Nepal - Third Narayani Irrigation Project

Dmme f The World Bank FOR omcwL. USE ONLY Report No. P-4332-NEP REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO TRE EXECUTIVE DIRECTORS ON A PROPOSED CREDIT OF SDR 21.6 MILLION TO THE KINGDOM OF NEPAL FOR A NARAYANI III IRRIGATION PROJECT June 2, 1986 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Is contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS US$1.0 = KRs 20.5 ABBREVIATIONS AND ACRONYMS AG - Auditor General AIC - Agricultural Inputs Corporation BSC - Branch Secondary Canal CCA - Cultivated Commanded Area DG - Director General (DIHM and DOA) DIHM - Department on Irrigation, Hydrology and Meteorology DOA - Department of Agriculture FAO - Food and Agriculture Organization GM - General Manager cOI - Government of India HMGN - His Majesty's Government of Nepal ICB - International Competitive Bidding IDA - International Development Association LCB - Local Competitive Bidding M&E - Monitoring and Evaluation MOA - Ministry of Agriculture MSC - Main Secondary Canal MWR - Ministry of Water Resources NEC - Nepal Eastern Canal NZIDB - Narayani Zone Irrigation Development Board NZIDP - Narayani Zone Irrigation Development Project (Stages I, II and III areas) O&M - Operation and Maintenance SA - Special Account SDC - Swiss Development Cooperation Stage I Area - Narayani Zone-Blocks I-VI--15,900 ha Stage II Area - Narayani Zone-Blocks VII-XII--12,800 ha Stage III Area - Narayani Zone--Blocks XIII-XV--8,700 ha TC - Tertiary Canal T&V - Training and Visit System (of Agricultural Extension) USAID - United States Agency for International Development WUG - Water Users' Group FISCAL YEAR July 16 - July 15  FOR OFFICIAL USE ONLY NEPAL NARAYANI III IRRIGATION PROJECT Credit and Project Summary Borrower: Kingdom of Nepal Amount: SDR 21.6 million (US$24.5 million equivalent) Terms: Standard Project Objective The main objectives of the Project are to increase and Description: dry-season agricultural production and reduce the risks to monsoon crop production by introducing an equitable, predictable and reliable irrigation system in the Narayani irrigation scheme. The proposed project is the third phase of an IDA-supported program and would complete the development of irrigation and drainage infrastructure over about 37,400 ha served by the Nepal Eastern Canal in the Narayani Zone of the Central Region of Nepal. The project would also provide for: flood protection and river training works; improvements to village roads and canal service roads; support to agricultural extension and research; a regional workshop; training of project staff; consulting services; funding for project establishment and O&M; a small component for groundwater development; and monitoring and evaluation. In view of the experience with the implementation of the first and second projects, no major risks are anticipated regarding the physical implementation of the project. Possible risks that could affect project objectives include: HMG's failure to make adequate provisions for OEM financing after contributions from the credit phase out at the end of implementation; a major flood damage to the main canal and other essential irrigation infrastructure; and inadequate water management. With respect to these risks, the cost of project establishment and ObM would be financed under the credit on a declining basis; special training would be provided to project staff in water management and water users' groups would be strengthened; and project planning and design would enable the introduction of a water management system that would enable the irrigation service to be timely, reliable and equitable. This document has a rstricted distribution and may be used by recipients only in the performance | of their offiil duties Its contents may not otherwie be disclsed without World Dank authoriation.  Estimated Costs: a1 US$ Millions- Project Component Local Foreign Total NEC Improvement and Repairs to the Tilawe Barrage 1.2 1.0 2.2 Irrigation and Drainage (Stage III Areas) 1.5 3.0 4.5 Irrigation and Drainage (Stage I and II Areas) 1.2 2.2 3.4 Flood Control and River Training 0.5 1.1 1.6 Upgrading of Road Network 0.5 1.1 1.6 Equipment and Radio-Communication System 0.1 1.3 1.4 Regional Workshop 0.1 0.9 1.0 Technical Support 1.6 2.5 4.1 Establishment and O&N 3.6 1.8 5.4 Land Acquisition and Crop Compensation 0.6 - 0.6 TOTAL BASE COSTS 10.9 14.9 25.8 Contingencies Physical Contingencies 1.1 1.8 2.9 Price Contingencies 3.0 3.8 6.8 TOTAL PROJECT COSTS 15.0 20.5 35.5 Financing Plan: b/ --US$ Millions-- Local Foreign Total IDA 9.2 15.3 24.5 SDC 2.3 5.2 7.5 HMGN 3.5 5.2 3.5 TOTAL 15.0 20.5 35.5 a/ Not including taxes and duties estimated at about US$0.5 million. b/ SDC grant is denominated in Swiss Francs and is fixed at 15 million Swiss Francs: the US$ equivalent of 7.5 million (using exchange rate of April 22, 1986) may vary with exchange rate movements. Cofinancing is on a joint basis following Bank Group's procurement and consultants guidelines.  -iii- Estimated Disburseuents: IDA FY FY87 FY88 FY89 FY90 FY91 FY92 FY93 FY94 a/ (a) For IDA Credit Annual 0.8 2.3 3.4 5.0 6.5 3.7 2.3 0.5 Cumulative - 3.1 6.5 11.5 18.0 21.7 24.0 24.5 (b) For SDC Grant Annual 0.2 0.7 1.1 1.5 1.6 1.3 0.9 0.2 Cumulative - 0.9 2.0 3.5 5.1 6.4 7.3 7.5 Rate of Return: 21 percent Appraisal Report: NEPAL: Narayani III Irrigation Project, Report No. 6067-NEP, dated June 2, 1986 Map: IBRD 19549 a/ One semester.  INTERNATIONAL DEVELOPMENT ASSOCIATION REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED CREDIT TO THE KINGDOM OF NEPAL FOR A NARAYANI III IRRIGATION PROJECT 1. I submit the following report and recommendation on a proposed development credit to the Kingdom of Nepal in an amount of SDR 21.6 million (US$24.5 million equivalent) on standard IDA terms to help finance the Narayani III Irrigation Project. Cofinancing has been arranged with the Swiss Development Cooperation (SDC) for a grant of Sw F 15.0 million (about US$7.5 million equivalent). PART I - THE ECONOMY 1/ 2. The most recent economic report, Nepal: Prospects for Eccnomic Adjustment and Growth (Report No. 5867-NEP), was distributed to the Executive Directors on December 17, 1985. The principal features and recent performance of the economy are described below. Country data are shown in Annex I. 3. Nepal is one of the least-developed countries in the world. Per capita income is estimated at US$170 (1983) and health and education standards are well below the average for South Asia. Life expectancy at birth is about 46 years, infant mortality is about 145 per 1,000 and adult literacy is only 19 percent. The population, estimated to be 16.3 million (mid-1984), grew at a rate of about 2.7 percent per year between 1971 and 1984. About 95 percent of the population lives in rural areas. 4. Population density with respect to arable land (394 persons per sq km) has reached very high levels, and cultivation has been extended to marginal lands and forests. Forests have been denuded further to meet the growing demand for fuelwood, on which Nepal depends for more than 90 percent of its energy consumption, mostly for household cooking and heating. Because of deforestation and excessive grazing on hills and mountains, when rainfall is abundant, accelerated soil erosion occurs causing rivers to silt and flood with consequent loss of agricultural productivity. 5. Agriculture, largely rainfed, accounts for nearly 60 percent of Nepal's GDP and merchandise exports and provides the main source of livelihood to more than 90 percent of the population. Crop production 1/ Substantially unchanged from Cottage and Small Industries II Project (Report No. P-4295, dated April 24, 1986).  -2- accounts for about 60 percent of agricultural output, livestock for 30 percent, and forestry for 10 percent. Apart from agricultural land, Nepal's only other important exploitable resources are hydropower and tourism. Exploitation of its vast hydropower resources will depend upon the Government's ability to enter into complex agreements with neighboring countries regarding the use and development of water resources and the exchange of water-related benefits. The tourism sector, based primarily on Nepal's Himalayan environment provides about 20 percent of the country's foreign exchange earnings, but accounts for only about 1 percent of GDP. 6. Following centuries of self-imposed isviation, efforts to develop the economy of Nepal began in the mid-1950s--a time when the country had virtually no physical infrastructure, an ancient administrative system, and very limited educational and health services. Between 1955 and 1975, the country's primary development goal was to build basic infrastructure and provide a basis for future economic growth. Reasonably good progress has been made. A basic road network now exists. Schools accommodating almost half of the children of primary school age have been built, as have a number of secondary schools and a national university. A rudimentary hospital system, including rural health posts, has also been established. Then, in the Fifth Five-Year Plan the Government shifted its development objectives to stress accelerating economic growth and creating employment, as well as raising living standards. These objectives were reiterated in the Sixth Plan (FY81-FY85) and in the Seventh Plan (FY86-FY90), which also appropriately assigned high priority to developing agriculture, small-scale industries and Nepal's abundant water resources. Additionally, both Sixth and Seventh Plans stressed the need to conserve soil, control population growth, make better use of existing infrastructure, expand absorptive capacity and develop human resources. But despite rapid expansion of development expenditures, sup- ported by growing foreign assistance, from US$103 million (7 percent of GDP) in FY75 to US$421 million (18 percent of GDP) in FY85, per capita real income grew at only 0.5 percent annually during this period. 7. The country's difficult terrain, landlocked position, and poor natural resource base have contributed to its disappointing economic performance. Other important factors are the Government's severely limited capacity to manage the economy and to administer rapidly expanding develop- ment programs. 8. Over the past ten years, public expenditures have continued to grow faster than revenues, with increasing shares of the growing budget deficits financed by aid flows. The situation deteriorated sharply, starting in FY83 when large unanticipated emergency expenditures due to a drought necessitated recourse to significant domestic bank borrowings. The budget position has remained unstable since then, and the continued reliance on domestic bank financing has created inflationary pressures. Serious balance of payments problems have also emerged in the past three years as the cumulative result of a decade of poor economic management, as characterized by low real GDP growth, and dwindling agricultural surpluses for export. The external pay-  -3- ments position remained precarious in FY84 and FY85, with the country con- tinuing to lose foreign exchange reserves. By June 1985, gross official international reserves had declined to the equivalent of 1.6 months of imports compared with the peak of 6.2 months at the end of FY82. 9. To restore financial stability, the Government needs urgently to step up domestic resource mobilization while stringently controlling the growth of expenditures in order to reduce domestic bank borrowings. As a result of efforts to improve income tax assessment and collection and to apply indirect taxes, revenues have steadily increased, but the tax structure remains inelastic and narrowly based. Immediate reform should be geared to rationalizing the structure of taxation and widening the tax base, for example, by reducing income tax exemptions and deductions and eliminating sales tax rate differentials between imported and domestically-produced goods. 10. To control expenditure, the Government must contain the growth of wages and salaries, now the largest component in the regular budget. A freeze on further civil service hiring is required over the next few years. Implicitly, selective redeployment of positions is also required in order to achieve priority objectives in some sectors. Also, in the wake of a hefty 35 percent general salary increase introduced in FY85, no increases should be allowed in the Sev-enth Plan period. Additionally, public enterprise reform must be pursued in order to reduce subsidy and transfer payments to public corporations, some of which are causing a serious drain on the budget. Development expenditures should be directed toward activities that will produce economic results efficiently and quickly. To this end, existing productive capacity and infrastructure need to be strengthened to increase their usage, for example, through measures to improve operations and maintain roads and irrigation canals. Resources for new investments should be directed to activities that will earn additional foreign exchange for the economy within short gestation periods. To lessen the burden of counterpart funding, the Government should take a critical look at the pipeline of ongo- ing operations and re-evaluate the returns to the economy of completing each project. Tough decisions will likely be requi:ed to postpone, re-design or cancel any ongoing project that does not measure up to the criteria applied. 11. Concurrently, additional foreign exchange needs to be generated through export promotion and efficient import substitution in order to stabi- lize the country's precarious external payments position and to accelerate real GDP growth in the medium to longer term. To improve its agricultural trade position, the Government's immediate priority should be to secure an adequate supply of foodgrains (rice, maize, wheat) and principal food crops (sugar, oil seeds) to eliminate the sporadic requirement for food imports in years when the monsoon fails. An effort should also be made over the longer term to promote the export of minor cash crops such as ginger and cardamom. The key elements to improve agricultural production over the medium term include: improvements in the supply and distribution of agricultural inputs; increased access by farmers to credit; investments in transport, storage and  -4- other basic infrastructure to facilitate marketing; and a more effective and flexible agricul.ural pricing policy. The development of cottage and small industries (CSI) should also receive high priority over the next few years because of their potential for earning foreign exchange. Currently, the output from CSI, such as carpets, ready-made garments, and handicrafts, accounts for 30 percent of Nepal's total merchandise exports. In recent years, the Government has legislated a wide range of fiscal and administra- tive incentives to stimulate private investment in CSI as well as the export of CSI products. Implementation of these measures, together with the alleviation of severe transport and transit constraints, constitute essential elements of an export trade promotion strategy for Nepal. 12. In late 1985, the Government took major first steps toward stabilizing, and stimulating growth of, the economy. Effective November 30, 1985, the Nepalese Rupee was devalued by about 14 percent. Subsequently, the Government introduced a financial stabilization program as part of a 13-month standby arrangement with the International Monetary Fund. Major features of the program are: (a) maintenance of a flexible exchange rate policy; (b) restraints on public regular and development expenditures; (c) strengthened tax administration to help reduce the budget deficit; (d) restraint on the creation of domestic credit, especially bank credit to the public sector; (e) maintenance of key bank deposit rates at positive real levels; (f) increases in the prices charged by public enterprises and a reduction in the subsidies received by them; (g) restraint on external comr mercial borrowing; (h) increased numbers of licenses for commercial imports; (i) abolition of a 10 percent cash subsidy on exports; and (j) a number of procedural and institutional reforms liberalizing and rationalizing the trade and exchange regime. 13. The tasks that Nepal must undertake to address its multiple long-term development problems are challenging. While it attempts to mobilize domestic resources to finance about 40-50 percent of development expenditures, exter- nal assistance at concessional terms will continue to play an important role in financing investment and achieving economic growth. In the last three years, aid commitments to Nepal have averaged US$250 million per year, and have almost entirely been in the form of grants or concessional credits with grant elements exceeding 70 percent. Gross disbursements grew from about US$130 million in FY81 to US$165 million in FY85. Nearly 70 per_ent of total aid disbursements have come from members of the Nepal Aid Group, formed in 1976 and now comprising eight Developing Assistance Committee (DAC) countries and four multilateral agencies. 14. By December 1984, Nepal's official foreign debt outstanding and disbursed amounted to about US$430 million. As virtually all loans have been concessional, debt-service payments, including payments to the International Monetary Fund (IMF), have remained small in relation to exports of goods and services: in FY85, debt-service payments amounted to about US$17 million, equivalent to 5 percent of exports of goods and services. These payments  -5- over the medium term, are anticipated to remain at about 7 percent of Nepal's exports of goods and services. PART II - BANK GROUP OPERATIONS 15. Bank Group operations in Nepal began in 1969 with an IDA credit of US$1.7 million equivalent for a telecommunications project. Since then, 43 additional credits have been approved, bringing total IDA assistance to Nepal to US$599.1 million equivalent, net of cancellations. In view of Nepal's many development needs, this assistance has been for projects in a wide variety of sectors. Five of these sectors account for about 90 percent of IDA credits by-amount: irrigation/agriculture (US$192.0 million for 16 projects); water supply and sewerage (US$46.8 million for three projects); power and energy (US$168.0 million for four projects); telecommunications (US$41.7 million for four projects); and highways (US$67.0 million for three projects). The proposed credit of US$24.5 million would be the second to be approved in FY86. No Bank loans have been made to Nepal. IFC has made three investments in Nepal, the first in FY75 (US$3.1 million) for the expansion of the Soaltee Hotel project in Kathmandu, the second in FY82 (DM 14.5 million) to Nepal Orind Magnesite Company for the mining and production of dead burnt magnesite, and a third approved in FY84, but not yet signed to NepaL Metal Company (DM 7.8 million), for a zinc/lead mining and concentrates project. Annex II contains a summary statement of IDA credits and IFC operations as of March 31, 1986. 16. Bank Group lending to Nepal has been modest until now, considering the country's need for external assistance. The international community has shown considerable interest in Nepal's economic development and, to date, shortage of funds has not been a major bottleneck. The main constraint on the utilization of increased aid has been Nepal's limited absorptive capacity, affecting the pace of project preparation and implementation. The Bank Group has provided assistance to the Government in project preparation through two Technical Assistance Credits (Cr. 659-NEP and 1379-NEP) and by acting as Executing Agency for a number of technical assistance projects financea by UNDP. Project completion reports have been prepared for six projects: First Telecommunications (Cr. 166-NEP), First Highways (Cr. 223-NEP), Tourism (Cr. 291-NEP), Birganj Irrigation (Cr. 373-NEP) the Settlement (Cr. 505-NEP), Bhairawa-Lumbini Irrigation (Cr. 654- NEP), and the First Rural Development (Cr. 617-NEP) Projects. 17. In recent years Bank lending has attached particular importance to (a) agriculture (including irrigated agriculture) and forestry; (b) population control; and (c) education and training. Agriculture, a main source of livelihood to over 90 percent of the population, accounts for about 60 percent of CDP and of merchandise exports. The primary objective of our Lending in this sector is to increase production and employment. To that end, we will emphasize actions and investments aimed at improving the supply of inputs, strengthening support services to maximize benefits from existing  -6- infrastructure and equipment, upgrading the irrigation network, and improving operation and maintenance in medium and large scale irrigation projects. In forestry, the Bank Group will support reforestation schemes at the community level. Investments in agriculture and forestry would have to be supplemented by effective programs to control population growth, particularly in the hill areas, where a rapidly growing need for food, fuelwood and fodder is causing serious environmental degradation. The manpower development objectives will be to improve the quality of primary education and to increase the supply of trained technical manpower for public administration. Outside these three areas of primary emphasis, Bank Group involvement would concentrate in areas where investments would complement growth in production capacity. Accordingly, we plan to maintain some support to the power sector which previously abeorbed a significant portion of our lending; we envisage our future role in the sector more as a provider of technical assistance and a catalyst for mobilizing additional external resources. In the transport sector, our plan is to combine technical assistance through sector work with selected interventions designed to facilitate regional integration and improved rural access to markets and input supplies. We also propose to continue supporting cottage industries where previous investments have made a notable contribution to export promotion, import substitution and rural employment generation. 18. In allocating resources, the Bank Group's basic approach will be to strike a proper balance between quick and high yielding investments (e.g., agriculture), which is dictated by Nepal's precarious budgetary and balance of payments position, and an equally important commitment to those sectors whose impact cannot be felt immediately but which nevertheless are vital to the country's long-term development (e.g., population and human resource development). Some of the Bank Group's operations would be deliberately targeted to the poorest and least developed parts of the country, such as the hill area3. 19. The proposed Narayani III irrigation project would contribute to Nepal's policy objective to utilize more fully, and more rapidly, existing irrigation infrastructure and thereby enable past investments to realize their expected return. The project would complete the construction and development of the physical infrastructure (water distribution system, drainage, farm roads) in the course of which it would apply the lessons learned during the first two phases of the scheme. PART III - SECTORAL BACKGROUND General 20. Agriculture is the mainstay of the economy. However, the resource base for agricultural production is restricted due to the rugged terrain; only about a sixth of the land area (3.1 million ha) is suitable for  -7- cultivation, of which some 50 percent is irrigable. Decades of inefficient land use and exploitation of natural resources have resulted in severe agro- ecological imbalance, particularly in the Hills, and have placed severe constraints on the development of the country. While HMGN's development strategy and investment priorities for the agriculture and rural sectors have been generally consistent with the national and sectoral needs, achievements have fallen short of the targets for the production of basic agricultural commodities, correction of the agro-ecological imbalances, and improvement of the socio-economic conditions in rural areas. This has been so because some of the investment programs were not well designed and many were not effec- tively implemented due to shortages of skilled manpower and local funds, and weaknesses in the relevant institutions, administrative structure and opera- tional procedures. 21. Agricultural production during the last decade increased only by about 0.7 percent per annum, while population surged by about 2.7 percent per annum, thus leading to a progressively deteriorating food balance. An FAO study on food and security, dated September 1984, estimated that 39 out of the 75 districts currently have a deficit in food production and unless production trends are changed, domestic production of cereals would meet only about 65 percent of Nepal's consumption requirements by year 2000. 22. The present forest area in Nepal is about 5.3 million ha. These figures represent a 33 percent reduction in forest areas since 1964. Destruction is accelerating because of tree felling for fuelwood and addi- tional cultivable lands, and reduction of regeneration and seedling growth by uncontrolled grazing. As the forests are destroyed and fuelwood sources become remote and relatively inaccessible, use of dried dung and crop residues for fuel is increasing, thereby depriving the soil of what are often the main sources of nutrient replacement and resulting in a continuous declint in productivity. The disappearance of forests is also resulting in increased damage to agricultural lands in the lower catchments of the water- sheds and, in general a degradation of the environment. With the increased population pressure on the land, accessible forests in the Hills are faced with the grim possibility of complete denudation within the next 15 years, and those in the Terai within 25 years, unless reforestation and conservation efforts are enhanced. The Irrigation Subsector 23. Water Resource Utilization. Nepal has abundant surface water resources. Annual average discharges of its rivers total about 150 billion m3 and would be capable of irrigating 8 to 10 million ha. However, there are only about 1.3 million ha suitably located for gravity irrigation. The major and minor rivers can serve relatively small command areas in Nepal while they are costly to develop, because of the Large diversion structures needed to spill the huge monsoon floods and the sediments that should be desilted out of the systems every year in very large quantities. The development of these rivers is further constrained by the need for legal  -8- agreements with India. Groundwater resources are abundant in the Terai, but development is constrained by lack of infrastructure to keep scattered pumps and engines operating reliably. Electric power to energi,e tubewells is severely restricted in extent and amount, particularly in the more remote parts, but the situation is improving. 24. Irrigation Development. At present, only about 540,000 ha have some form of irrigation, of which about 140,000 ha are under public schemes. The inventory of irrigation facilities (1985) by ecological zones and development regions is as follows: Region Mountain Hill Terai Total Z __ --(_______ha)