Nepal - Country assistance strategy progress report

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 24170-NEP MEMORANDUM OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ONA COUNTRY ASSISTANCE STRATEGY PROGRESS REPORT FOR THE KINGDOM OF NEPAL November 18, 2002 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.  The last Country Assistance Strategy for Nepal (Report No. 18578-NEP) was discussed on December 13, 1998. Currency and Equivalents Currency Unit = Nepali Rupee (NRs.) US$1 = NRs. 76.733 (as of November 18, 2002) Fiscal Year July 15 - July 14 (FY03 is from July 15, 2002 to July 14, 2003) Abbreviations and Acronyms AAA Analytical and Advisory Activities LIL Learning and Innovation Loan ACS Anti-Corruption Strategy LSG (A) Local Self-Governance (Act) ADB Asian Development Bank MDGs Millennium Development Goals ADB/N Agricultural Development Bank of Nepal MFA Multi-Fiber Agreement AML Anti-Money Laundering MIGA Multilateral Investment Guarantee Agency APL Adaptable Program Loan MoF Ministry of Finance BPEP Basic and Primary Education Project MTEF Medium-Term Expenditure Framework CAN Country Assistance Note NBL Nepal Bank Limited CAS (PR) Country Assistance Strategy (Progress Report) NDF Nepal Development Forum CBOs Community Based Organizations NGOs Non-Governmental Organizations CEO Chief Executive Officer NTIDC Nepal Industrial Development Corporation CFAA Country Financial Accountability Assessment NLSS Nepal Living Standards Survey CIAA Commission for the Investigation of the Abuse NPA Non Performing Assets of Authority CPAR Country Procurement Assessment Report NPC National Planning Commission DDC District Development Committee NRB Nepal Rastra Bank DfID UK Department for International Development NTC Nepal Telecomrnmunications Corporation DHO(s) District Health Office(s) OECD/DAC Organization for Economic Corporation and Development/Development Assistance Committee DIMC Decentralization Implementation Monitoring OED Operations Evaluations Department Comnmittee DPR Development Policy Review PAC Public Accounts Committee DTT Deloitte Touche Tohmatsu, USA PAF Poverty Alleviation Fund FAP Foreign Aid Policy PERC Public Expenditure Reform Commission FCGO Financial Comptroller General's Office PRGF Poverty Reduction and Growth Facility FSSS Financial Sector Strategy Statement PRS (P) Poverty Reduction Strategy (Paper) FSTA Financial Sector Technical Assistance (Credit) PWGs Public Works Guidelines FY Fiscal Year RBB Rastriya Banijya Bank GDP Gross Domestic Product RMC Reform Monitoring Committee GTZ Gesellschaft fur Technische Zusammenarheit RWSSP Rural Water Supply and Sanitation Project (German Agency for Technical Cooperation) HIMGN His Majesty's Govemment of Nepal SAC Structural Adjustment Credit LAP Immediate Action Plan SEIP(s) Sub-Health Post(s) IDA Intemational Development Association SLC School Leaming Certificate IDF Institutional Development Fund SMC(s) School Management Commnittee(s) IF Integrated Framework TA Technical Assistance IFC International Finance Corporation UML United Marxist Leninist (Party) IMF Intemational Monetary Fund UNDP United Nations Development Program INGOs International Non-Govemmental Organizations USAID United States Agency for International Development JBIC Japan Bank for Intemational Cooperation VDC Village Development Committee LGs Local Govemments WTO World Trade Organization Vice President: Mieko Nishimizu, SARVP Country Director: Kenichi Ohashi, SACNP Task Team Leader: Deborah Bateman, SACNA  FOR OFFICIAL USE ONLY NEPAL Country Assistance Strategy Progress Report TABLE OF CONTENTS Summary A. The Bank Group's Assistance Strategy ........................................................1 Introduction ....................................................... 1 B. The Evolution of the Setting for the Bank Group's Assistance Strategy ...................... ..............2 Social Context ......................................................2 Political Developments ......................................................3 Economic Developments ......................................................4 C. The Reform Program-The Government's Response .......................................................6 Introduction ......................................................6 Fiscal Policy and Economic Management .......................................................7 Governance, including Civil Service and Decentralization ....................................................... 8 Private Sector Development and Financial Sector Reform ....................................................... 10 Improving Aid Effectiveness ....................................................... 11 The Human Development Agenda ...................................................... 12 Enviromnental Management ...................................................... 12 D. Progress In Implementing the Bank Group's Strategy ................................ ...................... 13 Background ...................................................... 13 IDA Program ...................................................... 13 IFC ...................................................... 16 MIGA ....................................................... 16 E. The Way Forward ....................................................... 16 The Current Situation-A 'Twin Crisis" ...................................................... 16 The Bank's Assistance into FY04 ...................................................... 17 Risks ....................................................... 20 BOXES Box 1 Achieving the MDGs-Nepal's Progress in the 1990s .3 Box 2 The 2002 NDF .7 Box 3 The Process and Substance of the Draft 10" Plan/PRSP .8 Box 4 Progress in Decentralization .9 Box 5 Rastriya Banijya Bank and Nepal Bank Limited .10 Box 6 Review of Development Partnerships in Nepal ............................... 11 Box 7 Monitoring Poverty .12 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.  TABLES Table 1 Selected Economic Indicators, FY98-FY03 ......................................5 APPENDICES Appendix I: Expediting the Reforms-The Immediate Action Plan Appendix I: The CAS Consultations-A "Pulse-Taking" Appendix III: Performance on CAS Triggers ANNEXES Annex Al Key Economic and Program Indicators-Change from Last CAS Annex A2 Nepal At a Glance Annex B2 Selected Indicators of Bank Portfolio Performance and Management Annex B3 Bank Group Program Summary for Nepal (IDA, IFC, MIGA) Annex B4 Summary of Non-Lending Services Annex B6 Key Economic Indicators Annex B7 Key Exposure Indicators Annex B8 Operations Portfolio (IDA, IFC) Annex B9 CAS Program Matrix-Change From Last CAS 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.  NEPAL Country Assistance Strategy Progress Report November 18, 2002 - Summary. The last Countrv Assistance Strateg, (CAS)-discussed at the Board in Decemnber 1998-put forth' atrategy 'aimed:at helpinig Nepal overcb 'ne; ,major.donistraints to development-poor governance and economic weaknesses, including poor.p_k1ic- expenditure management, ineffecfie public service delivern, and aiweak financial sector. Although Ntepal,has reirnained- n.the"ITow Case" through much' oF the period, the disciplined approach by the Bank to link its lending:level-to impro,vements in governance has contributed to bringing this issue to the center of -the policy dialogue.'. The i-9-98 CAS fundamentals remain valid and wvill continue to guide the Bank's work program:--A hull -Banl Group' CAS is planned in FY'04, following the Poverty Reduction Strategy Paper (PRSP) currently under preparation. - i,> n the: May 't999 general elections, the Nepali- Cp,ngress-.Party secured: a comfortabie nmaojfit',. Contrarty to expectations, thie ruling party's parliamentary majority 'did not translate'into political stability or consistent reform weftbrts. The instability, and paralysinthat plagued a series' of coalitions'during- 1994 -99 persisted, and continued'fictional in-fighting led to the dissolhtion.6fthe' lower -hduse- i' Ma 2002. As it became clear that nationa eiecti6ns could nbt be held as scheduled because of the' security situation, Prine Minister Sher BahadurDeuba recommended a one-year postponement. In response, King G)anendra invoked Article, 127 of the Cn'stitution to dismiss the Deuba cabirtet 'on' October 4th and-.temporarily took' o'er executive powers. Mr. Lokendra Bahadur Chand was, appointed Prime Ministerbythe King on October l l and heads an interim Governtentcharged with restoring peace.and holding 'ffe'suspen'ded:elections.,T ,,',.,,--1 The Mviaoist insurgeny 'began in 1996 as a low intensity and mainly rural ampaign to, replace the present polity \vith a "people's-republic." In November2601-` the -Madists.eicalated violence by attacking tarme'iistallati6ns for the .first time- 'A state of emergency was declared and the,army zsas mobilized.. The conflict has claimed7 ov'er-1,000 lives, more.than half of thbm ,duringrthe last year. ,-Wbile the deplovment 'of the arms could contain the insurgency, lasting peace will remain ,elusive uless theoroot causes are addressed, including improved service..deliyery-and social inclusion. , ' ' . !' -. -'..~Since the' last-GAS, Nepal's economy has gone thro ug-hacycl eleroftad growth a nd relatively strong macroeconomnicposition to -rapid deceleration and increasiig frEagility, Theworened security situation has.hurt the tourism industry and business confidence in 'eneral.;- The abiity Qof Nepal to export to a highlyI competitive global market is,being questioned. Serious reforms will be nieeded to protect macro balances and improve general economic competitiveness. As threat of the insurgency intensified and fiscal pressures,built the Government has become'increasingly more serious about reform implementacion. Over the past year or soz aespite th6continued-political-turmoil, the-reform efforts-largely'led by tecbnocrats-seem to have gained momentum and resolve. .Significant progress has been already made m severalareas,'including the financial sector, public expenditure'mianagement, service .delivery, the fiht against- corruptionand donor c;o6rdination. To integrate and push lorward these reforms, an Immediate Action ,Plan.(IP3,has been under implementatio'n wsith uncommon vigor.and-seriousness. A quiet governance revolution-seems-to have begun in Nepal. These changes have been me.twith strong public support and merit the fullest -support of the Bank Group. Given the broad-based, oross-cutting nature of on-going reforms, promoted by the emerging coalition bf.key'ref6rmers, the Bank Avili move to a Base Case scenario and start,to ddevelop a programnmalic approach lo 'finsncial assistance. In moving toward such an approach-to-be fully developed in the next CAS. in line. witli tie PRSP -,the proposed'program could be anchored by a Structural Adjust4i6ent Credit (SAC) cast in the context, of a medium-term. reform program. Such an operation would be c,ontingent. upon -a satisfactor) rmacroeconomic 'framework and the continued implementation-of a cohe'rent,set of reforms. .These reformrs contained in the- LAP-are designed to further improve public expenditure. management, . enhan'ce. thd transparency and accountability of the public sector and 'strengthen implementation of poverty programs; Prv,ided that the 'current reform process continues, such an operation woul,d be m;effective way- to- recogze Wh~e'im portait' progress that-has been,already made. By financial he fiscal cost- ofreforms, it would also.help the Government sustain and deepen the process by fuiancing the fiscal-cost of carrying forward the changes to create more accountable and effective public institutions. The programnalso envisions some innovative prdject interventious and a substantike non-lending programu reflecting a shif tovward the Bank's role' as a change facilitator.... .................................................__.._._._.._._._   NEPAL Country Assistance Strategy Progress Report (CAS PR) November 18,2002 A. The Bank Group's Assistance Strategy Introduction 1. With a late start to economic development, Nepal has seen vast improvements since the 1950s. Access to basic social services-including primary education and health care-has increased greatly, as has access to other services such as drinking water, electricity, telecommunications and rural infrastructure. Nevertheless, Nepal remains one of the world's poorest countries, with an annual per capita income of about US$250 with many indicators showing a bleak quality of life. 2. Progress in the fight against poverty has been hampered by a number of factors, including successive ineffective and unstable Govemments. More recently, the challenge has intensified with the escalation of the Maoist insurgency, the imposition of a nine-month state of emergency and lingering instability in the Govemment, including dismissal of the Deuba Govemment by King Gyanendra and the formation of an interim Government in October 2002. Security concems are heightened and there is a fear of wider civil disturbance. Together with the global economic slowdown that has affected Nepal's trade-dependant economy harshly, these domestic events-along with the June 2001 tragedy in the Royal family-have led to a sharp downtum in economic activities. Related to these is a potential fiscal crisis in which development expenditures could be severely affected, as public spending is up on account of the security needs, while revenue collections are low. In reality the crisis is even deeper, as it represents a questioning of the legitiracy of the state as an institution of public policy-making and a provider of public services. There is widespread belief that the Maoist insurgency is fundamentally a challenge to a state that has not been effective. 3. Nonetheless, this picture of instability and uncertainty is incomplete without noting that amidst all the turbulence, His Majesty's Govermment of Nepal (HMGN) has been implementing a wide range of reforms over the last year or so. Those reforms are being pushed by a persistent core group of committed technocrats and are gaining momentum. The growing political turmoil over the last several months seems to have given these technocrats more space to push forward with the reform agenda and their position appears to have been strengthened further under the interim Government. In fact, with the growing demand for a more accountable and transparent Government, the roll-back of the undue political interference by ministers in administrative functions is likely to be lasting, thereby giving the technocrat- led reform process some durability. Notable progress has been made in developing the country's Poverty Reduction Strategy (PRS, see Box 3) and in implementing reforms in the financial sector (see paragraph 29), public expenditures (see paragraph 23), fight against corruption (see paragraph 25), infrastructure regulatory environment (see paragraph 28) and the Immediate Action Plan (IAP, see Appendix I). 4. The last Country Assistance Strategy (CAS) for Nepal'-discussed at the Board on December 13, 1998-was prepared in a relatively uncertain and unstable environment. There had been numerous changes in Government-five since 1994-along with internal dissention in all three major political parties. In addition, it was widely believed that corruption was pervasive, leading to misallocation of public resources, delays in project implementation, difficulties in launching private investments and rapid turnover and perverse incentives for public servants. Despite generally acceptable macroeconomic I Report Number 18578-NEP, dated November 17, 1998.  NEPAL: Country Assistance Strategy Progress Report Page 2 of 21 management, the economy suffered from a number of factors-including poor public expenditure management and a weak financial sector-and Nepal had been unable to exploit its assets-fertile land in the Terai, access to greater donor aid, strong tourism appeal and enormous water resources and hydropower export potential. 5. The CAS identified poor governance as the fundamental constraint restricting Nepal's development. Evidence supporting this diagnosis included the observations that: (i) many public sector institutions are viewed as ineffective, wasteful and corrupt; (ii) public services in general do not reach the poor; (iii) political commitment to reform is weak; and (iv) leakages from the public expenditure system are high2. To address these constraints, the CAS proposed a two-pronged approach, specifically: (i) bringing resources to the grassroots levels through mobilization of social capital; and (ii) improving the effectiveness of the Government's development program. 6. The strategy contained three elements to effect this approach. First, supporting HMGN's own policy of greater decentralization, the Bank would provide funding for projects designed to bring more resources to grassroots levels. Second, the Bank would encourage reforms at the central level of Government by linking the overall lending level to progress in improving Government effectiveness. Third, the Bank would strengthen donor coordination so that the strategic focus would be shared more widely, and hence, become more powerful. 7. As will be discussed in more detail below, although Nepal remained in the "Low Case" scenario during much of the period, consistent implementation of the strategy has helped to highlight the importance of governance issues. The fundamentals of the CAS remain valid today and will continue to guide the Bank's work program until a new CAS is prepared. The basis for the next CAS will be HMGN' s Poverty Reduction Strategy Paper (PRSP), currently under preparation. B. The Evolution of the Setting for the Bank Group's Assistance Strategy Social Context 8. During the 1990s, Nepal's economic performance improved with per capita income growth increasing to about 2.5 percent as the economy responded to macroeconomic stability, the first round of liberalization and falling population growth rates. Nevertheless, economic growth has not been sufficient to bring about a substantial reduction in poverty and about 42 percent of the population lives below the poverty line3. Progress towards attaining most of the Millennium Development Goals (MDGs) in Nepal has remained slow and the country faces many challenges towards achieving them (see Box 1). Not only are social indicators low, but they are alarmingly low for the very poor. There are also wide disparities across income/consumption groups, between urban and rural areas and within jurisdictions, and across 2 The Public Expenditure Review (Report No. 2021 1-NEP, April 11, 2000) subsequently elaborated on many of these themes, especially on the failure of public spending to deliver services. The constraints identified included: (i) a dysfunctional budget system; (ii) lack of ownership of donor-assisted projects both by the Government and population at large; (iii) institutional weaknesses in implementation; (iv) poor governance; (v) poor resource allocation patterns; and (vi) poor performance of public enterprises. 3 This is based on the 1995/1996 Household Survey. A Nepal Living Standards Survey (NLSS) will be launched in early-2003 to update household level information on trends in consumption, poverty and their determinants. It should be noted that HMGN's official estimate of poverty is 38 percent (as cited in Box 3), which is based on an extrapolation carried out by the National Planning Commission (NPC).  NEPAL: Country Assistance Strategy Progress Report Page 3 of 21 Box 1: Achieving the Millennium Development Goals (MDGs)-Nepal's Progress in the 1990s Key Targets Current Levels and Recent Trends Halve, between 1990 and 2015, the It is estimated that 42% of the Nepali population are below the poverty line. As proportion of people whose income is comparable estimates are lacking-until finalization of the soon to be initiated less than US$1/day. NLSS II-it is impossible to know the trend, but given recent low levels of economic growth it is unlikely that there have been noticeable improvements. Enroll all children in primary school by There is evidence that the enrolment rate of primary-aged children rose in the 1990s 2015. reportedly to 80%. Nevertheless, if recent improvement rates are not accelerated, it will be difficult to meet the goal. Make progress towards gender equity & 1999 ratios for different levels show significant improvements in the relative access empowering women by eliminating of girls to school education. While it is unlikely that the targets will be reached by gender disparities in primary/secondary 2005, the girls to boys gross enrolment ratios for both primary and lower secondary education by 2005 and all levels by 2015. should reach close to 90%. Reduce infant and child mortality rates There have been considerable reductions in infant and under-5 mortality within the by two-thirds between 1990 and 2015. last decades, with the former declining to 64 (per 1,000 live births) and the latter to 91. Nevertheless, there are large regional variations, with rates higher in rural areas. Reduce matemal mortality ratios by Matemal mortality was estimated at 539 (per 100,000 live births) in 1996, however, three-quarters between 1990 and 2015. previous estimates are not comparable. There has been a slight improvement in deliveries attended by health care providers, but it will be difficult to meet the goal. Have halted by 2015 & begun to reverse Due to a lack of updated, reliable data, it is impossible to obtain an accurate the spread of HIV/AIDs, incidence of assessment of the HIV/AIDs situation; however, it has been suggested that the HIV malaria & other major diseases. rate is rising rapidly. Integrate the principles of sustainable There are issues-i.e., deletion of soil nutrients and arsenic contamination in the development into country policies and Terai-that show environmental sustainability remains a problem. However, other programs and reverse the loss of initiatives-in drinking water and forestry-indicate that problems associated with environmental resources. sustainable development can be solved. A national strategy for sustainable development will be formulated by 2005. Halve by 2015 the proportion of people Access to drinking water has increased rapidly and data (although with problems) without sustainable access to safe suggest that Nepal will reach near-universal access to drinking water by 2015. drinking water. Nevertheless, while there is access, the safety of drinking water is a concem. Sources: Nepal Country MDG Progress Report, UN Country Team, February 2002; and staff estimates. different socio-ethnic groups. More specifically, growth has been concentrated in urban areas, leaving behind 86 percent of the population who live in rural areas, where per capita agricultural production has grown minimally and the overall level of economic activity has been sluggish. Compounding the situation is the virtual absence of a poverty monitory system; hence, hampering policy formulation and evaluation of outcomes. Political Developments 9. Shortly after the presentation of the last CAS, the Nepali Congress Party secured a comfortable majority in the May 1999 general elections. Contrary to expectations, however, the ruling party's parliamentary majority did not translate into political stability nor a consistent effort at addressing Nepal's development problems. Rather, the instability and paralysis that plagued a series of coalitions ruling Nepal between 1994-1999 persisted and in the last nine months the political landscape in Nepal has been extraordinarily unstable. Following the dissolution of the Parliament on May 22, 2002, Prime Minister Sher Bahadur Deuba continued as caretaker prime minister and announced general elections for November 13, 2002-two years ahead of schedule. 10. Around the same time, factional in-fighting in the ruling party climaxed and resulted in a split in the top leadership. Subsequently, the Election Commission recognized the faction led by former Prime Minister G.P. Koirala as the "official" Nepali Congress Party, leading Mr. Deuba to form a new party. During an all-party meeting convened by Mr. Deuba in late-September, it was concluded that the Maoist  NEPAL: Country Assistance Strategy Progress Report Page 4 of 21 insurgency was too big a security threat to ensure free and fair elections. Just prior to this, insurgents had stepped up their campaign to prevent the elections, often targeting potential candidates-e.g., reportedly 60 United Marxist Leninist (UML) party workers had been killed or abducted by insurgents. Hence, in late-September Mr. Deuba recommended deferment of the election by over a year. Determining that Mr. Deuba's actions amounted to dereliction of duty, the King dismissed Mr. Deuba and temporarily took over all executive powers. In the search for a new Government, the King was clear that it should be headed by and composed of individuals of "clean image" who would not run for office in the forthcoming elections-the dates of which are still unannounced. 11. On October 11, 2002, veteran politician Mr. Lokendra Bahadur Chand was appointed by King Gyanendra as the new Prime Minister-Nepal's eleventh in the last seven years and the fourth since the 1999 elections. Mr. Chand, who has previously served as Prime Minister-briefly in a coalition Government in 1998 and in 1990 as the last Prime Minister in the party-less Panchayat regime-heads a nine member cabinet which appears to have fair regional and ethnic representation. The broad responsibilities given to the interim Govermnent include: (i) restoring peace; (ii) holding the suspended elections; (iii) controlling official corruption; (iv) maintaining friendly relations with all countries; and (v) running the day-to-day affairs of the country effectively and efficiently to serve the people. 12. The Maoist insurgency-previously a low intensity and mainly rural campaign to replace the present polity with a "people's republic"-has claimed more than 7,000 lives by official accounts and has escalated into Nepal's longest and bloodiest conflict since the mid-1700s unification campaign. In mid- 2001 a truce was reached with the insurgents and the Government embarked on a process of negotiations, hoping to assimilate the Maoists into the political mainstream. But in November 2001, the Maoists broke off talks with the administration, ostensibly over the Government's refusal to call a constituent assembly to examine the nation's political future. This was accompanied by a wave of attacks on security forces and public installations, provoking the Deuba Government to brand the insurgents as "terrorists" and declare a state of emergency on November 26, 2001 which for the first time pitted the army (as opposed to the police and paramilitaries) against the insurgents. According to some official accounts, casualties during the first year of the military action have topped 4,300. The emergency order, which also curtailed press freedoms and many fundamental rights, was first ratified by Parliament in late-February 2002 and subsequently extended through an Ordinance, remaining in effect until late-August when it was allowed to expire. 13. The conflict is effectively a battle for control of governance in the rural areas. Since the restoration of Parliamentary democracy in 1990, chronically weak governments have patronized the urban elite, bred corruption and delivered very little in the impoverished rural areas where poverty has been exacerbated by ethnic and social tensions. The insurgents have exploited this vacuum. The deployment of the army could force the insurgents to abandon most of their territorial gains but, as with all guerilla wars, a lasting peace will remain elusive unless governance is improved and eamest efforts are made to address the poverty and exclusion that drive the conflict. Economic Developments 14. On the economic front, since the last CAS Nepal's economy has gone through a cycle of accelerated growth and relatively strong macroeconomic position to rapid deceleration and increasing fragility. Aggregate GDP grew on average by 5.2 percent per annum between FY99 and FY01, but growth in FY02 sharply dropped to 0.8 percent (see Table 1). The recent slowdown is pervasive, but principally led by contractions in manufacturing and tourism, a deceleration in agricultural growth and a steep drop in exports. Increasing fiscal stress also challenges economic management. Revenue collections have slowed sharply due to the economic slowdown and at the same time security-related  NEPAL: Country Assistance Strategy Progress Report Page 5 of 21 expenditures have increased causing a sharp increase in domestic borrowing. These features of the economy persist into the current fiscal year and the medium-term outlook is challenging. 15. From FY98 to FY00, economic growth accelerated primarily due to booming exports and non- agricultural growth, but also because of improved agriculture sector performance. The economy responded well to macroeconomic stability and the liberalization of the investment and trade regimes of the early-1990s. The economy became more open with rapidly growing trade-especially exports, which grew more than 15 percent per year (in US$ terms) to OECD countries and India. Growth also became more broad-based as agriculture grew due to a number of factors, including an increase in the use of fertilizer, diversification of cropping patterns to cash crops, improvement in rural infrastructure and availability of agricultural credits. 16. Starting in the last quarter of FY01, a combination of factors has led to a rapid economic slowdown. The global economic slowdown whose effects worsened in the aftermath of September I 1'h particularly affected trade within the region and demand for exports from Nepal. These adverse factors were compounded by the Royal family tragedy, political instability-including the in-fighting within the Nepali Congress Party and frequent cabinet changes-and investor uncertainty caused by the escalation of the conflict. These have collectively contributed to the contraction of manufacturing and tourism (airline arrivals declined by 38 percent in FY02), and halted the growth of the non-agricultural sector. Growth in agriculture-which accounts for more than one-third of the economy-also declined (to 1.5 percent in FY02) due to untimely rains. Table 1. Nepal: Selected Economic Indicators, FY98-FY03 Nominal GDP (FY01): US$5,562 million Population (PY01): 23.6 million FY98 FY99 FY00 FY01 FY02 FY03 Estimate Projections Growth (percent change)" Real GDP at market prices 2.9 4.5 6.2 4.8 0.8 3.8 Savings and investment (percent of GDP) Gross investnent 24.8 20.5 24.2 24.3 23.6 25.4 National savings 22.1 21.0 24.7 25.4 24.6 25.6 Of which: Public savings 1.3 0.9 1.1 0.2 -1.0 -0.9 Prices (percent change) Consurperipces (end-of-periodtl2-month) 12.0 9.0 0.6 3.4 3.5 4.3 CPI (average) 3.3 t2.8 3.4 2.4 2.9 4.0 GDP deflator 4.2 8.8 4.4 3.1 3.5 4.3 Govermsent budget (percent of GDP) Total revenue 10.5 10.2 10.7 11.4 11.4 11.6 Total expenditure 16.8 15.4 15.7 17.6 17.4 17.5 Currentexpenditure 9.2 9.4 9.6 11.2 12.4 12.6 Capital expenditure and net lending 7.6 6.1 6.1 6.4 5.0 5.0 Overall deficit after grants 4.5 3.9 3.5 4.5 4.0 3.6 Overall deficit before grants 6.3 5.2 5.0 6.2 6.0 6.0 Dormstic financing (net) 0.6 1.4 0.9 2.7 2.6 2.3 I/ Growth projecdons are as of July 2002 and expected to be revised dowwniards. Fiscal projections are based on authorities prelirninary estimates. 17. Exports-the engine of economic growth in the 1990s along with tourism-have been particularly severely affected. In US$ terms, the growth of exports was 18 percent in FY99 and 27 percent in FY00 with the exports of three items-garments, carpets and pashmina-accounting for 50 percent of total export earnings. During FY02, exports to countries other than India declined by 37 percent (compared to 4 percent growth in FY01) and export growth to India decelerated from 23 percent to 11 percent. Correspondingly, imports fell by 9.5 percent in FY02 (compared to 3.5 percent growth in FY01), indicating an economic slowdown. While the renewal of the Indo-Nepal Trade Agreement in March 2002 helped to ameliorate uncertainty about trade with India, the new agreement has imposed  NEPAL: Country Assistance Strategy Progress Report Page 6 of 21 considerably more stringent value-added requirements and quotas to restrict Nepali exports, thereby raising obstacles to the recovery of trade and the economy. 18. Despite the slowdown in exports, the balance of payments position (with reserves of about eight months of imports of goods) and current account balance remain relatively sound due to off-setting factors-i.e., a doubling of labor remittances in FY02 compared to FY99 and the slowdown in imports. The danger is that the on-going instability in the country could reduce the flow of remittances, in which case the macroeconomic position would be less secure. 19. Since the last quarter of FY01 fiscal stress has been growing. In FY99 and FY00, the deficits were about 5 percent of GDP and revenue increased by 35 percent due to tax policy reforms and improvements in administration. But the economic slowdown has led revenue increases of only 3.3 percent in FY02 in spite of introducing mid-.year tax measures. The recent trend in the rise of regular expenditures to meet security expenses and lack of growth of revenues resulted in an estimated fiscal deficit of 6.0 percent of GDP in FY02. Equally significant has been the rise of domestic financing of the deficit from 0.9 percent of GDP in FY00 to 2.6 percent of GDP in FY02. While most-i.e., more than 80 percent-comes from commercial banks and non-bank purchases of treasury bills (with insurance companies and pension funds being the major buyers among the latter group), its effect on interest rates have been muted by the slow economy. Nepal's financial regulations-limiting Central Bank deficit financing (less than 20 percent of domestic financing in FY02) to 5 percent of revenue collections of the previous year-have also helped to dampen inflationary pressures. 20. Several factors contribute to rather gloomy medium-term prospects for the non-agricultural sector. First, security concerns and attacks on economic targets have worsened the business climate and increased investor uncertainty aside from directly adversely affecting tourism. Second, the prospects for' Nepal's exports to OECD countries are weakened both by the on-going global slowdown and the phasing out of Multi-Fibre Arrangement (MFA) quotas. Third, the growing fiscal imbalance could threaten macroeconomic stability. To counter these negative developments and shocks, there is a need to: (i) restore security and confidence of the private sector; (ii) maintain macroeconomic and fiscal stability to create an enabling environment for the private sector; and (iii) take urgent measures to increase productivity and reduce the costs of doing business in the face of increasing global competition. C. The Reform Program-The Government's Response Introduction 21. While Nepal's planning objective shifted explicitly to poverty reduction after the 6h Five Year Plan (1980-1985), with the launching of the 9^ Five Year Plan (1997-2002) Nepal expressed a strong commitment to poverty alleviation, along with setting long-term targets for poverty-related indicators. Implementation of reforms and poverty-oriented programs had been slow, and by the time of the Nepal Development Forum (NDF) held in Paris in April 2000, there was a growing recognition in HMGN that poor governance was undermining the whole Government system, including its ability to address poverty issues effectively. With a renewed sense of urgency, HMGN designed and unveiled a comprehensive reform program for poverty reduction at the 2000 NDF. The announced reform program focused on the key constraints hampering economic growth and poverty reduction, including: (i) fiscal policy and economic management; (ii) governance, including civil service reform and decentralization; (iii) private sector development and the financial sector reform; and (iv) improving aid effectiveness. These reforms were place in the context of: (i) the human development agenda; and (ii) environmental management. Recognizing the urgency of initiating the financial sector reforms in particular-especially resolving the deteriorating situation in the two largest banks (discussed below)-the Ministry of Finance (MoF) made  NEPAL: Country Assistance Strategy Progress Report Page 7 of 21 this sector the "rallying point" for reform. This was also seen as a Box 2: The 2002 NDF major step in changing the "old Amidst tremendous challenges, the 2002 NDF-fully prepared ways" of doing business that and managed by HMGN-was held in Kathmandu and Pokhara on breed corruption. HIvMGN February 4-7. An impressive process preceded the NDF in which background papers were made widely available-including being provided a progress report on posted on a Government website-and discussed by civil society. reform implementation at the Nearly 1,000 persons-from all facets of Nepali society-participated 2002 NDF (see Box 2). in the opening session, with about 200-including NGOs and private sector representatives-participating in subsequent sessions. 22. The implementation of In addition to providing an update on reform implementation, reforms has been uneven and the meeting focused on the substance and process for the l0e Five Year much slower than expected for Plan/PRSP/MTEF exercises. While the development partners expressed some time, in large part due to the general support to HMGN, the key message delivered at the meeting continuing lack of strong political was the need to focus on implementation on the ground through leadership. As the economy improved service delivery to the poor and a demonstration that started to slow in the second half development programs are having an impact on poverty. ofre FYo slow and continued itond hf HGN actively sought programmatic support/budget of FY01 and continued into FY02, assistance from the development partners. While a number of donors the threat of the insurgency indicated that they would favorably consider such an approach, it was intensified and fiscal pressures indicated that this would only be possible with effective built, HMGN has become implementation-including evidence of better service delivery to the increasingly serious about reform poor-and strict monitoring and controlling corruption. implementation. While many political leaders continue to show a lack of commitment to real reform, some reform-minded leaders-a core group of technocrats-are acting with a sense of urgency. In recent months, the reform efforts have intensified in several areas-especially the financial sector, fighting corruption, public expenditures and the development and with implementation of the Immediate Action Plan (IAP, see Appendix I). As a fundamental response, HMGN has announced that it will make the 10t Five Year Plan its Poverty Reduction Strategy (PRS, see Box 3) and will back it up with a Medium-Term Expenditure Framework (MTEF). Fiscal Policy and Economic Management 23. With regard to fiscal policy, Nepal has a relatively efficient tax system for its income level based on low income tax rates and a VAT. Nevertheless, with the increased security spending and econornic slowdown, there is a need to raise revenues and streamline spending. In the case of public expenditures, an important development started with the work of the Public Expenditure Reform Commission (PERC), whose March 2001 report made a number of far-reaching recommendations to reform public expenditures. This has led to the preparation of the MTEF that provides the fiscal underpinnings of the 10' Plan/PRSP. In the FY02 and FY03 budgets, PERC recommendations have been incorporated, including prioritizing the development budget, introducing the MTEF, initiating pension reform and expanding decentralization. The first drafts of the MTEF for five key line ministries were presented at the 2002 NDF and preparation of the MTEF in all ministries has been completed. 24. For all ministries, the MTEF spells out: (i) sector visions, (ii) national sectoral goals based on the 10"' Five Year Plan approach paper; (iii) mission statements; (iv) sectoral objectives; (v) outputs and activities to achieve the objectives; (vi) strategies to achieve sectoral objectives; (vii) prioritization of existing projects staying within the three-year resource ceiling; and (viii) a list of projects that would be undertaken if additional resources were made available. To sharpen prioritization, the FY02/FY03 budgets increased the share of overall expenditures on important public goods and services, including education, health, local development and agriculture. At a more disaggregated level, the budgets contained more intra-sectoral prioritization and provide higher allocations (relative to FY01 expenditures)  NEPAL: Country Assistance Strategy Progress Report Page 8 of 21 to a number of important pro-poor programs. In priority sectors, the budget is the first year of a rolling MTEF. Box 3: The Process and Substance of the Draft 10th Plan/PRSP HMGN intends the 10h Five Year Plan (2002-2007) to be the country's Poverty Reduction Strategy (PRS). The preparation process is underway and as part of the "pre-NDF' consultations, an approach paper for the PRSP/10h Plan was prepared and widely discussed. The Vice Chairman of the National Planning Commission (NPC) heads a Steering Committee providing the strategic leadership for the exercise and various sub-committees have coordinated the background studies and reports. Technical teams headed by Ministry Secretaries had primary responsibility for sector strategy formulation leading to strong inter-agency participation and ownership. The first draft was discussed in five regional workshops along with special consultations organized with key segments of civil society (i.e., women, dalits, migrant workers, trade unions, etc.). Recommendations emerging from the public consultations included the need to: empower/strengthen local government institutions; modernize/commercialize agriculture; promote basic/technical education; provide more facilities for basic health and drinking water; and implement strong measures for improving bureaucracy and reducing corruption. Furthermore, in June 2002 DffD sponsored a workshop to examine environmental aspects of the PRSP, that will be followed up on during the preparation of the Bank/IMF Joint Staff Assessment. HMGN released the Nepali language draft of the 10 Plan/PRSP in late-September and a national seminar was held to discuss the draft. The PRSP has the following features: * As indicated, the process has been very participatory and wholly country-driven. * The strategy is results-oriented with a clear target-i.e., to reduce the poverty rate from 38% to 30% by FY07. Explicit targets have been set for 13 social goals-including most of the MDGs-and economic management goals have been clearly defined and benchmarked. * Emphasizing the importance of the private sector and export-led growth, the strategy has four pillars: (i) high, sustainable and broad-based growth; (ii) development of social sectors and infrastructure; (iii) targeted programs for the poor and excluded; and (iv) good governance. * The development budget allocation associated with the PRSP is well-prioritized, emphasizing social sectors (39%), physical and rural infrastructure (37%) and agriculture and forestry (24%). However, the draft PRSP is still relatively weak in a number of areas, including: (i) sectoral policies and strategies are not adequately prioritized, specified or mapped to targets; (ii) monitoring and evaluation arrangements (see Box 7); and (iii) there are major omissions, such as a lack of analysis on the Maoist conflict and its implications. Nevertheless, HMGN is working to address these issues. Governance, including Civil Service and Decentralization 25. Although poor governance remains the fundamental challenge in Nepal, the country has made good progress in developing accountability and financial management institutions, but the effectiveness of many of these institutions still suffers from capacity constraints. Prior to dissolution of the lower house of Parliament, the country had an active Public Accounts Committee (PAC). It also has an independent Auditor General, a Financial Comptroller General's Office (FCGO) with generally ;ood accounting procedures, an increasingly active independent Commission for the Investigation of the Abuse of Authority (CIAA) and a newly-created Special Court for corruption cases. Recently, CIAA has taken actions against 22 civil servants in the MoF and has also initiated actions against the Executive Chairman of the national airline and a Joint Secretary of the Ministry of Physical Planning on suspicion of amassing wealth beyond normal circumstances. Two former ministers and two other officials of the Ministry of Water Resources have been arrested and placed under judicial remand for 25 days on corruption charges. This is the first time that the Special Court has acted against ministerial-level personnel (though to date no prominent figure has been successfully prosecuted). While financial management and accountability issues persist-including a widespread perception of corruption-the recent efforts are commendable and in the right direction. In addition, the PERC made several recommendations pertaining to financial management and a national steering committee has been created to implement the recommendations of the recently-concluded Country Financial Accountability Assessment (CFAA-see paragraph 41).  NEPAL: Country Assistance Strategy Progress Report Page 9 of 21 HMGN has taken steps to address the issue of anti-money laundering (AML), primarily through the drafting of an AMEL Act-currently being discussed by the Central Bank Board-that includes the establishment of a Financial Intelligence Unit. Furthermore, by contributing to future greater trade policy transparency, Nepal's efforts to join the World Trade Organization (WTO) have the potential to create irreversible steps to improve governance. Nevertheless, progress in implementing civil service reforms has been slow and there have been few accomplishments, other than the elimination of some vacant civil service positions. 26. Decentralization. Recognizing the potential for more efficient service delivery through decentralization, Nepal has one of the more advanced legislative frameworks for decentralization in South Asia, but implementation of decentralization has been slow. The 1999 Local Self-Governance Act (LSGA) set ambitious decentralization targets and despite some accomplishments (see Box 4), much remains to be done to achieve results on the ground-including addressing capacity constraints at the local levels. At the 2002 NDF, HMGN presented a three-pronged Box 4: Progress in Decentralization decentralization strategy that The 9h Five Year Plan aimed to achieve the poverty reduction targets by includes: (i) fiscal devolution; (ii) enhancing public services through decentralization. To this end, the capat bfollowing initiatives have been taken: capacity building; and (mil) . The Local Self-Governance Act (LSGA, passed in 1999) lays the monitoring and evaluation. While foundation for a local self-governance system recognizing the role the Decentralization of local self-governance and devolution to Local Governments Implementation Monitoring (LGs); Committee (DIMC) has approved * Parliament approved the LSGA Regulations and Financial the fiscal decentralization Regulations in 2000; framework, it is yet to be * A high level Decentralization Implementation Monitoring operationalized. The overlap Committee (DIMC) chaired by the Prime Minister was formed; between local Government * DIMC approved a comprehensive (with more than 60 activities) functions and those of the de- time-bound decentralization implementation plan and instructed all concentrated units of the sectoral ministries to start implementation; line agencies of the central * The FY02 budget devolved basic and primary education, primary Government also needs to be health, agriculture and other services to LGs. Under the IAP, resolved. Co,iplementig .transfer of primary schools and sub-health posts to LGs has been resolved. Complementing initiated; decentralization, the Government * Bills to amend 10 sectoral acts that conflict with the LSGA were has decided to provide direct presented to Parliament; and support to community-based * A Fiscal Decentralization Commission was established to oversee development schemes. To this the gradual implement of the recommendations made in the report end, an autonomous and of the Local Bodies Finance Commission. transparent Poverty Alleviation Fund (PAF) is being explored to finance human resource development, small-scale infrastructure schemes demanded by communities and support for income generating activities. If a credible, transparent and cost-effective PAF is established, it could expand to a broader scope, replacing many of the existing HMGN-financed programs and becoming the implementation vehicle for many donor-funded programs. 27. In raid-July 2002, the decentralization process suffered a set-back when the terms of locally- elected bodies-both at the village/municipality and district levels-were allowed to expire. The Government had already exercised the constitutional option to extend the tenure of the local bodies for one year and felt that it could not grant a further extension, leading to the current situation in which local bodies-Village Development Committees (VDCs), municipalities and District Development Committees (DDCs)-are being run by Government bureaucrats. While local plans for FY03 were mostly completed before the suspension, it is unclear how the planning process for FY04 will be accomplished without elected officials in place. As such, to minimnize the disruption in the work of local Governments, there is a need to hold local elections as soon as possible.  NEPAL: Country Assistance Strategy Progress Report Page 10 of 21 Private Sector Development and Financial Sector Reform 28. Nepal has made significant progress in implementing regulatory reforms to expand infrastructure provision with private sector participation. A number of regulatory bodies have been set up-in power and telecommunication-and private sector operators have been issued licenses to provide services in these sectors. In general, there is a lack of restrictions in the investment climate and recently announced initiatives will help to make the labor market more flexible. Public enterprises-dominant in utilities and airlines and to a lesser degree in construction and agriculture distribution-have normally not been loss- making or a large drain on the budget. Although there have been some efforts in the last year, little progress has been made in privatization. A number of factors continue to hinder the process, including: (i) labor problems; (ii) environmental issues; and (iii) failure of bids to meet technical qualifications. 29. The financial sector reforms are elaborated in the Government's Financial Sector Strategy Statement (FSSS: adopted in December 2000) and include reforming the Central Bank (Nepal Rastra Bank: NRB) to strengthen its autonomy and authority, and strengthen supervision and management of commercial banks4. The NRB Act (revised January 2002) increases the independence and authority of NRB, establishes transparent rules governing hiring and firing of its Governor and gives NRB greater authority to supervise commercial banks, including taking over the management of troubled banks and severely punishing irregularities by bank officials. In addition, the Deposit Taking Institutions Act will tighten regulatory rules governing all financial bodies, including other non-banking deposit-taking financial institutions. 30. Other important reforms Box 5: Rastriya Banijya Bank and Nepal Bank Limited include reducing the role of the The two largest banks in Nepal-Rastriya Banijya Bank Government in the financial (RBB) and Nepal Bank Limited (NBL)-account for around 50 sector as a direct owner of percent of total banking system assets. With IDA support, a financial institutions, beginning comprehensive assessment of these two banks (carried out under the with the two largest banks- direction of NRB in 1999/2000) found serious shortfalls in all aspects Rastriya Banijya Bank and Nepal of their governance, management and operations. The report Bank Limited (see Box 5). After concluded that the banks' loan assets are highly overstated and considerable delay, an external extremely risky and that, as a consequence, the banks are technically managemen teamhasakinsolvent. It was estimated that these two banks had losses (as of management team has taken over mid-1998) of as much as US$450 million-equivalent to around 46 the management of NBL to help percent of the Government budget or 8.6 percent of GDP. Inevitable address its deep-rooted deterioration since mid-1998 implies that these losses would have management and financial increased significantly since then. problems. On March 8, 2002 The assessment confirmed that: (i) the management of the NRB removed the NBL Board on banks is basically dysfunctional; (ii) there is no reliable data on loan account of failure to manage NBL portfolios; (iii) financial accounting is primitive and not according to properly and replaced it with an international standards; (iv) business strategies are not in place; (v) NRB-appointed Board. At the human resource policy is weak and counterproductive; (vi) same time, ICC Bank management information systems and record keeping are basic; and (Irelnd)/ank f Sctlan was (vii) governance and management are highly politically driven and (Ireland)/Bank of Scotland was lack a conmmercial focus. To begin tackling these issues, in September invited to Kathmandu to negotiate 2000 NRB advertised internationally to recruit professional a management contract. management teams to take over RBB and NBL. Negotiations took place in April and management control was turned over to the new team in mid-July. The team has moved swiftly and decisively to stir up NBL and the banking system; however, the long-term restructuring plan for the institution remains to be determined. While commitment to undertake similar actions in RBB is strong, 4 Financial sector reforms and institutions are discussed in length in "Nepal: Financial Sector Study", Report No. 24959-NEP, October 16, 2002.  NEPAL: Country Assistance Strategy Progress Report Page 11 of 21 new management is not yet in place. Following the broken contract with Deloitte Touche Tohmatsu5, an expatriate CEO has been selected and is expected to be in place by the end of the year. Seven additional support positions (for treasury management, credit, accounting, internal audit, information technology, loan recovery and human resources), as well as for an accounting firm to provide support were advertised in the international press and are expected to be selected and in place in early-2003. HMGN has also initiated reforms-with support from ADB-to improve the viability/sustainability of the Agricultural Development Bank of Nepal (ADB/N) and the Nepal Industrial Development Corporation (NIDC). Improving Aid Effectiveness 31. The Government has made impressive efforts-through an extensive participatory process-to prepare its Foreign Aid Policy (FAP). The main objectives of the FAP are to: (i) increase convergence of development priorities; (ii) improve quality, effectiveness and efficiency of operation; (iii) enhance economic growth for poverty reduction and human development; and (iv) facilitate equitable participation of donor institutions and Nepal. The FAP outlines HMGN's steps to achieve these objectives, including the formulation of new guidelines, strategies and policies aimed at influencing/regulating the flow and composition of aid and for ensuring better utilization of such assistance. In addition, the FAP proposes adjustments to the development partners' assistance programs and policies in order to strengthen their support to Nepal's development effort. In late-2001 the development partners themselves undertook a review of their practices, which reached sirnilar conclusions and recommendations (see Box 6). Box 6: Review of Development Partnerships in Nepal* In late-2001, a multi-donor team (headed by OECDtDAC) carried out a review of development partnerships in Nepal with the objective of helping donors reflect on their past assistance efforts, particularly the ways in which they worked with the process of Nepal's own development efforts and to make suggestions on how to improve effectiveness. The findings of the review are consistent with the issues raised in the FAP, with a key message being that the present relationship between donors and Nepal is far from ideal. From a quantitative perspective, Nepal is heavily dependent on donor assistance because of the extent of poverty, few internal resources, huge needs and the low level of national and local revenues. By tending to supplant Nepali efforts with aid money and by diverting the attention of Nepalis in positions of power towards securing new aid commitments, donors have inadvertently and indirectly contributed to the failure of Nepal to resolve its own problems. In addition, a general concern was expressed that donors are too dominant and that the impact of aid and overall development efforts are not generating satisfactory and sustainable results on the ground. On their part, donors have felt that they have responded to the ineffectiveness and lack of direction of HMGN by taking more responsibility for designing and implementing programs and projects. As such, some donors have reduced their aid levels and formulated strong conditions in their aid programs, while others have reduced their efforts to work through the central Government and instead work more directly with local Governments, NGOs and communities or engage their own implementing agencies and consulting companies. Aid has provided important contributions to the improvement in living standards in isolated valleys and hillsides and has. resulted in some significant improvements in program implementation. Nevertheless, without a strong collaboration with national institutions, the sustainability and replicability of many programs remains uncertain. There is a general perception within Nepali civil society that in the past two decades the national institutional capacity for development has eroded partly due to increased donor activism. In order to reverse this situation, the national actors need to take charge of their program. * From "Review of Development Partnership in Nepal: Review Team's Main Findings and Recommendations," January 21, 2002, paper presented at the 2002 NDF. A contract was signed on January 31, 2002 between NRB and Deloitte Touche Tohmatsu, USA (DTT) for the later to take over the management of RBB effective the first week of March. Given the prevailing security situation in March the DTT team was hesitant to travel to Nepal. In early-July DTT informed HMGN that they were not able to carry out the contract; hence, breaking it.  NEPAL: Country Assistance Strategy Progress Report Page 12 of 21 The Human Development Agenda 32. Although the impact on human development is not yet apparent, many recent changes are likely to begin improving education and health outcomes in Nepal materially in the coming years. As mentioned below (see paragraph 39), in education, the Basic and Primary Education Project (BPEP) is supporting the strengthening of institutional capacities at national, district and school levels to plan and deliver more efficient and better quality education services. In turn, this is expected to lead to increased levels of learning resulting from improved student retention (especially for girls and children from socially disadvantaged groups), more effective teacher performance and efficient teacher deployment practices. This program has been under implementation for over three years and modest, yet steady progress is being made (see Annex 9). Furthermore, BPEP has placed emphasis on improving education offered to working children. Through the Nepal Understanding Child Labor Project-a joint effort of the Bank, ]LO and UNICEF-a report has been drafted and discussed with HMGN that attempts to analyze the issue of child labor more holistically by examining the determinants of child labor in Nepal, along with the policy environment and response. 33. In the health sector, a reform strategy has recently been developed by the Ministry of Health (in a participatory manner) to assure available, accessible and effective essential health care services. Currently, this strategy is being translated into a specific sector program-containing a detailed implementation plan-that will be supported in a programrnatic manner by Box 7: Monitoring Poverty the development partners. The draft 10h Plan/PRSP includes targets for a number of Complementing these actions, through the indicators, including the incidence of income poverty, illiteracy, implementation of the IAP, important infant mortality, maternal mortality and life expectancy. UNDP initial steps are being taken in the has supported work to identify key poverty monitoring indicators decentralization of public primary schools resulting in the establishment of a set of indicators that partially and health posts (see Appendix I) overlaps with the MDGs. While there is no shortage of Nevertheless, monitoring and analytical indicators, there are serious weaknesses in tracking indicators- Nevertheless, monitoringicandrsanalytical including the MDGs-in Nepal. Specifically: (i) on data capacity for social indicators-including collection, few tools are used systematically-i.e., a poverty-remain weak and need to be comprehensive strategy is lacking and surveys/studies are strengthened (see Box 7). generally funded by donors on a "one-off' basis so that results are not comparable over time; and (ii) on data use, an Environmental Management institutional setup is lacking to track indicators over time, coordinate collection and analysis and provide data to policy- 34. Nepal's efforts to address makers. These issues will continue to be addressed through the environmental management began with MTEF, PRSP and other vehicles. As an example, another round the 6h Plan, since which time of the NLSS-comparable to the 1995/96 survey-will be envirornmental conservation activities launched shortly (with Bank support) and allow for poverty to be carried out in parallel with sectoral comparisons over time. programs. At all levels-including municipalities and VDCs-formulation of periodic plans has started to integrate environmental issues. More recently, emphasis has been placed on Environmental Impact Assessment capacity building in line with the newly implemented institutional and legislative framework contained in the Environmental Conservation Act and its regulations. Plans have been developed to implement the convention on Biological Diversity and a Sustainable Development Agenda for Nepal has been prepared. Nevertheless, implementation of environmental and natural resource conservation and policies have suffered due to a number of problems, including weak capacity and poor coordination. There are many active donors and NGOs in this area and funding does not appear to be a constraint.  NEPAL: Country Assistance Strategy Progress Report Page 13 of 21 D. Progress in Implementing the Bank Group's Strategy Background 35. The Operations Evaluation Department (OED) carried out a Country Assistance Note (CAN) for Nepal in November 19986. Overall, the CAN painted a fairly dismal picture assigning the following ratings: (i) Outcome-unsatisfactory; (ii) Institutional development impact-modest; (iii) Sustainability-uncertain; (iv) Bank performance-unsatisfactory; and (v) Borrower performance- unsatisfactory. With regard to the unsatisfactory Bank performance, a number of factors-including a limited policy focus in a poor policy environment, a generally low level of activity, a narrow focus on agriculture, controversial performance under Arun mH7, uncoordinated aid along with aid fatigue and sound but sparse economic and sector work-were cited as key problems. In retrospect, it suggested that the Bank should have done more to help address the fundamental institutional and policy constraints to create an enabling environment for: (i) cost-effective and sustainable public investment; and (ii) greater private sector activity. These considerations have been taken into account during CAS implementation and in many respects, this Progress Report further integrates then in the evolving country assistance program. IDA Program 36. Since the Board discussion of the CAS, given the limited slow progress in implementing reforms Nepal has been in the "Low Case." Unless there are substantial improvements in governance and public service delivery, more financial assistance from IDA will not be a solution to Nepal's problems. The Government clearly recognizes poor governance-reflected most acutely in weak implementation of reforms, poor service delivery and corruption-as the central obstacle to development. The introduction of a MTEF and the LAP have been prompted by the Bank's dialogue with HMGN. The rational of the Bank's position has been appreciated by the Nepali public in general and also has shown some results (see Appendix II). Today, there is a great realization within Nepal that the Bank is truly concerned with the well-being of the poor and that it is not possible to simply "negotiate" aid out of IDA. 37. In response to the program presented at the 2000 NDF and based on the growing realization of the urgency of financial sector reform-specifically, the possible risk of a financial sector crisis, the huge drain on public resources and an indication of HMGN's willingness to do away with the "old way" of doing business-key steps. in this area became the "litmus test" for moving into a "Base Case" scenario. 38. Lending. The Low Case lending program focused on community-based projects-to mobilize and leverage social capital at the grassroots level-and on supporting specific but modest reform efforts. Implicitly assuming a quick transition to the Base Case, the Bank continued to prepare a number of larger, "reform-heavy" projects and in retrospect may have missed an opportunity to develop and deliver a few more "Low Case appropriate" projects. This tactical error is being corrected. 39. Since the last CAS, four projects have been approved for a total of US$94.6 million; specifically: 6 This was subsequently reclassified as a Country Assistance Evaluation (Report No. 19850) and released in November 1999. 7 Arun m-a two-phase 400 MW power project-was dropped in 1995. Doing so generated wide negative publicity for the Bank, strained relations with HMGN for a period thereafter and consumed substantial Bank administrative and human resources. Even in 2002 there is frequent mention of the Bank and this particular project in the Nepali press, confirming that it is far from forgotten.  NEPAL: Country Assistance Strategy Progress Report Page 14 of 21 * The Second Basic and Primary Education Project (BPEP, Cr. 3185-NEP) was approved in March 1999 (US$12.5 million). Conceived as an Adaptable Program Loan (APL), the objectives of the first phase are to develop institutional capacity for qualitative and quantitative improvements in primary education. The project incorporates "basket funding" with a number of donors-including IDA, Denmark, the European Union, Finland, Norway, Japan, UNICEF and the ADB-providing joint support to a well-formulated ten-year sectoral program; * The Rural Infrastructure Project (Cr. 3215-NEP) was approved in May 1999 (US$5 million) to strengthen the institutional capacity of a decentralized governance system in its planning and managing capabilities to improve the quality, efficiency and sustainability of rural roads with active participation of the project beneficiaries. Given limited Bank experience implementing community- based road projects in Nepal, a Learning and Innovation Loan (LIL) was selected as the appropriate vehicle to test this fundamental shift in approach. Through this project a number of decentralization options are being tested, including working: (i) directly with the DDCs; (ii) with DDCs through contractors; (iii) with Community Based Organizations (CBOs); and (iv) through Non-Governmental Organizations (NGOs). The many implementation challenges associated with this project have made it a learning experience for all involved. Nevertheless, recent results are promising as confidence and experience are being accumulated to work more effectively at grassroots levels; * The objective of the Road Maintenance and Development Project (Cr. 3293-NEP)-approved in November 1999 (US$54.5 million)-is to help achieve sustainable maintenance, rehabilitation and construction of an economically justifiable strategic road network, while also promoting more sustainable funding and efficient public sector management of road maintenance. The project supports key sectoral policy reforms by establishing a Roads Board and Road Fund to assure a stable source of funding for maintenance expenditures, while at the same time providing motorable access to isolated districts in the Mid- and Far-West regions of the country (the heart of the insurgency area); and * The Telecommunications Sector Reform Project (Cr. 3581-NEP) was approved in December 2001 (US$22.6 million) and supports on-going sectoral reforms and increase rural access to telecommunications services through the licensing of a private operator (selected on a competitive basis) and establishing public telecommunications centers. 40. Economic and Sector Work Consistent with the Low Case scenario, strong emphasis was placed on helping to build the agenda and needed consensus for reform. The Public Expenditure Review (April 2000) was very influential in this regard. As indicated previously, this work helped to shape the framework for the many of the public expenditure reforms that are currently under implementation or envisioned. This has been followed up with intensive technical assistance and dialogue-in collaboration with the UK Department for International Development (DflD)-which have helped (and will continue to help) HMGN develop and implement the MTEF. As important, the Bank's continuing dialogue with the authorities on the topic of the financial sector reforms-including financing the RBB/NBL report and the Nepal: Financial Sector Study (October 2002)-have kept the process on track, although admittedly progress has at times been slow8. Other key pieces have also focused on reform agenda items, including: (i) Priorities and Strategies for Education Sector Reform (July 2001) which helps to identify and build consensus on a comprehensive reform agenda at all levels in this fundamental sector; (ii) Proposed Power Sector Development Strategy (March 2001) which identifies the key constraints and makes 8 DfID and the International Monetary Fund (IMF) have been important partners in these efforts. In addition, IMF has been providing technical assistance to NRB.  NEPAL: Country Assistance Strategy Progress Report Page 15 of 21 recommendations to expand Nepal's hydropower resource potential to service the electricity needs of the people and to generate export potential; and (iii) The Business Environment and Manufacturing Performance in Nepal (December 2000), the first investment climate survey carried out in the South Asia Region. 41. The other area of focus of our Analytical and Advisory Activities (AAA) has been on governance, decentralization and improving service delivery. The study Poverty at the Turn of the Twenty-First Century (May 1999) analyzed poverty trends and projections, the poverty profile and key elements for a poverty alleviation strategy. Related to service delivery, the Terai Options Study (October 2000) examines experience with various institutional arrangements for delivery of rural services in the Terai and makes recommendations for future development of cost-effective service delivery in the context of decentralization. A Country Procurement Assessment Report (CPAR) was finalized in FY01 and many of its recommendations are being implemented. A Country Financial Accountability Assessment (CFAA)-carried out with an extremely committed Government partner and other donors-was completed in FY02, also with an agreed action plan currently under implementation9. In the area of decentralization, three on-going studies-on fiscal decentralization, the proposed PAF'