China - Rural Water Supply Project

DoM f of The World Bank FOR OmCIAL USE ONLY C64 /s>g-cs RePut N.. P-3910-CHA REPORT AND RECOMeNDATION OF THE PRESIDENIT OF TEE INTERNATIONAL DEVELOLMN ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED IDA CREDIT OF SDR 82.1 bILLION TO THE PEOPLE'S REPUBLIC OF CHINA FOR A RURAL WATER SUPPLY PROJECT March 20, 1985 I bh dcameNt bw a resicted disft9ihih mad my be wed by rechipents eily ini the peirfamnance of dSind m lb it tmt my nothermib db &lwsed widha Woud Bek auibo,eu.  CURRENC EQUVAE Currency Unit = Yuan (Y) 1984 January 1985 - $1.00 = Y 2.50 Y 2.80 Y 1.00 = $0.40 $0.36 FISCAL YEAR January 1 to December 31 WEIGHTS AID MEASURES cubic meter (cu m) or ton of water = 264 US gallons hectare (ha) = 10,000 square meters or 2.47 acres Liter (1) = 0.26 US gallons gram (g) = 0.002 US pounds ACRONYMS ABC - Agricultural Bank of China CNTIC - China National Technical Import Corporation CPHCC - Central Patriotic Health Campaign Committee CPO - County Project Office EEC - European Economic Community .FRG - Federal Republic of Germany DPO - National Project Office PPO - Provincial Project Office PEF - Provincial Revolving Fund SAA - Srate Audit Administration TAC - Rural Water Supply and Sanitation TecLnical Advisory Center (of the China Institute of Health in the China National Cencer for Preventive Hedicine) WFP - World Food Program  FOR O *ICAL USE ONLY RURAL WATER SUPPLY PROJECI Credit and Project Summary Borrower: People's Republic of China Amouat: SDR 82.1 million ($80.0 million equivalent) Terms: Standard Relending Terms: from the Government to provinces: Z5 years including 10 years of grace, and zero interest. From province to villages: 10 to 15 years including two to four years of grace, and zero interest. Project Description: The objectives of the project are to build water supply facilities and to- develop and strengthen systemc, insti- tutions and technology for the implementation of China's rural water supply program. The project would provide safe drinking water to some six millior people in 4,650 villages of 25 counties located in the provinces of Liaoning, Sh7anxi, Sichuan and Ziejiang and the municipality of Beijing. The beneficiary villages are selected because their present water supply is inadequate, contaminated or too distant. The types of water systems range from hand- pumps and rainwater storage tanks to pumped and piped systems (including some with treatment) with standpipes or house connections, dependent upon environmental and economic conditions. The institutional component of the project includes: ti) the development of management and monitoring systems and regulations for revolving funds, construction and operations; Cii) the preparation of design, construction and operation manuals; and (iii) a training program for trainers, planners, engineers, technicians and operators at the national, provincial, county and village levels. Revclving funds would be established in the beneficiary provinces which would be used to provide safe water in sther villages, thereby more than doubling the initial number of beneficiaries during che 25 year period that funds remain with the provinces. The credit is consequently levered so that $7 of credit funds provides safe water to one person. Cofinancing by the Federal Republic of Germany will fund the foreign cost of training ($1.5 million), and the World Food Program is to provide food aid (equivalent to $10.5 million) to the participating counties in the provinces of Liaoning and Shaanxi. - This document has a resticted distribution and may be used by recipients only in the performance of their offici duties. Its contents may not oherwise be discksed without World Bank authoriation.  - ii - The principal risk relates to the ability of the project management organization, a new entity, to direct the project appropriately. The risk is mitigated by the policies and procedures developed during the preparation of the project, the recent strengthening of project office staff, and the good project implementation experience which exists at the county level where the bulk of the implementation work will be done. Estimated Costs: Local Foreign Total ($ million) Civil Works 38.9 2.2 41.1 Materials and Equipment 38.9 59.8 98.7 Trai g 1.6 1.1 2.7 Land Acquisition 9.3 - 9.3 Design, Supervision and Management 8.0 0.4 8.4 Sub-total 96.7 63.5 160.2 Physical Contingencies 9.6 6.4 16.0 Price Contingencies 18.2 13.8 32.0 Subtotal/a 124.5 83.7 208.2 initial Working Capital 2.0 0.0 2.0 Total Project Cost 126.5 83.7 210.2 Financing Plan: Local Foreign Total - S million) IDA - 80.0 80.0 National Government 1.2 0.5 1.7 Provincial Governments 14.5 1.7 16.2 County Governments 18.3 - 18.3 Villages and Individuals 82.0 - 82.0 Federal Republic of Germany - 1.5 1.5 World Food Program 10.5 - 10.5 Total 126.5 83.7 210.2 /a Project-financed goods are exempt from import duties and taxes.  Estimated Disbursemencs: Bank FY 1986 1987 1988 1989 1990 _______ - ($ llion A4nual 4.0 20.0 32.0 22.0 2.0 Cumulative 4.0 24.0 56.0 78.0 80.0 Rate of Return: N/A ; Staff Appraisal Report: No. 5358-CHA, dated March 14, 1985.  REPORT AND RECOMHENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPHENT ASSOCIION TO THE EXECUTIVE DIRECTORS ON A PROPOSED CREDIT TO THE PEOPLE'S REPUBLIC OF CHINA FOR A _VRAL WATER SUPPLY PROJECT l. I submit the following report and recommendation on a proposed IDA credit to the People's Republic of China to help finance a rural water supply project. The Credit, for SDR 82.1 million ($80 million equivalent), would be * on standard IDA terms. The Government would onlend $79.5 million equivalent to the participating provinces/municipality interest-free for a term of 25 years including 10 years of grace. Provinces would onlend part of such pro- ceeds to counties/villages interest-free for a term of 10 to 15 years includ- ing 2 to 4 years of grace. Service charges, however, would be borne by the sub-project entities - counties or villages, townships or vater companies within counties. The foreign exchange risk would be borne by the provinces or municipality and would not be passed on to the counties or villages. Cofinancing has been tentatively arranged tith the Federal Republic of Germany ($1.5 million grant) for training and the World Food Program ($10.5 millon grant) for food aid. PART I - THE ECONOMY 2. A country economic memorandum, entitled "China: Recent Economic Trends and Policy Developmentst' (No. 4072-CHA), was distributed to the Executive Directors on March 31, 1983. An economic mission that visited China early in 1984 is currently preparing a report on long-term development issues and options, which is expected to be submitted to the Executive Directors by May 1985. Basic data on the economy are given in Annex 1. Background 3. To address problems of economic inefficiency and structural imbal- ances, the Government initiated a program of reform and adjustment in 1979. Reform implementation proceeded most rapidly in agriculture and culminated with the introduction of the "producti=_ responsibility system" (in various forms), which gave households and small groups autonomy in production and investment decisions and ailowed them to keep most income earned after con- tracted payments to the state and collective. By the early 1980s, the vast majority of production teams in China had implemented such a system. Reform of the urban economy started out much more slowly, but nevertheless signifi- cant systemic changes occurred. including bonuses for individual workers; profit retention by state-owned industrial enterprises (at first on an experi- mental basis); fiscal decentralization measur2s,-which allowed provinces to share in the benefits of increased revenues and gave them more freedom in budgeting; and some decentralization of foreign trade authority. Adjustment policies resulted in an increase in the share of consumption in CDP; a rise in the share of light industry in total industrial output, substantial improve- ments in living standards, rapid grovth of foreign trade (particularly  -2- manufactured exports), and relatively modest (in relation to past trends) CDP growth. 4, A number of problems emerged in the process of reform and adjust- ment, including large budget deficits in 1979 and 1980, a deterioration of the external position and a significant current account deficit in 1980, inflationary pressures and some overt price increases, and excessive invest- ment demand resulting from decentralization of investment decision making and financing. In response to these difficulties the Government imposed a stabil- izatioG program in early 1981, which relied mainly on administrative con- trols. It resulted in a slowdown in growth, a reduction in price inflation (to around 2X p.a.), a s-harp cutback in budget-Financed investment, a lower budget deficit (1X of GDP ia 1981); and a currert account surplus of $1.5 bil- Lion in 1981 and $5.6 billion in 1982. Economic Performance, 1981-84 5. Economic growth picked uo in 1982 with the resumption of rapid growth of heavy industry and the rebound in investment. Overall performance has continued to be strong since then, and real GDP growth averaged over 82 p.a. from 1981 to 1984. Shortages of energy, many producer goods, and con- struction materials were exacerbated by the rapid growth of demand, yet price increases were limited by further strengthening of administrative price controls (particularly in 1983). Government budget revenue grew very slowly in 1982 (1.3%) but much more rapidly in 1983 (7.9%) and 1984 (as much as 10%), due to a new tax on enterprise retained funds and extrabudgetary incomes of Government organizations. This permitted an increase in budget expenditures on investment of 17Z in 1983 and a further rise in 1984, while maintaining a relatively small budget deficit (less than 2% of GDP in 1983). Growth of subsidies was largely stemmet by stopping increases in most of the agricul- tural procurement prices. 6. Gross industrial output value grew at over 102 p.a. between 1981 and 1984, with heavy industry growing somewhat faster than light industry (12Z vs. 9M)I a reversal of the 1978-81 pattern. The energy constraint on industrial growth was eased by rising coal output (8X p.a. in 1981-84) and maintaining annual crude oil output at over 100 miLlion tons, along with improvements in the efficiency of energy utilization (primary commercial energy consumption grew only 60% as fast as GDP in 1981-83). Agriculture has continued its very strong performance, with gross agricultural output value rising at 9% p.a. in 1981-84 and grain output at 7% p.a. (reaching over 400 million tons in 1984). Cash crops and animal husbandry have also grown very rapidly, stimula- ted by rising demand and attractive prices. 7. There have been impressive increases in personal incomes throughout the period 1978-83. Average per-capita income in rural areas rose by about 12% p.a. in real terms and urban incomes by about 5% p.a. Rural income growth was mainly due to production increases, efficiency improvements, and growth of employment in iDonagricultural activities, as well as substantial agricultural procurement price increases (through 1981). Urban income growth, on the other hand, can be attributed primarily to wage and benefit increases, which have exceeded growth of labor productivity.  -3- 8. Control of the aggregate level of investment and its composition has continued to be a serious problem. Enterprise and local government investment continued to increase sharply in 1982, far exceeding plan guidelines. In 1983, more stringent measures brought this part of investment under control (though it still exceeded plan targets). But investment outside the rural sector remains rather inefficient, and improvements in efficiency have been hindered by administrative controls. Construction costs have risen contiuaously (10 p.a. in 1978-83). 9. China has maintained a strong external position. The dollar value of both exports and imports stagnated in 1981-83, but this masked considerable increases in the volume of foreign trade. Since 1983, imports have grown more rapidly than exports, and in 1984, exports rose by an estimated 10Z and imports by 25X. Manufactured export growth was slower in 1981-84 than in 1978-81, but it started from a much higher base and occurred in the face of worsening world market conditions. Frreign debt and debt service ratios remained at very low Levels ($6.4 billion and 5.5Z respectively in 1983); China's foreign currency reserves (excluding gold) rose to $17 billion (over 7 months' imports) by mid 1984 and have stabilized at that level since then. The value of the Chinese renminbi declined y about 36Z against the SDR between the end of 1981 and late 1984 (60X against the US dollar). Recent Reforms 10. Rural reforms have continued to progress more rapidly than reforms elsewhere in the economy. A salient trend has been the spread of nonagri- cultural activities like processing, transport, and commerce. "Specialized households" (which concentrate ou one type of pursuit - often cash crops, animal husbandry, or nonagricultural activities) and pooling of capital by small groups of households in various types of ventures are becoming increas- ingly common forms of economic organization in China's rural areas. Wholesale markets for some agricultural products have emerged. To encourage investment in land improvement and development, farming contracts between collectives and peasant households (which typically had been fixed for no more than 3-5 years) can now be extended to as long as 15-20 years. In early 1985, it was announced that planned procurement quotas for agricultural conmnodities will be abolished; more methods of financing investment in rural nonagricultural activities will be permitted (including tax exemptions, local government bonds, higher interest rates to attract more saving, etc.); and the growth of the agricultural processing industry in coastal areas will be promoted. 11. The momentum of urbax. reforms has revived, with significant progress on a number of fronts. Since early 1984, a main focus has been further broadening and clearer delineation of the decisionmaking authority of urban enterprises. Profit retention now extends almost universally to state-owned industrial enterprises and in nonindustrial ^ectors like transport, commerce, construction, and other services. Urban collectives and individual enter- prises as well as a variety of joint ventures between them and state enter- prises have grown rapidly (the number employed in urban individual enterprises rose from 150,000 in 1978 to 2.31 million in 1983).  -4- 12. In financial reforms, the most important new development was the implementation of a profit tax system to replace profit remittances to the Government budget by state enterprises. Though most enterprises have switched to this system, the benefits have been limited because of the application of a different effective tax rate for each enterprise, to offset the impact of distorted relative prices and other factors. Similar problems have resulted in the abandonment of an attempt to impose a fee or charge on the fixed capi- tal provided to state enterprises by the Government, and they have hindered the shift from grant to loan financing of new fixed investment, despite strong Government support. Financial discipline at the enterprise level remains weak, in spite of efforts to strengthen accounting and auditing systems and more strictly enforce existing financial regulations. 13. In the crucial area of price reform, a major price adjustment for textiles and textile raw materials occurred in early 1983; it helped balance supply and demand, to a Large extent equalized profit rates for synthetic and cotton textiles (which are close su.stitutes in production and consumption), and drastically reduced subsidies for cotton procurement, with only a small net effect on the Covernment budget. Prices of many "minor" consumer goods (which individually do not have a significant impact on living standards) and the majority of agricultural commodity prices have been decontrolled and are nov set by negotiations between producers and commercial units. "Floating prices" (up to 20% above or below official prices) are now allowed for many industrial producer goods (either for all output or for output above the mandatory plan target). Price adjustments for key energy products and raw materials (which in many cases are severely underpriced) and for subsidized basic consumer goods like grain and edible oil have proven more difficult to implement, hindered by the potential impact of price changes on urban living standards and on the finances of energy-using enterprises. Nevertheless, some price rises have occurred (e.g. for coal and petroleum), and moreover the share of free market transactions (at largely uncontrolled prices) has increased in recent years. 14. Reforms in the employment and wage system have made limited pro- gress. The bulk of urban labor is still allocated administratively, and transfers of workers or professionals among enterprises are heavily impeded. Numerous attempts are being made to link individual performance more closely with-rewards, including piece-rates, "floating wages," and various types of contractual "responsibility systems." These have achieved some success, but problems of egalitarian distribution of bonuses remain, and many enterprises give out bonuses in kind or disguise them as allowances in order to evade regulations. 15. China's foreign exchange rate system has been unified with the abolition of the "internal settlement rate" (Y 2.8 to $1) at the beginning of 1985. Direct foreign investment (which was first allowed in the late 1970s but developed sLowly due to the lack of a legal framework) is being actively encouraged and joint venture agreements have increased sharply. In addition to four "special economic zones" open to foreign investment and subject to more flexible policies, 14 coastal cities were recently opened up in the same way.  16. Significant steps have been taken to develop new tools of indirect macroeconomic management. The central banking functions of the People's Bank of China were separated from its commercial banking functions (which were given to the newly established Industrial and Commercial Bank of China) at the beginning of 1984. The centrql bank relies on redeposit requirements and a discount window to influence the operations of specialized banks, and even- tually may use discount rates and interest rates in general as a flexible tool of macroeconomic management. Adjustments in indirect taxes may be used to affect profitability and supply, in the absence of or as a supplement to price reform. Scope for horizontal flows of investment funds is also being widened, with enterprises investing in each other and in joint ventures and in some cases individuals purchasing stocks. Though restrictions on secondary trading remain, Covernment bonds purchased by individuals now can be sold to banks or used as collateral for loans. Long-term Issues and Prospects 17. The Central Committee of the Chinese Communist Party issued a major document on urban reforms in October 1984, which reaffirmed and consolidated recent reforms and gives some general guidelines for the direction of future reform. It emphasizes the need for breakthroughs in the following areas: (a) enlivening and better motivating urban enterprises; (b) clearly separating Government and enterprise functions (and limiting direct intervention by Government organizations in enterprises' day-to-day operations); (c) reforming the price system; (d) improving incentives in the wage and bonus system; (e) establishing a planning system that is in harmony with greater reliance on the market mechanism and developing indirect macroeconomic management; (f) up- grading managerial personnel to meet the new demands on them in a reformed economy; (g) removing obstacles to a unified national market and promoting cooperation and technology transfer among regions; and (h) expanding utiliza- tion of foreign capital and advanced technology. Among the main themes of the document are the role of competition in promoting a more dynamic, flexible economic system; the recognition that a certain degree of income inequality is necessary to provide better incentives for economic development; the need for clear responsibilities and appropriate incentives at all levels in the econ- omy; and the recognition that thoroughgoing price reform must involve liber- a'izing the mode of price determination, not just adjustments in administra- tively set prices. Managers of large state-owned enterprises, however, will still be appointed by Government organizations; a few key products will remain subject to mandatory planning and distribution by the Government; state ownership and control over certain institutions like banks and railways will not be relinquished; and establishment, relocation, changing product lines, mergers, and shutdown of enterprises will still be subject to Government approval. 18. The Central Committee declaration represents a political commitment to economic reform, which will help foster an environment in which fundamental reforms can be gradually implemented in a coordinated way. But specific policy measures will -take a considerable length of time to design and then to implement. Many of the reforms required will be very difficult, particularly since reforms in different areas are closely interrelated, and thus appropri- ate sequencing and coordination become essential. For example, price reform  -6- in the absence of improvements in enterprise financial discipline will have Limited benefics, yet the more profit-oriented behavior that would result from tighter financial discipline would exacerbate the adverse impact of distorted prices. Similarly, reform of the labor allocation system will be incomplete without eliminating many of the "social responsibilities" of enterprises (which now provide housing, medical care, and pensions for their workers and in many cases education and jobs for workers' children) and replacing them with Government supported social service programs. 19. China's objective of quadrupling the gross output value of industry and agriculture between 1980 and 2000 (which means CDP growth of well over 6Z p.a.) will require significant improvements i; efficiency as well as continued high saving and investment rates. There will be major structural changes in s the economy over the next two decades, including a reduction in the share of agriculture, a rise in the share of industry and possibly in that of services (which at present is unusually low), and substantial urbanization (in smaller towns if not in large cities). There will also be a shift within agriculture, away from grain and basic crops and into cash crops and animal husbandry. 20. Certain physical/technical constraints will hinder the attempt to achieve China's targets for the year 2000 and its longer-term goal of catching up with the developed countries. Despite rapid growth and substantial improvements in efficiency in recent years, agriculture may again become a constraint on overaLl growth, since land in China is severely limited. In energy, shortages of fuel (primarily coal) and electricity may continue to constrain growth as they do now. Transport and commercial infrastructure will become increasing drags on the economy without large new investments (as well as improvements in efficiency). In mobilizing resources in all these areas, China could profitably make use of foreign borrowing. Finally, the rising share of the elderly in China's popuLation (related to the slowdown in popu- lation growth) means that more resources will have to be devoted to main- taining their consumption levels, especially in the docades after 2000. 21. Poor motivation and inefficient utilization of labor in the state sector of the economy are a major problem which can be solved only by coor- dinated reforms in labor allocation, the wage system, enterprise management, and social services, among other things. Reforms in the system of education and training to develop China's "human capital" potential also are crucial. Backward technology and inefficient utilization of existing technology must be dealt with by a combination of reforms, appropriately directed investment, and transfer of advanced foreign technology. Irrational location of factories, suboptimal scale of many plants, and poor utilization of physical capital in general are related problems. 22. If reforms successfully transform the economic system, with a beneficial impact on growth and efficiency, a new set of issues will come to the fore. Management of a reformed economy with indirect fiscal, monetary, and other instruments is one of the most important issues. In this context, maintaining an adequate saving rate (if the Government no longer accounts for the bulk of aggregate saving) and avoiding inflation (as well as deep cyclical downturns) will be major goals. Assuring an adequate minimum standard of living for the population and an appropriate level of social services will  -7- become a major challenge as enterprise and rural communal responsibilities in these areas are reduced. The problem of poor, backward rural areas in various parts of the country will continue to require attention. Redistribution of financial resources through the fiscal system, easing restrictions on migra- tion out of the poorest areas. and Lower nonagricultural wages to make invest- ment in them more attractive are among the options for alleviating poverty in these areas. 23. The Government is now in the process of finalizing its Seventh Five Year Plan (covering the period 1986-90). The combination of potentially fundamental refGrms and the urgent need for large investments in many parts of the economy to build the foundation for further growth makes this task a difficult one. In order to mobilize the investment resources needed for rapid, sustained economic growth and development, China will need to rely in part on foreign borrowing. This is recognized by the Government, which plans to gradually draw down its substantial-foreign exchange reserves and hopes to attract foreign capital through a variety of channels. China also has a claim to concessionary lending because it is still one of the poorer countries of the world But its access to concessionary capital to finance its development and modernization program is limited; apart from Bank Group funds, a significant amount of concessionary capital is likely to come only from Japan and a few other bilateral donors and will probably average no more than $500- 600 million p.a. during the rest of the 1980s. PART II: BANK GROUP OPERATIONS Z4. For China to sustain rapid growth over the coming decades, with increases in efficiency and innovation while maintaining equity in distribu- tion, will require continuing and fundamental reforms. These challenges are compounded by China's large investment requiremcats and the difficulties associated with its efforts to open up to the rest of the world. In light of this, there are several broad objectives for the Bank to pursue in its relationship with China. First, the Bank can offer China its development experience and institutional knowledge as well as the opportunity for inter- action with the Bank's other member countries. Second, the Bank can assist China in removing major constraints on development and in improving investment planning and policy coordination in the priority sectors - particularly - energy, transport, other infrastructure, human development and industry. Third, the Bank can assist the Covernment in its efforts to remove the remaining pockets of poverty. 25. The Bank Group's strategy to meet these objectives is formulated in line with China's broad development priorities and related issues outlined in Part I of this report. However, Bank Group lending can provide only a small portion of overall resource needs. As a key element of the strategy, there- fore, the Bank's lending operations will aim to create a substantial demon- stration effect applicable to China's overall development efforts. For example, projects involving new techniques for land development or for provi- sion of social services have been designed so that they can be repeated by local authorities within their existing resources. Some of the agriculture projects and the rural health projects are examples of this approach. The introduction of international competitive bidding through Bank projects (first  - ~ ~ ~ ~ ~ ~ ~ 8 to finance goods, and later civil works) is nov being adopted by the Government for most local purchases and many domestic construction projects. 26. Bank assistance can help improve the efficiency of investment, through introduction and dissemination of improved analytical techniques for investment and project plannidR and through institution building. Preparation of the project appraisal manuals for the China Investment Bank and the Agricultural Bank of China, consultant assistance and the EDI-sponsored programs, as well as specific sector work in transport, industry, health, - education and other sectors have improved the quality and content of project proposals. Assistance to Chinese enterprises and agencies through staff training, consultant assistance, creation or reorganization of institutions, -and improvement of costing and financial management has been included in a number of projects ranging from the ports and railway projects to the several education and petroleum projects. Specific sector work in enterprise manage- ment, urban development, health and industry has also provided assistance for ipo mt of investment efficiency. 27. Humna resource constraints are a particularly serious problem for China's deveLopment. There are severe scarcities of higher level trained manpower. Substantial economic and sector work and technical assistance and training components in most of the Bank projects are providing support. In terms of poverty alleviation, the rural health project, proposed urban and water supply projects and sector work on labor mobility and regional develop- ment options address poverty, health and equity issues. 28. Transfer of technoLogy in the broad sense is of fundamental impor- tance in Chi;n's efforts to improve efficiency of the economy. Outmoded, inefficient and costly industrial technologies are serious impediments to development and are wasting valuable energy resources. Here, the Bank can pLay the role of an intermediary. In transportation, energy, industry, agriculture and even education, the Bank can finance transfer of technology through equipment imports, provision of foreign consulting assistance, sarragement of training and promotion of licensing and other agreements such as are now being discussed in the railways and other projects. Long-term investment for new technology will require increased foreign borrowing in the future and the Bank can assist China through cofinancing. Progress is being made in introducing co-financing under the first and second power projects, coal, urban, and some agriculture projects, as well as the proposed project, and the Bank will continue these efforts. 29. For most of these elements of country strategy, however, progress will be gradual and will require sustained Bank involvement over a series of projects in various sectors. Economic and Sector Work 30. Economic and sector work in China was Lnitially designed in part as a learning experience to provide the Bank with a basis of knowledge on the development and functioning of the Chinese economy. It also introduced the Government to alternative ways of economic analysis and views about its achievements.  -9- 31. In the last four years, the above approach has been well received and has allowed economic and sector work to be particularly relevant to the problems of adjustment and reform which have been in the forefront for the Government. Followup to the first economic report emphasized technical assistance and sector work for investment analysis and selection techniques and enhanced sector pLanning. The content of the lending program has been directly influenced as a result. The rural credit project, the China Invest- ment Bank projects, and future regional industry projects are among examples * of the links between economic and sector work and the lending program. * 32. More fundamental research into the problems of enterprise management is now nearing completion in collaboration with Chinese economic research institutions. It has yielded insights into the thinking and reaction of enterprise managers to system reform and led to better understanding of how policy changes can improve planning, performance and management of enterprises. In addition, there is a variety of project-related sector work underway through studies included in the projects. These are expected to produce the brasis for detailed discussion of development options and policies in the various sectors. 33. Current economic work focuses on future options and issues to the year 2000 and a comprehensive report will be ready later this fiscal year. In light of the experience of other countries in making the transition from 1G..' to middle income levels, the report will pay special attention to inter- sectoral linkages and economy-wide issues. 34. Future economic and sector work will be based on the conclusions of the economic report. It wi-ll continue to improve our knowledge of the economy - its structure, the issues and cosztraints in key sectors, and the function- ing of -he economic management system. Collaboraticn on issues of institu- tional and policy change with Chinese research institutions will continue. Review of the investment program in key sectors when the Seventh Five Year Plan (1986-90) is finalized will help develop the next generation of projects for the lending program. Lending Operations 35. Since China's change of representation in the Bank Group in May 1980, 22 projects involving lending of $2.274 billion to China have been approved. Annex II contains a summary statement on these loans and credits as of September 30, 1984. For this fiscal year we hope to present a total of twelve projects to the Board. These include the already approved Second Agricultural Research Project, the Second Power Project, the Second University Development Project, the Changcun (Luan) Coal Mining Project and the proposed Rural Water Supply Project, as well as projects in seeds development, roads, railways, fertilizer industry, gas engineering and Pishihang-Chaohu area development. 36. For FY86 and beyond, the China lending program should continue to grow from current levels. Areas of emphasis would include development of energy resources, transport infrastructure, skilled manpower and improved *-- technology. We will also investigate the feasibility of a regional approach in a number of sectors and will take better account of intersectoral link&ges.  - 10 - 37. In the energy sector, lending has included six projects, which have emphasized increased energy output and technology transfer through financing of equipment, technical studies, training and consultant assistance. The Lubuge Hydropower Project has resulted-in the Government's extensive use of competitive bidding for power projects. The Second Power Project placed particular emphasis on better'systea planning. Fuel alternatives for electricity generation, power plant location and interconnection of power grids will be the subject of future work. For develonment of China's petroleum and coal resources, Bank Group assistance will emphasize acquisition of appropriate technologies, least -ost planning of investment and related transport investment programs. -38. In the transport sector, railway, port and road capacity must be substantially increased. So far, one project each in ports and railways has focussed on increasing capacity, upgrading technology for lower cost opera- tictns and establishing better costing systems. Expanding domestic capacity to manufacture improved transport equi*ment will continue to be a theme in the sector and this should provide scope for substantial foreign private sector involvement. Improved management and information systems and analytical tech- niques for better cost control will be encouraged under the projects, which, once proven, wilL be suitable for wider use throughout transport enterprises. Inter-modal coordination and planning and assessment of alternative investment choices will have increasing prominence in both lending and sector work. 39. In agriculture, seven projects have emphasized support services through improved research and education, prod-uction increases through new land development, reclamation, use of improved technologies and management, and strengthening of the agricultural credit system. Future projects in seeds development, forestry and agricultural credit will continue to strengthen sup- port services and rural institutions. Land and area development projects will endeavor to provide models of integrated regional development. Specialized activity projects such as fisheries, livestock and agro-processing may also be developed to support on-going structural transformation in agriculture. 40. In the industrial sector, two projects have focused on establishing and strengthening the China Investment Sank. Improved investment selection criteria, incentives for more efficient management, technology transfer, and energy conservation are priorities for future projects. Lending will have a two-pronged approach - further strengthening of the China Investment Bank (and perhaps other financial intermediaries) and financing large regional production-oriented projects such as for fertilizer, machine tools, and cement, to expand output and demonstrate the merits of improved subsector analysis and planning. 41. Further expansion of higher education and improvement of teaching, curricula and graduate quality will be needed to the end of the century. Ihe human resource constraints have already been addressed by four education projects and a component of the Rural Realthl/edical Education Project. The value of international competitive bidding for equipment purchases and of international advisory panels for educational policy and curriculum reform has been demonstrated in the first projects. Improved university management is being encouraged through establishment of quantitative targets for growth,  - 11 - been demonstrated in the first projects. Improved university management is being encouraged through establishment of quantitative targets for growth, student-teacher ratios, classroom utilization, laboratory experiments per- formed, and other reforms (including development of evaluation and monitoring procedures and greater decentralization). The proposed water supply project and future projects in health, urban deveLopment and water supply will assist the Government in addressing difficult poverty-linked questions of affordability, cost recovery, and minimum standards with focus on particularly impoverished regions. 42. Implementation. Project implementation is generally proceeding ( well. While there were some initial delays in procurement because of the Government's unfamiliarity with the concept of bidding, it has since estab- lished a specialized central procurement agency and has largely overcome this problem. Most project agencies, as well as the Ministry of Finance and the State Planning Commission, have establisthed and staffed offices to handle Bank Group projects. To support further expansion of the lending program, accelerate project prerptration, improve project implementation, and facilitate further economic and sector work, the Bank Group is planning to open a resident office in China early in FY86. PART III - THE WATEE SUPPLY SECTOR Introduction 43. The lives of China's 80C -aillion rural inhabitants have improved markedly in modern times. There have been major gains in health, housing, and agricultural productivity. Health improvements have resulted largely from health education campaigas, improved nutrition and sanitation, better maternal and child care, immunization, and modest improvements in drinking water facilities. But about 40Z of the rural population - some 300 million people - still have critical water supply needs: the supply for 45 million people has excessive fluoride concentration; 63 million drink saline or alkaline water; 150 million use untreaLed surface water contaminated by domestic, industrial or agrochemical wastes and 42 million live in water scarce areas. 44. Traditionally rural water supply has been obtained from individual or household systems such as bucket wells, hand pump wells, and rainwater collection tanks, or fetched from rivers, springs or ponds. Most people are still served in this manner. Drinking water is generally boiled and this helps control bacterial infections, though it does not prevent illness caused by chemical substances, found naturally or introduced by agricultural or industrial discharges. With rising incomes, rural people are demanding and can increasingly afford improvements in housing, education and public services. Many have come to expect and are willing to pay for piped systems purveying safe and convenient water, sometimes by public standpipes but more commonly to the house or courtyard. Wastewater mibagement in rural areas is generally not a problem. Flush toilets are not used. Excreta is collected, frequently treated by digestion and used as fertilizer. Sullage water is used to water animals or for irrigation, or allowed to drain avay in rainwater channels or seepage pits.  - 12 - Sector Organization 45. The water supply sector is organized separately for urban and rural areas. For both urban and rural, local initiatives and finance ar!,the prime movers for development. In urban areas, the municipal govetiments- are largely responsible for financing, designing, and building wacer and waste systems; this is usually done by the municipal finance, design, and construc- tion bureaus. All urban water supply projects have to be reported to the Ministry of Urban and Rural Construction and Environmental Protection but approval is not needed unless the project has a capacity in excess of 100,000 tons per day or central government financial assistance is sought. If a project extends beyond the city, such as the water supply for Tianjin City which involves the diversion of a river, it is classified as a national project and this may make it eligible for central government participation. 'here a project is estimated to cost more than Y 10 million, approval by the State Planning Coruission is required. For very large projecta costing over Y 100 million and where foreign loans ire involved, further approval by the State Council is necessary. 46. For rural areas, China's policy of self reliance has resulted in the villages being largely responsible for sector development and for providing their own water supply. The initiative for planning, financing and operating water systems originates at the village Level with a substantial part of the funds - usually 90Z - coming from individuals and collectives. Plans for waterworks are submitted fur approval ro the county, which helps to design and purchase material, and decides on the need for subsidies. The provincial government in turn compiles plans submitted by the counties and may provide some financing. The central governmet has only recently become move active in providing guidance and coordination, and provides financing only in exceptional cases. 47. Most waterworks in rural areas are owned, managed and operated by the villages. But in some areas collectively owned water companies have been established under the guidance of townships or counties, especially where several villages can be served more efficiently by a common system. Water companies are more likely to be found in industrialized provinces where there is suitable managerial and technical expertise. 48. Prior to China's endorsement of the UN Drinking Water and Sanitation Decade Program in 1980, no single agency was responsible for the rural sector. Planning and programming were done primarily at the local level. In 1981, the State Council designated the Central Patriotic Health Campaign Committee (CPHCC) as the unit responsible for organizing Decade activities. The Minister of Public Health, who is concurrently one of the deputy chairmen of the CPNCC, was designated Chairman of the National Executive Committee for 11 Municipalities generally have populations in excess of 100,000; there are 289 in China. Towns have populations ranging upwards to 100,000, and there are 3,200 in China. The 800 million rural Chinese live in some 718,000 villages.  - 13 - Decade activities. The actual work was delegated to the CPICC's executive office. CPHCC has thus become responsible for development of the ruraL water supply sector, although its responsibilities are not confined to this sector. It has taken this assignment seriously and water supply improvement has become one of its primarycurrent concerns. 49. The CPHCC has as members senior officials from some thirty minis- tries and agencies active in health, water and environmental matters incl-uding a the State Planning Commission and the Ministries of Public Health, Urban and - Rural Construction and Environmental Protection, Finance, Water Conservancy and Machine Building. The Committee's objectives are health promotion and disease prevention (e.g., elimination of "the four pests") through education and organized mass participation in health and environmental activities. The membership structure of the committee is repeated at the provincial, county, and village levels, that is, each has its health campaign committee which, in turn, has as members the local health, finance, construction and water conservancy bureaus. The local comuittees are responsible for implementing the Central Committee's policies and priorities and their presence has resulted in successful implementation of the Gentral Committee's objectives. Many of China's rural health gains can be attributed to the work of this Committee and its ability to command and coordinate the activities of its members. Rural Water Supply Program 50. A national rural water supply program was initiated in 1981 in con- junction with the UN Decade. Although some physical works have been con- structed at local levels as Decade activities, to date the program has concen- trated on information dissemination, training and project preparation. This has been done by the CPHCC and its National Project Office (NPO), with the technical assistance of UNDP, WHO, the Federal Republic of Germany (FRG) and IDA. (IDA technical assistance, described more fully in para. 62, in particular has been targeted at the NPO, which competently used and disseminated it to other central agencies and the provinces, counties and villages.) The project for which this credit is recommended is the first in the rural water supply program which is coordinated, managed and partially financed at national and provincial levels. National, prerincial and county project offices have been established for the project and these will serve as models for water supply improvement offices in nonproject provinces and counties. Sector Financing 51. The virtual absence of central government financing for rural water supply distinguishes China from most other developing countries. Local governments, rural enterprises and individuals are expected to provide financ- ing for capital costs and rural and urban consumers almost always pay the recurrent costs. In villages householders share the costs with funds derived from communal activities. Water charges normally cover the cost of operations and maintenance, and occasionally some depreciation. Metering is increasingly common in urban areas but in rural areas peer pressure is effective in controlling wasteful consumption.  - 14 - Sectoral Issues 52. Water Supply Targets and Programs. In 1981 China set a tentative target to provide safe drinking water for all by 1990, the goal of the UN Decade, but soon realized that this could not be achieved because of finan- cial, organizational, and technical constraints. The current target is to have 802 of the rural population adequately served by 1990. This would be achieved largely by the villages constructing water systems under their own initiatives, but with increasing guidance and support from the provinces and counties. In general terms, the CPHCC has divided Decade activities into three phases: 1981 - 83 for preparation; 1984 - 86 for popularization; 1987 - 90 for implementation on a national scale. But there is no concrete national plan, nor a compilation of provincial plans for rural water supply improve- ments. During the current period of popularization, a major activity for the CPHCC is to implement the proposed project so that it can serve as a model for water supply improvements throughout China. 53. Because of the size and relative autonomy of the provinces, rural water supply and sanitation sector planning is best done at the provincial level. A Rural Water Supply and Sanitation Technical Advisory Center (TAC) has been established in the existing National Institute of Health, and this center, with financial support from the NPO, is conducting a survey of rural water conditions throughout China which will provide the basis for rational sector planning. The NPO and TAC, with support from IDA, will assist the pro- vinces in analyzing institutional and financial arrangements and developing plans for the sector. Two or three provinces will be selected initially as prototypes for this work. 54. Financing Sources and Arrangements. To meet rural water supply and sanitation targets the Government estimates that about Y 15-20 billion would be required. Although rural incomes have increased significantly in recent years, without seed capital and appropriate financing mechanisms s-ctor advancement will be slow. The Government will continue to require virtually full cost recovery, but within that context it is considering options for financing facilities and revolving funds. An assessment is needed of the participation required of the village, county, province and central government and of how revolving funds can best be set up and operated. The experience gained while implementing the proposed project will help in this assessment and in the development of policies. 55. Institutional Framework. The government policy of self reliance has placed the responsibility for rural water development on the township and the village. These communities, however, often lack the administrative, financial and technical skills required to plan, construct and maintain the more elabor- ate piped and pumped water systems, especially where water treatment is required. Assistance in these areas is sometimes provided by the county or the province, but capabilities, methods and procedures vary from place to place and are often ad-hoc. The Covernment is f6rming a structure and mechan- ism under the direction of the CPHCC for providing technical assistance nationwide, to county and provincial levels of government, to support the villages. Through improved organization, standardized methods and better staffing, the national and provincial project offices are also being streng-  - 15 - thened in their abiLity to plan and organize sector programs and carry out projects. And the CPHCC is designing, with FRG financing and technical assistance, provincial and county-level training programs for planners, designers, and water system managers and operators. IDA staff have been assisting this effort and wouLd continue to do so under the project. 56. Technical Considerations. The technical capabilities of the provinces and counties vary greatly across China, but generally are more advanced in the industralized regions. Poor capability in non-industrialized areas is partly due to China's previous isolation, the setback in education in * the 1960s and poor communications among provinces. As a result, designs are c sometimes inappropriate and inefficient. Since subprojects are to be designed in great numbers at the county level with only selective checking at the provincial and central level, it is necessary to find some means to ensure planning and design quality. To this end, as a part of the preparation of the proposed project, a rural water supply planning manual was prepared and intro- duced in 1984 under the direction of the CPHCC and with IDA assistance. The manual, 19,000 copies of which have been distributed throughout China, guides technicians through key planning steps such as comparing alternatives, select- ing water sources, and laying out distribution systems. Provincial and county staff are presently being trained in its use. Assurances have been obtained that the manual would be updated in accordance with a timetable acceptable to IDA (Section 3.04 and Schedule 4, para. l(b) of the draft Development Credit -greement); an understanding was reached that this would be done by June 1987. Additional manuals will be prepared (with corresponding training courses) for design, construction and operation and maintenance, thereby increasing the productivity of technical and operations manpower. 57. Water Pollution. The growing population and industrialization of China has caused widespread air, water and land pollution, often contaminating drinking water supplies. In some regions more distant water sources must be tapped, or, where chemical pollutants are involved, specialized (and costly) treatment is required. In 1979, China enacted an environmental protection law, and in 1984, a water pollution control law, but enforcement has been difficult because of costs, the large number of old industrial, plants and their importance to the economy. Current policy is to relocate waste-produc- ing industries away from populated places, and to require that industries meet prescribed effluent standards. Old and inefficient industries are gradually being shut down. In some places industries are charged or penalized for discharging wastes, with funds so derived used for pollution abatement * measures or facilities. The overall approach is sound but the process will require time-and steady vigilance and funding. The Bank is providing some assistance in this field through a proposed project to improve Shanghai's environment. Bank Group Role and Sector Lending Strategy 58. IDA's experience with programs in other countries enables it to assist China in many aspects of implementing a rural water supply and sanitation program on a national scale. The more important of these as related to the rural water supply sector and project development are: (a) overall planning, to develop realistic service targets and programs to achieve _  - 16 - those targets; (b) organizational arrangements and institutional development, to improve the capabilities at the national, provincial, county and village level for project planning, implementation and operations; tc) staff development; (d) financial anaiysis and funding arrangements for rural water supply (suc!i as revolving funds, cost sharing, payback terms, cross subsidies and afforda2iility); and (e) plannzing and design of projects and individual subprojects to ensure that project organizations and resources are coordinated and that subprojects are technically appropriate and cost effective. IDA will also assist the NPO and TAC in guiding the provinces with developing sector plans and strategies for rural water supply, and will guide preparation of Euture rural water surply projects which could be supported by the Bank and other donors. 59. For the urban sector the Bank is involved in planning for Shanghai's urban development under a cofinancing arrangement with Australia. This is a consequence of the sank's 1982 urban sector memorandum on Shanghai which recommended a coucentrated planning efEort in the areas of wastewater management, housing, traffic and transport. Bank staff are presently assisting Shanghai and Australian technical teams working on these plans, and the effort is expected to lead to projects in environmental improvement and housing upgrading. The Shanghai studies are being monitored by urban development specialists in the central government and other major cities, and may be used by them as a guide for their own planning. PART IV - THE PROJECT Origin 60. In 1981 a UN mission comprising representatives of UNDP, WHO and the Bank Group visited China to survey the water supply and sanitation situation there. Its report, while recognizing the significant strides made in the sector since 1949, also drew attention to the large and urgent needs in water supply in both urban and rural areas. Consequently, UNDP funded a water supply and sanitation technical assistance project which was executed by WHO and provided training, information exchange, specialist services and support for the preparation of water supply projects. In 1983, China requested the Bank Group to consider a rural water supply lending operation. A mission in August 1983 identified a project and provided guidance for its preparation. The Government initially proposed a project for 13 provinces covering 5,000 villages in 21 counties. Since much of the preparation and implementation is done at the provincial level, and the provinces require guidance and instruction, the number of provinces was reduced to four, plus the Municipality of Beijing, to keep the project manageable and to ensure its success. Rural water supply improveenwts in other provinces and counties are proceeding in parallel with the work on this project, but with the traditional arrangements for funding. The project was appraised in September 1984 and negotiations were held in Washington from February 27 to March 4, 1985. The Chinese delegation was headed by Mr. Ce Fucun of the Ministry of Finance. A staff appraisal report (No. 5358-CHA, dated March 14, 1985) is being distributed separately to the Executive Directors. Supplementary project data are provided in Annex III. _  - 17 - Objectives 61. The physical objective of the project is to provide safe and ade- quate potable water supply to some six million people who now are drinking contaminated water, have an inadequate supply or must travel an excessive distance to obtain it. The iDstitutional objectives of the project are to develop national and provincial planning capability, improve the cost- effectiveness of and financial arrangements for projects, and ensure their adequate operation. The strategies to achieve these are to: (i) improve the organizational arrangements for preparing and .rsplementing broad-scoped projects; (ii) introduce economic and affordability considerations in project planning; (iii) improve design and equipment technology and improve construc- tion quality; (iv) intLoduce revolving funds as new financing mechanisms; (v) train manpower in planning, design, construction, management and operation of water systems; and (vi) assist in developing sector plans and strategies. Rationale for IDA Involvement 62. The rationale for IDA involvement in the project is to: (i) draw upon the Association's experience with projects in other countries and thereby to give advice and support in project planning and implementation; (ii) help provinces and local governments establish facilities and management systems needed to design, construct and maintain water systems; and (iii) to assist provinces and local governments to build instirutions that will, in the longer term, permit extension of water systems to other areas in the beneficiary provinces and serve as models for programs in other provinces. In the prepar- ation stage, IDA assisted the Government, provinces and sub-project entities to prepare the project with minimal use of foreign consultants. IDA staff provided advice on organizing the project, staffing, subproject planning and design, managing revolving funds, regulating construction, and managing and operating water systems. IDA also helped to arrange participation of foreign donors. Consultants funded by the FRG have assisted in preparing the training program (and the FRG is expected to fund the foreign costs of training) and the World Food Program is expected to provide food aid for village labor in two of the five beneficiary provinces. During implementation, IDA will continue to assist with measures for ensuring project success: reviewing subproject design; using competitive methods for procurement; controlling quality of goods and construction; and preparing manuals for design, construction and operations. Scope and Planning 63. The project, to be implemented durizg the period from 1985 to 1989, would cover some 4,650 villages with 5.9 million people (as of 1982) in 25 counties of the provincef of Liaoning, Shaanxi, Sichuan and Zhejiang and the municipality of Beijing-/ (herein referred to as the provinces). These 2/ Beijing is classified as a municipality but 3.6 million (40X) of its 9 million people live in suburban and rural areas. It enjoys the same status as a province.  - 18 - provinces have a total population of 213 million and a rural population of 172 million, uf which 117 million do not have safe water supply. The 25 counties included in the project have a rural pcpulation of 13.9 million, almost 802 of which lack safe water. The villages were selected because: (i) their present water supply is inadequate, unsafe or too distant; (ii) they want and are willing to pay for improved water supply; (iii) they are geographi- cally diverse and provide a variety of technical solutions for demonstration purposes; and (iv) they are relatively poor. Fifty-two percent of the project villages are presently using polluted and untreated water; for another 32X, the water is scarce or too distant; 11 are using water with excessive fluoride and 5X with excessive salinity. The proposed subprojects are planned for a 15-year time horizon and in consultation with the villages by persons trained in the use of the planning manual. Assurances were obtained that subprojects would be planned in accordance with the manual (Section 3.04 and Schedule 4, para. l(a) of the draft Development Credit Agreement and Section 2.05 of the Project Agreement). The manual introduces, for the first time in China, economic, financial and affordability criteria in the selection and planning of waterworks. The types of waterworks would range from non-piped individual systems such as rain water storage tanks and hand pumps (which would serve 161 of the beneficiary population), to piped water systems with ground water or surface water sources and with varying degrees of treatment. (Physical, climatic and economic conditions vary widely; hence technical solu- tions also vary.) The water produced would generally meet China's drinking water standards, which are generally in line with WHO standards. About 80Z of the services from piped systems would be by house connecticns, and the balance by standpipes, with the type of service dependent upon climatic conditions, the preference of the beneficiaries ,ad their ability to afford the service. Household connections are not included because of the added capital and recur- rent costs for metering, but some counties expressed interest to install meters at a later date if needed to control uneconomic use. A summary design report will be prepared for each subproject which, in addition to descriptive information, would contain quantitative parameters, such as cost per capita, to enable judgments to be made on the appropriateness of design and the affordability of the scheme. Institution Building and Training 64. Project offices at the central, provincial and county levels have been established and almost fully staffed to carry out the project. The project includes continued assistance to these offices in developing proced- ures for planning and impleaienting projects, monitoring progress, and training staff. 65. Durirg p'-- p;epirut'jn the NPO's training advisors and foreign training speciaL : ved ;y f'je FRG developed a training component which, while initicaliv