Dnomm of The World Bank FoR OFIMCL USE ONLY Report No. P-4295-NEP REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED CREDIT OF SDR 8.7 MILLION TO KINGDOM OF NEPAL FOR A SECOND COTTAGE AND SMALL INDUSTRIES PROJECT April 24, 1986 This document has a restricted distribution and may be used by recipients only in the perforrnance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. CURRENCY EQUIVALENT (As of December 18, 1985) Currency Unit - Nepalese Rupees (Rs) US$ 1.00 - Rs 20.8 Rs 1.00 - US$0.05 ABBREVIATIONS ADBN - Agricultural Development Bank of Nepal BTI - Bankers Training Institute CGC - Credit Guarantee Corporation cDB - Cottage Industry Development Board CIED - Cottage Industry Export Division CMDE - Cottage Industry Handicraft Emporium CSI - Cottage and Small Industry CTA - Chief Technical Advisor DCVI - Department of Cottage and Village Industries EDP - Entrepreneurship Development Program EEE - Exporters' Exchange Entitlenent ESC - Export Service Center GIZ - German Technical Corporation RMG - His Majesty's Government NAB - Nepal Arab Bank, Ltd. NBL - Nepal Bank Ltd. NIDC - Nepal Industrial Development Corporation NMTC - Nepal Metal Trading Company NRB - Nepal Rastra Bank NWTC - Nepal Wool Trading Company PCI - Participating Credit Institutions PDC - Product Development Center PONf - Products of Nepal PCU - Project Coordination Unit RBB - Rastriya Banijya Bank ENAC - Royal Nepal Airlines Corporation SBPP - Small Business Promotion Progran TA - Technical Assistance TPC - Trade Promotion Center UNDP - United Nations Development Program FISCAL YEAR EEG/Financial Institutions: July 16 to July 15 FOR OMCIAL USE ONLY NEPAL SECOND COTTAGE AND SMALL INDUSTRIES PROJECT Proiect Svmarv Boxrower : Kingdom of Nepal Beneficiaries : Rastriya Banijya Bank (RBB), Nepal Bank Limited (NBL) and the Agricultural Development Bank of Nepal (ADBN). Amount :IDA Credit SDR 8.7 million (US$10.0 million equivalent). Tenns : Standard Cofinancinr : UNDP would provide a grant of US$1.8 million on a parallel basis. Relendiur Terms : The Government would relend about US$7.6 million of the IDA Credit to the Nepal Rastra Bank (NBB) at a rate of not more than 3.25 percent per annum repayable over 14 years, including three years of grace. NRB would use these funds to refinance at a rate of not more than 6.75 percent per annum subloans made to cottage and small-scale industries by participating credit institutions, Subloans to cottage and small- scale industrial borrowers would be at the greater of 13.5 percent per annum or the maximum deposit rate set by JIB and paid by participating credit institu- tions. Repayment would range from two to seven years, including from 9 months to two years of grace. The Goverument would bear the foreign exchange risk. Project Objectives : The proposed project would support the Government's objectives of development of efficient industries, export growth, and increasing output, export earnings and employment in small and cottage industries. Project DescriRtion : The proposed project would: (i) finance private projects in cottage and small industries through the financial system; (ii) strengthen the term-lending capability of participating credit institutions (PCIs) and upgrade overall operations of two coxmercial banks; (iii) strengthen public and private agencies in providing marketing, raw material supply and training services to Cottage and Small Industries (CSIs); and (iv) support improvements in policy and procedures to foster efficient industrial investment. The ultimate beneficiaries would be Cottage and Small Industries (CSIs), marketing agents servicing CSIs and raw material supply companies which meet eligibility IThis docunmnt has restricted distribution and may be used by recipients only in the perfomance of their official dutie.ts contents may not otherwie be disclosed without World Bank authorization. criteria in 27 districts included in the project area. About 4,720 subloans would be made by participating credit institutions to CSI projects. Average cost per job is estimated to be about uS$900 and the incremental employment generated under the project would be about 21,000 jobs. The major risk affecting maiwfacturing projects in rural areas is uncertain supplies of raw materials and a weak marketing system. This risk is expected to be minimized by support provided under the project to local marketing agents and the Cottage Industry Handicraft Ehporium. To help achieve its objective of enhancing exports, the project provides support for improvement in import and export procedures, including duty drawback and quota allocation systems, and for market research and product development. To help minimize project implementation risks, the project provides for a full-time chief technical advisor advisor and supporting exports. Estiuated Costs Local Foreign Total -- (US$ Million)- Subloan Component 8.1 3.8 11.9 Technical Assistance 2.3 3.1 5.4 10.4 6.9 17.3 Financing Plan: IDA 4.9 5.1 10.0 UNDP 1.8 1.8 Goverment 1.1 1.1 CSI Assn. 2.4 2.4 PCIs 2.0 2.0 10.4 6.9 17.3 Disbursements: Bank Group Fiscal Year FY88 FY91 FY92 FY93 - --------- (US$ Million) - Annmal 1.5 1.5 2.0 2.5 1.0 1.0 0.5 Cumulative 1.5 3.0 5.0 7.5 8.5 9.5 10.0 Economic Rate of Return: Not applicable Staff ADDraisal Report: No. 6112-NEP, dated April 11, 1986 Mak: IBRD 19604 INTERNATIONAL-DEVELOPMENT ASSOCIATION REPORT AND RECOMMENDATION OF IHE PRESIDENT 70 7IE EXECUTIVE DIRECTORS ON A PROPOSED CREDIT TO TME KINGDOM OF NEPAL FOR A SECOND COTTAGE AND SMALL INDUSTRIES PROJECT 1. I submit the following report and recommendation for a proposed Development Credit to the Kingdom of Nepal for Special Drawing Rights (SDRs) 8.7 million (US$10.0 million equivalent) on standard IDA terms to help finance a Cottage and Small Industries.Project. The Goverment would relend about US$7.6 million of the IDA Credit in Rupees to the central bank at a rate of no more than 3.25 percent per annum repayable over 14 years including three years of grace, vith the Goverment bearing the foreign exchange risk. The central bank would lend to participating credit institutions (PCIs) at an average rate of 6.5 percent per annum, retaining 0.5 percent per annum to cover administrative costs and 3 percent per annum for credit guarantee. Repayment by PCIs to the central bank would be at the time that repayments are made by sub-borrovers. PCIs would charge sub-borrowers a standard annual interest rate at least equal to 13.5 percent or the maximm annual deposit rate set by NRB paid by PCIs, whichever is higher. Maturities and grace periods for subloans would range from two to seven years, including grace periods of from 9 months to two years. UNDP proposes to provide US$1.8 million equivalent to assist with the financing of the technical assistance Component. PART I - THE ECONOMY 2. The most recent economic report, Nepal: Prol!ects for Economic 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 -2- 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 accounts for about 60 percent of agricultural output, livestock for 30 percent, and forestry for 10 percent. Apart frm 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 vater resources and the exchange of water-related benefits. The tourism sector, based primarily on Nepal's Hiimalayan environment provides about 20 percent of the country's foreign exchange earnings, but accounts for only about 1 percent of GDP. 6. Following ceuturies of self-imposed isolation, 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 accornodating almost half of the children of primary school age have been built, as bave a nmber 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, mall-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, supported 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 development 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 -3- problems have also emerged in the past three years as the cumulative result of a decade of poor economic managenent, as characterized by low real GDP growth, and dwindling agricultural surpluses for export. The external payments position remained precarious in FY84 and FY85, with the country continuing to lose foreign exchange reserves. By June 1985, gross official interDational reserves bad 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. Itmediate 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 t;z 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. Iaplicitly, 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 Seventh 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 prodactive capacity and infrastructure need to be strengthened to increase the-ir 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 ongoing operations and re-evaluate the returns to the economy of completing each project. Tough decisions will likely be required 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 stabilize 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 imediate 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 other basic infrastructure to facilitate marketing; -4- and a more effective and flexible agricultural pricing policy. The development of cottage and small industries (CSI, should also receive high priority over the next few years because of their great 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 administrative 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 ar 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 redrce 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 then; (g) restraint on external commercial 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, external 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 percent 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 .o 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 over the medium term, are anticipated to remain at about 7 percent of Nepal's exports of goods and services. -5- 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, 36 additional credits have been approved, bringing total IDA assistance to Nepal to US$547.7 million equivalent, net of cancellations. No Bank loans have been made to Nepal. Five sectors account for about 90 percent of IDA credits by amount: (i) irrigation/agriculture (US$192.0 million for 16 projects); (ii) power and energy (US$168.0 million for four projects); (iii) highways (US$67.0 million for three projects); (iv) water supply and sewerage (US$46.8 million for three projects); and (v) telecommunications (US$41.7 million for four projects). Since the mid-1970s, three IDA credits have been extended for the industrial sector, one of which was a first CSI project for US$6.5 million in FY82. The proposed credit of US$10.0 million would be the first to be approved in FY86. IFC has made three investments in Nepal, the first in FY75 (US$3.1 million) for the expansion of the Soaltee Hotel in Katbmandu, 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), 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 so far has been modest compared to the country's need for external assistance. The international community has shown considerable interest in Nepal's economic development and, to date, a shortage of funds has not been a major bottleneck. The main constraint on the use of increased aid has been Nepal's limited absorptive capacity which has retarded 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 Cr. 1379-NEP) and by acting as Executing Agency for a nmber of technical assistance projects financed by UNDP. Project completion reports have been prepared for seven projects: First Telecommunications (Cr. 166-NEP), First Highways (Cr. 223-NEP), Tourism (Cr. 291-NEP), Birganj Irrigation (Cr. 373-NEP), Settlement Project (Cr. 505-NEP), Bhairawa-Lumbini Irrigation (Cr. 654-NEP), and the First Rural Development Project (Cr. 617-NEP). 17. In recent years, Bank Group lending has attached particular importance to agriculture, forestry, and human resource development. The primary objective of agricultural lending is to increase production with a view to maintaining self-sufficiency in foodgrains, particularly in the hills, and to achieving larger surpluses for exports. Investments aimed at improving the supply of inputs and strengthening support services to maximize benefits from existing infrastructure and equipment are being emphasized. In forestry, the principal focus is on reforestation efforts at the community level. Investments in agriculture and forestry would need to be supplemented by effective programs to control population growth, particularly in the hill areas where a rapidly growing need for food, fuelvood, and fodder is causing serious environmental degradation. In education and training, objectives are to improve the quality of primary education, as well as to increase the supply of trained technical manpower for greater efficiency in public administration. In other sectors, Bank Group investment assistance would complement growth in productive capacity. Accordingly, support of the energy -6- sector, vhich previously absorbed a significant portion of lending, would be maintained, but increasingly as a source of technical assistance and as a catalyst for mobilizing additional external resources. In transport and comunications, technical assistance through sector work would be combined with selected interventions designed to help integrate the country's disparate regions and to improve access to markets and supplies in rural areas. 18. The development of the industrial sector would contribute to export promotion and import substitution. The objectives of Bank Group assistance include assistance on policy formulation, improving industrial performance and, in some cases, restructuring public sector enterprises, as vell as developing more effective procedures for export pronotion. Experience indicates that scope exists for successfully developing selected product groups such as leather and leather -oods, light engineering products, handicrafts, processed agricultural goods, building materials, and some consumer products. Appropriate balance will be sought between efficient investments with quick returns and slow-yielding inwestments that are critical to the country's long-term development. PART III - THE INDUSTRIAL SECTOR 19. Role of Industry. Nepal's industrial sector is small and undeveloped. Industrial development is constrained by the limited natural resource base, small effective domestic denand, lack of technical and managerial skills and a geographical position that isolates Nepal fram raw materials and markets. About 63 percent of industrial value added is contributed by construction and mining and about 37 percent by manufacturing of predominantly consumer goods (footwear, textiles, processed foods), construction materials and simple assembly itens. Large scale manufacturing is the domain of public enterprises located in or near Kathmandu Valley as well as in the low-lands of Nepal known as the Terai. Public enterprises contribute only 13 percent of manufacturing value-added. The private sector, concentrated mainly in small and cottage industries, produces 87 percent of manufacturing value-added. Outside Kathmandu Valley, cottage industries service the rural subsistence economy, providing woolen goods, cotton handloom textiles, food, and simple wooden and metal products. 20. While the bulk of the country's agricultural exports is directed to India, 70-75 percent of manufactured exports, go to other countries, the largest potential markets. Total exports to countries other than India increased from less than US$3 million in FY82-83 to more than US$60 million in FY84-85. Cottage and small-scale industrial exports, broadly defined as including carpets, garments and handicrafts, accounted in 1980/81 for about 30 percent of overseas exports, while leather (hides and skins) contributed 22 percent and jute-based exports 20 percent. By 1984/85, CSI exports accounted for about two-thirds of total overseas exports with carpets and garments occupying close to 97 percent of the CSI share. 21. The Seventh Five-Year Plan (FY85-90) calls for increased support for the development of cottage and small-scale industries to supplement rural incomes and employment and to expand non-traditional exports. In March 1982, -7- IDA approved a project, (Cr. 1191-NEP), to support the development of CSIs serving local and export markets. This project, which is scheduled to be completed in June 1986, has provided direct technical and commercial services and credit in the private sector as well as training, consultancy and marketing assistance to Government institutions dealing vith CSIs. With continued and expanded institutional support for training, credit and market development, there is scope for increasing cottage industry exports from urban areas and expanding rural production to produce domestic consumer goods and labor-intensive intermediates for export. 22. Industrial Policy and Procedures. The basic legal and incentive framework for industries is contained in the 1982 Industrial Enterprise Act and Foreign Investment and Technology Act. The former specifies licensing requirements and provides incentives including generous income and excise tax holidays, based on the size of the enterprise and the value-added it contributes. It stipulates sales tax and import duty concessions for imported equipment, machinery and tools for industry, and provides a basis for tariff protection for import-coapeting industries. So far, the acts have had limited effect in promoting private industrial investments and exports. Investors continue to show strong preferences for trade, real estate and construction which provide more attractive and rapid returns than industrial projects. 23. Inefficient procedures to implement trade and industrial policies have limited the growth and efficiency of industrial investment. The industrial incentive system needs to be streamlined. The uncertainty and inconsistent application of the industrial licensing system create delays in undertaking new investment, increase risks to entrepreneurs, and create monopoly profits for successful applicants. Wbile the average level of protection is not extremely high, levels of protection are uneven and the incidence of protection bears little relation to the country's potential comparative advantage. Tax exemptions are widespread and more generous than necessary, eroding the tax base without providing an effective investment incentive. Under the ongoing IDA-assisted Industrial Development Project (Cr. 1535-NEP), provision has been made for technical assistance to improve the industrial incertive system. 24. Industrial public sector enterprises absorb a significant portion of public sector expenditures. Nany operate at low levels of capacity utilization and with financial losses. The Government has agreed to an IDA proposal to study public enterprises with the objective of fornulating recomendations to improve management systems and the efficiency of their operations. The study possibly would be financed under an existing IDA Technical Assistance Project (Cr. 1379-NEP). 25. Numerous problems relate to import and export procedures, particularly as they affect export manufacturers. In spite of the Industrial Enterprise Act policy to impose only a 1 percent duty on inputs for industrial production and low sales tax rates, import duties and sales taxes are levied on many key inputs and are modified and increased on an ad hoc basis. In its statement of December 1985 on the economic program, the Government announced its intention to establish an effective bonded warehouse system to permit duty free access to raw materials and intermediates for export production (see para 57). 26. Many imported goods are effectively channeled through Government- owned or controlled companies, such as National Trading Limited (NTL) and the Cottage Industry Handicraft Emporium (CMUE). In other cases, only one import license is allowed to a private trader, who then has an effective monopoly and passes on high prices, as well as sales and excise taxes and import duties, to industrial users. For wool carpets, which constitute a 22 percent (and growing) share of exports, only one private company is licensed to import dyes, which currently comnand high prices. More importantly, imports of raw wool (other than Tibetan wool) are now effectively channeled through the Nepal Wool Trading Company (IWTC). NWTC has recently followed a practice of selling cheaper wool from New Zealand and Australia at prices above cost to help defray the cost of buying more expensive wool from one group of domestic Tibetan wool traders. NWTC has been denied import licenses for additional shipments of overseas raw wool unless it purchases and sells the high-cost Tibetan wool supplied by certain trading groups, even though Tibetan wool is often available through other sources in the domestic market at lower prices. Carpet exporters, particularly smaller companies, must bear the cost of higher overall wool prices. In the case of metal, the Nepal Metal Trading Company (NM1C) was established to provide metal at low cost, with import duty and sales tax exemptions, to artisans manufacturing metal products for export. In practice, however, metal imports have been directed to domestic utensil manufacturers rather than to artisans making export products (see paras 59 and 60). 27. All export shipments are subject to inspection by customs authorities. Facilities at Tribuvan Airport in Kathmandu are inadequate to handle the volume of export cargo. The Government recently constructed a 5,000 metric-ton storage facility at the airport, and an access road is under construction (see para 57). 28. For numerous products, particularly ready-made garments, which are the fastest growing export category, an export tax is levied by the Customs Department and an export "service charge" is levied by the Industrial Services Center (ISC) for making an evaluation of value-added, as required under the terms of the Trade and Transit Treaty with India. Additionally, export licenses are required for most products. The value-added assessment and export licensing unnecessarily delay the shipment of goods for export, thereby adding to the administrative costs borne by manufacturers. 29. Because of Nepal's landlocked position and the inefficiency of overland transport through India or Bangladesh, many export goods, particularly fashion items such as ready-made garments with short delivery times, must be air-freighted to Europe or the United States. Special Commodity Rates (SCR.) under the International Air Transport Association (IATA) exist for air cargo from Bombay, India and Dhaka, Bangladesh, offering discounts of about 40 percent below the best general cargo rates for eligible items. SCRs 'rom Katbmandu are not available for key export products such as carpets and garments. In December 1985, the Government announced its intention to lower freight costs on key export products. Currently Royal Nepal Airline Coporation's (RNAC) rates are lower than IATA rates, and REG will continue to look for measures to reduce freight costs (para 57). -9- 30. To address the above-mentioned constraints to the expansion of industrial exports, the Government has announced its intention to modify existing trade policies and procedures (see para 57). 31. Industrial Finance. Nepal's financial sector consists of: the central bank (Nepal Rastra Bank [NRB3); three commercial banks; two specialized financial institutions-the Agricultural Development Bank of Nepal (ADBN) and the Nepal Industrial Development Corporation (NIDC); a provident fund corporation and an insurance company. Two publicly-controlled coamercial banks, Nepal Bank Ltd. (NBL) and Rastriya Banijya Bank (RBB), dominate the financial sector, accounting for 75 percent of total assets and virtually all deposits. 1/ 32. In 1974, the Goverrment initiated a priority sector program, directing its two commercial banks to land 8 percent of deposits to small farmers, cottage and small-scale industries, and small-service enterprises. However, by April 1985, lending under the priority sector program was only 5 percent of total lending. Term lending by the banks effectively began only under the priority sector program. By April 1985, term loans outstanding were Rs 290 million; about half the loans vere to CSIs. Direct commercial bank lending to such clients even on the basis of the priority sector program has remained limited because the spread on priority sector loans (other than those loans financed under the first CSI project) is inadequate to provide an incentive for increased lending. The average cost of funds to banks is about 11 percent and administrative costs average 5-6 percent; the lending rate under the priority sector program, including CSI loans, is 11 percent. While the priority sector program is funded by the banks' own resources, subloans under the first CSI project are refinanced through the central bank, providing banks a spread of 4-6 percent, making such lending more attractive to them. About 240 branches of the two national commercial banks are involved in the priority sector program, including 35 branches handling CSI project subloans. Subloans under the first CSI project and the priority sector program have similar terms and conditions, although there is more enphasis on collateral under the priority sector program. 33. The Credit Guarantee Corporation (CGC), owned by the central bank and two national commercial banks (NBL and RBB, respectively), was set up in 1974 to provide credit guarantees to the two commercial banks for priority sector loans. CGC charges a 1 percent premium on priority sector loans. As of April 1985, total guarantees outstanding were Rs 160 million; total capital and reserves were Rs 18 million, or 11.4 percent of exposure. CGC's exposure far exceeds its ability to cover the risks. A study, financed under the first CSI project, is underway to analyze CGC and recommend an appropriate package of technical and financial assistance to strengthen the capital base and operations of the CGC. 1J Nepal Bank Ltd. (NBL) and Rastriya Banijya Bank (RBB) are owned by HM to the extent of 51 percent and 100 percent respectively. The third cammercial bank, the Nepal Arab Bank, Ltd., is owned by Dubai Bank (30 percent), H1G (30 percent), NIDC (10 percent) and private shareholders (30 percent). -10- 34. Lending rates to industry currently range from 11 percent to 17 percent per annum depending on the purpose of the loan and the size of tbe borrower. NIDC, which extends financing to medium and larger-sized industrial establishments, charges interest on term loans to industry at rates of 12 percent per annum for fixed investment and 15-17 percent per annum for working capital. As mentioned previously (para 32), loans for fixed investment under the priority sector program, including those under the first CSI Project, are 11 percent. Interest is currently paid on savings deposits at the rate of 8.5 percent per annum while rates paid on fixed deposits range from 4.5 percent per annum for three-month deposits to 13.5 percent per annum for deposits of two years and more. In the period FY79-85, inflation in Nepal averaged about 11 percent. Current projections of Nepal's inflation are in the range of 6-9 percent for FY86 and over the medium term. From the foregoing, it can be concluded that while, in general, interest rates in Nepal are positive in real terms, a few anomalies exist in the structure of interest rates that are producing deleterious effects regarding financial flows and resource allocation. These are: (i) term deposit rates exceed sectoral lending rates in some cases; (ii) commercial bank spreads, with the exception of lending under the ongoing CSI project are inadequate on loans to the priority sector (small farmers, CSI and small service enterprises), thus creating disincentives in this area; and (iii) lending rates of the financial institutions are set by sector and have been fairly invariant which likely is contributing to inefficiencies in intersectoral resource allocation. The Goveroment is aware of these problems and is currently preparing a plan of action (see para 49). IDA Assistance Strategy 35. While the legislative framework for industrial policies (para 22) has had limited impact in promoting private large and medium-scale industrial investments and exports, cottage and small-scale industry exhibit considerable potential for developing Nepal's relative comparative advantage in producing low volume-high value cottage industry goods. Bank Group assistance strategy in the sector is designed to achieve three objectives: (i) to provide advice in formulating, modifying and implementing industrial policies for more effective support to prospective private entrepreneurs; (ii) to consolidate the financial resources and technical assistance already provided by IDA (through two previous projects Cr. 705-NEP and Cr. 1535-NEP) to the Nepal Industrial Development Corporation as the main promoter of large- and medium-scale private industrial investment; and (iii) to continue to provide financial resources and technical assistance to develop further the country's comparative advantage in cottage and small-scale industry. The broader goal is to develop the industrial sector so that it complements the country's agricultural base, while effectively generating foreign exchange through increased exports and effective import substitution. 36. IDA Assistance for Cottage and Small Industries. The first CSI project (Cr. 1191-NEP) was designed to assist in establishing a financial and technical infrastructure to promote and support cottage industry in Nepal. Under the credit component, which channeled IDA funds through cummercial banks, the project provided an important opportunity for banks to operate more professionally and to promote entrepreneurship through project-based lending rather than relying entirely on collateral. The project introduced investment r'romotion, project appraisal and supervision of term loans for -1l- CSIs. The project also helped upgrade input supply companies and marketing agents. One of the most rapidly disbursing projects supported by the Bank Group in Nepal, the credit component (US$4 million), has been committed and disbursed as projected at appraisal. Approximately 45 percent of lending under the credit component was to export-oriented industries, such as wool and metal products; the remainder was for import-substituting activities, including textiles and agro-based enterprises. About 30 percent of lending went to rural beneficiaries in the Gandaki Zone, with an average subloan size of Rs 21,000 (US$1,200 at the exchange rate prevailing then). In Kathmandu Valley, which received about 70 percent of total lending, the average subloan size was Rs 39,000 (US$2,200). Of the approximately 2,000 projects financed, woollen carpets and garments accounted for about 36 percent by amount, cotton products 21 percent, metal products 6 percent, forest-based products 12 percent, agro-based products 8 percent and others 16 percent. The average investment per job was Rs 5,368, or US$306. Recovery performance under the first CSI project was about 45 percent of amounts due when loan collection began, but with intensified collection efforts, stronger signals from head office management, and staff incentives based on collection performance, recovery has increased to about 65 percent and is expected to improve further. 37. Export development under the first CSI project was directed by the Cottage Industry Export division (CIED) of the Government's Trade Promotion Center, established under the project to assist exporters with market contacts, product development and expansion of the supply base. Product specialists, sales and exposure trips for private exporters and a new overseas promotional and market intelligence office were financed. It was learned from executing the export development component that adequate time needs to be allowed for resolving material supply, product design, and marketing problems particularly regarding new products and production for export in rural areas. The project introduced a "performance contract" program, which was intended to induce exporters to obtain products in the rural hills. But it was unsuccessful for a number of reasons, including poor management by CIED, limited managerial resources of Kathmandu exporters, and difficulties in managing rural material supply, quality control, and product collection from Katbmandu. In the proposed second project, the program to support rural-based marketing agents as the link between rural producers and Kathmandu-based exporters would be strengthened. The Government-sponsored Products of Nepal (PON) office in New York, now fully staffed, has made important contributions in product-specific market analysis and feedback to exporters (especially for wool carpets and garments). PON has arranged for Nepalese exporters to participate in trade fairs in the United States and Canada, obtained trial orders for a variety of cottage industry products and pursued American buyers' contacts with Nepalese manufacturers. 38. Under the first CSI project, the Cottage Industry Development Board (CIDB), which had been a shell within the Department of Cottage and Village Industries (DCVI) of the Ministry of Industry, was activated. CIDB achieved its quantitative targets for training rural artisans, and CIDB staff were successful in reaching more remote areas of rural districts. In the first three years of project implementation, more than 2,000 artisans received training in producing textiles, woolen carpets and goods, basketry and metal crafts. About 30 percent of the artisans are employed as a result of CIDB training, and about 30 percent of CIDB-assisted entrepreneurs successfully -12- applied for bank financing for their projects. CIDB emphasized the training of new artisans, while the original objective had been upgrading the skills of established artisans. This was because CIDB staff members often had only rudimentary training, thus their ability to upgrade the skills and product quality of existing artisans was limited. In the proposed project, substantial training of CIDB trainers would be provided in order to reinforce their abilities to upgrade skills of existing artisans. Under the first CSI project, training courses, planned at headquarters, often did not introduce and improve skills based on local demand for conumer products. In the proposed project, planning for training would be based on surveys of local markets, and CIDB staff would be rotated among product development centers to provide a greater range of skills in each area. For entrepreneurship development, small groups of entrepreneurs would be assisted in identifying products with good local demand and in developing project plans for bank financing. 39. The first project strengthened the supply of raw materials by establishing and financing private import and supply companies for wool and metal and by assisting the Cottage Industry Handicraft Emporium (CMIE) to expand its operations in procurement and distribution of cotton yarn, handloam accessories, and textiles in the project area. CMHE tripled the availability of cotton yarn in Gandaki Zone, provided dyed yarn to rural areas in collaboration with CIDB, and provided price competition to private traders, reducing seasonal fluctuations in yarn prices. CMHE maintains large cotton yarn inventories, and while some branches, such as Pokhara in the first project area, are profitable in cotton yarn and equipment distribution as well as handicraft sales, others in Nepal operate at a loss. The proposed second project would provide technical assistance in inventory and operations management, and CMHE would continue to be eligible for financing under the credit component of the project. 40. The private metal- and wool-importing companies established under the first CSI project have had a dramatic impact on increasing the availability and reducing the prices of these raw materials. The NWTC has imported more than 600 tons of Australian and New Zealand wool, providing a regular source of wool to complement erratic supplies of Tibetan wool. By improving availability, raw wool imports reduced the price of Tibetan wool in the domestic market from about Rs 120/kg in the first year of the project to about Rs 60/kg in 1985. The NWTC, after long delays in receiving sales and duty concessions promised by the Goverment, has imported 185 tons of metal for distribution to artisans and manufacturers. However, abilities of NTC and NMTC to assist CSI pose constraints which are currently being addressed (paras. 59 and 60). 41. Responsibility for project coordination and management under the first project was vested with the Project Coordinating Committee (PCC), chaired by the Secretary, Ministry of Industry, and comprising high-level representatives from all implementing agencies and relevant government departments. The Industrial Services Center (ISC) acted as secretariat to the PCC, summarizing progress reports of the various implementing agencies for review and action by the PCC. During the project mid-term evaluation, it was decided that full-time monitoring and coordination of project activities was needed, and a small Project Management Unit (PXD) was established, comprising a full-time chief technical advisor (CTA), support staff, and a -13- Joint Secretary from the Ministry of Industry. The PMJ was successful in easing bottlenecks in project implementation and in getting key government officials from relevant ministries involved as needed for effective implementation. The PMU reports on a regular basis to the Project Coordinating Committee. PART IV - THE PROJECT 42. The proposed project was appraised in August 1985. A Staff Appraisal Report (No. 6112-NEP dated April 11, 1986).is being distributed separately to the Executive Directors. Negotiations were held in Washington, D.C. from March 31 to April 7, 1986. The Nepalese delegation was led by Mr. I.L. Shrestha, Secretary, Ministry of Industry. A Supplementary Project Data Sheet is attached as Annex III. Obiectives. Scope and Financins 43. Proiect Objectives. The proposed second CSI project would support the Government's objectives of development of efficient industries, export growth, and increasing output, export earnings and employment in small and cottage industries. The project would provide for improvements in the overall policy and procedural framework affecting CSI, increase financing for CSI investments and strengthen the public and private agencies providing managerial, technical, marketing and other services to CSI. 44. Project DesiRn and GeomraDhical ScoDe. The proposed project would strengthen the credit system by providing institutional support to banks in order to extend improved banking practices into new geographical areas and to new artisans. Public agencies supporting training, as well as product and market development, would be provided with technical and managerial assistance as would the public and private raw material supply agencies in order to improve their operations. The project is designed to strengthen the financial sector by providing technical assistance in project and credit evaluation and loan administration to improve the overall operations of the two national commercial banks. In Kathmandu Valley, training and technical service inputs would be channelled to both export and import substituting activities; the project would be geared to support the growth of CSI exports in promising product lines. Outside of Kathmandu Valley, the project would support product development and distribution networks aimed mainly at local and regional markets. Effective implementation of trade and industrial policies would be addressed through technical assistance to the Government and understandings would be reached on steps to improre import-export procedures, including those relating to the availability of raw materials and to duty drawbacks, customs clearance, and export licensing and taxes. The project would include a total of 27 districts in seven zones in the Central, Mid-Western and Western Development Regions. 4.. Components: Major components of the proposed second CSI project are: (a) Credit: Subloans to eligible CSIs, marketing agents, and raw material supply companies; -14- (b) BankinQ ODerations: & program to improve and upgrade overall operations of the two national commercial banks, local and foreign training for CSI officers of the three participating banks, and strengthening of the central bank CSI Unit; (c) Export Development: An export development program, in which the Export Service Center (ESC) and New York-based Products of Nepal office (PON) would carry out product and market development, including design, production techniques, cost reduction and quality control; and in which manufacturer/exporter associations would be strengthened to improve communication and information flows between industry and Government; (d) Policy Reform: A program to help the Government formulate and implement improved industrial and export policies; (e) Trainiu and Entrepreneurial Develonment: A program of extension services for the training of artisans and entrepreneurial development to be executed through the Cottage Industry Development Board (CIDB), as vell as the establishment of a Raw Material Procurement and Marketing Fund and the provision of technical services to improve the supply of raw materials and the marketing of rural artisans' products; and (f) Project Management Sunport: A program to provide management support and to monitor and evaluate project coaponents, with a Chief Technical Advisor financed by IDA under the project. 46. Proiect Costs and Financinz. The total cost of the project is estimated to be US$17.3 million with a foreign excbange cost of US$5.2 million. The proposed IDA Credit of US$10.0 million would finance 58 percent of total project cost; 74 percent (US$5.1 million) of the foreign exchange costs and 47 percent (US$4.9 million) of local costs. The remainder of the costs of the credit component would be met by the participating credit institutions and sub-borrowers. The remainder of the technical assistance costs would be financed on a parallel basis through a United Nations Development Program (UNDP) grant of US$1.8 million. Arrangements are underway to appoint a suitable executing agency for the UNDP-financed component. The signing of the UNDP Project Agreement would be a condition of effectiveness of the proposed Credit as would the appointment of an entity acceptable to the Government, UNDP and IDA to execute the UNDP-financed portion of the project. The Credit Comnonent 47. As under the first CSI project, the two national commercial banks, (BBL and RBB), and the Agricultural Development Bank of Nepal, (ADEN), would make subloans to eligible CSIs, marketing agents and raw material supply conpanies in the project area. The central bank would use IDA funds to refinance 80 percent of the subloan amounts. Agreement on the management of the CSI Refinance Unit was reached during negotiations. -15- 48. Onlendina Terms. The Government would onlend about US$7.6 million of the proceeds of the IDA credit for the credit component to the central bank at 3.25 percent per annum for subloans above Rs 40,000, and 2.0% per annum for subloan amounts up to Rs 40,000, which would provide a margin to the Government for bearing the foreign exchange risk. The loan would be repayable in 14 years, including three years of grace. Cottage and small scale entrepreneurs have inadequate formal credit experience to enable them to bear the foreign exchange risk. Signing of the Subsidiary Loan Agreement between the Government and the central bank would be a condition of effectiveness of the proposed credit. The central bank would lend to participating credit institutions at 6.75 and 5.5 percent per annum depending on the size of the subloan, keeping 0.5 percent per annum to cover administrative costs and 3 percent per annum for the Credit Guarantee Scheme, which will be administered by the central bank to provide credit insurance for CSI subloans until the Credit Guarantee Corporation is restructured (see para 33). The central bank would not bear any foreign exchange or credit risk. Participating credit institutions would maintain spreads of 8 percent for subloans up to Rs 40,000, and 6.75 percent on other subloans. These spreads should provide an adequate return on investment, as administrative costs averaged 6 percent in the first CSI project and credit risk is partially covered by the Credit Guarantee Scheme. The participating credit institutions would charge CSI subborrovers a standard annual interest rate at least equal to the maximum deposit rate set by NRB, which is currently 13.5 percent. Maturities on subloans refinanced under the Project would be from two to seven years, iucluding grace periods ranging from nine months to two years; banks would determine appropriate maturities and grace periods for each subloan based on the subproject's debt-service capability. The above-mentioned onlending terms and conditions were agreed at negotiations. 49. The Government is currently undertaking a review of interest rate policy with a view to developing a program of appropriate reforms (see para 34). Agreement was reached at negotiations that initial onlending rates under the proposed project would be set at the greater of 13.5 percent per annumm or the mximum rate set by NRB on deposits taken by PCIs. Also discussed during negotiations was the need to raise the lending rate to CSIs not receiving financing under the proposed project (currently 11 percent) as well as the lending rate under che ongoing Industrial Development Project (currently 12 percent). It was understood that EMH intends to bring lending rates for industry in line with the rate which would prevail under the CSI Project. It was agreed at negotiations that the lending rates under the proposed CSI project would be reviewed at least annually to ensure that interest rates are positive in relation to medium-term inflation projections; minimum spreads to participating credit institutions are maintained to provide an adequate return on CSI lending; and lending rates remain at least equal to maximum deposit rates. 50. SubDroiect and Subloau Eligibility. Eligible enterprises would be: cottage and small industrial enterprises, as defined by the Industrial Enterprise Act of 1982, engaged directly in manufacturing; raw material supply companies; firms providing commercial services to CSI units in rural districts and CIRE, NWTC and NNTC subject to specific conditions which were agreed at negotiations (paras. 59 and 60). Project appraisal methods adopted by PCIs in the first CSI project include a financial rate of return on subjects financed under the project. In view of the rudimentary appraisal -16- capabilities of PCIs, appraisals of subloans below the free limit do not include an economic rate of return or domestic resource cost analysis. Subprojects financed under the CSI project are generally assumed to be efficient in economic terms because a significant portion of CSI products is exported and, in the case of import substitution industries, the Level of import tariffs is generally low and the open border with India allows for relatively free trade vith Indian goods, which are the greatest source of competition for Nepalese products. Eligible expenditures would be foreign and local costs of fixed assets and permanent working capital for new subprojects, or for strengthening, modernizing, or expanding existing subprojects. Marketing agents eligible for CSI subloans normally would be small-scale manufacturers who expand or specialize in distributing and marketing their own and other manufacturers' goods. Marketing agents would be required to obtain their products in rural districts, outside Katbmandu Valley, and could distribute in regional markets or to exporters in Kathmandu. Katbmandu-based exporters obtaining goods for export in rural areas could be financed as non-manufacturing marketing agents. It was agreed at negotiations that a maximum of 30 percent of the subloans made by each participating credit institution could be for marketing agents. 51. The maximum subloan size would be Rs 1.0 million (approximately US$50,000), including fixed investments and working capital, except in the case of the raw material importing and distributing companies. Normally, subloans would constitute no more than 80 percent of subproject costs, with 20 nercent financed by sponsors' equity. IDA's prior review and approval would be required for refinance applications for all subloans in excess of Rs 500,000 (US$25,000). This procedure is expected to result in pre-approval review by IDA of some 40 subprojects, or 15 percent of all subloans by amount. 52. Participatine Credit Institutions (PCIs). In addition to NBL, RBB, and ADBN, other financial institutions also would be eligible if the Goverrment, IDA and the Central Bank agree on an institution's creditworthiness and if it has complied with the conditions of participation. The credit component would not be allocated among the PCIs, but would be available on a first-came first-served basis. To be eligible for refinance, each PCI would need to have complied with minimum staffing and training requirements and collection performance, and have adopted standards and procedures acceptable to IDA. Agreement was reached at negotiations regarding PCI eligibility and participation criteria. At least two PCIs would have to become eligible before the proposed IDA Credit would become effective. 53. As -a condition of participation, each PCI would establish and/or maintain a head office CSI Unit, to deal exclusively with the proposed project and would maintain sufficient staff to implement the project. Under the proposed project, the PCIs and each individual branch would be required to achieve minimum collection levels. Initial participation conditions would require that each bank collect at least 60 percent, and each participating branch 70 percent, of amounts due under the first CSI project. Continued participation would require that banks increase overall collections on principal and interest due under both the first and second CSI projects by five percentage points per annum per bank, and three percentage points per annum per branch. Compliance would result in collections of 75 percent of -17- anounts due by each participating bank, and 79 percent of amounts due by branch, by the end of the three-year project implementation period. Collection performance would be monitored quarterly, and a bank or branch would remain eligible for onlending as long as required collection levels renain within the established limits. It was agreed at negotiations that the branch staffing criteria would be reviewed annually starting May 1, 1987 by the central bank in consultation with IDA. 54. The second CSI project would continue the institution-building measures initiated under the first CSI project, while also funding substantial technical assistance to improve overall operations of the two national commercial banks. The commercial banks in Nepal are conservative, with a tradition of making personal loans against sizeable collateral, usually gold and silver, for working capital loans. Project-based lending was initiated under the first CSI project. Profitability is low (less than 1 percent) and administrative costs are high (about 6 percent) on CSI lending. Credit procedures need to be simplified and standardized, and systems are needed to enable better liquidity management. Reporting procedures are weak, with headquarters frequently having no record of branch lending. The banks need to strengthen their operations to achieve their development lending objectives and to reduce the costs of financial intermediation. Agreement would be sought on a short list of international banks to assist the participating coammercial banks, on terms of reference for a first phase of technical assistance to the PCIs, and on a timetable for implementing the program of technical assistance acceptable to IDA prior to the implementation of such a program. 55. CSI Refinance Fund. Under the first CSI project, a CSI Refinance Fund was established in the central bank to provide IDA refinance for subloans made by participating banks. The central bank set up a CSI Refinance Unit, with its own policies, procedures, staff and financial resources, within the Banking and Credit Division, to administer the Refinance Fund, which has been managed successfully. CSI staff of the central bank supervise, monitor, and provide technical assistance for implementation of the credit component of the project. The CSI Unit has a manager, about 30 professional staff and an expatriate credit advisor funded under the first CSI project. The Unit's professional staff received intensive training in credit operations and refinance. With the assistance of a credit advisor provided under the project, the Unit and the PCIs established satisfactory lending policies and procedures and reporting requirements, and central bank staff assisted with training CSI staff of the PCIs. Under the proposed project, the credit advisor vould continue to work with PCI and central bank staff and would increasingly concentrate on direct assistance to the participating commercial banks on CSI operations. Agreement was reached on management of the CSI Refnance Unit. Approval of a revised Statement of Policies of the Unit would be a condition of effectiveness of the proposed credit as would issuance by the central bank of revised instructions to PCIs. 56. Credit Guarantee. Commercial bank loans to the priority sector not financed under the first CSI project are covered by the Credit Guarantee Corporation Private Limited (CGC). Because of the weakness in the CGC (see para 33), a Credit Guarantee Scheme was established in the central bank under the first CSI project to provide credit insurance for CSI subloans. Coverage -18- was provided for 75 percent of subloan amounts, and the premium charged was 1 percent per annum on outstanding, guaranteed amouuts. Participation in the scheme was mandatory for all subloans refinanced under the project and was autcmatic once refinance was approved by the central bank. Under the proposed project, credit insurance would initially continue to be administered by the central bank Credit Guarantee Scheme. Transfer by the Govermment of an initial amount of Rs 2 million to this Scheme would be a condition of disbursement to the credit component and it was agreed during negotiations that the Government would pay additional amounts so that capitalization c. the Scheme i8 maintained at no less than 10 percent of the guarantees outstanding in any fiscal year. The premium on CSI subloans would be increased to 3 percent per annum to provide reserves adequate to cover anticipated reasonable levels of defaults. Depending upon the outcome of the ongoing study of CGC being financed under the first CSI project (para 33), UNDP funding under the second CSI project could be made available to provide technical assistance to strengthen the CGC. Once the CGC has been sufficiently strengthened financially and technically, the Credit Guarantee Scheme in the central bank could be transferred to the CGC and merged with an insurance program that was established for the priority sector, subject to agreenent between the Government and IDA. Institutional SupDort to CSI 57. Exuort Development. The second CSI project would continue the program of market analysis, sample market testing, product development and export promotion initiated under the first project. Export development activities would focus on products with demonstrated export potential- particularly carpets and ready-made garments-while continuing to support systematic market research and product development for traditional handicrafts, such as metal and wooden products and handmade paper, as well as newer products, such as knitwear. The Export Service Center (ESC) in Kathmandu would be responsible for overall management of the export development component. ESC would report to the Government's Trade Promotion Center (TPC) regarding performance in meeting broad objectives but would have considerable discretionary power to carry out work programs and to make staffing arrangements. A PON office in New York would report to the Project Director of ESC. Close links vould be maintained among ESC and TPC and PON, and staffing would be reviewed annually by the Government and IDA. ESC would continue to be headed by a Project Director, to be assigned by TPC or to be recruited from the private sector. Given the importance of the export development component, management in ESC and PON would need to be acceptable to IDA. The Project Director would report to TPC and would maintain close eammunication with the Ministry of Commerce. ESC currently has a Project Director and three full-time technical staff and assistants. During execution of the proposed project, about three additional technical specialists would be recruited. Agreement was reached during negotiations that Ci) the management of ESC and PON would have to be acceptable to IDA; (ii) qualifications, experience and terms of reference of UNDP-financed consultants to strengthen manufactured exporters' association would be acceptable to IDA; (iii) ESC would prepare annual action prograns, to be acceptable to IDA; (iv) eligibility criteria for direct assistance to exporters would be acceptable to IDA; and (v) ESC would adopt a Statement of Policies and Operating Procedures satisfactory to IDA, adoption of which would be a condition of disbursement for the export development component. -19- Additionally HNG would appoint consultants, financed by UNDP, acceptable to IDA vith satisfactory terms of reference, to assist in the preparation of an action program for improving import and export procedures. This would include developing suitable procedures to allocate U.S. import quotas on ready-made garment exports and setting up effective systems for duty-free raw material imports for export production. The study and action program would be completed by September 30, 1987. At negotiations agreement was reached that the Government would submit to IDA for coment a draft of this action program by December 31, 1987. In addition, it was agreed that H1G and IDA would exchange views on a regular basis regarding key CSI policies and procedures. Consultant assistance would be provided under the project to help implement detailed recommendations. As mentioned above, the Government is considering measures to establish a bonded warehouse with a view to providing duty-free access to key raw materials (para 25); (b) a storage facility has been constructed at Tribuvan Airport (para 27); and (c) EHG will continue to investigate measures to reduce freight costs (para 29). 58. Trainin2. Entrepreneurial Development. and Extension Services. The Cottage Industry Development Board (CIDB) of the Departmevt of Cottage and Village Industries (CIDB) would continue to be responsible for extension services, including technical training and entrepreneurial development, management of product development centers in remote rural areas, implementation of a handmade paper production component and operation of a local currency raw material supply fund. It would also assist rural artisans with marketing activities. CIDB currently has 225 staff members, of which about 60 are technical trainers. CIDB vould recruit and train additional technical staff under CSI II. 59. Raw Material SuppLy. Uncertain availability and price volatility of raw materials affect manufacturers serving export and local markets. In rural areas, private traders supply cotton yarn, tools, dyes and other materials irregularly, and prices vary with local shopkeepers' inventory levels. The Cottage Industry Handicraft Emporium (CIHE) maintains large inventories of cotton yarn to be able to prevent wide price swings with fluctuations in private inventories. Under the first CSI project, CIHE received a grant from HMG and borrowed from commercial banks a total of about US$180,000 (Rs 3.2 million) to import cotton yarn, looms and other equipment for distribution in the project area. CIRE is evaluating a proposal to establish central storage and distribution facilities along the main east-west higbway to reduce scorage and distribution costs. Under the second CSI project, a managenent advisor would work with CMUE for about six months, with the Emporium having the option to extend the contract. The advisor would review the operating costs and profitability of the entire range of CIHE's operations and would recommend improvements. It was agreed during negotiations that the qualifications, experience and terms of reference for the adviser would be acceptable to IDA. Although CIHE's presence in rural markets provides price stability, costs for dyed yarn and equipment in rural areas is significantly higher than in Katbmandu, and yarn supplies in rural branches often do not match local requirements. The CIHE advisor would develop an inventory management program to reduce costs and monitor inventory levels and would evaluate a proposal to open a central supply depot and additional branches in the Project area. Once CMUE has implemented a program to improve the efficiency of its operations, it will be eligible for medium term credit under the same terms and conditions as other borrowers. -20- Depending on the advisor's recommendations regarding the central supply depot and additional branches, long term financing could be made available under the project to finance the depot and branches, subject to prior agreement by IDA. Because of the importance of raw wool imports for carpet exports, at negotiations, it was agreed that RMG would adopt a Statement of Policies and Operating Procedures, acceptable to IDA, for the NWTC, which would include a comitment by Goverment to provide wool import licenses in a timely manner without restrictions regarding purchase of domestic wool. Approval by the Government of this statement, acceptable to IDA, would be a condition of disbursement of the credit component. In the first CSI Project, CIDB operated a US$30,000 fund to procure raw materials and some key equipment (such as handlooms) from local CIBE branches or depots. Under the second CSI project, the fund vould be expanded to US$100,000 to accommodate new districts. CIDB staff would transport materials to product development centers for sale to artisans. Agreement was reached during negotiations that the Government would adopt policies and operating procedures for the Raw Material Procurement Fund acceptable to IDA. Approval by CIDB's board of the Statement of Policies and Procedures for the Fund, acceptable to IDA, would be a condition of disbursement to the Fund. 60. The Nepal Metal Trading Company (NHTC) Was established in 1982 to import metal for private manufacturers of cast metal export products with the understanding that rhe Government would reduce the normal duty and sales tax on metal imports to 1 percent. The tax concessions, however, were not made available until Februar-, 1984, and they were rescinded due to a change in the Industrial Enterprises Act in mid-July 1984. During the brief period of tax-free status, the NMTC imported about 90 tons of copper, zinc, and brass for sale to 137 cottage and small industry establishments. Since July 1984, it has imported an additional 95 tons of metal without tax concessions. Under the proposed project, the INUTC would be eligible for further lending as soon as approval by Government is obtained on a Statement of Policies and Operating Procedures acceptable to IDA which would allow manufacturers and exporters to import metal at international prices. Agreement was reached at negotiations that adoption by NMTC's board of a Statement of Policies and Operating Procedures acceptable to IDA, would be a condition of eligibility for NMTC to receive subloans under the project. 61. Project Coordination. Under the proposed project, implementing agencies would continue to prepare, and operate according to, annual action plans, approved by IDA and the Government. The Project Coordination Unit in the Ministry of Industry would be maintained to coordinate implementation and monitor project progress. It was agreed at negotiations that a full-time Chief Technical Advisor (CTA), with qualifications, experience and terms of reference acceptable to IDA, who would report to, and liaise closely with, the Joint Secretary for Cottage Industry Promotion, would be appointed. The Project Coordination Unit, including the CTA's salary, would be financed with proceeds from the proposed IDA credit. Appointment of the CTA would be a condition of effectiveness of the proposed credit. Administration 62. Procurement: (1) Subloans - Given the expected size of contracts and the maximum subloan amount under the Credit, international competitive bidding would not be required. Participating banks would apply their current -21- procurement procedures and vould be responsible for ensuring that items procured for subprojects are suitable, reasonably priced and that sub-borrowers have adequately canvassed the main sources of supply; the central bank would monitor these procurement procedures. Goods and services procured locally would be procured at reasonable and competitive prices from reputable suppliers. Selection of a supplier should be justified on the basis of price, dependability of supply, availability of spare parts and service, performance guarantee and arrangements for installation and training where necessary. Contracts for goods or services procured outside of Nepal costing the equivalent of US$5,000 or more per item, or US$25,000 or more per contract, would be on the basis of international shopping fron three qualified suppliers eligible under the Bank's procurement guidelines. Since it would be difficult and costly to seek quotations for smaller contracts, these provisions would not apply, but participating banks would maintain appropriate records of the method of procurement for post-review by the central bank's CSI Unit staff and IDA supervision missions; (ii) Other comDonents. All Civil Works would be simple structures of standardized designs and vould be built at different locations throughout the country and at different times. This would render them unsuitable for International Competitive Bidding (ICB). Civil works contracts would be awarded on the basis of competitive bidding advertised locally, in accordance with procedures satisfactory to the Association. Furniture, equipment, raw materials and vehicles would be procured on the basis of competitive bidding advertised locally, acceptable to IDA. It was agreed at negotiations that consultants financed by IDA would be retained in accordance with Bank guidelines and that UNDP-financed consultants would be appointed in accordance with UNDP procedures with qualifications, experience and terms of reference satisfactory to IDA. All bidding packages for works or goods estimated to cost US$10,000 equivalent or would be subject to pre-review by IDA. The Government would be required to furnish the first two contracts to IDA for approval and remaining contracts would be monitored by IDA supervision missions with the understanding that they would be eligible for IDA financing as long as they are awarded in adherence to agreed documents and procedures. 63. Disbursement. The proposed project is expected to be committed in three-and-a-half years and disbursed in seven years. This disbursement period conforms with the South Asia Regional Profile for DFI lending. (i Subloans. IDA disbursements for eligible subloans would be against 100 percent of the cost of imported and local goods and services refinanced by the central bank. For subloans below the IDA review limit and for the CIDB Raw Material Procurement Fund, disbursement would be made against statements of expenditure. Supporting documentation would be kept on file for inspection by IDA supervision missions. Disbursements for subloans above the free limit and other project expenditures would be made against standard documentation; (ii) Other Comvonents. IDA would finance 100 percent of foreign expenditures and 100 percent of local expenditures (ex-factory cost) on vehicles, equipment, furniture and raw materials; 70 percent of local expenditures for other items procured locally; 60 percent of total expenditures on civil works; 100 percent of IDA-financed consultants; 100 percent of equipment, consultancy and technical services, and other operating costs of the Overseas Products of Nepal offices. IDA would finance a declining portion of incrementel Government staff salaries as follows: for ESC and the PCU, 100 percent in the first year, declining to 70 percent in -22- year four of the project; for CIDB, 60X in year one declining to 20% in year four; and for CIRE, 50 percent in year one declining to 20 percent in year four of the project. 64. To reduce the interval during which the Goverment would finance 1DA's share of project costs vith its own resources, the Goverment might request IDA to make advance payments from the credit account into a Special Account, to be opened in US dollars in the Nepal Rastra Bank, and which would be available for reimbursing the Government for IDA's share of project cost. The total amount in the Special Account would not exceed US$300,000, estimated to be required for about four months of project execution. The Government would be entitled to make withdrawals from the Special Account in Rupees or in foreign currencies, at the exchange rate applicable on the day the Special Account is debited. IDA would replenish the Special Account for the amount of withdrawals for eligible expenses at the request of the GoverLment in accordance with procedures agreed between IDA and the Government. 65. Audit. It was agreed during negotiations that the Governnent would cause participating agencies to establish and maintain separate account for the Project in accordance with sound accounting practices and would ensure that these accounts as well as the statements of expenditure would be audited annually by an independent auditor acceptable to IDA and furnished to IDA not later than nine months after the close of the fiscal year. Benefits and Risks 66. The Project would contribute to the Government's objectives of expanding output, enployment and exports in the CSI subsector. The project would strengthen the capabilities of public and private agencies supplying credit, marketing services, raw materials and training. Significant direct benefits are expected in incremental enployment and earnings in the 27 districts covered by the project, as well as in foreign exchange earnings through sustained export growth. An important benefit of the project would be the initiation of measures to improve industrial incentives, export procedures and administration. 67. Under the subloan component, about 4,720 subloans would be made by participating credit institutions. The majority of these would be for cottage and anall-scale enterprises; a maximum or 30 percent of subloan amounts would be for marketing agents and about 5 percent would be for raw material supply companies. The average investment per job is estimated to be about US$400, and incremental employment generated would be more than 21,000 jobs, excluding subloans to raw material supply companies. In Kathmandu, which is estimated to absorb about 56 percent of total lending by amount, incremental employment would be full-time (or 250 days per year) for a total of approximately 8 million man-days in the three-year project period. In rural districts where incremental employment t-ould supplement agricultural employment (hence workers would be available for about 150 days per year), incremental employment generated would be about 3.8 million man-days. A general benefit of the project would be strengthening the overall operations of the two national commercial banks through reducing their administrative costs and improving tteir efficiency and profitability. These improvements would have an ispact on priority sector and other lending outside the -23- immediate sphere of the proposed project. The project would also strengthen and upgrade the operations of privatz and public export pramotion training and raw material supply agencies. 68. Providing Nepal maintains a realistic ezchange rate, the project is also expected to arrest the decliue of traditional handicraft exports and strengthen carpet and ready-made garment exports. With product development and marketing inputs under the project, the 6 percent decline in trsditional handicraft exports between 1984 and 1985 could be reversed; traditional handicraft exports could increase by 5-10 percent per annum over the medium term. Cost reduction, product development and sarketing inputs for carpet production under the project are expected to result in at least 20 percent growth per annum in carpet export volumes over the medium term, which would contribute at least US$35.5 million in incremental foreign exchange earnings over the first three-and-a-half years of project implementation. For ready-made garments, the project would support diversification, efficient allocation of quotas to principal export markets and cost reduction. The project would also provide investment credit for export manufacturers. Assuming a suitable system to allocate quotas is set up, the project would conservatively be estimated to support export growth of 50 percent in CSI products over the first three-and-a-half years of project implementation, contributing incremental foreign exchange of as much as US$150 million over that interval. 69. Since participating credit institutions are rapidly gaining experience with project-based lending, other implementing agencies have experience vith CSI project programs, and most key staff are in place, no significant delay in project start-up is expected. In rural areas, the major risks facing successful establishment of manufacturing projects are uncertain supplies of raw materials and weak marketing systems. Experience to date with local marketing agents has been positive, and under the proposed project, additional agents would be identified and provided credit. Additionally, improving CIHE operations, particularly in the area of raw material supply, expanding the distribution and marketing assistance provided through CIDB, and channeling assistance to districts with good access to roads and project offices should minimize this risk. 70. In the export development component, projections for increased export growth depend crucially on thorough market research and product development activities for traditional handicrafts and carpets. For ready-made garments, the probable imposition of U.S. import quotas poses a risk. Sustained export growth will depend on effective implementation of procedures for duty-free access to fabrics imported from countries other than India to allow diversification into nw quota categories and efficient allocation of quotas to reliable, high-value manufacturers. A key project component would assist the Government in implementing such procedures. The activities of market research, product adaptation, product demonstration, and the provision of workshops and seminars introduced under the first project would be continued to heighten exporter ewareness of the need for improving product design and quality and to assist manufacturers with needed changes. 71. To minimize the risk of uneven implementation of project components, a Chief Technical Advisor would coordinate mnd monitor project inputs, ongoing assistance to the Government for policy implementation, and -24- recruitment and supervision of technical experts and consultants. As in the first project, frequent supervision by Bank staff members would be needed. PART V - RECOMMENDATION 72. I am satisfied that the proposed Credit would comply with the Articles of Agreement of the Association and recommend that the Executive Directors approve the proposed Credit. A. W. Clausen President Attachments Washington, D.C. April 24, 1986 -25- ANNEX I & A A L C 3' Page 1 of 6 NEPAL - SOCIAL INuICAbOUr OTA SheT NEAL IrF"C FIs t(dEIGhTtfl AVEBAGES) /a 'onIit? RICKfl KMsTZNATK) lb RECENT LOV IhCOWL nIDue. INCON Io96Dt 1971./b ETL'iATrIb ASIA & PACIFIC ASIA i FACIFIC Amu (THNoSUD sq. a) TOTAL 14D.8 140.6 140.8 AGRICULTURAL 35.1 36.8 41.2 OW NI C4A0UL^ 3) .. .. 160.0 278.3 1011.1 WSNT WS0 W1OY PnR CAPITA CKILOrGRA Or OIL EQUIVALFNT) 3.0 10.0 10.0 285.7 566.6 POPULAnTO AND VITAL STISTICS POPUIATION.'ID-YEAt (THOUSANDS) 9404.0 11350.0 15736.0 URANE POPULATION CZ OP TOTAL) 3.1 3.9 4.9 22.3 35.9 POPULATIN PROJCTIONS POPULATION IN YEAR 2000 (CMLL) 24.5 STATIONARY POPULATION (tILL) 74.0 POPULATION MCZHNTUN 1.8 POPULATION DENSITY PER SU. Klt. 66.8 80.6 111.5 173.t 3b6.9 PeR sq. C. AGRI. LAND 264.2 308.4 374.5 353.3 1591.2 POPULATION AGE STRUCTURE CX) 0-14 RS 39.0 '2.0 42.8 30.3 3a.2 15-64 YTS 57.4 55.0 54.2 59.4 57.7 65 AND ANNE 3.4 2.9 2.9 4.3 3.5 POPULATION GROHTN RATE (t) TOMAL 1.4 1.9 2.5 2.u 2.3 Lil;lA 4.5 4.2 5.0 4.1 '.1 CRUDE KRTH RATE (PER THOUS) 45.9 *6.3 41.6 27.5 30.1 CRUMI DEATH RATE (PER THOUS) 25.h 23.0 18.1 10.2 9.4 GROSS REPRODUCTION RATE 2.7 3.1 3.0 1.7 1.9 FAYMLY PLANNING ACCXPTORS. ANNUAL (THOS) .. 29.7 223.2 USERS tS OF MARBIED WOMEN) .. .. 7.0 49.4 56.5 FMO AMNID' l[TX INDEX OF FOOD PROD. PER CAPITA (1969-71-100) 106.0 101.0 86.0 116.6 Li'.. PER CAPITA SUPPLY OF CALORIES (C OF RELUIWIENTS) 87.0 94.0 89.0 1u0.3 115.7 PROTEIS (GRAMS P
Группа Всемирного банка · Memorandum & Recommendation of the President
Nepal - Second Cottage and Small Industries Project
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