Nicaragua - Economic Recovery Credit

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 14829 PROJECT COMPLETION REPORT NICARAGUA ECONOMIC RECOVERY CREDIT (CREDIT 2302-NI) JULY 5, 1995 Country Operations Division Country Department II Latin America and the Caribbean Region This document has a restricted distribution and may be used bv recipients only in the performance of their ofricial duties. Its contents may not otherwise be disclosed without World Bank authorization.  Glossary BI Banco Inmobiliario BND Banco Nacional de Desarrollo BNIC Banco Nicaraguense de Industria y Comercio BP Banco Popular CO Cordoba Oro CORFIN Corporaci6n Financiera de Nicaragua CORNAP Corporaciones Nacionales del Sector Publico ERC Economic Recovery Credit ESAF Extended Structural Adjustment Facility GDP Gross Domestic Product GON Government of Nicaragua IDA International Development Association IDB Interamerican Development Bank IFI International Finance Institution IMF International Monetary Fund PCR Project Completion Report SAC Structural Adjustment Credit SITC Standard International Tariff Classification SOE State-owned Enterprise TFAL Trade and Financial Adjustment Loan UNDP United Nations Development Programme UNO Uni6n Nacional Opositora USAID United States Agency for International Development  FOR OFFICIAL USE ONLY THE WORLD BANK Washington, D.C. 20433 U.SA Office of Director-General Operations Evaluation July 5, 1995 MEMORANDUM TO THE EXECUTIVE DIRECTORS AND THE PRESIDENT SUBJECT: Program Completion Report on Nicaragua - Economic Recovery Credit (Credit 2302-NI) Attached is the Program Completion Report (PCR) for the Nicaragua Economic Recovery Credit (Credit 2302-NI, approved in FY92) prepared by the Latin America and Caribbean Regional Office. Part II was prepared by the Borrower. The PCR gives a very good account of the preparation and implementation of the ERC. The principal objective of the credit was to support the Government's endeavor to arrest the decline in the economy and revive growth on a sustained basis. The reforms proposed were to help reorient the economy from a command to a competitive free-market system. The program was prepared in close coordination with the IMF. Important risks - weak institutions, resistance by interest groups, a reluctant private sector - were identified in the President's Report and judged to be manageable. Through the ERC, IDA was successful in mobilizing substantial support from other donors, including financing for clearance of Nicaragua's arrears to the Intemational Financial Institutions. The credit itself was cofinanced by the Inter-American Development Bank and the Governments of Japan, Germany and Switzerland. All tranche release conditions were met and the credit was fully disbursed within one year of approval. The outcome, however, was disappointing: contrary to expectations, GDP remained stagnant in 1992-93 and both the budget deficit and resource gap were larger than predicted. Restoration of private sector confidence remained elusive and, following second tranche release, there were some policy reversals. The program did not directly address Nicaragua's enormous debt burden: the external debt has remained at about eight times the level of GNP. The risks associated with the operation were underestimated and the assumption in the President's Report that implementation of the proposed reforms would yield fairly quick results proved far too optimistic. On balance, the outcome of the ERC is rated as marginally unsatisfactory. Given the prevailing political uncertainty and limited institutional capacity, sustainability is rated as uncertain. The institutional impact is rated as negligible. Following a policy impasse in 1993, conditions started to improve in 1994. In June 1994, two years after the closing of ERC I, a follow-up operation, ERC II, was approved by the Board. A joint audit of ERC I and ERC II is planned, after completion of ERC II. Attachment This document has a restricted distribution and may be used by recipients only in the performance of their official dulies. Its contents may not otherwise be disdosed without World Bank authorization.   FOR OFFICIAL USE ONLY TABLE OF CONTENTS Page PREFACE EVALUATION SUMMARY .......................................... i PART I. PROGRAM REVIEW FROM IDA'S PERSPECTIVE ............... 1 A. PROGRAM IDENTTrY .................................. 1 B. BACKGROUND ...................................... 1 C. THE STABILIZATION AND ADJUSTMENT PROGRAM OF THE GOVERNMENT ................................ 3 D. THE ROLE OF IDA .................................... 4 E. PROGRAM OBJECTIVES AND DESCRIPTION .................. 6 F. ERC OBJECTIVES, DESIGN AND ORGANIZATION .............. 6 G. PROGRAM IMPLEMENTATION ........................... 7 H. MACROECONOMIC RESULTS AND ASSESSMENT OF THE ECONOMIC RECOVERY CREDIT (ERC) ............... 10 1. SUSTAINABILITY ..................................... 14 J. LESSONS LEARNED ................................... 16 PART H. PROGRAM REVIEW FROM THE BORROWER'S PERSPECTIVES ..... 17 A. THE BORROWER'S ERC REVIEW .......................... 17 B. THE BORROWER'S PERFORMANCE ........................ 17 C. IDA'S PERFORMANCE ................................. 18 D. RELATIONSHIP BETWEEN IDA AND THE BORROWER .... ....... 18 E. RELATIONSHIP BETWEEN CO-FINANCERS AND THE BORROWER .. 18 F. ADEQUACY AND ACCURACY OF FACTUAL INFORMATION IN PART III ......................................... 18 PART I. STATISTICAL INFORMATION ............................ 19 A. PROJECT TIMETABLE ................................. 19 B. CUMULATIVE LOAN DISBURSEMENTS ..................... 19 C. STAFF INPUTS ....................................... 19 D. MISSION DATA ...................................... 20 ANNEX. MATRIX OF ACTIONS 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 wiLhout World Bank authorization.   PREFACE This is the Project Completion Report (PCR) of the Economic Recovery Credit to the Republic of Nicaragua for which Credit 2302-NI in the amount of SDR 83.5 million was approved by the Board of Executive Directors on September 26, 1991. It was disbursed in two equal tranches and was closed on June 10, 1992, upon disbursement of the second tranche. The PCR was jointly prepared by the Country Operations Division (LA2C2) of the Latin American and the Caribbean Office (Preface, Evaluation Summary, Parts I and III) and by the Borrower (Part II). Preparation of the PCR started during a mission to Nicaragua in mid-September, 1993. It is based on the Report and Recommendation of the President of the International Development Association to the Executive Directors on the Economic Recovery Credit, the Development Credit Agreement, mission reports, correspondence between IDA and the Borrower, and discussions with Bank staff, Nicaraguan officials who worked on the Credit Program, and representatives of major donor/assistance organizations in Nicaragua.  1.  NICARAGUA PROJECT COMPLETION REPORT ECONOMIC RECOVERY CREDIT (2302-Ni) EVALUATION SUMMARY 1. Project Objectives (paras. 23-28). The main objective of the Economic Recovery Credit (ERC) was to support the Government of Nicaragua in its endeavors to arrest the ongoing decline in the economy, to achieve lasting price stability and to revive economic growth on a sustained basis. This was to be achieved with structural reforms that were to return Nicaragua to a private-sector-led economy from the command economy which lasted from 1979 till 1990. 2. The ERC supported the adjustment program which consisted of downsizing and restructuring the public sector, privatizing the state-owned enterprises (SOEs), reforming the financial system to improve resource allocation, establishing a competitive environment to widen the private sector participation in economic activities, and reforming the incentive system by eliminating existing barriers to private sector's entry into production and trade. The ERC was designed as a first step to assist Nicaragua's efforts through an IDA credit totalling SDR 83.5 million which was released in two equal tranches upon full completion of the conditionalities specified for each tranche. 3. Implementation ExDerience (paras. 29-34). IDA coordinated the efforts to put together a financial package to clear Nicaragua's arrears to International Financial Institutions (IFIs). It also helped the authorities to prepare the documents for the Paris Club debt restructuring. This led to the resumption of much needed financial assistance to Nicaragua. The financial package included, in addition to the IDA credit, US$130 million from IDB and US$193 million equivalent from other bilateral donor agencies. IDA also assisted the Government in shaping the required policy objectives and actions more concretely. In addition, Nicaragua signed a stand-by agreement with the IMF. 4. Between April and June 1991 IDA fielded several missions culminating in the negotiations of July 1991 and leading to the Board approval and signing of the credit documents upon which the first tranche of the credit was released. The second tranche was disbursed in June 1992 again upon verification of the compliance with the conditions set out in the Development Credit Agreement. 5. Program Results: Macroeconomic Performance (paras. 35-51). The Government of Nicaragua was extremely optimistic with respect to the impact of the economic recovery program on growth. IDA took a much more cautious attitude, and a modest economic recovery was foreseen for only 1993. Even the cautious optimism proved to be an over-estimation. In fact, the economy declined. Several factors explain this situation. First, the political stability hoped for after the elections never materialized. Second, the process to address the property rights issue was extremely slow. Third, the Government wavered in its efforts to reform the public sector and gave conflicting signals to the private sector. As a result, the hoped for take-off of private sector expansion never occurred. While exports stagnated, imports rose; investment did not rise. Fourth, after the release of the second tranche backslidings and policy reversals occurred in a number of areas, especially in financial sector reform. Public banking institutions continued to crowd out newly set up private banking institutions. Other reversals occurred in raising the protection  ii on imports. 6. Nicaragua has yet to experience a major economic recovery. The high risk of doing business did not diminish substantially. The main barrier to private sector development continues to be the fragile political environment. The managerial capabilities of the Government are still limited despite considerable but unfortunately uncoordinated technical assistance, and the financial dependency on foreign assistance continues. 7. These developments should not necessarily be taken as a criticism of either the conception or implementation of the ERC setting the framework for adjustment. Without the ERC much needed imports could not have been financed and Nicaragua would have no access to international credits. Without the World Bank's efforts a financial package most probably could not have been put together; the arrears could not have been cleared, and Nicaragua would have been deprived from the financial and technical assistance of the donor community. 8. Sustainability (paras. 52-57). Under the present circumstances the limited success of the restructuring and adjustment efforts cannot be sustained, unless a more stable political environment is achieved and the Government makes further efforts to streamline its budget, enhance its institutional capacity for a better economic management, resolves the property rights issue, and realizes the financial reforms which were designed before the release of the second tranche, but were never fully carried out. 9. Nicaragua continues to depend on external assistance and the extent and likely reduction in donor support are disconcerting. Without further financial and technical assistance the sustainability of the limited results already achieved will be in jeopardy. If sufficient foreign aid does not come forth in subsequent years and if an institutionalized aid coordination effort is not made within the Government to allocate such aid efficiently in full accordance with the restructuring efforts, the gains made so far are likely to be lost. 10. The private sector hesitates to respond to the Government's reform and restructuring efforts. Restoring political stability and resolving the property rights issues, as foreseen in ERC's design, are two of the most essential elements for the sustainability of the project results. 11. The weakness of the overall administrative capacity of the central and local governments also endangers sustainability. The weakness partly stems from the excessive number of civil servants and the budget constraint that impedes their better remuneration, which in turn hampers efforts to improve public management. Failure to improve public management leads to waste and inefficient administration and prevents in turn concerted efforts to improve public management. Unless the budget, current and investment, is trimmed and unless a concerted effort is undertaken to improve public management with better remunerated civil servants, Nicaragua will continue to depend on technical assistance and the economic reform will be extremely slow in taking off. 12. Nicaragua needs to accelerate its structural transformation and move rapidly towards a market- based economy with a much smaller but more efficient public sector. The public sector is still oversized and inefficient, crowding out the private sector and generating waste. The Government has spread its limited managerial capabilities too thinly and its specialized human capital skills in too many activities. The sustainability is challenged unless public sector functions efficiently and stops crowding out the private sector.  iii 13. Lessons Learned (paras. 58-61). Several lessons emerge from IDA's experience. First, when the countries' credit needs are inextricably related to transforming rather than reforming their economies, a longer term vision is necessary. In an economy where institutions are being overhauled and new organizations are being created, the "adjustment" necessarily takes much longer than in market-oriented economies. Concomitantly with structural adjustment, long-run development problems must also be tackled from the outset. IDA's longer range view with respect to Nicaragua's restructuring and adjustment program is yet to be carried out. 14. Second. with the view that there would be follow-up structural adjustment credits, the ERC did not always contain sufficiently tightly designed conditionalities; in some cases leaving the completion of actions to the follow up operations. Each ERC should be self-contained without leaving the completion of actions to other operations. 15. The third lesson that emerges is that a much better donor technical assistance coordination is a sine qua non. IDA should insist on an effective aid coordination that would set the priorities and be an integral part of the adjustment package. Especially in cases where transformation of the economy is in question, as was the case in Nicaragua, to set up such a coordination mechanism within the Government may very well be considered as one of the conditions for the tranche release. IDA should make every effort to secure the coordination of technical assistance via an appropriate mechanism as warranted. 16. The fourth lesson is that the extent and the depth of technical assistance and training needs must be estimated correctly. If not, to improve the economic management capabilities of the public sector becomes a near impossibility.   NICARAGUA PROJECT COMPLETION REPORT ECONOMIC RECOVERY CREDrr (2302-NI) PART I: PROGRAM REVIEW FROM THE IDA'S PERSPECTIVE A: PROGRAM IDENTITY Credit Name: Economic Recovery Credit Credit No.: 2302-NI Region: Latin America and the Caribbean Country: Republic of Nicaragua Sector: Non-Project Lending B. BACKGROUND 1. The Economic Recovery Credit (ERC) in the amount of SDR 83.5 million (equivalent to US $ 110 million) was approved by the Board of Executive Directors on September 26, 1991 and signed on October 8, 1991. ERC was released in two tranches of US$ 55 million each (equivalent of SDR 41.75 million) and was closed on June 30, 1992. The credit was designed to help the Government in its efforts to transform the economy from a command to a market economy and improve resource allocation by establishing a competitive environment with private sector participation. The Government's structural adjustment program consisted mainly of downsizing and restructuring the public sector and privatizing the SOEs; reforming the financial system; reforming the system of incentives and eliminating the obstacles to private sector's entry into production and trade, liberalizing trade, and easing or abolishing price controls and related regulations. 2. Nicaragua was declared eligible for IDA-only support on April 15, 1991, and the ERC carried standard IDA-only terms, including repayment in 40 years and a grace period of 10 years. Co-financing was provided out of concessionary funds from the Inter American Development Bank (IDB) and the Governments of Japan, Germany, and Switzerland. 3. The credit extended by IDA was surrounded by a set of unusual economic and political circumstances. It was one of the first - if not the first - attempt to assist a country to move from a command to a market economy. After the demise of the Somoza regime in 1979, the Sandinista  Government established a centrally controlled economy, confiscated or expropriated many privately- owned firms, nationalized the financial and external trade sectors, and heavily regulated the remaining private sector. The Sandinista Government's inappropriate macroeconomic policies and price controls distorted resource allocation. Gross inefficiencies in resource use resulted. Public sector expenditures trebled over the decade, reaching an average of 57 percent of GDP in 1983-87. The Government's resort to central bank financing fueled an inflation level that reached 14,300 percent in 1988. The guerrilla warfare against the Sandinista regime (Contra War), the United States trade embargo, the worsening of the terms of trade in general, and natural disasters that afflicted heavy losses on the agricultural sector compounded the problems. The deterioration in the economy accelerated towards the end of the eighties. The real GDP that had grown only at the moderate annual rate of 1.0 percent at the beginning of the eighties declined at the annual average rate of 4.1 percent during 1985-1990. By the end of the decade real per capita GDP had fallen drastically (from US$ 730 in 1980 to US$ 448 in 1990), total exports in current dollars amounted to less than half the levels achieved in the mid-1970s, inflation had spiralled out of control, and the public sector deficit averaged 20 percent of GDP during the period 1985-1990. During the same period the current account deficit averaged 33 percent of GDP and it was mainly financed through grants and the accumulation of arrears with foreign creditors, on which the country had grown extremely dependent. External debt, including accrued interest, ballooned from US$ 1.7 billion in 1978 to over US$ 10 billion in 1990, at more than 6 times the estimated GDP. 4. The Sandinista Government launched an emergency stabilization package to curb hyperinflation in 1989. The program significantly reduced the public sector deficit by halving Central Government expenditures, dramatically cutting credit to the public sector, and frequently devaluing the currency to create a 90 percent real depreciation of the Cordoba in 1989. Inflation was temporarily reduced to only 4700 percent in 1989, and the current account deficit was narrowed slightly. However, in early 1990, the Sandinista Government abandoned the program without waiting for its full results and returned to highly expansionary policies. In only three months public sector wages were raised by 800 percent in nominal terms, while public sector prices remained fixed. The Central Bank financed the ensuing deficits; and, as inflation accelerated, the Cordoba appreciated by 45 percent in real terms. 5. The political coalition Uni6n Nacional Opositora (UNO) headed by Violeta Chanorro that took office in April 1990 inherited a totally devastated economy with an oversized and extremely inefficient public sector which had crowded out private sector participation through a deep involvement in economic activities and ownership of productive means. Total non-financial public sector expenditures represented about 50 percent of GDP, while state-owned financial enterprises accounted for another 29 percent of GDP. The banking system was completely nationalized and bankrupt after a decade of mismanagement during which credit was allocated largely according to political criteria. Foreign trade was heavily regulated, with state trading companies accounting for almost all exports and over 50 percent of imports. Import transactions were subject to a multiple exchange rate system and a high and dispersed tariff structure. In domestic commerce, over 50 products were subject to price control. The legal framework that defined and enforced property rights and the land tenure system became inappropriate and inoperative. Many skilled technicians and managers had left the country. 6. The tasks of achieving stability, economic revival, and the prerequisites for sustained growth were daunting. Moreover, the economic agenda had to be pursued in the environment of a very fragile political peace. The new Administration, which had received from the people a clear mandate to govern at the February 1990 elections, had to come to terms with the Sandinistas, and felt the transfer of power was only possible with the proviso that the armed forces and the police be left to Sandinista supervision and control. This was to contribute to political instability in subsequent years; yet at the time of the 2  installation of the Chamorro Administration no other recourse appeared to be feasible. 7. The new Government hoped to restructure the economy in a relatively short time. Yet it was fully aware that neither the financial nor human resources of the public sector would allow it to undertake such a drastic change on its own. It needed the full support of IFIs, i.e., the IMF, the World Bank, and the Inter-American Development Bank (IDB), and bilateral agencies of the whole donor community, including the USA, not only for financial resources, but for technical advice as well. The new Government re- established its ties with both development banks almost immediately by indicating its intentions to take steps to clear its arrears with the Bank and IDA undertake a program of economic reforms. It attempted to implement a combination of fiscal and monetary policies aimed at reducing the size and role of the government, as well as increasing reliance on market forces. 8. The Government approached the Bank and IDA to support its stabilization and recovery efforts after six years of near interruption of relations with the two institutions. Beginning in April 1990 Bank staff visited Nicaragua on several occasions, assessed the economic situation, and discussed with the authorities the elements of a program for stabilization and adjustment. At the same time the Government initiated measures to stabilize the economy. As a result, Central Government expenditures rose by only 2 percentage points of GDP in 1990 despite the doubling of the wage bill resulting from the wage increases prior to the new Government's term. The financial performance of the public utilities improved dramatically after prices were raised and then indexed to the US dollar. However, the 1990 measures fell significantly short of achieving the objectives: government revenue declined by 7 percentage points of GDP; the overall public sector deficit widened to 43 percent of GDP; and domestic bank credit increased rapidly because of deficits in state enterprises. 9. In May 1990, the Government introduced a currency of account, the Cordoba Oro (CO), and pegged it to the US dollar. It was used to pay part of public sector wages. Loans and deposit rates were indexed to the CO. The introduction of the CO in an inflationary environment, however, complicated monetary management. The fact that transactions were denominated in CO and effected in Cordobas sped circulation of the Cordoba. Lax financial policies combined with enforcement of parity to the US dollar also depleted scarce international reserves. Economic performance continued to worsen throughout 1990. This was exacerbated by political volatility and persisting macroeconomic imbalances. The GDP dropped by 4.4 percent. Unchecked monetary expansion and a large fiscal deficit caused the annual inflation rate to accelerate to over 7,400 percent. The current account deficit remained high (18.5 percent of GDP). C. THE STABILIZATION AND ADJUSTMENT PROGRAM OF THE GOVERNMENT 10. The most significant achievements of the Government in 1990 were the progress toward establishing peace and reaching broad national consensus on the main thrust of its economic policies after an initial period of prolonged strikes. The efforts culminated in the October 1990 agreement of "Concertaci6n Econ6mica y Social" (Economic and Social Accord) between the Government and worker and employee representatives that secured a formal consensus on the need for structural reforms: liberalizing trade, removing state monopolies from the financial and foreign trade sectors, and returning expropriated properties to their rightful owners. The Chamorro Administration also enacted significant policy changes in tax and tariff reforms and the de-regulation of the economy. 11. On March 3, 1991, the Government announced a major stabilization and adjustment program with the support of the IMF and IDA. The IMF/IDA coordination allowed the Government to take steps 3  towards the implementation of the stabilization program. The program called for a balance between the money supply and the demand for real balances in order to constrain the Central Bank's stock of net domestic credit. It adopted a fixed exchange rate policy. The Cordoba Oro was devalued by 400 percent and set at 5 new Cordobas per US dollar. The correction of the exchange rate and increased competition in input and output were aimed at providing appropriate price incentives for a production recovery in the tradables sector. Strict ceilings were placed on expenditures and credit expansion. A public sector employment reduction program was initiated, financed mainly with foreign grants. The aim was to downsize the public sector and balance revenue and expenditures through selective expenditure cuts and better revenue collection procedures. The financial sector was to be reformed. A system of incentives was to be restored to assure the private sector's participation in a market-oriented environment. Trade was to be liberalized by reducing nominal tariffs. Distorting domestic regulatory practices were to be erased by reducing the Government's involvement in the economy and changing the regulatory framework governing the SOEs. The remaining agricultural support prices were to be eliminated. D. THE ROLE OF IDA 12. An IDA mission visited Nicaragua during January 15-31, 1991, to initiate the preparation of the proposed ERC. It reviewed the developmental issues and policies and identified those to be incorporated into the ERC. The mission received good cooperation from the Government, and meetings were held with key ministers, high level ministerial staff and advisers, with members of parliament, and business and labor leaders. The mission interacted with the IMF and IDB missions in the field and reached understandings with the authorities on the broad outline of an economic recovery and adjustment program. 13. At first the authorities expressed some concern regarding the implications of implementing a far- reaching stabilization and adjustment program and indicated that they had already taken significant steps towards stabilization and adjustment. But through background analyses and a series of meetings the mission succeeded in reaching an understanding with the Government on the urgent need for a major stabilization effort and the measures necessary to restructure the economy. 14. There was basic agreement from the start on the direction of adjustments towards a market- oriented economy free of unnecessary regulations and government ownership in the productive sectors. The mission worked with the authorities on the components of such a program. In the final meeting the officials indicated their full agreement with the assessments and the recommended policies. The consensus was that there was no viable alternative to a credible stabilization and adjustment program to overcome the current economic crisis and that, with its timely implementation, ties would be re-established with international financial institutions, and bilateral donor support would be mobilized. 15. An IDA pre-appraisal mission visited Nicaragua between April 22 and May 7, 1991, to work on the details of the program. 16. In June 1991 the IDA fielded an appraisal mission which was joined by two persons from the Overseas Economic Cooperation Fund of Japan and a representative of IDB. The Japanese Government and the IDB intended to cofinance the ERC. The mission discussed with the authorities the details of the Government's economic recovery program. Agreements were reached with the Government in line with the policies and measures presented in the Memorandum. A draft "Letter of Development Policy" was prepared by the authorities which was fully consistent with the policy matrix approved by the Operations 4  Committee. It was initialed by the members of the Economic Cabinet. 17. The appraisal mission observed that the stabilization program announced on March 3, 1991, had already had a visible impact on price levels. After a major initial rise, price increases had moderated dramatically in late March, April, and May, with the consumer price index declining by 6 percent in May. The Government had adhered to the expenditure ceilings, and public revenues had displayed a rising trend above programmed levels. It was not possible for the mission to establish with any precision the 1991 trends in output, due to shortcomings in statistical data. However, it appeared that the recession in the economy had not worsened since the initiation of the stabilization program. If anything, output was expected to be around 1990 levels. The Government had engaged in lengthy negotiations with labor and business representatives to review and revise the "concertation" agreement that was to provide the basis for the settlement of labor demands. The issues of compensating labor further for price changes and the settlement of property rights appeared to be the major preoccupation of the parties engaged in deliberations. The outcome of these discussions had a strong bearing on the Government's ability to carry through its program for stabilization and adjustment. Negotiations took place in Washington in July 1991. 18. IDA also played a key role of mobilizing the support of various donors. In a May 1990 Rome meeting coordinated by the World Bank the donors discussed the multifaceted aspects of Nicaragua's economic situation and the need for external support. In December 1990 the first Consultative Group chaired by the Bank convened in Paris. The Group urged the Government of Nicaragua to develop a stabilization and adjustment program with the support of the World Bank and IMF. Subsequently in March 1991 another donor meeting was held in Washington in which the Government of Nicaragua explained its stabilization program and the structural measures already taken. Eventually in Paris, in the May 1991 Consultative Group meeting, the donors pledged strong support for Nicaragua's stabilization and adjustment program and also agreed on a plan to clear the arrears to the World Bank and to IDB which stood at US$ 327 million. The plan provided for bridge loans of US$ 193 million from Mexico, Venezuela, Spain, and Colombia, and bilateral contributions from other donors. These countries would be paid back from the proceeds for their repayment from the IMF, IDA's ERC (co-financed with Japan and Switzerland) and IDB's Trade and Financial Adjustment Loan (TFAL) operation of USS 130 million. Hence IDA's ERC became the catalyst of a concerted effort to revive the economy that was highly distorted by the policies of the previous regime and severely damaged by the subsequent armed conflict between the Contra guerrillas and Sandinista forces. 19. Thus, assistance to Nicaragua started at the end of 1991 after meticulous preparation of a well- coordinated multifaceted aid/credit package. IDA, sensitive to the needs of the new Government, acted with speed (the first tranche was released only nine months after the initiation of the Project preparation). It also provided technical input to steer the Government's restructuring policy in the appropriate direction. Last but not least, it mobilized the donor community. Expectations ran high and the new Government appeared determined to put the economy on the right track. 20. It is important to point out several outstanding contributions of IDA to the Government's program. First and foremost, during the preparations IDA helped the Government to shape the required policy objectives and actions more concretely. The Government had inherited a weak civil service and apart from the high echelon of decision-makers (ministers, vice-ministers, and their handful of advisers) it lacked the internal mechanisms and know-how to mold the broad policy actions precisely. Moreover, the decision-makers themselves, though committed to stabilization and restructuring, did not have the experience in administering such a program. IDA's presence, therefore, contributed to crystallize a 5  coherent vision of the direction of the stabilization and restructuring program and also provided part of the much needed technical input. Secondly, to help the Government in both implementing the adjustment program and in dealing with IDA with respect to its requirements, the World Bank also established a resident mission (January 1992) in Managua, which is the World Bank's only resident mission in Central America. The main function of the resident mission was to assist the Government of Nicaragua with policy dialogue and monitor the implementation of the adjustment program. E. PROGRAM OBJECTIVES AND DESCRIPTION 21. The principal aim of the Government was the re-orientation of the economy from a command system to one based on competitive free market forces. It called for structural changes in macroeconomic policies, public and financial sector reforms, revamping the incentives system, and redesigning the property rights, including privatization. 22. The Government's program consisted of: * introduction of a macroeconomic policy framework supportive of price stability, trade and exchange rate liberalization, and balance of payments equilibrium; * restraining the growth in public expenditures and significant reduction in military expenditures; * reduction in public sector employment and initiation of an occupational conversion program; * major reduction in the size of the state enterprise sector through privatization and restructuring; * redesigning property rights to foster private investment and growth; * reforming the tax system and improving the tax administration to increase efficiency in collections and raise government revenues; * liberalizing domestic trade through the elimination of price controls; * improving the allocation of financial resources and efficiency of financial intermediation; * expanding output by increased private sector participation in trade; * lowering tariff protection; and n minimizing welfare losses and creating focused social safety nets. F. ERC OBJECTIVES, DESIGN AND ORGANIZATION 23. The ERC was designed as a first step in support of a longer-term structural adjustment program for Nicaragua that aimed at moving the economy as fast as possible from a command to a market-led economy. The Credit was to support the Government's structural adjustment program described in 1 22. 6  24. The implementation of the structural adjustment program intended to promote growth through increased private sector participation, improved incentives for production, and a more efficient allocation of domestic resources. It aimed to increase employment opportunities, help alleviate poverty, and facilitate the flow of external financing and foreign investment. The program was not without risks, the principal ones of which were perceived as weaknesses in institutional capacity to carry out the program, resistance on the part of organized groups to fiscal and financial restructuring, slow private sector response due to uncertainty regarding the property rights, and shortfalls in timely donor support. 25. The Credit was a key instrument in clearing Nicaragua's substantial arrears to multi-lateral agencies and paved the way for the resumption of lending programs to support further structural reforms. The solution to problems of macroeconomic instability, deteriorated infrastructure, unemployment, poverty, and environmental degradation, and a speedy transformation from the command to the market economy could not all be attained with domestic resources alone and with the existing institutional capacity of the public sector. Hence IDA's assistance had to address the right areas, since the problems called for the mobilization of a multi-faceted assistance. The Credit, in terms of its scope, design, and scale, was well prepared and timely. 26. The proceeds of the ERC to support the Government's program were to be disbursed in two tranches. The Government was to take measures, prior to Board presentation, aimed at achieving a set of objectives prior to the disbursement of the first tranche. A second set of actions were stipulated as conditions for the release of the second tranche. The Annex details the objectives and the corresponding actions to be taken prior to making the first ERC tranche available and releasing the second tranche. 27. The ERC was to reimburse the C.I.F. cost of general imports excluding those financed by other multilateral or bilateral sources, luxury goods, military equipment, and those in the negative list of SITC. Because of lack of adequate procurement procedures, a cut-off limit of US$ 3 million was adopted for international competitive bidding. Imports valued at below that level were to be procured with established commercial practices. Public sector imports valued at US$ 1 million or less could be procured as long as at least two suppliers entered competitive bidding. The Central Bank was entrusted with the administration of the ERC and reviewed relevant procurement documentation according to eligibility criteria. 28. The first tranche of the ERC amounting to SDR 41.75 million (US$ 55 million) was disbursed upon effectiveness of the Credit Agreement. The second tranche was disbursed in June 1992 as anticipated, after compliance with the conditions for tranche release, including maintenance of a consistent macroeconomic framework, as specified in the Credit Agreement, was established. G. PROGRAM IMPLEMENTATION 29. The Board presentation was conditioned on a set of policy actions (see also Annex) by the Government of Nicaragua. These can be grouped into three categories: * Fiscal actions: * Reduction of non-interest current expenditures to the equivalent of US$ 325 million in the FY 1992 budget to be accomplished partly by reducing public sector employment by 8,000 through a voluntary employment reduction scheme; 7  * improvement of tax administration with specific emphasis on the General Value Tax and the Income Tax; * removal of income tax exemptions and phasing out the exemptions from indirect taxes and import duties; and * an action plan satisfactory to IDA to privatize CORNAP (Corporaciones Nacionales del Sector Pdblico) enterprises. * Monetary and Banking actions: * creating a Banking Superintendency; * an action plan satisfactory to IDA for restructuring the state-owned banks; and * cessation of Central Bank subsidies and discounts, except for micro enterprises in agriculture. * The Foreign Trade Regime: * lowering protection to the 10-60 percent level; * automatic registration of importers and exporters; and * a price-based mechanism with variable levies for rice and corn with the aim of liberalizing agricultural trade. 30. The Government of Nicaragua took these actions, the accomplishment of which was verified by IDA. This led to taking the project to the Board and eventually the release of the first tranche of the ERC in December 1991. 31. The release of the second tranche hinged upon the following actions of the Government of Nicaragua: (a) the budget for Fiscal Year 1992 has been adopted; (b) an action plan for the carrying out of the recommendations of the study on public expenditures carried out by the Borrower has been presented to the Association; (c) the following measures to strengthen tax administration have been taken: (i) the unit in the Borrower's Internal Revenue Service (Direcci6n General de Ingresos) in charge of large taxpayers has become operational; (ii) decrees imposing sanctions for non- compliance and/or late payments of taxes have been issued; and (iii) programs on automated management control system, computerized taxpayer identification system and training for personnel of the Borrower's Internal Revenue Service (Direcci6n General de Ingresos and Customs (Direcci6n General de Aduanas) have been initiated; (d) the privatization of at least 25 companies under the control of the Borrower, through 8  CORNAP, has been completed; (e) the devolution to the original owners or the liquidation or the transfer to the private sector of at least 50 companies under the control of the Borrower, through CORNAP, has been completed; (f) at least 30 companies under the control of the Borrower, through CORNAP, other than those referred to in paragraphs (d) and (e) above, have been prepared for sale to the private sector; (g) BI (Banco Inmobiliario) has been liquidated or merged with BNIC (Banco Nicaraguense de Industria y Comercio); (h) CORFIN (Corporaci6n Financiera de Nicaragua) has been dissolved; (i) progress has been achieved in the carrying out of the action plan, agreed with the Association, for the restructuring of BNIC, BND (Banco Nacional de Desarrollo) and People's Bank (BP); (j) a bill or bills of law regulating the functions and activities of the banks and other similar financial institutions operating in the territory of the Borrower has been presented to the Borrower's National Assembly; (k) at least 2 licenses allowing private banks to operate in the territory of the Borrower have been issued; (I) the protection resulting from combined tariffs and taxes that apply to imports in Nicaragua has been reduced to a minimum of 10 percent and a maximum of 40 percent, except with respect to medicines, books and newsprint which may be exempt from such tariffs and taxes or subject to tariffs and taxes at a combined rate lower than the minimum rate referred to above; (m) the quotas on the importation of rice, yellow corn and white maize have been abolished and a mechanism for the importation of such commodities, based on price with variable levies, has been established; (n) all restrictions on the importation of food grains other than those referred to in paragraph (m) above have been abolished; and (o) a certified copy of the audit report referred to in Section 3.03(ii) of this Agreement in respect of the First Tranche has been furnished to the Association. 32. In mid-June 1992 IDA reviewed compliance with the second tranche conditionalities and reached the conclusion that all the stipulated conditions had been met. The budget for FY 1992 and the recommendation of IDA public expenditure study were adopted. The large taxpayer unit had begun to operate, sanctions were put in place, and a computerized management system and training were initiated at the Ministry of Finance. CORNAP was set up to supervise the state-owned enterprises and privatize them according to an agreed upon program. The speed of the divestiture process was faster than expected. 9  Twenty-five SOEs were privatized; 50 SOEs were either returned to their original owners, liquidated, or transferred to the private sector; and 30 companies were in the process of being prepared for privatization. In fact, by mid 1992 the Government had privatized 161 out of 352 enterprises, and the share of SOEs in GDP was reduced from 30 to 20 percent. 33. Conditions referring to financial reform were met. CORFIN, the holding company for state- owned banks, was dissolved; the plans for restructuring the National Development Bank (BNIC) and the People's Bank (BP) were prepared; a draft law was submitted to the National Assembly to regulate financial institutions, and 7 private banks (5 more than targeted) were licensed to operate in Nicaragua by the Superintendency of Banks. 34. The Government of Nicaragua took the measures to reduce the distortions in the trade sector. Import duties were reduced as stipulated. A price mechanism was established for rice, corn, and sorghum. And in March 1992 all restrictions on the importation of food grains were abolished. H. MACROECONOMIC RESULTS AND ASSESSMENT OF THE ERC 35. The Government of Nicaragua was extremely optimistic that the economic recovery program would succeed in attaining a real growth rate of about 10 percent in GDP. IDA was much more cautious; it expected a positive real growth rate, but at a modest amount reaching 4 percent by 1993. Even IDA's modest projections did not materialize. GDP declined by 0.4 percent in 1991 as opposed to the projected growth rate of 1.0 percent. It increased by a mere 0.8 percent in 1992 as opposed to the projected rate of 3.0 percent. Currently, the growth rate is estimated at a decline of 0.7 percent in 1993.1 The national accounts statistics do not include the informal sector. The growth in GDP may, therefore, be underestimated given the informal sector's rather rapid annual rate of growth (40 percent during 1990- 1993).2 The estimates regarding the size of the informal sector vary; but the consensus is that it represents no less than 30 percent of the economy. Part of the reasons for the phenomenal growth of the informal sector may be attributed to the layoff of public employees, part of whom have moved into the sector, and the attractiveness of contraband imports under the lax border controls. 36. The resource balance/GDP ratio3 has also worsened. While the original figures were -25.2, - 22.7, and -21.6 percent for the three years in question, the revised figures reveal somewhat larger negative figures of -29.9, -31.9, and -23.0 percent, respectively. 37. Although gross domestic investment was stable around 19 percent of GDP during 1990-1992, the I These and subsequent figures are taken from the Credit Document and the Bank's new estimates of June 1993, which give actual data for 1991, and estimated and projected figures for 1992 and 1993, respectively. 2 The national income accounting in Nicaragua leaves much to be desired, since the methodology used at present suffers from a variety of shortcomings. Therefore, the degree of confidence of the published statistics is rather low. See 'Cuentas Nacionales de Nicaragua: Evaluaci6n y Propuestas," Convenio FMI/BID, Informe sometido 14 de mayo de 1993. ' The resource balance is the difference between resources available (GDP) and resources utilized for consumption and investment. A negative balance indicates that expenditures exceed output. This is also reflected in imports exceeding exports. 10  share of private domestic investment was halved between 1990 and 1992 to about 9 percent of GDP, reflecting the deteriorating investor confidence in the economy. 38. The performance of government revenues was better than expected. The tax-to-GDP ratio was 24.6 percent in 1991 as opposed to the expected ratio of 22.6 percent. The ratio is estimated to be 27.7 percent in 1992 as opposed to the projected 23.7 percent; and the projection for 1993 is revised to rise to 28 percent as opposed to 23.9 percent. While tax revenue exceeded expectations, expenditures rose. In 1991 with the planned expenditure cuts at the time of extending the Credit the expenditure-to-GDP ratio was reduced from the expected 34.8 percent to 32.1 percent. In 1992 and 1993, however, the ratios are revised to be higher than those estimated and projected. In 1992 the ratio is estimated to be 36.6 percent rather than 32.6 percent; and in 1993 it is projected to be 36.4 percent rather than 29.3 percent. As a result the budget deficit persisted and worsened slightly. 39. Successful implementation of various aspects of the fiscal program were linked to the timely availability of technical assistance. The technical assistance program to improve tax administration, financed by IDB, to the order of US$ 2.5 million, did not in fact start until November 1992. It was inflicted with several problems. For one, to assign the right counterparts to the international experts was and still continues to be a difficulty for the "Direcci6n General de Tributaci6n" (General Tax Directorate). The provision of hardware and software took longer than programmed. Secondly, the planned training was also slow in starting and did not begin until recently. Thirdly, the operations of the Large Taxpayer Unit were confined to Managua and were extended to two additional "departamentos" only recently. The efforts to improve tax administration were further fortified by three IMF missions. The July 1992 mission provided technical input to design the strategy for an administrative reform. The December 1992 mission helped the administration with informatic requirements, and the July 1993 mission dealt with problems of control and auditing. It is evident, therefore, that any increase in Government revenues from improvements in tax administration cannot be expected earlier than 1994/95. Customs continue to be problematic as well. The design of the training program was a second tranche release condition. However, the implementation of the program is yet to start. At present too much is left to the discretion of untrained customs officials; also clear customs rules and regulations are absent. Discretion breeds mismanagement and loss of revenue. Also, not all exemptions have as yet been eliminated. Aware of the need to modernize the customs, the Government recently secured a loan of US$ 14 million from CABEI (Central American Bank for Economic Integration) to overhaul the customs administration and its procedures. Again, any improvements resulting from this program cannot be reflected in higher revenues any earlier than 1995/96. 40. While exports stagnated, imports increased much faster than expected. The export-to-GDP ratio declined while the import-to-GDP ratio continues to hover around 50 percent. This was particularly due to the stable real exchange rate resulting from foreign aid inflows combined with a tightened monetary policy. These measures prevented a major run on the Cordoba, but led to the deterioration of export incentives. The overvaluation of the Cordoba was only partly corrected early in 1993 when it was devalued by only 20 percent (despite IMF's higher recommendation), because the Government of Nicaragua considered that a higher devaluation would have entailed an adjustment in public sector salaries, which the Government could ill afford, and an inflationary impact which, politically, the Government was not willing to face. The 20 percent devaluation was not sufficient to stimulate the exports. At the same time the terms of trade worsened in contrast to their projected stability at the time of Board Approval. World prices for all export products fell, except for shrimp and lobster. Also production and yields declined reflecting a loss of competitiveness. The most important reason in the decline of production and yields occurred in cotton. During the Sandinista regime cotton was the most 11  important export commodity. However, its cultivation was maintained by heavily subsidized fertilizer prices and indiscriminate use of pesticide. When the present Government eliminated the subsidy on fertilizers, cotton stopped being an attractive export crop for the private sector. Moreover, to remedy the ecological damage to the soil caused by the indiscriminate use of pesticides became an expensive proposition for the private sector. Coupled with the decline in cotton prices in the world market, cotton exports became totally uncompetitive. 41. The Government maintained a tight monetary policy. The trauma caused by the hyperinflation of the previous years and possible political repercussions that inflationary pressures may generate were phenomena that the Government could not afford. The tight monetary policy targeted especially the reduction of the large Central Government budget deficit and the control of the state banks' credit to the private and public sectors. During implementation a tight rein was maintained on domestic credit and money supply. 42. After the release of the second tranche there was some policy backsliding. Even though there was an ongoing policy dialogue with the Government, IDA did not have an active instrument to deal with the issue. First of all, in February 1993 stamp duties on certain items were raised from 3 to 5 percent which, in turn, caused the nominal import duties on certain items to rise from 40 to 45 percent. Secondly, the Superintendency of Banks does not function properly and the restructuring of state banks is yet to be carried out. At the time of release of the second tranche (June 1992) the two state banks continued to dominate the financial sector holding 86 percent of total loans and 72 percent of total deposits. The situation is basically unchanged. This stems from two reasons. One is a constitutional impasse arising from the constitution's provision that the financial system belongs solely to the state. The legal boundaries between the constitution and the existing banking law, which allows private banks, were to be delineated by the Superintendency. This has not yet been done; the Superintendency still lacks complete autonomy as well as well-trained and qualified personnel. The second reason is the Government's conviction that state banks are necessary since they mostly lend to small rural borrowers. This is contradicted by the fact that small rural producers and micro enterprises are served mostly by informal credit markets, as stated by several bankers, with the state banks reaching only a fraction of the intended beneficiaries. The Superintendency at present is not an independent entity, and hence its actions are not free from political considerations and pressures. Nor does it have sufficient instrumentalities, human resources, informatics to carry out its functions properly. In short, the serious reduction of the state's role in the financial sector is yet to be achieved. Finally, although CORNAP has gone beyond ERC's targets in privatization, part of this success consisted of the quick devolution of the confiscated medium and small enterprises to the rightful owners. The larger enterprises, such as public utilities which were not under CORNAP's supervision, are yet to be privatized, and so are some large agricultural enterprises, because the property rights issue has not been solved. 43. As can be gauged from the previous analysis, Nicaragua has yet to experience a major economic recovery. The legitimate question, therefore, is whether the ERC failed in its objectives or whether other circumstances impeded the originally foreseen recovery. Before answering the question regarding the ERC's role in the economic recovery, it should be pointed out that in Nicaragua five factors, among others, have played a prominent role in preventing the economic recovery from taking off. These are (i) the political instability that continues to reign in the country; (ii) the slow process in solving the property rights issues; (iii) the slow response of public sector institutions to the program; in consequence (iv) the hesitation and slow response of the private sector to engage in productive activities; and (v) the obsolete machinery and equipment imported from various socialist countries incompatible with each other, and the dire shortage of spare parts. 12  44. The high risk of doing business in Nicaragua did not, and could not be expected to, diminish substantially. As anticipated by the IDA, the main barrier to private sector development was the fragile political environment. The delicate balance worked out between the Sandinistas and the Chamorro Government (leaving the control of the army and the police force in the hands of Sandinistas) eventually became a source of friction. The National Assembly became inoperative in late 1992. The political climate worsened in 1993 with incidents of hostage taking in August. In addition, economic policy management continued to rely on excessive discretion which spread the fear that in the event of worsening macroeconomic conditions the Government could reverse policies. This easily becomes a self-fulfilling prophesy with increases in tax rates, import duties, etc., and impedes private sector development. Also, a variety of political factors have prevented the Government from solving once and for all the property rights issue and overhauling the judiciary system. Hence, in a climate of political uncertainty the expected private sector investments that could have contributed to economic growth did not take place. The delicate political balance still continues. 45. The managerial capabilities of the Government of Nicaragua are limited. It is doubtful whether the managerial requirements of the economic recovery program are fully understood and fulfilled by all public sector managers. After 10 years of managing the economy by command, it was overoptimistic to expect a drastic change in the organizations, established habits, and ingrained inflexibilities in the institutional set up in only a short period of two years. The mid-level public management cadre is yet to be developed and the expected influx of human capital has yet to take place.4 46. In addition, the public sector is still oversized and the expenditures have not yet been sufficiently reduced. The Government continues to be involved in activities that are normally performed by the private sector, such as banking, and hence crowds it out from areas in which it should be engaged. 47. Finally, natural disasters, namely the eruption of the Cerro Negro volcano in April 1992 and tidal waves in the Pacific Coast in September 1992 have had considerable negative impacts on the economy. Agricultural production, forestry, fishing, and tourism were seriously affected. The direct damage is estimated to amount to US$ 25 million. The direct and indirect impact combined was estimated to be 0.5 percent of GDP of that year. 48. These developments should not be taken as a criticism of either the conception or implementation of the ERC. It would be inappropriate to assess the impact of a US$ 110 million credit only in quantitative terms. For, first of all, in the absence of the credit much less of the needed imports could have been financed and Nicaragua would have no access to international credits. Secondly, IDA played a very important catalytic role in mobilizing co-financing from bilateral assistance. Thirdly, IDA assisted the Government to articulate and take or initiate the right policies and drove the Government in the direction of opening the economy to the private sector. Finally, IDA directly or indirectly led to the provision of technical assistance by bilateral and multilateral ageilcies. ' A USAID project (implemented from June 1990 to December 1992) had the purpose of providing technical advisors to the ministries to enhance their capabilities and train counterparts. In total 33 advisors were funded by the project about half of whom were Nicaraguans residing abroad. At the end of the project none stayed with the public sector, simply because the public sector could ill afford the salary scales paid by USAID. Many went back, and due to lack of counterparts very little training took place. The expected reverse brain drain did not take place; this could not be otherwise without changing the overall working conditions in the country and establishing a lasting stability. 13  49. The Bank itself conducted two important studies in support of institutional strengthening and better economic management of the public sector. "Public Expenditure Review" (Report No. 10785-NI, September 11, 1992) aimed at assisting the Government of Nicaragua to improve the allocation of public resources and strengthen the institutions involved in financial management and project implementation. Another study "Deregulation of Public Utilities and Natural Resources" (June 1993) examined the structure of these sub-sectors, highlighted the features that generate bottlenecks for growth, and made recommendations for a market-oriented growth strategy and for the improvement of their management. 50. Other assistance agencies also extended support to the new Government. To help implement the ERC, IDB financed technical assistance to the Ministry of Finance (US$ 2.5 million) and IMF provided direct technical assistance to improve the tax administration. UNDP, within the fifth cycle of its five-year country program of US$ 39 million, fielded several technical assistance missions aimed at public sector institutional strengthening. External cooperation, privatization, macroeconomic policy-making have been some of the attention areas for the UNDP. In addition, UNDP also extended technical assistance for sectoral development. USAID's technical assistance was also spread over a number of areas. One consisted of providing various ministries, for at least one year, with high level experts (mostly Nicaraguans living abroad). In addition, the project also aimed to reverse the brain drain. USAID also provided twelve short-term technical assistance between December 1991 and mid-1993 to various ministries for institutional strengthening and macroeconomic policy formulation. This assistance amounted to about US$ 2 million. USAID will implement in early 1994 another technical assistance of US$ 8 million over the next five years, directed to the provision of assistance to the Economic Cabinet. 51. The major technical assistance programs summarized above do not constitute a complete inventory of assistance extended to Nicaragua, but highlight the major ones. It is important to note that these programs were not well coordinated. The responsible entity for aid coordination in the Government is the Ministry of External Cooperation. This Ministry was not fully effective in coordinating external assistance, nor did it have the capacity for priority setting. As a result the totality of technical assistance is yet to yield optimal results. The diffused and uncoordinated technical assistance tends to result in conflicting opinions and confusion in the Government. The need to coordinate technical assistance became apparent at the time when ERC was being prepared. Initially, IDA was not prepared to undertake the coordination of technical assistance; nor did the Government make a formal request to that effect. As the necessity of coordination became apparent as an essential component of overall assistance, IDA indicated its willingness to assume such a responsibility. But there was no consensus within the Government as to which international agency should be responsible for it, nor which government entity should be the counterpart organization. UNDP was also reluctant to support IDA's leadership on the matter. Hence, no coordination took place and each agency began to provide assistance as it saw fit. On the Government's side the Ministry of External Cooperation remained ineffective as an aid coordination organization. With respect to external resource transfers, IDA, however, did succeed in coordinating the efforts of several donor agencies to put together a financial assistance package which helped clear the arrears. I. SUSTAINABILITY 52. All the expected results of the reform and restructuring initiated with the support of the ERC are yet to become apparent. Nicaragua continues to depend on external assistance and the extent and likely reduction in donor support are disconcerting. While imports surged, exports at best stagnated and investment did not take place in sufficient magnitudes to bring about economic growth and allow 14  adjustment to occur. Given the uncertain political conditions and yet to be resolved property rights issues, the private sector is hesitant to respond to the Government's reform and restructuring efforts. Unless political stability begins to reign and property rights issues are resolved, the originally perceived reform and restructuring will lack one of the most essential element for their successful implementation and whatever meager achievements attained thus far are likely to dissipate in the future. 53. Sustainability is also dubious because of the weakness of the overall administrative capacity of the central and local governments. The weakness partly stems from the excessive number of civil servants and the budget constraint that impedes their better remuneration, which in turn hampers efforts to improve public management. Failure to improve public management leads to waste and inefficient administration and prevents in turn concerted efforts to improve public management. Unless the budget, current and investment, is trimmed and unless a concerted effort is undertaken to improve public management with better remunerated civil servants, Nicaragua will continue to depend on technical assistance and the economic reform will be extremely slow in taking off. 54. The current expenditures of the Central Government need to be reduced further. The "Public Sector Expenditure Review" conducted by the Bank suggested that the number of the civil servants be streamlined so that salaried of the professionals can be adjusted. However, expenditures on goods and services, and for defense spending also need trimming. It is yet to be seen whether the Government can tackle these issues in a proper and timely manner. The reduction of defense expenditures alone will in all probability not suffice. Moreover, public investment program was much too large for the Government's imnplementation capacity. The need continues to lie in mastering the techniques of prioritizing public investment projects. 55. Finally, Nicaragua needs to realize that foreign aid may not be forthcoming as abundantly in the future as it did in the past. Yet, it is highly dependent on foreign aid. For example, the temporary stoppage in 1992 of US$ 104 million (equivalent to 7 percent of GDP) of the US$ 450 million United States direct support aggravated the resource problem and put the stabilization program off-track. When the aid was subsequently restored, it did solve the short-term liquidity problem. The incident revealed the fragility of the stabilization effort and the high dependence on foreign aid. If sufficient foreign aid does not come forth in subsequent years and if an institutionalized aid coordination effort is not made within the Government to allocate such aid efficiently in full accordance with the restructuring efforts, the gains made so far are likely to be lost. 56. Nicaragua needs to accelerate its structural transformation and move rapidly towards an export- oriented market-based economy with a much smaller but more efficient public sector. The public sector is still oversized and inefficient, crowding out the private sector and generating waste. Central Government expenditures still command the highest share of GDP in Central America. The Government has spread its limited managerial capabilities too thinly and its specialized human capital skills in too many activities. The sustainability is challenged unless public sector functions efficiently and stops crowding out the private sector. 57. Nicaragua still continues to depend on financial and technical assistance. If such assistance were not to come forth, and if the ERC is not followed by another Economic recovery credit from IDA, the sustainability of the policies of the Government and the limited results achieved so far will certainly remain in doubt. 15  J. LESSONS LEARNED 58. Several lessons emerge from the Bank's experience. First, when the countries' credit needs are inextricably related to transforming rather than reforming their economies, a longer term vision is necessary. In an economy where institutions are being overhauled and new organizations are being created, the "adjustment" necessarily takes much longer time than in market-oriented economies. Nicaragua is a case of the former type. In retrospect, the expectations for the degree of change under the ERC within a relatively short period of time have proven to be optimistic. 59. Second, concomitantly with structural adjustment, long run development problems must also be tackled. From the outset IDA conceived the ERC only as a first step in a medium-term adjustment process. But long-term adjustment and transformation of the economy was not detailed in a comprehensive and consistent fashion. Nor was there any demonstrable willingness or ability from the part of the Government to follow up such a long-term adjustment process at the time of the ERC design. Once, for example, the political and economic problems became persistent and the Government was unable to come to an agreement with IMF on ESAF (Extended Structural Adjustment Facility), IDA was unable to follow up the first operation with subsequent credit operations for a long time. It is only recently that the Government was able to commit itself to the preparation of an ERC II operation. When the structural adjustment in fact is part of the transformation process of the country, the time horizon of the lending needs to be much longer. At the same time, each ERC should be self-contained, without leaving the completion of actions to other operations. 60. The third lesson that emerges is that much better donor technical assistance coordination is a sine qua non. IDA should have insisted on an effective aid coordination. (he proposed ERC II operation is being supported by a Technical Assistance Credit that will address the key institutional weakness in the public sector.) that would set the priorities and be an integral and effective part of the Economic Cabinet. A proper functioning of aid coordination might have been one of the tranche release conditions. At present the Nicaraguan institutional weakness for the formulation and execution of integral technical assistance policies creates a situation in which each donor, agency, or organism with its respective national counterparts has no choice but to act in a separate and autonomous manner to achieve sectorial goals that in many cases do not complement each other or are even sometimes plainly contradictory. There is an urgent need to formulate integral policies for a rapid transition to market economy and concomitantly the technical assistance required. If this is not done, the tardy implementation of these policies could imply the undoing or substantial modification of policies already in execution with subsequent delays and risks. 61. The fourth lesson is that the extent of technical assistance needs to be estimated correctly. In Nicaragua the width and the depth of technical assistance was underestimated. At a time when the country was just beginning to transform from a command to a market-based economy, political complications and administrative capacities were underestimated. The political stability was assumed to settle in rapidly; this was not the case and had negative repercussions on reform and adjustment. In addition, one of the essential elements of the assistance package should have been a well-conceived and well-designed longer- term package directed to the improvement of the economic management capabilities of the public sector, including a strong training component. Instead the practice, in more cases than not, consisted of the temporary utilization of technical assistance experts in the role of civil servants. 16  PART II. PROGRAM REVIEW FROM THE BORROWER'S PERSPECTIVE This review was prepared by the Government of Nicaragua, upon request of the World Bank, as part of the Project Completion Report on the Economic Recovery Credit to the Republic of Nicaragua (Credit 2302-NIC). A. THE BORROWER'S ERC REVIEW The assessment of program implementation in Part I confirms that the ERC's first and second tranche release conditions were met on schedule by the Borrower. The analysis in Part I also documents that the program did not fully achieve its hoped-for impact: the program succeeded in eliminating hyperinflation and stopping the decline in output, but so far has not succeeded in reviving economic growth as has been projected for 1992 and 1993. While implementing free markets and uprooting private sector constraints were the essential focus of structural reforms supported by the ERC, the key issue is whether these adjustments were enough to produce sustained growth in the case of Nicaragua. The question whether the ERC objectives were too ambitious is a legitimate one. Government's responsibility for the program outcome has to be recognized. Nonetheless, the more basic question of means-to-ends adequacy has to be fully taken into account for future ERCs. Part I mentions a few instances of policy "backsliding" (with respect to tariff reductions, tax increases and downsizing of the state banks) after the last tranche of ERC was released. However, the Government of Nicaragua does not consider these to have been very significant, neither in terms of constituting major policy reversals nor in explaining the lack of growth response. Rather, the main factors that prevented the hoped-for revival of growth included three successive years of unusually bad weather conditions, international commodity price declines, interruptions in aid flows from bilateral donors, and a fragile political situation that prevented a quicker resolution of property conflicts in rural and urban areas. These factors, in turn, also generated uncertainties among private investors that resulted in a slower response that initially projected to the reforms made. The Government believes that, in spite of these adverse circumstances, the policy reform process has been maintained substantially on the course envisaged when the program was adopted. This first experience of Nicaragua with an ERC confirms that greater economic efficiency is an indispensable, although insufficient condition for sustained growth. In sum, a more balanced approach to the Nicaraguan adjustment was required that should have provided for reform policies to drive private investment and improve the relative price structure in behalf of the Nicaraguan tradeables and exports. In view of the program results, as documented in Part I, we consider that the reform measures taken so far were necessary for providing a better basis than existed before for achieving faster and sustained growth, but have not been sufficient to ensure that such growth materializes. B. THE BORROWER'S PERFORMANCE The Government of Nicaragua demonstrated a strong commitment to its reform program, as evidenced by its fulfillment of the ERC disbursement conditions, in spite of severe political and external constraints. Progress in implementing the structural adjustment measures came about at high political 17  cost for the Government, to the extent of putting at risk its continuation in power on several occasions. The maintenance of a fragile political balance has been fundamental in determining the Government's ability to function effectively, including its ability to maintain public security. The need to sustain this political balance revealed itself as equally important for purposes of reaching fundamental program objectives as maintaining economic balances in order. A major lesson learned during the implementation of the ERC supported program is that the advancement of reforms demands a supportive political environmental and a firm national consensus on the future socio-economic development of the country. C. IDA'S PERFORMANCE The Government of Nicaragua wishes to use this opportunity to express its high praise for the World Bank in making this first ERC for Nicaragua possible. The Bank played a very valuable role in the preparatory stages of the program. With its help, Nicaragua was able to normalize its relations with the international financial community and develop a policy framework for designing and implementing its adjustment program. The ERC itself provided necessary financial report to the Government's effort since March, 1991 in sustaining macroeconomic stability and in facilitating the reform measures designed to create a more market-based and private sector oriented economy. An undisputed achievement of the ERC was the mobilization of sufficient foreign financial assistance to render the Government's stabilization program successful. This made a key difference compared to previous adjustment attempts in Nicaragua. D. RELATIONSHIP BETWEEN IDA AND BORROWER The Bank's missions during the ERC's preparatory stage were effective and timely in helping the Government prepare its structural adjustment program. The cooperation between the Bank's and Government's staff was fluid and fruitful during the course of ERC preparation and implementation. Furthermore, the Bank opened a resident mission in January 1992, which reinforced relationships with the Government in policy dialogue, the ERC implementation and technical assistance. The ERC funds were disbursed in a timely manner, based on the compliance by the Central Bank of Nicaragua with the ERC procurement, disbursement and auditing guidelines. E. RELATIONSHIP BETWEEN CO-FINANCIERS AND THE BORROWER Disbursement of ERC co-financing commitments by the official agencies of Germany, Japan, and Switzerland proceeded in an agile and expedite manner. F. ADEQUACY AND ACCURACY OF FACTUAL INFORMATION IN PART m The description of the program elements, and the timing of Bank's missions and disbursements, conform with the Government's figures and information base. 18  PART III. STATISTICAL INFORMATION A. PROJECT TIMETABLE Core Steps Orieinal Plan Revised Plan Init. Memo 01/10/91 01/10/91 Prep. mission 01/15/91 01/15/91 FEPS/IM-OC 05/13/91 05/13/91 Depart appr. 06/06/91 06/06/91 Yellow cover 07/05/91 07/05/91 Docs to RVP 07/11/91 07/11/91 Start neg. 07/23/91 07/23/91 Board approv. 09/26/91 09/26/91 Signing date 12/31/91 12/31/91 Credit closing 06/30/92 06/30/92 PCR complet. 12/15/93 03/31/94 B. CUMULATIVE LOAN DISBURSEMENTS (US $ million) 1991 1992 Appraisal estimate 110 - Actual 55 55 Actual as % of estimate 50 100 Date of final disbursement June 1992 C. STAFF INPUTS (staff weeks) 1M1 1992 1993 LENA 11.5 11.2 LENP 86.3 LENN 25.0 SPN 44.9 1.0 PCR 10.0 Total 9. 81.1 11.0 19  D. MISSION DATA LQI # of Staff Month/Year Weeks Persons Weeks Preparation January 1991 2 7 14 Pre-appraisal April 1991 2 12 24 Appraisal June 1991 2 5 10 Negotiation July 1991 (no mission) Supervision Dec. 1991 2 1 2 Supervision Feb. 1992 2 3 6 Supervision April 1992 1 3 3 Supervision May 1992 1 1 1 Supervision June 1992 2 2 4 20  ANNEX. MATRIX OF ACTIONS 21  I  Annex Matrix of Actions Page 1 of 9 Issues and Objectives Actions Adopted Actions to be Adopted Before Negotiations Before Board Presentation Before Second Tranche Macroeconomic Policies A stabilization prograrn has Maintenance of an Maintenance of a and Program Inplementation been initiated: Cordoba was appropriate macroeconomic macroeconomic policy evaluated by 400 percent. framework, including fiscal framework consistent with the Achieve and maintain a deficit and domestic credit objectives of the program. macroeconomic policy Expenditures targeted in line ceilings consistent with framework consistent with the with expected revenue. stabilization objectives Satisfactory progress achieved objectives of price stability, (Board Presentation by the Borrower in the carrying trade and exchange rate Adopted cash-budgeting Condition. of the Program. liberalization, and balance of procedures for expenditures. payments equilibrium. Maintenance of exchange Monthly credit ceilings for rate policy which is Central Bank credits consistent with export established. competitiveness, and which reflects changes in monetary, balance of payments, and trade and foreign exchange reserve indicators. Satisfactory progress implementation (Board Presentation Condition). 23  Annex Matrix of Actions Page 2 of 9 Issues and Objectives Actions Adopted Actions to be Adopted Before Negotiations Before Board Presentation Before Second Tranche * Public Expenditures Large size of public sector Budgetary expenditures for Reduction of Central (a) The Budget for Fiscal Year with high total FY91 have been restrained, Govermnent non-interest 1992 has been adopted; expenditures/GDP ratio and including a significant current expenditures in the current expenditure/GDP ratio. reduction in military proposed FY92 budget to (b) an action plan for the expenditures. less than US$325 million carrying out of the equivalent (Board recommendations of the study on Presentation Condition). public expenditures carried out by the Borrower has been presented to the Association. Weak institutional capacity to plan and monitor public expenditures. 24  Annex Matrix of Actions Page 3 of 9 Issues and Objectives Actions Adopted Actions to be Adopted Before Negotiations Before Board Presentation Before Second Tranche Public Sector Employment Excessive public sector Government demobilization of employment and large wage 35,000 military draftees and bill. militia and retiring of 5,000 military officers. Resource public sector work force and facilitate reallocation Institution of a hiring freeze of redundant labor to in Central Government. productive employment in the private sector, especially in tradeables. Introduction of an externally Completion of the processing funded 'employment of voluntary employment reconversion program to reduction in the public sector relocate 9,000 of 69,000 for 8,000 personnel (Board central government Presentation condition). employees, including an additional 3,000 military personnel during 1991. Preparation of an action plan Satisfactory progress in to extend employment implementing the action plans reconversion program to the for employment reconversion entire public sector with a program. target of 10,000 employees including CORNAP, public utilities, and the banking sector. 25  Annex Matrix of Actions Page 4 of 9 Issues and Objectives Actions Adopted Actions to be Adopted Before Negotiations Before Board Presentation Before Second Tranche * Public Utilities Major restructuring of public Elimination of indiscriminate Initiation of a study with IDA utilities is needed to improve price subsidies for the goods support, on Public Enterprise efficiency in their operations and services supplied by most rationalization. and responsiveness to the state enterprises. demands of a growing and competitive economy. Creation of an informal oversight central government committee for public utilities. 26  Annex Matrix of Actions Page 5 of 9 Issues and Objectives Actions Adopted Actions to be Adopted Before Negotiations Before Board Presentation Before Second Tranche Privatization Major reduction of the size of Established CORNAP and Adopt an action plan, (d) The privatization of at least state enterprise sector. endowed it with responsibility satisfactory to IDA, to 25 companies under the control for both managing and privatize CORNAP of the Borrower, through privatizing about 350 state enterprises (Board CORNAP, has been completed. Quick sales of state enterprises enterprises. Presentation condition). to reduce the structural deficit (e) The devolution to the of the public sector, to original owners or the encourage private sector Study completed on liquidation or the transfer to the participation, and to generate privatization strategy. private sector of at least 50 revenue. companies under the control of the Borrower, through Strategy for divestiture is CORNAP, has been completed. Clarify and guarantee private worked out. 86 companies property rights to remove have already been retumed to (f) At least 30 companies under uncertainty and foster private previous owners, liquidated or the control of the Borrower, investment and growth. privatized, including one large through CORNAP, other than group of agricultural those referred to in paragraphs enterprises -Matonic-. (d) and (e) above, have been prepared for sale to the private sector. 27  Annex Matrix of Actions Page 6 of 9 Issues and Objectives Actions Adopted Actions to be Adopted Before Negotiations Before Board Presentation Before Second Tranche Public Revenue Increase and maintain tax Tax reform measures were revenue to ensure objectives of implemented, including stabilization and non- reduction in the number of inflationary finance of brackets in personal income medium-term government tax, and reduction of top rates program. for personal and corporate income taxes. Withholding provisions were Removal of income tax Satisfactory progress in improved, and new exemptions, and approval of implementing the action plan to presumptive methods were a program to phase out phase out indirect tax introduced for both of above indirect tax exemptions exemptions. taxes. including import tax exemptions (Board (c) The following measures to Presentation Condition). strengthen tax administration have been taken: (i) the Unit in The General Value Tax base the Borrower's Internal Revenue was expanded and the rate Service (Direcci6n General de increased to 15 percent. Ineresos) in charge of large taxpayers has become Administratively granted tax operational; (ii) decrees exemptions were eliminated. imposing sanctions for non- compliance and/or late payments Simplify and strengthen tax Adoption of a plan, Initiation of an action plan, of taxes have been issued; and administration. satisfactory to IDA, to satisfactory to IDA, to (iii) programs on automated improve tax administration improve tax administration management control system, with emphasis on GVT and with specific emphasis on computerized taxpayer Income Tax Collections. GVT and income tax identification system and training collections (Board for personnel of the Borrower's Preparation of a pilot project Presentation Condition). Internal Revenue Service to register and collect taxes (Direcci6n General de Ingresos) from large tax payers. and Customs (Direcci6n General de Aduanas have been initiated. 28  Annex Matrix of Actions Page 7 of 9 Issues and Objectives Actions Adopted Actions to be Adopted Before Negotiations Before Board Presentation Before Second Tranche Financial Sector Improve the allocation of Established deposit interest Adoption of an interest rate financial resources by rates at 12 percent and policy which approximated rates rationalizing regulations on lending rates at 18 percent to market rates, by setting up a banking activities and by and tied both to dollar. band for lending rates and strengthening instruments of freeing the deposit interest rates. monetary control. Introduced a monthly deposit rate for non-indexed deposits. Improve the efficiency of Assembly approved a bill for Adoption of regulations, Preparation of transitory financial intermediation setting up a Superintendency. satisfactory to IDA, for the normatives to establish necessary through the development of a implementation of the prudential regulations. profit oriented, private sector Superintendency law. based financial system. Appointment of a superintendent and start-up (g) BI has been eliminated or of Superintendency activities merged with BNIC. (Board Presentation Condition). (h) CORFIN has been dissolved. Adoption of an action (i) Progress has been achieved in program, satisfactory to the carrying out of the action IDA, for the restructuring of plan, agreed with the state-owned banks, along Association, for the restructuring with cessation of Central of BNIC, BND and BP. Bank subsidies and discounts except for agriculture and (j) A bill or bills of law micro enterprises (Board regulations the functions and Presentation Condition). activities of the banks and other similar financial institutions Preparation of terms of operating in the territory of the reference for developing and Borrower has been presented to implementing the new Law the Borrower's National for Banking and Financial Assembly. Institutions which identifies a term, a technical assistance (k) At least 2 licenses allowing financing source, and a private banks to operate in the timetable. territory of the Borrower have been issued. 29  Annex Matrix of Actions Page 8 of 9 Issues and Objectives Actions Adopted Actions to be Adopted Before Negotiations Before Board Presentation Before Second Tranche Trade Regime Increase output and Trade Deregulation Decree Consolidate the legal framework diversification of tradables by opens import and export trade to ensure permanence of increasing private sector to the private sector. minimum government participation in trade. intervention in foreign trade. After the devaluation of the Allow full foreign exchange Cordoba, foreign exchange retention for exporters under Achieve full current account allocation mechanisms were an Export Promotion Decree. convertibility of the Cordoba. significantly liberalized, eliminating ministerial and Central Bank permits for importers, and giving de-facto full access to foreign exchange to exporters (except cotton and coffee exporters). Move to a more uniform, Reduction in the dispersion Lowering nominal protection (1) The protection resulting from transparent, and lower nominal and average 'basic" tariff in trade sector to a range of combined tariffs and taxes that protection structure. rates. 10%-60% through a apply to imports in Nicaragua combination of reductions in has been reduced to a minimum Elimination of selective the levels of tariffs, SCT, of 10 percent and a maximum of consumption tax on a number and stamp tax; and 40 percent, except with respect of imports. announcement of a target to medicines, books and tariff range of 10%-20% and newsprint which may be exempt Conclusion of a free elimination of SCT and from such tariffs and taxes or agreement with Mexico to stamp tax by 1993; and subject to tariffs and taxes at a become fully operational by approval of arrangements for combined rate lower than the 1996. automatic registration for minimum rate referred to above. imports and exports (Board Presentation Condition). Develop action plan to Satisfactory progress in the provide free trade status, implementation of the action i.e., exemption of tariffs and plan for giving free trade status indirect taxes, for exporters. to exporters. Design a price-based (m) The quotas on the mechanism with variable importation of rice, yellow corn levies for rice, yellow corn and white maize have been and white maize (Board abolished and a mechanism for Presentation Condition). the importation of such commodities, based on price with variable levies, has been established. (n) All restrictions on the importation of food grains other than those referred to in (m) above have been abolished. 30  Annex Matrix of Actions Page 9 of 9 Issues and Objectives Actions Adopted Actions to be Adopted Before Negotiations Before Board Presentation Before Second Tranche Deregulation Curb and eventually minimize Elimination of most domestic Abrogation of the legal static and dynamic welfare price controls other than those framework permitting price losses occasioned by pervasive of public utilities and the controls, except for natural state intervention. fiscal industries. monopolies. Removal of transitory price setting adopted for selected products in government-owned stores. Abrogation of legal export Present an action plan, monopolies for several satisfactory to IDA, to remove products by allowing private price controls of the fiscal sector access to export industries and to reformulate the licenses. ISC extending it to luxury goods. Elimination of barriers to entry to natural resource exploitation by transferring licensing regulations from Implementation of the study's state enterprises to the findings on a regulatory Ministry of Economy. framework for the management Prepare terms of reference of natural resources. for studies on the regulatory framework of natural resources. Disallow ENABAS to trade in all but basic grains. Elimination of support prices Present a program for for basic grains. ENABAS privatizing ENABAS retail and to begin offering services wholesale outlets, such that at (storage, bundling import least 20% of its corresponding orders) and to rent facilities assets will be sold to private to private entrepreneurs. parties or to laborers by March 1992 and the remainder will be divested by the end of 1992. Present an action plan to redefine the future role of ENA3AS. 3 1    i,~~ ~ ~~~~ ' l i . . 7 N iLl , -~ ~ - I