Uzbekistan - Country Assistance Strategy

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 17376 UZ MEMORANDUM OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT AND THE INTERNATIONAL FINANCE CORPORATION TO THE EXECUTIVE DIRECTORS O NA COUNTRY ASSISTANCE STRATEGY FOR THE REPUBLIC OF UZBEKISTAN FEBRUARY 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.  CURRENCY EQUIVALENT (Exchange Rate on February 13, 1998) Currency Unit = Sum Sum = US$0.0123 US$ = 81.32 Sum GOVERNMENT'S FISCAL YEAR January 1 - December 31 ABBREVIATIONS AND ACRONYMS ADB Asian Development Bank ASBP Aral Sea Basin Program CAS Country Assistance Strategy CIS Commonwealth of Independent States CPI Consumer Price Index EBRD European Bank for Reconstruction and Development ECA Europe and Central Asia EU European Union EU-TACIS European Union - Technical Assistance for the Commonwealth of Independent States ESW Economic and Sector Work FBS Family Budget Survey FSU Former Soviet Union GDP Gross Domestic Product GEF Global Environment Fund GOU Government of Uzbekistan GTZ Gesellschaft fur Technische Zusammenarbeit IBRD International Bank for Reconstruction and Development IBTA Institution Building and Technical Assistance IFC International Finance Corporation IFI International Financial Institutions ILO International Labor Organization IMF International Monetary Fund JEXIM Japan Export-Import Bank KfW Kreditanstalt fbir Wiederaufbau MIGA Multilateral Investment Guarantee Agency NEAP National Environmental Action Plan ODA Overseas Development Assistance OECF Overseas Economic Cooperation Fund (Japan) PAYG Pay-As-You-Go PIF Privatization Investment Fund SME Small and Medium Enterprises TA Technical Assistance UNDP United Nations Development Program USAID United States Agency for International Development The Bank Group Team Vice President: Johannes Linn (IBRD); Jemal-ud-din Kassum (IFC) Country Director: Ishrat Husain (IBRD); Andre Hovaguimian (IFC) Task Team: Robert J. Anderson, Pirouz Hamidian-Rad, Robert Christiansen, Philip O'Keefe, Michael Fuchs, Jean-Charles Crochet, Itzhak Goldberg, Stoyan Tenev, Gorton De Mond  FOR OFFICIAL USE ONLY ANNEXES Annex Al: Uzbekistan at a Glance Annex B 1: Uzbekistan - CAS Program Matrix Annex B2: Uzbekistan - Selected Indicators of Bank Portfolio Performance and Management Annex B3: Uzbekistan: page 1 Bank Group Program Summary, FY98-00: Proposed IBRD Intermediate-Case Lending Program page 2 IBRD Lending Program page 3 IFC and MIGA Program Annex B4: Uzbekistan - Summary of Nonlending Services Annex B5: Uzbekistan - Social Indicators Annex B6: Uzbekistan - Key Economic Indicators Annex B7: Uzbekistan - Key Exposure Indicators Annex B8: page I Status of Bank Group Operations in Uzbekistan - IBRD Loans and IDA Credits in the Operations Portfolio page 2 Uzbekistan - Statement of IFC's Committed and Disbursed Portfolio Annex B9: Uzbekistan - CAS Summary of Development Priorities Attachment: Uzbekistan - Private Sector Strategy Map 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.  FOR OFFICIAL USE ONLY UZBEKISTAN COUNTRY ASSISTANCE STRATEGY TABLE OF CONTENTS SUMMARY I. BACKGROUND ...............................................1 II. MACROECONOMIC PERFORMANCE, PROSPECTS AND EXTERNAL ENVIRONMENT ...............................................2 A. Recent Economic Developments ............... ................................2 B. Macroeconomic Prospects .............................................. S5 C. External Environment ..............................................6 III. UZBEKISTAN'S DEVELOPMENT AGENDA ..............................................7 A. Macroeconomic Stabilization ..............................................7 B. Rapid, Sustainable Economic Growth ...................... .........................7 C. Human Development and Social Protection ............................................... 9 IV. BANK GROUP COUNTRY ASSISTANCE STRATEGY ..................................... 12 A. Progress Under the Previous CAS .................. ............................ 12 B. Strategic Focus and Approach of the FY98-00 CAS .................................... 13 C. Linkage to Policy Performance .............. ................................ 14 D. Country Program Elements .............................................. 16 E. Country Program Monitoring and Risk Management .......................... ......... 21 V. CONCLUDING REMARKS ............................................... 22 LIST OF TABLES Table 1: Macroeconomic Performance Indicators-I 992-1997 ......................................2 Table 2: Macroeconomic Scenarios ................................................5 Table 3: Triggers for Lending Program ............................................... 15 LIST OF BOXES Box 1: Living Standards in Uzbekistan ................................................4 Box 2: EDI in Uzbekistan ............................................... 19 Box 3: Aral Sea Basin Program ............................................... 20 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.  UZBEKISTAN COUNTRY ASSISTANCE STRATEGY SUMMARY i. This country assistance strategy (CAS) has been prepared jointly by IBRD and the IFC, in consultation with the Government of Uzbekistan. Its presentation fully integrates the programs of the Bank Group. A private sector strategy attachment supplements the information provided on the Bank Group's approach to private sector development. ii. The last CAS for Uzbekistan was prepared in early 1995 in a highly uncertain environment, setting out a strategy for the Bank program that drew heavily on the pattern of fast reformers in the region. However, that strategy has not worked well, as the Government is not prepared at this time to change the pace and intensity of its reform efforts. Despite good initial progress in achieving macroeconomic stability, the implementation of structural reforms has lagged substantially-particularly in the case of foreign and domestic trade liberalization. The Government's program, backed initially by the IMF's Structural Transformation Facility and an IBRD Rehabilitation Loan, and subsequently by an IMF stand- by arrangement, was entirely derailed in the last quarter of 1996 by the Government's decision to renege on key policy reforms and highly expansionary macro policies. iii. Despite initial progress in reforming the economy, the Government retains a number of controls, including direct coordination of output decisions, allocation of foreign exchange and investment resources and wide discretionary powers in the microeconomic management of the economy. These actions, in our view, have created rent-seeking opportunities for certain vested interest groups and raise concerns about the overall environment for private sector development, public sector accountability and governance structure. The Government, however, disagrees with the Bank's understanding of their approach towards, and rationale for, economic management. The Government states that it remains committed to economic reforms and market liberalization, and that the speed at which the reforms proceed in Uzbekistan is merely a matter of deliberate and careful choice. But there remains a sharp disconnect between Government statements and the actual functioning of policies except in the area of macroeconomic stability. iv. Given that Uzbekistan is highly cautious in liberalizing the economy, and that the partial nature of macroeconomic reforms creates severe risks to the viability of investments, the Bank's strategy is to create incentives for deeper structural reforms in Uzbekistan through carefully selected investment operations, in parallel with a continuing policy dialogue. IFC activities will complement IBRD's efforts on private sector development through project lending of about US$50-60 million per annum in the financial sector and export-oriented industries. As one of EDI's focus countries, we will also be using a variety of knowledge instruments to help open up the policy dialogue in a few key areas. This, combined with the Bank's proposed non-lending instruments will complement the learning achieved through investment operations. v. In this vein, the Government and the Bank Group have agreed to work on four key challenges in the short to medium-term to support sustainable, broad based development with poverty reduction. These are: (a) liberalizing the trade and exchange rate regimes and minimizing distortions in the financial sector; (b) improving incentives for increased output and employment, particularly in agriculture; (c) removing the inefficiencies in resource utilization in the municipal services and infrastructure; and (d) addressing the environmental damage resulting from the mismanagement of natural resources in the Aral Sea Basin. IBRD and IFC will work closely to support Government's efforts in promoting private sector and capital markets development by providing both project lending as well as advisory services and policy dialogue.  Recognizing Government's past approach to reform, the Bank Group strategy has been designed with triggers to ensure links between Government performance and further Bank engagement. vi. The CAS envisions three IBRD lending scenarios for Uzbekistan. Should the Government continue to have reservations about an agreement with the IMF but maintain basic macroeconomic stability and a policy framework consistent with the success of supported investment projects, as well as a fully satisfactory portfolio implementation record, we would continue to operate in the present (intermediate, or most likely scenario) mode. Under this scenario we commit a modest amount of about US$300-350 million in ten investment operations over the FY98-00 period (compared with US$306 million over the previous three years) in a series of pilot operations. However, shifting to a high case would require significant improvement in macroeconomic management (as evidenced by a new IMF arrangement) and a strong program of structural reform and liberalization, including liberalization of agricultural output prices throughout the economy; elimination of state orders on cotton and wheat; and unification of the exchange rates. We would then deliver up to three adjustment operations in support of the private sector, financial sector, and agriculture sector reforms, and ten investment operations totaling US$800-900 million over the FY98-00 period. A low case scenario would be triggered by the disintegration of macroeconomic stability and non-compliance with the intermediate case triggers; it would only allow for a few nonlending services and operations that focus on poverty reduction and environmental problems. vii. The rationale for our choice of instruments (i.e., conventional investment operations) for enhancing policy dialogue rests on the premise that effective use of the foreign exchange provided through adjustment operations cannot be assured in the absence of a satisfactory macroeconomic framework. Investment operations, on the other hand: (a) provide flexibility in terms of the scope and size of a particular operation; (b) freedom to use an adaptable lending instrument approach if circumstances warrant; and (c) recognize the realities of the situation in Uzbekistan. The ability to scale the size and scope of the operation to the potential pay-off in terms of policy and institutional changes likely to be achieved makes pilot investment operations an attractive instrument. viii. The rationale for the choice of sectors (selectivity) rests on two broad principles: (i) generating the greatest supply response and demonstration effect through strengthening the incentive and regulatory structure in agriculture; privatizing industrial enterprises; and improving the management and regulation of the financial sector; and (ii) improving the efficiency of public sector management and introducing cost recovery. In all scenarios, lending for poverty reduction and environmental problems will be maintained. Finally, the programs and activities of other donors, including the EBRD, EU, ADB, and OECF, are recognized by trying to make our operations both complementary and cooperative. ix. Our nonlending program provides maximum flexibility at the request of the government in the composition, timing and content via provision for client-demand-driven-development strategy assistance: as and when there is internal consensus within the Government about a particular reform to be implemented the Government would like to approach the Bank for quick response assistance. The tasks under this rubric include informal notes, joint work on small, well defined tasks, policy seminars, study visits, and exchange of views with policy practitioners from other countries, which could be used to complement the lending program to maximize the demonstration and consensus building impact. x. The IFC program will contribute to the objectives laid down in the CAS by focusing on the financial sector, agricultural equipment and agro-processing, and support to SMEs while recognizing that the scope and scale of their program will depend ultimately on the enabling environment, and hence demand, for private sector investments in the country. IFC is continuing to sponsor periodic ii  Investors' Conferences for Uzbekistan; the most recent was held in January 1998 in Tokyo. MIGA has currently 15 preliminary applications for total potential investments of US$500 million in finance, manufacturing, cotton, energy and mining; it has so far insured only one project (mining) in Uzbekistan. xi. UJzbekistan's development program enjoys the support of a number of bilateral and multilateral donors, many of whose programs complement those of the Bank. Collaboration and coordination with other donors and international financial institutions (IFIs) is good and continues to strengthen-under both case-by-case and standing coordination arrangements. In the area of macroeconomic management, the Bank assistance program complements the efforts of other donors, particularly the IMF, USAID and Japan (JEXIM). While EBRD has taken the lead in provision of infrastructure finance, and ADB in education, the Bank has focused on supporting health and pension reforms. In providing support to the emerging private sector, IBRD and IFC have cooperated effectively with USAID, EBRD, ADB, EU-TACIS, UK-Know-How Fund and KfW. The Aral Sea Basin Program has been the focal point for donor coordination in supporting the Government's program to address environmental degradation in the region. xii. The strategy proposed here has high risks in so far as that the Government may find it difficult to fully implement the reforms embedded in the pilot and demonstration projects, and even if it does so in the context of these projects, there may be further impediments in replicating these reforms throughout the economy. To address these risks, we have linked our level of assistance-even under the intermediate scenario-to the reforms and performance at the project level in the earlier years. We are not investing large amounts in these projects, but this will give us the opportunity to test government commitment to reforms, and positive results would provide the basis for encouraging the Government to move ahead more broadly. Thus, the strategy is a risky one but one that could potentially have large pay-offs over the medium term with a moderate level of engagement by the Bank. Items for Board Discussion xiii. Uzbekistan is pursuing a slow reform strategy and adopting policies different from those adopted by the neighboring countries. The intermediate case outlined here envisions a broad-spectrum of investment projects to support economic and institutional reform without the traditional macroeconomic conditionalities adopted as part of our engagement with other FSU countries. The proposed lending program is relatively heavily weighted toward infrastructure/municipal services and institution building, reflecting Government priorities and the emphasis on public sector reforms, as well as other development partners' activities in other key sectors. The Board may wish to consider the following questions: * Is the Board comfortable with supporting this gradual-pilot-demonstration-replication approach to promote market-based economic reforms throughout the economy? * Does the Board think that the lending program strikes an appropriate sectoral balance? * Does the Board think that the strategy strikes an appropriate balance between risk and return and incorporates adequate risk management mechanisms? Have we calibrated our assistance carefully given the risks? . .   MEMORANDUM OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A COUNTRY ASSISTANCE STRATEGY OF THE WORLD BANK GROUP FOR THE REPUBLIC OF UZBEKISTAN I. BACKGROUND 1. Situated at the cross-roads between Europe and China along the fabled "Silk Road", Uzbekistan has long been a center of east-west commerce and a much sought after prize in age- old struggles for commercial and political hegemony in this region. Each conquest left its imprint on the modem day nation, reflected in the cultural, ethnic, and religious mosaic which characterizes Uzbekistan today. Although its present day population (23 million, the largest of the Central Asian nations), is predominantly rural (60 percent), of ethnic Uzbek origin (71 percent), and Muslim (88 percent), there remains substantial diversity and a rich cultural heritage. Its average family income levels were, at independence, also relatively low, and remain so today (Box 1). As in other FSU countries, human development indicators are strong, with relatively long life expectancy (70.4 years in 1994), high adult literacy (98.7 percent in 1994), and low maternal mortality (17.3 per 100,000 births in 1994). 2. In this century, during its membership in the Soviet Union, Uzbekistan became the leading center of cotton production in the FSU and a major cotton producer on the world scene as the vast water resources of the Syr Darya and Amu Darya Basins were developed for use in irrigated agriculture in Central Asia. It also became a major gold producer (second largest in the FSU, eighth largest in the world) and producer of natural gas. Its industrial potential, however, apart from industry directly related to agriculture, was relatively less developed than in several neighboring states. Like the other Central Asian republics, it depended on budget transfers from the central government in Moscow to finance a substantial portion of its expenditures. 3. Uzbekistan declared its independence in August 1991 with the de facto dissolution of the Union. The former First Secretary of the Uzbek Communist Party, Islom Karimov, was elected President in December 1991, and a new constitution providing for a strong presidential form of government came into effect in late 1992. A referendum held in 1995 extended President Karirnov's term until 2000. The President and most senior government officials and members of parliament are affiliated with the People's Democratic Party, which is the direct successor of the Communist Party. Decision making is highly centralized, with the President serving as the ultimate arbiter in his capacity as President and Chairman of the Cabinet of Ministers. There is at present no open political opposition or independent press. A recent independent public opinion poll' found a very high (absolutely and in relation to other Central Asian countries in which comparable polls have been taken) professed degree of public satisfaction with and ' Wagner, Steven (1997). Public Opinion in Uzbekistan in 1996. International Foundation for Election Systems.  2 UZBEKISTAN CAS support for the Government and its policies. The survey also shows a very high degree of public support for maintaining a strong government hand in guiding the economy. II. MACROECONOMIC PERFORMANCE, PROSPECTS AND EXTERNAL ENVIRONMENT A. Recent Economic Developments 4. To achieve macroeconomic stability and address key structural rigidities, the Government in 1994 embarked on a comprehensive reform program, which was backed initially by the IMF's Structural Transformation Facility and an IBRD Rehabilitation Loan, and subsequently by an IMF stand-by arrangement. The program envisaged continuing financial stabilization and gradual, phased liberalization of external trade and payments regimes, and structural reforms encompassing privatization and restructuring of medium- and large-scale enterprises, liberalization and land reform/farm restructuring in agriculture, and reform of the financial sector. Considerable progress was made under the program in reducing the fiscal deficit, bringing down inflation, and re-establishing growth (see Table 1). These achievements notwithstanding, the reform program broke down during the fourth quarter of 1996. Fiscal and Table 1: Macroeconomic Performance Indicators - 1992-19972 1992 1993 1994 1995 1996 1997e Fiscal Balances (% of GDP) Revenues 31.3 36.0 29.2 34.6 34.2 30.0 Expenditures 43.4 53.6 33.3 38.1 39.8 33.8 Health & Education 14.7 13.4 11.8 11.0 11.1 10.2 Public Investment 0.0 2.2 3.5 6.1 7.1 7.4 Subsidies & Transfers 10.6 7.6 2.7 3.4 4.0 3.4 Net Lending ... 14.8 0.5 3.6 ... Extra-budgetary funds -6.3 7.2 -2.0 -0.7 -1.7 0.2 Overall Balance -18.4 -10.4 -6.1 -4.2 -7.3 -3.9 Current Account Balance (% of GDP) -11.8 -7.8 2.1 -0.5 -7.9 -6.5 GDP Growth (% p.a.) -11.1 -2.3 -4.2 -0.9 1.6 2.4 Inflation - CPI - eop 1281 117 64 40-50 Source: IMF monetary policy were relaxed when net lending equivalent to 3.6 percent of GDP, financed by bank credit, was extended to finance the cotton harvest and to clear accumulated inter-enterprise 2 Due to deficiencies in the coverage, accuracy, and accessibility of available data on Uzbekistan's economy, the data and projections presented in this section should be regarded as indicative and subject to higher than normal margins of error. The authorities acknowledge these problems and have requested assistance from the Bank and other donors to deal with them (see para 53).  UZBEKISTAN CAS 3 wage and pension arrears. After declining to 0.5 percent of GDP in 1995, the current account deficit increased to almost 8 percent of GDP in 1996, or about US$1.1 billion. This was due primarily to substantial increases in the volume and unit cost of grain imports, substantial increases in payments for imported machinery associated with Uzbekistan's investment program and a stronger-than-expected economy, and some decline in all major categories of export receipts with the exception of gold. In conjunction with the relaxation of its financial policies, the Government sharply tightened restrictions on imports and access to foreign exchange. These restrictions were formalized in a system of multiple exchange rates early in 1997. As a result, substantial and widening spreads opened up between exchange rates in the auction, cash bureaus and curb market with the tightening of these restrictions. While the spread between the auction and cash bureaus rate has been limited administratively to 12 percent, since late 1996 the curb market rate has averaged over two times the rate established in the auction market. 5. The Government moved quickly in early 1997 to regain fiscal control. The consolidated budget deficit was reduced to about 3.9 percent of GDP, and tighter control of money and credit was reinstated. While the temporary loss of fiscal and monetary control late in 1996 caused some acceleration in inflation late in 1996 and early in 1997, the tight policies followed since early 1997 have been effective in returning inflation to its earlier downward trend. Restrictions on trade and payments were retained and controls were introduced on the sale of important food items which repressed inflation, however, and the stand-by arrangement with the Fund lapsed in March 1997 with substantial undrawn balances. A modest reduction in the current account deficit to 6.5 percent of GDP (US$910 million) is estimated for 1997, largely as a result of reduced foodstuff import quantities and unit costs and trade and payments restrictions which have sharply compressed imports not related to Uzbekistan's investment program. Reserve losses amounted to over one-third, bringing reserves to about 3.5 months of imports at year end. 6. Growth accelerated during 1997, although the extent of this acceleration is at present unclear. Early GDP estimates based on interim production targets suggest real growth of 5.2 percent or slightly more on the year. Adjustment of these estimates to reflect partial updated production data suggest a considerably lower figure, on the order of 2.4 percent for the year. 7. The Government has made generally satisfactory progress toward market institution building, sectoral development, and improving social protection. Much of the institutional framework needed for a market economy to operate is in place or in the process of development. Basic laws and regulations (e.g., on banking, bankruptcy, companies, etc.) have been enacted. A stock exchange and depository have been established. Small scale privatization has been substantially completed. An innovative program has been initiated with Bank technical assistance for mass privatization of medium and large scale enterprises through privatization investment funds (PIFs). Uzbekistan's banks are being required to adopt international accounting standards, and to submit to strengthened supervision and prudential regulations. Social protection expenditures-with the exception of pensions-have been trimmed to levels consistent with resources and eligibility requirements have been tightened to strengthen the correspondence between need and receipt of funds. The Pension Fund has been kept roughly in balance (although this has required the levy of additional taxes). Considerable emphasis has  4 UZBEKISTAN CAS been placed on investment in the modernization of the productive sectors of the economy. Public investment spending-mainly associated with the modernization of state enterprises- has increased substantially and rapidly. There has also been substantial investment in joint- ventures and in major state enterprises. 8. Less progress has, however, been made against benchmarks for the structural adjustment reforms (e.g. privatization, liberalization of agricultural prices, land reform and farm restructuring) of the program. While there have in general been few outright reversals in areas other than trade and payments, the pace and scope of reform have been disappointing in relation to the modest benchmarks envisaged at the outset of the reform effort. As a result, the state at present still retains and exercises wide discretionary powers in the microeconomic management of the economy, at relative prices that bear little relationship to market reference points. In these respects, the present situation bears a strong resemblance to the pre-independence economic system. 9. While good progress was made in updating certain elements of commercial law-the pledge law, the company law, and bankruptcy law-there remain several problems in the area of pledge law (see Attachment 1, Private Sector Strategy, para 8). Uzbekistan has also enacted a modern company law, and the bankruptcy law was amended in August 1996 with the active involvement of IFC, to reflect the concept of limited liability of shareholders in joint-stock companies and the priority of secured lenders over claims of other creditors. However, despite this progress, there remain uncertainties about, and inconsistencies in, the legal and regulatory framework, and a lack of a uniform system of law has undermined private sector confidence and created rent-seeking opportunities, therefore, adding to the cost of conducting business in Uzbekistan. 10. The information on the extent and nature of poverty in Uzbekistan remains incomplete. Data from a survey conducted in the late 1980s indicate that about 44 percent of the population lived below the unofficial poverty line of 75 rubles per capita per month-second highest among the Soviet Republics (see Box 1)-with a strong rural bias. These results were confirmed by a sample survey conducted in selected parts of the country in 1995, which indicated that Karakalpakstan (a semi-autonomous republic in the far western part of Uzbekistan) is the poorest part of the country due chiefly to its remote location and poor Box 1: Living Standards in Uzbekistan Family Budget Survey (FBS) data from the end of the 1980s indicate that gross per capita income in Uzbekistan was among the lowest of the Soviet republics, and that the share of the population living below the unofficial poverty line of 75 rubles per capita per month was the second highest, with around 44 percent of the working population below this line. The distribution of poverty also showed a strong rural bias, with around 57 percent of collective farm workers living below this line, and around 39 percent of workers. At the same time, the distribution of income was only slightly worse than the FSU average, with a Gini coefficient in Uzbekistan of 0.30 and in the FSU as a whole of 0.29. The FBS data are known to have a number of problems associated with the sampling method employed and valuation of own-produced food. The Government therefore is exploring collaboration with donors on modifications to the survey which should make it more representative, and a Living Standards Assessment, supported by the Bank, is planned for 1999.  UZBEKISTAN CAS 5 resource endowment. Using the minimum wage as the threshold for an absolute poverty line, the incidence of poverty nationally was found to be 30 percent, of whom about 17 percent were very poor. The incidence of poverty was much higher in both rural and urban Karakalpakstan, with rates 69 and 49 percent, respectively. The estimated rate of severe poverty (defined as 50 percent of the minimum wage per capita) was 41 percent in rural and 27 percent in urban Karakalpakstan. B. Macroeconomic Prospects 1 1. With growth in 1996 and 1997, the economy brings some modest momentum and several sources of potential strength into the coming years. It has a strong base of human, infrastructure and natural resources on which to build. Its central location in the region, relatively large population, and relative political stability render it attractive on these accounts to potential foreign development partners. It is relatively unencumbered with an overdeveloped, fundamentally uneconomic industrial base. It is relatively free of debt. And it has made progress in establishing some of the basic laws and institutions needed for a modem market economy (para 7). However, it also faces some difficult macroeconomic policy problems and tradeoffs as a result of the imbalances in its foreign exchange markets, deferred adjustment in most sectors of its economy, and the tougher environment now facing emerging market countries. How it copes with these will have a major impact on the extent to which it is able to capitalize on its inherent economic strengths. 12. Base Case Scenario: Slow Liberalization. The Base Case macro scenario assumes a continuation of the policies of the recent past, with very slow liberalization and structural adjustment, continuing efforts to maintain a modicum of fiscal and monetary restraint, and continuing relatively high saving and investment. Under this policy scenario, average real GDP growth over the projection period (1998-2007) would be relatively modest-averaging about 3 percent annually3 (see Table 2). Growth would be driven by increases in investment under the Government's activist approach to industrial policy (see para 21). Productivity growth would Table 2: Macroeconomic Scenarios Estimate Base Case High Case 1997 1998-00 2001-07 1998-00 2001-07 GDP Growth 2.4% 2.7% 3.0% 3.5% 5.9% Consumption pc growth -3.6% -1.9% 0.6% -0.6% 1.6% Inflation 40.0% 25.8% 25.0% 18.3% 6.6% Fiscal Balance -3.9% -3.5% -2.4% -3.4% -2.7% Current Account -6.5% -5.0% -5.2% -5.3% -4.8% Debt Service/Exports 14.8% 15.9% 29.1% 14.6% 18.4% 3 The scenarios presented here are based on the lower estimate of 1997 GDP growth. See para 6.  6 UZBEKISTAN CAS be relatively low. Budget deficits (3-4 percent range) and inflation (20-30 percent range) would be moderate to high and variable as efforts to establish firmer fiscal and monetary control would be hampered by lack of structural adjustment in the real and financial sectors of the economy. overall, this would be a very uncomfortable scenario, confronting Uzbekistan's policy makers with a relatively unpalatable menu of tradeoffs between low or no consumption growth or high levels of indebtedness, with a perpetually tight balance of payments, low overall growth, and occasional bursts of inflation associated with temporary softening of enterprise budget constraints. 13. High Case Scenario: Strong Stabilization and Structural Reform. Under a High Case scenario, in which financial policies would be strengthened and backed by early liberalization of trade and payments regimes and resumption of structural reforms to increase the efficiency of utilization of resources, combinations of somewhat higher aggregate growth, higher productivity growth, higher consumption, lower inflation and lower indebtedness could be envisaged. The key reforms in this regard would be full domestic currency convertibility and establishment of current account convertibility in the foreign exchange market, elimination of quantitative restrictions on trade in favor of a modest level of relatively uniform tariff protection, liberalization of prices and marketing in agriculture, strengthened prudential regulation and supervision of a gradually-liberalized banking system, transformation of the system of tax administration to accommodate these changes without unduly sacrificing revenue, privatization of industrial and agricultural enterprises, and a strengthened social safety net to protect those who would be adversely affected by these other measures. In this decisive reform scenario, growth rates would rise gradually to perhaps 6 percent annually and inflation would decline into the 5-10 percent annual range in the first years of the next century. 14. There would, however, be some serious political barriers to reforms under this scenario. The segments of Uzbek industry that have benefited most from the protection afforded by current restrictions on trade and payments would be squeezed. Those consumers benefiting from the implicit subsidies conferred on them by the present multiple exchange rate system would also oppose the reforms, notwithstanding the countervailing social safety net measures. Budget pressures would intensify with the elimination of the controls (e.g., restrictions on conversion of deposits into cash) which currently reinforce fiscal revenue collection mechanisms. These are among the reasons cited by the authorities for proceeding on reform with caution (para 32) and may explain the attitudes expressed by the Uzbek public (para 3) concerning reform. C. External Environment 15. As a primary commodity exporter, Uzbekistan is highly exposed to external shocks, including wide fluctuations in world prices for its major exports-cotton and gold. In addition, poor cotton and/or wheat harvests and/or low/high prices for cotton/wheat still have the potential to do serious damage to the economy. Regional stability will also be an extraordinarily important factor, affecting economic outcomes through trade linkages and factor flows in the region and economic policy via its impact on the Government's assessment of the  UZBEKISTAN CAS 7 political and social risks of development policy alternatives. Severe setbacks in Asian countries could also have debilitating effect on Uzbekistan economy by eroding its competitiveness- especially when the Uzbek sum has been appreciating in real terms vis-a-vis its major trading partners-and through a reduction in foreign direct investment and availability of project finance at affordable interest rates. III. UZBEKISTAN'S DEVELOPMENT AGENDA 16. The stated objectives of the Government's development policies and programs are to: (i) strengthen and maintain Uzbekistan's fiscal and balance-of-payments performance consistent with low inflation and prudent levels of external debt; (ii) achieve relatively rapid, sustainable economic growth; (iii) maintain a high level of development of human resources and social protection. A. Macroeconomic Stabilization 17. The Government targets low double digit inflation and real growth of more than 6 percent within the next two-to-three years. On the fiscal front, it projects a fiscal deficit of 3 percent or less of GDP, which the authorities believe can be financed without recourse to external borrowing. To this end, strong revenue performance would be maintained on the basis of the new Tax Code, sustained improvements in tax administration, improved cost recovery, and the robust real growth it expects. On the expenditure side, the Government expects to continue restraint and rationalization of expenditure. B. Rapid, Sustainable Economic Growth 18. Enabling Environment. The Government's agenda embraces the development of the laws, regulations, and agencies necessary for the establishment and management of a market economy. The Government recognizes that suitable policies and institutions are essential to promote growth. The program adopted in 1995 envisaged the gradual elimination of most restrictions on trade and payments by the end of 1996. The Government reaffirms its commitment to these objectives but, as of yet, has not announced a strategy or a timetable for liberalizing trade or phasing out multiple exchange rates and restrictions on currency convertibility. The Government has, in addition, announced its intention to seek membership in the World Trade Organization. It has not as of yet submitted its memorandum of policies to commence the formal accession procedure. 19. Financial Sector Development. The development of financial markets and institutions is accorded high priority by the Government. The GOU's objectives with respect to financial sector reform include the strengthening of the legal and regulatory framework for financial intermediation, adoption of internationally accepted accounting systems for banks, strengthened supervision of banks (with some attention to bank restructuring), and capital markets development. Over the last year, particularly as a result of the implementation of the Law on Banks and Banking Activity adopted in April 1996, there have been certain encouraging  8 UZBEKISTAN CAS developments. From late 1996, commercial banks started to set aside reserves against non- performing loans. All banks are now required to have annual audits performed by international accounting firms. The payment system has become fully automated, resulting in a major reduction of settlement times. A recent presidential decree called for increased private sector participation and reduced administrative interventions in the banking system. 20. Agriculture. Agriculture is the cornerstone of the Uzbek economy. It is a major foreign exchange generator, with cotton alone accounting for approximately 45 percent of merchandise export revenues, and a major source of income and employment. As noted above, 60 percent of the population lives in rural areas. The Government's agricultural development program envisages strengthening agricultural incentives by (i) phasing out state orders and liberalizing markets for cotton and wheat-paralleling earlier developments in markets for most other agricultural commodities, (ii) phasing out subsidies for agricultural inputs and state participation in the direct distribution of agricultural inputs and liberalizing distribution and trade, (iii) distributing land under long-term leases to individual farmers or groups of farmers, and (iv) promoting the efficient use of irrigation water and cost recovery. The program also envisages strengthening of support services for agriculture, including targeted support to cotton producers in improving the quality of Uzbek cotton for export, and overall improvement in research, extension and credit services available to farmers. 21. Industrial Development, Employment and Privatization. The Government's strategy envisages an active state role in enterprise restructuring, in coordinating production and investment decisions in strategic segments of Uzbek industry, and in attracting foreign investment. Accordingly, the Government has programmed (through the public investment program) and undertaken major investments in rehabilitation and new, greenfield industrial development projects. These projects are geared primarily, at least initially, to import substitution. Several major projects have been completed or are underway in energy (petroleum refineries, natural gas production and transmission, power), agro industry (textiles, cotton processing, agricultural machinery), and chemicals. Projects typically are financed, in part, by the domestic banking system.4 With the re-imposition of controls on trade and payments and formal introduction of a multiple exchange rate system, these projects also typically qualify for priority access to imports and foreign exchange at the official rate. 22. The Government also has a number of programs intended to foster the development of small and medium enterprises. Subsidized credit and business assistance is available to medium enterprises from a Privatization Fund and to smaller, primarily rural enterprises through the Business Fund, both funded mainly from the proceeds from privatization. Credit lines and assistance financed by the European Bank for Reconstruction and Development (EBRD), Asian Development Bank (ADB), Japan Overseas Economic Cooperation Fund (OECF), and Central Asia-America Enterprise Fund are also available, although these funds are primarily accessed by firms at the upper end of the SME range. 4 Many projects also draw upon foreign debt and equity finance.  UZBEKISTAN CAS 9 23. Privatization is the third pillar of Uzbekistan's strategy for industrial development. Its privatization program encompasses the complete divestiture of small enterprises (including houses and apartments) and the phased privatization of most medium- and large-scale enterprises. The framework for privatization of medium- and large-scale enterprises was considerably improved with Resolution No. 220 of the Cabinet of Ministers "On Measures for Organization of the Activities of the Investment Funds" of June 18, 1996. This Resolution provides the framework for the program of privatization through wholly private Privatization Investment Funds (PIFs) which issue shares and use the proceeds to purchase state shares in enterprises offered in auctions. Recently, the Governrment announced a case-by-case privatization program of large enterprises, which may attract foreign strategic investors. 24. Infrastructure. The Government's strategy envisages major investments in and restructuring of Uzbekistan's transportation and communications infrastructure. Development of vvater supply and sanitation is also a very high priority. The Government's main strategy is to provide a new set of incentives to transformn the sector by (i) instituting new pricing and cost- recovery mechanisms; (ii) encouraging competition in areas such as road and air transport; (iii) encouraging the development of competitive support services such as gas stations, repair shops and spare parts supply for the private sector; and (iv) encourage private sector participation in developing the country's infrastructure. 25. Natural Resources and Environment. The desiccation of the Aral Sea is in many respects a metaphor for a much more comprehensive set of economic and environmental problems that afflict Uzbekistan with increasing urgency. The Government is currently identifying and prioritizing these problems in a National Environmental Action Plan (NEAP), now being prepared with support from the Bank and from other donors.5 Many of the problems identified afflict agriculture and threaten its future productivity. Competition for water for alternative uses (primarily for power generation) from the upper basin states and salinization of land and water and waterlogging of land pose increasing threats to future agricultural production. Remedying these problems will require strict water conservation, supported by water pricing and farm restructuring, and substantial investment-also partially financed through water pricing-in rehabilitation of irrigation and drainage. In addition to these predominantly rural problems, "brown" environmental issues are concentrated in a number of industrial centers as a result of poor environmental performance of old and inefficient heavy industries. The solution to these industrial pollution problems is linked to industrial restructuring and modernization, along with strengthening the framework for environmental regulation. C. Human Development and Social Protection 26. Health and Education. Expenditures on health and education have taken substantial "hits" in the post-independence expenditure cuts, declining from about 15 percent of GDP in 1992 to an estimated 10 percent of GDP in 1997, and from 34 percent of total expenditures in 1992 to about 30 percent in 1997. This has been inevitable given their weight in total spending and the 5 See also paragraph 53.  10 UZBEKISTAN CAS steep cut in expenditures that had to be made to conform to the post-transfer budget environment. A sobering corollary, however, is that the quantity and/or quality of services available to the Uzbek public has declined and probably-given budget pressures-will continue to do so. It is noteworthy that in a public opinion poll that generally accorded the Government high marks (para 3), health services and the affordability of food were the two areas in which widespread dissatisfaction was expressed. A fundamental re-thinking of approaches to providing services and safety nets will thus be required to maintain human capital intact while adjusting to hard budget realities. 27. The Government's medium term reform strategy for education embraces increased emphasis on market needs in development of education programs, development of educational standards, development of new syllabi and curricula, improving evaluation of skills and training needs of teaching staff, improving quality assessment mechanisms in educational institutions, and introduction of new streams in vocational and post-secondary education. In health, the strategy aims to enhance the efficiency in the use of constrained resources, to improve the quality of services, to improve cost-effectiveness, and to target vulnerable groups. The strategy also recognizes the need for urgent reorganization in health financing, and the importance of health education and promotion. 28. Social Assistance and Poverty Alleviation. The Government is aware of the extent of poverty and wide divergence in rural and urban income. It maintains an extensive social safety net, which consists of various benefits, transfers and allowances amounting to about 3.4 percent of GDP in 1997, down from 10.6 percent of GDP in 1992. The main elements of the system are subsidies for central heating and urban transport, subsidies for housing and municipal services, and allowances paid to families, vulnerable groups (single mothers, children under 2, and pensioners), and low-income families. The latter are managed by local committees (mahallahs), which target payments on the basis of central guidelines as well as local knowledge and discretion. Government plans call for a phased elimination of subsidies, partially compensated by means-tested allowances. 29. Pensions. Uzbekistan, like most of the other FSU states of the region, operates a pay-as- you-go (PAYG) pension system. Pension expenditures are high by regional standards (i.e., about 6 percent of GDP, in comparison with 5.0 percent of GDP in Kazakhstan and 5.5 percent of GDP in Russia). This is in part due to the relatively limited reform of the Uzbek PAYG system to date, and the Government's efforts to maintain the real value of pensions. At the same time, there appear to be emerging financing problems with the unreformed system. The Government is thus considering a number of reform options for introduction of a three pillar system by complementing a streamlined version of the present PAYG system with mandatory and voluntary funded pillars. Bank's Assessment of Government's Agenda and Areas of Difference 30. While good progress has been made (see para 7), much remains to be done in many areas of market liberalization and structural reform, as well as developing a coherent poverty reduction strategy. As in other countries in transition, serious inconsistencies in legislation,  UZBEKISTAN CAS 11 weak administrative capacity to implement the law and considerable remaining scope for bureaucratic discretion in application of laws and regulations pose serious barriers to the development of stable, predictable commercial relationships (See Attachment, Private Sector Strategy, paras 6-8). Privatization of medium and large scale enterprises is still proceeding at a very slow pace. Fewer than 20 percent of existing medium and large scale enterprises have been privatized to date. Implementation of reforms in the provision of health and education is only beginning, and the Government still has yet to come to grips fully with the difficult financing and service quantity/quality tradeoffs it will have to face as a result of budget constraints. Continuing fiscal pressures will also require further adjustments to reduce the cost of the social safety net. In the area of pension reform, this will also require complementary development of the financial sector and regulatory capacity if the kind of systemic reforms the Government is considering are to succeed. Government institutions and processes have not yet been transformed to support the need of a market economy. Absence of efficient mechanisms for forging consensus, highly centralized decision-making, and fragmented and unresponsive local government in the oblasts are major deterrents to administrative and economic reform and promotion of private initiatives. 31. The greatest challenges, however, remain in the area of liberalization of the economy. Steps taken previously to liberalize trade and payments were, as noted above, reversed in late 1996 and the reversals remain in effect. State orders for grain (which were to have been eliminated for the 1997 crop year) and cotton (which were to have been eliminated for the 1998 crop year) reportedly will remain in effect for the 1998 crop year. The marketing of cotton (which was to be gradually opened to competition under the program agreed with the Bank) remains the preserve of the enterprises of the Ministry of Foreign Economic Relations. Wholesale trade in a number of foodstuffs (e.g., edible oil, sugar) recently were made subject to centralized Government procurement. Privatized industrial and agricultural enterprises generally remain subject, formally or informally, to the production plans of the enterprises from which they were formed and/or to formal/informal government coordination through line ministries, associations and holding companies. Bank credit decisions are still largely at Government direction. Virtually all foreign investment, including that financed by the IFC, occurs in the context of joint ventures with state-owned corporations. 32. The Government in discussions with the Bank and its other development partners reaffirms its commitment to continuing structural reform and eventual liberalization of the economy. It maintains, however, that the controls now in place are necessary-as a transitional measure-to prevent the collapse of output, to ensure the import of essential foodstuffs at affordable prices, and to enhance the productivity and promote the dynamic comparative advantage of Uzbek industry. The Government believes that corruption and criminality would become more serious if liberalization were undertaken before an effective market institutional framework was in place. What distinguishes Uzbekistan from most other adjusting ECA transition economies are not its ultimate objectives, the authorities emphasize, but rather the pace and sequencing of implementation of measures, particularly the liberalization of markets, toward these ends-the Uzbek "step-by-step approach" to economic reform. In our view, however, Government's decision to retain a number of controls, including direct coordination  12 UZBEKISTAN CAS of output decisions, allocation of foreign exchange and investment resources and wide discretionary powers in the microeconomic management of the economy, have created rent- seeking opportunities for certain vested interest groups and raise concerns about the overall environment for private sector development, public sector accountability and governance structure. There is also a sharp disconnect between Government statements and the actual functioning of policies except in the area of macroeconomic stability, which undermines confidence. IV. BANK GROUP COUNTRY ASSISTANCE STRATEGY A. Progress Under the Previous CAS 33. The previous CAS for Uzbekistan was discussed by the Board in March 1995. It envisaged investment and technical assistance support for strengthening basic market institutions, IFC financing and advice to support private sector development, addressing environmentally and poverty related water supply, health and sanitation problems in the area around the Aral Sea, strengthening of social protection and the provision of social services, and the strengthening of institutions and restructuring of agriculture. It also envisaged a gradual but time-bound structural reform program in agriculture, privatization and finance supported by adjustment lending as the principal vehicle for promoting growth. 34. At the time the previous strategy was discussed by the Board, there was a perceived window of opportunity to support an accelerated program of structural reform. A STF arrangement with the IMF was in place and discussions on a stand-by arrangement were underway. The previous strategy sought to capitalize on this opportunity by holding forth the prospect of substantial financial support from the Bank, the IMF and other donors. Although the risks were recognized, the Bank invested heavily in building and maintaining readiness to undertake adjustment lending. As noted above, this strategy did not succeed as both the intensity and the pace of reform it envisaged did not suit the political economy imperatives of Uzbekistan's Government. 35. The continuing divergence of views with the Government notwithstanding, the dialogue on the timing and degree of liberalization and structural reform has been increasingly candid and pointed. Much of the dialogue has been carried out in the context of preparation of adjustment operations that would support privatization and financial sector reform. Recently, at the Government's request, the Bank sponsored and conducted a two-and-one-half day seminar for the Government's senior-most officials responsible for economic policy on the experiences of other countries in liberalization and structural reform. In this seminar, Uzbek officials had an opportunity to discuss first hand with officials from other countries how these countries have come to grips with the same kinds of concerns that have impeded progress in Uzbekistan. Although this has not had an impact on policy, it has added credibility to the dialogue and improved inter-ministerial dialogue within Uzbekistan on development policy options. 36. As a result of the policy developments summarized above, lending-with the exception of a Rehabilitation Loan supporting the initiation of the Government's reform program-has been  UZBEKISTAN CAS 13 limited to investment, engineering and TA operations. To date, the Bank group has financed 15 projects (IBRD 5, IFC 10) with a total project cost of about $800 million [IBRD-US$306 million, IFC-US$486 million (of which US$98 million for its own account)]. Experience with this element of the strategy has also been mixed, but satisfactory overall and improving. Operations have generally been two-to-three times more expensive and time consuming to prepare than in neighboring countries due to the multi-layered decision process through which all Government decisions pass. Recently, steps have been taken to reduce the number of layers of review through which Bank Group projects must pass. It is too soon to evaluate the effect of these changes, but preliminary signs are encouraging. 37. Implementation has been a problem. Although performance has improved considerably, one out of four IBRD projects currently in implementation have been rated unsatisfactory one or more times during implementation but all projects currently in implementation are now rated satisfactory. The one operation that has closed-Rehabilitation Loan-rated unsatisfactory at closing. Experience with these projects as well as with projects now under preparation suggests that through intensifying participation of stakeholders during project preparation, piloting, and designing projects to require that implementation arrangements be concluded early in the project preparation cycle, in combination with intensive supervision and early identification of problems, performance can be improved and life-cycle costs lowered. 38. Implementation of several of IFC's projects has been hampered by certain aspects of the legal framework related to the country's commercial and bankruptcy laws. To address these issues, IFC helped Uzbekistan draft a bankruptcy law and implement a number of changes in the legal framework for commercial transactions. IFC also helped Uzbekistan draft a mining code when it became apparent that the existing code was not adequate to attract new investments. Issues of foreign exchange regime, cotton price controls, competition policies and transparency in the regulatory process are often raised in the context of IFC projects in Uzbekistan. All projects currently in implementation, however, are now rated satisfactory. 39. While raising policy issues in the context of project financing is often an effective instrument for improving the overall business climate it may not always provide general solutions to investors' problems. IFC and IBRD have complemented project related advisory services with free-standing advisory services in the area of business environment for private investment, mainly through FIAS. B. Strategic Focus and Approach of the FY98-00 CAS 40. Given that Uzbekistan is highly cautious in liberalizing the economy, the current Bank Group strategy is to identify a common set of sectoral opportunities and interventions where there appears to be a convergence between the GOU's agenda and the Bank's objectives and on which the Government has stated that it is prepared to act. The strategic approach proposed by the Bank Group is designed to address the Government's concerns about the possible negative consequences of reforms by demonstrating the benefits and consequences of policy and institutional reforms in the context of pilot investment operations (IBRD) and private sector investments (IFC), and through continuing dialogue. The Bank's financial assistance will be  14 UZBEKISTAN CAS modest to begin with-much lower than that accorded to other Central Asian countries in per capita terms-but there will be a great deal of experimentation, piloting and demonstration built into the conventional investment operations. The GOU has indicated that it agrees with this approach and that, if the policy and institutional reforms proposed in these operations prove successful in the limited areas and spheres of activities chosen, it would be prepared to replicate these reforms nationwide. If and when they do so, the Bank would be forthcoming with a much larger package of financial assistance. 41. In discussions held on the Bank Group's CAS for FY98-00, it was agreed that the Bank Group would focus on four key challenges facing the Uzbek economy in the medium term: (a) liberalizing the trade and payments regimes and minimize distortions in and promote the development of the financial sector; (b) complete the liberalization of domestic trade and improve incentives for increased output and employment in productive private sectors, particularly agriculture; (c) remove the inefficiencies in resource utilization in the municipal services, infrastructure and the social services; and (d) address priority environmental damage problems, particularly those associated with the mismanagement of natural resources in the Aral Sea Basin. 42. These areas have been chosen because progress in them would have a substantial ameliorating impact on constraints that bind heavily on Uzbekistan's low income families. Liberalization of trade and payments and domestic trade is likely to be particularly beneficial to the development of small and medium scale enterprises and agriculture, where the best prospects for growth of remunerative employment reside. The strategy entails direct poverty reduction interventions, including: (i) investing in provision of drinking water supply, sanitation and health in the poorest region of the country-Karakalpakstan-where the Aral Sea desiccation has made the lives of the people living in the region intolerable. In this region, environmental degradation has caused severe poverty. The proposed program for drainage will help reclaim agricultural land from salinity and enable the poor farmers to resume their productive activities. The project financed by the GEF will also contribute to improved enviromnental practices in the Aral Sea region; (ii) inclusion of Karakalpakstan as an area of emphasis in the pilot Social Transformation Fund (FY99); and (iii) inclusion of one of the poorest oblast (Ferghana) in the pilot component of the Health Reform project (FY98). C. Linkage to Policy Performance 43. The Bank Group believes that the success of pilot operations and carefully selected private sector investment operations, backed by intensified dialogue and technical assistance to build the capacity for economic management will demonstrate the benefits of reform and thereby provide a solid basis for replicating these reforms throughout the economy. However, recognizing the risks involved in this approach, the strategy has been designed with well- defined triggers to ensure links between Government performance and further Bank Group engagement.  UZBEKIS TAN CAS 15 Table 3: Triggers for Lending Program Prior Actions Actions During Implementation ............................................................................................................. ................................................................................................................... Intermediate Case (I) Maintain basic macroeconomic stability (as evidence, for example, inflation < 30%, budget deficits < 3% of GDP, non-interest current account deficits < 15% of exports) and a policy framework consistent with the success of supported investment projects. (2) Agreement with Bank Group on policy (2) Complete the implementation of the agreed innovations including: actions, including: (i) issuing Government order to restructure farms (i) restructuring farms in six raions by transferring in six raions by transferring land titles to land titles to farmers; farmers; (ii) issuing Government order to liberalize (ii) liberalizing agricultural output pricing in six agricultural output pricing in six raions; raions; (iii) rationalize health facilities and personnel in (iii) rationalizing health facilities and personnel in three oblasts; three oblasts; (iv) introduce cost recovery for water supply and (iv) introducing cost recovery for water supply and sanitation in Tashkent and Bukhara; sanitation in Tashkent and Bukhara; (v) privatize 300 enterprises through the PIF (v) privatizing 300 enterprises through the PIF program. program. (3) Portfolio implementation: At most one-third of projects (by number) with unsatisfactory Implementation Progress (IP) rating; maximum of 40% of projects (by number) with unsatisfactory Development Objectives (DO) rating; and disbursement ratio of 13% in FY98, 15% in FY99, and 18 % in FY00. .......... ,...... .......................... .;... .. . . . .. .. . . . . .. . . .. . . . . . . . . ........ ... .... . .. .. . . .. . . . . .. . . . .. . .. . .. . .. . . . . . .. . .. . .. . . . .. . . . . . .. High Case Meeting all requirements of the intermediate case. In addition: (1) IMF program in place, including unifying the (1) Maintaining a unified exchange rate, and meeting exchange rate. agreed quarterly targets for fiscal deficit, net domestic financing, and credit to the private sector. (2) Implementation of agreed structural reforms (2) Maintenance/deepening of structural reforms including: including: (i) issuing Government order for elimination of (i) farmers' freedom in choice of cropping. state orders on cotton and wheat. (ii) issuing Government order for liberalization of (ii) liberalizing agricultural output prices cotton export marketing. throughout the economy. (iii) privatization of 300 enterprises through the (iii) completion of privatization of an additional PIF program and designation of a total of 300 300 enterprises through PIFs. additional enterprises for privatization through PIFs. (iv) elimination of de facto controls on the (iv) completion of restructuring of at least two conversion of bank deposits into cash. state-owned banks, including at least 40 percent private ownership. (3) Portfolio implementation: No projects with unsatisfactory IP rating; maximum of 25% of projects (by number) with unsatisfactory DO rating; and disbursement ratio of 17% in FY99 and 20% in FY00, and thereafter.  16 UZBEKISTAN CAS 44. The strategy envisages three IBRD lending scenarios for Uzbekistan. If the Government continued to have reservations about an agreement with the IMF but maintain: (a) a modicum of macroeconomic stability and policy framework consistent with the success of supported investment projects; and (b) fully satisfactory portfolio implementation record, including a disbursement ratio of 13 percent in FY98, 15 percent in FY99 and 18 percent in FY00, we would continue to operate in the present (intermediate, or most likely scenario) mode (see Table 3). Under this scenario we commit a modest amount of about US$300-350 million in ten investment operations over the FY98-00 period (compared with US$306 million over the previous three years) in a series of pilot operations. However, shifting to a high case would require a strong program of structural reform and liberalization which could be supported by a new IMF arrangement and Bank adjustment lending. Specific triggers for such a scenario include: liberalizing agricultural output prices throughout the economy; elimination of state orders on cotton and wheat; unification of the exchange rates; and sharply lowering the fiscal deficit and inflation. We would then deliver up to three adjustment operations in support of the private sector, financial sector, and agriculture sector reforms, as well as ten investment operations, totaling US$800-900 million over the FY98-00 period. A low case scenario would be triggered by the disintegration of macroeconomic stability and non-compliance with the intermediate case triggers; it would only allow for a few nonlending services and operations that focus on poverty reduction and environmental problems. D. Country Program Elements 45. Portfolio Management. Under the intermediate scenario, the number of operations in implementation would increase from 4 to 7 by the end of FY 98, and would continue to increase by three operations per year thereafter. While implementation has been a problem, the trend is positive as a result of better project design (e.g., through use of pilots, more systematic participation and social analysis, more flexibility in design), intensive supervision and growing experience in working together. The Resident Mission is being strengthened to provide more on-site, on-demand supervision services, and the Government is considering the establishment of a Coordinating Unit for Project Implementation in the Ministry of Macroeconomics and Statistics. One of the main functions of this new Unit would be monitoring of project implementation and early identification of problems needing attention. 46. New Lending. In the intermediate case, the proposed IBRD FY98-00 lending program for the next CAS period would include up to ten operations totaling US$300-350 million, supporting incremental reforms in key sectors. This lending program would concentrate on: * Utilizing the gradual and innovative approach to privatization through PIFs and initiating a new case-by-case privatization program for large strategic enterprises (Enterprise Reform Institution Building), as the cornerstones of further industrial enterprise restructuring along with institutional building in enterprise and financial sector. * Strengthening financial sector institutions and infrastructure (Financial Sector Institution Building) would support the adoption of a new accounting  UZBEKISTAN CAS 17 framework for banks based on international standards and would provide assistance with respect to bank supervision, bank restructuring, bank licensing, bank accounting, legal issues, commercial bank strategy development, credit risk assessment, bad debt work out, and capital market development. Restructuring farms (Agricultural Enterprise Restructuring Project - AERP) by starting in a few raions where land titles will be transferred to private farmers, policy impediments removed, and output pricing and marketing mechanisms liberalized; support services provided. Inasmuch as agricultural restructuring will have the biggest single impact on poverty reduction, successful implementation of AERP could be followed at the end of the CAS period with AERP-II, which would support replication of AERP. * Piloting the rationalization of health facilities and personnel and improving the training of medical personnel in three oblasts (Health Reform). * Addressing poverty alleviation with a pilot social fund that features modest infrastructure interventions in selected poor regions and stresses support to small- and medium-scale enterprises and micro-credit initiatives for the self-employed (Social Transformation Fund). * Emphasizing cost recovery, institution strengthening, and privatization of municipal services (Tashkent Solid Waste Management, Urban Transport, Bukhara-Samarkand Water Supply and Sanitation). * Introducing cost recovery and improved agricultural water management and irrigation system management (Improvement of Irrigation Infrastructure). * Adopting alternative approaches to drainage improvement in order to mitigate the adverse environmental effects of increased soil salinity in the Aral Sea Basin (Drainage). 47. Under the intermediate case, IFC's program size is expected to be about US$50-60 million per annum for IFC's own account. IFC's investments are most likely to be concentrated in the financial sector and export-oriented industries. In the latter, IFC would encourage value-added processing of agricultural material and increasing productivity in the sector by introducing modem equipment and extension services. Together with Case Corporation from the US, IFC is financing three inter-related projects in the manufacturing of agricultural equipment, which will together produce cotton pickers and grain headers for mechanized harvesting of cotton and grain, provide leasing services for agricultural equipment, and provide after sales maintenance services for the equipment. This integrated multi-component project will introduce new technology, management know-how and market forces to the agriculture sector and accelerate its transformation to a market-based system. A fourth project in the area of agricultural machinery is currently under evaluation by IFC to produce tractors and other agricultural equipment. All four projects envision a strong localization program to produce locally up to 50 percent of the value of all parts and components which would benefit local suppliers through transfer of technology and employment generation. 48. Complementing IBRD, IFC is following an integrated approach to assist directly the development of SMEs. First, a special instrument has been designed for countries including  18 UZBEKISTAN CAS Uzbekistan-Extending IFC's Reach-to support small investments. One project in furniture manufacturing has already been approved through this vehicle and several other projects are at an advanced stage. Second, IFC is also exploring means to facilitate the growth of SMEs through large foreign investors that are already in the country by capitalizing on the their demand for auxiliary services and inputs. Third, IFC has initiated, in conjunction with EDI, courses in accounting and management for local entrepreneurs and is exploring opportunities to commercialize this program. Currently, IFC is working on a project to establish an Executive Training Center (ETC) in Tashkent to provide training courses and workshops for Uzbek managers in fields such as marketing, general management and accounting. ETC is also expected to provide business consultancy services for joint ventures, state-owned enterprises and SMEs, thus contributing to the development of an indigenous consulting industry. In addition, IFC will seek opportunities to address the financing needs of SMEs indirectly through credit lines to financial intermediaries and through its overall program in the financial sector. 49. Should the triggers points for a high case scenario be met, IBRD projects lending would be complemented with up to three adjustment operations supporting privatization, financial sector reform, and agriculture sector reform. This would bring IBRD lending up to US$800- 900 million in thirteen operations. In privatization, the adjustment operation would support sales of shares in a substantial number of medium and large scale enterprises through the PIF program, and transparent case-by-case privatization of a smaller but still substantial number of large scale strategic enterprises. In finance, the adjustment operation would support bank restructuring, increased competition in banking, and capital market development. In addition, provided the Government is prepared to move ahead on the basic reforms of the agricultural sector, we would be prepared to support a strictly time bound program of reform through an Agricultural Sector Adjustment Loan. 50. Under a high case scenario, the overall demand for IFC's services and the potential areas for IFC's involvement would also be expected to expand resulting in a program size of about US$80-90 million per annum. In addition to financial services and export-oriented sectors, the improved business climate is likely to generate investment opportunities in infrastructure and in projects oriented toward the domestic market. 51. MIGA currently has 15 preliminary applications for total potential investments of US$500 million in finance, manufacturing, cotton, energy and mining, however, to date has insured only one project (in mining). 52. Non-Lending Activities. Our resource commitment was relatively small during the previous CAS period. Traditional economic and sector work (ESW) was not a particularly effective device for advancing the reform agenda, however, informal notes, joint work on small, well-defined tasks, policy seminars, study visits, and exchanges of views with policy practitioners from other countries have had an impact on the quality of the dialogue and are desired by the client. The Government has requested that there be the maximum possible flexibility in the composition, timing and content of the non-lending program: as and when there is internal consensus within the Government about a particular reform to be implemented they would like to approach the Bank for quick response assistance.  UZBEKISTAN CAS 19 53. The planned program is intended to provide this flexibility via provision for client demand driven Development Strategy Assistance. Individual tasks under this rubric could, for example, provide analytical support and advice concerning alternatives for liberalizing trade and payments and/or on pension reform and/or on financing and other sectoral reform issues in the social services and social protection. The precise activities undertaken in this regard would be decided in consultation with the Government. In addition, the planned program also includes five pre-identified tasks which have previously been requested by the Government. These are: (Data and Forecasting IDF-which would support the government's efforts to strengthen basic government economic data and forecasting capability, Policy Analysis IDF-which would support the strengthening of the Government's capacity to carry out analyses of macroeconomic policy options, Public Investment Policy Note-which would examine the policies currently governing Uzbekistan's public investment program, Karakalpakstan/Khorezm Economic Report-which examines the development issues and options confronting the Uzbek portion of the Aral Sea "Disaster Zone", and National Environmental Action Plan-which maps out a prioritized program of action for dealing with the environmental problems facing Uzbekistan today. The last Bank economic report on Uzbekistan was completed in 1994. A brief Economic Update and a series of Macroeconomic Policy Notes are planned for FY98, following up on the recent high level policy seminar (para 35). The possible impact of the Asian countries financial crisis on Uzbekistan's competitiveness and its access to foreign direct investment, and measures to mitigate such impact will be analyzed in the context of a policy note to be discussed with the Government. 541. A Living Standards Assessment is Box 2: EDI in Uzbekistan planned to be completed in FY99, to assess the surrent natur and extent o poverty on aEDI has identified Uzbekistan as a focus country over the next two to three years. Additional consistent basis and identify issues and resources will be devoted to EDI-sponsored courses evaluate options with respect to the and seminars conducted for Uzbeks. The emphasis of Government's program for improving living EDI's activities will complement those Bank standards in Uzbekistan. As one of EDI's operations that are trying to demonstrate the "benefits focus countries, we will be using a variety of and consequences of structural reform." Particular emphasis will be given to macroeconomic stability, knowledge instruments to help open up the agriculture restructuring, and privatization. policy dialogue in a few key areas. This, The EDI methodology is particularly well- combined with the Bank's proposed non- suited to circumstances in Uzbekistan because of the lending instruments, will complement the need to: (a) emphasize the lessons of experience in learning achieved through investment other parts of the world; and (b) crystallize the operations. experience that emerges from the pilot operations and the accompanying structural reforms. In particular, 55. Should it be possible to operate in a High EDI plans to organize seminars on the experience of Cae p , tother countries on privatization and farm restructuring. Case program, the IBRD would in addition EDI will also select one of the pilot operations and stand ready, at the authorities request, to monitor it in order to synthesize the emerging lessons convene Consultative Group meetings for for Government. Uzbekistan. IFC is continuing to sponsor periodic Investors' Conferences for Uzbekistan. The most recent was held in January 1998 in Tokyo.  20 UZBEKISTAN CAS 56. Partnerships. Uzbekistan's development program enjoys the support of a number of bilateral and multilateral donors, many of whose programs complement those of the Bank. Collaboration and coordination with other donors and international financial institutions (IFIs) is good and continues to strengthen-under both case-by-case and standing coordination arrangements. In the area of macroeconomic management, the Bank assistance program complements the efforts of other donors, particularly the IMF, USAID and Japan (JEXIM). Support is given for the establishment of an independent Macroeconomic Policy Institute, macroeconomic and sector policy seminars for senior officials and through economic advisors to the Cabinet of Ministers, Ministry of Finance and the Central Bank. While EBRD has taken the lead in provision of infrastructure finance, and ADB in education, the Bank has focused on supporting health and pension reforms. In the case of urban infrastructure, for example, we have joined with EBRD in preparing the proposed Tashkent Solid Waste Management project. In providing support to the emerging private sector, IBRD and IFC have cooperated effectively with USAID, EBRD, ADB, EU-TACIS, UK-Know-How-Fund and KfW in providing training, SME lines of credit, establishment of Enterprise Funds (USAID, EBRD) as well as providing technical assistance to the Central Bank. 57. Co-financing operations have been undertaken with KfW, Switzerland, Kuwait Fund and OECF (yet to be finalized) for the recently approved Water Supply, Health and Sanitation Project for affected population in the Aral Sea region. Further co-financing operations are foreseen. In the area of rural development, EU-TACIS, GTZ, USAID, Israel and the Bank are co-operating in terms of sharing information on the respective experiences of Pilot operations and in complementing technical assistance needs in our proposed Agricultural Enterprise Restructuring project, e.g. Land registration with EU-TACIS support. In the development of the Social Transformation Fund, the Bank enjoys close collaboration with UNDP and the ILO. KfW is also co-financing the Health Reform project. 58. The Aral Sea Basin Program (Box 3) is also a focal point for coordinating donor activities. A new organization (EC-IFAS) has been established and staffed and is now responsible for organizing and coordinating donors as illustrated through the recent successful organization of a Donor Participants Conference in Tashkent. The most active donors which collaborate Box 3: Aral Sea Basin Program The desiccating Aral Sea is the most visible and striking symptom of an unsustainable model of water and land management. Over-expansion of irrigation combined with indiscriminate and inefficient usage have led to rising salinization and desertification of densely populated river deltas. The Aral Sea Basin Program (ASBP), supported by the Bank and other donors, is aimed at stabilizing the environment of the Aral Sea Basin, rehabilitating the disaster zone around the sea, improving the management of the basin and developing the capacity of the regional institutions. The ASBP comprise a broad set of eight inter- linked program elements and 18 projects, including the proposed Uzbekistan Drainage Project (FY00). The preparation phase was completed in 1997. Bank-funded Water Supply and Sanitation Project has started in Turkmenistan and Uzbekistan, and a GEF project on water and environmental management for the basin is scheduled for presentation to the Executive Directors in FY98, including pilot activities in improving water use and development of a national water and salinity management strategy. Adoption of this strategy will have major implications for investment in irrigation, drainage and urban water supply.  UZBEKISTAN CAS 21 periodically are the Dutch, EU-TACIS, UNDP, GEF/WB, USAID and many other bilateral institutions. Future potential donors are OECF, ADB, Canada and the Scandinavian countries. The World Bank continues to play central coordinating role through the Resident Mission and GEF related project management. E. Country Program Monitoring and Risk Management 59. Strategic Risks. As noted above, the strategy outlined here is based on the working hypothesis, discussed with and agreed to by the Government, that policy-based pilot/demonstration investment projects, backed by a continuing dialogue-would be effective in advancing the structural reform agenda in selected areas. Inasmuch as this premise is untested, there are substantial risks that this approach will not work. In this regard, there should be no illusions about the results of Bank involvement and the risks inherent in this approach. To minimize them, the lending program has built-in triggers that would lead to an exit to the core scenario if Government's acceptance of the structural reforms built into these operations is not forthcoming. In each of the proposed lending operations there are clearly specified policy and institutional reform objectives along the lines indicated above (para 46). During CAS discussions with the Government, it was agreed that successful implementation of a pilot operation would lead to eventual broader structural and institutional reform in that sector as well as increased lending by the Bank Group. If, in the more detailed discussions with Government in the early stages of project preparation, there is no agreement on either the objectives underpinning any of the specific operations or such a link, we would not- proceed with that particular operation. Further, operations in the final year of this CAS period (FY00) would be linked to progress achieved during the first two years of the period. For example, the continued preparation of the Drainage and Irrigation projects depends critically on the implementation of policy and institutional changes that have been agreed recently as part of the Agricultural Enterprises Restructuring operation. Similarly, we would be unlikely to proceed with the Samarkand-Bukhara Water project if the institutional changes agreed as part of the current Water Supply, Sanitation and Health Project are not reflected in Government's strategy. 60. Creditworthiness. Current debt and exposure indicators are well within prudent limits, debt service experience to date is good, and the Government has given every indication that it intends to maintain prudent external financial policies. The Government is strengthening its external debt management capability with support from the Bank provided by the Institution Building Technical Assistance (IBTA) project. Nonetheless, with loss of about one-third of its international reserves during 1997 and imports severely compressed, the near-term balance of payments situation will be tight. Furthernore, the economy is highly exposed to external shocks, including wide fluctuations in world prices for Uzbekistan's major exports-cotton and gold. Asian countries crises could also adversely affect the economy by eroding its competitiveness and through a reduction in foreign direct investment and availability of project finance at affordable interest rates. Under a "Base-Case-like" scenario the authorities would be likely to be confronted with relatively unattractive medium-term choices between very slow (i.e., less than 3 percent per annum) growth, unacceptably (and perhaps dangerously from a social perspective) slow or no per capita consumption growth, unacceptably high inflation,  22 UZBEKISTAN CAS and/or rapidly increasing external debt. Achievement of these modest targets could seriously be threatened should the economy become exposed to external shocks including those mentioned above. Depending upon how the Government makes these tradeoffs, debt could become a problem. Accordingly, borrowing and debt service capacity will be closely monitored over the CAS period. V. CONCLUDING REMARKS 61. Uzbekistan has chosen its own pace, path and priorities for the transition to market based economy. While it is serious in maintaining macroeconomic stability it is more cautious in liberalizing the economy and removing microeconomic distortions. The previous Bank strategy has not worked well, as the Government is not prepared at this time to change the pace and intensity of its reform efforts. The proposed strategy is therefore based on demonstrating the benefits of reforms in key areas such as privatization of agriculture, enterprise reform and cost recovery in municipal services in the context of selected pilot investment operations (in addition to poverty reduction and environment operations). If the reforms in these pilot operations prove successful the Government will replicate them throughout the economy. The Bank has agreed with the Govemnment that it will commit only modest financial resources under the current scenario of limited reforms but if the Government moves to implement broad-based policy reforms the financial support will increase significantly. James D. Wolfensohn President By: Caio K. Koch-Weser Jannik Lindbaek Attachment February 17, 1998 Washington D.C.  Annex AI Page I of 2 Uzbekistan at a glance 8/20/97 Europe & Lower- POVERTY and SOCIAL Central middle- Uzbekistan Asia Income | Development diamond' Population mid-1996 (millions) 23.1 479 1,125 Atlas GNP per capita 1996 (US$) 1,010 2,180 1,750 Life expectancy Atlas GNP 1996 (billions US$) 23.5 1,043 1,967 Average annual growth, 1990-96 Population ('A) 2.1 0.3 1.4 GNP Gross Labor force (%) 2.8 0.5 1.8 per pnmary Most recent estimate (latest year available since 1989) capita enrollment Poverty: headcount index (% of population) Urban population (% of total population) 39 65 56 Life expectancy at birth (years) 70 68 67 Infant mortality (per 1,000 live births) 26 26 41 1 Access to safe water Child malnutrition (36 of children under 5) Access to safe water (% of population) . 78 lliteracy (% of population age 15+) 3 Uzbekistan Gross prmary enrollment (% of school-age population) 77 97 104 Male 78 97 105 Lower-middle-income group Female 76 97 101 KEY ECONOMIC RATIOS and LONG-TERM TRENDS 1976 1985 1995 1996 Economic ratios' GDP (billions USS) . 10.0 13.6 Gross domestic investment/GDP 20.9 16.1 Exports of goods and services/GDP 36.0 30.5 Openness of economy Gross domestic savings/GDP 20.5 8.6 Gross national savings/GDP 20.4 8.2 Current account balance/GDP -0.5 -7.9 Interest payments/GDP 0.3 0.8 S n Total debtGDP 17.8 17.0 Total debt service/exports 6.4 6.9 1 Present value of debtVGDP 6 5 |6 Present value of debt/exports 38.4 Indebtedness 1975-85 1986-96 1995 1996 1997-05 (average annual growth) Uzbekistan GDP -0.9 1.6 3.0 GNP per capita -3.5 -1.0 Lower-middle-income group Exports of goods and services 0.3 3.7 STRUCTURE of the ECONOMY 1975 1986 1995 1996 (% of GDP) Growth rates of output and investment I%) Agriculture 32.1 26 0 20 T Industry 27.8 27.4 10 Manmfacturing .. E Services 40.1 46.6 -90 Private consumption 60.4 66.3 -20 General govemment consumption 19.1 25.1 GD GDP Imports of goods and services 38.4 38.0 - 1975485 1986-96 1995 1996 (average annual growth) Agriculture - 2.0 -7.0 Industry -5.6 1.7 ManuLfacturng .. Services 2.3 2.0 Private consumption General govemment consumption Gross domestic investment 3.2 -0.1 Imports of goods and services Gross national product -1.8 1.1 Note: 1996 data are preliminary estimates. Figures in italics are for years other than those specified. The diamonds show four key indicators in the country (in bold) compared with its income-group average. If data are missing, the diamond will be incomplete.  Annex Al Page 2 of 2 Uzbekistan PRICES and GOVERNMENT FINANCE 1975 1985 1995 1996 Domesffc prices Inflation (9 change) i,ooo - Consumer prices 305.0 54.0 i lmplicitGDPdeflator 371.0 82.0 !500._. Govemment finance (% of GOP) 0 Current revenue 34.6 34.2 91 92 93 94 es 96 Current budget balance 3.2 1.5 GDP def. -O--CPI Overall surplus/deficit -4.1 -7.3 1 TRADE 1975 1985 1995 1996 (millions USS) Export and import levels (mill USS) Total exports (fob) 3,806 3.781 25,000 - Cotton 1,800 1.748 Gold 611 832 20.000 - Manufactures 15... 000 Total imports (cif) .. .. 3597 4,712 Food 687 1,391 10