Nepal - Country assistance strategy

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 18578-NEP MEMORANDUM OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A COUNTRY ASSISTANCE STRATEGY OF THE WORLD BANK FOR NEPAL November 17, 1998 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  The last Country Assistance Strategy for Nepal was dated April 30, 1996 CURRENCY EQUIVALENT Currency Unit = Nepali Rupee (NR) US$1 = NR 67.93 (November 1998) FISCAL YEAR July 16 - July 15 ACRONYMS ADB Asian Development Bank BPEP Basic and Primary Education Project CAS Country Assistance Strategy CBO Community Based Organization CRR Cash Reserve Ratio DANIDA Danish International Development Association DDC District Development Committee DFID Department for International Development ECG Environmental Coordination Group EDI Economic Development Institute ESW Economic and Sector Work GDP Gross Domestic Product GNP Gross National Product GTZ German Society for Technical Cooperation HNP Health, Nutrition and Population IDA International Development Association IFC International Finance Corporation LACI Loan Administration Change Initiative LIL Learning and Innovation Loan MCH Maternal and Child Health Care MLD Ministry of Local Development NBL Nepal Bank Limited NEPAP Nepal Environment Policy and Action Plan NGO Non Governmental Organization NIDC Nepal Industrial Development Corporation NORAD Norwegian Agency for Development Corporation NPC National Planning Commission NRB Nepal Rastra Bank NTC Nepal Telecommunications Corporation OED Operations -ivaluation Department RBB Rastrya Banijya Bank PER Public Expenditure Review RNAC Royal Nepal Airlines Corporation SDC Swiss Development Corporation UNDP United National Development Program VAT Value Added Tax VDC Village Development Committee WTO World Trade Organization WWF World Wildlife Fund Vice President Mieko Nishimizu Country Director Hans M. Rothenbuhler Task Leader -Peter Nicholas  FOR OFFICIAL USE ONLY NEPAL COUNTRY ASSISTANCE STRATEGY Table of Contents Paze No. Executive Summary ...........................i L Country Context .....................1 A. Nepal's Political Economy .................................. , .1 B. Economic Management .4 II. Nepal's Unrealized Potential ..4 L. Formulating an Assistance Strategy . 10 A. The Government's Development Strategy .10 B. CAS Consultations . 0 C. Lessons From the Past ......................... ,.. 11 IV. The Country Assistance Strategy ..13 A. Emphasis on Participation/Ownership and Donor coordination .13 B. Governance . 16 C. IDA Lending Levels .1 7 Low Case .17 Base Case .18 High Case .19 D. Implementing the Assistance Strategy .19 E. Risks .21 Annex 1 Sector Strategies Agriculture .............................................1 Forestry and Land Management ..2 Infrastructure ......................,.2 Power ......................4 Health and Population ......................4 Education ......................5 Financial Sector ......................6 Telecommunications .....................7 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 Banlk authorization.l  Annex Al CAS Program Matrix Annex B 1 Nepal at a Glance Annex B2 Selected Indicators of Portfolio Performance Annex B3 Bank Group Program Summary, FY1999-2001 Annex B4 Summary of Nonlending Services Annex B5 Social Indicators Annex B6 Key Economic Indicators Annex B7 Key Exposure Indicators Annex B8 Status of Bank Group Operations in Nepal Annex B9 Statement of IFC's Portfolio Annex B 10 Summary of Development Priorities Map  NEPAL CAS EXECUTIVE SUMMARY i. Economic development only began in the 1950s in Nepal. Since then the Government has provided greatly increased access to primary education, a country-wide network of health posts, a basic road network in the low-land Terai and part of the hills, substantially expanded irrigation and community forestry, and a basic electricity and telephone netwiork. Despite this, Nepal remains one of the world's poorest countries; in the rural areas, where 85 percent of Nepalis live, population increase has outpaced agricultural growth in recent years. ii. More rapid progress in the fight against poverty has been hampered by ineffective and increasingly unstable governments. There have been five governments since 1994, and two of the three major parties have split in the past year. Corruption is perceived to be widespread, contribut- ing to misallocation of government resources, delays in project implementation, difficulties in obtaining approval for private investments, and rapid turnover and perverse incentives for civil servants. And while macroeconomic management has generally been acceptable, the economy has suffered from the lack of proper management of public expenditures, stagnant real revenues, large and inefficient parastatals, and a weak financial sector. As a result Nepal has not been able to adequately exploit its assets--fertile land in the Terai, access to generous donor aid, strong tourism appeal, and enormous, if partly seasonal, water resources and hydropower export potential. This discouraging picture may be a factor in the recent emergence of a low-intensity, but violent, Maoist insurgency. iii. The CAS aims to help Nepal overcome these constraints to development. It was elaborated in a participatory process involving extensive consultations. Our strategy has two new prongs: bringing resources closer to the beneficiaries, where they are most likely to be productively used; and collective donor action to foster the stronger governance needed to reduce waste and mismanagement. To these ends, we will support: (i) a greater reliance on local stakeholder and private sector participation in project preparation and implementation; and (ii) closer cooperation among donors linking donor assistance to improved governance. At the same time we will continue to look for major improvements in national economic and fiscal management, especially further privatization, a continued strengthening of the tax base, better allocation and management of public resources, and reform of the financial sector. iv. The degree to which the government will be able to take such action will depend to a large extent on its political strength. Whether a stronger government will emerge will become apparent only after the next parliamentary elections, due within a year. Accordingly, we have developed three scenarios for IDA involvement. (i) A low case of IDA lending of $0-$150 million in FY99- 01, in the event the recent efforts at turning around economic management and governance are not sustained, resulting in renewed budgetary slide, worseningt of the security situation, and government paralysis and inaction; (ii) a base case of IDA lending of $200-$350 million, with the specific amounts within this range dependent on the degree to which reform moves beyond silmple stabilization of economic management, e.g. increased revenues, productively prioritized and managed expenditures, and improved civil service effectiveness, in particular in delivering services in the field; and (iii) a high case of $400 million (or more, subject to an interim progress review) in the event of major structural and governance reforms, including improved public resource management, civil service reform, privatization, and financial sector reform.  - 11 - Issues for Discussion v. In their review of the CAS, the Executive Directors may in particular want to discuss the following issues: * The CAS emphasizes participatory development, ownership, results-oriented lending linked to progress in reforms, and donor cooperation. Given the record of the past, this represents an ambitious agenda. Does the strategy adequately deal with the challenges to its implementation arising from the current uncertain political environment? And how can we convince the donor community as a whole to help foster more effective development assistance to Nepal in line with this strategy? * The strategy presents some serious relational and economic dislocation risks. Coordinated donor response at the bottom of the Low Case is likely to have a substantial impact on Nepal's balance of payments and its formal economy. Are we prepared to accept this risk, and are the plans for managing it adequate?  MEMORANDUM OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A COUNTRY ASSISTANCE STFRATEGY OF THE WORLD BANK FOR THE KINGDOM OF NEPAL I. COUNTRY CONTEXT A. NEPAL'S POLITICAL ECONOMY 1. A LATE START IN MODERN DEVELOPMENT. Until the 1950s, Nepal had virtually no modem social services, infrastructure, cash economy or significant economic linkages to the rest of the world. Since then, Nepal has made major strides, opening up the country and putting in place many of the basic elements of a modem government and market economy, at least in the Kathmandu Valley. And in the rest of the country, significant progress has been made in providing basic infrastructure and social services. With active support from a wide range of donors, the Government has succeeded to: * Provide primary education for almost all boys and most girls., with now almost half of those over 6 years of age able to read; * Improve health conditions, for example halving the infant mortality rate; * Help increase effective irrigation coverage to 25% of cultivated land, raising yields on newly irrigated plots by four to five times, and more than doubling foodgrain production; * Secure access to piped water supply to 48% of households, with an increasing number of rural water supply systems managed by user groups; * Increase the road network from 124 km in 1956 to 15,000 km (including rural roads) today, and the number of households served by electricity from less than 10/% in 1956 to 15% today; a Hand over 400,000 hectares of forest to user groups comprising over 600,000 households, helping improve sustainable access to fuelwood, fodder and timber, and * Provide a basic telephone network, with 180,000 telephone connections (mostly in Kathmandu, but covering all 75 districts). 2. NEPAL REMAINS ONE OF THE POOREST COUNTRIES. Despite these achievements, an estimated 40-50% of the population still live below the poverty line. The absolute number of poor people has been rising as the population has grown faster than the economy's capacity to generate additional income. Over nine million are now below the poverty line, most of them in rural areas. Many basic services are still underdeveloped, with for example only 6% of the population having access to sanitation (as against 30% in Bangladesh and India). and only 48% having access to safe water (as against 83% in Bangladesh and 63% in India). Only in primary education enrollment for boys does Nepal outperform the South Asia average. While notable progress is now being made in improving provision of infrastructure and government services through community-driven initiatives, there is little immediate prospect of the sustained and broad-based economic growth necessary to significantly raise rural household incomes. The pressure of population growth oll scarce and fragile land means that the benefits of better education or irrigation are often oiutweighed by more fragmented land  - 2 - holdings and reduced availability of fodder, biomass and firewood. And the social fabric of the country is under serious strain, with social and political unrest, including political violence (notably a Maoist insurgency), on the rise. In a vicious circle, the diminishing social consensus makes it more difficult to find public acceptance for necessary reform measures. Box 1: Poverty In Nepal In 1995/96 a detailed Living Standards Measurement Study was undertaken.' It revealed that, even after decades of development effort, the number of poor people continues to Irow, with about half the population still below the poverty line. But the study-along with two more qualitative reports -also provided insights into why development efforts are not reaching the very poor (defined as the poorest quartile). * Much like the rest of the population, the very poor depend on agriculture for their livelihood. But their productivity is lower, because they, farn land of poorer quality which is seldom irrigated, and have limited access to modem inputs and technology. The very poor rarely if ever see extension or veterinary agents, and they have little access to credit at affordable rates-only 8% had loans outstanding with formal or semi-formal institutions, half the rate for other households. * The gender gap is still very large, although declining. The gap in literacy rates between men and women is 35% (with 54% of men literate as against 19% of women). Fortunately, there are signs that this gap is narrowing (with a gender gap of only 15% in the 10-14 age group), and that gains for poor girls are comparable to those for better-off girls. * Access to infrastructure is limited for all Nepalis, but especially for the very poor. The rural poor live on average more than five hours away from the nearest dirt road, as compared to three hours for others. Only 3% of the very poor has access to electricity, as against a country-wide average of 15%. This reduces their prociuctivity and employment opportunities. * The lack of transport infrastructure-rural roads in particular-constrains the potential for agriculture, as it increases the cost of inputs arnd reduces the value of marketable output. Whether or not the road was a paved all-weather road made no significant difference. * The very poor have much worse educational outcomes than others. Only 22% of the very poor are literate, as compared to 40% for the others. A very poor child of primary school age has only 2/3 the probability of attending school as other chilciren. A year of public schooling costs on average more than three months' per capita consumption for the very poor. Lack of parental education, the need to work, cost, and remoteness all reduce the probability that a child will be in school, Lack of education compounds the impact of lack of access to infrastructure in limiting employment opportunities for the very poor. * Additionally, the very poor seek health treatment less frequently when they are sick (only half, as against 70% for the rest of the population)-again, partly because of remoteness and partly because of cost-the average cost of treatment for an episode of illness is equal to one-and-a-half month of per capita consumption for the very poor. In addition, limited access to safe water and sanitation adds to the health risks faced by the poor-only 40% of the very poor have access to (relatively) safe drinking water, as compared to 60% for others. III health further reduces the productivity of the very poor. * There are in practice no public safety nets for the poor. Remittances are important, with one in five very poor households receiving remittances, accounting for 27% of their income, and so is seasonal migration, with again one in five households having a member who migrates. 'Its fiidings are analyzed in Nepal: Poverty at the Turn of the Twenty-First Century. 2 By Action Aid & University of East Anglia and by Action Aid, Plan International Nepal, and New Era. 3. MIGRATION AN4D CHILD LABOR. Another consequence of the severe pressures on Nepal's land is large-scale migration. This migration takes two main forms: migration from the hills to the terai (both towns and rural areas); and mig.dtion to India (both pennanent and temporary) and to the Middle East, and the more developed East Asian countries. Labor migration has two important benefits to  - 3 - Nepal: it helps alleviate the pressures on land and the labor market; and it brings workers' remittances to Nepal. To date migration to Nepal's capital has not reached the scale seen in most other developing countries, but this partly reflects the gap between the skills needed for many jobs in Kathmandu and the low level of human capital in the rural areas. Indeed much of the migration to Nepal's towns is by Indian workers who have skills not available in Nepal. At the saime time many children work, with an estimated one quarter of 5-14 year olds in some form of family or wage iabor. 4. FACTORS BEHIND NEPAL'S SLOW DEVELOPMENT. Even under the best of circumstances, Nepal's development would present a formidable challenge given the many constraints it faces, including its forbidding terrain and tough climatic conditions, its landlocked position, and the diversity of its society, which is barely emerging from its feudal past. EBut there are other important factors. One is that implementation of development policies and programs has been uneven, with good progress at some times in some sectors, but never the sort of sustained, broad-based accomplishments needed to achieve a major reduction in poverty. Even where good policies or programs have been adopted formally, they have often been countermanded by politically motivated measures at cross- purposes with stated policies. And substantial volumes of foreign assistance, while contributing significantly to many of the development achievements referred to above, have created an environment of generally weak Government ownership. Traditional "top-down" development assistance has also stifled beneficiary ownership of programs and the institutional development necessary for durable economic and social progress. 5. CORRUPTION. Corruption is a further major obstacle to using Nepal's assets more productively. It is generally perceived to be widespread, contributing to misallocation of government resources, severe delays in project implementation, difficulties in obtaining approval for private investments, and rapid turnover and perverse incentives for civil servants. Government salaries are very low, with senior civil servants' salaries of about US$1,000 a year, well below executive pay in the private sector. Partly as a result, some politicians and civil servants feel the need to augment their incomes through a range of corrupt practices. While most corrupt officials may receive relatively small amounts from such abuses, a minority of people do, according to newspaper allegations, make considerable sums. Corruption is reflected, it is claimed, in the large "fees" paid to obtain certain government jobs. At the same time fear of accusations of corruption makes many officials push decisions on procurement and other routine matters to the highest possible level, thereby delaying decision-making, often for months. 6. DEVELOPMENT UNDER THE NEW DEMOCRACY. In 1990, multi-party democracy was established, and the new democratic Government gave increased momentum to the reform process, aiming at accelerating development, including deregulation and. a closer link between development programs and public needs. The non-agricultural sector has grown at almost 7% a year for the last ten years, with industrial activity expanding to 19% of GDP. The financial sector was partially deregulated, and trade was liberalized, with exports of goods and services now constituting 22% of GDP. Growth accelerated, and for a while there was good progress in economic restructuring and development. In the 1994 parliamentary election, no party won an overall majority. Since then, there have been a series of shifting coalitions, with no Government able to last more than a year and a half, and many much less. Political stability has been further compromised by deep splits within the major political groupings, with two of the three major parliamentary parties formally dividing earlier this year. This political instability has focused the attention of politicians on short-term maneuvering and led to increasing politicization of the administration. Development has suffered as key decisions have not been made on time or not been adequately implemented, resulting in a fall in GDP per capita in FY 1998 for the first time in a decade.  - 4 - 7. SOME PROMISING RECENT DEVELOPMENTS. In April 1998 the fifth Government in less than four years was swom in. The new Government started out on a promising note, with a major effort to improve revenue collection, notably by pushing through the introduction of VAT in the face of very strong opposition. I]n addition, the Government is placing a new emphasis on reducing corruption, and there are so far fewer reports of high-level abuse. The Government is also making an increased effort to control the Maoist insurgency that is threatening development efforts in a number of Districts. In August the Govermment broadened its political base by including members from one of the former opposition parties. And in September it successfully held locsl elections in a number of Districts where they had been postponed because of the insecurity created by the Maoist insurgency. Even so, there is no guarantee of an end to the political uncertainty and shifting coalitions caused by the political fragmentation. It thus remains to be seen if the Government will be able to make durable progress in overcoming political inertia and politically motivated interference in development plans. In any case, a new parliamentary election is due within a year, and is currently expected to be held in spring 1999; but whether that election will produce a strong government remains an open question. B. ECONOMIC MANAGEMENT 8. MACROECONODMIC STABILITY, BUT SLOW GROWTH. Successive Governments have maintained macroeconomic stability, but budgets have been consistently unrealistic, and past allocations to politically-motivated projects have compromised adequate funding of priority programs. At the same time the pace of structural reform in areas Box 2: GROWTH AND POVERTY such as privatization and banking has faltered, and 2: growth ANd poverty growth has fallen from 5.5% in FY91-94 and 4.4% in Faster growth holds the key to poverty FY95-96 to an estiimated 4.0% in FY97 and 1.9% in reduction in Nepal. Projections undertaken in FY95-96 to an estimated 4.0% in FY97 and 1.9% in analyzing the Nepal Living Standards FY98. Measurement Study (see Box 1) show a major difference for poverty reduction between a 9. RESOURCE MOBILIZATION. Slow economic growth rate of 4% for the next five years, and a growth and a weak tax base have meant that debt- growth rate half a percent higher. The higher service has been rising faster than revenues, with debt- growth rates would, assuming a population service now equal to 25% of domestic revenues and growth rate just below 2.5% and consumption subject to exchange rate effects. Near-termn prospects growing in line with GDP, result in a reduction in the nurnber of poor people of over half a for a substantial reduction in this burden are slim. million. The lower growth rate would leave the Fiscal balance is being maintained by program credits, number of poor people unchanged. These but without real growth in revenues these credits will projections assume constant inequality. If themselves add to the debt-burden. Revenue however, inequality was to increase by one collection started ito falter early last fiscal year, percentage point a year in terrns of the Gini threatening Nepal's ability to finance vital services and coefficient, the number of poor people would be investments, but recently collection rates have unchanged even under the higher growth scenario. recovered and the revenue situation has improved. Nepal is trying to move away from a heavy dependence on import taxes to a more broad-based system relying more on domestic taxation of consumption, supplemented by low rates of customs duties and by income tax at the central level. The new VAT is the cornerstone of this effort. Implementation of the VAT has, however, met concerted opposition, and the introduction of VAT on retail sales for small businesses has been delayed. The VAT will also need to be complemented by efforts to widen the tax base, rationalize other taxes (particularly income taxes and customs duties), simplify tax legislation and improve tax administration. 10. WEAK PUBLIC EXPENDITURE MANAGEMENT. The management of both current and capital expenditures is weak, lowering the returns to private investment by stymieing the growth of human  capital and the provision of needed infrastructure. Public expenditure management suffers from a lack of multi-year investment planning, although successive budgets have promised this in recent years. As a result, there are now over one hundred more projects in the development budget than at the time of the last CAS. With more projects and fewer resources, budget availabilities per project have declined in real terms, with the capital budget suffering more than the recurrent (and within the recurrent budget wage and allowance expenditures rising at the expense of operation and maintenance), forcing the government to resort to ad hoc funding cuts and delays in fund release. Such rationing has generally favored quick spenders rather than priority projects, and as a result, the social sectors and agriculture have had their allocations cut disproportionately. 1 1. INEFFICIENT PUBLIC ENTERPRISES. Public enterprises, whose capital was equivalent to 25% of GDP, are a major drag on growth and a drain on public resources, consuming more than 7% of public revenues. To date sixteen public enterprises have been privatized and one closed. Further privatization or closure of key enterprises would help improve the economy's performnance in several ways: breaking up public sector monopolies (such as telecommunications) will open up new and profitable avenues for private investment and provide important signals to the private sector; removing price controls and subsidies will help eliminate remaining distortions in the economy, and create a level playing field where the private sector can compete with public enterprises on equal terms. The private sector in turn can bring in management skills and entrepreneurship, and help improve the quality and delivery of services. To create such an environment, the privatization program needs to be accelerated. To make the privatization process more meaningful, the government will need to focus on larger and potentially profitable enterprises, and not merely on loss-makers, and improve privatization procedures. Moreover, change in ownership structure alone (for example, through share issues) will help very little to foster the management and entrepreneurial changes that are needed to improve perfor mance; and other alternatives to bring in capital, know-how and better management need to be considered. For enterprises that will remain in the public domain, increased autonomy, particularly in management, pricing, and employment decisions will be essential. Such enterprises will need to be subjected to a hard budget constraint. 12. WEAK FINANCIAL SECTOR. While a start was made on liberalizing the financial sector during the last ten years (recent NRB attempts to induce a reduction in interest rates are seen as a temporary measure), there remain serious problems, especially with the state of the two largest banks. The central bank's regulatory capacity is still weak and insufficient to effectively regulate and supervise the banking institutions, much less the larger number of financial and leasing companies. And while the legal framework is generally adequate, operating incentives are seriously distorted by Government mandates reflecting concerns about access to credit in rural areas and the competitiveness of local banks with foreign financial institutions. These mandptes include requirements for priority sector lending, conditions on private banks opening new branches, and restrictions on entry of foreign banks into the market. Such weaknesses could mask capital inadequacies and create systemic risks. In the Government-owned sector, liquidity problems (resulting mostly from growing non-performing assets) have in the past affected the capacity of institutions to lend, in turn driving up real lending rates to borrowers and constraining the availability of credit to the private sector. While majority ownership of the Nepal Bank Limited (one of the two public commercial banks) has been transferred to the private sector, the bank's management is still controlled by the Government. For the Rastriya Banijya Bank (RBB), which owns about 35% of banking system assets, restructuring and divestiture has not so far been possible. A start in improving its viability has, however, been made by improving loan recovery, with a concerted campaign to recover overdue payments.  -6 - 13. FOREIGN TRADE AND INVESTMENT. Nepal's trade and foreign exchange regime is already quite liberal. Nevertheless further improvements in trade and investment policies can help stimulate exports, private sector activity and economic growth. Nepal needs to improve its competitiveness by ensuring duty-free imports ifor exporters, technological upgrading, skill development, export and tourism promotion, as well as investments aimed at supplying the neighboring Indian market. Nepal also needs to work out appropriate administrative arrangements with India and undertake the necessary investments in transport improvements, in order to take advantage of recent bilateral trade and transit agreements. Given its land-locked location and small domestic market, Nepal is unlikely to attract significant amounts of foreign investment in the near future, except in areas where it has a comparative advantage-power development, tourism, and possibly some services. To this end, the government will need to clearly define its privatization policy (e.g. in telecommunications) and remove existing obstacles to foreign (and domestic) investment. For example, the "one window" system for the approval of new industrial units needs to be made effective; administrative bottlenecks which are holding up foreign investment in the services sector need to be removed; the Foreign Exchange Regulation Act will need to be amended in order to reflect liberalization of the foreign exchange market; and a clear and transparent tax system needs to be developed. 14. THE EXTERNAL ENVIRONMENT AND MACROECONOMIC PROSPECTS. Economic growth is likely to rebound modestly to about 4% in FY99. A good monsoon and improved fertilizer availability will help a recovery in agriculture to about 3%. Stronger domestic demand, together with increased exports to India, a continuing pick-up in tourism and a somewhat expansionary budget will in turn provide stimulus to non-agricultural growth. The effect of the recession in East Asia on Nepal will be relatively small unless the global economy deteriorates significantly. While the inflow of tourists and remittances from East Asia is likely to be affected, Nepal will benefit from cheaper imports. The virtual absence of non-concessional foreign borrowing, a closed capital account and an exchange rate pegged to the India rupee also provide some cushioning to Nepal against wide short-term exchange rate fluctuations. Nevertheless, with 70% of its imports coming from countries other than India, Nepal remains vulnerable to fluctuations in the rupee exchange rate. In the immediate future Nepal should benefit from the good growth prospects for India, particularly the expected rebound in agricultural production. This, together with a favorable outlook for Nepal's agriculture itself and the usual seasonal decline in prices, is likely to help bring the domestic inflation rate back to single digit levels in the coming months. II. NEPAL'S UNREALIZED POTENTIAL 15. NEED FOR FASTER GROWTH. There is little scope in Nepal for improving the living standards of the poor through redistribution. Agriculture is a key to poverty-reducing growth in the near term, with power exports providing a longer-term prospect of substantially greater export earnings and govermment revenues. Fortunately there is considerable potential for growth in both agriculture and power. As discussed in paragraph 18 below, realizing that potential will require significant investments in human capital, irrigation, forest management, and rural infrastructure (roads, power distribution, water supply, telecommunications). But it will also require an economic environment conducive to private sector growth. 16. NEPAL'S ASSETS. If overall economic management and governance can be improved and population pressures eased, sustained income growth, especially also among the rural poor, is possible. Nepal does have a number of assets: agricultural land that could support much higher output, particularly in the Terai; people, especially women, accustomed to extremely hard work; access to  -7 - quite generous donor aid of some $20 per capita per year; a large and growing market in neighboring India that is now accessible on preferential terms; enormous, if seasonal, water resources giving it a massive hydropower export potential; and scenery and a cultural inheritance that make it a major tourist destination. The challenge facing Nepal is to harness these assets to sustain rapid and broadly- based growth, while reducing the birth rate so that the growth is realized in higher per capita income rather than an ever-increasing population density. 17. KEY CONSTRAINTS TO GROWTH. Unfortunately the potential of the above assets has not been realized, for a number of reasons. * Low Productivity of Agricultural Land. Agricultural output-in both volume and value terms- is well below its potential. Paddy yields, which were once tlhe highest in South Asia, are now the lowest. The green revolution has yet to have much impact, and per capita production of staple foodgrains is actually declining. Many Nepalis in the hills still live more than a day's walk from a road. Intensive cropping has reduced soil nutrients, as inadequate government fertilizer distribution and increased use of biomass for fuel and stall feeding has limited nutrient replace- ment. In Bangladesh nutrient use is three times higher. Irrigation is limited by poor operation and maintenance of Government schemes and often low returns to private investments because of highly fragmented land-holdings (even in the Terai less thian a third of the land is effectively irrigated, of which only 20% is irrigated year-round). Commercial production of fruit and vegetables is hampered by poor knowledge and lack of roads and telecommunications in the hills. The problem is not lack of donor assistance-over US$500 million has been committed for agricultural development since 1990. The problem is rather that the investment of many of these resources has not been closely enough linked to stakeholder needs, and the policy framework has not been conducive to high returns on investments. - Poor Productivity of Rural Labor. Labor productivity is low in the rural areas. Farming is still highly labor-intensive, with very little mechanization and severe land fragmentation-householders may have to walk hours just to visit highly dispersed but tiny land holdings. The pressure of a rapidly growing population severely exacerbates an already difficult situation, and without a much greater effort to reduce fertility other progress may be nullified. The growing population unfortunately has few opportunities outside agriculture, wvith non-agricultural production still rudimentary, contributing only 20% of rural household income. Adult literacy is very low: only 19% of women are literate, as against 38% in India and 87% in Sri Lanka. This is a major obstacle to improving productivity, since women do the majorily of the productive work. Labor productivity is also hampered by the fact that outside of farming much time and effort-again mostly women's-is spent collecting domestic water and firewood from sources often hours distant. Poorly-managed Government water supply schemes mean that only 48% of the population have sustained access to piped or other water supply system (although awareness of the benefits of environmental sanitation is growing, with increased construction and use of toilets). Over- exploitation of Government forests have made firewood and fodder extremely scarce in most areas. The time spent collecting water and firewood prevents women engaging in more productive activities, such as raising poultry or livestock. Once freed from these chores, rural women consistently say that skills training is one of their highest, priorities (higher even than new or improved roads, which top many male villagers' list of priorities). * Low Returns on Public Investments. Overall returns on public investments have been disappointing. One reason is that Nepal has intrinsically high infrastructure investment costs  - 8 - because of its difficult terrain and late start in modern development. But adequate returns to public investment have also been hampered by slow and haphazard project implementation, lack of consultation with beneficiaries on their needs, and little Government attention to-or community participation in--operation and maintenance. Nor is the situation improving. As mentioned in paragraphs 5-6 above, the unstable political situation has detracted from the focus on development work, making strong decision-making difficult, and allegations of corruption surface regularly. At the same time, government officials are increasingly tending to push decision-making up to higner levels, where matters often languish for many weeks. Nonetheless, one bright spot is that the management of IDA projects has improved perceptibly due to increased attention on both sides. * Inadequate Government Services. Government services are, on paper, mostly adequate outside of the social sectors. But actual outlays do not always correspond to the budget, with some projects suffering because of last year's revenue shortfalls and diversion of resources to unbudgeted expenditures. Even when outlays are close to adequate, actual progran delivery is hampered by low wages and morale among civil servants, insufficient incentives for government employees to operate in the field, and corruption and political interference in the hiring of the whole range of public officials from central ministry staff right down to village schoolteachers. Lack of knowledge among beneficiaries as to the services they are supposed to receive reduces public pressure on public officials. In the social sectors-health in particular-these problems are compounded by an inadequate allocation of funds, even on paper, and poor motivation and skills. Public health expenditures barely exceed 1% of GDP and education is less than 3%, as against a combined 10-15%,10 in countries that have done better in human capital development. 18. REALIZING NEPAL'S POTENTIAL. Our current strategy provides support for investments and initiatives designed to improve development effectiveness in these four areas. I Improving Lancl Productivity. Agricultural output is growing only slowly, and a cornerstone of Government policy is the Agricultural Perspective Plan supported by the ADB and other donors, which focuses on irrigation and food crop development in the terai, where the majority of the population lives, and on promotion of high value crops and sustainable natural resource management in the hill areas. We are actively supporting the Plan through our agriculture lending and-as importantly-our roads and transport lending. In FY98 we began financing a major Irrigation Sector Project, which promotes demand-driven irrigation schemes managed by water user groups-specifically it envisages rehabilitation and development of 40,000 hectares of farmer- owned and managed irrigation schemes, improvement and transfer to farmers of a further 20,000 hectares of public irrigation, and development of a Water Resources Strategy. This focus on beneficiary involvement should enable the project to overcome the poor long-term performance of many previous irrigation projects. Also recently approved is a project promoting user-oriented agricultural research and extension, and better knowledge dissemination. The project will emphasize decentralized extension services working with farmer self-help groups. In rural transport we have an extensive portfolio, with credits financing feeder, District and strategic roads, thereby helping to reduce transport costs for both agricultural inputs and outputs. * Raising Rural Labor Productivity. Human capital is woefully low in rural areas. While education levels have improved significantly with the support of a number of IDA Credits, quality remains poor and primary cycle completion rates are very low. The FY99 Education Project aims to address these shortcomings, in part through more decentralized management and giving priority to education quality. Progress in improving health standards-and most importantly reducing  -9- fertility-is hampered by very low levels of Government spending (US$2 per capita, as against over US$6 per capita in out-of-pocket expenditure). But increased expenditures on their own are not the answer. Absorptive capacity is weak, and strained by the large number of donors and NGOs operating in a piecemeal and uncoordinated manner in the sector. The relatively low level of human capital development is compounded by the fact that many people need to spend large amounts of time in unnecessarily labor-intensive activities, such as fetching potable water, wood, fuel and fodder. We are trying to reduce this wastage in a number of ways. Our transport projects are reducing time and cost for moving goods, and bringing people closer to schools and health centers. The planned assistance in the power sector will support rural power generation and distribution, bringing electricity for the first time to many areas. The Rural Water Supply Project has successfully pioneered user-group managed water supply schemes, greatly reducing the time women spend collecting water. The Hill Community Forestry Project has likewise helped promote forestry user groups, which have had great success in taking over the management of denuded or deteriorating Government forest land and turning it into productive and sustainable forest providing timber, fodder and fuelwood. The Land Resource Manageiment Study and possible follow-up credit would support further measures to ensure natural resource sustainability. In all projects, we will aim to improve design and delivery so as to better reach women and increasing, directly or indirectly through better education and health, their income-earning potential. Raising Returns on Public Investments. A major focus of our strategy has been on raising the efficiency of public investments. Our Public Expenditure Review is examining in detail ways in which the impact of Government investments can be improved, both through better allocation and release of public funds, and through improvements in the transparency and monitoring of public expenditures. A special emphasis will be placed in this study, and in a parallel study of decentralization, on ways in which the returns to government investments can be raised through greater involvement and monitoring at the local level. Likewise, IDA-supported projects are paying increasing attention to supervision and encouraging a greatly enhanced role for stakeholders and NGOs. Our irrigation, forestry, water supply and road projects are giving substantially increased responsibility in design and implementation to beneficiary groups, supported as needed by local NGOs. Thus, for example, our FY99 LIL for Rural Infrastructure envisages a greatly increased role for the Districts and close involvement of local NGOs, beneficiaries and the private sector, and the proposed FY99 education project emphasizes district level planning and implementation. We are also monitoring procurement more vigilantly, backed by a move of supervision resources to the field, and by decentralization of an increasing proportion of disburse- ment decisions to the Nepal Field Office. * Improving Government Services. Government service delivery has, as noted above, been particularly weak in Nepal. Here too we are supporting the transfer of more responsibility to stakeholder groups and NGOs. Service delivery has been especially poor in the area of operation and maintenance, with only 20% of our completed irrigation projects rated by OED as likely to be sustained (ways to improve O&M and cost-recovery are being developed under the ongoing Irrigation Sector Project). For this reason we have greatly increased the involvement of stakeholders in the operation and maintenance of our irrigation projects, and likewise emphasized stakeholder participation in the operation and maintenance of water supply, roads and forestry schemes. The ongoing Public Expenditure Review will look closely at ways to improve the allocation, flow and monitoring of recurrent expenditures across all sectors. Increasing transparency and stakeholder awareness of the services they should be receiving will be especially important. We also hope to work closely with the ADB in their preparation of a Civil Service  10- Reform study and possible subsequent program credit. The study and credit will focus on the crucial areas of civil service size, salaries, incentives and transparency of operations. Measures to restrain theft and corruption in government services will be a key criterion of the level of future lending. III. FORMULATING AN ASSISTANCE STRATEGY A. THE GOVERNMENT'S DEVELOPMENT STRATEGY 19. THE NINTH PLAN. The Government's development strategy, as articulated in its Ninth Plan (which covers FY98-02, and was finalized in July 1998 after nearly two years of preparation), emphasizes eradication of Nepal's widespread poverty as its major development objective. To achieve this, the Ninth Plan recognizes the need to accelerate economic growth (from an average of 4.5% p.a. in the past decade to 6.0% p.a. over the Plan period and to over 7% in the following decade and a half) and slow down population growth (2.5% p.a. currently) to a rate consistent with reduLing total fertility to the replacement level ioy FY2017. The Plan also stresses the need for increasing employment opportunities for a rapidly expanding labor force, accelerating social development and improving access to basic infrastructure (both to raise living standards and facilitate economic development), while reducing regional, gender and ethnic disparities. To accelerate economic growth, the Plan proposes harnessing the considerable growth potential in agriculture, forestry, hydropower and tourism; undertaking much-needed investments in infrastructure and human resource development; and developing the base for industrialization through expanding trade and investment opportunities with neighboring countries and at the regional level. The Plan highlights the enhanced role of the private sector in economic development, the need for a complementary role for the public sector as a facilitator and provider of social and economic infrastructure, and the importance of liberal and open market- oriented economic policies. 20. IMPLEMENTATION PROSPECTS. Although the desirability of its broad objectives is beyond doubt, the Plan suffers from a number of weaknesses: (i) Its key targets are very ambitious, unless institutional impediments which have hampered progress of reforms in the past can be effectively addressed. For example, the Plan envisages eliminating illiteracy (currently 52 percent for those over 15), reducing the child mortality rate (currently 118 per thousand) to 63 per thousand, and increasing average life expectancy by 12 years-all by FY 2017; (ii) Its macro-economic framework (which calls for rapid improvements in national savings, revenue mobilization and aid disbursements) is unlikely to be fully realized; and (iii) It is also doubtful whether the expenditure priorities envisaged in the plan can be effectively implemented without a significant improvement in the political environment. Thus, this Plan runs the same risks as past Plans which have lacked a clear government commitment to their implementation as well as the lack of well defined implementation strategies. B. CAS CONSULTATIONS 21. STAKEHOLDER DISCUSSIONs. The process of formulating the CAS has provided a good opportunity to review how we can make a more decisive contribution to further the objective of combating poverty. The Country Director and members of the Regional Management Team and Country Team had extensive consultations with village user groups, government officials at all levels, NGOs (both Kathmandu and field-based), the private sector, academics, senior officials from recent governments, and journalists. Members of the Country Team, including the Country Director, participated in the Village Immersion Program, which covered villages in both the terai and the hills.  - 11 - Altogether, close to one thousand Nepalis, ranging from bonded laborers and village farmers to university professors and high government officials, participated in these exchanges of view. Translators and facilitators supported the process; simultaneous translation was arranged for the large public CAS discussions. In addition, a Poverty Report based on a Living Standards Measurement Study is close to completion (see Box 1), and a number of studies have been conducted on the impact of decentralization on the poor with funding from the Strategic Compact (see Box 3). Box 3: Decentralization and the Poor With funding from the Strategic Compact, a number of studies were commissioned to take a closer look at how the poor participate in the development process. The studies looked at the legal framework for decentralization and the changes brought about by the Decentralization Bill; the use of central government grants to VDCs; and corruption in rural public works. The main conclusions from these studies are: * The current legal framework for decentralization (the 1997 Act and the pending 1998 Decentralization Bill), potentially gives more voice to the poor in local decisions, by making ward (neighborhood) committees elected bodies, increasing the role of village and municipal councils, and emphasizing the participation of local people in the preparation and implementation of District development plans. * But these instruments do not per se ensure that the views of the poor are represented. There is a need to raise awareness among the poor of the existence of programs and of mechanisms to influence the allocation of resources. * Women, even those of higher social status, often have as little awareness of, and participation in, development programs as the most disadvantaged men. * Where the poor are informed about projects, and have mechanisms to check that they receive their share -- for example, in rural public works programs where project expenditures are known to all and payments take place in public -- the implementation record improves and corruption diminishes. * Donors can help decentralized programs reach the poor by supporting awareness measures, capacity building and transparency. 22. CONCLUSIONS OF THE CAS CONSULTATIONS. These consultations reinforced our convictions that corruption is a key problem (the solution of which calls for increased transparency and community participation), and that local ownership is crucial to success (although it also led us to a new understanding of the need to avoid local elites running projects for their own benefit, a need that emphasizes the importance of widespread participation). In our rural consultations especially, stakeholders were adamant that if they had more control, governnent and donor money could be used much more productively; corruption would be reduced, project design improved, operation and maintenance made a priority, and government staff performance enhanced. Our consultations also brought home again an awareness of the critical role women play in sustainable development and the dismal conditions that most women still have to endure: low literacy, health hazards still associated with pregnancy, and a lack of opportunities to participate in any activities outside of agriculture or housekeeping. C. LESSONS FROM THE PAST 23. AID NOT USED EFFECTIVELY. Aid has been much higher per capita in Nepal than in most other South Asian countries, with a plethora of donors quite eager to provide financial assistance for Nepal's  - 12 - development (see Annex Al for a summary of areas of donor support). But, as discussed in paragraph 17 above, the potential of donor assistance has not been fully realized. Although aid has had some successes, the question can be asked as to whether the quite significant aid volumes should not have produced more results, particularly among the most disadvantaged-the rural population that still represent the overwhelming majority of Nepal's people. Lately, there is a growing recognition among many, if not all, donors that the past approach to development aid simply cannot go on since, even when there are results, their sustainability is often far from certain. 24. WEAK GOVERNMENT OWNERSHIP. Government ownership of many programs has been weak, and the degree of consistency and coordination among donor-assisted programs has varied widely. In this context the major lesson we have learnt since the last CAS is that donor-aided projects have relied too heavily on the "top-down" development model, supporting projects which: (i) were designed from Kathmandu and failed to adequately meet villagers' needs; (ii) were executed by centralized ministries that did not have tlhe capacity or internal incentives to implement the projects effectively; (iii) were ill- coordinated, with donors sometimes competing rather than cooperating in aid allocations; and above all (iv) did not have mechanisms and local ownership to ensure adequate, sustainable operation and maintenance. Part of the problem has been that donors have been slow in developing a common insistence on good governance at the central level as a condition for continued high levels of lending. Indeed, as mentioned in paragraph 22 above, our rural CAS consultations confirmed that stakeholders believed strongly that if they had more control development assistance could be much more productively used. 25. LESSONS FROM IDA's EXISTING PORTFOLIO. In the past, IDA's portfolio suffered from a large number of problern projects, with many examples of slow and poor quality implementation. After analyzing the causes of this poor implementation performance we have taken a number of remedial steps. * The Finance M[inistry and we are now jointly monitoring IDA-supported projects. Staff from the Financial Comptroller General's and Auditor General's Offices (which we are helping to strengthen through a series of three IDF grants) must now be present during project preparation to ensure that a sound financial management system would be included for all projects. * We are, as mentioned before, increasingly involving beneficiaries and NGOs in IDA-supported projects at all stages of design and implementation, thus helping-as in the Rural Water Supply Project-to avoid past problems of inappropriate design and insufficient attention to operation and maintenance. . More supervision resources have been moved to the field, with much procurement and disbursement work decentralized to the Nepal Field Office. And borrowers are being trained in procurement policies. * We are placing a very high priority on sound financial management. All IDA-financed projects must now have a financial management assessment. This helps ensure that the implementing agency has a good financial management system, with project management reports furnished on a trimesterly basis, and audit reports within 6 months of the end of the fiscal year. * A Country Profile of Financial Accountability has been carried out, with major recommendations for improving the financial management system at various levels in Nepal.  - 13 - These measures have helped ensure that by the end of FY98 onily two out of 14 projects were rated unsatisfactory for both development objectives and implementatlion performance, down from seven in FY96. And disbursement performance has improved from 14% in FY95 to over 20% in FY98.' 26. LOCAL OWNERSHIP. At the local level, the poor performiance of so many government projects and programs also results more from lack of ownership than lack of money. However, opportunities have emerged for much greater responsiveness to local needs with the advent of a democratic govern- ment in 1991 and a slow, but promising, shift in donors' aid paradigms. One of the new democratic Govermnent's first initiatives was to introduce two decentralization Acts, aimed at increasing village self-governance and control of development projects. In areas such as forestry, water supply and irrigation, community commitment to locally-managed projects has grown to a point where they are proving self-sustaining. A study on corruption in rural public works has confirmed the validity of these views: when villagers were informed of the rules of the program, all payments were made in public, and there were mechanisms to address complaints, corruption was reduced significantly and implementation performance greatly improved. Indeed, many IDA-supported projects are already benefiting from increased local involvement, particularly in forestry, irrigation, roads and rural water supply. In other sectors-telecommunications, urban water supply, power-we are moving towards a much greater reliance on the private sector. Of course government involvement in overall project and program management is still essential, and this aspect cannot be neglected if the decentralization initiatives are to succeed. At the same time, strengthening of private sector activities in infrastructure, industry and finance remains a major task. 27. OED FINDINGS. The Bank's Operations Evaluation Department has prepared a Country Assistance Note for Nepal, which is scheduled to be circulated to the Executive Directors prior to Board discussion of this CAS. The Country Assistance Note shares the general diagnoses of this CAS, and notes the need for: * A greater policy focus in our activities-this is a central theme of this CAS (see e.g. paragraphs 36- 37 below). * Improved public sector management-again this is a key therne (see e.g. paragraphs 18 and 34-35). * Social-fund type interventions to build rural infrastructure-a more decentralized, community- driven approach is being pioneered in the Rural Infrastructure LIL (see paragraphs 18 and 29). * Integration of the critical role of India into the Bank's assistance strategy-we are participating in the South Asian Sub-regional Growth Quadrangle initiatives and carrying out an India-Nepal trade study (paragraph 47) and seek to support better integration of Nepal's power system with the Northern and Eastern Indian grids (paragraph 12 of Annex 1). * Clear delineation of areas of focus-the CAS sets out the criteria for future support (paragraphs 38- 44 and Table 1). IV. THE COUNTRY ASSISTANCE STRATEGY A. EMPHASIS ON PARTICIPATION/OWNERSHIP AND DONOR COORDINATION 28. TWO-PRONG STRATEGY. In line with these findings, we have developed a strategy with two key new prongs: bringing resources closer to the beneficiaries, where they are most likely to be productively used; and collective donor action to foster the stronger governance needed to reduce ' It should, however, also be noted that the portfolio at end FY98 was very mature (only four projects were approved in the four fiscal years FY95-98).  - 14- waste and mismanagement. To these ends we will support: (i) greater reliance on local stakeholder and private sector participation in project preparation and implementation; and (ii) closer cooperation among donors to bring about the stronger governance which is needed to reduce waste and mismanagement, linking improved governance and donor lending levels. 29. EMPHASIS ON LOCAL/PRIVATE SECTOR IMPLEMENTATION. We are thus proposing a strategy which would both put much more emphasis on local/private project implementation and social inclusion at that critical level, while at the same time working more systematically to strengthen central Government's crucial responsibility for monitoring and evaluation. We would focus a greater proportion of our financing-through LILs and regular credits-on those Districts which are starting to work with stakeho]lders and the private sector to manage resources in an efficient and transparent manner. While there is danger that this strategy will favor the better-off Districts-an initial analysis showed that the Districts making progress on decentralization were on average slightly above the median-the expected effect is that it introduces competition between Districts for donor resources, hopefully raising the capacity of all. Stakehoider involvement in the design, implementation and operation/maintenance of District projects would be a key criterion in this allocation process. So too would community cost-sharing as a sign of genuine beneficiary commitment. There are good reasons for choosing this moment to accelerate support for districts which are working with local stakeholders and the private sector to improve the productivity of resource use: * The new Local Self-Governance Bill is an important signal of the government's renewed commitment to giving more power to the Districts. It would allow District Development Committees to set up their own sector management units, replacing the concerned central line agency (although the national Government would still have the right to depute staff to these District managernent units). * We have begun to see results from the Government's and donors' efforts to strengthen District level absorptive capacity. These efforts have been supported in twenty Districts by the UNDP Participatory District Development Program (with support in a further twenty districts now being provided by the Local Governance Program), by similar District institution-building initiatives supported by DANIDA, NORAD and SNV, and by sector-specific initiatives such as those in rural infrastructure backed by IDA2, ADB, SDC, GTZ and WWF. * UNCDF is proposing to set up a District Development Fund to provide program support to Districts where institutional strengthening is well underway, and, if successful, we should consider providing additional support as needed using IDA's larger resource availabilities. We would earmark a substantial proportion of our support for Districts where there is a demonstrated interest and capacity among local officials and stakeholders to become involved in improving the quality of social sector service delivery. * We are preparing a test for this new approach through a LIL which will support demand-driven, labor-based road maintenance in those districts-and only those districts-which have proven capable of handling such a decentralized approach. Beneficiaries will be closely involved in design, construction and maintenance. This is the first stage of a longer-term effort to move management of rural infrastructure to the District level. 2 The Pilot Labor-Based Road Rehabilitation and Maintenance component of the ongoing Road Maintenance and Rehabilitation Project.  - 15 - 30. INVOLVEMENT OF WOMEN. Similarly, it is essential to increase the participation of women in development activities. Women continue to be mostly employed in agriculture, as opportunities in the off-farm sector are almost non-existent. The dismally low level of female literacy and the health hazards associated with pregnancies constitute an additional barrier to women's opportunities. Yet, few agricultural programs are designed to reach women, and the number of female teachers and health workers remains very low. Decentralization initiatives may increase the potential for women to participate, if they are accompanied by complementary programs to draw women into the implementation of project activities. 31. IMPROVING THE DISSEMINATION OF INFORMATION. If this new approach is to work beneficiaries need to be informed of the services that they are supposed to receive, and better able to monitor the flow of funds. We will make an effort in new projects-and in the supervision of existing projects-to ensure that the Government makes better use of available media, especially radio, to educate people as to what services they should be receiving. We will also use the District Information Centers being established under the Participatory District Development and Local Governance Programs. Thus, for example, we will ensure that farmers are aware that they should be receiving visits from agricultural and veterinary extension agents, rather than traveling long distances themselves to visit the agents' offices. On-site advice and care of crops and livestock could make a significant impact on agricultural productivity compared with academic discussions in a District office. We will also prepare a regular newsletter in Nepali and English describing IDA-supported initiatives and the services they should be delivering, as well as giving other donors and NGOs an opportunity to contribute news of innovative projects or programs. A forum for comment and discussion on the effectiveness of current development programs will also be provided. At the same time we will work to ensure greater transparency in the flow of funds and greater cost awareness at the local level, with the use of public boards indicating the planned flow of funds under project sub-components. 32. DONOR COORDINATION. Donors' effectiveness needs to iimprove through more cooperation and less competition. We and UNDP have taken an active role in overall and sector-specific aid coordination, jointly chairing regular donor meetings in Kathmandu. And at the next Aid Group meeting we plan to have an extended session on how donors' rural development aid can collectively support the major elements of the Agriculture Perspective Plan, which is the cornerstone of future rural income growth. This will be a test case of the donor community's willingness to work together to help improve aid effectiveness. We will also try and encourage joint or concurrent missions with key donors to help ensure better harmonization in policy guidance and project design. But ultimately the key is the Government's own control over donor aid. Our Public Expenditure Review will provide the analytical basis for Government to rationalize their donor assisitance requests, while also helping the Government to channel and leverage its own limited public expenditure resources to maximum effect. On economic issues we have coordinated closely with the IMT7 and the ADB, for example in our joint work with the Government in 1995-96 on a draft Policy Framework Paper. 33. GOVERNMENT OWNERSHIP. Donor assistance has not only shielded Nepal from underlying structural problems, but it has also tend& J to substitute for the creation of national capacity to plan and implement development programs. In many sectors donors have major-and sometimes inconsistent-roles in managing public expenditures. The Finance Ministry and the National Planning Commission are aware of the damaging effect this has on the integrity and sustainability of the devel- opment process, and want to take steps consistent with our Partnership for Development strategy to ensure that the Government as a whole takes greater responsibility for shaping and managing the development process. In the current country environment, as described above, this will not be an easy  -16 - endeavor, but it deserves our full support since it goes to the heart of the institutional challenges Nepal faces today. A miove to greater local project and program management is one important step in ensuring that Nepal and not its donors control the key development decisions. Indeed, the importance of greater local responsibility for project design, implementation and operation was one of the strongest messages at our rural CAS discussions (see paragraphs 21-22). B. GOVERNANCE 34. LMPROVING IGOVERNMENT IMPLEMENTATION CAPACITY. For this approach to work central Government will need to make significant improvements in its capacity to manage resource flows efficiently and monitor their use effectively. At present the central government interferes too much in some areas (teacher hiring for example), and too little in others (for example ensuring that health workers, agricultural extension agents and veterinarians actually go out into the field). At the more general policy level, too, central government has often made local/private sector involvement more difficult, with excessive control by parastatals over areas such as sugar production and forest product marketing. We will thus work with other donors to link our collective lending much more closely to improved governance within each sector. Already in education we are collaborating with most key donors on a common core program, whose financing would be linked to Government progress in improving educational quality. Indeed our goal more generally is to match the overall level of donor aid in each sector to the government's ability to carry out its fiduciary responsibilities and ensure the quality of the investments or services it provides. We will work closely with the donor community to achieve this sector-by-sector, but where we cannot reach a common understanding we will lead by example by conditioning our own lending envelope on improved governance (see Table 1 and Annex Al). 35. NEXr STEPS ON GOVERNANCE AND CORRUPrION. The challenges of improving governance and reducing corruption were discussed with the Government and other stakeholders during CAS preparation. * The Government has recently requested the Bank for assistance in tackling the problem of corruption in donor-assisted projects, which they see as resulting inter alia in implementation delays and shortcomings in the quality of project execution. This request received considerable publicity in Nepal. We are now working with the Government to define the measures which should be taken and the ways we can assist in their implementation in order to initiate serious efforts at remedial action. * We will also support improvement in central government's overall capacity when and to the extent the political situation allows, in response to the Government's request for assistance on the broader governance issues. We will coordinate closely with ADB's work on civil service strengthening, focusing on specific weaknesses in fiscal and public expenditure management, such as deficiencies in the tax administration which affect revenues. We plan to address such institutional issues through our lending and ESW. The Public Expenditure Review-the cornerstone of our ESW- will focus not just on the allocation of resources, but also on how government resources as whole can be more effectively managed. In addition, we have ongoing studies which pay close attention to institutional issues in health, education, power, land resource management and rural development.  - 17- C. IDA LENDING LEVELS 36. LINKING LENDING TO PROGRESS OF REFORMS. Given the political and economic uncertainties, we are proposing a Low Case which starts at zero lending. This would-if conditions should again deteriorate -- drive home the message that business as we have had it in the past cannot continue and that serious action is needed. Beyond this pessimistic scenario, we propose an approach which will remain flexible and, to some extent, even opportunistic: we must be ready to seize opportunities for constructive cooperation and action where circumstances arise which make reform possible or even promising. If the momentum for reform accelerates after the elections, we will work with Government on a more systematic and longer-term reform and development agenda that we could support in a major way. The degree to which the government will be able to take action on a reform agenda will depend to a large extent on its political strength. The basic scenarios described below reflect this uncertainty, and a reassessment of our strategy may be called for after the elections. In the meantime we envisage three lending scenarios (summarized in Table 1). 37. PARAMETERS FOR BANK ASSISTANCE. The key parameters determining the level and nature of our future assistance will be: * Progress in administrative management, measured by: (a) implementation of administrative decentralization measures; (b) initiation and implementation of measures against corruption; and (c) civil service reform, starting simply with compliance with existing rules and regulations (such as those concerning staff transfers) and with existing obligations under projects (such as those relating to the regularization of teachers or health workers recruited under Bank-financed projects) and proceeding to long-standing key issues (e.g. incentives for field work, numbers and remuneration of civil servants). - Progress in overall economic management, measured by: (a) sustained turning around of budget management, both in terms of revenue collection and prioritization of expenditures; (b) cooperation in the execution of the PER and implementation of its recommendations; (c) creation of a competitive private sector environment, including further privatization; and (d) implementation of critical reforms to strengthen the financial sector. I. LOW CASE 38. CRITERIA. This assumes renewed deterioration in economic management and governance: renewed budgetary slide, deterioration of the security situation, continued government inertia and inaction, delaying important decisions on assistance strategy and/or project issues. Specifically, the low case envisages: * No sustained recovery in revenues, and an increasing budget deficit. * Continued poor management of public expenditures, with a further increase in the number of projects in the public investment program and a resulting failure to adequately fund donor-assisted and other priority projects. * No progress on financial sector reform, privatization or civil service reform. * Only slow progress in decentralization and improvements in district level project and program implementation. * Continued strong indications of high levels of corruption and misuse of funds without serious attempts at remedial action. * Little or no improvement in efficiency of the central government.  -18 - 39. ASSISTANCE OPTIONS. If all these conditions applied, the country's development path would not be sustainable. Further lending would simply add to the country's debt burden, and we would need to look to non-lending services to help Nepal's decision makers face the reality of the drastic reforms that are needed. A slightly less pessimistic scenario is one in which the country is in danger of sliding towards a full-blow"n Low Case, although with limited progress being made on some of the above parameters. Under these circumstances we would maintain a small arnount of lending-up to $150 million in FY99-01-where there is support for tangible Government reform addressing some of the issues listed above, notwithstanding the lack of progress on the overall reform agenda and the deterioration of the country's macro-economic situation which define the Low Case. Potential examples of operations deserving our support even under such dire circumstances are highly decentralized initiatives that can have a substantial impact on poverty despite a weak central government. A case in point could be a second rural water supply project, which would support community-managed water supply schemes and free up women's time for productive activities. Other possibilities include community-driven projects for health, rural roads or irrigation, maybe in the form of LILs which develop procedures for effective delivery of assistance at the local levei. ESW as a basis for further dialogue with the government on necessary reform measures would continue, as would project preparation where feasible to ensure that we could swiftly restart our financial support once conditions improved. rI BASE CASE 40. CRITERIA. This covers a broad range of situations and corresponding lending scenarios. The political uncertainty makes it very hard to predict the will for reform, and whether it can be acted upon and maintained, andl this makes a range necessary. At the lower end of the range, the Base Case assumes stabilization of the situation by the government, and thus no further deterioration in economic and administrative management, but also no major turn-around. Specifically, lending at the lower end of the range would require: * A continued reversal of the recent sharp decline in real revenues, with domestic revenues as a share of GDP remaining at or above 11%, and domestic borrowing below 2% of GDP, and satisfactory implementation of VAT. * Improved management of public expenditures, with no further increase in the number of projects in the public investment program, and adequate funding for donor-assisted and other priority projects. 41. BEYOND STABILIZATION. If, beyond stabilization, a maybe modest, but clear reform effort can be started, this would be reflected in steps such as: * Tangible progress in decentralization and local self-government, with greater local involvement in the management of development programs. * Action on improving central Government administrative performance, such as stricter enforcement of rotation rules. * Privatization of three public enterprises, and improvement of the efficiency and transparency of privatization procedures and decision-making processes. * Introduction of three-year rolling investment program, and full funding of core programs and projects. * Progress in restructuring RBB and preparation of its divestiture, completing the privatization of NBL, improving banking regulations, and progress in improving NRB's supervisory and regulatory capacity.  - 19 - * Progress in telecommunications reform, including introduction of competition. * Introduction of new measures to reduce corruption. 42. ASSISTANCE OPTIONS. Our lending levels under the Base Case would depend on how much progress is achieved on this reform agenda. At the lower end, with stabilization of the situation to lay the basis for more proactive reform, an amount in the order of US$200 million for FY99-01 is envisaged, to build some reform momentum and encourage, both at the level of government and public opinion, more energetic action. As elements of the above reform agenda materialize, the 3-year envelope would increase up to a maximum of US$350 million. III HIGH CASE 43. CRITERIA. For this scenario, we would need to see a major reform agenda, clearly defined, and a decisive start on implementation action, translating into the following steps, over and above those mentioned in paragraph 41 above: * An increase in revenues to over 11.5% of GDP, and a fall in domestic borrowing to below 1% of GDP. * Elimination of unbudgeted expenditures except where justified by unforeseeable circumstances. * Privatization of 7-8 public enterprises, and tangible progress in privatizing the larger public enterprises such as the telephone company and the airline. * Divestiture of RBB, and build-up of strong NRB supervisory and regulatory capacity. * Civil service reform, with marked improvements in terms of turnover, more rapid decision making, and improved service delivery in the field. * Significant decentralization, with widespread, substantial improvements in the implementation capacity at the DDC and VDC levels. 44. ASSISTANCE OPTIONS. Implementation of such a reform package would increase the country's absorptive capacity, thus justifying a gradual further increase in assistance, bringing the total to of the order of $400 million for FY99-01 or more, depending on the outcome of a mid-term progress review. D. IMPLEMENTING THE ASSISTANCE STRATEGY 45. STAKEHOLDER SUPPORT. It is important to communicate our analysis and strategy not only to Government but also to the public as a whole, so that all stakeholders realize how serious the situation is. It is also vital that our strategy be supported by the donor community as a whole. There is a danger that external aid will continue to shield Nepal from the full extent of its economic mismanagement, merely postponing-and deepening-the eventual inevitable crisis, until the situation finally deteriorates to the point where circumstances force painful emergency adjustments on Nepal. To preclude this possibility, we will call upon other donors to share in our strategy, ensuring that it is fully credible and effective. 46. LINKS BETWEEN THE STRATEGY AND IDA'S PORTFOLIO. The strategy of focusing on ownership, development results and governance can only be credible if we show a willingness to suspend lending where goals are not being met. We have already moved a long way in establishing tougher standards (see paragraph 25 above). These efforts will continue, with a renewed focus on realistic supervision assessments which will provide early wamings on project failures. The Bank will continue to work in partnership with the Government in pursuing results-oriented portfolio  - 20 - management and in developing an action plan to ensure that sound financial management is in place for all projects, so that the Loan Administration Change Initiative (LACI) can be implemented successfully in Nepal. 47. SEcroR STRATEGIES, BENCHMARKS AND ECONOMIC & SECTOR WORK. The sector strategies which emerge from this assistance framework are detailed in Annex 1, and the benchmarks for measuring sectoral progress are described in Annex Al. We will continue to develop our economic and sector work, both as a basis for the policy dialogue with Government and civil society more generally and for future operations. A major Public Expenditure Review is aimed at improving the allocation and-as importantly-the management and control of public resources. It is hoped that it will-in conjunction with the support of the ADB and other donors for civil service reform and decentralization initiatives by the Government-lay the basis for significantly better service delivery by Government and, subsequently, for more productive yearly joint reviews of budgetary priorities. Our economic reports will continue to provide the basis for dialogue on accelerating the pace of economic reforms and improving the policy framework. A study on Indo-Nepal trade should provide a better understanding of the linkages between the economies of Nepal and India and their implications for Nepal's economic policy management, as well as identify ways for Nepal to take better advantage of the huge market of its major trading partner. Other studies already under way or yet to be launched should help improve the linkages between sectoral policies and overall development strategy, as well as provide a rational basis for possible assistance operations. These include studies focusing on the causes and effects of poverty, terai rural development opportunities, education and health reform, land resource management, the financial sector and energy development. 48. ROLE OF EDI. EDI plans to offer a series of learning activities with the aim of creating national capacity and indigenous skills to formulate and implement the country's development agenda. These activities would support the overall strategy in the areas of building institutional capacity for local management of projects, governance, and economic management. To help create local capacity in project selection, bidding, negotiation, and award of government contracts/concessions, training activities in project appraisal and management are envisaged. In the area of governance and anti- corruption, EDI will conduct a Service Delivery Survey in a targeted sector. Training may also be designed to providie grassroots management training for poor women, and for government officials in linkages between growth and poverty, fiscal decentralization, and microfinance. EDI will also continue to support increased involvement of stakeholders in the operation and maintenance of irrigation projects, and will in addition look for opportunities to provide such support in rural water supply, roads, and forestry schemes, in close coordination with the sector management units. 49. IFC's STRATEGY. IFC has been actively participating and plans to further increase its role in helping Nepal establish a strong physical infrastructure and well-functioning markets, as well as reforming and restructuring its financial sector. In infrastructure, IFC's strategy remains to support privately financed small- and medium- sized hydropower plants. IFC is also interested in supporting the telecommunications sector, once the Government provides a sound regulatory environment and fully opens up the sector to private participation. In both cases, co-ordination with IDA is crucial. IFC is further planning to continue its institution-building role through the development of viable financial firms which benefit from the expertise of strong foreign partners. Aside from its planned investment in the leasing sector, IFC is seeking out further investments in project finance and small enterprise lending. While of somewhat lower priority, IFC will also consider industrial and tourism projects, which would contribute to economic development and foreign exchange earnings.  -21 - E. RISKS 50. RISKS FACED BY THE NEW STRATEGY. Our strategy faces a number of risks which could arise either from the internal or external environment: (a) Increased political instability and uncertainty. A weak and unstable Government distracted by tactical political maneuvering and the corresponding need to please many constituencies would make implementation of reform difficult. And there is a risk that political blockage and inaction would produce increasing social unrest which could further complicate the political situation, and even compromise security, impeding Governmnent and donor operations and other economic activities. The wide range of lending options will allow us to respond flexibly to any such developments, matching our lending and other support to absorptive capacity, measured in terms of prospects for reform and development results. (b) Economic dislocation and lack of donor coordination. In case implementation of the strategy should require substantially lower new lending commitments by IDA, and other donors follow this approach, the reduction in resource transfers could have a substantial impact on Nepal's balance of payments and its formal economy, if this were to happen abruptly. This negative impact would occur long before a turnaround in the implementation of reforms and renewed assistance and aid effectiveness would start to produce the development results and economic growth which are the objectives of the strategy. The donor community as a whole would therefore need to implement this approach in measured steps while monitoring carefully how Nepal's economic parameters evolve and if the reforms to be supported through the strategy start taking place and producing results. Successful CAS, implementation will thus require much more donor coordination of assistance than in the past. This will also be necessary because, in the absence of such coordination, the approach of linking IDA's financial support to progress in reforms cannot be effective. Given the growing recognition among donors that radical changes are needed to enhance aid effectiveness, our continued efforts at donor consultation and coordination should mitigate these risks. (c) External risks. The inevitable linkage of Nepal's economy to India is a major exogenous factor affecting Nepal's development and thereby implementation of the CAS. A significant reversal of the steady improvement in Nepal's trade and other relations with India would adversely affect prospects for exports, private investment and economic growth in Nepal. We will carefully monitor developments in these areas and support ongoing efforts among the countries in the region to strengthen their cooperation. 51. These risks are significant. But we believe that the strategy presented in this CAS holds out the hope that the many millions still in poverty in Nepal will be empowered to help themselves. James D. Wolfensohn President By: Caio Koch-Weser  -22 - Table 1: Lending Triggers SCENARIO LENDING LEVEL TRIGGERS (FY99-O1) Low Case $0-150m * No sustained revenue recovery and a rising budget deficit * Poor expenditure management, inadequate funding for priority projects * No action in financial sector and civil service reforms and privatization * Continued strong indications of high levels of corruption and misuse of funds without serious attempts at remedial action * Slow decentralization efforts Base Case $200m-$350m * Domestic revenues as share of GDP at or above 11.0%. * Satisfactory implementation of VAT * Domestic borrowing below 2% of GDP * No increase in number of projects under public investment program * Three year rolling investment program, and full funding of priority proj- ects and programs * Privatization of three enterprises, improvement of privatization procedures, and introduction of competition in telecommunications * Good progress in RBB restructuring and preparation of its divestiture. * Tangible progress in decentralization, and local self-government, with greater local involvement in the management of development programs * Improved central Govemment administrative performance, e.g. stricter enforcement of rotation rules * New measures to reduce corruption High Case $400m (or more*) * Revenues over 11.5% of GDP and borrowing below 1% * No unbudgeted expenditures * Privatization of 7+ enterprises and tangible progress in privatizing the larger public enterprises such as the telephone company and the airline * Divestiture of RBB and strong build-up of NRB supervisory and regulatory capabilities. * Civil service reform, with marked improvements in terms of tumover, more rapid decision making, and improved service delivery in the field. * Decentralization, with widespread, substantial improvements in implementation capacity at DDC and VDC level. * Subject to midterm progress review.  Annex 1 Page 1 of 8 SECTOR STRATEGIES Agriculture 1. With the number of rural poor increasing in Nepal, and 80% of the labor force in agriculture, faster agricultural growth is crucial. Achieving this goal has been constrained by: a rural socio-economic system that has significant feudal characteristics, including an archaic land tenure and labor system (instances of bonded labor are prevalent); topography and location which make trade and infrastructure investment and maintenance costs extremely high. Aside from the Terai zone there are few areas suited to large scale agricultural development, although there is some potential in the hills for intensive horticulture. 2. The main lessons from 25 years of agricultural lending are that project and program development is slow, and that sustainability has suffered from poor quality at entry and insufficient emphasis on policy reforms, stakeholder participation, and monitorable indicators. Policy dialogue has been sporadic except in the irrigation sector where we have had substantive discussions in the context of the FY98 Irrigation Sector Project. The sector has been over- centralized, making area development projects particularly problematic. Recently, however, the Government and donors are looking much more to a decentralized approach through local communities and governments. 3. Our strategy will focus on support for implementation of the Agriculture Perspective Plan, including the prioritized agricultural investment program now being prepared. Within the APP framework, we will likely focus in particular on irrigation and food crop development in the Terai, where the majority of the population lives, and on promotion of high value crops (including for agro-industries) and sustainable natural resource management in the hill areas. Rural infrastructure development (roads, telecommunications and market development especially) will closely complement our activities in both regions. We will emphasize: (a) being more client oriented and demand driven at the grass roots level in setting our priorities; (b) carrying out critical economic and sector work to support our lending, including a major water resources strategy, which will tie into our work on regional integration; (c) ensuring projects are better prepared at entry, better targeted, implemented and coordinated, and take into account the lessons leamed from previous IDA financed and other donor investments; (d) greatly increasing the role of local and district stakeholders in project preparation, implementation and operation and maintenance; and (e) closer donor coordination. 4. Future lending will have a strong policy orientation, and will emphasize quality at entry, with up-front policy reforms as necessary. Areas of possiblie lending intervention include groundwater development in the terai, rural water supply (based on the successful experience of the ongoing project), and rural/area development projects (using LILs and APLs) in the Terai and hills, to be implemented by VDCs and DDCs to capitalize on the current decentralization policy of the client. Our economic and sector work will focus on subsidies on capital investments and on the operation and maintenance needs of public irrigation systems. Other critical topics include public expenditure trends and effectiveness, public sector management, land tenure and related social issues, off-farm employment and agro-marketing opportunities.  Annex 1 Page 2 of 8 Forestry and Land Management 5. Forestry i's crucial not only in terms of timber production, but also to the sustainability of agriculture and rural life through the provision of fuelwood, biomass and fodder. The Bank, along with other donors, has played a key role in reviving community forestry and reversing the deforestation in the hills. In 1992, the World Bank undertook a review of 25 years of experience of natural resource management in Nepal. The review identified the urgent need for support to the sector, for as natural capital deteriorates, the possibility of devising viable strategies diminishes. The need for an integrated approach linked to policy changes substantiated by a systematic economic analysis of the costs and benefits of sustainable and biodiversity friendly management practices was also identified. Future Bank lending will take these lessons to heart. As a first step we are preparing a Land Resource Management Study in preparation for a follow- up project, which will take a more integrated approach to the forestry sector as a whole. 6. The study is: * Examining the costs and benefits of existing forest use from three perspectives, individual and community, national, and global, with a particular focus on their impact on biodiversity and the sustainability of agricultural production systems; * Examining the causes of the divergence between private and public costs and suggesting measures to reduce this divergence through the introduction of more sustainable practices or management systems, or making changes in policy, institutions, or regulations, in the light of known social or political constraints; * Prioritizing areas for change, recommending different sub-regional strategies according to the management programs and environmental or other constraints predominant in each of the physiographic regions of Nepal; - Identifying ways in which IDA support could facilitate the implementation of necessary changes and introduce innovative programs and financing mechanisms for the management of a range of forest products. * Follow-on IDA and GEF projects will emphasize the mainstreaming of biodiversity conservation using innovative funding mechanisms, such as the development of a Biodiversity Trust Fund. Infrastructure 7. Better infrastructure is a precondition for broad-based growth in Nepal. Without a more comprehensive all-weather road network access to agricultural inputs and ready marketing of crops and produce will be impossible, and access to education, health care and modem agricultural techniques will continue to be greatly constrained. Without more hill roads horticulture cannot grow. We will thus focus on: 8. More efficient infrastructure spending, along the lines of the recent transport-sector Priority Investment Plan, which was completed in February 1997 with IDA assistance and identified priority projects for sustainable development of the strategic and rural transport  Annex 1 Page 3 of 8 network for 1997-2006. IDA will support balanced investment in rehabilitation and maintenance of existing assets, complemented with cost-effective and environmentally sound construction and maintenance of priority feeder roads and district roads, and an, emphasis on a balanced approach between investments in strategic and in feeder roads to realize the potential of previous road investments. * Decentralization and local government capacity building. While the Government has embraced decentralization for local development, there is a lack of capacity for planning and managing rural infrastructure development in the district and village development committees, as well as in the central Ministry of Local Development (MLD). Our operations in rural infrastructure will emphasize building up the capacity of local governments, and assisting MLD to strengthen its role in monitoring and providing policy guidance to the development activities of local government. * Capacity building at the central agencies. In the roads sector IDA will continue to assist in to improving the planning and monitoring capability of the Department of Roads (DOR), and encourage DOR to concentrate its resources and efforts in managing the strategic network with improved financial and administrative management practices. * Supporting beneficiaries, NGO participation and private sector involvement. As part of the strategy of local government capacity building, IDA's operations in roads and rural infrastructure will pursue the approach of increased beneficiary and NGOs participation dur- ing project preparation and implementation. Private sector involvement will be actively encouraged in the construction and maintenance of infrastructure and other feasible areas, inter alia following up on the recommendations of the recent FIAS report on foreign direct investment. 9. Our lending will support these objectives, and at the same time invest in selected priority infrastructure projects that will bring maximum impact on poverty reduction. The proposed operations include (1) Road Maintenance and Development Project, which will focus on the strategic network and DOR; (2) Rural Infrastructure Projects, which will concentrate on local governance and district roads using an adaptable program lending approach; (3) Public Expenditure Review, which will assist the implementation of the strategy and expenditure prioritization. The success of this operational support depends on the Government's commitment to pushing through institutional and policy reforms. 10. Our lending in the urban infrastructure and urban environment sector will depend on the outcome of the restructuring of the largely unsuccessful Urban Water Supply and Sanitation Project, which now is to support handing over management of the water utility in the Kathmandu Valley to the private sector. In addition, under the Public Expenditure Review exercise, which is on-going, an Urban Development Sector Review will form the basis for determining the extent of our future involvement in the urban sector. Such an involvement could possibly follow a city assistance strategy approach, based on individual cities' commitment to address urban problems. In the urban environment sub-sector, the Government's strategy is to avoid adding to the numerous donors already involved. We are discussing working with ADB to provide some overarching assistance in setting the policy framework for multi-donor assistance in the urban sector, including the urban environment.  Annex 1 Page 4 of 8 Power 11. Only 15% of Nepal's population currently has electricity, and the Govermnent wants to exploit Nepal's vast hydro-electric potential, estimated at about 43,000 MW, of which only about 260 MW has so far been developed. To this end the Government's 1992 Hydropower Development Policy encourages private sector investment, both domestic and foreign, in all areas of the power sector, to overcome public sector capacity constraints. It also aims to: (i) expand transmission and distribution systems, including rural electrification to assist in agricultural production and cottage industries; (ii) improve the quality and reliability of electricity supply; develop small hydropower projects both for connection to the national grid and to meet demand in isolated areas, and district-level projects under decentralization schemes to meet demand in hilly and remote areas; (iii) utilize indigenous labor, skills and resources to complement foreign investment and technology; (iv) develop electric vehicles, including three- wheelers, to reduce pollution and petroleum imports; and (v) rationalize tariffs. Government priorities also now include biogas, solar and other forms of alternative energy. 12. Especially given Nepal's unhealthy dependence on aid as a source of Government revenues and foreign exchange, hydropower development will be a crucial long-term component of sustained growth. The Government's strategy has been to seek donor support for hydropower projects while creating a policy and regulatory framework which will increasingly encourage private finance to invest in the sector. Significant progress has been made, with 285 MW of generating capacity in the pipeline (including the ADB-supported 144 MW Kali Gandaki project and the IFC-supported 60 MW Khimti Khola and 36MW Upper Bhote Koshi projects). This additional capacity will be enough to double domestic power production by 2002 and meet pro- jected domestic demand in that year. IDA also hopes to present to the Board soon a project supporting: (i) expanded transmission and distribution, and better interconnections with the Eastern India and Northern India grids so as to increase power exchange; (ii) a Power Development Fund, which will serve as a catalyst for long-term private investment in small and medium size projects that have passed through an extensive screening and ranking exercise, including environmental and social criteria. The Government is at the same time beginning to explore the options for private sector finance for large hydropower projects for export purposes. 13. We will integrate our initiatives in the power sector into an overall approach to water resource use through the development of an overall water resource strategy as part of the Irrigation Sector Credit. This will allow assessment of the optimum joint use of water projects for both irrigation and drinking water and power. We also hope to help develop, through an Energy Sector Strategy, a more coherent approach to implementing structural changes in Nepal's power sector, developing rural energy supply, and advancing the export of hydropower. Health and Population 14. The challenge of Nepal's health and population problems is enormous. Health indicators are among the worst in the world, and mortality remains high despite some recent declines. As worryingly, population growth remains high, threatening the gains from other developmental efforts. Donor-supported efforts to improve health and family planning standards have suffered from the absence of a well-coordinated and cost-effective approach to the planning, provision, and financing of health care. The IDA-supported Population and Family Health Project has been hampered by slow decision-making and staff changes, although it has picked up momentum  Annex 1 Page 5 of 8 since the extended Mid-Term Review in 1997. Despite almost universal knowledge of family planning methods, only 31 percent of married women use a modem method, partly as a consequence of a lack of timely counseling. And the ability to meet future demand is threatened by increasing supply constraints. Public expenditure in health represents merely two dollars per capita annually, the quality of service is poor, and the sector suffers from over-centralized planning, budgeting and implementation, slow decision-making, high turnover of managers and service providers, lack of essential drugs in many health posts, widespread absenteeism in the remoter areas, lack of program ownership by the local communities; and little involvement of the NGOs and the private sector in the planning, delivery and financing of HNP services. While the poor, especially those in remote areas, often have to turn to unqualified providers for essential care, the relatively better-off often rely on hospitals that may lack appropriate quality control. Cost-recovery thus has particular potential in the tertiary sector if quality can be improved. 15. Given this context, the vision for the sector for the near future needs to be realistic and simple-cost-effective delivery of the most essential health services, with special attention to the poor and under-served populations. The goal would be to ensure a package of affordable, sustainable and prioritized interventions, based on burden of disease, reproductive and child health needs, nutrition, equity and quality of care considerations. We will focus on: (i) a clear policy framework to pursue the above goal, backed by unambiguous political commitment; (ii) increased emphasis on decentralized/private sector management of health service delivery, along with improvements in administrative and planning capacities at the central level; (iii) resource mobilization and utilization much beyond the current levels if absorptive capacity justifies, and effective donor coordination; and (iv) consolidating critical components of primary health care and building a functional first level referral care system at the district level under the public sector, with adaptations to specific local needs-with Govermient playing a facilitating and regulatory role for the private sector with respect to specialized tertiary care. Public-private partnership will be especially important in the urban areas. In the Kathmandu Valley and major industrial municipalities and VDCs of the Terai, the opportunities for promoting collaboration between the public, private, and non-governmental sectors are already considerable and will become larger over time. The public sector will be able to focus a larger share of its efforts on the finance and regulation of health services that will be increasingly provided through private and non-governmental mechanisms. Finally, Nepal's health sector has had both the opportunity and the burden of extensive collaboration with Nepal's foreign partners. Improving the efficiency and effectiveness of foreign assistance to the health sector will require that continuous efforts be undertaken to move toward sector wide approaches to such assistance, and to the donor's increasingly working in a more consortium like manner Education 16. Nepal has come further in improving education than in irnproving health conditions. Gross enrolLment rates are very high, and access to schools is impressive (almost 90% of school-age children can reach schools within 30 minutes) given the remoteness of much of the population. IDA's support under Primary Education Project, Earthquake Schools Rehabilitation Project and Basic and Primary Education Project (BPEP) has contributed significantly to this end. Education quality, however, is often poor. Participation rates are low, retention poor, and sector management is weak, particularly for implementing the much needed decentralization of the financing and management of schooling. In fact since the early 1970s, the central government has assumed many powers and responsibilities once exercised by district and local educational  Annex 1 Page 6 of 8 authorities. Som.e consequences are weak administrative capacity at the district level, shortage of qualified personnel, and a lack of community ownership of schools and an unnecessarily high burden on the Government budget. Large subsidies to higher education add to the budgetary burden. Teacher absenteeism is high, reflecting low accountability of the system due to weak management and supervision of schools as well as the lack of effective community involvement. Many professional functions such as curriculum renewal, teacher training, and design of non- formal education programs have been performed by the donor-supported BPEP. 17. Due to poor quality of education in Government schools, parents who have the means are increasingly sending their children to private schools, and this trend is increasing every year. Although primarily an urban phenomenon, private schools are opening in semi-urban and some rural areas as well. Many teachers in Government schools also send their children to private schools. Private enrollment at the primary level is around 8% but it is more than 30% at the secondary level where there has been much less Government involvement. 18. The proposed second Basic and Primary Education Project would introduce more decentralized implementation arrangements, supporting implementation of the Government's plans to devolve responsibility for the management and financing of schooling with the intention of raising overall accountability of Government schools. We envisage: (i) the progressive introduction of "lbottom-up" planning, budgeting and monitoring by local bodies, who would have responsibility for implementing comprehensive school improvement plans; (ii) priority setting and supervision of implementation at the district level with particular focus on teacher rationalization anid school mapping to sustain the program; and (iii) improvements in classroom processes and practices through continuous assessment, better use of instructional materials, recurrent teacher training and more effective academic supervision and teacher support mechanism. The project would aim to raise the net enrollment ratio from less than 70% to 90% by 2003. Educationally and socially disadvantaged groups which have low rates of participation and poor retention, especially girls, would be targeted for project interventions. The project aims to increase the primary cycle completion rate now about 40% to close to 75% by 2003. 19. We are also supporting two higher education projects and we are currently reviewing overall needs in the education sector. One of the issues we are studying is the rapidly increasing demand for secondary education as primary enrollments and completions accelerate. We recognize that the probItm is particularly acute at the higher secondary level and for private schools where the absence of regulation is especially worrisome. We will consider supporting reform and investment in the secondary education sector, particularly the higher secondary level, if our analysis confirms sufficient commitment for reform and willingness to implement cost- effective strategies that ensure a supply of qualified graduates to the job market. Financial Sector 20. As mentioned in paragraph 12 of the main text, there are very serious problems in the financial sector, with the two largest banks in poor condition. The Bank has been working with the Government inI reforrning the financial sector since 1990, but its continuing weakness shows that our strategy has not been fully successful. Consequently our future work will focus on those areas in which our expertise, and/or lack of other donors interest will provide the biggest return from our investment in terms of time and money effort. Specifically we will focus on four core areas:  Annex 1 Page 7 of 8 * help the Government restructure and privatize the two commercial banks, RBB and NBL. Such assistance should result in the exit of the Government from all commercial banking activities, an efficient operation of private commercial banks without lending or branching restrictions, * support NRB's regulatory and supervisory Department to reach the required levels of technical capacity, administrative autonomy and staff numbers to reduce systemic risks in the financial sector, * create a simple and uniform legal framework for the operations of Nepal's financial system; and * establish private financial institutions, using IFC's capacity to take corporate risk and to bring in strong technical partners to achieve a transfer of know-how. 21. We would implement this strategy through two credits, supported by an ongoing PHRD grant. The first could support strengthening of financial regulation and infrastructure and could be funded by a LIL, which can be processed very quickly. The speed of processing will depend on the government's actions in completing project preparation, implementing financial policy reform measures and taking actions to privatize NBL. The second part of the reform program would support the restructuring and privatization of RBB and would be financed by a Financial Sector Development Credit. Processing of this project would be contingent on progress in implementing the LIL, completing the studies for RBB, implementing the study's recommenda- tions, retaining a financial advisor for the sale and commissioning an independent portfolio review. IFC's investment and lending activities will complement this approach by strengthening the capacity of the private sector to intermediate capital. Given the very limited availability of domestic term finance, IFC will initially focus on leasing and project finance companies. The success of such companies will however depend on the introduction of adequate regulation as well as the reduction of distortions in the domestic financial nmarket. IFC is also supporting the necessary changes in leasing regulation to make leasing a viable financing instrument. Telecommunications 22. Nepal's telecommunications coverage is low, reflecting iin part the small size of the urban population. Fewer than one in a hundred people have a telephone, one of the lowest ratios in the world, and main telephone line growth has failed to meet demand for basic services, particularly in semi urban and rural areas. The Nepal Telecommunications Corporation (NTC) has been a monopoly provider of basic services; while line installation costs have been remarkably low, the monopoly has not been conducive to commercial operations and consumer orientation. Recently, however, the Government established a regulatory agency, the Nepal Telecommunications Authority, and has taken initiatives to privatize NTC and introduce competition in basic, cellular and other services by private operators. 23. To date IDA-supported projects in the telecommunications sector have had unusually few implementation problems, with very successful donor cooperation. We aim to build on this successful record through a proposed Telecommunications Sector Reform Credit, which would continue to support public sector intervention in the rural areas, but would help move urban telecommunications services to the private sector. To this end we would support the  Annex I Page 8 of 8 Governent's efforts to: (i) ensure the efficient operation of NTA and of a frequency management and monitoring system; (ii) introduce competition, including facilitating interconnection between public/private networks; (iii) advise on conversion of NTC under the Company Act and eventual privatization; and (iv) expand the availability of rural telecommunications, with the aim of providing telephone connections in the majority of the 2,500 villages currently without service. We hope to work closely with NGOs and community groups in the provision of rural services, and to develop the provision of telephone services as a local income generator. Already at a CAS meeting on the telecommunications sector, NGOs have expressed an interest in collaborating in extending, operating and maintaining rural access.  Annex Al Page 1 of 2 NEPAL: CAS PROGRAM MATRIX Performance ]enchmarks Diagnosis Strategy Overall IDA-Assisted Initiatives I-struments Other Donon Publc Expenditure Improve prioritization and Introduce three year rolling expend- Rational criteria for selection of PER Review DFID (UK) Poor prioritization and manage- management of public funds iture & full funding of core projects core investment program; ensure ment of public expenditures; pri- & programs; reduce number of priority funding for core invest- ority projects/programs often projects in PIP; eliminate ment and recurrent expenditures. underfunded unbudgeted expenditures. Health and Family Planning Provide essential health/family By 2004: lower infant mortality to Good supervision, training and Population and health WHO, UNICEF, High infant mortality (75 per thou- planning services & safe water 60 per thousand; reduce total fertil- career development for MCH project; rural water UNFPA, UNCD, sand); low contraceptive preva- supply through public/privatel ity rate to 4.2; improve sustainable workers; increase contraceptive supply projects. UNDP, USAID, UK, lence rate (30%), and high total CBO sectors; improve periph- access to safe water by 15 percent- prevalence rate to 36% by 2004; EU, Japan, Norway, fertility rate (4.6); low life expec- eral health facilities - PHCs, age points. 900 user-group managed niral Germany, India, tancy (55 years); low access to safe HPs/SHPs, district hospitals; water schemes by March 2002. China, Switzerland, water (44%). enhance institutional capacity INGOs. of, and devolve adequate authority to, DHOs for imple- mentation of essential preventative & curative health services. Educntion Increase quality of, and access By 2004: increase primary cycle By 2004: increase net enrollment Basic & primary edu- ADB, UNICEF, Literacy level at 48% for those to, education, especially for completion rate from 41% to 70%; rate from 68% to 80%; increase cation 11; possible sec- NORAD, UK, over 6 years old; boys' net primary girls & women; introduce decrease primary school completion literacy rate from 48% to 55%; ondary education proj- Denmark. school enrollment 80(%, but girls demand-driven vocational edu- from 1 1.8 years to 9.5 years; one 100/o gross enrollment for girls ect if ongoing study only 58%; quality is low, and cation where feasible; improve female teacher in each school; and disadvantaged children in makes good case; repetition rates are high. instructional delivery; improve increase overall percentage of each BPEP district; increase possible LIL for educational facilities and, where female teachers from 19% to 30%/o. average scores for grades 3 & 5 vocational education quality can be maintained, from 50% to 70%; increase pass increase accommodation to rate for grades 4 & 5 from 70% facilitate higher enrollment. to 800/%. Rural Development Increase agricultural productiv- Increase agricultural output growth Increase area under year-round Irrigation & research ADB, UK, FAO, Agriculture yields lowest in South ity/yields and on/off farm em- to 5% a year from its current level irTigation by 40,000 hectares in & extension projects; USAID, Japan, Asia; only 20% of arable land irri- ployment to reduce poverty below 3%. Increase yields of NISP districts, and increase forest management IFAD, OPEC Fund, gated year-round, high levels of while ensuring sustainable paddy, wheat & maize by 15% by yields by 15-20% & incomes by study; future lending Kuwait Fund, rural underemployment; localized management of natural 2004 from their current levels of 20% by 2004; develop location- in irrigation, land Sweden, Germany, deforestation and biodiversity loss. resources. 2.3, 1.4 & 1.7 tons/hectare. specific agricultural techniques resource management Switzerland, Increase area under year-round to increase yields; increase bene- and biodiversity, rural Australia, Denmark, irrigation from 350,000 hectares to ficiary participation. Increase water supply projects; Finland, Saudi Fund, 450,000 hrs by 2004. Improve input number of extension worker field support for ADB dia- INGOs. quality control & agricultural days & farmer classes by 20% by logue; water resource technologies and practices. Extend 2004. Implement a sustainable & terai development the community forestry activities to financing mechanism for strategy studies, & cover 45% of the rural population biodiversity conservation. study for PER of role by 2004. of public sector in I _. rural development. I  Annex Al Page 2 of 2 NEPAL: CAS PROGRAM MATRIX Performance Benchmarks Diagnosis Strategy Overall I IDA-Assisted Iniffatives Instruments Other Donors Infrastructure Improve road maintenance and Balance between recurrent and 300 km labor-based feeder roads LIL for rural infra- ADB, UK, Sweden, Low road density 0.1I km per sq rehabilitation; also invest in c-apital expenditures in accord with constructed; DDCs able to plan structure; road mainte- Japan, India, China, km; problems created by difficult new infrastructure, including roads Priority Investment Plan; 56% and manage 700 km of district nance II; Urban Water Germany. geography compounded by inade- low-cost labor-based roads, of s'rategic highways network in road maintenance and upgrada- and Sanitation quate road maintenance; poor man- where required; improve qual- good or medium condition; tion and other rural infrastruc- Rehabilitation; Multi- agement of urban water supply in ity and increase quantity of adoption of labor-base technology ture; eight Districts with sustain- Modal Transit Project. Kathmandu; inadequate sewer con- water to consumers. in district road construction; able district-managed mainte- nections and water supply in the increased reporting of outputs nance by 2005. Private sector Kathinandu valley. achieved against budget categories; managed Kathniandu water 10% increase in sewer connections; supply; increase yearly water unaccounted water reduced from supply in the Kathmandu valley 35% to 25%. to 6Mm3 and 4Mm3 outside of the valley by 2004. Financial Secior Improve efficiency and Comprehensive fnancial sector Divestiture of Rastriya Banijya PHRD Grant; Finan- ADB, USAID, Weak central bank regulatory stability of financial sector. reform introduced, including for Bank; reduce NPA to I 0%; cial Sector Credit Germany, Denmark. capacity; burdensome government Improve accounting and rural banking. reduce the number of loss- mandates; banking system domi- auditing standards and practices making rural branches; improve nated by inefficient state-owned to international standards. internal management of major banks. . banks; Telecomnunications Increase rural telephone con- Increase rural connections to almost NTA/MOIC regulatory capacity Telecommunications Denmark, Finland, Low level of rural telephone con- nections; adequate interconnec- all 4,000 VDCs; adequate intercon- strengthened; NTC made ready Sector Reform Project Japan. nections; lack of private sector tion provision; license second nection provision; license second for privatization; cellular & other participation and competition operator to compete with NTC operator to compete with NTC; special service providers and introduce private sector decrease the number of staff per licensed; ensure timely submis- competition in telecommunica- 1,000 working lines from 25 to 15 sion of financial statements. tions. by 2002. Power Increase domestic power Increase power generation to 550 Act as catalyst for 200MW of Power Development ADB, USAID, Low level of access to electricity supply and facilitate private- MW by 2004; increase rural con- new private-sector power Project UNDP, Japan, (only 15% of population, compared sector export where feasible; nections to 50,000; enhance energy generation; 420 circuit km of Finland, Germany, to 34% SA average); huge hydro- conservation measures; establish power transmission and 2,800 Canada, Norway. power export potential clear framework for private sector km of distribution lines con- investment. structed.  Annex B1 Page I of 2 Nepal at a Glance 111 POVERTY and SOCIAL South Low- Nepal Asia Income Development dlamond' 1997 Population, mid-year (millions) 22.6 1,289 2,048 Life expectancy GNP per capita (Atlas method, US$) 210 390 350 GNP (Atlas method, US$ billions) 4.7 502 722 Average annual growth, 1991-97 Population (%) 2.7 1.9 2.1 A Labor force (%) 2.4 2.2 2.3 GNP Gross per - primary Most recent estimate (latest year available, 1991-97) capita enrollment Poverty (% of population below national povertfy line) 42 Urban population (% of total population) 11 27 28 Life expectancy at birth (years) 57 62 59 Infant mortality (per 1,000 live bitths) 88 71 78 Child malnutrition (% of children under 5) 70 .. .. Access to safe water Access to safe water (% of population) 44 77 71 Illiteracy (% of population age 15+) 73 51 47 Gross primary enrollment (% of school-age population) 109 99 91 Nepal --Low-incomegroup Male 129 109 100 - ea -Lwicm ru Female 88 89 81 KEY ECONOMIC RATIOS and LONG-TERM TRENDS 1976 1986 1996 1997 Economic ratios' GDP (US$ billions) 1.5 2.9 4.5 4.9 3ross domestic investmentVGDP 15.1 19.0 22.9 21.4 Trd Exportsofgoodsandservices/GDP 10.8 11.7 22.3 26.2 rade Grossdomesticsavings/GDP 11.7 10.6 9.4 9.1 Gross national savings/GDP 15.6 12.2 11.2 11.1 Current account balance/GDP 0.3 -6.8 -11.7 -10.2 Domestic Interest paymentslGDP o 0 0.4 0.7 0.6 Savingsti , _ investment Total debtVGDP 3.4 26.5 53.5 49.1 Total debt servicelexports 1.0 7.5 7.7 7.0 Present value of debtUGDP 0.0 0.0 25.6 Present value of debtlexports 0.0 0.0 103.9 Indebtedness 1976-86 1987-97 1996 1997 1998-02 (average annual growth) GDP 3.4 5.1 5.3 4.0 4.6 GNP per capita 0.7 2.5 1.8 1.6 2.2 Nepal - Low-income group Exports of goods and services 3.4 15.7 -3.2 22.6 7.3 _ STRUCTURE of the ECONOMY 1976 1986 1996 1997 Growth rates of output and Investment(%) (X of GOP) Agriculture 69.3 51.5 41.5 41.4 3 Industry 8.9 15.9 22.9 22.2 20 Manufacturng 4.2 6.2 9.6 9.3 * a Services 21.9 32.7 35.6 36.4 0 Private consumption 80.8 80.3 81.4 81.8 .10 . 92 93 94 95 96 97 General govemment consumption 7.4 9.1 9.2 9.1 GDI o GDP Imports of goods and services 14.2 20.1 35.8 38.5 1976-86 1987-97 1996 1997 Growth rates of exports and Imports (average annual growth) Agriculture 2.7 2.6 5.0 3.5 50 Industry 7.8 9.6 6.4 0.6 40 Manufacturing . 6.9 11.4 6.6 0.6 30- Services 6.9 5.8 5.9 6.0 20 Private consumption 3.3 5.1 10.2 4.6