management will offer direct and immediate benefits for many of the nation's poorest. The poor will also benefit from activities to: supply water and electricity to low-income and rural areas; promote energy conservation (lowering fuel costs and wood collection time); and improve the accessibility and quality of local health and education services, in large part through support to local communities. 34. An important role in the CAS is assigned to monitoring intermediate outcomes that would indicate progress towards poverty reduction, until the high performance targets come within reach. Outcomes monitored would include, for example: measures tied to the quality of public services, including enrollment and pass rates, number of teachers, supply of medicines, and the condition of rural roads; execution of the public investment program, particularly in the social sectors; job creation, foreign investment and tourist activity; and progress in privatization. Current Portfolio 35. IDA has a substantial portfolio in Madagascar, and attention to ensuring its effective implementation and linkage with CAS objectives is a first priority of the Bank's strategy. Maximizing use of the existing portfolio will be an important input to the timing and composition of future new lending; this is particularly true of the agriculture sector (Box 5). IDA's 17 credits to Madagascar address needs in human resource development, agriculture, energy, and reform of the financial sector; links with CAS objectives are laid out in the CAS Matrix (Appendix A). The portfolio is yielding clear results on the ground (Box 6). Vigorous pursuit of implementation issues in recent years will be sustained; portfolio scrutiny will also be intensified as part of a Region-wide plan to review each project in FY97. 36. Portfolio Performance. Between FY92 and FY96, the disbursement ratio rose from 7% to 21%, and the share of unsatisfactory projects fell from 27% of the portfolio to 5% in terms of development objectives, and from 27% to 10% in terms of implementation progress. No new  12 BOX 5. CAS PLAN FOR AGRICULTURE AND RURAL DEVELOPMENT Bank support for agriculture and rural development will come from a substantial existing portfolio in the sector, proposed operations in related sectors, and efforts to develop, with wide country participation, a rural development strategy.f The Bank's comprehensive approach reflects wide-ranging constraints: state intervention; insufficient maintenance of and investment in critical infrastructure; inadequate development and transfer of improved technologies, poor access to inputs and credit, and problems of land tenure security; inadequate develop- ment of farmer organizations and private animal health services; and weak local capacities for planning and implementation. Porolio: Operations in the Agriculture portfolio address needs in Research, Extension, Irrigation, Livestock and Rural Finance (pilot). Other operations (Environment Program (EPI), Social Fund and Energy Sector Development) aim to improve agricultural productivity, natural resource management and rural infrastruc- ture, all in support of rural development. The portfolio has contributed to several achievements (Box 6), including higher cropping intensity and yields, self-sufficiency in rice and higher-yielding agricultural systems. However, tdisbursement rates have been low (10%), and overall portfolio performance modest relative to that needed. Proposed operations. Divestiture of agriculture parastatals (vanilla, cotton, sugar) is being pursued under structural adjustment and as a first step to attracting foreign investment in the sector. The Second Phase Environ- ;ment Program will curb soil degradation, offer solutions to farmers with soil and water constraints, address land tenure issues, support rural incomes and build community-level capacities in managing natural resources. The Rural infraructure project will focus on roads, to give farmer communities access to markets and public services, while the Financial Sector project aims to address needs in rural financial intermediation. Rural development strategy. The Bank will bring together central and local government units, rural citi- zens, the private sector and other donors to jointly define a rural development strategy that would rely on empowered local communities. Objectives would be to: define agricultural policy; integrate household food security and nutrition policy into rural development operations; support markets and agribusiness; develop new approaches to rural finance; address land policy and land reform issues; and incorporate efforts towards agricultural intensification and natural resource management. Improving results on the ground: Efforts will include: developing project synergies (e.g., EPI is implementing a river basin rehabilitation programl with the Irrigation project and a hillside fodder program with the Livestock project); working closely with local communities to address grassroots-level constraints; refining monitoring indicators; and reducing govemment counterpart funding levels to ensure uninterrupted implementation. problem projects were added in FY96; issues concerning the two remaining problem projects are being addressed. The Antananarivo Plain project is advancing on institutional issues (entities have been created to manage works and their financial autonomy provided for); the Petroleum Sector project was slow to start but is gaining momentum, following a restructuring and partial cancellation. Increased supervision has been a key factor, in particular through a general implementation specialist in the Resident Mission. Field presence has enabled systematic monitoring and 'walk-in-clinics' on disbursements, procurement and audits. regular contact with project implementation units, and greater reliance on participatory processes. Resident Mission efforts have also improved the quality and timeliness of audit reports (100% compliance). 37. Country Portfolio Performance Reviews (CPPRs) are being enriched by increased local preparation and participation. Local project staff are becoming increasingly knowledgeable, and ongoing training should help sustain such improvement. The CPPR held in June 1996 was managed by the Resident Mission with participation by NGOs, donors, members of Parliament, mayors and beneficiaries. Important progress was made on procurement issues. Participants stressed the need to: better coordinate among ministries and donors and realize greater synergy among projects; reinforce local institutional capacities; give more voice to beneficiaries, and build environmental concerns into lending. At the request of the mayors, it was agreed that the next CPPR would be held outside the capital city to enable greater regional participation.  13 BOX 6. RESULTS ON-THE-GROUNb: PORTFOLIO HIGHLIGHTS * Area of Supported Achievements Intervention by: Direct Food Security *Nutrition: Malnutrition down by 10% in Antananarivo and 7% in Tulear for target Poverty and Nutrition children; iodine deficiency disorders eradicated through successful national campaign; Allevigtion (Social Fund 200,000 person-days of employment (60% women) covering Anta- *Poverty alleviation: Rehabilitation of primary schools, health and nutrition centers, nanarivo,Tul- feeder roads, small bridges, micro-irrigation ear provinces) *Development of SMEs and local consulting firns: Training in labor-based works techniques and engineering methods, financing of income-generating activities Social Natl. Health; *Creation of non-profit private drug procurement unit Sectors Education *Establishment of 111 health districts (with decentralized staff and budget) Sector eAgreement on cost recovery, community management (Health) Reinforcement *Improved delivery of primary school education in 20 districts nationwide Environment Environment *Increased international visibility of Madagascar Program I :Progress in institutional building, policy framework *Management of 26 (out of 38) protected areas *Introduction of land-titling pilot operations *Integration of environmental concerns into tourism, roads, energy operations *1000 demand-driven projects with substantial field impact and demonstration effect (reduced wood collection and cooking time; lower wood and charcoal consumption; higher income from entry fees to protected areas; higher farm income from increases in yield) Agriculture Research; *Development of higher-yielding varieties and improved technologies Extension; *Adoption of new technologies: Livestock; *-- 65,000 farmers in FY96 compared to 34,000 in FY95 Irrigation *-- 28,000 square km of surfact area compared to 10,000 in FY94 *Creation of effective livestock producer associations; devolution of animal health services to private sector; increased meat and milk production *Devolution of operation and maintenance to water user associations; full financial participation of water users in O&M; increased irrigation efficiency and agricultural production Rural Rural Finance *Creation of 51 savings and credit associations (5600 members) Finance Pilot *Poor families' savings deposits resulting in (i) reduced borrowing at usurious rates and (ii) more lending for income-generating purposes Urban infra- AGETIPA *83,000 person-months of employment structure *Rehabilitation of 90 km streets / 80 km sewerage *Technical/management training for workers/subcontractors *Improvement in traffic in capital city, reduced cost of car maintenance Financial APEX *Financing of: Sector *sales advisors and conservators in support of divestiture of the two state banks *50 private sector projects (impact on exports/employment currently being assessed) *70 technical assistance projects to help SMEs create and finance businessses (APEX) * Also see Box 3 outlining achievements in economic and financial reform, resulting largely from steadfast policy dialogue on macroeconomic issues and under the financial and petroleum sector projects, and most recently as part of up-front actions for the proposed first structural adjustment credit. 38. Increasing Portfolio Effectiveness. Project design and implementation will systematically incorporate beneficiary involvement, capacity building, transparency and communication -- the common thread among projects in Madagascar that have produced results. These projects are in high demand: the government has asked the Bank to extend AGETIPA to four other cities and to rehabilitate two major national roads, and to expand the activities of the Social Fund (FID) nationwide (resulting in a second credit, effective FY96). Areas requiring  14 greater attention are: implementation capacity; definition of organizational responsibilities; donor coordination; cross-project synergies; counterpart fund availability; and project design (to ensure simplicity). A clear system of monitoring and evaluating performance will be established for each project, measuring not only disbursement but also on-the-ground impacts. Portfolio effectiveness will also benefit from the recent addition of a national as deputy portfolio officer in the Resident Mission, setup of a unit for supervision of the proposed Environment Program, and efforts under the Public Sector Capacity Building project to strengthen monitoring. Assistance in FY97-99 39. Broad-based growth led by private, foreign investment. The Bank will support macroeconomic stability and structural reforms, to open up the economy, make it more competitive, and improve the climate for investors. These objectives underpin the Policy Framework Paper (PFP) for 1997-99, prepared with Bank and Fund assistance, and the proposed Structural Adjustment Credit (SAC). The SAC will provide balance of payments support and lend credibility to the government's reform program, key to bringing about the quantum leaps in foreign investment and tourism needed for poverty reduction. Improving macroeconomic stability will require: controlling expenditures and increasing tax revenue, pursuing an active monetary policy to lower inflation, and maintaining a free and stable exchange rate. Structural reforms -- most of them completed under up-front actions for SAC negotiations -- are aimed at opening the economy, in particular the telecommunications, air transport and petroleum distribution sectors. A Private Sector Capacity Building project (FY97) is proposed to support privatization as well as tax and incentives reform. If first-round adjustment efforts gather momentum, the Bank could increase adjustment support through a second SAC and a financial sector credit (FY99), promoting greater competition, state divestiture and stronger institutions. 40. Broad-based growth will not be possible without badly needed infrastructure to support investment, tourism and agriculture. Liberalization of air transport should improve quality and lower the cost of domestic travel. In addition, the proposed Transport Sector Development project (TSD, FY98) aims to support the government's maintenance and management of its roads, ports, rail and marine transport systems through divestiture, liberalization, institution- strengthening and physical investment, including efforts to leverage private investment together with IFC. The TSD seeks to meet priority demand and unlock the economic potential of isolated areas, and will also address cost recovery issues. 41. Finally, the CAS recognizes an important lesson of global experience: few low-income countries have achieved rapid non-agricultural growth without corresponding rapid agricultural growth. The Bank plans to directly attack impediments to farmer productivity and participation in the market economy, through portfolio restructuring and new interventions addressing needs in environment (EP2, FY97), decentralization and rural infrastructure (both FY98). The infrastructure operation would apply the successful principles of the ongoing Urban Works (AGETIPA) project in rural environments. Towards a more comprehensive approach for the medium term (see Box 5), the Bank will undertake analytical work as a first step to elaboration of a participatory rural development strategy -- using the Groupware methodology -- to be implemented through a sector investment operation (FY99). The Bank Group will also support government efforts to revive interest from Zimbabwe, Mauritius, South Africa and Reunion in agricultural investment in Madagascar.  15 42. Economic and Sector Work in support of broad-based growth will include, in addition to the rural development analysis noted above, a Country Economic Memorandum (FY97), annual Public Expenditure Reviews, and short policy papers used to advance key areas of dialogue and support of public information campaigns (e.g., land tenure). A paper addressing issues in agriculture is also expected as an output of the portfolio restructuring planned in that sector. 43. Human Capital Development. The CAS addresses this objective under a wide range of existing and proposed projects; the latter will target at least 70% of beneficiaries from the rural population. Greater dissemination of the highly participatory Education sector strategy prepared in FY95 constitutes a proposed non-lending task. New lending in education (FY98) will support government efforts to reverse declines in enrollment, by revitalizing primary education (better school-level infrastructures and teaching/learning processes) and improving secondary education (stronger teacher skills). In health, the Bank has played a key role in furthering policy dialogue and donor coordination. The recently restructured Health Sector Improvement project has supported institutional strengthening and disease control programs against malaria, tuberculosis and STD/AIDS, and helped prepare the Health Policy Framework and Master Plan for 1997- 2001. A new Health and Nutrition project (FY98) aims to improve the quality of health services in the newly created 11l health districts, and prevent the spread of AIDS. It will also expand the activities of the ongoing and highly successful Food Security and Nutrition project (SECALINE). 44. Promoting human capital development will also require direct poverty alleviation efforts as well as infrastructure projects that improve prospects for rural health and education. The Social Fund -- a component of SECALINE recently extended nationwide -- will help create employment around infrastructure subprojects, develop health and education facilities, develop farm-to-market roads, provide soil erosion protection, develop arable land, and finance micro and small enterprises. The Transport, Rural Infrastructure and Water Supply projects (all FY98) aim to improve access to education and health services, and to potable water. 45. Economic and Sector Work in support of human capital development will comprise primarily annual Public Expenditure Reviews. Opportunities will be sought for inter-sector reallocation and restructuring within the health and education sectors, to ensure delivery of services to the poorest layers of the population. Other ESW under consideration relates to private sector provision of health services. 46. Strengthening of Public Sector in its new role. Madagascar's public sector must create and maintain an enabling environment for business and provide quality public services in areas unsuitable for private enterprise. The Bank is well-placed to support this objective, drawing on lessons learned and recent innovative approaches (e.g., to civil service reform). While project activities regularly address needs in institutional strengthening, the Public Sector Capacity Building project (PAIGEP, FY97) takes a comprehensive approach. PAIGEP will help: build capacity for designing and implementing economic policies; allocate public resources; reduce corruption; establish a strong judiciary; develop an efficient and well-paid civil service; forge a strong partnership between the public and private sectors; and adopt an inclusive, transparent approach to governing, through efforts to promote public understanding of policies. Efficient delivery of public services at reasonable cost and with possible private sector/NGO involvement is supported both under PAIGEP and a proposed Decentralization project (FY98). As authority and funds are transferred out of the center, major gaps in local financial and human capacities are  16 becoming evident; PAIGEP will address these through studies, training and pilot programs. State planning and oversight will also benefit from support for poverty monitoring (para. 49). 47. Economic and Sector Work: Apart from the annual Public Expenditure Reviews that will assess the scope and means for redirecting resources from debt relief, privatization and tax reform to the social sectors, ESW will take the form of advice and support to budget management at the local levels, as well as the sharing of best practice on decentralized delivery of public services. Other Non-Lending will include taking the lead on mobilizing donors and all concerned towards development of strategies for rural development and poverty monitoring. 48. Natural Resource Management. The Bank has played a leading role since 1987 in formulating and implementing the NEAP. Continued involvement -- through support for the program's second phase (EP2) -- is essential to sustain the government's commitment to difficult and critical changes in its public investment program and to mobilize the support of other donors, including GEF. IDA itself would be the lender of last resort, with appraisal and supervision focusing on the entire program and use of its resources defined through the annual programming process. EP2 was prepared with extensive donor coordination and has a strong poverty focus: primary beneficiaries are among the country's poorest. Rural/village incomes are expected to benefit from improved agricultural productivity (Box 7), land tenure security and eco-tourism development. An innovative component recognizes the rights and capacities of the rural population, whose role will be central to the outcome. BOX 7. EP2'S MINI-PROJECTS:. CLOSE-UP This component of the 0Second Environment Program will' benefit smallholder farming communities by raisingi agricultural productivity, reducing: soil degradation and contributing to rural development. Densely populated farming co6mmunities facing:severe land ,constraints (uneven topography, highly erosive soi1) would be key beneficiaries. EP Wpro oses about 4000 mini-protects, quadrupIing coverage under EP 1. Mini-projects typicaily have multiple components with direct on-the-ground .i,mpact. Results under EPI (based on a limited:sample) suggest a stong positive impact on:tyield increases; crop diversification; adoption of techniques; familyi income; bush fire incidence; soil loss ; and time/money savings tied to woodfuels use. Mmni-project components under EP2 could include: - Small-scale irrigation infrastructure -- raises yields and production on bottom: land, improves nutrition * lHillside hedgerows -- stabilizes soil terosion,nimproves yields :and soil content, provides mulch for cattle feed * Vegetable gardens/fruit trees4-- increases iand diversifies household revenues and family nutrition s Comnnunity-level tree planting -- controls erosion and makes favailable wood for fuel and construction * Provision of potable water -- reduces disease Mini-projects are lemandAdriven, low-cost anduincludetcost-sharing arrangements; these features promote ownership by participants, andtisustainability. Participants typically assume 20%-50% of costs, although the amount may range from..60/0.90%.E 49. Poverty Monitoring. Several activities in recent years lay the groundwork for a coherent poverty monitoring system in Madagascar. A number of surveys were carried out in preparation for the Poverty Assessment and for other project evaluation, including an integrated household survey covering 4500 families. In addition, the staff of the National Institute of Statistics (INSTAT) received training on survey organization and analysis. The government is beginning to monitor poverty, through a high-level Adjustment Monitoring unit and a Household Survey Division at INSTAT, explicitly mandated to carry out regular updates of the Living Standards Measurement Survey. The Bank will: (a) support, under PAIGEP, two priority surveys and dissemination of the results of the integrated household survey; and (b) develop jointly, with all  17 concerned donors (USAID, UNDP, UNICEF, EU, FAC), a poverty monitoring system, with involvement by NGOs, universities and the private sector as appropriate. BOX 8. SUMMARY OF CAS PLAN FOR POVERTY REDUCTION PA Finding (from Box 2) Actions envisaged / Ongoing Results targeted 70% of Malagasy are poor Macro stability (SAC) -- Less inflation, more purch. power -- GDP growth: 9.5% a year Structural reforms, economic opening -- Poverty incidence: 35% (SAC) -- More (salaried) jobs from increased private investment 85% of poor are rural Raise agricultural productivity -- Higher rural incomes (due to higher -- Pursue research, extension activities yields, access to markets and goods, (Agriculture portfolio) reduction of anti-competitive practices, -- Improve soil/water management lower transport/transactions costs, (Environment, Water, Tana Plain) improved access to credit / land / foreign -- Privatize vanilla parastatal, remove exchange, fewer bribes) vanilla export tax (SAC) -- Alleviation of extreme poverty -- Address land titling issues (Envirmt.) -- Reduction of slash and burn agri- -- Increase rural infrastructure (FID; Rural cultural practices AGETIPA, Transport, Decentralization) -- Functioning rural road network -- Support community/regional capacity -- Systematic approach to alleviating building re: management/funding of rural constraints to development road maintenance (Decentraliz.) -- Increased market power for farmers -- Increase level of expenditures (inv. and -- Higher incomes from eco-tourism recurrent) for infrastructure development -- More off-farm employment /maintenance (Decentraliz.) -- Increase access to credit, foreign exchange (Financial Sector portfolio; FID) -- Launch work on rural devel. strategy -- Strengthen farmer organiz. (Extensn.) -- Require that for all physical projects, 70% of beneficiaries should be rural Wage earners are least Develop potential for Salaried, Off-farm -- 60,000 new jobs in formal sector by likely to be poor Economic Opportunities 2000, 1 million by 2015 -- Encourage Private Sector Development, -- Increase in off-farm employment expand Export Processing Zone (SAC, through expanded EPZ, agribusiness Priv.Sector Capacity Building) -- Improved access to credit of farmers -- Encourage development of grassroots and micro-entrepreneurs savings and loans (Rural Finance) -- Increased incomes (salaried jobs) from -- Promote park preservation (Environmt.) eco-tourism Social indicators are weak Restructure public expenditures, -- Better targeting of public expen- address needs of social/infrastructure ditures to benefit bottom 20% of sectors, and target extreme poor in population poverty alleviation activities -- Increase in primary enrollment -- Work with central and local govern- -- Improved access to schools ments to reallocate public expenditure -- Improved health status (mortality across and within sectors to benefit poor rates, malnutrition, immunization) (PAIGEP, PERs, Decentr.) -- Prevention of spreading of AIDS -- Implement national Health strategy in -- Increased access to medical personnel, 111 health districts drugs and health care outside Tana -- Increase quality of primary Education -- Reduction in health care costs -- Address rural infrastruct. constraints -- Increase in temporary employment -- Extend direct poverty allev. activities to (support for household income) all 6 regions of country (Social Fund 2) -- Improved institutional capacity at -- Improve security (PAIGEP) local levels to manage delivery of -- Strengthen decentralized units in infrastructure, health services planning and management of public services (PAIGEP, Decentralization)  18 50. Gender Issues. Women in Madagascar fare better than in many other developing countries; gender issues exist, however, and are addressed in the CAS. Among them are access to safe water, access to credit and women's role in natural resource management. The beneficiary assessment carried out for the proposed Water Supply project focuses especially on women's concerns; the project aims for better health and hygiene, time saving in fetching water, and new opportunities in education and entrepreneurial activities. The Bank is improving women's access to credit and employment opportunities under the Rural Finance, SECALINE and Social Fund projects. For example, credit schemes for viable rural off-farm activities and labor-intensive work programs offer women employment, paid for with food allowances and nutrition education, along with opportunities to start up small-scale income-generating activities. Ongoing environmental activities benefit women in many ways (faster cooking, less time spent on firewood gathering, and lower fuel expenditures). EP2 is also addressing other concerns of women (staffing of implementing agencies; design of program activities and access to related education opportunities; and development of women's organizations). Alternative economic and lending scenarios PROPOSED LENDING PROGRAM FY97-99 51. Appendix B compares the three (US$ millions) macroeconomic scenarios used to develop Base Low High the CAS, including poverty and GDP per (Base plus:) capita outcomes. In the high case economic Sectors scenario, Madagascar successfully opens up (AGETIP) 30 20 the country and reduces poverty incidence to Education 30 20 a third of the population in one generation. Health 30 20 The CAS base case is also structured around Water 26 26 an adjustment scenario, but the gains in Transport 50 Ag.Sector Invest. Program 20 foreign investment would be less impressive Capacity Building and the reduction in poverty more modest, Public sector * 14 14 with half the population still below the Private sector * 20 5 poverty line. In the low case economic Decentralization 30 scenario, poverty would rise steadily, to Adjustment 84% of the population. The latter is an SAC I * 70 unacceptable outcome that perpetuates bad SAC II 70 policies, isolation and the decline of the last Financial sector 30 quarter century. At this low level of Environment * 30 30 performance, core lending (US$135 Total Commitments 330 135 450 million) would support only capacity * FY97 credits building, natural resource management and public services to address basic rural needs. Base case lending would expand the scope of some of the above projects (US$45 million) and add new ones (US$285 million), totaling US$330 million. The Private Sector Capacity Building project, for example, would be expanded to initiate privatization and facilitate private investment through matching grants and other risk-reducing activities. New projects in the base case would include balance of payments assistance and support transport infrastructure and decentralization. New lending in the high case (US$120 million, all in FY99) would help the financial and agriculture sectors and provide additional balance of payments support, bringing total high case lending to US$450 million.  19 52. The adjustment scenario is seen as the most likely outcome. An ESAF was recently approved (para. 54) and a SAC has been negotiated. Actions needed before Board presentation have been delayed because of elections, but required steps are being taken and should soon be completed, given sustained affirmations by leading candidates. Key triggers for base case (see Appendix C) are compliance with ESAF targets and completion of outstanding actions agreed under the SAC. The base case economic scenario would result in progressive recovery (7.5% GDP growth in 2006) based on sustained donor support and foreign investment rising to US$100 million. Such a recovery, while substantial, would represent only a starting point for Madagascar, given both its poverty and potential; the base case must be seen as a stepping stone from which to rapidly move forward. High case lending would require continued liberalization by: abolishing remaining monopolies in key sectors; rapidly divesting major PEs; and making the regulatory regime one of the most investor-friendly in the developing world. Such policies could gradually raise foreign investment to US$300 million by 2006, implying growth rates that could cut poverty incidence to a third of the population by 2015. Backtracking on reforms already achieved would trigger core lending. Partnership and Aid Coordination 53. NGOs. Many NGOs in Madagascar have a history of positive development impact. The Bank is seeking their partnership in: directly alleviating poverty (particularly in the social and infrastructure sectors); engaging in outreach activities; and supporting decentralization. Stronger Bank/NGO relations are being pursued through: active support for a law giving NGOs legal status, adopted by the National Assembly in September 1996; a new NGO relations officer at the Resident Mission; monthly meetings; NGO participation for the first time in the CPPR; and consultations on the CAS. Efforts to build NGO capacity include training in project implementation, with particular emphasis in the SECALINE and Social Fund projects. The Bank is also directly supporting NGOs in micro-enterprise creation and through funds under the Bank- wide NGO Outreach Initiative (a first women's bank in Madagascar could open the door to funds from the Grameen Bank to expand small rural credits for women). In coming months, the Bank will seek to identify NGOs that could potentially become effective Bank partners. 54. IMF and Other donors. Close partnership with donors is a priority in Madagascar, to further dialogue with the government, achieve results in reform, maximize funding efficiencies, and share information. Coordination was noteworthy in preparation of the Environment Program and the National Health Sector Plan, as was Bank/IMF teamwork -- with the EU and traditional bilateral donors in a key supportive role -- in helping the government prepare the stabilization and adjustment programs enshrined in the 1997-99 PFP. A three-year agreement under the ESAF in an amount equivalent to SDR 81.4 million and the first annual arrangement thereunder (SDR 27.1 million) was approved on November 27, 1996. Donor support, in the form of debt relief, balance of payments financing and investment projects in priority areas, will be crucial for the success of Madagascar's reform program. Public Expenditure Reviews (PERs) have been undertaken with participation by major donors, aimed at ensuring that external aid finances priority projects within coherent sector strategies. The Bank has also organized numerous informal donor meetings; a Consultative Group is planned for later in FY97. 55. IFC and MIGA. IFC has eight investment operations in Madagascar. Restoration of investor confidence should significantly increase potential for direct investment by IFC, which  20 could then catalyze and facilitate other private investment. IFC and Bank staff jointly prepared the Private Sector Assessment, which underpins many of the actions under the SAC and Private Sector Capacity Building credit. IFC is expected to focus on sectors producing for export: tourism, fisheries, agribusiness and EPZ. IFC involvement could also include establishment of a leasing company, participation in the privatization of the state insurance companies and credit lines to the local commercial banking system. IFC will also look at instruments to limit risk and increase the comfort of other investors: it could set up a Madagascar Fund to mobilize portfolio investment; take up a share of new investment to limit the capital required by the promoters; and act as agent for opening up the capital of PEs to private investors. MIGA has already issued three guarantees for expected investments in the tourism sector and will likely be called upon to issue guarantees to potential investors in other sectors. 56. EDI. EDI can play a key role in narrowing Madagascar's large information gap and building consensus to strengthen the political will for reform. To date, EDI has: (i) organized a series of seminars in Madagascar aimed at furthering private sector development; and (ii) helped prepare a series of Assises Economiques planned by the government to explain economic reform to the country. Additional contributions from EDI will be explored, through participation in the country team and including efforts to build media capacity. Risks 57. In implementing its reform program, the Government intends to explicitly address the risks arising from a fear that opening the country to foreign investors will result in the exploitation of Madagascar's natural resources at the expense of its citizens. The Government has embarked on a series of public information campaigns run by the Secretariat Technique de l 'Ajustement (STA) with Bank support. These aim to mobilize the public in favor of better goods and services at lower prices and against attempts to portray the reforms as "selling the country to foreigners". The message is that Madagascar is caught in a poverty trap and in a vicious circle without foreign investment and donor support; economic recovery fueled by foreign investment will open opportunities to all Malagasy, allowing the relative wealth and income disparities to be closed without lowering the incomes of the current elite. 58. Despite these steps, the risk remains that the reform momentum will not be maintained due to weak implementation capacity and renewed political opposition from those adversely affected in the near term by reform. The poor and emerging private entrepreneurs will gain from employment creation, higher incomes, increased competition, reduced entry costs and improvements in the availability, price and quality of goods and services. The poor will also benefit from enhanced donor support in the social sectors and a restructuring of public spending in their favor. Employees of state-owned enterprises, rent-seeking bureaucrats and protection- spoiled entrepreneurs stand to lose, however. Under liberalization, their future will depend on more effort and dynamism compared to relying on the rents offered by the status quo. Moreover, key civil servants are likely to lose opportunities for sharing rents with favored entrepreneurs, with little prospect for compensation through a fast recovery in official salaries. 59. In sum, the risks underlying this CAS are significant. Present circumstances suggest, nevertheless, that the strategy has a reasonable chance to succeed: (i) pro-reform forces have pushed through significant measures and no backtracking has yet occurred; (ii) public opinion demands change, and the presidential candidates have publicly supported economic reform; and  21 (iii) capacity building efforts are planned, to support implementation. Furthermore, the payoff for success is high: revival of investor confidence and resulting growth in investment and economic activity could indeed achieve dramatic, and long-elusive, progress in poverty reduction. The CAS argues, therefore, that assuming the risks entailed is worthwhile. Should the government stall in its implementation of reform, the Bank would withhold future adjustment lending as well as major sector investment operations and limit its exposure by paring down lending to a core program focused on long-term and direct poverty alleviation objectives. E. Agenda for Board Consideration 60. Madagascar's history of policy reversals could warrant a conservative strategy, with modest interventions making a difference only at the margin. The CAS takes a bolder approach: the Bank has been helping the government establish and sustain first-rate, unprecedented policies while undertaking wide-ranging interventions to alleviate poverty directly. Under this adjustment scenario, the CAS takes a comprehensive approach to lending assistance, including balance of payments support, support for capacity building, and investment lending to several sectors, with emphasis on rural areas. (a) Does the Board agree with the overall approach underlying the CAS, given the risks identified above? (b) Does the Board agree with the focus and sectoral allocations of the CAS? James D. Wolfensohn President by Gautam S. Kaji Washington, D.C. January 17, 1997  APPENDIX A. CAS MATRIX SUMMARY OF CAS OBJECTIVES, MONITORABLE ACTIONS AND BANK SERVICES MONITORABLE ACTIONS AND BANK SERVICES PERFORMANCE INDICATORS Broad-based growth led by private, foreign investment Lendinc: - Macro-economic stability. -Maintain inflation under 12% in 1997, 8% thereafter. Adjustment: SAC I (FY97 base) - Open, competitive environment -Raise tax revenue to 11% of GDP by 98 SAC 11 (FY99 high) - Disengagement of state -Limit budget deficit to 3.6% of GDP in 1997, 2.1% in 1999. Financial Sector (FY99 high) - Sound legal and regulatory framework -Limit BOP current account deficit to 3% in 1997, 2.9% in 1999. Investment: _Priv. Sect. Capacity (FY97 base) - Private sector incentives -Increase private investment to 7% of GDP in 1999 Rural AGETIPA (FY98 low) - Adequate infrastructure -Mobilize FDI of $30 million in 1997, $40 million in 1999. Transport (FY98 base) - Effective financial intermediation Increase tourists to 100,000 by 1999 Agriculture (FY99 high) - Private sector capacity -Obtain Naples Plus terms at Paris Club ESW: Annual Public Expenditure reviews - Increase exports by 4% in 1997, 7% by 1999. Country Economic Memorandum -Ensure: at least one private operator in telecoms Short policy papers (eg., land tenure) and petroleum distribution; Portfolio Mananement: -Opening of Malagasy skies and ground service to AGETIPA, Agr. Ext., Agr. Livestock, foreign competition. Irrigation, Tana Plain, FINDEP, - 22 PEs privatized Energy/Petroleum - Allow foreigners access to land Disengage from state banks by end-1997 - Increase in agricultural production (425,000 tons) - Increase in adoption of technologies ('96-98: 1,200,000 farmers. 580,000 ha) - Growth in agricultural revenue: USS 8, 17 and 28 million in 96, 97 and '98 - Livestock: 200 associations of livestock/milk producers by 99; 90 private vets by 97; 60% natl. vaccination coverage for cattle by 99: annl. milk M production gain of 32 mil.litres by 99; 23 animal breeding centers privatised N Irrigation: Transfer of O&M responsibility to 40 mater user groups by 2000; increased annl. production of 20,0000 tons of crop by 2000; Increased access to credit for 3% of total rural population, increased loan size Human capital development -Increase education expenditures to 3.5% of GDP Lendinq: -Pro-poor public expenditures -Increase primary enrollment to 70% by 1999. Investment: Environment (FY97 low) -Quality primary education - Rehabilitate 2000 schools nationwide Rural AGETIPA (FY98 low) -Quality, affordable basic health care Increase access to water Education (FY98 low) -Access to clean water, sanitation -Rehabilitate / Maintain rural roads Health (FY98 base) -Adequate rural infrastructure -Finalize strategy for developing and maintaining Water (FY98 base) -Support to rural incomes rural road network by 6/97 Transport (FY98 base) -Direct poverty alleviation activities -Create employment (under AGETIPA) ESW: Annual Public Expenditure Reviews -Reduce flooding Increase in rural family income (from extension activities): US$200-600/campaign ONLT: - Dissemination of Education Study Increase daily net income of milk producer from FMG730 to 2,350 by 99 - Groupware re: strategy for rural road Under Social Fund: Implement 200 rural infrastructure maintenance / rural development subprojects (70% primary school rehabilitation, 20% - IEC Campaign on AIDS rural roads); issue 100 micro-credits (50 to women): Portfolio Manaqement: create 200,000 person days of employment Social Fund, Health, Education, Vocational 160-80% for poor womenl Training, food Security & Nutrition, Rural -Establish 200 nutrition centers in 2 regions Finance -Improved quality of health services in 111 health districts -Finalize/implement health sector policy framework and master plan -Reduce morbidity / mortality rates tied to malaria, TB -Improved drug avaibility / affordability 1 85% of facilitiesl -Cost reconery on drugs in 75% ot managed communities -Avoidance of exponential increase in AIDS FN. CAS_OBJ11XLS Printed: 1/21/97 11 03AM  2 APPENDIX A. CAS MATRIX SUMMARY OF CAS OBJECTIVES, MONITORABLE ACTIONS AND BANK SERVICES MONITORABLE ACTIONS AND BANK SERVICES PERFORMANCE INDICATORS Strengthening public sector in its changing role Lendinq - Civil service reform -Conduct diagnostic studies of 4 ministries Investment: Public Sect. Capacity (FY97 low) - Transparency - Conduct workshops on Government modernization Decentrallization IFY98 base) - Decentralization Perform Treasury audit Transport (FY98 base) Legal, ludicial reform - Publish budget data monthly Environment (FY97 low) - Monitoring of macro/social indicators - Implement PIP and PEP ESW Annual Public Expenditure Reviews - Information/ education/ communication - Perform audit of planning/ economic services - Advice / support for local budget mgmt. - Complete studies, pilot operations (eg., tax census) on - Sharing of best practice on decentralized decentralization delivery of public services - Enact legal reforms, publish laws ONLT: Donor coordination on: Rural development - Prepare Poverty Monitoring Strategy strategy, Poverty montoring. Managing natural resources Lending: - Soil and Water management Implement 4,000 micro projects for sustainable soil and Investment: Environment (FY97 low) - Forest management water management - Protected areas tourism - Put in place new legal framework for forest management - Marine / coastal / urban management and land tenure; arrangements for mgmt of 8% of forest - Support activities cover. - Complete estabtishment of 40 protected areas, place 22 parks under proper management Design policies, plans, institutional arrangements for marne Icoastal/urban needs - Improve environmental content of education and training, conduct national information compaigns. - Set up monitoring systems with key indicators on status of environmental resources and impact of program. r, ONLT - Other Non-Lending Tasks IEC - Information, Education, & Communications  24 Appendix B: Madagascar -- Comparison of CAS Scenarios 1996 1997 1998 1999 2000 2005 2010 2015 Priv. Consumption PC (1996 US$) Core 269 263 260 258 256 250 231 211 Base 269 263 260 258 256 274 333 408 High 269 263 260 258 260 295 388 525 Headcount Index Core 72% 72% 73% 74% 75% 77% 81% 84% Base 72% 72% 73% 74% 75% 72% 610% 49% High 72% 72% 73% 74% 73% 67% 52% 35% GDP growth rate Core 2.0 2.3 2.2 2.0 1.8 1.5 1.0 0.9 Base 2.0 3.0 3.5 4.5 5.2 7.3 7.5 7.5 High 2.0 3.0 3.5 4.5 5.5 9.5 9.5 9.5 GDP per capita in m 1996 US$ Core 303 302 300 298 295 280 258 236 Base 303 304 306 311 319 383 480 601 High 303 304 306 311 320 416 572 786 Total Government Expend. (less Interest) in 1996 US$ per capita Core 37 37 36 35 34 26 21 19 Base 37 40 42 44 47 58 73 95 High 37 40 42 44 45 62 95 143 External Financing (US$ millions) Current Account Deficit (excl. Grants) Core 314 202 171 153 166 147 138 131 Base 314 297 306 282 327 300 247 177 High 314 297 306 282 349 457 438 378 Official Development Assistance: existing and expected commitments Core 232 230 199 173 162 145 140 132 Base 232 258 272 285 288 285 383 480 High 232 258 272 285 289 324 367 454 Foreign Direct Investment Core 14 10 10 10 10 10 10 10 Base 14 29 35 41 43 59 85 122 High 14 29 35 41 70 233 300 390 Headcount Index GDP per capita in 1996 US$ Percent of population below 100% I800 Indonesia in 1996 Bo% 600 1g 60% 400 = Ba0e 200 20% t Core 0% 4 -0 1995 2000 2005 2010 2015 1995 2000 2005 2010 2015 Source: Bank staff estimates.  25 Appendix C. Summary of Lending Program and Triggers under Alternative Scenarios SCENARIO TRIGGER POINTS PROPOSED OPERATIONS Low Case * Back-tracking on reforms already achieved Support for rehabilitation of social and rural (US$ 135 million) [restructured public expenditure program, infrastructure, protection of the environment, ( .S$ 135 million) liberalized exchange rate, positive real and improvement in capacities for macro- rates of interest]. economic management. * Non-compliance with the macroeconomic - Public Sector Capacity (FY97) targets of the IMF program set out in the - Environment (FY97) PFP. - Rural AGETIPA (FY98) - Health (FY98) * Deterioration in portfolio performance. - Water (FY98) - Education (FY98) - Private Sector Capacity (FY98, scaled down) Base Case * Compliance with the macroeconomic Core plus support for: pro-competitive (US$ 330 million) targets of the IMF program set out in the foreign and domestic investment, PFP. liberalization of air transport and . . . ~~~~~telecommunications, private sectorl * Implementation (with no back-tracking) of development and public sector structural reform to open the economy to devestment l foreign investment and tourism; initiation disinvestment. of divestiture from public enterprises, particularly the state owned commercial - SAC I (FY97) banks; restructured public expenditure - Private Sector Capacity (FY97) program; liberalized exchange rate; - Transport (FY98) positive real rates of interest. - Decentralization (FY98) * Sustained government commitment to poverty reduction [samples of indicators in CAS Matrix]. * Continued improvement in portfolio performance ratings and disbursement levels. High Case * All-out effort by Government to attract Base plus additional support for financial and investment and establish investor private sector and rural development. (US$450 million confidence - with a demonstrable response from new investors in air transport, -SAC 11 (FY99) telecommunications and industry - leading - Financial Sector (FY99) to the high growth scenario: abolishing the - Agriculture Sector Investment Program remaining monopolies in finance, (FY99) agriculture and transport; rapid divestiture from the 22 major public enterprises; making the regulatory regime in Madagascar one of the most investor friendly in the developing world by taking steps to facilitate entry into agriculture, mining, transport, infrastructure provision, tourism, financial and business services  26 APPENDIX D. MADAGASCAR: DEBT SUSTAINABILITY ANALYSIS External debt. At the end of 1996 Madagascar is projected to have an external debt of US$4.4 billion of which US$2.1 billion in arrears. Official bilateral debt comes to US$2.7 billion (62 percent) with Paris Club debt accounting for US$1.8 billion (41 percent) and Russian debt US$0.5 billion (12 percent). Private debt is less than 1 percent at US$41 million and multilateral debt is US$1.6 billion (37 percent). The World Bank group is responsible for US$1.1 billion-- one quarter of the debt-- almost all IDA. Most of the debt is highly concessional with an average interest rate of about 1 percent and an average maturity of 38 years. Nevertheless the debt service burden is not tolerable with a present value of 450 percent of exports at end 1996 and a debt service ratio to exports of 45 percent. Projections without rescheduling. Debt service has been declining (from 60 percent of exports of goods and services in 1994 to 45 percent in 1996), reflecting the reduced capacity to borrow in recent years in response to poor policies and external arrears accumulation. Although scheduled debt service is projected to continue declining, until 2000 it will remain above the 20-25 percent considered manageable. Moreover, over the next ten years the net present value of the debt relative to exports would remain above 200-250 percent, the target for sustainability. Impact of Naples terms debt relief. Should Madagascar proceed with an ESAF from the IMF in 1997, as expected, it would qualify for debt relief through Paris Club rescheduling on Naples Terms and rescheduling of other bilateral debt on similar terms. Of the US$ 2.7 billion of bilateral debt, about US$200 million is post cut-off date debt owed to the Paris club and not subject to rescheduling. Our projections assume a flow rescheduling on the eligible debt on Naples terms (67% reduction in present value of eligible debt) in 1997, followed by a stock of debt operation in 2000. Rescheduling on these terms would provide US$2.1 billion in debt relief in 1997 and allow external arrears to be settled. The assumed rescheduling would, however, offer only limited net reductions in debt service of US$18 million (2 percent of exports) on average for the next three years. This is because about half the debt is in arrears and rescheduling, would increase scheduled debt service. Nevertheless, due to the decling debt service profile, debt service would be significantly reduced from US$235 million in 1996 to US$165 million in 1997 (US$188 million before rescheduling). Scheduled debt service (after Naples and before adding debt service on future borrowing) would rise by about 4 percent a year through 2010 and debt service payments are expected to average US$160 million per year over 1997-2000 and US$121 million over 2001-2005. External debt sustainability. Based on the macroeconomic scenario underpinning the base case, the debt service ratio will be under 20 percent in 1997-2000 and would remain below that level provided exports grow by at least 4 percent. The net present value of debt would also fall below 200 percent of exports of goods and non-factor services after 2000. Thus, these projections show that debt relief on the basis of available mechanisms will reduce Madagascar's debt burden to manageable levels early in the next decade. However, debt and debt service would remain very large compared to the Government's fiscal resources for the next ten years. External debt service would still amount to 81 percent of tax revenue in 1997, and even assuming substantial reduction following the assumed stock of debt operation in 2000, will take about ten years to decline to 20 percent. The present value of external debt relative to Government revenue while substantially reduced by Naples terms rescheduling from 1,323 in 1995, will remain high for the next ten years (990 percent in 1996). It will exceed 200 percent in 2004 and 300 percent  27 until 2001. External interest payments after Naples terms restructuring would average 19 percent of revenues from 1996-98 and remain above 1O percent of revenues until 2002. The Government will, therefore, face a difficult liquidity situation for some time to come. This situation might be worsened by domestic debt service payments of about 8.6 percent of revenues in 1996. Vulnerability. By some indicators, Madagascar is less vulnerable than other highly indebted poor countries (see Table 1). Exports are relatively diversified with the largest earner of foreign exchange (coffee) accounting for 14 percent of exports (44 percent for HIPCs) and the top three traditional exports (coffee, vanilla and cloves) accounting for 24 percent of exports (68 percent for HIPCs). Madagascar is also less dependent on aid which is projected to provide less than 50 percent of financing needs for 1996-2000 (HIPCs receive 61 percent). Similarly, Madagascar has a lower external debt burden; external debt service will take up a little over one third of government revenue after the stock of debt operation in 2000 (HIPCs over 40 percent); one quarter of Government expenditure (HIPCs one third) and will be equivalent to 4 percent of GDP (HIPCs 8 percent). However, Madagascar has a high domestic debt burden and is more vulnerable to external shocks with reserves of 1.3 months of imports (and not projected to recover significantly) compared with 2.9 months for HIPCs. Conclusions. Eligibility for the HIPC initiative is expected to be assessed in 1999. Should Madagascar perform as indicated in the base case scenario, our analysis suggests that the country may not require further debt relief beyond available mechanisms. The situation should continue to be closely monitored. It is clear that Naples debt relief is not sufficient to liberate enough budgetary resources to restore essential public services (non-interest expenditure has been cut from 16.6 percent of GDP in 1992 to 12.3 percent of GDP in 1996 and is projected to only partially recover to 14 percent of GDP in 1999, assuming a return of donor support to historical highs. The Government is therefore likely to face considerable difficulties in meeting debt service payments and some form of exceptional donor support may be required for the country to make debt service payments (even after benefiting from debt relief) while financing essential services. TABLE 1. VULNERABILITY INDICATORS Madagascar Average of HIPCs Share of Top export 14 44 Share of Top Three Products in Exports a/ 24 68 Average Non-Interest Current/GDP b/ -3.5 -7.2 Percent Contribution to Financing Need b/ c/ Net Official Finance 49 61 of which: Grants 31 38 Loans 18 22 Reserves in Months of Imports, 1995 1.3 2.9 Reserves in Months of Imports, 2000 2.6 4.0 External Debt Service/Government Revenues, 2000 d/ 35 40 External Debt Service/Government Expenditures d/ 25 32 External Debt Service/GDP d/ 3.6 8.3 Tax Revenue/GDP e/ 8.4 15.1 Grants/GDP e/ 3.2 5.5 NPV of External Debt/GDP b/ 55 95 a/ Coffee, vanilla and cloves b/ Average 1996-2000 c/ Financing need is current account deficit (excluding official transfers), amortization payments and increase in international reserves. d/ After assumed stock of debt operation by Paris Club. e/ Average for 1996-1997  28 CAS Annex Al Run Date: 11/11/96 Data as of 1111/96 Madagascar - Selected Indicators of Bank Portfolio Performance and Management Indicator FY94 FY95 FY96 FY97 FY97 Actual Porfolio Performance Number of projects under implementation 24.00 23.00 20.00 24.00 19.00 Average implementation period (years)' 4.35 4.53 4.23 4.61 4.61 Percent of problem projects rated U or HU"' (for past years, rated 3 or 4) Development objectives' 16.67 17.39 5.00 0.00 0.00 Implementation progress (or overall 12.50 13.04 10.00 10.53 10.53 status for past years)d Canceled during FY in USSm 69.92 9.04 1.49 0.00 0.00 Disbursement ratio (/o) 15.07 20.23 20.43 20.00 6.16 Disbursement lag (%/o)r 20.76 35.94 34.94 34.00 34.53 Memorandum item: %completed projects 48.15 41.94 42.86 40.00 42.S6 rated unsatisfactory by OED Portfolio Management Supervisionresources(totalUS$thousands) 1584.63 1887.27 1239.27 1171.50 348.89 Average supervision (US$ thousands/project) 66.03 82.06 61.96 4S.83 18.36 Supervision resources by location (in %/6) Percent headquarters 44.49 51.55 46.74 50.60 66.67 Percentresidentrmission 55.51 48.45 53.26 49.40 33.33 Supervision resources by rating category (US$ thousands/project) Projects rated HS orS 70.59 80.18 60.20 70.00 19.08 ProjectsratedUorHU 48.89 94.54 77.83 70.00 11.78 Memorandum item: date of last/next CPPR a. Average age of projects in the Bankes country portfolio. b. Rating scale: "HS" denotes "Highly Satisfactory", "S" denotes "Satisfactory", "U" denotes "Unsatisfactory", and "HU" denotes "Highly Unsatisfactory". c. Extent to which the project will meet its development objectives (see OD 13.05, Annex D2, Preparation of Implementation Summary [Form 590]). d. Assessment of overall performance of the project based on the ratings given to individual aspects of project implementation (e.g., management, availability of funds, compliance with legal covenants) and to development objectives (see OD 13.05, Annex D2, Preparation ofImplementation Summary (Form 590]). The overall status is not given a better rating than that given to project development objectives. e. Ratio of disbursemerAs during the year to the undisbursed balance of the Bank's portfolio at the beginning of the year: investment projects only. f For all projects comprising the Bank's country portfolio, the percentage difference between actual cumulative disbursements and the cumulative disbursement estimates as given in the "Original SAR/PR Forecast" or, if the loan amounts have been modified, in the "Revised Forecast." The country portfolio disbursement lag is effectively the weighted average of disbursement lags for projects comprising the Bank's country portfolio, where the weights used are the respective project shares in the total cumulative disbursement estimates. Note: Disbursement data is updated at the end of the furst week of the month. Supervision resources include Salaries, Benefits, and Travel for all sources of funds but excludes FAO staff and PCR task costs.  29 CAS Annex A2 Run Date: 11/11196 Dataasof: 11/11/96 Madagascar - Bank Group Fact Sheet FY 1994-2000 IBRD/IDA Lending Program, FY 1994-2000 Past Current Planned' Categoly FY94 FY95 FY96 FY97 FY98 FY99 FY00 Commitments (USSm) 83.3 46.4 86.0 136.8 106.0 110.0 120.0 Sector (%/) Agriculture 0.0 100.0 0.0 0.0 0.0 0.0 16.7 Education 0.0 0.0 0.0 0.0 28.3 0.0 0.0 Elec.power,oth.engy. 0.0 0.0 53.5 0.0 0.0 0.0 0.0 Environmnent 0.0 0.0 0.0 21.9 0.0 0.0 0.0 Finance 0.0 0.0 0.0 0.0 0.0 45.5 0.0 Industry 0.0 0.0 0.0 16.8 0.0 0.0 0.0 Multi Sector 15.7 0.0 0.0 51.2 0.0 0.0 58.3 Oil & Gas 62.3 0.0 0,0 0.0 0.0 0.0 0.0 Pop/health/nutrition 0.0 0.0 0.0 0.0 0.0 27.3 0.0 Public SectorMgmnt 0.0 0.0 0.0 10.1 0.0 0.0 0.0 Social Sector 22.0 0.0 46.5 0.0 0.0 27.3 0.0 Transportation 0.0 0.0 0.0 0.0 47.2 0.0 0.0 Urban Development 0.0 0.0 0.0 0.0 0.0 0.0 25.0 Water Supply & Sanit 0.0 0.0 0.0 0.0 24.5 0.0 0.0 TOTAL 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Lending instrument (