Nepal - Policies for improving growth and alleviating poverty

Report No. 7418-NEP Nepal Policies for Improving Growth and Alleviating Poverty October 14,1988 Asia Country Department I FOR OFFICIAL USE ONLY Document of the World Bank This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS Year US $1 Equivalent (Avg.) 1982/83 Rs 13.9 1983/84 Rs 15.3 1984/85 Rs 17.8 1985/86 Rs 19.8 1986/87 Rs 21.5 1987/88 Rs 22.1 September 30, 1988 Rs 24.2 Since November 30, 1985, the Nepali rupee has been floating with respect to a basket of currencies in which the Indian rupee has high weight. Fiscal Year (FY) July 16 - July 15 A1.1 years refer to the Gregorian calender.  FOR OFFICIAL USE ONLI List of Abbreviations and Acronyms Used ADB - Asian Development Bank ADBN - Agriculture Development Bank of Nepal AIC - Agricultural Inputs Corporation ASC - Agricultural Service Center BNP - Basic Needs Program CIDA - Canadian International Development Agency CPR - Contraceptive Prevalence Rate DOA - Department of Agriculture DOI - Department of Irrigation EPF - Employee Provident Fund EPI - Expanded Program of Immunization FP/MCH - Family Planning/Maternal and Child Health FPAN - Family Planning Association of Nepal GDP - Gross Domestic Product HMG - His Majesty's Government HYV - High Yielding Variety IATA - International Aviation Transport Association IDA - International Development Association IFC - International Finance Corporation IMR - Infant Mortality Rate INGO - International Non-Governmental Organization IRDP - Integrated Rural Development Project KOE - Kilograms of Oil Equivalent LRMC - Long Run Marginal Cost MOEC - Miristry of Education and Culture MOF - Ministry of Finance MOH - Ministry of Health MPLD - Ministry of Panchayat and Local Development NARC - National Agricultural Research Committee NARSC - National Agricultural Research and Services Center NB - Nepal Bank NEA - Nepal Electricity Authority NFC - National Food Corporation NGO - Non-Governmental Organization NHFC - National Housing Finance Company NIDC - Nepal Industrial Development Bank NPC - National Planning Commission NRB - Nepal Rastra Bank This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  ii O&M - Operations and Maintenance OGL - Open General License PBPM - Program Budgeting and Project Monitoring PCRW - Production Credit for Rural Women PDLT - Panchayat Development and Land Taxes PE - Public Enterprise PFP - Policy Fram.ework Paper PHC - Primary Health Care PM - Program Budgeting QR - Quantitative Restriction RBB - Rashtriya Banijya Bank SAF - Structural Adjustment Facility SAL - Structural Adjustment Loan SAP - Structural Adjustment Program SC - Service Centers SFDP - Small Farmers' Development Program SLC - School Leaving Certificate SSNCC - Social Services National Coordinating Council SWER - Single Wire Earth Return T&V - Training and Visit TA - Technical Assistance TPR - Total Fertility Rate TP - Town Panchayat UNDP - United Nations Development Program  jij NEl1AL POLICIES FOR IMPROVING GROWTH AND ALLEVIATING POVERTY TABLE OF CONTENTS Page lo. SUMM4ARY AND CONCLUSIONS ..................................... i Chapter I. RECENT GOVERNMENT INITIATIVES A. THE CONTEXT: POVERTY AND PAST ECONOMIC PERFORMANCE.... 1 Poverty in Nepal ......... ..................... ...... 1 The Beginnings of Development ....................... . 3 The Sixth Plan 1980/81-1984/85 ...... ................. 5 B. .nE STRUCTURAL ADJUSTMENT PROGRAM ...... ................ 8 Background and Program Summary ...... ................. 8 Macroeconomic Developments Under the SAP ............ . 10 Impact on Poverty .................................... 14 C. THE BASIC NEEDS PROGRAM ................................ 15 Background and Objectives ........ .................... 15 Sectoral Programs and Targets ....... ................. i5 Employment, Distribution and Finance ............... .. 18 The Future Agenda .................................... 20 Chapter II. SECTORAL POLICIES FOR MEETING BASIC NEEDS A. AGRICULTURE ............................................ 21 Structure, Performance, and Constraints . . ............. 21 Recent Government Initiatives: The BNP ............ ... 25 An Assessment of the BNP ............................. 26 Improving Irrigation Facilities and Delivery of Inputs and Services .................... .. 28 B. INDUSTRY ............................................... 33 Structure, Performance and Constraints ............ ... 33 Policies to Alleviate Constraints ............. .... . 34 Basic Needs and Industry's Role ................... ... 37 C. POWER ............................................... 38 Overview ............................................. 38 Future Investments and Policies ...... ................ 39 Power Exports to India ......... ...................... 40 Rural Electrification .......... ...................... 42 D. EDUCATION .............................................. 43 Status and Key Issues ................................ 43 Internal Efficiency and Quality ................... ... 44 Institutions and Management ....... ................... 46 Equity and External Efficiency ... .................... 47 Budgets and Donor Inputs ............................. 48 The Basic Needs Program .............................. 49  iv E. POPULATION AND HEALTH ..... ............................. 50 Demographic Prospects .......... ...............0...... s Health Status ........................................ 53 Population and Health Strategies ..................... 54 Programs and Institutions ... ......................... 55 Expenditures and Financing ..... ...................... 57 Basic Needs and Future Orientation .. ................. 58 Chapter III. EFFICIENT RESOURCE MOBILIZATION A. PUBLIC REVENUES .............................. 60 Overview ........................ .................... 60 Imp-oving Tax Administration ....... .................. 60 Broadening the Tax Base .............................. 61 Increasing Non-Tax Revenues ....... ................... 64 B. ALLOCATING RESOURCES EFFICIENTLY TO THE PRIVATE SECTOR ................................ 64 Overview ............................................. 64 Central Bank Supervision and Regulatijn .............. 66 Directed Credits and Branching Policies .............. 66 Interest Rate Policy .......... ....................... 68 Strengthening Financial Institutions ..... ............ 70 Chapter IV. INSTITUTIONAL ISSUES A. DEVELOPMENT ADMINISTRATION AND CIVIL SERVICE PERFOP.MANCE ................. 73 Reasons for Unsatisfactory Performance ..... .......... 74 Refotm Efforts ....................................... 77 Future Priorities ..................................... 79 Conclusions .......................................... 81 B. DECENTRALIZATION ....................................... 81 Background ..........................................81 An Assessment of Decentralization ........ ............ 82 Future Directions .................................... 85 C. NON-GOVERNMENTAL ORGANIZArrONS ........... .............. 87 A Profile of NGOs in Nepal ......... .................. 87 Reconmendations ...................................... 90 Chapter V. BASIC NEEDS, GROWTP. AND EXTERNAL ASSISTANCE A. THE BASIC NEEDS PROGRAM: AN OVERVIEW ..... .............. 91 Objectives and Approach .... ......... ................ 91 Planning, Implementation and Financing ..... .......... 92 B. A MACROECONOMIC FRAMEWORK ......... ..................... 95 C. THE ROLE OF FOREIGN AID ................................ 98 Review of External Assistance ......... ............... 98 Donor Coordination and Institutional Development ..... 99 External Assistance Requirements and Priorities ..... 101 STATISTICAL APPENDIX HAP  v The report is base( on the work of two missions. The main mission, in April 1988, consisted of Mateen Thobani (Mission Leader), Eric Cruikshank (Industry, Power), Soon-Hee Heu (Donor Coordination), Anand Ra3aram (Directed Credit and Fiscal), Hisan Shishido (Macroeconomics), W. James Smith (Social Sectors) and Herman van Wersch (Agriculture). A second mission, in May 1988, looked at institutional issues and consisted of Nigel Roberts (Mission Leader), Duane Kissic, Peter Nicholas, Jacob Pfohl and David Walker. The report also drew on the work of a social sector strategy review mission comprising W. James Smith (Mission Leader), Howard Barnum, Jack Duloy, Frank Farner, Ian Morris and C.C' Pannenborg.  NEPAL : POLICIES FOR IMPROVING GROW1TH AND ALLEVIATING POVERTY SUMMARY AND CONCLUSIONS 1. Nepal faces a critical juncture in its modern economic history. Despite developmental efforts spanning several decades, sustained economic growth in excess of that of population has yet to be achieved. Thus, scant progress has been realized in alleviating the poverty situation. In recent years, the Government has launched a number of major initiatives to reorient policies and institutions to accelerate growth and meet basic needs. These efforts represent a more coordinated and intensive approach than pasc programs and thus the opportunity for achieving structural refor...s is that much greater. However, these initiatives, as in the past, may run into resistance. If the pace of reforms is not maintained, this period may be viewed as yet anot..er lost opportunity. This report reviews the economic developments in the 1980s which precipitated these major policy initiatives, particularly in the context of Nepal's basic needs concerns, and presents a policy agenda for the coming years. I. RECENT GOVERNMENT INITIATIVES The Context: Poverty and Past Economic Performance 2. Nepal's per capita GDP of US$160 places it among the very poorest countries in the world, a situation perpetuated by accelerated population growth. Other health and social indicators confirm Nepal's degree of poverty and deprivation. The National Planning Commission (NPC) has estimated that 42.5% of the population are absolutely poor. The limited on-farm opportunities due to small fragmented land holdings, combined with the low productivity of land, causes many Hill and Mountain people to seek low-paying off-farm employment and to migrate to the Ter&i or India--such migration has been proceeding for well over a hundred years. Many of the reasons for continued poverty can be attributed to problems in the agriculture sector. Between 1974/76 and 1985/86, grain production increased by only 1.5% p.a., while population growth was in excess of 2.5Z p.a.; consequently, per capita food production fell from 922 of requirements in 1976 to between 80-85% at present. Simultaneously, the productive potential of the natural resource base has been undermined by human and livestock pressures--resulting most critically in extensive degradation of the country's forest and pasture land, particularly in the Hills.l/ 3. This disheartening poverty situation has persisted despite several decades of concerted efforts to accelerate development. Few countries, however, began their development as late and with such a meagre resource 1/ Nepal can be divided into three ecological zones: the mountains of the Himalaya, bordering Tibet to the north, the middle Hills, and the Terai plains to the south, bordering India.  -ii- endowment -- a situation compounded by Nepal's land-locked location, rugged terrain and weak institutions. Nepal emerged from self-imposed isolation in the early 1950s with practically no infrastructure and with less than one percent of the school-age children attending school. Not surprisingly, basic infrastructural development, particularly roads, emerged as the priority investment during the first four development plans (1956/57-1974/75). Development in the productive sectors, however, was constrained by this very lack of infrastructure, weaknesses in public administration, and Nepal's low absorp-ive capacity for foreign aid. Moreover, because of the capital-inten -ve nature of the investment and its focus on infrastructure, little direct impact was registered on incomes and living standards with annual per capita income growth averaging less than one percent. Although th3 Fifth Plan (1975/76-1979/80) substantially increased public investment, gearing it towards quicker yielding investments and social services, economic growth barely exceeded population growth due to a series of poor agricultural harvests. 4. During the Sixth Plan (1980/81-1984/85) growing frustration with past economic performance manifested itself in surging public expenditures to accelerate the pace of development, causing the overall budget deficit to rise from 6.1Z of GDP in 1980/81 to 12.32 in 1982/83. This led to strong demand pressures reflected in higher domestic prices, a doubling of the current account deficit and a substantial fall in international reserves. While GDP growth was higher than in past years, it became clear that the growth was not sustainable. Consequently, towards the beginning of the Seventh Plan, the Government implemented a stabilization program, which was supported by a Fund Standby Arrangement in December 1985. Realizing that macroeconomic stability by itself would not lead to accelerated growth, the Government implemented a structural adjustment program (SAP) to address some longer-term constraints to growth. Simultaneously, the Government launched a far-reaching initiative to meet the basic needs of the populace. The Structural Adjustment Program 5. Together, the stabilization policies initiated in 1985, combined with the institutional and sectoral reforms supported under the World Bank Structural Adjustment Loan (SAL) and the IMF Structural Adjustment Facility (SAF) form the crux of the Structural Adjustment Program (SAP). The major theme of this program is to strengthen macroeconomic and sectoral development policies and improve the efficiency of public sector investments and institutions. The stabilization measures included actions to relieve pressures on the budget by restraining public expenditures, especially in the regular budget; increasing revenues; and tightening monetary policies. To strengthen Nepal's external position, the rupee was devalued by about 15% in rupee terms and several procedural and institutional reforms were taken to liberalize the import regime. The structural measures addressed constraints to growth in the agricultural and industrial sectors in addition to improving development administration. The program for agriculture focused on improving the availability of inputs and services by improving the effectiveness and efficiency of public institutions providing the services, liberalizing the pricing and distribution of inputs while increasing the role of the private sector, and  -iii- improving irrigation services. In forestry, the Government enacted appropriate legislation to permit community-level forest user groups to manage and retain their earnings from these forests to control further deforestation. Industrial policies were aimed primarily at partiaily liberalizing the industrial licensing and trade regime while correcting discrimination against exports. This was done by introducing tariff reform, a system of duty drawback and bonded warehouses for exporters, an OGL/passbook system for industrial importers and a system of auctioning import licenses for commercial items. Improvements in development administration were introduced by a program budgeting and project monitoring system to help establish a sound portfolio of "core" projects and to improve project implementation and budget release procedures. Efforts to improve the performance of public enterprises included identifying enterprises to be privatized and to begin a process of divestiture. 6. Macroeconomic performance during the last three years has been encouraging. GDP is estimated to have continued to grow by over 4Z annually despite erratic weather. There is an upward trend in foodgrain production due largely to acreage expansion and the index of industrial production is estimated to have increased by as much as 70Z. More significantly, the growth is likely to be more sustainable because of a build-up on international reserves which, prior to the SAP, had fallen to precariously low levels, threatening a clampdown of imports. International reserves grew from 3 months worth of imports coverage in 1984/85 to almost 6 months by 1987/88, reflecting strong growth in exports of cariets and garments (1462 in dollar terms) following the liberalization o' imported raw materials, a more than doubling of tourism receipts and an increase in aid disbursements (792). Carpets and garments accounted for 50Z of merchandise exports in 1987/88 as compared to 26% in 1984/85. 7. Under the SAP, the overall budgetary deficit fell only sightly from 10.1% of GDP in 1984/85 to 9.3X by 1987/88. At the same time, gross domestic borrowing fell from 4.12 to 1.6% of GDP, thus allowing more resources to flow to the private sector. This outcome reflects strong growth in revenues which increased by 1.9% of GDP coupled with a jump in aid disbursements which increased by 2.52 of GDP due to quick disbursing adjustment lending accounting for 12 of GDP and some improvements in budget release procedures. The growth in revenues was attributable to reforms in tariffs, discretionary tax mea3ures and substantial proceeds from the auctioning of commercial import licenses, which transferred economic rents to the budget. Regular expenditures were kept in check because of tight wage and employment policies while development expenditures grew briskly in line with developmental needs. External financing (both grants and loans) almost doubled during this period; consequently credit expansion to the public sector was cut by one-half. Although the current macroeconomic balances are sustainable, Nepal will need to continue its adjustment measures to accelerate growth, while ensuring continued macroeconomic stability. These measures fall broadly into three areas: (i) macroeconomic policies, including specific measures to improve the efficiency of thrn tax system and implement financial sector reforms; (ii) sound sectoral policies to accelerate growth and satisfy basic needs; and (iii) strengthened institutions and processes to serve the above two objectives.  - iv- The Basic Needs Program (BNP): A Desctiption 8. While an emphasis on basic needs has been a major theme for at least the last two development plans, the current effort is unique in its longer timeframe and its focus on a subset of development objectives. It has received high visibility and support since His Majesty's speech in December 1985, when he identified 2000 as the year by which the Nepalese people would attain a standard of living "commensurate to lead a life with human dignity by Asian standards." Aimed no less than at the eradication of absolute poverty by the year 2000, BNP seeks to provide goods or services in six areas: food, clothing, shelter, health, education and security. The program assumes that self-sufficiency in the production of these goods and services is required to provide these goods. Based on accepted national and social indicators, production targets were calculated down to the district level and input and financing levels identified using fixed input-output coefficients. 9. The focus of BNP is on identifying sectoral production targets and input requiremer:n;. In food, self-sufficiency implies that foodgrain production would need to grow at 4.8Z annually as compared to 1.5? during 1974/75-1985/85, At the same time, foodgrain productivity would need to increase by 3.7? annually versus an annual decline of 0.5Z. To do so, irrigation coverage would need to expand by 68,000 hectares annually, about three/four times past levels. In order to meet per capita clothing needs, cloth and footwear production would need to rise by 15X and 7.5Z p.a. respectively. In housing, since 931 of Nepalese own their houses, the focus is on housing improvement and provision of essential utilities. In education, universal primary education is established as the goal requiring an increase in primary enrollments from 1.8 million in 1985/86 to 2.9 million by 2000, and an increase in teachers from 51,000 to 88,000. In health, the emphasis is on the expansion and improvement of primary health services. As a result, the growth rate of population is to be reduced from 2.7? to 1.9Z p.a., life expectancy increased from 51 to 65 years, and infant mortality from 111 to 45 per thousand. 10. Recognizing that the Government alone cannot achieve these ambitious targets, participation of the private sector is emphasized, as is the role of community groups and NGOs. While the strategy of achieving the increases in agricultural production focuses on areas with the highest potential for output increases, mainly the irrigated fertile areas, the Government has a number of targeted subsidy programs to try to reach the absolute poor in the rainfed marginal Hill areas. It also stresses the need for labor intensive production technologies and the need to redistribute assets through land reform, though it does not get into specifics. In order to achieve the target income level by the year 2000, GNP growth rates of 4.5X p.a. (1985/86-1989/90), 5.7? (1990/91-1994/95) and 7? p.a. (1995/96-2000) are required. The public investment levels reauired to achieve this growth are high. These are to be financed in part by increased domestic resource mobilization, including the introduction of an agricultural tax, but mainly by foreign financing which is to increase its contribution from about 50? of development expenditures in the past to an average of 70X in the period covered by the BNP.  -v- II. SECT'RAL POLICIES FOR MEETING BASIC NEEDS Agriculture 11. Because 902 of Nepal's population live in rural areas, the key to alleviating poverty lies in improving agricultural performance. The reasons for the poor agricultural growth reflect numerous problems in the agricultural system, many of which have proven thus far to be intractable. These include the inadequate transport infrastructure; a large number of poorly-fed livestock with low productivity; an inadequate and declining forage base; declining soil fertility due to environmental degradation, particularly in the Hills; and adverse and erratic weather. Nepal has not followed inappropriate producer pricing and trade nolicies and therefore these cannot be blamed for agriculture's poor performance. The major constraint to agricultural growth has been ineffective irrigation delivery, particularly in public irrigation schemes where only a small part of the command area actually receives reliable delivery. Other factors that have contributed to low growth and productivity include problems in the delivery of fertilizer, slow progress in developing yield-increasing technologies, and weak research and extension. 12. The Basic Needs Program for agriculture correctly recognizes that significant increases in output can only come from improved irrigation and concentrating investments and programs (fertilizer distribution, improved seeds, research and extension) in areas with high production potent.al. At the same time, several programs to target the poor, such as directed credit programs, as well as research and extension for rainfed areas are to be expanded. The emphasis on small- and medium-scale irrigation with strong farmer participation is appropriate. There are, however, some issues that need to be addressed in implementing the BNP, many of which arise as a result of the top-down planning approach which takes as a starting point the premise that self-sufficiency in foodgrains is necessary to fulfill basic needs. 13. In the Nepal context, the priority given to food security is understandable. Trade may provide one means of securing adequate food supplies but domestic production has and will undoubtedly continue to meet the bulk of local food requirements. For the majority of the poor farmers living in remote areas with limited transport infrastructure, producing foodgrains for home consumption may be essential. Moreover, much of the Terai is a food surplus area and in fact exports food to India. For parts of the Hills and the Terai, where transportation and marketing facilities exist, however, some farmers may be better off producing cash crops. The recent expansion in cash crop production suggests that this process may already be occurring and should be nurtured. Thus, the priority given to food self-sufficiency in the BNP needs to be sensitive to the benefits gained from diversification in areas where it is clearly profitable. 14. To give local implementors commitment to the program, the Government program should involve them and not use top-down targets mechanistically to achieve goals which may result in detailed input and output targets inconsistent with realities at the field level. If the targets are calculated without regard to implementation capacity or what  -vi- can be effectively absorbed, the resulting high investment allocations may put such pressures on implementing agencies that spending targets become an end in themselves. This may be the case in the proposed construction and staffing of the Agricultural Service Centers (ASC). Similarly, the ambitious irrigation targets are unlikely to be achieved given the implementation capacity of the recently reorganized Department of Irrigation. 15. An alternative approach, which is used in this report, would begin by identifying the well-known reasons for low agricultural productivity and performance and why past Government efforts have been unsuccessful. The policies devised and investments prepared on this basis would better address the sector's problems. Such an approach would lead to a more flexible interpretation of irrigation targets to focus more on consolidating past investments and improving irrigation intensity. The priority would need to be on investments of short to medium gestation. Emphasis should be given to: (a) groundwater development, especially shallow tubewells; (b) completion of ongoing public sector irrigation projects; (c) improvement of farmer-managed schemes; and (d) new construction of farmer-managed schemes. 16. Another important factor would be to accord priority to those projects which maximize farmer responsibility for O&M. This approach would reduce the fiscal and managerial burden on Government, as well as the level of water charges that would be required to support public sector management of irrigation systems. Recognizing the problems with past approaches, the Government has recently initiated a sector program for irrigation development and investment which emphasizes direct farmer involvement and participation, in contrast to the top-down, project-by-project approach of the past. Under this program, farmer-managed schemes would be constructed or improved, construction costs would be shared by both government and farmers and a program for cost recovery would be devised. 17. In fertilizer, efforts should focus on continuing with a pricing policy that discourages deflection. while simultaneously taking measures to further liberalize distribution and encourage private sector participation by equalizing incentives between private dealers and Sajhas. In research and extension, the strategy would result in increased funding for research while unifying the diverse and uncoordinated extension systems in Nepal. The above approach, while increasing investment requirements for agriculture from past levels, would need significantly less resources than those envisaged in the BNP. Industry 18. Because Nepal's industrial sector depends so heavily on imported inputs, its restrictive industrial licensing and trade regime has been a serious constraint to industrial growth. Nepal's trade regime is unique: the Nepali rupee is fully convertible vis-a-vis the Indian rupee but inconvertible against cther currencies. In addition, the border between the two countries is long and porous, through which both goods and people move freely. Nepal is limited in its ability to liberalize the import regime. If it adopts the Indian structure of protection, trade between  -vii- India and Nepal would be harmonious but the restrictions would be inappropriate for Nepal's development. If Nepal liberalizes differently from India, liberalization would immediately lead to large-scale smuggling of goods imported from third countries to India. If Nepal met the hard currency demands for these imports, it would run down its reserves; if it auctioned the currency, the exchange rate against India could not remain fixed. Nepal's import regime is thus an attempt to balance these goals and maintain a protective structure appropriate to its needs. However, this has distorted the structure of Nepali industry in favor of rent-seeking acti-ities involving little value-added and established primarily to exploit the highly protected Indian market. 19. Under the SAP, the Government has instituted several reforms to liberalize the industrial and trade regime. For commercial imports, the Government introduced a system of import license auctions, which, in effect, resulted in a protection structure for commercial imports being similar to that in India. For selected raw materials, on which the Government wished to keep low protection, an OGL/Passport system was itntroduced, which, while more liberal than the old license system, still reetained controls to minimize smuggling. In addition, the Government introduced legislation to remove discrimination against selected exports. The Government should continue this process by expanding the number of items under the OGL/Passbook system so as to include some intermediate and capital goods, liberalizing the number of items under the auction system for import licenses, and expediting implementation of the measures already introduced, especially on incentives for export. 20. In meeting the BNP's target for providing clothing, the Government has assigned primary responsibility to the private sector, limiting its own involvement to that of creating a favorable business climate through liberalizing industrial and import licenses, granting tax concessions and providing supporting services. Given the existing excess capacity, these measures should allow attaining the targets for footwear and clothing, at least for the next few years. If Nepal's comparative advantage truly lies in these industries, significant new investments would be needed to sustain the required growth rates in the longer-term. 21. There are, however, two caveats to this strategy. First, the newly introduced tariff exemptions and increased foreign exchange availability for inputs could lead merely to their re-export to India. Second, self-sufficiency in domestic production is unlikely to be the best way of providing cheap cloth to the poor--reducing the tariffs and taxes on imported cloth would have a more pronounced effect. On the other hand, such an approach would not help develop a domestic industry. There is an obvious short-term conflict here between promoting a new industry and meeting consumer interests, although if Nepal is a competitive producer, the trade-offs may not be substantial or permanent. Power 22. Although Nepal is endowed with vast hydroelectric potential, theoretically of some 83,000 MW, less than 200 MW have been tapped to date, and Nepal remains a country with inordinately low consumption of energy.  -viii- After an in-depth review of options, the Government and major donors have agreed on the Arun-3 hydropower project as the appropriate next investment in new generation capacity to meet Nepal's forecast domestic demand for power. Arun-3 is a 402 MW run-of-the-river project to be commissioned during 1995-2003, and could be accelerated to accommodate bulk export sales to India. It is now important for Nepal to avoid undertaking other large power projects over the next decade unless financing for the projects are strictly additional, highly concessional and the projects can be implemented without excessively burdening Nepal's existing institutions and administrative capacity. In addition, in order for the project to be implemented effectively, the Government needs to take a number of steps to strengthen the Nepal Electric Authority's (NEA) ability to carry out this enormous investment program as well as continue to raise electricity tariffs--presently electricity tariffs are less than half the long-run marginal cost of electricity generation and distribution. 23. Given Nepal's huge hydropower potential and India's stated desire to import any available quantity of power exports over the medium-term, Nepal needs to continue its effort to develop this export market. To do so it needs to develop a position on several complex issues and then to enter into serious negotiations with India. At the same time, it needs to carry on with its technical and related studies. Negotiations on the export of power of about US$60 million annually from Arun-3, which is smaller and does not involve additional water resource issues, is a useful starting point for er,tering into bulk export arrangements from mega-projects. 24. Rural electrification (RE) is considered by some to be the answer to both generating rural income and employment as well as mitigating the environmental degradation caused by the preponderant reliance of rural Nepalis on fuelwood. Although there is some experience with small hydroelectric systems and with grid extensions passing through rural areas, concerted efforts to introduce RE have not yet taken off in Nepal. However, work undertaken by a special task force suggests that anticipated rural electrification benefits have not yet materialized; in rural areas of Nepal that have been electrified, its impact on generating income and employment has been small compared to the cost of providing the power, and electrification has yet to generate significant fuelwood savings. If the Government wishes to increase rural electrification, the appropriate starting point would be to connect communities already electrified by the Indian grid or served by diesel or small hydro. Beyond this, priority should be assigned to those areas where the scope for productive use of electricity has been market tested. Additionally, for RE to provide maximum contribution to developmental and environmental objectives, it should be undertaken as part of a broader sot of rural development activities. Technical assistance is about to be initiated to provide guidance on the best strategy for RE. Education 25. While enrollments have risen more than five-fold between 1965 and 1986, two-thirds of Nepal's population remains illiterate with major implications for the potential pace of development and for the success of health and population programs. Enrollments, which are officially  - ix- estimated at 822 for primary schools are overstated, partly due to high drop-out rates and the fact that many students enrolled do not actually attend. Low attendance and high drop out rates are directly related to the poor quality and lack of relevance of the education currently offered -- problems that stem from policies which have concentrated on expansion of facilities and have somewhat neglected quality considerations. A period of consolidation in which quality issues are attended to as a major priority appears to be necessary in order to reduce waste in the system, and to ensure that enrollment growth will surge once again. 26. Both primary and secondary schools could usefully absorb additional funds. For this reason, BNP's orientation toward primary schools is appropriate. Expanding capacity, however, will require significant improvements in quality in order to generate demand. To do so would need a significant expansion in teacher training, especially for women, and an improvement in the curriculum and teaching materials. At the university too, there is a need to improve the quality of instruction and facilities while restricting the growth of overall enrollments and altering budget priorities in favor of science, engineering and technical subjects. In dddition, beneficiaries need to pay a larger share of expenses. While the shares of Government expenditure devoted to secondary and higher educatior have been falling, the share going to university (25Z) is still high giveu that it accounts for less than 3Z of enrollments. Furthermore, despite a sizeable student grant system, annual fees of Rs 240-360 ($10-15) are less than those in secondary schools if in-kind payments are included. Population and Health 27. Nepal's demographic situation is serious. However successful efforts to curb fertility during the next decade may prove, the country's population will still reach about 24 million in the year 2000, compared to an estimated 17.5 million today, and will double by the year 2015. Although little can be done to change events in this generation, prompt action is nonetheless needed to lessen demographic damage to the next. Realizing the dangers inherent in continued rapid population growth, the Government formally adopted a National Population Strategy in 1983 and has endorsed it in the Seventh Plan and BNP. The strategy provides for a broad mix of contraceptive services and demand motivation and recognizes the important interactions between fertility, education and income. Despite this strong commitment, little success has been achieved in curbing population growth. While sterilization attempts have been successful and now account for about 85% of contraception, temporary methods have not been successfully delivered. The reasons have to do more with difficulties in organizing sustained and motivated outreach work in village comnunities than with a lack of political will, weak demand or inadequate funding. 28. Health coverage has expanded considerably and several health indicators have improved during the last forty years. To an extent, this is the result of successful health programs in immunization and home oral rehydration techniques. The picture today, however, remains bleak, with widespread diarrheal and parasitic diseases and malnutrition that results in high rates of goitre and cretinism. While successes would significantly benefit from economic development leading to better education for personal  and domestic hygiene, and the availability of safe drinking water and sanitary excreta disposal, the Government needs to improve its efforts in the sector. 29. Since 1975, Government health policy has been directed towards providing minimum services to the maximum number of people. The BNP in health, which is essentially a full-fledged primary health care (PHC) policy statement with an appropriate emphasis on family planning and child care, in effect, endorses a continuation of this strategy. Although the strategy is sound, as in many other areas, there is a need to consolidate existing programs and improve their quality before embarking on a major increase in coverage. Most of the improvements need to be concentrated in institutional areas that affect the civil service as a whole; other issues that need immediate attention are problems of inadequate medical supplies and training for extension workers, absenteeism, and a paucity of house-to- house visiting, especially by female workers. Apart from general administrative reforms, improved health service delivery will require a sustained increase 'n funding, the development of supervision and management systems at the district level, a significant increase in the hiring of female health workers, and the introduction of systematic rural residency and in-service training for rural health workers. III. EFFICIENT RESOURCE MOBILIZATION Public Revenues 30. Nepal's tax system has suffered from a number of structural flaws that have inhibited economic growth and caused inequities. These flaws have related mainly to gaps in the tax base due to tax exemptions and tax holidays and also to the use of specific rather than ad valorem rates, and problems with tax administration. Because of the gaps in the tax base, the tax elasticity is low. As a consequence, the Government has relied on ad hoc discretionary interventions in the tax system to generate revenue growth. By needing to announce new tax measures each year just to keep revenues growing in line with economic activity, this has contributed to economic uncertainty, discouraging private investment. Government policies to promote certain sectors or activities through tax concessions have not only caused economic distortions but have also led to additional wasteful rent-seeking activities whereby interest groups spend resources to try and obtain similar exemptions. That large components of the economy are virtually tax exempt has also been inequitable. The problem has been worsened by the weak institutional base for tax collections. With the passage of the new Industrial Enterprises Act and tariff reforms in 1987/88, the Government has done much to reduce tax concessions and improve tax administration. However, the Government has also introduced new tax exemptions in its 1988/89 budget in connection with the BNP. Furthermore, the bulk of tax revenues still comes from indirect taxes, mainly sales and trade taxes, which are subject to high variance depending on exogenous factors. Thus, measures to improve the tax system must continue to focus on broadening the tax base and improving tax administration. These measures are likely to result in a more elastic tax system, diminishing the need for disruptive new tax measures in the future.  -xi- 31. To improve tax administration, the Government is in the process of unifying the three revenue departments to create a specialized career path. Other steps include increased use of regular field audits, the extension of training programs for revenue officers, a substantial increase in penalties for tax evasion and late filing of returns, the introduction of audits for tax assessors, and the strengthening of the information base. To broaden the tax base the Government needs to reduce tax exemptions for companies. In addition to a loss of revenues, these tax concessions tend to have a high economic cost and are often inequitable. A major inequity in the tax system and a reason for the low tax base is that the share of agricultural taxes in total tax revenues has fallen from about one-quarter in the 1960s and 1970s to 2.5Z today. Therefore, the Government's announced intention of reintroducing the Panchayat Land Development Tax (PDLT), a proxy of an agricultural income tax, is to be welcomed. 32. Although opportunities to raise non-tax.revenues significantly are limited, there are areas where revenues could be increased and others that impose hidden costs on the economy and the Government. User charges, when they exist, are typically low due to inadequate indexation of charges and often uncollected due to poor administration and a lack of willingness to pay because of the poor service quality. While virtually all public enterprises show only marginal profits or losses, this is largely due to inadequate accounting procedures that disguise losses, and hidden subsidies, such as Government guarantees on loans to loss making enterprises. Recent Government efforts to strengthen accounting procedures in key public enterprises, and to conduct an external audit of the public financial institutions, are therefore appropriate. Similarly, its program of public enterprise divestiture should help both in obtaining revenues from the sale of enterprises and in reducing subsidies, explicit or implicit, to their enterprises. Financial Sector Issues 33. Nepal's financial system faces a number of sericus problems. The most critical threat involves the financiel status of the two largest commercial banks, Nepal Bank (NB) and Rastriya Banijya Bank (RBB", and the two development banks, National Industrial Development Corporation (NIDC), which lends to medium-and large-scale industry, and the Agricultural Development Bank of Nepal (ADBN), which lends to small-scale industry and agriculture. All four banks would almost certainly show losses and even possibly negative equity (except NIDC) if they were to take provisions and suspend accrual of interest on non-performing loans using internationally accepted accounting practices. The main factor responsible for the serious position is financial indiscipline. Many borrowers, both in the public and private sectors, are unable or unwilling to repay their loans, while banks continue to accrue interest, showing profits and paying out dividends. This problem is exacerbated by inadequate Central Bank suDervision and regulation which does not adequately penalize either banks or borrowers for non-payment of loans such that even when some borrowers are able to service their loan, insufficient pressure is applied to coerce payment. In addition, the Government has used its control over the institutions, formally and informally, to direct credit to preferred sectors and borrowers. These directed credits misallocate investment into less  -xii- profitable uses; this manifests itself in the lowered profitability of these banks. Furthermore, ADBN and the two large commercial banks have been coerced into opening many branches in recent years, most of which do not cover costs. 34. To increase the level of credit going towards production rather than the more traditional trading activities, the Government has required commercial banks to lend 252 of their total credit to productive sectors, of which 8X has to be lent to priority sectors, comprising agriculture, small-scale industry and services. A portion of these administratively costly and higher risk loans have to be at concessional rates. At a minimum, these rates should be increased substantially. In addition, banks often are fo.ced to open unprofitable branches in rural areas, where even one bank is likely to be unprofitable. More autonomy thus needs to be given to commercial banks over branching policies. 35. The Government has recently proposed to gradually but sharply expand the scope of its directed credit to meet dramatically increased credit targets to the priority sectors and to the absolute poor. To facilitate the process, it has introduced a Lead Banking Scheme. This concept assigns a number of complex planning and coordinating functions to the lead bank. While there are some merits to the scheme, the banks probably do not have the capacity to carry out their new functions, some of which are questionable. Furthermore, the increased administrative burden would add to their high operating costs when banks are already overextended. In addition, the credit targets need to be reconsidered given the likelihood that if the targets are enforced, they could trigger a collapse of the financial system because of the high costs of lending to such groups, and leave virtually no funds available for lending to others. 36. Although most interest rates have now been freed, the Government can and does influence their level. The current level of deposit rates is slightly positive in real terms and probably not out of line with where it would be set by market forces. However, the system by which rates are set is not responsive to market forces and the term structure of deposit rates appears steep, with real term deposit rates being high. Until a market for long-term Government securities is available, the Government might consider linking the rates paid on its savings certificates and development bonds to its short-term market-determined bill rate that the Government plans to introduce shortly. At the same time, it may reconsider its decision to grant these instruments tax-free status. Presently, the tax-free interest rates of 10.52 and 13% on Government bonds and savings certificates force commercial banks to offer 12.52 to 142 on their term deposits, thereby driving up lending rates, reducing the profitability of banks and discouraging private investment. 37. To improve supervision of banks, the NRB needs to be able to assess and quantify the problem of delinquent loans in the banks and the extent to which these problems have undermined the state-owned banks' viability. An efficient continuous supervision based on bank returns should be developed to gradually replace the heavy emphasis on periodic on- site inspection, which is becomirLg increasingly less effective as a means of gaining insight into the financial problems. At the same time, NRB  -xiii- needs to strengthen regulations and their enforcement by (a) setting limits on a bank's maximum loans outstanding to any one borrower and minimum capital requirements in relation to total assets; and (b) improving accounting and reporting systems to better monitor Government guaranteed loans and loans to public enterprises and to enable banks to assess the quality of their portfolios and to provide for possible bad debts. 38. As a result of improved super sion and regulation, the four large banks will need to adjust. To facilitate recapitalization of NB, the Government may consider reducing its share below the current 50%. RBB, which is 100Z Government-owned, requires major restructuring--options include recapitalization, sale, down-sizing or merger with another institution. While continuing to experience collection difficulties, ADBN has been recently instituting more satisfactory accounting policies for provisioning and suspension of interest accrual and has initiated legal action as part of a successful program to improve collections. It needs time to consolidate these gains before taking on significant new burdens under the lead bank scheme, and so it is important that ADBN's growth be restrained to the agreed 15X per annum and that it not be required to open up many new branches. NIDC, which is more heavily capitalized, needs to enhance its autonomy and commercial orientation by allowing private sector participation in its management, and possibly, ownership. In addition, it needs to increase its interest rates on new and newly rescheduled loans to match commercial bank term lending rates and to restructure its portfolio. IV. STRENGTHENING INSTITUTIONS Development Administration and Civil Service Performance 39. Weak public administration is one of the root causes of Nepal's disappointing development performance in the modern era; sectoral growth has been hampered more by institutional deficiencies and ineffective service delivery than by sheer resource shortages or by distortionary economic policies. Although specific policy reforms are not suggested, the BNP stresses the need to improve public administration, recognizing that the Government's institutional shortcomings must be addressed if economic and social service delivery is to improve to the extent required by BNP. 40. The unsatisfactory performance of public administration stems from four causes. First, given the poor communications, the heavy concentration of decision-making personnel and processes in Kathmandu leads to serious implementation problems at the district level. Second, there are problems of staff motivation, incentives and terms of service: salaries are typically inadequate; technical staff find opportunities for promotion are limited; field staff are not compensated adequately for the high incremental costs of fieldwork; and personnel evaluation systems offer little basis for merit assessment. Third, the planning and resource allocation mechanism, with its restriction that only projects in the Five Year Plan may be funded, leads to a lack of prioritization, over- commitment, underfunding, especially where O&M expenditures are concerned, and ad hoc arrangements for obtaining resources during implementation. Fourth, stringent accounting requirements and bureaucratic procedures  -xiv- arising from elaborate rules governing procurement and contract supervision result in slow implementation of projects, leading to cost overruns. 41. The Go-rnmer,t h*. sponsored much excellent analytical and prescriptive wor'- to address these problems. Commissions entrusted with this responsibility as far back as 1968 and 1975 have advocated the introduction of a merit-based reward and promotion system based on rigorous job-classification, the adoption of program budgeting and the strengthening of planning cells in line ministries, an overhaul of budget release procedures, and revamped administrative processes and structures. Implementation, however, has been slow. Recently, there has been significant headway in many of these reforms under the 1982 Decentralization initiative, the SAP, and more recently, the BNP, but the major structural deficiencies remain. Decentralization 42. The Government has long recognized that effective grass-roots development in Nepal requires a strong measure of local participation in the cultivation of self-reliance: poor communications, limited central budgetary resources and a weak civil service all place strict limits on the capacity of central government to cater to local needs. Building on earlier initiatives, the 1982 Decentralization Act devolves considerable authority in planning and implementation of projects to the elected bodies in the districts and empowers the Village and District Panchayats to levy taxes and tolls for development purposes. Centrally managed projects, however, which account for three-quarters of development expenditures, do not fall within the district's purview. 43. There have been teething problems with decentralization, but also some promising signs of progress. Devolution of authority to local bodies will inevitably be a slow process, given the weak technical and managerial capacities of local bodies. There are many examples of the successful use of local planning and implementation procedures to mobilize effective participation in the construction of roads, water systems and rural infrastructure. Similarly, technical assistance and training in 33 town panchayats has strengthened the delivery of municipal services and the management of local financing. There are, however, several problems that need addressing. 44. One problem is that the Act fails to define district-level and central projects with a sufficient degree of financial specificity leading to ambiguity in ultimate responsibilities. In light of the Government's commendable commitment to decentralization, donors should consider avoiding project arrangements which bypass the district-level planning and implementation process, even if the arrangements are conducive to short- term efficiency and productivity gains. Local resource mobilization remains another area of weakness. There is still a high degree of local budgetary dependence which reinforces perceptions created by the top-down planning process, that development projects are central government projects to be implemented and maintained by the central government. Therefore, the Government announcement in the 1988189 budget speech of once again activating the PDLT is to be welcomed. Presently, there is a perception  -xv- that BNW, which reinforces certain line agency functions, may run counter to the decentralization process. In fact, BNP relies on an efficient decentralized structure for its implementation. It is therefore recommended that the HMG issue a clarification to line agencies, emphasizing the interdependent nature of the two initiatives. Finally, to ensure the success of decentralization and improve district-level planning and implementation of projects, it will be necessary to improve the calibre of district staff. The Role of Non-Governmental Organizations (NGOs) 45. BNP acknowledges that NGOs have an important role to play in the delivery of economic opportunities and services, particularly in rural service delivery and poverty alleviation work. The NGOs fall under the purview of the Social Services National Coordinating Council (SSNCC) which serves as a regulatory body registering NGOs and coordinating their efforts, and as a support agency, extending technical and financial support to local NGOs. The technical capacity of SSNCC is correctly being enhanced. At the same time, international NGOs (INGOs) should be responsive to HMG concerns about the use of expatriates and about costly overheads. INGOs would do well to concentrate direct project implementation on a few key pilot activities, and to focus their energy on supporting central or local government activities and on providing catalytic su-port to Nepalese NGOs by providing modest sums of program assistance to the sector. These funds should be routed through SSNCC in the form of block grants, to be passed on both to national NGOs (particularly to enable them to assist smaller grassroots-level NGOs) and directly to local NGOs. V. BASIC NEEDS, GROWTH AND EXTERNAL ASSISTANCE The Basic Needs Program: An Overview 46. BNP is the country's first full-fledged poverty alleviation program; it elevates the issues to the importance it deserves over a timeframe more appropriate to the nature of the problem and with a tighter thematic focus than the more conventional five-year plans. It recognizes that increasing the incomes of the poor is the only sustainable route to poverty alleviation and that growth must be driven largely by a private sector which is permitted to respond positively to market signals. The temptation to create new government economic entities in order to force the pace of growth is wisely avoided--in fact, BNP states that the Government will privatize certain of the more inefficient parastatals. Furthermore, in recognition of the limited capacity of the Government to deliver goods and services, the program assigns appropriate roles to local government, community user groups and NGOs. 47. The designers of BNP faced a quandry in trying to target their programs to the absolute poor. The very poorest are concentrated in the Hills and Mountains, often on steep and infertile rainfed soils and with little or no access to advice, credit or inputs, and limited scope for raising agricultural productivity. Increases in incomes of most of the  -xvi - poor in the Hills and Mountains can only come as more and more of them emigrate to faster growing areas, thereby reducing the pressure on Hill agriculture. Rathe' than being drawn by the plight of these people to propose a massive on-site poverty alleviation campaign of uncertain prospects with large elements of explicit or implicit subsidy, BNP instead correctly stresses the development of the more fertile farmland through the intensified use of production inputs. This may be the only alternative under known technological conditions. At the same time the Government has introduced or expanded a number of programs targeted directly on the poor. However, such interventions are typically costly and thus limited in scope. 48. While the orientation of BNP is correct, the Government needs to give further thought to a number of planning and imp'lementation issues inherent in the design of the program, particularly to the premise that the way to get basic needs goods to the poor is by producing them domestically. Given the open border with India and limited ability of the poor to buy goods, self-sufficiency in production is neither necessary nor sufficient to meet basic needs. In some cases, the poor could buy the goods more cheaply from India; producing them domestically, with the support of high protection, would only make the goods less accessible to the poor. What has been correctly identified by the Government is the need to raise incomes and employment; self-sufficiency in production is not likely to be the best way to do so. 49. The self-sufficiency goal and fixed input-3utput coefficients lea! to physical and financial input targets that may bear little relation to demand or the ability to implement or finance the proposed investment targets. While BNP acknowledges that weak implementation of the development program is a major and persistent problem in Nepal, it does not come to grips with the reasons for the past poor performance; nor does it propose specific reforms or tailor its targets in recognition of these constraints. A number of basic needs programs are highly ambitious in quantitative terms when viewed against recent past achievements. Increasing pressures are thus likely to be brought to bear on line agencies to deliver outputs that will deviate further and further from the attainable as the year 2000 approaches. This, in its turn, would heighten the possibility of managerial and budgetary neglect of important non-BNP programs, and could dissipate the potential impact of the program budgeting process and other resource allocation mechanisms. It could also strengthen the inclination of line ministries to pursue more interventionist policies. Eventually a situation might arise in which quantitative shortfalls seriously discredit the BNP in the eyes of the public, to the point where success itself is obscured by the failure to achieve some original target. 50. It will be important to review previous constraints to achieving basic needs goals, and to revise policies, make investments, or strengthen institutions in order to address the constraints. While many of the policies envisaged under the BNP are in line with the recommendations in such an approach, in some cases this approach would lead to greater flexibility in interpreting targets, and focus more heavily on getting the institutional and policy framework right before embarking on an ambitious investment program. Analysis in this report shows that the economic returns, of a strategy that focuses on consolidating past investments and  -xvii - improving its efficiency are likely to be higher than those associated with rapidly expanding investments or services. Such an approach would also reduce financing needs to levels that could be financed from projected foreign disbursements and domestic resource mobilization. Growth Prospects and Foreign Aid 51. If the Government continues with its structural adjustment program, Nepal's GDP could realistically grow at 4-5Z on a sustainable basis. This would require agriculture to grow at 3-4% partly as a consequence of improved availability of input supplies and better irrigation. Manufacturing could grow rapidly following the ongoing industrial licensing and trade reform. Construction activity also should continue to grow rapidly as a result of increased private and public investments. 52. Fiscal policy needs to emphasize improving the quality of Government expenditures rather than raising the level of either Government spending or of taxes. At the same time the Government needs to ensure that adequate financial resources to flow to the private sector. At the aggregate level, this scenario would require containing the domestic financing of the fiscal deficit to below 1.5Z of GDP. To limit domestic financing of the budget to prudent levels while increasing public savings to finance the increased investment efforts, public revenues would need to increase by about 0.4Z of GDP annually in the medium-term. These should follow readily from the ongoing reforms to improve tax administration and broaden the tax base, which is expected to result in a more efficient and equitable tax system. Given projected fiscal expenditures, this scenario would be consistent with a fiscal deficit (before grants) limited to 8-92 of GDP. At the same time, in order to improve financial discipline in the private sector while strengthening institutions and allocating credit more efficiently, the Government needs to improve Central Bank supervision and regulate, slow down on its policies of directed credits and forced branching, rationalize interest rate policies and reform the large financial institutions. Also, to ensure more productive public investments, the Government needs to continue its efforts on program budgeting and monitoring as well as improve budget release procedures and continue with institutional reforms. 53. Given this scenario, there will be no major changes in the balance of payments situation. Merchandise exports and tourism aro projected to grow strongly; the former mainly as a result of increased exports of carpets and ready-made garments; and the latter due to strengthened promotion and marketing measures, improved access through the purchase of two new commercial aircraft and the development of new areas of mountaineering and trekking. Because of the comfortable reserve position and good export prospects, the Government is considering pre-paying during 1988/89 one of its aircraft loans that was contracted on commercial terms. Imports are projected to grow at 82 to 102, slightly more than economic activity, because of improved budget release procedures and import liberalization. Despite the faster growth of exports, the current account deficit, after a spurt in 1988/89 caused by the aircraft purchase, is projected to stay just under 72 of GDP. In dollar terms, this would imply  -xviii- an increase in the current account deficit from US$240 million in 1987/88 to over US$300 million in 1991/92. 54. Since donors have financed about half of Nepal's development efforts in the past and that there are now opportunities for adjustment finance, it should be possible for external financing to sustain such a current account deficit, while allowing amortization payments and a modest build-up of reserves. Between $310 and $380 million in aid disbursements are projected annually for the next few years, of which about $70 million are likely to come as adjustment lending. In addition to augmenting foreign exchange resources, adjustment operations can provide an appropriate policy framework for donors to continue with project-related operations. 55. Aid commitments need to be linked to Government development strategies: (i) policy and institutional adjustment; (ii) the Basic Needs Program; (iii) major infrastructure; (iv) decentralization; and (v) public administrative reform. In particular, in order to improve the quality of individual projects, more attention needs to be paid to improving policies and strengthening institutions both through project-related finance as well as through adjustment operations. In the past, the degree of reliance on external resources has had some unintended consequences; in combination with the imperfect planning mechanisms and weak institutional structures, it has sometimes led to inconsistent sectoral strategies and investments, and has contributed to an excessive number of projects in the Government portfolio (over 1300 active in 1987). The Government and donors need to carefully scrutinize each new investment to ensure not only that it fits with strategic priorities, but that it is economically sound and can be implemented under current institutional conditions. The on-going reforms in development budgeting should facilitate this effort. Similarly, programmatic approaches to sectoral development as are being followed in the irrigation, forestry and power sectors are working well and could be extended to other sectors. In addition, projects could be further reduced by merging similar projects at the design stage and encouraging cofinancing. Recent Government attempts to delegate an individual bilateral donor as having the lead in a given sector for small projects would also help ensure coordination and reduce the number of projects. 56. The sectoral composition of aid should reflect the following priorities on investments and the policy and institutional framework. Agricultura needs to be given priority through investments in irrigation (rehabilitation and completion of existing works, increased development of ground water, and promotion of private and public farmer managed schemes), financing for fertilizer imports, support for research and extension systems, increased agricultural credit and improving the delivery mechanisms for inputs. Key policy measures in this area would be to encourage increased participation of farmers in the development and management of public irrigation schemes, to continue measures to facilitate private distribution of fertilizer while ensuring that fertilizer prices follow those in India, and to strengthen AIC to better carry out its role. In industry, technical assistance should continue to support measures to streamline export and import procedures and to privatize or improve the efficiency of public enterprises. In addition, the trade liberalization  -xix- measures need to be continued while announced measures need to be implemented quickly and efficiently. In the education and health sectors, initial emphasis should be on consolidating gains in coverage by improving the quality of service through training, management, improved delivery system and supplies, including drugs. This would improve the productivity of existing infrastructure and prepare for a much-needed expansion in expenditures and facilities. I hydropower, donor attention should be given to ensuring the rapid implementation of the Arun-3 project, in order to ward off power cut backs in the mid-1990s and to develop export revenues.  I: RECENT GOVERNMENT INITIATIVES A. The Context: Poverty and Past Economic Performance Poverty in Nepal 1.01 Nepal's per capita GDP of US$160 places it among the very poorest countries in the world, a situation perpetuated by a population growth rate which accelerated from 1.62 in the 1950s to 2.71 by the late 1970s. Other statistics confirm Nepal's degree of poverty and deprivation; life expectarncy at birth (54 years for males, 51 for females) and infant mortality rates (111 per 1000) are comparable with the world's least developed countries as a group. 1.02 Nepal is extremely dependent upon agriculture, which contributes about 552 of GDP and employs 93Z of the work force. The agriculture sector, moreover, is afflicted by mounting population pressure on limited arable land resources, by a falling trend in productivity and by accelerating environmental deterioration. Rapid population growth has largely offset the income opportunities presented by the virtual elimination of malaria in the Terai by the 1960s;l/ as a result, about seven people are currently dependent for their livelihood on each hectare of arable land, a figure similar to population densities in the more fertile Asiatic delta regions (e.g. 8.5 per hectare in Bangladesh); the ratio of population to arable land in the Hills is considerably higher. Between 1974/75 and 1985/86, as increasingly marginal Hill and Mountain land has been brought under cultivation, grain production has risen by only 1.5% p.a., while productivity has fallen by 0.5Z p.a.; in consequance, per capitr food consumption fell from 92Z of requiren.ents in 1976 to between 80-85% at present. Simultaneously, the productive potential of the natural resource base has been undermined by human and livestock pressures - resulting most critically in extensive degradation of the country's forest and pasture land, particularly in the Hills. Over the past fourteen years alone, national forest crown cover has been reduced by 25Z--contributing to soil erosion, fuelwood shortages and the increasing use of animal dung as fuel, to the growing detriment of soil fertility. 1.03 Equally, Nepal has not witnessed the growth in non-agricultural income needed to help relieve pressures on the agricultural sector. Non- agricultural labor increased from 0.24 million persons in 1960 to only 0.52 million by 1980, while those employed in agriculture increased by 2.6 million. Levels of rural underemployment are as high as 40-50%, and the off-farm earnings of the agricultural poor are comparable to or less than their on-farm earnings. Migration, principally from the Hills into the Terai or India, has been proceeding for well over a hundred years and 11 Nepal can be divided into 3 broad ecological zones: the mountains of the Himalaya, bordering Tibet to the North, the middle Hills and the Terai plains to the south, bordering India. Approximately 42% of the population live in the rural areas of the Hills, and a similar number in the rural Terai; 8% live in the Mountains, and 72 in urban areas.  -2- provides the only major vent for population growth; between 1971-81, the Terai population as a whole grew by over 4? annually, Terai urban areas by 8-12?, and the Hill and Mountain populntion by 1.5Z. 1.04 Using minimum daily caloric requirements as a basis, the National Planning Commission (NPC) has estimated a poverty line income of Rs 1971 (US$110) per person per annum in 1984/85 prices.2/ It is estimated that some 42.5? of the population fall below this stringent floor, a figure that would rise to about 60? if a poverty line income equivalent to US$200 were used. Thus a significant proportion - and probably the majority - of Nepal's population can be classified as absolutely poor. 1.05 Using the more conservative NPC measure, the majority of the Hill and Mountain population and a quarter of the Terai population fall below the poverty threshold. Poverty is also predominantly a rural phenomenon in Nepal. Even adjusting for higher urban living costs, only some 152 of Nepal's small urban pcpulation fall below this poverty line, while about 50? of the rural population do; indeed, 97Z of the absolute poor are found in rural areas, with a particular concentration in the Hills and Mountains, and only 32 in the cities and towns. 1.06 Poverty in Nepal is linked predominantly to a shortage of productive agricultural land; in general, the absolute poor in the Hills are those owning less than 0.5 ha (over 50Z), and in the Terai, those owning less than 0.3 ha (about 30Z). A composite profile of a poor rural family suggests a homestead of just under 0.5 ha producing grain sufficient to feed the family for less than six months of the year. It is likely that up to half of this meagre crop will be owed either to a landlord or to a better-off local villager as repayment for consumption loans taken out to meet social obligations (marriages, festivals etc.) or crises (crop failures, medical emergencies). In such families, undernutrition is commonplace, provoking the virtual certainty that one or more children will die from the gamut of illnesses affecting the family. Hanging over this inherently unstable situation is the prospect of further subdivision of the family farm among the children; typically, the family is only sustained on its land by off-farm labor, which provides up to a half of total family income (principally through portering and laboring, often from family members who have in effect migrated in search of work elsewhere in Nepal, or in India). With returns to off-farm labor of less than a healthy subsistence wage for those from poor families, leaving the farm is more of an expression of despair than a pursuit of opportunity. 2/ The poverty line for the Hills is considered to be higher, due to greater caloric requirements and higher prices. The national figure of Rs 1971 is a weighted composite of Rs 2277 for the Hills and Rs 1438 for the Terai ("Programme for Fulfillment of Basic Needs 1985-2000", NPC, 1987).  1.07 Data on per capita income indicates a fairly egalitarian distri- bution of earnings in Nepal (Gini coefficient of 0.25).3/ Incomes are also distributed fairly evenly by area and by rural/urban category, with the exception of the Mountains - where an almost uniform level of poverty prevails (Table I.A.,). Nepal thus demonstrates a flat distribution of income around a very low average. Poverty in Nepal is primarily a function of severe population pressure on limited land resources, and of sluggish compensatory growth in off-farm productivity. The country's income profile suggests that there is little scope for a redistribution of earnings. The principal asset in Nepal is land; although land ownership is highly skewed, it is a very limited resource and thus the scope for land redistribution programs is limited. The key to the future lies with accelerating economic growth with a concerted effort to control population growth. Table I.A.1 : PER CAPITA INCOME DISTRIBUTION IN NEPAL (Percentage Share of Income) Income All -----------Rural ----- ----Urban---- Group Nepal Terai Hills Mountain Terai Hills Bottom 40? 23 24 23 33 27 24 Middle 502 54 53 56 54 52 56 Top 10 23 23 21 13 21 20 Source: Based on Multi-Purpose Household Budget Survey, Rastra Bank Vol. I Tables XIV and XVI, 1987. The Beginnings of Development 1.08 The disheartening poverty situation just depicted has persisted despite several decades of concerted efforts to accelerate development. Few countries, however, began their development as late and at such a natural disadvantage as Nepal. The country emerged from self-imposed isolation in the early 1950s with practically no infrastructure. Transportation and communications over the hilly terrain were almost exclusively by foot. There were fewer than 300 university graduates in the country; less than one percent of the school-age children attended schools; public health services were virtually non-existent. Not surprisingly, basic infrastructural development, particularly roads, emerged as the 3/ The Gini coefficient of total household income, at 0.57, is a less appropriate measure than per capita income, and disguises the fact that in Nepal wealthier households support significantly larger numbers than do poor households. For Nepal as a whole, average household size increases monotonically with total household income, ranging from less than four members per household at the lowest income class to more than thirteen at the highest. With this exceptionally wide range, it can readily be appreciated that correcting for household size reduces the skewness of the income distribution and strongly influences estimates of the proportion of the population in poverty.  -4- priority investment during the first four development plans (1956/57-1974/75). New ministries were also established and modern budgeting and accounting practices introduced. Major emphasis was placed on education, especially higher education, and at the same time liberal use was made of technical assistance to alleviate the severe shortages of trained manpower. Development in the productive sectors, however, was constrained by this very lack of infrastructure, weaknesses in public administration, small market size, and Nepal's low absorptive capacity for foreign aid. Despite rapidly increasing deveiopment expenditures, investment remained low--less than 10? of estimated GDP during this period. Over these two decades, growth of real per capita incomes averaged probably less than one percent per annum. 1.09 The Fifth Plan (1975/76-1979/80) marked a change in strategy. The major thrust of a substantially increased public investment program was towards smaller, quicker-yielding investments and the social services. Despite significant progress in increasing development expenditures, which rose by about 17? annually in current prices (6-7X in real terms) and were facilitated by a rapid growth in aid, economic performance under the Fifth Plan did not live up to expectations, with real GDP growth barely exceeding the growth in population. The primary cause was a shortfall in agricul- tural production which then comprised over 60? of GDP (Statistical Appendix Table 2.2A), and stagnation in agricultural value-added. Rice exports which once exceeded 200,000 tons in the mid-1970s, fell to negligible pro- portions by the end of the decade, in the process driving down total export earnings. Performance in other sectors was mixed. Agro-related industries primarily rice and oilseed mills suffered from poor agricultural harvests. Industrial performance was also hindered by power shortages as major hydro- electric investments were significantly delayed. Efforts to develop social services met with only partial successes. Education enrollments exceeded expectations, but the achievement indicators associated with health and family planning were particularly disappointing. Table I.A.2 : GDP Growth (Percent per annum in 1974/75 prices) Fifth Plan a/ Sixth Plan a/ 1975/76-1979/80 1980/81-1984/85 GDP 3.1 4.5 b/ Agriculture -0.1 4.0 Non-Agriculture 8.8 5.2 b/ a/ Since 1979/80 was an exceptionally bad year for agriculture, the base year 1979/80 was normalized by averaging the data for 1978/79, 1979/80 and 1980/81. b/ See footnote 4. Source: Statistical Appendix Table 2.1.  -5- The Sixth Plan 1980/81-1984/85 1.10 Erratic Growth. Performance during the Sixth Plan is more difficult to characterize.4/ After adjusting for an abnormal base year, the GDP estimates suggest that growth averaged over 4? per annum during this period. There were, however, wide fluctuations from year to year as poor weather led to negative growth in agriculture followed by major recoveries when agriculture output was estimated to have increased by as much as 10? (Table I.A.3). Furthermore, if the recent revisions to the GDP series are discounted (see footnote 4), growth averaged closer to 3.5Z p.a. There is some evidence of improved performance in agriculture, particularly outside of foodgrains in cash crops such as potatoes and sugarcane, which benefited from the better services available in the Terai; however, physical output indicators as well as trade data suggest that while crop production likely grew faster than in the previous decade, agricultural growth was probably not much more than 3? per annum. Progress in the forestry sub-sector also fell far short of what was hoped for or required. Under its many afforestation programs, the Government achieved annual planting rates of only 2,500 to 5,000 ha during the Sixth Plan. This was grossly inadequate relative to the scale of environmental degradation and to the country's long-term energy needs. 1.11 The manufacturing sector continued to expand, but still accounts for less than 5? of GDP. General improvements in raw material supplies and availability of power facilitated production in key industrial sub-sectors such as sugar and jute manufactures; over time, however, the relative importance of these activities have declined in favor of a small group of emerging new industries producing textiles, beverages and minor consumption items such as soap and biscuits. Whereas manufacturing sector production in the 1970s was adversely affected by the stagr..-tion in agriculture, since about 70 percent of industrial productioin is derived from processing agricultural commodities, the pattern in the 1980s shows evidence of diversification into products which depend more on minerals and imported raw materials. 4/ Part of the problem reflects long-standing weaknesses in the availabiilty and quality of statistical information. This applies, inter alia, to estimates of production by sector, to budget accounting practices which inter-mingle current and capital spending, to lack of reliable data on aid commitments, disbursements and the pipeline and t6 the scarcity of price indices. Complicating the analysis are major revisions in the historical series for GDP growth, the basis for which is unclear. For example, GDP growth for 1984/85 was revised upwards just a few months ago from 3.0 to 7.9Z, due to an increase in the estimated growth of non-agriculuture value-added from 4.0? to 16.6Z. However, an examination of the sectoral components components which suggest that most of the increase ostensibly came from upward revisions in construction and government services, does nct support the results. An upward adjustment is also reflected in the growth numbers for 1983/84 based solely on a change in deflators.  -6- Table I.A.3 The Sixth Plan - Key Performance Indicators 1980/81 1981/82 1982/83 1983/84 1984/85 GROWTR PERFORMANCE (Annual X Change) Real GDP Growth 8.3 3.8 -3.0 9.7 7.9 Agriculture 10.4 4.6 -1.1 9.5 2.4 Non-agriculture 5.5 2.6 -5.8 9.9 16.6 BUDGETARY PERFORMANCE (Rs. Million) Revenue 2419 2680 2842 3409 3917 Expenditure 4092 5361 6979 7437 8395 Regular 1361 1634 1997 2274 2906 Development 2731 3727 4982 5164 5489 Overall Deficit 1673 2682 4138 4028 4478 Financed by : Foreign Grants 869 993 1090 877 923 Gross Foreign Borroving 693 730 986 1671 1755 Gross Doau stic Borrowing 111 959 2062 1480 1800 (Percent of GDP) Revenues 8.9 8.6 8.4 8.7 8.8 Expenditure 15.0 17.3 20.7 18.9 19.0 Regular 5.0 5.3 5.9 5.8 6.6 Development 10.0 12.0 14.8 13.1 12.4 Overall DefLcit 6.1 8.7 12.3 10.2 10.1 Gross Domestic Borrowing 0.4 3.1 6.1 3.8 4.1 BALANCE OF PAYMENTS PERFORMANCE (USS Million) Exports of Goods & Non Factor Services 294 278 249 273 301 Imports of Goods and Non Factor Services 446 451 520 499 523 Current Account Balance -96 -120 -217 -179 -179 Intl. Reserves (end of period) 196 233 230 203 142 MONETARY PERFORMANCE (Annual X Change) Money and Credit Credit to Government 0.4 63.3 98.4 23.0 29.1 Credit to Nonfinancial Public Enterprises 34.8 -11.2 35.4 -16.2 22.0 Credit to Private Sector 25.8 6.4 3.9 17.7 27.4 Broad Money 20.0 18.2 23.6 13.4 17.6 Consumer Prices 13.4 10.4 14.2 6.2 4.1 Source : Statistical Appendix Tables 2.1, 3.1, 5.1, 6.1 and 9.1  -7- 1.12 The power sector expanded rapidly under the Sixth Plan at an annual average rate exceeding 10?. This was largely due to completion of the 60 MW Kulekhani hydroelectric project. In road transport, the groundwork for a basic road network was established with completion of the last portion of the East-West Highway in 1984/85 and priorities have now begun to shift in favor of feeder roads. Perhaps the most visible growth during the Fifth and Sixth Plans came from tourism where foreign exchange earnings quadrupled from the mid-1970s to about $60 million in the early 1980s. Earnings then fell sharply because of the international recession but has since more than recovered. 1.13 Developments in the social sectors continued to be mixed. Both in education and in population and health, expenditures increased rapidly (with annual development expenditures rising by 21? and 29? respectively, in nominal terms), and infrastructure was significantly expanded, leading to greater access of the population to basic education and primary health care. In response, enrollments in the education system rose by a third, literacy increased from a quarter to a third of the adult population, life expectancy rose from &5 years (1977) to 52 years, and contraceptors rose from 71 to 15? of the fertile population, largely through sterilization. Despite these impressive achievements, illiteracy and ill-health remained at very high levels and the uptake of family planning methods was still unacceptably low; in the meantime, education and health programs were beginning to show signs of institutional stress from their rapid period of expansion. 1.14 Excessive Fiscal Expansion. While growth performance during the Sixth Plan was probably moderately better than in the previous decade, it was nevertheless erratic and, in terms of the stimulation provided by public outlays, was unsustainable. Growing frustration with the lack of tangible progress through successive five year plans manifested itself in a surge in public outlays during the Sixth Plan Period, far outstripping the growth in revenues, progressively reducing revenue surpluses and generating large domestic borrowings financed primarily through the banking system. The overall budget deficit rose from 6.1? of GDP in 1980/81 to 12.3? in 1982/83 and domestic borrowings, negligible in 1980/81, shot up to 6.1? of GDP in 1982/83 (Table I.A.3). This led to strong demand pressures reflected in higher domestic prices and a deterioration in the balance of payments. The rapid growth of public expenditures from 1980181-1982/83 reflected sharp increases in regular expenditures due to periodic major salary adjustments as well as civil service employment growth of 3Z annually, and an increase in development expenditures of about 35? per annum. While the magnitude of these budgetary deficits fell toward the end of the Sixth Plan, the pressures on the monetary system persisted. Domestic credit expansion, which peaked at 40? in 1982/83, was still running at about 25? in 1984/85. 1.15 Deteriorating Balance of Payments. The excessive demand pressures emanating from fiscal deficits also manifested themselves in substantial losses of foreign reserves (Table I.A.3). With the jump in imports, the current account deficit more than doubled between 1980/81-1982/83, reaching almost 9? of GDP and gross reserves which averaged around $200 million at the beginning of the Sixth Plan (equivalent to 5-6 months of imports) fell to about $140 million (equivalent to about 3 months coverage) by 1984/85.  -8- 1.16 In the remaining years of the Sixth Plan, the precarious macroeconomic situation began to threaten the viability of Nepal's development effort. Consequently the Government took steps to implement a stabilization program supported by an IMF Standby Arrangement in December 1985. Recognizing that a stabilization program by itself could not of itself lead to sustained and more rapid growth, the Government subsequently embarked on a structural adjustment program to address the long-term constraints that have contributed to low growth. This was supported first by a Structural Adjustment Loan (SAL) financed by IDA in March 1987 and later by an IMF Structural Adjustment Facility (SAF) for 1987/88. Simultaneously, His Majesty launched a far-reaching initiative to meet the basic needs requirements of the populace. These programs are discussed in the rest of this chapter. B. The Structural Adjustment Program Background and Program Summary 1.17 Together, the stabilization policies initiated in 1985 combined with the institutional and sectoral reforms supported under the SAL and SAF form the crux of what has become known within Nepal as the Structural Adjustment Program (SAP). The major theme of this program is to strengthen macroeconomic and sectoral development policies and improve the efficiency of public sector expenditures. The measures instituted to stabilize the economy concentrated on addressing weaknesses that had emerged in the management of fiscal and monetary policy as well as reforms in the trade and exchange regime. Specific actions were taken to relieve pressures on the budget by restraining public expenditures, especially in the regular budget; increasing revenues; and tightening monetary policies. To strengthen Nepal's external position, the rupee was devalued by 15Z and several procedural and institutional reforms were taken to liberalize the import regime. 1.18 Having established an appropriate macroeconomic framework, the Government turned its attention in the ensuing years towards implementing a broad range of sectoral and financial measures to effect the much needed structural reforms in the system. These reforms which from the core of HMG's Policy Framework Paper, finalized in late 1987, have two major objectives. First it was recognized, that the highest priority has to be placed on accelerating growth if a sustained basis for alleviating poverty is to be established, and that critical to this effort is increasing production in agriculture. In addition, development in other key sectors, particularly industry, had been adversely affected by an overly restrictive trade regime and inappropriate incentives. Thus a major feature of the SAP was to address the major structural constraints to growth in these two sectors. Second it was recognized that in order for the public sector to become more effective in managing the development process, particularly in terms of financial control functions and implementation of the development program, that new processes had to be devised, institutions strengthened, and the range of areas where the government was heavily involved scaled back. Special consideration was given to the need to improve the performance of public enterprises which have been a major burden on the  -9- banking system. A number of specific actions were taken over the past three years in fulfillment of the above objectives. 1.19 Macroeconomic Policy. The principal focus of macroeconomic policy has been to improve budgetary management, carefully control net credit expansion and non-concessional external borrowing and maintain a realistic exchange rate. On the resource generation side, efforts have been made to increase revenues through the tariff reforms, introduction of an auction system for import licences, broadening of the sales tax base, introduction of a flat corporate tax, reduced tax exemptions and increases in the 'Ise of ad valorem duties. Regular expenditures were to be restrained through moderation in general salary increases and a near freeze on hiring. The financing of development expenditure was to be strengthened through generation of larger budgetary surpluses, improved aid absorption and reduced bank borrowing. With the reduction of fiscal pressures, combined with a more flexible exchange rate policy and trade reforms, it was hoped that the balance of payments position would improve. 1.20 Agricultural Policy. As discussed in more detail in Chapter II, the program for agriculture focused on increasing the effectiveness and efficiency of public sector institutions in supplying inputs and supporting services, providing adequate price incentives to producers, liberalizing the distribution of inputs while also increasing the role of the private sector, and improving irrigation services. Much of the initial efforts were concentrated on strengthening the financial position and management of the National Food Corporation (NFC) and the Agricultural Inputs Corporation (AIC). NFC activities have now been redefined. Its procurement from domestic production is now done at market prices rather than through obligatory concessional sales, and in place of subsidized foodgrain sales concentrated in the Kathmandu valley, a price stabilization scheme has been substituted. AIC is the major government entity encharged with the import and distribution of fertilizer, the latter function relying heavily on the cooperatives (sajhas) at the wholesale/retail levels. Fertilizer prices have now been adjusted to reflect rough parity with India, thus effectively curbing unofficial exports and alleviating supply problems. Considerable progress has also been made in registering private dealers to operate at the retail level. In addition, extensive technical assistance has been utilized to strengthen the financial and management capabilities of both institutions. 1.21 More recently, attention has also been given to the limited returns realized from past irrigation development. Public sector irrigation development has been hindered by the very high costs of medium and large-scale gravity schemes, which have been aggravated by inefficient management and unsatisfactory water charge collections. HMG is now rethinking its irrigation strategy so as to rely more on increased farmer participation in public scheme management and more consistent and uniform cost recovery policies. 1.22 In the forestry subsector, HMG has intensified efforts to heighten public awareness of the consequences of deforestation and enacted appropriate legislation to permit committee-level forest user groups to manage and retain their earnings from these forests.  -10- 1.23 Industrial Policies. In support of the growth orientation of the SAP, the Government restructured the trade and industrial regime to provide Nepalese producers with improved incentives for both exports and import substitutes. Aside from the exchange rate adjustment, a system of duty drawback and selective sales tax rebates was introduced. Many of the quantitative restrictions were removed, and more reliance has been placed on a new simplified tariff system. The Government also introduced an import paes-shok system for industrialists, placed several important raw material imports under OGL, and established an auction system for import licenses. To reduce excessive regulatory controls) the number of items which are subject to industrial and export licensing has been significantly reduced as has the number of procedural steps involved in making an export shipment. 1.24 Managing Development Expenditures. While HMG recognized that more fundamental reforms in the performance of the public sector would require major changes in the public administrative systems, implementing such reforms would be difficult and time consuming. Thus initial efforts have concentrated on improving the budgeting and monitoring of development expenditures. Extensive technical assistance efforts, supported by the UNDP and ADB, are underway to help establish a sound portfolio of "core" projects selected on the basis of their economic efficiency, foreign aid content, nearness to completion and strategic importance to the overall development program. In addition, the Government has established special units in the Ministry of Finance and line ministries to monitor the funding and implementation status of projects with the view to accelerating implementation. The focus of these efforts was initially concentrated in the Ministry of Finance but is now shifting to strengthening the Planning Commission and line ministries to improve project identification and selection. 1.25 A related initiative has been the effort to address the poor performance of public enterprises. The 60 fully state-owned public eaterprises have suffered from rapid staff turnover, political interference in their operations, and a lack of clear guidance concerning their role. The Government has begun to tackle these problems at the general level by classifying PEs into those which will remain fully or partly under Government control and those which will be privatized because of the absence of any strong rationale for continued public sector involvement. The initial efforts to privatize some PEs, however, were unsuccessful because of inadequate bids, political sensitivities, and public opposition. HMG has now decided to draw on IFC assistance to help make this program a reality. In addition, long-term assistance is being provided to improve the performance of selected enterprises, in particular, NFC and AIC. Macroeconomic Developments Under the SAP 1.26 Production Trends. Macroeconomic performance under the SAP has been encouraging. Although reliable estimates of value-added by sector are not yet available, the evidence thus far suggests that GDP growth during the three years 1985/86-1987/88 exceeded 4? per annum. Agricultural production and exports, however, remained vulnerable to the vagaries of the weather as evidenced in the drought affected harvest in 1986/87. Production appears to have recovered in the past year. There is an upward  -11- trend in foodgrains production due largely to acreage expansion. Much of this expansion, however, is occurring on marginal lands; consequently yields have remained constant. Productivity of cash crops has increased over the past five years. Part of the success is reflected in increased fertilizer sales which are 302 higher in 1987/88 compared with 1984/85. Acreage under improved seeds, however, has not changed much in the 1980s suggesting limited success in extending reliable irrigation services. Industrial growth accelerated under the SAP. The index of industrial production is estimated to have increased by about 70% during the SAP period. Much of this expansion reflects a surge in production of textiles, cement, beverages and sugar. Trade liberalization has significantly improved access of industr'alists and small enterprises to much needed imported raw materials and intermediate goods. Jute manufactures which still account for the largest share of industrial production at. about 20%, however, continues to stagnate. The contribution of public expenditures to growth was also substantial. Public consumption and investment may have increased by more than 5% in real terms during the SAP period, but in contrast with the first half of the 1980s, this growth was financially sustainable and did not generate excessive demand pressures. 1.27 Fiscal Performance. Under the SAP, the overall budgetary deficit fell from 10.1Z of GDP in 1984/85 to 9.3Z by 1987/88 (Table I.B.1). At the same time, gross domestic borrowing fell from 4.12 to 1.6% of GDP. This outcome reflects strong growth in revenues which increased by 1.9% of GDP coupled with a jump in aid disbursements which increased by 2.5% of GDP due to quick disbursing adjustment lending equivalent to 1% of GDP and some improvements in budget release procedures. The growth in revenues was attributable to reforms in tariffs, discretionary tax measures and substantial proceeds from the auctioning of commercial import licenses. Regular expenditures were kept in check because of the tight wage and employment policies while development expenditures grew briskly in line with developmental needs. Because of the increase in external financing, credit expansion to the public sector was cut by one-half. Inflation did not fall over this period due both to higher drought-induced inflation in India and the devaluation. Because of the open borders between Nepal and India and a bilateral exchange rate that tends to remain fixed, Nepal's inflation tends to parallel India's. Similarly, Nepal's interest rates follow those in India; presently real deposit rates on savings are about zero, although term deposit rates are significantly positive. 1.28 Balance of Payments. Despite a deterioration in Nepal's terms of trade, the balance of payment position improved steadily during this period. It is difficult to determine the impact of devaluation in this process, which some observers believe generated mostly inflationary pressures because of supply rigidities in agriculture, but enhanced incentives has undoubtedly contributed to the encouraging growth in non- traditional exports, particularly garments and carpets in addition to tourism, which were helped by measures that liberalized charter flights, developed new areas for mountaineering and trekking, restored historical sites and improved air access to Nepal through the acquisition of a commercial aircraft. Exports of garments and carpets grew from $40 million  -12- Table I.B.1 Structural Adjustment Program - Key Performance Indicators 1984/85 1985/86 1986/87 1987/88 GROWTH PERFORMANCE (Annual X Change) Real GDP Growth 7.9 3.9 2.4 7.1 Agriculture 2.4 4.3 1.0 8.7 Non-agriculturt 16.6 3.5 4.4 5.0 BUDGETARY PERFORMANCE (Rs. Million) Revenue 3917 4645 5975 7320 Expenditure 8395 9797 11513 13678 Regular 2906 3584 4135 4789 Development 5489 6213 7378 8889 Overall Deficit 4478 5153 5538 6358 Financed by : Foreign Grants 923 1173 1285 2078 Gross Foreign Borrowing 1755 2501 2706 3191 Gross Domestic Borrowing 1800 1479 1547 1088 (Percent of GDP) Revenues 8.8 9.0 10.2 10.7 Expenditure 19.0 18.9 19.7 20.1 Regular 6.6 6.9 7.1 7.0 Development 12.4 12.0 12.6 13.0 Overall Deficit 10.1 10.0 9.5 9.3 Gross Domestic Borrowing 4.1 2.9 2.6 1.6 BALANCE OF PAYMENTS PERFORMANCE (US$ Million) Exports of Goods & Non Factor Services 301 329 348 421 Imports of Goods and Non Factor Services 523 559 596 731 Current Account Balance -179 -194 -194 -239 Intl. Reserves (end of period) 142 165 202 337 MONETARY PERFORMANCE (Annual X Change) Money and Credit Credit to Government 29.1 15.5 16.2 8.5 Credit to Nonfinancial Public Enterprises 22.0 48.4 7.5 13.2 Credit to Private Sector 27.4 24.6 18.6 19.6 Broad Money 17.6 23.3 15.4 20.4 Consumer Prices 4.1 15.9 13.3 11.6 Source----Statistical----Appendi-----Tables---2.1,---3.1,---5.1---6.1--and---9.1 Source : Statistical Appendix Tables 2.1, 3.1, 5.1, 6.1 and 9.1  -13- in 1984/85 to $98 million in 1987188 while tourism receipts grew from $41 million to $120 million. Because of the long open border with India, it is difficult for Nepal to effect a sustained real depreciation against the Indian rupee and by the end of 1987/88, the bilateral real exchange rate between Nepal and India was virtually restored to its pre-devaluation level; however, the Nepalese rupee has depreciated in real terms vis-a-vis third countries. Imports, excluding the purchase of a $55 million aircraft in 1987/88, grew by 31X over this period due to revived growth, a larger development expenditure program and trade liberalization. Buoyed by greater aid inflows and an increase in private transfers which doubled over 3 years to almost $100 million in 1987/88, international reserves rose by about $100 million. Reserves at the end of 1987/88 stood at $337 million or almost 6 months imports coverage as compared to $142 million or 3 months imports coverage in 1984/85. 1.29 Development Expenditures. Reflecting the growth orientation of the program, development expenditures expanded by 172 annually under the SAP (Table I.B.2). While data on private investment are not very reliable, private investment's share of GDP was estimated to have remained virtually constant at 10.42. As compared to the end of the Sixth Plan period, the most significant increases in Government development expenditures occurred in the social sectors, communications and electricity while the share of agriculture (including irrigation and forestry) fell substantially. For the 1988/89 budget, in an attempt to compensate for agriculture and transport's declining share of the development budget and reflecting agriculture's prominence in the BNP (see below), the Government increased their allocations dramatically while proposing expenditures that were 50% higher than the 1987/88 level. Based on experience, it is unlikely that these levels will be realized; however, even if the historical utilization of 85X of allocations is realized, it remains to be seen whether the funds could be utilized effectively. Table I.B.2 Development Expenditures by Sector Average ---------------- Actual ------------------------------- Budget 1975/76- 1981/82 1982/83 1983/84 1984/85 1985/86 1986/87 1987/88 1988/89 1980/81 (percent of total) Education 11.5 11.1 12.1 13.1 11.7 14.2 14.0 13.1 10.9 Health 5.1 4.1 4.3 3.9 4.6 4.1 4.2 5.6 6.1 Drinking Water 2.9 2.9 4.9 4.3 3.7 3.7 3.7 3.6 3.9 Agriculture 10.9 12.6 13.4 10.6 12.8 13.8 9.2 8.4 10.1 Irrigation 9.4 9.6 9.8 10.6 11.9 13.6 11.5 8.1 13.0 Forestry 3.5 5.0 4.6 4.5 5.3 5.9 5.3 4.6 4.8 Industry & Mining 6.4 7.1 7.5 12.6 6.3 6.4 5.1 6.6 7.2 Comnunications 0.9 1.3 1.5 1.9 1.6 1.4 1.9 5.8 2.5 Transportation 26.1 20.0 16.1 14.5 16.8 11.5 13.4 13.2 17.9 Electricity 13.2 10.3 8.9 12.6 9.2 16.7 16.8 17.4 10.4 Other 10.1 16.1 16.9 11.4 16.0 8.7 14.9 13.7 13.2 TOTAL DEVT. EXPENDITURE 1652 3727 4982 5164 5489 6213 7378 8889 13368 Nominal Growth (X) 18.9 36.5 33.7 3.6 6.3 13.2 18.7 20.5 50.4 Source: Statistical Appendix Table 5.3.  -14- Impact on Poverty 1.30 The SAP has had a generally favorable impact on poverty. This stems from three factors. First, the program was designed to be growth oriented rather than one of fiscal austerity; public expenditures have continued to expand in real terms. This has been possible because of enhanced foreign assistance including SAL/SAF resources coupled with intensified tax efforts. Consequently, major programs including social expenditures have not been cut back but have grown in line with developmental needs. 1.31 Second, sectoral policies have led to increased production, particularly in agriculture where the bulk of the poor are located. The abolition of compulsory procurement at concessional prices has enhanced production incentives while the policies to liberalize distribution of fertilizer and prevent leakages to India have improved the domestic supply situation. Although official prices of some fertilizers have increased to bring them to parity with Indian prices, they are unlikely to affect the price paid by small farmers, who, in the past paid exorbitant prices because of distributional bottlenecks which led to periodic shortages. The improved supply situation through private sector distribution and diminished smuggling would benefit most farmers, especially the smaller ones. The new regulations governing revenues from Panchayat Protected Forests will have an immediate and direct benefit for the poor. Previously forest revenues were collected by the Ministry of Finance, to be returned, if at all, only with considerable delay. Now the community will retain these revenues, some of which will provide employment for nursery staff, watchmen, and other forest workers. In the longer-term the new regulations should also encourage communities to preserve what is a crucial and irreplaceabLe resource. 1.32 Third, outside of agriculture, the adjustment reforms are largely concerned with liberalizing investment and import licensing procedures and thus reducing economic rents or transferring them to the budget. This will hurt primarily those (generally higher income people) who had been receiving the economic rents. But the incomes of many of the urban poor will increase as improved incentives generate productive employment. Already carpet and textile production, which employ lower income urban workers, has increased, largely as a result of the more liberal trade regime. Similarly, private investment in small-scale industry, which predominantly employs poorer people, will benefit from the improved incentives. 1.33 Fourth, the very poor are largely outside the cash economy, whereas to the extent the SAP has led to cuts in benefits, these have been concentrated on the monetized sectors *'nd activities where the benefits were being accrued by the better off groups in society. The abolition of the public subsidized food distribut:ion program and the creation both of more targeted programs for the poor and a price stabilization scheme will on balance confer greater benefits to the poor. The previous food subsidy scheme largely benefitted the Kathmandu Valley which is relatively better off. The thrust of the fir.ancial sector reforms also will not have any significant adverse effects on the poor, since their economic activities lie primarily in subsistence agriculture. Moreover, the creation of viable  -15- rinancial institutions should, in the longer-run, allow more credit to flow on a sustainable basis to a wider range of productive activities. C. The Basic Needs Program Background and Objectives 1.34 HMG's concern with poverty and income distribution issues received initial prominence in the Fifth and Sixth Five-Year Plans (1978-85). The Basic Principles of the Seventh Plan (March 1984) echoed this theme, pointing to a need to 'focus the entire attention and endeavor of the nation on the tasks of increasing production and employment opportunities, and fulfilling the minimum basic needs of the common man". The Principles then went on to define as minimum basic needs 'foodgrain, clothing, fuelwood, drinking water, primary health care and sanitation, primary and skilled-based education, and minimum rural transport facilities". Fulfillment of minimum basic needs was conceived of primarily in terms of a selective intensification of existing mainline sectoral and sub-sectoral programs in both the productive and the social sectors, with stress placed upon enabling the poor to purchase essential goods and services. Thus, employment generation and income enhancement were emphasized. Despite the conceptual prominence given them in the Seventh Plan documents, however, basic needs concerns represented but one among several important themes in the national development program in the early Plan years, and were not singled out at that point out for exceptional attention. This situation has now undergone a dramatic change, with the Basic Needs Program (BNP) coming in the past year to dominate discussion of Nepal's future both in the press and in National Assembly meetings. Two events in particular brought about this transformation: most importantly, His Majesty's call on Constitution Day (16 December) 1985 for the attainment by the year 2000 of a standard of living for the Nepalese people 'commensurate to lead a life with human dignity by Asian standards'; and subsequently, the definition in quantitative form of a set of basic needs indicators on a per capita basis, and the translation of these indicators into national program targets. 1.35 His Majesty's speech identified six basic needs areas: food, clothing, shelter, health, education and security. Following the speech, a task force was constituted by the Palace with participation from the Planning Commission, Ministry of Finance and Central Bank; this task force established a 'basket' of basic needs targets, quantified where possible. In June 1987 a detailed program including prospective costs over the 15-year period (1985-2000) was endorsed by the National Development Council, meeting unde: His Majesty's chairmanship. The 1987/88 budget discussions in the National Assembly in July 1987 revealed a certain discontent at the pace of implementation of BNP to that point, and created a climate of expectation to which the 1988/89 budget has been obliged to cater. 1.36 The line ministries responsible for BRP execution have in the past year been preparing BNP implementation documents; and their elaboration continues. The papers focus principally on the remaining years of the Seventh Plan (i.e. up to FY 1989/90). Other important preparatory activities undertaken since mid-1987 are a wide ranging structural  -16- reorganization of line ministries involved in BNP and the creation of new assistant-ministerial portfolios to oversee BNP implementation (reviewed in Section IV.A); and the conduct on a crash basis in April-June 1988 of a survey, in every ward of the country, to identify the poor. BNP stresses the need for commitment at all levels of society, with leadership in the first instance due from the "political level". Monitoring of BNP in.plementation is thus entrusted not only to the Planning Commission and line Ministries, but also to those of the National Assembly represented on the National Development Council, whose periodic findings are to be made public. 1.37 Aiming at no less than the eradication of absolute poverty in Nepal by the year 2000, BNP reflects the approach to basic needs fulfillment advocated in the Seventh Plan - "increasing the income and purchasing power of the target population" rather than "direct distribution of goods and services" other than in the social sectors. The strategy proposed is to selectively intensify ongoing sectoral development programs as well as to expand or develop special "targeted" employment or income generation programs. Due to the profile of the BNP target population (predominantly rural, largely in the Hills and Mountains) and its dispersion, and to the disaggregated nature of rural development, stress is laid on the need for community participation in accordance with HMG's decentralization policies; the need for private sector and NGO participation is also emphasized, in further recognition of the limited ability of government to shoulder the program alone. Nonetheless, the critical importance of more dynamic development administration is alluded to at several points in the document. Sectoral Programs and Targets 1.38 The bulk of the BNP document is devoted to a discussion of sectoral development programs. At the aggregate level, these simply derive from scaling up the per capita basket of basic needs goods and entitlements in accordance with projected population figures (it is assumed that population growth rate will fall from 2.66Z (1985) to 1.9Z by 2000, giving an overall population of 23.2 million at that date); they also assume that production of most items would take place entirely within Nepal. The programs are summarized below, and analyzed in more detail in Chapter III. (a) Food. A national per capita calorie consumption level of 2250 per day (2340 Hills, 2140 Terai) is to be achieved by the year 2000; some 87Z of this would be provided by grains, pulses and potatoes, and the rest by vegetables, milk products, meat etc. Self- sufficiency in food is to be pursued, requiring substantial annual production and productivity increases. Grain production, for example, is slated to grow by 4.8Z p.a. between 1985-2000 (compared with 1.5Z p.a. from 1975-85), and grain productivity by 3.7? p.a. (cf -0.5Z p.a. in 1975-85). BNP's production strategy emphasizes the expansion of irrigated areas (68,000 ha annually as compared to 15-20,000 ha in the past) and the widespread dissemination of modern inputs and associated practices. Recognizing that this orientation does not capture many of the poorer farmers, BNP also proposes a special emphasis on the Hills  -17- - with a stepped-up rainfed research and extension effort and through unspecified "intensive' programs in food-deficit areas. (b) Clothing. Minimum per capita cloth consumption of 11 meters per annum is targeted by 2000, as well as the purchase of one pair of shoes per person each year. Once again, it is assumed that domestic production should meet the needs stipulated. This requires raising annual cloth production from 29 million meters to 255 million meters by 2000, and shoe production from 58 million to 232 million pairs p.a. In pursuit of this program, reliance is to be placed on the private sector, regulated in such a way as to ensure the use of labor-creating technologies. In order to attract private investment, "appropriate protection policies and initiatives will be adopted", including priority access to credit and foreign exchange and a liberalization of manufacturers, licensing procedures. Cotton, wool and hides production would also be "encouraged", and rural cottage industries would receive technological support and access to imported inputs. (c) Housing. Since 93Z of Nepalese own thei^ own houses, the focus of this program is on the improvement of housing anr of essential utilities, though credit would be made available for new construction: a Housing Finance Company would be established in the private sector with concessional loans available to low-income families; a Housing Fund would also be established for the poor. Urban sites would be acquired by the Government and developed with private sector and local government participation, while urban roads, water and sewerage would be developed and systematically maintained by the town panchayats; special attention would be paid to cost recovery on urban services. (d) Education. Universal primary education is established as the goal for the year 2000. This will require an increase in primary enrollments from 1.8 million (1985/86) to 2.9 million, in the number of schools from 11,900 from 17,700, and in teachers from 51,000 to 88,000. Associated measures would aim to improve the selection, training and career streaming of teachers, to establish a school inspection system, and to provide incentives to schools and families to increase female enrollment. Adult literacy and education programs would also be stressed. (e) Health. Population growth is to be reduced from 2.72 to 1.92 p.a., life expectancy increased from 51 to 65 years, and infant mortality reduced from 111 to 45 per 1000. This is to be achieved by the expansion and improvement of primary health services. Particular measures in the program include the nationwide integration of the country's "vertical" primary health services; the creation of sub-health posts and the selection of health volunteers in each panchayat; attention to health personnel careers and incentives (to include improved living facilities and compensatory training opportunities for those serving in rural areas); arnd national self-sufficiency in "essential drugs".  -18- (f) Security. BNP includes among its security-related proposals the care of Nepal's handicapped and disabled, and the provision of "smooth supplies of essential commodities - such as -ice, pulses, sugar, firewood, salt, kerosene oil, and edible oil", to include maintaining buffer stocks through the country. Employment, Distribution and Finance 1.39 BNP urges special attention to the alleviation of unemployment (some 52 of the work force) and underemployment (41% of person-days available in rural areas and some 25Z in urban areas) and to the channeling of income generation opportunities towards the poor. At the macroeconomic level, special consideration would be given to employment issues in the formulation of taxation, exchange rate, interest rate and wage policy. In the agriculture sector, where "much of the required employment will by necassity have to be generated' work would result from the expansion of irrigation facilities, while labor-intensive crops and multiple cropping would be 'encouraged' and mechanization "generally discouraged". In the non-agricultural sectors, small/labor-intensive industries would also be encouraged. In addition, rural public works programs (including afforestation) would be intensified to create employment. 1.40 BNP lists a number of special (or targeted) programs designed specifically with the poor in mind, many of which are to be expanded under the program. These include the following: (i) Among the credit programs, the Small Farmers' Development Program (SFDP) and Production Credit for Rural Women (PCRW) lend money to the rural poor and, in the case of PCRW, also support a range of community initiatives. There is also a pilot Women's Development Program within SFDP. So far these programs only reach a small proportion of the poor (about 1 percent in total), but present plans call for a three-fold expansion over the next 5-7 years. Some of the features of these schemes are similar to those of the Lead Bank Scheme, another initiative introduced under the BNP. (ii) The Basic Needs Program includes the establishment of special Sajhas for the poor. Sajhas are local government-sponsored cooperatives whose membership is, in effect, compulsory for landowners and tenant farmers. Decision-making within the Sajha reflects the power-structure of the village. (iii) In the Afforestation and Tree Tenure Schemes introduced under the BNP, consumption loans are to be provided to families who temporarily loose income as a result of tree planting. (iv) Food Distribution. National Food Corporation (NFC) runs a program which aims to provide food at subsidized prices to 50 districts, mostly in the hills. In addition, the World Food Program (WFP) supports, amongst others, food-for-work and nutrition supplement schemes, although these schemes do not reach the remote areas. Total food aid is currently $7-8 million, and may rise in the next few years to $14-15 million.  -19- 1.41 BNP also advocates changes in asset distribution. It is argued that programs to promote small business and rural private sector activity (e.g. production and sale of improved livestock) will effectively redistribute assets. BNP, moreover, advocates 'strengthening" the Land Reform program to make it 'more effective vis-a-vis its stated objectives", though it does not offer any specific guidance beyond this. 1.42 In order to achieve the target Basic Needs per capita income of Rs 1971 per annum, GNP growth rates of 4.52 p.a. (1985/86-1989/90), 5.72 p.a. (1990/91-1994195) and 7Z p.a. (1995/96-2000) are required, in combination with a shift in the share of the bottom 42.5Z's personal income up to 232 of the national total. Attainment of the basic needs growth rates is estimated to require Rs 50,410 million development expenditure in the Seventh Plan period, Rs 80,640 million in the Eighth and Rs 134,000 million in the Ninth, of which 422 would be provided by the private sector. It is noted that expenditures, and thus Government income, must increase steeply if the requisite growth is to be achieved (Table I.C.1). BNP accordingly enumerates a series of domestic resource mobilization measures, including the introduction of 'appropriate taxation measures" in agriculture, the activation of the Panchayat Development and Land Tax, and the reform of revenue administration methods. External resource mobilization is to be accomplished by promoting exports and tourism and by efforts to mobilize additional foreign assistance. Table I.C.1 Financing of Government Development ExRenditures (in millions of 1984/85 rupees) 7th Plan 8th Plan 9th Plan Period Period Period (1985-90) (1990-95) (1995-2000) Revenue 23990 35110 56010 Normal Growth 22060 30710 47550 Additional Efforts 1930 4400 8460 Regular Expenditures 18970 26750 35800 Development Expenditures (inc. subsidies & loans) 29000 46600 77500 Financing: Revenue Surplus 5020 8360 20210 Foreign Aid 20480 33550 52100 Deficit Financing 3500 4690 5190 Source: Programme for Fulfillment of Basic Needs, National Planning Commission, September 1987.  -20- The Future Agenda 1.43 Meeting the objectives of the BNP will be an enormous challenge. By correcting the macroeconomic imbalance that threatened the viability of Nepal's development efforts, the structural adjustment program has paved the way for sustained growth that is essential to meeting basic needs. In the process, the Government has demonstrated a strong commitment to implementing appropriate actions. However, as discussed in subsequent chapters, much more still needs to be done and the pace of actions accelerated. If these efforts are sustained and provided donors continue to be supportive of this effort, Nepal could make significant headway in its fight against poverty. 1.44 The proposed agenda covers broadly three areas: (i) macroeconomic policies; (ii) sound sectoral policies to accelerate growth and satisfy basic needs; and (iii) strengthened institutions and processes to serve the above two objectives. This report is structured as follows: Chapter II analyzes issues in selected sectors, ones that are most directly related to the basic needs program. While recognizing that transport, forestry, and tourism are key to the development effort, these are excluded from this report in order to make the task more manageable and to allow the focus described above. Similarly, environmental issues, which affect many of the sectors and the livelihood of virtually all Nepalis, are not addressed here; they are being taken up in an ongoing policy-oriented study of natural resource management for sustainable development. Chapter III discusses in greater depth specific measures to improve the efficiency of the tax and financial systems. Chapter IV addresses institutional concerns that most observers perceive to be a major constraint to development. Chapter V outlines the broad macroeconomic framework in addition to providing an overview of the Basic Needs Program and external assistance requirements.  -21- II: SECTORAL PROGRAMS FOR MEETING BASIC NEEDS A. Agriculture Structure, Performance and Constraints 2.01 Agriculture dominates Nepal's economy. Although largely rainfed and characterized by small-scale subsistence farming, agriculture accounts for about 552 of GDP and provides employment to more than 90Z of the working population. Crop production contributes about 602 of total agricultural output, livestock 302, and forestry 10Z; fisheries is limited to catches in rivers and streams and some aquaculture activities in the Terai. Foodgrains account for about 842 of the gross cropped area with paddy accounting for almost half the area under foodgrain cultivation. The bulk of the sector's output is consumed domestically; however, modest quantities of rice, maize, oilseeds, timber and wood products, and jute and jute products are exported, mainly to India. Until recently, agricultural exports accounted for about 702 of merchandise exports; however, due to declining exportable surpluses and a sharp increase in exports of carpets and garments, the share of agricultural exports has fallen to about 302.5/ Recognizing that the agricultural sector is not only the major producer and an important source of foreign exchange, but also the primary employer and the sector most able to absorb the growing labor force, HMG has, since the early 1960s, given high priority to the development of agriculture, allocating 212 of its development expenditures over the period 1975/76-1987/88. But the results have been mixed at best. 2.02 Forestry is intimately linked to agricultural production, especially in the Hills, because of the symbiotic relationship between subsistence farming and forest resource use (fodder, grazing, mineral nutrients and fuelwood). Forests are essential to protect the environment, particularly in the Hills. Fuelwood is the country's main source of energy. Overutilization had led to a steady decline in Nepal's forest resource. It is recognized that public sector management of forests has failed and the Government has a policy of handing over management of most forests to the local communities under the community forestry concept. The recently completed Forestry Sector Master Plan provides a perspective for integrated development and management of all forest resources and inter alia fully endorses the community forestry approach. 2.03 The resource base for crop production is severely limited by the rugged terrain. Of the 147,484 sq. km of land in Nepal, only about 20X is cultivated, and topographic conditions do not permit cultivation expansion of a significant scale. Understanding Nepal's agricultural resource base requires an appreciation of the country's physiographic structure consisting of three main zones which differ greatly from one another in topography, climate, agricultural productivity and population density. A little over one-third of the cultivated land is in the Hills which presents 5/ At t.ie same time, Nepal imports substantial quantities of agricultural goods; on net terms, Nepal is likely to be only a marginal exporter of agricultural products.  -22- a highly dissected topography and a wide range of altitudes and exposures over wnich agriculture is practiced. Most of the cultivated land (54%) is located in the humid tropical lowland of the Terai which stretches along the east-west border with India. Finally, the Mountain zone comprises only 8.62 of the cultivated land. Besides cultivated land, the other major land use categories are grassland (122), forest land (382) which is in part highly degraded, and shrubland (52). Agricultural production takes place on about 2.2 million farms, but land ownership is highly skewed, with 16.1? of the farmers owning 62.82 of the land. Half of the farm holdings consist of less than 0.5 ha each, averaging a mere 0.15 ha per farm, and only 3.4% of the holdings have 5 ha or more. Farm holdings are typically very small by international standards. A large farm in the Terai is defined as one in excess of 5.4 ha, while a large farm in the Hills is one with 1.05 ha or more. Farming is practiced under vastly different conditions in the Hills and in the Terai. 2.04 Terai Agriculture accounts for about two-thirds of Nepal's total crop production. There are few agronomic constraints to crop production in the Terai but its very substantial potentiai remains significantly underutilized due to poor use of available water resources, poor accessibility and limited farmer services including input supplies. Food crops, mainly rice, wheat and maize, comprise about three-quarters of the gross cropped area, and pulses, sugarcane, tobacco and oilseeds are the main cash crops. Average yields are low due to uncertain water availability and poor cultivation practices. Irrigation is the key to increased production and productivity in the Terai. Apart from doubling the yields of most foodgrains, it enables introduction of a wide variety of second crops. Most importantly, it induces farmers to make intensive use of modern inputs. Roughly 670,000 ha (51% of cultivated land) in the Terai receive some form of irrigation, including about 540,000 ha of farmer- managed schemes. However, performance of most public irrigation schemes has been disappointing for reasons discussed below. 2.05 Hill Agriculture, by contrast, is subject to serious constraints and difficulties and is almost totally subsistence-oriented. Limited by the topography to valley bottoms, small plateaus along the river banks and terraced slopes, the cultivated area covers about 0.9 million ha (37Z of the country's total crop land). Climate and soils vary greatly over short distances because of topography, and this has resulted in numerous micro- climatic pockets. The traditional methods of farming in the Hills involve continuous and exhaustive cropping of the limited crop land. The rugged terrain and the rudimentary road network restrict the supply and use of chemical fertilizers; consequently, productivity is low and maintained from a small supply of livestock manure and mineral nutrients obtained in the forest. These factors, combined with limited transport and communication facilities, have led to farming systems which are characterized by substantial diversity and a high degree of self-reliance. Because of population pressure, more and more marginal areas are being cultivated while many adult males leave the Hills in winter for temporary employment in the plains. Even though over 90X of the cropped area is devoted to foodgrain production, mainly maize, wheat and millet, the overall picture is one of growing dependence on foodgrains imported from other areas.  -23- 2.06 Production and Productivity Trends. Agricultural value added from 1974/75 to 1985/86 6/ has only increased at an average rate of 2.2? per year as compared to population growth of 2.7? over the period. Furthermore, most of this increase has been due to an increase in area rather than productivity. With the exception of wheat, oilseeds and sugarcane, average cropping przductivity (as reflected in average yields) has not increased measurably over this period (Statistical Appendix Tables 7.1 and 7.2) -- or has in fact declined (e.g., maize, millet, barley). Per capita food production has fallen significantly over time, especially in the Hills and Mountains, reducing average farm and per capita incomes in these areas and leading to accelerating migration. Cash crop production, on the other hand, has fared much better; these crops are mainly grown in the Terai where the prevailing price relationships have favored their cultivation over that of foodgrains, and farmer access to crucial inputs, credit, support services and markets is significantly better than in the Hills. 2.07 The reasons for the low rate of agricultural growth reflect numerous problems in the agricultural system, many of which have proven thus far to be intractable, particularly those problems which reflect the technical and economic viability of agricultural systems. These include the inadequate transport infrastructure, a system of absentee land ownership and share-cropping which has left cultivators with little incentive tc adopt improved practices, small fragmented land holdings, a large number of poorly-fed livestock with low productivity, an inadequate and declining forage base, declining soil fertility due to environmental degradation and adverse and erratic weather. One view advanced is that actual performance has, in fact, been better than that reflected in the production statistics.7/ Other explanations for the dismal produ ztivity record include: failure to develop yield-raising technologies, weak extension coverage, inadequate levels of modern inputs and services, 6/ Since 1987/88 figures are still provisional and 1986/87 was an unusually poor crop year, this period is appropriate on which to base recent long-term performance. 7/ A serious problem is the very poor statistical data base--for example, different surveys give widely divergent data on farm holdings and cultivated area. The reliability of most other data such as crop area, yields, production, HYV coverage, and livestock numbers is equally suspect. Most o