Turkmenistan - Country assistance strategy

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 21530 TM MEMORANDUM OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ONA COUNTRY ASSISTANCE STRATEGY FOR TURKMENISTAN December 22, 2000 Central Asia Country Unit Europe and Central Asia Region This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS (as of November 1, 2000) Currency Unit = Manats US$1 = 5,200 Manats (official rate) US$1 = 19,000 Manats (black market rate) WEIGHTS AND MEASURES Metric System ACRONYMS AND ABBREVIATIONS ASBP Aral Sea Basin Program CAS Country Assistance Strategy CBT Central Bank of Turkmenistan CIS Commonwealth of Independent States DSR Debt Service Ratio EBRD European Bank for Reconstruction and Development ECA Europe and Central Asia Region FDI Foreign Direct Investment FERF Foreign Exchange Reserve Fund GDP Gross Domestic Product IBRD International Bank for Reconstruction and Development IBTA Institution Building/Technical Assistance IDA International Development Association IDF Institutional Development Fund IFC International Finance Corporation IMF International Monetary Fund LSMS Living Standards Measurement Survey MIGA Multilateral Investment Guarantee Agency MOEF Ministry of Economics and Finance NEAP National Environmental Action Plan NGO Non Governmental Organization PER Public Expenditure Review SAFI State Agency for Foreign Investment TACIS Technical Assistance to the Commonwealth of Independent States USEXIM United States Export Import Bank UNDP United Nations Development Program UNICEF United Nations International Children's Education Fund WBI World Bank Institute TURKMENISTAN's FISCAL YEAR January 1 - December 31 Vice President: Johannes F. Linn Director: Kiyoshi Kodera IFC Director: Khosrow Zamani CAS Team Leader Tony Cholst CAS Team Members Guijahan Kurbanova Chandra Pant Michael Mills Gerhard Botha Mark Lundell Andriy Storozhuk Gorton De Mond, IFC Jim Anderson, IFC Jens Wandel, UNDP  FOR OFFICIAL USE ONLY TURKMENISTAN COUNTRY ASSISTANCE STRATEGY TABLE OF CONTENTS EXECUTIVE SUMMARY ........................................ . i-iii I. INTRODUCTION .........................................1 II. POLITICAL AND ECONOMIC ENVIRONMENT .........................................,.1 A. Political Developments and Prospects .........................................1 B. Economic Developments .........................................I C. Near and Medium Term Economic Prospects .........................................2 D. The Government's 10 Year National Program .........................................4 E. Global and Regional Linkages .....6...................................6 III. KEY DEVELOPMENT CHALLENGES ...... ...................................7 A. The Foundation: Improving Living Standards in Turkmenistan ................................................7 B. Strengthening Public Resource Management .................... ..................................9 C. Improving Health and Social Services ...................................................... 13 D. Developing an Efficient Rural Economy ...................................................... 15 E. Supporting Private Sector Development ...................................................... 16 F. Protecting The Environment and Conserving Water ................................................ ...... 18 IV. WORLD BANK STRATEGY ...................................................... 18 A. Lessons Learned from Past Bank Experience ...................................................... 18 B. Bank Program for FYO1-03 ...................................................... 20 C. IFC Program ...................................................... 25 D. Other Bank Group Activities ...................................................... 26 E. Partnerships with other Donors ...................................................... 27 F. Program Performance Indicators ...................................................... 27 V. MANAGING RISKS AND UNCERTAINTIES ...................................................... 28 VI. CONCLUDING REMARKS ...................................................... 30 LIST OF TABLES AND CHARTS Table 1: Key Economic Statistics ......................................................2 Chart 1: Turkmenistan: Projected Economic Growth and Sources of Growth ...............................................3 Chart 2: Distribution of Consumption in Turkmenistan ......................................................7 Table 2: Comparative Health Indicators .....................................................8 Table 3: Proposed Turkmenistan Country Program: FYO1-03 ..................................................... 22 Table 4: Selected Performance Indicators ..................................................... 28 LIST OF BOXES Box 1: Longer Term Governance Issues ..................................................... 13 Box 2: Proposed National Economic Forum ............................................. 20 Box 3: Budget and Debt Management Triggers for New Lending .................... ......................... 23 Box 4: Proposed Base Case Loans ............................................. 24 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not be otherwise disclosed without World Bank authorization.  ANNEXES Annex 1: Letter from the Government on the CAS .................................................. 31 Annex 2: Status of Projects Under Execution .................................................. 34 Annex 3: Round-Table Discussions with NGOs and the Private Sector .................................................. 35 Annex 4: Key Reforms for Lending Beyond the Base Case ................. ................................. 38 Annex 5: Turkmenistan's Growing Knowledge Base .................................................. 42 CAS TABLES Table A2: Turkmenistan at a Glance .43 Table B2: Selected Indicators of Bank Portfolio Performance and Management .45 Table B3: Bank Group Program Summary .46 IFC and MIGA Program Summary Table B4: Summary of Non-Lending Services .......................... 47 Table B5: Turkmenistan Social Indicators .48 Table B6: Key Economic Indicators .49 Table B7: Key Exposure Indicators .51 Table B8: Operations Portfolio .52 Table B9: CAS Program Matrix .53 Table B 10: CAS Summary of Development Priorities ....................................... 56  TURKMENISTAN COUNTRY ASSISTANCE STRATEGY Executive Summary i. Since independence in 1991, Turkmenistan has adopted a gradual approach to the transition to a market economy, so as to improve the living standards of its people. Extensive consultations with the Government, civil society and the private sector during the preparation of the Bank's Country Assistance Strategy (CAS) indicate that the prospects for a fundamental change in this policy stance during the next few years remain uncertain. Against this background, the Government and the Bank have agreed on a CAS program for the next three years that focuses on improving the efficiency and transparency of public resource management, including poverty monitoring and the targeting of social assistance. ii. Economic Performance: Turkmenistan has had a sharp economic upswing over the past few years and continued growth in the near term is likely in light of recent gas sale agreements. However, this growth is built atop an economic structure that may be unstable in the long term -- with a large degree of state involvement, dependence on energy sales prone to fluctuation, and water-intensive agriculture. Key reform goals to create a more solid foundation to achieve sustainable growth are outlined both in the 1997 CAS and the Government's 10 year National Program for 2000-2010 - improved budget and debt management, trade and exchange rate liberalization, agricultural reform, and privatization. Yet there has been limited progress in identifying and taking near term actions to meet these goals. Public investments have been large (about 40% of GDP) and have been pursued in roads, construction, oil refining, textiles, electrification and food processing. However, most of this is financed through off-budget funds and external borrowings and does not appear to have been adequately reviewed and prioritized against economic returns, factoring in opportunity and recurrent costs and future debt service. There appears to be limited commitment to make far-reaching but necessary systemic changes in the near term. If stronger reform is not achieved, the economy is likely to face significant risk of economic disruption in coming years. iii. The Government has recently raised the possibility of moving forward on key economic issues such as liberalizing the exchange rate regime and improving public resource management - including stronger debt management, budget consolidation, and splitting the administrative and commercial activities of Ministries. The Bank agrees that these are priorities. A critical element in making these refortns work will be the more rational use of Turkmenistan's largest extra-budgetary fund, the Foreign Exchange Reserve Fund (FERF), which now serves several functions with limited transparency and unclear allocation criteria. Progress on rationalizing the FERF, including defining rational and transparent rules for a currency reserve to facilitate exchange rate management, an inter-generational savings fund to help offset future shocks, and public investments that are reviewed within the budget framework would be an important step in improving exchange rate and public resource management. iv. Living Standards: Absolute poverty in Turkmenistan appears low compared to other CIS countries, although this masks several important challenges. First, about half the population appeared to be living on less than the official minimum wage in 1998 (as measured by cash income), assisted by heavy subsidies on commodities and utilities. The Government is reluctant to eliminate subsidies out of concern that this would increase poverty. However, many of these subsidies do not target those who are worse off, they reduce incentives for conservation and maintenance of water and energy, and they create distortions in the economy. Reducing subsidies, combined with a more transparent and targeted i  approach to social assistance for the most needy, needs careful consideration. Second, Turkmenistan's health statistics were among the worst in the CIS in 1997, although official statistics show recent improvement. A number of maj or health concerns exist, including limited access to potable water and sanitation. The need for deepening health system reformn in budgeting, staff training, and the availability of essential pharmaceuticals and equipment is also high on the agenda. Third, there is a wide disparity between the living standards of those in the capital city and those in rural areas. Most of the poor live in rural areas, and the lack of income opportunities and deteriorating irrigation infrastructure pose key risks to them. v. Bank Involvement: The 1997 CAS was designed around mixed signals from Turkmenistan, with an official gradual approach to reform and indications of the potential for stronger reform, particularly in agriculture, foreign exchange management, and price liberalization. However, since then reform progress has been weak. The Bank has sought to support reform through several pieces of Economic and Sector Work (ESW), but these appear to have had little visible impact on decision making. The Bank has also struggled with portfolio implementation. All three on-going loans have experienced difficulties. During 1998-99, disbursements were suspended, due to procurement problems. The suspension was lifted in June 1999, and the Bank has resumed implementation of ongoing loans and technical assistance. However, Turkmenistan is in violation of the Negative Pledge Clause contained in its loan agreements with the Bank and has not met minimum debt reporting obligations to the Bank; and therefore it does not currently have access to new Bank borrowing. Many international institutions and donors have pulled back their activities. These include the IMF, which could not get adequate basic macroeconomic data for Article IV consultation, the EBRD, which prepared a country strategy early this year which does not contain public sector lending, and bilateral agencies, which have reduced their assistance considerably. All of this suggests the need for a more cautious and limited approach in the current CAS. vi. In light of the above, the role of the Bank over the next three years is sequenced in three phases. . Initial Phase: During the first phase the Bank will help Turkmenistan build a more solid foundation of economic capacity and transparency, from which it can launch deeper reforms when it is ready. Without this foundation, more direct efforts to strengthen the economy and improve living standards are unlikely to prove successful. To this end, the initial limited role of the Bank will be primarily to engage in policy dialogue and extend non-lending analytic support to (i) strengthen economic management capacity within the Government, (ii) increase transparency of, and access to, economic and public resource information within Turkmenistan, and (iii) improve living standards monitoring and social assistance targeting mechanisms. The Bank will also support strategy design in key national and regional issues (water, energy, environment). During this phase, on the overall issue of fiduciary accountability, the Bank will continue to stress the importance of transparent accounting and procurement procedures. Supervision of on-going projects will remain a top priority. * Second Phase: Given the loan clause violation and Turkmenistan's limited reform progress, it is likely to prove extremely difficult for the Bank to extend new lending in the near term. However, the Bank will go forward with a small 1-3 loan program over 3 years for urgent priorities if (i) the Negative Pledge Clause violation is resolved, (ii) performance of ongoing projects is improved, and (iii) progress is achieved on key budget and debt management areas, including the reform of the FERF. The envisaged lending will be on priority human needs (a health project) and disaster prevention and water management (a canal rehabilitation project). The improvement of services ii  for the rural economy (a crop protection project) would also be supported, contingent on improving farmers ability to generate income, pay for the above services, and conserve water. Longer Term Agenda: If the Government shows strong commitment to moving resolutely forward on a deeper reform agenda, the Bank will consider additional support. Such support would be considered in light of progress in, and commitment to, reforms in key policy areas and achievements in near term CAS benchmarks including improvements in living standards monitoring and targeting. In this event, a CAS update will be prepared. vii. The Board may wish to address the following issues during its discussion: * Is the proposed strategy -- focusing initially on non-lending services until the Negative Pledge Clause violation is resolved, performance of ongoing projects is improved, and progress is achieved on key public resource management areas, including the FERF -- an appropriate one? * In the event that the lending triggeis are met for a small 1-3 loan program, are the areas for new borrowings identified herein - in health, canal rehabilitation, and crop protection - the right priorities? * How can the Bank do more to move the reform agenda forward in an environment where some of the basic conditions that would support systemic reform may not be apparent? . .   MEMORANDUM OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A COUNTRY ASSISTANCE STRATEGY FOR TURKMENISTAN I. Introduction 1. This is the second Country Assistance Strategy (CAS) document of the World Bank for Turkmenistan. The first (R97-93/1) was discussed by the Board on May 27, 1997. To prepare the CAS, the Bank conducted four missions to Turkmenistan during the past year, and met with Government officials, parliamentarians, donors, NGOs and representatives from the private sector. The Government of Turkmenistan has added a letter with its comments on the CAS (Annex 1). II. Political and Economic Environment Political Developments and Prospects 2. The political landscape has not changed significantly since the previous CAS was prepared in 1997, and does not appear likely to change much over the current CAS period. The President and Prime Minister since independence in 1991, Saparmurat Niyazov, plays a dominant role in the political, economic and social life of the nation. The constitution was amended in December 1999 to permit the first President to remain in his post for life. Parliamentary elections were held in December 1999, but these were criticized by international organizations for the limited choice among candidates or parties. Official Turkmen policy recognizes the need for a gradual move towards a multi-party system. 3. Political stability through the centralization of power has a price. There are few checks and balances within the government and between the government and other institutions, a situation that can result in sub-optimal political and economic choices. Outside of the office of the President, government agencies and officials have limited authority to make key policy decisions. There is wariness of sharing information across institutional lines and with international organizations. Most importantly, policies and investment decisions which are not shaped through a participatory process are often less than optimal and lack the broad ownership to make them sustainable in the long run. 4. Turkmenistan maintains a foreign policy of "permanent neutrality" recognized by the UN, is a signatory to several UN conventions, is a member of the Economic Cooperation Organization (ECO), and is a member of the "six plus two" group seeking a resolution to the Afghan conflict. Economic Developments 5. Following independence in 1991, the economy of Turkmenistan experienced a steep decline, caused by disruption in oil and gas exports, poor harvests, and weak economic management. Between 1992-97, it is estimated that real GDP fell cumulatively by about 50 percent, comparable to that experienced by other CIS states. With the discontinuation of gas exports to Ukraine in 1997 the economy fell further, and the current account deficit rose to over 20 percent of GDP in 1997 and to  33 percent of GDP in 1998. Financing of such a sizeable external gap led to a 200 percent increase in external debt between 1996 and 1998. However, beginning in 1998 the economy started to grow, according to official statistics by 7 percent in 1998 and 17 percent in 1999, fueled in part by a recovery in agriculture output and (starting in 1999) energy exports. The prospects for 2000 continue to be bright, and GDP is projected to rise by 18 percent, powered by oil and gas I. Key Ecoinomic Statistics production (particularly a resumption in gas 19E 19 19990* sales to Russia and Ukraine). 0GblJphkat*offcia2.7' 2.8 3f3x 43 itte)23 28 33 * 6. Apart from energy sales and agricultural metch tadAlias 640 550 660 70 production, growth has also been spurred by a Real GDP growth,% -11 7 17 18 large public investment program (about 40 kfl0o 2 % 1 22 20 20 14 percent of GDP) in roads, railways, oil ttBU4t 'xpC tur 25 25 22 21 refineries, textiles, construction, electrification * fw2 25of S 22 21 and food processing. However, much of this B Dalime 0 -3 0 0 has been carried out through extra-budgetary 614 1,164DP37 funds, and the financial and economic returns MR. $ I of many of these investments do not appear to N p1an ;ise In0outa, g l0 4 have been adequately reviewed and prioritized, ma. S factoring in opportunity and recurrent costs, and E xt 1e7a22l23 2.32 future debt servicing. According to official bin. I statistics, inflation is in check and the official ran. $ 263 313 480 374 state budget is in balance.4.6 5,0 520 2G 7. While these are important achievements, ; ; X5 there is need for caution in their interpretation. Suc:Vro*~W i~aet M,G~ a~~~t~ Fist, concerns remain about the reliability of national accounts and trade price/volume data.1 Limited access to full and reliable economic and fiscal data remains a major issue. Second, the deceleration in officially recorded inflation is to some extent due to the control of prices of utilities and some commodities, as well the availability of cheap imports from its neighbors due to an overvalued exchange rate. Underlying inflationary pressures are still likely to be high, as reflected in the parallel exchange rate (which is over three times the official rate) and growing money supply. Third, the balanced state budget represents only a small subset of public revenues and expenditures, due to large extra-budgetary activities (see para. 28-31). Near and Medium Term Economic Prospects 8. Economic Projections: In the near term, the economy is likely to continue to grow significantly, even with limited policy reforms. The potential for this growth rests to a very large degree on Turkmenistan's tremendous hydro-carbon endowment 2 combined with below full utilization of currently available capacity in the gas sector. Turkmenistan's pre-independence production level of natural gas has been estimated at 80-90 bcm. The resumption of gas exports will l For example, while Turkmenistan's national accounts appear to be compiled in general accordance with international standards, significant revisions in past data are not uncommon. Also about half of gas exports is conducted in barter and agriculture production is considered by some to be overstated. 2 Turkmenistan has the fourth largest gas reserves in the world, amounting to 2-3 trillion cm in known reserves (and potential reserves are estimated to be much larger). This could allow Turkmenistan to maintain a production capacity of 100 billion cm per year for the next 20-30 years. 2  raise Turkmenistan's gas production to about 45 bcm in 2000, and Turkmenistan has recently agreed to increase production levels further. Specifically, it has agreed to increase its supply of gas to Ukraine from 5 bcm in 2000 to 30 bcm in 2001 and is negotiating an agreement to supply Russia with 30-40 bcm in 2001 (up from 20-30 bcm in 2000). This, combined with smaller but rising levels of gas exports to Iran and domestic use, will enable it to reach full utilization of existing capacity over the CAS period, with most of the production growth taking place in 2001. Earnings related to Turkmen gas are more dependent on negotiations as regards supply routes rather than fluctuations in world energy prices (the price of Turkmen gas is estimated to remain at about $38-42 per 1,000 cm for the CAS period). The oil sector also continues to attract foreign investor interest and is expected to grow robustly, especially considering the relative transportability of oil compared to gas. 9. Prospects beyond the energy sector seem less bright given the limited commitment to fundamental reform, particularly as regards implementing agriculture liberalization and reducing barriers to private sector development. Turkmenistan has planned for a significant growth in agriculture production, including cotton and wheat. However, such growth is unlikely to be achieved without giving farmers greater control over their production and creating incentives to conserve water. Growth in infrastructure and construction may continue, mostly supported by continued large public investments. 10. In sum, GDP growth is expected to be on the order of 21 percent in 2001, after which it Chart 1h Turkmeeistan: Projected Economic Growth and Sources of Growth (1998 = 100) may level off to about 5 percent per year (see --_ Chart 1). The source of this growth is expected S tn on 5% 3* to be concentrated in the energy sectors. It 160 _ OH | 21* 5 should be noted that the impact associated with 160 JU _P this growth is moderated due to the fact that 14m 40-50 percent of gas exports to CIS countries is 207% payable in kind. In addition, unless part of 100 energy sector proceeds are plowed back to 80 maintaining production facilities and pipelines, 60 energy production may not be sustainable over 40 the longer term. As noted, these projections 20 assume little reform progress. On the other 0 hand, if Turkumenistan were to proceed with a 199S 199 2000 2001 2002 2003 2004 more systemic reform program, growth Source: Turknen authorities' historical data and World Bank projections would be even higher. staff proiections 11. The Risk of Economic Disruption: This economic growth projection is, however, subject to considerable risk, as the economy is highly dependent on (i) oil and gas exports which may fluctuate significantly due to price considerations, export route disruptions and payment difficulties3 and (ii) water intensive agriculture which is both dependent on regional cooperation and over the long term contributes to the salinization of land and reduces yields. Turkmenistan's large public investment and construction program, which often appears to be pursued without feasibility studies or proven financial and economic rates of return, represents another source of concern. Not only is the current capital investment level (about 40% of GDP according to official statistics) high by international standards (South East Asia has averaged about 30%) but it locks Turkmenistan into high recurring costs to maintain these projects. Finally, Turkmenistan has relied heavily on public 3 For example, due to payment problems, gas exports to Ukraine were discontinued in 1997, resulting in a sharp decline in GDP. The various pipeline proposals to Turkey, Pakistan, Iran and China would reduce economic risk if realized. 3  and publicly guaranteed debt to finance public investments, and servicing this debt could be problematic if oil and gas revenues are ever disrupted. 12. The risk of economic disruption can only be mitigated by (i) improving public resource management, (ii) accelerating market reforms which will permit more diversified private sector led growth and investment and (iii) improving national water management. However, Turkmenistan's efforts on these fronts have been limited. Budget and debt management are strongly in need of improvement (see paras 27-37), 'although the Government has recently indicated interest in moving forward in this area as well as in foreign exchange market liberalization. Barriers to private sector development, including limited access to foreign exchange and trade restrictions, are quite high (see paras 48-53). Agriculture policies are still predicated on the state order as well as excessive water usage and drainage (including the creation of a new large collector lake in the Karakum Desert) rather than conservation (see paras 42-47). 13. Therefore, unless greater reform progress can be made, growth outside of the energy sector will be hard to sustain and the potential for a significant economic downturn caused by a disruption in gas supply routes will remain. Sensitivity analysis indicates that a suspension of natural gas exports to Russia and Ukraine would result in an immediate GDP drop of over 20 percent, and a marked slowdown in growth thereafter. Such a downturn could have a significant impact on the living standards of the people of Turkmenistan. In this event, the large external debt burden may also limit the availability of further external financing to help manage the impact of a downturn. Even if growth is maintained, Turkmenistan runs the risk of becoming an energy enclave, with limited benefits trickling down to the bulk of the people, especially those living in rural areas. The Government's 10-Year National Program 14. The Government's goals are articulated in the National Program "Strategy Of Socio-Economic Developments in Turkmenistan For The Period Up To 2010" (hereafter referred to as the National Program) published in December 1999. The National Program identifies four primary goals. These are: (i) Economic Independence (including increasing economic growth through private sector and foreign investment), (ii) Food Safety (including increasing domestic food production and promoting food exports), (iii) Social Security (including labor rights, employment opportunity, and a social safety net), and (iv) Ecological Safety (including preventing disaster in the Aral Sea region; providing high quality drinking water, and reducing soil salinity). The National Program devotes considerable attention to meeting these goals by establishing production targets. For example, by 2010, cotton and wheat production would both double to 3 million tons each, sugar beet would triple to 900 thousand tons, and the number of sheep and goats would double to 16 million. There are production targets for eggs, melons and berries as well. Gas production is targeted to triple to 120 bln cubic meters and oil production to rise five times by 2010. There are similar details about each branch of the economy. 15. The National Program also describes in broad terms some of the public policies by which these objectives will be met, albeit without specificity of detail nor implementation time frame: (i) Fiscal and Monetary Policy: The budget should be expanded to cover all government transactions and to eliminate all extra-budgetary accounts. Tax policy will aim at reducing the burden on enterprises, and promoting import-substitution and exports. The budget deficit and 4  monetary policy will be tightly controlled to reduce inflation. Directed credits will be eliminated, and positive refinancing rates will be phased in, supported by a market for government securities. (Qi) Foreign Exchange and External Debt Management: A market based exchange rate will be introduced. External debt management is to be strengthened to ensure a reasonable volume of borrowing and its efficient utilization. (iii) Investment Policy: Investments will be maintained at a high level to achieve the government's ambitious growth objectives. State commercial banks will be encouraged to extend long term credits and new financial institutions are to be created as well. Remunerative yields will be offered to mobilize household savings. Foreign investment and joint ventures will be encouraged. With the strengthening of their financial positions, enterprises will begin to rely on their own funds for investment purposes. (iv) Private Sector and Financial Sector Development: Bureaucratic obstacles to private businesses and small enterprises will be reduced. Privatization through auctions or corporatization will be continued but in ways that ensure that living conditions are not worsened. In agriculture, the transfer of land ownership to private farmers will continue. In the financial sector, the development of a stock market and an insurance market will be encouraged. (v) Social Welfare: Efforts noted above to stimulate economic activity will help generate increased employment. In addition, the Government will continue to provide free gas, electricity, water and salt (up to a fixed limit) at least up to 2005, as well as free health and education services. Reform of the pension system and allowances is envisaged to make these more effective. 16. Analysis of the Program: The National Program contains many of the goals related to a transition to a market economy, and the Bank can therefore in principle find a match between many of the government's stated goals and the policies it regards as necessary to build sustainable economic growth and poverty reduction. However, there are some serious concerns. A critical concern is that there is an inherent contradiction in the National Program between the aim of creating a market economy and conserving the environment on the one hand and on the other hand mandating large growth targets for output of various commodities up to year 2010 that is reminiscent of a centrally planned economy. For example, enforcement of targets for ever increasing cotton sales would reinforce the state-order system and undermine the ability of farmers to freely choose which types of crops to grow. Water conservation could also be undermined by the significant growth in land under irrigation needed to meet projected agriculture production. 17. Other general concerns exist. First, the National Program has a strong emphasis on import substitution. While understandable as a reaction to the narrow specialization of Turkmenistan during the Soviet era, state-sponsored protectionary policies ultimately can be very costly as experience in other countries has shown. Second, the government policy of providing free commodities and utilities up to set limits, including water, electricity, flour, and gas can undermine its own goals of promoting water and energy conservation and environmental protection. The provision of these free goods also undermines the potential for commercialization of providers of these goods. Finally there are some important issues that are likely to arise during the transition that have not been adequately addressed. These include, for example, the restructuring of state banks and state enterprises. 5  18. Beyond these general concerns, within each sector, the National Program does not spell out specific priority actions and time frames within which they should be implemented. In fact, there appears to be a disconnect between the government's stated goals in the 10 year National Program and activities being pursued in practice. Therefore, the Bank's CAS seeks to identify priority sectors on the basis of improving the living standards of the people of Turkmenistan, and then to help translate many of the Government's long term goals in these priority sectors into near term policy actions necessary to achieve these goals and enable Turkmenistan to transition to a well functioning market economy (see section III). Global and Regional Linkages 19. Following independence, Turkmenistan has focused on building its national identity. However, Turkmenistan is a country of only about 5 million people and is geographically distant from many of the advanced economies. The speed at which it develops is likely to depend on how well it can (i) participate in global knowledge sharing and initiatives on key development issues and (ii) cooperate with its neighbors on key regional issues. 20. Global Knowledge Sharing: The most important global public good that Turkmenistan needs access to is knowledge - particularly knowledge about best practices in areas such as taxation, debt management, budget reform, exchange rates, privatization, pensions, health reform, energy contracts, water conservation in agriculture, etc. There are many ways to do this including training, learning forums, and the internet. To maximize its ability to participate in global knowledge transfer, Turkmenistan needs to increase its support for training of officials and provide permission for private internet providers to operate. The benefit related to such knowledge transfers will likely be directly proportional to how widely it is made available within Turkmen society. Numerous global initiatives exist, such as the Consultative Group on International Agriculture Research (CGIAR), the Global Water Partnership, Distance Learning Networks, and the Global Gateway which can facilitate such knowledge transfer. Participation by Turkmenistan in such initiatives could yield positive results. 21. Regional Cooperation: The most important regional issue is water. Turkmenistan is dependent for both drinking and agricultural water on the flow from the Amu Darya - which travels from Afghanistan and Tajikistan through Uzbekistan and Turkmenistan to the Aral Sea. There are limited rules governing how each country treats the water and there are few incentives to conserve water, reduce contaminants, or assist in infrastructure maintenance. As a consequence the overall water quality and flow of the river has deteriorated. To ensure long term viability of this regional lifeline, the first priority is for all states in the region to improve water management. Beyond this, the international community supports the Aral Sea Basin Initiative to improve regional water use. Turkmenistan currently holds the rotating Chair of the Executive Committee of the International Fund for Saving the Aral Sea (IFAS). At the same time, it has recently announced the development of a new drainage collector reservoir which falls outside the Aral Sea Basin Program parameters, and this needs to be carefully reviewed against financial, regional and environmental concerns. Beyond water, there are other critical areas in need of regional cooperation such as energy supply routes, the ecology of the Caspian Sea, and trade that would benefit from a regional approach. 6  III. Key Development Challenges 22. The Bank and Turkmenistan have agreed that the priorities identified within the CAS be based on the extent to which they contribute to improving the living standards of the people of Turkmenistan. In light of this strategic foundation, and taking into account the Government's 10 year National Program, the CAS identifies five focus areas noted below and specific actions needed within each in order to implement the Government's program and improve the living standards of the poorest parts of the population. * Strengthening Public Resource Management * Improving Health and Social Services * Developing an Efficient Rural Economy * Supporting Private Sector Development * Protecting the Environment and Conserving Water The Foundation: Improving Living Standards in Turkmenistan 23. A growing literature exists on living standards and poverty in Turkmenistan, including the UN Human Development Report, reviews of the education and health sectors, and a World Bank analysis of one of the poorest regions, Dashowitz. Most recently, a Livings Standards Survey was conducted by the Statistics Agency in 1998 and has been further analyzed by the Bank.4 While the absolute incidence of poverty appears low, about half the population appeared to be living on less than the official minimum wage in 1998 (as measured by cash income). 3 Most of these are supported by heavy subsidies on rt 2: Distribution of Consumption in Turkmenistan commodities and utilities. It also reveals a large level of inequality, with almost (1998) half the national consumption being IS _ consumed by only 10 percent of the 16 90 percentof population (see Chart 2). There is a E 14 population 10 percent population consuming 44 R 1 2 consuming 56 percent of national total consumption particularly stark difference between n to percent of those who live in Ashgabat, where 8 0 total national almost no poverty is recorded, and the | 6 - rest of the country, particularly in the 4 rural areas. Beyond geography, the 2 most distinguishing features of the 0 poorest group are their high numbers of Manat (100) per capita per day, 1998 children and their low access to some infrastructure (such as piped water). 4 "A Profile of Living Standards in Turkmenistan" (World Bank, Jan. 2001) 5The measurement of poverty has proven difficult in Turkmenistan. The results of the 1998 Living Standards Survey indicated that 7% lived below the $2.15 poverty line using purchasing power parity. However, this data should be used with caution as it depends on calculations of purchasing power parity based on uncertain price indicies. As noted, the income of about half the population fell below the minimum wage in 1998, if only cash income is counted. However, it is uncertain what the impact of recent increases in wages and economic growth over the past few years has been on living standards. Turkmen authorities have recently suggested using another measure - the share of population with incomes below 50% of the median per capita income. According to government statistics, only 1% of the population currently falls below this level. Additional work on developing a common and appropriate poverty line is needed. 7  24. Key Areas in the Battle Against Poverty: The Profile of Living Standards identifies the following areas as being in urgent need of attention to improve the level and sustainability of living standards of the poorest segments of the population: * Improving the Effectiveness of Public Support for the Poor: While the policy of providing goods and services (eg. flour, salt, gas, oil, water, electricity) free or at very low prices has served to alleviate the conditions of those with limited incomes, it has also reduced incentives to conserve, maintain and improve services. Further, these subsidies are only partially paid for explicitly from the budget and farmers both have to sell their crops to the state-order and obtain subsidies in return, which makes it difficult to determine net benefits. Hidden subsidies distort the ability of enterprises supplying and receiving such commodities to operate on a market basis. Finally, there is evidence that such subsidies are not well targeted, and much of the benefit may be absorbed by those better off.6 To improve long term financial sustainability and the quality of service, increased charges for commodities and public utilities combined with a targeted benefits program transparently provided by the budget should be phased in. A reduction in subsidies without an approach to increasing income generating opportunities and a safety net for those left behind is likely to hurt living standards, at least in the short term. A holistic approach is therefore needed to address these issues together.7 A central element in such an approach ought to be transparency and accountability, to ensure adequate support is provided to those most in need. * Improving Health Care: In terms of human Table 2: Comparative Health development indicators, health is a top priority. Indicators (1997/98) (1 Turkmenistan has historically had some of the Life Infant lowest life expectancy rates and highest infant Expectancy Mortality mortality rates in the CIS (see Table 2), although (yrs) (#/1000 official statistics suggest that there have been some births) improvement recently. These issues affect the poor Turkmenistan 66 33 (2) in particular, as they tend to have more children Kyrgyz Rep 69 24 and more limited access to piped water, and cannot Bulgaria 71 18 afford unofficial payments to health care workers. Albania 73 33 There are three key components that impact health Kazakhstan 68 24 indicators: (i) poor water quality and sanitation (1) Statistics are from the Bank's live data base or from the UNDP's "Human Development Report," 1999. which leads to infectious and parasitic diseases, (2) Recent government reports indicate this may have particularly in infants, (ii) life-style factors fallen to as low as 26/1000 (including consumption of fat, smoking, drinking) which increases the incidence of heart disease and related ailments, and (iii) the quality of the health care system. On the last, Turkmenistan has initiated some improved policies including better family planning services, some staff retraining, and a stronger emphasis on primary care. It is critically important that these initial reforms be supported and deepened, including through changes in the budgetary and incentive systems. 6 Although there are eligibility criteria for subsidized flour (children, elderly, veterans, disabled), in practice over 60% of the population receive this. Also, many of the poorest do not receive piped water and have few electric appliances. There are official limits to free utilities, but meters and taps are scarce and there are few incentives for conservation. 7 In late 1999 the Government introduced a new system to provide one-time grants of assistance to the most needy. Local commissions are being formed at the etrap and town level to identify those that require assistance. The system is still in its infancy, and its effectiveness is not yet known, but it could be a foundation to build on. 8  * Supporting Education: While basic education continues to provide near universal literacy, there are worrying signs of deterioration, particularly as regards the time spent in primary and secondary grades, the content of the curriculum, and access to higher education. The link between education and employment also appears weak at present, and this will become more important as the move towards a market economy progresses. It is critical for the Ministry of Education to address these systemic issues facing the sector. * Strengthening the Rural Economy: The vast majority of those in the lowest income quartile live in the rural areas. In 1998 all of the surveyed residents of Ashgabat lived above the level of 50 percent of mean consumption, and in each of the five regions, there is a higher incidence of poverty in the rural rather than urban areas.8 The best way to address income inequality and improve the living standards of the poorest is therefore to improve the efficiency and market orientation of the rural economy (including the elimination of the state order), providing the poor with both increased income and greater employment opportunities. Preventing the breakdown of the poorly maintained irrigation infrastructure is equally important. But the two go hand-in- hand. Providing farmers with greater income potential will enable them to pay for, and maintain, water and irrigation services. 25. Poverty Monitoring: A key element in moving forward with poverty focused development is a strong poverty monitoring system and reliable statistics on key indicators. Turkmenistan has a statistics agency which takes the lead in most such efforts, including the preparation of the 1998 Living Standards Survey, but there is a significant need to improve its capacity and train its staff to produce and analyze reliable statistics that meet international standards. A number of government and donor-sponsored reviews now exist on key social sectors (education, health, living standards, employment, human development etc) but continuing work on these is needed. The statistics agency has requested Bank support for improving its capacity to monitor living conditions. 26. Gender Issues: Turkmen society involves both traditional roles for women as well as support for modern equality rights which are embedded in the constitution. Although available information on gender issues is limited, there do not appear to be large differences in women's and men's access to basic education or other social services. The UN's gender-related human development index and Gender Empowerment Measure (measuring participation in parliament, public administration) also do not indicate significant inequality, although there is some indication that women may be underrepresented in some key ministries and higher education opportunities. Maternal mortality figures are high but official statistics suggest they may be decreasing, as with the case of infant mortality. Looking towards the future, the Bank will emphasize the need to deepen Turkmenistan's knowledge base on gender issues, particularly in the context of its planned support for monitoring living standards statistics. In the Bank's round-table discussions with NGOs (see Annex 3), training for potential women entrepreneurs was suggested as an important development tool. It will also be important to factor in the role of women in agriculture reform, both in terms of land ownership and working conditions. Strengthening Public Resource Management 27. The living standards profile highlights the importance of a transparent budget-based approach to transfers to the poor, and the weak connection currently between the extensive funds made 8 The Living Standards Survey may, however, exaggerate somewhat the real difference in living standards between urban and rural areas, since rural residents may be able to grow some food for themselves, and have a stronger level of community support. 9  available for public investments on the one hand, and critical unmet needs in basic health and education on the other. At the root of both of these concerns is a public resource management system that requires serious systemic improvements in investment review and allocations, in transparency, and accountability. In light of these considerations the top development priority of Turkmenistan is to put in place a transparent system of public resource management that can direct public resources to priority uses. With a better system in place, Turkmenistan could use its considerable natural resource wealth to address the large level of income inequality and improve basic living standards with its own resources. Without such a system, more direct assistance to strengthen particular sectors of the economy and reduce poverty are unlikely to have a lasting development impact. 28. Budget Management and Transparency: At present the Ministry of Economy and Finance provides allocation management and oversight over only a small portion of government revenues and expenditures through the state budget. The rest is managed by autonomous extra-budgetary funds and ministries that follow their own sectoral priorities. There are five major extra-budgetary funds (the Oil and Gas Fund, the Transport Fund, the Agricultural Fund, the Health Fund and the Foreign Exchange Reserve Fund) as well as smaller funds and off-budget ministerial activities.9 This makes it difficult to ensure that public spending as a whole reflects the government's priorities and is used effectively. Inclusion of many state enterprises within the Government also misdirects scarce budget funds for activities that ought to be done by the private sector. The non-transparency of key operations makes accurate measurement and analysis of investments across sectors difficult. For example, self-financing ministries appropriate after-tax surpluses from enterprises under their control to fund other operations (including capital expenditures and cross-subsidized services to the population) without considering investments elsewhere. 29. In the 1997 CAS, the Bank indicated that fiscal discipline, including consolidating all fiscal funds into the budget, would be the linchpin of reform. The government's 10 Year National Program has also established strong goals in this area. All extra-budgetary accounts are to be eliminated, and all investments are to be included in an investment budget with an appropriate analysis of rates of return. Also selected government companies are to be separated from ministries to facilitate privatization. Very limited progress has been made since then, although some progress was made in FYOO by presenting planned revenues and expenditure outlays of most extra-budgetary funds in the state budget document. 30. The World Bank has made a number of concrete suggestions to the government to promote a transparent, rational and efficient utilization of scarce public resources.10 An important recommendation is that budget coverage must be made more complete by progressively eliminating the funds and integrating their activities in the budget. A transparent process should be put into place to evaluate and prioritize investments within a common framework, and with adequate review by sector specialists. The commercial activities of the self financing ministries must be separated from the non-commercial ones and the latter incorporated in the budget. Quasi-fiscal operations such as subsidized credit should also be included in the budget. Until such time as these measures are implemented, regular reporting to the MOEF of all expenditures and revenues of the funds and self-financing ministries, including the Foreign Exchange Reserve Fund, should be 9 It has been estimated that the expenditures under the state budget which are allocated by the Ministry of finance represents only about 20 percent of all public expenditures. 10 Turkmenistan: Improving the Management of Public Expenditure, World Bank, October 1998. 10  enforced." Consolidated budget information should be widely available. These efforts should be supported by procurement reform, the introduction of international accounting standards, and a reduction in netting (non-cash offsets between institutions). The Bank is supporting the modernization of the budget process through its on-going IBTA loan (see Annex 2), although the effectiveness of this will depend on progress on the more fundamental reforms noted above. 31. The Bank has recently advised the Government of Turkmenistan that a central element in good budget management will be establishing improved and transparent rules for the largest extra- budgetary fund, the Foreign Exchange Reserve Fund (FERF). Only limited information is available on the size, rules, and transactions of the FERF. However, it is estimated to be on the order of about $1.7 billion (equal to about 14 months of imports) held abroad. A large percentage of foreign currency earnings (possibly on the order of 30% - 50%) on exports of energy, cotton, and possibly other transactions are transferred to this fund each year, and large public investment expenditures are made out of it. The FERF also may include elements of a foreign reserve management function (though the Central Bank has only limited control) and an inter-generational savings fund to cover future shocks. If public resources are to be managed transparently, it is therefore essential that the rules governing these FERF functions should be carefully considered in light of international experience. This will be a critical element in exchange rate management as well (see Annex 4). The Bank is prepared to provide advice to the government on the reform of the FERF based on international experience during the CAS period. 32. Debt Management: Currently, there is no clear system to consolidate all external debt obligations, and ensure that debt service is monitored and paid when due. Part of the external debt is managed under the Central Bank and part under the State Bank for Foreign Economic Affairs. Further the process of making public investments and contracting foreign debt are often separated. Many investments appear to have been undertaken on an ad-hoc basis and without considering future debt service obligations, and recurrent costs of investments.12 This has resulted in large levels of external public debt and debt service payments which could limit Turkmenistan's creditworthiness and future access to external capital if poor debt management persists.'3 Faced with an increase in foreign debt, a Presidential decree was issued in 1999 seeking greater control on the project formulation and loan approval process. Accordingly, all investment projects must be evaluated by the State Agency for Foreign Investment (SAFI). The Deputy Chairman of the Cabinet of Ministers in charge of the national economy must personally sanction all new projects above a certain threshold. It is unclear, however, how effective these procedures are. 33. The rising level of external debt was flagged as an important creditworthiness issue in the 1997 CAS. The government's 10 Year National Program also establishes improved external debt management as a key goal, with the targets of increasing its credit rating, improving the efficient use of borrowed funds and establishing a reasonable level of total borrowing and government control. It also proposes a central process for external debt repayments under the government budget. 11 In the past, audited accounts of extra-budgetary funds were not made available to the MOEF. It is reported that as of July 2000, MOEF has had access to such accounts. Such access will need to be carefully verified and monitored. 12 The MOEF maintains an overall plan for "centralized investments" which are largely funded in domestic currency and implemented through ministries. However, foreign borrowing generally falls outside this framework. 13 Turkmenistan's stock of debt has increased from $1.7 billion at end 1997 (66% of GDP) to about $2.3 billion in March 2000 (about 50% of GDP). Debt service payments are now about $400 million annually (about 15% of exports). Given the expected rise in exports and GDP, this level of debt, although large, is not unmanageable with appropriate review of new debt proposals and public investments, and greater economic diversification. 11  34. The government needs to take a number of near term steps to meet its goal of strengthening its debt management. Appropriate limits should be placed on all new external borrowing (including publicly guaranteed debt) and borrowed resources should be used only for priority investment projects with high economic rates of return. Appropriate institutional arrangements to manage external debt need to be put in place. These include (i) a high level policy making body that sets strict borrowing ceilings for each year, approves external borrowing proposals of the government and specifies the responsibilities for debt service, etc; (ii) a debt management unit that is responsible for the daily management of all external debt, collecting information on foreign debt contracts, and preparing periodic status reports and projections on debt; and (iii) a debt law that clearly sets out debt management limits, procedures and responsibilities. In addition, international experience suggests that providing access to external debt information is an essential element in building relationships with external investors and donors. The Bank is supporting these efforts through an IDF grant for debt management, which has placed an international debt advisor with the Government. 35. Good Governance and Transparency: There is a strong need to improve information transparency and information sharing in Turkmenistan. As noted, there is limited information on the bulk of government spending and on debt. Most enterprises do not operate using international accounting principles and there is a heavy use of non-cash transactions. During CAS consultations with civil society and the private sector, many participants indicated that the main issue is not the existence of good laws, but the transparent application of laws.14 The basis for good public management has to be access to appropriate information, both information generated within Turkmenistan and outside information (best practices etc). Limited transparency can also lead to a lack of accountability and is often a leading ingredient in rent seeking. Limited transparency is of course primarily an internal issue, but also prevents a more robust cooperation with foreign investors 15 and international institutions 36. Inadequate and non-transparent accounts also hamper control over improper practices and corruption (bribes, kickbacks, favoritism, etc). Levels of corruption are hard to measure given the non-transparent nature of public investment activities, but are generally considered to be significant. In this light, it is essential to build a system of public financial accountability and control. Turkmenistan has taken initial steps in this regard by drafting a Public Procurement Law, which is expected to be submnitted to Parliament over the coming year with the support of the Bank. Turkmenistan is also beginning to introduce International Accounting Standards, also supported by the Bank, which should help improve accountability over expenditures. Looking towards the future, these specific activities need to be institutionalized in a way that facilitates implementation and makes them sustainable. 37. Good governance involves many aspects besides information sharing and transparency. For example, it requires establishing rules and institutions that separate regulatory and business functions and other forms of checks and balances. Transparency in public resource management should therefore be considered as a first step, which will help to (i) reduce incentives for officials to 14 The one area where the civil society roundtable did, however, indicate a need for a new law was in the legal status and registration of NGOs themselves, without which they face restrictions in carrying out their activities. The enactment of an effective legal framework for NGOs would be an important step in enhancing the delivery of social services. 15 For example, adequate information on the full budget, extra-budgetary funds, and debt will be an important element in determining the extent of Bank activities. A recent IMF Mission in November, 2000 was also unable to obtain the information it needs to prepare the ground for an Article IV Consultation. 12  engage in inefficient or corrupt activities in the absence of checks and balances and (ii) set a good foundation for future work in improving governance. However, a longer term governance agenda should be recognized and begin to be discussed as well (see Box 1). Box 1: Longer Term Governance Issues Given the large role of the Government in the economy, and the centralized decision-making process, the level of checks and balances within the system will require considerable enhancement. Beyond increasing transparency, some longer term challenges include: * Separation of Government from Commercial Activities: In most sectors, Ministries act as both regulator of commercial activities, and as the operator of enterprises. This leads to a conflict of interest. The separation of commercial and non-commercial activities within ministries would both lead to greater financial discipline in enterprises and permit the Government to concentrate on supervision and regulation. * Reduction in Government Controls Over Normal Transactions: High levels of Government control over normal transactions, such as trade and exchange activities, can provide an opportunity for rent seeking. Similarly, registration requirements for most business transactions with the State Commodity Exchange provides scope for harassment of the private sector and for corruption. The liberalization of trade and exchange regimes w3uld therefore be particularly effective in eliminating the opportunity for corruption. * Improvement in Procurement/Auditing Practices: Turkmenistan is readying itself for the adoption of internationally acceptable procurement and accounting principles. And yet, it needs to be recognized that much of the economy continues to operate on non-cash transactions and on informal arrangements. Strong banking and auditing institutions are needed if there is to be substance behind these procurement and accounting practices. * Public Accountability of Officials: Many countries are adopting disclosure laws and monitoring met,hanisms to prevent nepotism, corruption, and conflict of interest. Given the small population, and tendency for individuals to handle multiple positions, it will be important for Turkmenistan to consider an appropriate approach to this important issue. * Independent Legal Institutions: In discussions with the civil society and the private sector, the single most important issue mentioned was not the lack of good laws, but the transparent and objective application of these laws. There is also a need to develop appropriate institutions to enforce private contracts. * Greater Level of Participation in Informing Decision-Makine: Experience has indicated that the greater the level of participation in the government decision making process, the more sustainable those decisions are, and the more likely that they will be effective. Improving Health and Social Services 38. Health Services: The Living Standards Survey indicates that there is a strong need to strengthen health services, and that the development of the health care system is a main priority for Turkmenistan. Turkmenistan' s health indicators (such as life expectancy and infant mortality) were historically among the worst in the FSU countries. According to the official data, however, there have been improvements in recent years in the maternal and infant mortality rates. It will be important to test the accuracy of the official statistics after the results of the recent demographic and health survey have become available. In addition, there has been a reported decline in several types of infectious diseases (such as blood circulation diseases, respiratory diseases and genital-urinary diseases). Despite these improvements, life expectancy (at 66 years) and infant mortality (reported 13  by the government at 26/1000 in 1999) remain of major concern. 39. The 1997 CAS recognized the critical priority of improving health indicators, and proposed an immediate pilot health reform project. The government's 10 year National Program establishes significant long term goals in the health services area. These include maintaining free medical services, raising the amount spent on health to 7% of GDP, vaccinating up to 99% of children, and the intensive development of the domestic pharmaceutical industry. It also recognizes the need to stimulate the development of private services in health care. The Government has recently introduced a system of medical insurance for employed citizens. 40. There are many health challenges to address, including life styles and environment. However, two critical issues that should be tackled as a priority in the near term are the quality of drinking water and sanitation, and the health care system: Drinking Water and Sanitation: Many of the poor do not have a piped water supply, but rather have to obtain water from wells or canals (which are often polluted). Few have adequate sanitation. For those with piped water, there are additional concerns relating to the poor state of repair of the pipes aid pumps, as well as the quality of water, much of which comes from the Karakum Canal or downstream Amu Darya and also has contaminants. These problems have contributed to the still high incidence of infectious and parasitic diseases, particularly in infants. The Government, with donor support, is working on addressing these water supply issues. Participants in the NGO Roundtable agreed that the top sectoral priority is water supply. Introducing improved management of water supply systems, including charging for water, can assist in ensuring sustainability and improving service. Of course, such an approach also needs to ensure access to safe water by those most in need and unable to pay for services. The current Bank project in Water Supply and Sanitation is playing a critical role in helping to improve the provision of water supply in one of the poorest regions of Turkmenistan (see Annex 2). * The Health Care System: A critical element in need of reform is the manner in which the health care system is organized, funded, and staffed. Basic medicines and medical equipment (such as syringes) are in severe shortage, and patients often have to buy them themselves in order to get services, despite the newly introduced insurance policy. There is therefore a need to ensure that the poor have adequate access to care. A fundamental reason for the inefficiencies in the health care delivery system is the poor system of budgeting. The overall health budget may be adequate, but a high proportion of it goes to funding tertiary level facilities. Further, reforms are required in the continued reliance upon the use of outdated norms to determine service and resources, and more attention needs to be paid to the quality of care provided. Some institutional reform towards a more quality oriented primary care system, appears to be underway. It is critically important that these reforms be supported and deepened. The proposed Pilot Health Project would play a critical role in this regard (see Box 4). 41. Other Social Services: On general social support, the Government's 10-year National Program provides for free access to water, gas, electricity and salt up to fixed limits. At the same time, the Living Standards Profile has identified the need to move away from general subsidies through a more targeted approach to social protection. A small program to provide one-time support payments through local communities has recently been initiated, and could provide a foundation for a larger effort. Beyond this, a deteriorating education system (including reduced time in secondary school, a sub-standard curriculum, and limited access to higher education) is a key concern, althougl. there 14  appears to be only limited commitment to addressing these systemic issues at this time. Developing An Efficient Rural Economy 42. The dynamic growth of the agriculture sector is especially important to address the income inequality between the urban and rural areas and reduce poverty. First, the sector accounts for a substantial share of GDP and is a source of livelihood for a major part of the population. Agriculture contributed 26 percent to GDP in 1999 and it employs more than 45 percent of the labor force. Agricultural growth will therefore have a significant impact on the overall economy and the living conditions of the population, both in rural and urban areas. Second, most of the poor, as earlier noted, live in rural areas. Growth in agriculture and the generation of employment opportunities in the rural areas is the most effective way to lift the living standards of the population, including those that are poor. According to the Living Standards Profile, the elasticity of poverty with respect to economic growth is about 1.75. That is, a 5% growth in income of the population close to the poverty line is likely to reduce poverty by about 9%. 43. The 1997 CAS highlighted the substantial progress on changing the status of most farmers into "lease-holders" at that time, and reported on government intentions to give efficient lease-holders private title to their land (albeit with some restrictions) within a few years. It was in fact, envisaged that by 1999 half of the land would be privately owned. However, progress since then has been limited, and only a very small portion of lands has been transferred to private ownership. Further, both lease-holders and private farmers access to critical inputs, storage facilities, marketing facilities and credit is limited unless they fulfill state orders. 44. The government's 10 year National Program envisions rapidly expanding agricultural production, including a doubling of wheat and cotton production. At the same time, it indicates that by 2010 57% of all agricultural production will be under private ownership. The programme also recognizes the importance of developing the agro-processing industry and the development of new hydro facilities and pumping stations. 45. The near term challenge to increase rural income should be to stimulate market based growth in agriculture. An environment must be created in which agricultural activity is not discriminated against and private farmers are induced to increase their productivity and adopt best cultivation practices. About 75% of arable farmland is used for cotton and wheat. At present virtually all of cotton and wheat sales are carried out through the state order system. State procurement prices for cotton and wheat paid to farmers in local currency average about 50%-60% of world prices valued at official exchange rates, and less than 20% when valued at the parallel (street) rate. It has been estimated that these prices, net of subsidized water, fertilizers, and other inputs, resulted in a real transfer of resources from agriculture to the rest of the economy equal to as much as 15% of GDP.16 A further significant burden is that farmers would likely be able to obtain even greater benefits if given the opportunity to grow and market alternative crops. 46. These restrictions on farmer income will have to be reversed if agricultural growth is to be stimulated. For this, the scope of the state order system should be progressively reduced and farmers should be able to sell their produce freely in the domestic market or export it. At the same time, input subsides should be phased out to prevent wasteful use, and in particular user charges for water 16 "Turkmenistan - The Burden of Current Agricultural Policies" (IMF Working Paper, June 2000) 15  must be gradually raised to recover costs (see Annex 4). Introducing payments would be particularly important in order to (i) help maintain rapidly deteriorating agriculture irrigation and other infrastructure, and (ii) help provide the incentives for water and other input conservation, vital to building a sustainable approach to water management. These are both urgent needs. On the first, there are increasing reports of the deterioration of the Karakum Canal, putting millions of people at risk of a serious health and environmental disaster. On the second, it is estimated that water loss on the Canal approaches 50% due to evaporation, over-use and poor management. The Bank's proposed Karakum Canal Rehabilitation project would seek to address these concerns (see box 4). 47. Removing restrictions on farmers without giving farmers access to alternative input and sales opportunities is also not likely to produce significant improvements. To alleviate this problem, the government must encourage private sector investment in marketing, storage and cotton ginning facilities and accelerate the privatization of agro-industries. The government has already begun to improve its pest control services to farmers, and the Bank's proposed Crop Protection project would help to ensure that these were provided on a commercial service-oriented basis (see box 4). Supporting Private Sector Development 48. Private sector development is critical to stimulate the income and jobs necessary to provide opportunity to the population of Turkmenistan. A vibrant private sector is also essential to provide an alternative to public investment, to diversify the economy, and to create a favorable atmosphere for foreign investment, in and outside the energy sector. The roundtable with Civil Society in particular highlighted the importance of strengthening the private sector environment to both improve social services and generate additional income in poor communities, including among women entrepreneurs. Although estimates of the extent of the private sector in Turkmenistan differ'7, there is general agreement that its contribution to the economy remains well below its potential. 49. The government's 10 year National Program recognizes the importance of the private sector and seeks to raise the non-Government share in GDP to 67% by 2010. It also advocates the liquidation of bureaucratic obstacles to private businesses and continuation of the privatization process for selected governmental companies. The program also establishes the goal of moving to a market based exchange rate system. W0. The 1997 CAS notes the Government's emphasis on private sector growth (particularly through land reform - see previous section) and privatization, particularly of small scale enterprises. In 1996/97 the government had issued a decree on small enterprise privatization and was preparing regulations for the mass privatization of medium and large enterprises. However, after privatizing about 2000 small scale enterprises, mostly in the field of trade and catering, since the end of 1998 the privatization process has essentially stalled.18 A key reason for this is the poor environment for private sector enterprises to flourish. Further progress on privatization, while important, is unlikely to be successful until the overall environment for private sector development and foreign investment is improved. 'M The government claims the private sector accounts for 30-40% of GDP. Other estimates are in the range of 20-25%. At the same time, the Government has indicated its intention to draw up a list of larger enterprises for privatization. 16  51. Consultations with the private sector identified two key constraints that dampen private activity, particularly in the SME sector, and provide a breeding ground for rent seeking and corruption. These should be addressed with some urgency (see Annex 4 for a fuller discussion): * Limited Access to Foreign Exchange at a Single Exchange Rate: The foreign exchange regime of Turkmenistan is highly distorted, with a restrictive exchange rationing system and a wide difference between the black market and the official rate. Participation in foreign currency auctions is carefully screened, and the inter-bank market was closed in 1998. Since then the government has imposed significant additional restrictions. More recently the government has indicated its intention to unify its official rate and the black market rate, and is piloting a lower- than-official rate in a few public enterprises. The Bank has indicated that the first steps towards sustainable currency reform should be to provide the Central Bank with adequate foreign exchange to support the exchange rate, to reduce restrictions on participation in auctions, and to re-open the inter-bank market. * Excessive Trade Restrictions: While import tariffs are at minimal levels, there remain significant trade barriers including rationing of foreign exchange (noted above), export licensing requirements, and a requirement that all exported goods be pre-paid (In the case of imports too there is a requirement that they be paid for only on delivery.) But by far the most egregious controls are implemented through the State Commodity Exchange (SCE), for which almost all trade must be registered. Such registration can be time-consuming and costly. Differences over "appropriate" prices have limited legitimate transactions, led producers to import inferior products, and provided opportunity for rent seeking. 52. A well run financial sector is another essential element in creating a positive environment for private sector development. The financial sector in Turkmenistan has recently undergone some consolidation with the merger of several insolvent banks with other institutions in 1998, but there is need for further improvement. At present the banking sector operates largely as a conduit for channeling state funds for designated activities to large state owned enterprises rather than as an evaluator of risk and financial return on market-based investments. There are only two private commercial banks operating in the financial sector, and these are subject to continuing government interference. A wide range of interest rates and directed credits for different categories of customers exist. Finally, the central bank is developing an electronic inter-bank payment system, although there continues to be significant use of non-cash transactions between enterprises. The IFC has approved a small loan to a private bank to help provide a best practices model for the banking sector (see paras 71-73) 53. Beyond these urgent issues, other factors dampen private sector activity including (i) the limited state of internet access, which is an essential business tool, (ii) continued non-transparency, conflict of interests, and bureaucracy in licensing and application of regulations, (iii) harassment of private sector enterprises by various government agencies, (iv) the required majority state participation in joint ventures, (v) limited vocational learning opportunities, and (vi) heavy restrictions on travel including leaving the country (eg requirement of an exit visa), travel within the country (eg checkpoints) and for foreign businessmen visiting Turkmenistan. All of the above issues are critical for foreign investors as well as local businessmen. If the investment climate is improved, MIGA's online information systems, IPAnet and PrivatizationLink, can help attract investment in key sectors such as mining, oil, and gas (see para 74). 17  Protecting the Environment and Conserving Water 54. Turkmenistan faces serious environmental problems in both the industrial and the agricultural sectors which affect the living standards of the population. In industry, oil refineries are major sources of pollution. Pollution occurs also from the burning of associated gas from oil fields as well in the processing of gas to reduce its sulfur content. Industrial pollution is particularly a concern around the Caspian Sea area. In agriculture, groundwater and the soil are contaminated by pesticides and fertilizers. But perhaps the primary environmental issue facing the country is the overuse of water to irrigate cotton fields and a lack of incentives for individuals and businesses to conserve water. This overuse has increased the salinity of the soil with a resultant reduction in crop yields. The overuse of water is also a source of regional environmental concern. The recent plans to build a large reservoir from drainage water should be reviewed further against such concerns. 55. The government's 10 year National Program identifies Ecological Safety as a key goal, including ensuring environmental considerations in industrial development, insuring a high quality of drinking water, the reduction in harmful chemicals in agriculture, and the prevention of ecological disaster in the Aral Sea region. The Government has signed important international conventions on bio-diversity and climate change, and currently holds the Chairmanship of the Executive Committee of the International Fund for Saving the Aral Sea (IFAS). It has also published a "Red Book" on flora and fauna, and is in the middle of preparing a National Environmental Action Plan (NEAP), supported by the Bank. 56. While there are many environmental actions needed, the government's policy of providing free water and energy for domestic and agricultural uses requires priority attention as a large amount of water is being wasted. As mentioned, it is necessary to introduce user charges, and other measures (including taps and meters) to encourage wiser, economical use of water and energy. This would both promote conservation and help mobilize the necessary funds to maintain irrigation and water supply equipment. Of course, in implementing this, care needs to be taken to ensure that those most in need are not adversely impacted by such charges. The institutional capacity for environmental management needs to be strengthened to prevent fragmentation of responsibilities, to develop appropriate strategies, and tighten enforcement. IV. World Bank Strategy Lessons Learned From Past Bank Experience 57. Policy Reform: The 1997 CAS presented a program designed around mixed signals on the pace of reform. On the one hand it indicated that the Government preferred a more gradual pace of reform implementation than the Bank thought warranted. At the same time, it observed that there was agreement on overall development goals and that there was some indication that the Government might be willing to accelerate the reform effort, including the potential for implementing an IMF-supported program that would unify the exchange rate and reduce price controls. The government had indicated that a significant proportion of land would be privatized 18  within a few years and regulations for privatizing medium and large enterprises had been prepared. The results since 1997 indicate that this later view was too optimistic. The key priority goals outlined in the 1997 CAS - budget and debt management, rural development, trade and foreign exchange liberalization, and privatization of larger enterprises - remain outstanding issues. 58. As a result of this experience, the current CAS scales back both the Bank's expectation of more rapid reform and the extent of Bank support, particularly as regards lending. For the FY01-03 period, the Bank will concentrate on building a stronger foundation of shared approaches with the government, and providing practical, non-lending support to build the Government's capacity to move forward at its own pace. 59. Lending: The Bank has extended three projects to Turkmenistan. These are the Institutional Building Technical Assistance (IBTA) Loan approved by the Board in FY95, and the Urban Transportation Loan and the Water Supply and Sanitation Loan approved by the Board at the time of the 1997 CAS. No further lending was extended from FY98 to FY00 due to (i) a misprocurement issue which took more than a year to resolve and suspended both new lending and disbursements on existing loans (this suspension was lifted in June 1999) and (ii) a negative pledge clause violation which was identified in 1998 and continues to prevent new lending. All three ongoing projects have experienced problems due to (i) procurement and implementation difficulties and (ii) failure to achieve adequate institutional change. Annex 1 provides the specific status and plans for each project. 60. On the overall issue of fiduciary accountability, the Bank must continue to heighten the awareness of the importance of good accounting and procurement, including helping the Government to bring the public procurement law into being and providing training in international accounting (both supported by IDF grants).'9 Continued use of PIUs will, however, be necessary for the near future. Supervision of on-going projects will remain a top priority. New loans will need to be stricter on confirming Government commitment to both technical activities and policy reforms, regularly monitoring progress and providing for more hands-on support for implementing reform measures. It is also recommended that the Government strengthen its own capacity to help review projects and resolve key issues. 61. Loan Covenant Violation and Debt Reporting: Turkmenistan is in violation of the Bank's Negative Pledge loan covenant. It has also not met its debt reporting obligations to the Bank. Until these issues are resolved, the Bank can not extend any new loans. On the first, Turkmenistan has recognized the problem with collateralizing other lenders over the Bank and has issued a Presidential Decree prohibiting such practices. The Government has indicated that since then, similar operations have not been entered into. However, it has been unable to renegotiate the pertinent clauses of the offending loan.20 In the absence of being able to address the issue directly, the Bank is ready to explore ways of meeting the loan clause provision through obtaining equal and ratable collateral. As regards debt reporting, Turkmenistan has not submitted any debt reports to the Bank's Debt Reporting System in over one year. However the Bank has supported the placement of a debt advisor with the Government and the Government has indicated that it would provide debt statistics by the end of the first quarter of 2001. 19 These efforts will assist both on the immediate tasks of passing the public procurement law and providing training in accounting, as well as the development of longer term institutional structures to make these efforts sustainable 20 The violation is related to a 1996 loan provided by a consortium of German banks, for the rehabilitation of the Turkmenbashy Oil Refinery. Proceeds of oil sales are collected in an overseas collateral account to repay the loan. 19  62. Non-Lending Experience: To date, the bulk of the Bank's non-lending work has been in the form of major policy papers. Other donors have also contributed to this knowledge base including various papers on private sector development by USAID, a 1997 Education Review by UNDP, and the annual UNDP Human Development Report (Annex 4 provides a list of major studies undertaken recently). More recently, the Bank has also begun to provide hands-on policy advice through the placement of a debt advisor in the Government, and a review of a draft tax code. It is, however, too soon to tell whether these hands-on efforts will yield better results. The Government has also expressed a strong interest in such hands-on support, most recently requesting a grant to help introduce international accounting principles. Ultimately, the effectiveness of ESW may depend less on how it is delivered, and more on whether there is continual follow-up by the Bank and the borrower, since change is likely to be a long term process. Bank Program for FY01-03 63. Initial Phase: Over the next 1-3 years the Bank will largely limit its focus to strengthening the implementation of existing projects and helping Turkmenistan build a stronger foundation for pursuing reform through non-lending activities. Any such support would depend on adequate access to basic information necessary to complete individual tasks. 64. Within this non-lending phase, primary emphasis will be placed on improving public Box 2: Proposed National Economic Foru resource management and governance. e p N Eo F would Specific support will be provided for (i) budget : modernization (through the IBTA Loan), (ii) -- Be prepared with the Government, Donors, civil debt management (through the IDF Debt society, and other parties Management Grant) and (iii) helping to host a "National Economic Forum", which would -- Focus on bringing best practice information fromn fiate io Enformationsri whihi wuand outside of Turkmenistan as well as disseminaig facilitate information sharing both within and existing information generated within Tuwk -eitan.00 outside the Government (see Box 2). The Bank e ita would also foster international standards of -- Have a public event where participants could present financial accountability through (iv) support key studies and activities, as well as pivate meet*i for bringing a public procurement law into with decision-makers on key topics. operation and (v) an international accounting -- Identify how to continue such information flows standards IDF grant. As noted in para 62, the (annual event, standing secretariat, internet page etc) effectiveness of such efforts depends on I continuing follow-up. Thus, these efforts would support both specific immediate actions as well as building institutions to enable these efforts to be sustainable over the long term. 65. The Bank will also engage Turkmenistan on poverty monitoring (through a Living Standards Monitoring and Targeting IDF grant), the environment (eg the NEAP, comprehensive water strategy), and private sector development (a downstream energy sector study). The Bank also stands ready to engage in shorter policy advice on various issues including the FERF and agriculture reform. Given the importance of fostering transparency (see paras 35-37), in all these efforts the Bank will seek to encourage and facilitate as wide dissemination of information as possible. 66. Second Phase: Given the weak reform progress and the loan clause violation, it is likely to prove extremely difficult for the Bank to extend new loans in the near term. However, the Bank 20  would provide a small 1-3 loan program over three years of $10-20 million per year if (i) the loan covenant violation is resolved, (ii) performance of ongoing projects is improved, and (iii) substantial progress is achieved on budget/debt management and transparency, including improved management of the Foreign Exchange Reserve Fund. Possible lending operations fall into the area of priority human needs (e.g. a pilot Health project) and disaster prevention and water management (e.g. the Karakum Canal Rehabilitation). This latter project would be important in improving water management, from both a national and regional perspective. The Bank would also consider a project to support the improvement of environmentally friendly services for the rural economy (e.g. a Crop Protection and Animal Health Project), contingent on improving farmers' ability to generate income to pay for the proposed services as well as conserve water.2' The need for and commitment to these potential loans are described further in Box 4. 67. Longer Term Agenda: There are many challenges to be addressed in Turkmenistan. The key element to moving forward on them is the commitment of the Government to take concrete actionable steps. The CAS lays out a longer term agenda in agriculture reform, foreign exchange and trade liberalization, and improving the environment for private sector development. Continued improvement in public resource management and governance beyond the measures taken in the initial stage would also be important. The Bank will consider additional loans and non-lending support in these areas in light of progress in, and commitment to, reforms in key policy areas -- access to foreign exchange at a single exchange rate, substantial reduction in the state-order, and reform of the State Commodity Exchange -- and achievements in near term CAS benchmarks (see Table 4) including improvements in living standards monitoring and targeting. In this event, the Bank will prepare a CAS update outlining progress on reform programs and identifying specific Bank interventions. 68. Field Presence: Given overall resource constraints and the limited reform progress by the Government, it would not be cost-effective to upgrade the Liaison Office to a Resident Representative Office at this time. Using the limited budget to support a more continuous ESW effort, with follow-through, might be more effective. However, implementation of agreed activities would be facilitated by a second national professional in the country office to help with operations supervision, collection of information, external affairs etc. It should also be noted that the Government has indicated an interest in having a Resident Representative. This issue will be monitored over the CAS period and could be reconsidered in light of Turkmenistan's reform progress and available resources. 21 The primary role of the Bank in these projects would be on project design. Because of creditworthiness concerns, the level of Bank lending would be kept limited and significant cofinancing from the Government and other donors would be sought. In this light, even if the conditions for Bank lending are not fully met, the Bank could consider the possibility of designing these projects for the Government and other donors, without direct Bank financing. 21  Table 3: Proposed Turkmenistan Country Program: FY01-FY03 Non-Lending Services Oning FY01 !Oo2-03 -- Debt Management -- Downstream Energy Study -- Water Strategy Grant (IDF) -- Macro/Sector Reform Dialogue -- Living Standards -- Public Procurement -- Int'l Accounting Principles (IDF) Monitoring (IDF) Grant (IDF) -- Country Economic -- Living Stand. Profile Memorandum -- NEAP (PHRD) -- National Econ. Forum On-Going Lending -- IBTA Project ($9 million undisbursed - closing date 12/01) -- Urban Transport Project ($13 million undisbursed - closing date 12/01) -- Water Supply Project ($28 million undisbursed - closing date 2/04) New Lending . . 7 r-- -7: 77 E S - : T--:----7777 70.77}ij ... ,... TriggersFY20 Basic -- resolution of loan covenant violation Pilot Health Project Needs -- significant improvement in the number of ($10 million) on-going loans rated satisfactory Karakum Canal -- Progress in budget/debt management and Rehabilitation Project transparency (see Box 3 for details) ($20 million) Base Case -- Satisfactory performance as above plus Above loans plus -- Approve an acceptable time-bound action plan, with immediate first steps, to reduce Crop Protection the state order on cotton and wheat and Project increase the ability of farmers to process ($15 million) and export crops on a market basis. -- Institute at least 20% cost recovery on a cash basis for agriculture water supply Stronger Reform -- Satisfactory performance as above plus Additional Lending to --Progress on near term CAS benchmarks be Determined (table 4) including improved approach to (CAS Update Would be poverty monitoring and targeting Prepared) -- Reduction in foreign exchange and trade controls including: (i) substantially open access to foreign exchange at a single exchange rate, (ii) substantial reduction in the state-order, and (iii) significant reform of the State Commodity Exchange. 22  Box 3: Budget and Debt Management Triggers for New Lending Each of the actions described below would need to be acceptable to the Bank: Debt Management Obiective: to strengthen the management and transparency of external borrowing and to ensure timely repayment Basic Actions Necessara: (i) Submit an acceptable consolidated debt report regularly to the World Bank Debt Reporting System, as required by Bank regulations. (ii) Establish tight borrowing ceilings and monitoring mechanisms consistent with the budget and macro- economic framework. (iii) Establish institutional arrangements with clear terms of reference and action plans to: a) regularly affirm debt statistics, decide on annual borrowings in the context of the budget, approve external borrowing proposals of the government (and other public organizations), specify the responsibility for debt service, and establish other rules for sound debt management. b) have day-to-day responsibility for the management of external debt (such as registering all foreign debt contracts and loan information, preparing reports on debt and projected debt, issuing borrowing guidelines, and analyzing the impact of borrowings on the budget and debt structure). (iv) Submit a debt law to Parliament providing the legal process for debt management. Budget Management: Objective: to consolidate revenues and expenditures in a single framework and make this more transparent so as to facilitate conformity of spending decisions with national priorities. Basic Actions Necessara: (i) Approve a time-bound action plan, with inmmediate first steps, to separate and clarify the functions of the FERF - with the assignment of adequate foreign currency reserves and management to the Central Bank, the establishment of a contingency and/or savings fund operating under clearly defined and transparent rules, and the integration of the public investment function fully into the budget framework. (ii) Enforce detailed quarterly reports of revenue and expenditure of all extra-budgetary funds to the MOEF, including the FERF, and inclusion in the overall budget framework. (iii) Prepare a plan for the dissemination of the full budget each year after parliamentary passage. (iv) Establish institutional arrangements to prepare and agree with Ministries a list of enterprises to be separated from Ministries and time-table for implementation. In this context, establish a secretariat to be responsible for the day to day management of this activity (such as maintaining an updated list of enterprises to be separated, preparing status reports on such enterprises, & establishing methods of separating such enterprises.) 23  Box 4: Proposed Base Case Loans In light of the overall weak commitment to reform and the poor experience to date in project implementation, it is essential that any new project have both a strong developmental impact and demonstrated commitment from the Borrower in working with the Bank to introduce change. In all three proposed loans, the Bank's financial contribution would be quite small, and would be used to leverage both more systemic reform, and Government and other donor funding. Also, each would need to be prepared and supervised with careful financial diligence (see para. 66). Pilot Health Project Health has been identified as a top social development priority for Turkmenistan, and is one of the few areas where the Government has started to introduce some reform, with the assistance of the Bank (which prepared a Health Sector Report in 1997), WHO and UNICEF. The pilot project would help to deepen this effort by allowing the Government to test specific reforms in a single district including the consolidation of health services, tying budgets to performance, and introducing new protocols of care. It would also support efforts to strengthen the training of health workers, rehabilitate peripheral facilities, and adequately fund basic supplies and equipment. The proposed project would include a monitoring component so that the lessons learned through this pilot effort could be later scaled up in a systemic manner. The Bank could play a critical role in ensuring that health reforms, now ongoing, are deepened and extended in line with international approaches. Karakum Canal Rehabilitation Project International experts have indicated that the unstable canal alignment, rapid sedimentation, and deteriorating and under-sized control structures could take the Canal out of operation. This would seriously affect the living conditions within Turkmenistan, as close to half the population depend on it as their aor source for both drinking water and irrigation. But beyond this disaster concern, better water management in the Amu Darya river basin is also a top regional priority, as the over-use of wateri in upnver structures like the Canal can lead to a worsening of conditions downriver. By repairing key structures, impring communication along the canal to better regulate flows, and piloting efforts to reduce water use in farms both of these concerns would be addressed. Turkmenistan has identified this as their top priority for Bank lending. Several other lenders such as the Kuwait Fund and the Islamic Development Bank have also indicated to the Government that they would be interested in cofinancing such a project. Bank involvement would ultimately be critical to ensuring that any rehabilitation and reform of Canal management isrit towards using less water rather than more. Crop Protection and Animal Health Project The project will assist the Government in making a first step in reforming the agriculture service sector. Prior to independence, Turkmenistan had an extensive system of environmentally friendly crop protection using insects to combat bollworm, a major cotton pest. This system deteriorated on independence but improvement has begun. However, in the event that farmers are given more choice in inputs and sales (a cordition of this loan), there is concern that farmers might turn to more pesticide use without reform of this key service. This project would support the rehabilitation of insectories into fee-based and service-oriented commercial providers, improve pesticide detection, and help develop a pest management policy. It would also support the introduction of private veterinary services, and the provision of essential vaccines to enhance animal health, a key limiting factor. Since most livestock is now privately held, this would further support rural income. The Government has already begun rehabilitation efforts even without Bank involvement. Bank involvement would, however, be critical to ensuring that such efforts are sustainable, generate income for service providers, and provide cost-effective inputs to farmers. 24  69. Choice of Lending Instrument: Turkmenistan is currently an IBRD-only country. Turkmenistan's GNP per capita ($660 in 1999) has fallen below the IDA operational cut-off ($885 in 1999) as calculated using World Bank Atlas methodology for the past four years. However, this drop below the cut-off appears temporary, resulting from disruptions in natural gas exports, poor harvests, and economic mismanagement. With the resumption of significant gas sales to Russia and Ukraine, Turkmenistan's Atlas GNP per capita is projected to rise over the IDA operational cut-off during the CAS period, even allowing for limited reform and some depreciation of the exchange rate. In view of this, it is appropriate for Turkmenistan to remain an IBRD-only country. 70. IBRD lending to Turkmenistan is constrained by creditworthiness concerns related to their high debt and continuing weak economic management (see paras 80-84). As a result, the Bank will only extend new IBRD loans if there are improvements in debt and budget management, and even in this case such lending would be tightly limited in size. At the same time, Turkmenistan's creditworthiness and economic growth - and hence its potential for IBRD lending - would rise if Turkmenistan pursued a stronger reform path. Both IBRD creditworthiness and IDA-eligibility indicators will be carefully monitored during the current CAS period. IFC Program 71. The IFC has undertaken a number of initiatives over the past two years in order to develop an investment program. These initiatives have included: the hiring of a fulitime local field officer stationed in the IBRD Ashgabad Office; utilizing outside consultants on four extended missions to survey the market and identify potential projects and sponsors; technical assistance to project sponsors for business plan preparation; over 20 missions by IFC headquarters and regional staff to the country for both promotion and evaluation of potential projects; organizing training seminars for private businesspeople as well as trade finance seminars for staff of the only two local private banks in the country; and the preparation of a study by Petroconsultants-MAI, together with EBRD, to define market needs and a proposed strategy for development of the oil and gas support services sector. These initiatives, unfortunately, have produced little in the way of investment opportunities for IFC due to the difficult environment for private sector development as well as continuing governmental bureaucracy and interference in private enterprises as described in paragraphs 48-53. 72. IFC has approved a small loan to a private bank under its Extending IFC's Reach Initiative. This investment, while small, is the first foreign investment in a local financial institution and is designed to serve as a best practices model for the banking sector. As part of its investment in the bank, IFC is providing institution building technical assistance financed by Dutch Trust Funds. Another approved investment in the dairy industry was subsequently cancelled. 73. IFC can envisage a more active investment program in Turkmenistan once the business environment becomes more conducive to private sector development and foreign investment, though this is not expected in the near term. As a result, IFC' s role over the next three years covered by this CAS can be divided into two phases. * Initial Phase: During the current phase, IFC will continue to focus on institution building in the financial sector, including institutions to serve micro-enterprises, with an enhanced emphasis on technical assistance and institution building rather than direct project lending. It is anticipated that IFC will, when possible, work with private service providers which have the capacity to support the 25  oil and gas industry as the lynchpin in private sector development. As part of IFC's institution building role, it will also seek to support the development of the leasing industry. IFC believes that leasing is one of the most effective means of channeling capital investment funds to local SMEs. As part of this initiative, IFC will undertake a study of the market and regulatory environment for private sector leasing as well as identification of a potential technical partner for establishment of the first private joint venture leasing company in the country IFC will also look into providing financial support for micro-enterprises through one or more intermediaries. Total lending under the first phase scenario is likely to remain below $3 million over the coming three years. * Second Phase: Should major reforms take place in the country, such as unification of exchange rates and free access to foreign exchange, removal of trade restrictions, a reduction in governmental controls and bureaucracy, and elimination of state orders in agriculture, then IFC would see a stronger investment program and move into the second phase. This scenario would therefore require deeper reform, particularly on issues affecting the private sector, than the IBRD's triggers for its second phase (basic lending) scenario. In its second phase, the IFC would play a more active role in the financing and development of larger financial intermediaries that could play a significant part in financial intermediation of medium and long-term financing to SMEs. IFC could look at investment in larger projects as foreign investors become more attracted by a more liberal private sector regime, particularly those in construction materials, infrastructure as well as the oil and gas production sector. With the removal of state orders in agriculture and the privatization of the cotton and food processing industries, IFC could also play a role in the development of processing projects in this area, both in terms of technical assistance and investment. Other Bank Group Activities 74. MIGA Activities: MIGA operations in Turkmenistan have been relatively modest. Not many investors have applied for MIGA coverage. However, in fiscal 1999, MIGA signed its first contract on Turkmenistan in the manufacturing sector for US$8 million, and this is operating successfully. Currently, MIGA has one active application and a number of preliminary applications targeting projects in mining, oil and gas, and manufacturing in Turkmenistan. MIGA's online informnation systems, IPAnet and PrivatizationLink, feature information on the investment climate and privatization investment opportunities. These programs cannot be accessed in Turkmenistan due to underdeveloped internet systems. However, information about Turkmenistan's developing businesses can be disseminated via these information services, which also serve as tools for outreach to attract investment in key sectors such as mining, oil, and gas. 75. WBI Activities: WBI has prepared a number of regional seminars, but has not been very active in Turkmenistan to date. Part of this relates to the fact that the Government has thus far provided only limited funds for public officials to travel and attend regional seminars. Given the need for capacity building and training, WBI is exploring the possibility of providing increased training support, provided the Government also increases its support. Such WBI assistance, if it materializes, could support both in-country and external training. 26  Partnerships With Other Donors 76. Selectivity and Partnership: In light of slower than anticipated reform progress, many international institutions and donors have pulled back their activities. These include the IMF which has withdrawn its Resident Representative, the EBRD which has recently prepared a country strategy which does not contain public sector lending, and USAID which has reduced its assistance considerably. Turkmenistan has just become a member of the Asian Development Bank, which will be considering its focus in the coming months. Given the current focus of the EBRD, TACIS, and the IFC on private sector development, there is arguably a greater role for the Bank to play in public resource management. 77. Nevertheless, many of the activities that the Bank intends to focus on - improving capacity within the government, information transparency, and deepening poverty monitoring and analysis - are generally considered to be high priorities for the donor community. Rather than splitting our assistance, it would be better to pool each institutions limited capacity and focus together on the top priorities. Specifically, we intend to work closely with the following partners: * IMF on budget, macro-economics, and tax codes * USAID on budget improvement, and the water strategy - UNDP on debt management, NEAP, and the water strategy - UNICEF on health and the water strategy - TACIS on tax codes, training, and international accounting - UK possibly on living standards and statistics - Japan and Switzerland on the NEAP - EBRD is collaborating closely with IFC on several private sector studies - AsDB possibly on the water strategy and public procurement 78. The proposed "National Economic Forum" would be developed in close collaboration with the Government and all other donors, providing them an opportunity to bring their expertise to the forefront. Since there is no Consultative Group for Turkmenistan, this would help to build a shared understanding between the Government and donors of the challenges ahead, and provide a mechanism to deepen coordination. Program Performance Indicators 79. The Government has developed a set of long term goals, as expressed in their 10 year National Program. Based on this, and an analysis of living standards, the Bank has compiled a set of five priority challenges outlined in Chapter III, and identified a number of near term performance benchmarks for each that are listed in Annex Table B9. Table 4 below extracts some of the key government goals and near term performance benchmarks to be monitored over the CAS period. Since there is limited data available, these benchmarks concentrate on the establishment of good information and plans as a first step. It should be noted that while the Bank can support Turkmenistan in achieving some of these near term goals, the Bank will have limited avenues of support over the CAS period; most of them will depend more on the commitment of the Government. For the Bank's own portfolio, new lending is conditioned on raising the number of projects rated satisfactory. The Bank will continue regular consultations with the Government, donors, and civil society, as was done as part of this CAS (see Annex 3), to gain further feedback. 27  Table 4: Selected Performance Indicator: Governent Long Term Goals a/ Bia Near Term Bechmarks -- Eliminate all extra-budget accounts -- Adoption of an effective plan to rationalize the Publk -- Include all investments in budget with FERF Resource analysis of rates of return -- Wide dissemination of the full budget Management -- Centralize debt repayment under budget -- Submission of debt reports to Debt Reporting -- Introduce internat'l accounting standards Service -- Adoption of a Public Procurement Law -- Improved dissemination of macroeconomic data -- Education expenditures to reach 10% of GDP -- Improved country approach to poverty Healthnd 5 -- Teaching to meet world standards monitoring and targeting. sociai -- Health care expenditures to reach 7% of GDP -- Increase in % of population with access to safe Sekes -- Vaccinate up to 99% of children water. Build a framework for introducing -- Water, gas, electricity to be free up to a limit water charges for conservation & maintenance. from 2000-2005 An ffcient -- 57% of land to be under private ownership -- Gradual increase in % of private farmers Rural -- Double cotton and wheat production -- Gradual reduction in % sold via state orders. Economy2 0 -- Construct new hydro/pumping stations -- Cost recovery for agriculture water at least 20% -- Establish market based foreign exchange -- Improved access to foreign exchange at a single Private S system rate Sec 0 tor : -- Liquidate bureaucratic obstacles to private -- Exemption of most private sector transactions Development -- businesses. from registration in the commodity exchange. Non-government share of GDP to rise to 67% Creation of a list of public companies to be -- Private housing share to increase to 90% separated from ministries and commercialized Protection of -- provide quality drinking water and reduce -- Publication of an effective National :Environment 0 harmful chemicals in agriculture Environmental Action Plan (NEAP) -- Prevent disaster in Aral Sea region Portfolio 0 0a -- Improvement in the number of on-going loans Performane ;rated satisfactory a/ goals for 2010 as stated in the 10-Year National Programme V. Managing Risks and Uncertainties 80. Creditworthiness: Turkmenistan has an unusual position among developing countries as both a major debtor and a major creditor. In January 2000 Fitch IBCA confirmed Turkmenistan's long-term sovereign rating of B- . Moody's has given a rating of B2 to Turkmenistan's long term foreign currency bonds. These ratings both indicate significant risk and are below investment grade. They reflect on the one hand a rising debt service burden and limited debt management capacity but on the other hand large foreign exchange reserves. Reserves are estimated at $1.7 billion, equal to 14 months of exports, although part of the reserves may not be freely available. However, while the short term outlook for oil and gas sales remains strong, Turkmenistan's failure to be transparent about public investments and its debt (about 50 percent of GDP) and debt service (about 15 percent of exports) could hurt its creditworthiness. At this level, debt is worrisome, but not unmanageable with appropriate borrowing controls, adequate reserves, and growing exports. However, in the absence of good debt and public investment management, payment difficulties to several international creditors have arisen in the past, and may continue to occur periodically. Turkmenistan also faces several investment disputes with foreign investors. 28  81. Turkmenistan contends that its debt situation should be considered in light of the fact that it is a large creditor of other CIS countries with claims of around $1.2 billion22 for gas deliveries as well as uncleared balances dating back to the collapse of the Soviet Union. However, much of this is not currently being serviced, or is being paid in-kind at inflated prices. Turkmenistan has thus far resisted participating in Paris Club relief efforts for countries where it has outstanding loans. 82. Risk: Turkmenistan has large potential for exports of oil and gas which if properly managed can boost economic growth and generate sufficient foreign exchange resources to service debt. The high growth rates achieved in 1999 and projected for 2000 were in fact triggered by increased exports of gas. If agreement is reached and maintained between Russia and Turkmenistan on a long term gas delivery contract, if public resources are well managed, and if progress continues towards addressing the major constraints to private sector development, the prospects for growth and foreign exchange earnings appear to be good. The main risks to the economy are: (i) Heavy Reliance on Energy Exports: Oil and gas export earnings could fluctuate significantly because of price changes or because of demand changes, pipeline delivery disruption or payment difficulties in key markets (such as Russia, Iran and Ukraine). The potential for disruption can be mitigated by accelerating market reforms which will permit more diversified private sector led growth. Especially important in this regard are agricultural reforms, liberalization of the trade and exchange rate regime, and elimination of various registration/licensing requirements that inhibit the private sector. (ii) Heavy Reliance on Water Intensive Agriculture: Beyond energy, the most important sector for Turkmenistan is agriculture, in which about half the population is employed. Since rainfall is limited, Turkmenistan relies on an extensive irrigation infrastructure inherited from the former Soviet Union. However, over time, water intensive agriculture will act to reduce yields by increasing salinization. It will be important for Turkmenistan to begin to reduce water usage, which should be feasible with appropriate incentives and support. Water intensive agriculture also increases the need for greater cooperation with other users of the Amu Darya (Tajikistan, Uzbekistan). (iii) Weak Public Resource Management: As already noted, public resource management is in need of significant improvement. The state budget managed by the Ministry of Economy and Finance covers only a small fraction of public resources. The rest is managed through extra-budget funds and ministries that follow their own sectoral priorities and often support uneconomic investments. There is still no effective system for external debt management and debt and debt service levels appear to have reached worrisome levels. Lack of reliable information on basic economic parameters such as the full budget and external debt further undermines efficient economic management and confidence. Measures to bring about transparency and rationality in the budget and debt management process are critical. (iv) Slow Transition to a Market Economy: Growth prospects also will depend on how quickly market oriented reforms are implemented. Price controls remain for many commodities, services, and utilities; trade and foreign exchange controls are still significant. Privatization beyond small companies has stalled, and the general business environment has not yet attracted significant foreign investment nor national private sector growth. In agriculture, there has been some transfer of land ownership to private farmers, but state orders for wheat and cotton are still prevalent. Many public enterprises continue to operate to a large 22 Most of them on Ukraine, Georgia, and other CIS countries. 29  degree through non-cash transactions, and benefit from large scale subsidies, explicit and hidden. To obtain the benefit of private sector growth, the environment for private sector development must be improved, and the state needs to focus on non-commercial activities. 83. As far as the Bank is concerned, notwithstanding periodic short term arrears due to poor debt management, risk is limited by the low level of debt. The Bank's share in total debt is currently extremely small (about $29 million outstanding) in comparison to Turkmenistan's total debt outstanding (estimated at about $2.3 billion), and is expected to remain below 3 percent even if lending is resumed. New lending is contingent on resolving the Negative Pledge Clause violation and agreed actions to better manage public resources and debt. In such a scenario, the debt service to export ratio is expected to level off at about 15%, which, while grounds for caution, is within limited creditworthiness parameters. 84. Finally, Turkmenistan's economic development is closely linked to other Central Asian countries. Regional cooperation in water usage, in power generation, in trade, in pipeline development, in knowledge sharing, and in environment will have a large impact on development in Turkmenistan as well as other Central Asian countries. Bank supported activities will, therefore, need to be considered against regional issues and concerns, as well as national priorities. VI. Concluding Remarks 85. With good near term growth prospects, but also an economy with substantial risks, Turkmenistan now has an important window of opportunity to accelerate reform while avoiding the social disruption that has plagued other CIS countries. The Government has a National Program which includes a number of important goals, but it has yet to translate these goals into appropriate concrete action plans. The Bank will therefore match its program of assistance to Turkmenistan's progress on reform, and assist Turkmenistan in the near term mainly by providing non-lending support for building economic capacity within the government, improving information flows, and deepening living standards monitoring and analysis mechanisms. 86. Although moving beyond this role is likely to prove extremely difficult, the CAS sets out a road-map of first-step actions necessary to jump-start the reform process, and enable the Bank to resume lending. A central element of this is improved public resource management, including strengthened budget and debt management, and the rational reform of the Foreign Exchange Reserve Fund (FERF). If basic conditions for lending are met, the Bank would extend a small lending program aimed at priority human development needs, disaster prevention, and rural development. This approach should help establish a stronger foundation for a more ambitious Bank program of support in a few years, if the government decides to move forward at a faster pace. James D. Wolfensohn President By: Sven Sandstrom Washington, D.C. December 22, 2000 30  ANNEX 1: CABINET OF MINISTERS TURKMENISTAN Reference No. 13-2252 December 19, 2000 Mr. Kiyoshi Kodera Director Central Asia Country Unit The World Bank Dear Mr. Kodera: I would like to express my appreciation to you and to your team for your intensive work during the last few months to prepare a new Country Assistance Strategy for Turkmenistan that will determine the future direction of our mutually beneficial cooperation. We view the World Bank as a reliable partner that provides necessary technical assistance and finances priority areas in the development program of Turkmenistan. In the process of preparing the CAS we had the opportunity to discuss in a productive manner the main parameters of economic policy and challenges that we face in the period of transition to a market economy. Despite the fact that we pursue common development objectives - the rational use of public resources, the liberalization of exchange rate and trade regimes, speeding up the privatization process and agricultural reform - we do not always agree on the issue of how best to achieve these objectives. We think that a gradual approach in addressing these issues is the most reliable path in making the difficult transition from our recent past to the sustainable productive development of our state. We are very interested in continuing constructive cooperation with the World Bank; however, unfortunately, we should note that the World Bank's lending is small. I would also like to note that this CAS does not quite objectively reflect the current situation and the long term development strategy of the Government of Turkmenistan. Immediately after Turkmenistan became independent, the country declared and started to implement with the utmost priority a policy of social protection for its people and guarantees against poverty, which has allowed us to ensure social and political stability and build confidence in the reform policy being pursued. Turkmenistan, in addressing the challenges of transition, is taking significant steps to promote economic growth and to improve the well-being of its people. I would like to share with you several examples of the results of these efforts. a From January to October 2000 the growth of GDP was 17% over the same period a year ago. There was a significant improvement in performance in the main sectors of the economy. Industrial output increased by 23% in comparable prices, including the electric-power complex (by 11%), energy/fuel sector (by 71%), chemical industry (by 19%), and the textile industry (17%). Agriculture output rose by 18%. 31  * As a result of positive trends in the real sector of the Turkmen economy and an increase in the income of economic entities, the state budget of Turkmenistan for January-October 2000 had a surplus in the amount of over 205 billion Manats.