Nepal - Second Structural Adjustment Credit Project

Document of The World Bank FOR OMCAL USE ONLY Repot No. P-5038-NEP REPORT AND PECOMM1ENDATION OF THE PRESIDRNT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED CREDIT OF SDR 46.2 MILLION TO THE KINGDOM OF NEPAL FOR A SECOND STRUCTURAL ADJUSTMENT CREDIT June 5, 1989 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may oot otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS (as of February 28, 1989) Currency Unit - Rupee (NRs) US$1.00 NRs 25.7 Government Fiscal Year July 16 - July 15 Abbreviations and Acronyms Used ADB - Asian Development Bank ADBN - Agriculture Development Bank of Nepal AIC - Agricultural Inputs Corporation BNP - Basic Needs Program CBPASS - Comme:cial Bank Problem Analysis and Strategy Study CIB - Credit Information Bureau DOA - Department of Agriculture DOI - Department of Irrigation DP - Decentralization Program ESAF - Extended Structural Adjustment Facility FAO - Food and Agricultural Organization GDP - Gross Domestic Product GNP - Gross National Product HMG - His Majesty's Government of Nepal IDA - International Development Association IFC - International Finance Corporation IMF - International Monetary Fund KFW - Kreditanstalt fUr Wiederaufbau MFN - Most Favored Nation MOF - Ministry of Finance MIS - Management Information System NB - Nepal Bank NFC - National Food Corporation NIDC - Nepal Industrial Development Corporation NPC - National Planning Commission NRB - Nepal Rastra Bank ODA - Overseas Development Administration OECF - Overseas Economic Cooperation Fund O&M - Operation and Maintenance OGL - Open General License PB/PM - Program Budgeting/Project Monitoring PE - Public Enterprise PDLT - Panchayat Development and Land Tax PFP - Policy Framework Paper POL - Petroleum, Oil and Lubricant RBB - Rastriya Banijya Bank SAF - Structural Adjustment Facility SAL - Structural Adjustment Lending SAP - Structural Adjustment Program SOE - Statement of Expenditures SDR - Special Drawing Right TA - Technical Assistance UNDP - United Nations Development Program VAT - Value-Added Tax  FOR OMC'AL USE ONLY TABLE OF CONTENTS Credit and Program Swmmary . . . . . . . . . . . . . . . . . . . . . i I. The Econom . . . . . . . . . . . . . . . . . . ..1...... . . Economic Development Constraints .. .. . ..... 1 Recent Macroeconomic Developments and Reform Efforts . . . . . 2 Future Adjustment Policy Issues ... . . . . . . . . . . . . . . . 9 Financing Prospects and Rationale for Bank Support . . . . . . . . 10 II. The SAL Program. ............... . . . . . . . . . 13 A. Macroeconomic Management . .. .... 13 1. Rationalizing the Revenue System . . . . . . . . . . . . . . 13 2. Public Expenditure Management . . . . . . . . . . . . . . . 15 3. Trade Reforms . . . . . . . . . . . . . . . . . . . . . . 16 B. Agricultural Reforms . . . . . . . . . . . . . . . . . . . . . . 18 1. Fertilizer Distribution... . . . . . . . 18 2. Irrigation.. . . ... 20 C. Financial Sector Reforms . . . . . . . . . . . . . . . . . . . . 23 III. The Proposed Operation . . . . . . . . . . . . . . . . . . . . . . . 25 History .. . .. . . . . . *.. 25 Key Actions in the Proposed Operation . . . . . . . . . . . . . . . 25 Benefits and Risks . ............ . . . ...... 26 Poverty and Adjustment Lending . .......... . 27 Addressing Environmental Concerns .*. .-. .-. .-. .. . . ...... . 28 Proposed Financing . . . . . . . . . . . . . . . . . . . . . . . . 29 Credit Administration and Management . . . . . . . . . . . . . . . 29 Disbursements and Procurement ......... . . 29 Accounts, Audits and Reporting . ..... . ... ...... 30 Monitoring and Tranche Release ...... . . . ...... 31 IV. Bank Group Operation and Strategy . ... . .32 V. Collaboration with the Di . . . . . . . . . . . . . . . . . . . . . 33 VI. Recommendation . ............. .... ... ... ... . 34 This document has a restricted disttibution 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.  TABLE OF CONTENTS (Continued) Text Tables Table 1: Key Economic Indicators ... ............................. 4 Table 2: Effects of Current Trade and Transit Difficulties .... 8... Table 3: Summary of External Capital Requirements and Sources: 1988/89 - 1989190 ............................. 12 Annexes I Socio-Economic Data ........... .................................... 36 II Status of Bank Group Opera 'ons ................................... 41 III Supplementary Project De- ;heet .................................. 43 IV Structural Reform PrograL *Aatrix of Actions) ..................... 45 v Letter of Development Policy ...................................... 60 MAP: Nepal - IBRD 10154R2  KINGDOM OF NEPAL SECOND STRUCTURAL ADJUSTMENT CREDIT Credit and Program Summary Borrower: Kingdom of Nepal Amount: IDA Credit: SDR 46.2 million (US$60.0 million equivalent) Cofinancing: RFW (On a parallel basis): DM 10 million (USS5.0 million equivalent) Terms: IDA Credit: Standard IDA Terms (40-year maturity) Description: The proposed financing is intended to support the next phase of the Government's structural adjustment program initiated under the First Structural Adjustment Operation (SAL I). The main objective of the program is to accelerate sustained economic growth by reorienting the economy towards a path relying more on the private sector, and on improved allocation of public and financial resources. It consolidates the policies already adopted and reinforces the adjustment process by additional measures. The economic program supported by SAL I emphasized appropriate macroeconomic management, strengthened institutions supporting agriculture, an enhanced role for the private sector in agriculture and forestry, a more liberalized trade regime and commencement of public enterprise reform. Policy performance thus far has been encouraging. In addition to fiscal and monetary stabilization efforts, program budgeting of development expenditures was started, sales tax and import tariff systems were simplified, the import regime was liberalized, and fertilizer prices were adjusted. Implementation of public enterprise divestiture, however, has been proceeding more slowly than initially expected, and the Government has requested UNDPIIFC technical assistance for more rapid and effective implementation. The Government's new commitment to pursue and strengthen the measures initiated under SAL I has been affirmed in the second- year PFP, which was presented to the Committee of the lhole on December 6, 1988. In addition, the recent impasse in the renewal of trade and transit treaties with India increased the need for continued reform outlined in the PFP. The measures to be supported by the proposed credit will strengthen the ongoing policy reforms, notably those aimed at: (i) continued sound macroeconomic management with enhanced revenue elasticity; (ii) improved development expenditure management by, inter alia, institutionalizing program budgeting  - ii - in line ministries; (iii) continued trade liberalization consistent with the new trade regime; (iv) improved access of farmers to fertilizers and irrigation water by enhancing the role of the private sector in their distribution and delivery; and (v) improved financial institutions that are able to allocate resources more efficiently and to operate on a sounder financial basis. Estimated Disbursements: The proceeds of the proposed IDA credit would be disbursed in three tranches. The first tranche of US$20 million equivalent would be available for disbursement upon credit effectiveness. Disbursement of the second tranche (of US$20 million equivalent) would be contingent upon adequate progress made in the implementation of th,. program demonstrated by, inter alia the Government's designing a medium-term policy framework as exemplified by a satisfactory Policy Framework Paper and adoption of an automatic fertilizer price adjustment mechanism. The third tranche (of US$20 million equivalent) would be contingent upon the Government's taking the actions enumerated in paragraph 94 of this report. Performance review would be held around April 1990 before the release of the third tranche. Disbursements of the entire credit are expected to be completed within 18 months after credit effectiveness. App-aisal Report: Not applicable Map: IBRD 10154R2  REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED DEVELOPMENT CREDIT OF SDR 46.2 MILLION (US$60 MILLION EQUIVALENT) TO THE KINGDOM OF NEPAL FOR A SECOND STRUCTURAL ADJUSTMENT PROGRAM 1. I submit the following report and recommendation on a proposed Second Structural Adjustment Credit (SAL II) to the Kingdom of Nepal for SDR 46.2 million (US$60 million equivalent) on standard iDA terms. 2. The first SAL (SAL I) for Nepal was approved by the Executive Directors in April 1987 for a sum of US$50 million. In parallel, Nepal negotiated an arrangement with the DMF for a Structural Adjustment Facility (SAF) loan based on the first Policy Framework Paper (1987-1989) for a total of SDR 24 million, to be disbursed over a three-year period. A Bank mission reviewed the implementation of SAL I in November 1987, and the second tranche was released in April 1988. 3. An economic memorandum on Nepal (Report No. 7418-NEP) was distributed to the Executive Directors on October 14, 1988. The Report focused on the Government's initiatives to implement the structural adjustmert and the basic needs programs, and emphasized policy reform priorities for the next phase of the Government's adjustment program. The Government requested IDA assistance in support of the second phase of the adjustment program in May 1988. This program was appraised during a mission in February 1989, the conclusions of ,which are reflected in this report. Country data are attached as Annex I. I. The Economy Ecanomic Development Constraints 4. Nepal's per capita income of about US$170 (1987/88) places it among the poorest countries in the world. Statistics on life expectancy, infant mortality, and literacy are below the South Asian averages. Chronic poverty and deprivation is perpetuated by rapid population growth; currently at 18 million and growing at 2.7 percent a year, the population continues to exert severe pressure on Nepal's limited productive natural resources resulting in widespread deforestation and soil erosion. Its predominantly rural economy (with over 90 percent of the work force employed in agriculture) is further plagued by stagnant or declining agricultural productivity and historically slow off-farm employment growth. 5. Few couzLtrieR began their development as late and with such a meager resource endowment as Nepal--a disadvantage compounded by the country's land- locked location and rugged terrain. Emerging from self-imposed isolation in the early 1950s, the country endeavored belatedly to construct the modern physical and administrative infrastructure required for development. However, three decades of concerted effort has so far proved insufficient to alleviate the prevailing condition of poverty. Although there has recently been some acceleration of growth rates as discussed below, average annual growth of real GDP prior to 1980 barely kept pace with population growth. During this  period, however, Nepal did not experience chronic or severe macroeconomic imbalances. 6. The long open border with India provides Nepal with both opportunities for economic growth and certain constraints to efficient economic management. India's future demand for energy resources constitutes a large potential market for Nepal's huge untapped hydropower resources, once the political complexities involved in moving towards bulk export agreements are resolved. At the same time, the virtually free movement of goods, people, and capital between the two countries have limited Nepal's autonomy in economic management. By tending to making prices in the two countries similar, these factors have made it difficult for Nepal to implement, for example, price and crade policies appropriate for Nepal independent of these policies in India. These concerns along with recent political devslopments have contributed to at least a temporary breakdown in trade and transit relations with India (see paras. 18-19). 7. To compound inherited meager natural resources and geographical problems, attempts to develop the country's human and institutional resources have often been constrained by the vestiges of traditional social and political systems. Furthermore, the Government's management of Nepal's development has suffered from several weaknesses. Economic planning has repeatedly overestimated government's implementation capacity while the budget mechanism has led to insufficient focus and prioritization. In addition, the Government has often established, in the past, inappropriate interventions to direct economic activity creating distorted incentives and an eventual drain on resources. Recent Macroeconomic Developmentz and Reform Efforts 8. The government is tackling the country's difficult development issues through three major initiativess the Structural Adjustment Program (SAP), the Basic Needs Program (BNP), and the Decentralization Program (DP). 9. Growing frustration with the lack of tangible progress through successive five year plans manifested itself in a surge in public expenditures during the Sixth Plan (FY81-85), far outstripping growth in revenues. This led to a higher rate of real GDP growth at close to 42 per year during the same period, which proved to be unsustainable; severe internal and ext:ernal imbalances rapidly emerged as a result of the expansionary policy. The overall budge. deficit rose from 6.1Z of GDP in FY81 to 12.3? in FY83 leading to strong demand pressures; domestic credit expansion, which peaked at 402 in FY83 was still running at about 25? in FY85. Imports surged and the current account deficit more than doubled between FY81 and FY83 reaching almost 92 of GDP, while gross reserves fell from the equivalent of 8 months of imports to 3 months by the end of FY85. The precarious macroeconomic situation threatened the viability of Nepal's development program; consequently, the Government took steps to implement a stabilization program supported by an 1MF Stand-by Arrangement in December 1985. Recognizing that stabilization measures by themselves could not lead to sustained and more rapid growth, the Government soon thereafter began to implement a structural adjustment program to address the long-term constraints that have contributed tc slow growth. This was  supported by the first Structural Adjustment Credit (SAL I) in April 1987 and by an IMF Structural Adjustment Facility (SAF) for FY88. The stabilization policies initiated in 1985, combined with the macroeconomic and sectoral reforms supported under SAL I and SAF, form the core of Nepal's Structural Adjustment Program (SAP). The major theme of this program to date has been to build the foundations for more rapid and sustained growth by: (i) implementing an appropriate macroeconomic adjustment program; (ii) reorienting policies and strengthening the institutions supporting agriculture and industry to increase production; and (iii) improving the efficiency of the public sector in terms of its financial and budgetary management aad performance of public enterprises. 10. Simultaneously, His Majesty the King launched a far-reaching initiative to meet the basic needs requirements of the people. The objective of the Basic Needs Program (BNP) is for the Nepalese to attain a standard of living 'commensurate to lead a life with human dignity by Asian standards by year 2000' by increasing the provision of goods and services in six areas: food, clothing, shelter, health, education and security. The BNP emphasizes the need for production increases, principally by revitalizing agriculture and private sector participation, and is thus consistent with the thrust of the ongoing structural adjustment propram. However, the BNP's ambitious targets are likely to prove beyond the country's absorptive capacity both in terms of financial resources and its institutional capacity. 11. The Government has also embarked on a significant Decentralization Program aimed at improving the capacity of local administration to implement development p: )grams and designed to encourage greater private sector participation in the development process particularly in the areas of social service delive I and management of community forests and irrigation facilities. 12. SAL I. SAL I supported most of the critical reforms under the SAP addressing issues in five areas: macroeconomic policy, public enterprise performance and divestiture, agriculture and forestry policies, industry and trade, and development administration. In macroeconomic policy, SAL I supported continuation and deepening of the Government's adjustment effort initially supported by the Fund's Stand-by (see para. 9 above) to reorient macroeconomic policies to address weaknesses that had emerged in fiscal and monetary management: to restrain public expenditures, especially recurrent expenditures by curbing the public sector wage bill; and to increase revenues through tax and tariff reforms. To improve its external position, the Nepalese rupee was devalued by 15Z in 1985 and measures were taken to liberalize the import regime. SAL I also complemented these macroeconomic policies by supporting the Government's introduction of much needed structural reforms in the major productive sectors. In agriculture, efforts were concentrated on improving the performance of public agencies providing requisite services, rationalizing pricing of both inputs and outputs, and establishing adequate incentives for private sector participation, particularly in fertilizer distribution and the seeds sub-sector. In industry, the Government liberalized trade and industrial investment policies to provide producers with improved incentives for production of exports and import substitutes. SAL I also supported the Government's longer-term  initiative to enhance its efficiency in managing the development process. Priority has been given to developing the information base and systems for program budgeting, improving performance of public enterprises, and scaling back activities where public sector involvement Was counter-productive, including taking the decision to privatize certain public enterprises. 13. P-rformance under SAL I. Macroeconomic performance during the SAL I period (FY86-FY88) has been encouraging (Table 1). GDP growth averaged 4.52 despite highly erratic weather. Investment has stabilized at a relatively high level of 19-202 of GDP with an increasing share coming from the private sector, and national savings increased from 112 in FY83 to 132 of GDP in FY88 primarily through an increase in public sector savings. The increased public savings was achieved through an increase in government revenues from 82 of GDP in FY83 to 10.52 in FY88 as a result of SAL-supported tax reforms and auction of import licenses, while expenditures have been kept constant at 18-192 of GDP. The overall budget deficit, consequently, decreased from 122 of GDP in FY83 to 82 in FY88; net domestic financing declined from 6 to 0.92 of GDP. Nepal's balance of payments perfo-mance was also satisfactory: the current account deficit (excluding aircraft purchases) has recently been about 72 of GDP compared with 92 in the early 1980s. Commodity exports relative to GDP almost doubled between FY83 esnd FY88 reaching 62. In particular, non- traditional exports (mainly carpets and garments) rose sharply and coupled with increased private remittances and aid inflows, reserves rebounded to 5 months of coverage of imports at the end of FY88. Commodity imports rose to 202 of GDP in FY88 from 182 in FY83. As a result of sound fiscal measures coupled with a tight credit policy, inflation declined from 162 in FY86 to 11l in FY88. Table 1 Nepal: Key Economic Indicators ---------------------------------------------------------__------------------__--------- 1982/83 1983184 1984/85 1985/86 1986/87 1987/88 ------------------------------------------- Preli- Actuals minary --------------------------------------------------------------__-------------__--------- GDP growth 1/ -3.0 9.7 3.0 3.9 2.4 7.1 Gross domestic investment/GDP 19.6 17.9 19.5 19.3 19.4 22.0 Government revenues/GDP 8.1 8.0 8.7 8.9 10.0 10.5 Government expenditures/GDP 2/ 19.8 17.4 18.4 18.0 18.8 18.9 Government budget balance/GDP 3/ -11.7 -9.4 -9.7 -9.1 -8.9 -8.4 Exports/GDP 3.3 4.1 6.2 6.0 5.1 6.0 Imports/GDP 4/ 18.3 15.8 17.7 18.1 18.6 20.5 Current account (in US$ mns.) -217.3 -182.5 -182.6 -197.5 -201.5 -277.8 Current account/GDP 4/ -8.7 -6.8 -7.4 -7.5 -7.4 -9.0 Debt service ratio 5/ -3.9 -4.3 -4.8 -6.9 -6.9 -8.8 1/ At constant prices. 2/ Includes net lending. 3/ Excludes grants. 4/ Includes the acquisition of one aircraft in 1987/88. 5/ As a percent of exports of goods and services and private transfers.  14. Longer-term programs to improve development administration have also shown progress; core priority projects and programs were identified according to a pre-determined set of criteria and a management information system (MIS) was developed based on the up-to-date information of project implementation. This MIS is now being installed in selected line ministries and in the offices of key decision makers such as the Prime Minister's office, the Palace, the Planning Commission and the Finance Ministry. In trade policy, substantial import liberalization took place including initiating import license auctioning and converting rigid quantitative restrictions to more flexible passbook or open general license (OGL) systems. A duty drawback system was offi;cially introduced for ready-made garment producers. These moves led to the aforementioned increase in non-traditional exports and consequently a significant improvement in the balance of payment3. 15. In the areas of agriculture and forestry, the latter having major environmental implications, the outcome has also been generally encouraging despite a number of implementation delays with regard to fertilizer price adjustment and forestry legislation which delayed second tranche release. Implemented reforms include: (a) discontinuaticn of subsidized foodgrain sales and producers' levies; (b) establishment of legal and institutional arrangemerts in the seeds subsector that form a basis for more coordinated research, production and marketing activities and for an increased use of quality seeds; (c) adjustment of fertilizer prices to minimize price.induced incentives for re-exporting imported fertilizers to neighboring countr